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Edexcel
A-level
ECONOMICS
THIRD EDITION
Quintin Brewer
311923_FM_MRN_EdA_Ec3_001-010.indd 1
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Every effort has been made to trace all copyright holders, but if any have been inadvertently
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opportunity.
Although every effort has been made to ensure that website addresses are correct at time of
going to press, Hodder Education cannot be held responsible for the content of any website
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the address of the home page for a website in the URL window of your browser.
Hachette UK’s policy is to use papers that are natural, renewable and recyclable products
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our website: www.hoddereducation.co.uk
ISBN: 978 1 3983 1192 3
© Quintin Brewer 2021
First edition published in 2016.
This edition published in 2021 by
Hodder Education,
An Hachette UK Company
Carmelite House
50 Victoria Embankment
London EC4Y 0DZ
www.hoddereducation.co.uk
Impression number
Year
10 9 8 7 6 5 4 3 2 1
2025 2024 2023 2022 2021
All rights reserved. Apart from any use permitted under UK copyright law, no part of this
publication may be reproduced or transmitted in any form or by any means, electronic
or mechanical, including photocopying and recording, or held within any information
storage and retrieval system, without permission in writing from the publisher or under
licence from the Copyright Licensing Agency Limited. Further details of such licences (for
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Cover photo © deepika
Illustrations by Aptara, Inc.
Typeset in India by Aptara, Inc.
Printed by Bell & Bain Ltd, Glasgow
A catalogue record for this title is available from the British Library.
311923_FM_MRN_EdA_Ec3_001-010.indd 2
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Countdown to my exams
2
Economics as a social science
11
Positive and normative economic statements
13
The economic problem
15
Production possibility frontiers
Free market economies, mixed economy and command economy
Demand
27
31
3
Tick to track your progress
9
Supply
35
Price elasticity of supply
6
4
99
Equilibrium levels of real national output
109 Output gaps
110 Trade (business) cycle
112 The impact of economic growth
10 Macroeconomic objectives and policies
116 Possible macroeconomic objectives
117 Demand-side policies
123 Supply-side policies
38
Price determination
41
The price mechanism
42
Consumer and producer surplus
43
Indirect taxes and subsidies
Theme 3 Business behaviour and the labour market
46
Alternative views of consumer behaviour
11 Business growth
125 Conflicts and trade-offs between objectives and policies
130 Size and types of firms
Market failure
49
Types of market failure
50
Externalities
54
Non-provision of public goods
55
Information gaps
132 Business growth
135 Demergers
12 Business objectives
137 Profit maximisation
138 Revenue maximisation
Government intervention
57
Government intervention in markets
62
Government failure
138 Sales maximisation
139 Satisficing
13 Revenues, costs and profits
Theme 2 The UK economy: performance and policies
5
Injections and withdrawals
Economic growth
Cross elasticity of demand
Income elasticity of demand
34
Long-run aggregate supply
98
107 Factors that could cause economic growth
Price elasticity of demand
32
Short-run aggregate supply
National income, output and expenditure
107 Causes of growth
How markets work
24
Characteristics of aggregate supply
National income
97
101 The multiplier
Specialisation and the division of labour
20
Rational decision-making
Net trade (X – M)
94
8
18
24
Government expenditure (G)
Aggregate supply
94
The nature of economics
11
Investment (I)
88
88
141 Revenue
Measures of economic performance
66
Economic growth
69
Inflation
74
Employment and unemployment
78
Balance of payments
144 Costs in the short run
149 Costs in the long run
152 Profit
14 Market structures
156 Efficiency
Aggregate demand
158 Perfect competition
82
Characteristics of aggregate demand
161 Monopolistic competition
84
Consumption (C)
162 Oligopoly
Check your understanding and progress at www.hoddereducation.co.uk/myrevisionnotes
5
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311923_FM_MRN_EdA_Ec3_001-010.indd 5
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Production possibility frontiers
✚ Renewable resources are those that can be replaced naturally after use,
e.g. solar energy, wind power, wood and fish. Such resources are likely to
be sustainable unless they are consumed more quickly than they can be
replaced.
✚ Non-renewable resources are those where continued consumption will
eventually result in their exhaustion, e.g. oil, copper, platinum.
The importance of opportunity costs to
economic agents
Non-renewable resources
are those that will eventually
be completely depleted.
A production possibility frontier (PPF) shows combinations of two goods that
could be produced by an economy if all of its resources are employed fully and
efficiently (see Figure 1.1).
A
B
A production possibility
frontier illustrates the
maximum potential output
of an economy when
all resources are fully
employed.
X
C
Opportunity cost is linked to scarcity as explained below:
✚ Scarcity implies that choices must be made.
✚ Each choice involves an opportunity cost.
✚ This may be explained as follows: if a country’s resources are used to
manufacture one product, then it must forgo an alternative product that
could have been produced. The next best alternative forgone is called the
opportunity cost of what has been produced.
✚ Opportunity cost, therefore, is a real cost measured in terms of something
that is forgone.
Examples of opportunity cost in relation to different economic
agents include:
✚ For a consumer: a university student might have enough money to buy
either a jet ski or a surfboard. If the student decides to buy the jet ski then
the opportunity cost is the surfboard.
✚ For a firm: the firm might have to make a choice between its two priorities,
e.g. buying a new IT system or building a new factory. If it chooses the IT
system then the opportunity cost is the new factory.
✚ For the government: suppose the government has £10 million with which
to fund one of its two main priorities that both require a £10 million
investment — building a new school or building a new university. If it
decides that its first preference is the school while the second preference is
the university, then the opportunity cost of building the school is building
the university.
You can also keep track of your revision by ticking
off each topic heading in the book. You may find it
helpful to add your own notes as you work through
each topic
Renewable resources are
those whose stock levels can
be maintained at a certain
level.
Consumer
goods
1 The nature of economics
The distinction between renewable and
non-renewable resources
1 The nature of economics
1
86
91
Theme 1 Introduction to markets and market failure
4
Use the revision planner on pages 4 to 6 to plan your
revision, topic by topic. Tick each box when you
have:
✚ revised and understood a topic
✚ tested yourself
✚ practised the exam questions and gone online
to check your answers and complete the quick
quizzes.
7
Exam breakdown
My Revision Planner
My Revision Planner
My Revision Planner
Everyone has to decide their own revision strategy,
but it is essential to review your work, learn it and
test your understanding. These Revision Notes will
help you to do that in a planned way, topic by topic.
Use this book as the cornerstone of your revision
and don’t hesitate to write in it — personalise your
notes and check your progress by ticking off each
section as you revise.
Opportunity cost is the
next best alternative that is
forgone when a choice is
made.
Making links
Opportunity cost is an
important concept that has
relevance throughout the
course so it is important for
exams to ensure that you
have a secure understanding
of the concept.
For example, this concept
is relevant in considering
economic growth using
production possibility
frontiers in Theme 1 (see
page 15), normal profit in
Theme 3 (see page 153)
and the law of comparative
advantage in Theme 4 (see
pages 188–190).
Exam tip
Now test yourself
6 A firm has £1 million that it could use to build a new factory or to buy five robots.
What is the opportunity cost if the firm decides to build the factory?
Answers available online
Opportunity cost must be
measured as a real cost,
in other words in terms
of goods forgone when a
choice is made, and not in
money terms.
Economic goods and free goods
Economic goods are created from resources that are limited in supply and so
are scarce. Consequently, they command a price.
Free goods are unlimited in supply, such as sunlight or sand on a beach.
Consumption by one person does not limit consumption by others. Therefore,
the opportunity cost of consuming a free good is zero.
Now test yourself
7 Why does the consumption of free goods not incur an opportunity cost?
Answers available online
14
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O
Capital goods
Figure 1.1 A production possibility frontier (PPF)
In constructing the PPF in Figure 1.1 it is assumed that the economy can
produce either consumer goods or capital goods.
✚ Capital goods are those required to produce other goods — both capital
and consumer goods, e.g. machinery, factory buildings.
✚ Consumer goods are those that give satisfaction (or utility) to consumers,
e.g. smartphones, curry and cars.
✚ By definition, any point on the PPF, e.g. A, B or C, implies that all resources
are fully and efficiently employed. Therefore, all points on the PPF indicate
the maximum productive potential of an economy and that resources are
being used efficiently.
✚ However, if the economy was operating inside its PPF, e.g. at point X, then
it would indicate that there are unemployed resources in the economy. For
example, some workers may be unemployed or machinery may be unused.
It could also imply that resources are not being allocated efficiently.
Now test yourself
8 Classify the following into capital and consumer goods:
a) A laptop used by a company director for his business
b) A curry eaten by Marie for her lunch
c) A visit to a spa by Kirsten
d) A car used to transport a manager between offices
Answers available online
Possible and unobtainable production
Any points inside or on the PPF represent combinations of the two products
that are obtainable. However, any points to the right of the PPF would be
currently unobtainable. They could only become obtainable if there was
economic growth.
PPFs and opportunity cost
✚ The PPF is drawn as a curve (concave to the origin) in Figure 1.1. This may be
analysed in terms of the concept of opportunity cost and marginal analysis.
✚ Marginal analysis involves consideration of the impact that small changes
have on the current situation.
✚ Therefore, a marginal increase in the output of capital goods means that
some consumer goods must be sacrificed (the opportunity cost).
✚ In Figure 1.2, when output of capital goods is increased from 0M to 0S, the
output of consumer goods is reduced from 0L to 0R.
Marginal analysis is
concerned with the impact of
additions to or subtractions
from the current situation.
The rational decision-maker
will only decide on an option
if the marginal benefit
exceeds the marginal cost.
15
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Features to help you succeed
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Exam tips
Exam skills summary
From the start of the course it is important to adopt
a critical approach to the assumptions behind
the models that are being considered so that you
develop skills of evaluation.
These summaries highlight how to specific skills
identified or applicable in that chapter can be
applied to your exam answers.
Typical mistakes
The author identifies the typical mistakes candidates
make and explain how you can avoid them.
Now test yourself
These short, knowledge-based questions provide the
first step in testing your learning. Answers are at the
back of the book.
Definitions and key words
Clear, concise definitions of essential key terms are
provided where they first appear. Key words from
the specification are highlighted in bold throughout
the book.
Making links
This feature identifies specific connections between
topics and tells you how revising these will aid your
exam answers.
Get the most from this book
Get the most from this book
Revision activities
These activities will help you to understand each
topic in an interactive way.
Exam practice
Practice exam questions are provided for each topic.
Use them to consolidate your revision and practise
your exam skills.
Summaries
The summaries provide a quick-check bullet list for
each topic.
Online
Go online to check your answers to the exam
practice questions and try out the extra quick
quizzes at www.hoddereducation.co.uk/
myrevisionnotesdownloads
3
Edexcel A-level Economics Third Edition
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My Revision Planner
My Revision Planner
Countdown to my exams
Exam breakdown
Theme 1 Introduction to markets and market failure
1
2
3
4
The nature of economics
11
Economics as a social science
11
Positive and normative economic statements
13
The economic problem
15
Production possibility frontiers
18
Specialisation and the division of labour
20
Free market economies, mixed economy and command economy
How markets work
24
Rational decision-making
24
Demand
27
Price elasticity of demand
31
Cross elasticity of demand
32
Income elasticity of demand
34
Supply
35
Price elasticity of supply
38
Price determination
41
The price mechanism
42
Consumer and producer surplus
43
Indirect taxes and subsidies
46
Alternative views of consumer behaviour
Market failure
49
Types of market failure
50
Externalities
54
Non-provision of public goods
55
Information gaps
Government intervention
57
Government intervention in markets
62
Government failure
Theme 2 The UK economy: performance and policies
5
6
4
Measures of economic performance
66
Economic growth
69
Inflation
74
Employment and unemployment
78
Balance of payments
Aggregate demand
82
Characteristics of aggregate demand
84
Consumption (C)
Check your understanding and progress at www.hoddereducation.co.uk/myrevisionnotesdownloads
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8
Investment (I)
88
Government expenditure (G)
88
Net trade (X – M)
My Revision Planner
7
86
Aggregate supply
91
Characteristics of aggregate supply
94
Short-run aggregate supply
94
Long-run aggregate supply
National income
97
National income, output and expenditure
98
Injections and withdrawals
99
Equilibrium levels of real national output
101 The multiplier
9
Economic growth
107 Causes of growth
107 Factors that could cause economic growth
109 Output gaps
110 Trade (business) cycle
112 The impact of economic growth
10 Macroeconomic objectives and policies
116 Possible macroeconomic objectives
117 Demand-side policies
123 Supply-side policies
125 Conflicts and trade-offs between objectives and policies
Theme 3 Business behaviour and the labour market
11 Business growth
130 Size and types of firms
132 Business growth
135 Demergers
12 Business objectives
137 Profit maximisation
138 Revenue maximisation
138 Sales maximisation
139 Satisficing
13 Revenues, costs and profits
141 Revenue
144 Costs in the short run
149 Costs in the long run
152 Profit
14 Market structures
156 Efficiency
158 Perfect competition
161 Monopolistic competition
5
162 Oligopoly
Edexcel A-level Economics Third Edition
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165 Monopoly
My Revision Planner
169 Monopsony
170 Contestability
15 The labour market
173 The demand for labour
173 The supply of labour
174 Wage determination
16 Government intervention in product markets
181 Types of government intervention
183 The impact of government intervention
Theme 4 A global perspective
17 International economics
185 Globalisation
187 Specialisation and trade
191 Patterns of trade
192 Terms of trade
193 Trading blocs and the World Trade Organization
195 Restrictions on free trade
198 The balance of payments
200 Exchange rates
204 International competitiveness
18 Poverty and inequality
207 Poverty
208 Inequality
19 Emerging and developing economies
212 Measures of development
213 Factors influencing growth and development
218 Strategies influencing growth and development
20 The financial sector
228 Financial markets
229 The role of financial markets
229 Market failure in the financial sector
231 The role of central banks
21 The role of the state in the macroeconomy
233 Public finance
233 Public expenditure
236 Taxation
240 Public sector finances
242 Macroeconomic policies in a global context
Glossary
6
Exam practice answers and quick quizzes online at
www.hoddereducation.co.uk/myrevisionnotesdownloads
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311923_FM_MRN_EdA_Ec3_001-010.indd 6
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6–8 weeks to go
One week to go
✚ Start by looking at the specification — make sure you
✚ Try to fit in at least one more timed practice of an
know exactly what material you need to revise and
the style of the examination. Use the revision planner
on pages 4 to 6 to familiarise yourself with the topics.
✚ Organise your notes, making sure you have covered
everything on the specification. The revision planner
will help you to group your notes into topics.
✚ Work out a realistic revision plan that will allow you
time for relaxation. Set aside days and times for all
the subjects that you need to study, and stick to your
timetable.
✚ Set yourself sensible targets. Break your revision
down into focused sessions of around 40 minutes,
divided by breaks. These Revision Notes organise the
basic facts into short, memorable sections to make
revising easier.
entire past paper and seek feedback from your
teacher, comparing your work closely with the mark
scheme.
✚ Check the revision planner to make sure you haven’t
missed out any topics. Brush up on any areas of
difficulty by talking them over with a friend or getting
help from your teacher.
✚ Attend any revision classes put on by your teacher.
Remember, your teacher is an expert at preparing
students for examinations.
2–6 weeks to go
✚ Read through the relevant sections of this book and
✚
✚
✚
✚
refer to the examiners’ tips and summaries, exam
skills and key terms. Tick off the topics as you feel
confident about them. Highlight those topics you find
difficult and look at them again in detail.
Test your understanding of each topic by working
through the ‘Now test yourself’ questions in the book.
Look up the answers at the back of the book.
Make a note of any problem areas as you revise, and
ask your teacher to go over these in class.
Look at past papers. They are one of the best ways
to revise and practise your exam skills. Write or
prepare planned answers to the exam practice
questions provided in this book. Check your answers
online and try out the extra quick quizzes at
www.hoddereducation.co.uk/
myrevisionnotesdownloads
Track your progress using the revision planner and
give yourself a reward when you have achieved your
target.
Countdown to my exams
Countdown to my exams
The day before the examination
✚ Flick through these Revision Notes for useful
reminders, for example the examiners’ tips and
summaries, exam skills and key terms.
✚ Check the time and place of your examination.
✚ Make sure you have everything you need — extra
pens and pencils, tissues, a watch, bottled water,
sweets.
✚ Allow some time to relax and have an early night
to ensure you are fresh and alert for the
examinations.
My exams
A-level Economics Paper 1
Date:........................................................................................
Time:.......................................................................................
Location:.................................................................................
A-level Economics Paper 2
Date:........................................................................................
Time:.......................................................................................
Location:.................................................................................
A-level Economics Paper 3
Date:........................................................................................
Time:.......................................................................................
Location:.................................................................................
7
Edexcel A-level Economics Third Edition
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Exam breakdown
Exam breakdown
What is the format of the exam?
The A-level Economics A examination has three papers, as shown in the table
below.
Paper
Length
Marks
Percentage of final mark
Paper 1: Markets and
business behaviour
2 hours
100
35%
Paper 2: The national and
global economy
2 hours
100
35%
Paper 3: Microeconomics
and macroeconomics
2 hours
100
30%
What is being assessed in each paper?
Paper 1 Markets and business behaviour
✚ This paper is assessing microeconomics.
✚ It will test the material covered in Theme 1 and Theme 3 in this book.
Paper 2 The national and global economy
✚ This paper is assessing macroeconomics.
✚ It will test the material covered in Theme 2 and Theme 4 in this book.
Paper 3 Microeconomics and macroeconomics
✚ This paper is synoptic and, therefore, covers the whole specification.
✚ It will test the material covered in Themes 1, 2, 3 and 4.
How is the subject assessed in each paper?
Papers 1 and 2
These papers have exactly the same exam format:
Section A: Short answers and multiple choice
✚ This section is worth 25 marks.
✚ There are 5 questions.
✚ Each of the 5 questions is worth 5 marks of which 1 mark will be
for a multiple-choice question and the other 4 for either one or two
­short-answer questions.
Section B: Data response
✚ This section is worth 50 marks.
✚ The question will consist of extracts and/or data and charts.
✚ There will be 5 questions based on the material provided with the
following mark allocations: 5, 8, 10, 12 and 15.
Section C: Essay
✚ You choose one essay (from a choice of two).
✚ The essay is worth 25 marks.
8
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Paper 3
This paper consists of two sections, A and B.
Exam breakdown
Section A and Section B
✚ Each section is worth 50 marks and has an identical format as indicated
below.
✚ The first question will consist of extracts and/or data and charts.
✚ There will be questions based on the material provided with the following
mark allocations: 5, 8, 12 and 25.
✚ The 25 mark question is an essay (you choose one from a choice of two).
What skills are assessed?
Papers 1 and 2, Section A: Short-answer and
multiple-choice questions
✚ Many of the questions will require calculations, especially those on
Paper 1.
✚ Others will test knowledge and one-stage analysis.
✚ None of the questions in this section require evaluation.
Papers 1 and 2, Section B: Data response questions
The 5 and 8 mark questions are assessed according to a points-based mark
scheme.
✚ 5 mark question: tests knowledge, application and analysis, and may
require a diagram or calculation. The exact allocation of marks for this
question depends on the nature of the question.
✚ 8 mark question: tests all four assessment objectives with 2 marks being
allocated to each. Typically, you will be asked to identify, analyse and
evaluate two factors/issues.
The 10, 12 and 15 mark questions are assessed according to a levels of
response mark scheme. They all require evaluation.
✚ 10 mark question: the command word used is ‘assess’. Again, this will test
all four assessment objectives with 6 marks for knowledge, application and
analysis and 4 marks for evaluation.
✚ 12 mark question: the command word used is ‘discuss’. In this case there
are 8 marks for knowledge, application and analysis, and 4 marks for
evaluation.
✚ 15 mark question: the command word used is ‘discuss’. There are 9 marks
for knowledge, application and analysis, and 6 marks for evaluation.
Papers 1 and 2, Section C: Essay
✚ The essay is worth 25 marks in total.
✚ The command word used is ‘evaluate’ or ‘to what extent’.
✚ The essay is assessed according to a levels of response mark scheme.
✚ There are 16 marks for knowledge, application and analysis, and 9 marks
for evaluation.
✚ For the knowledge, application and analysis marks it is necessary to define
terms accurately, provide relevant examples or context, and include chains
of reasoning to demonstrate analytical skills. Diagrams should be included
where appropriate and integrated into the written analysis.
✚ Evaluative skills should be demonstrated to access the full range of marks.
For the essay, this involves making an ‘informed judgement’.
9
Edexcel A-level Economics Third Edition
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Exam breakdown
Paper 3: Data response questions
The 5 and 8 mark questions are assessed according to a points-based mark
scheme.
✚ 5 mark question: tests knowledge, application and analysis and may
require a diagram or calculation. The exact allocation of marks for this
question depends on the nature of the question.
✚ 8 mark question: tests all four assessment objectives with 2 marks being
allocated to each. Typically, you will be asked to identify, analyse and
evaluate two factors/issues.
The 12 mark question is assessed according to a levels of response mark
scheme. The command word used is ‘discuss’. In this case there are 8 marks
for knowledge, application and analysis, and 4 marks for evaluation.
Paper 3: Essays
These are assessed in the same way as those for Papers 1 and 2. However, to
achieve the highest level it is essential to consider both microeconomic and
macroeconomic factors in your answer.
10
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1 The nature of economics
Economics as a social science
Thinking like an economist
✚ Economics is concerned with the ways in which societies organise
scarce productive resources in order to satisfy people’s wants.
✚ It provides a unique and special way of examining many areas of human
behaviour, which involves using the economist’s toolkit of concepts,
theories and techniques to analyse economic issues and problems.
✚ Economists often use models to develop theories of behaviour. These
models are usually based on assumptions from which certain deductions
may be made.
Exam tip
From the start of the course it
is important to adopt a critical
approach to the assumptions
behind the models that are
being considered so that you
develop skills of evaluation.
The use of the ceteris paribus assumption in
building models
✚ When building models, economists work on the basis that all other
variables are held constant to enable deductions to be made.
✚ This is called the ‘ceteris paribus’ assumption, which means ‘other things
being equal’.
✚ This helps to simplify analysis so that the impact of a single change in a
variable can be examined.
Ceteris paribus means that
when the effect of a change
in one variable is considered,
it is assumed that all other
variables are held constant.
Exam tip
Now test yourself
1 Why is the ceteris paribus assumption necessary when building economic models?
Answers available online
Analysis is usually based
on the ceteris paribus
assumption. However,
removing this assumption
may be useful in evaluation.
The inability in economics to make scientific
experiments
✚ It is impossible for economists to conduct laboratory experiments because
economics is a social science involving people.
✚ Consequently, economic policies that may have been effective at one time
in one country may not have the same impact at another time or in
another country.
Positive and normative
economic statements
Positive economics
✚ Positive economic statements are based on facts that can be proved or
disproved. They include what was, is or will be, and these statements can
be verified as being true or false by reference to data or evidence or by
using a scientific approach.
Positive economic
statements are objective
statements based on
evidence or facts that can,
therefore, be proved or
disproved.
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1 The nature of economics
✚ Economists often use models as a way of predicting behaviour. It is
possible to make positive statements on the basis of ‘models’, such as the
impact on price of a product following an increase in demand.
✚ Positive economics relates official data such as gross domestic product
(GDP), the price of oil, the rate of unemployment and the rate of tax
on sugar. It may also be associated with the use of models as a way of
predicting behaviour.
Now test yourself
2 Why do economists use models to predict economic behaviour?
Answers available online
Normative economics
Normative economic statements are based on value judgements and are,
therefore, subjective. They relate to what:
✚ might be good or bad, or
✚ should be or ought to be, or
✚ would be fair or unfair.
Normative economics is usually associated with discussions about economic
policy. In this unit, for example, it is concerned with issues such as whether or
not there should be:
✚ a minimum price for alcohol
✚ subsidies for green energy, e.g. solar energy
✚ road tolls
✚ an increase in the tax on cigarettes
✚ more private sector provision in the health service.
The role of value judgements in influencing
economic decision-making and policy
Normative economic
statements are subjective
statements based on value
judgements and cannot be
proved or disproved.
Exam tip
When defining normative
statements it is better
to use the terms ‘value
judgements’ or ‘subjective
views’ rather than ‘opinions’
to describe them.
✚ As explained previously, scientific, laboratory experiments are impossible
in economics.
✚ Economists often develop models to help them to predict what might
happen in the real world. However, the assumptions underlying these
models are invariably based on value judgements.
✚ Similarly, the economic policies promoted by economists are likely
to be heavily influenced by their values and politics. For example, if a
government wanted to reduce its budget deficit, a left-wing economist
might favour wealth taxes or higher taxes on those with high incomes. In
contrast a right-wing economist might prefer cuts in welfare benefits to
the unemployed.
Now test yourself
3 Which of the following are positive statements and which are normative
statements?
a) Healthcare workers should be paid more.
b) The USA’s GDP fell by over 30% in the second quarter of 2020.
c) The use of robots will create unemployment in jobs that can be automated.
d) High energy prices are unfair on the poor.
e) Wealth inequality is greater than income inequality in the UK.
Answers available online
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The problem of scarcity
All societies face the problem that wants are infinite but resources are limited
in supply. This is the underlying reason for the fundamental economic
problem of scarcity. Therefore, choices must be made. The issue of scarcity
means that societies face a series of questions:
✚ What to produce and how much to produce? This relates to the different
types of goods the economy should produce and how much of each.
✚ How should the goods and services be produced? Production may be
labour intensive, i.e. a high proportion of labour used relative to capital, or
capital intensive, i.e. a high proportion of capital used relative to labour.
✚ How should the goods produced be allocated? This is concerned with the
distribution of the goods produced and affects the degree of equality in the
society.
Now test yourself
4 What is the basic economic problem?
Answers available online
Scarcity exists because
resources are finite whereas
wants are infinite.
Exam tip
To avoid confusion between
capital goods and consumer
goods, consider how they
are used: anything that is
an aid in the production of
other goods is classified as
a capital good. In contrast,
anything used by someone
for final consumption is
classified as a consumer
good.
1 The nature of economics
The economic problem
Resources
The resources of a country are referred to as ‘factors of production’. Four
factors of production may be identified:
✚ Land: includes all natural resources, raw materials, the fertility of the soil
and resources found in the sea.
✚ Labour: refers to those involved in the production of goods and services
and includes all human effort, both physical and mental.
✚ Capital: any man-made aid to production including factory buildings,
offices, machinery and IT equipment that is used to make other goods and
services.
✚ Enterprise: the entrepreneur performs two essential functions:
✚ bringing together the other factors of production so that goods and
services can be produced and
✚ taking the risks involved in production.
Factors of production
are resources and include
land, labour, capital and
enterprise.
