Please note: Spine = 11.5mm based on 256pp 90g Matt Art Economics for CSEC® Examinations Economics for CSEC® Examinations Economics for CSEC® Examinations is one of a series of texts written especially for students studying for the CSEC examinations in business subjects. The authors are all highly experienced teachers at Caribbean schools. The books have been designed to make it easy to study a whole topic from scratch, or to seek out answers to individual problems. They include: nLearning objectives stated at the beginning of each chapter and a summary at the end n Keywords highlighted in the margins form a glossary n A chapter on the SBA component nQuestions throughout the text allow students to check their understanding as they study nExamination-style questions and multiple choice questions for review purposes and examination practice Principles of Business for CSEC® Examinations 5th Edition Waterman, Ramsingh, Ramsaroop 978-0-230-71644-5 Principles of Accounts for CSEC® Examinations Holdip and Lamorell 978-0-230-02874-6 for CSEC® Examinations Patricia Gopie Patricia Gopie has taught Economics for the past 20 years. Her wealth of teaching experience also includes Management of Business at 6th Form level and Principles of Business, Computer Studies and Information Technology at 5th Form level. She is currently Head of Business at St. Joseph’s Convent, St. Joseph, Trinidad. She has considerable experience as an examiner and has participated in several examination item writing exercises. Dr Mike Taylor has been actively involved in education and teaching for over forty years. He has considerable experience of teacher training and has examined science at ‘O’ and ‘A’ levels all over the world. He is the series editor of Macmillan’s Science for CSEC® Examinations series as well as the Business for CSEC® Examinations series. Economics Other books available from Macmillan: Patricia Gopie Series Editor: Dr Mike Taylor CSEC® is a registered trade mark of the Caribbean Examinations Council (CXC). Economics for CSEC® Examinations is an independent publication and has not been authorized, sponsored, or otherwise approved by CXC. Find us on Facebook /macmillancaribbean Find us on Twitter @MacCaribbean www.macmillan-caribbean.com CSEC Economics.indd 1 I S B N 978-1-405-08648-6 9 781405 086486 09/12/2014 09:34 Economics for CSEC Examinations ® Patricia Gopie CSEC® is a registered trade mark of the Caribbean Examinations Council (CXC). Economics for CSEC® Examinations is an independent publication and has not been authorized, sponsored, or otherwise approved by CXC. Macmillan Education Between Towns Road, Oxford, OX4 3PP A division of Macmillan Publishers Limited Companies and representatives throughout the world www.macmillan-caribbean.com ISBN: 978-1-4050-8648-6 Text © Patricia Gopie 2010 Design and illustration © Macmillan Publishers Limited 2010 All rights reserved; no part of this publication may be reproduced, stored in a retrieval system, transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publishers. Designed and typeset by Jim Weaver Design Cover design by Gary Fielder at Conka Illustrated by Jim Weaver, Gary Wing and Peter Harper Cover photographs by iStock, F. Mazouca/Macmillan Publishers Limited The authors and publishers would like to thank the following for permission to reproduce their photographic material: Alamy pp14(l), 16(r), 70(l), 109(r), 194(r), 197 BananaStock p150(B) Corbis pp14(r), 70(r), 101, 110, 182(r), 194(l) DigiStock pp150(C), 211 e-bay, courtesy of e-bay inc p216 Getty pp10, 16(l), 109(c), 151, 182(l) Reuters pp93, 158 Dean Ryan p109(l) Photos on pp17 and 105(a) supplied by author These materials may contain links for third party websites. We have no control over, and are not responsible for, the contents of such third party websites. Please use care when accessing them. Printed and bound in Malaysia 2015 2014 2013 2012 2011 10 9 8 7 6 5 4 3 2 To my family for their love and support, and to my students, for in teaching you, I learnt. Contents List of figures and tables viii Series preface xi About this book xii 1 Basic economic concepts The definition of economics The scope of economics Summary Answers to ITQs Examination-style questions 1 1 2 6 6 7 2 Economic decisions Economic decisions Influences on economic decisions Summary Answers to ITQs Examination-style questions 9 9 9 12 12 12 3 Factors of production Factors of production Primary and secondary factors of production Summary Answers to ITQs Examination-style questions 14 14 19 21 21 22 4 Economic systems Resource allocation Economic systems Comparison of economic systems Summary Answers to ITQs Examination-style questions 24 24 25 29 31 31 32 5 Costs in the short run and the long run The cost of production Summary Answers to ITQs Examination-style questions 34 34 38 38 39 6 Business organisations in the free market economy Types of business organisation Sole proprietorships Partnerships Joint stock companies Cooperatives Multinational corporations (MNCs) Summary Answers to ITQs Examination-style questions 41 41 42 43 44 46 47 48 49 49 iii Contents iv 7 Economies and diseconomies of scale Productive capacity Economies of scale Diseconomies of scale Division of labour Summary Answers to ITQs Examination-style questions 51 51 52 53 54 55 55 55 8 Market forces Market forces Determinants of demand Summary Answers to ITQs Examination-style questions 57 57 61 63 64 64 9 The theory of supply Firm and industry supply Determinants of supply Summary Answers to ITQs Examination-style questions 66 66 68 70 71 71 10 Equilibrium in the market Demand and supply in the market Shortages and surpluses Shifts in demand and supply Summary Answers to ITQs Examination-style questions 73 73 75 75 77 77 77 11 Elasticity Elasticity Degrees of elasticity Factors affecting the price elasticity of demand Price elasticity of supply Summary Answers to ITQs Examination-style questions 79 79 81 83 87 88 88 90 12 Market structure Spectrum of markets Summary Answers to ITQs Examination-style questions 92 92 97 97 98 13 Market failure Market failure Causes of market failure Consequences of market failure Summary Answers to ITQs Examination-style questions 100 100 100 104 105 106 106 14 The financial sector Money Features of money Functions of money The money supply 108 108 110 110 111 Contents The financial sector The informal sector in Caribbean economies Summary Answers to ITQs Examination-style questions 112 113 113 114 115 15 The central bank and other financial institutions The central bank Functions of the central bank Commercial banks Share market Credit union Development bank Insurance company Mutual fund Building society Investment trust company Informal credit institutions Financial instruments Summary Answers to ITQs Examination-style questions 116 116 116 118 118 119 119 120 120 120 121 121 121 122 123 124 16 Government in the economy and national income Introduction Expenditure The circular flow of income National income Nominal, real and potential output Summary Answers to ITQs Examination-style questions 126 126 127 128 129 131 132 133 133 17 Inflation, recession and unemployment Introduction Policies used by government to achieve macroeconomic goals Inflation and its causes Consequences of inflation Measures to reduce inflation Recession Unemployment Summary Answers to ITQs Examination-style questions 135 135 136 137 138 139 140 142 145 146 146 18 Growth and development Economic growth Drivers of economic growth Economic development Growth versus development Summary Answers to ITQs Examination-style questions 148 148 149 151 152 152 153 153 19 Trade unions Trade unions Types of trade union Labour in the free market economy 155 155 156 157 v Contents vi Trade unions and the supply of labour The role of trade unions in a free market economy Some costs of trade union activity Summary Answers to ITQs Examination-style questions 157 159 159 159 160 160 20 International trade International trade The rationale for international trade Factors that influence international trade The theory of absolute advantage The theory of comparative advantage Terms of trade Gains from trade Summary Answers to ITQs Examination-style questions 162 162 163 165 166 167 168 168 169 169 170 21 Exchange rates Exchange rates The fixed exchange rate system The floating exchange rate system Factors influencing the exchange rate The managed exchange rate regime Summary Answers to ITQs Examination-style questions 173 173 174 175 177 178 178 179 179 22 Balance of payments Balance of payments Structure of the balance of payments Balance of payments deficits Balance of payments surpluses Summary Answers to ITQs Examination-style questions 181 181 182 184 186 187 188 188 23 Globalisation and trade liberalisation Protectionism Preferential tariffs Trade liberalisation Globalisation Effects of trade liberalisation and globalisation Summary Answers to ITQs Examination-style questions 190 190 191 192 193 195 198 199 199 24 Caribbean economies Caribbean economies Economic problems facing Caribbean economies Development strategies for Caribbean economies in a globalised environment Summary Answers to ITQs Examination-style questions 201 201 203 204 206 206 206 Contents 25 Economic integration and CARICOM Single Market and Economy Economic integration The CARICOM Single Market and Economy (CSME) Examples of economic integration Summary Answers to ITQs Examination-style questions 208 208 209 211 212 213 213 26 E-commerce What is e-commerce? Advantages of e-commerce Challenges of e-commerce Summary Answers to ITQs Examination-style questions 215 215 217 218 219 219 219 27 School-based assessment Introduction Choosing a topic and formulating a topic statement Sample school-based assessment project Conclusion 221 221 222 223 235 Answers to multiple choice questions Index 236 238 vii · List of figures and tables Figures 1.1 1.2 1.3 1.4 3.1 3.2 4.1 5.1 5.2 5.3 5.4 6.1 6.2 7.1 7.2 8.1 8.2 8.3 8.4 8.5 8.6 9.1 9.2 9.3 9.4 9.5 9.6 10.1 10.2 10.3 10.4 10.5 10.6 10.7 10.8 11.1 11.2 11.3 11.4 11.5 11.6 12.1 12.2 12.3 12.4 viii Production possibility frontier An outward shift of the production possibility frontier A pivot of the production possibility frontier Scarcity Production Types of goods produced The mixed economy – a mix of free market and command economies Diagram showing a firm’s total fixed costs of production Diagram of a firm’s total variable costs Auntie Kay’s output and costs Auntie Kay’s marginal and average costs The two types of joint stock company The relationship between an mnc and its host country The long-run average costs of a firm Employee numbers in small/large firms Market forces Abe’s demand curve Market demand curve The demand curve as an indicator of change A demand curve shift: fall in demand A demand curve shift: rise in demand Supply curve Industry supply curve for bananas Movements along the supply curve The price of factors of production Shifts in the supply curve: fall in supply Shifts in the supply curve: rise in supply Equilibrium – a state of balance Market demand curve for bananas in Hinterland Industry supply curve for bananas in Hinterland Market demand and industry supply curves Demand (D) and supply (S) curves in the market: a rise in demand Demand (D) and supply (S) curves in the market: a fall in demand Demand (D) and supply (S) curves in the market: a rise in supply Demand (D) and supply (S) curves in the market: a fall in supply Perfectly inelastic demand Fairly inelastic demand Unitary elasticity Fairly elastic demand Perfectly elastic demand The degrees of elasticity Spectrum of markets Perfect competition: many sellers, many buyers Monopoly: one seller, many buyers Oligopoly: few sellers, many buyers 4 5 5 6 19 19 28 36 36 36 37 44 47 52 52 58 60 60 61 62 62 67 67 68 68 69 69 73 74 74 74 75 75 76 76 82 82 83 83 83 87 92 93 94 96 List of figures and tables 14.1 15.1 15.2 15.3 16.1 16.2 16.3 16.4 17.1 17.2 17.3 17.4 17.5 17.6 17.7 18.1 19.1 21.1 21.2 21.3 21.4 21.5 22.1 23.1 23.2 26.1 26.2 26.3 The money supply Central bank deflationary monetary policy Central bank reflationary (expansionary) monetary policy Types of securities Government expenditure Fiscal year 2007 The circular flow of income The circular flow of income in a real-world economy Inflation rates in Jamaica The wage–price spiral The effects of inflation on purchasing power Deflationary fiscal policy Deflationary monetary policy The trade cycle Real-wage unemployment Outward shift of the production possibility frontier, showing economic growth The collective bargaining process Devaluation of the tt$ Revaluation of the tt$ Equilibrium price A change in the demand for TT$ A change in the supply of TT$ Investment flows for Tropic Island The effects of trade liberalisation Barbados’ trade with the uk Logo of ebay.com B2b commerce B2C commerce 111 117 117 122 127 127 128 129 137 138 139 140 140 141 143 149 157 174 174 175 176 176 183 193 197 216 216 216 Tables 1.1 1.2 3.1 4.1 5.1 5.2 8.1 8.2 8.3 8.4 8.5 8.6 9.1 9.2 9.3 9.4 10.1 10.2 10.3 10.4 11.1 11.2 11.3 11.4 Definitions of economics Combination of goods Factors of production and reward Comparison of the four main economic systems Breakdown of Auntie Kay’s costs Auntie Kay’s marginal and average costs Abe’s individual demand schedule Betty’s individual demand schedule Cara’s individual demand schedule Total demand schedule Price change and effect Summary of shifts in the demand curve Supply schedule Supply schedule comparison Supply schedule for bananas in Hinterland Summary of a change in price and its effects Market demand for bananas in Hinterland Industry supply schedule for bananas in Hinterland Industry position for bananas in Hinterland The effect on equilibrium price and quantity of a shift in demand or supply Elasticity when price rises Calculation of elasticity of demand (price rising) Elasticity when price falls Calculation of elasticity of demand (price falling) 2 4 20 29 36 37 59 60 60 60 61 63 67 67 67 68 74 74 74 76 80 80 81 81 ix List of figures and tables 11.5 Degrees of elasticity 11.6 Income elasticity of demand 11.7 Cross elasticity of demand in practice (1) 11.8 Cross elasticity of demand in practice (2) 11.9 The degrees of elasticity of supply 11.10 The price elasticity of supply 12.1 The features of each market structure 13.1 Externalities 13.2 Summary of the causes of market failure 16.1 The role of the different sectors in the economy 16.2 Gross domestic product at market prices 16.3 Gross domestic product at factor cost 16.4 National income 17.1 Inflation rates in Jamaica 17.2 Unemployment and inflation rates in three Caribbean countries, 2006 18.1 Economic growth for Economy Woodland 18.2 Human Development Index for the Caribbean countries 20.1 A simple world economy 20.2 The results of specialisation 20.3 Absolute advantage 20.4 A table of opportunity costs 20.5 Partial specialisation 20.6 Deterioration of trade 21.1 A summary of the movements in the exchange rates 21.2 Depreciation and appreciation 22.1 Balance of payments for Trinidad and Tobago, 2007, US$ million 24.1 The main exports of Caribbean economies 24.2 Country data for Caribbean economies x 82 85 86 86 87 88 96 103 104 128 130 130 131 137 142 149 152 167 167 167 167 168 168 177 177 182 202 203 · Series preface This new series of textbooks for the Caribbean Examinations Council (CXC) General Proficiency examinations has been developed and written by teachers with many years’ experience of CSEC examinations in Caribbean schools. A textbook is used in different ways at different times. Readers might be starting a topic from scratch, and need to be led through a logical explanation one step at a time. Students with a working knowledge of a topic might need to clarify a detail, or reinforce their understanding. Or they may simply need to believe that they do have a good grasp of the material being studied. In this specially created format (the same used for all of the books in the series) the pages are designed to allow study of the text, uninterrupted by anything but essential diagrams. Additional material, including references to unfamiliar technical terms, is placed where it can readily be consulted, in the side column. Examination-style questions are provided for each chapter, and short ‘In-Text Questions’ (ITQs) (with answers) are placed throughout the text, allowing students to check their understanding as they read. Teachers throughout the region emphasise that inclusion of school-based assessment (SBA) material is of immense help and value. The CSEC syllabus states the rationale for the SBA exercise, and explains its expected structure. Accordingly, an entire chapter is given over to discussion of suitable topics and an example of a project that a student might create. Dr Mike Taylor Series Editor xi About this book This book isn’t just words on a page. This one has some important features. Each will help you, in its own way, if you take advantage of it. xii • There are TWO COLUMNS. • The bigger column has the text and some really large diagrams; you can read straight down it without interruption. • The smaller column has other diagrams that are mentioned in the text. Look at them carefully, as you need them. You could find that a few seconds spent looking at a diagram is worth several minutes’ reading. • The first time that an important NEW WORD occurs, it is repeated in the smaller column. If you want to check what a word means, you can find it quickly. • In this book, CURRENCY is mentioned in ‘dollars’. But which dollar? If it is necessary, a currency is specified; for example, TT$. Otherwise you can assume that it is your dollar which is being used. Exchange rates are correct at the date of publication. • There are QUESTIONS called ‘In-Text Questions’ (ITQs). When you have read the nearby paragraph in the main column, try to answer the question in your head, or on paper, just as you wish. • If you can, you’re on the road to understanding. • If you can’t, just go back and read that bit again. • Answers are at the end of each chapter, so you can tell how accurate your answer was. • There is a whole chapter about the SBA. It includes an example of an SBA project. Don’t copy it – use it as a model for designing and executing your own work. • There is a detailed INDEX. Don’t be afraid to use it to find what you want. • At the end of each chapter, there are some EXAMINATION-STYLE QUESTIONS. Your teacher will suggest how you can best use them. 1 By the end of this chapter you should be able to: Concept map Basic economic concepts define the term ‘economics’; explain what an economy is; explain the concept of ‘scarcity’ and the inevitability of ‘choice’; define ‘opportunity cost’; differentiate between ‘opportunity cost’ and ‘money cost’; define and illustrate the ‘production possibility frontier’; illustrate efficiency using the ‘production possibility frontier’. The nature of economics economics and the economy unlimited wants limited resources scarcity production possibility frontier choice opportunity cost versus money cost economic efficiency The definition of economics economics • As you embark on your study of economics, you will hear the comment that there are as many definitions of economics as there are economists. Here are what some of the great thinkers in this field had to say about the subject matter of economics. The famous eighteenth-century economist Adam Smith declared his work to be ‘an inquiry into the nature and causes of the wealth of nations’. J. S. Mill viewed economics as ‘the practical science of the production and distribution of wealth’. Alfred Marshall declared economics to be ‘the study of mankind in the ordinary business of life’. He further stated that economics examines ‘action … connected with the attainment … of the material requisites of well-being’. Modern economists define economics as the study of how man allocates scarce resources, which have alternative uses, to achieve given ends or goals. The following table explains the meaning of economics based on these definitions. 1 1 · Basic economic concepts Table 1.1 Definitions of economics Economist Definition What economics is Adam Smith 1723–90 ‘an inquiry into the nature and causes of the wealth of nations’ the creation of wealth from scarce resources J. S. Mill 1806–73 ‘the practical science of the production and distribution of wealth’ the production and distribution of goods and services for consumption and further production Alfred Marshall 1842–1924 ‘action … connected with the attainment … of the material requisites of well-being’ the behaviour and interaction of man to improve his well-being Modern economists the study of how man allocates scarce resources, which have alternative uses, to achieve given goals the fact that there is a trade-off, or opportunity cost, involved in production and consumption Economics is a social science. It is a science because it consists of an organised body of knowledge. Also, economists use a set method of inquiry, called ‘the scientific method’, in order to formulate theories and general laws. It is a social science, as it deals with human behaviour in society. Therefore, we can say that economics is a social science that deals with: • the creation of wealth from scarce resources; • the production and distribution of goods and services for consumption; • the behaviour, interaction and well-being of the groups involved in the above activities; • the fact that there is a trade-off involved in production and in consumption. ITQ1 What makes economics a science? The scope of economics The economy economy • ITQ2 Name some activities in the economy that the economist studies. household • firm • government • Economics recognises that resources are scarce. The economy is the mechanism through which these scarce resources are organised for the production of goods and services. These goods and services satisfy the needs and wants of the different groups in the economy. The three main groups in the economy are households, firms and the government. • A household is one decision-making unit. In economics, two assumptions are made about households. First, households consume goods and services. Second, households are the owners of the factors of production. A factor of production (factor input) is any resource used to produce goods and services. The four factors of production are land, labour, capital and entrepreneurship. Chapter 3 discusses the factors of production in more detail. • A firm is also a decision-making unit. This is the unit that produces goods and services. To produce these goods and services, firms buy factor services from households. • The government provides the framework of rules and laws for households and firms to operate within; in some economies, the government is also involved in production. Needs and wants needs • wants • ITQ3 Give an example each of a need and a want. 2 Man has needs and wants. Needs are any goods and services that are essential for life. Wants are goods and services that are desired to improve the quality of life but are not essential. Basic clothing is necessary for life and, as such, is a need. However, a shirt decorated with sequins is not vital to life (as some teenagers would have their parents believe!) and is therefore classified as a want. 1 · Basic economic concepts But Dad, I can’t possibly go to college without it. Needs and wants. In the economy, individuals, firms and government are involved in the creation of wealth from scarce resources. Firms produce goods and services, and distribute these goods and services to consumers in the domestic market and abroad. Economics is the study of how wealth is created, how these goods and services are produced and distributed, and the behaviour and interactions of the three main groups involved. Economics also deals with how the activities of each group affect the welfare of the other groups in the economy. Scarcity and choice Which one? basic economic problem • scarcity • ITQ4 Suggest one reason for building: (a) the school; and (b) the hospital. choice • Man’s wants are unlimited. If we were all to write down all the goods and services we desire, our lists would be many pages long! However, economic resources are limited, in that there are not enough resources to produce all the goods and services desired. This imbalance between unlimited wants and limited resources is the basic economic problem. It is not possible for each of us to have all the goods and services we want: there is not enough to go around for all of us. Goods and services, and the resources used to produce them, are scarce. They are scarce relative to our demand for them. Therefore, in any given economy, scarcity exists. Scarcity is the economic condition where all resources and goods and services, though they may be plentiful, are not sufficient for all those who desire them. Scarcity exists for all the groups in the economy. A householder might want to buy a microwave oven and a toaster oven but have limited savings. The householder will have to choose which appliance he wishes to buy. A Barbadian firm might wish to build one plant in Dominica and another in St Lucia. Since its resources are limited, and it cannot invest in both countries, it will have to choose where to invest. A food-processing firm might wish to produce both juices and milk drinks. However, the firm has to choose what to produce, as it does not have the resources to produce both. The government might wish to build a school and a hospital but its resources are limited. The government will have to choose on which project to embark. In all of the above examples, we see that scarcity exists. The resources of the different groups in the economy are limited. The wants of the groups are unlimited. Wherever scarcity exists, choice is inevitable. definition: Choice is the range of options available to the individual household, firm or government when making a decision. Opportunity cost In each of the cases above, a choice has to be made, and some good or service or venture has to be given up. The householder has to do without the toaster 3 1 · Basic economic concepts opportunity cost • ITQ5 What is the opportunity cost in the other three cases based on the choices stated? money cost • ITQ6 Name some of the other inputs used to produce the shirt. oven, if he chooses to buy the microwave oven. The Barbadian firm will have to give up investing in St Lucia, if it chooses to invest in Dominica. The foodprocessing firm will have to forgo fruit juice production in order to produce milk drinks. The government might choose to build the school and not the hospital. In each of the above cases, a choice has to be made and the alternative or next best option has to be forgone. Opportunity cost is defined as ‘the next best alternative forgone’. As resources are scarce, choices must be made as to what to produce and consume. When making a choice, the producer or consumer has to do without – or forgo – some good or service or course of action. This is the opportunity cost. In purchasing the microwave oven, the householder incurs an opportunity cost. The opportunity cost of the microwave oven is the toaster oven the householder has to forgo. He has to sacrifice the toaster oven. In doing without it, he bears a cost, an opportunity cost. Economists also deal with another cost concept – money cost. This involves what was actually paid for the inputs used to produce a given good or service. For instance, a garment factory produces a shirt. The money cost of the shirt is the actual cost of the fabric and the labour, among other inputs, used to produce the shirt. The production possibility frontier production possibility frontier • Table 1.2 Combination of goods Point Watermelons Wafers A 100 0 B 95 20 C 85 40 D 70 60 E 50 80 F 0 100 ITQ7 The production possibility frontier (also called a production possibility ‘curve’ or ‘boundary’) is a graph showing the various combinations of two goods that an economy is able to produce with fixed resources. A production possibility frontier is drawn on the following assumptions. • The economy produces only two goods. • The amount of resources is fixed. • Each of the goods can be produced using changing ratios of the factors of production. This is called ‘variable factor proportions’. Assume that, in a given economy, the only two goods that can be produced are watermelons and wafers. Table 1.2 shows the various combinations of both goods that the economy can produce. Plotting this data, we get the following production possibility frontier: watermelons Plot this production possibility frontier in your notebook. A B H C D G E F 0 wafers Figure 1.1 Production possibility frontier Observing the production possibility frontier, we see that it is downward sloping from left to right. This indicates that it is only possible to produce more of one good by giving up some units of the other good. The production possibility frontier is bowed out or concave to the origin. As resources are moved away from wafer production, more and more wafers must be foregone to grow the extra watermelons. Point B is an attainable combination that the economy can produce. Any combination within the frontier, such as point G, is also attainable. However, 4 1 · Basic economic concepts once an economy is operating inside the boundary, this indicates that there are idle resources, or that resources are being used inefficiently. Points outside the frontier, such as point H, are unattainable. For instance, the economy cannot move from point C to point H, where the economy is producing more of both goods. However, if the production possibility frontier shifts or pivots outwards, the economy can move from point C to point H. Factors that could cause the production possibility frontier to move outwards are: • economic growth; • discovery of new natural resources; • growth in population; • technological progress; • improvements in labour productivity. watermelons i g 0 h j wafers Figure 1.2 An outward shift of the production possibility frontier Production possibility frontiers are sometimes named by labelling the x and y intercepts. In Figure 1.2 the initial production possibility frontier is gh. Any of the above factors can cause the production possibility frontier to shift outwards from gh to ij, as shown in Figure 1.2. Figure 1.3 shows a pivot of the production possibility frontier from ab to ac. Assume that the industry for good Y uses a high proportion of labour (labour intensive industry) and the industry for good x uses a high proportion of capital (capital intensive industry). What could have caused a pivot from ab to ac in Figure 1.3? Notice that the industry producing good X can now produce more of good X. good Y a 0 b c good X Figure 1.3 A pivot of the production possibility frontier There is an improvement in technology and this benefits the capital intensive industry more than it does the labour intensive industry. The production possibility frontier illustrates the concepts of scarcity, choice 5 1 · Basic economic concepts and opportunity cost. In Figure 1.4, the economy cannot produce more of both goods – say, move from A to D. Therefore, scarcity exists. The economy cannot produce all combinations on the frontier – say, both A and B. It must choose one combination. It can choose A and produce 0i watermelons and 0g wafers. watermelons D A i B j C 0 g h wafers Figure 1.4 Scarcity ITQ8 Look at Table 1.2, and also at Figure 1.1 (or the diagram in your notebook if you answered ITQ7). Work out the opportunity cost of 20 more wafers as the economy moves from points A to B, B to C, and so on right down to F. Now assume that consumers in this economy demand more wafers. To obtain more wafers, the economy must produce fewer watermelons. Production will move from A to B. To gain gh more wafers, ij watermelons have to be given up, assuming that nothing changes. The opportunity cost of obtaining gh more wafers is the ij watermelons that must be forgone. Economic efficiency efficient • When an economy is producing on its production possibility frontier, that economy is said to be efficient. All resources available in the economy are being used to produce one of the maximum possible combinations of goods. In Figure 1.4, whether the economy produces combination A or combination B, it is producing efficiently. However, if it produces combination C, it is not producing efficiently. Economics is the scientific study of how man uses scarce resources to produce goods and services to satisfy his wants. The economy is the mechanism through which these scarce resources are organised for the production of goods and services. Economic activities are conducted in the economy. The main economic agents are households, firms and the government. Since resources are scarce and wants are unlimited, scarcity exists. Scarcity necessitates choice, and making a choice involves incurring an opportunity cost. Money cost is what is paid to produce a good or a service and is different from opportunity cost, which is the alternative forgone. To explain production in the economy, economists use the production possibility frontier. The production possibility frontier can be used to illustrate scarcity, choice and opportunity cost. 1 As with the other sciences – for example, chemistry and physics – economics has an organised body of knowledge. Economists also use a fixed scientific method to formulate theories, general laws and principles. 2 Economists study: • production of goods by firms; • investment by firms; 6 1 · Basic economic concepts 3 4 5 6 7 8 • purchase of goods and services by households, firms and government; • other activities of the government; • production by government. When hungry, a need is food and a want is an ice cream. If there is a growing young population in need of school places, the government will have to build the new school. The government will want to build the hospital if there are more sick people or if there is a need to improve the quality of health care offered to the population. The opportunity costs are: • Barbadian firm – investing in St Lucia; • food-processing firm – producing fruit juice; • government – building the hospital. Some other inputs are thread, buttons and electricity to power the sewing machine. Check your answer against Figure 1.1 in the text. The opportunity cost of producing 20 more wafers as the economy moves from points A to B right down to F is as follows: From No. of wafers gained Opportunity cost of wafers (watermelons forgone) A to B 20 5 B to C 20 10 C to D 20 15 D to E 20 20 E to F 20 50 Notice that as the economy produces 20 more wafers each time, more and more watermelons have to be forgone. The opportunity cost of each additional 20 wafers is increasing. As long as the production possibility frontier is concave to the origin, the opportunity cost increases as we produce more of one good. Examination-style questions Multiple choice questions (answers are on p. 236) 1 What is the fundamental economic problem faced by any society? a limited resources and limited wants b unlimited resources and limited wants c the alternative forgone d limited resources and unlimited wants 2 Economics is concerned with all of the following except: a the allocation of scarce resources to produce goods and services b explaining what factors influence consumer behaviour c the construction of buildings in the economy d the factors that determine the goods that firms produce 3 A man spends $10 to take a chance in a raffle. He wins the first prize of a trip to Tobago, or he can instead choose a cash sum of $500. He chooses the trip. What is the opportunity cost of choosing the trip? a $10 b $490 c the lunch he had to forgo when he bought the ticket d $500 7 1 · Basic economic concepts 4 A factor that may cause the production possibility frontier to move outwards is: a efficient use of resources b depletion of natural resources c fall in population through migration d technological progress 5 What is opportunity cost? a the alternative foregone b the choice made c unlimited wants d limited resources 6 The production possibility frontier shows: a the maximum amount of resources that an economy possesses b the maximum amount of two goods that an economy can produce with fixed resources c the unlimited resources of an economy d all the goods an economy can produce while leaving some resources idle 1. a ppf is a graph that shows the maximum amount of two goods that can be produced with fixed resources d) assume that the economy only produces two goods - assume that the technology is fixed and constant - resources used to produce one product can produce many others - resources must be fully used and fully used efficiently. Structured questions 1 a What is the production possibility frontier? [2] b Draw a production possibility frontier and, in the diagram, insert an attainable combination and an unattainable combination. [5] c Show a combination that indicates that resources are idle in the economy. [2] d State three assumptions made when drawing a production possibility frontier. [6] 2) Opportunity cost is the profit forgone as a result of an alternative choice. Ex: A firm wants to produce milk and cookies, but resources are limited so they choose to produce milk. The opportunity cost would be the profit they would've made from producing cookies. 2 a Define opportunity cost and give an example. b Sketch a production possibility frontier. c Show how the production possibility frontier illustrates the concepts of scarcity, choice and opportunity cost. Essay question [4] [4] [4] [20] a Define the term ‘economics’. [2] b Show how scarcity leads to choice and opportunity cost within an economy. [4] c Explain the assumptions made when drawing a production possibility frontier. [6] d With the aid of an example, use the production possibility frontier to illustrate the concepts of opportunity cost and efficiency. [8] Economics is a social science that deals with the creation of wealth from goods and services, the production and distribution of goods and services and the behavior, well-being and interaction between the groups involved in the activities stated above. An economy is a mechanism that organizes resources for good and service production to satisfy the needs and wants of a society. 8 2 By the end of this chapter you should be able to: Economic decisions explain what an ‘economic decision’ is; list the main influences on individuals in making economic decisions; list the main influences on firms in making economic decisions. Concept map Economic decisions sectors in the economy individuals firms government other factors affecting individuals’ and firms’ decisions Economic decisions economic decisions • The economy is dynamic. Individuals or households are constantly choosing on what goods and services to spend their income. They are choosing whether to save or to spend. They are even considering where to work. Firms are constantly choosing what goods to produce in what quantities, and at what prices to sell those goods. These activities all involve economic decisions where an individual is faced with options and chooses one course of action. Influences on economic decisions Factors influencing the economic decisions of households (consumers) Households or individuals in the economy are the consumers of goods and services and the owners of the factors of production. These individuals make economic decisions, such as what goods or services to buy, or where to work. Individuals are not isolated – each interacts with others and with the environment. The following factors influence the economic decisions of households. • Personal choice. Personal choice is a desire for a product that is acted upon. People acquire goods and services that they want or need. Mr Chai might choose to buy a set of pliers but Mrs Chai might choose to buy a matching brooch and scarf. • Size of income. Generally, growing incomes allow for the purchase of more goods and services, and, conversely, declining incomes mean that fewer 9 2 · Economic decisions Satisfaction. bandwagon effect • ITQ1 Mr Ali decides to buy a sports utility vehicle (SUV). What factors might have influenced his economic decision? ITQ2 Which factors would influence you in choosing between a cell phone and an MP3 player? 10 purchases are possible. A higher income also allows the individual to buy better quality goods and services. • Bandwagon effect. Some people might buy an item because everyone else is buying it. This is the case with a fad. Nowadays, many residents in the Caribbean want to own a cell phone or an iPod. It is a form of peer pressure where consumers of all ages try to keep up with the purchases of their peers. Across the Caribbean, communication is easier You might not feel as if if you own a cell phone. For many people it is a you are part of the crowd necessity as well as a fashionable accessory. unless you, too, own a cell phone or an iPod. It is also called the ‘keeping up with the Joneses effect’. • Type of work. This could influence the type of clothes the individual wears or the type of car he owns. It could also affect the decision about where to live. Some people prefer to live near to their workplace. Others prefer to be at a distance. Some have no choice in the matter. • Level of education. This influences the type of items we like to own, such as books or a laptop computer. Students have different needs from those of other individuals. Your education can also affect your interests. A geography teacher might subscribe to the National Geographic magazine, while a beauty salon owner might buy Vogue magazine. • Rate of interest. If the rate of interest offered by banks on saving accounts is high, individuals will tend to save more. If the rate of interest is low, people will save less and spend more. They will even borrow to purchase consumer durables, such as cars, computers and television sets. • Climate and weather conditions. The weather will affect economic decisions of households, as it has a direct influence on comfort and safety. Hot Caribbean weather means that more and more individuals are purchasing air conditioning units for their homes. The threat of hurricanes makes individuals more cautious about purchasing beachfront properties. In September 2004, Hurricane Ivan did a great deal of damage in Grenada and Grand Cayman; some individuals lost their livelihood. In such a situation, people do not have the means or the desire to purchase goods and services, but are only concerned with obtaining the necessities of life. 2 · Economic decisions Factors influencing the economic decisions of firms (producers) supernormal profit • ITQ3 Why do firms need profits? industrial relations • ITQ4 Snack Time, a small firm catering party snacks, opened in October 2005. What factors might have influenced its decision to provide this good and when it chose to open its business? ITQ5 How can gasoline impose a cost on society? ITQ6 Give some examples of occupations where such exceptions might apply. As do individuals, firms also make economic decisions, such as what to produce and how to produce. Firms are affected by factors internal to the firm, and the external environment. Some influences on firms in making economic decisions are: • Costs of production. Increasing costs can reduce a firm’s output, unless the prospects for profits are high. In such a case, the firm will produce even if costs are increasing. • Profits. Supernormal profit is the excess of total revenue over total costs. Once there is a potential for profits, firms will invest. In economics, we assume that producers are rational and that they are attracted by profits. • Resource base. The resource base is the quality and type of resources available to a firm. The availability of resources will affect the firm’s decision to produce a particular good. If resources are not available, then the firm will not be able to produce. • Industrial relations. The relationship between the management of a firm and the workers (usually represented by a trade union) is called ‘industrial relations’. Cordial industrial relations will make the firm willing to employ more labour. Poor industrial relations will make the firm more inclined to use capital instead of labour. • Changing demand for the product. If a firm is faced with falling demand for the good it produces, the firm will make a decision to cut back on production. If there is increasing demand, then the firm will produce more, provided that it is able to obtain all the factors of production to produce the given goods. Government influences on economic decisions The government influences economic decisions in a number of ways. These include: • Laws and grants to induce firms to locate in a particular region of the country. • Taxes on the production and consumption of goods that impose a cost on society; for example, cigarettes and gasoline. Taxes increase the price the consumer has to pay for the good, and so they tend to curb consumption and production of such goods. In Trinidad and Tobago, there are excise duties on cigarettes, alcohol and gasoline. • Setting up of industrial zones to encourage and facilitate the activities of firms. • Provision of infrastructure, such as roads, bridges and ports. In Trinidad and Tobago, the opening up of the port at Point Lisas encouraged many firms to locate there. These firms located there to take advantage of the port facilities for importing raw materials, and for easy transportation of finished bulky goods. • General laws to direct firms’ activities; for example, the setting of the minimum wage of TT$9 per hour in March 2005 by the government of Trinidad and Tobago. This will affect the numbers employed by firms. In this country, the government also wants to close down casinos to discourage gaming and gambling. The government enforces its laws to regulate firms. • Laws concerning the employment of disabled persons. Section 8 of the Equal Opportunity Act, 2000, Trinidad and Tobago, states that an employer shall not discriminate against any person when offering employment. However, the Act further states that this will not apply if the person’s disability will prevent him from carrying out his job, or if his disability will result in risk to others or to himself; or if, to carry out the job, the person requires facilities that other workers do not need that will cause the employer hardship. Employers are therefore governed by this law. 11 2 · Economic decisions Factors affecting the decisions of individuals are: • personal choice; • size of income; • bandwagon effect (peer pressure); • type of work; • level of education; • rate of interest; • climate and weather conditions. Factors affecting the decisions of firms are: • costs of production; • profits; • resource base; • industrial relations; • changing demand. The government and other factors in the economy influence the decisions of the households and firms. 1 Mr Ali might be influenced by: • an increase in the level of his income; • his transport needs; • the changing trend in the economy towards SUV ownership; • the fact that his neighbour or close friends already own a SUV. 2 Some factors that will influence you in buying a cell phone or an MP3 player are: • whether your friends own one; • your allowance; • and, for the MP3 player, whether you enjoy listening to music. 3 Firms need profits to reward their investors. Profits can also be ploughed back into the business to expand the business. 4 Snack Time might be influenced by: • the prospects of high profits; • availability of resources – land, labour, capital and entrepreneurship; • increasing demand for the snacks; • increasing demand for party snacks during the Christmas season, leading them to open at this time of year. 5 Gasoline imposes a cost on society when drivers use their vehicles and cause congestion and air pollution. This discussion will be further developed when you study market failure in Chapter 13. 6 Pilots need 20–20 vision. School bus drivers need to have sound eyesight and hearing. Construction workers must have all limbs intact. Examination-style questions Multiple choice questions 1 12 Which of the following does not influence a cement-manufacturing firm in making economic decisions? a the level of costs b the availability of resources c the strength of the workers’ trade union d the government spending on tourism 2 · Economic decisions 2 Sheldon purchases the latest Harry Potter best-selling book. His decision may be determined by all of the following except: a level of education b the profits of the publisher c personal choice d bandwagon effect 3 Firms will produce more when: a costs are increasing b they expect profits to increase c sales are declining d resources become difficult to obtain 4 When governments want to encourage firms to set up and produce, it will do all of the following except: a place subsidies on the goods the firm produces b set up industrial zones c provide infrastructure like roads and bridges d place taxes on the goods the firm produces 5 The rate of interest affects economic decisions in that: a The higher the rate of interest, the greater will be borrowing to buy cars and consumer durables. b The lower the rate of interest, the higher will be the level of savings in banks. c The higher the rate of interest, the lower will be borrowing to buy cars and other consumer durables. d The lower the rate of interest, the lower will be borrowing to buy goods. 6 Under what conditions will a firm employ less labour? a when industrial relations are poor b when labour is relatively cheap compared to other resources c when there is changing demand for the product d when the price of the product is falling Structured question 1 Alight Candles is a small firm manufacturing candles in Jamaica. It employs 40 workers, 35 of whom work on the production line. These 35 workers are paid the minimum wage of $80 per hour. The government increases the minimum wage to $100 per hour. a Suggest three other occupations that the other five workers could perform within the firm. [3] b Explain two courses of action that the manager of Alight Candles could take, given the change in the minimum wage. [6] c It is suggested that the firm can produce more candles per week. Explain two factors that will affect this firm’s decision whether or not to do so. [6] Essay question [20] a Using examples, explain four factors that influence the economic decisions of households. b How can government influence the economic decisions of firms? [12] [8] 13 3 By the end of this chapter you should be able to: Factors of production define a ‘factor of production’; identify the four factors of production; describe each factor of production, giving examples; define ‘production’; distinguish between ‘production’ and ‘productivity’; match each of the four factors of production with its appropriate factor payment; explain the relationship between ‘factor payments’ and ‘costs of production’. Factors of production Concept map factors of production land rent labour + wages production capital + interest entrepreneurship + profit factor rewards Factors of production factors of production • Factors of production are the economic resources that are used to produce goods and services. There are four factors of production. They are land, labour, capital and entrepreneurship (or entrepreneurial talent). Land: the naturally-occuring factor of production. 14 Labour: in this case the physical labour of man contributes to the production process. 3 · Factors of production land • labour • capital • entrepreneur • Factors of production can be classified as human or non-human. The human resources of a country are the labour force and the entrepreneurs. A nonhuman resource is land. Capital is a both a human and a non-human resource. Land is defined as all the naturally occurring free gifts of nature. Labour is the physical and mental effort of man in the production process. Capital refers to all the goods used to produce more goods. Entrepreneurship refers to the risks involved in organising the other three factors for production. An entrepreneur is one who is willing to take on substantial financial risks to begin or organise a business; the entrepreneur organises the other three factors of production. Land ITQ1 Give an example of each of the different types of the factor land. Land is defined as all the factor services available naturally, whether on, above or beneath the earth’s surface. It is made up of all the free gifts of nature. There are different types of the factor ‘land’: • land itself on the earth’s surface that can be used to grow crops or build homes, offices and factories; • land above ground – for example, gases in the atmosphere and the climatic conditions; • seas and rivers – for example, fish in the seas or rivers, and coral reefs for tourists to visit; • resources beneath the earth – for example, mineral deposits such as bauxite and petroleum. As you might realise, land is another term the economist uses in a special way. Seas and rivers are part of the factor land; minerals below the earth’s surface and the sunny conditions in the sky are also part of the factor land! Land possesses three characteristics that distinguish it from other factors: • Land is fixed in supply. The amount of the factor land on the planet Earth is fixed. We can never acquire more in that sense. However, man’s ability to tap the resource ‘land’ could increase as he acquires more capital and other resources. For example, the purchase of an additional boat will allow Stingrae Caribbean Ltd, a seafood company, to catch more fish even though that purchase does not increase the number of fish in the sea. • Land has no cost of production. You or I might have to pay for a plot of land on which to build a house. Extracting minerals from the earth requires large amounts of other factors of production; for example, extracting oil from the earth requires large amounts of capital. Preparing a plot of land for agricultural use requires clearing and ploughing. However, it never costs society, as a whole, anything to produce the land itself. Land often needs labour to reach its full production potential. 15 3 · Factors of production mobility • ITQ2 Give two examples where land is geographically immobile. ITQ3 Give one example where land is occupationally immobile and one example where land is occupationally mobile. • Land is geographically immobile. Mobility is the ease with which a factor of production can move from one place to another (geographical mobility) or one use/occupation to another (occupational mobility). Some climatic conditions and landscapes are immobile, as they cannot be moved from one place to another. Modern technology is challenging the concept of occupationally immobile land, as land has been reclaimed in many coastal areas, including Singapore and even Port of Spain. Even more spectacular is the creation of islands in the shape of the world in Dubai. Some land is occupationally mobile. The use to which it can be put varies. A plot of land is mobile occupationally in that in can be used to build a house or a factory. Land is an important factor of production. It is used in the production of almost all goods and services. The hairdresser and the doctor use the factor land when supplying their services. So do all factories, large and small. See if you can think of a good or service produced without the use of the factor land! Labour labour supply • ITQ4 The labour supply refers to those people who are available for work in the economy. The store clerk at RIK bookstore provides the factor labour. So, too, does the construction worker at the housing development site. Give three examples of the factor ‘labour’ in your school. ITQ5 What kind of labour does each of the workers in the photographs provide? A construction worker. ITQ6 Give an example where labour is geographically immobile and one where it is occupationally immobile. 16 A teacher. Labour has the following characteristics: • Labour is the human factor. Labour services are provided by man. • Only the worker himself can sell his labour services. In the case of skilled labour, no one else can perform his services. • Labour services cannot be stored in the same way as units of land or capital. • Labour is geographically and occupationally more mobile than land. • Labour is not homogeneous (uniform). Each unit of labour has different skills and abilities. Labour performs a very important function in the production process, as labour represents man in the production process. Now there are improvements in technology, and capital (machinery) is replacing labour. There are expert systems in medicine diagnosing patients’ illnesses, and ‘intelligent’ computers 3 · Factors of production division of labour • specialisation • labour force • supply of labour • that can make decisions based on data input. However, many producers still choose to retain some labour in production. These producers agree that the human factor is, at this time, still needed, especially for decision-making. And who will service and repair the machinery, anyway? There are also some occupations where labour has been replaced by automated systems because of the dangerous nature of the job – for example, nuclear plant operators – or simply to reduce the work involved. In many factories, there is division of labour. This is where the production process is divided into a series of separate tasks. Workers specialise in a particular task. Specialisation occurs when workers focus on a specific task and so become skilled in that area. Specialisation and division of labour will be discussed in greater detail in Chapter 7. The labour force is the number of people willing to work in the economy. The total number of hours that they are willing to work is the supply of labour; for example, 10 men each working for 50 hours supply 500 man-hours. The supply of labour is dependent on three factors: • The size of the population. The larger the population, the larger the supply of labour, and the converse is also true. • The proportion of the population willing to work. Those who continue to study after the age of 16, housewives and the disabled decrease the supply of labour. • The number of hours worked by each individual. Overtime increases the supply of labour. Capital investment • Capital, in the economic context, refers to goods used to produce more goods. These goods are not wanted for their own sake but, rather, to help in the production of other goods and services. The purchase of capital goods is investment, as such a purchase is not part of current consumption. Capital is yet another term the economist uses in a special way and it must not be confused with its everyday meaning of ‘money’. Capital is, therefore, any manmade goods used in production. The sewing machine used by the village seamstress is her capital. The crane used by port workers to lift heavy containers from ships is also a unit of capital. A crane is a unit of capital used in the production process. 17 3 · Factors of production Capital possesses certain features: • capital is man-made, as opposed to land which is naturally occurring; • units of the same type of capital are homogeneous; • mobility of capital varies with size and the job that the unit of capital is meant to perform; • capital can be imported from other countries. ITQ7 Name two ways the government of your country is improving the human capital. capital accumulation • ITQ8 What are some of the effects on labour of these changes in technology? There are different types of capital: • Working capital is the raw materials and intermediate goods used in the production process. A higher level of output requires more working capital and a lower level less. • Fixed capital comprises the factories and machinery used in production. This remains fixed for a certain range of output. This capital is also called ‘physical capital’. • Social capital (infrastructure) is normally provided by the government and is made up of roads, schools, hospitals and housing. In some newer housing developments, these might be provided by the developer as a condition of getting planning permission. Generally, government provides this capital to increase the productivity of the workforce. • Human capital is another type of capital that economists are now recognising. Human capital consists of people’s abilities, knowledge and skills. This capital is also important to production. For human capital to grow, there must be education, skills training and health care for all citizens. Capital accumulation is the increase in the capital stock of a country. For there to be capital accumulation, society must forgo present consumption. The public must consume less and save some income. Firms will borrow the funds saved to purchase more capital. The increased capital increases the productive capacity of the country. In recent times, there have been many advances in technology. These advances are making capital more and more versatile. Capital is important, as it is now replacing labour in the workplace. The bottling process in Carib Brewery in Trinidad is now fully automated and so there is no need for workers on the production line. Automated teller machines have replaced bank tellers in many banks. Capital is also important because it can be imported. This means that a country can increase its productive potential by importing capital goods. Entrepreneurship / entrepreneurial talent entrepreneurship • 18 Entrepreneurship is now regarded as a separate factor of production. In the past, it might have been considered to be part of labour. The entrepreneur performs two functions. First, he combines the other three factors of production in a profitable manner. Second, the entrepreneur is the factor that bears the risk of production. The risk involves paying for the factors required to produce goods before any revenue is received from selling the good produced. Note that the entrepreneur might receive a negative return (loss) for his services, unlike any of the other factors. The entrepreneur is very important in the modern economy because all firms, small and large, start out with an entrepreneur. Such a firm is funded by the owner/entrepreneur or shareholders who invest in the company. They provide the money to start up the company and so each bears a risk. The government could also act as an entrepreneur and provide the funds for a public enterprise to set up business; for example, the National Petroleum Company in Trinidad. The entrepreneur is the foundation of the modern economy. In Chapters 4 and 6, we will discuss private and public enterprises. 3 · Factors of production Primary and secondary factors of production primary factor of production • secondary factor of production • Sometimes, economists speak of primary and secondary factors of production. A primary factor of production is one that occurs naturally, such as land or unskilled labour. A secondary factor of production is one created by man or developed in some way; for example, capital, entrepreneurship or skilled labour. Production production • goods • services • Production can be defined as the conversion of factors of production into goods and services that consumers wish to consume. Production is illustrated in Figure 3.1. Goods are tangible products whereas services are intangible. Bermudez Biscuit Company Ltd produces goods such as Crix cheese-andspinach crackers. You can hold the snack, touch it and – of course – eat it! Senses Salon and Day Spa provides services such as facials, body scrubs, manicures and pedicures. Though you feel better after one of their treatments, you cannot hold or touch the treatment. factor inputs production output Figure 3.1 Production producer goods • intermediate goods • final goods • Producers might produce producer goods, intermediate goods or final goods. Producer goods are goods, such as machinery, that help in the production of other goods and services. Intermediate goods are goods that are used as inputs in the production of other goods and services. You will realise that both producer goods and intermediate goods are capital goods. Final goods are goods that are bought by consumers for use or consumption. Some goods can be both an intermediate good and a final good depending on the consumer. In Trinidad, National Flour Mills Ltd combines the four factors of production to produce the Lotus all-purpose flour that consumers in Trinidad and Tobago buy. If Mrs Daniel buys this flour to prepare bread and roti for her family, then this flour is a final good. However, if Kiss Baking Co. buys this flour to bake bread and cakes for sale to consumers in the region, then this flour is an intermediate good. Other producers might buy the intermediate goods from a firm to produce other final goods. Consolidated Appliances might buy paint from Penta Paints to coat its gas cookers. The paint is an intermediate good. Figure 3.2 shows the various types of goods produced, based on what each is used for. production goods producer goods intermediate goods services final goods Figure 3.2 Types of goods produced 19 3 · Factors of production Productivity productivity • Productivity is a measure of output per unit of input. Labour productivity is output per unit of labour input; for example, number of refrigerators made per person employed. Production is simply the act of converting raw materials to goods and services, whereas productivity is a measure of how rewarding a factor of production is in terms of output produced. While labour productivity is often spoken about, especially among trade unions, economists also measure the productivity of land and the productivity of capital. Here is a breakdown of the types of productivity: Labour productivity is a measure of output per unit of labour used: Quantity of output Labour productivity = Quantity of labour used Productivity of land is a measure of output per unit of land used: Quantity of output Productivity of land = Quantity of land used Productivity of capital is a measure of out put per unit of capital used: Quantity of output Productivity of capital = Quantity of capital used We can illustrate the concept of productivity as follows. A small garment factory in Fitts Village, Barbados, employs 4 seamstresses. There are 2 sewing machines. In Week 1, they completed 12 dresses. In Week 2, they were able to complete 16 dresses. The productivity of labour in Week 1 is: ITQ9 What is the productivity of capital in this garment factory? The sewing machines are the units of capital for the garment factory. factor payment • Quantity of output = 12 = 3 dresses per worker Quantity of labour = 4 In Week 2, the productivity of labour increased to 4 dresses per worker (16 dresses divided by 4 workers). Each factor of production provides a factor service. For this factor service, the factor receives a factor payment. This factor payment is also called a ‘factor reward’ or a ‘factor earning’. Table 3.1 shows each factor of production and the corresponding factor reward. Table 3.1 Factors of production and reward Factor of production Factor reward Land Rent Labour Wages Capital Interest Entrepreneurship Profit Payments to factors and production costs If a firm were to employ the four factors of production to produce goods, then it would have to make payments to each of the factors. The total of its payments would be the sum of the factor rewards. Also, the total of the firm’s payments would be the total costs faced by the firm to produce a given output. See Chapter 5 for a definition of costs of production. These are simply two different ways of looking at the same thing – the outlay or expenditure of the firm. Mr Penny decides to add to his family’s income by making pickled plums and selling them. He pays Mr Bim $5 to pick 100 plums from the tree in his 20 3 · Factors of production Enterprise. ITQ10 Name the factors of production used by Mr Penny and the corresponding factor payments. backyard. He buys $4 of seasonings to put in the plums. He pays Mrs Penny $10 to use her stove and pots, and for her labour to prepare the pickled plums. He estimates the cost of his risk-taking and putting together of the other factors at $6. Though Mr Penny does not pay himself, his risk-taking and putting together of the other factors are part of his cost of production. The payments to land, labour, capital and enterprise total $25. This $25 is also the cost of producing the 100 pickled plums. Therefore, factor payments for the factors employed are the same as costs of production. A factor of production is an economic resource used in the production of goods and services. There are four factors of production – land, labour, capital and entrepreneurship. Land is all the free gifts of nature. Labour is the physical and mental effort of man in production. Capital is goods used to produce more goods. The entrepreneur is the risk-taker and organiser of the other factors of production. Primary factors of production are those that occur naturally, and secondary factors of production are those that are created or developed by man. Production is the conversion of economic resources into goods and services. Productivity measures how efficient a factor of production is in the act of production. It is measured as output per unit of input. The factor land earns rent, labour earns salaries and wages, capital earns interest and the entrepreneurship earns profits. The sum of all the payments to the factors of production used to produce a given amount of a good is the same as the firm’s costs of production for that good. 1 Wind powering windmills; rivers used as waterways to transport goods and people; water from rivers and seas used to cool industrial machines; gold and diamonds extracted from the earth; land to rear animals. 2 Sunny Caribbean weather cannot be transported to Siberia. The cool climatic conditions of the Jamaican Blue Mountains cannot be transported to Hawaii. 21 3 · Factors of production 3 The terrain of the Jamaican Blue Mountains is suited to coffee production and cannot be used to grow sugar cane. Land in the Central Plains of Trinidad can be used to grow a variety of crops, and even build houses and offices. 4 Labour in school includes: the teachers, the laboratory technicians, the security guard at the gate, the janitors, the cafeteria workers and the handyman. You might even have some of your own to add to this list. 5 The construction worker provides physical labour, skilled and unskilled; the teacher provides mental labour. 6 Any unit of labour that is unwilling to move to another location in order to live and work is geographically immobile; for example, a Jamaican schoolteacher from Kingston who is unwilling to move to Negril to work. A small appliance repairman is occupationally immobile, as he might not be able to repair cars or computers or, furthermore, put a filling in one of your teeth. 7 A government can improve human capital by providing training for workers; for example, YTEPP in Trinidad and Tobago, and HEART in Jamaica. Health care that reduces the number of sick days taken will also improve human capital. 8 One effect is that less labour is being demanded, as producers use more capital in the production process. Also, labour has to be retrained to operate the machinery that is used in the production process. 9 In Week 1, the productivity of capital is 6 dresses per sewing machine (12 dresses divided by 2 sewing machines). In Week 2, the productivity of capital increased to 8 dresses per sewing machine (16 dresses divided by 2 sewing machines). 10 Mr Bim picking the plums and Mrs Penny preparing the plums are the factor labour, which earns wages; the seasonings, pots, gas cooker are the factor capital, which earns interest; Mr Penny taking risks and organising the other factors is the factor entrepreneurship, which earns profit. Examination-style questions 22 Multiple choice questions 1 All of the following are factors of production except: a land b the mental effort of man c a school d entrepreneurship 2 All of the following are part of the factor ‘land’ except: a fish in the ocean b diamonds on a necklace c the element palladium from underground d a sugarcane field 3 Flour bought by a baker is an example of: a an intermediate good b a final good c the factor ‘land’ d a consumer good 3 · Factors of production 4 All of the following are factor payments except: a wages labour b interest capital c profits entreprenuership d income 5 At an auto dealership, 2 mechanics service 6 cars in total per day. When a third mechanic joins them, they each service 3 cars per day. What has happened to labour productivity when the third mechanic joined the company? a Labour productivity has increased. b Labour productivity has decreased. c Labour productivity has remained constant. d The information given is insufficient to determine the effect. 6 All of the following are features of land except: a it has no cost of production b it is geographically immobile c it is fixed in supply d it is a homogeneous factor Production is the process of using the factors of production to produce goods and services for consumption. b) Land, labour, capital, entrepreneurship c) Land - these are the natural resources located on, below and above the earth's surface which are also known as gifts from God. The reward for land is rent Labour - this is the physical and mental effort that is put into the production process by humans. The reward for labour is wages. Structured questions 1 a Define production. [3] b Name the four factors of production used to produce goods and services. [4] c For two factors of production, describe the factor, give an example and state the reward. [4] 2 a State which factors of production are human and which are non-human. b Give examples of two different types of the factor ‘land’. c Explain two features of the factor ‘land’. d Explain which factor of production a skilled surgeon is. Human - skilled labor, capital, entrepreurship Non-Human - land, unskilled labour Land types. Seas and rivers - fish and coral reefs Minerals and Oil (below earth's surface) Land is fixed in supply - even though we as humans can purchase more land/ natural resources, we dont increase the amount of land available to us as a society as it is fixed geographically immobile has no cost of production - it does not cost us as a society to produce the land as it already there for us so it has no production cost. these are incurred when employing factors of production such as capital, labour and entrepreneurship. [4] [4] [4] [3] Essay question [20] a b c d [3] [3] [6] Distinguish between production and productivity. Define labour productivity using an example. Explain three features of labour. Using examples, show how labour can be both immobile and mobile. [8] 23 4 Economic systems By the end of this chapter you should be able to: Concept map explain the meaning of ‘resource allocation’; describe the features of the ‘traditional economic system’; describe the features of the ‘command economy’; describe the features of the ‘free market economy’; describe the features of the ‘mixed economy’; compare the economic systems; assess the benefits and problems associated with the command and free market economies. Resource allocation limited resources traditional economic system unlimited wants command economy free market economy mixed economy merits and demerits Resource allocation resource allocation • Resource allocation is the act of dividing up the scarce resources of the economy to produce different goods and services to meet the needs and wants of society. Resource allocation is the distribution of the economy’s scarce resources among alternative uses. The economy has scarce resources. Man’s wants are unlimited. Therefore, each economy must find a way to allocate the finite resources to fulfil competing wants. When allocating resources, certain basic questions must be answered. They are: • what to produce; • how to produce; • for whom to produce. What to produce? Firms and governments must decide what goods and services are to be produced. Should the economy produce only the basic items that people need, such as rice, vegetables, meat, roads, schools and medicine? Or should the economy produce other items which are wants, such as cars, designer clothing 24 4 · Economic systems ITQ1 Suggest three other needs and three other wants for your community. and candy? The economy has to decide whether only needs will be satisfied. If wants are to be satisfied, the economy must find a way to determine what people really want. Which way? How to produce? capital intensive • labour intensive • Firms and governments must also decide on how output is to be produced. The method of production can be capital intensive, meaning that a great deal of capital is used in relation to each unit of labour in the production process. A labour intensive method can be adopted, where a great deal of labour is used in relation to each unit of capital. Production can also take place on a large scale, where output is mass-produced, or on a small scale, where output is custommade to suit the individual needs of the buyer. For whom to produce? Economies must also decide how the goods produced with the limited resources available are to be shared out amongst members of society. Some goods are distributed based on ability to pay the price. Whether or not you own a BMW depends, at least in part, on your ability to pay the price. Sometimes, the government might distribute some goods based on need: subsidised housing and some other goods are distributed free of charge; for example, street lamps. To allocate these scarce resources in the world today, different economic systems have evolved. The four main types of economic systems that have evolved in the Caribbean and the rest of the world are: • the traditional economic system; • the command economy (also known as the planned economy); • the free market economy; • the mixed economy. Economic systems The traditional economy traditional economic system • direct production • A traditional economic system is an economy that is self-sufficient. This economic system is also known as the subsistence economy. Here, man’s needs are satisfied mainly through direct production; that is, through his own production of goods and services. There might be some surplus produced, which can be 25 4 · Economic systems barter • traded or stored for later use. These economies do not use money, so trade is limited to barter – the exchange of goods for goods. Some examples of traditional economies are the isolated tribes of Asia, Africa and South America. Closer to home, the closed Amerindian communities of Guyana exist in traditional economies. The Wai-Wai Indians reside in the north central area of the Brazilian Amazon close to the border of Venezuela and also in Guyana. As these economies are isolated, they remain largely unaffected by developments in the modern world. Traditional economies are closed; they have limited contact with the rest of the world. Therefore, resource allocation decisions are based on what the economy is accustomed to doing. As the economy is closed, there is no innovation; therefore, decisions on what to produce, how and for whom remain generally the same over time. This is one of the reasons that such economies are, in fact, called traditional economies. Production decisions are based on long-established habits. If the community is used to planting four plots of cassava in the rainy season, they will continue to do this for a long time. The features of the traditional economy are: • ownership of resources is based on what is passed on to you by your ancestors; • there is no formal government, though many of these societies have a leader and systems to ensure justice and order; • private individuals own and allocate resources; • resource allocation is based on tradition: what to produce, how to produce and for whom to produce are all based on what the economy is accustomed doing; • there is no money in this economy, so trade is done by barter; • the economy is closed to outside trade and external influences. The command economy command economy • public sector • 26 In the command economy, production is concentrated in the hands of the state. The state owns all economic resources, and production decisions are made by the state. Cuba is an example of a command economy. The State decides what to produce based on what the government thinks is best for all members of society. There is a public sector, where government-owned firms operate to allocate resources and to produce goods and services. In some command economies, there is also a national planning authority that makes planning decisions on behalf of the state. The state decides how to produce based on what resources it has, the level of technology present and other government goals. In such an economy, the state might, in fact, choose to use a labour-intensive form of production even though it has the technology to produce a good more efficiently. This could be because it wishes to create jobs for the population. The state also decides for whom to produce, based on the needs of the population, and might direct labour into whatever work is thought necessary. Resources might not be used to produce luxury items. The features of the command economy are: • the state owns all the factors of production and business units; • the government assumes full responsibility for the economy – the government makes laws, provides infrastructure and is involved in production; • there is no private sector; • the state, through the central planning authority, allocates resources; • all workers are employed by the state; • there is restricted choice for the consumer, since producers are told what to produce by the central planning authority and there are not many firms producing the same product; 4 · Economic systems • prices are fixed – shortages do not lead to price rises but to some form of rationing; • there are no shareholders in companies, and production is not profit-driven. The free market economy free market economy • private sector • price mechanism • profit motive • The free market economy is an economy in which private individuals allocate resources. In this economy, private individuals also own resources. These private individuals own and operate firms. That part of the economy containing such private firms is called the private sector. The USA is perhaps the world’s best-known example of a free market economy. In the free market economy, resources are allocated according to the market mechanism, otherwise known as the price mechanism/system. The price mechanism allows price to be determined by the interaction of the forces of demand and supply. The decisions of sellers are linked to the decisions of buyers by the price mechanism. Firms decide on what to produce based on what is being demanded by buyers. Each time a product is sold, this is a signal to producers to supply more of this item. Purchases, therefore, act as votes towards the production of a particular product. Producers will move more resources into the production of goods that are in high demand. When goods are not bought, this is also a signal to producers – a signal to supply fewer of these goods. Resources are then moved out of the production of such goods. Price, therefore, has a signalling function. Firms decide on how to produce based on factor availability, the level of technology, and the relative costs of factors of production. Bico Ice Cream Co. might decide to use more labour in the factory, if labour is easier to obtain than capital. If the technology is advanced and capital is very productive, firms might choose to use the capital instead of labour. Firms will choose more productive capital, even if the initial capital outlay is very expensive, because it is productive. A firm will employ either the cheaper factor or the more productive factor, even if this means that some labour will be unemployed. Firms decide on for whom to produce based on the price mechanism. If the price mechanism signals that sugar-free snacks are in high demand, firms will produce them. Clearly, they are producing for those who wish to watch their sugar intake. If computer firms observe a fall in demand for floppy diskettes and an increase in demand for flash drives, then they will produce more flash drives. They are producing for those computer users who use flash drives. Price has a rationing function. Since scarcity exists and there is not enough of any good for all of us to obtain the quantities that we desire, goods and services are allocated to us based on our ability to pay the price. Firms produce for those who can pay the price. The features of the free market economy are: • Private individuals own all the factors of production and business units. • The government assumes full responsibility in the economy for making laws and providing infrastructure. • The private sector owns and allocates resources. • Resources are allocated through the price mechanism. • Producers are guided by the profit motive. This means that the possibility of earning profits motivates production. • There is freedom of choice for the consumer. Choices are determined by the range of goods produced by firms – consumers can choose to buy or not to buy. • Workers can also choose whatever occupation they wish, as well as for whom they work. A CAPE graduate can choose whether she becomes a doctor or an engineer. When she becomes an engineer, she can choose to work in Petrotrin or Schlumberger Trinidad Inc., provided they are both willing to employ her. 27 4 · Economic systems • There is consumer sovereignty, where consumers’ purchase or failure to purchase a good determines which goods are produced and in what quantities in the economy. The mixed economy mixed economy • ITQ2 Is the economy you live in a mixed economy? How do you know? In the mixed economy, both private individuals and the government allocate resources. There is both a private sector and a public sector. The Caribbean countries – such as Barbados, Jamaica and Dominica – are all mixed economies. Figure 4.1 illustrates how the mixed economy has elements of both the command and the free market economies. free market economy command economy private sector public sector mixed economy Figure 4.1 The mixed economy – a mix of free market and command economies ITQ3 Name two firms in the private sector of your economy. ITQ4 Name two firms in the public sector of your economy. 28 Privately owned firms operate in the private sector. Economic decisions on what to produce are based on the price mechanism. A higher price for a good pulls more resources into the production of that good, whereas a lower price diverts resources elsewhere. How to produce decisions are based on the costs of the factors of production, their availability and their productivity. Unlike the government in the public sector, private sector firms aim to minimise costs, and so firms will choose the cheaper factors of production relative to their productivity. They will also choose the more efficient factor, even if this means that some labour will not be employed. Decisions with regard to for whom products will be produced are also based on who wants to buy the good and whether that consumer can pay the price. Remember that resource allocation in this sector is identical to resource allocation in the free market economy. The public sector is that part of the economy in which government-owned firms operate. Just as in the command economy, public sector decisions on what to produce, how to produce and for whom to produce are based on what the government thinks is best for the economy and the people. In Trinidad and Tobago, the National Flour Mills is owned by the government. This firm supplies oil, flour and rice to the market in Trinidad and Tobago. The government considers these goods to be essentials and so has decided to supply them to the market. Some of the goods are sold at subsidised prices to ensure affordability by all consumers. This is an example of a what to produce decision based on what is best for the consumers. How to produce decisions are often based on employment considerations. As mentioned earlier, firms in the public sector might employ large amounts of labour, even though such labour is inefficient or more expensive than capital. This is because the government wishes to maintain the employment levels, even though this is expensive. For whom to produce is based on the unsatisfied needs of different groups in society. The Public Transport Services Corporation in Trinidad and Tobago provides transport services all over the island, based on needs. The Barbados Transport Board provides transport in Barbados. Commuters coming into the city daily (for work and school) from all towns can use the bus service. These commuters might not have cars, or might be unable to use their cars because of congestion and high parking fees. The government decides to provide this service to those groups. Most economic systems will contain a mix of the features of the command economy and the free market economy, which is why they are called mixed economies. Mixed economies came about because it has been recognised that both the government and the private sector add to the efficiency of the economy. 4 · Economic systems Comparison of economic systems Table 4.1 shows a comparison of the four main economic systems: Table 4.1 Comparison of the four main economic systems Economy Ownership of the factors of production Role of government Role of private sector How resources are allocated Traditional the entire society owns no formal government resources; they are passed on to future generations by ancestors no formal private sector; however, private individuals allocate resources based on what was done by ancestors decisions based on customs and habit Command state none allocates resources and is producer of goods and services central planning authority allocates resources based on the state’s decision as to what is best for individuals and the economy Free market private individuals • provides the framework • owner of factors of of laws production • provides the aids • allocates scarce to trade – roads, resources electricity, water • no role in the allocation of resources • price mechanism Mixed government and private individuals • provides the framework • owner of factors of of laws production • provides the aids to • allocates scarce trade resources • producer of some goods and services • government • price mechanism Some possible merits of a command economy • Factors of production can be organised to produce public goods. • Factors of production can be organised to produce merit goods. • As the state owns all the resources, any profits belong to the state. Profits can be redistributed to benefit all citizens. • The state can ensure that people work in healthy and safe conditions. Also, the state can ensure that its firms will not cause any pollution. • Goods and services are priced so that everyone can afford them. • The distribution of income and wealth is even. No one group can become richer because of earnings from land or capital they own. Some possible demerits of a command economy • People cannot influence the production of goods and services by demand or lack of it. • The government makes decisions about what to produce. If the planning authority is not in touch with what people need and want, there can be long delays in the provision of goods and services. This sometimes makes production inefficient. • All profits go to the state. There is the absence of the profit motive and so there is no incentive for managers to give of their best. This can lead to corruption in state-owned companies. • As there is no price system, there could be shortages of goods in high demand, or surpluses of goods that consumers are not buying. Shortages serve a function by indicating to producers that they should supply more, and surpluses indicate that there is need to cut back production. However, their existence indicates that there is a misallocation of resources. Moreover, surpluses could lead to wastage. 29 4 · Economic systems Some possible merits of a free market economy shortages • surpluses • invention • innovation • • There is freedom of choice as to what to produce, what to consume and where to work • Shortages occur, where consumer demand exceeds supply. This results in higher prices and more of the good in short supply being produced, thus eliminating the shortage. Surpluses occur, where supply exceeds consumer demand. This results in lower prices and less of the good in oversupply being produced, thus eliminating the surplus. • The price mechanism works quickly and so saves time. There is less bureaucracy and ‘red tape’. • The price mechanism does not need civil servants and officials to decide on what to produce. This saves valuable government resources. • The government is not involved in the production of goods and services, and so is free to perform its other functions efficiently. • The profit motive encourages producers to produce at the lowest possible cost in order to make higher profits • There are many firms in each industry. Such competition results in the production of quality goods and services. • The availability of profits and the attraction of even higher profits encourage firms to spend on research and development (R&D). This results in innovation and invention. Invention is the creation of something new and original. Innovation is improving or making changes to something already in existence. Some possible demerits of a free market economy public goods • ITQ5 Give an example of a public good, explaining why your choice is a public good. merit goods • ITQ6 Give an example of a merit good, explaining your choice. 30 • Firms operate with very little government intervention. They might produce to make a profit and will not always ensure that pollution levels are kept down. • As there is little government control of the economy, firms might seek to maximise profits. Firms might not regard the working conditions and level of workers’ wages as important. Workers might be exploited, especially in industries where there is an oversupply of workers. • It is not possible to produce public goods through the market mechanism. Public goods are goods that are consumed collectively; for example, street lighting and defence. It is difficult to charge for street lighting based on who uses the good. It is also difficult to exclude those who do not pay for the good from using it. This makes public goods nonexcludable. Public goods are also non-diminishable. Consumption of the good by one individual does not reduce the amount available for others to consume. There is no incentive in the market economy for firms to produce public goods. • Merit goods are not produced and consumed in adequate amounts. Merit goods are goods where the welfare to society from its consumption exceeds the costs of the good. Some examples of merit goods are education and health. If left to individuals to choose how much they consume in the way of merit goods, they might choose to forgo consumption in favour of goods that yield short-term benefits, such as DVDs and holidays. • Firms might grow in size and take over smaller firms. This could result in monopoly power in the market. When the firm is the only supplier, consumers can be exploited in terms of higher prices or reduced quality. • The owners of land and capital earn considerable income and become rich. The owners of unskilled labour, the sick and the unemployed remain poor. This leads to an unequal distribution of wealth. 4 · Economic systems Resource allocation is the sharing of resources to produce different goods and services. Four economies have evolved in today’s world to allocate scarce resources. They are: the traditional economy, the command economy, the free market economy and the mixed economy. The traditional economic system is one in which resources are allocated according to tradition or habit. It is based on subsistence farming and bartering as a form of trade. The command economy is an economy where government owns and allocates all the factors of production. Firms belong to the public sector. In a free market economy, resources are owned and allocated by private individuals. Firms belong to the private sector. The traditional economy has each individual producing to meet his or her needs. The government is the main player in the command economy. Private individuals decide on resource allocation according to the price mechanism in the free market economy. The mixed economy has both the government and the private sectors. The merits of the command economy are based on the equality of opportunity and access to goods and services for all individuals, which the government ensures. The problems of this economy stem from the lack of competition and the absence of the profit motive, which reduces product quality and economic growth. The merits of the free market economy stem from the nature and strength of the private sector. There is production of a variety of goods and services, innovation, increasing incomes and growth. However, demerits emerge because of the absence of government to look after the material well-being of all. The presence of the government in the mixed economy helps that economy to reap the benefits of the command economy. The spirit of the firms in the private sector of the mixed economy helps the economy to reap the benefits of the free market economy. The mixed economy has elements of both the command and the free market economies. As the mixed economy is a combination of both the command and the free market economies, it draws on the benefits of both while the disadvantages of both are reduced. 1 Students need certain textbooks, and people need shoes and water, of course. People in the community might want cell phones with cameras, iPods and laptop computers. 2 All Caribbean economies are mixed economies. Once there is a private sector and a public sector, the economy is mixed. However, note that the nature of the mix varies. This means that the relative size of the private sector to that of the public sector varies. 3 This answer will vary, depending on where you are from. Remember that the private sector has firms owned and controlled by private individuals. 4 This answer will also vary, depending on where you are from. Remember that the public sector has firms owned and controlled by the state. 5 An example of a public good is a lighthouse. It is impossible to exclude ships that do not pay for the lighthouse services from the use of the lighthouse signal. These ships are called ‘free-riders’ – a consumer of a good or service who does not pay for the good or service. Also, the service is non-diminishable. This means that if ten ships use the services of the lighthouse, it does not reduce the service available to an eleventh ship! 6 Fire services are an example of a merit good. If people had to pay for fire services in the same way as they purchase insurance, many would not 31 4 · Economic systems buy this service. The benefits to society of the government providing fire services are that our homes will be safe should there be a fire! The benefits outweigh the costs of the government providing this service. Examination-style questions Multiple choice questions 1 A mixed economy is one in which: a There is a well developed industrial sector. b People of all races work in the economy. c All economic activity is controlled by the government. d Part of the economy is owned and controlled by the government. 2 Which of the following will not take place in a free market economy? a government ownership of factors of production and of production of goods and services b private ownership of the factors of production c the price mechanism determining the allocation of resources d producers being motivated by profits 3 Which is not a benefit of a centrally planned economy? a Factors of production can be organised to produce public goods. b Factors of production can be organised to produce merit goods. c Goods and services are priced so that everyone can afford them. d Some individuals can become richer because of earnings from land or capital they own. 4 Which is not a feature of the traditional economic system? a direct production b government ownership and control of resources c the economy being closed to outside influences d trade by barter 5 The three basic questions of resource allocation are: a what to produce? b how to produce? c how much to produce? d for whom to produce? 6 Rationing is a feature of which type of economic system? a the traditional economic system b the command or planned economic system c the free market economy d the mixed economy Structured questions 1 2 32 a What is an economy? b Name three types of economies. c Give an example of each type of economy named in part b above. d Describe how resources are allocated in one of the economies named in part b above. [3] [3] [3] [6] In the Caribbean, there are mixed economies and traditional economies. [4] a Who owns the resources in each of these economies? b Give an example of these economies in the region. [2] c Compare and contrast resource allocation in these economies. [9] 4 · Economic systems Essay question [20] a Name three types of economies and give examples of each. b Explain three features of each type of economy. c Explain four benefits and four disadvantages of one type of economy. [3] [9] [8] 33 5 By the end of this chapter you should be able to: Costs in the short run and the long run define ‘costs of production’; distinguish between the ‘short run’ and the ‘long run’; define ‘fixed’, ‘variable’ and ‘total’ costs; define ‘average’ and ‘marginal’ costs. Concept map short run Short-run and long-run costs fixed costs total costs long run variable costs The cost of production ITQ1 What are the four factors of production and what are the rewards of each? A firm uses a combination of the four factors of production to produce its output. The firm pays for these factors of production. They are the expenses of the producer to produce a given level of output. DEFINITION: The sum of the payments for all the factors used to produce the good is the cost of production. In the production process, economists usually define two periods of time: the short run and the long run. DEFINITION: The short run is that period of time when it is not possible to vary the quantities of all the factors of production used in the production process. short run • long run • The short run is defined as that time during which it is not possible to vary the quantities of all the factors of production used in the production process. In the long run, it is possible to vary all factors of production. DEFINITION: The long run is that period of time when all factors of production in the production process are variable. variable factors • If a firm wishes to increase production in the short run, it might do so by increasing some factor inputs and by keeping some constant. The factor inputs that are varied are termed variable factors. DEFINITION: A variable factor is one the amount of which can be varied in the short run. Labour and raw materials are variable factors. Their quantities can be varied in the short run to increase or decrease production. In the short run, labour and raw material are considered variable 34 5 · Costs in the short run and the long run fixed factors of production • factors, since the amounts of these factors used can be varied at short notice in order to increase production. Raw materials can be increased within hours by just using up more from stocks at the factory. Orders and delivery of stocks can be made in days. Also, new workers can join the firm in a matter of days. The factors of production remaining unchanged in the short run, even when production increases, are termed fixed factors of production. DEFINITION: A fixed factor is a factor the amount of which it is not possible to vary in the short run. Land and capital are usually fixed factors. ITQ2 Give some examples of Solo’s variable factors. ITQ3 What are Solo’s fixed factors of production? In the short run, land and capital are generally considered fixed factors, as increased amounts cannot be acquired within a reasonable time to increase production. In the long run, if the firm wishes to increase its output (and it cannot increase its efficiency by changing the quantities of the variable factors used), it can do so by increasing all its factor inputs. Additional labour and raw material can be used. Land and machinery can also be acquired. Therefore, in the long run, all factors of production are variable. The short run and the long run are not specified in terms of weeks or months. These periods vary with the good being produced and the factors of production used. For instance, the Solo Beverage Company Ltd soft drink factory might wish to produce more soft drink to meet increasing demand. In the short run, they could do so by employing more labour, using more raw materials, and working more and longer shifts in the factory. Solo cannot produce more soft drink by using a second production plant. Building a second plant will take time, maybe a year. This is the long run for this firm; that is, the time it takes to vary all factor inputs. In the long run, Solo can build its second plant and expand production. The firm will then use more land, labour, capital and even entrepreneurship to produce more output. Investment in fixed factors of production can only be undertaken in the long run. total fixed costs • total variable costs • ITQ4 Fixed costs for a given firm are $4000 when output is 100 units. What are fixed costs when output rises to 200 units? From the above discussion, it can be seen that, in the short run, the firm uses both fixed and variable factors in the production process. The payments to the fixed factors of production are termed the firm’s total fixed costs (TFC). The payments to the variable factors are termed total variable costs (TVC). The fixed factors are fixed in quantity in the short run, regardless of the amount of output produced. It follows, then, that the payments to the fixed factors – that is, total fixed costs – will remain unchanged regardless of the level of output produced. Whether the firm produces zero output, 100 units or 1000 units in the short run, the fixed costs of production remain constant. Figure 5.1 illustrates the relationship between fixed costs of production and output. 35 5 · Costs in the short run and the long run total fixed cost TFC 0 output As output increases, more variable factors are used. Therefore, as output increases, payments to the variable factors – that is, total variable costs – increase. If output has to be reduced, the amount of variable factors used will be decreased. Therefore, as output decreases, the payments to the variable factors – that is, variable costs – decline. This means that there is a direct, or positive, relationship between variable costs and output. Figure 5.2 illustrates the relationship between total variable costs and output. This figure shows a simple total variable cost curve. Note that when output is equal to zero, total variable costs are also equal to zero Figure 5.1 Diagram showing a firm’s total fixed costs of production TVC total variable cost 0 Diagram of a firm’s total variable costs Figure 5.2 total cost • ITQ5 Give an example of each of the four factors of production used by Auntie Kay in her business. Table 5.1 Breakdown of Auntie Kay’s costs output Total cost (TC) is the sum of total fixed costs and total variable costs incurred in producing a given level of output. Recall, total fixed cost (TFC) is the sum of all payments for fixed factor inputs. Total variable cost (TVC) is the sum of all payments for the variable factor inputs. The relationship can be summarised using the following equations: TC = TFC + TVC so, TVC = TC – TFC and TFC = TC – TVC To illustrate all these new cost terms, let us look at a very simple example. Auntie Kay produces guava jam in a small business run from her home. This is a cottage industry. Table 5.1 shows a breakdown of Auntie Kay’s costs. Note that total fixed costs and total variable costs can also be referred to simply as variable costs and fixed costs. Note that Auntie Kay’s fixed costs remain fixed regardless of the number of bottles of jam produced. Variable costs are zero when output is zero, and increase as output increases. Total costs increase as output increases. Total fixed costs Total variable costs Total costs 0 10 0 10 1 10 5 15 60 2 10 12 22 50 3 10 17 27 40 total fixed costs 4 10 34 44 30 total variable costs 5 10 55 65 Output and costs 70 costs Output total costs 20 10 0 1 2 3 output Figure 5.3 and costs 36 Auntie Kay’s output 4 5 6 5 · Costs in the short run and the long run marginal cost • ITQ6 What is the vertical distance between any two corresponding points on the total variable cost and the total cost curves? What is the value of the distance between the two points and to what is this equal? Looking at Figure 5.3, we can describe the shape of each cost curve. The total fixed cost curve is a horizontal straight line showing that as output increases, total fixed costs remain constant. The total variable cost curve starts off at the origin. It is upward sloping, indicating that there is a direct relationship between total variable costs and output. This is also true for the total cost curve. However, the total cost curve starts off at the point where the total fixed cost curve starts off. Remember that TVC + TFC = TC Therefore, at zero output where TVC is zero, total cost is equal to total fixed costs. The curves in Figure 5.3 show the typical shape of the total variable cost curve and the total cost curve. One of the most important concepts that you will meet in your study of economics is the concept of marginal cost. Marginal cost (MC) is the addition to total cost from the production of one more unit of output. When Auntie Kay produces 1 bottle of jam, it costs her $15. When she produces 2 bottles, the total cost is $22. The marginal cost of the second bottle of jam is $7. You will realise from this that we took away the cost of the first bottle of jam from the cost of the second bottle of jam. Marginal cost can be found by using the following formula: MCn = TCn – TCn-1 average total cost • ITQ7 Look at the column for total variable costs in Table 5.1. If it is possible, calculate marginal costs from total variable costs. Compare your answers with marginal costs in Table 5.2. where n is the given level of output for which you wish to find marginal cost. Economists also speak of average total cost. Average total cost (ATC) is the cost per unit of output. It is found by dividing total costs by output. Here is the formula: TC ATC = Output Let us now look at the data in Table 5.2, compute the marginal cost and average total cost, and plot those cost curves. Table 5.2 Marginal and average costs marginal and average costs 25 20 15 marginal cost average total cost 10 5 0 1 2 3 4 5 output Output Auntie Kay’s marginal and average costs Total cost Average total cost Marginal cost 1 15 2 22 7 11 3 27 5 9 4 44 17 11 5 65 21 13 15 Let us now discuss the shape of both curves. The average total cost curve is U-shaped. At first, average costs fall, then they reach a minimum, and then they increase. The marginal cost curve is shaped like a tick, falling at first and then rising continuously. There are some important points to note about the relationship between average and marginal costs. When marginal cost is below average cost, average cost is falling. When marginal cost is above average, average cost is rising. Finally, the marginal cost curve cuts the average cost curve at the latter’s minimum point. Figure 5.4 Auntie Kay’s marginal and average costs 37 5 · Costs in the short run and the long run Cost of production is the sum of payments for all factors used to produce a given quantity of a good. The short run is the period of time during which some factor inputs are variable and some are fixed. Therefore, to vary production levels, only variable factors can be changed. The long run is that period during which all factor inputs are variable. Therefore, to vary production levels, all factors can be changed. Fixed costs are payments for the fixed factors of production. In the short run, since all factors are fixed, total fixed costs are also fixed. Variable costs are payments to the variable factor inputs. In the short run, quantities of the variable factors will change with output levels, and so variable costs will also change. Total fixed costs and total variable costs added together make up total costs. Marginal cost is the addition to total cost from the production of an additional unit of output. The marginal cost of the nth unit of output is: MCn = TCn – TCn–1. Note that the marginal cost of the nth unit of output is: MCn = TVCn – TVCn–1. Average cost is the cost per unit of output. It is found by dividing total cost by units of output. 1 The four factors of production are land, labour, capital and entrepreneurship. The four factor rewards are rent, wages, interest and profits. 2 Solo’s variable factors are labour and raw materials. Labour comprises factory workers, deliverymen and office clerks. 3 Solo’s fixed factors are the land, plant and large-scale machinery. These cannot be varied in the short run. 4 When output rises to 200 units, fixed costs remain at $4000. 5 In Auntie Kay’s business, the room in which she prepares the jam is the factor ‘land’. The cooker, pots, pans, spoons and knives are her ‘capital’. Guavas, sugar, spices, jars and labels (raw materials) are also the factor ‘capital’. Auntie Kay, as the person who prepares the jam and bottles it, is the factor ‘labour’. She is also the ‘entrepreneur’, as she bears the risk and combines the other three factors to produce the jam. ‘Land’ and ‘capital’ are fixed factors, and ‘labour’ and some ‘capital’ (raw materials) are variable. 6 The vertical distance between any two corresponding points on both curves is 10, which is equal to total fixed costs: at output 0, the distance is 10 (10–0); at output 1, the distance is 10 (15–5); at output 2, the distance is 10 (22–12); at output 3, the distance is 10 (27–17); at output 4, the distance is 10 (44–34); at output 5, the distance is 10 (65–55). This confirms the relationship that total costs minus total variable costs is equal to total fixed costs. 7 Marginal costs can also be derived from total variable costs. Total variable costs change and this causes total costs to change. Any change in the cost of production due to a change in output – marginal cost – can be measured using total cost or total variable cost. 38 5 · Costs in the short run and the long run Examination-style questions Multiple choice questions 1 Which of the following is true in the long run? a All factors of production are fixed. b All factors of production are variable. c All costs of production are fixed. d All factors of production are variable with the exception of land. 2 Which of the following statements is true? a At zero output, fixed cost is equal to total cost. b At zero output, fixed cost is equal to variable cost. c At zero output, variable cost is greater than fixed cost. d At zero output, variable cost is equal to marginal cost. 3 Which of the cost curves in the diagram below shows the typical shape of the marginal cost curve? costs a b c d 0 quantity 4 Fixed costs are: a costs that vary in the short run b costs that never change c costs incurred by society d costs which do not vary with output in the short run 5 What is marginal cost? a the addition to total cost when one additional unit is produced b the cost of plant and machinery c the cost per unit of output d fixed cost plus variable cost 6 At a factory, total fixed cost is $2000. When 200 units of output are produced, average total cost is $18.00. What is total variable cost? a $3600 b $36 000 c $1600 d $10.00 Structured question 1 a Define total fixed and total variable costs, giving an example of each. b If fixed costs are zero, what is the relationship between variable costs and total costs? c Define marginal cost and average cost. d Draw a diagram showing both the marginal cost and average total cost curves. [4] [2] [4] [5] 39 5 · Costs in the short run and the long run Essay question [20] Fran is a seamstress and has set up a shop in Spanish Town. She operates this shop from a small room built at the side of her home. She wants to hire a worker to help with the actual sewing of the clothing. a Give two examples of Fran’s fixed factors and two examples of her variable factors. [4] b Define fixed costs, variable costs and total costs, giving examples of each in Fran’s business. [6] c Sketch a diagram of Fran’s average cost and marginal cost curves. [4] d Explain the shape of the total fixed cost, total variable cost and total cost curves. [6] 40 6 By the end of this chapter you should be able to: Concept map Business organisations in the free market economy name and define the business organisations that operate in a free market economy; explain the features, advantages and disadvantages of a ‘sole proprietorship’; explain the features, advantages and disadvantages of a ‘partnership’; explain the features, advantages and disadvantages of a ‘private joint stock company’; explain the features, advantages and disadvantages of a ‘public joint stock company’; explain the principles and disadvantages of a ‘cooperative’; explain the features, advantages and disadvantages of a ‘multinational corporation’. The free market economy free market economy private sector sole proprietorship partnership private joint stock company joint stock company cooperative multinational corporation public joint stock company Types of business organisation sole proprietorship • partnership • In the free market economy, resources are owned and controlled by private individuals. In a pure free market economy, there is the private sector where all firms are owned and operated by private individuals. In this type of economy, many forms of business organisations have evolved. The main types of business organisations in this economy are: • Sole proprietorship. This is a business owned and controlled by a single person. Some examples of sole proprietorship are: the village/town barbershop, the roti shop and the doubles vendor. • Partnership. This is a business organisation owned by two or more persons. 41 6 · Business organisations in the free market economy private joint stock company • public joint stock company • cooperative • multinational corporation • • Private joint stock company. This is a business with 50 or fewer shareholders (the actual number may vary from country to country) where issued shares cannot be bought and sold in the stock exchange; for example, Caribbean Bottlers Ltd. • Public joint stock company. This is a company with a minimum of seven shareholders with rights to sell company shares on the stock exchange; for example, Republic Bank Ltd. • Cooperative. This is an enterprise that is jointly owned and controlled by a group of persons who have set up the enterprise to meet their economic needs; for example, to sell the produce of its members. An example of a cooperative is the Jamaica Agricultural Society’s Coffee Growers Cooperative Federation. • Multinational corporation. This is a firm that owns and operates production units or sales outlets in a number of foreign countries; for example, Nestlé Ltd. Sole proprietorships In a sole proprietorship, one person owns the business – he is a sole trader. However, this does not mean that the owner is the only person who works in the business. The owner might or might not have to work in the business. The sole proprietorship is the most common form of business unit in the Caribbean economy. In the free market economy, innovation and enterprising activity is encouraged. The sole proprietorship is a form of innovation, as a creative and enterprising individual has an opportunity to start his own business. In fact, many a sole trader is the seed from which large organisations sprout. In the Caribbean, many food shops and restaurants are sole proprietorships. Also, many housewives with grown children might decide to offer babysitting services to working parents, and some might even start pre-schools. These are also sole proprietorships. Features of sole proprietorships cottage industry • • Sole proprietorships are usually small businesses. • They are easy to establish, as very little capital is needed to start one up. • They are easy to operate, as the business might be involved in just one or two activities; for example, production and selling, or providing a service. • They are generally, though not always, small retail shops. • They are often started up in the home. Many sole traders in the Caribbean are cottage industries. A cottage industry is an industry based in the home; for example, preparation of peanuts, jams and even pastries for sale from the home, or using one’s home as a base from which to offer babysitting services. The products are distinctive and one of a kind, as they are not mass produced in a factory. Advantages of sole proprietorships • A sole proprietorship is easier to establish and manage than a larger company. • Decision-making is quick, as the owner/manager is there on spot. Also, decisions can be made and put into effect immediately, as there are no other owners to consult. • Customers receive special attention, as the clientele is small. The owner is there to give service the personal touch. • Profits are for the owner alone, as there are no other investors that have a claim on the earnings of the company. 42 6 · Business organisations in the free market economy • There is less wastage of resources and time, as the owner/manager works there and supervises employees. The owner can also give his personal touch to the actual running of the business, and so increase efficiency. • As a small number of workers are employed, a good working rapport can develop between employees and owners. • There are no business taxes. The owner pays tax as an individual income earner. Disadvantages of sole proprietorships unlimited liability • ITQ1 Name five sole proprietorships in your community or the school environment. • There are long working hours and it is difficult for the owner to take a vacation, as he is the one in charge. • There is lack of continuity. If the owner dies, the business dies unless there is an heir trained and willing to take over the business. • There is sometimes a lack of competition. There might not be any rival firms to encourage quality. • The owner is the manager. Managerial skills are therefore limited to those of the owner. • The owner might have problems in raising initial and additional capital. • There is unlimited liability. Unlimited liability is the situation where, if the business becomes indebted and cannot pay off its debts, creditors can be paid from the private funds of the owner. Therefore, the owner has unlimited liability, as the business debts extend to him and his personal assets. The owner must settle any losses himself. Similarly, any surplus funds from the business are solely for the owner. Other examples of sole proprietorships in the Caribbean are minimarts and village shops, small farming and gardening services, hairdressing and beauty shops. Partnerships A partnership is a business that is jointly owned and operated by the parties involved. It is a business that is owned by two or more persons (with a maximum of 20 persons, in some countries). Each partner can conduct business on behalf of the business or the other partners. Features of partnerships • Partners provide the financial capital needed. • Partners share profits as well as losses. • Partners bear the liabilities for debts incurred by the business. • Partners need to register the business with the Registrar of Companies. Advantages of partnerships • A partnership is easier to form and manage than a company. • It is also less costly to set up a partnership, as it is smaller than a company. • As more financial capital is brought into the business than in a sole proprietorship, a larger-scale operation can be undertaken. • The partnership increases the ability of the partners to obtain financing for the business. • Each partner can be responsible for a certain aspect of the business, thereby developing his/her skills in that area and so increasing efficiency. Partners can also pool skills and abilities, and work as a team to increase efficiency. 43 6 · Business organisations in the free market economy unlimited liability • limited liability • • Partnerships have unlimited liability. In the repayments of debts, creditors can lay claims on the assets of all partners. The law, however, provides for different types of partners. A general partner is responsible for the running of the business and has unlimited liability with respect to the debts of the business. A limited partner has no personal responsibility for the debts of the business. He has limited liability. If the business is liquidated, his responsibility in respect of the payment of debts is only up to the amount he has invested in the business. However, there might be more than one general partner in a business, meaning that liability does not rest with one person, as is the case with a sole proprietorship • There is better distribution of workload, as there is more than one owner. The responsibility of running the business does not fall on one person. • No corporation taxes have to be paid. The owners pay individual taxes. • Unlike companies, a partnership is not subject to control by a board of directors. Disadvantages of partnerships • Each partner has to take responsibility for the actions of the other partners, as each partner’s action is binding on the other partners. • Decision-making is slower and more difficult than in a sole proprietorship, as partners will not always agree. • Operating costs are higher than in a sole proprietorship. • The partnership has a limited life. The affairs of the business are affected by the removal of a partner through death, retirement, or even if the partner leaves the business for a while. Affairs are also affected if a new partner is admitted to the business. • Although the limited partner(s) has (have) limited liability, at least one partner will have unlimited liability. Joint stock companies joint stock companies private joint stock / private limited company public joint stock / public limited company Figure 6.1 The two types of joint stock company Joint stock companies are companies owned by a number of individuals who have purchased shares in the company, or company stock. These individuals are shareholders. The companies are called joint stock companies because the shareholders come together and contribute to the company stock; that is, they join stock together. The shareholders have limited liability, and so joint stock companies are also called ‘limited companies’. There are two types of joint stock (or limited) company: • Private joint stock (limited) companies; • Public joint stock (limited) companies. Figure 6.1 shows the two types of joint stock companies. Private joint stock company (private limited company) This is a business with up to 50 owners, all of whom own shares in the company. Features of private joint stock companies ITQ2 Think of some examples of what the business can do as a separate entity. 44 • The business is a distinct entity in the eyes of the law, separate from its owners. This means that it is an individual with its own identity. A customer or a creditor can file a suit against the company but not the owners. • The owners (those who finance the business) are called shareholders. The shareholders are private individuals in the economy and could be family members. Shareholders have limited liability. Recall, limited liability means that, in the event that the business is liquidated, the shareholders are only liable to pay debts to a maximum of the amount invested in the business. 6 · Business organisations in the free market economy • The company must be registered with the Registrar of Companies in the country in which it is operating. The name of the business must include the word ‘Limited’ (Ltd). • By law, this business must have a minimum of two members and a maximum 50. • The company’s accounts must be audited by an established auditor. The accounting records must be properly kept. These records can be inspected by shareholders and the authorities. Advantages of private joint stock companies • The private joint stock company has an unlimited life. Years after the founding members have died, the company can still be operated. • Shareholders have limited liability. Shareholders cannot be held liable for the company’s debts, as the business is a legal entity in its own right. • The company has limited liability. This means that the debts of the company are limited to funds of the company itself. • The company has a larger capital financial base than a sole proprietorship. • Generally, shareholders do not manage the company. The company can hire trained managers with the skills to manage efficiently. Disadvantages of private joint stock companies • The law does not permit the public issuing of shares to members of the public. This limits the ability of the firm to raise capital (funds). • A company must make known or file its annual financial report with the Registrar of Companies. All operations must be legal, and company records must follow standard accounting practices. The need to comply with these requirements imposes an extra administrative burden on the company, and will probably imply the need to hire professional advisers. • It is not easy for shareholders to sell their shares, as shareholders cannot participate in the stock exchange. ITQ3 Name three private joint stock companies in your economy. Some examples of private joint stock companies are: Southern Medical Clinic Ltd, Caribbean Glass Company Ltd, Flame Industries Ltd, Innovative Business Solutions (Trinidad and Tobago), Meldam Company Ltd (Jamaica) and Armstrong Agencies Ltd (Barbados). These companies are registered with the Registrar of Companies and have limited liability. Public joint stock company (public limited company) ITQ4 Explain whether a public limited company is part of the private sector or the public sector. • A public joint stock (limited) company comprises a group of persons coming together to conduct some form of business activity. This form of business is also a legal entity. The business is separate from shareholders. Features of public joint stock companies • Funding for this business comes through borrowing from banks and other financial institutions, or through the sale of stocks and shares on the stock exchange to members of the public. • Members of the public purchase stocks and shares from their savings. • Shareholders have limited liability. • A minimum of seven persons can begin business operations. There is no limit to the maximum number of investors. 45 6 · Business organisations in the free market economy Advantages of public joint stock companies economies of scale • • Public joint stock companies are able to raise large amounts of capital easily. • It is easy for them to borrow money, as banks and other lending institutions know of the business and its successes. This can work against the company if lenders know of past company failures! • They are more likely to achieve economies of scale because they are involved in larger-scale business operations. Economies of scale are benefits (including a fall in unit costs) that accrue to a firm as it grows larger. This concept will be treated in greater detail in Chapter 7. Disadvantages of public joint stock companies • They are difficult to manage, as operations are extensive and the firm might employ a large number of persons. • They can become too large and lose touch with their customers. • With growth, the company can also lose touch with its workers. Examples of public limited companies in the Caribbean are A. S. Bryden & Sons Ltd, Neal & Massy Holdings Ltd, Angostura Holdings Ltd, Berger Paints Jamaica Ltd and Demerara Mutual Life Assurance Society Ltd. Cooperatives Robert Owen, a nineteenth-century British social reformer is considered the pioneer of the cooperative movement. The Rochdale Society of Equitable Pioneers was one of the first cooperatives, founded in 1844 in Rochdale, England, by a group of 28 weavers. Influenced by the theories of Robert Owen, they opened a cooperative grocery store. It was so successful that they were able to establish a cooperative factory and textile mill. A cooperative is an independent group of persons who set up an enterprise to meet their economic needs. Agricultural cooperatives are set up to sell or process the produce of its members – the farmers. A consumer cooperative is set up to supply goods at a competitive price to its members. A credit union is also a cooperative set up to meet the financial needs (savings and loans) of its members. Each member purchases shares in the cooperative. This is the source of funds for the business. If a member wishes to leave the cooperative, the value of his shares is returned to him. The principles of cooperatives: • Membership is voluntary. It might, however, be based on a particular occupation; for example, coffee growers will be part of a coffee growers’ cooperative. Taxi and minibus drivers could form part of a transport cooperative. • Cooperatives are democratic. They are controlled by their members and each member has one vote. • There is a limit on the percentage of shares that any one member can hold. • The surplus for a financial period, after all expenses are taken care of, is used for developing the cooperative – placing some as reserves, benefiting members according to their participation, and supporting any other activities approved by the members. • Cooperatives are committed to supporting and cooperating with other cooperatives. • Cooperatives are committed to the education and training of their members. • Cooperatives work for the development of their communities. 46 6 · Business organisations in the free market economy Advantages of cooperatives • Members of cooperatives benefit from lower prices. • Members benefit from guaranteed markets for their products and general benefits from pooling with others of similar occupations or background. • They could benefit from employment opportunities. • The cooperative is not guided by the profit motive that could exploit consumers. Disadvantages of cooperatives • Cooperatives do not have professional management. • The capital of the enterprise is limited to the amount of the members’ total investment. • There might be conflicts, especially if there are members from factions with opposing goals or views on how the cooperative should be run. Multinational corporations (MNCs) parent company • home country • host country • ITQ5 Give an example from the Caribbean region of an MNC conducting production activities. A multinational corporation (MNC) is a giant international firm. The very large multinationals are, nowadays, called transnational corporations (TNCs). The firm operates from its corporate headquarters in the home country, but it conducts business activities through its subsidiaries (branches of the company) across the globe. The parent company is the main company. Multinational corporations carry out production activities and sales activities. The home country is the country where the multinational company is based and where its headquarters is located. The USA, Germany and the UK are the main home countries of MNCs. The host country is the country where the multinational company establishes a subsidiary firm. The countries of the Caribbean are host countries to many multinational corporations. The relationship between the MNC and host country is illustrated in Figure 6.2. ITQ6 subsidiary in host country Give an example from the Caribbean region of an MNC conducting selling activities. parent company home country The primary sector comprises firms and individuals conducting economic activity in agriculture, mining and fishing. The secondary sector comprises firms and individuals conducting economic activity in construction and manufacturing. The tertiary sector comprises firms involved in banking, insurance, retailing and the services industries. Figure 6.2 The relationship between an mnc and its host country Features of MNCs • MNCs invest heavily in the primary and secondary sector in the host countries. 47 6 · Business organisations in the free market economy • They have branches or subsidiaries in many foreign countries. Globalisation has allowed these companies to extend their geographical reach. • The subsidiary might not be totally owned by the parent company. However, the parent company has the controlling share in subsidiaries. Multinational corporations invest in developing countries. However, they are private firms – which, in economics, we assume to be rational. This means that they are profit-seeking organisations. They are neither aid nor developmental agencies: therefore, their activities result in both benefits and costs to the host country. Advantages of MNCs • The host countries benefit from the large injections of foreign currency that the multinational corporation might bring. This source of external finance is sometimes larger than official loans and grants. • The MNC introduces new and advanced technology. This increases productivity in the sectors where it invests. • The MNC provides employment. • The country earns more tax revenue as the tax base is widened. • Locals employed in the industries receive high levels of training, as international standards must be met and maintained. Disadvantages of MNCs • MNCs are sometimes accused of interfering in the political life of countries by supporting, or not supporting, certain government policies. • MNCs might use overseas personnel instead of recruiting workers locally. This is especially true for management and skilled worker positions. • The MNC might take profits out of the country back to the main firm in the home country. These are repatriated profits. • The MNC might also declare higher profits in countries where tax on profits is low. This is a common practice. • It can be difficult for governments to control MNCs because of their size and power. Some examples of MNCs in the Caribbean are: Schlumberger Trinidad Inc., Unilever, Shell, Nestlé and Digicel. The main types of business organisation in the free market economy are the sole proprietorship, the partnership, the private joint stock company (often called a private limited company), the public joint stock company (often called a public limited company), the cooperative and the multinational corporation. Sole proprietorship is a one-man business where the owner has unlimited liability. A partnership occurs where two or more persons join up to form a business and make a profit. Shareholders provide funding through the purchase of shares to form the joint stock or limited company – this can be private or public. In a private limited company, the owners have limited liability in the eyes of the law and shares cannot be sold on the stock exchange. In a public limited company, the owners have limited liability in the eyes of the law and shares can be sold on the stock exchange. A cooperative is an enterprise that is jointly owned and controlled by a group of persons. They set up the enterprise to meet their economic needs. A multinational corporation is a company that has many branches in countries around the world. 48 6 · Business organisations in the free market economy 1 You can give named examples from your experiences, which your teacher can correct. The main businesses in the occupation of sole traders are gardeners; village shops; roadside and market vendors; the pie man around the corner (Trinidad doubles vendors); seamstresses and tailors; and shops offering hair, nail and other beauty services. 2 As a separate entity, the business can purchase and sell assets. It can make investments in other businesses. It can take legal action against another business or an individual, or it can be sued. 3 Think of any companies in your economy where shares are not traded on the stock exchange. Discuss your responses in class, as some of these companies might be partnerships. 4 A public joint stock company is part of the private sector in an economy. The owners are all private individuals (members of the public) who buy company shares. Even though it is called ‘public’, the owners are not the government and so it is not part of the public sector. 5 Some MNCs conducting production activities are British Gas and Unilever. 6 Some companies conducting selling activities are PriceSmart (Trinidad) Ltd, Cable & Wireless, and Unilever. Firms such as Unilever, Johnson & Johnson (Trinidad) Ltd and Nestlé conduct both production and selling activities. Examination-style questions Multiple choice questions 1 All of the following are business organisations in a free market economy except: a sole proprietorship b partnership c public joint stock company d state enterprise 2 Which of the following is a feature of a private joint stock company? a There must be at least three members up to 49 members. b There must be at least three members up to 50 members. c All owners bear liability for the debts of the business. d Shares are sold on the stock exchange. 3 Which of the following is true of a partnership? a All partners have limited liability. b A partnership cannot have more than two persons. c There is lack of continuity if one partner dies. d The partners are called shareholders. 4 Which of the following is not a type of cooperative? a producers’ cooperative b consumers’ cooperative c credit union d mutual fund 5 Cooperatives are governed by all of the following principles except: a Membership is voluntary. b Cooperatives are democratic. c There is no limit on the percentage of shares that a member can hold. d Cooperatives invest in education and training of its members. 49 6 · Business organisations in the free market economy 6 What is the main difference between a public limited company and a private limited company? a The private limited company has unlimited liability and the public limited company has limited liability. b The private limited company can sell shares on the stock exchange but the public limited cannot. c The private limited company has limited liability and the public limited has unlimited liability. d The public limited company can sell shares on the stock exchange but the private limited cannot. Structured question 1 50 a Name three types of business organisation operating in a free market economy. b For each type of organisation stated in a above, list one advantage and one disadvantage. c For each type of business organisation, give an example from the Caribbean region. [3] [6] [6] Essay question [20] a Compare the private and the public joint companies. b Contrast the private and the public joint stock companies. c Explain two benefits and two costs to the host country of a multinational company locating there. [4] [4] [12] 7 By the end of this chapter you should be able to: Economies and diseconomies of scale describe what ‘economies of scale’ are; explain the types of economies of scale; describe what ‘diseconomies of scale’ are; explain the types of diseconomies of scale; illustrate economies and diseconomies of scale on the long-run average costs curve diagram; define ‘division of labour’; explain the advantages and disadvantages of division of labour. Concept map Economies and diseconomies of scale growth of a firm economies of scale internal economies of scale diseconomies of scale external economies of scale division of labour Productive capacity The real world is dynamic and firms are constantly growing. As a firm grows, its productive capacity increases and it experiences economies and, subsequently, diseconomies of scale. DEFINITION: Economies of scale are the cost advantages that accrue to a firm as the firm increases in size. Economies of scale are measured by the decrease in the long-run average costs of the firm. Figure 7.1 shows the long-run average costs of a firm. Output (quantity produced) is plotted on the x-axis, and long-run average cost is plotted on the y-axis. The long-run average cost curve is U-shaped. When long-run average costs are falling (between points A and B), the firm is experiencing economies of scale. The level of output that corresponds to point 51 7 · Economies and diseconomies of scale B is the optimum output. In the long run, it is the point at which all available economies of scale are achieved. It is also the point at which long-run average costs are at a minimum. long-run average costs A B 0 output Figure 7.1 The long-run average costs of a firm Economies of scale internal economies of scale • external economies of scale • There are two types of economy of scale: internal economies of scale and external economies of scale. DEFINITION: Internal economies of scale are benefits to the firm that originate from the organisation itself. DEFINITION: External economies of scale are benefits given to the firm that originate from outside the firm, especially from neighbouring firms. Internal economies of scale can be subdivided: ITQ1 Give an example of a firm that enjoys marketing economies. manager workers small firm managers = 13 ≈ 0.3 workers manager middle manager workers larger firm managers = 33 = 1 workers Figure 7.2 Employee numbers in small/large firms 52 • Marketing economies. A large firm can purchase inputs at a lower price than a smaller firm. Larger firms will tend to buy in bulk and so secure discounts. As a main customer of the supplier, the firm will be able to communicate directly with the supplier. It can set standards and prices to suppliers. The large firm is also able to afford to advertise, thereby increasing sales. This increases market share. For the large firm, output is large and advertising costs are spread over a larger output. Therefore, advertising costs per unit are low. • Financial economies. Large firms are considered less risky and are therefore able to secure loans at lower rates of interest than small firms. Also, larger firms have more sources of finance; for instance, a public limited company can sell shares on the stock exchange and thereby acquire more funds, unlike a private limited company. • Managerial economies. Large firms are able to employ a greater number of managers and middle managers. The management-to-worker ratio in a large firm might be lower than in a small firm. They are also able to attract and pay for the best managers. • Research and development economies. A large firm will have the funds to set up its own research and development department. It will be able to employ top innovators and scientists. • Welfare economies. Large firms can use funds to improve the working conditions and overall welfare of their employees; for example, recreation rooms, canteens with subsidised meals, and free or subsidised health care. • Technical economies. Certain types of machinery come in a fixed size. A small firm might underutilise such a piece of machinery, whereas a larger firm with a higher output will use the machinery more efficiently. For instance, Mama’s Bakery purchases an industrial oven for $10 000. 7 · Economies and diseconomies of scale ITQ2 A firm tries to produce four batches of bread per day but fails. What might have caused this failure? This oven can bake 400 loaves at a time but she only bakes 100 per day. Bunty’s Bakery sells bread to shops all over island and uses this same oven to bake 2 batches of loaves each day. Bunty’s Bakery uses the capital more efficiently than Mama’s Bakery. • Economies in the use of labour. As the firm employs more labour, greater division of labour is possible. This leads to greater productivity and increased output. Division of labour will be discussed in greater detail later in the chapter. External economies of scale arise outside the firm as a result of the growth of the whole industry: • Improved infrastructure. Large firms might induce local governments to improve roads, bridges and general infrastructure. All firms in the area will benefit. Firms might indirectly contribute to infrastructure development when they pay fees for planning and building permission. • Agglomeration. Large firms might encourage related firms to set up nearby. There is, therefore, a cluster of similar firms that benefit from each other. • Labour. The clustering of firms encourages the development of a skilled pool of labour. Workers trained by one firm might shift to another firm nearby, benefiting the firm that did not spend on the training. Nowadays, a firm does not even have to be located physically close to another firm to benefit from this external economy, as workers, trained by a given firm, might migrate to another country to work in a related industry; for example, European immigration into the UK, and Caribbean emigration to the USA, UK and other Caribbean states. • Use of waste products. Some firms might use other firms’ waste, or even by-products, in their production process. These firms benefit by locating close to the firm that produces the waste product. Diseconomies of scale diseconomies of scale • ITQ3 Explain how communication might not flow freely up and down the organisation. As a firm continues to grow, diseconomies of scale set in. Diseconomies of scale are disadvantages that result from the ongoing growth of the organisation. These disadvantages result in increases in the average cost of production. When long-run average costs are rising, the firm is experiencing diseconomies of scale. This is represented in Figure 7.1 by any point beyond point B. The diseconomies of scale are: • Loss of managerial control. As a company grows, it might become difficult to manage effectively. There might be too many levels of management. Communication might not flow freely up and down the organisation. This is common in very large organisations in the private sector, and in government organisations. In addition, middle managers are often thought of as being unproductive – and even meddling – especially in government bodies. • Poor industrial relations. As the company grows, workers become isolated from the management. This can, for example, lead to halfhearted working, poor-quality output, work stoppages and strikes, as workers do not have a voice in the decision-making process. • Overspecialisation. As workers become more and more specialised, this might lead to boredom and reduced quality of work. In recent times, modern management strategy includes allowing workers to see a product through the entire production line. This is found to increase output, efficiency and the quality of the product. 53 7 · Economies and diseconomies of scale Division of labour division of labour • ITQ4 What is labour productivity in the factory with no division of labour and in the factory where there is division of labour? The eighteenth-century economist Adam Smith coined the term ‘division of labour’. Division of labour is the splitting up of tasks in the production process. As a company grows, it is able to practise division of labour. Adam Smith showed that when firms practise division of labour, output is increased. In Adam Smith’s day, the process of pin manufacture involved 18 separate tasks. He argued that a worker new to the task of pin making and unfamiliar with the machinery would scarcely make one pin a day, much less 20, even though he might have worked very hard. In a workshop Smith visited, ten men were employed and there was division of labour. Some men performed more than one task. However, their total output was 48 000 pins a day; that is, an average of 4800 pins per man. Compare this with 20 per man where there is no division of labour! Advantages of division of labour • There is an increase in output. • As workers perform the same task over and over again, there is a saving of time. • As workers perform the same task repeatedly, their skills improve. • Division of labour makes the use of machinery possible. It is easier to invent a machine to perform one or two tasks than to perform a series of processes. • As the worker has simple tasks to perform, he suffers from less fatigue. • The worker might have the chance to choose the task for which he has the greatest ability. Disadvantages of division of labour • There is monotony of the work, as each worker performs a small part of the operations. He has to repeat the same simple task all day. This leads to boredom and indifference. • The workman ceases to be a craftsman; that is, a skilled creator of a product. He is just part of the production process. He could be described as a ‘wage slave’, someone employed in a mindless job for his livelihood. • Division of labour makes the worker a specialist in a small task. The more specialised a worker, the more difficult it is for him to find a job if the firm is closing down. specialisation • 54 When workers in a production process specialise, this is called division of labour. It is possible to have other levels of specialisation. Specialisation occurs when a worker, a region or a country concentrates on one activity. When people in an economy choose an occupation and become skilled at this occupation, this is called specialisation. Mr Netter might specialise and become a teacher, while his sister, Dr Gray, might specialise and become a dentist. With such specialisation, these workers perform their jobs, receive payment and use the money earned to meet their needs, such as housing, food, travel and entertainment. Specialisation therefore necessitates the use of money and the exchange of goods. Regions might specialise in the production of particular goods and services. In Trinidad, the south of the island has firms that specialise in oil, energy and petrochemical production. The north of the island has firms involved in light manufacturing. There is also international specialisation, where a country produces goods and services according to the natural resources and factors of production with which it is endowed. Barbados specialises in tourism, Grenada 7 · Economies and diseconomies of scale ITQ5 What are the levels of specialisation? specialises in nutmeg production, and Trinidad specialises in oil and energy products. Note that these countries do produce other goods and services, but the majority of their resources are used in producing the specialised good. Economies of scale are the cost advantages that benefit an organisation as it grows. There are internal economies, which are economies that originate from the firm itself. External economies come from the surrounding firms. Diseconomies are the disadvantages that affect an organisation as it grows even larger. Division of labour is the splitting up of tasks in a production process. As organisations grow, there is greater division of labour. There are benefits and disadvantages to the firm in respect of division of labour. Specialisation is a term related to division of labour. It can occur at different levels: people specialise, regions specialise and countries specialise. 1 Commercial banks in the region are able to afford advertising more easily than the smaller credit unions. Large firms such as Coca Cola can advertise more than smaller soft drink firms such as Solo and S.M. Jaleel (manufacturers of Chubby). 2 There could be overutilisation of the oven within a short space of time. Such overutilisation will lead to wear and tear on the machinery. 3 When there are many workers employed and management posts a notice, some workers might not read it. In a large organisation, workers might not ever have face-to-face contact with the top managers. Any complaints that an employee might have must go through his immediate superior and might never reach top management. 4 With no division of labour, labour productivity is 20 pins per worker. When there is division of labour, labour productivity is 4800 pins per worker. 