Exam tip
When referring to capital
as a factor of production,
remember that it is
something used to make
other goods, and that it
does not refer to money.
Making links
Enterprise is considered more fully in Chapter 11 and labour is considered in
Chapter 15.
Now test yourself
5 Identify the factor of production in each of the following cases:
a) Copper deposits in Zambia
b) A woman who opens a hairdressing salon
c) Machinery used in car production
d) An engineer making computer games for a company
Answers available online
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1 The nature of economics
The distinction between renewable and
non-renewable resources
✚ Renewable resources are those that can be replaced naturally after use,
e.g. solar energy, wind power, wood and fish. Such resources are likely to
be sustainable unless they are consumed more quickly than they can be
replaced.
✚ Non-renewable resources are those where continued consumption will
eventually result in their exhaustion, e.g. oil, copper, platinum.
The importance of opportunity costs to
economic agents
Opportunity cost is linked to scarcity as explained below:
✚ Scarcity implies that choices must be made.
✚ Each choice involves an opportunity cost.
✚ This may be explained as follows: if a country’s resources are used to
manufacture one product, then it must forgo an alternative product that
could have been produced. The next best alternative forgone is called the
opportunity cost of what has been produced.
✚ Opportunity cost, therefore, is a real cost measured in terms of something
that is forgone.
Examples of opportunity cost in relation to different economic
agents include:
✚ For a consumer: a university student might have enough money to buy
either a jet ski or a surfboard. If the student decides to buy the jet ski then
the opportunity cost is the surfboard.
✚ For a firm: the firm might have to make a choice between its two priorities,
e.g. buying a new IT system or building a new factory. If it chooses the IT
system then the opportunity cost is the new factory.
✚ For the government: suppose the government has £10 million with which
to fund one of its two main priorities that both require a £10 million
investment — building a new school or building a new university. If it
decides that its first preference is the school while the second preference is
the university, then the opportunity cost of building the school is building
the university.
Now test yourself
6 A firm has £1 million that it could use to build a new factory or to buy five robots.
What is the opportunity cost if the firm decides to build the factory?
Answers available online
Renewable resources are
those whose stock levels can
be maintained at a certain
level.
Non-renewable resources
are those that will eventually
be completely depleted.
Opportunity cost is the
next best alternative that is
forgone when a choice is
made.
Making links
Opportunity cost is an
important concept that has
relevance throughout the
course so it is important for
exams to ensure that you
have a secure understanding
of the concept.
For example, this concept
is relevant in considering
economic growth using
production possibility
frontiers in Theme 1 (see
page 15), normal profit in
Theme 3 (see page 153)
and the law of comparative
advantage in Theme 4 (see
pages 188–190).
Exam tip
Opportunity cost must be
measured as a real cost,
in other words in terms
of goods forgone when a
choice is made, and not in
money terms.
Economic goods and free goods
Economic goods are created from resources that are limited in supply and so
are scarce. Consequently, they command a price.
Free goods are unlimited in supply, such as sunlight or sand on a beach.
Consumption by one person does not limit consumption by others. Therefore,
the opportunity cost of consuming a free good is zero.
Now test yourself
7 Why does the consumption of free goods not incur an opportunity cost?
Answers available online
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Consumer
goods
A production possibility frontier (PPF) shows combinations of two goods that
could be produced by an economy if all of its resources are employed fully and
efficiently (see Figure 1.1).
A
B
A production possibility
frontier illustrates the
maximum potential output
of an economy when
all resources are fully
employed.
X
C
O
Capital goods
1 The nature of economics
Production possibility frontiers
Figure 1.1 A production possibility frontier (PPF)
In constructing the PPF in Figure 1.1 it is assumed that the economy can
produce either consumer goods or capital goods.
✚ Capital goods are those required to produce other goods — both capital
and consumer goods, e.g. machinery, factory buildings.
✚ Consumer goods are those that give satisfaction (or utility) to consumers,
e.g. smartphones, curry and cars.
✚ By definition, any point on the PPF, e.g. A, B or C, implies that all resources
are fully and efficiently employed. Therefore, all points on the PPF indicate
the maximum productive potential of an economy and that resources are
being used efficiently.
✚ However, if the economy was operating inside its PPF, e.g. at point X, then
it would indicate that there are unemployed resources in the economy. For
example, some workers may be unemployed or machinery may be unused.
It could also imply that resources are not being allocated efficiently.
Now test yourself
8 Classify the following into capital and consumer goods:
a) A laptop used by a company director for his business
b) A curry eaten by Marie for her lunch
c) A visit to a spa by Kirsten
d) A car used to transport a manager between offices
Answers available online
Possible and unobtainable production
Any points inside or on the PPF represent combinations of the two products
that are obtainable. However, any points to the right of the PPF would be
currently unobtainable. They could only become obtainable if there was
economic growth.
PPFs and opportunity cost
✚ The PPF is drawn as a curve (concave to the origin) in Figure 1.1. This may be
analysed in terms of the concept of opportunity cost and marginal analysis.
✚ Marginal analysis involves consideration of the impact that small changes
have on the current situation.
✚ Therefore, a marginal increase in the output of capital goods means that
some consumer goods must be sacrificed (the opportunity cost).
✚ In Figure 1.2, when output of capital goods is increased from 0M to 0S, the
output of consumer goods is reduced from 0L to 0R.
Marginal analysis is
concerned with the impact of
additions to or subtractions
from the current situation.
The rational decision-maker
will only decide on an option
if the marginal benefit
exceeds the marginal cost.
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MS is LR consumer goods.
✚ Since the PPF has been drawn as a curve, it can be seen that as output of
capital goods is further increased, e.g. by SV, the opportunity cost rises, i.e.
by RT consumer goods. The main reason for this is that some resources
will be better suited to the production of consumer goods while others
are better suited to the production of capital goods. Therefore, when more
and more capital goods are produced, the opportunity cost in terms of
consumer goods increases.
Exam tip
If the PPF were a straight
line then the opportunity
cost would be constant.
Consumer
goods
1 The nature of economics
✚ Therefore, the opportunity cost of increasing the output of capital goods by
A
L
B
R
C
T
O
M
S
V Capital goods
Figure 1.2 Production possibility frontiers and opportunity cost
PPFs, economic growth and economic decline
Consumer goods
PPFs may be used to illustrate economic growth.
✚ Refer back to Figure 1.2. Suppose that the economy is currently operating
at point A on the PPF with 0L consumer goods and 0M capital goods being
produced.
✚ It is also assumed that the 0M capital goods produced are just sufficient to
replace worn-out machinery.
✚ If there is a reallocation of resources so that the production of capital goods
is increased to 0S, then only 0R consumer goods can now be produced.
✚ Therefore, the opportunity cost of producing MS more capital goods is LR
consumer goods.
✚ This reduction in the output of consumer goods implies a fall in current
living standards.
✚ However, in the long run, there will be economic growth because the
extra capital goods will cause an increase in the productive capacity of the
economy resulting in a rightward shift in the PPF, as shown in Figure 1.3.
Economic growth refers
to an increase in the
productive capacity of the
economy indicating an
increase in real output.
E
A
X
0
Capital goods
Figure 1.3 Production possibility frontiers and economic growth
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E then more of both capital goods and consumer goods could be
produced. In turn, this implies that living standards would increase
in the long run.
✚ In contrast, economic decline would be associated with an inward
shift in the PPF and might have occurred as a result of resources being
reallocated from the production of capital goods to the production of
consumer goods. For example, if the production of capital goods was
reduced below 0M then there would be insufficient production of
capital goods to cover depreciation, so reducing the productive
capacity of the economy. Other factors causing shifts in the PPF are
outlined below.
Economic decline
refers to a decrease in
the productive capacity of
the economy indicating a
decrease in real output.
Now test yourself
Consumer
goods
9 Study the diagram below and answer the questions that follow.
1 The nature of economics
✚ It can be seen that if the economy moved from point A to point
Y
A
R
B
S
Z
0
L
M
Capital goods
a) What does point Z represent?
b) What is the opportunity cost of increasing the output of consumer goods
by RS?
c) Would the opportunity cost of producing more and more consumer goods
increase or decrease?
10 How might economic growth be affected if a country produces more and more
consumer goods and fewer and fewer capital goods?
Answers available online
Movements along and shifts in a PPF
Movements along a PPF
✚ A change in the combination of the two goods being produced, e.g.
capital goods and consumer goods, would cause a movement along a
given PPF.
✚ Such a change might occur if the economy devoted more resources to
the production of capital goods and fewer to the production of consumer
goods. This would involve an opportunity cost (see pages 15–16).
Shifts in a PPF
A range of factors could cause a shift in the whole PPF. These are outlined in
the following two sections.
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1 The nature of economics
Factors causing an outward shift in the PPF
Factors that might cause an outward shift in the PPF include:
✚ discovery of new natural resources, e.g. rare minerals
✚ development of new methods of production that increase productivity
✚ advances in technology
✚ improvements in education and training that increase the productivity of
the workforce
✚ factors that lead to an increase in the size of the workforce, e.g.
immigration, an increase in the retirement age, better childcare enabling
more women to join the workforce.
Factors causing an inward shift in the PPF
Factors that might cause an inward shift in the PPF include:
✚ natural disasters, e.g. earthquakes or floods that cause a destruction of
productive capacity
✚ depletion of natural resources
✚ factors causing a reduction in the size of the workforce, e.g. emigration, an
increase in number of years spent in compulsory education
✚ a deep recession that results in a loss of productive capacity with factories
closing down permanently.
Making links
It can be seen from the above analysis that PPFs may be used in exams when
considering opportunity cost and will be of relevance for economic growth (see
Chapter 9) and for the law of comparative advantage (see Chapter 17).
Exam tip
Remember that the PPF
represents the possible
outputs of two goods
that could potentially be
produced. Points on the
PPF do not represent what
is actually produced unless
all resources are fully
employed.
Now test yourself
11 What will be the effect on a PPF of each of the following?
a) An improvement in education and training leading to an increase in labour
productivity
b) A prolonged drought in North Africa causing agricultural land to be turned into
desert
c) An increase in the amount of capital per worker
d) An increase in immigration of people aged between 16 and 65
Answers available online
Specialisation and the division
of labour
The meaning of the division of labour
Division of labour occurs when workers specialise on very specific tasks. For
example, the work is divided up into many smaller parts so that each worker
is responsible for a very small part of the product or service being provided.
Division of labour occurs
when the work is split up
into small, specialised tasks.
Adam Smith and the division of labour
✚ In The Wealth of Nations Adam Smith set out the view that economic growth
could be achieved by increasing the division of labour.
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✚ This involved the breaking down of a task into many small jobs with
1 The nature of economics
workers specialising on a particular task without the need to change jobs
during the day.
✚ Smith used the example of pin-making: one person doing all the tasks
could make 1 pin a day. However, if each of the skills that go into making
a pin were divided into 18 different operations with 18 different operators
who pass the pin along an assembly line then 12 pounds of pins per day
could be produced.
✚ This would save time and enable each worker to become an expert in one
specific task, so increasing their productivity.
Advantages and disadvantages of
specialisation and the division of labour in
organising production
Advantages
Disadvantages
Each worker specialises in tasks for which that worker is
best suited.
Monotony and boredom for workers: this could result in a
decrease in productivity.
The worker only has to be trained in one task. Therefore,
training costs for the firm are likely to be lower.
Loss of skills: workers trained in one particular task have only
limited skills. This could be a problem if they are made redundant.
Less time is wasted because a worker no longer has to
move from one task to another.
A strike by one group of workers could bring the entire
production facility to a standstill.
In manufacturing, such an approach enables production
line methods to be employed and allows an increased
use of machinery. In turn, this helps to increase
productivity and to reduce average costs of production.
There is a lack of variety because all goods produced on a
production line are identical.
Now test yourself
Exam tip
12 How might a firm benefit from the division of labour?
Note that the division of
labour enables training
costs to be reduced
because the worker only
has to be trained in one
particular task.
Answers available online
Making links
For the exam you should be able to understand the significance of the division
of labour for productivity (see Chapter 7), the labour market (see Chapter 15) and
economic development (see Chapter 19).
Advantages and disadvantages of
specialising in the production of goods and
services to trade
Advantages
Making links
If a country specialises in the production of certain goods and services and
then trades these in exchange for goods and services that it does not produce,
then it can benefit from increased output, greater choice and lower prices.
Disadvantages
Such specialisation might mean that a country becomes over-dependent on
imported goods and services. If its goods and services are uncompetitive
then unemployment could result, and the country’s value of imports may
persistently exceed the value of its exports.
You will study more
about specialisation and
trade in Chapter 17 when
you consider the law of
comparative advantage,
which provides the basis
for free trade. In exams
you would need to use
comparative advantage when
considering specialisation.
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1 The nature of economics
Limits to the division of labour
Certain factors limit the extent to which the division of labour can be applied:
✚ The size of the market: if there is only a small market then it is more
difficult to specialise.
✚ The type of product: for example, designer fashion products are likely to be
unique and not suitable for the division of labour.
✚ Transport costs: if these are high then large-scale production and the
division of labour may not be possible.
Now test yourself
13 What might limit the division of labour in a firm making individual jewellery?
Answers available online
The functions of money
Money performs various functions, which help to facilitate specialisation and
the division of labour. The key functions are:
✚ As a medium of exchange enabling people to specialise, exchanging the
money earned from doing a specialist job for the goods and services they
wish to buy.
✚ A store of value enabling people to save in order to buy goods in the future.
✚ A measure of value enabling people to assess the value of different goods
and services by comparing prices.
✚ A means of deferred payments enabling people to buy goods and pay for
them on credit.
Now test yourself
Money refers to anything
that is used as a means of
exchange for goods and
services.
Making links
In exams you need to
be able to explain the
importance of money for
specialisation.
14 Explain the importance of money as a medium of exchange.
Answers available online
Free market economies,
mixed economy and
command economy
Economies may take different approaches to the economic problem of scarcity
and of answering the questions of what to produce, how to produce, and how
the goods produced should be allocated, as described below.
Free market economies
The free market economy is one in which the above questions are determined
by market forces. The main characteristics of such economies are as follows:
✚ There is private ownership of resources.
✚ Market forces, i.e. supply and demand, determine prices.
✚ Producers aim to maximise profits.
✚ Consumers aim to maximise utility (satisfaction).
✚ Resources are allocated by the price mechanism.
A free market economy
refers to an economic
system in which prices
are determined by supply
and demand with no
government intervention.
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Adam Smith
✚ In his book The Wealth of Nations, written in 1776, Adam Smith suggested
1 The nature of economics
that when individuals follow their own self-interest, they indirectly
promote the good of society.
✚ Consequently, the free market economy would result in an ordered market
with producers responding to changes in consumer wants in such a way
that there was little waste.
✚ Smith believed that the role of the government should be limited to
providing defence, justice and some ‘public goods’ such as roads.
Friedrich Hayek
✚ In the twentieth century Friedrich Hayek offered a strong defence of the
free market along with support for private property.
✚ Further, he argued in his book The Road to Serfdom that attempts by
governments to determine the answers to the questions of what to
produce, how to produce and for whom were doomed to failure.
✚ State planning would involve restrictions on freedom and the use of force.
Now test yourself
15 Identify four characteristics of a free market economy.
Answers available online
Command economy
The command or centrally planned economy is one in which the above
questions are determined by the state. The main characteristics of such
economies are as follows:
✚ There is public (state) ownership of resources.
✚ The state determines price.
✚ Producers aim to meet production targets set by the state.
✚ The state allocates resources.
✚ There is greater equality of income and wealth than in a free market
economy.
A command economy
or centrally planned
economy is one in which
resources are allocated by
the state.
Karl Marx
✚ Writing in the nineteenth century, Karl Marx thought that capitalism was
inherently unstable because workers are exploited by the bourgeoisie (the
owners of the factors of production).
✚ Ultimately, there would be a proletariat revolution in which communism
would result.
Mixed economy
The mixed economy is a mixture of the free market economy and the
command economy.
✚ In practice, there are no absolutely free market or command economies:
most are mixed economies.
✚ In mixed economies, some resources are allocated by the price mechanism
while others are allocated by the state. What differs between countries is
the degree of that mix.
A mixed economy is
a combination of a free
market economy and a
command economy.
Now test yourself
Remember that in a pure
free market economy
there is no government
intervention.
16 What is the main characteristic of a command economy?
Answers available online
Exam tip
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1 The nature of economics
Advantages and disadvantages of free
market economies
Advantages
Disadvantages
Consumer sovereignty: this implies that consumer spending Inequality: those who own resources are likely to become
decisions determine what is produced.
richer than those who do not own resources.
Flexibility: the free market system can respond quickly to
changes in consumer wants.
Trade cycles: free market economies may suffer from
instability in the form of booms and slumps.
No bureaucracy: officials are not needed to allocate
resources.
Imperfect information: consumers may be unable to make
rational choices if they have inadequate information or if
there is asymmetric information (see Chapter 3, page 55).
Efficiency: competition and the profit motive help to
promote an efficient allocation of resources.
Monopolies: there is a danger that a firm may become the
sole supplier of a product and then exploit consumers by
charging prices higher than the free market equilibrium.
Increased choice: consumers have a wide choice of goods
and services compared with a command economy.
Externalities: these are costs and benefits to third parties
that are not taken into account when goods are produced
and consumed.
Economic and political freedom: consumers and producers
have the right to own resources.
Now test yourself
Exam tip
17 What is meant by ‘consumer sovereignty’?
When thinking about
the advantages and
disadvantages of a free
market economy, consider
the impact on individuals,
businesses and the whole
economy.
18 Why does inequality occur in a free market economy?
Answers available online
Advantages and disadvantages of
command economies
Advantages
Disadvantages
Greater equality: the state can ensure that everyone can
enjoy a minimum standard of living and that no one is
extremely rich.
Inefficiency: the absence of the profit motive and
competition may result in an inefficient allocation of
resources.
Macroeconomic stability: the state can ensure that booms
and slumps are smoothed out.
Lack of incentives to take risks: again, the absence of the
profit motive may reduce incentives for investment.
External benefits and external costs: these may be taken
into account when planning production.
Restrictions on freedom of choice: people would be
directed into the jobs the state deems necessary.
No exploitation: privately owned monopolies are unable to
exploit workers and consumers.
Shortages and surpluses: if the state miscalculates supply
and demand then there may be excess demand and/or
excess supply of goods and services.
Full employment: the state can ensure that all workers are
employed.
Bureaucracy: a vast army of officials is needed to allocate
resources.
Resources may be allocated by the state to maximise social
welfare.
No consumer sovereignty: decisions by the state rather
than consumers determine what is produced.
Inflexibility: the state may be slow to react to changes in
consumer needs.
Now test yourself
19 Why might there be inefficiency in a command economy?
Answers available online
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The role of the state in a mixed economy
The state performs a variety of roles, many of which depend on the
political priorities of the ruling party. However, in most economies the
state has a number of key roles, which include the following to a
greater or lesser degree:
✚ Defence and internal security
✚ Provision of public goods
✚ Provision of public services such as education and health
✚ Redistribution from the rich to the poor
In Chapter 3, you will be studying
market failure. In exams you may
use the different reasons for
market failure as the basis for a
mixed economy, i.e. reasons for
government intervention in an
economy.
Summary
You should have an understanding of:
✚ what economics is
✚ the four key factors of production: land, labour, capital
and enterprise
✚ the meaning of scarcity and the need to make choices
✚ the difference between consumer goods and services,
and capital goods and services
✚ the difference between labour intensive production
and capital intensive production
✚ opportunity cost and its significance for individuals,
firms and the government
✚ the distinction between free goods and economic
goods
1 The nature of economics
Making links
✚ positive and normative economic statements
✚ production possibility frontiers including the ability to
draw them accurately
✚ the use of PPFs to illustrate opportunity cost and
economic growth
✚ factors that cause an inward or outward shift in the PPF
✚ the meaning of specialisation and the division of labour
✚ advantages and disadvantages of the division of labour
✚ free market, command and mixed economies.
Exam skills
Having started the course you are beginning to develop
some of the skills necessary to achieve highly in
economics. These include:
✚ Precision: it is really important to be able to define
terms accurately and precisely, e.g. positive and
normative economic statements, opportunity cost.
✚ Thinking skills: the ability to see both sides of an
issue, e.g. the benefits and problems associated with
the division of labour, or the importance of questioning
assumptions behind models, e.g. the assumptions
underlying the production possibility frontier analysis.
✚ Building blocks: the material covered in this section
forms the basis of your study of economics so it is
important to have a clear understanding of concepts
such as ‘ceteris paribus’, opportunity cost, resources,
mixed economies, etc.
Exam practice
1 During the years 2010 and 2019 economists disagreed
about whether to continue with austerity measures.
a) Statement 1: ‘Austerity measures have resulted in
a reduction in government borrowing.’
Statement 2: ‘Austerity measures should be
abandoned because they harm the poorest people
in society.’
Which of the following best describes the two
statements above?
A Both statements are positive.
B Statement 1 is positive and Statement 2 is
normative.
C Both statements are normative.
D Statement 1 is normative and Statement 2
is positive.
[1]
b) Explain one reason why economists might
disagree about an economic policy.
[2]
c) Why do economists use models in their analysis? [2]
2 In the airline industry there is a very high degree of
division of labour.
a) Which one of the following is most likely to result from
an increase in specialisation and the division of labour?
A Reduction in the amount of machinery used
in production
B Increase in the cost of training an individual
worker
C Reduction in total output
D Increase in output per worker
[1]
b) Explain two advantages of the division of
labour to an airline.
[4]
3 North Korea is an example of a state that makes
fundamental decisions about how its economy is
organised.
a) Explain two possible problems faced by a
command economy.
[4]
b) Which one of the following is a function of
the price mechanism in a free market economy?
A To stabilise prices
B To enable the government to set prices
C To ration scarce goods
D To reduce consumers’ surplus
[1]
Answers and quick quizzes online
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2 How markets work
Rational decision-making
The standard neoclassical analysis makes two very significant assumptions
about the ways in which consumers and firms behave:
✚ Consumers act rationally by aiming to maximise their utility (satisfaction).
✚ Firms also act rationally by aiming to maximise profits.
These assumptions provide a powerful tool for analysis and this chapter
explores how this can be applied in theory and in real-world examples.
However, some economists have criticised the validity of these assumptions
which has led to the development of a new branch of economics called
‘behavioural economics’. This is considered at the end of this chapter.
Utility refers to the
level of satisfaction a
consumer receives from the
consumption of a product
or service.
Making links
In exams you should recognise the assumption of rationality when explaining, for
example, price changes in a free market (see pages 39–40) and market structures (see
Chapter 14).
To secure marks for evaluation, you may then suggest that the outcome may be
different if the assumption of rational behaviour is removed.
Demand
Demand refers to the amount demanded by consumers at given prices over
a certain period of time. It is important to include a reference to prices and to
the time period in a definition of demand.
Demand is not the same as ‘want’ — ‘wanting’ a product that one cannot
afford is not demand. Demand must include the ability to pay for the product
or service.
Demand is how much is
demanded at each price
over a certain period of
time.
Shape of the demand curve
Price per unit ($)
Figure 2.1 shows that the demand curve is downward sloping from left to
right, indicating that more will be demanded as price falls.
P1
B
Contraction in demand
A
Pe
0
Q1
Qe
Avoid confusing ‘want’ with
‘demand’. ‘Wants’ simply
refer to desires, and desires
may be unaffordable,
whereas ‘demand’ is backed
by money.
Extension
of demand
C
P2
Exam tip
Demand
curve
Q2
Quantity demanded
per week (kilos)
Figure 2.1 Movements along a demand curve
24
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The demand curve demonstrates how a fall in price will cause an increase in
the quantity demanded (or an extension in demand) and a rise in price will
cause a decrease in quantity demanded (or contraction in demand).
2 How markets work
This is based on:
✚ The substitution effect: when there is a rise in price, the consumer (whose
income has remained the same) tends to buy more of a relatively lowerpriced good and less of a higher-priced one.
✚ The income effect: when there is a rise in price, consumers will suffer a
fall in their real incomes, i.e. the purchasing power of their money incomes
falls. With normal goods, the fall in real incomes will lead to a fall in the
quantity demanded.
Movements along the demand curve
✚ It may be seen from Figure 2.1 that movements along a demand curve
would be caused by price changes.
✚ Given that the demand curve has a negative slope, a rise in price would
cause a fall in quantity demanded and a fall in price would cause a rise in
quantity demanded.
Now test yourself
1 When defining demand, what must it be related to?
2 If there is an increase in price, what movement would there be along a demand
curve?
Answers available online
Shifts in the demand curve
Various factors can cause a shift in the whole demand curve. These include
changes in:
✚ Real incomes: an increase in real incomes implies that incomes (after
discounting the effects of inflation) have increased. This would result in an
increase in demand for most goods and services, causing a rightward shift
in the demand curve.
✚ Size or age distribution of the population: an increase in the size of the
population causes an increase in demand for most goods and services.
✚ Tastes, fashions or preferences: for example, a decrease in the popularity
of cabbage will cause a leftward shift in its demand curve.
✚ Prices of substitutes or complements: if there is a change in the price of a
related good, it will affect the demand curve for the product. For example,
if the price of beef rises, the demand for a substitute such as lamb will
increase. In contrast, if there is a rise in the price of petrol (a complement
to cars), the demand curve for cars would shift to the left.
✚ The amount of advertising or promotion: a successful advertising
campaign would cause an increase in demand.
✚ Interest rates: affect the cost of borrowing money. For example, a rise in
interest rates increases the cost of borrowing money for mortgages, so
causing a decrease in demand for houses.
Exam tip
It is only when there is a
change in the conditions
of demand that the whole
demand curve shifts. Price
changes cause a movement
along an existing demand
curve.
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Price per
unit ($)
2 How markets work
Figure 2.2 illustrates how an increase in demand would cause the whole
demand curve to shift to the right, whereas a decrease in demand would
cause the whole demand curve to shift to the left.
Increase in demand
Decrease in
demand
D3
0
D1
D2
Quantity demanded
per week (kilos)
Figure 2.2 Shifts in the demand curve
Now test yourself
3 What would be the effect of the following on the demand for houses in the UK?
a) An increase in immigration into the UK
b) A decrease in real incomes
c) An increase in the price of rented accommodation
d) A rise in mortgage interest rates
Answers available online
The concept of diminishing marginal utility
and its influence on the demand curve
This principle is based on the idea that consumers gain satisfaction or utility
from the goods they consume.
✚ Total utility represents the total satisfaction gained from the total amount
of a product consumed.
✚ Marginal utility represents the change in utility from consuming an
additional unit of the product.
✚ The law of diminishing marginal utility states that as a person consumes
more and more of a product, the marginal utility (extra satisfaction or
benefit) falls. Consequently, people are prepared to pay less as their
consumption increases with the result that there will be an inverse
relationship between the price and quantity demanded.