5 People specialise when they choose an occupation. Regions in a country might specialise in the production of a particular good. Countries might specialise, thus creating international specialisation and the need for trade. Examination-style questions Multiple choice questions 1 What is an economy of scale? a a rise in unit cost of production b a fall in short-run average cost of production c the advantages that accrue to a firm as it increases in size d a rise in long-run average cost of production 2 All of the following are types of economies of scale except: a welfare economies b financial economies c technical economies d cost economies 3 What are diseconomies of scale? a a fall in unit cost of production b a fall in short-run average cost of production c the advantages that accrue to a firm as it grows d a rise in long-run average cost of production 55 7 · Economies and diseconomies of scale 4 The following diagram shows the long-run average cost curve for a firm. What is the firm experiencing at point X? average costs long-run average cost curve X 0 a b c d output external economies of scale diseconomies of scale internal economies of scale diminishing returns 5 Which of the following is an external economy of scale? a technical economies b improved infrastructure c overspecialisation d marketing economies 6 What is division of labour? a the splitting up of tasks in the production process b countries specialising in the production of some goods c a region of a country producing one type of good d workers dividing up the working week Structured question 1 56 Myra has a sewing shop. She and her two employees cut and sew women’s clothing all day. They cut fabric and sew dresses, skirts, trousers, jackets and blouses. Each employee cuts and stitches one garment at a time, and then the employee attaches buttons and irons the garment that she has sewn. Myra’s daughter has just learnt about division of labour in her economics class. She suggests to her mother that she tries this technique in her shop. a What is division of labour? [3] b Suggest how Myra could practise division of labour in her shop. [4] c Explain two benefits that Myra and her employees can enjoy as a result of division of labour. [4] d Explain one problem that could result from Myra’s division of labour. [4] Essay question [20] a Explain the different levels of specialisation. b Explain the term ‘division of labour’, giving an example. c Discuss the effects of division of labour. [4] [4] [12] 8 By the end of this chapter you should be able to: Market forces define the term ‘market’; say what ‘market forces’ are; explain the ‘ceteris paribus assumption’; define ‘effective demand’; distinguish between ‘individual (household) demand’ and ‘market demand’; define and illustrate ‘demand schedules’ and ‘demand curves’; illustrate a movement along the demand curve and explain what causes that movement; explain the determinants of demand; illustrate shifts in the demand curve and explain the factors that cause shifts. Concept map Market forces market buyers sellers demand goods and services supply goods and services determinants: • price • income • tastes and fashions • population • seasonal factors • price of other goods • rate of interest • expectations • advertising Market forces market • ITQ1 For each of these markets, say who is (are) the seller(s), who are the buyers and what products are being sold. A market is any mechanism that facilitates the interaction of buyers and sellers with a view to the purchase and sale of a good or a service. A market can be an actual physical location such as a supermarket, a vegetable market, a gas station or even shops at the mall. However, with the development of e-commerce, a market does not have to be a physical location. A buyer on his computer in Jamaica, using his credit card to purchase skincare products from the sellers in the USA, is operating in a market. Trinidadians often speak about the oil 57 8 · Market forces ITQ2 Name two other markets such as this. ITQ3 Who comprises the market for infant disposable diapers? market. Again, this is not an actual place where oil is bought and sold. Rather, the oil market is made up of the buyers and sellers of oil and the product oil. Sometimes, economists speak of ‘the market for a product’. In this context, a ‘market’ refers to all the people who buy that product. The market for ‘Economics for CSEC’ texts will comprise all those students and teachers who wish to buy these books, along with sellers of the book such as retail book stores. The biology teacher is probably not part of the market for an economics text. Figure 8.1 illustrates this example. teachers teachers of other subjects economics teachers economics textbooks economics students sellers Figure 8.1 Market forces demand • The market consists of a potential buyer, a seller and a product or service. In the market, buyers demand a good or service. DEFINITION: Demand is the desire and willingness to buy a product, backed by the ability to pay for the good or service. supply • Sellers supply the good or service to the market. Supply is the provision of a good or service for sale in the market at a particular price at a particular time. DEFINITION: Supply is the provision of a good or service for sale in the market at a particular price at a particular time. market forces • The factors that affect demand are called ‘determinants’ of demand or ‘forces’ of demand. The factors that affect supply are called ‘determinants’ of supply or ‘forces’ of supply. Together, the forces of demand and supply are called market forces. They are factors that cause changing conditions in the market. DEFINITION: Market forces are the conditions of demand and supply that affect demand and supply in the market. ceteris paribus • 58 Ceteris paribus is the Latin phrase meaning ‘other things remaining constant’ – or, ‘if nothing else changes’. Economists use this assumption all the time. Other scientists – such as the physicist or the biologist – have laboratories to conduct experiments and control variables. These scientists can actually hold the temperature or the quantity of a variable used in an experiment constant. However, the economist observes the real world, where conditions are constantly changing. Economists study human behaviour and attempt to make predictions about such behaviour based on observation. Many factors affect human behaviour and it is very difficult to isolate cause and effect as in the natural sciences. Economists cannot hold conditions constant in the real world, unlike scientists in their laboratories. In order to make predictions about consumer behaviour and to establish relationships between variables, economists use the ceteris paribus assumption. When the economist is reasoning, certain factors are assumed to be holding constant. For instance, economists 8 · Market forces effective demand • ITQ4 Name two goods/services that you effectively demand and two goods/services that you desire but you do not effectively demand. individual demand • individual demand schedule • will say, what will happen to the demand for chicken if the price goes down, ceteris paribus? All conditions of demand are assumed to be unchanging. The answer is, demand will increase. However, we know that in the real world, even if the price of chicken were to go down, demand might not increase, as other factors – such as the threat of bird flu – could, in fact, cause demand to fall! Here, we see how the ceteris paribus assumption is a useful tool. When a consumer demands a good, it means that the consumer desires the good and is willing and able to buy the good. Economists call this demand ‘effective demand’. Mrs Harry has a wedding to go to and she needs a new pair of shoes. She has money put aside to buy the shoes. She forms part of the effective demand for shoes, ceteris paribus; that is, provided that she does not spend the money on something else! However, Mr Harry is a teacher and he owns an old-model Toyota car. He greatly desires a BMW; however, he does not have the means to purchase a BMW. Although he wants a BMW, his demand is not effective. His demand is not backed by the ability to pay. Of course, Rihanna or Sean Paul (Caribbean singers who have been successful in the US) may form part of the effective demand for BMWs. Therefore, effective demand is the desire for a good or service, backed by a willingness and ability to pay. Economists differentiate between ‘individual demand’ and ‘market demand’. Individual demand is the demand by one consumer for a good or service. Let us assume that in Hinterland there are only three inhabitants who buy bananas. The three inhabitants are Abe, Betty and Cara. The following is Abe’s individual demand schedule for bananas. The individual demand schedule is a table showing the price of a good and the quantity demanded at each price by an individual consumer. Look at Table 8.1. Table 8.1 Abe’s individual demand schedule Price $ Quantity demanded (Qd) Abe 5 10 4 20 3 39 2 54 1 80 Abe likes bananas because they have appeal. individual demand curve • Note that the ceteris paribus assumption includes the idea that Abe’s appetite for bananas is unchanging! He doesn’t get sick of eating them! From Table 8.1, we can see that at high prices Abe demands fewer bananas, and at low prices he demands more bananas. This reflects general consumer behaviour. As price increases, less of a good is demanded and as price falls, more is bought. There is an inverse relationship between the price of a good and the quantity demanded. This is the First Law of Demand and Supply – the lower the price, the greater will be the quantity demanded, and conversely the higher the price, the smaller will be the quantity demanded. Some economists simply call this the Law of Demand. From this demand schedule, we can construct a demand curve showing Abe’s demand for bananas. The individual demand curve is a graphical representation of the quantities demanded of a good by a consumer at each price. Note that price is on the y-axis and quantity demanded of bananas is on the x-axis. This is seen in Figure 8.2. 59 8 · Market forces Abe’s demand curve price in $ 6 d 4 2 d 0 0 50 100 quantity demanded bananas (kg) Figure 8.2 Abe’s demand curve market demand schedule • The demand curve is downward sloping from left to right. It is labelled dd. This is an individual demand curve. The downward slope of the curve shows that there is an inverse relationship between price and quantity demanded. Abe, Betty and Cara form the market for bananas in Hinterland. Recall our definition of the market at the beginning of the chapter. Tables 8.2 and 8.3 show the individual demand schedules for Betty and Cara. Using this data and the data from Abe’s demand schedule, we can construct the market demand schedule for bananas in Hinterland as seen in Table 8.4. The market demand schedule is the horizontal summation (or sum) of the demand of all buyers in the market at each price. Table 8.2 Betty’s individual demand schedule Table 8.3 Cara’s individual demand schedule Price $ Quantity demanded (Qd) Betty Price $ Quantity demanded (Qd) Cara 5 10 5 10 5 30 4 22 4 18 4 60 3 34 3 27 3 100 2 56 2 40 2 150 1 70 1 70 1 220 Table 8.4 Total demand schedule Price $ Total quantity demanded (Qd) market Figure 8.3 shows the market demand curve as derived from the market demand schedule. Note that the curve is also downward sloping from left to right. It is labelled DD. It is downward sloping because all consumers buy more at lower prices and less at higher prices. Stop and check the data in the demand schedules to verify this. Market demand curve price in $ 6 D 4 2 D 0 0 100 200 quantity demanded bananas (kg) Figure 8.3 Market demand curve 60 300 8 · Market forces The demand curve is labelled DD in Figure 8.4. When the price of a good increases, there is a fall in quantity demanded of the good. The price increase causes a contraction of demand, resulting in a movement along the demand curve from point B to point A. When the price of a good decreases, there is a rise in the quantity demanded of the good. This is called an extension of demand. This also causes a movement along the demand curve. In Figure 8.4, this movement along the demand curve is from point B to point C. Therefore, movements along the demand curve are always due to changes in the price of the good, because the demand curve connects only demand and price. price D A B C D 0 Figure 8.4 The demand curve as an indicator of change quantity demanded Table 8.5 gives a summary of the change in price and its effects on quantity demanded. Table 8.5 Price change and effect Price change Effect Increase movement (upwards) along the demand curve; contraction of demand, or fall in quantity demanded Decrease movement (downwards) along the demand curve; extension of demand, or rise in quantity demanded Determinants of demand ITQ5 Name two products where tastes and fashions have caused demand to rise and two products where tastes and fashions have caused demand to fall. ITQ6 Name three other seasons/times of the year when there is a fall or rise in demand for certain goods/services. At the beginning of the chapter, determinants of demand were mentioned. These are market forces that affect demand. These determinants are also called ‘conditions of demand’ or ‘factors affecting demand’. Here are the determinants of demand: • The price of the good itself. The price of the good is considered to be the first condition of demand. As we have seen above, as price increases, quantity demanded falls; and as price decreases, quantity demanded rises. • Changes in population. Increases in population cause demand to increase. Decreases in population cause demand to decrease. • Changes in income. Increasing income causes demand to rise and decreasing income causes demand to fall. • Tastes and fashions. A change in tastes or fashions in favour of a good will cause demand for that good to increase. When tastes and fashions move away from a product, demand for it will fall. • Seasonal factors. Seasons and times of the year will cause demand to change. In the rainy season, the demand for umbrellas increases. At Christmas time, there is an increase in demand for toys, paint and curtain fabric. • The prices of other goods. • If there is an increase in the price of butter, the demand for margarine will 61 8 · Market forces substitutes • complement • ITQ7 Name two sets of substitutes and two sets of complementary goods. ITQ8 Give an example of a product for which increased advertising caused an increase in demand. rise, even though all conditions in the margarine market remain unchanged. Margarine and butter are considered substitute goods. Products B and M are considered substitutes for each other if as the price of B changes, the quantity demanded of M moves in the same direction; • Also, if there is an increase in the price of ackee, consumers will demand less ackee. They might also demand less saltfish to cook with the ackee. It is exactly the same if we speak about crab and callaloo. These goods are complementary goods. Good A is considered a complement to good B if, as the price of good A changes, the demand for good B moves in the opposite direction. • Advertising. An increase in advertising causes an increase in demand and a decrease in advertising causes a fall in demand, ceteris paribus. • Rates of interest on consumer credit. When interest rates on loans to buy consumer goods are low, demand increases. If interest rates rise, demand decreases. • Expectations of future price changes. If consumers expect that the price of a product will increase in the near future, demand increases in the present. Similarly, if they expect prices to fall soon, consumers might choose not to buy now (demand falls) and wait for the price fall. With the exception of price, changes in a condition of demand, ceteris paribus, cause the demand curve to shift. The demand curve might shift to the right indicating a rise in demand. The demand curve might shift to the left indicating a fall in demand. In Figure 8.5, demand curve D0 shifts to D1. This is a shift to the left and it shows a fall in demand. price P0 D1 0 Figure 8.5 A demand curve shift: fall in demand Q1 D0 Q 0 quantity demanded At price P0, quantity demanded was Q0 and then it fell to Q1, price remaining constant. In Figure 8.6, the demand curve shifts from D0 to D2. This is a shift the right and it shows a rise in demand. price P0 D0 Figure 8.6 A demand curve shift: rise in demand 62 0 Q0 Q2 D2 quantity demanded 8 · Market forces At price P0, quantity demanded was Q0 and then it rose to Q2, price remaining constant. In both cases, price remained constant but demand changed. NOTE: All the determinants of demand, except price, cause shifts in the demand curve. ITQ9 Make a list of all the conditions of demand that will cause the demand curve to shift as in Figure 8.5. ITQ10 Make a list of all the conditions of demand that will cause the demand curve to shift as in Figure 8.6. A discovery that chicken is affected by a deadly virus will cause the demand curve for chicken to shift, as in Figure 8.5. Demand has fallen, other things remaining constant. Prices and all other conditions of demand have remained unchanged. Increasing incomes will cause the demand curve for chicken to shift, as in Figure 8.6. There will be an increase in demand, ceteris paribus. Prices and all other determinants of demand remain unchanged. Table 8.6 gives a summary of the shift in the demand curve and the effect on demand. Table 8.6 Summary of shifts in the demand curve Shift Effect Shift of the demand curve to the right A rise in demand Shift of the demand curve to the left A fall in demand It is important not to confuse a change in quantity demanded with a change in demand. A change in quantity demanded (an extension or a contraction) is due to a change in price. This is shown as a movement along the demand curve. A change in demand is due to change in the conditions of demand. This is reflected by a shift in the demand curve. A market is where buyers and sellers come together to exchange a good or service. Market forces are the determinants of demand and supply. These factors cause conditions in the market to change. Ceteris paribus – or, ‘other things remaining constant’ – is an assumption used by economists when they wish to hold factors constant in theory. In the real world, it is usually difficult to hold these factors constant. Effective demand is the desire for a good or service backed by a willingness and ability to pay. Generally, when consumers want goods they do not form part of the effective demand. ‘Individual demand’ is the demand for a good or service by an individual consumer. For this individual, it is possible to construct an individual demand schedule and an individual demand curve. ‘Market demand’ is the demand for a good or service by all consumers in the market. It is possible to construct a market demand schedule and a market demand curve. Determinants of demand are factors affecting demand. Price of the good, incomes, population, fashions and tastes, seasonal factors, price of other goods, advertising, rates of interest and expectations are all determinants of demand. Changes in price cause a movement along the demand curve. This causes increases (extensions) or decreases (contractions) in quantity demanded. A demand curve might shift to the left (a decrease in demand) or to the right (an increase in demand). Determinants in demand other than the price of the good will cause a shift in demand. 63 8 · Market forces 1 Buyer Seller Good/service Consumers Grocer Rice, flour, sugar, and so on Consumers Vendors Pumpkin, fruits, chives, and so on Vehicle drivers Service attendant Petrol Mall ladies Boutique owner Dresses, skirts, and so on Consumers Hair salon owner Perm, haircut, and so on You may give other examples. 2 The markets for gold, tin, methanol and rubber are similar markets. These are international markets and are also called ‘commodity markets’. 3 All the parents of infants who use disposable diapers or anyone who buys the diapers for the infant. 4 You might effectively demand snacks, soda or lunches in the school cafeteria. You might desire a car, a diamond necklace or a stereo music system but such demand might not be backed by an ability to pay. 5 Tastes and fashions have caused the demand for laptop computers and cell phones to increase. Girls will tell you how the demand for sequinned blouses, skirts and jeans is also increasing because of tastes and fashions. The demand for recording cassettes is falling as tastes and fashions move away from these goods towards CDs. 6 Easter – increased demand for Easter eggs, bonnets, and baskets; July– August vacation – increased demand for bathing suits, beach clothes and sandals (school books too!); Carnival (crop-over) – hats, jeans, beads and feathers for costumes. 7 Two sets of substitutes are, for some people, coffee/tea and hotdogs/ burgers. Sets of complements are toothbrush and toothpaste, hotdogs and hotdog bread, and cars and petrol. 8 Advertising makes the consumer aware about the product. It informs and entices the consumer. Advertisements for Blackberry cell phones have caused demand to increase. 9 This is a fall in demand – incomes fall, population falls, there are expectations of a price fall, rates of interest rise, fall in price of substitute and rise in price of complement are possible reasons for such a shift. 10 There is a rise in demand – incomes rise, population rises, there are expectations of a price rise, rates of interest fall, rise in price of a substitute, fall in price of a complement, and advertising rises. Examination-style questions 64 Multiple choice questions 1 The demand curve shows that: a As price decreases, demand increases. b Price changes are always in the same direction as demand changes. c As price increases, quantity demanded increases. d As price decreases, quantity demanded increases. 2 Which of the following will not shift an individual consumer’s demand curve for butter? a the price of butter b the price of margarine c the consumer’s income d the consumer’s tastes 8 · Market forces 3 According to economic theory, a change in demand of any good is not caused by: a changes in consumers’ preferences for that good b changes in the general income levels of the consumers who buy that good c an increase or decrease in the population d changes in the price of that good 4 A rise in consumers’ incomes will cause: a a movement along the demand curve b an increase in quantity demanded c the demand curve to shift to the right d the demand curve to shift to the left 5 A demand curve is normally drawn with: a price on the vertical axis and population on the horizontal axis b price on the vertical axis and quantity demanded on the horizontal axis c quantity demanded on the vertical axis and income on the horizontal axis d quantity demanded on the vertical axis and price on the horizontal axis 6 All of the following are conditions of demand except: a productivity b population c income d tastes and fashions Structured questions 1 2 a Define the following terms: i demand; ii supply. b Explain the difference between a change in demand and a change in quantity demanded. c With the aid of a diagram, explain the effects of an increase in the price of bananas on the quantity demanded of bananas. d State the Law of Demand. [4] [4] [4] [3] a Identify two determinants of the demand for laptop computers. [2] b Explain each determinant of demand stated. [4] c Using one of the determinants of demand for laptop computers given in part a above, explain how this determinant can cause [6] an increase in demand. d With the aid of a diagram, explain the effect of a fall in price on [3] quantity demanded. Essay question [20] a Explain ‘effective demand’, using an example. [4] b Explain two factors that will cause the demand curve to shift to the left. [8] c Explain two other factors that will cause the demand curve to shift to the right. [8] 65 9 By the end of this chapter you should be able to: The theory of supply define ‘supply’; distinguish between ‘firm’ and the ‘industry’ supply; define and construct a supply schedule and a supply curve; explain and illustrate movements along the supply curve; explain the determinants of supply; explain and illustrate shifts in the supply curve. Concept map Theory of supply market buyers sellers demand goods and services supply goods and services determinants: • price • price of factors of production • improvements in technology • taxes and subsidies • number of sellers • price of other goods Firm and industry supply supply • firm • firm’s supply schedule • ITQ1 firm’s supply curve • Name any two firms that supply seasonings in the Caribbean. ITQ2 Name two other firms in the Caribbean and a product that each supplies. 66 In Chapter 8, we defined supply as the amount of goods or services a seller is willing and able to make available for sale at each price during a given period. A firm is an entity through which factors of production are combined to produce goods and services for supply to the market. A firm’s supply schedule is a table showing the quantity of the good (or service) that the firm is willing to supply at various prices. From the supply schedule of the firm, we can construct a firm’s supply curve. Just as for the demand curve, we can represent the data in the schedule on a graph. The supply curve is a graphic presentation of the quantity supplied at each price. Table 9.1 shows the supply schedule for bananas in Firm 1 in Hinterland. More bananas are supplied at a higher price and fewer bananas are supplied at a lower price. All rational producers supply more of their good when the price increases in order to capitalise on potential profits. There is, therefore, a ‘direct’ or ‘positive’ relationship between price and quantity supplied. 9 · The theory of supply Table 9.1 Supply schedule Price $ Quantity supplied (kg) Firm 1 From the data in the supply schedule, we can plot a supply curve as shown in Figure 9.1. Quantity supplied is placed on the x-axis and price on the y-axis. The curve is labelled ss (supply curves for a single firm are normally labelled in lower case letters). Note that the supply curve is upward sloping from left to right. This reflects the positive or direct relationship between price and quantity supplied. 5 120 4 95 3 55 2 30 6 1 18 5 price in $ Supply curve, Firm 1 s 4 3 2 1 s 0 0 50 100 150 quantity supplied bananas (kg) Figure 9.1 Supply curve industry • firm’s supply • industry’s supply • industry’s supply schedule • industry supply curve • Table 9.2 Supply schedule comparison Price $ Quantity supplied (kg) Firm 1 Quantity supplied (kg) Firm 2 5 120 80 4 95 65 3 55 45 2 30 40 1 18 17 An industry is made up of a number of firms. A single firm’s supply is simply the quantity that a particular firm is willing to make available for sale at each price for a given period. An industry’s supply is the sum total of the output of all firms in the industry that they are willing to make available for sale at each price per period. Let us now construct an industry supply schedule and an industry supply curve. Let us assume that there are two firms in the banana industry in Hinterland – Firm 1 and Firm 2. Table 9.2 shows the supply of bananas of both firms at each price. To derive the industry supply schedule, we can simply add the quantities supplied by Firm 1 and Firm 2 at each price. Table 9.3 shows the industry’s supply schedule for bananas in Hinterland. The industry’s supply schedule shows the quantity supplied by all the firms in the industry at each price. From this, we can construct the industry supply curve for bananas. This is shown in Figure 9.2. The curve is labelled SS (capital letters for industry curves). The industry supply curve is a graphic representation of the various quantities supplied by all the firms in the industry at each price. It is upward sloping from left to right, showing a direct relationship between price and quantity supplied. As price decreases, quantity supplied decreases. As price increases, quantity supplied increases. This relationship is called the Second Law of Demand and Supply. It can be seen from the supply schedule or the supply curve. Some economists simply call this the Law of Supply. Industry supply curve 6 S Table 9.3 Supply schedule for bananas in Hinterland Price $ Total quantity supplied (kg) in industry 5 200 4 160 3 100 2 70 1 35 price in $ 5 4 3 2 1 S 0 0 50 100 150 200 250 quantity supplied bananas (kg) Figure 9.2 Industry supply curve for bananas 67 9 · The theory of supply Determinants of supply Movements along the supply curve ITQ3 What kind of relationship is there between price and quantity supplied? When the price of a good increases, there is a rise in quantity supplied of the good. It causes an extension of supply. This causes a movement along the supply curve. This can be seen in Figure 9.3 as a movement along the supply curve from point B to point C. When the price of a good decreases, there is a fall in the quantity supplied of the good. This is also called a contraction of supply. This also causes a movement along the supply curve. In Figure 9.3, there is a movement along the supply curve from point B to point A. Therefore, movements along the supply curve are always due to changes in the price of the good because the supply curve relates only to supply and price. (Recall that a change in price also causes a movement along the demand curve.) price S C B A S 0 Figure 9.3 Movements along the supply curve quantity supplied Table 9.4 gives a summary of the change in price and its effects on quantity supplied. Table 9.4 Summary of a change in price and its effects income per unit profit per unit production cost per unit 0 Figure 9.4 The price of factors of production ITQ4 What factor(s) change(s) and what remain constant when there is a shift along the supply curve? 68 Price change Effect Increase Movement (upwards) along the supply curve; extension of supply or rise in quantity supplied Decrease Movement (downwards) along the supply curve; contraction of supply or fall in quantity supplied Determinants The determinants of supply are the factors that affect supply. They determine supply conditions in the market. • The price of the good itself. Price affects supply. As price increases, ceteris paribus, quantity supplied increases. The greater the price, the higher the quantity the producer will wish to supply, ceteris paribus (to capitalise on potential profits). The lower the price, the lesser the quantity the producer will wish to supply, ceteris paribus (to retain resources for more profitable use later on). Note that changes in the price of the good cause a movement along the supply curve. Changes in any other determinant of supply cause a shift in the supply curve. • The price of factors of production. Higher factor prices raise production costs. This causes profits to decline. Firms move out of these less profitable business activities and so supply falls. In contrast, lower factor prices reduce production costs and increase profits. This is an incentive for firms to increase supply. Figure 9.4 shows how increased prices of factors of production cause total cost to increase. 9 · The theory of supply • Technology. Improvements in technology make it possible for firms to produce more goods using fewer resources (and so lowering costs). This increases supply. • Taxes and subsidies. Businesses treat most taxes as costs. The imposition of a tax has a similar effect to an increase in costs. Taxes, therefore, lead to a fall in supply. Subsidies reduce costs and so lead to an increase in supply. • Number of sellers. Other things being equal, the larger the number of suppliers, the greater the industry’s supply. As firms leave the industry, the total industry supply will fall, ceteris paribus. • Prices of other goods. As prices of other goods increase, these suppliers earn more profits, ceteris paribus. This will induce firms involved in activities that not as profitable to switch production to the more profitable goods. Production and supply of the less profitable goods will fall. • Weather. For agricultural commodities, a decrease in supply can be caused by drought or unseasonal weather which adversely affects crop yields. Good weather can cause a bumper harvest and an increase in supply. Shifts in the supply curve ITQ5 Why do some economists call an upward shift of the supply curve a shift to the left? Just as with demand curves, supply curves can also shift. In Figure 9.5, the supply curve S0 shifts to S1. This is an upward shift (some economists say ‘a shift to the left’) and it shows a fall in supply. At price P0, quantity supplied was Q0 and then it fell to Q1, price remaining constant. price S1 S0 P0 0 Q1 Q0 quantity supplied Figure 9.5 Shifts in the supply curve: fall in supply In Figure 9.6, the supply curve shifts from S0 to S2. This is a downward shift (a shift to the right) and it shows a rise in supply. At price P0, quantity supplied was Q0 and then it rose to Q2, price remaining constant. price S0 S2 P0 0 Q0 Q2 quantity supplied Figure 9.6 Shifts in the supply curve: rise in supply 69 9 · The theory of supply ITQ6 Make a list of all the conditions of supply that will cause the supply curve to shift as in Figure 9.5. ITQ7 Make a list of all the conditions of supply that will cause the supply curve to shift as in Figure 9.6. In both cases, price remained constant but supply changed. All the determinants of supply, except price of the good itself, cause shifts in the supply curve. A change in price causes a movement along the supply curve. This is the same as for demand curves. Movements along the demand curve are due to price changes. The other determinants of demand cause shifts in the demand curve. As there are constant developments in the computer industry, storage media such as flash drives have become more popular. Flash drives are less prone to disk corruption and store much more information than floppy diskettes. The market for floppy diskettes has contracted. Suppliers have switched to the production of the more profitable product, flash drives, and have moved resources out of the production of floppy diskettes. This causes the supply curve for floppy diskettes to shift as in Figure 9.5. There is a fall in supply, ceteris paribus. Prices and all other determinants of supply remain unchanged. Consumers all over the world have witnessed the increased supply of personal computers and other digital devices. This increase is due to improvements in technology as well as lower prices of factor inputs (microchips). So, improvements in technology, along with lower factor prices, cause a shift to the right (downward) of the supply curve and an increase in supply as seen in Figure 9.6. Prices and all other conditions of supply have remained unchanged. The development of new technology means that the supply of older products is reduced. Change in quantity supplied and a change in supply ITQ8 What happens to supply when there is an increase in price? Recall also that, in Chapter 8, we differentiated between a change in quantity demanded and a change in demand. This distinction also applies to supply. It is important not to confuse a change in quantity supplied with a change in supply. A change in quantity supplied (an extension or a contraction) is due to a change in price. This is shown as a movement along the supply curve. A change in supply is due to change in the conditions of supply, other than price. This is reflected by a shift in the supply curve. Supply is the amount of a product that the firm/industry is willing and able to make available for sale at each of a set of possible prices in a given period. The firm’s supply is the amount of a product that an individual firm is willing and able to make available for sale at each price per period. The industry’s supply is the amount of a product that all firms in the industry are willing and able to make available for sale at each price per given period. A supply schedule is a table showing the quantity supplied at each possible price. The supply curve is a graphic representation of this data. The supply 70 9 · The theory of supply curve is upward sloping from left to right, showing a direct or positive relationship between price and quantity supplied. It is possible to have supply schedules and supply curves for the individual firm and for the entire industry. Changes in price cause a movement along the supply curve. This causes increases (extensions) or decreases (contractions) in quantity supplied. Determinants of supply are the factors affecting supply. Price of the good, prices of factor inputs, technology, taxes and subsidies, number of sellers and prices of other goods are all determinants of supply. A supply curve might shift upwards (decrease in supply) or downwards (increase in supply). Determinants in supply – other than changes in the price of the good – will cause a shift in supply. A change in quantity supplied refers to contractions and extensions in supply when there are price movements. A change in supply is the result of changes in the other determinants of supply. 1 Two examples are Grace Kennedy & Company Ltd (Jamaica) and Nestlé Ltd (Trinidad and Tobago, and Jamaica), which provides Maggi seasonings. 2 You can name any firms in the region and your teacher can verify the answers. Some choices are Neal & Massy – cars; Sagicor – insurance services; Carib Breweries – Carib beer; Hi Lo Food Stores – foods (for example, jam, bread, tea and flour); Courts – furniture and appliances; RBTT – banking services. 3 This is a positive or direct relationship. It is indicated by a positively sloped curve. 4 Price changes cause a movement along the supply curve. Determinants of supply remain constant, hence the phrase ceteris paribus. 5 This is simply because all points on the new supply curve are to the left of the original supply curve. 6 This is a fall in supply. A rise in the price of factors of production, a rise in taxes, fall in subsidies, a fall in the number of sellers and a rise in the price of other goods will cause a fall in supply. 7 This is a rise in supply. A fall in the price of factors of production, improvements in technology, a fall in taxes, rise in subsidies, a rise in the number of sellers and a fall in the price of other goods will cause a rise in supply. 8 There is an extension of supply or an increase in quantity supplied. Examination-style questions Multiple choice questions 1 The supply curve shows: a the amount that sellers are willing and able to offer b the amount that sellers are willing and able to offer for sale at all possible prices c a list of price and quantity supplied combinations d the amount consumers will buy from what is supplied 2 A decrease in supply, ceteris paribus, will: a raise both the equilibrium price and the equilibrium quantity b reduce both the equilibrium price and the equilibrium quantity c raise the equilibrium price and reduce the equilibrium quantity d reduce the equilibrium price and raise the equilibrium quantity 71 9 · The theory of supply 3 Which of the following is not a determinant of the supply for a product? a consumers’ incomes b the price of the product c the prices of inputs to the product d the state of technology 4 A fall in the price of steel will cause the supply curve for motor vehicles to: a become steeper b intersect with the demand curve c shift to the right d shift to the left 5 Which of the following causes a contraction of supply? a a change in price b consumers’ incomes c improvements in technology d increase in labour productivity 6 A shift to the right of the supply curve shows: a an increase in quantity supplied b an extension of supply c a contraction of supply d an increase in supply Structured questions 1 a Identify three determinants of supply for laptop computers. [3] b Using one of the determinants of supply of laptop computers given in part a above, explain how this determinant can cause an increase in supply. [6] c Using one of the determinants of supply for laptop computers given in part a above, explain how this determinant can cause a fall in supply. [6] 2 a Define supply. b i State the Law of Supply. ii Illustrate this law with the aid of a diagram. c Explain three factors affecting supply. Essay question [2] [2] [5] [6] [20] a Explain the difference between a change in quantity supplied and a change in supply. [4] b Draw a diagram showing an increase in supply, and explain two factors that could cause this. [8] c Draw a diagram showing a decrease in supply, and explain two factors not used in part b that could cause this. [8] 72 10 By the end of this chapter you should be able to: Equilibrium in the market define the term ‘equilibrium’; illustrate equilibrium in a particular market; illustrate the changes in demand and supply conditions, and the effects on equilibrium. Concept map Equilibrium in the market demand EQUALS supply equilibrium shifts in supply shifts in demand change in equilibrium price and quantity Demand and supply in the market equilibrium • We can now bring together demand and supply in the market. Buying decisions of households and selling decisions of firms interact to determine price in the market. The term equilibrium means ‘state of balance’ or ‘state of rest’. It is where opposing forces are equal and so there is no tendency to change. In the market, equilibrium occurs at the intersection of the demand and supply curves. It is where demand is equal to supply, as illustrated in Figure 10.1. demand supply Figure 10.1 Equilibrium – a state of balance Using the data from Chapters 8 and 9, we will now determine equilibrium in the banana market in Hinterland. Table 10.1 shows the market demand for bananas in Hinterland and Figure 10.2 shows the market demand curve derived from the data in the table. 73 10 · Equilibrium in the market Table 10.1 Market demand for bananas in Hinterland Total quantity demanded (Qd) Market 5 30 6 D 5 4 price in $ Price $ Market demand curve 3 4 60 3 100 1 2 150 0 1 220 2 D 0 50 100 150 200 250 quantity demanded bananas (kg) Figure 10.2 Market demand curve for bananas in Hinterland Table 10.2 shows the industry supply schedule for bananas in Hinterland and Figure 10.3 shows the supply curve plotted from this data. Table 10.2 Industry supply schedule for bananas in Hinterland Industry supply curve Total quantity supplied (kg) in industry 6 S 5 price in $ Price $ 4 5 200 4 160 3 100 1 2 70 0 1 35 3 2 S 0 50 100 150 200 250 quantity supplied bananas (kg) Figure 10.3 Industry supply curve for bananas in Hinterland Let us now combine the data in both schedules, as seen in Table 10.3. This table shows the various prices of bananas, the total quantity demanded by the market, the total quantity supplied by all the firms in the industry at each price in Hinterland. From the data in Table 10.3, we can now plot the market demand and industry supply curves together in one diagram. In Figure 10.4, the curves are plotted on the same axes. Table 10.3 Industry position for bananas in Hinterland Quantity supplied (Qs) in Industry Quantity demanded (Qd) in market 5 200 30 4 160 60 3 100 100 2 70 150 1 35 220 D 5 price in $ Price $ Market demand and industry supply curves 6 S 4 Pe $3 2 1 D S 0 0 50 Qe 100 150 200 quantity demanded and supplied bananas (kg) Figure 10.4 Market demand and industry supply curves 74 250 10 · Equilibrium in the market The intersection of DD and SS shows equilibrium, indicated by the point e. The corresponding price at e is the equilibrium price (Pe) and the corresponding quantity is the equilibrium quantity (Qe), or the amount traded. The equilibrium price is $3 and, at this price, the quantity 100 kg of bananas is traded. It is also called the market-clearing price. At that price, all that is produced for sale is sold. There is no surplus and no unsatisfied demand or shortage. In the example, 100 kg of bananas are produced and bought up at a price of $3. ITQ1 Shortages and surpluses From Table 10.3, what is the surplus at price $5? At prices above the equilibrium price, quantity supplied exceeds quantity demanded. A surplus is said to occur. A surplus occurs when there is excess supply at the prevailing price. At a price of $4, there is a surplus of 100 kg of bananas. At prices below the equilibrium price, quantity demanded exceeds quantity supplied. A shortage is said to occur. A shortage occurs when there is excess demand in the market at the prevailing price. At a price of $2, there is a shortage of 80 kg bananas. surplus • shortage • ITQ2 From Table 10.3, what is the shortage at price $1? Shifts in demand and supply In Chapters 8 and 9, you learnt about determinants of demand and supply. You learnt that changes in the determinants of demand other than price cause the demand curve to shift, ceteris paribus. Changes in the determinants of supply other than price cause the supply curve to shift, ceteris paribus. We will now examine the effects of such shifts on the equilibrium quantity and equilibrium price in the market. Figure 10.5 shows demand (D) and supply (S) curves in the market. Initially, equilibrium quantity is at Qe and equilibrium price is at Pe. There is a rise in demand. The demand curve shifts to the right from D0 to D1. Equilibrium price increases to P1 and equilibrium quantity increases to Q1. ITQ3 Name one factor that can cause an increase in demand. price price S S P1 P2 e Pe D0 0 e Pe Qe D1 D2 Q1 quantity demanded and supplied Figure 10.5 Demand (D) and supply (S) curves in the market: a rise in demand ITQ4 Name one factor that can cause a decrease in demand. 0 Q2 Qe D0 quantity demanded and supplied Figure 10.6 Demand (D) and supply (S) curves in the market: a fall in demand Figure 10.6 shows demand (D) and supply (S) curves in the market. Initially, equilibrium quantity is at Qe and equilibrium price is at Pe. There is a fall in demand. The demand curve shifts to the left from D0 to D2. Equilibrium price decreases to P2 and equilibrium quantity decreases to Q2. The Third Law of Demand and Supply states that: i An increase in demand, ceteris paribus, will tend to increase both equilibrium price and the equilibrium quantity traded; and 75 10 · Equilibrium in the market ITQ5 Name one factor that can cause a rise in supply. ii A decrease in demand, ceteris paribus, will tend to decrease both equilibrium price and the equilibrium quantity traded. Figure 10.7 shows demand (D) and supply (S) curves in the market. Initially, equilibrium quantity is at Qe and equilibrium price is at Pe. There is a rise in supply. The supply curve shifts downwards (to the right) from S0 to S1. Equilibrium price decreases to P1 and equilibrium quantity increases to Q1. price price S0 Pe e S2 S1 P2 e Pe P1 D D 0 Qe Q1 S0 0 quantity demanded and supplied Figure 10.7 Demand (D) and supply (S) curves in the market: a rise in supply ITQ6 Name one factor that can cause a fall in supply. Q2 Qe quantity demanded and supplied Figure 10.8 Demand (D) and supply (S) curves in the market: a fall in supply Figure 10.8 shows demand (D) and supply (S) curves in the market. Initially, equilibrium quantity is at Qe and equilibrium price is at Pe. There is a fall in supply. The supply curve shifts upwards (to the left) from S0 to S2. Equilibrium price increases to P2 and equilibrium quantity decreases to Q2. The Fourth Law of Demand and Supply states that: i An increase in supply, ceteris paribus, will tend to lower equilibrium price and increase the equilibrium quantity traded; and ii A decrease in supply, ceteris paribus, will tend to increase equilibrium price and lower the equilibrium quantity traded. Table 10.4 summarises the effect on equilibrium price and quantity of a shift in demand or supply, ceteris paribus. From Table 10.4 we can draw two conclusions: 1 a change in demand causes equilibrium price and equilibrium quantity to move in the same direction as that change in demand; 2 a change in supply, ceteris paribus, causes equilibrium quantity to move in the same direction as the change in supply, and equilibrium price to move in the opposite direction. Table 10.4 The effect on equilibrium price and quantity of a shift in demand or supply Shift of curve Effect on equilibrium price Effect on equilibrium quantity Law of Demand and Supply Increase in demand (shift to the right in the demand curve) Increase in equilibrium price Increase in equilibrium quantity Third Law of Demand and Supply Decrease in demand (shift to the left in the demand curve) Decrease in equilibrium price Decrease in equilibrium quantity Third Law of Demand and Supply Increase in supply (downward shift of the supply curve) Decrease in equilibrium price Increase in equilibrium quantity Fourth Law of Demand and Supply Decrease in supply (upward shift of the supply curve) Increase in equilibrium price Decrease in equilibrium quantity Fourth Law of Demand and Supply 76 10 · Equilibrium in the market Equilibrium is a state of rest. It is where opposing forces are in balance. Equilibrium in the market occurs where demand and supply are equal. The market is cleared. This means that all the goods produced for sale have been bought up by buyers. Graphically, equilibrium occurs where the demand curve intersects with the supply curve. That point is equilibrium. The corresponding price is the equilibrium price and the corresponding quantity is the equilibrium quantity. When demand increases, ceteris paribus, this causes a shift to the right of the demand curve. This causes an increase in equilibrium price and quantity traded. When demand decreases, ceteris paribus, this causes a shift to the left of the demand curve. This causes a decrease in equilibrium price and quantity traded. This is the Third Law of Demand and Supply. When supply increases, ceteris paribus, this causes a shift to the right (downward) of the supply curve. This causes a decrease in equilibrium price and an increase in equilibrium quantity. When supply decreases, ceteris paribus, this causes a shift to the left (upwards) of the supply curve. This causes an increase in equilibrium price and a decrease in equilibrium quantity. This is the Fourth Law of Demand and Supply. A change in demand causes equilibrium price and equilibrium quantity to move in the same direction as that change in demand. A change in supply, ceteris paribus, causes equilibrium quantity to move in the same direction as the change in supply, and equilibrium price to move in the opposite direction. 1 The surplus at price $5 is 170 kg. 2 The shortage at price $1 is 185 kg. 3 Factors that can cause an increase in demand: incomes rise, population rises, there are expectations of a price rise, rates of interest fall, a rise in price of a substitute, fall in price of a complement and a rise in advertising. 4 Factors that can cause a decrease in demand: incomes fall, population falls, there are expectations of a price fall, rates of interest rise, a fall in price of substitute and a rise in price of a complement. 5 Any of the following can cause a rise in supply: a fall in the price of factors of production, improve­ments in technology, a fall in taxes, rise in subsidies, a rise in the number of sellers and a fall in the price of other goods. 6 Any of the following can cause a fall in supply: a rise in the price of factors of production, a rise in taxes, fall in subsidies, a fall in the number of sellers and a rise in the price of other goods. Examination-style questions Multiple choice questions 1 What is meant by market equilibrium? a Market demand and industry supply are equal at a given price. b Demand is less than supply at a given price. c Demand is greater than supply at a given price. d The forces of demand and supply are not in balance. 2 What is the effect on equilibrium price of an increase in supply of a commodity, ceteris paribus? a price rises b price falls c price remains constant d cannot be determined 77 10 · Equilibrium in the market 3 What is the effect on equilibrium price of an increase in demand for a commodity, ceteris paribus? a price rises b price falls c price remains constant d cannot be determined 4 What is the effect on equilibrium quantity of a decrease in supply of a commodity, ceteris paribus? a equilibrium quantity remains constant b equilibrium quantity rises c equilibrium quantity falls d cannot be determined 5 What is the effect on equilibrium quantity of a decrease in demand for a commodity, ceteris paribus? a equilibrium quantity remains constant b equilibrium quantity rises c equilibrium quantity falls d cannot be determined 6 What is a surplus in the market? a excess demand in the market b supply equalling demand c demand being greater than supply d excess supply in the market Structured question 1 a What is equilibrium? b Draw a diagram to show equilibrium in the market for ice cream. c Explain the effect on equilibrium, price and quantity of a fall in supply, ceteris paribus. d Explain the effect on equilibrium price and quantity of a fall in demand, ceteris paribus. Essay question a Suppose that there is an increase in consumers’ income in your economy, ceteris paribus. Using diagrams, explain what will happen in the market for orange juice. b Suppose there were improvements in technology, ceteris paribus, which is used in the production of cell phones. Using diagrams, explain what will happen in this market. 78 [1] [4] [4] [5] [20] [10] [10] 11 Elasticity By the end of this chapter you should be able to: Concept map define and explain ‘price elasticity of demand’; calculate price elasticity of demand; illustrate, by graphs, the degrees of elasticity of demand; explain the factors affecting price elasticity of demand; explain ‘income elasticity of demand’; explain ‘cross elasticity of demand’; explain ‘price elasticity of supply’; calculate income elasticity of demand, cross elasticity of demand and price elasticity of supply; illustrate, by graphs, the degrees of elasticity of supply. Elasticity elasticity measures the responsiveness of price elasticity of demand quantity demanded to a change in price income elasticity of demand quantity demanded to a change in income cross elasticity of demand quantity demanded to a change in price of another good price elasticity of supply quantity supplied to a change in price Elasticity ITQ1 Define, according to economists, the term ‘demand’. ITQ2 Explain the meaning of the term ceteris paribus. price elasticity of demand • In Chapter 8, we defined the term ‘demand’ as the desire and willingness to buy a product, backed by the ability to pay for the good or service. We also established a relationship between price and quantity demanded. There is an inverse, or negative, relationship between price and quantity demanded. When price increases, ceteris paribus, quantity demanded decreases. When price decreases, ceteris paribus, quantity demanded increases. Let us analyse the relationship between price and quantity demanded further. When price rises, quantity demanded falls. In this chapter, we will look at by how much quantity demanded falls. When price falls, quantity demanded rises. In this chapter, we will look at by how much quantity demanded rises. This is what elasticity measures. Here is a formal definition of elasticity of demand. Price elasticity of demand (PED) measures the responsiveness of quantity demanded to a change in the price of the good. For example, if the price of butter falls, the quantity demanded will rise. What elasticity of demand 79 11 · Elasticity formula for price elasticity of demand • attempts to predict is the amount by which the quantity demanded will rise. How responsive is quantity demanded to this fall in price? Will quantity demanded be very responsive or not responsive at all? The formula for price elasticity of demand is: Percentage change in quantity demanded (Qd) Percentage change in price Let us continue with the butter example. Say that, when the price of a 500 g tub of butter is $10, the quantity demanded is 8 tubs. Then, if price increases to $12, the quantity demanded falls to 6 tubs. The information is summarised in Table 11.1. Table 11.1 Elasticity when price rises Price per 500 g butter ITQ3 Quantity demanded Original price and quantity $10 8 tubs New price and quantity $12 6 tubs The change in quantity demanded is: What is the change in quantity demanded of butter? New quantity demanded – original quantity demanded The percentage change in quantity demanded is: Change in Qd × 100 Original Qd ITQ4 What is the change in the price of butter? PED • Using the example in Table 11.1, the change in quantity demanded is –2 (6 tubs – 8 tubs). Note here that the minus sign before the 2 indicates that there is a fall in quantity of butter demanded by 2 tubs. The percentage change in quantity demanded is –25 per cent ( –2 8 × 100). Again, the minus before the percentage change in quantity demanded indicates that quantity demanded has fallen. Now we can work out the percentage change in price. The change in price is: New price – Original price The percentage change in price is: Change in price × 100 Original price Continuing with the example in Table 11.1, the change in price is $2 ($12 $2 × 100). Do not omit – $10). The percentage change in price is +20 per cent ( $10 the positive sign, as it shows clearly that the price of the good has increased. Inserting this data into the elasticity formula, we can work out the price elasticity of demand for butter. PED stands for price elasticity of demand. Percentage change in Qd –25% = = –1.25 PED = Percentage change in price +20% This figure (–1.25) is called the ‘elasticity of demand coefficient’. Table 11.2 summarises what we have done so far: Table 11.2 Calculation of elasticity of demand (price rising) Original Qd New Qd Change in Qd % 8 tubs 6 tubs –25% Original price New price Change in price % $10 $12 + 20% 80 PED = Change in Qd % Change in price % –25% = –1.25 +20% 11 · Elasticity Now let us look at what happens when the price of a good falls. We will use the same example of butter. Look at the data in Table 11.3. Table 11.3 Elasticity when price falls ITQ5 Price per 500 g butter What is the percentage change in price? Qd Original price and quantity $10 8 tubs ITQ6 New price and quantity $9 12 tubs What is the percentage change in quantity demanded? Now the price of butter has fallen from $10 to $9 and the quantity demanded has risen by 4 tubs. Table 11.4 Calculation of elasticity of demand (price falling) Original Qd New Qd Change in Qd % 8 tubs 12 tubs +50% PED = Change in Qd % Change in price % +50% = –5 –10% Original price New price Change in price % $10 $9 –10% Look at Table 11.4. The percentage change in the quantity demanded of butter is +50%: New quantity 12 – Old quantity 8 = change of +4 (increase) Change of +4/Old quantity 8 × 100 = +50% percentage change The percentage change in the price of butter is –10%: New price $9 – Old price $10 = change of –$1(decrease) Change of –$1/ Old price $10 × 100 = –10% percentage change We can now work out the elasticity of demand: PED = price elasticity of demand coefficient • ITQ7 Will the elasticity coefficient be negative or positive if as price rises, quantity demanded rises also? Percentage change in Qd +50% = = –5 Percentage change in price –10% In both examples, the elasticity coefficient is negative. In the first example, prices rose and quantity demanded fell. This made the percentage change in quantity demanded negative. This, in turn, caused the elasticity coefficient to be negative. In the second example, price fell. This made the percentage change in price negative even though the percentage change in quantity demanded was positive (representing an increase). The fall in price led to a negative elasticity coefficient. We can therefore conclude that the price elasticity of demand coefficient will always be negative once there is a negative or inverse relationship between price and quantity demanded. Every time price falls, the percentage change in price will be negative, leading to a negative elasticity coefficient. The percentage change in quantity demanded will be positive. Every time price rises, quantity demanded will fall and the percentage change in quantity demanded will be negative, leading to a negative elasticity coefficient. Degrees of elasticity degree of elasticity • elastic • inelastic • Economists also speak of degrees of elasticity. The degree of elasticity describes how responsive quantity demanded is to changes in price. It is the range of possible elasticity of demand coefficients for a good or service. If quantity demanded is very responsive to a change in price, quantity demanded is elastic. If quantity demanded is very unresponsive to changes in price, quantity demanded is inelastic. Table 11.5 shows the degrees of elasticity and their meaning. 81 11 · Elasticity Table 11.5 Degrees of elasticity Degrees of elasticity of demand Meaning Elasticity of demand coefficient Perfectly inelastic The percentage change in quantity demanded is zero. Quantity demanded does not respond to a change in price. PED = 0 Fairly inelastic The percentage change in quantity demanded is less than the percentage change in price. 0 < PED < 1 Unitary elasticity The percentage change in quantity demanded is equal to the percentage change in price. PED = 1 Fairly elastic The percentage change in quantity demanded is greater than the percentage change in price. 1 < PED < infinity Perfectly elastic Quantity demanded changes when there is no change in price. PED = infinity Figure 11.1 represents perfectly inelastic demand. Price increases from P to P1 (or decreases from P1 to P) and quantity demanded remains the same, at Q. Quantity demanded is therefore totally unresponsive to changes in price. PED is equal to zero. price price D D P1 P1 P P 0 Q quantity demanded Figure 11.1 Perfectly inelastic demand 0 Q1 Q quantity demanded Figure 11.2 Fairly inelastic demand Figure 11.2 represents fairly inelastic demand. Price increases from P to P1 (or decreases from P1 to P) and quantity demanded decreases (increases) by a less than proportionate amount. Quantity demanded is therefore not very responsive to changes in price. Figure 11.3 represents unitary elasticity. Price increases from P to P1 (or decreases from P1 to P) and quantity demanded decreases (increases) by the same proportion. Quantity demanded therefore responds to price by the same proportion as the change in price. Figure 11.4 represents fairly elastic demand. Price increases from P to P1 (or decreases from P1 to P) and quantity demanded decreases (increases) by a more than proportionate amount. Quantity demanded is therefore fairly, or even very responsive to changes in price. Figure 11.5 represents perfectly elastic demand. Quantity demanded changes (Q to Q1) without there being a change in price. Quantity demanded therefore changes totally irrespective of changes in price. 82 11 · Elasticity price price P1 P P1 D P D 0 Q1 Q 0 quantity demanded Figure 11.3 Unitary elasticity Q1 Q quantity demanded Figure 11.4 Fairly elastic demand price P 0 D Q1 Q quantity demanded Figure 11.5 Perfectly elastic demand Factors affecting the price elasticity of demand The following factors affect the value of the elasticity coefficient: • Price of the good. If the price of a good is high, the price elasticity of demand will be more elastic than if the price is low. Cars will have a more elastic demand than bicycles. If the price of a new car increases by 50 per cent, quantity demanded will fall by a larger percentage as the car now becomes unaffordable for many consumers. If the price of a bicycle increases 83 11 · Elasticity Are you sure I can’t tempt you? ITQ8 If the price of cigarettes goes up by 50 per cent, what will happen to quantity demanded? ITQ9 What are some of the uses of aluminium? 84 by 50 per cent, quantity demanded will also fall, but by less than 50 per cent. This is because the price of a bicycle is low relative to that of a car. • Number and closeness of substitutes for the commodity. The more and better the available substitutes for a commodity, the greater is the price elasticity of demand for that commodity. Teas will have a greater price elasticity of demand than a soda such as Coca-Cola, as the drinkers of the latter will say that this good has no true substitute. If the price of Coca-Cola increased, demand might fall, but by a less than proportionate amount. • Price of the commodity as a percentage of total expenditure. The lower the percentage of income spent on a good, the more inelastic demand is expected to be. The larger the percentage of income spent on the good, the greater the price elasticity of demand. Thus, the demand for newspapers is likely to be more inelastic than the demand for television sets. Expenditure on newspapers forms a small percentage of total monthly income. • Adjustment time. The longer the period allowed for adjustments in quantity and price, the more elastic demand will be. This is so because it takes time for consumers to learn of new prices and new products. Switching from one product to another will take time. The price of your contact lenses goes up. It might take some time for you to become aware of the price changes. You might still continue to buy that brand as you learn more about other brands and their prices. Eventually, you might switch to another brand because of the price rise. • Habit. Goods that are habit-forming generally have a lower elasticity of demand. Consumers continue to buy similar quantities of the good even when price increases because the consumer cannot do without the good. Habit-forming goods can also be addictive goods; for example, cigarettes and alcohol. It might also be a brand of a consumer good – such as toothpaste that the consumer is ‘in the habit’ of buying. The consumer is loyal to that brand. • The degree of necessity of the good. The more necessary a good, the more inelastic demand will be. Demand is not very responsive to price increases if the consumer needs the good, and the consumer will continue to buy similar amounts. When price decreases, the consumer will again buy similar amounts, as there is only so much of the good the consumer can use. A good example of this is salt. • The number of uses of the good. If the commodity has a large number of uses – such as aluminium – the greater will be the elasticity of demand. As price falls, a more than proportionate amount will be bought for all its different uses. • The definition of the good. The more narrowly defined a good is, the more elastic demand will be. The broader the definition, the more inelastic 11 · Elasticity ITQ10 Give another example of where the definition of the good is linked to its elasticity. demand will be. A Sony CD will have an elastic demand because, as the price increases, users might switch to another brand – say, Maxell. However, if the price of compact disks goes up in general, demand will remain more or less the same, as there are really no close substitutes for compact disk products. Income elasticity of demand income elasticity of demand • YED • Income elasticity of demand (YED) measures the responsiveness of quantity demanded to a change in income. The formula for income elasticity of demand is: Percentage change in Qd YED = Percentage change in income As income changes, demand will change. Income elasticity of demand measures whether demand is responsive or not very responsive to changes in income. Table 11.6 Income elasticity of demand Original demand New demand Change in demand % YED coefficient Change in demand % Change in income % 4 loaves of bread 7 loaves of bread +75% +75% = +1.5 +50% Original income New income Change in income % $1000 per week $1500 per week +50% ITQ11 What is the income elasticity of demand if income falls to $900 per week and the demand for bread falls to 3 loaves? normal goods • A consumer’s income increases from $1000 per week to $1500 per week, ceteris paribus. His demand for bread increases from 4 loaves to 7 loaves. Table 11.6 shows the income elasticity of demand using the formula above. Both income and the demand for bread increase. The percentage change in each case is positive, giving a positive income elasticity of demand coefficient of +1.5. Goods with a positive income elasticity of demand coefficient are normal goods. Normal goods are goods the demand for which increases as income increases, and vice versa. Cross elasticity of demand cross elasticity of demand • XED • Cross elasticity of demand (XED) measures the responsiveness of quantity demanded of one good to a change in the price of another good. Percentage change in Qd of good X XED = Percentage change in the price of good Y Sometimes demand for a good might change not because of a change in the price of the good, but because there are changes in the price of another good. The demand for butter might increase even though the price of butter is constant. It might be that the price of a substitute – such as margarine or jam – increased, making butter relatively cheaper. Cross elasticity of demand measures this type of behaviour. The following consumer behaviour was observed at Sam’s Mini Mart. The price of butter remains constant. However, the prices of other goods change. This affects the demand for butter. In the first instance, the price of guava jam increases from $6 to $12 a jar, a 100 per cent increase. The demand for butter increases from 6 tubs per week to 8 tubs per week – a 33.3 per cent increase. Since all other factors remain constant, we can conclude that the increase in demand for butter is due to the increased price of guava jam. The cross elasticity 85 11 · Elasticity I can’t afford to have any week left over at the end of the housekeeping! Table 11.7 of demand for butter with respect to the price of guava jam is +0.33. The cross elasticity of demand for substitutes is positive. As the price of one good increases, the quantity demanded of its substitute also increases. This is true for guava jam and butter. They are substitutes. People are buying less guava jam, as the price has gone up, and are buying more butter. See Table 11.7. Cross elasticity of demand in practice (1) Original Qd for butter New Qd for butter Change in demand % XED coefficient Change in demandbutter % Change in priceguava jam % 6 tubs per week 8 tubs per week +33.3% +33% = +0.33 +100% Original price of guava jam New price of guava jam Change in price % $6 $12 +100% In the second case (see Table 11.8), the price of bread increases from $5 to $6, a 20 per cent increase. The demand for butter falls from 10 tubs per week to 9 tubs per week, a 10 per cent decrease. Since all other factors remain constant, we can conclude that the fall in demand for butter is due to the increased price of bread. The cross elasticity of demand for butter with respect to the price of bread is –0.5. The cross elasticity of demand for complements is negative. As the price of one good increases, the quantity demanded of its complement falls. This is true for butter and bread. They are complements. People are buying less bread and less butter to eat with their bread. Table 11.8 86 Cross elasticity of demand in practice (2) Original Qd for butter New Qd for butter Change in demand % XED coefficient Change in demandbutter % Change in pricebread % 10 tubs per week 9 tubs per week –10% –10% = –0.5 +20% Original price of bread New price of bread Change in price % $5 $6 +20% 11 · Elasticity Price elasticity of supply price elasticity of supply • PES • Price elasticity of supply (PES) measures the responsiveness of quantity supplied to a change in price of the good. Percentage change in quantity supplied PES = Percentage change in price When the price of a good increases, ceteris paribus, quantity supplied will increase. When the price of a good falls, ceteris paribus, quantity supplied falls. This is the direct or positive relationship between price and quantity supplied. Price elasticity of supply measures how responsive quantity supplied is to changes in price. Will supply change by a large proportion or by a small proportion when price changes? The degrees of elasticity of supply range from perfectly inelastic to perfectly elastic. An explanation of the degrees of elasticity of supply can be found in Table 11.9. Table 11.9 The degrees of elasticity of supply Degrees of elasticity of supply Meaning Elasticity of supply coefficient Perfectly inelastic The percentage change in quantity supplied is zero. Quantity supplied does not respond to a change in price. PES = 0 Fairly inelastic The percentage change in quantity supplied is less than the percentage change in price. 0 < PES < 1 Unitary elasticity The percentage change in quantity supplied is equal to the percentage change in price. PES = 1 Fairly elastic The percentage change in quantity supplied is greater than the percentage change in price. 1 < PES < infinity Perfectly elastic Quantity supplied changes when there is no change in price. PES = infinity These can be illustrated graphically, as seen in Figure 11.6. 1 price 3 4 3 2 5 0 quantity supplied Figure 11.6 The degrees of elasticity You might find the following tips useful for remembering the diagrams for price elasticity of supply: • A perfectly vertical supply curve has a price elasticity of demand of zero, perfectly inelastic – supply curve 1 in Figure 11.6. 87 11 · Elasticity • If the supply curve starts from the quantity axis, price elasticity of supply is inelastic – supply curve 2. • Any supply curve that starts from the origin has a unitary price elasticity of supply – supply curves labelled 3. • If the supply curve starts from the price axis, price elasticity of supply is elastic – supply curve 4. • A perfectly horizontal supply curve has a price elasticity of supply of infinity, perfectly elastic – supply curve 5. Table 11.10 The price elasticity of supply ITQ12 Sketch Kendra’s supply curve for pencil cases. ITQ13 What is the price elasticity of supply if the price of pencil cases falls from $10 to $6 and quantity supplied falls from 5 to 4 pencil cases? Original Qs New Qs Change in Qs % XED coefficient Change in Qs % Change in supply % 5 pencil cases 7 pencil cases +40% +40% = +2 +20% Original price New price Change in price % $10 each $12 each +20% Kendra makes pencil cases for sale. As with all rational producers, Kendra supplies more pencil cases as price increases. Price increases from $10 to $12 per pencil case. Kendra’s supply increases from 5 to 7 pencil cases. Table 11.10 shows the price elasticity of supply using the formula given. Both price and the quantity supplied of pencil cases increase. The percentage change for both variables is positive, giving a positive price elasticity of supply coefficient. The price elasticity of supply coefficient is positive (+2), as there is a positive or direct relationship between price and quantity supplied. Price elasticity of demand measures the responsiveness of quantity demanded to changes in price. The degrees of elasticity of demand range from perfectly inelastic to perfectly elastic. These can be illustrated graphically. The factors affecting price elasticity of demand are the price of the good, the number and closeness of substitutes, the price of the commodity as a percentage of total expenditure, adjustment time, habit, the degree of necessity of the good, the number of uses of the good and the definition of the good. Income elasticity of demand measures the responsiveness of quantity demanded to changes in income. The income elasticity of demand coefficient for a normal good is positive. Cross elasticity of demand measures the responsiveness of quantity demanded of good X to a change in the price of good Y. Substitutes have a positive cross elasticity of demand coefficient; complements have a negative cross elasticity of demand coefficient. Price elasticity of supply measures the responsiveness of quantity supplied to a change in the price of the commodity. The coefficient for price elasticity of supply is positive. The degrees of elasticity of supply range from perfectly inelastic to perfectly elastic. These can be illustrated graphically. 1 The term ‘demand’ is defined by economists as the desire and willingness to purchase a product, backed by the ability to pay for it. 2 Ceteris paribus means ‘other things remaining constant’. When price changes, this causes demand to change. No other determinants of demand 88 11 · Elasticity change. It is assumed that they all remain constant. Therefore the change in demand can only be due to price and price alone. 3 Previously, 12 tubs were demanded and now only 10 are demanded. There is a fall in quantity demanded of 2 tubs. This is a –2 change in the demand for butter. 4 There is a $2 increase in the price of butter. This is a +2 change in the price. The positive sign shows that the price increased. 5 The percentage change in price is –10 per cent. The minus sign indicates a fall in price. 6 The percentage change in quantity demanded is +50 per cent. The positive sign indicates a rise in quantity demanded. 7 The elasticity coefficient will be positive, since the percentage change in price will be positive and the percentage change in quantity demanded will also be positive. If price fell and quantity demanded fell, the elasticity coefficient would also be positive. The percentage change in quantity demanded would be negative and the percentage change in price would be negative. A negative divided by a negative will give a positive coefficient. 8 Quantity demanded will fall, but by a less than proportionate amount. This is because many cigarette smokers will continue to buy the same amount of the good because they are addicted. Some will consume less, but not a great deal less. 9 Some of the uses of aluminium are to make foil paper, pots, pans and appliances, cars and other engine parts. 10 In general, cars will have an inelastic demand, as there are no close substitutes. The demand for Toyota cars will be more elastic, as there are other types of cars the buyer might see as a substitute. 11 (New demand – original demand) is (3 loaves – 4 loaves), which is –1 (fall in demand). The percentage fall is –41 = –25 per cent. (New income – original income) is ($900 – $1000), which is –$100 (fall in income). $100 = –10 per cent. The percentage fall in income is –$1000 25% . Income elasticity of demand is 2.5; that is, ––10% 12 The supply curve will be upward sloping from left to right as there is a direct relationship between price and quantity supplied. As the price elasticity coefficient is +2, the supply curve will start off from the price axis. Price elasticity of supply is elastic. If you plot the two points given and extend the curve, you will see that this is true. price supply of pencil cases 0 quantity supplied 13 Quantity supplied falls from 5 to 4 pencil cases, a 20 per cent fall (–20 per cent). Price falls from 10 dollars to 6 dollars, a 40 per cent fall (–40 per cent). –20% The elasticity of supply coefficient remains positive at +0.5 (–40% ). 89 11 · Elasticity Examination-style questions Multiple choice questions 1 Define price elasticity of demand. a the responsiveness of price to a change in quantity demanded b the responsiveness of quantity demanded to a change in price c the responsiveness of supply to a change in demand d the responsiveness of quantity demanded to a change in income 2 What is the price elasticity of demand for good X if price increases by 20 per cent and quantity demanded decreases by 50 per cent? b +2.5 c –0.4 d +0.4 a –2.5 3 Which of the following factors does not affect the price elasticity of demand? a the number and closeness of substitutes b the percentage of income spent on the good c the time it takes to adjust to a new product d the level of supply 4 What is cross elasticity of demand? a the responsiveness of price to a change in quantity demanded b the responsiveness of quantity demanded of good A to a change in the price of good B c the responsiveness of supply to a change in demand d the responsiveness of quantity demanded of good A to a change in the price of good A 5 Calculate the income elasticity of demand for a good when income increases from $500 per week to $750 per week and quantity demanded increases by 10 units to 50 units b –0.5 c +0.5 d +0.4 a +2 6 Which of the curves in the diagram below shows a price elasticity of unity (one)? a price b c 0 90 d quantity demanded 11 · Elasticity Structured questions 1 a Define elasticity of demand b Work out the price elasticity of demand for this product from the data provided: Quantity demanded Price 100 units $5.00 125 units $3.75 c Explain why the price elasticity of demand coefficient is negative. d Name and explain two factors affecting the price elasticity of demand. 2 a Define income elasticity of demand b June’s income increases from $100 to $150 per week. She buys three packs of juice now instead of two. What is her income elasticity of demand for juice? c What is the formula for price elasticity of supply? d Name and explain four factors affecting the price elasticity of demand for a good. [2] [4] [3] [6] [2] [3] [2] [8] Essay question [20] a Explain the concept of elasticity of demand. b Giving reasons, explain what degree of elasticity of demand the following goods will have: i cigarettes; ii newspapers; iii a diamond bracelet. c Draw supply curves to show: i elastic supply; ii inelastic supply; iii unitary elasticity of supply. [3] [12] [5] 91 12 By the end of this chapter you should be able to: Concept map Market structure define the term ‘market structure’; define ‘perfect competition’; explain the features of perfect competition; define ‘monopoly’; explain the features of a monopoly; define ‘monopolistic competition’; explain the features of monopolistic competition; define ‘oligopoly’; explain the features of an oligopoly. Market structure market structures in the economy monopoly oligopoly monopolistic competition perfect competition the firm is the industry competition amongst the few competition amongst many firms many buyers and many sellers Spectrum of markets market structures • ITQ1 Identify a product and name the firms in your economy or the region that produce this product. In the economy, there are many different types of firms, each producing different products. Economists prefer to classify firms and industries according to the type of market in which they operate. Such classifications are called ‘market structures’. The spectrum or range of market structures is seen in Figure 12.1. DEFINITION: A market structure is defined as the features that determine the behaviour and performance of firms in the industry. spectrum of market structures in the economy monopoly Figure 12.1 Spectrum of markets 92 oligopoly monopolistic competition perfect competition 12 · Market structure In the economy, there are four main market structures. In Figure 12.1, at one extreme there is the monopoly, where there is no competition as the firm is the industry. At the other extreme, there is perfect competition, where there is total competition in the market. In between these two extremes, there is the oligopoly, where there is some competition amongst firms, and monopolistic competition, where there is even more competition than in oligopoly. As we move from left to right on the spectrum of markets, the level of competition amongst the firms increases. As we move from right to left on the spectrum of markets, the level of competition amongst the firms decreases. Monopoly, oligopoly and monopolistic competition are considered to be imperfect competition. Perfect competition DEFINITION: Perfect competition is a market structure in which there are many sellers and many buyers, producing a homogeneous product. seller seller seller seller buyer buyer buyer buyer Figure 12.2 Perfect competition: many sellers, many buyers perfect competition • ITQ2 Why is a small business unlikely to conquer the market for a product? In perfect competition, there are many sellers in the industry and there are many buyers (see Figure 12.2). By ‘homogeneous’, we mean that each unit of the product is identical. Therefore, buyers will buy from any seller. There is perfect knowledge in this market. This means that all buyers and sellers are aware of the product, its features, its price and the other buyers and sellers. There is one price prevailing in the market. Whatever quantity of the product that firms produce in the market will be sold at the prevailing price. No firm can influence price, as a firm’s output is only a small part of the total output of the industry. The firm is therefore a price-taker. The individual firm has no market power. There is freedom of entry and exit. A new firm can enter the industry and start producing at any time. An existing firm is free to leave the industry. The stock exchange is a fast-paced world in which buyers purchase and sell company shares. It is an example of a perfectly competitive market. 93 12 · Market structure ITQ3 Determine which of the features of perfect competition exist for gas stations and the stock exchange. Now you can see why perfect competition has this name. There is competition amongst the firms in the market, and this competition is perfect, or complete. Note that ‘perfect competition’ is a theoretical concept and, in the real world, there are no perfect markets. It is not possible to find a market where all features exist. Gas stations and the stock exchange are perhaps two of the best real-world examples of firms that fall under the perfectly competitive market structure. Monopoly DEFINITION: A monopoly is a market in which there is only one seller and there are many buyers. seller buyer buyer buyer buyer buyer buyer buyer buyer Figure 12.3 Monopoly: one seller, many buyers monopoly • Anyone would think they don’t want us! 94 Figure 12.3 illustrates a monopoly, with one seller and many buyers. In a monopoly, the firm is the industry. There is no competition, as the firm has no other firm with which to compete. There are many buyers of the product. The product itself is unique and has no close substitutes. There is imperfect knowledge in this market. This means that buyers and sellers are not aware of all the information in the market. The monopolist can only sell more at a lower price and, if price increases, less will be sold. The firm produces a given quantity and sells it at the price the market is willing to pay. Or the firm might choose a particular price and sell whatever it can at that price. The firm is therefore a price-maker. The House of Angostura Bitters and Carib Brewery Ltd are examples of monopolies in Trinidad. Carib Brewery in St Kitts is also a monopoly producer of beer in the island. The state-owned water and electricity companies in the Caribbean Islands are also monopolies – in this case, government ones. Barriers to entry exist that prevent firms from entering the industry. There is thus no free entry into the industry. Barriers to entry enable the firm to remain a monopolist, as no new firms can enter and compete with the monopolist. 12 · Market structure DEFINITION: A barrier to entry is anything that prevents new firms from entering and competing in an industry. Some barriers to entry are: • Government regulations. These are laws that prevent new firms from entering an industry; for example, in Caribbean economies there is only one firm providing water, due to government regulations. • Patents. A patent grants to the inventor exclusive rights to the patented product or process. • Large capital outlay that prevents smaller firms from entering an industry; for example, oil refining. • Ownership by the firm of a scarce factor of production. For example, Angostura Trinidad Ltd is the only firm that possesses the knowledge of the secret ingredient in the Angostura bitters recipe. (This is the factor ‘capital’, or ‘know-how’.) Monopolistic competition DEFINITION: Monopolistic competition is a market structure in which there is competition amongst many firms. monopolistic competition • product differentiation • ITQ4 Name some other branded products where the brands have differentiated the product. ITQ5 From the features, give some other examples of monopolistic competition. ITQ6 Name the features of monopolistic competition that are from perfect competition and those that are from monopoly. ITQ7 oligopoly • Name the firms producing these products in the region. A market structure of monopolistic competition has features of both perfect competition and monopoly. In fact, even the name of this market structure is a combination of monopoly and perfect competition. In this market structure, there are many buyers and many sellers, just as in perfect competition. The product is similar yet differentiated through branding. This is product differentiation. This means that the product is made to look different in the eyes of the consumer. This can be achieved through packaging or even slight differences in product features and, of course, giving the product a brand name. The products are still close substitutes. Product differentiation gives the individual firm some degree of market power. For example, only one firm produces Grace jerk seasoning. There is no substitute for Grace jerk seasoning, even though other firms produce jerk seasoning! This is especially true for the loyal consumer. In monopolistic competition, there is imperfect knowledge in this market. This means that buyers and sellers do not have all the information on the product, its features, its price and the other buyers and sellers. As with the monopolist, more can only be sold at a lower price and less is sold if the price increases. The firm is therefore a price-maker. It can choose a given quantity to produce, and sell this at the price the market is willing to pay. Alternatively, it can choose a price and sell whatever quantity it can at that price. There might be some barriers to entry in this market, though they are not difficult to break through. While pure monopoly and perfect competition are rare, monopolistic competition is more common in the region and throughout the world. Some examples are restaurants, hair and beauty salons, and supermarkets. Monopolistic competition is therefore a combination of the monopoly market structure and perfect competition. Oligopoly DEFINITION: An oligopoly is a market structure in which there are a few firms competing in the market. Examples of an oligopoly in the region include: commercial banks, beer brewing, petrol refining and the production of household detergents and personal care products. In an oligopoly, there are few sellers and many buyers. The product might be homogeneous (unleaded petrol) or differentiated (detergents). There is imperfect 95 12 · Market structure few sellers buyer buyer buyer buyer buyer buyer buyer buyer Figure 12.4 Oligopoly: few sellers, many buyers knowledge in this market, as firms and buyers might not know of all sellers, buyers, prices and products available. Firms tend to avoid price competition and so prices remain rigid or there is price-stickiness. Figure 12.4 shows an oligopoly. DEFINITION: Price rigidity means that prices remain at a certain level over a long period. ITQ8 Using a simple numerical example, illustrate how revenue will fall. If firms increase prices, competitors will not follow, and so the given firm will lose customers to its rivals (market share and revenue will also decline). If the firm lowers prices, its competitors will also follow and so the firm will not gain additional customers, market share or revenue. In fact, revenue will fall. Cutting of prices will lead to price wars – benefiting no firm, only the consumer. DEFINITION: A price war occurs when rival firms continuously reduce prices to undercut each other. Oligopolies might choose to enter into agreements with, or collude with, other firms to maximise profits. DEFINITION: Collusion occurs when there are price and quantity agreements with other firms. cartel • A group of sellers colluding in this way is called a cartel. In many countries cartels are illegal. There are high barriers to entry in this market, usually due to high set-up costs. A private individual cannot simply take a loan from a bank and set up a bank or an oil refining company, as he does not have the knowledge or the large capital outlay. The oligopoly is also a typical market structure in the real world, unlike perfect competition and monopoly. Table 12.1 summarises the features of each market structure. Table 12.1 The features of each market structure 96 Monopoly Oligopoly Monopolistic competition Perfect competition Number of sellers one few many many Number of buyers many many many many Product unique homogeneous/ differentiated differentiated homogeneous Knowledge of market imperfect imperfect imperfect perfect Price price-maker price-maker with price rigidity price-maker price-taker Entry conditions no free entry high barriers to entry low barriers to entry freedom of entry 12 · Market structure A market structure is defined as the features that determine the performance and behaviour of firms in the market. There are four main market structures: monopoly, oligopoly, monopolistic competition and perfect competition. Monopoly, oligopoly and monopolistic competition are imperfect competition. In perfect competition, there are many sellers and many buyers, the product is homogeneous and there is perfect knowledge in the market. The firm is a price-taker and there is freedom of entry into the industry. A monopoly has one seller and many buyers, the product is unique and there is imperfect knowledge in the market. The firm is a price-maker and there are barriers to entry. Barriers to entry prevent firms from freely entering the industry. They might be legal barriers, patents, high set-up costs or inability to access all factors of production. In monopolistic competition, there are many sellers and many buyers, the product is similar yet differentiated and there is imperfect knowledge in the market. The firm is a price-maker and there might be simple barriers to entry. An oligopoly has few sellers and many buyers, and a differentiated or homogeneous product; there is imperfect knowledge in the market. There is price rigidity and there are high barriers to entry. Oligopolists might collude to make maximum profits and reduce the chance of a price war, which will not benefit any firm. 1 Furniture – Courts Trinidad Ltd, Standard Distributors Ltd, Singer, The American Stores Ltd in Trinidad. Soft drinks – S.M. Jaleel (Cole Cold), Solo Beverage Company Ltd, Caribbean Bottlers Ltd (Coca Cola). Of course, when you discuss this in class many other products and firms will come up. 2 The output of a small business will not be sufficient to cater for all consumers. Also, it will have only one brand and variety of the product rather than a range of different versions of the product. 3 Here is a checklist in the form of a table: Features of perfect competition Gas stations Stock exchange many sellers true true (firms selling shares) many buyers true true homogeneous product petrol is homogeneous, but the gas station service is not true for shares of any one firm (they are identical) perfect knowledge false true one price in the market – price-taker true true for shares of one firm freedom of entry and exit conditions entry restricted, exit free controlled by the government 4 Apple J made by the Solo Company in Trinidad stands out as a brand of soda with no close substitutes. Locally, you can think of your favourite brands of toothpaste, soap or shampoo. 5 Auto supply shops, clothes boutiques, food processing firms and stationery shops are some other examples of firms operating under monopolistic competition. Note that entry into the industry is relatively easy. 97 12 · Market structure 6 Perfect competition – many buyers, many sellers, freedom of entry. Monopoly – imperfect knowledge, price-setter. Each firm is also a ‘monopolist’ in the production of its own brand. 7 Banking – RBTT, Scotiabank and Republic Bank; beer brewing – Carib Breweries in St Kitts and Trinidad, Banks (Barbados) Breweries Ltd and Desnoes & Geddes Ltd in Jamaica (Red Stripe beer); petroleum refining – Petrotrin, British Gas, BP; household detergents and personal care products – Unilever, Johnson & Johnson. 8 Total revenue is price multiplied by quantity sold. If the quantity sold is 200 units at a price of $5, the total revenue is $1000. If the price falls to $4 and the quantity sold remains at 200 units as the firm gains no additional customers, the total revenue will fall to $800. Examination-style questions 98 Multiple choice questions 1 In a monopoly: a There are many firms. b The product has no close substitutes. c There are low barriers to entry. d The firm follows the price in the market. 2 In perfect competition there is/are: a product differentiation b a few firms c freedom of entry and exit d lack of perfect knowledge 3 An oligopoly: a is an industry in which there is price rigidity b produces only homogenous outputs c is an industry into which entry is relatively easy d is a situation in which there is no collusion 4 A market of few sellers and many buyers is: a a monopoly b perfect competition c monopolistic competition d an oligopoly 5 All of the following are barriers to entry except: a government regulations b patents c the ‘know-how’ of a firm d interdependence 6 Which is a feature of monopolistic competition? a a small number of firms b the firms producing homogenous output c high barriers to entry d product differentiation 12 · Market structure Structured questions 1 2 a Name the four types of market structures. b List four features of perfect competition. c Compare these features with the features of another market of your choice. [2] [4] [9] a What is a monopoly? [2] b List the features of a monopoly. [5] c Choose a monopoly in your economy or the region. Using each [8] of the features, explain why the firm chosen is a monopoly. Essay question [20] a b c d [2] [2] [6] [10] What is an oligopoly? Give two examples of oligopolies in your economy or the region. Why is there price rigidity in the oligopoly? Compare oligopoly with monopolistic competition. 99 13 By the end of this chapter you should be able to: Market failure define ‘market failure’; state and explain the causes of market failure; explain the consequences of market failure. Concept map Market failure causes • public goods • merit goods consequences market failure • externalities • monopoly • retrenchment • unemployment • economic depression • poverty • reduced provision for society’s welfare Market failure market failure • Market failure is the inability of the market to allocate resources efficiently to best satisfy society’s wants. Markets fail for a number of reasons. The causes of market failure lie in four areas: • The provision of public goods. There is a market for public goods, yet no private firms are willing to supply these goods. This is a case of a ‘missing market’, a cause of market failure. • The provision of merit goods. The socially desirable quantity of these goods is neither produced nor consumed. Since there is under-production and under-consumption, this causes the market to fail. • Externalities – positive and negative. Externalities are the spillover effects of production and consumption. When externalities are created, it means the market is not operating as efficiently as it should. • Monopoly. When there is a monopoly operating, prices are higher and output is lower than if a number of firms were operating in that industry. Causes of market failure To understand market failure, we can take examples from public goods, merit goods, externalities and monopolies. Public goods public goods • non-excludability • 100 One cause of market failure might lie in the provision of public goods. Public goods are goods that are collectively consumed by society. They possess two characteristics: non-excludability and non-exhaustibility. Non-excludability 13 · Market failure non-exhaustibility • means that a consumer cannot be excluded from consuming the good, even if he or she did not pay for it. There is an absence of ownership rights attached to the purchase of these goods. Non-exhaustibility (non-diminishability) means that consumption of a public good by one individual does not reduce the amount available for other individuals to consume. A public good can be consumed simultaneously by numerous individuals. Examples of public goods are streetlights, lighthouses and defence. A lighthouse is a public good: it is used by numerous individuals (and ships) who did not pay for it directly. free-riders • ITQ1 What will too many free-riders do to the firm? marginal cost • ITQ2 Explain how lighthouses and defence are public goods. Let us use an example to illustrate this further. There is a demand for streetlights by most citizens. A private firm might wish to supply streetlights. However, because of the nature of the good, the firm cannot exclude the services of the streetlight from an individual who did not pay for the service. People who do not pay for a good or service but enjoy its benefits are freeriders. If streetlights are provided by a private firm, there will be many freeriders. Streetlights are non-excludable. Also, economic theory states that, for resources to be efficiently allocated, the price of the good must be equal to the marginal cost (P = MC). This means that the value society places on the last unit of the good produced – price – must be equal to the value of the additional resources used to produce that good – its marginal cost. The cost of providing an additional house with streetlight services is the marginal cost to the firm. This cost is zero on a street where there are already streetlights and a new house does not need any extra streetlights. Streetlights are non-diminishable in nature. For economic efficiency to exist, price must also be zero! No firm will supply a good at a price of zero (which is the implication of non-diminishability) and no firm will supply a good where no one can be made to pay for it (which is the implication of non-excludability)! If no firm supplies street lighting in an economy and there is a demand for this good, then this is a case of a ‘missing market’. The market has failed to allocate resources efficiently to satisfy society’s wants. This is a cause of market failure. When there is market failure as a result of the provision of public goods, there is an economic role for government to play. The government intervenes and supplies public goods, and this is financed out of taxation. When the government supplies the public good, this market failure is eliminated, as the good is provided for consumers – government supplies the good, society collectively consumes the good and it is paid for out of taxation. Merit goods merit goods • ITQ3 Show how the fire service is a merit good. A second cause of market failure is in the provision of merit goods. Merit goods are goods for which the social benefits to the community of the consumption of the good far outweigh the private benefits to the consumer. Some examples of merit goods are education and health care. When there is a healthy and educated workforce, all of society benefits. Productivity increases, crime falls and output increases. The consumption of merit goods results in benefits falling on the entire society. 101 13 · Market failure If the choice was left to the consumer, an individual might not consume adequate amounts of merit goods. Society under-consumes merit goods (that is, it consumes less than the socially optimum quantity). Firms also underproduce merit goods (they produce less than the socially optimum quantity). They do not supply adequate amounts of merit goods at an affordable price. The market fails, as the quantity of the good that is produced and consumed is not sufficient to maximise society’s welfare. When there is market failure in the provision and consumption of merit goods, the government might intervene. The government then provides these merit goods free of charge or at a subsidised price. This encourages more consumption of the merit goods, and the market failure is reduced. This also explains why there is so much government activity in the health and education sectors of the economy. Scholarships are a subsidy to a prospective buyer of educational services. A scholarship is awarded based on merit. Other forms of educational assistance are given based on need; for example, HELP – the Higher Education Loan Programme in Trinidad and Tobago. Free primary and secondary schooling in Caribbean territories, and free tertiary education in Trinidad and Tobago, ensure that education is not under-consumed. Health care is provided free of charge in many Caribbean countries. All these measures encourage the consumption of merit goods that might otherwise be underconsumed, usually by the poor. Government provision of merit goods reduces market failure, as more of the good is consumed than would have been the case had government not intervened. Externalities externalities • 102 Externalities are spillover effects of production or consumption that fall on a third party. When externalities are created, the market also fails. The producer and the consumer are the two parties to a transaction. In the course of producing a good or consuming a good, a third party might be affected. The third party is external to the transaction. This third party might be affected negatively or positively. When the third party is affected, this is an externality. When the third party is affected negatively, this is an ‘external cost’ or a ‘negative externality’. When the third party is affected positively, this is an ‘external benefit’ or a ‘positive externality’. When externalities result from production activities these are called ‘production externalities’. When externalities result from consumption activities these are called ‘consumption externalities’. Table 13.1 gives examples of the various types of externalities. With externalities, the third party has nothing to do with the transaction, but is nonetheless affected. The market has therefore failed to satisfy society’s wants efficiently. The buyer and the seller might be satisfied. However, the market is not efficient, as there is a spillover on the third party. Note that positive externalities are still a form of market failure as, in the operation of the market, too little of the good is being produced. If more of the good is produced, then more of the good and more of the positive externalities will both be enjoyed. More obviously, when there is a negative externality, a cost falls on a third party and he is in no way compensated for this cost. Too much of the good is being produced. Therefore, with negative and positive externalities, the market fails. When there are negative and positive externalities, the market fails. In economics, we assume that the government will do what it can to promote the welfare of citizens. The government will try to intervene and reduce the market failure. The government might tax firms that produce negative externalities so that the firm reduces production. It might even place a direct control, limiting the quantity produced by the offending firm. When production is reduced, the negative externality (pollution) will also be reduced. The government might even use the revenue collected from the tax to clean up the pollution 13 · Market failure Table 13.1 Externalities Type of externality Consumption externalities Production externalities Negative externalities The noise of your neighbour’s CD player disturbing your afternoon nap The emissions of a nearby factory affecting breathing and causing dust on walls and furniture 1 Positive externalities 2 One neighbour enjoys looking at his neighbour’s garden 3 Water from a nearby factory warming the river for bathers 4 ITQ4 Who is the third party in each of the cases shown in the table? of the firm, or to provide public goods and merit goods. The government can encourage firms that are producing positive externalities to produce more; it can do so by giving the firms subsidies or grants. Monopolies marginal cost • Markets also fail when there are monopolies. As mentioned earlier in this chapter, a firm is allocatively efficient when the price of a product is equal to marginal cost (P = MC). Marginal cost is the value of the last unit produced, based on producer costs. 103 13 · Market failure DEFINITION: Marginal cost is the additional cost from the production of an extra unit of output. ITQ5 What has the government done in your country to reduce monopoly power? Price is the value that society places on the last unit produced. The value that the producer places on the last unit produced (marginal cost) ought to be the same as the value society places on this unit (price). When this is true, then there will be allocative efficiency and no market failure. However, the monopolist sells at a price that is greater than marginal cost (P>MC). Too little of the good is produced and it is sold at too high a price. In the monopoly market, there is therefore market failure. The government might intervene in the monopoly market to reduce market failure by: • passing laws discouraging or limiting the formation of monopolies; • encouraging firms to enter industries where there are monopolies; • taking over industries where monopolies cannot be avoided – for example water and electricity – and thereby regulating prices (water and electricity rates). Table 13.2 summarises the causes of market failure. Table 13.2 Summary of the causes of market failure Causes Result public goods ‘missing market’ at zero price merit goods underproduction (too little) negative externalities overproduction (too much) positive externalities underproduction monopoly underproduction, as P>MC Consequences of market failure retrenchment • unemployed • 104 When markets fail in an economy, all groups in the economy are affected – firms, households, the government, and the economy as a whole. In developed countries, the government will try to intervene to correct market failure. In developing countries, the government might not have the resources to intervene and reduce market failure. In such economies, the consequences of market failure are: • retrenchment; • unemployment; • economic depression; • a rise in the levels of poverty; • a decline in provisions for societal welfare. Retrenchment occurs when workers lose their jobs due to the declining activity of a firm. If a firm that is producing a negative externality is forced to reduce output or close down, then workers will be retrenched. When the firm produces less output, it will use less factor inputs – land, labour, capital and entrepreneurship. If monopolies reduce economic activity due to government restrictions, retrenchment will also occur. As workers are retrenched or laid off, they might be unable to find jobs; perhaps there are none available, or maybe their skills do not match the skills needed for the available jobs. They become unemployed. The unemployed refers to those persons who are actively seeking jobs but are unable to find a job. If the market fails to provide merit goods such as education, workers will be unable to develop new skills. The poor will receive no education or training for jobs. Lack of health care can result in more days lost by workers due to sickness. Absent workers lead to a fall in productivity. Employers, where they can, will substitute capital for labour, and unemployment therefore grows. 13 · Market failure economic depression • increase in poverty • social welfare • Economic depression occurs when there is falling output in the economy and rising unemployment. Market failure leads to economic depression, as monopolies and firms producing negative externalities reduce output. These activities lead to unemployment. If government does not take up the slack and provide public goods and merit goods, there can be further unemployment. It’s a hard life. When people are out of jobs, and health and education services are produced in insufficient quantities and at very high prices, this leads to an increase in poverty. The poor have no jobs. They cannot afford education and training to make them employable. Also, they cannot afford the expensive health care, and so might be sick and unable to work. They might even be victims of firms creating negative externalities in the community. They have to buy goods and services from firms selling at high monopoly prices. They have no avenue to escape the poverty that is the result of market failure. Unless government intervenes to provide merit goods and public goods and to reduce negative externalities, the poor will remain in their poverty. When there is market failure, government has to intervene. The government has to use its resources to provide public goods and merit goods. Firms producing positive externalities must be given grants to increase output. There are, therefore, fewer resources available for government to provide for the welfare of citizens. Social welfare to the poor includes: education, health services, subsidised transport and training programmes. However, the provision of public goods and merit goods by the government forms part of its welfare service to the citizens of the country. Market failure is the inability of the market to produce the quantity of the good that maximises society’s welfare. One cause of market failure is in the provision of public goods. Public goods are non-excludable. This means that there are free-riders, which will affect a firm’s ability to make a profit. Public goods are non-exhaustible and so marginal cost is zero. Price must therefore also be zero. No firm will sell a good at a price of zero. The public goods market therefore consists of ‘missing markets’. Markets fail in the provision of merit goods. Too few of these goods are produced and consumed than is good for the community. Markets fail when there are negative and positive externalities. Negative externalities impose a cost on a third party and too much of the good is produced. Positive externalities place benefit on a third party and too little of the good is produced. When a private monopoly operates, there is also market failure, as price is greater than marginal cost. Too little of the good is produced, and it is sold at too high a price. When market failure takes place, the government might intervene to reduce the market failure. If government does not have the resources to intervene, market failure will have many consequences. 105 13 · Market failure Market failure leads to retrenchment and unemployment. It also leads to economic depression, a rise in the levels of poverty, and a reduction in the provision for society’s welfare. All of this is because the market does not provide public goods and merit goods; the firms creating negative externalities overproduce, and the firms creating positive externalities underproduce; and firms grow into monopolies, and so might exploit the consumer. 1 If there are too many free-riders, the firm will not earn any revenue. It will be impossible for it to operate. 2 A lighthouse is non-excludable, as all ships can use its services without paying for it. Its service is also non-diminishable, as consumption of the service by one ship does not diminish the signal available for all other ships. Defence is non-excludable as, in times of war, the entire country is defended rather than only those who might have paid for the service. Defence is non-diminishable, as defending one home does not reduce the defence available for a neighbouring home. Also, the cost of defending an additional baby being born is zero! The marginal cost of the defence of one more inhabitant is zero. 3 Fire service is a merit good, as in the event of a fire in his house, consumer A’s consumption of fire services will also benefit his neighbours, whose houses are kept from catching fire. If homeowners had to purchase fire services from a private firm, many would not purchase the service. The service would be under-consumed. Government therefore provides fire services free of charge and finances them from taxation. 4 Example 1 – you; Example 2 – residents in the nearby community; Example 3 – the neighbour looking at the other’s garden; Example 4 – bathers. 5 The governments of the Caribbean countries run the state monopolies; for example, Trinidad and Tobago – Water and Sewerage Authority, Jamaica – National Water Commission, St Kitts – Water Services Department. Electricity is provided in these islands by state-owned monopolies – Trinidad and Tobago Electricity Commission, Jamaica Public Service Company Ltd and the Electricity Department in St Kitts. Having taken over these industries, the governments aim to run them for the good of society as a whole, rather than allowing market forces to lead to an underproduction and under-consumption of these goods and services. Examination-style questions 106 Multiple choice questions 1 What is market failure? a when supply is greater than demand b when demand is greater than supply c the inability of the market to allocate resources efficiently d the provision of private goods 2 All of the following are causes of market failure except: a the provision of merit goods b public goods and ‘missing’ markets c the operation of markets under perfect competition d the spillover effects of negative and positive externalities 13 · Market failure 3 Which of the following is not true about public goods? a They are financed out of taxation. b They are collectively consumed. c Consumption by one individual does not diminish the amount available for consumption by others. d These goods possess property rights, and consumption by one individual excludes others from consuming the good. 4 Which of the following is a merit good? a cigarettes b streetlights c roads d health care 5 Which of the following is an example of an externality? a a cigarette smoker who gets lung cancer b your neighbour enjoying music from his new CD player c residents affected by dust from a nearby factory d a consumer having an alcoholic drink 6 All of the following are consequences of market failure except: a fewer merit goods being supplied in the market b retrenchment c a fall in societal welfare d unemployment Structured questions 1 2 a Define ‘public goods’. b Give two examples of public goods. c By referring to the features of public goods, discuss whether roads are public goods. [4] [2] [9] An aluminium processing company wants to set up a plant in the island of Surfsea, but the residents are protesting. They fear the loss of the plant and animal life on the island, as well as environmental damage. They are also concerned about the emissions from the plant and its effects on their health and that of their families. Residents nearby the plant will have to be relocated. The government says the plant will create jobs, and that taxes on the firm’s profits will add to the government’s revenue, which can help to provide much needed health services and education. a What is an externality? [3] b From the extract, name two externalities and state their types. [6] i What is market failure? [2] ii How does the government intend to reduce market failure? [4] Essay question [20] a What is market failure? b Explain three causes of market failure. c Discuss the consequences of market failure in your economy. [3] [9] [8] 107 14 The financial sector By the end of this chapter you should be able to: Concept map barter define the term ‘money’ and recount its history; list and explain the functions and features of money; explain what ‘money supply’ is; describe the ‘financial sector’ in an economy; explain the role and functions of the financial sector; describe the ‘informal sector’ in Caribbean economies. The financial sector commodity money fiat money money $ financial sector $ spenders • individuals • firms • government savers • individuals • firms • government Money The history of money barter • Long before money was used, trade and exchange used to take place through barter. Barter is the direct exchange of goods and services for other goods and services. In barter, a farmer might trade his surplus corn for fish from the fisherman. Barter enables an individual to trade his surplus output for other goods he needs. The individual will enjoy a greater variety of goods. Under successful bartering, the farmer in our example can enjoy corn pie and fish for dinner. However, there are problems associated with barter. Here is an everyday situation to illustrate the kind of problems that can arise with barter. This is an advertisement in the newspaper. One red, size small dress in exchange for one Sony 21" colour television set 108 To barter or not to barter? 14 · The financial sector Maybe this wasn’t such a good idea. money • commodity money • fiat money • token money • The difficulties in this form of trade are: • Unequal value of exchange. The dressmaker might feel that the value of the dress is equal to that of the television, but the television set owner/trader might think his television is worth four dresses. Traders in the barter system have difficulty in determining the relative value of goods. • Double coincidence of wants. The dressmaker will have to find someone who wants a red dress, size small who also has a Sony 21” colour television set to trade. This is another difficulty with the process of barter. A trader has to find someone who wants his good and has exactly what he wants to trade it for. • Impossibility of saving. When barter takes place, saving is difficult. Saving of goods requires storage space. A producer might not have enough space to store bulky goods. Also, some goods – such as fish – might be perishable and so difficult, if not impossible, to store. Here, we have defined barter as the exchange of goods for goods. However, we can use the term ‘barter’ in another context, where the buyer and seller barter or bargain with each other. This means that they negotiate to achieve a mutually agreeable price for a product. The modern economy uses money as a means of facilitating trade and exchange. Firms and individuals trade the goods and services produced for money and, in turn, they use the money received to purchase the goods and services they wish to consume. Therefore, the producer/owner of the dress will sell it to someone who wants a dress of that colour, size and style. With the money received (and some more!) he/she can purchase a Sony television set. Money is, therefore, a medium of exchange. Money is defined as anything that is acceptable as a means of settling debts. It is anything that is acceptable to both buyers and sellers as a means of paying for goods and services. In the past, many items have been used as money – cowrie shells, beads, cattle and even cigarettes in World War II. Commodity money consists of items used as money that are, in themselves, valuable. Examples of commodity money are cigarettes, cattle, tobacco, gold, silver and iron. Nowadays, the money we use is fiat money – items that serve as money but which have no value in themselves. The piece of paper on which a $100 bill is printed is basically worthless. Fiat money is sometimes called token money. Commodity money: gold and cattle have a value. Fiat money: bank notes represent value, but the paper they are printed on is almost worthless. 109 14 · The financial sector In many civilisations, over the centuries, precious metals such as gold were used as money. People stored their gold with goldsmiths. Every time a trader wanted to buy goods, he would go the goldsmith for his gold so that he could trade. As gold and other metals were difficult to carry around, traders started to leave their gold with goldsmiths and simply carried around IOUs or promissory notes issued by the goldsmith promising to pay the given amount of gold to the bearer of the note. The trader would purchase goods and the seller accepted the note. The seller now had a claim to gold with the goldsmith equal to the value of the note. This was the origin of paper currency as money. In fact, UK paper money says ‘I promise to pay the bearer on demand the sum of X pounds’, signed by the Chief Cashier of the Bank of England. This is a quaint survival from the past, but it makes the point that the paper money that we use today is a stand-in for the real thing – gold. Features of money ITQ1 If money is not uniform, what problems could there be? ITQ2 Give an example of a commodity that cannot be used as money because it lacks some of these features. ITQ3 Give an example of such a situation. ITQ4 Give an example of where money is legal tender but it is not acceptable. ITQ5 Name three countries with coins milled around the edges. Check your local currency and coins left over from vacations abroad. For anything to function as money, it must possess certain features or characteristics. • It must be homogeneous. All units of money must be identical or uniform. • It must be divisible. Money must be able to be divided into smaller units. Not that the coin (or note) itself has to be split into smaller pieces. Rather, larger denominations of notes and coins must be able to be converted into smaller units. This will enable the buyer to pay smaller amounts for cheaper items. Also, the seller will be able to give change. • It must be portable. Money must be easy to carry around. This will enable transactions to take place in all areas without inconvenience. • It must be legal tender. This means that a creditor is legally obliged to accept the money in settlement of a debt. Notes and coins are legal tender. Small denominations of money (coins) are not legal tender for large debts. Cheques are not legal tender. No creditor is bound to accept cheques as a means of payment. • It must be acceptable. Everyone must be willing to accept money as a means of settling debts. It is from our willingness to accept money as a means of payment that money obtains its value. • It must be durable. Money must be longlasting and not easy to wear away. If it is not durable – for instance, if it crumbled or melted away – it would be useless as money. In the UK in the 1600s, silver coins were illegally ‘clipped’ in order to make more coins. This was the reason for introducing the milled edge to reduce such debasement of the currency. • It must be relatively scarce. Money must be relatively scarce for it to have value. No one would want to work hard all day and then be paid in pebbles that you can pick up from the sidewalk. Functions of money The milled edge of coins makes them harder to forge. Money functions as: • A medium of exchange. Money is acceptable as a means of payment for goods and services. A farmer can sell his bananas at the market for money. He can use this money to purchase other goods and services. In the earlier example of the red dress and the television set, trade would be held back if 110 14 · The financial sector ITQ6 Into what other assets might people choose to put their savings? we had to barter. With the use of money, the dressmaker can sell the dress and, with the money received, she can purchase the television or any good she desires. Money, as a unit of account, eliminates the problem of requiring a double coincidence of wants that occurs in barter. • A store of value. Unlike some goods, money can be stored or saved for use at a later date. It gives the saver purchasing power in the future. However, some people might choose to save by storing valuables such as real estate, paintings or jewellery. In times of inflation, when money is losing value, people might choose to save in other assets. Money might, therefore, eliminate the problem of difficulty in saving that is present with barter. • A unit of account. This means that money is a measure of value. All goods and services can be given prices in terms of money. It is not necessary to give goods a value in terms of other goods; for example, declaring one economics textbook to be worth 150 oranges. This also makes accounting simpler, as the total value of any set of goods or group of assets can be measured using money. This function of money helps to eliminate the problem of unequal value of exchange, as prices are quoted exactly in terms of money. • A standard of deferred payment. In the modern economy, a consumer might buy a good today and derive satisfaction from consuming it now. However, he might choose to pay for the good some time in the future. Many furniture stores give credit, where the consumer makes a down payment on the good (although sometimes this is not required), and the consumer pays for the good by instalments over a number of years. Money facilitates this kind of deferred, or postponed, payment. In barter, if you were a farmer paying for furniture by bananas, you might be able to pay only when the bananas are harvested. In the months when the crop is growing, you will not be able to make payments. Also, the future crop of bananas might not be as healthy as the previous crop. The creditor will not want to give another banana farmer credit as he might have more bananas in the future than he can eat! Credit under barter would be difficult and confusing. The money supply money supply • The money supply is the total stock of money in the economy at a particular time. The supply of money in the economy is determined by the central bank. The money supply can be defined in terms of M1 and M2 as seen in Figure 14.1. money supply M1: narrow money • notes and coins • chequing deposits • travellers’ cheques M2: broad money • M1 • savings deposits • money market accounts Figure 14.1 The money supply narrow money • ITQ7 How does the $100 bill of a country differ from the money used in a game of ‘Monopoly’? Narrow money is called M1. This narrow money can be used directly for transactions. It consists of all notes and coins in circulation, all deposits on which cheques can be drawn, and travellers’ cheques. DEFINITION: Narrow money (M1) consists of all notes and coins in circulation, all deposits on which cheques can be drawn, and travellers’ cheques. 111 14 · The financial sector ITQ8 Name two items that notes are being used less and less to purchase. broad money • • Coins – issued for the convenience of small everyday transactions; for example, purchase of newspapers. • Notes – issued to purchase general goods and services. Some items – for example, lunch, foodstuffs and taxi fares – can only be paid for with notes and coins. However, notes are being used less for the purchase of dearer items. • Deposits on which cheques are drawn – can be used to buy foodstuffs, furniture or even a car. This is considered money because a chequebook is equivalent to dollar bills in your pocket. • Travellers’ cheques in foreign currency – can be used to purchase goods and services directly, or can be changed into cash to do so. Broad money (called M2) consists of M1 plus savings accounts in financial institutions and money market accounts. Savings accounts and money market accounts are considered part of broad money, as such savings can easily be converted into cash or transferred to a cheque account to be used as money. The financial sector financial sector • financial intermediaries • The financial sector is that part of the economy involved in financial businesses. These businesses act as the link between spenders and savers, so they are called ‘financial intermediaries’. They are involved in money transactions and the provision of finance to individuals, firms and government. The financial sector consists of the central bank at the apex of the sector; commercial banks; and other bank and non-bank financial institutions, such as building societies, credit unions, development banks, insurance companies and stock exchanges. The financial sectors of the larger Caribbean islands of Jamaica, Guyana, and Trinidad and Tobago have grown from being dominated by commercial banks into a sector with a variety of financial institutions offering a range of services. The financial sector provides finance for firms in the form of loans. Also, when shares are purchased by individuals and other firms, the firm in question also receives funds. This is discussed in detail in Chapter 15. The financial sector provides a variety of savings options for households and firms. Functions of the financial sector 112 The financial sector has many functions in the economy: • It attracts funds from businesses and private individuals. Firms and individuals with extra funds are encouraged to save in the financial institutions. It provides people with an alternative place to put their extra funds. Note, too, that the financial sector performs the important function of encouraging those who might not otherwise have saved to save some of their income. It makes savings attractive by paying interest on the sum saved and by keeping the funds secure. The financial institutions are supervised by the central bank. A strong financial sector gives savers confidence, and people feel that it is safe to deposit their savings. • It affords these businesses and private individuals an opportunity to earn interest on their idle money balances. When you deposit a sum of money in a financial institution, you are paid interest by the institution, since you are forgoing the use of the deposited money for a period of time. • It provides the government with a source of funds for investment purposes. Banks use the funds deposited with them to purchase treasury bills and bonds issued by the government. This constitutes a loan to the government. This is discussed in Chapter 15. • It provides the private sector with a source of funds for investment purposes. Financial institutions purchase, or facilitate the purchase of, corporate bonds and company shares. The purchase of corporate bonds provides loans to businesses. The purchase of company shares provides equity capital to businesses. 14 · The financial sector • It provides private individuals with a source of funds for investment or spending. Private individuals can borrow from financial institutions to buy homes and cars, as well as to go on foreign trips or start up a business. • It allows the private sector and private individuals the opportunity for part ownership of companies. Through the purchase of company shares, private individuals are part owners of companies. Holders of ordinary shares have voting rights in companies. If company A buys some shares of company B, then company A is a part owner of company B. • It provides compensation when mishaps occur, thus reducing risk in the economy. There is insurance for firms and individuals. Insurance companies provide compensation for policyholders in the event of a loss. They provide this service for a fee called a ‘premium’. The informal sector in Caribbean economies informal sector • ITQ9 Name two activities that take place in the informal sector. moonlighting • ITQ10 Give some examples of jobs in the informal sector. The informal sector is that part of the economy where economic activities are not under official control. Caribbean economies have very large informal sectors. The business activity in this sector is not included in official business activity. Production in this sector is not considered in the computation of national income statistics (see Chapter 16). Income earners in this sector do not pay taxes. Workers in this sector might be considered unemployed according to official statistics. A worker might belong to both the informal and the formal sectors. For example, Albert is a washing machine repairman. He is employed by Reliable Appliances, a firm that imports and manufactures home appliances, to repair appliances still under warranty. After working hours and on weekends, he repairs washing machines for people in the surrounding areas for a charge. As a worker, he pays taxes – he is employed by a firm that is governed by official regulations; Albert belongs to the formal sector. His extra job, of which there are no official records, is carried on in the informal sector. This is called moonlighting. The informal sector provides jobs and reduces unemployment, but in many cases the jobs are low-paid and there is no job security. This sector facilitates the growth of entrepreneurial activity among the lower income groups, but the entrepreneurs might not abide by tax and labour regulations. The size of the informal labour market varies from the estimated 4–6 per cent in the high-income countries to over 50 per cent in the low-income countries. The size and role of the informal sector in the economy increase during economic downturns. When there is an economic downturn or recession, there is falling national output and employment. This will be discussed in Chapter 16. As people become unemployed in the formal sector, they turn to the informal sector for jobs. The informal sector provides participants with informal sources of finance. There are moneylenders, pawnbrokers, rotating savings (for example the sou sou – see Chapter 15), friends and relatives who supply loans. Suppliers and shopkeepers might provide credit. More notes and coins are used in this sector, as opposed to other forms of money. The informal sector in the Caribbean, as in other developing countries, is quite large. This sector contributes to the material well-being of many Caribbean people. It is, therefore, an important part of Caribbean economies. Barter is the exchange of goods and services for other goods and services. Barter enables people with a surplus to exchange goods and so enjoy a variety of goods. 113 14 · The financial sector The problems of barter are that there must be a double coincidence of wants, it is difficult to arrive at a value of exchange and it is difficult to save. Over the years, money developed as a medium of exchange. Money is anything that can be used as means of settling debts. To perform its functions adequately, money must have certain features. They are: homogeneity, divisibility, portability, acceptability, durability and relative scarcity. It must also be legal tender. The four functions of money are as a: medium of exchange, store of value, unit of account and standard of deferred payment. M1 is notes and coins in circulation, travellers’ cheques and all chequing accounts. M2 is M1 plus savings deposits and deposits in money market accounts. The financial sector has businesses – banks and non-banks – involved in the mobilisation of funds from savers, and the supply of these funds to spenders. Spenders can be households, firms and the government. 1 If bank notes are not uniform, people might attach value to particular units of money and therefore hold on to them, or the more attractive notes might command more goods and services than the less attractive notes of equal value. You can discuss what happens when someone has an extremely worn (old) note or a torn note, and what happens when someone has a very new crisp note. 2 Cattle are neither divisible nor homogeneous. Bars of gold are difficult to carry around. Cigarettes and cattle are not durable. Cattle might succumb to mad cow disease and a smoker might smoke the cigarette. 3 A car dealership is not legally bound to accept a sack full of coins in payment for a car. 4 In times of very high inflation, money can lose value quickly. The currency of the country might be legal tender, but no one wants to accept this currency in settlement of debts. In these times, a foreign currency might be used as money. 5 Coins from many countries of the world are milled around the edges. 6 The very rich might buy paintings, but the average income earner might buy a house, a car, a piece of jewellery, or units in a unit trust or mutual fund. (These financial institutions are discussed in Chapter 15.) 7 A $100 note of ‘Monopoly’ money is smaller than a $100 bill of a country. ‘Monopoly’ money is not printed on the back, there is no watermark or national emblem, and it is not as durable as real paper currency. 8 Notes are being used less to purchase items such as dinner, clothing and furniture. Larger businesses tend to accept cheques, credit cards and debit cards. 9 Some examples are: private loans of money from one individual to another, buying foreign currency from someone you know, employing the lady who lives down the street to clean your house, joining up with a friend to start up a small shop on the corner. 10 Some jobs are: paid domestic workers, house repairmen, gardeners, dressmakers, and street and market vendors. 114 14 · The financial sector Examination-style questions Multiple choice questions 1 What is money? a notes and coins b cheques and debit cards c anything that is acceptable as a means of settling debts d anything the seller pays to settle a debt 2 Which is not a function of money? a store of value b unit of value c standard of deferred payment d medium of exchange 3 Which of the following is not a feature of money? a portability b uniformity c divisibility d suitability 4 What is the definition of broad money? a notes and coins, all chequing accounts and travellers’ cheques b notes and coins plus savings deposits and money market accounts c M1 plus money market accounts only d M1 plus savings deposits and money market accounts 5 What is the role of the financial sector in the economy? a It attracts funds from lenders which it loans to firms, private individuals and the government. b It issues notes and coins for circulation. c It obtains foreign loans for the government. d It lends money to individuals free of interest. 6 Which of the following is part of the informal sector? a a credit union b an insurance company c a building society d a money lender Structured question 1 a Explain the concept of ‘barter’, giving an example. [3] b What are two difficulties of barter? [4] c Explain how the use of money alleviates the problems of barter explained above. [8] Essay question [20] a b c d [2] [6] [2] [10] What is the ‘informal sector’ of the economy? Using examples, explain the workings of this sector. What is the ‘financial sector’? Discuss the role and functions of this sector. 115 15 By the end of this chapter you should be able to: The central bank and other financial institutions say what the ‘central bank’ is and explain its functions; explain the functions of commercial banks in the Caribbean; name and describe the role of other financial institutions in the Caribbean economies; name and describe the financial instruments used in the Caribbean. Concept map The central bank and other financial institutions central bank financial institutions • commercial banks • development banks • insurance companies • credit unions • mutual funds • investment trusts • stock exchanges • building societies buy and/or sell financial instruments The central bank central bank • The central bank is the head of the financial sector in any economy. The central bank is not involved in ordinary banking business. Its twofold purpose is: • to oversee the operations of all financial institutions in the economy; and • to implement monetary policy on behalf of the government. Among the central banks in the region are the Central Bank of Trinidad and Tobago, the Central Bank of Barbados, the Bank of Guyana, the Bank of Jamaica and the Eastern Caribbean Central Bank. Functions of the central bank The central bank performs the following functions: • It has the sole rights to issue notes and coins for the country. The central bank is the sole issuer of new notes and coins in the economy. It also accepts and replaces unfit notes and coins. 116 15 · The central bank and other financial institutions ITQ1 Can a private individual open an account with the central bank? national debt • repo rate • • It is the bank for all commercial banks. All commercial banks must keep a percentage of their deposits as cash reserves at the central bank. The central bank lends to the commercial banks if this is necessary. Commercial banks also seek and accept advice from the central bank. They have to report regularly to the central bank on various aspects of their operations. • It is banker to the government. The central bank keeps the accounts of the government. Just as corporations and individuals hold deposit accounts at commercial banks, the government holds deposit accounts at the central bank. These accounts are used for receiving funds, making payments and clearing cheques issued by government departments. The central bank lends to the government if the government needs money. It manages the national debt of the government. The national debt is the sum of all outstanding government borrowing, internally (within the country) and externally (abroad). • It implements monetary policy on behalf of the government. When there is inflation and the economy is overheating, the central bank will implement deflationary monetary policy; for example, it might increase interest rates. This will reduce borrowing by firms and individuals, and then investment and consumption in the economy will fall. This will reduce aggregate demand and national income. Inflation will fall. This is summarised in Figure 15.1. In May 2006, the Central Bank of Trinidad and Tobago raised the repo (or, ‘repurchase agreement’) rate from 6.75 per cent to 7 per cent. The repo rate is the rate at which the central bank provides overnight liquidity to commercial banks. This is an opportunity to convert assets to cash. As the repo rate rises (or falls), the interest rate will rise (or fall). This was done to combat rising inflation. central bank increases repo rate interest rates of commercial banks rise investment and consumption fall aggregate demand falls demand-pull inflation is reduced (see page 137) Figure 15.1 Central bank deflationary monetary policy When there is unemployment and low national income in the economy, the central bank will implement expansionary monetary policy; for example, it might decrease interest rates. This will increase borrowing by firms and individuals, and then investment and consumption in the economy will rise. This will increase aggregate demand and national income. Unemployment will fall. This is summarised in Figure 15.2. central bank decreases the repo rate interest rates of commercial banks fall investment and consumption rise aggregate demand rises national income and employment increases Figure 15.2 Central bank reflationary (expansionary) monetary policy • It manages foreign exchange reserves. The central bank looks after the foreign exchange reserves account. It ensures that the country always 117 15 · The central bank and other financial institutions non-bank financial institutions • has sufficient reserves and, if it does not, it advises the government on appropriate policy. It also protects the exchange rate from fluctuations. Finally, the central bank is the government’s representative in all international financial matters. • It supervises non-bank financial institutions (NFIs). In most countries, the central bank supervises the operations of other financial institutions – such as insurance companies, pension funds and investment trusts; for example, this is the case in Trinidad and Tobago. Commercial banks commercial bank • rate of interest • financial intermediaries • ITQ2 Why is the rate of interest higher on commercial bank loans than deposits? A commercial bank provides individuals and firms with banking services. Commercial banks are profit-making enterprises. Some commercial banks in the Caribbean region are: RBTT, Scotiabank and Republic Bank. • Commercial banks accept deposits from individuals and firms. The depositors are paid interest by the bank. The rate of interest is the price charged for borrowing money. • Commercial banks make loans to individuals, firms and the government. Individuals might need a loan for purchasing a house, for educational purposes or to start a small business. Firms use loans to invest, and they might create more jobs. The government might need a loan to meet expenses or to bridge its current expenditure if revenues do not come in on time. • Commercial banks offer safekeeping services. Customers use the bank safety deposit boxes to store important documents and valuables, such as property deeds and jewellery. • Commercial banks offer a wide range of services. Services offered by the banks include: letters of credit, bills of collection, customer payment services, cheque services, credit and debit card services, and 24-hour banking. • Commercial banks offer foreign currency banking services. Banks issue travellers’ cheques, and buy and sell foreign currency. They issue bank drafts in foreign currencies. Commercial banks in the region now accept deposits in foreign currency such as the US dollar, the Canadian dollar and the pound sterling. Commercials banks are financial intermediaries. They bridge the gap between borrowers and lenders. By offering a rate of interest on deposits, banks entice individuals and firms to save. Savings form the basis of growth and development in the economy. Savers are paid interest to deposit their funds in banks, and borrowers borrow these funds at a higher rate of interest. The banks, therefore, provide funds for activities such as investment, home ownership and education. They provide services that aid trade within a country and between countries. Share market stock market • share market • shares • stock • 118 A stock market, or share market, is a market for the trading of company stock or shares. A company’s assets can be divided into equal parts called shares. A collection of shares is called stock. At times, the terms ‘stock’ and ‘shares’ are used interchangeably. An investor might own, say, $5000 worth of company stock, which could be 1000 × $5.00 shares or 2000 × $2.50 shares. The stocks might be listed on the stock exchange or traded privately. The term ‘the stock market’ is simply the mechanism that enables the trading of company stocks. The sellers in the share market are the company itself and other holders of shares. The buyers might be other companies, bank and non-bank financial institutions, or private individuals. The items traded are the shares of different companies. 