Example
Utility of consuming apples
The table below is a worked example showing the utility gained from consuming apples.
Number of apples
Total utility
0
0
1
20
2
34
3
44
4
50
5
52
Marginal utility
Total utility is the amount
of satisfaction a person
derives from the total amount
of a product consumed.
Marginal utility is the
change in total utility from
consuming a unit of a
product.
The law of diminishing
marginal utility states
that as consumption of a
product is increased, the
consumer’s utility increases,
but at a decreasing or
diminishing rate.
20
14
10
6
2
✚ The table shows that as a person consumes more and more apples to satisfy their
26
hunger, total utility increases but the marginal utility gained from consuming each
extra apple decreases.
✚ If monetary values were assigned to marginal utility then it is clear that a rational
consumer would be prepared to pay less for each additional apple. This principle
provides the basis for the quantity demanded increasing as price falls.
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4 Suppose someone has six ice creams. What happens to marginal utility as each
extra ice cream is consumed?
Answers available online
Price elasticity of demand
Price elasticity of demand (PED) is a measure of the responsiveness of
quantity demanded of a product to a change in its price.
Making links
In exams, price elasticity of demand and price elasticity of supply (see pages 37–39)
may need to be considered together, for example, when considering the impact of
a tax or subsidy (see pages 43–45) or when considering consumers’ surplus and
producers’ surplus (see Pages 42–43).
Price elasticity of
demand measures the
sensitivity of the quantity
demanded of a product to a
change in its own price.
2 How markets work
Now test yourself
Measuring price elasticity of demand
PED =
percentage change in quantity demanded
percentage change in price
Exam tip
To calculate a percentage change in, say, quantity demanded, it is necessary to divide
the change in quantity demanded by the original quantity demanded and multiply the
result by 100.
Calculations of PED and interpretation of
results
PED will always have a negative value because price and quantity move in
opposite directions (since the demand curve is downward sloping).
Example
Price inelastic demand
Suppose a 100% increase in the price of oil led to a 20% fall in quantity demanded,
then PED would be:
–20
100
= –0.2
Exam tip
Demand is said to be price inelastic (or relatively price inelastic) because a change in
price has led to a smaller percentage change in quantity demanded.
When demand is price inelastic, the value of PED will be between 0 and –1.
When required to calculate
PED in the exam, remember
to include the negative sign.
Now test yourself
5 Calculate the PED if a 20% fall in the price of petrol leads to a 2% increase in the
quantity demanded.
6 Is demand price elastic if a 20% increase in price results in a 10% fall in quantity
demanded?
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2 How markets work
Exam tip
When considering whether demand is price elastic or price inelastic, compare
the percentage changes in price and quantity. If the percentage change in
quantity demanded is larger than the percentage price change, then demand
is price elastic.
Example
Price elastic demand
Suppose a 5% decrease in the price of a package holiday to Florida led to a 20%
increase in quantity demanded, then PED would be:
+20
= –4.0
–5
Demand is said to be price elastic (or relatively price elastic) because a change in price
has led to a larger percentage change in quantity demanded.
When demand is price elastic, the value of PED will be less than –1.
Figure 2.3 illustrates an inelastic and an elastic segment of a demand curve.
(b) Elastic segment of a demand curve
Price ($)
Price ($)
(a) Inelastic segment of a demand curve
1000
Demand
900
200
100
Demand
0
0
100 120
1000
Quantity sold per week
2000
Quantity sold per week
Figure 2.3 An inelastic and an elastic segment of a demand curve
Examples
Unit elastic demand
Suppose a 15% decrease in the price of a digital camera
led to a 15% increase in quantity demanded, then PED
would be:
Demand is said to be perfectly price inelastic because a
change in price has had no effect on quantity demanded.
+15
= –1.0
–15
When demand is perfectly price inelastic, the value of
PED will be 0 and the demand curve will be vertical (see
Figure 2.4).
Demand is said to be unit elastic because a change in
price has led to the same percentage change in quantity
demanded.
When demand is unit elastic, the value of PED will be
equal to –1 and the demand curve will be a rectangular
hyperbola (see Figure 2.4).
Perfectly inelastic demand
28
0
= 0.0
10
Suppose a 10% increase in the price of salt led to no
change in the quantity demanded, then PED would be:
Perfectly elastic demand
Suppose a small increase in the price of a product causes
the quantity demanded to fall to zero, then demand is said
to be perfectly elastic.
When demand is perfectly elastic, the value of PED will
be infinity and the demand curve will be horizontal (see
Figure 2.4).
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Price per unit
2 How markets work
Perfectly inelastic
demand (PED = 0)
8
Perfectly elastic
demand (PED = − )
0
Unitary
elasticity
of demand
(PED = −1)
Quantity demanded per week
Figure 2.4 Demand curves showing unitary elasticity of demand, perfectly inelastic
demand and perfectly elastic demand
Making links
Although perfectly elastic demand is unlikely, this concept is used in considering the
model of perfect competition (see pages 158–160) and will be required in exams.
Exam tip
Think of perfectly inelastic
demand as a set amount
demanded whatever the
price. The demand curve
must therefore be vertical.
Now test yourself
7 Calculate price elasticity of demand in the following examples and comment on
your results:
a) A rise in the price of electricity from 25 pence to 30 pence per unit causes the
quantity demanded to fall from 10 000 kilos to 9000 kilos.
b) A rise in the price of gold watches from $1000 to $1100 causes demand to fall
from 200 to 170 per week.
c) A 6% reduction in the price of tomatoes causes a 6% increase in quantity
demanded.
Answers available online
Factors influencing price elasticity
of demand
Factors that influence the PED include:
✚ Availability of substitutes: if substitutes are available there will be a strong
incentive to shift consumption to them when the price of the product
rises. The existence of substitutes therefore tends to make demand for the
product elastic.
✚ Proportion of income spent on a product: if only a small percentage
of income is spent on a product such as salt then demand tends to be
inelastic, whereas if a high percentage of income is spent on the product
then demand tends to be elastic, e.g. exotic holidays and works of art by
famous artists.
✚ Nature of the product: if the product is addictive, e.g. alcohol and tobacco,
then demand tends to be inelastic.
✚ Durability of the product: if the product is long-lasting and hard-wearing,
e.g. furniture and cars, then demand is fairly elastic since it is possible to
postpone purchases. However, demand for non-durable goods, e.g. milk
and petrol, tends to be inelastic because these must be replaced regularly.
✚ Length of time under consideration: it usually takes time for consumers to
adjust their expenditure patterns following a price change. For example, it
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2 How markets work
takes time for motorists to switch from fuel-greedy to more fuel-efficient
cars. Consequently, demand is usually more price elastic in the long run
than in the short run.
✚ Breadth of definition of a product: if a product is broadly defined, e.g. fruit,
demand is likely to be price inelastic. However, demand for particular
types of fruit, e.g. apples, is likely to be more price elastic.
Making links
In exams you should be able to apply the factors influencing PED to those influencing
the elasticity of demand for labour (see page 178).
Exam tip
When considering PED
always refer to the demand
for product X as being
elastic or inelastic. It is
imprecise to describe a
product as being elastic or
inelastic.
Now test yourself
8 If there are many substitutes for a brand of batteries, is demand likely to be price
elastic or price inelastic?
Answers available online
The relationship between price elasticity of
demand and total revenue
There are key relationships between PED and total revenue (TR):
✚ When demand is inelastic, a price change causes total revenue to change
in the same direction.
✚ When demand is elastic, a price change causes total revenue to change in
the opposite direction.
Total revenue is the value
of goods sold by a firm and
is calculated by multiplying
price by quantity sold.
✚ When demand is unit elastic, a price change causes total revenue to
remain unchanged.
✚ When demand is perfectly inelastic, a price change causes total revenue to
change in the same direction by the same proportion.
✚ When demand is perfectly elastic, a price rise causes total revenue to fall
to zero.
Making links
This analysis is very significant, not only for explaining the relationship between TR
and PED, but also their relationship with marginal revenue (see pages 143–144).
Exam tip
Note that if TR remains
constant following a
price change, there must
have been an exactly
proportionate change
in quantity demanded.
Therefore, demand would
be unitary elastic.
Now test yourself
9 What can be inferred about PED in each of the following examples?
a) An increase in the price of petrol results in an increase in total revenue of oil
companies.
b) A rise in the price of gold jewellery leads to a fall in the total revenue of shops
selling this type of jewellery.
c) An increase in the price of iPads has no effect on total revenue.
Answers available online
Significance of PED
For firms
✚ If firms know that demand for their product is price inelastic then they can
increase TR by increasing price.
✚ However, if firms know that demand is price elastic, then they can
30
increase TR by reducing price. For example, if there are a lot of restaurants
in a high street then one of these might have special offers on certain days,
knowing that this will increase their revenue.
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For consumers
✚ If demand is price inelastic then firms may raise prices (to increase their
2 How markets work
total revenue) but this would reduce the real incomes of consumers.
For the government
✚ If the government wishes to maximise its tax revenue then it will place
indirect taxes on those products whose demand is price inelastic, e.g.
goods such as alcohol, petrol and tobacco. However, in this case the
consumer bears most of the tax burden.
✚ The government may also tax products and services whose demand is
price elastic, so that producers bear a higher proportion of the tax burden.
However, this could make the business unprofitable.
Making links
Elasticity of demand is a concept that is relevant in both microeconomics and
macroeconomics. For example, in macroeconomics it is relevant when considering
changes in the aggregate supply curve on real output and the price level (see page
100). With regard to exchange rates it is significant when considering the impact of a
change in the exchange rate on the current account of the balance of payments.
Now test yourself
10 Would an increase in tax on sugary drinks increase total tax revenue if demand
was inelastic?
Answers available online
Cross elasticity of demand
The meaning of cross elasticity of demand
Cross elasticity of demand (XED) is a measure of the responsiveness of
quantity demanded of one product (Y) to a change in the price of another
product (X).
Measuring cross elasticity of demand
XED =
percentage change in quantity demanded of product Y
percentage change in price of product X
Interpreting results
For XED, the sign is very significant.
✚ A positive sign indicates that the products are substitutes, e.g. a rise in the
price of one product will cause an increase in demand for another product.
✚ A negative sign indicates that the products are complements, e.g. a rise in the
price of one product will cause a decrease in demand for another product.
Cross elasticity of
demand is the sensitivity
of demand for one product
to a change in the price of
another product.
Significance of cross elasticity of demand
to firms
✚ A knowledge of XED is helpful to firms in setting prices for their products.
For example, if the firm is selling a product with a close substitute then
it will expect demand for its product to fall considerably if it decides to
increase its price.
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✚ Firms also know that complementary goods can command high prices. For
2 How markets work
example, printers are often relatively cheap but the ink cartridges required
for them are relatively expensive.
Now test yourself
11 Would the XED between liquid soap and soap bars be positive or negative?
Exam tip
If the XED is close to zero
then it implies that the
products are not closely
related.
Answers available online
Income elasticity of demand
Income elasticity of demand (YED) is a measure of the responsiveness of
quantity demanded of a product to a change in real income.
Measuring income elasticity of demand
YED =
percentage change in quantity demanded
percentage change in real income
Interpreting results
For YED, the sign is very significant.
✚ A positive sign indicates that the product is a normal good, i.e. a rise (fall)
in real income will cause an increase (decrease) in demand.
✚ A negative sign indicates that the product is an inferior good, e.g. a rise in
real income leads to a fall in demand for the product.
Examples
Income elastic demand
If a 5% increase in real income leads to a
25% increase in demand then:
25
YED =
= +5
5
Demand is income elastic because the
change in real income has led to a more
than proportionate change in demand.
Whenever YED is greater than +1, demand
is income elastic.
Income inelastic demand
If a 10% increase in income causes a 3%
increase in demand then:
3
YED =
= +0.3
10
Demand is income inelastic because the
change in real income has led to a less
than proportionate change in demand.
Whenever YED is between 0 and +1,
demand is income inelastic.
Income elasticity of
demand is the sensitivity
of demand for a product
to a change in real income.
Note: real income discounts
the effects of inflation.
Exam tip
When interpreting YED
remember that if the result
is positive then the good is
a normal good, but if the
result is negative then the
good is an inferior good.
Inferior goods
As discussed above, a negative sign
indicates that the product is an inferior
good, e.g. a rise in real income leads to a
fall in demand for the product.
If a 6% increase in real income resulted in
a 3% fall in demand then YED would be
negative:
YED =
−3
= −0.5
6
As the name suggests, inferior goods
are those for which consumption
declines as real incomes increase
because consumers can now afford
better, higher-quality alternatives.
Now test yourself
Exam tip
12 For each of the following, calculate the income elasticity of demand and comment
on your answer:
a) A 3% decrease in real incomes causes a 9% fall in the demand for new cars.
b) A 5% increase in real incomes causes a 2% fall in demand for soya.
c) A 10% increase in real incomes causes a 2% increase in the demand for oranges.
It is not helpful to use
the idea of luxuries and
necessities as a factor
influencing income elasticity
of demand because
what is a necessity or a
luxury changes over time.
This distinction is far too
imprecise to have any value.
Answers available online
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The relationship between demand and income may be illustrated
diagrammatically. For a normal good there is a positive relationship between
income and demand but for an inferior good the relationship is negative, as
shown in Figure 2.5.
D
(b) Inferior good
Income
Income
(a) Normal good
2 How markets work
The relationship between income and demand
D
0
Quantity demanded of product X
0
Quantity demanded of product Y
Figure 2.5 The relationship between demand and income
Significance of YED
For firms
✚ If firms know that demand for their product is income elastic then
they know that demand and total revenue will increase significantly
during periods of rapid economic growth but fall significantly during
recessions.
✚ Consequently, knowledge of income elasticity of demand may be
important for firms when making investment decisions.
For the government
✚ If the government wishes to maximise its tax revenue during an economic
boom it will place indirect taxes on those products whose demand is
income elastic.
✚ Knowledge of income elasticity of demand might also help the government
in estimating tax revenues from indirect taxes on particular goods and
services.
Now test yourself
13 Why is the government’s tax revenue likely to fluctuate more for electric cars than
for petrol?
Answers available online
Making links
Income elasticity of demand is relevant when considering, for example, tourism as a
strategy for development (see Chapter 19, pages 223–234), and changes in the pattern
of global trade (see Chapter 17, page 191).
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Supply refers to the amount supplied by producers at given prices over a
certain period of time. As with demand, it is important to include a reference
to prices and to the time period in the definition.
Supply refers to how much
is supplied at each price over
a certain period of time.
Shape of the supply curve
Figure 2.6 shows that the supply curve is upward sloping from left to right,
indicating that more will be supplied as price increases.
Price per unit ($)
2 How markets work
Supply
P2
Supply
curve
P1
Extension in supply
Contraction in supply
P3
0
Q3
Q1
Q2
Quantity supplied per week (kilos)
Figure 2.6 Movements along a supply curve
✚ When the price rises it becomes more profitable for producers to supply a
product and so they have an incentive to increase production.
✚ In contrast, when there is a fall in price it becomes less profitable to supply
a product and so firms will reduce output and/or exit the market.
Therefore:
✚ A rise in price causes an increase in the quantity supplied (or an extension
in supply).
✚ A fall in price causes a decrease in quantity supplied (or contraction in supply).
Movements along the supply curve
It may be seen from Figure 2.6 that movements along a supply curve are
caused by price changes. Given that the supply curve has a positive slope,
then a rise in price will cause a rise in quantity supplied and a fall in price will
cause a fall in quantity supplied.
Now test yourself
14 If there was a rise in price would there be an extension or contraction of supply?
Answers available online
Shifts in the supply curve
Various factors will cause a shift in the whole supply curve. These include
changes in:
✚ Costs of production. These include wages, raw materials, energy and
rent. An increase in costs of production, such as electricity prices, will
cause the whole supply curve to shift to the left.
✚ Productivity of the workforce. Labour productivity refers to the output per
worker per hour worked. If there is a rise in productivity then the whole
supply curve will shift to the right.
34
Exam tip
It is only when there is a
change in the conditions
of supply that the whole
supply curve shifts. Price
changes cause a movement
along an existing supply
curve.
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✚ Indirect taxes. An indirect tax raises the cost of supply and so causes the
2 How markets work
supply curve to shift to the left. A rise in VAT will cause the supply curve
to become steeper because it is a percentage of the price of a product,
whereas a rise in a specific tax, e.g. 20p per unit, will cause a parallel
leftward shift in the supply curve.
✚ Subsidies. These are grants to producers from the government that
effectively lead to a reduction in costs of production so causing a rightward
shift in the supply curve.
✚ Technology. New inventions and new technology usually result in an
increase in productivity so causing the supply curve to shift to the right.
✚ Discoveries of new reserves of a raw material. If, for example, a country
discovers new oil reserves, the supply curve will shift to the right.
Price per unit ($)
Figure 2.7 illustrates that an increase in supply causes the whole supply curve
to shift to the right, whereas a decrease in supply causes the whole supply
curve to shift to the left.
S3
S1
Decrease in supply
S2
Increase in supply
0
Quanity supplied per week (kilos)
Figure 2.7 Shifts of a supply curve
Exam tip
Remember that an increase in supply will cause the supply curve to shift to the right.
Now test yourself
15 What would be the effect of the following on the supply of coffee?
a) An increase in wages of coffee plantation workers
b) A decrease in costs of transporting coffee beans to coffee manufacturers
c) A drought in coffee-growing regions
Answers available online
Price elasticity of supply
Price elasticity of supply (PES) is a measure of the responsiveness of quantity
supplied for a product to a change in its price.
Measuring price elasticity of supply
PES =
percentage change in quantity supplied
Price elasticity of supply
is the sensitivity of supply
of a product to a change in
its price.
percentage change in price
Interpreting results
PES always has a positive value because price and quantity move in the same
direction (since the supply curve is upward sloping).
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2 How markets work
Price inelastic supply
Suppose a 10% increase in the price of wheat led to a 5%
increase in quantity supplied, then PES would be:
5
= 0.5
10
✚ Supply is said to be price inelastic (or relatively price
Price per unit (£)
Example
Inelastic supply
Elastic
supply
inelastic) because a change in price has led to a smaller
percentage change in quantity supplied.
✚ When supply is price inelastic, the value of PES will be
between 0 and 1 (see Figure 2.8).
Price elastic supply
Suppose a 2% decrease in the price of a PC led to a 12%
decrease in quantity supplied, then PES would be:
–12
= 6.0
–2
✚ Supply is said to be price elastic (or relatively price
elastic) because a change in price has led to a larger
percentage change in quantity supplied.
0
Quantity supplied per week (kilos)
Figure 2.8 Inelastic and elastic supply
✚ When supply is price elastic, the value of PES will be
greater than 1 (see Figure 2.8).
Now test yourself
16 The price of face masks rose by 20% in April 2020 but the quantity supplied only
increased by 4%. Calculate the price elasticity of supply and comment on the result.
Answers available online
Making links
In exams you may be asked to calculate PES. There is a clear link with PED because the
formula is very similar, with the percentage change in quantity as the numerator (on the top
of the equation) and the percentage change in price as the denominator.
Example
Unit elasticity of supply
Suppose a 7% increase in the price of bread led to a 7% increase in quantity supplied,
then PES would be:
7
= 1.0
7
✚ Supply is said to be unit elastic because a change in price has led to the same
percentage change in quantity supplied.
✚ When supply is unit elastic, the value of PES is equal to 1 and the supply curve is a
Price per unit (£)
straight line drawn through the origin, as shown in Figure 2.9.
S1
S2
S3
0
36
Quantity supplied per week (kilos)
Figure 2.9 Unitary elasticity of supply
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Perfectly inelastic and perfectly elastic supply
Suppose a 10% increase in the price of a product led to no change in the quantity
supplied, then PES would be:
2 How markets work
0
= 0.0
10
✚ Supply is said to be perfectly price inelastic because a change in price has had no
effect on quantity supplied.
✚ When supply is perfectly price inelastic, the value of PES is 0 and the supply curve
is vertical (see Figure 2.10).
✚ On the other hand, if an infinite amount could be supplied at a certain price, supply
Price per unit (£)
is said to be perfectly elastic. When supply is perfectly elastic, the value of PES is
infinity and the supply curve is horizontal (see Figure 2.10).
Perfectly inelastic
supply (PES = 0)
8
Perfectly elastic
supply (PES = )
0
Quantity supplied per week (kilos)
Figure 2.10 Perfectly elastic and perfectly inelastic supply
Now test yourself
Exam tip
17 There are 2295 seats for a performance at the London Palladium. How would you
describe the elasticity of supply?
A simple rule that applies to
all elasticity calculations is
that quantity is always the
numerator, i.e. the top part
of the formula.
Answers available online
Factors influencing the price elasticity
of supply
Factors that influence the price elasticity of supply include:
✚ Time: elasticity of supply is very likely to vary over time. In economics,
the short run is defined as that period of time in which at least one factor
of production is fixed, whereas the long run is the period of time in which
all factors of production are variable. Consequently, it is often difficult to
change supply quickly in response to a price change, making supply very
inelastic in the short run. However, in the long run, supply is likely to be
more elastic because all resources are variable.
✚ Stocks: if stocks of finished goods are available, then supply will be
relatively elastic because manufacturers will be able to respond quickly to
a price change.
✚ Spare capacity: if a firm has underutilised machinery and underemployed
workers, or if it is possible to introduce a new shift or workers, then supply
is likely to be elastic.
✚ Availability and cost of switching resources from one use to another:
if resources, such as labour, have specific skills or machinery is highly
specific, or if it is expensive to reallocate resources from one use to
another, then supply will be relatively inelastic.
Short run is a time
period in which there is at
least one fixed factor of
production.
Long run is a time period
in which all factors of
production can be varied.
Exam tip
Remember that the factors
influencing elasticity of
supply are those affecting
businesses, not consumers.
This should help you to
avoid confusing them with
factors that affect PED.
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2 How markets work
Making links
In exams, you should be able to apply the factors influencing PES to those influencing
the elasticity of supply of labour (see page 179).
Now test yourself
18 Why might you expect the supply of tomatoes to be inelastic?
19 Under what circumstances might the supply of butter be elastic?
Answers available online
Price determination
The equilibrium price and quantity are determined by the interaction of
supply and demand (see Figure 2.11).
Price per
unit ($)
When the quantity supplied is equal to the quantity demanded of a particular
product, equilibrium is said to exist. The equilibrium price and quantity will
not change unless one of the conditions of supply or conditions of demand
changes.
D
S
Excess supply
Equilibrium (price and
quantity) is determined
by the interaction of the
supply and demand curves.
The equilibrium price and
quantity would not change
unless there was a change in
the conditions of demand or
supply.
Exam tip
Pe
Equilibrium point
Excess demand
S
D
The demand curve must
be downward sloping.
To remember this note
that there is a negative
relationship between price
and quantity demanded, i.e.
as one rises the other falls.
Qe Quantity demanded and
supplied per week (kilos)
0
Figure 2.11 Equilibrium price and quantity
Excess demand and excess supply
Price per unit ($)
Figure 2.12 illustrates what happens if the price is not currently at its
equilibrium level.
S
P1
Pe
Exam tip
Before considering any
change in equilibrium
price and quantity, you
should always begin with a
diagram showing the initial
equilibrium price and output.
E
P2
D
0
38
Qe
Q2 Q4
Q3 Q1
Quantity demanded and supplied per week (kilos)
Figure 2.12 Excess demand and excess supply
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Pe. For example, if the price is at P1 then the quantity demanded will be
only Q1, while the quantity supplied will be Q2, so there will be a surplus
of Q1Q2. Market forces will cause price to fall to Pe, which will lead to
an extension of demand and a contraction in supply, so eliminating the
excess supply.
✚ Excess demand. This occurs if the price is below the equilibrium price
of Pe. For example, if the price is at P2 then the quantity demanded
will be Q4 while the quantity supplied will be only Q3, so there will be
a shortage of Q3Q4. Market forces will cause price to rise to Pe, which
will lead to an extension of supply and a contraction in demand, so
eliminating the excess demand.
Excess supply implies
that the quantity supplied
is greater than the quantity
demanded at the existing
price.
Excess demand implies
that the quantity demanded
is greater than the quantity
supplied at the existing
price.
2 How markets work
✚ Excess supply. This occurs if the price is above the equilibrium price of
Making links
In exams you will need to be able to apply the concepts of excess demand and
excess supply in relation to real-world issues involving maximum prices and
minimum prices).
Now test yourself
20 If the current price is above the free market price, identify whether there is excess
supply or excess demand.
21 If the existing market price is above the equilibrium price, explain how equilibrium
is restored.
Answers available online
Changes in the equilibrium price
A change in the equilibrium price can be caused by:
✚ a change in the conditions of demand (which would cause the demand
curve to shift) or
✚ a change in the conditions of supply (which would cause the supply
curve to shift).
An increase in demand
Price per
unit (£)
This would cause a rightward shift in the demand curve, a rise in price and an
increase in the quantity, as shown in Figure 2.13.
D1
D2
S
P2
P1
0
Q1
Q2
Quantity demanded
and supplied per week
Figure 2.13 An increase in demand
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A decrease in demand
Price per
unit (£)
2 How markets work
This would cause a leftward shift in the demand curve, a fall in price and a
decrease in the quantity, as shown in Figure 2.14.
D2
D1
S
P1
P2
0
Q2
Q1
Quantity demanded
and supplied per week
Figure 2.14 A decrease in demand
An increase in supply
Price per
unit ($)
This would cause a rightward shift in the supply curve, a fall in price and an
increase in the quantity, as shown in Figure 2.15.
D
S1
S2
P1
P2
Exam tip
0
Q1 Q2
Quantity demanded
and supplied per week
Figure 2.15 An increase in supply
Remember that an increase
in supply means that more
is supplied at each price, so
the supply curve must shift
to the right.
A decrease in supply
Price per
unit ($)
This would cause a leftward shift in the supply curve, a rise in price and a
decrease in the quantity, as shown in Figure 2.16.
D
S2
S1
P2
P1
Exam tip
0
40
Q2 Q1 Quantity demanded
and supplied per week
Remember that a decrease
in supply means that less is
supplied at each price, so
the supply curve must shift
to the left.
Figure 2.16 A decrease in supply
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Now test yourself
2 How markets work
22 For each of the following, explain what happens to the equilibrium price and
quantity (you might find it helpful to sketch supply and demand diagrams):
a) The effect of an increase in tax on foreign holidays
b) The effect of an increase in real incomes on the market for sports cars
c) An increase in the productivity of workers harvesting strawberries
d) A health scare relating to diesel cars
Answers available online
The price mechanism
The key functions of the price mechanism in a free market economy may be
summarised as follows:
✚ As a rationing device: market forces will ensure that the amount
demanded is exactly equal to the amount supplied.
✚ As an incentive: the prospect of making a profit acts as an incentive to
firms to produce goods and services.
✚ As a signalling device: to producers to increase or decrease the amount
supplied.
✚ To determine changes in wants: a change in demand will be reflected in a
change in price.
Exam tip
The forces of supply and demand (market forces) help to determine the equilibrium
price but this does not mean that prices are stable. Remember that any change in the
conditions of supply and demand will cause the equilibrium price to change.
Making links
In exams, you should be able to apply the functions of the price mechanism to specific
markets, e.g. the housing market or the labour market (see pages 174–175).
The price mechanism in different types
of markets
✚ A market refers to all those buyers and sellers of a product or service
involved in making exchanges with each other and who help to determine
its price.
✚ Consequently, there are many different forms of market and, therefore,
they do not necessarily operate in one geographical location.
✚ They may be local, national or global. For example, farm shops could be an
example of a local market since the produce is grown and sold locally. On
the other hand, there are national and/or international markets for certain
goods such as wheat and rice, or certain types of labour, e.g. nurses and
teachers. The internet has enabled markets for some goods and services
to become much wider because it has made it easier to bring buyers and
sellers together.
Now test yourself
23 How would the price mechanism act as a signal to house builders to build more
houses?
Answers available online
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2 How markets work
Consumer and producer surplus
Consumers’ surplus
This refers to the difference between how much a person is willing to pay
and how much they actually pay, i.e. the market price. Diagrammatically,
the consumers’ surplus is the area under the demand curve and above the
market price.
Consumers’ surplus is
the difference between
how much consumers are
willing to pay and what they
actually pay for a product.
Producers’ surplus
This refers to the difference between the price the producer receives and the
cost of supply. Diagrammatically, the producers’ surplus is the area between
the supply curve and the market price.
Price per unit (£)
Figure 2.17 illustrates both consumers’ surplus and producers’ surplus.
A
Producers’ surplus is the
difference between the
price the producers receive
and the cost of supply. In
other words it represents
profit.
Supply
PAB: Consumer surplus
CPB: Producer surplus
P
B
Exam tip
C
Demand
0
Quantity per week (kilos)
Figure 2.17 Consumers’ and producers’ surplus
A simple way to avoid
confusing producers’
surplus with consumers’
surplus is to think that
producers’ surplus relates
to suppliers and so is the
area above the supply curve
and below the equilibrium
price.
Making links
In exams, these concepts may be useful in analysis of market structures on price
discrimination (see pages 167–168).
Now test yourself
24 What is another word for producers’ surplus?
Answers available online
Factors affecting consumers’ surplus
✚ The gradient of the demand curve: the steeper it is the greater the
consumers’ surplus will be.
✚ Changes in the conditions of demand: for example, an increase in demand
will increase the amount of consumers’ surplus, as shown in Figure 2.18.
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A
Supply
2 How markets work
Price per unit (£)
E
P1AB: original consumer surplus
P2
P1
F
P2EF: new consumer surplus
B
D2
C
D1
Quantity per week (kilos)
Figure 2.18 Effect of an increase in demand on consumers’ surplus
Factors affecting producers’ surplus
✚ The gradient of the supply curve: the steeper it is, the greater the
producers’ surplus will be.
✚ Changes in the conditions of supply: for example, an increase in supply
Price per unit (£)
will increase the amount of producers’ surplus, as shown in Figure 2.19.
A
S1
S2
P1
CP1B: original producer surplus
B
P2
G
HP2G: new producer surplus
C
H
Demand
Quantity per week (kilos)
Figure 2.19 Effect of an increase in supply on producers’ surplus
Now test yourself
25 How would an increase in tax on chocolate affect consumers’ surplus?
Answers available online
Indirect taxes and subsidies
Indirect taxes
Indirect taxes are taxes on expenditure and include taxes such as Value
Added Tax (VAT), excise taxes and taxes on gambling. Such taxes cause an
increase in the cost of supply and so cause the supply curve to shift to the left.
There are two types of indirect taxes: ad valorem and specific.
Indirect taxes are taxes
on expenditure.
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2 How markets work
Ad valorem taxes
Ad valorem taxes are a percentage of the price of a product or service and
so cause the supply curve to shift to the left and become steeper than the
original supply curve. An example of an ad valorem tax is VAT, which is
currently levied at 20% in the UK.
Ad valorem taxes are a
percentage of the price of
the product.
Specific taxes
In contrast, a specific tax or flat rate tax is a set amount of tax on each unit
consumed. Therefore, the effect of a specific tax is to cause the supply curve
to shift to the left, parallel to the original supply curve.
Specific taxes are a set
amount per unit of the
product.
Now test yourself
26 What is the difference between an ad valorem tax and a specific tax?
Answers available online
Price per unit (£)
Figure 2.20 illustrates the impact of a specific tax when demand is inelastic.
S2
D
S1
P2
A
P1
B
E
C
Q2 Q1
Exam tip
Remember that an indirect
tax causes the supply curve
to shift to the left — it does
not cause a shift in the
demand curve.
Quantity supplied
and demanded per week
Figure 2.20 Indirect tax when demand is inelastic
✚ P1 is the initial equilibrium price and Q1 is the initial equilibrium output.
✚ An indirect tax causes the supply curve to shift to the left from S1 to S2.
✚ In turn, this causes the price to increase to P2 and the quantity to fall to Q2.
✚ It can be seen that when demand is inelastic the consumer bears a much
larger proportion of the tax burden (P1P2AB), whereas the producer bears a
much smaller part of the tax burden (EP1BC).
✚ This distribution of the tax burden is called the incidence of tax.
✚ The total tax revenue to the government is therefore EP2AC.
Incidence of tax relates
to how the burden of a
tax is distributed between
different groups, e.g.
producers and consumers.
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S2
D
2 How markets work
Price per
unit (£)
In contrast, Figure 2.21 illustrates the impact of a specific tax when demand is
elastic.
S1
L
P2
P1
M
R
T
0
Q2
Q1
Quantity per week
Figure 2.21 Indirect tax when demand is elastic
✚ P1 is the initial equilibrium price and Q1 is the initial equilibrium output.
✚ An indirect tax causes the supply curve to shift to the left from S1 to S2.
✚ In turn, this causes the price to increase to P2 and the quantity to fall to Q2.
✚ It can be seen that when demand is elastic the producer bears a much
larger proportion of the tax burden (RP1MT), whereas the consumer bears
a much smaller part of the tax burden (P1P2LM), i.e. the incidence of the tax
falls mainly on the producer.
✚ The total tax revenue to the government is therefore RP2LT.
Now test yourself
27 If demand were price inelastic, would producers or consumers bear most of the
tax burden after a tax has been imposed on bread?
Answers available online
Subsidies
A subsidy is a grant from the government. These grants have the effect of
reducing costs of production. Consequently, subsidies cause the supply curve
to shift to the right.
Price per unit (£)
Figure 2.22 illustrates the impact of a subsidy.
A subsidy is a grant from
the government that has the
effect of reducing costs of
production.
S1
D
A
E
S2
P1
P2
0
B
Q1
Q2
Quantity per week
Exam tip
Figure 2.22 The effect of a subsidy
✚ The initial equilibrium price and quantity are P1 and Q1, but after the
government grants the subsidy to producers the new equilibrium price
falls to P2 and the quantity rises to Q2.
✚ AB represents the subsidy per unit and the total cost of the subsidy to the
government is P2EAB, i.e. the subsidy per unit multiplied by the quantity.
Remember that a subsidy
affects costs of production
(and, therefore, suppliers)
and so affects the supply
curve, not the demand
curve.
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2 How markets work
Making links
Indirect taxes are considered at a macro level in relation to withdrawals from the
circular flow of income (see page 90) and public finance (see Chapter 21). In exams,
you might be required to consider the micro and macro effects of a change in indirect
taxes and subsidies.
Now test yourself
28 For consumers to benefit most from a subsidy, would demand need to be elastic
or inelastic?
Answers available online
Alternative views of consumer
behaviour
✚ As indicated at the beginning of this chapter, standard economic analysis
makes the assumption that people act rationally and aim to maximise
utility.
✚ In practice, this assumption may be unrealistic because people’s behaviour
is subject to a range of influences and motives.
✚ Behavioural economics applies psychological insights into human
behaviour to explain economic decision-making.
Behavioural economics
is a method of economic
analysis that applies
psychological insights into
human behaviour to explain
economic decision-making.
Reasons why consumers may not behave
rationally
There are several key reasons as to why consumers may not behave rationally.
✚ Consideration of the influence of other people’s behaviour. Much of a
person’s behaviour is affected and influenced by that of others. Indeed, it
is argued that a person subconsciously learns from the behaviour of others
as a guide to their own behaviour — a process known as ‘social learning’.
Examples of how our behaviour is dependent on others’ might include the
clothes and smartphones we buy or the food we eat.
✚ The importance of habitual behaviour. The frequency of our past
behaviour influences our current behaviour. Consequently, such behaviour
involves little or no thought — it is just done automatically. Habits
are difficult to change if they are repeated frequently and if they are
associated with rewards that arise quickly after the action. Incentives
(which may be financial or non-financial) may be required to change such
habits. For example, charging for plastic bags has had a major impact in
countries such as the UK, Ireland and South Africa.
✚ Inertia. This might arise because people are loss averse, i.e. they will put
more effort into preventing a loss than winning a gain. This could explain,
for example, why a relatively small proportion of consumers switch their
bank accounts or their energy suppliers.
46
Other reasons why consumers might not make an active effort to change their
behaviour include:
✚ information overload
✚ the complexity of the information available
✚ too much choice available
✚ consumer weakness at computation, as people tend to pay more attention
to recent events than to distant events when they make decisions. Linked
with this, consumers find considerable difficulty in calculating the
probability of something happening. They are also influenced by how a
choice is presented.
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The points outlined above mean that standard mathematical analysis based
on the neoclassical principles of rationality will not accurately describe
human behaviour. Consequently, they might have perverse and unintended
results when used to formulate policy.
A key implication of this approach therefore is that policy-makers need to
place greater emphasis on the psychology of behaviour when devising policy.
Summary
You should have an understanding of:
✚ the assumption of rationality and the reasons why
consumers may not behave rationally in practice
✚ how a price change causes a movement along a
demand curve
✚ how changes in the conditions of demand cause shifts
in the demand curve
✚ how a price change causes a movement along a supply
curve
✚ how changes in the conditions of supply cause shifts in
the demand curve
✚ how the equilibrium price and output are determined
✚ the causes of changes in the equilibrium price and
quantity
✚ how market forces will eliminate excess demand and
excess supply
✚ price elasticity of demand: how it is calculated and how
to interpret the results
✚ the factors influencing price elasticity of demand
✚ the relationship between price elasticity of demand and
2 How markets work
Implications of behavioural economics
total revenue
✚ income elasticity of demand: how it is calculated and
how to interpret the results
✚ the distinction between normal goods and inferior
goods
✚ cross elasticity of demand: how it is calculated and
how to interpret the results
✚ the distinction between complements and substitutes
✚ price elasticity of supply: how it is calculated and how
to interpret the results
✚ the factors influencing price elasticity of supply
✚ the functions of the price mechanism
✚ consumers’ surplus and producers’ surplus and the
factors influencing each of these concepts
✚ the effect of indirect taxes and subsidies using supply
and demand analysis.
Exam skills
In this chapter you have been developing some skills that
will be relevant throughout the course. These include:
✚ Numerical skills: the ability to calculate percentages
(in relation to elasticities).
✚ Diagrammatic skills: using supply and demand
diagrams.
✚ Application skills: the ability to apply concepts in
unfamiliar situations, for example, using supply and
demand analysis to explain changes in the price of rice.
Exam practice
1 A free market economy is often assumed to be the
most efficient way of allocating resources.
a) What is the underlying assumption of the behaviour
of consumers in a free market economy?
A They will minimise current consumption.
B They will maximise satisfaction.
C They will minimise profits.
D They will maximise costs of making a
decision.[1]
b) Explain two disadvantages of a free market
economy.[4]
2 Research has shown that demand for landline phones
reached a peak a few years ago and is now declining.
a) What is the key prediction of the law of diminishing
marginal utility as a person consumes more of a
product?
A Total utility will increase at an increasing rate.
B Marginal utility will always increase.
C Total utility will always be negative.
D Marginal utility will eventually decrease.
[1]
b) How does the law of diminishing returns help to
explain the shape of the demand curve?
[4]
3 In 2020 robotic vacuum cleaners became widely available
in shops. They are subject to 20% VAT in the UK.
a) Calculate the price of a robotic vacuum cleaner
if the price before VAT is £400.
[2]
b) Why might the demand curve for robotic vacuum
cleaners shift to the right?
A A decrease in costs of production
B A decrease in VAT on robotic vacuum cleaners
C An increase in the productivity of workers
producing robotic vacuum cleaners
D An increase in the real incomes of consumers [1]
c) Explain one reason why demand for robotic
vacuum cleaners might increase in the future
among hotel owners.
[2]
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2 How markets work
4 Potato famers in Ireland face an upward sloping supply
curve.
a) Explain one reason why the supply curve is
upward sloping.
[2]
b) Which one of the following would cause the
supply curve for Irish potatoes to shift to the left?
A The cost of fertiliser increases.
B There is an increase in advertising of potatoes.
C New machinery enables more potatoes to be
produced per acre.
D The price of rice, a substitute for potatoes,
increases.[1]
c) Researchers discover that when the price of
potatoes increases by 10%, the supply increases
by 1%. Calculate the price elasticity of supply of
potatoes.[2]
5 Tom Baker sells 100 cream cakes at $5 each on a
particular day. When he reduces the price to $4
on the following day, his sales rise to 140 cakes.
a) Calculate the change in total revenue resulting from
the price reduction.
[2]
b) What may be inferred about the price elasticity of
demand for cakes?
[2]
c) Which one of the following would make the demand
for Tom Baker’s cakes more price elastic?
A A decrease in the price of cream cakes
B A rival baker opens up a shop near the Tom
Baker shop
Extract A: Supply of olive oil
C A reduction in the cost of flour and sugar
D An increase in the price of doughnuts
[1]
6 a) 100 000 jars of jam are demanded per day at £2 a
jar. If the price elasticity of demand for these jars
is –3 and the price is raised by 10%, the number of
jars demanded per day would fall to:
A 60 000
C 80 000
B 70 000
D 90 000
[1]
b) Explain two factors that might influence the price
elasticity of demand for strawberries.
[4]
7 In 2019 about 5.9 million people in the UK switched
electricity suppliers out of a total of 28.5 million electricity
customers. Many more could have saved several hundred
pounds by switching suppliers but did not do so.
a) Why might a person switch their energy supplier from
Company X to Company Y to get a cheaper deal?
A They believe that prices charged by Company Y
will rise in the future.
B They are unable to calculate the potential
benefits of switching suppliers.
C Company X, their current energy supplier, will
reduce its prices next year.
D They are aiming to maximise their total utility. [1]
b) Explain two reasons why another person may
not switch their energy supplier even though
[4]
competitors are charging lower prices.
8 Read the extracts below and answer the questions that
follow.
Olives start to bear fruit in the tree’s fifth year, with full
fruit production occurring in 7–8 years after initial planting,
when grown in the traditional open-grove way. A tree can
take up to 80 years to reach a stable yield — after that,
production starts to progressively lessen for the rest of
the tree’s life, although potentially the trees can produce
fruit for hundreds of years.
yields have declined by 60% since 2013. This has caused
a sharp increase in unemployment among agricultural
workers in the areas where olive trees are grown. In
turn, the economies of these regions have been badly
affected. For example, the damage to the olive trees also
causes a fall in the value of land and makes the region
less attractive to tourists.
A deadly bacterium has affected olive trees in Europe. It
is transmitted by bugs that suck the sap from the trees.
Starved of water, the trees are weakened and eventually
die. One badly affected country is Italy, where crop
More recently, the bacterium has been found in Spain,
France and Portugal. Italy, Spain and Greece account for
95% of European olive oil production.
Extract B: Demand for olive oil
There has been a steady rise in the demand for olive
oil in recent years, as the popularity of Mediterraneanstyle diets has increased. Extra virgin olive oil is a
speciality food and is widely regarded as a luxury food
item. Studies have suggested that the price elasticity
48
a) With reference to Extract B, calculate the
percentage change in the quantity demanded of
extra virgin olive oil if the price increases by 20%.
Comment on your result.
[5]
b) With reference to Extract A, examine whether
the short-run supply for olive oil is likely to be
price elastic or price inelastic.
[8]
c) With reference to Extract B, assess the cross
elasticity of demand between a change in the
price of extra virgin olive oil and vegetable oils. [10]
of demand for extra virgin olive oil in the USA is –0.45.
However, it should be noted that there are different
varieties of olive oil and vegetable oils. The income
elasticity of demand for Italian extra virgin olive oil is
over +1.
d) With reference to Extract A and Extract B, discuss
why the price of olive oil is likely to increase
in the future. Illustrate your answer with a
supply and demand diagram.
[12]
e) With reference to Extract B, discuss the factors
influencing the income elasticity of demand
for olive oil.
[15]
f) With reference to the information provided,
evaluate the effects of falling olive oil output on
consumers, workers and producers.
[25]
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3 Market failure
Types of market failure
The meaning of market failure
Market failure refers to the failure of the market system to allocate resources
efficiently. It arises because the price mechanism has not taken into account
all the costs and/or benefits in the production or consumption of the product
or service.
Market failure occurs
when the forces of supply
and demand (market forces)
do not result in the efficient
allocation of resources.
Types of market failure
There are various reasons why the free market system may fail, including:
✚ externalities
✚ non-provision of public goods
✚ information gaps
✚ monopoly
✚ moral hazard
✚ immobility of labour
✚ speculation and market bubbles.
The first three of these market failures are considered in detail later in this
chapter. The others are considered later in this book.
Making links
Market failure is an issue that occurs several times throughout the course and is a
reason why markets might not allocate resources efficiently. In exams, you should be
ready to apply the concepts mentioned above in a relevant context:
✚ Externalities in relation to the macroeconomic objective of a clean environment
(see Chapter 10)
✚ Non-provision of public goods in relation to public expenditure (see Chapter 21)
✚ Immobility of labour and its impact on employment/unemployment (see
Chapter 15)
✚ Moral hazard in relation to bank loans (see Chapter 20)
Reasons for market failure
✚ For resources to be allocated efficiently, it is necessary for social marginal
costs (SMC) to be equal to social marginal benefits (SMB).
✚ In practice, some costs and/or benefits may not be included because they
may not be known or may be difficult to quantify.
✚ Social marginal cost refers to the addition to total cost of producing an
extra unit of output, whereas social marginal benefit refers to the addition
to total benefits of consuming an extra unit.
Now test yourself
1 Give three reasons why a free market might not allocate resources efficiently.
Answers available online
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3 Market failure
Externalities
The meaning of externalities
✚ Externalities are costs and benefits to third parties who are not directly
part of a transaction between producers and consumers.
✚ They are, in effect, spillover effects arising from the production or
consumption of a product or service that are not taken into account by the
price mechanism.
✚ Externalities are therefore a form of market failure because market forces
will not result in an efficient allocation of resources.
Externalities affect parties
that are not directly involved
in a transaction and may be
either costs or benefits.
Types of externality
Two types of externality may be distinguished:
✚ External costs (negative externalities)
✚ External benefits (positive externalities)
Now test yourself
2 How might a third party be affected if someone smokes?
Answers available online
Exam tip
Think of externalities as
effects on stakeholders, e.g.
consumers, firms, workers,
the government, who are
not part of a transaction
between others.
Private costs
Private costs are those costs paid directly by the producer and consumer in a
transaction.
✚ Private costs of a producer: typically these will include wages, rent, raw
materials and energy.
✚ Private costs for a consumer: the cost to the consumer is usually the price
paid for the product/service.
Private costs are the
direct costs to producers
and consumers for
producing and consuming a
product.
External costs (negative externalities)
External costs are costs to third parties, i.e. other than to the producer or
consumer directly involved in the transaction. They are spillover costs from
the production or consumption that the market fails to take into account.
Examples of external costs of production include:
✚ air pollution, e.g. noxious gases from a factory
✚ noise pollution, e.g. from building work associated with a new factory or
from machinery used in the production process
✚ pollution arising from the destruction of the rainforest to grow crops.
Examples of external costs of consumption include:
✚ passive smoking, i.e. a non-smoker might suffer from adverse health
effects through being in the presence of a smoker over a period of time
✚ overeating by individuals, i.e. obesity might result in significant costs for
the National Health Service and, in turn, taxpayers.
External costs are the
costs in excess of private
costs that affect third
parties who are not part of
the transaction.
Exam tip
Diagrammatic analysis
of the external costs of
production is required for
the examination but it is not
required for the external
costs of consumption.
Social costs
Social costs are simply the sum of private costs and external costs. So:
Social costs = private costs + external costs
Therefore:
Social costs are the sum
of private costs and external
costs.
External costs = social costs – private costs
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Now test yourself
Answers available online
Analysis of external costs of production
Costs and benefits
Figure 3.1 illustrates the welfare loss occurring from the production of a good
which results in external costs to third parties.
SMC
PMC
B
A
To determine the welfare
loss, remember that at
the free market output
the social marginal cost
is greater than the social
marginal benefit.
PMB = SMB
Socially optimal
output
Y
X
In questions relating to
externalities do not use
basic supply and demand
curves in your analysis.
External costs of production
are an extra cost to third
parties, so this means that
the social marginal cost
curve must be to the left of
the private marginal cost
curve.
C
0
Exam tips
3 Market failure
3 Are external costs the same as social costs?
Free market
output
Output
Figure 3.1 External costs of production
✚ In Figure 3.1, the private marginal benefit curve (PMB) is the demand
curve and indicates that private benefits to the consumer decrease as
consumption increases. In this case, it is assumed that there are no
external benefits so the PMB will be the same as the social marginal
benefit (SMB) curve.
✚ The private marginal cost (PMC) curve is the supply curve and indicates
that the private costs of providing the product rise as output rises.
✚ In a free market economy, therefore, the equilibrium is determined from
the equilibrium point at which PMB = PMC, which will be output 0X.
✚ However, 0X would not be the socially optimal level of output because no
account has been taken of the external costs of production.
✚ The social marginal cost (SMC) curve includes both the private costs and
external costs and is therefore drawn to the left of the PMC curve.
✚ The socially optimal level of output is determined from the equilibrium
point at which SMC = SMB, which will be 0Y.
Welfare loss
✚ It can be seen that in a free market economy there is over-production and
over-consumption of XY.
✚ This results in a welfare loss, shown as ABC in Figure 3.1.
Making links
In exams you should be ready to consider external costs of production in relation to
the macroeconomic objective of a clean environment (see Chapter 10).
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3 Market failure
Now test yourself
4 A firm producing chemicals pays another firm for its raw materials and pays an
average wage of £35 000 to its workers. It discharges its waste into a river adjacent
to the factory, which causes the fish to die. Fishermen downstream suffer from a
loss of income. Farmers pay the chemical company £100 per kilo for the fertiliser
produced by the chemical company.
In the extract above, which are private costs and which are external costs?
Answers available online
Private benefits
Private benefits are those benefits that are received directly by the producer
and consumer in a transaction.
✚ Private benefits to a producer: typically these will include the revenues
received from the sale of the product/service.
✚ Private benefits to a consumer: these are the utility (satisfaction) gained by
the consumer from the consumption of the product/service.
Private benefits are direct
benefits to producers and
consumers for producing
and consuming a product.
External benefits
External benefits are benefits to third parties, i.e. other than to the producer
or consumer directly involved in the transaction. They are spillover benefits
from the production or consumption that the market fails to take into
account.
The following are examples of external benefits of consumption:
✚ Individuals who decide to have vaccinations preventing the spread of
disease to others.
✚ Households with well-kept gardens increasing the market value of
neighbouring properties.
External benefits are
benefits in excess of private
benefits that affect third
parties who are not part of
the transaction.
The following are examples of external benefits of production:
✚ A farmer who keeps bees to make honey. The bees will benefit
surrounding farmers by pollinating their crops.
✚ A firm that trains workers in computing skills. Other firms that do not
train workers might benefit from employing workers from this firm.
Social benefits
Social benefits are simply the sum of private benefits and external benefits.
So:
Social benefits = private benefits + external benefits
Social benefits are the
sum of private benefits and
external benefits.
Therefore:
External benefits = social benefits – private benefits
Now test yourself
5 A person has a vaccination against measles. What type of externality is this?
Answers available online
Analysis of external benefits of consumption
Figure 3.2 illustrates the welfare gain that occurs due to the consumption of a
good which results in external benefits to third parties.
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Costs and benefits
3 Market failure
PMC = SMC
E
F
G
SMB
PMB
0
Free market output
X
Y
Socially optimal output
Output
Figure 3.2 External benefits of consumption
✚ In Figure 3.2, the private marginal benefit curve (PMB) is the demand
curve and indicates that private benefits to the consumer decrease as
consumption increases.
✚ The private marginal cost (PMC) curve is the supply curve. In this case, it is
assumed that there are no external costs, so the PMC will be the same as
the social marginal cost (SMC) curve.
✚ In a free market economy, therefore, the equilibrium is determined from
the equilibrium point at which PMB = PMC, which will be output 0X.
✚ However, 0X would not be the socially optimal level of output because no
account has been taken of the external benefits of production.
✚ The social marginal benefit (SMB) curve includes both the private benefits
and external benefits and is, therefore, drawn to the right of the PMB
curve.
✚ The socially optimal level of output is determined from the equilibrium
point at which SMC = SMB, which will be 0Y.
Welfare gain
✚ It can be seen that in a free market economy there is under-production and
under-consumption of XY.
✚ If the socially optimum output is produced, then there will be a welfare
gain, shown as EFG in Figure 3.2.
Exam tip
Diagrammatic analysis of
the external benefits of
consumption is required for
the examination but it is not
required for the external
benefits of production.
Exam tip
To determine the welfare
gain remember that, at
the free market output,
the social marginal benefit
is greater than the social
marginal cost.
Making links
In exams you should be ready to consider external benefits of consumption in relation
to public expenditure on health and education (see Chapter 21).
Now test yourself
6 An 18-year-old student decides to do a 2-year apprenticeship in the hotel industry.
Although she is paid a small wage, she estimates that she has forgone £20 000 by
doing the apprenticeship rather than going into full-time employment. Research
suggests that after apprentices complete their courses, they secure more
interesting and satisfying jobs that pay higher wages than non-apprentices. Also
they learn transferable skills that can help to increase productivity in the economy
leading to a higher rate of economic growth.
In the above extract, which are private benefits and which are external benefits?
Answers available online
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3 Market failure
Non-provision of public goods
The difference between public and private
goods
Public goods are unique as the benefit that they provide affects many people
rather than just one individual. There are two special characteristics that
distinguish public goods from private goods:
✚ Non-rivalrous: this means that consumption by one person does not limit
consumption by others, i.e. the benefit to others is not reduced by one
person’s consumption.