15 · The central bank and other financial institutions Stock markets • The stock market is one of the most important sources through which companies can raise money. • At the stock market, investors can quickly and easily sell shares, and so obtain cash. This is an advantage of investing in stocks, compared with, say, real estate. • The price of shares can be an indicator of business conditions in an economy. Rising share prices, for instance, tend to be associated with an increase in business investment, and falling share prices with a decrease. • Share ownership allows private individuals to earn additional income. • A stock exchange is often the most important component of a stock market. Stock exchange stock exchange • stockbroker • A stock exchange is a corporation that brings buyers and sellers of company stock together. The stock exchange is also called a ‘bourse’. It provides facilities for stockbrokers and traders to trade company stocks. A stockbroker is a licensed individual who acts as an agent for clients, buying and selling shares in the market on the client’s behalf. The stockbroker really makes the market, as he/she brings buyers and sellers together. To be able to trade shares on a certain stock exchange, the company has to be listed there. The company must be a public limited company. Some examples of stock exchanges in the region are the Trinidad and Tobago Stock Exchange, the Jamaica Stock Exchange, the Guyana Stock Exchange and the Eastern Caribbean Securities Exchange. • The stock exchange facilitates the trading of shares, as the exchange is responsible for the collection and delivery of shares. It guarantees payment to the seller. This eliminates the risk to an individual buyer or seller that the other party could default on the transaction. • The stock exchange contributes to increased prosperity of the economy as businesses obtain funds, and companies and households have the opportunity to invest and even make profits. Credit union credit union • A speedy way to get his wheels. development bank • A credit union is a cooperative financial institution that is owned and controlled by its members. Credit unions differ from traditional financial institutions in that the members who have accounts in a credit union are that credit union’s owners. Some credit unions in Trinidad and Tobago are: the Eastern Credit Union Cooperative Society Ltd, the Teachers Credit Union Co-operative Society Ltd and the Trinidad & Tobago Police Service Credit Union Co-operative Society Ltd. Only a member of a credit union can deposit money with that credit union, or borrow money from it. Credit unions are committed to helping members improve their financial situations. Credit unions typically pay higher dividends on shares (or interest on deposits) and charge lower interest rates on loans than banks. Credit union revenues (from loans and investments) must exceed operating expenses and dividends (or interest paid on deposits) in order for the credit union to stay in business. Credit unions are not as profitable as banks, as they focus on serving members. Development bank A development bank is an institution set up to facilitate growth and production in a particular sector in the economy. It grants loans at competitive rates to potential investors. Developments banks do not accept deposits from the general public. Funds are obtained from international and regional institutions, and grants from the government. The development bank might invest its idle 119 15 · The central bank and other financial institutions ITQ3 In what sectors are there development banks? funds in securities in order to increase its earnings. An example of a development bank is the Agricultural Development Bank (ADB) of Trinidad and Tobago. Insurance company insurance • premium • ITQ4 Give three examples of loss that insurance holders suffer. Insurance is an agreement whereby a company guarantees to give compensation for loss of life or property, for damage to property, for injury or for illness in return for payment of a regular sum of money. This sum of money is called a ‘premium’. Insurance companies provide insurance. Some examples of insurance companies in the region are: Sagicor and CLICO. They operate on the principle that not everyone will suffer the same loss to the same extent at the same time. Insurance companies receive funds from the payment of premiums by those who buy insurance. When the buyer suffers a loss, the insurance company must compensate the buyer of insurance or his beneficiary. Better safe than sorry. • The services offered by insurance companies are a security to firms and individuals. Private property is protected against risk of loss. Businesses are protected against loss of or damage to property by fire, and stock and goods in transit are protected against loss. Insurance offers security for traders. • Insurance companies use their funds to purchase government and private sector securities. Therefore, insurance companies also provide a source of funds to government and businesses. Mutual fund mutual fund • ITQ5 Why would a new investor invest in a mutual fund? A mutual fund is a collective investment company. An investor buys a share in the mutual fund and is paid a dividend based on the number of shares he holds. The dividend might be at a fixed rate, or it might vary depending on the performance of the fund. The fund pools money from many investors and invests their money in a range of securities. The advantage of the mutual fund is that the investor has the services of an expert fund manager to make investment decisions. The investors’ collective funds are used to invest in securities to which the individual investor might not normally have access. Building society building society • 120 A building society is a financial institution owned by its members that offers banking and other financial services, especially mortgage lending. The term ‘building society’ first arose in the nineteenth century in the UK. Groups of people pooled savings so that members could buy or build their own homes. Today, building societies offer services similar to those offered by commercial banks. Such services include a range of savings accounts, money transfers and 15 · The central bank and other financial institutions ITQ6 Why did institutions such as the building society develop? foreign currency transactions. They still offer loans and mortgages for home and land ownership. Also, in some building societies, loans are available to non-members. Two examples of building societies in the region are the Jamaica National Building Society and the New Building Society Ltd of Guyana. Investment trust company trust company • A trust company accepts deposits from the public. These deposits fund commercial mortgages for the corporate sector. Trust companies, therefore, make funds available to very large firms so that they are able to make capital investments. In Trinidad and Tobago, trust companies also service the lower end of the market, one such being the Housing Development Corporation (HDC). By servicing the HDC, funds are made available for the government to provide low-cost housing. Trust companies have assisted in the development of the capital market in the economy through the management of share issues of public companies. They also assist through the purchase of government and private securities. As buyers of securities, investment trusts are a source of funds to the private and public sector. Informal credit institutions ITQ7 Six friends get together to have a sou sou from the end of July. They each make a monthly payment of $1000. There is no box. When will the sou sou end and what is the value of each hand. ITQ8 Explain whether it is ethical for a boss to participate in a sou sou with his/her subordinates. ITQ9 What problems can you foresee with a sou sou? money lenders • For many years, the financial sector in the Caribbean economies remained relatively underdeveloped. However, the people of the Caribbean had financial needs that had to be satisfied. Informal financial institutions developed, arising from the needs of the people. In later years, formal financial institutions extended to reach a larger part of the population. However, the people of the Caribbean still held onto these simpler institutions. As a result many of these informal institutions exist to this day. Some of them include: • Sou sou. This is an informal arrangement where a small group of people contribute an equal fixed sum each week or month on payday to a common fund, called a pot. The total amount paid in by all participants goes to one member of the group each week or month. This sum is called a hand. In some sou sou, there is a small tax on participants to pay the person running the sou sou. This is called a box. People will ‘throw’ a sou sou with others whom they know, such as neighbours or work colleagues. Clearly, if you took one of the earlier hands, it is as if you are borrowing the sum of money at zero per cent interest and repaying by instalments in later weeks/months. If you took a later hand, then it is as if you were saving up your money to get a lump sum later. The sou sou lives on to this day in Caribbean islands such as Trinidad and Tobago, St Lucia, St Kitts and Tortola. Versions of this arrangement are called Partner and Meeting Turns. This savings scheme is popular amongst Caribbean people, South Americans, and Africans and their descendants in other parts of the world, such as the USA. • Money lenders. In Caribbean societies, money lenders or usurers also used to conduct a fair amount of business. We might question how fair the business was, though. The usurers usually lent money at very high rates of interest to borrowers. However, the borrower might not have to put up any security (collateral) to obtain the loan. Money lenders and their activities still survive in Caribbean societies, especially the rural areas. Financial instruments financial instruments • Companies and governments (through the central bank) issue financial instruments. These instruments provide a means for other companies and individuals to participate in business activity by lending or investing (and 121 15 · The central bank and other financial institutions securities • earning an income), and even decision-making. These instruments are called securities. Securities are certificates proving entitlement to debt repayment or part-ownership of a company. Securities are traditionally divided into debt securities and equity. Debt securities are a loan to the business or the government. Equity security constitutes part-ownership of company. Figure 15.3 shows the difference between debt and equity securities. securities debt securities • a loan to the issuer • principal and interest to be repaid; e.g. bonds, debentures, notes/bills equity securities • ownership in company • entitled to dividends and voting rights in the case of ordinary shares; e.g. company stocks Figure 15.3 Types of securities Treasury bills • bonds • corporate bonds • municipal bonds • equity securities • dividends • The types of securities are: • Treasury notes (bills) and bonds. These are debt securities issued by the government, hence the use of the term ‘Treasury’. Bills and bonds represent loans to the government. The buyer of a bill or bond is giving the government a loan. Treasury bills are short-term loans, usually for 91 or 182 days. The Bank of Guyana issues 364-day Treasury bills. Bonds are longterm loans of a 5-, 10-, 20- or 30-year period. Government bonds carry a lower rate of interest than corporate bonds. These securities are considered low risk, as the government does not default on repayment. They are a source of finance to the government. • Corporate bonds. Corporate bonds are long-term debt security issued by companies or corporations. A bondholder is a creditor who has a claim against the company equal to the value of the bond. Once the claim of the bondholder is paid off, the bondholder has no claim on the company. Corporate bonds are a source of finance for companies. • Municipal bonds. Municipal bonds represent the debt of a municipality or other governmental unit other than central government. It is a source of finance and is a loan made by the buyer to the government unit. The funds received from the sale of these bonds are used to finance community projects such as road building, drainage and park maintenance. Some municipal bonds might entitle the holder to tax credits. • Equity securities. These are certificates of stock that represent ownership in the company. A stockholder is a part-owner of the company. For example, if a company has 100 000 shares of stock and you own 1000, you own one per cent of the company. As a part-owner, you are entitled to part of the profits, which are paid in the form of dividends. As a holder of ordinary shares, you also have a right to vote in the selection of management. The central bank is head of the financial sector in the economy. The central bank issues notes and coins, is the bank for all commercial banks, is banker to the government, implements monetary policy on behalf of the government, manages the foreign exchange reserves of the country and oversees the operations of other financial institutions. Commercial banks accept deposits, and offer loans and a wide range of services to individuals and firms. These banks play an important role in mobilising savings in the economy and facilitating trade. 122 15 · The central bank and other financial institutions The share market comprises the buyers and sellers of company shares. A stock exchange is a company that provides the facility for the exchange or buying and selling of shares. A credit union is owned and controlled by its members. It operates for the benefit of its members, providing loans at lower rates of interest than other financial institutions. Development banks are set up to encourage investment in a particular sector in the economy by granting low-cost loans to potential investors. Insurance companies are non-bank financial institutions that provide the service of insurance to firms and individuals, and are also a source of funds for firms and government. A mutual fund is a business that specialises in collective investment of investors’ funds. Investment trusts accept deposits from the public and offer corporate mortgages to the business sector. An informal credit institution in the Caribbean, one that has survived to this day, is the sou sou. Another practice that originated a long time ago is enterprising and wealthy individuals taking on the role of moneylenders. Financial instruments are called ‘securities’. There are ‘debt securities’ and ‘equity securities’. Debt securities constitute a loan to the company or the government. Equity securities give the holder part-ownership in the company. Financial instruments include: Treasury notes (bills) and bonds, corporate bonds, municipal bonds and equity securities. 1 No. The central bank does not accept deposits from a private individual. A private individual wishing to open an account has to go to a commercial bank or other financial institution. 2 Commercial banks receive interest payments on loans. When interests on deposits are paid out, at an interest rate which is a lower figure, the remainder is payment to the banks for their services. 3 There might be development banks in agriculture and in industry in order to assist investors by providing low-cost loans and technical advice. The ADB of Trinidad and Tobago lends for all types of agribusiness (agricultural businesses), from farming and livestock rearing to processing. 4 Some examples of loss are: destruction of home by fire, loss of car by theft, and injury through vehicular accident. 5 The mutual fund offers the services of an expert and manager to make your investment decisions. 6 Such institutions developed because potential homeowners needed loans and were unable to obtain them, and/or the rates of interest were too high. 7 The sou sou will end at the end of December and the value of each hand is $6000. 8 It is not ethical for a boss to participate in a sou sou with his/her subordinates since it might give the appearance that the boss favours the participants of the sou sou over non-participants. Workers might feel they have to participate in the sou sou because otherwise it might affect their job negatively. 9 Many of the participants in the sou sou will want their lump sum early. All participants must be trustworthy, as each has to be relied upon to pay up until the end of the entire period. 123 15 · The central bank and other financial institutions Examination-style questions Multiple choice questions 1 Which of the following is a function of the central bank? a It accepts deposits. b It is banker for the government. c It makes loans to individuals. d It issues foreign currency. 2 Which of the following is a function of a commercial bank? a It issues notes and coins. b It sells insurance policies. c It manages the country’s foreign exchange reserves. d It makes loans to firms and individuals. 3 How is a commercial bank different from a credit union? a A credit union is owned by its members. b A commercial bank is owned by its depositors. c Commercial banks charge a lower rate of interest than credit unions. d Unlike commercial banks, credit unions do not give loans. 4 Which is not a financial institution in the Caribbean? a mutual fund b stock market c building society d sou sou 5 Which of the following are equity securities? a Treasury bills b government bonds c corporate bonds d company shares 6 How is a corporate bond different from a government bond? a A corporate bond is issued by a firm and a government bond is issued by the government. b A corporate bond is equity security and a government bond is debt security. c A corporate bond is short term and a government bond is long term. d A corporate bond gives the holder a claim on the company that issues it. Structured questions 124 1 a What is a Treasury bill? [2] b Explain two differences between a Treasury bill and a corporate bond? [4] c Who provides funds for businesses to grow? [1] d Explain the role of two financial institutions in your economy. [8] 2 Penny and Bill are newlyweds. They wish to purchase a new home, as well as to start a joint savings account for the future. a Giving reasons, explain which financial institution the newlyweds should go to obtain a homeownership loan. [6] b Giving reasons, explain which financial institution the couple should save with. [6] c Explain why the informal sector might not be useful for their needs. [3] 15 · The central bank and other financial institutions Essay question [20] a How does the existence of the stock exchange assist public limited companies and potential investors? [4] b Why does a credit union charge a lower rate of interest than a commercial bank for the same loan? [4] c Explain four functions of a central bank. [12] 125 16 By the end of this chapter you should be able to: Government in the economy and national income explain the role of the different sectors in the economy, including government; explain and illustrate the simple ‘circular flow of income’; calculate from data the ‘gross domestic product’ (GDP) and ‘gross national product’ (GNP); distinguish between GDP and GNP; show the difference between the terms ‘nominal’, ‘real’ and ‘potential’ output; explain the uses of national income statistics; define concepts related to public (government) finance. Government in the economy and national income Concept map households firms national income/output gross domestic product (GDP) gross national product (GNP) Introduction closed economy • household • firm • plant • government • 126 A closed economy is an economy that does not engage in international trade. There are three sectors in a closed economy. The three sectors are: households, firms and government. • A household consists of one or more persons living together in one housing unit, making single consumption decisions. Households are the owners of the factors of production (and, therefore, sellers of factor services) and they are the consumers of goods and services. • A firm is an enterprise controlled by one management unit. A firm is made up of a number of plants. A plant is a production unit. In economic theory, firms are buyers of the services of factors of production and the producers of goods and services. • Government taxes individuals and firms, and so obtains a large percentage of its revenue. This revenue is then used to finance government expenditure. 16 · Government in the economy and national income Expenditure capital expenditure • current expenditure • ITQ1 Give one example of capital expenditure and one example of current expenditure. transfer payments • There are two types of government expenditure: capital expenditure and current expenditure. Capital expenditure involves investment in capital goods such as roads, schools and even government enterprise to produce goods. This expenditure is also called development expenditure. Current expenditure is spending on goods for present consumption and expenditure on wages and salaries of government workers. Final goods for present consumption include paper for government departments, boots for soldiers and drugs for hospitals. Governments also make transfer payments to the elderly and the needy in the economy. Transfer payments are monies given to one group by another for which no productive activity took place; for example, government payments of social security benefits. Since current expenditure takes place repeatedly each week or month (that is, it recurs), it is called recurrent expenditure. Figure 16.1 shows the division of government expenditure into capital and current expenditure. capital expenditure investment in different forms of capital; e.g. roads, schools and hospitals income from taxes current expenditure spending on final goods and wages and salaries Figure 16.1 Government expenditure ITQ2 Government expenditure was projected at TT$41 billion for 2007. How much funding is allocated to education? Government expenditure can also be broken down according to the percentage of government expenditure allocated to different sectors in the economy. Figure 16.2 shows government expenditure by sector for Trinidad and Tobago for 2007 (estimates). A pie chart is usually used to illustrate this data as it shows how the national pie is shared! administration, public relations and information 3% Ministry of Finance debt servicing Tobago House of Assembly and local government Figure 16.2 Fiscal year 2007 international sector • foreign trade sector • 24% 10% 10% 11% 7% 6% health justice and security social services and pensions 8% infrastructure and development 9% utilities and energy 12% education An open economy is an economy that engages in international trade. Most economies in the real world are open economies. In an open economy, there are households, firms and the government, just as in the closed economy. There is also an international sector. The international sector – or foreign trade sector – is made up domestic firms which purchase imports, and other domestic consumers of imports. It also consists of foreign firms and foreign consumers who purchase exported goods and services. Table 16.1 shows the roles of the different sectors in the economy. 127 16 · Government in the economy and national income Table 16.1 The role of the different sectors in the economy Sector Role Households owners of factors of production; buyers of goods and services Firms buyers of factor services; producers of goods and services Government taxes households and firms to earn revenue; engages in recurrent and capital expenditure; makes transfer payments to the elderly and poor Foreign trade sector domestic buyers of imports; foreign buyers of the exports of the given country The circular flow of income circular flow of income • Elementary National Income Theory is based on a closed economy with no government. This is a hypothetical economy, as there are no real economies such as this. In this imaginary economy, there are two sectors: households and firms. Firms buy the factor services of households and pay to the households a factor income. Households, in turn, use this factor income to purchase goods and services produced by firms. This flow of funds in the economy is called the circular flow of income. DEFINITION: The circular flow of income is that flow of factor incomes from firms to households in return for factor services. This factor income then flows back to firms as payment for goods and services that the households purchase. expenditure on goods and services goods and services households firms factor services – land, labour, capital and entrepreneurship payments of factor incomes Figure 16.3 The circular flow of income real flows • money flows • ITQ3 Use an example to show how the income in the circular flow remains the same. 128 Figure 16.3 shows the flow of factor services from households to firms. Firms use these factor services to produce goods and services. There is a flow of goods and services from firms to households. The flow of goods and services and factor services are called real flows. Firms pay incomes for the factor services. Factor incomes flow from firms to households. Households then take this factor income to pay for goods and services purchased from firms. The flow of factor incomes from firms to households and the flow of expenditure from households to firms are balanced. These are money flows. Altogether money flows and real flows make up the circular flow of income. Whatever the value of the income, it remains the same as income flows from households to firms and back to households, because there are no additions or withdrawals from the circular flow of income. 16 · Government in the economy and national income In the real world, the circular flow of income is modified to reflect the presence and activities of the financial sector, government and the foreign trade sector. This is seen in Figure 16.4. foreign trade sector payments for imports of goods and services payments for exports of goods and services expenditure on goods and services goods and services taxes households taxes government expenditure government government expenditure firms factor services – land, labour, capital and entrepreneurship payments of factor incomes savings financial institutions investment Figure 16.4 The circular flow of income in a real-world economy leakages • savings • disposable income • investment • injections • The relationship between households and firms remains the same. However, when households receive income, some might be saved, some might be paid in taxes and some is spent on imports (although for simplicity this is not shown in the diagram). Savings, taxes, and expenditure on imports are leakages, or withdrawals, from the circular flow of income. Leakages are income of households and firms that is not passed on in the circular flow of income. Savings consist of all income that is not consumed. Firms pay taxes to the government (a leakage). Households also pay taxes. Taxation consists of compulsory payments to the government based on income earned or expenditure. Disposable income is total personal income minus taxes. Imports are expenditure on foreign-produced goods and services. Both households and firms purchase imports. Firms receive payment for goods and services from households, but they can also go to financial institutions to borrow funds for investment purposes. Recall that investment is the purchase of capital goods (goods used to produce other goods). Government also spends in the economy and adds to the circular flow of income. Firms can receive grants and subsidies from the government. Some households might be employed by the government, and so earn an income. This is government expenditure. Firms might also sell some of their output to foreigners. Earnings from the sale of domestic output abroad are recorded as exports. Investment, government expenditure and export earnings are injections. Injections are additions to the circular flow of income. National income national income • Economists calculate national income statistics to measure economic activity in an economy. National income is a measure of economic activity in an economy 129 16 · Government in the economy and national income ITQ4 What is investment? GDP at market prices • GDP at factor cost • ITQ5 Name the four factors of production and the income of each. Table 16.2 over a given period, usually one year. National income can be calculated using one of three methods. The three methods are: the expenditure method, the income method and the output method. The total expenditure in the economy is equal to the total of all factor incomes earned which, in turn, is equal to the value of total output in the economy. For example, when you go to the grocer to buy 1 kg of flour, the $10 you pay over the counter represents expenditure on your part, the buyer. It represents income received on the part of the seller. It also represents the value of the flour – output. In fact, these are simply different ways of looking at the same thing – the value of output. In the same way, for the economy as a whole, total expenditure is equal to total income, which is equal to total output. Tables 16.2, 16.3 and 16.4 show a breakdown of the computation of national income using the expenditure method. To compute national income using the expenditure method, we can look firstly at the illustration in Table 16.2. Recall that the sectors in an open economy are households, firms, government and the foreign trade sector (see pp.126 and 127 and Table 16.1). • Households consume goods and services. The consumption activities of all households are collectively recorded as private consumption, or simply consumption (C). Since it is the total spending of all households in the economy, it is an aggregate or total value. • Firms’ spending activity is investment, and this is recorded as ‘gross domestic fixed capital formation’ or simply ‘investment’ (I). This is also an aggregate value. • Total or aggregate government expenditure is also recorded and the abbreviation for this is G. • Another group that purchases the output of the economy consists of foreign firms and individuals. Foreign firms’ expenditure on exports of the economy represents output from the domestic economy. So, therefore, we must add together private consumption, investment, government expenditure and exports. From this, we must subtract imports, as the spending of each group in the economy can have an import component. Imports represent output of foreign countries. The sum is gross domestic product (GDP) at market prices. GDP at market prices is national output for the year computed by adding together the spending of all sectors and subtracting imports. However, GDP is computed by adding up spending, so it includes the effects of indirect taxes and subsidies on prices in the market. Taxes make prices of goods higher than they really are, if we simply tally payments to the four factors of production. Subsidies make goods look cheaper than they are, if we simply tally payments to the four factors of production. To obtain GDP at factor cost, we must subtract indirect taxes and add subsidies. This can be seen in Table 16.3. GDP at factor cost is national output for the year measured at the prices paid to the factors of production to produce the output, and it excludes the effects of indirect taxes and subsidies. The sum of the payments to the all the factors of production will also give GDP at factor cost. This is GDP according to the income method. A sum of the value-added output of each industry in the economy will also give GDP at factor cost. This is GDP according to the output method. Theoretically, all methods should give the same value for GDP at factor cost. Since all economies have Gross domestic product at market prices Consumption (C) Investment (I) Government expenditure (G) Exports (X) less Imports (M) GDP at market prices 130 500 1100 1375 400 (425) 2950 Table 16.3 Gross domestic product at factor cost GDP at market prices less Taxes plus Subsidies GDP at factor cost 2950 (30) 20 2940 16 · Government in the economy and national income GNP • national income • Table 16.4 National income GDP at factor cost Net property income from abroad GNP less Capital consumption Net national product (NNP) or national income (NI) 2940 (220) 2720 25 2695 countless activities taking place, there might be errors and omissions. National income statisticians introduce a statistical discrepancy figure to account for any errors in collecting the data. In our simple national income example, we assume that there are no errors. Once a common value for GDP at factor cost is arrived at, this statistic can now be refined to compute other useful national income statistics. GDP at factor cost plus net property income from abroad will give you the gross national product (GNP). This is seen in Table 16.4. Net property income from abroad is positive if the total investment income flows into the domestic economy are greater than the investment flows out of the country; that is, inflows > outflows. Net property income from abroad is negative if investment income flows into the domestic economy are less than investment flows out of the country; that is, inflows < outflows. If you see a GNP value, you can assume it is at factor cost unless otherwise stated. GNP minus capital consumption or depreciation will give you net national product. This is also called national product, or national income. National income is the money value of goods and services (output) produced in an economy over a given period, usually one year. DEFINITION: Gross domestic product (GDP) is a measure of output produced in a country over a given period, usually one year, using the factors of production located in that country irrespective of whether the factors of production are locally owned or foreign owned. DEFINITION: Gross national product (GNP) is a measure of output over a given period, usually one year, the output being produced by factors of production owned by nationals of a country, irrespective of whether the factors of production are located in the country or in another country. The difference between GDP and GNP is net property income from abroad. Nominal, real and potential output nominal output • real output • potential output • ITQ6 Why is an economy producing potential output on its production possibility frontier? Instead of saying ‘national income’ or ‘national output’, some economists might simply say ‘output’. ‘Nominal output’ is the level of output produced in a country for a given year, measured in prices for that year. ‘Real output’ is the level of output produced in a country for a given year, measured in prices for a base year. When economists wish to eliminate the effects of inflation on the value of output, they measure output for a number of years at the prices prevailing in one year. In this way, comparisons can be made to see by how much real output has changed. ‘Potential output’ is the level of output that an economy is capable of producing when all its factors of production are fully employed. If the actual output produced is less than potential output, it means that there are unemployed resources in the economy. When an economy is producing on its production possibility frontier, it is producing its potential output. Uses of national income statistics National income statistics have several uses. • The primary purpose of national income statistics is to measure the level of economic activity in a country. Increasing real output indicates improving economic performance. Falling real output requires investigation as to why output is falling, and decisions as to what can be done to increase output. • Governments use national income statistics as an indicator of the standard of living of the people in a country. Higher real incomes indicate that the quality of life has improved. Lower real incomes indicate that there might have been a worsening of the quality of life of some residents. 131 16 · Government in the economy and national income • Governments measure economic growth by looking at the change in real per capita national income. • International agencies use national income statistics to classify countries according to different levels of development. This classification can be further used to determine aid and assistance for countries. Public finance balanced budget • budget deficit • fiscal deficit • national debt • The national budget is presented to parliament at the start of the fiscal year. There is a balanced budget when expenditure is equal to revenue. Sometimes the government will spend more than it earns. There is a budget deficit when expenditure exceeds revenue. This is also called a ‘fiscal deficit’. When there is a budget deficit, the government must borrow locally and abroad to meet the revenue shortfall. The sum of government borrowing (locally and abroad) over the years to finance budget deficits is the national debt. DEFINITION: The national budget is a statement of government’s estimated revenue and expenditure for a country for the coming year. budget surplus • There is a budget surplus when revenue exceeds expenditure. Governments might use this surplus to pay off past borrowing. In such a way a budget surplus leads to a reduction of the national debt. In an open economy, there are four sectors: the household sector, the firm sector, the government and the foreign trade sector. The government earns revenue mainly through taxation and spends this revenue on capital and current expenditure. Government also spends on transfer payments. The circular flow of income is that flow of factor incomes from firms to households for factor services. This income then flows back to firms as payment for goods and services that the households purchase. The simple circular flow of income is based on flows between households and firms. In real-world economies, there are injections into and leakages from the circular flow of income. National income can be calculated using any or all of three methods: the expenditure method, the income method and the output method. • The expenditure method sums the spending on domestic goods and services of the four main groups: households, firms, government and foreigners. • The income method sums the income received by the four factors of production. • The output method sums the value added of firms in the domestic economy. Gross domestic product (GDP) is a measure of output produced in a country using factors of production located in that country, regardless of whether the factors of production are locally owned or foreign owned. Gross national product (GNP) is a measure of output produced by factors of production owned by nationals of a country, regardless of where the factors of production are located. Nominal output is the level of output produced in a country for a given year, measured in prices for that year. Real output is the level of output produced in a country for a given year, measured in prices prevailing in a base year. Potential output is the level of output that an economy is capable of producing when all its factors of production are fully employed. The uses of national income statistics are to measure economic performance, the standard of living and economic growth, and as an indicator of the need for aid. 132 16 · Government in the economy and national income The national budget is an estimate of revenue and expenditure for a country for the coming year. 1 Capital expenditure can be: bridges, police stations, water and electric companies, and drainage. Current expenditure includes salaries to teachers, nurses and doctors. Uniforms for police and fire officers are also part of current expenditure. There are many other examples; your teacher will check your suggestions. 2 The answer is that 12 per cent of $41 billion is $4.92 billion. 3 Start with either households or firms. Say, for example, firms produce $100’s worth of output. The $100 is paid to the owners of land, labour, capital and entrepreneurship. This is factor income. When households (sellers of factor services) receive this $100 in income, they spend it on goods and services. This is the expenditure in the economy. Firms then use this $100 to produce more goods and services, and the cycle continues. 4 Investment is the purchase of capital goods – that is, goods used to produce more goods. 5 The four factors of production are: land, labour, capital and entrepreneurship. The four factor incomes are, respectively: rent, wages, interest and profits. 6 The economy is producing potential output on its production possibility frontier, as all resources are fully employed once the economy is on its frontier. Recall this from Chapter 1. Examination-style questions Multiple choice questions 1 The simple circular flow of income shows: a the flow of income from households to firms b the flow of expenditure from households to firms c the flow of savings from households to the financial sector d the flow of taxes from firms to the government 2 In National Income Theory, all of the following are forms of expenditure in an economy except: a consumption b investment c expenditure on imports d expenditure on exports 3 The difference between gross domestic product and gross national product is: a net property income from abroad b capital consumption c taxation and subsidies d imports and exports 4 What is national income? a government taxation minus subsidies b imports minus exports of a country c a measure of inflows and outflows for a given time period, usually one year d a measure of economic activity of a country for a given time period, usually one year 133 16 · Government in the economy and national income 5 How is nominal output different from real output? a Real output has been adjusted for any price increases. b Nominal output has been adjusted for price increases. c Real output is what the economy is capable of producing if all its resources are fully employed. d Real output is the output for a given year expressed in terms of prices in that year. 6 To obtain gross domestic product at factor cost from gross domestic product at market prices, economists must: a add the cost of imported raw materials b add subsidies and subtract taxes c add exports and subtract imports d subtract capital consumption Structured question 1 134 The following data are given for a certain country: exports 11 9 government expenditure imports 13 investment 15 consumption 32 net property income from abroad +2 taxes on expenditure 6 subsidies 2 a What is the gross domestic product at market prices? b What is national income? c Explain the difference between ‘gross domestic product’ (GDP) and ‘gross national product’ (GNP). [2] [4] [9] Essay question [20] a b c d [4] [4] [6] [6] Draw a diagram of the simple circular flow of income. Explain this diagram. Explain the role of government in the economy. Explain three uses of national income statistics. 17 By the end of this chapter you should be able to: Inflation, recession and unemployment define the term ‘inflation’; explain the causes and consequences of inflation; define the term ‘recession’; explain the causes and consequences of a recession; explain how the government will reduce inflation; explain how the government will relieve a recession; define ‘unemployment’ and list the types of unemployment; explain the causes of each type of unemployment; explain the measures to reduce unemployment. Concept map Inflation, recession and unemployment fiscal policy government inflation recession monetary policy unemployment Introduction macroeconomics • four goals • In Chapter 16, we discussed government’s role in the economy. Government earns revenue mainly through taxation, and spends its earnings on the provision of goods and services. This is only part of the government’s responsibility – its job is also to manage the economy. The government goals are to ensure that: • prices are stable; • unemployment is at a minimum; • there is economic growth in the economy; • there is balance of payment equilibrium. Macroeconomics is the study of the economy as a whole, rather than the individual markets and other elements of which it consists. These are the four goals (or objectives) of government macroeconomic policy. In this chapter, we will examine the achievement of price stability, and the nature and causes of unemployment. We will also examine the nature of a recession. In Chapter 18, we will examine the goal of economic growth and later, when we have looked at international trade and the balance of payments, we will examine how government achieves balance of payments equilibrium in Chapter 22. 135 17 · Inflation, recession and unemployment Policies used by government to achieve macroeconomic goals fiscal policy • monetary policy • reflationary monetary policy • deflationary monetary policy • 136 The government pursues fiscal and monetary policies to achieve its macroeconomic goals. Fiscal policy is the use of government spending and taxation to control aggregate demand in the economy. ‘Aggregate’ is a term used in macroeconomics and means ‘total’. ‘Aggregate demand’ is total demand in the econ­omy. When the government increases government spending and/or reduces taxes, this increases aggregate demand in the economy, and is thus termed ‘expansionary’ or ‘reflationary’ fiscal policy. When the government decreases government spending and/or increases taxes, this decreases aggregate demand, and so is termed ‘contractionary’ or ‘deflationary’ fiscal policy. Monetary policy is the use of interest rates and other direct measures to control the money supply and, consequently, aggregate demand in the economy. Other instruments of monetary policy are: open market operations and adjustment of the required reserve ratio. Monetary policy that increases the money supply and aggregate demand is termed ‘expansionary’ or ‘reflationary’ monetary policy. These policies include: • Reducing interest rates. When interest rates fall, individuals save less and spend more. They also borrow to make purchases. This increases the money supply in the economy. • Improving the availability of credit by decreasing the down payment needed and increasing repayment periods on loans. A lower down payment makes it easier for individuals to enter into a hire-purchase agreement. Having to make a down payment of only 10 per cent on a car to obtain a loan from a bank is much easier than having to make a 15 per cent down payment. Also, longer repayment periods on loans mean that each monthly instalment is smaller. This also makes borrowing more attractive. • Open market operations. This is the buying and selling of government securities (bonds and Treasury bills) on the open market. When the government (through the central bank) buys back securities from the holders of these securities, the government pays them money, which increases the money supply, as money enters the financial system. • Reducing the required reserve ratio. All banks are required by law to keep a certain percentage of their deposits as reserves. The lower the reserve requirement, the more banks can lend and the greater the money supply will be. Monetary policy that decreases the money supply and aggregate demand is termed ‘contractionary’ or ‘deflationary’ monetary policy, and includes: • Increasing interest rates. When interest rates rise, individuals save more and spend less. They are less likely to borrow, as the cost of borrowing is higher. This reduces the money supply in the economy. • Making credit less accessible by increasing the down payment and decreasing repayment periods on loans. A higher down payment makes it more difficult for individuals to enter into a hire-purchase agreement. Having to make a down payment of a larger percentage of the value of a purchase to obtain a loan from a bank is more difficult than having to make a smaller percentage down payment. Also, shorter repayment periods on loans mean that each monthly instalment is larger and might be more difficult for the borrower to meet. • Open market operations. When the government sells securities to individuals and firms in the domestic economy, the buyers pay the government money, which decreases the money supply, as money leaves the financial system. • Increasing the required reserve ratio. The higher the reserve 17 · Inflation, recession and unemployment requirement, the less the amount that banks can lend, which will lead to a smaller money supply. When there is pressure in the economy for the money supply to contract, this is called a ‘credit squeeze’. Inflation and its causes inflation • retail price index • Inflation is defined as the steady and continuous rise in the general price level (that is, an average of all prices in the economy). A one-off increase in prices is not inflation. Prices must rise steadily and over a prolonged period for it to be considered as inflation. An increase in a small number of prices does not constitute inflation either. Inflation is measured by a rise in the retail price index (RPI) from year to year. The retail price index is computed by measuring the change in prices of a given ‘basket’ of goods that consumers buy. In the first stage, each good in the basket is given a weight based on how much consumers spend on that good. Next, changes in the price of the goods in the basket are recorded. Finally, the change in prices is multiplied by the weight for that good and then an average change in the price level is computed. Table 17.1 shows the inflation rate in Jamaica for seven years. The data are plotted in the bar graph in Figure 17.1. Table 17.1 Inflation rates in Jamaica Inflation rates in Jamaica Inflation rate (%) 2003 7.0 2004 10.3 2005 12.4 2006 15.3 2007 5.8 2008 9.5 Source: www.indexmundi.com 16 14 inflation rate Year 12 10 8 6 4 2 0 2003 2004 2005 2006 2007 2008 years Figure 17.1 Inflation rates in Jamaica demand-pull inflation • aggregate demand • cost-push inflation • The types of inflation are defined in terms of its causes. The four contributing causes of inflation are: • demand-pull inflation; • cost-push inflation; • imported inflation; • an increase in the money supply. Demand-pull inflation is caused by an increase in demand in the economy. Total demand in the economy by all groups – households, firms, government and the export sector – is termed ‘aggregate demand’. When aggregate demand increases and the supply of goods in the economy cannot be expanded to meet this increase in demand, the result is rising prices. Cost-push inflation is caused by an increase in the prices of the factors of production. This causes firms’ costs to rise. The four factors of production are: land, labour, capital and entrepreneurship. If payments to any of these factors of production increase, this will cause costs to increase. Firms will, in most instances, increase prices in order to maintain profit levels. Here is an example to illustrate: 137 17 · Inflation, recession and unemployment ITQ1 Give another example where a business might find its total costs rising due to increasing factor costs. wage–price spiral • The total revenue of O’Jay’s Orange Juice Company is $20 000 per month from selling 400 cases of orange juice at $50 per case. It costs O’Jay’s $12 000 to produce 400 cases of orange juice (that is, $30 per case). Profit is total revenue ($20 000) minus total cost ($12 000), which is $8000. If the total cost of producing 400 cases increases from $12 000 to $14 000 due to an increase in the price of oranges, O’Jay’s must increase the price of orange juice to $55 per case (to earn total revenue of $22 000) to maintain profits at $8000 per 400 cases. This causes inflation. A main form of cost-push inflation is the increase in wages, the payment to ‘labour’. When labour costs rise faster than labour productivity, it is inflationary. The tendency for wages to increase and for this increase in wages to fuel price increases – which in turn cause labour to demand even higher wages – is termed the ‘wage–price spiral’. This is seen in Figure 17.2 price level increases employees demand higher wages employees demand higher wages price level increases further Figure 17.2 The wage–price spiral imported inflation • monetarists • an increase in the money supply • Another cause of inflation is imported inflation. The Caribbean economies import a large proportion of their food and other finished goods. Increasing world prices will result in the domestic prices of these imported goods rising. Caribbean economies also import capital, raw materials and fuel such as oil. Rising world prices of these factors also contribute to imported inflation. This element of imported inflation contributes to cost-push inflation. A group of economists called the monetarists attribute inflation to an increase in the money supply in the economy. An increase in the money supply causes an increase in aggregate demand. Just as in demand-pull inflation, this increase in aggregate demand, output remaining constant, causes an increase in prices. This is why you might have heard the expression ‘inflation is too much money chasing after too few goods’. Consequences of inflation ITQ2 Give an example to show how the purchasing power of money falls when there is inflation. 138 When there is inflation it affects all the different groups in the economy. The following are some of the consequences of inflation: • Fixed income earners suffer a fall in real income. The purchasing power of money falls during inflationary times, so that a given amount of money can buy fewer goods and services. The purchasing power of money is what goods and services the money can buy. This is illustrated in Figure 17.3. 17 · Inflation, recession and unemployment After inflation: Figure 17.3 The effects of inflation on purchasing power • When prices are increasing in the domestic economy, it means that the prices of goods that the country is exporting will rise. As prices rise, foreigners will demand fewer of the country’s goods and services. This means that the given country will earn less foreign exchange. If the level of exports falls and the level of imports remains constant, the country will suffer a trade deficit (see Chapter 22). Also, if the price of imports is lower than the rising price of domestic goods, the country will import more. This will lead to an even greater trade deficit. • Borrowers gain as the value of the debt to be repaid in real terms falls during an inflationary period. Inflation tends to encourage borrowing. • Creditors lose out because the sum to be repaid will now be able to buy less. Imagine you lent your friend $1000 a year ago. Now, when prices have risen, you receive that same $1000. Your $1000 is now worth less than when you made the loan! Inflation tends to discourage borrowing. • Looking for better prices in times of continuous inflation means that people might have to walk from place to place. These are costs in terms of time and effort, and they are called shoe leather costs. • Shops, stores and restaurants also have to change price tags and menus. These are called menu costs. • Rising costs of production cannot be passed on. Some firms might find it difficult to survive when their costs of production are rising and they cannot pass on this increase in costs in the form of higher prices to consumers. This is the case for goods with substitutes, and such producers might be forced out of the market. • Employers might be forced to reduce the quantity of labour employed because of rising labour costs. This could result in some unemployment. Measures to reduce inflation • Demand-pull inflation. In order to reduce demand-pull inflation, the government must put in place deflationary fiscal policy. Reducing government expenditure and increasing taxes reduces total spending in the economy, which in turn reduces the pressure on prices. This can be seen in Figure 17.4 Deflationary monetary policy will also be effective, as higher interest rates and a credit squeeze will limit borrowing and spending. This will reduce inflation, as there is less spending and less pressure on prices to increase. This is illustrated in Figure 17.5. 139 17 · Inflation, recession and unemployment government expenditure falls taxes increase Looking at Figure 17.1, what could the government of Jamaica have done to reduce inflation? larger down payments and shorter repayment periods total spending decreases total spending decreases inflation falls inflation falls Figure 17.4 Deflationary fiscal policy ITQ3 higher interest rates Figure 17.5 policy Deflationary monetary • Cost-push inflation. Regulations to limit the power of trade unions to increase wages will be effective in curbing cost-push inflation. Also, government subsidies and grants to firms to help increase production will make more goods and services available. This will put less pressure on prices by increasing overall supply of goods in the economy, even though aggregate demand in the economy remains the same. • Imported inflation. Cutting back on imported goods will reduce this type of inflation. If both final goods and imported capital and raw materials are substituted by local goods, the country will buy less imports. This, in turn, will reduce imported inflation. • Inflation due to increases in the money supply. Deflationary monetary policy will be effective because higher interest rates and a credit squeeze both reduce the money supply in the economy. Reduced money supply and limits on borrowing will reduce spending in the economy and so take away pressure from prices. Recession recession • depression • A recession is a period during which the total output in the economy declines. During a recession, firms are producing less, so national output decreases. As firms are producing less, it means that firms will use less factor inputs, including labour. Unemployment grows during a recession. A recession is short term, lasting some months or up to a year. A recession can develop into a depression, lasting several years. A depression is falling national output over several years, with high levels of unemployment. Causes of a recession trade cycle • 140 • The trade cycle. Economists have observed economic activity over the last two centuries. Economic activity increases and then declines over time. This is called the trade cycle. Economic activity will not simply increase all the time. The peak of economic activity is called a ‘boom’ and the trough is called a ‘depression’. As the economy slides from a boom, this is a recession. A recession signals the end of the boom stage of the trade cycle. At the point at which economic activity declines, this is the onset of the recession. This is seen in Figure 17.6. 17 · Inflation, recession and unemployment GDP boom recession recovery depression time Figure 17.6 The trade cycle • During a boom, demand is increasing. This increasing demand will fuel inflation. As the government puts in place deflationary fiscal and monetary policy, this will cause aggregate demand in the economy to fall. Prices will stabilise but there might be a decline in output and a rise in unemployment. This is a recession. • Cautious entrepreneurs might feel pessimistic about the future. This might simply be an instinct that demand will fall in the future. As a result, they might cancel investment plans. They might even avoid undertaking replacement investment. This fall in investment will lead to a fall in national output. • The demand of households, firms, government and the export sector might fall. This will cause aggregate demand in the economy to fall, thereby causing output to fall. • If firms are not making sufficient profits, they will close down. This will cause a contraction of national output. Consequences of a recession • In a recession, output is falling. This means that GDP and standard of living is falling. • If output is falling, firms will use fewer factors of production, including labour. This will cause rising unemployment • Rising unemployment and falling GDP will result in people having less income to purchase goods and services. There will, therefore, be a fall in consumption. • Rising unemployment and falling incomes will result in less inflationary pressure in the economy. Prices will stabilise. • The government will find that its tax revenue from taxes on goods and services and taxes on incomes will decline, as there is falling income and rising unemployment in the economy. This will affect government’s ability to spend on the provision of merit goods, such as health and education, and other amenities, such as water and electricity. Government will also have to spend more on unemployment-related benefits • In a recession output is falling, incomes are falling and unemployment is rising. This leads to falling demand. This might result in further pessimism amongst entrepreneurs and investors as they predict falling demand. • Falling incomes means that consumption will fall and, with the fall in consumption, there will be a fall in the level of imports. 141 17 · Inflation, recession and unemployment Government policies to reduce a recession reflationary fiscal policy • reflationary monetary policy • • Fiscal policy. Reflationary fiscal policy will relieve a recession. Increasing government expenditure will create jobs for the unemployed. When they receive their incomes, this will lead to increased spending in the economy. Cutting income taxes and taxes on goods and services will encourage consumers to spend more. Reducing corporation taxes (taxes on the profits of firms) will encourage firms to invest more. The increased spending in the economy will encourage firms to produce more. They will employ more labour, and national income and output will rise. • Monetary policy. Reflationary monetary policy will also relieve a recession. Reducing interest rates will encourage firms to invest, and individuals will borrow more and so consume more goods and services. Even governments will have access to borrowing at lower rates of interest. Easier accessibility to loans will also encourage more spending. More spending by households, firms and government increases aggregate demand. As aggregate demand increases, firms will increase output. They will have to employ more labour, thus reducing unemployment. Output and incomes in the economy will increase. Unemployment unemployed • unemployment rate • Any person who is actively seeking employment and is willing and able to work but unable to find work is considered to be unemployed. The unemployment rate is the number of unemployed persons measured as a percentage of the labour force. Number unemployed × 100 Unemployment rate = Labour force Table 17.2 shows estimated unemployment and inflation rates for three Caribbean countries for 2006. Table 17.2 Unemployment and inflation rates in three Caribbean countries, 2006 Country Unemployment rate (%) Inflation rate (%) Trinidad and Tobago 6.2 8.3 Barbados 10.7 7.6 Jamaica 11.3 5.8 Types of unemployment unemployment • 142 There are various types of unemployment in the economy. The following are the types of unemployment existing in an economy, together with an explanation of the possible cause of each. • Frictional unemployment. The frictionally unemployed are occupationally or geographically immobile. Though there are jobs available, these unemployed do not have the skills to match the jobs, or they are unwilling or unable to move to the part of the country where the job is. Therefore, they remain unemployed. Also considered to be frictionally unemployed are those persons who are in between jobs. • Search unemployment. This occurs when someone who is unemployed does not take the first job that he or she is offered. The unemployed person opts to search for a better paying or more suitable job. • Seasonal unemployment. Some workers only have jobs at certain times of the year, when there is a demand for certain products or when a particular crop might be in ‘season’. The workers employed in that industry might be seasonally employed and then, for the rest of the year, the worker remains unemployed. Workers involved in constructing carnival costumes might only 17 · Inflation, recession and unemployment ITQ4 Give some examples of workers who might be seasonally unemployed. ITQ5 Name a product that is obsolete due to technological progress. ITQ6 What is aggregate demand? ITQ7 How many workers are firms willing to employ at W1? How many are unemployed? be employed in the few months prior to the festival. Workers involved in tourism and agriculture might also be seasonally unemployed. • Structural unemployment. This occurs when there is a change in the structure of an industry. As a result, workers become unemployed. The following are causes: • Structural unemployment can be due to improvements in technology enabling capital to replace labour. This type of structural unemployment is also called technological unemployment. • For small open economies, structural unemployment can also arise from falling world demand for an export. The firms in the export sectors are forced to reduce output and so employ less labour; for example, falling world demand for bananas (due to more foreign competition) has resulted in unemployment in some Caribbean territories. In Trinidad and Tobago, the closure of Caroni (1975) Ltd, the state-owned sugar producing enterprise, has also resulted in structural unemployment. • Technological progress can also make the products of an industry obsolete and so cause demand to fall. • Cyclical unemployment. This type of unemployment is also called Keynesian unemployment or demand-deficient unemployment. There is a fall in aggregate demand in the economy (not in demand for a particular product, as in structural unemployment). Consumption might fall, investment of firms might fall, government expenditure might fall, or there might be a fall in foreigners’ demand for exports. As aggregate demand falls, firms in the economy reduce output. As output is reduced, firms will employ less of all factors of production, including labour. The result is unemployment of labour. • Real-wage unemployment. This occurs when trade unions succeed in raising the wage rate above the equilibrium level. At a wage above the equilibrium level, supply of labour exceeds the demand for labour. The surplus labour is unemployed. In the diagram below, DL is the demand curve for labour in the economy and SL is the supply curve of labour. The equilibrium wage rate is at We. Trade unions, through negotiations and perhaps industrial action, succeed in raising the wage rate to W1. At W1, the supply of labour exceeds the demand for labour. XY workers are unemployed. wage rate SL W1 We DL 0 X Y quantity labour Figure 17.7 Real-wage unemployment 143 17 · Inflation, recession and unemployment The effects of unemployment Possible benefits of unemployment • The unemployed have an opportunity to do extra training or to pursue hobbies. This is only true if they have the money to pursue these activities. The unemployed also get a chance to look for a better job, especially persons who might have been ‘stuck’ in one job for a long time. • When workers become unemployed, they embark on retraining programmes. Such training develops the workforce. • Unemployment reduces cost-push inflation, as there are fewer workers in jobs to demand higher wages and so put pressure on prices. • When there are unemployed workers, it means that the labour market is a buyer’s market. The buyers of labour have the upper hand, as they are demanding fewer workers than there are available for work. Such a situation makes workers less willing to take industrial action. Workers will be more productive and might voluntarily take on training. Possible costs of unemployment ITQ8 How does unemployment erode the quality of human capital? • The unemployed do not have the economic means to enjoy a good quality of life. Unemployment therefore leads to a fall in standard of living. • The unemployed might be depressed and discontented, adding to social problems such as crime, drug abuse and idleness. • When people are unemployed for a long time, it erodes the quality of the human capital in the economy as they lose skills due to lack of practice. • Unemployment means that society is not using all its resources to produce goods and services. Having unemployed persons signifies a loss of output to society, as society does not benefit from the output the unemployed could have produced. When persons are unemployed it means that there is less income in the economy. There is, therefore, a fall in government revenue from taxation. Measures to reduce each type of unemployment • Retraining programmes will aid those who are occupationally immobile and thus frictionally unemployed. Retraining also makes those who are unemployed through structural unemployment more employable. Training will also assist those who are seasonally unemployed to find jobs during the ‘low’ seasons of the year. • Government projects, such as the construction of housing developments, schools, shopping malls and sports facilities in areas where there are jobs available will lure workers into the area. This will also reduce frictional unemployment for workers who are geographically immobile. • Job centres and more advertising of available jobs will also reduce frictional and search unemployment. It increases the chances of those between jobs and those searching for better jobs to find jobs. • Reflationary fiscal policy will reduce unemployment. Government spending on development projects can directly provide jobs for the unemployed. This reduces seasonal, structural and cyclical unemployment. The workers receive a wage, part of which is spent, and so aggregate demand in the economy increases. Government grants to firms located in areas where there are unemployed persons will reduce frictional unemployment. 144 17 · Inflation, recession and unemployment Government can also spend directly on the creation of job centres and retraining programmes. The government of Trinidad and Tobago has the Multi-Sector Skill Training Programme (MuST). On the taxes side, a fall in taxes increases consumption and investment, and so increases aggregate demand. This also reduces cyclical unemployment. • Reflationary monetary policy will also expand aggregate demand in the economy. Falling interest rates boost the spending of firms and individuals. This increases aggregate demand in the economy. Firms will expand output to meet the rising demand and so employ more workers. • Regulations and agreements with trade unions to avoid making demands to increase the wage rate above the equilibrium wage rate will help to reduce real-wage unemployment. The government goals are: stable prices, low unemployment, economic growth and balance of payment equilibrium. Fiscal policy is the use of government spending and taxation to control aggregate demand in the economy. Monetary policy is the use of interest rates and other direct measures to control the money supply and, consequently, aggregate demand in the economy. Inflation is defined as the steady and continuous rise in the general price level (that is, an average of all prices in the economy). The retail price index is used to measure inflation. It is a weighted price index. The four contributing causes to inflation are: demand-pull inflation, costpush inflation, imported inflation and an increase in the money supply. The consequences of inflation include: fixed income earners suffering a fall in real income, falling exports and rising imports, borrowers gaining and creditors losing out, shoe leather costs, menu costs, closing down of some firms and some unemployment due to cost-push inflation. To reduce demand-pull inflation, the government must put in place deflationary fiscal policy. To reduce cost-push inflation, there must be regulations to limit the power of trade unions, and government subsidies and grants to firms to help increase production and make more goods and services available. Cutting back on imported goods will reduce imported inflation. Deflationary monetary policy will be effective, as higher interest rates and a credit squeeze will reduce the money supply, so reducing inflation caused by too much money in the economy. A recession is a period during which the total output in the economy declines. The causes of a recession are: the trade cycle, where economic output naturally peaks and then declines; government deflationary fiscal and monetary policy to combat inflation; cautious entrepreneurs; falling demand of households, firms, government (the export sector might also fall); and insufficient profits of firms. Some consequences of a recession are: falling GDP and standard of living, rising unemployment, falling consumption, low inflation, falling government tax revenue, further pessimism amongst entrepreneurs and investors, and a fall in the level of imports. Reflationary fiscal and monetary policy will relieve an economy that is in a recession. The unemployed consist of all those persons who are willing and able to work, actively seeking work, but who are unable to find jobs. The types of unemployment are: frictional unemployment, search unemployment, seasonal unemployment, structural unemployment, cyclical unemployment and real-wage unemployment. 145 17 · Inflation, recession and unemployment Effects of unemployment include: more time for training and hobbies, the opportunity to look for a better job, workforce development, less cost-push inflation, workers being less willing to take industrial action, workers being more productive, and workers perhaps voluntarily taking on training. However, the unemployed do not have the economic means to enjoy a good quality of life. The unemployed might be depressed and discontented, adding to social problems. Unemployment erodes the quality of the human capital in the economy. Unemployment signifies a loss of output to society and there is, therefore, a fall in government revenue from taxation. Measures to reduce unemployment include: job centres, training programmes, advertisements of available jobs, projects to make the location of jobs attractive, reflationary fiscal and monetary policy, and regulations to restrict trade union activity. 1 An increase in the price of gas will increase the transport costs of most goods. Increases in the price of flour will increase the price of bread and cakes. Increasing labour costs will increase the prices of goods that use labour, unless the firm is able to absorb these costs. 2 Mrs Morgan buys 4 cans of tuna at a price of $3 per can. Therefore, she spends $12 on tuna. When the price of tuna increases to $4 per can, the same $12 can only buy her 3 cans. The purchasing power of money has fallen as the price has increased. 3 The government could have pursued deflationary fiscal and monetary policy. Imports might be reduced to the extent that the inflation is partly imported inflation. Limiting wage increases will also reduce cost-push inflation. 4 Workers harvesting cane or bananas might be seasonally unemployed when the harvesting season has passed. Staff at hotels might become unemployed during the low season. 5 The demand for floppy diskettes is falling due to technological progress. Fortunately, many of the firms that are producing floppy diskettes have switched to producing compact disks and flash drives. 6 Aggregate demand is total demand in the economy by all the groups in the economy; for example, households, firms and government. 7 Firms are willing to employ 0X workers. However, 0Y are willing to work. Therefore, XY workers are unemployed. 8 Workers are out of work and so lose skills. Also they miss out on on-the-job training when new technology is introduced. They may not have the money to enrol in retraining programmes. Examination-style questions 146 Multiple choice questions 1 A fall in aggregate demand, ceteris paribus, may lead to: a an increase in the price level b recovery after a recession c unemployment d an increase in output 2 Expansionary fiscal policy is most likely to: a worsen a recession b help an economy to recover from a recession c reduce inflation d increase unemployment 17 · Inflation, recession and unemployment 3 Which of the following is expansionary monetary policy? a buying bonds on the open market b increasing interest rates c increasing government spending d reducing the repayment period on loans 4 Which type of unemployment will retraining programmes help to reduce? a search unemployment b real-wage unemployment c demand-deficient unemployment d structural unemployment 5 Cyclical unemployment occurs when: a There is a fall in aggregate demand in the economy. b Workers cannot find jobs at a particular time of the year. c The unemployed do not have skills to match the jobs available. d Wages rise, and employers demand less labour than is being supplied. 6 A consequence of inflation is: a The price of imports rise. b Creditors lose out when the sum borrowed is repaid. c Debtors lose out when the sum borrowed is repaid. d The prices of exports fall. Structured question 1 a Define the term ‘unemployment’. b Name two types of unemployment and explain the causes of each. c For each type of unemployment stated, describe policies you would recommend to reduce the unemployment. Essay question [2] [6] [7] [20] a What is inflation? [2] b What policies would you recommend to a government faced with inflation coming from an increase in the prices of imported food and raw materials? [6] c What is a recession? [2] [6] d How can the government relieve a recession? e Explain how such policies can have side effects in the economy. [4] 147 18 Growth and development By the end of this chapter you should be able to: Concept map define ‘economic growth’; explain how economists measure economic growth; describe the drivers of economic growth; describe the different aspects of economic development; explain how economists measure economic development; compare economic growth and economic development; list the sources of underdevelopment. Growth and development freedom and social justice education for all reduced negative externalities modern infrastructure diversification of the economy increase in leisure health for all economic growth economic development Economic growth economic growth • real per capita GDP • ITQ1 What is a country’s real per capita GDP if its real GDP is $2 900 000 and its population is 1000 persons? Economic growth is the increase in real per capita gross domestic product (GDP). Real per capita GDP is the real GDP per head of the population. This is found by dividing GDP by total population. Real GDP Real per capita GDP = Total population If there is economic growth, there is an increase in real per capita GDP. Output in the economy is not only increasing, but doing so at a faster rate than any increase in population. The formula for economic growth is: Economic growth in year 2 = 148 Change in real per capita GDP from year 1 to year 2 × 100 Real per capita GDP in year 1 18 · Growth and development Table 18.1 gives economic growth for Economy Woodland. Table 18.1 Economic growth for Economy Woodland Year 2000 Real per capita GDP Change in real per in $ capita GDP __ 9 600 Economic growth (%) 2001 10 500 10 500 – 9 600 = 900 9.4 2002 10 100 10 100 – 10 500 = –400 – 3.8 Therefore, to calculate economic growth for a country, we must first work out the change in real per capita GDP. This is simply the new real per capita GDP minus the real per capita GDP of the previous year. In Table 18.1, this is 10 500–9600 for 2001. This change is then divided by the real per capita GDP of the previous year and multiplied by 100 to find the percentage change. In 2001, there is economic growth of 9.4 per cent. Citizens of a country have 9.4 per cent more real income with which to purchase goods and services. However, in 2002 country X experienced negative economic growth. Negative economic growth occurs when there is a fall in real per capita GDP. This means citizens of the country had less income in that year with which to purchase goods and services than in the previous year. Economic growth is illustrated by an outward shift of the production possibility frontier, as shown in Figure 18.1 below. The economy can now produce more of both goods. good Y i g Figure 18.1 Outward shift of the production possibility frontier, showing economic growth 0 h j good X Drivers of economic growth drivers of economic growth • ITQ2 Name a country with no natural resource endowment and no growth. ITQ3 Name two problems a country might face with the factor ‘land’. The drivers of economic growth are the determinants of economic growth. An increase in the quality or quantity of the factors of production enables a firm to produce more goods and services. In the same way as for the economy as a whole, as the quantity and/or quality of the factors of production increase, national output will increase. The drivers of growth are therefore: • Land. Land, water and other natural resources are all included in the factor ‘land’. When a country is well endowed with the factor ‘land’, this results in greater economic growth. This is true for countries such as Canada. However, there are countries with little or none of the factor ‘land’, yet there is economic growth; for instance Singapore and Taiwan. There are countries with a great deal of the factor ‘land’ and little growth; for example, Argentina and Brazil. Brazil is the fifth largest country in the world and Argentina is the eighth largest country in the world, in terms of land area. There is one country that is increasing its endowment of the factor ‘land’ – but not by invasion of other lands. Dubai has created man-made islands offshore. The Palm Jumeirah has been completed (in the shape of a palm tree). Two more palm-shaped islands and one man-made archipelago in the shape of the continents of the world are under construction. 149 18 · Growth and development dependent population • ITQ4 What benefits might you have to forgo if your mother is working? • Labour. A large labour force will contribute to economic growth. However, this labour force must also be trained. A trained labour force is more productive. This contributes to economic growth. The labour force must not have a large percentage of the population dependent on it. The dependent population comprise: people over the age of retirement, children below the age of 16 years, students, housewives and the unemployed. If the dependent population is a larger part of the total population than the labour force, then the income created by the labour force will have to be shared amongst more people. Imagine your home with just your father working. His income must be used to satisfy the needs of everyone in the home: your parents, your grandparents, and you and your younger brother. You would have more income to meets the needs of the family if your mother was also working. But you might have to forgo other benefits. When you go out to work, you will also add to the income of the home! Therefore, a large trained labour force will result in greater economic growth. • Capital. Recall, capital is goods used to produce more goods. When workers have machinery, tools and equipment to work with, this increases their productivity and leads to economic growth. This is physical capital. A B C ITQ5 What is the capital in each picture? All of these workers use physical capital, whether in the form of a pen, kitchen equipment, or a drill. human capital • ITQ6 What problems might a country have with respect to its human resources? ITQ7 Which came first? 150 Now, economists speak of human capital; that is, people’s knowledge and skills. When people have more education and training, output increases. Trinidad and Tobago’s government has placed much importance on human capital by devoting money and resources to education. • Technological advancements. Technological advances improve capital equipment. Innovations lead to better machinery and tools. • New discoveries in the field of medicine, science and technology give a country a competitive advantage. Technology leads to increased productivity of capital and labour. • Enterprise and innovation. Enterprising individuals who start up new businesses, and innovative ideas that lead to product development and improvement both contribute to economic growth. 18 · Growth and development Economic development economic development • ITQ8 How can a country grow without developing? Economic development is the sustainable increase in the quality of life of residents in developing counties due to the changing structure of the economy. Human well-being must improve if we are to say that development has taken place. Economic development is multi-dimensional; that is, there are many aspects to economic development. There must be continuous economic growth (increased real per capita income), better education and health, as well as conservation of the environment. The country must move from being a developing country to being a developed country. There must be job creation. Economic development, in its simplest form, is the creation of economic wealth for all citizens in the different levels of society so that all people have access to potentially increased quality of life. Some aspects of economic development are: • an increase in real per capita GDP; • diversification of the economy from primary production (agriculture and natural resource extraction) to secondary and tertiary production, and economic activity; • increased access to health services; • increased access to education; • infrastructure development enabling the creation of a modern transport and communication network; • a low level of negative externalities; • freedom and social justice. The development of transport networks needs to keep pace with development in other areas. Measures of economic development measures of development • Human Development Index • The United Nations has developed two measures of development: • The Human Development Index (HDI) measures a country’s average achievements in three basic aspects of human development: life expectancy, educational attainment (literacy rate), and adjusted real income. It is a means of measuring quality of life, welfare and the level of development. Based on the HDI, we can determine whether a country is developed, developing or underdeveloped. In 2006, Norway topped the list of 177 countries, with a Human Development Index (HDI) of 0.965. The country with the lowest HDI for 2006 was Niger at 0.311. Table 18.2 shows the Human Development Index for the Caribbean countries. 151 18 · Growth and development Rank Country 37 Barbados 0.903 47 Antigua and Barbuda 0.868 52 The Bahamas 0.856 62 St Kitts and Nevis 0.838 64 Trinidad and Tobago 0.837 69 St Lucia 0.821 73 Dominica 0.814 74 Grenada 0.813 91 St Vincent and the Grenadines 0.772 93 Belize 0.772 Source: United Nations Development Programme’s Human Development Report 2009, compiled on 2007 data Table 18.2 Human Development Index for the Caribbean countries Human Poverty Index • Human Development Index 2009 97 Suriname 0.769 100 Jamaica 0.766 114 Guyana 0.729 149 Haiti 0.532 • The Human Poverty Index (HPI) measures deprivation using the percentage of people expected to die before age 40, the percentage of illiterate adults, the percentage of people without access to health services and safe water, and the percentage of underweight children under five years old. Growth versus development Economic growth is, therefore, simply the increase in real per capita GDP. Economic growth is but one aspect of development. A country can experience growth but no development. For economic development to take place in a country, there must be a reduction in poverty. Food, shelter and health care must reach all citizens. There must be social and economic equality. Unemployment must be reduced. As the United Nations Development Programme states in the Human Development Report 1996, ‘human development is the end – economic growth a means’. Countries remain poor and underdeveloped for a variety of reasons. Some of these include: • insufficient natural resources; • a lack of human capital; • attitudes and culture of the people; • the behaviour of the elite groups in the economy; • high birth rates and population growth rates; • a breakdown in the rule of law. These are the sources of underdevelopment. Economic growth is the increase in real per capita GDP. Economic growth can be positive or negative. The drivers of growth are the factors that encourage growth. They are: available land, labour, capital, technological advancements, and enterprise and innovation. Economic development is a sustainable increase in the quality of life of residents of a developing country. The aspects of economic development are: economic growth, diversification of the economy from primary to secondary and tertiary economic 152 18 · Growth and development activity, increased access to health services and education, modernised infrastructure, reduced negative externalities, and freedom and social justice. The Human Development Index (HDI) and the Human Poverty Index (HPI) are measures of economic development. Economic growth is simply an increase in real per capita GDP. Economic growth is one aspect of economic development. Economic development implies an increase in the quality of life of all residents of a country The sources of underdevelopment in poor countries are: insufficiency or absence of natural resources, lack of human capital, attitudes and culture of the people, behaviour of the elite groups in the economy, high birth rates and population growth rates, and a breakdown in the rule of law. 900 000 . 1 Its real per capita GDP is $2900; that is, –$21000 2 One such country in this region is Haiti. 3 A country might be gifted with a wide expanse of the factor ‘land’ but possess very little capital and wealth to put the land to effective use. Also, the land might be dry and barren, as in Haiti and Santo Domingo, or simply mountainous and inaccessible. 4 You might have to forgo hot meals when you get home from school, clean laundry and ironed shirts. When you look for your favourite jersey to wear, it might still be in the laundry basket from when you wore it last week. 5 The pen in Photo A, the oven in Photo B and the drill in Photo C are all forms of capital – goods used to produce more goods and services. 6 The human resources of a country might be plentiful but unskilled. Skilled workers and professionals might migrate, causing a ‘brain drain’, as is the case in some Caribbean countries. In the very poor countries of Africa and Asia, disease might plague the factor. In an unusual situation, the human factor might be underemployed; that is, the worker is overqualified for the requirements of the job. 7 The nail. Nails were made in the UK from early times and were commonplace by 1500. The first UK screw-making factory (Nettlefold & Chamberlain) was opened in 1749 and built up a huge export trade. 8 The country might experience economic growth – that is, there is an increase in real per capita GDP – without the increased income being enjoyed by all. For a large part of the population, there might be environmental degradation, poor housing and a lack of basic amenities such as water and electricity. Examination-style questions Multiple choice questions 1 What is economic growth? a an increase in real per capita gross domestic product b an increase in real gross domestic product c an increase in national income d national income increasing at a faster rate than the rate of inflation 153 18 · Growth and development 2 All of the following are drivers of economic growth except: a human capital b land and other natural resources c a large dependent population d technological advancements 3 Economic development leads to all of the following except: a increased access to health care b increased real per capita gross domestic product c increased access to education d increased dependence on the agricultural sector 4 What is not a source of underdevelopment? a insufficient natural resources b high birth rates c undeveloped human capital d increasing gdp 5 The Human Development Index measures all of the following except: a the literacy rate b the unemployment rate c life expectancy d real income 6 Which statement is false? a There can be growth without development. b The Human Poverty Index is a measure of economic growth. c Economic growth may be positive, zero or negative. d Economic development entails freedom and social justice. Structured question 1 154 a What is economic growth? b Distinguish between growth and development. c Explain how three drivers of economic growth can help a country achieve economic growth. [2] [4] [9] Essay question [20] a What is economic development? b What are two measures of economic development? c Discuss the statement: ‘A country can have growth but no development.’ [4] [4] [12] 19 By the end of this chapter you should be able to: Trade unions say what a ‘trade union’ is; give examples of trade unions in the Caribbean region; identify international and regional labour organisations; explain the concept of ‘collective bargaining’; explain the role of trade unions in a free market economy. Trade unions Concept map workers trade union employers collective bargaining higher pay and better terms and conditions of work industrial unrest Trade unions As a worker, if you went to your boss for a pay increase, your boss might ignore you or he might even fire you. Even if you and a co-worker went together to ask for a pay increase, your boss might ignore you both! Either way, you will have difficulty in convincing your boss that you deserve a pay increase. I only asked … 155 19 · Trade unions trade union • ITQ1 Name two unions in your country or the region. Over the years, workers of all occupations have learnt this lesson, and so they believe this maxim to be true: ‘In unity, there is strength.’ Consequently, you will find that workers of the same occupations have come together to form trade unions. A trade union is an association of workers, of the same occupation, or with a common employer, who have come together to protect and seek the interests of all the members. Some trade unions in Trinidad and Tobago are: the Oilfields Workers’ Trade Union (OWTU); the Trinidad and Tobago Unified Teachers’ Association (TTUTA); the Public Services Association (PSA). In Barbados, there is the Barbados Workers’ Union, a general trade union. In Jamaica, there are the Dockers and Marine Workers’ Union, the Jamaican Airline Pilots’ Association and the Jamaica Civil Service Association. In St Lucia, there are the St Lucia Seamen Waterfront and General Workers’ Trade Union, the St Lucia Workers’ Union and the St Lucia Nurses’ Association. In Guyana, there are the Guyana Agricultural and General Workers’ Union, the Amalgamated Transport and General Workers Union and the Guyana Postal and Telecommunications Workers Union, amongst others. Historically, trade unions were formed to achieve better working conditions for workers and increased pay, amongst other benefits. They continue to seek workers’ interests but their role has expanded to include education and training of workers. Industrial relations legislation generally provides that all workers are permitted to form or join unions of their own choosing. Types of trade union general unions • craft unions • industrial unions • tertiary sector • white-collar unions • ITQ2 What type of trade union is the Public Transport Workers Association of Jamaica? There are various types of trade union. In general unions, membership is open to all types of workers. Workers might be from different occupations, skilled or unskilled, and might come from any industry. The OWTU has grown into a general union in Trinidad and Tobago. The Barbados Workers’ Union is also a general union. In some countries, where the population is small, there might be one general trade union for a number of industries. Members of craft unions are workers who have the same skills; for example, electricians, accountants, engineers and architects. The workers might be working in different industries. Examples of industrial unions are the Dockers and Marine Workers’ Union of Jamaica and the Seamen and Waterfront Workers Trade Union of Trinidad and Tobago. Industrial unions have as members all or most of the workers from a particular industry. In the modern economy, there is a large tertiary sector (service sector) with a growing part of the population working in this sector. White-collar unions have evolved to cater to the needs of this group of workers. Teachers’ unions and nurses’ unions are white-collar unions. The International Labour Organization International Labour Organization • 156 The International Labour Organization (ILO) is an agency of the United Nations, which deals with labour issues. Its headquarters is in Geneva, Switzerland. The functions of the ILO are: • to promote employment creation; • to ensure that workers’ rights are maintained; • to promote social protection – that is, to ensure that workers operate in safe and secure conditions; • to promote social dialogue – that is, talks between and/or amongst workers, employers and government; • to provide opportunities for training and technical assistance for workers. 19 · Trade unions The Caribbean Congress of Labour Caribbean Congress of Labour • The Caribbean Congress of Labour (CCL) is a regional trade union federation. It represents members in affiliated unions across Caribbean nations. The federation represents trade union concerns to the CARICOM (see p. 212 for a discussion of CARICOM), the Association of Caribbean States (ACS), and the Organization of Eastern Caribbean States (OECS). Labour in the free market economy goods market • factor market • ITQ3 Boysie is selling pineapples from his estate in a fruit shed on the roadside. What market is Boysie selling in? ITQ4 What affects the demand for labour? closed shop • demarcation • In the free market economy, all resources are owned by private individuals. These private individuals decide what to produce, how to produce and for whom. In Chapter 8, you learnt that a market is any mechanism that facilitates the interaction of buyers and sellers with a view to the purchase or sale of a good or a service. There are two main types of market in the economy. They are the goods market and the factor market. In the goods market, firms sell goods and services, and households buy these goods and services. In the factor market, households sell factor services (factors of production) and firms purchase these factor services. One factor of production is ‘labour’. There is, therefore, a labour market. In this labour market, firms (small and large) are the buyers of labour services. They demand labour services. Households are the owners/sellers of labour services. They supply labour. When workers form trade unions, the trade union is able to influence the supply of labour. Trade unions and the supply of labour Trade unions work by affecting the supply of labour. This can be achieved in the following ways: • Some unions practise a closed shop policy. All employees in a given workplace or in a given occupation must belong to a specific union. A worker is either a union member before he is employed or, immediately after being employed, the worker must join the union. • The practice of demarcation. This is where the tasks of a job can be done only by the members of a particular union. This occurs where there are several trade unions representing different occupational groups in the workplace. The collective bargaining process collective bargaining • Collective bargaining is the process by which trade union officials, representing workers, meet with employers to negotiate for higher wages and better terms and conditions of work. The term ‘collective’ is used since workers do not go in individually to make requests. The union bargains for all workers as a group. It trade union successful satisfied workers with higher wages and better terms and conditions of work Figure 19.1 The collective bargaining process collective bargaining employers unsuccessful strikes sit-ins sit-downs slow-downs work to rule sabotage lockouts 157 19 · Trade unions industrial unrest • strike • is a bargaining process, since one party does not demand or request a certain benefit and the other give in to the request. Usually, there is discussion and compromise. There might be disagreement. Collective bargaining aims to secure for workers: • higher wages and incomes, including bonuses and overtime benefits; • improved terms and conditions of employment. Collective bargaining encourages communication between workers and employers, and workers might get a chance to contribute to the decisionmaking process. Industrial unrest is the term used to describe activities undertaken by workers when they protest against pay or terms and conditions of work. Industrial unrest might take many forms, including: • Strikes. A strike is a work stoppage caused by the mass refusal by employees to work. Workers on strike might have demonstrations – that is, walk with placards to highlight their situation – or they might form a picket line preventing other workers from entering the company premises. Strikes can cause serious disruption if work is suspended for long periods. sit-in • sit-down strike • slow-down • work-to-rule • sabotage • lockout • 158 • Sit-ins. A sit-in involves one or more persons non-violently occupying an area for protest. In a sit-in, protesters usually seat themselves and remain seated until they are evicted, usually by force, or until their requests have been met. • Sit-downs. A sit-down strike involves workers on strike occupying the area in which they would be working, and refusing to leave so they cannot be replaced with other labour. • Slow-downs (go-slows). A slow-down occurs when employees perform their duties but try to reduce productivity when performing these duties. Unlike a strike, in a slow-down the worker will still get paid. Also, in a strike the worker might be replaced, but this is not the case in a slow-down. • Work-to-rule. In a work-to-rule, workers ‘follow the rules’, obeying each and every rule to the letter, thereby reducing productivity. • Sabotage. Workers cause sabotage – by, say, wrecking company machinery or a work process – in order to place a cost on the firm or to reduce productivity. Unlike other courses of action, this is illegal. • Lockouts. A lockout is when an employer takes action to lock entrances and so debar workers from entering the workplace. 19 · Trade unions The role of trade unions in a free market economy ITQ5 Name two issues affecting workers that they will wish to discuss with government. Trade unions play an important role in the free market economy. Here are their functions: • Trade unions secure higher wages for their members. • Trade unions secure improved terms and conditions of employment – safer, healthier working environments (airy, well-lit, clean and cool rooms), protection of workers’ privacy, hours of work, time-off periods, maternity leave, holiday entitlement (with pay), promotion, pay when on sick leave, pension plans, opportunities for training and job security. • Trade unions can hold training sessions for workers. These might be work related, or could be motivational lectures or education on the rights of workers. This increases productivity and prevents the workers from being exploited by the employer. • Trade unions ensure that there is equity of treatment of all workers. • Trade unions contribute to the development of the country as workers bargain in an organised fashion. There is communication between workers and management. Workers negotiate in an orderly way. There is little or no disorder. However, there might be industrial unrest or the threat of industrial unrest. When there is industrial unrest, it leads to a fall in productivity. Generally, though, trade unions contribute to stability and economic progress. • Trade unions can also meet with government (the Ministry of Labour) to represent the workers’ views with respect to issues that affects workers. Some costs of trade union activity ITQ6 Use an example to illustrate this occurrence. • By demanding higher wages that do not match productivity increases, trade unions can contribute to cost-push inflation. Trade unions cause wages to increase. When wages increase, labour costs and total costs of the employer increase. Employers increase prices for the products so that profits remain the same. • When a trade union succeeds in increasing wages, this might contribute to unemployment. The demand curve for labour is downward sloping from left to right, indicating that at higher wages fewer workers are demanded, and at lower wages more workers are demanded. When the wage rate increases, ceteris paribus, fewer workers will be demanded. • Trade unions contribute to a fall in economic activity and efficiency, and to social disorder when they engage workers in protest. In Trinidad and Tobago, all employees – except those in ‘essential services’, which include police and fire officers, and physicians – have the right to strike. A trade union is an association of workers of the same occupation or with a common employer who have come together to protect and seek the interests of all members. There are four main types of trade unions: general trade unions, craft unions, industrial unions and white-collar unions. The International Labour Organization is a United Nations body looking after worker and labour issues. The Caribbean Congress of Labour is a regional federation of trade unions. In the labour market (a factor market), firms are the buyers of labour and households are the sellers of labour. Trade unions, as the representatives of workers, can affect the supply of labour. They do so through closed shop policies and demarcation. 159 19 · Trade unions Trade unions meet with employers, and negotiate for higher pay and better terms and conditions of work through the collective bargaining process. Industrial unrest or protests by workers include: strike action, sit-ins, sitdowns, slow-downs (go-slows), work to rule, sabotage and lockouts. Trade unions secure higher pay and better terms and conditions of work; for example, protection of workers’ privacy, safety and health in the workplace, hours of work, time-off periods, maternity leave, holiday entitlement, promotion, pay when on sick leave, pensions, opportunities for training and job security Other functions of trade unions are: provision of training for workers, ensuring equity of treatment of workers, organising labour talks in an orderly fashion and representing workers’ views to the employer and government. Some costs of trade union activity are: increasing prices, falling employment and a fall in economic activity. 1 Some trade unions are: the Antigua Workers’ Union, the National Workers’ Union (Guyana), the Bustamante Industrial Trade Union in Jamaica, and the St Kitts and Nevis Trades and Labour Union. 2 This is an industrial trade union, as it has the workers of the public transport industry as its members. 3 Boysie is selling in the goods market. He is a producer of pineapples, and the goods that he is selling to households or consumers are pineapples. 4 Firms’ activities will affect the demand for labour, as firms are the buyers of labour services. If firms wish to increase output, they might demand more labour. 5 New labour laws, closure of companies, and unemployment and redundancy are a few examples. 6 Total costs are $1000. Total revenue is $1500. Output sold is 100 units at a price of $15 each. Profits will be $500. When wages increase, total costs increase to $1200. If profits are to remain at $500, then total revenue must be $1700. Now, 100 units must be sold at a price of $17 each. Examination-style questions Multiple choice questions Questions 1, 2 and 3 are based on the following case: APE is the Association of Professional Engineers. It is a trade union for engineers only. Petroleum Services Limited has made an agreement with APE that it will only employ workers who are members of APE. 1 160 What is a trade union? a a group of firms who employ the same type of workers b an association of workers who bargain for increased wages for some workers c a group of workers who go to complain to the boss about an issue d an association of workers who have come together to protect and represent the interests of all the members 19 · Trade unions 2 What type of trade union is APE? a a general union b a craft union c a workers’ union d an industrial union 3 What is the name of the policy being practised by Petroleum Services Limited? a closed shop b open door c sit-in d demarcation 4 All of the following are forms of trade union unrest except: a go-slows b lockouts c sit-downs d picketing 5 Which of the following may be a cost to the economy of trade union bargaining? a collective bargaining b higher wages for workers c inflation d employment of workers 6 All of the following are functions of the International Labour Organization except: a promoting employment creation b encouraging sweatshop conditions for workers to operate in c encouraging talks between employers and government d providing opportunities for training for workers Structured question 1 a What is a trade union? b Give an example of a trade union in your economy. c Explain the role of trade unions in a free market economy. Essay question [2] [1] [12] [20] Workers involved in the communication industry in Coral Isle belong to a trade union called the Communication Workers’ Trade Union (CWTU). Negotiations between employers and the trade union have broken down and the workers are protesting. a What kind of union do these workers belong to? Explain your answer. [3] b What is the name given to discussions between employers and union officials? [2] c Name two specific benefits the trade union might want to obtain for its workers. [2] d Name and explain two other forms of industrial unrest that the [4] workers might participate in. e Discuss three ways in which the CWTU activities can benefit Coral [9] Isle. 161 20 International trade By the end of this chapter you should be able to: Concept map define ‘international trade’; define related trade terms; explain the rationale for international trade; explain the advantages and disadvantages of trade; explain the factors influencing international trade (import side / export side); explain ‘absolute’ and ‘comparative’ advantage; explain ‘gains from trade’; explain ‘terms of trade’. International trade absolute advantage income levels terms of trade gains from trade comparative advantage exchange rate international trade advantages and disadvantages of trade relative prices quality of goods media and tastes what goods you produce International trade ITQ1 Name three countries that your country trades with. international trade • closed economy • open economy • 162 International trade is part of all our lives. Trinidadians drive Japanese cars, Barbadians use Hewlett Packard (HP) computers and Americans drink Jamaican Blue Mountain coffee. Within Guyana, a rice farmer in Berbice might sell rice to a grocer in Georgetown. This is trade within a country. However, this farmer might also export rice to the UK. This is international trade. International trade is the exchange of goods and services across international boundaries. The following are some useful trade terms: • A closed economy is one that does not engage in international trade. • An open economy is one that engages in international trade. In the world today, all economies are open, but some are more open than others; for 20 · International trade protectionism • example, Trinidad and Tobago is more open than Cuba. This means that Trinidad and Tobago’s foreign trade comprises a greater percentage of its GDP than in the case of Cuba. • Protectionism is a policy of protecting home industries from foreign competition by the imposition of trade barriers on imported goods and services; for example, up until 2006 the Caricom countries (see p. 212 for a discussion of CARICOM) protected the cement industry by placing a 15 per cent common external tariff on cement imported from outside the region. This was later suspended to accommodate increasing demand by the region that could not be satisfied by regional firms. You can check Chapter 23 for the forms of protectionism. Money makes the world go round. free trade • World Trade Organization • ITQ2 Name an international trade dispute with which you are familiar. • Free trade is a policy of imposing no restrictions on the movement of goods and services between countries. Increasingly, in this age of globalisation, countries are engaging in free trade because they find it beneficial. The World Trade Organization (WTO) is the international body that oversees trade between countries. The WTO replaced the General Agreement on Trade and Tariffs (GATT). When GATT met in the Uruguay round of trade talks (which ended in 1994), it created the WTO. The WTO was set up on 1 January 1995, and it has 150 member countries at the time of writing. The WTO has three objectives: • to help global trade flow as freely as possible; • to reduce trade restrictions; • to provide an impartial means of settling disputes. The rationale for international trade ITQ3 By recalling what you learnt in Chapter 3 and Chapter 7, explain the concept of specialisation. As individuals in a modern economy, we do not produce all that we consume. We are each endowed with different talents and abilities. Each of us (adults) specialise in a given occupation, trade this factor service for money, and then use this money to purchase other goods and services. Such specialisation leads to increased output for all. Countries, as with people, are also endowed with different resources. It makes sense for each country to specialise in a product or products that it is good at producing, trade this, and purchase what it cannot produce. As will be seen later in this chapter, such specialisation leads to increased output. 163 20 · International trade International trade is a win–win situation All countries produce products for which they have the economic resources. They do so more cheaply than countries which have fewer of them. When there is trade, a country imports what it cannot produce. Therefore, the countries of the world benefit. The following are further advantages of trade: The advantages of trade ITQ4 Name three products that you see in shops that are imported. • Free trade opens up the world as a market for your product. Small Caribbean countries with small populations now find themselves with a much larger market for their products. • Countries now have a larger variety of goods and services and a higher standard of living. As the Caribbean countries engage in more international trade there is a greater variety of goods available. One glance at the supermarket shelves will reveal a range of chocolates, biscuits, wines, condiments, soaps and shampoos that have been imported. • With a larger market, firms produce more. As firms produce more, they grow in size and can therefore benefit from economies of scale. • As firms produce more for sale, they become better at producing those goods. They might purchase machinery to assist in production. All this increases efficiency. • As industries grow, output increases. Factor inputs must be increased; that is, land, labour, capital and enterprise. This creates increased employment. • As firms have a wider market and they sell goods and services, the firms earn valuable foreign exchange. • As a range of industries grows and develops, this leads to economic development in the producing country. • International trade allows countries of the world to specialise and produce the goods that they are best suited to produce. This leads to an efficient allocation of the world’s resources. Countries produce based on the skills and expertise of their labour and/or its factor endowments. • International trade promotes better international relations among the countries of the world. All of these advantages lead to an improved quality of life for the residents of a country. Disadvantages of international trade • International trade can make a country dependent upon other countries for vital goods; for example, foodstuffs. If prices increase or if quantity supplied decreases, the importing country will suffer. • International trade exposes domestic industries to unfair foreign competition. Foreign firms might be well-established and able to offer cheaper prices for a better-quality product. Quantity demanded of local goods by foreigners and domestic residents will fall, and so will employment. The firms might even be forced to shut down. • Many developing countries might trade primary products; that is, minerals and agricultural produce. When a country has continuous trade and keeps on producing, this might lead to depletion of mineral resources. When this occurs, the country might not have other export alternatives to produce for trade. Examples of non-renewable resources in the region that will eventually be depleted are: petroleum, natural gas and bauxite. 164 20 · International trade ITQ5 What is a ‘sweatshop’? • Overseas markets in underdeveloped countries might find the workers paid very poorly, even by the standards of that country. Cheap production in China, India and Africa has led to exploitation of workers through low wages and poor working conditions. Factors that influence international trade ITQ6 What does a depreciation do to the price of imports? ITQ7 Give an example of a product that the region produces mainly for export. When a country participates in international trade, it imports and exports goods and services. The following factors affect the level of imports in a country: • Domestic income levels. Higher incomes enable consumers to purchase more imports, and lower incomes allow for fewer imports. • The exchange rate. The higher the value of the currency, the greater the level of imports. The lower the level of the currency, the lower the level of imports. Assume the exchange rate is: [Equation A] $1.00 US = $2.00 TT then it changes to: $1.00 US = $4.00 TT [Equation B] Equation A shows a higher value for the TT$. Trinidadians have to spend only TT$2 to buy, say, a pencil case for US$1. They can therefore demand many pencil cases. Equation B shows a lower value for the TT$. Trinidadians have to spend TT$4 to buy that same pencil case for US$1. They will therefore demand fewer pencil cases. In Chapter 21, you will learn that a change from situation A to situation B is a depreciation of the TT$. It makes imports more expensive in terms of the domestic currency. • Domestic product prices versus foreign product prices. If domestic product prices are high compared with foreign product prices, the country will import more and buy fewer locally produced goods. If domestic product prices are low compared with foreign product prices, the country will import fewer and buy more locally produced goods. • Quality of domestic goods. If domestic goods are of a low quality when compared with the imported goods, the country will import more and buy fewer locally. If domestic goods are of a high quality when compared to the imported goods, the country will import fewer and buy more locally, ceteris paribus. More recently though, developed countries are finding that their locally produced quality goods are being outsold by cheaper goods of lower quality. Consumers in the Caribbean are making purchasing decisions that are causing the same thing to happen. There is a flood of cheap goods, especially appliances, coming in from abroad. Consumers are taking advantage of the lower prices, even though the goods might be of a lower quality than other more expensive imports. • Information, the mass media and changing tastes of consumers. The small Caribbean economies are very open to foreign television, where viewers are exposed to the lifestyle and products of large developing countries. This has the effect of changing the tastes of consumers in favour of the products of these countries; for example, clothes, shoes, chocolates, make-up, and electronic devices such as cell phones and iPods. • The goods produced in the country, together with the tastes of the consumers. If a country produces goods for trade but its consumers do not consume these goods, then the country will have to import what they consume. Distinguished historian, Eric Williams, described the Caribbean economy as one in which ‘we consume what we do not produce and produce what we do not consume’. An example of this phenomenon is the export of bananas and the importing of apples. Although it is true that Caribbean people do eat bananas, we prefer foreign fruits such as apples and grapes. If a country consumes what it produces, it will import less. 165 20 · International trade Even Abe enjoys a change now and again! The following factors affect the quantity of goods exported: • Foreign income levels. Higher incomes in the rest of the world enable a given economy to export more. Lower incomes reduce the level of exports of a given economy to the rest of the world. • The exchange rate. When the value of a country’s currency is low, its goods will be relatively cheaper and so it will be able to export more goods. When the value of a country’s currency is high, its goods will be relatively dearer and it will be able to export fewer goods. Assume the exchange rate is: US$1.00 = TT$4.00 [Equation A] then it changes to US$1.00 = TT$2.00 [Equation B] Equation A shows a lower value for the TT$. If a mango costs TT$1, a foreigner can purchase four mangoes with US$1 (TT$1 = US25 cents). Equation B shows a higher value for the TT$. Foreigners can only get two mangoes with the US$1 (TT$1 = US50 cents). Foreigners will therefore demand fewer mangoes. • Domestic product prices versus foreign product prices. If domestic product prices are high compared with foreign product prices, the country will not be able to export a large quantity of goods. If domestic product prices are low compared with foreign product prices, the country will export a greater quantity. • Quality of imported goods. If foreign goods are of a high quality when compared with locally produced goods and are technologically superior, then fewer domestic goods will be exported. If locally produced goods are of a high quality when compared with the foreign goods, the country will be able to export more. • Information and changing tastes of consumers in the rest of the world. We live in the age of the information revolution, cable television and the Internet. When foreigners become aware of the products of the region, we will be able to export more. The tastes of the consumers might change in favour of the products of a given country and this will boost exports. The theory of absolute advantage absolute advantage • 166 A country has an absolute advantage if it produces more goods and services compared with other countries with the same quantity of resources. For illustration, assume a simple world economy with only two countries, Country 20 · International trade Table 20.1 A simple world economy Rice Cloth Country A 10 18 Country B 20 8 World output 30 26 Table 20.2 The results of specialisation Rice Cloth Country A 0 36 Country B 40 0 World output 40 36 A and Country B, and two products, rice and cloth. Assume, also, that each country has two baskets of resources (see Table 20.1). With one basket in rice production and one basket in cloth production, Country A produces 10 units of rice and 18 units of cloth. With one basket in rice production and one basket in cloth production, Country B produces 20 units of rice and 8 units of cloth. Country A has an absolute advantage over Country B in the production of cloth. Country B has an absolute advantage over Country A in the production of rice. This is because, given the same resources, Country A can produce more cloth than Country B, and Country B can produce more rice than Country A. Country A puts its two baskets of resources into cloth production. Country B puts its two baskets of resources into rice production. Country A therefore specialises in the production of cloth and Country B specialises in the production of rice. Then, the two countries can trade. Table 20.2 shows the results of specialisation. Note that, when there is specialisation, world output increases (from 30 to 40 for rice, and from 26 to 36 for cloth). Each country can then trade the good that it produces for the good that it does not produce. The theory of comparative advantage comparative advantage • Table 20.3 Absolute advantage Rice Cloth Country X 100 50 Country Y 5 20 World output 105 70 ITQ8 Why does country X have an absolute advantage in the production of both goods? This theory states that a country should specialise in the production of the good in which it has the least opportunity cost or the greatest advantage. Comparative advantage occurs when a country can produce a good at the lowest opportunity cost when compared with other countries which have the same resources. When a country produces a good in which it has a comparative advantage, it can trade this for goods in which it has a lower comparative advantage. Assume the same case of a simple world economy with two countries (Country X and Country Y), two products (rice and cloth), and two identical baskets of resources for each country. As shown in Table 20.3, Country X can produce 100 units of rice and 50 units of cloth, using a basket of resources for the production of each good. On the same basis, Country Y can only produce 5 units of rice and 20 units of cloth. Country X has an absolute advantage in both rice and cloth production. It might appear that specialisation and trade will not benefit Country X. David Ricardo, a nineteenth-century economist, developed the theory of comparative advantage. He argued that, in a situation where one country has the absolute advantage in the production of both goods, specialisation and trade can still benefit both countries. Let us analyse this situation. Table 20.4 A table of opportunity costs ITQ9 By recalling what you learnt in Chapter 1, explain the concept of opportunity cost. Rice Cloth Country X X has to give up 0.5 C to obtain 1 R X has to give up 2 R to obtain 1 C Country Y Y has to give up 4 C to obtain 1R Y has to give up 0.25 R to obtain 1C 50 As shown in Table 20.4, Country X has to give up 0.5 ( 100 ) units of cloth to 100 obtain 1 unit of rice and it has to give up 2 ( 50 ) units of rice to obtain 1 unit of ) units of cloth to obtain 1 unit of rice and cloth. Country Y has to give up 4 ( 20 5 5 ) units of rice (R) to obtain 1 unit of cloth (C). Let us it has to give up 0.25 ( 20 now compare opportunity costs. Country X only has to give up 0.5 C to get 1 R while Country Y must give up 4 C to get 1 R. Clearly, Country X has a lower opportunity cost in the production of rice. Country Y has only to give up 0.25 R to obtain 1 C while Country X must give up 2 R to obtain 1 C. Therefore, Country Y has a lower opportunity cost in the production of cloth. Country 167 20 · International trade ITQ10 Which country has the comparative advantage in which good if country X can produce 100 units of rice or 50 units of cloth with a basket of resources, and country Y can produce 20 units of rice or 10 units of cloth with an identical basket of resources? X has a comparative advantage in the production of rice and Country Y has a comparative advantage in the production of cloth. Country X can specialise in rice production while Country Y can specialise in cloth production. Let us see what happens if the countries decide on partial specialisation. Table 20.5 Partial specialisation Rice Country X ITQ11 Work out how many units of rice and cloth country X produces. ITQ12 Name a country and its comparative advantage. Cloth 120 40 Country Y 0 40 World output 120 80 As shown in Table 20.5, Country Y produces cloth only with its two baskets of resources. Country X uses 1 15 baskets of resources to produce rice and 45 baskets to produce cloth. The results show that, with specialisation, world output has increased. The countries can specialise and then trade. Terms of trade terms of trade • ITQ13 Why are average prices used in calculating the terms of trade? base year • The terms of trade are defined as the ratio of export prices to import prices. Economists use the export price index and the import price index. The formula for the terms of trade is: Export price index × 100 Terms of trade index = Import price index The export price index is the weighted average of export prices. The import price index is the weighted average of import prices. The terms of trade really show how many imports a given quantity of exports can buy. In the base year, the value of both the export price index and the import price index is 100. Data for all other years are measured against base year data. A rise in the value of the terms of trade index is described as a favourable movement of the terms of trade. A given amount of exports can now buy more imports. The terms of trade have improved. A fall in the value of the terms of trade index is described as an unfavourable movement of the terms of trade. A given amount of exports now buy fewer imports. The terms of trade have deteriorated. Consider Table 20.6. Table 20.6 Deterioration of trade ITQ14 What happens if the index of import prices is equal to the index of export prices? Year Export price index Import price index Terms of trade 2000 100 100 100.0 2001 120 115 104.3 2002 130 110 118.2 2003 125 130 96.2 Points to note from Table 20.6: • The base year is 2000. • The terms of trade improved in 2001 and 2002. • In 2003, the terms of trade deteriorated. • The terms of trade can fall to below 100. Gains from trade gains from trade • 168 The gains from trade are the advantages that a country obtains as a result of trade. If there were no trade, each person would have to be self-sufficient. Imagine having to produce your own food, clothes and toiletries such as soap and toothpaste! Trade allows people and countries to specialise. People produce according to their abilities, skills and talents. Regions and countries produce 20 · International trade according to the factors of production they have, and exchange goods produced for other goods that they cannot produce efficiently. Recall that, with specialisation, there is increased output. There are two main sources of gains from trade: • Countries differ in climate and factor endowment. Each country has advantages in producing some goods, but cannot produce other goods efficiently, or at all. The flat undulating plains and the warm climate of the Caribbean are suited to sugar cane production. South Africa produces diamonds, as it has the mineral deposits. Trinidad produces oil, because of its oil deposits. The smaller Caribbean islands have sandy beaches and so specialise in tourism. • As countries specialise and increase production, their industries earn economies of scale. There is, therefore, a fall in unit costs of production. The countries can make greater profits and/or pass on some of these cost advantages to the consumer, who will get the product at a lower price. International trade is the exchange of goods and services across international boundaries. The World Trade Organization is the body that oversees the flow of international trade. International trade must take place, as regions have different climates and factor endowments. The advantages of trade are: larger markets, a greater variety of goods, economies of scale, increased efficiency, employment, foreign exchange, economic development, efficient allocation of the world’s resources and better international relations. The disadvantages of trade are: dependency, foreign competition and resource depletion. Factors influencing trade on the import side are: domestic income levels, the exchange rate, domestic prices relative to foreign prices, quality of the goods, changing tastes, and the correspondence between tastes and what is produced domestically. Factors influencing trade on the export side are: foreign income levels, the exchange rate, relative prices, quality of goods and changing tastes. A country has an absolute advantage if it can produce more goods and services compared with other countries with the same quantity of resources. When countries enjoy an absolute advantage, specialisation leads to increased output. Then, a country can trade to obtain all the goods it needs. A country is said to have a comparative advantage in the production of a good when its opportunity cost in the production of that good is lower than that of other countries. When countries enjoy comparative advantage, specialisation leads to increased output. Trade will lead to benefits. The ‘terms of trade’ is the ratio of export prices to import prices for a country for a given year. Gains from trade are the benefits from trade. Because of factor endowments, a country can produce some goods more cheaply than others. As the country produces a large quantity, it also experiences lower unit costs (economies of scale). 1 Most Caribbean countries trade with the USA, Canada and the UK. They also trade with each other. Guyana exports rice to Trinidad and Tobago, Jamaica and countries in Europe. 169 20 · International trade 2 The US and EU steel dispute, where the USA placed high tariffs on imported steel (2002). The ‘Banana Wars’ between US and Europe (1999). In 2005, the WTO ruled that US subsidies on cotton were illegal. 3 Specialisation occurs when a person produces a product or service that he/ she is good at producing. Specialisation by countries means that a country produces a good for which it has the resources, and trades this good for the other goods it needs from other countries. 4 You will see imported brands of cereal, cans of mushrooms from China, toothpaste from the USA and clothes from India, to name a few. 5 ‘Sweatshop’ is a term used to describe a factory where working conditions fall below the acceptable standard. The term has its origins in London and New York in the 1800s, where a ‘sweater’ (or middleman) directed others in the making of clothing (garments). Asian and eastern European countries are accused of having shoe and clothing sweatshops. 6 Depreciation makes the price of imports more expensive because you have to spend more TT$; for example, TT$4 instead of TT$2 to buy the pencil case. 7 Bauxite, methanol, petroleum and bananas are some of the products which the region produces for export, and which the countries themselves do not use in any great quantity. 8 Country X can produce more rice (20 times) and more cloth (2½ times) than Country Y, using the same amount of resources. Therefore, Country X has an absolute advantage in the production of both rice and cloth. 9 Opportunity cost is the alternative forgone. Country X cannot produce more cloth and more rice. To produce more cloth, Country X has to give up rice. To obtain an extra unit of cloth, Country X has to give up two units of rice. 10 Neither country has any comparative advantage. The opportunity cost of cloth is the same in both countries (2 R for 1 C). The opportunity cost of rice is also the same in both countries (0.5 C for 1 R). Neither country can gain from specialisation and trade. 11 In Country X, one basket of resources yields 100 units of rice, Therefore, 1 15 baskets of resources will yield 65 × 100 = 120 units of rice. One basket of resources will yield 50 units of cloth. Therefore, 45 basket of resources will yield 45 × 50 = 40 units of cloth. 12 Guyana – bauxite, sugar, rice; Jamaica – bauxite, sugar, coffee; Japan – cars and computer-related products; New Zealand – milk, butter and cheese; France – wines. 13 Average prices for imports and exports are used, because countries export and import many goods. Prices can fall, rise or remain constant. An average of how prices changed gives a fair picture. 14 The terms of trade will have the value of 100. This is described as ‘balanced terms of trade’. If the index of export prices is 120 and the index of import × 100. prices is 120, the terms of trade index is 100; that is, 120 120 Examination-style questions Multiple choice questions 1 170 What is a disadvantage of international trade? a The world is a market for your product. b There is a larger variety of goods available. c A country is able to earn foreign exchange. d A country may become dependent on other countries for vital products. 20 · International trade 2 If an economy is closed, which benefits will it enjoy? a the benefits of a larger variety of goods b the benefits of self-sufficiency c the benefits of the world as a market d the benefits of improved international relations 3 Which of the following factors influence the level of exports? a the exchange rate b domestic income levels c the type of goods imported d the quality of imported goods 4 A country’s export price index fell from 120 to 117. The import price index remained constant at 112. What is the effect on the terms of trade? a The terms of trade deteriorated. b The terms of trade improved. c The terms of trade remained constant. d The terms of trade fell to 95. Country Cereal Shoes Alpha 100 50 Beta 40 30 Answer questions 5 and 6 using the table above. 5 Which of the following statements is true? a Alpha has an absolute advantage in cereal production only. b Beta has a comparative advantage in cereal production. c Alpha has an absolute advantage in the production of shoes only. d Beta has a comparative advantage in the production of shoes. 6 What are the sources of gains from trade? a plentiful unskilled labour b rising exchange rates c varying factor endowments between one country and another d changing tastes in the domestic economy Structured questions 1 Country Cassava Fish Forest Land 10 7 Sandy Isle 15 10 The above data show the production for two countries, each with two baskets of resources. a Define ‘absolute advantage’ and ‘comparative advantage’. [4] b Which country has an absolute advantage in cassava production and why? [5] c Which country has a comparative advantage in cassava production and why? [6] 171 20 · International trade 2 a b c d e Year 172 Define ‘terms of trade’. What is the formula for the terms of trade index? From the table below, calculate the terms of trade for each year. In which years did the terms of trade improve? What does an improvement indicate? Export price index Import price index 2005 100 100 2006 120 105 2007 105 110 2008 107 110 [2] [2] [4] [4] [3] Essay question [20] a What is ‘international trade’? b What are the ‘gains from trade’? c Explain when international trade might not be beneficial to a country. d Explain the factors that affect trade on the import side or on the export side. [3] [5] [6] [6] 21 By the end of this chapter you should be able to: Exchange rates define ‘fixed exchange rates’; explain downward and upward adjustments to the value of a currency; define ‘floating exchange rates’; explain an ‘appreciation’ and a ‘depreciation’ of a currency; explain the factors that affect the exchange rate; define ‘managed exchange rates’. Concept map Exchange rates appreciation/ revaluation fixed exchange rate exchange rate floating exchange rate depreciation/ devaluation managed exchange rate Exchange rates ITQ1 Name the currencies of five countries of the world. exchange rate • foreign exchange market • ITQ2 What item is bought and sold in the foreign exchange market? Countries of the world engage in international trade. However, each country has its own currency. As countries trade with each other, importers must purchase currency to make payments for the imports. Also when you visit a foreign country you must purchase the currency of that country to pay for the hotel, transport and any shopping that you will do. The exchange rate is the rate at which one currency can be exchanged for another country’s currency in the foreign exchange market. It is really the price of a currency in terms of another. For instance, the Trinidad and Tobago dollar can be bought on the foreign exchange market at a price of: TT$1 = US16 cents This means that if a visitor or an importer from the rest of the world wishes to purchase a Trinidad and Tobago dollar on the foreign exchange market, he will have to pay US16 cents for each TT$. The foreign exchange market is a market that specialises in the sale of different currencies. The exchange rate can also be expressed as the price of a US dollar in terms of TT dollars. It is: US$1 = TT$6.33 This is the way most of you might be familiar with the exchange rate. If 173 21 · Exchange rates ITQ3 In 2009, how much would you have had to pay for each of these currencies in US$? residents wish to buy US$, they will have to spend TT$6.33 dollars to obtain US$1. In 2009, the prices of the US$ in the Caribbean countries’ currencies were: Barbados dollar US$1.00 = BB$2.00 Eastern Caribbean dollar US$1.00 = EC$2.69 Guyana dollar US$1.00 = GY$194.80 Jamaica dollar US$1.00 = JM$86.95 Source: www.exchangenote.com 1 2 3 The exchange rate of a country can be determined by using: a fixed exchange rate mechanism; a floating exchange rate mechanism; a managed exchange rate. The fixed exchange rate system fixed • devaluation • When the government sets the exchange rate, the rate is said to be ‘fixed’. The government, through the central bank, announces a value for the exchange rate. Prior to April 1993, Trinidad and Tobago operated under a fixed exchange rate regime. When the rate is fixed, the government can choose to change the rate at any time. If the government makes a downward adjustment of the exchange rate, this is a devaluation of the exchange rate. This means that the domestic currency has become cheaper on the foreign exchange market. DEFINITION: A devaluation is a downward movement in the domestic currency, making the currency cheaper on the foreign exchange market. Consider the following example, where the exchange rate is: TT$1 = US50 cents The government then decides the make a downward adjustment in the exchange rate. It moves to: TT$1 = US25 cents The TT$ has become cheaper on the foreign exchange market. We can also look at the exchange rate in terms of the price of the US$. NOTE: In practice, the adjustments that are made are never as dramatic as this example! Give an example of a devaluation of Guyana’s dollar. price of US$1 in TT dollars 5.0 Devaluation of the TT dollar 2.5 price of US$1 in TT dollars ITQ4 US$1 = TT$2 is adjusted to US$1 = TT$4 This is exactly the same rate of exchange as above. Domestic residents now have to pay more for a US$ because the TT$ is worth less (see Figure 21.1). 4.0 3.0 2.0 1.0 0.0 before devaluation after devaluation Figure 21.1 Devaluation of the tt$ 174 Revaluation of the TT dollar 2.0 1.5 1.0 0.5 0.0 Figure 21.2 before revaluation after revaluation Revaluation of the tt$ 21 · Exchange rates If the government makes an upward adjustment of the exchange rate, this is a revaluation of the exchange rate. This means that the domestic currency has now become more expensive on the foreign exchange market. DEFINITION: A revaluation is an upward adjustment of the domestic currency, making the currency more expensive on the foreign exchange market. ITQ5 Give an example of a revaluation of Guyana’s dollar. ITQ6 How much will TT$1 exchange for in terms of £ sterling? Consider the situation where the price of the TT dollar is: TT$1 = US50 cents The government then makes an upward adjustment of the exchange rate so it becomes: TT$1 = US67 cents The TT$ is now more expensive. Again, the exchange rate can be expressed as the price of the US$ in terms of the TT$. The revaluation will be expressed as: US$1 = TT$2 is adjusted to US$1 = TT$1.50 The foreign currency has now become cheaper on the foreign exchange market as the domestic currency has gained value. Residents will now pay less for one US$, as seen in Figure 21.2. As you read your newspapers or visit the bank, you might also see your currency expressed in terms of £ sterling, Canadian dollars or euros. In September 2009, a holder of TT dollars could purchase £1 sterling for TT$9.90. The floating exchange rate system floating exchange rate system • price of TT$ in US dollars S exchange rate D quantity supplied and demanded Figure 21.3 Equilibrium price Under the floating exchange rate system, the forces of demand and supply operate to determine the value of the currency. There is no interference by the government. This exchange rate regime is more often called a freely floating exchange rate system. Foreigners demand the domestic currency. These foreigners fall under three main groups: • those who wish to buy the exports of the country; • those who wish to visit the country; • those who wish to invest in the country. At a low price, more of the currency is demanded. At a high price, less is demanded. The demand curve for any currency is downward sloping from left to right, just the same as the demand curve for any other good or service. Residents who conduct transactions abroad supply the domestic currency to the foreign exchange market (to buy foreign currency such as £s sterling, euros or US$s). They fall into three main groups: • those who wish to buy imported goods and services; • those who wish to visit foreign countries; • those who wish to invest in other countries of the world. At a low price, less of the currency is supplied. At a high price, more is supplied. The supply curve for any currency is upward sloping from left to right. At the intersection of the demand and the supply curves of the currency, there is the equilibrium rate of exchange. Figure 21.3 shows how the exchange rate is determined under the floating exchange rate mechanism. The demand curve is labelled D and the supply curve is S. At the intersection is the equilibrium rate of exchange. The currency is the same as any other commodity that has a price. Where demand and supply intersect, this is the equilibrium price. 175 21 · Exchange rates depreciation • Just as for any other commodity, as demand falls or supply increases, the currency becomes cheaper. This is a depreciation of the currency. DEFINITION: A depreciation of a currency is a fall in the external value of that currency due to changes in the forces of demand and/or supply. price of TT$1 in US dollars In Figure 21.4, demand for the currency falls, ceteris paribus. The demand curve, D, shifts to the left to D1 and the price of the currency (TT$) falls from US50 cents to US25 cents. Or supply could have increased, ceteris paribus, as seen in Figure 21.5. The supply curve, S, shifts to the right (downward) to S1 and the price of the currency (TT$) falls from US50 cents to US25 cents. Depreciation has the same effect as devaluation. The currency is losing value. TT$1 = US50 cents depreciates to TT$1 = US25 cents S US50 cents US25 cents = After depreciation = D D1 0 Before depreciation quantity demanded and supplied Figure 21.4 A change in demand for TT$ appreciation • It follows, then, that as foreigners demand less of the domestic currency, other things remaining constant, the currency depreciates. There is a shift of the demand curve to the left. Also, as domestic residents and firms supply more domestic currency (that is, they wish to purchase more foreign currency for imports, holidays or investments), the currency loses value. There is a shift of the supply curve to the right. As demand increases or supply falls, the currency becomes more expensive. This is an appreciation of the currency. price of TT$1 in US dollars DEFINITION: An appreciation of a currency is a rise in the external value of that currency due to changes in the forces of demand and/or supply. In Figure 21.4, demand for the currency increases, ceteris paribus. The demand curve, D1, shifts to the right to D and the price of the currency (TT$) rises from US25 cents to US50 cents. Or supply could have decreased, ceteris paribus, as seen in Figure 21.5. The supply curve, S1, shifts to the left (upward) to S and the price of the currency (TT$) rises from US25 cents to US50 cents. This has the same effect as revaluation. The currency is gaining value. TT$1 = US25 cents appreciates to TT$1 = US50 cents S S1 US50 cents US25 cents = After appreciation = D 0 quantity supplied and demanded Figure 21.5 A change in the supply of TT$ 176 Before appreciation 21 · Exchange rates ITQ7 What is the difference between a revaluation and an appreciation? It follows then that, as foreigners demand more of the domestic currency, other things remaining constant, the currency depreciates. Also, as domestic residents and firms supply less domestic currency (that is, they wish to purchase less foreign currency for imports, holidays or investments), the currency gains value. When the exchange rate is fixed, the terms ‘devaluation’ and ‘revaluation’ are used, respectively, to indicate a fall and a rise in the external value of the currency. When the exchange rate is floating, the terms ‘depreciation’ and ‘appreciation’ are used, respectively, to indicate a fall and a rise in the external value of the currency. The terminology is summarised in Table 21.1. Table 21.1 A summary of the movements in the exchange rates Exchange rate movement Fixed exchange rate regime Floating exchange rate regime A fall in the external value of the currency devaluation depreciation A rise in the external value of the currency revaluation appreciation Factors influencing the exchange rate We can now state some general rules: • A depreciation is caused by falling demand and/or rising supply of a country’s currency. • An appreciation is caused by rising demand and/or falling supply of a country’s currency. These are summarised in Table 21.2. Table 21.2 Depreciation and appreciation ITQ8 How does each of these two situations affect demand for and supply of the currency? Effect on exchange rate Change in demand for domestic currency Change in supply of domestic currency Depreciation falling demand increasing supply Appreciation rising demand falling supply The following factors affect the demand and/or supply of the currency and so influence the exchange rate: • Domestic prices compared to foreign prices. If local prices are low compared with foreign prices, then residents and foreigners will buy more domestic goods. There will be a currency appreciation. If local prices are high compared with foreign prices, then residents and foreigners will buy more foreign goods. There will be a depreciation of the currency. • Domestic income levels. If domestic income levels are increasing, ceteris paribus, residents might purchase more imports, which will cause the exchange rate to depreciate. On the other hand, falling incomes will reduce the demand for imports, and the currency will appreciate. There is a general rule in economics that, as incomes increase, consumption of all goods (including imports) increases, and diminishing incomes will lead to a reduction in consumption. • Changing tastes. If tastes change in favour of the products of foreign countries, then there will be more imports, and the currency will depreciate. Many countries owe the depreciation of their currency to the high level of preference for imports by their residents. We all enjoy clothes and shoes from abroad, as well as electronic gadgets and appliances. If tastes change in favour of the domestic product, then imports will decrease and the currency will appreciate. • Interest rate changes. As interest rates increase and become higher than those of other countries, foreign currencies might flow into the country to take advantage of the high rates of interest. This causes an appreciation 177 21 · Exchange rates of the currency. As interest rates fall and become lower than those of other countries, foreign currencies might flow out of the country to take advantage of the high rates elsewhere. This causes a depreciation of the currency. • Speculation. Speculators are people who buy and sell currencies in order to make a profit. They might buy US$ when the dollar is cheap and sell when it commands a higher price. In so doing, they make a profit. Speculators also operate according to what they believe will happen. If speculators think Jamaican interest rates will go up, they will purchase Jamaican dollars to earn the higher interest. As they buy more Jamaican dollars (causing demand for them to increase), the currency will appreciate. The managed exchange rate regime managed exchange rate • clean floating • dirty floating • When the currency is floating, it can fluctuate considerably from day to day. It can gain value or lose value rapidly over a short period. These fluctuations can cause residents to lose confidence in the currency. They can also hinder international trade, as a currency can change value between the time at which a trader buys imports and the time at which he actually pays for his purchase. In many countries, the currency is allowed to float. However, a government, through its central bank, can intervene in the foreign exchange market to maintain the rate at a certain value or within a range of values (for example, TT$6.25 < US$1.00 < TT$6.35). This is a managed exchange rate regime (or managed float). When the currency is losing value (or depreciating), it means that there is too much of this currency on the market. For example, no one wants to buy TT$ to purchase TT goods and/or TT importers are supplying lot of TT$ to buy imports! There is falling demand and/or increasing supply. The government enters the market and buys up the extra TT$ with US$. This helps to maintain the rate at the equilibrium level. When the currency is appreciating, there is too little of the currency on the market. Foreigners all want TT$ to purchase TT goods and Trinidadian residents are not buying many imports. There is rising demand or falling supply of the TT$. The government will supply TT$s to the market by exchanging TT$s for US$s. This helps to maintain the rate at the equilibrium level. When a currency floats with no interference from the government, this is clean floating. When a currency floats but there is interference from the government, this is dirty floating. The exchange rate is the price of one currency in terms of another. Exchange rates can be determined under the fixed system, the floating system or the managed exchange rate system. Under a fixed exchange rate regime, the government sets the exchange rate based on the performance of the country. Under the fixed exchange rate system, the rate can be devalued (a downward adjustment) or revalued (an upward adjustment to the currency). Under a floating exchange rate regime, the exchange rate is determined solely by the forces of demand and supply. Under the floating exchange rate system, the rate can depreciate (in which case the domestic currency loses value against the foreign currency) or appreciate (the domestic currency gains value against the foreign currency). A fall in demand for, or a rise in supply of, the currency, ceteris paribus, causes the currency to depreciate. 178 21 · Exchange rates A rise in demand for, or a fall in supply of, the currency, ceteris paribus, causes the currency to appreciate. The factors that determine the exchange rate are: the relative price levels, income levels, tastes, interest rates and speculation. These affect demand for and supply of a country’s currency. The managed exchange rate occurs when the government allows the exchange rate to be determined by the forces of demand and supply, but then intervenes to keep the rate at a certain value or between certain values. In this way, the rate does not fluctuate too greatly. 1 Some examples are: UK – pounds sterling, European Union – euro, Japan – yen, Switzerland – Swiss franc, and Venezuela – bolivar. Many countries have their own dollar. You might name the currencies of other countries. 2 The ‘good’ or commodity in the foreign exchange market is any currency, and the price is quoted in another currency. If you wish to buy US$, the price can be quoted in whatever currency you are paying. The US$ is the commodity. 3 US50 cents for BB$1; US37 cents for EC$1; approximately US1 cent for GY$2; US1.6 cents for JM$1. 4 When you have to pay more than GY$179.53 for US$1, it means that the Guyanese dollar has depreciated; for example, US$1 = GY$200. 5 When you have to pay less than GY$179.53 for US$1, it means that the Guyanese dollar has appreciated; for example, US$1 = GY$150. 6 TT$1 will exchange for about 8 pence; that is, £1 sterling/TT$12.94. 7 Both indicate a rise in the value of the exchange rate. Appreciation is used when the exchange rate is floating and revaluation is used when the rate is fixed and the government makes an upward adjustment in the rate. 8 As residents and foreigners buy more locally produced goods, the supply of TT$s falls and the demand for TT$ rises – appreciation. As residents and foreigners buy more foreign-produced goods, the supply of TT$ rises and the demand for TT$ falls – depreciation. Examination-style questions Multiple choice questions 1 What is a floating exchange rate? a an exchange rate set by the government b an exchange rate determined by the forces of demand and supply c an exchange rate set by the ratio of prices in two economies d an exchange rate determined by market conditions but controlled by the government 2 Olympus is a small country where the government injected $500 million into the economy to keep the exchange rate at a certain value. What kind of exchange rate does Olympus have? a a floating exchange rate b a freely floating exchange rate c a fixed exchange rate d a managed exchange rate 179 21 · Exchange rates 3 Which one of the following factors directly affects the exchange rate? a interest rates b the unemployment rate c economic growth d the money supply 4 What is an appreciation of the exchange rate? a a rise in the value of the foreign currency b a fall in the external value of the domestic currency c a rise in the external value of the domestic currency d more residents demanding the foreign currency 5 Suppose the US dollar / euro exchange rate is $1.5 = 1 euro. A milk shake costs 4.5 euros. How much is this in dollars? a 3 b 1 c 6.75 d 1.5 6 The yen/dollar exchange rate moves from $1 = 50 yen to $1 = 60 yen due to market forces. This is: a a depreciation of the dollar b an appreciation of the dollar c a devaluation of the dollar d a revaluation of the dollar Structured question 1 180 a Define a ‘currency depreciation’. b The exchange rate moves from US$1.00 = €1.50 to US$1.00 = €1.25. What has happened to the euro? c Give two possible causes of this movement of the exchange rate, explaining each. [3] [4] [8] Essay question [20] a Explain in detail the ‘floating exchange rate regime’. b How else can a country’s currency be determined? c Explain three causes of a depreciation of a country’s currency. [6] [4] [10] 22 By the end of this chapter you should be able to: Balance of payments distinguish between ‘balance of payments’ and ‘balance of trade’; construct a balance of payments account; explain the factors that give rise to a balance of payments deficit; explain the factors that give rise to a balance of payments surplus; describe the impact of a deficit; describe the impact of a surplus; explain the measures to reduce a deficit/surplus. Concept map Balance of payments • current account • capital account • official reserves account balance of payments surplus balance of payments in equilibrium deficit inflows > outflows inflows = outflows outflows > inflows Balance of payments balance of payments • During a given year, an economy participates in international trade. The sale of exports and other transactions will cause funds to flow into the country. When the country imports goods and services, or conducts other business abroad, funds flow out of the country. The balance of payments is a summary of the payments and receipts of transactions between a country and the rest of the world for a given period, usually one year. When there are foreign exchange flows into the country, these are called inflows or receipts. When there are foreign exchange flows out of the country, these are called outflows or payments. In Barbados in 2005, the balance of payments was in surplus by US$48.7 million. In Jamaica there was also a surplus, in this case of US$228.9 million. 181 22 · Balance of payments Structure of the balance of payments We will now look at the structure of balance of payments accounts. Table 22.1 shows the balance of payments accounts for Trinidad and Tobago for the year 2007. Table 22.1 Balance of payments for Trinidad and Tobago, 2007, US$ million A. B. C. Current account Export of goods Import of goods Export of services Import of services Balance of trade Transfers Investment income Current account balance Capital account Capital account balance Net errors and omissions Official reserves account (Official financing) Change in reserves (– increase) Inflows 13391.3 Outflows 7669.9 923.8 377.4 +6267.8 +60.2 –963.7 +5364.3 –3468.6 –354.6 –1541.1 + current account • merchandise balance • visible balance • ITQ1 Calculate the merchandise balance. ITQ2 Name two other services that might be included in this account. Tourism and travel make up a substantial part of the balance sheet of most Caribbean countries. 182 Net 0 As can be seen, the balance of payments is made up of three subsections or smaller accounts. They are: A. the current account; B. the capital account; C. the official reserves account. The current account records: • trade in goods; • trade in services; • transfers to and from private individuals and government; • flows of income from investments. The export of goods and the import of goods are the first two items on the current account. The balance for these two items is called the ‘merchandise balance’ or the ‘visible balance’. This sub-account is called the ‘visible trade account’. It is the value of goods exported minus the value of goods imported. In Trinidad and Tobago, the value of exports exceeded the value of imports. There is a surplus on the visible trade account, as inflows exceed outflows. The export of services and the import of services are the next two items on the current account. Services include banking, insurance, tourism and travel – all of which a country can sell or purchase. 