✚ Non-excludability: this means that if a good is available for one person,
it is available for everyone, i.e. it is impossible to prevent or exclude
anyone from using it.
Public goods are those
goods that have the two
key characteristics of being
non-rivalrous (amount
available does not fall after
one person’s consumption)
and non-excludable (cannot
prevent anyone from
consuming them).
This is in contrast to private goods that are rival and excludable, i.e.
consumption by one person means that it cannot be consumed by anyone
else and that it is not available to anyone else.
Now test yourself
7 How do private goods differ from public goods?
Answers available online
Examples of public goods
It is arguable whether there are any examples of pure public goods displaying the
characteristics described above, but examples commonly used include:
✚ street lighting
✚ nuclear defence systems
✚ national parks.
The free rider problem
The characteristic of a public good is that when it is provided by someone,
other people will be able to benefit from it without paying — in other words,
they get a ‘free ride’. This is a problem because in such circumstances the
market will fail: an insufficient number of people will be willing to pay for the
product and it will not be profitable for a business to provide it.
Making links
Free rider problem means
that once a product is
provided it is impossible to
prevent people from using
it and, therefore, impossible
to charge for it.
In exams you should be ready to consider the non-provision of public goods in relation
to public expenditure (see Chapter 21).
Now test yourself
Exam tip
8 Why does the free rider problem occur?
Although healthcare and
education may be provided
by the state, they should
not be regarded as public
goods because they are
both rival and excludable.
9 If a person buys a television, it is not possible to prevent them using it whether
or not they have a television licence. How do the authorities try to make this an
‘excludable’ service?
Answers available online
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Symmetric and asymmetric information
✚ The free market system is based on the assumption that consumers and
producers make rational choices and decisions are based on perfect and
equal market knowledge.
✚ In practice, this assumption may be unrealistic. For example, producers
may have more information than consumers about a product or service, or
consumers may simply not have sufficient information to make a rational
decision.
✚ As a result of this asymmetric information, resources may be allocated
inefficiently, resulting in market failure.
Symmetric information
is where both parties in a
transaction have the same
information.
Asymmetric information
is where one party in a
transaction has more
or superior information
compared to another.
3 Market failure
Information gaps
Examples of asymmetric information
The following are examples of markets in which asymmetric information is
possible.
✚ Housing market: estate agents may know more about the potential
problems of a house than the potential buyer.
✚ Life insurance: consumers may not reveal all aspects of their health profile
to the insurance company, making it difficult for the firm to assess the
risk.
✚ Second-hand car sales: the car salesperson knows more about the car than
a potential buyer.
✚ Financial services: a bank may be unaware of the likelihood of a default by
the borrower.
✚ High-tech products: consumers are unlikely to have as much information
as producers about products such as smartphones and pharmaceuticals.
Exam tip
Remember that asymmetric
information and incomplete
information are forms of
market failure because
they restrict the ability of
consumers and producers
to make rational choices.
Making links
In exams you should be ready to consider information gaps in relation to government
failure (see Chapter 4) and irrational behaviour (see Chapter 2).
Now test yourself
10 What information gaps might exist between a dentist and a patient?
Answers available online
Summary
You should have an understanding of:
✚ the meaning of market failure
✚ three types of market failure: externalities, public goods
and information gaps
✚ external costs and external benefits
✚ diagrams depicting external costs of production and
external benefits of consumption
✚ public goods: key characteristics, i.e. non-rivalrous and
non-excludable, and the free rider problem
✚ information gaps: meaning and significance.
Exam skills
In this chapter you have been introduced to some fairly
complex analysis, e.g. in relation to externalities. But
remember that for this specification you are only required
to understand two of the four externalities diagrams:
✚ External costs of production
✚ External benefits of consumption
While you need to understand external costs of
consumption and external benefits of production,
diagrammatic analysis is not required for these.
You will also be developing some critical thinking skills, for
example, in understanding that free markets do not always
result in an efficient allocation of resources.
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3 Market failure
Exam practice
1 An oil freighter runs aground not far from a seaside
resort. Damage to the freighter causes a major oil
spillage, which ruins the resort’s beaches. This deters
tourists, many of whom cancel their bookings at local
hotels.
a) Using examples from the above extract,
distinguish between the private costs and
external costs to a hotel owner.
[4]
b) What may be deduced from the above?
A Social costs are less than external costs.
B Private costs are greater than social costs.
C External costs are less than private costs.
D Social costs are greater than private costs. [1]
2 Street lighting is usually provided by the state and
financed from tax revenues.
a) Explain two characteristics of street lighting which
mean that it is usually provided by the state.
[4]
b) What might explain why people living in a private
road may be unwilling to contribute to the
resurfacing of the road?
A Irrational behaviour
B The free rider problem
C Asymmetric information
D Increasing incomes
[1]
3 Read the following extract and answer the questions
that follow.
Extract: Childhood vaccinations
In the United States alone, approximately 42 000 of the
4.1 million children born each year would die early deaths
as a result of diseases that could be prevented with
vaccines. However, many parents choose not to have
their children vaccinated. It has been estimated that
21 million hospitalisations and 732 000 deaths were
avoided among children born over a 20-year period
(1994–2013) because of vaccines.
Vaccinations to children born over a 20-year period are
estimated to save nearly $295 billion in direct costs,
which includes avoided hospitalisations and other
a) Explain the opportunity cost to a government of
providing vaccines for children.
[5]
b) Examine two reasons why healthcare is not a
[8]
public good.
c) Discuss possible reasons that might explain
why around 10% of children in the UK are not
vaccinated against common diseases.
[12]
medical care, and $1.38 trillion in total costs to society,
such as lost wages and decreased productivity. For all
babies born on a particular day, $13.5 billion in direct
health treatment costs are prevented and $70 billion in
lost productivity is avoided over a lifetime by preventing
diseases with vaccines.
In the USA healthcare facilities are mainly operated by
private sector businesses although over half of health
spending is paid for by the state. In contrast, in the
UK private healthcare accounts for only 8% of total
expenditure on health.
d) Discuss the private benefits and external benefits
of vaccinations. Illustrate your answer with an
externalities diagram.
[15]
e) Evaluate the economic arguments for an
increase in the private provision of
healthcare.[25]
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4 Government intervention
A government may intervene in markets to address market failures, to raise
revenue or for social and political reasons. The following types of intervention
are considered below: indirect taxes, subsidies, maximum prices, minimum
prices, tradable pollution permits, state provision of public goods, provision of
information and regulation.
Government intervention in
markets
Indirect taxes
✚ Indirect taxes are taxes on expenditure and include taxes such as Value
Added Tax (VAT), excise taxes and taxes on gambling.
✚ Such taxes cause an increase in the cost of supply and so cause the supply
curve to shift to the left.
✚ As outlined in Chapter 2, page 44, there are two types of indirect taxes:
ad valorem and specific.
Now test yourself
1 How would an ad valorem tax affect the supply curve?
Answers available online
✚ Indirect taxes may be used to deal with external costs. The aim of indirect
Costs and benefits
taxes is to internalise the externality by taxing the product so that output
and consumption are at the level at which SMB = SMC. This is illustrated in
Figure 4.1.
SMC
PMC + TAX
PMC
PMB = SMB
0
Y
X
Output
Figure 4.1 The effect of a tax on a firm producing external costs
✚ It can be seen that the tax will cause a leftward shift in the supply curve.
If judged correctly, the tax will cause consumption and output to fall to 0Y,
the socially optimum level.
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4 Government intervention
Advantages and disadvantages of indirect taxes
Advantages
Disadvantages
Incentive to reduce pollution — the most polluting firms pay
more than the least polluting firms
Ineffective in reducing pollution if demand is price
inelastic
Source of revenue for the government that can be used to
compensate those affected by the pollution
Difficulty of setting an appropriate tax because of the
problem of quantifying the external cost
Few administrative costs involved with this method
Increased business costs
Now test yourself
2 How does an indirect tax on a producer causing pollution ‘internalise the externality’?
Answers available online
Subsidies
✚ A subsidy is a grant to businesses that reduces their production costs.
✚ Therefore, the product or service can be provided at a lower price.
✚ Subsidies may be used in the case of external benefits of production. In turn,
Cost and benefits
this should encourage production so that the socially optimal level is reached.
Social
optimum
output
PMC = SMC
SMC + Subsidy
Market
equilibrium
SMB
PMB
0
X
Y
Output
Figure 4.2 A subsidy to encourage consumption of a product which has external benefits
It can be seen that the subsidy will cause a rightward shift in the supply
curve. If judged correctly, the subsidy will cause consumption and output to
rise from 0X to 0Y, the socially optimum level.
Advantages and disadvantages of subsidies
Advantages
Subsidies are government
grants to businesses that
reduce production costs,
causing a rightward shift in
the supply curve.
Disadvantages
Reduction in cost of production enabling Cost to the taxpayer of providing subsidies
suppliers to reduce the price
Incentive for people to increase
consumption
Ineffective in increasing consumption if
demand is inelastic
Might help to reduce inequality
Difficulty of setting an appropriate subsidy
because of the problem of quantifying the
external benefit
Now test yourself
3 Explain the effect of a subsidy to solar energy producers.
58
Answers available online
Exam tip
Subsidies affect the costs
of production and so cause
shifts in the supply curve
and not the demand curve.
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Indirect taxes and subsidies have significant implications for public finance (see
Chapter 21). In Paper 3 of the examination you may be required to consider these in
both a micro- and macroeconomic context.
Maximum prices
Governments have used maximum price controls or price ceilings in a variety
of contexts, e.g. on rented accommodation, for rugby league players and for
items of food.
Price per unit
Figure 4.3 illustrates the effects of a maximum price scheme.
D
S
A maximum price is a
price, usually set by the
government, which makes
it illegal for firms to charge
more than a certain price
for a given quantity of a
product.
4 Government intervention
Making links
Pe
Pmax
0
J
K
Output (kilos)
Figure 4.3 A maximum price set below the equilibrium price
✚ The equilibrium price is Pe.
✚ Suppose the government sets a maximum price (Pmax) below the
equilibrium price. This results in a shortage of JK kilos.
The shortage could result in a black market in which those with supplies of the
product sell it illegally at a price significantly higher than the maximum price.
Advantages and disadvantages of maximum prices
Advantages
Disadvantages
They enable consumers on low incomes to be able to
afford to buy a product.
There is a danger that shortages mean some consumers are
unable to find supplies of the product.
They help to prevent an increase in the country’s rate
of inflation.
Producers may exit the market in order to use their resources to
produce goods that are more profitable.
They can prevent exploitation of consumers by
monopolies.
If the government subsidises producers to encourage them to
maintain output, there will be a significant cost to the taxpayer.
Now test yourself
4 What would happen if a maximum price was set below the free market price?
Answers available online
Making links
Maximum prices may relate to a range of contexts. For example, they do apply to
wage limits in some countries (see Chapter 15) and in exams you should be ready to
use the relevant diagram to illustrate the impact.
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Minimum prices
4 Government intervention
✚ A government may set minimum prices to ensure that producers receive a
certain price for their product or that consumers have to pay at least a set
price for the product.
✚ Minimum prices may be used in a variety of ways:
✚ Commodities: a government may set a minimum guaranteed price (MGP)
for a particular commodity. This means that producers know in advance
that they will receive a certain price per kilo no matter how much is
produced. This is designed to ensure greater certainty and therefore act as
an incentive to producers to supply sufficient quantities of the commodity.
✚ Consumer goods: some countries use minimum prices for some goods
to deter consumption. For example, in 2018, Scotland introduced a
minimum price for alcohol.
✚ Labour market: many countries have a national minimum wage to
ensure that workers receive a minimum of a certain amount per hour
(see pages 176–177).
Minimum guaranteed
price is a price, usually set
by the government, which is
guaranteed to producers.
Price per
unit ($)
Figure 4.4 illustrates the effects of a minimum guaranteed price scheme.
S
D
MGP
Pe
0
L
M
Quantity per week (kilos)
Figure 4.4 A minimum guaranteed price scheme
✚ The equilibrium price is Pe.
✚ Suppose the government sets a minimum guaranteed price (MGP) above
the equilibrium price. This results in a surplus of LM kilos.
✚ The government buys this surplus and stores it for years in which there is
a shortage.
Advantages and disadvantages of minimum
guaranteed price schemes
Advantages
Disadvantages
Producers know in advance the price they will receive for
their product.
If the minimum guaranteed price is set too high, there will
be surpluses each year.
This greater certainty enables producers to plan investment
and output.
These schemes involve costs of storage, which must be
borne by taxpayers.
They can prevent exploitation of producers by wholesalers
and retailers who have significant buying power.
These schemes encourage over-production and may
therefore result in an inefficient allocation of resources.
Making links
60
Minimum prices may be used in developing economies to guarantee farmers a set
price per unit for their produce (see Chapter 19). In exams, you should be able to use
the relevant diagram to illustrate the impact of minimum price on a particular market
and on government finances.
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Now test yourself
Answers available online
Tradable pollution permits
✚ A tradable pollution permit scheme is another method used to reduce
external costs.
✚ The government issues permits to firms that allow them to pollute up to a
certain limit. Any pollution above this limit is subject to fines.
✚ The key to this system is that the permits may be traded between firms
so that ‘clean’ firms can sell their surplus permits to firms that are
more polluting.
Tradable pollution
permits (according to the
OECD) are rights to sell
and buy actual or potential
pollution in artificially
created markets.
4 Government intervention
5 What is the main purpose of a guaranteed minimum price for a product such as wheat?
Advantages and disadvantages of tradable pollution
permits
Advantages
Disadvantages
These schemes work through the market
mechanism.
Pollution will continue, albeit at a lower
level than previously.
They are an incentive for firms to reduce
pollution.
Large, efficient firms might buy up the
permits and continue to pollute.
The costs of administering these schemes
are low relative to those associated with
systems of regulation.
They need to be internationally enforced
to be effective.
There can be a planned reduction in
pollution over time.
They might make the country’s goods less
internationally competitive.
Now test yourself
6 Explain how the market mechanism is a key element of a tradable permit scheme.
Answers available online
State provision of public goods
✚ The usual policy response to the lack of provision of public goods by the free
market is for the government to provide them, financed through taxation.
✚ The most obvious benefit of state provision is that it ensures the product or
service is provided.
✚ However, a disadvantage of this approach is that ultimately politicians
determine the amount of resources allocated to these public goods without
direct reference to the consumers.
✚ Alternative methods of providing some public goods are via agencies
appointed by the government (contracting out) or by charities and
voluntary organisations.
Making links
The state provision of public goods implies public expenditure (see Chapter 21). In
exams, you should be ready to discuss the micro issue of government intervention in
particular markets, with the macro implication of more public expenditure.
Now test yourself
7 What are the two key characteristics of public goods which make it unlikely that
they would be provided in a free market economy?
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4 Government intervention
Provision of information
Information gaps may be closed by publications in the media, on the internet
and in printed form that are designed to inform consumers about issues
concerning products and services. Examples include information:
✚ for parents aimed at encouraging them to have their children vaccinated
against measles
✚ about the health risks associated with smoking or eating junk food
✚ about opportunities for apprenticeships and courses available in higher
education.
Obviously there is a cost associated with this and there is no guarantee that
the policy will be effective.
Now test yourself
8 Why is information important for the efficient operation of a market economy?
Answers available online
Regulation
Legal regulations can be imposed on the activities of consumers and
producers. Such measures include:
✚ a complete ban on the production of the good or provision of the service
✚ regulations that place limits on the production process or on the amount
of pollution allowed
✚ regulations relating to the consumption of a product, e.g. the prohibition of
smoking in public places or the age limit on buying cigarettes.
In theory, this should restrict the pollution to the required level, but without
enforcement, firms may not meet the legal requirements.
Advantages and disadvantages of regulation
Advantages
Disadvantages
Regulation can limit the amount
of pollution.
Enforcement of laws/regulations costs, e.g.
inspectors may have to be employed to ensure that
producers and/or consumers abide by the rules.
It might act as an incentive
to producers to develop new
technologies that reduce
pollution.
There is the problem of determining the socially
efficient level of pollution.
It can limit external costs without
an impact on price.
It limits consumer sovereignty.
Now test yourself
9 Suggest two reasons why regulation might be an ineffective means of reducing pollution.
10 Identify one disadvantage to a government of using regulation as a means of
controlling pollution.
Answers available online
Making links
Regulation is an area
that applies not only to
externalities but also, for
example, in controlling
monopolies, labour market
regulations, and health
and safety in factories.
In exams, you should
be able to consider the
micro- and macroeconomic
implications of such
regulations.
Government failure
✚ Government failure arises as a result of government intervention in a
62
market in an attempt to correct a market failure that causes output and
consumption to move further away from the socially efficient output.
Government failure
is when government
intervention results in a net
welfare loss.
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✚ In other words, government failure is a situation in which government
Now test yourself
Exam tip
11 Would government failure result in a movement closer to, or further away from,
the socially efficient level of output?
Ensure that you know
the distinction between
government failure and
market failure.
12 How might government failure occur if the government decided to impose a
maximum price for rented accommodation in a large city?
Answers available online
Causes of government failure
Distortion of price signals
4 Government intervention
intervention would result in a more inefficient allocation of resources and
would, therefore, lead to a net welfare loss.
✚ Government intervention often involves manipulation of prices, for
example, by maximum or minimum price controls.
✚ However, such measures would undermine the key functions of the price
mechanism such as signalling, rationing and incentives.
✚ Ultimately, this could mean that resources are not allocated efficiently.
Unintended consequences
✚ Some types of government intervention may have an impact that policymakers did not predict.
✚ For example, high taxes imposed on spirits in the UK designed to raise tax
revenues actually resulted in a decrease in tax revenues.
✚ Similarly, very high taxes on cigarettes in the UK have resulted in a
significant increase in cigarette smuggling from which the government
gains no tax revenue.
Excessive administrative costs
Although government intervention might seem to be desirable, the costs may
be considerable. For example, the cost of administering means-tested benefits
may be very large.
Information gaps
When a government intervenes in a market it is unlikely to have all the
information required. Consequently, the intervention could move output
further away from the socially optimal level.
Government failure in various markets
Government intervention in a market may have unforeseen and
undesirable consequences. The following are examples where government
failure might be observed:
✚ Indirect taxes: very high indirect taxes might result in smuggling as a means
of avoiding the tax. In addition, if the indirect tax is set too high it might result
in a movement further away from the socially optimum level of output.
✚ Agricultural stabilisation schemes: these might include, for example,
minimum guaranteed prices. As explained previously, these schemes
could result in massive surpluses, which involve huge storage costs.
Further, such surpluses imply that resources may not be allocated
efficiently. For example, in the case of wheat, it might suggest that land
should be used for alternative crops.
✚ Housing policies: state provision of housing at low rents might be thought
to be desirable for those on low incomes. However, housing subsidies
prevent the market from working efficiently. For example, there is little
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4 Government intervention
incentive for people to move even if their incomes rise, so limiting the
geographical mobility of labour.
✚ Environmental policies: subsidies have been given for the establishment
of wind farms but many argue that the energy produced from them is
relatively expensive and that they cause an environmental eyesore. A
further example of government failure in this context was the payment of
£9.3 million to wind farm owners on a single day in May 2020 to stop them
producing electricity because the electricity network was unable to cope
with the amount of energy being generated from this source.
These are just a few examples, but there are many others, such as:
✚ government intervention in the fishing industry, which may result in the
depletion of fish stocks, e.g. if quotas are set too high
✚ high taxes on alcohol and tobacco, which might encourage smuggling to
such an extent that a further tax rise on these products could result in a
fall in tax revenues.
Making links
Apart from government
failure in particular markets,
it may apply to macro
areas, for example the
apprenticeship levy.
Summary
You should have an understanding of:
✚ methods of providing public goods
✚ asymmetric information: meaning and significance
✚ ways of dealing with asymmetric information
✚ government failure: meaning and causes
✚ examples of government failure in different markets.
Exam skills
Having worked through the whole of the first theme, you
should be developing two very important skills:
✚ Analytical skills: the ability to develop step-by-step
explanations, for example, of changes illustrated in a
diagram.
✚ Evaluative skills: the ability to think critically about
issues. In many parts of this theme, there are tables
showing advantages and disadvantages of a particular
issue or policy. You may use these to think about how
one possible advantage might be offset by a problem
related to that advantage.
Exam practice
1 When a government increased the tax on whisky, the
tax revenue fell despite an increase in sales, because
there was increased tax evasion.
a) Which one of the following describes this situation?
A Market failure
B Asymmetric information
C External benefits
D Government failure
[1]
b) Explain two possible sources of government
failure.[4]
2 In 2020, Berlin passed a law that prevented any
increases in rent for apartments for 5 years. There is
already a shortage of accommodation in Berlin.
a) Draw a diagram to illustrate the impact of a
maximum price on the market for rented
accommodation in Berlin.
[2]
b) Previously an increase in rents of 10% led to a 2%
decline in demand for rented accommodation.
Calculate the price elasticity of demand for
rented accommodation.
[2]
c) Which one of the following is most likely to increase
the elasticity of supply of rented accommodation in
Berlin?
A An increase in the costs of building materials
B An increase in the price of land
C An increase in the availability of substitutes
D An increase in the availability of land for
apartments[1]
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3 Read the following extracts and answer the questions that follow.
Meanwhile, the supply of sugar increased. This
was partly linked to the collapse in oil prices.
When oil prices were falling, sugar mills did
not find it an attractive proposition to divert
sugar cane to the production of ethanol. It was
estimated that 33.1 million tonnes of sugar
would be produced in 2020–21 compared
with 26.6 million tonnes in 2019–20, because
sugar mills were allocating 42.1% of the cane to
produce sugar compared with only 34.1%
in 2019–20.
15.000
14.000
13.000
12.000
11.000
10.11
May
Jul
Sep
Nov
2020
Mar
4 Government intervention
The COVID-19 pandemic led to a lockdown in
many countries that resulted in the closure of
factories. For example, in India, wholesalers
stated that sales of sugar had halved after
bulk orders from confectioners, wedding
functions, the hotel industry, beverage
makers, tea vendors, bakers and ice cream
makers stopped overnight. As sales declined,
stocks piled up in sugar mills.
Sugar ($/lb)
Extract A: Fall in sugar prices
May
Figure 1 Price of sugar
Source: https://tradingeconomics.com/commodity/sugar
Extract B: Tax on sugar
In Mexico, a significant increase in obesity and diabetes
had become a major public health crisis. Consequently, a
sugar tax was introduced in 2014. Consumption of
sugary drinks dropped by over 5% in the first year and
almost 10% in the second year, with the biggest drop
(12%) being in families with the lowest incomes. This
reduction in consumption was expected to lead to
almost 200,000 fewer type 2 diabetes cases, over 20,000
fewer strokes and heart attacks, and 18,900 fewer
deaths by 2022. As a result, the tax would save Mexico
and its health service almost US$1 billion.
The UK introduced a tax on sugary drinks in 2018, which
caused prices to rise by around 13%. This led to a 12%
fall in sales of sugary drinks among low-income groups.
In contrast, there was a 50% increase in sales of Coke
Zero Sugar in the first year after the introduction of
the tax.
However, some economists consider that other methods
could be used to reduce sugar consumption, including:
✚ banning advertising sugary products on TV and online
✚ reducing price promotions of sugary food and drinks
✚ banning high-sugar foods from supermarket till areas
✚ new regulations to reduce portion size
✚ greater health education and information to increase
awareness of the dangers of too much sugar
consumption
✚ subsidies for fruit and vegetables and non-sweetened
beverages.
Extract C: Sugar production
Sugar production often involves undesirable
consequences. In Australia, for example, the expansion
of sugar cane production has caused a number of
problems such as drainage issues and disruption of
a) With reference to Extract B, calculate the
price elasticity of demand for sugary drinks in
the UK for low-income groups. Comment on
your result.
[5]
b) With reference to Extract B, examine the cross
elasticity of demand between the price of
sugary soft drinks and Coke Zero Sugar.
[8]
c) With reference to Figure 1 and Extract A, assess
how a fall in the price of sugar might affect the
price of biscuits.
[10]
wildlife habitats. Further, production is increasingly
dependent on the use of chemical fertilisers, which has
caused loss of fish, land erosion and a deterioration in
the quality of the land.
d) With reference to Figure 1 and Extract A, discuss
the reasons for the fall in the price of sugar.
Illustrate your answer with a supply and
demand diagram.
[12]
e) With reference to Extract C, discuss the external
costs of sugar production. Illustrate your answer
with an externalities diagram.
[15]
f) Evaluate the case for a tax on products
containing a large amount of sugar. Illustrate
your answer with an appropriate diagram.
[25]
Answers and quick quizzes online
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5 Measures of economic performance
Economic growth
Measuring economic growth using GDP
✚ Economic growth is a measure of an increase in real gross domestic
product (GDP). This is referred to as actual economic growth.
✚ GDP is the total amount of goods and services produced in a country in
1 year, or the total amount spent, or the total amount earned.
✚ Potential economic growth is a measure of the increase in the productive
capacity of an economy. It can be shown by a movement outwards of the
PPF curve (see Chapter 1, pages 16–17).
✚ A recession occurs when an economy suffers two consecutive quarters of
negative economic growth.
✚ If a country is in a recession there is less spending, income and output. It is
likely to lead to the closure of firms, causing increased unemployment and
a fall in living standards.
✚ Recent UK recessions occurred in 2008 following the global financial crisis
and in 2020 following the COVID-19 pandemic.
Making links
Economic growth is relevant as a macroeconomic objective (see Chapter 10) and for
emerging and developing economies (see Chapter 19).
Real means that inflation
has been taken into
account. Real values are
sometimes referred to as
‘constant prices’. If inflation
is left in the figures they
are known as ‘nominal’ or
‘current’.
Recession, in the
technical definition, is
when an economy has two
consecutive quarters of
negative economic growth.
A quarter is three months,
starting from January, April,
July or October.
Exam tips
Distinction between nominal and real GDP
✚ Nominal GDP is simply the money value of all goods and services produced
by a country in 1 year.
✚ Real GDP is the nominal GDP adjusted for inflation. Therefore, using
real GDP, it is possible to measure changes in the volume of output
over time.
Distinction between total and per capita measures
of GDP
✚ In 2019 total GDP in the UK was $2.93 trillion whereas it was $2.8 trillion in
India. However, for GDP to be meaningful as a measure of living standards,
population needs to be taken into account.
✚ GDP per capita is calculated by dividing GDP by the country’s population.
On this measure, UK GDP per capita was $46 867 whereas in India it was
$6670 in 2018.
Now test yourself
1 What are the characteristics of a recession?
2 How might it be possible for Country A to have a higher GDP than Country B but a
lower GDP per capita than Country B?
Remember that a falling
rate of economic growth
(assuming that it is positive)
means that real output is
still rising but at a slower
rate.
Economic growth is a change
in the level of real GDP, not
GDP itself. When referring to
economic growth, remember
that it refers to a percentage
change.
GDP per capita (per head)
is total GDP divided by the
population. Total population
figures cannot be assumed
to be constant when looking
at GDP, so GDP per capita
gives a better indicator of
living standards.
Answers available online
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✚ The volume of output measures the number/amount of goods produced.
✚ The value of output measures the amount of goods produced multiplied by
the price at which they are sold.
✚ Therefore, an increase in the volume of output does not always mean that
there is an increase in the value of output. For example, if prices are falling
then the value might fall even when volume increases.
Now test yourself
3 If GDP rises from $3 trillion to $3.3 trillion in a year, but inflation rises by 10%, has
real GDP increased?
Answers available online
Distinction between GDP and GNI
Exam tip
The ability to interpret
data is important in
examinations. In the context
of GDP, refer to the World
Bank website (https://data.
worldbank.org/indicator/
NY.GDP.MKTP.KD.ZG) to
compare growth rates in
different countries.
Gross national income (GNI) measures income received by a country both
domestically (gross domestic product (GDP)) and via net incomes from
overseas.
5 Measures of economic performance
Distinction between value and volume measures
of GDP
GNI = GDP + profits from companies operating abroad and income earned
from nationals living in foreign countries – profits from foreign-owned
companies and income earned from foreign nationals living in the country
that goes abroad.
Exam tip
GNI may be much less than GDP if much of the income from a country’s production
flows to foreign people or firms. But, if the people or firms of a country hold large
amounts of the stocks and bonds of firms or governments of other countries and
receive income from them, GNI may be greater than GDP.
Understanding purchasing power parities
Purchasing power parities (PPPs) are used to compare GDP in different
countries, and take into account the cost of a ‘basket of goods’ that could
be bought in each of the countries being compared. The PPP exchange rate
is the rate that equalises the purchasing power of different currencies by
eliminating differences in prices between countries.
Example
A Lady Gaga CD costs £10 to buy in the UK and $10 in the USA. The exchange rate on
the currency markets is £1 = $1.50 but the PPP rate is £1 = $1.
This means that the pound is overvalued (too strong) on the currency markets, and
you would expect the official exchange rate of the UK economy to give values for
incomes that are over-inflated in terms of PPP.
Now test yourself
4 Explain why GDP at PPP provides a more accurate means of comparing living
standards than nominal GDP data.
Answers available online
Comparison of rates of growth between countries
and over time
GDP data are used to compare the standard of living over time and between
countries. The standard of living refers not only to income but also to the
quality of life, which includes housing, health, the environment and safety.
Purchasing power
parities — when values
of income are expressed
at PPP it means that the
exchange rate used is the
one where the same basket
of goods in the country
could be bought in the USA
at this rate of currency
exchange.
Making links
PPP is a concept used in
connection with exchange
rates (see Chapter 17, pages
200–201). According to PPP
theory, exchange rates are
in equilibrium if, when one
currency is changed into
another, it could buy the
same basket of goods in
each country.
Quality of life is a measure
of living standards that
takes into account more
than just income (or GDP).
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5 Measures of economic performance
Limitations of using GDP to compare living
standards between countries
Two countries might have the same GDP but living standards might be
significantly different. Some reasons are listed below.
✚ Difference in population: it is necessary to calculate GDP per capita.
✚ Differences in rates of inflation: real GDPs must be compared.
✚ How much of the output is self-consumed so does not appear as GDP.
✚ Methods of calculation and reliability of data may differ.
✚ Type of spending by government: is money spent on warfare, or on quality
of life issues such as education and health?
✚ Differences in income distribution.
✚ Differences in exchange rates.
Limitations of using GDP to compare living
standards over time
The above points are all relevant to comparing living standards over time
with the exception of the last one relating to exchange rates.
Now test yourself
5 Country A has a higher GDP per capita than Country B. Why might Country A’s
living standards be lower than Country B’s?
Answers available online
Making links
The standard of living is
relevant to the study of
economic development in
emerging and developing
economies. For example, in
many very poor countries
the level of absolute poverty
is high, meaning that living
standards are very low.
(see Chapter 19)
National happiness
Given some of the limitations of GDP as a measure of living standards, several
countries try to measure ‘national happiness’.
UK national well-being
✚ The UK Government undertakes regular surveys of personal well-being
that make estimates of overall satisfaction with life. These surveys
measure emotions, such as happiness and anxiety, and the extent to
which people feel the things they do are worthwhile.
✚ These measures are strongly related to other important aspects of quality
of life such as health, relationships and employment.
✚ These surveys provide an attempt to measure subjective happiness.
The relationship between real incomes and
subjective happiness
Subjective happiness is a
measure of how people feel
about themselves.
✚ Research suggests that there is a positive relationship between income and
happiness up to a certain level of income.
✚ However, once incomes increase beyond that level, marginal gains in
happiness fall. This is referred to as the Easterlin paradox.
✚ A policy implication of the Easterlin paradox is that governments need to
focus not only on economic growth but also on other objectives such as
income equality and a clean environment.
Exam tip
68
Subjective happiness on any one day is an unreliable indicator, as our moods change
with the weather, short-term health issues (such as headaches) or events in the news.
So, for example, people might not be able to tell you accurately how they feel about
life on a particular day but if you keep on asking over several years they might be able
to give you a good overall view.
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Now test yourself
5 Measures of economic performance
6 Assess one way in which national happiness is considered more important than
economic growth as an objective of government policy.
Answers available online
Inflation
Inflation, deflation and disinflation
Inflation
Inflation is a sustained rise in the general price level. Most countries have some
degree of inflation but countries such as Iran and Argentina had inflation
rates of over 40% in 2019.
Deflation
Deflation is a sustained fall in the general price level. It is often a sign of
stagnation in an economy. The COVID-19 pandemic caused a severe recession
with the result that some countries experienced deflation.
Disinflation
Disinflation is a fall in the rate at which the general price level is rising. For
example, inflation might fall from 3% to 2%, meaning that the price level is
rising but increasing less rapidly than previously. In 2020, a fall in oil prices
brought about disinflation in many countries.
Exam tip
Now test yourself
Deflation is a fall in the
general level of prices.
Disinflation is a fall in the
rate of inflation, so the price
level is rising more slowly.
7 How would you describe the following?
a) The rate of inflation is –0.5.
b) The rate of inflation falls from 1.2 to 0.4.
Answers available online
Calculating the Consumer Price Index rate
of inflation
Inflation is a measure of the increase in the average price level. The price level
is the Consumer Price Index (CPI), which is a weighted average of items on
which people spend their money.
Key features of the CPI
✚ The rate of inflation is measured in the UK by changes in the CPI, and this
measure is used for inflation targeting.
✚ It is also used to make international comparisons of the rate of inflation.
✚ The CPI is an index number. This means that it is a number shown as a
percentage relative to the base year, which is given the value 100.
✚ Inflation is usually shown on a year-to-year basis, so you need to calculate
a percentage change using the following formula:
Change
× 100
Original
The Consumer Price
Index is the measure of
inflation used for inflation
targeting in the UK. It does
not include housing costs,
such as mortgage interest
repayments or rent. It is also
used to make international
comparisons of inflation rates.
An index number is a
number shown relative
to another number in
percentage terms, so the
actual figures are removed
and only the relative
difference is shown.
A base year is used to
compare price levels in
different time periods. It is
given the number 100.
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Example
5 Measures of economic performance
What is the rate of inflation if the CPI changes from 125 to 130?
Answer
This is an increase of (5/125) multiplied by 100, which is an inflation rate of 4%. It is not
5%. Most people divide by 100 rather than the ‘original’, which is 125.
How the CPI is calculated
✚ The Living Costs and Food Survey collects information from a sample of nearly
7000 households in the UK using self-reported diaries of all purchases.
✚ A price survey is undertaken by civil servants, who collect data once a
month about changes in the price of the 700 most commonly used goods
and services in a variety of retail outlets.
✚ Weights are assigned to each item the average household buys. The
weights reflect the proportion of income spent on each item in the average
shopping basket.
✚ The price changes are multiplied by the weights to give a price index.
The rate of inflation can then be measured by calculating the percentage
change in this index over consecutive years.
✚ The CPI does not include housing costs, such as rent payments and
mortgage interest repayments.
Weights show the
proportion of income spent
on items. They are used to
ensure that the percentage
change in price reflects
the impact on the average
family in terms of their
spending.
Making links
The CPI is an example of the use of index numbers. Index numbers may be used in a
variety of contexts because they simplify complex numbers and enable trends to be
determined easily. Other examples of using index numbers include:
✚ Export and import prices — the terms of trade (see page 192)
✚ Incomes (see Chapter 15)
✚ GDP, industrial production (see page 66)
✚ Employment (see page 74)
Now test yourself
8 Why are ‘weights’ used in calculating the CPI?
Answers available online
The limitations of CPI as a measure of the rate
of inflation
There are various reasons why the CPI has been criticised as a means of
measuring the rate of inflation:
✚ It does not include housing costs, which are a significant item of
expenditure for most households in the UK.
✚ Some people do not have representative spending patterns and so might
experience cost of living rises by more or less than the average shown by
the CPI.
✚ Attempts are made to take account of changes in the quality (e.g. mobile
phones) or weight of goods (e.g. when chocolate bars are made smaller) but
inevitably these adjustments may be imprecise.
✚ The list of 700 representative items is only changed once a year and so
sudden changes in spending patterns are not reflected in the CPI.
✚ There are sampling issues. For example, households might not provide
accurate information on their spending, such as understating the amount
spent on alcohol. Also, some households might not respond to the survey.
Exam tip
Many students think that
the CPI is inflation, but it
is changes in these price
levels that show inflation.
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It should be noted that the CPIH is now the Office for National Statistics’
preferred measure of inflation. It is the most comprehensive measure
of consumer price inflation because it extends the CPI to include owneroccupiers’ housing costs and council tax.
Now test yourself
9 Why might the CPI not be representative for a pensioner?
Answers available online
The Retail Price Index rate of inflation
The Retail Price Index (RPI) does include interest payments on mortgages, but
it is not as reliable as the CPI or CPIH for international comparisons. As a
result, this legacy measure of the rate of inflation is likely to be discontinued,
although it is still used in long-term contracts and index-linked gilts.
Now test yourself
Exam tip
Remember that if the rate
of inflation is falling but still
above zero then the price
level is still rising, although
at a slower rate.
10 If oil prices fall sharply is this deflation?
Answers available online
5 Measures of economic performance
CPIH
The causes of inflation
There are three main explanations as to why inflation can occur.
Demand-pull inflation
This occurs when aggregate demand (total demand) in the economy increases
at a faster rate than aggregate supply.
Cost-push inflation
This occurs when aggregate supply decreases, i.e. the total costs of production
increase.
The causes of these types of inflation are shown in Table 5.1.
Table 5.1 Causes of demand-pull and cost-push inflation
Causes of demand-pull inflation
Causes of cost-push inflation
A decrease in interest rates
A rise in oil prices and/or raw material prices
A rise in the level of business and consumer confidence
A fall in the exchange rate (making imports more expensive)
An increase in government spending
A rise in taxes on businesses
Exports rising relative to imports
An increase in the minimum wage or in wages generally
Depreciation of the exchange rate (increasing demand for
exports and reducing demand for imports)
Increased regulations, e.g. environmental regulations,
health and safety, that increase costs
Growth of money supply
✚ Some economists (monetarists) argue that the sole cause of inflation is
increases in the money supply.
✚ This is associated with an increase in aggregate demand in the economy.
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5 Measures of economic performance
Making links
Investment, government expenditure and exports are injections into the circular flow
of income, as is the multiplier, both of which are considered in Chapter 8. In exams, it
is important to be able to apply these concepts both verbally and numerically when
considering changes in GDP, unemployment, inflation and the net trade balance.
Demand–pull inflation is caused by a rise in aggregate demand, e.g. interest
rates might be cut so people spend more. More people buying the same amount of
goods means prices rise.
Cost–push inflation is caused by decreases in aggregate supply, or higher costs
of production, which lead to a rise in the price level and a more general increase in
costs across the economy.
Monetarism is the school of economics (particularly associated with Milton Friedman)
based on the belief that inflation is always a problem of too much money in the economy.
Making links
Diagrammatic analysis of the various causes of inflation may be found in Chapter 8. In
exams, it is important to support your written analysis with diagrams where appropriate.
Now test yourself
11 What type of inflation is associated with the following?
a) An increase in raw material prices
b) A significant increase in consumer expenditure
Answers available online
Exam tip
A fall in the value of a
currency (depreciation) can
lead to cost-push inflation
because imports become
more expensive or cause
demand-pull inflation
because exports become
more attractive and imports
less attractive.
The effects of inflation
Inflation is an important measure of the success of an economy, and inflation
rates that are too high or too low are a sign that the economy is experiencing
problems.
A high rate of inflation often has damaging effects on an economy as outlined
below.
Consumers
✚ For those on fixed incomes: inflation implies that their incomes would fall
in real terms.
✚ For those with savings: if the rate of inflation is higher than the interest
rate on savings, the real value of savings will decrease.
✚ For those with loans or mortgages: if the rate of inflation is higher than the
interest rate on loans, the real value of those loans will fall, making them
more manageable for consumers.
Firms
✚ Fall in exports: if the UK rate of inflation is higher than that of its main
trading partners, the UK’s international competitiveness will fall. A firm’s
exports become relatively expensive in foreign markets and imports from
abroad seem cheap. This tends to worsen the balance of trade.
✚ Uncertainty: a high rate of inflation might make it difficult for firms to set
budgets, which might result in a fall in investment.
Fixed incomes — many
groups, such as university
students and pensioners,
do not usually enjoy wage
increases in line with
inflation, meaning they
suffer when the cost of
living rises.
Real terms refers to
a value that has been
adjusted to take the effects
of inflation into account.
International
competitiveness is the
degree to which a country’s
goods and services can
be sold on international
markets.
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which could result in lower investment. However, some inflation is
desirable because it enables firms to increase revenues. In turn their
profits could increase (especially if there is demand-pull inflation) and this
might encourage them to invest.
✚ Impact on monetary policy: high inflation rates might cause the Monetary
Policy Committee (MPC) to increase interest rates. This is known as tight
monetary policy, and can have damaging effects, for example on
investment by firms (it falls because the cost of borrowing increases).
Now test yourself
12 Under what circumstances would inflation benefit firms?
Answers available online
The government
Tight monetary policy is
usually designed to reduce
the rate of inflation by:
✚ raising interest rates
✚ reversing quantitative
easing
✚ changing the criteria for
giving loans to make it
more difficult for firms
and consumers to
borrow money.
✚ Fall in the real value of the national debt: inflation would reduce the
value of the debt owed by the government. Therefore, it becomes less of a
burden.
✚ Increased inequality: inflation might make it more difficult for a
government to reduce income inequality because those on fixed incomes
will see a fall in the real value of their incomes.
✚ A deterioration in the balance of trade: if inflation causes a fall in the
country’s international competitiveness, its exports are likely to fall and
imports to increase. This causes a deterioration in the trade balance.
5 Measures of economic performance
✚ Lower profits: cost-push inflation is likely to cause a decrease in profits,
Workers
✚ For those in a weak bargaining position: if inflation is rising at a faster rate
than wage increases, workers become progressively worse off, even if in
nominal terms their wages have increased. However, if wages rise faster
than inflation then real incomes rise.
✚ Unemployment: according to some economists there is a short-run tradeoff between inflation and unemployment (the Phillips curve, see page 125).
A very low rate of inflation might imply a low level of demand in the
economy and a high rate of unemployment.
Making links
Inflation is a concept that is relevant to many areas of the course:
✚ It helps to distinguish between nominal and real values, which is relevant in
considering, for example economic growth (see Chapter 5, page 107).
✚ In considering its impact on international competitiveness and the balance of trade
(see Chapter 17, pages 204–205).
✚ In considering the trade-off between inflation and unemployment (see the Phillips
curve analysis in Chapter 10, page 125).
✚ In economic policies relevant to reducing the rate of inflation (see chapters 10 and 21).
In exams, you need to be able to demonstrate an understanding of the
interdependence between different economic variables, so it is important to identify
links between them as you continue your studies.
Now test yourself
13 Cherry gets a 1% pay rise from her employer, but the rate of inflation is 4%. What,
to the nearest whole number, happens to her real wage?
Answers available online
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5 Measures of economic performance
Employment and unemployment
Measures of employment
✚ The level of employment is the number of people in work.
✚ The employment rate is the number of people in work as a percentage of
the working age population.
Measures of unemployment
The Claimant Count
This is based on claimants of unemployment-related benefits, either from
Jobseeker’s Allowance (JSA) or Universal Credit (UC).
The International Labour Organization and
the UK Labour Force Survey
✚ The Labour Force Survey (LFS) is a survey of a sample of households.
✚ It asks people aged between 16 and 65 whether they have been out of work
over the last 4 weeks and if they are ready to start within 2 weeks.
✚ The LFS uses standard International Labour Organization (ILO) methods
Jobseeker’s Allowance
is paid to people who are
willing and able to work
but are not currently in
employment. When an
economy grows, JSA is
likely to fall as more people
who are willing to work do
manage to find work.
of measuring unemployment. Consequently, other countries use this
method of measuring unemployment, allowing for international
comparison.
Now test yourself
14 Why might the ILO measure of unemployment be higher than the Claimant Count
measure?
Answers available online
The distinction between unemployment
and underemployment
Unemployment
✚ The unemployment rate is the number of unemployed people as a
percentage of the labour force.
✚ The labour force (economically active population) consists of the
unemployed plus those in paid or self-employment.
✚ Unemployment can be measured as a level, i.e. the number of people looking
for work but unable to find it, or as a percentage, i.e. the number of people out
of work divided by the total economically active population, multiplied by 100.
✚ It should be noted that unemployment is not a static concept — each week
some people become unemployed while others get a job. Therefore the
level of unemployment increases when more people are made redundant
than find employment.
The labour force
(economically active
population) is those aged
16 and over who are either
employed or unemployed.
Underemployment
✚ Underemployment includes individuals who are seeking or available for
additional work.
✚ The Office of National Statistics (ONS) measures underemployment as all
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those workers wanting to work more hours than they currently do and
who are available to start in 2 weeks.
✚ The OECD also includes in the definition of underemployment those
people who are working in jobs where their skills are not adequately
utilised, i.e. they are overqualified for the job that they are doing.
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The benefits of increased employment might include:
✚ Increased GDP, i.e. with higher employment, output in the economy is
likely to increase.
✚ Increased revenues and profits for firms.
✚ Increased incomes, leading to an increase in the standard of living for
households.
✚ Improved skills (human capital) of workers.
✚ Higher government taxation revenue as more people pay tax and spend
more (VAT and corporation tax also tend to rise when employment rises).
Now test yourself
Human capital refers to
the knowledge and skills of
a workforce that determine
its productivity. Human
capital may be improved by
education and training.
15 What is the difference between unemployment and underemployment?
16 Will an increase in employment necessarily mean that unemployment is lower?
Answers available online
Significance of a decrease in the unemployment rate
The effects will be similar to those of an increase in employment and include:
✚ falling government spending on JSA, UC and other out-of-work benefits
✚ increased employment, which can have significant benefits because
people who are out of the job market for a long period become increasingly
unemployable
✚ the job market becoming less flexible (with fewer workers for employers to
choose from).
5 Measures of economic performance
Significance of an increase in the employment rate
Significance of changes in the inactivity rate
The economically inactive population measures those without a job but who
are not classed as unemployed. It includes students in full-time education,
parents looking after a family at home, those who have retired early and those
who are too sick to work.
If there is an increase in the inactivity rate, then:
✚ the productive capacity of the country will fall
✚ there may be more claims on state benefits
✚ the dependency ratio will increase (the number of inactive people that
active and employed people are supporting, directly or indirectly).
Economically inactive
refers to people not in
education, employment or
training and who are not
actively seeking work within
the last 4 weeks and who
are unavailable for work
within the next 2 weeks.
However, if an increase in the inactivity rate is due to more people in higher
education then this is likely to result in an increase in the skills of the future
workforce.
Making links
Employment and unemployment are linked to many other economic variables
including economic growth, consumer expenditure, poverty and inequality. In exams,
you should be able to draw links between these variables.
For example, regarding the distribution of income (see Chapter 18), an increase in
employment usually means that people have higher incomes than would be the case if
they were unemployed. In turn this implies a more even distribution of income, although
much depends on the type of employment (e.g. full time or part time, wage levels).
Exam tip
Remember that people
who are willing to work but
cannot find employment
are still classified as
economically active.
Now test yourself
17 Identify two reasons why the inactivity rate might increase.
Answers available online
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Causes (types) of unemployment
5 Measures of economic performance
✚ Cyclical (or demand-deficient): lack of spending in the economy/recession
means that people are out of work. You expect this type of unemployment
in a recession.
✚ Structural: where industries are in decline and workers’ skills are
becoming obsolete (out of date).
✚ Frictional: where people are between jobs.
✚ Seasonal: where people are out of work for some periods of the year, for
example ski instructors in the summer and surf instructors in the winter.
✚ Classical or real wage inflexibility: where there are problems with the
supply-side of labour, e.g. the minimum wage is too high and set above the
equilibrium wage. Some economists (classical approach) argue that this is
the cause of persistent unemployment in some countries.
Now test yourself
18 The long-term decline in demand for fossil fuels as a means of generating
electricity would result in which type of unemployment?
Answers available online
The significance of migration for
employment and unemployment
Migration refers to the movement of people from one country to another.
People migrate for many reasons including the following:
✚ Employment
✚ To earn a higher income
✚ For a better life, i.e. in terms of subjective happiness
✚ To study abroad
✚ To join other family members
✚ To escape conflict, discrimination or political problems
✚ To avoid high tax liabilities
✚ Remittances — family members may migrate in order to send money
home
Migration refers to both immigration and emigration. The significance of
migration for an economy depends, at least in part, on the reasons for the
migration as identified above. For example:
✚ If immigrants come into a country to fill vacancies then immigration leads
to an increase in employment.
✚ However, if immigrants are looking for work and either do not find it or
displace other people from work then employment may be unchanged and
unemployment might increase.
✚ Migration might have implications for public finances — if the migrants
find work then they will be paying taxes.
✚ If immigrants come to a country to earn money to send home to their
families (remittances) then this will adversely affect the current account of
the balance of payments, at least in the short run.
Making links
In exams, you need to consider the broad implications of migration since this has
many links with other parts of the course, for example its impact on:
✚ subjective happiness (see Chapter 5, page 68)
✚ the current account of the balance of payments (see Chapter 5, page 78)
✚ developing economies (see Chapter 19)
✚ public finances (see Chapter 21).
Migration in economics
refers to immigration,
emigration and the overall
balance between the two in
a country (net migration).
Immigration is when
people enter a country for
long-term stay.
Emigration is when people
exit a country for a long-term
stay in another country.
Exam tip
Remember that employed
immigrants pay taxes to the
UK Government, increasing
government revenue. Also,
immigrants of working age
increase the productive
capacity of the country.
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Skills are becoming ever more important in the labour markets of many
countries. A highly skilled workforce is likely to have the following impacts:
✚ The workforce is more productive, so helping to increase the country’s rate
of economic growth.
✚ Earnings of highly skilled workers are likely to be higher than those of
unskilled workers.
✚ Highly skilled workers are less likely to be unemployed, and have more
stable and secure employment.
✚ The above points mean that income inequality and poverty are likely to
be lower than if there was a large proportion of unskilled workers in the
labour force.
As economies become more developed, the demand for skilled workers
tends to increase relative to that for unskilled workers. This trend is likely
to continue with new technology and the increasing use of robots for
repetitive tasks.
Now test yourself
19 How might net migration out of the UK affect its productive capacity?
20 Why might an increase in the skills of the workforce reduce poverty?
Answers available online
Making links
The impact of migration and
skills on the labour force
and wage rates in particular
occupations is considered
in Chapter 15. In exams,
you will need to consider
both microeconomic and
macroeconomic impacts
of changes in the labour
market. Questions covering
both these impacts could
be set in Paper 3 of the
examination.
5 Measures of economic performance
The significance of skills for employment
and unemployment
The effects of unemployment
Table 5.2 illustrates some of the effects of an increase in unemployment.
Table 5.2 The effects of an increase in unemployment
On consumers
On firms
On workers
On governments and
society
Decrease in living
standards
Easier to recruit new
employees
Loss of skills — workers may not
have up-to-date training
Increased spending on
welfare benefits, e.g. UC
Loss of confidence
leading to lower
consumer spending
Less consumer spending
so firms face falling sales,
revenues and profits
Loss of income — welfare
benefits are rarely as generous
as paid employment
Less revenue from income
tax and indirect taxes
Danger of mental illness
if unemployed for a long
time
Since there is surplus labour
in the economy, firms might
be able to hold wages down
and, therefore, their costs
Lower living standards because
they have less income so quality
of life falls
Opportunity cost — the
goods and services that
could have been produced
by the unemployed workers.
Long-term unemployment may
make it more difficult to get a job
in the future
Inequality may increase,
perhaps resulting in more
crime and/or political unrest
May result in lower
house prices and a fall in
personal wealth
Making links
In exams you may consider unemployment through different perspectives, e.g. in
relation to:
✚ PPFs (Chapter 1, pages 14–17)
✚ output gaps, using aggregate demand and aggregate supply analysis (see
Chapter 9, pages 109–110)
✚ revenues and profits of businesses (see chapters 13 and 14)
✚ public finances (see Chapter 21).
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5 Measures of economic performance
Now test yourself
21 Why might unemployment of 2 million people over several years not result in a loss
of skills?
Answers available online
Balance of payments
The balance of payments is a record of international payments over the
course of a year.
Components of the balance of payments
The current account
The current account records payments for transactions between countries in
the present year. The key elements are as follows:
The trade in goods balance: value of goods exported – value of goods
imported
+
The trade in services balance: value of services exported – value of services
imported
= THE BALANCE OF TRADE
+
The primary balance (investment income): earnings of foreign investments
(interest, profits and dividends) – payments made to foreigners
+
The secondary balance (current transfers): relates to transfers in the form of
money or of goods and services, e.g. taxes and social security contributions,
foreign aid.
= THE CURRENT ACCOUNT
The capital and financial accounts
The capital account and the financial account relate to investments and
speculation. These will be considered more fully in Chapter 20.
The balance of trade
is the value of goods and
services exported minus the
value of goods and services
imported.
Exam tip
Remember that imports are
the flow of money out of a
country. If you go on holiday
in a foreign country, this
is recorded as an import
on the trade in services
balance because money is
flowing out of the UK.