22 · Balance of payments services balance • invisible balance • surplus • balance of trade • ITQ3 Calculate the services balance. Good ol’ Auntie Kay! capital account • The balance on this account is called the ‘services balance’ or the ‘invisible balance’. It is export of services minus import of services. Trinidad and Tobago exported more services than it imported. There is a surplus on the invisible trade account, as inflows exceed outflows. The balance on the goods and services account combined is called the ‘balance of trade’. This is US$6267.8 million, a surplus. You should note that in some countries economists and statisticians call the balance on the merchandise account the balance of trade. Also on the current account are transfers to and from private individuals and government, and flows of income from investments. Here is an explanation of each: • Transfers include gifts from private individuals, and government grants. If a student from Nevis receives a gift of US$20 from his aunt in New York City, this will be recorded as an inflow in this section of the current account. A positive transfers figure means that inflows exceeded outflows. A negative transfers figure means that outflows exceeded inflows. • Flows from investment incomes records the income received from foreign investment. Trinidadians receive incomes from their investment abroad in the form of interest and dividends. This is an inflow of investment incomes. Similarly, residents in other countries receive investment incomes from their investments in Trinidad and Tobago. This is an outflow of investment incomes. A positive investment incomes figure means that inflows exceeded outflows. A negative investment incomes figure means that outflows exceeded inflows. The capital account records: • Investment by the residents / domestic firms of the country in other countries. This is an outflow and is therefore a debit or minus item; for example, a Jamaican national buying shares in the Microsoft Corporation on the New York stock exchange. • Investment made in the country by foreigners. This is an inflow and is, therefore, a credit (or plus) item. The Bank of Baroda of India setting up an office in Trinidad represents an investment inflow to Trinidad and Tobago. These investment flows can be seen in Figure 22.1. investment outflow Wintryland Tropic Island Desert Land investment inflow Figure 22.1 Investment flows for Tropic Island deficit • ITQ4 What does a negative balance on the capital account mean? Investment is divided into private sector investment and government sector investment. Note that the balance on the capital account is negative. This means that foreign investment by Trinidadians flowing into countries abroad exceeded investment in Trinidad and Tobago by foreigners. This is a deficit, as outflows exceeded inflows. If the balance on the capital account were positive, this would imply that foreign (private and government) investment flowing into Trinidad and Tobago exceeded Trinidad and Tobago’s investment overseas. Inflows exceeded outflows. 183 22 · Balance of payments net errors and omissions • official reserves • official reserves account • balance of payments surplus • balance of payments deficit • balance of payments is in equilibrium • ITQ5 What is the value of the surplus? A balance of payments account records all the transactions of a country with other countries for one year. Statisticians depend on data from many firms, individuals and government agencies. Some data might not be available at the time of the compilation of the statistics. There is always the likelihood of errors in recording transactions and the omission of certain transactions. A value is placed in the accounts for net errors and omissions to account for all the discrepancies. Official reserves are the government store of foreign currency held by the central bank of a country. The official reserves account shows the effect of the flows of payments over the year on the official reserves of the country. At the year end, there might be a balance of payments surplus or deficit, or the balance of payments might be in equilibrium. A balance of payments surplus occurs when inflows are greater than outflows. A balance of payments deficit occurs when outflows are greater than inflows. When the balance of payments is in equilibrium, this means that inflows are equal to outflows. If the official reserves value is negative, there is surplus on the balance of payments account. If the official reserves value is positive, there is a deficit on the balance of payments account. From Table 22.1, we can see that there is a surplus for Trinidad and Tobago in 2007. Inflows exceed outflows by US$1541.1 million. In order to make the balance of payments accounts sum zero, we must make this excess negative. The opposite is done for a deficit. Balance of payments deficits Factors that give rise to a balance of payments deficit Recall that a balance of payments deficit occurs when outflows are greater than inflows. The country is making more payments abroad than it is receiving. Been nice knowing ya! A deficit might be due to: • increasing demand for imported goods and services; • falling demand for locally produced goods and services by foreigners; • an increase in holidays taken abroad; • a decrease in visitors to the country; • individual and governmental transfers out of the country being greater than those coming in; • investment incomes being paid out to foreigners being greater than investment incomes coming into the country; • a greater value of investments being made abroad by domestic residents than foreign investors are making in the domestic country. Behind all of these possible causes of a balance of payments deficit lies the assumption that all other factors remain constant; this is the ceteris paribus assumption. 184 22 · Balance of payments The impact of a deficit ITQ6 For what is the foreign currency demanded? A deficit on the balance of payments accounts will lead to a number of consequences: • Unemployment might increase. If the deficit is due to a deficit on the balance of trade account, this means that the domestic residents are demanding more imports. Foreign firms are supplying cheaper imports or better-quality goods. This is a leakage, and domestic firms will suffer a fall in demand leading to increased unemployment. • Falling foreign exchange reserves. A deficit means that outflows are greater than inflows. To finance the deficit, it is necessary to draw on reserves. • Exchange rate depreciation. A deficit means that the domestic residents are demanding more foreign currency. They will increase the supply of domestic currency to the foreign exchange market. This will lead to a depreciation of the domestic currency. Measures to reduce a deficit embargo • quota • tariff • ITQ7 Use an example to illustrate how the deficit will shrink. ITQ8 Is this an expenditure-switching policy or an expenditure-reducing policy? If a country has a balance of payments deficit, it means that more funds are flowing out of the country than the country is earning. A balance of payments deficit reduces the official reserves of a country. Any policy to reduce a balance of payments deficit will have to reduce the amount of funds flowing out of the economy, or increase inflows. Three such policies to reduce a balance of payments deficit are: • Reduction of aggregate demand through deflationary monetary and fiscal policy. Deflationary monetary policy is the increasing of interest rates. Consumers will save more and spend less. As consumers spend less, they will purchase fewer imports. Deflationary fiscal policy is the reduction of government spending and the increase of taxes. Less government spending will reduce incomes in the economy and this will reduce spending in general, and spending on imports in particular. Higher taxes will lead to less disposable income. Lower incomes mean less spending on domestically produced goods and imports. When imports fall, outflows are reduced and the size of the deficit is reduced. These are all expenditure-reducing policies. • Import controls. An embargo is a direct ban on the importation of a particular good. A quota is a limit on the amount of a good that can be imported. A tariff is a tax placed on an imported good. All of these are import controls. When an import control is placed on an imported good, it reduces the quantity of the good that can be imported. When imports fall, outflows are reduced and the balance of payments deficit shrinks. These are expenditure-switching policies, as domestic demand is switched away from imports to locally produced goods. • Devaluation. Recall that a devaluation of a currency is a fall in the value of a country’s currency. The lower the level of the currency, the lower the level of imports. Assume the exchange rate is US$1 = TT$2. Then it changes to US$1 = TT$4. This is a devaluation of the TT$. The TT$ is worth less, as you have to spend more to get US$1. In the first case, Trinidadians have to spend only TT$2 to buy, say, a pencil case for US$1. They can therefore demand many pencil cases. When the dollar devalues, Trinidadians have to spend TT$4 to buy that same pencil case for US$1. They will therefore demand fewer pencil cases. Outflows will fall. Also, the price of exports will fall and demand will rise, increasing inflows and reducing the size of the deficit. 185 22 · Balance of payments Balance of payments surpluses Factors that give rise to a balance of payments surplus A balance of payments surplus occurs when inflows are greater than outflows. The country is receiving more income from abroad than it is making payments. A surplus might be due to: • falling demand for imported goods and services; • increasing demand by foreigners for locally produced goods and services; • a decrease in holidays taken abroad; • an increase in foreign visitors to the country; • individual and governmental transfers into the country being greater than transfers out; • investment incomes paid into the country to domestic investors who invested abroad being greater than those being paid out to foreigners who invested locally; • greater investments in the local economy by foreigners than foreign investment made by domestic residents abroad. All of the reasons for a balance of payments surplus, as for the deficit, are given on the assumption that all other factors remain constant – again, the ceteris paribus assumption. The impact of a surplus A surplus on the balance of payments accounts will lead to a number of consequences: Hi! Nice to see ya! ITQ9 Why are foreign firms and individuals demanding domestic currency? • Falling unemployment. A surplus might mean falling unemployment, as foreigners demand more locally produced goods and services. Firms will expand to meet the increasing demand and so employ more labour. • Increase in reserves. A balance of payments surplus adds to a country’s foreign exchange reserves. • Exchange rate appreciation. Increasing demand for the domestic currency by foreign firms and individuals will lead to an appreciation of the exchange rate. • Inflationary pressures. If the source of the balance of payments surplus is increasing demand for the goods and services (which has led to a balance of trade surplus), this can be inflationary. This is especially true if there are few resources idle with which to increase supply to meet the increasing demand. Measures to reduce a balance of payments surplus If a country has a balance of payments surplus, it means that more funds are flowing into the country than the country is spending. On the face of it, a surplus might seem to be a good thing. This is true in the short run. However, note that 186 22 · Balance of payments if a country has a surplus, it means that its trading partners have deficits. A series of surpluses over a number of years means that trading partners have continuous deficits. Soon the buyers of your exports will be unable to purchase goods from you. This will lead to a fall in export earnings for the given country. Policies to reduce a surplus must reduce the inflows to a country or increase outflows. Some policies to reduce a balance of payments surplus are: • Increasing aggregate demand through reflationary monetary and fiscal policy. Reflationary monetary policy includes the reduction of interest rates. Consumers will save less and spend more. As consumers spend more, they will purchase more imports. Reflationary fiscal policy is an increase in government spending and a reduction of taxes. More government spending will increase incomes in the economy, and this will increase spending in general, and spending on imports in particular. Lower taxes will lead to higher disposable incomes. An increase in incomes means more spending on domestically produced goods and imports. When imports rise, outflows will increase and the size of the surplus is reduced. • Reduction of import controls. When import controls are removed, the price of imports will fall. There might be a removal of tariffs, or the relaxation of a ban or quota, either of which will lead to more imported goods being available at lower prices. As prices are lower, more imports will be demanded, and this will increase flows out of the country. Other things remaining constant, the size of the surplus will fall. • Revaluation of the currency. Recall that a revaluation is the rise in value of a country’s currency. The higher the level of the currency, the higher the level of imports. Assume the exchange rate is US$1 = TT$2. Then it changes to US$1 = TT$1.50. This is a revaluation of the TT$. The TT$ is worth more, as you have to pay less to acquire US$1. In the first case, Trinidadians have to spend TT$2 to buy, say, a pencil case for US$1. When the government revalues the dollar, Trinidadians have to spend only TT$1.50 to buy that same pencil case for US$1. They will therefore demand more pencil cases. The foreign good is cheaper for Trinidadians after the revaluation. A revaluation makes imports cheaper. More imports will be consumed. Outflows will increase, and the size of the surplus will shrink. Also, the price of exports will increase and demand will fall, reducing inflows and reducing the size of the surplus. The balance of payments is a summary of the payments and receipts of transactions between a country and the rest of the world for a given period, usually one year. The balance of payments is made up of the current account, the capital account and the official reserves account. A deficit might be due to increasing demand for imported goods and services, falling demand by foreigners for locally produced goods and services, an increase in holidays taken abroad, a decrease in visitors to the country, or larger outflows than inflows due to transfers, investment incomes and investments. A surplus might be due to falling demand for imported goods and services, increasing demand by foreigners for locally produced goods and services, a decrease in holidays taken abroad, an increase in visitors to the country, or larger inflows than outflows due to transfers, investment incomes and investments. The impacts of a deficit are: unemployment, falling foreign exchange reserves and depreciation of the exchange rate. The impacts of a surplus are: a fall in unemployment, rising foreign exchange reserves, appreciation of the exchange rate, and inflationary pressures. 187 22 · Balance of payments Measures to reduce a deficit are: deflationary monetary and fiscal policy, import controls and devaluation. Measures to reduce a surplus are: reflationary monetary and fiscal policy, relaxation of import controls and revaluation. 1 The merchandise balance is exports (inflows) – imports (outflows). This is 6402.9 – 4894.2 = 1508.7 (US$ million). 2 Transport and communication are two examples. 3 This is 850.8 exports – 371.3 imports = 479.5 surplus (US$ million). 4 A negative figure means that investment abroad by Trinidad and Tobago (outflows) is greater than investment in Trinidad and Tobago by foreigners (inflows). 5 The surplus is US$735.2 million. 6 The foreign currency is being demanded to buy more imports, send transfers and investment incomes abroad, and make investments abroad. 7 Foreign firms and individuals want domestic currency to purchase imports, send transfers or investments incomes, and to make investments. 8 Imagine imports are $20 million and exports are $15 million. The balance of payments deficit is $5 million. Then imports fall to $18 million while exports remain constant. The deficit shrinks to $3 million. 9 Devaluation is an expenditure-switching policy as, when imports are made dearer, consumers switch to locally produced goods. Examination-style questions 188 Multiple choice questions 1 What is the balance of trade? a the net of all inflows and outflows on the balance of payments b the net of all inflows and outflows arising from trade in goods c the net of all inflows and outflows arising from trade in services d the net of all inflows and outflows arising from trade in goods and services 2 A foreign computer firm called Pascal builds a subsidiary in Javaland. What is the impact on the balance of payments of Javaland? a an inflow on the current account b an outflow on the current account c an inflow on the capital account d an outflow on the capital account 3 Pascal makes profits in Javaland which it sends back to its home country to expand production there. What is the impact on the balance of payments? a an inflow on the current account b an outflow on the current account a an inflow on the capital account b an outflow on the capital account 4 A government may choose to reduce a balance of payments deficit by: a reducing interest rates b reducing income taxes c imposing higher tariffs d revaluing the domestic currency 22 · Balance of payments 5 Which of the following is an outflow on the current account? a domestic residents vacationing in Hawaii b tourists spending in the domestic economy c transfers from a national working abroad to his family d sales by a domestic firm to foreigners 6 Which of the following factors gives rise to a balance of payments surplus? a an increase in foreign visitors to the country, ceteris paribus b increasing demand for foreign services, ceteris paribus c increased investment incomes paid out to foreigners d greater investment made abroad Structured question 1 a Distinguish between the balance of payments and the balance of trade. [2] b Name three accounts in the balance of payments. [3] c Explain two factors that give rise to a balance of payments surplus. [4] d Explain two ways in which a surplus can be reduced. [6] Essay question a Distinguish between a balance of payments deficit and a balance of trade deficit. b Can a country have a balance of trade surplus and a balance of payments deficit? c Discuss the impact of a deficit on a country. d Explain three ways in which a surplus can be reduced. [20] [4] [1] [6] [9] 189 23 By the end of this chapter you should be able to: Globalisation and trade liberalisation define the term ‘preferential tariff’; identify the benefits and costs of preferential tariff arrangements; define ‘trade liberalisation’; explain the term ‘globalisation’; identify the drivers of globalisation; identify the social and economic benefits of large-scale production; explain the effects of trade liberalisation and globalisation on firms in the Caribbean; explain the effects of trade liberalisation and globalisation on consumers in the Caribbean; explain the effects of trade liberalisation and globalisation on the sovereignty of Caribbean territories. Concept map Globalisation and trade liberalisation preferential tariffs trade liberalisation firms globalisation consumers sovereignty of territories Protectionism tariff • 190 Protectionism is a policy of protecting home industries from foreign competition by the imposition of trade barriers on imported goods and services. Barriers to trade are measures designed to keep foreign goods out of domestic markets. Barriers to trade are either tariff or non-tariff. A tariff is a tax or duty on imported goods. Tariffs increase the price of imported goods and make the goods less price-competitive. Non-tariff barriers reduce or completely ban some imports into a country. Some non-tariff barriers to trade are: • Quotas. Restrictions on the amount of a particular good that can be imported. • Embargoes. An embargo is a total ban on a particular good, or a ban on goods coming from a certain country. 23 · Globalisation and trade liberalisation ITQ1 Why is an export subsidy considered to be a protectionist measure but not a barrier to trade? • Exchange controls. A limit on the amount of foreign exchange an importer can obtain to import goods. Less foreign exchange means the importer imports fewer foreign goods. • Voluntary export restrictions (VERs). This is where the exporting country agrees to export fewer goods to the importing country in return for the same benefit. Overall, this results in fewer imports for both countries and less trade. • Quality standards. Very high-quality standards in the importing country serve to reduce imports, as fewer goods – especially those of developing countries – will meet the required health and safety standards in developed countries. • Bureaucratic red tape. A great deal of paperwork requested by the importing country and licensing fees payable by the exporter of the goods serve as deterrents to trade. The requirement that a product must be labelled in the language of the importing country is an additional cost to firms that are exporting. It increases cost and is also a deterrent to trade. • Export subsidies. An export subsidy consists of some kind of assistance given to the firms of an industry that is exporting goods. When a government gives an export subsidy to such firms, costs of the firms are reduced. When the good is exported, the exporter will be able to sell at a lower price on the world market. An export subsidy is not a barrier to trade, but it is a form of protectionism. Some protectionist measures reduce world trade and reduce the welfare of consumers. Some countries have, in the past, placed preferential tariffs on a product coming from a particular country. Preferential tariffs preferential tariff • A preferential tariff is a reduced tariff granted by one country on certain goods from another country. It is a lower tariff or tax placed on goods imported from a given country by the importing country (compared with the tariff placed on the same goods imported from other countries). The reasons why preferential tariffs are granted are: • A developed country might grant a preferential tariff to developing countries in order to boost the developing countries’ exports and their economic growth. • Countries in a trading group might also grant a preferential tariff to their partners to promote trade within the group and develop trading ties; for example, countries in the ASEAN group and the CARICOM group (see p. 212 for a discussion of CARICOM) have preferential tariff arrangements. • Preferential tariffs might also be put in place for foreign policy reasons. A country might wish to reward another country with a lower tariff on a given good. This might be in return for support on some international issue. Or the country might wish to punish another country with a higher tariff. It might be that the country placing the higher tariff disagrees with the policies of the other country. The following example illustrates how preferential tariffs work. A given country, Wintryland, might import a particular good – say, sugar – from two countries, Tropica and Aguasol. Wintryland might favour Tropica by placing a lower tariff (5 per cent) on the sugar imported from Tropica. All other sugars will incur a 10 per cent tariff. If both countries have identical costs, the lower tariff on the sugar from Tropica will make it cheaper for consumers in Wintryland to buy Tropica’s sugar. Suppose that a 2 kg package of sugar from either of the exporting countries costs US$2.00; 191 23 · Globalisation and trade liberalisation ITQ2 How is this final price of Tropica’s sugar after tariff computed? a 5 per cent tariff will increase the price of Tropica’s sugar to US$2.10. The higher 10 per cent duty on the other sugar will lead to a final price of US$2.20 for Aguasol’s sugar. There is a preferential tariff on Tropica’s sugar, giving Tropica a price advantage in the sugar market in Wintryland. For the Caribbean territories, preferential tariffs have been around since ‘the days when sugar was king’. Centuries ago, when sugar was exported to the UK from the British West Indies, British West Indian sugar enjoyed preferential tariffs on the British market. Benefits of preferential tariffs • The exporting country benefits from the lower tariff, as the price of its product in the foreign market is lower than the same good imported from other countries. Producers in the country which benefits from the preferential tariff earn higher sales revenue, and employment in the industry in that country is maintained. • Preferential tariffs foster stronger trading ties between countries. They help to develop good international relations between the countries which grant and receive lower tariffs. • Preferential tariffs give developed countries an opportunity to assist poorer countries by making their exports price competitive. Traditionally, preferential tariffs have been granted to nations that were once colonies of the European countries. To some, it might be seen as a chance for the developed world to compensate for exploitation of land and people during the colonial rule of more than 300 years. Costs of preferential tariffs • The more efficient suppliers might have higher duties placed on their goods. As a result, consumers in the importing country will have to pay more for a good whose quality might be better (and price lower, before the tariff was placed) than the good with the lower tariff. • Consumers in the importing country do not benefit from the availability of goods from competing suppliers, or from the best prices. • Preferential tariffs cause other countries not in receipt of the lower tariff rate to become discontented. They might retaliate, with negative consequences for the country granting the preferential tariff. They might even complain to the World Trade Organization (WTO) about such practices. Perhaps one of the most well-known trade disputes involved US complaints to the WTO in 1996. The USA complained about preferential tariffs on bananas granted to former colonies (Caribbean exporters included) by the European Union (EU) and complicated licensing schemes necessary for other exporters of bananas to the EU. The WTO ruled in favour of the USA in this dispute, which is popularly known as the ‘Banana Wars’. Trade liberalisation trade liberalisation • 192 Trade liberalisation is the reduction, or even total removal of, barriers to trade. It allows the free flow of goods and services across international boundaries. Figure 23.1 shows how with trade liberalisation greater trade is achieved. Free flow of goods in international trade yields many advantages to the countries of the world. This was discussed in detail in Chapter 20. As a result of these benefits, the trend in the world today is towards trade liberalisation and free trade. Preferential tariffs that once protected many countries of the world are gradually being removed. In the context of the Caribbean, preferential tariffs 23 · Globalisation and trade liberalisation achieved trade possible trade achieved trade possible trade high trade barrier lower trade barrier Figure 23.1 The effects of trade liberalisation that once protected these territories are also being removed. Some are even considered illegal by the WTO. The impact of this trend in trade liberalisation is discussed later in the chapter. Globalisation globalisation • You might have heard the expression ‘The world is a global village.’ Globalisation is taking place in today’s world. Globalisation is the emergence of a single world market facilitated by improved technology and communications, and deregulation. It has led to an increasingly borderless world and the greater movement of people, goods, capital and ideas. In the modern world, there are great advances in technology, transport and communication. The world is shrinking. People are able travel to far-off lands in jet planes in a matter of hours for business or pleasure. Toronto New York Atlantic Ocean USA The Bahamas London Gatwick Cuba Ft. Lauderdale Miami Cayman Islands Haiti Dominican Republic Jamaica Puerto Rico Virgin Is. Anguilla Barbuda Antigua St Kitts and Nevis Guadeloupe Monserrat Dominica Caribbean Sea Aruba Netherlands Antilles St Vincent and the Grenadines Caracas Grenada Martinique St Lucia Barbados Tobago Trinidad P a c i fi c O c e a n Venezuela Guyana Airline connections Suriname French Guiana 193 23 · Globalisation and trade liberalisation ITQ3 Take a look around the classroom. Name some imported goods and identify each one’s country of origin. There is the greater and freer movement of goods, money, information, ideas and people across national boundaries. We can communicate with people all over the world cheaply and efficiently using telephones and the Internet. We can even see those with whom we are communicating using webcams and computer monitors. Through satellite television, we can view major sporting events, such as the FIFA World Cup and the ICC Cricket World Cup live. We can keep up to date with news and other events as they unfold. There is greater exposure to different cultures, especially through tourism, movies and television. Indeed, the world is a much smaller place than it was 20 years ago. The planet earth itself has not shrunk! However, goods and services, events and even food from distant lands, and travel to these countries are so accessible to everyone that it is as if the earth has shrunk. All these changes encompass globalisation. The drivers of globalisation The Internet has made international communication much easier. The following factors have fuelled the speeding train of globalisation: • Leaps in communication technology. The Internet, computers and satellites enable the movement of information, money (electronic funds), ideas and goods from one country to another. Goods flow through normal commerce and e-commerce channels. E-commerce is discussed in detail in Chapter 26. • Improved transportation. This has resulted in lower transport and shipping costs. Larger ships transport goods more cheaply to countries all over the world. ITQ4 How does technology assist in the flow of information, money, ideas and goods? Improved air and sea transport. Improved refrigeration and storage facilities enable the movement of all kinds of goods. People can travel all over the world quickly and with ease. • Trade liberalisation. The reduction, and even total removal of, barriers to trade allows for goods to move freely across international boundaries. There are few limits on what can be exported/imported. The opportunities are endless. 194 23 · Globalisation and trade liberalisation • Liberalisation of the capital markets. The market for financial instruments (as you learnt in Chapter 15) is open worldwide. Due to improvements in communication – by means of the Internet, computers and fax machines – traders in stock exchanges can purchase shares all over the world. Investors can move their funds instantly from one continent to another where there are better rates of interest. Companies are growing and are now setting up bases in different regions of the world. Producing for the world Our countries have lost markets – such as the UK sugar market to the beet sugar producers of Europe and the UK. However, all is not lost for Caribbean economies with the current trade liberalisation and the removal of preferential tariffs. The removal of trade barriers means that countries of the Caribbean region have access to world markets to sell their own goods and services. Caribbean economies now have to think big and produce for the world. Economic and social benefits of large-scale production ITQ5 Use an example to illustrate how lower costs can lead to increased profits. • Producing a larger output will enable small island economies to reap economies of scale. Economies of scale are the cost advantages that benefit an organisation as that organisation grows. These include marketing economies, financial economies, managerial economies, research and development economies, welfare economies and technical economies, as discussed in Chapter 7. When an industry reaps cost advantages, it can mean larger profits for producers, if prices and revenue remain constant. The firm can choose to pass on lower costs to consumers in the form of lower prices. When lower costs lead to lower prices, this can enable the firm to earn a larger market share. • There will be a reduction in unemployment as firms employ more labour to produce more goods. This is true unless the large scale leads to mechanisation and the use of more capital relative to labour. With lower costs and ready markets available, firms will always be able to sell for their products. They will not have to lay off workers. • There is open competition throughout the world. Competition will result in lower prices and better-quality goods for all consumers. However, goods produced in some low-cost economies, though cheaper, might not possess the same quality. You might see cheaper-priced home appliances in shops in your region – such as toaster ovens, blenders and irons – that might not be of the same quality as the well-known brands. • Caribbean people will feel a sense of worth as world citizens, as they are making products for the people of the world to consume. When we travel all over the world, we will see our products on the shelves of stores and we will feel a sense of pride. For example, Willie’s Ice Cream (Trinidad) has a store in Miami. There are Jamaican patties, Trinidadian doubles and Chubby soft drinks on sale in New York. Very soon, more Caribbean goods will be on sale all over the world. Trade liberalisation and globalisation will therefore afford the Caribbean the opportunity to produce goods on a large scale. Effects of trade liberalisation and globalisation Trade liberalisation and globalisation are having, and will continue to have, profound effects on firms and consumers in the Caribbean region. They will also affect the sovereignty of Caribbean territories. 195 23 · Globalisation and trade liberalisation Effects of trade liberalisation and globalisation on firms in the Caribbean ITQ6 Name a foreign good that has captured the tastes of consumers in your country in this way. • Domestic firms now have to compete with the products of foreign firms. With trade liberalisation and globalisation, there is an influx of a variety of goods from all over the world. These goods might be cheaper and/ or of a higher quality, and will compete with locally produced goods. These goods might not be substitutes for locally produced goods, but might be so advanced technologically that they capture the taste and incomes of the locals. • There is the rise of multinational corporations (MNCs), which continue to locate in developing countries. MNCs are also a source of competition to domestic firms. They locate to take advantage of natural resources and cheap labour supplies in the host country, or even to capture the markets of the developing countries. They provide employment. Government must monitor their activities to ensure that the relationship with the multinational corporations yields benefits to the host country and not only to the MNCs. • Caribbean firms will now have to advertise internationally to sell the products of the Caribbean. They will have to develop websites to advertise their products, advertise in foreign magazines and television, and participate in international trade shows to showcase the Caribbean. One website is www.caribbeanonlineyellowpages.com, where a visitor to the site can find information on any product or service, literally from A to Z; for example, hotels, companies and agriculture in the region. Effects of trade liberalisation and globalisation on consumers in the Caribbean • There will be an increased standard of living as consumers now have access to a greater variety of goods from all over the world. • The developed countries are exporting artificial wants. Because of the influence of television and the movies, the Caribbean consumer wants to buy these goods. Fashionable clothes, cosmetics and household gadgets are but a few of the goods we all want to buy, though we might not need such goods. • There is the spread of food culture; for example, pizza, gyros, roti, Thai cuisine, East Indian cuisine. The international culture is replacing local culture in food. Both travellers and locals can visit Arabian restaurants, and the more adventurous can have Japanese sushi meals. • There is the westernisation of the world due to television and media in developed countries. Some of us celebrate Halloween with costumes, parties and trick-or-treating, just as they do in the USA, Canada, UK and Ireland. Halloween celebrations date back to the ancient Celtic festival of Samhain. Some people believe that on the night of 31 October, the last day of the Celtic old year, the barrier between this world and the world of the dead becomes blurred. Hence, Halloween costumes tend to represent vampires, witches and ghosts, and pumpkins and lanterns are used for decoration. Thanksgiving, an American festival celebrated to commemorate the arrival of the Pilgrims on the Mayflower to the USA and to give thanks for a bountiful harvest, is also celebrated with the traditional turkey and cranberry sauce by some Caribbean residents. This shows that the people of the Caribbean are open to other cultures, which is admirable. However, the effects are that we are consuming fewer domestically produced goods and more imports. Imports use up valuable foreign exchange. • Workers lose jobs as Caribbean products are competing with world-class products. • There is an increase in international travel and tourism. Caribbean residents go the USA or other islands for the weekend, or even for the day; 196 23 · Globalisation and trade liberalisation for example, they might visit an island for a day to see a World Cup cricket match. They cross the Atlantic Ocean to visit the UK, sometimes just for a week. Planes carry passengers travelling for business and leisure to, from and around the Caribbean. Effects of trade liberalisation and globalisation on the sovereignty of territories in the Caribbean • Natural resources may be exploited by the multinational corporations (MNCs). As mentioned earlier, MNCs provide jobs, but Caribbean governments must be alert and ensure that these international giants do not exploit our people and resources. • Small and infant industries may close in the Caribbean because of competition with other foreign firms. This will lead to unemployment. Governments will have to develop policies to reduce such unemployment. With the closure of Caroni (1975) Ltd, a company producing sugar in Trinidad and Tobago, the government has granted land for housing and crop cultivation to the displaced workers. • Increasing imports may result in a trade deficit in Caribbean economies. Governments will be faced with the responsibility of finding ways to boost foreign exchange earnings. 70 60 value (£m) 50 40 30 Barbados imports from UK 20 Barbados exports to UK 10 0 2002 2003 2004 2005 years Figure 23.2 Barbados’ trade with the uk ITQ7 Describe Barbados’ trade position with the UK over the period shown in Figure 23.2. 2006 2007 Source: www.uktradeinvest.gov.uk Figure 23.2 shows Barbados’ trade with the UK. Other territories – such as Jamaica, Trinidad and Tobago, St Lucia, Guyana, Antigua and the Bahamas – enjoy considerable trade with the UK. 197 23 · Globalisation and trade liberalisation brain drain • • There is an increase in immigration from poor countries to countries with more opportunities. Governments will also have to plan for migration. An inflow of skilled professionals might take jobs from locals. An inflow of unskilled labour might depress living standards! Migration into a country must be of workers in occupations where there are not enough locals to fill jobs. By extension, countries must beware the ‘brain drain’, where skilled workers migrate to more developed countries in search of better opportunities. • Some territories will lose some of their sovereignty as countries integrate. Almost all of the 27 states (2009) of the European Union now share a single currency – the euro. The CARICOM Single Market and Economy (CSME) will eventually bring such changes to this region – harmonised fiscal and monetary policies. A country will not necessarily be able to make economic decisions on its own, but must in some cases consult with the other members of the union. Each country of the union will implement policies in agreement with other members. • National borders are disappearing. Goods, people and companies are moving freely into countries in this age of globalisation and free trade. Countries will have to adapt to these changes. Tax laws and laws relating to ownership of property will have to be adjusted to take into account the activities of foreigners and foreign companies. Laws governing holders of bank accounts have already been amended to allow for foreigners. Protectionism is a policy of protecting home industries from foreign competition by the imposition of trade barriers on imported goods and services. Barriers to trade are measures designed to keep foreign goods out of domestic markets. Barriers to trade are either tariff or non-tariff. A preferential tariff is a reduced tariff granted by one country on certain goods from another country. The benefits of a preferential tariff are lower prices for the good from the country with the preferential tariff, better trading relations between some countries, and assistance provided by richer countries to poorer countries. The costs of preferential tariffs are that countries with the lowest costs do not necessarily have the lowest price in the export markets, consumers in the export market will not get the best-quality and best-priced product, and that countries might retaliate and/or complain to the WTO. Trade liberalisation is the removal of barriers to trade, allowing for the free flow of goods across international borders. Trade liberalisation has meant the removal of preferential tariffs that once protected Caribbean territories. Globalisation is the emergence of a single world market with the greater movement of people, goods, capital and ideas across international boundaries. The drivers of globalisation are: leaps in technology, improvements in transport, trade liberalisation and improvements in capital markets. The advent of globalisation and trade liberalisation means that Caribbean territories will now have to aim to produce for a world market. The social and economic benefits of large-scale production are: economies of scale, increased employment, better quality goods, and pride and a sense of worth as the products of the Caribbean are sold all over the world. The effects of globalisation and trade liberalisation on firms in the Caribbean are: increased competition, the presence of more multinational corporations and the need to advertise globally. 198 23 · Globalisation and trade liberalisation The effects of globalisation and trade liberalisation on consumers in the Caribbean are: greater variety of goods, improved standard of living, development of new artificial wants, spread of food culture, westernisation of the world, workers perhaps losing jobs, and greater travel and tourism. The effects of globalisation and trade liberalisation on the sovereignty of Caribbean territories are: exploitation by MNCs, unemployment, trade deficits, greater migration, the need to make policy in conjunction with other partner states, and adjustment of laws to accommodate foreigners and foreign firms. 1 An export subsidy helps to make an exporting firm price-competitive, as the firm receives some kind of aid from the government (whether a grant, overseas advertising, low-cost loans, tax relief or funded research and development). The exporting firm is able to charge a lower price on the export market. The firm is therefore ‘protected’ and saved from declining sales and closure. Unlike other protectionist measures, an export subsidy encourages trade (of exports). 5 × $2.00 = 10 cents. At a 5 per cent tariff, 10 cents must be paid 2 This is 100 in duties. The 10 cents is added to the US$2.00 to give a final price of US$2.10. 3 You might name shoes, schoolbags, books, fans, light switches, perhaps key holders and pens from trips abroad. You and your teachers’ experiences on vacations spent abroad, or simply goods seen at the supermarket and stores, will show how globalisation touches all our lives. 4 Information flows rapidly and in large amounts across the Internet when we talk to others and when we visit sites to research or to trade. Money flows through electronic funds transfer. Ideas flow through books, television and the Internet. Caribbean residents now have websites and e-commerce sites. We can order goods online through e-businesses, or contact suppliers the traditional way through telephone or visits. Goods, however, must be brought into the country by air or sea cargo. 5 A firm sells 100 packs of fruit punch at $5 per pack. Each pack costs $3. Total revenue is $500 and total cost is $300. Profits are $200. If each pack now costs $2.50 and everything else remains constant, total revenue remains at $500 and total cost falls to $250. Profits will rise to $250. 6 iPods, cell phones and flash drives are some examples. 7 For each year shown, the value of Barbados exports to the UK is less than its imports from the UK. The value of Barbados exports to the UK fell over the period, and the value of Barbados imports from the UK rose over the same period. The result for Barbados is a growing trade deficit with the UK. Examination-style questions Multiple choice questions 1 All of the following are barriers to trade except: a embargoes b quotas c exchange controls d a tax on domestic goods 199 23 · Globalisation and trade liberalisation 2 One cost of a preferential tariff is the fact that: a Developed countries assist poorer countries. b Efficient suppliers of a good may have to pay higher duties. c Stronger trading ties are developed between participating countries. d Some countries may get to pay a lower tariff. 3 Globalisation is: a the extension of social activities across international boundaries b the extension of economic activities across international boundaries c the extension of social, political and economic activities across regions d interdependence of the growing countries of the world 4 Trade liberalisation involves: a removal of duties on imported goods b retaliating when a trading partner places duties on a country’s exports c placing very high-quality standards on imported goods d subsiding firms in the export sector 5 Which of the following is a driver of globalisation? a protectionism b improvements in technology c economic growth d high interest rates 6 In today’s world, local firms are being faced more and more with competition from foreign firms. This an effect of: a protectionism b export subsidies c trade liberalisation d preferential tariffs Structured question 1 a What is a preferential tariff? [2] b Explain two reasons why a country might grant another country a preferential tariff. [6] c Discuss the benefits of a preferential tariff arrangement. [7] Essay question [20] a What is globalisation? [2] b Identify two ways in which globalisation might affect the consumers in your country. [4] c Explain three drivers of globalisation. [6] d Compare the effects of globalisation on developed and developing countries. [8] 200 24 By the end of this chapter you should be able to: Concept map Caribbean economies identify and explain the main characteristics of Caribbean economies; explain the economic problems facing Caribbean economies; explain development strategies for Caribbean economies in a globalised economic environment. Caribbean economies Caribbean economies problems developmental strategies • monocrop economies • low per capita GNP • investment in human capital • small population and market size • unskilled labour • foreign direct investment • little access to technology • export-led growth • few or no natural resources • large food import bill • foreign borrowing • large primary sector • many poor • large informal sector • the ‘brain drain’ • the provision of social services to the poor • insufficient arable land • undeveloped infrastructure • entrepreneurial development • large debt burden USA 0 Gulf of Mexico 200 0 The Bahamas 400 200 600 800 400 km 600 miles Atlantic Ocean Cuba Cayman Islands Mexico G r e a t e r Haiti A n t i l l e s Puerto Rico Virgin Is. Anguilla Barbuda Antigua St Kitts and Nevis Guadeloupe Monserrat L Jamaica Dominican Republic es nt r A Guatemala Dominica se Belize Caribbean Sea Aruba Netherlands Antilles Nicaragua illes Honduras St Vincent and the Grenadines Grenada Martinique St Lucia Barbados Tobago Trinidad Costa Rica Venezuela Panama Colombia Caribbean economies monocrop economies • ITQ1 Name two Caribbean economies where tourism is an important economic activity. • The Caribbean economies are monocrop economies dependent on one export, usually from the primary sector; for example, agriculture and the extractive industries such as petroleum, natural gas and bauxite. The smaller islands specialise in tourism, which is a tertiary sector activity. However, 201 24 · Caribbean economies because the economies are dependent mainly on one industry, they are still monocrop economies. Table 24.1 shows the main exports of Caribbean countries. Table 24.1 The main exports of Caribbean economies small market • no natural resource • large primary sector • large informal sector • I get by with a little help from my friends. 202 Country Main export Antigua and Barbuda petroleum products, manufactured goods, sugar The Bahamas tourism, crude oil, seafood, fruits Barbados cement, sugar, tourism Dominica bananas, cocoa, citrus fruits, copra Grenada bananas, cocoa, mace, nutmeg Guyana rice, sugar, timber Jamaica alumins, bauxite, bananas, sugar St Kitts and Nevis sugar, light manufactured goods St Lucia bananas, coconut products, cocoa St Vincent and the Grenadines bananas, copra, eddoes and dasheen (taro) Trinidad and Tobago oil and natural gas • The Caribbean region comprises many small island states. In these countries, there are small populations. Jamaica, and Trinidad and Tobago are the more populated islands, with populations of 2.7 million and 1.3 million people respectively. As a result of the small populations, there is a small market for most goods and services. • With the exception of Jamaica, Guyana, and Trinidad and Tobago there is no natural resource endowment in the Caribbean islands. This is due, in part, to the small size of the countries. • In the Caribbean economies there is a large primary sector. In Jamaica, Guyana, and Trinidad and Tobago this sector is an extractive industry: bauxite in Jamaica and Guyana, and petroleum and natural gas in Trinidad and Tobago. In these larger Caribbean countries, the secondary and tertiary sectors are more developed than the smaller Caribbean states, but not as well developed as the true developed countries. In the smaller Caribbean islands, the primary sector is agriculture. The secondary and tertiary sectors in the smaller Caribbean states remain relatively undeveloped. • In the Caribbean economies, there is a large informal sector in which economic and financial activities take place. Economic activities include: the production of goods and services, and trade. There are also do-it-yourself 24 · Caribbean economies insufficient arable land • services and community members helping each other out in construction activities without payment. Financial activities include borrowing and lending between family members, friends and even moneylenders. All these activities take place without being officially recorded. • Again, with the exception of the larger three countries of Guyana, Jamaica, and Trinidad and Tobago, the smaller island states have insufficient arable land to cultivate sufficient food for their own populations. As a result the food import bills of these countries are quite high. Table 24.2 shows country data for the Caribbean economies. Table 24.2 Country data for Caribbean economies Country Area (km2) Population (2009) millions GNP per capita 2005 US$ Antigua and Barbuda 442 0.1 10 854 The Bahamas 13 864 0.3 15 232 Barbados 431 0.3 9 741 22 966 0.3 3 493 Dominica 750 0.1 3 750 Grenada 345 0.1 3 925 Guyana 214 970 0.8 1 011 Belize Haiti 27 750 9.2 455 Jamaica 10 991 2.7 3 396 St Kitts and Nevis 269 0.05 8 298 St Lucia 616 0.2 4 731 St Vincent and the Grenadines 389 0.1 3 613 Suriname 163 820 0.5 2 539 Trinidad and Tobago 5 128 1.3 10 444 Compiled from country data Economic problems facing Caribbean economies standard of living • • Low per capita GNP. Caribbean economies have low per capita GNP. This means that the average income enjoyed by an individual for a given year is low. As a result, the standard of living is low relative to the developed countries of the world. The standard of living is the level of economic wellbeing of an individual or a population. It takes into account income levels and the quality and quantity of goods and services consumed. It also includes non-monetary factors, such as the quality of a person’s living environment and work environment, hours of work, life expectancy, literacy rates and levels of externalities. • Large pool of unskilled labour. A large percentage of the population is unskilled and not trained for the modern industrial sector. This means that there is little human capital – that is, a highly skilled, trained and flexible labour force. • Little access to technology and use of capital in the production process. Although some firms use modern, highly efficient methods, many firms have labour-intensive production processes. This means that the ratio of labour to other factors of production is high. Less use of capital in the production process means lower productivity. 203 24 · Caribbean economies ITQ2 Name some goods that the Caribbean imports for current consumption. ITQ3 poverty line • Is the poverty line higher in developing or developed countries? Why? • Large food import bill. Many of the Caribbean countries have current account deficits. They spend more on the importation of goods and services than they earn in the export of goods and services. Much of this is expenditure on goods and services for current consumption; for example, food. While many of the countries are involved in agriculture, crops such as bananas, sugar cane and nutmeg are not food crops. • Large part of the population living under the poverty line. The poverty line is the minimum amount of income necessary to enjoy an adequate standard of living. The poverty line will vary from country to country. Some people live on less than US$1 per day. The poor have to rely on government provision of health care and other social services. Many of the poor go without electricity and potable water. Fortunately, the region does not have people living in extreme poverty; that is, lacking in the basic needs of food, clothing and shelter. NOTE: Extreme poverty occurs when people lack the very basic needs of food, clothing and shelter. debt burden • ITQ4 What kind of costs do economists call this? ITQ5 What is this concept called in economics? • Migration out of skilled professionals (the ‘brain drain’). Skilled labour and professionals leave the Caribbean region in search of better jobs and opportunities in developed countries. When people such as nurses, doctors, teachers and technicians migrate, the economy will have fewer of these workers available to provide for the needs of the population. In addition, resources spent to train these professionals are lost. • Undeveloped infrastructure hindering economic activity and trade. Some Caribbean economies do not have such efficient and modern transport and communication networks as developed countries, even though urban areas might have been developed. In some countries, remote areas are not accessible by paved roads and might not have access to piped water, electricity, telephones and the Internet. • Large debt burden. In the Caribbean economies, GNP is low but the countries need funds to finance infrastructure and the provision of services such as health and education. Export earnings are low, but the countries must import goods and services to satisfy basic needs. These countries are very poor and so have to borrow to meet expenditure. The result is that the countries have a large debt and, because of low GDP, they also have a large debt burden. The debt burden is the cost of the debt in terms of the strain it places on the government and people of a country. When funds are used to repay a debt and its interest, this represents a transfer of funds from the given country to a foreign government, bank or international institution. These funds could otherwise have been used in the country to provide goods and services such as health, education, infrastructure and social services. There is little capital investment and the country might experience little or no growth in real per capita GNP. The debt burden is measured by the debtto-GDP ratio. Development strategies for Caribbean economies in a globalised environment • Investment in human capital. Provision of education and training will reduce the extent of poverty in these countries. It enables the poor to find jobs, earn an income and increase their quality of life. Some examples of the government of Trinidad and Tobago’s investment in human capital are: investment in the University of Trinidad and Tobago, provision of free tertiary education, and investment in the Multi-Sector Skill Training Programme (MuST). 204 24 · Caribbean economies foreign direct investment • portfolio investment • structural adjustment policies • • Foreign direct investment (FDI). Foreign direct investment is the longterm investment in a country by an investor from abroad. The foreign investor sets up the firm or takes over a local company. By definition, the foreign investor must have control in the given firm. This is unlike portfolio investment, where a small foreign investor simply purchases shares in a local company and earns dividends on those shares. With FDI, the foreign firm locates in the host country to gain access to resources – that is, cheap labour and natural resources – and to gain access to markets. The FDI process consists of a parent firm setting up a subsidiary in a host country, thereby forming a transnational corporation (TNC), also called a multinational corporation (MNC). See Chapter 6 for a discussion of MNCs. When the foreign firm locates in the Caribbean economy, it will cause an initial inflow of foreign exchange and so help to improve a balance of payments deficit. FDI will increase the number of firms operating in a country. This will increase economic activity in the country. Increased economic activity will increase the jobs available and so help to reduce unemployment. It will increase access to technology, thus increasing labour productivity and introducing new methods of production to the region. More people employed means higher national income and, possibly, economic growth. It is possible for the foreign firm to provide jobs for the skilled. This might encourage would-be migrants not to migrate, and so reduce the brain-drain. • Export-led growth. Exports are an injection into the circular flow of income. Sale of exports increases the earnings of domestic firms, create employment and result in the growth of real GNP per capita (economic growth). This reduces the percentage of poor in the country. • Foreign borrowing. Countries can borrow from foreign governments, banks and international financial institutions in order to promote development. The World Bank has lent to the region to develop basic education, reform the postal sector and support HIV/AIDS programmes. The World Bank approved a US$20 million loan for HIV/AIDS prevention and control in Trinidad and Tobago in 2003. In Jamaica, there was the ‘Reform of Secondary Education’ World Bank project in 2002. Countries can also borrow to develop infrastructure. The International Monetary Fund (IMF) lends to countries that have balance of payment problems. The World Bank lends funds for development projects. To qualify for loans from these organisations, countries must implement structural adjustment policies in the economy. NOTE: Structural adjustment policies are policies that a country must implement in order to qualify for an IMF or World Bank loan ITQ6 What is a balanced budget? ITQ7 Name some social programmes offered by the government of your country. These include cutting spending on social services, devaluation of overvalued currencies, trade liberalisation, balancing budgets and not overspending, removing price controls, removing subsidies to state-owned enterprises, privatisation of state-owned enterprises, enhancing the rights of foreign investors and fighting corruption in public office. Structural adjustment policies are a device used by the lending organisation to ensure that the country is able to pay back the loan and that the loan is used for the purpose for which it was granted. • Provision of social services. Many governments have to provide social services to the poor in order to help them escape the cycle of poverty. Such services include: free education and health care, and subsidised transport and water. The Trinidad and Tobago government is providing low-cost housing to the poor and loans to low-income families to repair homes. There are training programmes such as MuST for the unemployed (mentioned earlier in this chapter). There is the Chronic Disease Assistance Programme 205 24 · Caribbean economies (CDAP) for all who suffer from chronic diseases. Such assistance to the poor will raise their quality of life and help in the alleviation of poverty. • Development of the entrepreneurial class. The development of a spirit of entrepreneurship amongst the people will encourage them to start new businesses. This will create jobs and increase national income. This is another development strategy open to Caribbean economies. Some programmes to develop entrepreneurship offered by the government of Trinidad and Tobago are the Micro Enterprise Training & Development Grant and the National Entrepreneurship Development Company (NEDCO). The characteristics of the Caribbean economies are: they are monocrop economies; they have a small population and market size, little or no natural resources, a large primary sector, a large informal sector and insufficient arable land. The problems facing the Caribbean economies are low per capita GNP, large numbers of unskilled workers, little access to technology, a large food import bill, a large percentage of poor people, the ‘brain drain’, poor infrastructure and a large debt burden. Some developmental strategies for the Caribbean economies are: investment in human capital, FDI, export-led growth, foreign borrowing and the provision of social services to the poor. 1 The Bahamas, Barbados, Antigua and Barbuda, St Lucia, and St Kitts and Nevis are some examples. 2 Some goods are clothing, shoes, books and household products. 3 The poverty line is higher in developed countries. This is because an ‘adequate’ standard of living in the developed world is much higher than in the developing world. 4 Economists call these ‘opportunity costs’ – the alternative forgone. 5 The growth in real per capita GNP is called ‘economic growth’. These countries experience zero or negative growth rates. 6 A balanced budget occurs when expenditure equals revenue. 7 Some other social programmes offered by the Trinidad and Tobago government are: Helping You Prepare for Employment (HYPE), Higher Education Loan Programme (HELP) and the National Commission for Self-Help. Examination-style questions 206 Multiple choice questions 1 What type of economies are Caribbean economies? a small closed economies b small open economies c developed economies d socialist economies 2 Which of the following is not a main characteristic of Caribbean economies? a high population b large informal sector c little or no natural resources d large primary sector 24 · Caribbean economies 3 All of the following are problems faced by Caribbean economies except: a low per capita income b a large pool of unskilled labour c the ‘brain drain’ d a diversified economy 4 What strategy is useful for Caribbean economies in a globalised world? a investment in human capital b investment in the stock exchange c importing more goods and services d investment abroad 5 Which is not a structural adjustment policy? a devaluation of overvalued currencies b budget deficits c trade liberalisation d removal of government subsidies to local firms 6 What is the debt burden? a the cost of a debt to an individual b the interest on a debt c the cost of the national debt to the country d the interest plus the sum borrowed Structured question 1 a Name three Caribbean economies. b Explain three features of these economies. c Discuss three problems facing these economies Essay question a How can the size of the Caribbean economies create problems for these economies? b Identify two other characteristics of Caribbean economies. c Explain two problems not mentioned in part a or b faced by Caribbean economies. d For each problem, discuss a developmental strategy that will alleviate this problem. [3] [6] [6] [20] [4] [4] [6] [6] 207 25 By the end of this chapter you should be able to: Economic integration and CARICOM Single Market and Economy define ‘economic integration’; explain the stages of economic integration; list the member states of the CARICOM Single Market and Economy (CSME); explain the features of the CSME; describe the benefits to its members of the CSME; identify some examples of economic integration elsewhere in the world. Concept map Economic integration and Caricom Single Market and Economy (Csme) free trade area customs union common or single market economic union features CSME benefits Economic integration economic integration • trading bloc • ITQ1 Give an example of a free trade area. 208 Economic integration is the coming together of national economies to operate as one economy. National boundaries disappear as economic activity develops across borders. Countries might adopt common trade, fiscal and monetary policies. Countries of the world are responding to trade liberalisation and globalisation by forging greater ties with neighbouring states. A common feature of the world economy today is the formation of mega-trading blocs. A trading bloc is a group of nations coming together to trade under a trading agreement. A mega-trading bloc is a large trading bloc. When countries unite and integrate, they are better able to face the world. There are four stages of economic integration. They are: 1 Free trade area a Countries belonging to a free trade area have no trade barriers against other member countries; b however, each member state determines its own trade policy (and tariffs) towards other countries of the world. 25 · Economic integration and CARICOM Single Market and Economy 2 3 4 CARICOM Single Market and Economy • Customs union a As in a free trade area, there are no barriers to trade between member states in a customs union; b unlike the states in a free trade area, all member states will have a common external tariff with countries outside the customs union. Common or single market a In a common market, as in a customs union there are no barriers to trade between member states; b as with a customs union, all member states will have a common external tariff with countries outside the common market; c there is free movement of labour and capital between member states; d there are common taxation policies, employment laws, product laws and competition policies. Economic union a There are no barriers to trade between member states in an economic union; b all member states will have a common external tariff with countries outside the customs union; c there is free movement of labour and capital between member states; d there are common taxation policies, employment laws, product laws and competition policies; e there is common fiscal and monetary policy made by a centralised body representing the government of each member state. The CARICOM Single Market and Economy (CSME) CSME stands for CARICOM Single Market and Economy. When fully implemented it will be a single economic system that will enable the Caribbean region’s financial, natural and human resources to come together to develop economic power. It will enable the region to respond to globalisation and the formation of mega-trading blocs. The CARICOM Single Market and Economy (see p. 212 for a discussion of CARICOM) came into being on 30 January 2006. The countries that signed the declaration of the CARICOM Single Market at that time were Barbados, Belize, Jamaica, Trinidad and Tobago, Guyana and Suriname. As of 3 July, 2006, Antigua and Barbuda, Dominica, Grenada, St Kitts and Nevis, St Lucia, and St Vincent and the Grenadines became members. Five of the twelve members of the CSME. 209 25 · Economic integration and CARICOM Single Market and Economy ITQ2 How can this free movement of wage earners benefit the economy? ITQ3 How can the free movement of capital assist firms in the region? ITQ4 Give three examples of services that a consumer can purchase from a foreign individual or firm. common external tariff • The CARICOM Single Market and Economy has certain features. When the CSME comes into full operation, it is intended that there will be: • Free movement of wage earners; this includes university graduates, sports persons, media persons, artistes, musicians, nurses, teachers, services providers and persons opening up businesses. • Free movement of capital, entrepreneurship and ideas. • Free movement of goods. This means that there will be no tariffs on goods coming from other CSME countries. • Free movement of services. Individuals and firms supplying services can locate anywhere in the region. • The freedom for firms to set up businesses in any member country. • Free movement of goods imported from outside the region that would require collection of taxes at first point of entry into the region. Such collected customs revenues are to be shared. • A common external tariff; that is, a rate of duty applied by all members of the single market to a product imported from a country that is not a member of the single market. • A common external policy with respect to tariffs and other trade relations with non-member countries. • Harmonisation of tax laws; that is, common income tax and corporation taxes. This must be so in order to prevent workers and firms from locating or declaring income in countries where taxation is lower. Many of the above features that the CSME will eventually have will take time to come into being, as they require individual governments to pass laws in home countries. All governments in the CSME will have to agree on common policy with respect to non-member countries and taxation in member countries. They will be achieved in the long term. The benefits of the CSME ITQ5 What is geographical immobility? ITQ6 Name a new service that can be provided to your country with the CSME. 210 The CSME, when fully operational, will be a single market and economy. Theoretically, such a union will bring to its members certain benefits. It is hoped that, in time, membership in the CSME will: • Give each country access to a larger market for its goods and services. There is a combined population of 6 million people in the CARICOM region, which is large when compared with the lower populations in the small states. • Enable the people of the region to improve their standard of living. Workers will move to where there are available jobs. It is sometimes argued that skilled labour and professionals are really the ones to benefit, as they will move to where the jobs are and also receive increased wages. However, unskilled labour cannot move across the region as freely, and so their earnings might not increase. Nevertheless, firms will locate and operate all over the region, thus providing employment and stimulating growth in less developed regions. • Enable the region to improve its standard of work. Competition amongst labour will raise the quality of the labour force. • Achieve full employment of labour, as people will move to the region where they can be employed. Labour, however, is the human factor, and as such is somewhat geographically immobile, because people have strong family and community ties, and so might be unwilling to relocate to another country. • Expand trade and economic relations with states outside the region. • Improve levels of international competitiveness, as competition amongst member states will raise the quality of goods and services available for sale. Services that were lacking in some regions will now be provided. • Increase production and productivity as firms in the region benefit from economies of scale. 25 · Economic integration and CARICOM Single Market and Economy • Increase inflows of new capital to the entire region. • Introduce entrepreneurship and technology from one member state to other member states. • Create more opportunities for travel, work and study in CARICOM countries by residents of member states. • Provide opportunities for companies and individuals to invest in companies all over the region through the purchase of company shares and mutual fund investments. Caribbean leaders have, indeed, realised that they need to deepen the economic integration process in order to respond to the changing world economic environment. The CSME is our response to the changing world. Examples of economic integration European Union – EU USA 0 Gulf of Mexico 200 0 The Bahamas 400 200 600 800 400 km 600 miles Atlantic Ocean Cuba Cayman Islands Mexico G r e a t e r Haiti A n t i l l e s Puerto Rico Virgin Is. Anguilla Barbuda Antigua St Kitts and Nevis Guadeloupe Monserrat L Jamaica Dominican Republic es nt r A Guatemala Dominica se Belize Caribbean Sea Aruba Netherlands Antilles illes Honduras St Vincent and the Grenadines Nicaragua Grenada Martinique St Lucia Barbados Tobago Trinidad Costa Rica Panama Venezuela Guyana Colombia Suriname CSME members The European Union was born out of the European Economic Community (EEC). The EEC was founded in 1957 and the EU was established in 1992. In 2009, there were 27 members in the Union. The EU represents cooperation at an economic and social level by the countries of Europe. The aim of the Union is a full economic union with deep integration of members. Most members already share a common currency – the euro. The UK is an exception, as this country still uses the pound sterling. Member countries have given up some of their sovereignty to the governing body that comprises representatives from all member states. A problem, though, is that many of the working committees producing numerous ‘directives’ to member countries are unelected, and are seen by some as meddlesome. North American Free Trade Agreement – NAFTA The euro is the common currency used by many EU countries, though not the UK. In January 1994, Canada, the USA and Mexico launched the North American Free Trade Agreement. This is the world’s largest free trade area. The Agreement has brought economic growth and increasing standards of living for people in all three countries. 211 25 · Economic integration and CARICOM Single Market and Economy Southern Common Market – MERCOSUR (Mercado Común del Sur) This is a common market of the South American countries of Argentina, Brazil, Uruguay, Paraguay and Venezuela. It was set up in March 1991. It aims to bring about the free movement of goods, services, capital and people among its member countries. The Association of Southeast Asian Nations – ASEAN The aim of this association is eventual full economic integration. Some members are Brunei, Indonesia, Malaysia, the Philippines, Singapore, and Thailand. In 1992, the ASEAN Free Trade Area (AFTA) was formed. Tariff and non-tariff barriers among member countries were eliminated. The Caribbean Community and Common Market – CARICOM The Caribbean Community and Common Market (CARICOM) was established by the Treaty of Chaguaramas, which was signed by Barbados, Jamaica, Guyana, and Trinidad and Tobago, and came into effect on 1 August 1973. CARICOM members are Antigua and Barbuda, Belize, Grenada, Montserrat, St Vincent and the Grenadines, Turks and Caicos Islands, The Bahamas, British Virgin Islands, Guyana, St Kitts and Nevis, Suriname, Barbados, Dominica, Jamaica, St Lucia, and Trinidad and Tobago. CARICOM aims at the eventual integration of its members and economies, and the creation of a common market. Free Trade Area of the Americas – FTAA This is an effort to unite the economies of the Americas into a single free trade area. Talks began at the Summit of the Americas in December 1994 in Miami, USA. There are 34 democracies in this association. Barriers to trade and investment will be eliminated over time. Economic integration is the coming together of national economies to operate as one economy. Countries can move through different stages of economic integration – from a free trade area, to a customs union, to a common or single market. Full integration involves becoming an economic union. The CARICOM Single Market and Economy (CSME) represents integration of the Caribbean economies. When the integration process is completed, the member states will operate with common external and some internal (taxation) policies. The features of the CSME are: free movement of goods, services, capital and labour; firms operating in any territory; free movement of imported goods; common external tariffs; common external policies and harmonisation of tax laws. The benefits of the CSME are: larger markets, increased standard of living, higher standard of work, full employment, expanded trade, greater international competitiveness, economies of scale and inflows of capital. Other benefits include: more opportunity for travel and work in the region, sharing entrepreneurship and technology, and opportunities to invest in firms all over the region. Some examples of economic integration are: the European Union (EU), the North American Free Trade Agreement (NAFTA), the Southern Common Market (MERCOSUR), the Association of Southeast Asian Nations (ASEAN), the Caribbean Community and Common Market (CARICOM) and the Free Trade Area of the Americas (FTAA). 212 25 · Economic integration and CARICOM Single Market and Economy 1 Free trade areas include the Free Trade Area of the Americas (FTAA) and the North American Free Trade Agreement (NAFTA). 2 Free movement of such wage earners will provide skilled labour in territories where this kind of labour is needed. Service providers will increase the range of services offered to consumers. Entertainers will spread the culture of the region. 3 Firms will obtain capital that will add to the productivity of labour. 4 A hairdresser, lawyer or computer technician can move from one CSME member state to another and sell their services to consumers there. Banks and insurance companies can locate in CSME member states, and consumers in that member state will purchase services. 5 Geographical immobility is the unwillingness of labour to move from one location to another to obtain employment. Family ties and a sense of belonging to your land of birth contribute to geographical immobility. 6 Specialist doctors might move to different islands. Massage therapists and beauty care professionals might spread their services to all islands. Examination-style questions Multiple choice questions 1 What is the correct order of the stages of economic integration? a customs union, to economic union, to free trade area, to common market b customs union, to common market, to free trade area, to economic union c free trade area, to common market, to customs union, to economic union d free trade area, to customs union, to common market, to economic union 2 How is a single market different from a customs union? a A customs union has a common external tariff with nonmembers but a single market does not. b A single market has common taxation policies but a customs union does not. c A customs union has free movement of labour but a single market does not. d A single market has common monetary policy but a customs union does not. 3 At what stage of economic integration is the CARICOM Single Market and Economy? a a customs union b a free trade area c a common market d an economic union 4 Which of the following is not a feature of the CARICOM Single Market and Economy? a free movement of goods and services b free movement of labour and capital c location of firms in any territory d limited movement of imported goods 213 25 · Economic integration and CARICOM Single Market and Economy 5 Which of the following of the following is not a benefit of the CARICOM Single Market and Economy? a free movement of goods and services b free movement of labour and capital c unemployment in some territories d location of firms in any territory 6 All of the following are examples of economic integration except: a FTAA b CSME c ASEAN d IMF Structured question 1 214 a What is the difference between a free trade area and a customs union? b Give an example of a free trade area. c Define an ‘economic union’ and give an example. d Discuss one way in which an economic union can benefit member countries and one way it can be disadvantageous. [2] [2] [3] [8] Essay question [20] The CSME is an example of Caribbean integration. a What does the CSME stand for? b Explain the features of a common/single market. c Discuss the benefits of the CSME to all Caribbean states. [1] [8] [11] 26 By the end of this chapter you should be able to: Concept map E-commerce explain what ‘e-commerce’/‘e-business’ is; describe the benefits of e-commerce/e-business; explain the challenges of e-commerce/e-business. E-commerce advantages • wider variety of goods • cheaper goods • ability to shop at home • faster shopping • easier shopping for the disabled • larger market • quick growth of business • flexible hours for owner • low set-up costs • jobs for delivery companies • foreign exchange earnings e-commerce B2B or B2C challenges • potential loss of income for traditional businesses • interaction between people and computers • credit card fraud • sites that are not reputable • difficulty in purchasing some items • delay before buyer obtains product • unemployment • poor site designs • difficulty in returning goods • limited availability of computer and Internet What is e-commerce? e-commerce • electronic commerce • e-businesses • ITQ1 Give one example of a good and one example of a service that you can purchase online. dot.coms • ITQ2 Name one business that operates only through its website. ITQ3 Name one business that operates in a store and also through a website. E-commerce or electronic commerce (also eCommerce) is the conducting of business (buying and selling goods and services) online. E-commerce relies on the Internet to transfer data from one party to another. Companies that conduct trade using e-commerce are e-businesses. There are two types of e-businesses: • The company might be a web-based company, its only contact with the buyer being the web page on which the company’s goods and/or services are advertised for sale. The company has no physical store where buyers can shop and interface with sellers. These businesses are called dot.coms. Dot.coms are Internet trading companies. Trinibiz.com is one such business. • The company might be a business with a store in an area where buyers come to shop. There is face-to-face consumer–seller contact. This is a ‘bricks and mortar’ company. However, the business extends its operations to a website to give its existing and potential customers the option to view the goods online and, if they wish, buy electronically. In so doing, the company increases its market to include consumers who shop online and who might be in foreign countries. The company then becomes a ‘bricks and clicks’ company. Whatever the type of business, e-commerce is a form of direct selling. The 215 26 · E-commerce Figure 26.1 Logo of ebay.com E-commerce: businesses sell goods through the Internet without the need for a physical shop. B2B (business-tobusiness) commerce • supplier can sell directly to the final consumer, thus eliminating some need for wholesalers and retailers. There is also less need for shops and shop attendants. Figure 26.1 shows the logo of an e-business, ebay.com. Here is how you purchase items from an e-business: 1 Obtain the website address of the business. 2 Log on to the Internet and visit the site. 3 Browse through the site. You should see an e-catalogue. This is simply a list of items for sale with the prices. There might be photographs or descriptions of the items to give the buyer a clearer idea of the purchase. 4 Select the items you wish to purchase. There might be an e-shopping cart in which you place your items. 5 ‘Proceed to checkout.’ 6 Pay for the items using your credit card. There is an electronic transfer of funds from your bank to the seller’s bank account. 7 Allow days to weeks for delivery, depending on where you live and where the business is located. The lock symbol on a site indicates that the site is secure and protected from hackers. Users can conduct transactions and give personal information without such information falling into the wrong hands. Businesses can sell goods and services to other businesses electronically; this is called B2B (business-to-business) commerce (see Figure 26.2). sells to business business Figure 26.2 B2b commerce B2C (business-toconsumer) commerce • e-tailers • Businesses can sell goods and services to consumers electronically; this is called B2C (business-to-consumer) commerce. Retailers who primarily sell on the Internet are called e-tailers. This is illustrated in Figure 26.3. An example of B2C commerce is Amazon.com. sells to business Figure 26.3 B2C commerce 216 private consumers 26 · E-commerce As countries develop, households and firms have increasing access to computers and the Internet. The volume and value of goods traded on the Internet through e-commerce has increased in the last few years. The variety of goods traded has also increased. Consumers can now purchase laptops, flash drives, T-shirts, Harry Potter dolls, CDs and even skincare products online. Many hotels advertise and offer reservation services online. Remember though, you cannot stay in a virtual room! Airlines now issue e-tickets to travellers. The traveller is able to hold a printed reminder of the date and time of the flight, and a confirmation number. This also serves as confirmation that he has paid! This reminder is not needed at check-in, as all passenger details are stored in the airline computer system. All the passenger has to do on checking in is to present positive identification, such as a passport. Advantages of e-commerce Advantages to the consumer • Consumers now have access to a range of firms from which to purchase. Caribbean shoppers can access cheaper products, better-quality products and different brands in another country within or outside the Caribbean region. Caribbean shoppers are no longer limited to what the shops of the region offer and the prices they sell at. Shoppers do not have to travel to a country to obtain a product of that country that a local firm does not import. • Goods are cheaper because e-shops do not have costs such as construction or rental of buildings, or payments to middlemen and workers such as shop attendants. However, the buyer now has to pay the cost of transportation. • Shopping can be done in the comfort of your own home at any time of the night or day. You can shop 24/7. • It is also faster – you do not have to go through traffic, as you might need to in order to get to the mall. Also, you do not have to walk down a shopping aisle to choose goods. You can simply click on items to place them in your e-shopping basket and pay for them by credit card. You will know immediately when an item is out of stock. You do not have to wait for a shop attendant to check out your purchase manually for you. • E-commerce makes it easier for people with disabilities to shop from the comfort of their homes. Advantages to the business • The world is the market for the business. Companies can reach consumers all over the world. No longer are companies limited to customers who live nearby or to tourists visiting a foreign country. The firms of the Caribbean region can reach customers all over the world. They can reach anyone with a computer and Internet access, be they in Antarctica, Australia, China, Africa or the UK. • Businesses can grow overnight, as an e-shop can reach millions of customers everyday. Profits can increase very quickly. • As the entire process is electronic, the owner of the e-business does not have to be present at the business all the time. The owner’s hours of work are flexible. • The cost of setting of the business is smaller. Anyone can set up an e-business. People can set up small home-based companies. Advantages to the economy • There will be jobs for parcel delivery service workers and companies to deliver packages to buyers. In the UK, where there is considerable 217 26 · E-commerce e-commerce activity, the letter delivery business has fallen off, but parcel sending has grown apace. • Foreign currency earnings can increase, if domestic businesses can sell goods in foreign markets. Challenges of e-commerce ITQ4 How can a company overcome the problems of buying clothes online? ITQ5 Name another good (apart from jewellery) that might be difficult to sell using e-commerce. • As e-commerce grows, some traditional shops lose business and so earn reduced profits. • People might choose to interact with computers rather than people. E-commerce does not allow people to go shopping with friends as a leisure activity – often important for those who are socially isolated. • Credit card fraud is an inherent risk in online shopping, as it involves the divulging of one’s personal details in order to enable the transaction to be authorised. • Some unknown sites might not be reputable and so the buyer might lose money. The product he/she receives might not be what is expected. • A photograph of the product and a description might not be sufficient for buyers to be persuaded to purchase some goods. Some shoppers might find it difficult to purchase well-fitting clothes in an online store – or even clothes of the right colour or fabric. Of course, companies recognise this and are overcoming these problems. Other shoppers might be reluctant to purchase jewellery unless the company is reputable and the goods are insured while being transported. • The buyer cannot obtain the product immediately. E-shoppers have to anticipate the need for products and allow time for delivery. • Unemployment might increase as traditional businesses close some shops and shift to e-commerce, thereby cutting staff levels. • Poorly designed sites might act as a turn-off to customers. • Goods will be difficult to return, especially for overseas customers. • Many households in developing countries will not have computers, access to the Internet and credit card facilities. E-commerce is not just about selling. There is e-banking, where many banks have made their services available online to their customers. You can visit your bank’s website and check your account balance, your credit card balance and even pay bills online; for example, Scotiabank offers these services to customers at www.tt.scotiabank.com. E-commerce is indeed the business of the future. E-commerce (or electronic commerce) is the conducting of business (buying and selling goods and services) using the Internet. Companies that conduct trade by using e-commerce are e-businesses. Some businesses trade only on the Internet. These are dot.coms. Other businesses have extended their operations to include e-commerce. Businesses can sell goods and services to other businesses electronically; this is called B2B (business-to-business) commerce. Businesses can sell goods and services to consumers electronically; this is called B2C (business-to-consumer) commerce. The advantages of e-commerce are: a wider variety of goods, cheaper goods, the ability to shop at home in comfort, faster shopping, easy shopping for the disabled, larger market for firms, quick growth of business, flexible hours for owner, low set-up costs, business for delivery companies and foreign exchange earnings. Some challenges that e-commerce pose are: loss of customers and profits for traditional businesses, interaction of people with computers instead of with other people, the possible exposure of the buyer to credit card fraud, sites that are not reputable, difficulty in purchasing some items, 218 26 · E-commerce delay before buyer obtains the product, e-commerce possibly leading to unemployment, site designs which might turn off shoppers, difficulty in returning goods, and some households’ lack of access to computers and the Internet. Even banks offer their services online. This is called e-banking. 1 Some goods that can be purchased online are: clothes, skin care products, Harry Potter dolls. Services include online virus checkers and access to public records. 2 Internationally, Amazon.com and e-Bay are such companies. They are called ‘pure plays’, as they sell only on the Internet and they have no physical store. 3 Some companies that have both a traditional store and a website are: David’s Bridal in the USA and Tesco in the UK. 4 Some sites selling clothing show coloured back and front photographs of the item. There are fabric details, and even tables showing sizes and corresponding measurements 5 Another example is food. Any item where the shopper’s personal taste is very important will be difficult to purchase online. Examination-style questions Multiple choice questions 1 All of the following are associated with e-business except: a B2C retailing b dot.coms c ‘bricks and mortar’ companies d ‘bricks and clicks’ companies 2 Which is not a benefit of e-commerce? a Goods are cheaper, as firms do not have building costs. b Consumers are no longer limited by what local shops offer. c You can shop in the comfort of your own home. d Traditional shops lose business. 3 E-commerce that involves business activity targeted by businesses at other businesses is called: a B2C b B2B c e-tailers d e-catalogue 4 All of the following can be purchased through e-commerce except: a wedding cards b books c cell phones d interior decorator services 5 Which of the following is a benefit of e-commerce to sellers? a comfortable shopping b faster shopping c samples of products have to ordered d wider markets 219 26 · E-commerce 6 Why might a buyer in the Caribbean be reluctant to purchase a good from North America online? a Goods are difficult to return. b The currency is different. c The good obtained online is of a better quality. d He can examine a range of goods online within a short time. Structured question 1 Dee Zyner wants to set up an e-business to sell a feminine clothing line. She wants to sell evening wear and daywear such as dresses, skirts, blouses and belts. a What is an e-business? [2] b How will Dee Zyner set up this business and how will customers buy from her? [4] c Explain three challenges that Dee Zyner might face. [9] Essay question [20] [2] a What is e-commerce? b Name two businesses in the region that participate in some form of [2] e-commerce. c Explain two benefits that businesses reap from participating in [6] e-commerce. d Explain two benefits that the economy reaps from increasing [6] e-commerce. e Explain two problems associated with e-commerce. [4] 220 27 By the end of this chapter you should be able to: School-based assessment choose a topic for your school-based assessment (SBA) project and formulate a topic statement; choose from suggestions for SBA projects; demonstrate an understanding of the format of the SBA project; follow guidelines for the successful completion of the SBA projects based on the sample project. Time frame Term 3 Form 4 • discussion of how to choose topic Term 3 Form 4 • discussion of topics • statement of problem • purpose of study • questionnaire design July–August • collection of data • tabulation of data • presentation of data • explanation of data Term 1 Form 5 • interpretation and analysis • findings • recommendations Introduction Students writing the CSEC Economics examination must submit a schoolbased assessment (SBA) project. This is a research project designed to develop your research skills and to allow you to apply the theories and principles of economics to the real world. This project is marked out of 40, and is 20 per cent of your final mark. The report itself must not be more than 1200 words. This means that you must be concise when writing the project. This project allows you to choose a topic from the syllabus. You must then observe the real world and collect data related to that topic. In the report, you must apply the economic concepts and principles of that topic to data collected from the real world. Many students might prefer to choose a topic from the first year of the course – microeconomics (sections 1 to 3) – as those topics are already covered when you begin the SBA in the third term of Form 4. However, you might prefer to do the SBA from later parts of the course, and this is acceptable, once you feel comfortable with the economic theory related to that topic. 221 27 · School-based assessment Choosing a topic and formulating a topic statement You might wish to choose a topic that you have already covered in class, or one that your teacher is covering soon. You might want to choose topical issues, as newspapers will have a great deal of information about them. Moreover, the persons from whom you are likely to gather data will have information on this issue if it is topical or current. You might want to base your project on the theory of demand, as it is a favourite topic for students. You might choose the demand for a good that is popular nowadays. Now that the topic is decided, you must choose the aspect of demand you wish to look at, the good or service in question and the section of the market you wish to observe. Perhaps you wish to examine the factors affecting demand. The commodity in question might be cell phones, as these are a very popular electronic gadget with adults and teenagers. Every day, the newspapers carry advertisements for cell phones. Also, young people are technology-savvy, so you might have additional knowledge about this good and what determines demand. The section of the market you might wish to base your study on could be high-school students. High-school students are a good choice, as they are easily accessible to you, the student, and you might have an interest in this area, as you are a student yourself. Also, being a student, you might have some preliminary ideas about what affects high-school students’ demand for cell phones. Once you have decided on all this, you might formulate your topic statement. Here is a suggestion: ‘An examination of the factors affecting the demand for cell phones among students in St James’ High School’ You might wish to replace ‘An examination of’ with: • An investigation of/into … • A study of … • An inquiry into … • An exploration of … • A survey of … • A review of … • An economic analysis of … • An assessment/appraisal of … All of the above are acceptable. The last two options require a bit more work, as ‘an economic analysis’ and ‘an assessment/appraisal’ give the impression of in-depth, higher-level work on the topic using more advanced economic theory. Appraisal or assessment implies that you are making a judgement. After you have chosen your topic and formulated your topic statement, ensure that your teacher reads and approves it. Suggestions for school-based assessment The following topics are suggestions for the school-based assessment project. The list is not exhaustive, but it might suggest topics that appeal to you personally. You might wish to customise the topic to suit your individual country, town or village, or school. You could do this by changing the industry or sector and the location of the study. The words in italics can be changed to suit your individual circumstances. In some cases, choices are also given. 1 The impact of tourism on the construction/services industry in Montego Bay, Jamaica 2 The impact of the CSME on the construction/services industry in Port-of-Spain, Trinidad 3 An examination of the types / the causes / the effects of unemployment in Moruga, Trinidad 222 27 · School-based assessment 4 The effects of the aspergillosis scare/pollution on the chicken/fish industry/ market in Toco, Trinidad 5 An investigation into the operations of any business – an economic perspective / economic analysis 6 An investigation into the economic effects of the operations of any business on the residents of any town – an economic perspective [a construction firm, a credit union, a bank, the village shop] 7 An examination of the economic benefits of tourism to a small business [supermarkets / taxi drivers / guest houses] 8 An investigation into the factors affecting the demand for Yummy pastels in New Kingston, Jamaica 9 The effects of the rising prices of some basic food commodities on households in Todd Street, San Fernando 10 An investigation of market failure in agriculture / the construction sector in Grenada 11 A comparative study of the cost of living in an urban and a rural area in Trinidad 12 A comparative study of the change in prices of specific food commodities in an urban and a rural area in St Kitts 13 The expanding market of the CSME and the opportunities for growth/ linkages in the beverage industry in Trinidad and Tobago 14 The economic effects of flooding in Caparo on the supply of melongene to the Chaguanas Market, Trinidad 15 An examination of the consumer behaviour of Form 5 students with respect to the purchase of school shoes in three schools in Berbice, Guyana 16 The economic effects of opening up the cell phone market in Barbados 17 An investigation into the effects of the activities of the Teachers Union on the education sector in Castries, St Lucia 18 An investigation into the demand for low-cost housing by the residents in San Fernando East, Trinidad 19 An examination of the economic effects of the Mango Tree housing development project on the neighbouring community 20 Trinidad and Tobago government’s provision of social services / unemployment relief and its effects on households in Chaguaramas. Sample school-based assessment project The following is a sample of a school-based assessment project. You are advised not to copy this project – teachers and examiners may have access to this text and might have read this sample SBA! It is merely a guide upon which you can model your individual project. The sample project is longer than the word limit allowed by CXC as it includes different examples of how to present the research. Be sure to check the word limit of your own project before submitting it. This is the cover page. Note its contents, and note that it is simply designed – clear and free of clutter. Name: Maya D. Best School: St. James’ High School St. James Subject: Economics Title: An investigation of the factors affecting the demand for cell phones among students in St. James’ High School Centre Number: 199001 Candidate Number: 0123 223 27 · School-based assessment This is not specifically required, but all good research projects are the result of the cooperation and support of people other than the researcher. You are encouraged to express a brief appreciation. Territory: Caribbean Island Date: March, 20xx Acknowledgements I would like to thank my teacher for her guidance. I would like to thank the respondents to my questionnaire and interviews for their cooperation. Their answers were the foundation of this study. I would like to thank my family for their support and advice. They all had important work to do but they always found time to discuss my project. While an introduction is not required, including one gives the examiner the context. It makes the project complete. The introduction also allows for an explanation of why this is an area of interest to the student. A clear table of contents will help the examiner locate the different sections of your SBA. Introduction Since the development of the cell phone market there has been one cell phone service provider in the country. The first company operating as a cell service provider was TransWorld Cell. This firm was a monopoly. Another company entered the market in 2005. The cell phone market now operates as a duopoly. As there are now two firms in the industry, supply increased and consequently price has decreased. More and more students are acquiring cell phones compared with a few years ago. Cell phones are the new fad, with the emphasis being on certain brands and advanced features, especially among teenagers. Table of contents Acknowledgements..................................................................... i Introduction................................................................................ii Table of contents........................................................................iii Title.......................................................................................... 1 Purpose of investigation.............................................................. 1 Methods of investigation............................................................. 2 Limitations faced........................................................................ 2 Presentation and explanation of data........................................... 3 Interpretation and analysis of data............................................... 7 Findings.................................................................................... 8 Recommendations...................................................................... 9 Bibliography........................................................................... 10 Appendix................................................................................ 11 The title of the project must be clear. You must include the title to earn the allotted 2 marks. 224 Title An examination of the factors affecting the demand for cell phones among students at St. James’ High School 27 · School-based assessment Purpose of investigation For your project to be meaningful, it is a good idea to have 3 to 5 purposes. Primary data consist of original data collected directly by the researcher. They are timeconsuming to collect and must be interpreted by the researcher. Remember to footnote that there is a sample of this questionnaire in the Appendix. Observation is another form of primary data collection. Secondary data refer to data that already exist in some form – text, charts, tables or diagrams. They are less time-consuming to collect. These texts are listed in the bibliography. These sites are also listed in the bibliography. You must show proof of your observation and quote from texts and websites to earn the allotted 3 marks. It is not sufficient to merely claim that you used these sources, as anyone can say that without really doing so. It is a good idea to mention limitations to let the examiner know that you are aware of certain problems with the study, and that you learnt lessons from the exercise. The purposes of the study are: 1. to establish the relationship between the price of cell phones and the quantity demanded of cell phones; 2. to determine whether cell phones are in perverse demand; 3. to determine the main factors affecting the demand for cell phones; 4. to examine the effects of an increase in demand for cell phones on substitute goods; 5. to examine the effects of an increase in demand for cell phones on complementary goods. Methods of investigation Primary sources of information used in this project are: 1. Questionnaire.* Thirty questionnaires were handed out to students, from Form 3 to Form 5. Ten questionnaires were given to each year group. The respondents are 15 boys and 15 girls. The age range is 13 years to 17 years. 2. Interviews. The researcher obtained an interview with the manager of the Transworld Cell office at the Crossing Mall. Secondary sources of information used in this project are: 1. Textbooks. Economics textbooks were used to verify the relevant demand theory. 2. Internet. The following websites were visited to obtain information. http://guardian.co.tt www.trinidadexpress.com Limitations faced The following limitations were faced: • Some students did not take the questionnaire seriously and so gave absurd responses or were dishonest. • Students did not understand some of the questions. • The open questionnaires gave the students a free response opportunity and the range of answers were difficult to tally (see questions 9 and 10). • No deadline was given to respondents, so the questionnaires took some time to collect. Presentation and explanation of data The following is the presentation of the data collected. Question 1. All respondents owned at least one cell phone. More than half the students owned two cell phones. No. of cell phones No. of students 1 cell phone 2 cell phones 3 cell phones 18 2 10 *A sample of this questionnaire is in the Appendix. 225 27 · School-based assessment Students and number of cell phones owned 2 10 1 2 3 or more 18 Question 2. Sixty per cent of the students bought their first cell phone after the new firm entered the market. Students purchasing cell phone before new firm entered 12 Students purchasing cell phone after new firm entered 18 When first cell phone was purchased number of students 20 15 no. of students 10 5 0 before new firm entered after new firm entered Question 3. Of the 20 students (see question 1) who owned more than one cell phone, 75 per cent or 15 bought the second phone after the new firm entered the market. Students purchasing cell phone before new firm entered 5 Students purchasing cell phone after new firm entered 15 When first cell phone was purchased number of students 20 15 5 0 226 no. of students 10 before new firm entered after new firm entered 27 · School-based assessment Question 4. Twenty students have cell phones with features like camera, Bluetooth, infrared and memory for music. Fifteen of these students were willing to and did purchase such phones even though price increased. Purchase cell phone with features even though price increasing 15 Did not purchase cell phone when price was increasing 5 Students purchasing cell phones when price increasing 5 purchase did not purchase 15 Question 5 & 6. The feature of the cell phone is the most important factor affecting demand. Price is important to a lesser extent. Factor affecting demand No. of students Price 5 Tastes & fashions 2 Features 12 Offers 4 Advertisements 4 Network rates 3 Factors affecting demand for cell phones ts 4 fe rs 4 of ad ve r tis em en ne tw or k ra t es 3 no. of students fe at ur es 12 ic e 5 pr ta st e s& fa sh io ns 2 0 5 10 15 227 27 · School-based assessment Question 7. Seventeen students, or 57 per cent, admitted that they switched to a cheaper network. 43 per cent remained loyal to Transworld Cell. Cheaper substitute No. of students Switched 17 Did not switch 13 Students switching to a cheaper substitute cell phone and network 13 (43%) switched did not switch 17 (57%) Question 8. The complementary good is cell phone cases. Most students did not purchase this complementary good. Complementary good No. of students Purchased 14 Did not purchase 16 Students who purchased complementary goods 16 (53%) purchased did not purchase 14 (47%) The researcher had to later find the respondents to confirm who were post-paid and who were pre-paid, as there were no questions on this. Try to anticipate all the questions you need to ask in order to avoid similar problems. 228 Question 9. 26 out of 30 students use phone cards. The other 4 are post-paid customers. Phone cards are another complementary good. These responses show that most students or their parents are spending on average $100 a month on cell phone cards. Value of phone cards purchased per month $20 $50 $100 No. of students 3 9 14 27 · School-based assessment value of phone cards Value of phone cards purchased per month $150 14 $100 9 $50 3 0 5 10 15 no. of students Question 10. The following table shows the responses for how to improve the cell phone market. Most students feel that offers and sales promotions are the best way to do this. Suggestion No. of students Government can open up the cell phone market 6 Government can subsidise the cell phone service 5 The firms can advertise more 8 The firms can give more offers and sales promotions 9 No response 2 Interpretation and analysis of data To ensure that your analysis is complete, it is a good idea to address the data for each question in consecutive paragraphs. The first paragraph deals with the respondents’ personal data, the second paragraph with question 1, and so on. Always explain and refer to diagrams in the project. Thirty students were given questionnaires. There were 15 girls and 15 boys. Ten were from the age group 11–13 years, ten from the age group 14–16 years and ten were 17 years and over. Of the 30 students, ten owned one cell phone, 18 owned two cell phones and two students owned three or more cell phones. This may be due to the fact that as the second firm entered the market, supply increased. This can be seen in Figure 1 where the supply curve shifts from S1 to S2 as supply increases. Price falls from P1 to P2 as supply increases. The fall in price causes a movement along the demand curve and an extension of demand. price D S1 S2 P1 P2 0 Remember to put a caption on all diagrams. Label the curves and the axes. quantity Figure 1: The effect of an increase in supply 229 27 · School-based assessment Footnotes are ideal for including some supporting theory for your analysis without increasing your word count. This is an excellent point, showing that the student has done some research. This student should show the source of this information, as it is not common knowledge and it will add to marks given for sources of information. All of this is very good discussion, but again remember to include the sources of information. Do follow an appropriate reporting style. Furthermore, 18 students purchased their cell phone after the second firm entered the market. Prices were lower then, and students bought cell phones. This shows that quantity demanded increased as price fell. The demand for cell phones follows the First Law of Demand1. There is also a ‘bandwagon’ effect, as teenagers buy cell phones because all their peers have cell phones and they want to ‘jump on the bandwagon’ also. There are 20 students who own two or more cell phones. Of this 20, 15 bought the second cell phone after the second firm entered the market. They responded to the fall in price. Also, all telephones belong to a group of goods that yield a ‘network’ externality2. This is a positive externality that falls on cell phone owners belonging to one network as the usefulness of your cell phone increases as others join the network. Therefore students would want to join the second network as more and more of their friends are in that network and they can all benefit from lower rates and sales promotions. Twenty students have cell phones with features. Fifteen bought these cell phones even though price was high and increasing. This shows that the demand for some cell phones is perverse, meaning that as price increased, quantity demanded increased. Some cell phones possess ‘snob appeal’ and are a status symbol. They are goods of ostentation. Some students will behave in this way. Features are by far the most important factor affecting demand. Price is the next most important factor. Advertising and offers are also important. Advertising makes the potential buyer aware of what the cell phone service provider if offering. The buyer can make comparisons and better buying decisions. Advertisements also entice the buyer, as different famous persons are associated with the different networks. One company’s advertising method is to encourage loyalty and patriotism, as it is a locally-owned company. Seventeen out of 30 students said that they switched to the cheaper network. This proves that the networks are substitutes for each other. Also they may have switched to benefit from network externalities. Cell phone cases are a complementary good to cell phones. Fourteen students bought cases while 16 did not. Perhaps teenagers like to show off their phones, or they find cases an unnecessary expense. Cases protect cell phones but are not necessary for them to function. A majority of the students buy phone cards, another complementary 1 The First Law of Demand states that as price decreases, quantity demanded increases, and conversely that a price increase will lead to a fall in demand. There is therefore an inverse relationship between price and quantity demanded. 2 An externality is a spillover effect on a third party from the consumption or the production of a good. 230 27 · School-based assessment good. Phone cards are convenient as they can be purchased almost anywhere, as well as letting friends and relatives text you money if you need. This form of service is very popular among teenagers. Respondents made suggestions that would benefit consumers in the market. They recognised that the presence of more companies will send cell phone prices and the cost of services further down. They called for more advertising and they wanted more offers and sales promotions. They even suggested that government could subsidise this market. However, governments will only subsidise the provision of merit goods (health and education) and necessities like water, public transport and low-cost housing. Two students did not respond. Findings Each finding should address a purpose. It is possible to have a finding that says that cell phones are not in perverse demand. This does not make your study incorrect. This is a very good recommendation that also shows that the student has a good grasp of economic theory and the cell phone market. Although this was not a purpose of the study, there was a question on the preferred form of advertising. This was used well to make a recommendation. This is an excellent comment on oligopoly theory. The findings of the study are: 1. There is an inverse or negative relationship between the price of cell phones and the quantity demanded of cell phones. As price decreases, quantity demanded increases and as price increases, quantity demanded decreases. 2. The more expensive cell phones are in perverse demand, as teenagers and even adults wish to own a cell phone with advanced features as a status symbol. Even if price increases, demand increases. However, cell phones in general follow the First Law of Demand for as price decreases, demand increases. 3. The main factors affecting the demand for cell phones are features, followed by price. Advertising and offers are also important. 4. TransWorld Cell experienced a fall in demand for cell phones as consumers switched to the new supplier. This supplier offers substitute cell phones and services. Some consumers went to the cheaper substitute 5. There is an increase in demand for complementary goods like phone cards. However, less than half of the respondents bought cell phone cases. Recommendations 1. The government can open up the market for cell phones further. This will add to competition. Competition will send prices down and improve the quality of services. Consumers will benefit as firms are forced to be competitive or leave the industry. 2. The two firms must increase advertising in newspapers, as this is the form of advertising that respondents prefer. Advertising is a factor affecting demand, there being a direct relationship. So more advertising will lead to increased demand. 3. The two firms in the industry should avoid a price war (where each firm lowers prices in response to its rival lowering prices). Such actions only harm the firms involved. 231 27 · School-based assessment Recommendations may also be made to future researchers: This is an alphabetical listing of textbooks and articles used in the SBA. You would have referred to this when you spoke of secondary data in methods of investigation. This bibliography is presented in the APA (American Psychological Association) format: see www.apastyle.org/ These articles do not exist, but newspaper webistes are a good source of reference material for your project. Bibliography Harvey, Jack. (1988) Modern Economics. New York: Palgrave. Lipsey, R. G., and Chrystal, K. A. (2004) Economics. New York: Oxford University Press. Paisley, R., and Quillfeldt, J. (1987) GCSE Economics. Essex, London: Longman. Green, A. C. (2006, July 13) ‘New cell phone company in the market’ Trinidad Guardian. Retrieved 2 January 2009 from http://guardian.co.tt Franklin, C. (2006, October 9) ‘Companies compete in the cell phone market’ Trinidad Express. Retrieved 14 February 2009 from www.trinidadexpress.com The Appendix must include sample copies of the questionnaire, photographs, newspaper clippings and other materials that will enhance your project. Number the Appendix, and in the body of the SBA remember to refer to the documents placed in the Appendix. A short introduction at the start of the questionnaire will satisfy the curiosity of respondents. Stating the name of the project is not a good idea, as it may influence their responses. These bio-data – though not absolutely necessary – are a good idea, as they may reveal other relationships. Questions must be simple and clear. Otherwise, respondents may get fed up or may stray from the purpose of the investigation. Appendix 1 Questionnaire My name is Maya D. Best. This questionnaire is part of research for my economics school-based assessment project. Your responses will be greatly appreciated. Name _________________________________ Sex male Age 11 – 13 years Form class female 14 – 16 years 17 and over ________ 1. How many cell phones do you own? One Two Three or more 2. When did you acquire your first cell phone? Before the 2nd firm entered the market After the 2nd firm entered the market When leaving the questionnaire with the respondent, set a clear date and time to collect the completed questionnaire. 3. If you have more than one cell phone, when did you acquire your second cell phone? Before the 2nd firm entered the market After the 2nd firm entered the market 232 27 · School-based assessment 4. Cell phones now have features like camera, Bluetooth/infrared and memory. If you have a cell phone with any of these advanced features, did you purchase it even though the price was increasing? Yes All these questions (1 to 9) are closed questions. They give the respondent a limited choice of replies. Closed questions are generally easier for tabulation of responses. No 5. Place a tick by the factors which affected your decision to buy a cell phone. Price Tastes and fashion Features Offers (as prices will increase in the future) Advertisements Network rates (price of complementary goods) 6. Rank the features you chose, starting with the most important as 1. Instead of ‘cheaper’ you might say ‘lowerpriced’, as some teenagers may not be honest about buying products described as ‘cheap’. Price Tastes and fashion Features Offers Advertisements Network rates 7. Did the availability of cheaper substitutes on the market cause you to change cell phones and service providers? Yes No 8. Do you own cell phone cases for each cell phone? Yes No 9. If you purchase phone cards, state the denomination of the card you purchase and how often. You may give an estimate. Denomination $__________ This is an open question. The respondent can give any response, using his or her own words. Open questions are more difficult to tabulate because of the variety of responses. Of course in a case such as this where you want ideas from the respondents, it is nevertheless a good idea to use an open question Once per week Once every two weeks Once per month Other (please specify) _____________ 10. Give one suggestion as to how the cell phone market can be improved. ________________________________________________________ ________________________________________________________ ________________________________________________________ 233 27 · School-based assessment 2 Sample letter If you are conducting research in another school or a business, you will have to seek written permission to conduct a survey. The following is a sample letter that you might find useful. The Principal, ……………………… ……………………… ……………………… 5 July 20xx Dear Sir/Madam, The bearer of this letter, Maya D. Best, is a Form 5 student of St James’ High School. She is conducting research for her Economics SBA, entitled ‘An investigation of the factors affecting the demand for cell phones among students in St James’ High School’. She wishes Form 4 and Form 5 students to respond to her questionnaire. Any courtesies extended to her will be greatly appreciated. Thank you, ………………….. J. Short Economics teacher …………………… M. Long Principal Making backup copies of your work is important, as every year students lose work on computers and floppy diskettes, flash drives and so on. Needless to say, this happens in the final weeks of the project. So make a few backup copies of your work. 234 27 · School-based assessment How to earn your marks! Follow these guidelines to earn your marks: Task Marks you will be awarded Put in a title, preferably at the very front of the project. 2 marks Break down the title into at least three aims or purposes. Do not confuse the general aims of the SBA (which is listed in the syllabus) with the aims of your study. 1 mark for each purpose, with a maximum of 3 marks State and show proof that you have used at least three sources of information. Include a copy of your questionnaire, interview questions and observation notes in the Appendix. Quote from texts, magazines and websites, and reference these in the bibliography. 1 mark for each source, once you have shown proof that you have used this source of information Present your data in graphs, charts, tables, photographs and even in text. a maximum of 7 marks for the accuracy of graphs, charts and tables, including labels; the data presentation method chosen must be suitable and the data presented must be relevant to the study Interpret and analyse data by putting into words what the charts and tables demonstrate. Then provide reasons why this might be so. These reasons must be informed by your theory. 5 marks and over for a satisfactory interpretation and analysis of the data up to a maximum of 10 marks for excellent work Write up at least three findings from the 6 marks for findings that are supported interpretation and analysis. Each finding by the data must be linked to a purpose. Findings must be supported by the data and not just invented. Think of at least three recommendations from your findings. Recommendations are suggestions for improvement in the working of the particular market, industry or sector you are investigating. From your investigation and understanding of the case, you can make recommendations to the government, the firm, the consumer or any other group. 4 marks for realistic recommendations; they must be based on the data collected Write your project using correct grammar, clear reporting skills and ensuring that there is a flow of ideas throughout the project. up to 5 marks for communication Conclusion Remember that the school-based assessment is an opportunity to earn some coursework marks before the final examination. You can earn up to 20 per cent of your final mark. Therefore, all registered students must make every effort to complete and submit the project. 235 Answers to multiple choice questions Chapter 1 1. d 2. c 3. d 4. d 5. a 6. b 2. b 3. b 4. d 5. c 6. a 2. b 3. a 4. d 5. c 6. d 2. a 3. d 4. b 5. c 6. b 2. a 3. c 4. d 5. a 6. c 2. a 3. c 4. d 5. c 6. d 2. d 3. d 4. b 5. b 6. a 2. a 3. d 4. c 5. b 6. a 2. c 3. a 4. c 5. a 6. d 2. b 3. a 4. c 5. c 6. d 2. a 3. d 4. b 5. c 6. b 2. c 3. a 4. d 5. d 6. d 2. c 3. d 4. d 5. c 6. a 2. b 3. d 4. d 5. a 6. d 2. d 3. a 4. d 5. d 6. a Chapter 2 1. d Chapter 3 1. c Chapter 4 1. d Chapter 5 1. b Chapter 6 1. d Chapter 7 1. c Chapter 8 1. d Chapter 9 1. b Chapter 10 1. a Chapter 11 1. b Chapter 12 1. b Chapter 13 1. c Chapter 14 1. c Chapter 15 1. b 236 Answers to multiple choice questions Chapter 16 1. b 2. c 3. a 4. d 5. a 6. b 2. b 3. a 4. d 5. a 6. b 2. c 3. d 4. d 5. b 6. b 2. b 3. a 4. b 5. c 6. b 2. b 3. a 4. a 5. b 6. c 2. d 3. a 4. c 5. c 6. b 2. c 3. b 4. c 5. d 6. a 2. b 3. d 4. a 5. b 6. c 2. a 3. d 4. a 5. b 6. c 2. b 3. c 4. d 5. c 6. d 2. d 3. b 4. d 5. d 6. a Chapter 17 1. c Chapter 18 1. a Chapter 19 1. d Chapter 20 1. d Chapter 21 1. b Chapter 22 1. d Chapter 23 1. d Chapter 24 1. b Chapter 25 1. d Chapter 26 1. c 237 Index Where more than one page reference is given, the bold number indicates the more detailed reference. absolute advantage 166–7 acceptability of money 110 adjustment time 84 advertising 62 international 196 jobs 144 agglomeration 53 aggregate demand 136, 137, 143, 185, 187 agricultural cooperatives 46 aid, indicator of need for 132 airlines 217 appreciation 176–7, 186 arable land 203 ASEAN 212 ASEAN Free Trade Area (AFTA) 212 Association of Southeast Asian Nations (ASEAN) 212 average total cost (ATC) 37–8 B2B (business-to-business) commerce 216 B2C (business-to-consumer) commerce 216, 217 balance of payments 135, 181–9 deficits 184, 184–5 factors giving rise to 184–5 impact of 185 measures to reduce 185 structure of 182–4 surpluses 184, 186–7 factors giving rise to 186 impact of 186 measures to reduce 186–7 balance of trade 182, 183 balanced budget 132 ‘Banana Wars’ 192 bandwagon effect 10 bargaining, collective 157–8 barriers to entry 94–5, 96 barter 26, 108–9 basic economic problem 3 bonds 122 booms 140, 141 borders, national 198 borrowing 113, 118 foreign 205 government 132 inflation and 139 ‘brain drain’ 198, 204 238 ‘bricks and clicks’ companies 215 broad money (M2) 111, 112 budget deficits 132 budget surpluses 132 building societies 120–1 bureaucratic red tape 191 business organisations 41–50 cooperatives 42, 46–7 e-businesses 215 multinational corporations 42, 47–8 partnerships 41, 43–4 private joint stock companies 42, 44–5 public joint stock companies 42, 45–6 sole proprietorships 41, 42–3 types of 41–2 buyers, number of 93, 94, 95, 96 capital 14–15, 17–18, 20 and economic growth 150 fixed capital 18, 150 flows in CSME 210, 211 large capital outlay 95 productivity of 20 capital account 182, 183 capital accumulation 18 capital expenditure 127 capital-intensive production 25 capital markets 118–19, 121–2 liberalisation 195 Caribbean Community and Common Market (CARICOM) 163, 191, 212 Caribbean Congress of Labour (CCL) 157 Caribbean economies 201–7 development strategies in a globalised environment 204–6 economic problems facing 203–4 informal sector 113 nature of 201–3 CARICOM 163, 191, 212 CARICOM Single Market and Economy (CSME) 198, 209–11 benefits of 210–11 central bank 112, 116–18 functions 116–18 ceteris paribus assumption 58–9 cheques 110, 112 choice 3, 5–6, 9 circular flow of income 128–9 in a real-world economy 129 clean floating 178 climate 10, 169 closed economies 26, 126, 162 closed shop 157 coins 112, 116 clipping 110 collective bargaining 157–8 collusion 96 colonialism 192 command economies 25, 26–7, 29 possible merits and demerits 29 commercial banks 113, 118 central bank functions and 117 commodity money 109 common external policies 210 common external tariffs 163, 210 common markets 209, 209–11, 212 communication technology 194 comparative advantage 167–8 competition CSME and levels of international competitiveness 210 foreign 164, 196 monopolistic 92, 93, 95, 96 open throughout the world 195 perfect 92, 93, 93–4, 96 complementary goods 62 consumer cooperatives 46 consumers advantages of e-commerce to 217 effects of trade liberalisation and globalisation on 196–7 factors influencing decisions of 9–10 sovereignty 28 tastes 61, 165, 166, 177 consumption 141 consumption externalities 102, 103 contraction of demand 61 contraction of supply 68 contractionary (deflationary) fiscal policy 136, 139–40, 185 contractionary (deflationary) monetary policy 117, 136–7, 139–40, 185 cooperatives 42, 46–7 corporate bonds 122 cost-push inflation 137–8, 144, 159 measures to reduce 140 costs of production 11, 34–40 factor payments and 20–1 land’s lack of 15 rising and inflation 139 cottage industries 42 craft unions 156 credit, availability of 136 credit card fraud 218 credit squeeze 137 Index credit unions 46, 119 creditors 139 cross elasticity of demand (XED) 85–6 CSME 198, 209–11 currency appreciation 176–7, 186 currency depreciation 176–7, 185 currency devaluation 174, 177, 185 currency revaluation 174, 175, 177, 187 current account 182–3 current expenditure 127 customs unions 209 cyclical unemployment 143, 144, 145 data analysis and interpretation 229–31, 235 data presentation 225–9, 235 debt, national 132, 204 debt burden 204 debt securities 122 decisions, economic see economic decisions deferred payment, standard of 111 deflationary fiscal policy 136, 139–40, 185 deflationary monetary policy 117, 136–7, 139–40, 185 degrees of elasticity 81–3, 87–8 demand 58–63 aggregate 136, 137, 143, 185, 187 change in quantity demanded 61 and change in demand 63 changing and producers’ economic decisions 11 cross elasticity of 85–6 determinants of 61–3 income elasticity of 85 price elasticity of see price elasticity of demand and supply in the market 27, 73–5 trade cycle 141 demand curve 74–5 individual 59–60 market 60–1, 73–5 movements along 61 shifts in 62–3, 75–6 demand-deficient unemployment 143 demand-pull inflation 137 measures to reduce 139–40 demarcation 157 dependency 164 dependent population 150 deposits 118, 121 depreciation 176–7, 185 depression, economic 104, 105, 140, 141 determinants of demand 61–3 determinants of supply 68–70 devaluation 174, 177, 185 development, economic see economic development development banks 119–20 development expenditure 127 differentiated product 95 direct production 25 direct selling 216 dirty floating 178 disabled persons 11, 217 discoveries, new 150 diseconomies of scale 53 disposable income 129 dividends 122 divisibility, money and 110 division of labour 17, 53, 54–5 dot.coms 215 double coincidence of wants 109 drivers of economic growth 149–51 durability of money 110 e-banking 218, 219 e-businesses 215 e-commerce 215–20 advantages 217–18 challenges of 218–19 making a purchase 216 economic activity 159 economic decisions 9–13 government influences on 11 influences on firms’ decisions 11 influences on households’ decisions 9–10 economic depression 104, 105, 140, 141 economic development 151–2, 159, 164 aspects of 151 classification by level of 132 growth vs 152 measures of 151–2 strategies for Caribbean economies in a globalised environment 204–6 economic efficiency 6, 164 economic growth 132, 135, 148–51 vs development 152 drivers of 149–51 export-led 205 measurement of 132 economic integration 198, 208–14 examples of 211–12 stages of 208–9 economic performance, measurement of 131 economic systems 25–30 command economy 25, 26–7, 29 comparison of 29 free market economy 25, 27–8, 29, 30, 157, 159 mixed economy 25, 28, 29 traditional economy 25, 25–6, 29 economic union 209 economics 1–8 definitions of 1–2 scope of 2–6 economies of scale 46, 51–3, 164, 169, 195 economy, the 2 advantages of e-commerce to 218 sectors of 2, 126–8 education level of and economic decisions 10 merit good 101, 102 EEC 211 effective demand 59 efficiency 6, 164 elastic demand 81–5 elasticity 79–91 cross elasticity of demand 85–6 degrees of 81–3, 87–8 income elasticity of demand 85 price elasticity of demand 79–85 price elasticity of supply 87–8 electronic commerce see e-commerce embargoes 185, 190 employment 164, 211 CSME and full employment 210 disabled persons 11 see also unemployment entrepreneurship 14–15, 18, 20, 150, 210, 211 development of an entrepreneurial class 206 entrepreneurs’ pessimism 144 entry conditions 93, 94–5, 95, 96 Equal Opportunity Act 2000, Trinidad and Tobago 11 equilibrium balance of payments in 184 in the market 73–8 equilibrium price 74, 75, 75–6 equilibrium quantity 74, 75, 75–6 equity securities 122 equity of treatment 159 e-tailers 216 EU 192, 198, 211 euro 198, 211 European Economic Community (EEC) 211 European Union (EU) 192, 198, 211 exchange controls 191 exchange rates 165, 166, 173–80 balance of payments and 185, 186, 187 factors influencing 177–8 fixed exchange rate system 174–5, 177 floating exchange rate system 175–7, 178 managed exchange rate regime 178 expansionary (reflationary) fiscal policy 136, 142, 144, 187 expansionary (reflationary) monetary policy 117, 136, 142, 145, 187 expectations of future price changes 62 expenditure method for GDP 130 export price index 168 export subsidies 191 exports 129, 130 Caribbean economies 201–2 export-led growth 205 factors affecting quality of 166 falling demand and structural unemployment 143 239 Index extension of demand 61 extension of supply 68 external economies of scale 52, 53 externalities 100, 102–3 factor endowments 169 factor market 157 factor rewards/payments 20 and production costs 20–1 factors of production 14–23 capital 14–15, 17–18, 20 entrepreneurship 14–15, 18, 20 firm’s ownership of a scarce factor 95 fixed and variable 34–5 labour 14–15, 16–17, 20 land 14–15, 15–16, 20 ownership of 26, 27, 29 price as determinant of supply 68 primary and secondary 19 production 19 productivity 20 fairly elastic demand 82, 83 fairly elastic supply 87, 88 fairly inelastic demand 82 fairly inelastic supply 87, 88 fashions 61 fiat money 109 final goods 19 financial economies of scale 52 financial institutions 112–13, 116–25 building societies 120–1 central bank 112, 116–18 circular flow of income 129 commercial banks 113, 117, 118 credit unions 46, 119 development banks 119–20 functions of the financial sector 112–13 informal credit institutions 121 insurance companies 113, 120 investment trust companies 121 mutual funds 120, 211 share market 118–19 financial instruments 121–2 financial intermediaries 112, 118 findings of SBA project 231, 235 firms 2–3, 66, 126, 128, 210 advantages of e-commerce to 217–18 circular flow of income 128–9 closures of 141, 197 effects of trade liberalisation and globalisation on 196 factors influencing decisions of 11 MNCs see multinational corporations national income 130 small firms 197 firm’s supply 67 firm’s supply curve 66–7 firm’s supply schedule 66–7 First Law of Demand and Supply 59 fiscal deficits 132 fiscal policy 136 deflationary 136, 139–40, 185 240 reflationary 136, 142, 144, 187 fixed capital (physical capital) 18, 150 fixed costs 35–7 fixed exchange rate system 174–5, 177 fixed factors of production 34–5 floating exchange rate system 175–7, 178 food culture 196 imports 204 foreign borrowing 205 foreign competition 164, 196 foreign currency banking services 118 foreign currency earnings 164, 218 foreign direct investment (FDI) 183, 205 foreign exchange market 173 foreign exchange reserves 117–18, 185, 186 foreign policy 191 foreign trade see international trade four goals 135 government policies used to achieve 136–7 Fourth Law of Demand and Supply 76 free market economies 25, 27–8, 29 business organisations in 41–50 labour in 157 possible merits and demerits 30 role of trade unions in 159 free-riders 101 free trade 163 Free Trade Area of the Americas (FTAA) 212 free trade areas 208, 212 freedom of entry 93 frictional unemployment 142, 144 FTAA 212 gains from trade 168–9 GATT 163 GDP see gross domestic product General Agreement on Tariffs and Trade (GATT) 163 general partners 44 general unions 156 geographical mobility 16 globalisation 193–5 development strategies for Caribbean economies in a globalised environment 204–6 drivers of 194–5 effects of 195–8 producing for world markets 195 GNP see gross national product gold 110 goods 2, 3, 19 definition and price elasticity of demand 85 export, import and balance of payments 182 free movement in CSME 210 number of uses 84 price and demand 61 price and price elasticity of demand 83–4 price as percentage of total expenditure 84 price and supply 68 produced and consumers’ tastes 165 substitutes 61–2, 84 variety of 164 goods market 157 government 159 central bank’s functions and 117 circular flow of income 129 in the economy 2, 126–8 fiscal policy see fiscal policy funds from financial sector 112 influences on economic decisions 11 macroeconomic goals 135 policies used to achieve macroeconomic goals 136–7 managed exchange rate regime 178 MNCs and governments 48 monetary policy see monetary policy public finance 132 role in economic systems 26, 27, 28, 29 role and market failure 101, 102, 102–3, 104, 105 tax revenue decline in a recession 141 Treasury notes and bonds 122 government expenditure 126, 127, 129 national income 130 government investment 183 government projects 144 government regulations 95, 145 grants 11, 129, 183 gross domestic product (GDP) 130–1, 141 at factor cost 130–1 at market prices 130 real per capita GDP 148–9 gross national product (GNP) 131 low per capita GNP in Caribbean economies 203 growth, economic see economic growth habit-forming goods 84 HDI 151–2 health care 101, 102 home country 47 homogeneity money and 110 products 93, 95 host country 47 households 2, 126, 128 circular flow of income 128–9 factors influencing decisions of 9–10 national income 130 HPI 152 human capital 18, 144, 150 investment in 204 Human Development Index (HDI) 151–2 Human Poverty Index (HPI) 152 Index ideas 210 ILO 156 IMF 205 immigration 198 imperfect knowledge 94, 95, 95–6 import price index 168 imported inflation 138 measures to reduce 140 imports 129, 130 factors affecting level of 165 free movement in CSME 210 import controls 185, 187, 190–1 increasing and globalisation and trade liberalisation 197 income 9–10, 61 domestic levels of 165, 177 disposable 129 during recession 141 foreign levels of 166 income elasticity of demand (YED) 85 income method for GDP 130 individual demand 59–60 individual demand curve 59–60 individual demand schedule 59, 60 industrial relations 11, 53 industrial unions 156 industrial unrest 158, 159 industrial zones 11 industry 67 industry supply curve 67, 74–5 industry supply schedule 67, 74 industry’s supply 67, 73–5 inelastic demand 81–2 inflation 135, 137–40, 142, 159 balance of payments surpluses and inflationary pressures 186 causes 137–8 consequences of 138–9 measures to reduce 139–40 informal credit institutions 121 informal sector 113, 202–3 information 165, 166 sources for SBA project 225, 232, 235 infrastructure 11, 18, 53, 204 injections 129 innovation 30, 150 insurance companies 113, 120 interest 20, 112 interest rates 10, 62, 118 and exchange rate 177–8 monetary policy and 136 intermediate goods 19 internal economies of scale 52–3 International Labour Organization (ILO) 156 International Monetary Fund (IMF) 205 international relations 164, 191, 192 international specialisation 54–5, 163, 164, 167–8 international trade 127, 162–72, 190–2 absolute advantage 166–7 comparative advantage 167–8 CSME 210 factors influencing 165–6 gains from trade 168–9 international sector 127, 128, 129 preferential tariffs 191–2, 192–3 protectionism 163, 190–1 rationale for 163–5 terms of trade 168 Internet see e-commerce invention 30 investment 17, 129, 211 capital account 183 investment income 131, 182, 183 investment trust companies 121 invisible balance 183 job centres 144, 145 joint stock companies 42, 44–6 private 42, 44–5 public 42, 45–6 Keynesian (cyclical) unemployment 143, 144 knowledge of the market 93, 94, 95, 95–6, 96 labour 14–15, 16–17, 20 division of labour 17, 53, 54–5 and economic growth 150 external economies of scale 53 in the free market economy 157 free movement of wage earners in CSME 210 internal economies of scale 52 productivity 20 reducing quantity of labour employed 139 unemployment and the labour market 144 unskilled 203 labour force 17, 210 labour-intensive production 25, 203 labour supply 16, 17 trade unions and 157 land 14–15, 15–16, 20 and economic growth 149–50 insufficient arable land in Caribbean economies 203 productivity of 20 large-scale production 25 economic and social benefits of 195 laws 11, 95 Laws of Demand and Supply First 59 Second 67 Third 75–6 Fourth 76 leakages 129 legal tender 110 limited companies see joint stock companies limited liability 44, 45 limited partners 44 living standards 131, 144, 196, 203, 210 loans 118 lockouts 158 long run 34–5 long-run average costs 51–2 macroeconomics 135–47 four goals of macroeconomic policy 135 government policies used to achieve the goals 136–7 inflation 135, 137–40, 142 recession 140–2 unemployment 135, 142–5 see also balance of payments; economic growth managed exchange rate regime 178 managerial control, loss of 53 managerial economies of scale 52 marginal cost 37–8 monopolies and market failure 103–4 public goods and market failure 101 market-clearing price 74, 75, 75–6 market demand 60–1, 73–5 market demand curve 60–1, 73–5 market demand schedule 60, 74 market failure 100–7 causes 100–4 consequences of 104–5 market forces 57–8 see also demand; supply market mechanism 27, 28, 30 market structures 92–9 monopolistic competition 92, 93, 95, 96 monopoly 92, 93, 94–5, 96 oligopoly 92, 93, 95–6, 96 perfect competition 92, 93, 93–4, 96 spectrum of 92–3 marketing economies of scale 52 markets CSME and access to larger markets 210 definition of a market 57–8 equilibrium in 73–8 global and e-commerce 217 globalisation and access to world markets 195 international trade and larger markets 164 small markets in Caribbean economies 202 Marshall, Alfred 1, 2 mass media 165, 196 medium of exchange 109, 110–11 menu costs 139 merchandise balance 182 MERCOSUR 212 merit goods 30, 100, 101–2, 105 migration 198, 204 Mill, J.S. 1, 2 mixed economies 25, 28, 29 MNCs 42, 47–8, 196, 197, 205 241 Index mobility factors of production 16, 18 globalisation and trade liberalisation 198 within CSME 210 modern economists 1, 2 monetarists 138 monetary policy 117, 136–7 deflationary 117, 136–7, 139–40, 185 reflationary 117, 136, 142, 145, 187 money 108–11, 116 features of 110 functions of 110–11 history of 108–10 money cost 4 money lenders 121 money market accounts 112 money supply 111–12 increase in as cause of inflation 138, 140 monocrop economies 201–2 monopolies 30, 92, 93, 94–5, 96 market failure 100, 103–4 monopolistic competition 92, 93, 95, 96 moonlighting 113 multinational corporations (MNCs) 42, 47–8, 196, 197, 205 municipal bonds 122 mutual funds 120, 211 NAFTA 212 narrow money (M1) 111–12 national borders 198 national budget 132 national debt 117, 132, 204 national income 129–32 methods for calculating 130–1 nominal, real and potential output 131 use of national income statistics 131–2 national planning authority 26 natural resources 15 depletion 164 exploitation by MNCs 197 no natural resource endowment in the Caribbean 202 necessity 84 needs 2–3, 24–5 negative externalities 102–3 net errors and omissions 182, 184 net national product 131 net property income from abroad 131 new discoveries 150 NFIs 118, 120–1 nominal output 131 non-bank financial institutions (NFIs) 118, 120–1 non-excludability 30, 100–1 non-exhaustibility (nondiminishability) 30, 100–1 non-renewable resources 164 non-tariff barriers 190–1 242 normal goods 85 North American Free Trade Agreement (NAFTA) 212 notes 110, 112, 116 number of suppliers 69 occupational mobility 16 occupations 54, 163 official reserves 184 official reserves account 182, 184 oligopoly 92, 93, 95–6, 96 open economies 127, 162–3 open market operations 136 opportunity cost 3–4, 5–6, 167 output falling in a recession 141 firms 51–2 and division of labour 54 optimum 52 national GDP 130–1, 141 GNP 131, 203 nominal 131 potential 131 real 131 unemployment and loss of 144 output method for GDP 130 overspecialisation 53 Owen, Robert 46 ownership of factors of production 26, 27, 29 paper money 110, 112, 116 parent company 47 part ownership of companies 113, 122 partial specialisation 168 partnerships 41, 43–4 patents 95 perfect competition 92, 93, 93–4, 96 perfect knowledge 93 perfectly elastic demand 82, 83 perfectly elastic supply 87, 88 perfectly inelastic demand 82 perfectly inelastic supply 87 personal choice 9 pessimism, entrepreneurs’ 144 physical capital 18, 150 plants 126 population, changes in 61 portability of money 110 portfolio investment 205 positive externalities 102–3 potential output 131 poverty 104, 105 Human Poverty Index 152 poverty line 204 preferential tariffs 191–2, 192–3 benefits 192 costs of 192 premium 113, 120 price elasticity of demand (PED) 79–85 degrees of elasticity 81–3 factors affecting 83–5 formula 80 price elasticity of demand coefficient 80, 81 price elasticity of supply (PES) 87–8 price-makers 94, 95 price mechanism 27, 28, 30 price rigidity 96 price stability see inflation price-takers 93 price wars 96 prices and demand effects of price changes 61 expectations of future price changes 62 price of the good 61 substitute goods 61–2 domestic product prices vs foreign product prices 165, 166, 177 e-commerce and 217 equilibrium price 74, 75, 75–6 inflation and export prices 139 and price elasticity of demand 83–4 price as a percentage of total expenditure 84 supply and price effects of changes in price 68 price of factors of production 68 price of the good 68 prices of other goods 69 wage–price spiral 138 primary factors of production 19 primary sector 202 private investment 183 private joint stock companies 42, 44–5 private sector 27, 28, 29 funds from financial sector 112 producer goods 19 producers see firms product 96 differentiated 95 homogeneous 93, 95 unique 94 production 19, 210 capital-intensive 25 costs of see costs of production direct 25 factors of see factors of production labour-intensive 25, 203 large-scale 25, 195 resource allocation and 24–5 what to produce 24–5 production externalities 102–3 production possibility frontier 4–6, 149 productive capacity 51–2 productivity 20, 210 profit motive 27, 30 profits 11, 20 MNCs and 48 protectionism 163, 190–1 public finance 132 public goods 30, 100, 100–1, 105 public joint stock companies 42, 45–6 public sector 26, 28 purchasing power of money 138–9 Index quality domestic goods 165 imported goods 166 standards 191 quantity demanded 61, 63 degrees of elasticity 81–3 equilibrium quantity 74, 75, 75–6 supplied 68, 70 quotas 185, 190 rationing 27 real flows 128 real output 131 real per capita GDP 148–9 real-wage unemployment 143, 145 recession 140–2 causes 140–1 consequences 141 government policies to reduce 142 recommendations of SBA project 231–2, 235 red tape, bureaucratic 191 reflationary fiscal policy 136, 142, 144, 187 reflationary monetary policy 117, 136, 142, 145, 187 regional specialisation 54 Registrar of Companies 44–5 regulations 95, 145 rent 20 repatriated profits 48 repo rate 117 required reserve ratio 136–7 research and development economies of scale 52 reserve ratio 136–7 resource allocation 24–5 and economic systems 26, 27, 28, 29 international trade and 164 resource base 11 resource depletion 164 retail price index (RPI) 137 retraining programmes 144, 145 retrenchment 104 revaluation 174, 175, 177, 187 Ricardo, David 167 Rochdale Society of Equitable Pioneers 46 RPI 137 sabotage 158 safekeeping services 118 savings 112, 118, 129 savings accounts 112 scale diseconomies of 53 economies of 46, 51–3, 164, 169, 195 scarcity, 2, 3, 5–6 money and relative scarcity 110 school-based assessment (SBA) project 221–35 formulating a topic statement 222 guidelines for earning marks 235 sample project 223–34 topic selection 222, 222–3 scientific method 2 search unemployment 142, 144 seasonal factors 61 seasonal unemployment 142–3, 144 Second Law of Demand and Supply 67 secondary factors of production 19 sectors of the economy 2, 126–8 securities 121–2 sellers, number of 93, 94, 95, 96 services 2, 3, 19 export and import 182–3 free movement in CSME 210 variety of 164 services balance 183 shareholders 44, 45 share market 118–19 shares 45, 113, 118, 122, 211 shifts in demand 62–3, 75–6 shifts in supply 69–70, 75–6 shoe leather costs 139 short run 34–5 shortages 29, 30, 75 signalling 27 single markets 209, 209–11, 212 sit-down strikes 158 sit-ins 158 slow-downs 158 small firms 197 small-scale production 25 Smith, Adam 1, 2, 54 social capital (infrastructure) 11, 18, 53, 204 social problems 144 social services 205 social welfare 104, 105 sole proprietorships 41, 42–3 sou sou 121 Southern Common Market (MERCOSUR) 212 sovereignty consumer 28 territorial 197–8 specialisation 17, 54–5 international 54–5, 163, 164, 167–8 overspecialisation 53 regional 54 workers 54, 163 speculation 178 standard of deferred payment 111 standard of living 131, 144, 196, 203, 210 stock 44, 45, 118, 122 stock exchanges 118, 119 stock markets 118–19 stockbrokers 119 storage 109 store of value 111 strikes 158, 159 structural adjustment policies 205 structural unemployment 143, 144 subsidiaries 47, 48 subsidies 69, 129, 130 export subsidies 191 substitutes 61–2, 84 supernormal profit 11 supervision 118 supply 58, 66–72 change in quantity supplied 68 and change in supply 70 and demand in the market 27, 73–5 determinants of 68–70 firm and industry supply 66–7 land is fixed in supply 15 price elasticity of 87–8 supply curve 74–5 firm’s 66–7 industry 67, 74–5 movements along 68 shifts in 69–70, 75–6 supply of labour see labour supply surpluses 25–6, 30, 75 tariffs 185, 190 preferential 191–2, 192–3 tastes 61, 165, 166, 177 taxes 11, 69, 129, 130 harmonisation of tax laws 210 revenues declining in a recession 141 technical economies of scale 52–3 technological unemployment 143 technology 211 advances and economic growth 150 advances and falling demand 143 advances and supply 69, 70 communication technology 194 and factors of production 16–17, 18 terms and conditions of employment 159 terms of trade 168 territorial sovereignty 197–8 Third Law of Demand and Supply 75–6 TNCs see MNCs token money 109 total costs 36–7 total fixed costs (TFC) 35–7 total variable costs (TVC) 35–7 tourism 196–7 trade, international see international trade trade cycle 140–1 trade disputes 192 trade liberalisation 192–3, 194 effects of 195–8 trade unions 155–61 collective bargaining 157–8 costs of trade union activity 159 real-wage unemployment 143, 145 and the supply of labour 157 role in a free market economy 159 types of 156 trading blocs 208 traditional economic system 25, 25–6, 29 training 144, 159 transfer payments 127 243 Index transfers 182, 183 transnational corporations (TNCs) see multinational corporations (MNCs) transportation 194 travel 193, 196–7, 211 travellers’ cheques 112, 118 Treasury notes (bills) and bonds 122 trust companies 121 unemployment rate 142 unique products 94 unit of account 111 unitary elasticity 82, 83, 87, 88 United Kingdom (UK) 197 United Nations 151–2 United States of America (USA) 27, 192 unlimited liability 43, 44 unskilled labour 203 underdevelopment, sources of 152 unemployment 135, 142–5, 159, 218 balance of payments and 185, 186 effects 144 market failure and 104, 105 measures to reduce 144–5 recession 141 trade liberalisation and globalisation 195, 196, 197 types of 142–3 value 109 variable costs 35–7 variable factor proportions 4 variable factors of production 34–5 variety 164, 217 visible balance 182 visible trade account 182 voluntary export restrictions 191 244 wage–price spiral 138, 159 wages 20 low 165 real-wage unemployment 143, 145 trade unions and 159 wants 2–3, 24–5, 196 waste products 53 weather 10 welfare economies of scale 52 westernisation of the world 196 white-collar unions 156 work, type of 10 work-to-rule 158 working capital 18 World Bank 205 world citizens 195 World Trade Organization (WTO) 163, 192 WTO 163, 192 .1DI' : H I -. .t ,, . il i djl' ~ " . ~: t l===; It!m M! 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