Now test yourself
Exam tip
22 You go to Spain for a holiday. Is this an export or an import on the UK’s balance of
payments?
Remember that investment
income (interest, profits and
dividends) is the reward for
investment, which is paid in
the current period.
23 What is the difference between the balance of trade and the current account?
Answers available online
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✚ A current account surplus implies that a country’s current account is
positive, i.e. that the combined value of the net trade balance, the net
primary balance and the net secondary balance is positive.
✚ A current account deficit implies that a country’s current account is
negative, i.e. that the combined value of the net trade balance, the net
primary balance and the net secondary balance is negative.
Table 5.3 gives an overview of the main causes of a current account deficit
and a current account surplus.
Table 5.3 Causes of a current account deficit and a current account surplus
A current account surplus
of the balance of payments
occurs when more money is
flowing into the country than
is flowing out.
A current account deficit
of the balance of payments
occurs when more money
is flowing out of the country
than is flowing in.
Causes of a current account deficit
Causes of a current account surplus
The currency is too strong relative to other countries. For
example, if the pound buys many euros then exports of
goods and services from the UK will be relatively expensive.
Meanwhile imports into the UK will be relatively cheap.
The currency is too weak relative to other countries. For
example, if the yuan is low against other currencies then
China’s exports will be relatively cheap. In contrast, imports
into China would be relatively expensive.
There is a high rate of inflation relative to other countries.
There is a low rate of inflation relative to other countries.
There are high wage costs relative to other countries.
There are low wage costs relative to other countries.
There is a high rate of economic growth in a country.
People have higher incomes and tend to buy more imports
from abroad.
There is a low rate of economic growth in a country. People
have less income to buy imports from abroad. In turn, this
creates a strong incentive for firms in the country to export.
5 Measures of economic performance
Current account deficits and surpluses
Making links
Current account imbalances have links to protectionism (see Chapter 17, pages 195–197),
and exchange rates and international competitiveness (see Chapter 17, pages 204–205).
In exams, you should be able to explain changes in a country’s current account balance,
and these factors provide a useful starting point.
Now test yourself
24 How might an increase in real incomes affect a country’s balance of trade?
Answers available online
The relationship between current account
imbalances and other macroeconomic
objectives
✚ If a country has a persistent current account deficit then it might imply
that the country’s goods are uncompetitive, which could cause an
increasing level of unemployment.
✚ In turn, this might lead to a fall in the rate of economic growth. However,
this may not be true if the deficit was caused by lower exports associated
with a boom in the economy and high levels of consumer expenditure.
✚ It could cause a fall in the country’s exchange rate against other
currencies. In turn, this would cause an increase in import prices, which
could be inflationary.
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5 Measures of economic performance
The interconnectedness of economies
through international trade
International trade means that countries are interdependent, i.e. they rely
on each other, for example through global supply chains. These involve a
worldwide network of suppliers, manufacturers, distribution centres and
retailers, which cross many countries and continents for the purpose of
sourcing and supplying goods. They involve not only the flow of resources but
also information and processes.
This interdependence may be beneficial because it reduces costs (and
therefore prices), and it promotes cooperation between countries.
However, it can also result in the establishment of trade blocs that become very
powerful, which can leave some developing countries unable to trade fairly.
Global supply chains
are worldwide networks
of companies and their
suppliers, manufacturers,
warehouses, distribution
centres and retailers. The
supply chain involves the
acquisition of raw materials,
which are then transformed,
manufactured and delivered
to customers.
Now test yourself
25 Why is international trade important for the production of cars in the UK?
Answers available online
Summary
You should have an understanding of:
✚ the way in which economic growth measures increase
in real GDP or in potential capacity in an economy,
which can lead to an increase in living standards
(although there are various problems in using GDP
to compare living standards over time and between
countries)
✚ GDP and national happiness, and that there is no clear
link between the two
✚ the Consumer Price Index, the internationally
comparable measure of inflation
✚ the distinction between inflation, deflation and
disinflation, and that inflation may be caused by
✚
✚
✚
✚
demand factors, cost factors or excessive increases in
the money supply
the ILO measure, a measure of unemployment used for
international comparisons
employment and unemployment, which are not
opposites but different ways of looking at the efficiency
in the use of a country’s workforce
underemployment, which is a good way of evaluating
the measure of unemployment
the balance of payments, which is another way to
judge the health of an economy, by looking at flows of
money in and out of the country. Exports bring money
flows into a country and imports see money flowing
out.
Exam skills
This chapter has introduced some key measures of
macroeconomic performance. The knowledge assessment
objective states that students should be able to:
apply knowledge and understanding to various
economic contexts to show how economic agents
are affected by and respond to economic issues.
demonstrate knowledge of terms/concepts and
theories/models to show an understanding of the
behaviour of economic agents and how they are
affected by and respond to economic issues.
In respect of economic growth, inflation, employment and
unemployment, and the balance of payments, you should
be able to:
✚ interpret data (numerical or charts), e.g. changes in the
rate of inflation on the average price level
✚ analyse the significance of changes in trends of these
variables, e.g. the impact of a fall in GDP on the level of
unemployment
✚ make calculations, e.g. changes in GDP per capita on
the basis of data on GDP and population.
The first phrase is particularly important because economic
growth, inflation, employment and unemployment, and the
balance of payments are the key concepts that need to be
known, understood and applied in the macroeconomics
part of the course (Themes 2 and 4).
These concepts also provide much scope to test the
application assessment objective, which states that
students should be able to:
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Exam practice
5 Measures of economic performance
1 Table 1 shows GDP at constant 2010 prices (in US$) and the UK population between 2008 and 2019. The last column
may be used for your own calculations.
Table 1 UK GDP, 2008–19
Year
GDP ($ billions)
Population (millions)
2008
2536
62.2
2009
2428
62.8
2010
2475
63.5
2011
2513
64.0
2012
2551
64.5
2013
2605
65.0
2014
2673
65.4
2015
2736
65.9
2016
2788
66.3
2017
2072
66.7
2018
2841
67.1
2019
2881
67.5
GDP per capita ($)
Source: World Bank
a) With reference to Table 1, explain one possible reason for the change in GDP per capita between
2008 and 2009.
b) Assess the possible link between changes in GDP per capita and national well-being.
c) With reference to Table 1, discuss reasons why changes in GDP per capita do not accurately reflect changes
in living standards over time.
[5]
[10]
[15]
%
2 Study Figure 1 and answer the questions that follow.
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
Figure 1 UK annual inflation rate as measured by the Consumer Price Index (CPI), 2008–2019
Data: World Bank
a) Which one of the following may be deduced from Figure 1?
A There was deflation between 2008 and 2009.
B The price level was lower in 2012 than in 2011.
C The price level was highest in 2017.
D There was disinflation between 2011 and 2015.
b) Explain how the CPI is calculated. Refer to weights in your answer.
[1]
[4]
Answers and quick quizzes online
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6 Aggregate demand
Characteristics of aggregate
demand
Meaning of aggregate demand
Aggregate demand (AD) is the total amount of planned spending on goods and
services at a given price level in an economy in a year.
Components of aggregate demand
AD is the sum of the following components: consumption (C), investment (I),
government expenditure (G) and exports – imports (X – M).
This may be written as a formula:
AD = C + I + G + (X – M)
Each of these components is explained in detail below.
Relative importance of the components of
aggregate demand
The following relate to the UK economy:
✚ Consumption is by far the most significant component of AD, comprising
about 60% of the total.
✚ Government expenditure usually comprises around 25% of AD, but during
the 2008 financial crisis and the 2020 COVID-19 pandemic this proportion
increased significantly (not least because overall AD fell considerably).
✚ Investment accounts for around 15% of GDP but this fluctuates according
to the state of the economy.
✚ Net trade is an insignificant element of AD.
Making links
The components of AD (C, I, G and (X – M)) are considered more fully in the rest of
this chapter. They are relevant in relation to injections (I, G and X), equilibrium level of
national income and the multiplier (see Chapter 8), to economic growth (see Chapter 9)
and to macroeconomic policies (see Chapter 10). They are applied again in much of
the macroeconomics considered in Theme 4.
In Paper 2 (and also in Paper 3) of the exam, you need to have a firm understanding
of the many interrelationships in macroeconomics so that you can develop wellreasoned answers.
Now test yourself
1 Which component of AD is the most significant?
Answers available online
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6 Aggregate demand
Price level
The AD curve
AD
0
Real GDP
Figure 6.1 An aggregate demand curve
The AD curve (see Figure 6.1) shows that as the general price level falls, real
output will increase. It can be drawn as a straight line or a curve.
The AD curve is downward sloping for the following reasons:
✚ The real balance effect: when the price level rises, the purchasing power of
cash assets falls, which leads to a decrease in the demand for real output.
✚ The international trade effect: a rise in the price level (relative to other
countries) causes a decrease in the international competitiveness of UK
goods, so causing a decrease in demand for exports and a rise in demand
for imports. This results in a contraction in AD, i.e. a movement up the
AD curve.
✚ The interest rate effect: assuming a constant money supply, a higher price
level results in an increased demand for money. As a result, interest rates
rise, reducing consumption and investment and so causing a contraction
in AD.
Exam tip
It does not make any
difference to your mark
whether you draw AD as
a straight line or a curve.
Choose the method that you
feel most comfortable with.
Now test yourself
2 What happens to AD if there is a rise in the price level?
Answers available online
A movement along the AD curve
✚ As explained above, a change in the price level causes a movement along
the AD curve.
✚ For example, a decrease in oil prices (causing a decrease in the costs of
Price level
production for all firms) would result in an expansion in AD and a fall
in the price level, as shown in Figure 6.2.
AD
0
Real GDP
Figure 6.2 Expansion in aggregate demand
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AD shifts when any one of the components C + I + G + (X – M) changes
(see Figure 6.3). The size of the change depends on the multiplier effect
(see pages 101–105).
Price level
6 Aggregate demand
A shift in the AD curve
Exam tip
Increase in AD
Decrease in AD
AD2
AD1
AD3
0
Real output
Remember to put the
(average) price level on
the vertical axis of your
diagrams. You will not gain
the marks if you simply
label it ‘Price’ because it will
look like a micro diagram.
Use ‘Real output’ and not
‘Quantity’ on the horizontal
axis.
Figure 6.3 Shifts in the aggregate demand curve
An increase in aggregate demand
✚ If AD increases, the AD curve shifts to the right, as illustrated in Figure 6.3.
✚ This implies that AD is higher at each price level.
A decrease in aggregate demand
✚ If AD decreases, the AD curve shifts to the left, as illustrated in Figure 6.3.
✚ This implies that AD is lower at each price level.
Now test yourself
3 What would happen to AD if imports increase with no change in exports?
Answers available online
Consumption (C)
Consumption is spending by households on goods and services. For example,
it records how much you spend on food and clothes. The main determinant of
consumption is disposable income.
Disposable income
✚ Disposable income relates to the money people have available to spend on
goods and services.
✚ It is the most important factor influencing consumer spending.
✚ The relationship between disposable income and consumption is
Disposable income is the
household income available
from employment, private
pensions, investments
and welfare benefits after
direct taxes such as income
tax, national insurance
contributions and council
tax have been deducted.
explained by the marginal propensity to consume (see page 102).
Making links
Disposable income is linked closely to taxes and welfare benefits (see Chapter 21). In
exams, it is important to understand that disposable income has a far more significant
impact on other economic variables such as consumption than does gross income.
Now test yourself
4 How would an increase in income tax rates affect disposable income?
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The relationship between savings and consumption
✚ In a simple economy with households and firms, any money that is not
spent by consumers is saved.
6 Aggregate demand
✚ The average propensity to consume (APC) is the proportion of disposable
income that is spent on consumer goods and services. It is calculated as
follows:
APC =
consumption
disposable income
× 100
✚ The savings ratio or average propensity to save (APS) is the proportion of
disposable income that is saved. It is calculated as follows:
APC =
savings
disposable income
× 100
Now test yourself
5 If consumers increase their savings as a proportion of disposable income then
what will happen to consumption?
Answers available online
Other influences on consumption
Interest rates (the cost of credit)
✚ If interest rates rise, then the cost of borrowing to consumers increases.
✚ It also increases the opportunity cost of spending (i.e. saving) — higher
interest rates mean that more money can be earned by leaving money in
the bank.
Consumer confidence
✚ If householders feel secure in their jobs and their future prospects then
The interest rate is the
cost of credit (borrowing) or
the reward for saving.
The wealth effect is the
effect on spending when
asset prices change.
they are more likely to buy big-ticket items such as new cars or expensive
electrical goods.
✚ Consequently, what people think is going to happen to the economy has a
big influence on the level of consumer expenditure.
Wealth effects
✚ An increase in house prices or share prices means that householders feel
wealthier.
✚ This encourages people to spend more.
✚ For example, if a house is worth more then the owner might take out a
larger loan on the house to finance the purchase of goods and services.
✚ Similarly, if the price of a person’s shares goes up they might be
more willing to book a foreign holiday or spend money on home
renovations.
Other factors influencing consumption include the level of employment,
welfare benefits and pensions.
Making links
In exams, you need to be able to explain the clear links between monetary policy
and its impact on macroeconomic variables, e.g. changes in interest rates and
consumption (see Chapter 10, pages 117–118).
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Now test yourself
6 Aggregate demand
6 What will happen to consumption if there is a decrease in interest rates?
Answers available online
Investment (I)
Distinction between gross investment and net
investment
Gross investment
✚ Investment is defined as an increase in the capital stock. In official
statistics investment is referred to as gross fixed capital formation.
✚ Gross investment refers to the total expenditure on new capital goods.
✚ Therefore:
Gross investment = net investment + depreciation
Net investment
✚ Depreciation refers to the fall in value of a capital asset due to wear and
tear and obsolescence.
✚ Net investment refers to new additions to capital stock after taking into
account the fall in value of capital assets.
✚ Therefore:
Exam tip
Note that investment, as
used in economics, refers to
an increase in capital stock
and not to investment of
money into a bank account.
Net investment = gross investment – depreciation
Net investment is more useful than gross investment as a sign of
improvements in the prospects for the economy.
Now test yourself
7 Give two examples of investment.
Answers available online
Influences on investment
The main influences on investment are as follows:
The rate of economic growth
✚ If there is an increase in real GDP then firms will need more capital in
order to meet the increased demand.
✚ Therefore, an increase in real GDP causes investment to rise, and an
increase in investment causes real GDP to rise. This is a virtuous circle.
Now test yourself
8 Explain how an increase in real incomes might affect investment.
Answers available online
Business expectations and confidence
✚ If firms expect to sell more in the future they are more likely to invest
today.
✚ Similarly, if business confidence is high, e.g. if economic growth is likely to
be sustained, then firms are likely to invest.
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Keynes and ‘animal spirits’
✚ John Maynard Keynes coined the term ‘animal spirits’ to describe the
6 Aggregate demand
instincts and emotions that may determine whether or not firms decide to
invest.
✚ Given the degree of uncertainty in which an economy operates, many
decisions about whether to invest are taken as a result of ‘animal spirits’.
Now test yourself
9 What is likely to happen to investment if there is a forecast of a recession in the
coming year?
Answers available online
Demand for exports
✚ A significant and sustained increase in demand for a country’s goods from
abroad is likely to stimulate investment.
✚ However, some firms are reluctant to export because of the rules,
regulations and other difficulties involved in international trade.
Interest rates
✚ If interest rates rise, investment tends to fall because it costs more to
borrow the money in order to invest.
✚ However, a rise in interest rates might not deter investment if businesses
think it would still be profitable or if they are funding the investment from
retained profits.
Access to credit
✚ Low interest rates do not necessarily mean that loans are readily available.
Banks might not be willing to take risks in their lending. In the aftermath
of the 2008 financial crisis, firms often found it difficult to borrow even if
they wanted to.
The influence of government
✚ Government policy might mean changes in tax rates that directly affect
firms.
✚ For example, if the government decides to cut corporation tax (a tax on
profit) then firms are more likely to invest.
Government regulations
✚ If the government relaxes planning restrictions, firms are more likely to
invest in building projects.
Corporation tax is a tax
on firms’ profits. It affects
firms’ level of investment
(AD) and the amount firms
are willing to supply at any
price level (AS).
Making links
In exams, you need to be able to explain the clear links between monetary policy
and changes in other variables, e.g. interest rates and investment explained above.
You should also note the significance of expectations in other areas of the course,
such as consumption (see page 85), speculation and market bubbles (see Chapter 20,
page 230).
Now test yourself
10 How is investment affected if banks are risk averse?
Answers available online
Exam tip
Do not confuse interest
rates with inflation.
Interest rates may be used
to control inflation, but
otherwise they are very
different concepts.
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6 Aggregate demand
Government expenditure (G)
Influences on government expenditure
The trade cycle
✚ The trade cycle refers to fluctuations in GDP around the long-run trend in
economic growth (see pages 110–111).
✚ During a downturn in economic growth, government expenditure is
higher because, for example, expenditure on welfare benefits is higher.
✚ The government automatically spends more in a recession, as government
spending increases on out-of-work benefits.
✚ The government automatically spends less in a boom, as government
spending on welfare benefits decreases.
Fiscal policy
✚ Governments may deliberately manipulate total spending in the economy
by changing their own level of spending. This is called discretionary fiscal
policy (For more on fiscal policy, see Chapter 10).
✚ Note that the government does not have to ‘balance its books’ in the short
run, meaning that it can spend more or less than it receives from tax
revenues.
Fiscal policy refers to
the use of government
expenditure and taxation
to influence the level of
economic activity.
Making links
This section is just an introduction to government expenditure. It links directly with
the trade cycle (see Chapter 9, pages 110–111), demand-side policies (see Chapter 10,
page 117) and with the public expenditure section in Chapter 21 (see pages 233–235).
In exams, you will need to have an overview of all of these links in order to provide a
high-quality response.
Now test yourself
11 Would you expect government expenditure to rise or fall in a recession?
Answers available online
Net trade (X – M)
The meaning of the net trade balance
Exam tip
Net trade is calculated by deducting the value of imports from the value of
exports. In the UK this is usually a negative figure, meaning that the outflow
of money for foreign goods and services is greater than the inflow which the
UK receives from its exports.
Remember that when a
country imports goods or
products, money is flowing
out of the economy. This
means that if there is an
increase in imports, there
is less spending within this
country, so AD falls.
Influences on the net trade balance
Real income
✚ If incomes rise within an economy then there is a reduced incentive for
domestic firms to export because they can sell their goods and services in
the domestic economy.
✚ In addition, higher real income leads to an increase in demand for
imports, depending on the value of the marginal propensity to import (see
Chapter 8, page 103).
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✚ If the exchange rate rises against other currencies, net exports are likely
to fall because exports become less competitive and imports become more
competitive in the domestic economy.
✚ However, in the short run a strong exchange rate might increase the value
of exports and decrease the value of imports. The reason for this is that the
demand for exports and imports is price inelastic in the short run because
spending patterns do not adjust quickly to price changes.
The exchange rate is the
price of one currency in
terms of another.
Net exports — this is the
difference between the
value of exports and the
value of imports.
Changes in the state of the world economy
✚ The value of UK exports is heavily dependent on growth rates around the
world.
✚ In 2020, the COVID-19 pandemic caused a global recession, which
inevitably resulted in a fall in demand for UK exports.
The degree of protectionism
✚ If there are high tariffs (taxes on imports) or other restrictions on trade,
firms find it difficult to export to certain countries.
Non-price factors
Demand for exports and imports may be influenced by factors other than
price. These include:
✚ quality and design
✚ reliability
✚ after-sales service
✚ transport costs.
Exam tip
If the UK’s currency gets
stronger, it means it can buy
more of a foreign currency,
so imports are cheaper and
exports cost more to people
abroad. To remember this,
use the mnemonic SPICED
— ‘Strong Pound, Imports
Cheap, Exports Dear
(expensive)’.
6 Aggregate demand
Changes in the exchange rate
Making links
This focuses on one part of the balance of payments accounts, namely the balance
of trade (introduced in Chapter 5, page 78). This concept is developed more fully in
Chapter 17).
In exams, you will also need to consider the impact that changes in exports and
imports have on injections and leakages, on the equilibrium level of real output (see
Chapter 8, pages 99–100) and for the exchange rate (see Chapter 17).
Now test yourself
12 What is the likely impact on the net trade balance of a fall in real income in the UK?
Answers available online
Summary
You should have an understanding of:
✚ aggregate demand, which is the total amount of planned spending on goods and
services at any price level in an economy, made up of C + I + G + (X – M)
✚ consumption, which is the largest component of AD in the UK at around
two-thirds of the total
✚ the fact that disposable income is the most important factor influencing
consumption (other factors include interest rates, consumer confidence and the
wealth effect)
✚ the idea that investment can be considered before it depreciates (gross
investment) or after (net investment)
✚ factors influencing investment, which include interest rates, expectations, taxes
and government policy
✚ how government spending is determined partly by the trade cycle, but also by
deliberate decisions on the part of the government, set out in its fiscal policy or
budget
✚ how net trade is money received from exports (X) less money spent on imports (M).
The overall impact is a determinant of growth.
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6 Aggregate demand
Exam skills
This chapter has introduced the first element of the AD/AS
model and is an opportunity to develop the analytical skills
required in economics. The analysis assessment objective
states that students should be able to:
analyse issues within economics, showing an
understanding of their impact on economic agents.
In terms of a 25 mark essay, the level of response criterion
states that:
analysis is clear, coherent, relevant and focussed. The
answer demonstrates logical and multi-stage chains
of reasoning in terms of cause and/or consequence.
The following steps show how a simple chain of reasoning
may be developed about the consequences of a cut in
income tax rates:
✚ Personal disposable income would increase, i.e.
consumers have more money to spend.
✚ Consumers would, therefore, increase their
expenditure.
✚ Since consumption is a component of aggregate
demand, then AD would increase.
✚ The AD curve would then shift to the right.
✚ In turn, this would cause an increase in real output and
a rise in the price level.
Exam practice
1 Between February 2020 and May 2020 the Central
Bank in Turkey reduced its base interest rate from
11.25% to 8.25%.
a) Explain the likely impact of this reduction in
interest rates on consumption in Turkey.
b) Which one of the following would cause
consumption to increase?
A A decrease in disposable income
B An increase in house prices
C A decrease in welfare payments
D An increase in unemployment
3 Table 1 shows the UK’s exports and imports for the
12 months to March 2020.
[4]
Table 1 UK’s exports and imports of services/goods,
March 2019–March 2020
£ billions
[1]
2 Gross business investment in the UK was very low
between 2018 and 2020.
a) Explain the difference between gross investment
and net investment.
[2]
b) How might a rise in interest rates affect
investment?[2]
c) Which one of the following is likely to cause an
increase in investment?
A A decrease in business confidence
B An increase in tax on company profits
C A decrease in the rate of economic growth
D An increase in exports
[1]
Exports of goods
36.9
Imports of goods
47.7
Exports of services
32.5
Imports of services
22.5
a) Calculate the UK’s balance of trade in
March 2020.
[2]
b) Explain how an improvement in the quality of the
UK’s goods and services would affect its trade
balance.[2]
c) Which one of the following is the most likely to
cause an increase in the UK’s exports?
A An increase in the UK’s exchange rate against
other currencies
B An increase in the global economic growth
rates
C An increase in protectionism by other
countries
D An increase in real incomes in the UK
[1]
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7 Aggregate supply
Characteristics of aggregate supply
Meaning of aggregate supply
Aggregate supply (AS) is the total amount of goods and services that all firms in
the economy are willing to supply at a given price level in an economy in a year.
The short-run aggregate supply curve
✚ The short-run aggregate supply (SRAS) curve is based on the costs of
production and incorporates rent, wages, interest and profits.
✚ It is upward sloping from left to right, indicating that when the price level
Price level
increases, firms in the economy as a whole are willing to supply more.
This is illustrated in Figure 7.1.
SRAS
PL2
Exam tip
PL1
0
Y1
Y2
Remember that when
drawing AS and AD curves,
you need ‘Price level’ on the
y axis and ‘Real output’ on
the x axis.
Real output
Figure 7.1 The aggregate supply curve
✚ A rise in the price level from PL1 to PL2 leads to a rise in real output from
Price level
Y1 to Y2.
✚ Alternatively, the SRAS curve may be drawn with a horizontal section
where there is spare capacity, an upward sloping part where there are
bottlenecks in the economy, and a vertical part at full employment. This is
a Keynesian AS curve, and is illustrated in Figure 7.2.
AS
PL2
PL1
0
Y1
Y2
Real output
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Figure 7.2 The Keynesian aggregate supply curve
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✚ As the price level rises, firms are generally willing to supply more but
7 Aggregate supply
there comes a point where firms reach maximum capacity, i.e. the full
employment level of real output when the AS curve becomes vertical.
A movement along the AS curve
✚ Movement occurs when there is a change in the price level caused by
factors that are not related to AS, i.e. changes in AD.
✚ For example, an increase in consumption would result in an expansion in
AS and a rise in the price level, as shown in Figure 7.1.
✚ On the other hand, if there is a decrease in AD then AS will contract and
there will be a fall in the price level.
Now test yourself
1 Outline one reason why the AS curve is upward sloping.
Answers available online
A shift in the AS curve
If the costs of production rise, the AS curve shifts to the left (upwards). For
example, this could be caused by:
✚ an increase in oil prices causing a rise in the production costs of firms
✚ an increase in employers’ national insurance contributions.
On the other hand, if the costs of production fall then the AS curve shifts to
the right (downwards). For example, this could be caused by:
✚ an increase in productivity
✚ a fall in raw material prices
Price level
Figure 7.3 illustrates this.
SRAS3
SRAS1
Decrease in
aggregate supply
SRAS2
Increase in
aggregate supply
0
Real output
Figure 7.3 A shift in the AS curve
Making links
Factors causing shifts in the short-run and the long-run AS curves are discussed more
fully below.
In exams, you will need to know the impact of these factors to determine which way
the AS curve shifts.
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Now test yourself
7 Aggregate supply
2 What would happen to the AS curve if:
a) there was an increase in wage rates throughout the economy?
b) there was a significant fall in raw material prices?
Answers available online
The relationship between short-run aggregate
supply and long-run aggregate supply
Short-run aggregate supply
✚ The short-run aggregate supply (SRAS) curve may be drawn as an upward
sloping curve from left to right.
✚ SRAS assumes that some resources, e.g. capital equipment, are fixed.
✚ However, it is possible to use existing resources more intensively. For
example, a car manufacturer faced with increased demand might employ
a night shift, so using machinery more fully.
✚ Therefore, a higher price level might result in an increase in real output.
Long-run aggregate supply
✚ As explained below, the long-run aggregate supply (LRAS) curve may be
drawn as a vertical line, i.e. it is perfectly inelastic (classical view), or a
backward sloping L curve (Keynesian view).
✚ LRAS assumes that all resources are variable.
✚ In the classical view, a shift in the AD curve has no impact on real output
since the AS curve is perfectly inelastic in the long run if the economy is in
equilibrium.
Different shapes of the LRAS curve
✚ As explained above, according to the classical approach, the AS curve is
Price level
vertical in the long run. This is illustrated in Figure 7.4.
0
LRAS
In the classical approach
the economy is selfadjusting if markets are
free from government
intervention. If there is
unemployment, wages fall
until people can find work
and full employment is
restored.
Y
Real output
Figure 7.4 A classical long-run AS curve
✚ The Keynesian approach suggests that output can be increased without
a significant increase in costs (that is, the AS curve is not vertical). In this
case there is spare capacity (or an output gap, see pages 109–110). This
implies that there are unused resources in the economy.
✚ Therefore, according to the Keynesian view an economy can be in
equilibrium and also have spare capacity, i.e. unemployed resources.
✚ Consequently, unemployment and recession will not disappear without
government intervention.
In the Keynesian
approach the economy
may be in equilibrium
with unemployment, and
governments may need to
stimulate AD to achieve
long-term growth and
employment.
Spare capacity is where
there are unemployed
resources in an economy.
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7 Aggregate supply
Making links
Exam tip
In Chapter 8, AS is brought together with AD (covered in Chapter 6) to determine the
equilibrium price level and real output.
It is probably worth using
the Keynesian AS curve in
your analysis rather than a
perfectly inelastic AS curve.
This will make it easier when
discussing output gaps (see
page 109). It will also make
it easier for you to evaluate,
as you can discuss where
the AD curve crosses the
AS curve, and the differing
impact of the price level on
real output that results.
In exams, it is important to decide whether or not a change impacts on the SRAS
curve or the LRAS curve (although a Keynesian AS curve may be used to illustrate
either a short-run or a long-run shift).
Now test yourself
3 What does a perfectly inelastic AS curve imply about the utilisation of resources?
Answers available online
Short-run aggregate supply
Factors influencing short-run aggregate supply
The following factors might cause a shift in AS in the short run:
✚ Change in the cost of raw materials: if the cost of electricity rises, the cost
of production of almost everything also rises, meaning that AS decreases
(the curve shifts to the left).
✚ Change in exchange rates: if the exchange rate of the pound increases
in value against other currencies then imports become cheaper and
LRAS increases.
✚ Change in tax rates: if there is a reduction in employers’ national
insurance contributions then the costs of firms fall and the SRAS curve
shifts to the right.
✚ Change in the level of tariffs (taxes on imports): if a country increases
tariffs on its imports then the costs for domestic firms rise. This causes a
leftward shift in the SRAS curve.
Exam tip
Remember that an increase
in AS makes the AS curve
shift right or down. This
is because when there is
an increase in AS the real
output increases at any
particular price level.
Now test yourself
4 What would be the effect on AS if the value of the pound falls against other
currencies?
Answers available online
Long-run aggregate supply
Factors influencing long-run aggregate supply
94
The following factors might cause a shift in AS in the long run:
✚ Technological advances: new robotics technology, for example, can reduce
costs for a broad range of firms, causing a rightward shift in the LRAS curve.
✚ Relative productivity changes: productivity is defined as output per unit of
input. If there is an improvement in productivity, the LRAS curve shifts to
the right.
✚ Education and skills changes: if more people are well educated then LRAS
increases.
✚ Changes in government regulations: if the government introduces laws to
reduce environmental pollution that require firms to change technology
then the LRAS curve may shift to the left if the laws cause a reduction in
the productive potential of the economy.
✚ Demographic changes and migration: demographic changes have a
direct effect on the supply, skills and cost of labour, and therefore impact
on LRAS. For example, if there is an ageing population and a smaller
Exam tip
When you are trying to
decide whether there will
be a change in AD or AS,
remember that AS is the
firms’ perspective. Think
about costs of production.
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These changes cause a change in the productive capacity of an economy,
or mean that the economy can produce more at any given price level, so
influencing the LRAS curve.
7 Aggregate supply
workforce then the dependency ratio will increase and aggregate supply
will fall. Migration has a specific demographic effect in that if many
immigrants are of working age then LRAS will increase.
✚ Competition policy: if the government makes new laws to make it easier
to set up and run businesses, then LRAS is likely to increase. This is
sometimes called a ‘cut in red tape’ or a ‘cut in bureaucracy’.
✚ Changes in the minimum wage: an increase in the minimum wage can
increase costs for firms, meaning that SRAS falls. However, there is
evidence that increasing minimum wages can increase the productivity of
workers, which might mean that LRAS increases.
Making links
Note that changes in the productive capacity of an economy may be illustrated not
only by an LRAS curve but also by a PPF (see Chapter 1, pages 16–17).
In exams, you should be able to use either piece of analysis in your answer, depending
on the focus of the question.
Now test yourself
5 How will an increase in the population of working age affect the LRAS curve?
Answers available online
Summary
You should have an understanding of:
✚ aggregate supply, which is the amount that all firms in
the economy are willing to supply at a particular price
level
✚ how when the price level changes there is a movement
along the AS curve, which occurs because there has
been a change in AD
✚ how AS expands when AD increases, and contracts
when AD decreases
✚ how the AS curve shifts when costs of production
change, or the amount firms can produce at any
particular price level changes
✚ short-run changes in AS, which occur when costs
change, e.g. changes in oil prices, exchange rates or
taxes
✚ long-run changes in AS, which occur when the
productive capacity of the economy changes, e.g.
changes in the quality of factors of production or new
technological innovations.
Exam skills
This chapter has introduced the second element of the AD/
AS model (i.e. aggregate supply). It provides an opportunity
to develop various skills that are vital to do well in
examinations.
✚ relevant diagrams, e.g. an AS diagram
✚ relevant data or written material, e.g. use of material
Knowledge
Analysis
Examples include the ability to:
✚ draw accurately labelled axes for an AD/AS diagram
✚ distinguish between a Keynesian and classical AS curve
and to draw each accurately
✚ identify factors that might influence the SRAS curve
and the LRAS curve.
These skills were described at the end of the previous
chapter. In this context, the following steps show how a
simple chain of reasoning may be developed in answering
a question on the impact of a new tax on employment:
✚ The new tax would increase costs to businesses.
✚ Higher costs cause a decrease in AS because less is
supplied at each price level.
✚ In turn, this causes the AS curve to shift to the left.
Application
Examples include the use of:
on changes in technology and how this impacts on the
LRAS curve.
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Exam practice
Index UK = 100
7 Aggregate supply
1 Study Figure 1 and answer the questions that follow.
140
130
Key
2015
2016
120
110
100
90
Japan
UK
Canada
Germany
France
Italy
G7 excl. UK
USA
Figure 1 Gross domestic product per worker in G7 countries, 2015–2016
Source: ONS
a) With reference to Figure 1, compare the UK’s productivity with that of Japan
[5]
and Germany in 2016.
b) Examine how investment could explain the change in Italy’s productivity
between 2015 and 2016.
[8]
c) With reference to Figure 1, discuss possible reasons for the difference
between the UK’s GDP per worker and that of the USA.
[12]
2 GDP per hour worked has increased significantly in Romania since 2008.
a) Explain what is meant by labour productivity.
[2]
b) Which one of the following factors could have caused this increase
in productivity in Romania?
A An increase in emigration of highly skilled workers
B An increase in the use of new technology by firms
C An increase in the costs of energy and raw materials
D An increase in the taxes on businesses
[1]
c) Explain the effect of this change in Romania’s productivity on its LRAS curve.[2]
Answers and quick quizzes online
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8 National income
National income, output and
expenditure
The circular flow of income
National income is the total value of all the goods and services produced by a
country in a year.
Figure 8.1 illustrates flows of income through a simple model of the economy
comprising just households and firms.
Goods and services
Consumer expenditure
Households
Wages, rent, dividends
Firms
Factors of production
Figure 8.1 The circular flow of income
✚ The households provide factors of production, e.g. labour in return for
which they receive wages.
✚ People then use their incomes to buy consumer goods and services.
✚ Given this circular flow of income, by definition national income = national
output = national expenditure.
Now test yourself
1 According to the circular flow of income, if a country’s value of output is
$10 trillion, what must be its national income?
Answers available online
Income and wealth
✚ Wealth is the value of the total assets of worth owned by an individual,
firm or country. It is therefore a stock concept and can be measured at a
particular point in time.
✚ Income is a flow of money received by factors of production, e.g. wages,
rent profit, interest. It is measured over a period of time.
✚ There is a strong correlation between income and wealth. The ownership
of wealth generates income such as rent or interest.
✚ When there is a change in the value of wealth, e.g. in house prices, there is
an impact on people’s spending and therefore incomes. This is called the
wealth effect (see page 85).
Wealth is a stock of assets.
Income is a flow of money.
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✚ For example, if a person’s house is worth more than they paid for it, they
8 National income
might feel more confident about buying a new car and the bank manager
might lend them the money because the person’s house could act as a
collateral asset.
Collateral assets are used
as security for a loan.
Making links
This provides an introduction to the concepts of income and wealth, which are
considered more fully in the context of inequality (see Chapter 18, page 208). In exams,
it is important to understand the distinction between income and wealth.
The wealth effect was considered in relation to the factors influencing consumption
(see Chapter 6, pages 84–85). In exams, you will need to explain this link precisely.
Now test yourself
2 Are the following classified as income or wealth?
a) A worker’s wages from employment
b) A person’s holdings of shares
Answers available online
Injections and withdrawals
Injections
Changes to the flow of income (see Figure 8.1) occur when there is a change in
one of the three injections into the circular flow of income.
Injections are additions to the circular flow of income. The three injections are:
✚ Investment (I): an increase in the capital stock (assets).
✚ Government expenditure (G): when the government spends money to
provide goods and services, such as healthcare through the NHS.
✚ Exports (X): when people from abroad buy domestically produced goods
and services.
Injections are additions to
the circular flow of income.
These inputs comprise
investment, government
spending and export
income.
Withdrawals
Withdrawals are leakages out of the circular flow of income. If money is not
re-spent within the economy then it is being withdrawn from the circular
flow. The three withdrawals are:
✚ Savings (S): when people decide to spend money later rather than now it
means that there is less spending in the current time period.
✚ Taxes (T): when the government imposes taxes then money leaks out of
the circular flow because it is no longer available to spend by consumers or
businesses.
✚ Imports (M): when goods and services are bought from abroad, money
flows out of the country. This means income is withdrawn from the
domestic circular flow.
Making links
Injections and withdrawals are relevant to the multiplier, which is considered in this
chapter on pages 101–104. In exams, you need to be able to explain the multiplier
effect of changes in any of the injections and also how changes in withdrawals can
affect the value of the multiplier.
Withdrawals are leakages
out of the circular flow of
income. These comprise
savings, taxation and the
money spent on imports.
Exam tip
Remember that saving
represents a decrease in
the amount of spending in
the economy as consumers
forgo current spending for
future spending.
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Now test yourself
8 National income
3 If the government decreases its spending on defence, what will happen to the total
amount of spending in an economy?
Answers available online
Equilibrium levels of real
national output
The concept of the equilibrium level of real
national output
Price level
When the AD curve intersects with the AS curve there is an equilibrium
point, which tells us the price level and real GDP of a country (see Figure 8.2).
An equilibrium is a
balancing point where there
is no tendency to change.
AS
PLe
AD
Ye
0
Real GDP
Figure 8.2 Equilibrium
An equilibrium is a balancing point where there is no tendency for the price
level or output level to change.
✚ If the price level was higher than the equilibrium point PLe, there would be
a tendency for it to fall. This is because AS would be greater than AD.
✚ If the price level was lower than the equilibrium point, there would be
shortages and the price level would start to rise in order to make sure that
everyone could get what they were prepared to pay for.
✚ If, for example, a worldwide recession and a fall in AD occurred, you would
expect to see a fall in the price level (or the price level rising more slowly).
The use of AD/AS diagrams to show how shifts
in AD or AS cause changes in the equilibrium
price level and real national output
An increase in AD
✚ When there is an increase in AD, the AD curve shifts to the right.
✚ This causes an increase in the equilibrium price level and an increase in
real national output (see Figure 8.3).
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Price level
8 National income
AS
PL2
PL1
Y1
AD1
Y2
AD2
Real GDP
Figure 8.3 The effect of an increase in AD
✚ However, this depends on the shape of the AS curve. The more elastic the
AS, the more the effect is seen on real output rather than on the price level.
If AS is perfectly inelastic (the classical approach, discussed on page 93),
then there will be no effect on real output, only an increase in the price level.
A decrease in AS
✚ When there is a decrease in AS, the AS curve shifts to the left.
✚ This causes an increase in the equilibrium price level and a decrease in
Price level
real national output (see Figure 8.4).
AS2
AS1
PL2
PL1
AD1
0
Y2 Y1
Real GDP
Figure 8.4 The effect of a decrease in AS
✚ However, the impact on the price level and real output depends on the
elasticity of the AD curve. If AD is relatively inelastic then the impact on
the price level will be greater than the impact on real output.
Making links
AD/AS analysis may be employed in a variety of contexts. Some examples include:
✚ a change in investment (see Chapter 6, pages 86–87)
✚ a change in net trade (see Chapter 6, pages 88–89)
✚ a change in productivity (see Chapter 7, page 92)
✚ a change in income tax rates (see Chapter 21, pages 238–239).
In exams, you need to be able to explain the effect on AD and/or AS and to be able to
illustrate this with an appropriate AD/AS diagram.
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Now test yourself
4 What would happen to real output if there was an increase in saving?
8 National income
Answer on p. xxx
The multiplier
The multiplier ratio
✚ The multiplier shows the amount by which a change in an injection or
leakage causes total income to change.
✚ It is the result of income being re-spent in the economy, having second
round and successive effects.
✚ The multiplier may be calculated as follows:
K [Multiplier] =
∆Y [Change in real GDP]
∆J [Change in injections]
✚ If the injections into the circular flow increase, then there will be a larger
The multiplier describes
the process by which a
change in an injection
(government expenditure,
investment or exports)
causes a more than
proportionate change in
national income.
final change in GDP in the economy.
✚ The formula may be rewritten as follows:
K [Multiplier] × ∆J [Change in injections] = ∆Y [Change in real GDP]
In other words, the multiplier multiplied by the injection gives the final
change in GDP.
Making links
The multiplier ratio is relevant whenever there is change in an injection, for example:
✚ a change in investment (see Chapter 6, pages 86–87)
✚ a change in government spending (see Chapter 6, page 88), fiscal policy (see
Chapter 10, page 119) and discretionary fiscal policy (see Chapter 21, page 242)
✚ a change in exports (see Chapter 6, pages 88–89).
In exams, you need to be able to explain the effect of a change in an injection on AD
and real output and to be able to illustrate this with an appropriate AD/AS diagram.
Now test yourself
5 What is the value of the multiplier if an increase in investment of £30 billion leads
to an increase in real output of £120 billion?
Answers available online
The effects of the multiplier on the economy
✚ The multiplier causes an injection to have a magnified effect on GDP.
✚ The International Monetary Fund (IMF) has estimated the value of the
multiplier in the UK to be between 0.9 and 1.7.
✚ This illustrates that it is not easy to accurately estimate the impact of an
injection on the economy. Much depends on, for example, the amount of
unemployed resources in the economy.
✚ A positive multiplier effect of an increase in an injection would cause a rise
in GDP, leading to a fall in unemployment and possibly a rise in the rate of
inflation if the economy is at full employment.
✚ The UK’s multiplier is relatively low, in part because of its high marginal
propensity to import.
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✚ Generally it is expected that the value of the multiplier is higher in
8 National income
developing economies than in developed economies.
Now test yourself
6 How might the economy be affected if there is a significant fall in injections into
the circular flow?
Answers available online
Understanding marginal propensities and
their effects on the multiplier
The marginal propensity to consume
✚ Definition: the marginal propensity to consume (MPC) refers to the
proportion of an increase in income that is spent.
✚ Formula for MPC:
Change in consumption
MPC =
ΔC
ΔY
Change in income
✚ Explanation: if I give you £10 and you spend half of it straight away, then
you have a marginal propensity to consume (MPC) of 0.5, that is, 50% of
any extra income will be re-spent in the economy.
✚ MPC and the multiplier: the higher the value of the MPC, the higher will be
the value of the multiplier and consequently the greater will be the impact
of an increase in an injection on GDP.
Exam tip
Remember that the higher
the value of the MPC, the
higher the value of the
multiplier.
Using the MPC, the multiplier is calculated as follows:
K=
1
1 − MPC
Now test yourself
7 What would be the value of the MPC if a £2500 increase in average wages led to an
average £1500 increase in consumer spending?
Answers available online
The marginal propensity to save
✚ The marginal propensity to save (MPS) refers to the proportion of an
increase in income that is saved.
✚ The formula for MPS is as follows:
MPS =
ΔS [Change in saving]
ΔY [Change in income]
✚ For example, if incomes rise by £100 million and a quarter of it is saved,
then the MPS is 0.25 — that is, 25% of any extra income will leak out of the
circular flow as savings.
MPS and the multiplier
✚ The higher the value of the MPS, the lower the value of the multiplier.
✚ This means that any change in an injection has a smaller impact on the
overall level of spending.
✚ In a simple two-sector economy using the MPS, the multiplier is calculated
as follows:
102
K=
1
1 − MPS
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Now test yourself
8 What would happen to the value of the multiplier MPS falls?
8 National income
Answers available online
The marginal propensity to tax
✚ The marginal propensity to tax (MPT) refers to the proportion of an
increase in income that is taxed.
✚ The formula for MPT is as follows:
MPT =
ΔT [Change in tax]
ΔY [Change in income]
✚ For example, if incomes rise by £100 million in income and 40% of it is
taxed, then the MPT is 0.4 — that is, 40% of any extra income will leak out
of the circular flow as taxation.
MPT and the multiplier
✚ The higher the value of the MPT, the lower the value of the multiplier.
✚ This means that any change in an injection has a smaller impact on the
overall level of spending.
The marginal propensity to import
✚ The marginal propensity to import (MPM) refers to the proportion of an
increase in income that is spent on imports.
✚ The formula for MPM is as follows:
MPM =
ΔM [Change in imports]
ΔY [Change in income]
✚ For example, if incomes rise by £100 billion and a fifth of that is spent on
imports then the MPM is 0.2 — that is, 20% of any extra income will leak
out of the circular flow as imports.
MPM and the multiplier
✚ The higher the value of the MPM, the lower the value of the multiplier.
✚ This means that any change in an injection will have a smaller impact on
the overall level of spending.
Now test yourself
9 What will be the value of the MPM if a rise in national income of $400 billion leads
to an increase in imports of $160 billion?
Answers available online
Calculations of the multiplier
What follows is a summary of methods of calculations of the multiplier:
K=
K=
1
1 – MPC
1
MPW
Note: MPW is the marginal propensity to withdraw, i.e. the sum of MPS, MPT,
MPM.
K=
ΔY [Change in real GDP]
ΔJ [Change in injections]
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Example
8 National income
Example 1
In this example you are given the value of the MPC.
What is the value of the multiplier if the value of the MPC
is 0.8?
Answer
1
K=
1 – MPC
1
=
1 – 0.8
1
=
0.2
If the leakages from the circular flow increase, then the
multiplier effect is smaller. For example, when the 2008
and 2020 recessions hit the UK, the saving ratio rose
significantly, reducing the value of the multiplier.
Example 3
In the following example, you are given values for each of
the withdrawals.
Calculate the value of the multiplier if the MPS is 0.1, the
MPT is 0.3 and the MPM is 0.4.
Answer
K=
=5
Using the above formula implies that the increase in total
spending depends on how much is left for spending in the
economy when all the leakages have been taken out.
Example 2
Looking at this in another way, if the MPW is 0.6, what is
the value of the multiplier?
=
=
1
MPS + MPT + MPM
1
0.1 + 0.3 + 0.4
1
0.8
= 1.25
Answer
1
K=
MPW
1
=
0.6
= 1.67
Now test yourself
10 What will be the change in the value of the multiplier if the MPC falls from 0.7
to 0.5?
11 What will be the value of the multiplier if the MPW is 0.5?
Answers available online
The significance of the multiplier for shifts in
aggregate demand
✚ If there is a change in any one of the injections or leakages, the total effect
on the economy as a whole will be much greater than the original change.
✚ The multiplier magnifies the impact of changes on the economy as a
whole — the larger the multiplier, the greater the impact of any changes in
injections or leakages.
✚ The bigger the value of the multiplier, the larger the overall shift in AD.
Remember that this can be a magnified increase or a magnified decrease
in real national output.
104
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The multiplier may be used in relation to changes in any of the three injections,
including:
✚ a change in investment (see Chapter 6, page 86–87)
✚ a change in government spending (see Chapter 6, page 88; Chapter 21, page 242;
and Chapter 10, page 119 in relation to demand-side policies)
✚ a change in net trade (see Chapter 6, pages 88–89 and Chapter 17, pages 198–199).
Changes in the propensity to save, tax or import would affect the value of the
multiplier, and include:
✚ a change in the MPS (see chapter 8, page 102)
✚ a change in the MPT (see chapter 8, page 103)
✚ a change in the MPM (see chapter 8, page 103).
8 National income
Making links
In exams, you need to be able to explain the effect of any of the above changes on the
wider economy.
The multiplier process
Assume that there is an initial injection of £100 billion and the MPC is 0.6 (see
Figure 8.5).
Injection
£100 billion
£40 billion
leaks out
2nd round
£60 billion
£24 billion
leaks out
3rd round
£36 billion
£14.4 billion
leaks out
4th round
£21.6 billion
Figure 8.5 The multiplier process
✚ The process begins with an injection (G, I or X) into the circular flow of
income.
✚ This spending forms the income of other groups of people. For example, if
there is a £100 billion investment in new hospitals, then many businesses
will benefit, e.g. construction firms.
✚ This generates new incomes to workers (wages) and shareholders
(dividends).
✚ Some of this income is spent (£60 billion) but some leaks out of the circular
flow in the form of savings, taxes or imports (£40 billion).
✚ In turn, the money spent (£60 billion) forms the incomes of another group
of people. Again, some is spent (£36 billion) and some leaks out of the
circular flow (£14.4 billion).
✚ This process continues until the full effects have worked through the
economy.
✚ Overall, this means that a new injection will have a magnified impact on
total expenditure in the economy. In this case, GDP will rise by £250 billion.
Now test yourself
12 Why will a £25 billion injection result in a larger increase in GDP?
Answers available online
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8 National income
Summary
You should have a clear understanding of:
✚ the circular flow of income and how this may be
affected by injections and withdrawals
✚ the aggregate demand and aggregate supply model,
and how it is the building block for much of the analysis
in macroeconomics
✚ the equilibrium price level and real output, which are
determined by the interaction of AD and AS
✚ the causes of the shifts in AD and AS — remember that
changes in injections are magnified by the working of
the multiplier, which is the impact of incomes being
re-spent in an economy, so any change in an injection
has second- and subsequent-round effects
✚ the multiplier ratio, which is calculated by dividing the
rise in national income by the injection
✚ the multiplier, which is calculated using the following
formulae:
K=
1
1 – MPC
or:
K=
1
MPW
Exam skills
This chapter has completed the AD/AS model and
introduced the concept of the multiplier. You will be using
them not only in the remainder of Theme 2 but also in
Theme 4. Apart from knowledge, application and analytical
skills, they provide an opportunity to develop evaluative
skills and quantitative skills.
curve is fairly elastic then the impact on real output
will be greater than the impact on the price level.
However, if there is full employment of resources
then the AS curve would be perfectly inelastic and a
rightward shift in the AD curve would cause a rise in
the price level but have no impact on real output.
With regard to evaluative skills, the assessment objective
states that students should be able to:
You will require the following quantitative skills:
✚ QS1: calculate, use and understand ratios and
fractions, e.g. calculations of the multiplier ratio.
✚ QS4: construct and interpret a range of standard
graphical forms, e.g. drawing AD/AS diagrams to
illustrate the impact of changes in AD and/or AS on real
output and the price level.
✚ QS9: interpret, apply and analyse information in
written, graphical, tabular and numerical forms, e.g.
in relation to AD/AS diagrams and the value of the
multiplier.
Evaluate economic arguments and use qualitative
and quantitative evidence to support informed
judgements relating to economic issues.
The following example of how you might evaluate relates
to a question about the effect of an increase in AD on real
output and the price level.
This will depend on the elasticity of the AS curve. If
there is spare capacity in the economy and the AS
Exam practice
1 In Malaysia, it has been estimated that the marginal
propensity to consume (MPC) out of disposable income
was 0.8 for low-income households to 0.25 for highincome households in 2018.
[2]
a) Explain what is meant by the MPC.
b) Suppose the Malaysian Government wanted to
reflate its country’s economy. Ceteris paribus,
which one of the following measures would cause
GDP to increase by the largest amount?
A An increase in taxes on the poorest households
B An increase in public expenditure on subsidies
for luxury goods
C An increase in welfare payments to the poorest
households
D An increase in the tax-free allowance for the
richest households
[1]
c) Suppose that, on average, the marginal propensity to
consume was 0.45 across all Malaysian households,
what would be the value of the multiplier?
[2]
2 In 1983, China’s marginal propensity to import was 0.1,
but it increased to 0.25 in 2019.
a) Define the term ‘marginal propensity to import’. [2]
b) Ceteris paribus, if the value of the multiplier
was 1.6 before the change,
calculate the new value of the multiplier.
[2]
c) Which one of the following is the most likely
cause of the rise in China’s marginal propensity
to import?
A A recession in China
B A decrease in unemployment in China
C A rise in income taxes in China
D A fall in the exchange rate
[1]
3 Evaluate the likely impact of a decrease in
consumer confidence on the UK economy.
Illustrate your answer with an AD/AS diagram.
[25]
Answers and quick quizzes online
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9 Economic growth
Causes of growth
Changes in real GDP were considered as a measure of economic growth on
page 66. This chapter provides more detailed analysis of economic growth by
considering the distinction between actual growth and potential growth, the
causes of economic growth, output gaps and the impact of economic growth.
The distinction between actual and potential
economic growth
Actual growth
✚ Actual growth is the measure of changes in real GDP, found by adding up
all the incomes in the country, or all the spending, or all the output.
✚ These measures give different estimates of GDP but between them, a good
indication of the changes of activity in the economy can be determined.
✚ In practice, it can be very difficult to measure actual output accurately, as
was the case during the COVID-19 pandemic in 2020, because many firms
that were temporarily closed did not complete surveys.
Potential growth
✚ Potential growth shows how much the economy could produce if there
was full employment of all the resources in the economy. Potential growth
is reflected in changes in LRAS.
✚ The difference between the actual and potential growth is the output gap
(see pages 109–110).
✚ Potential output is determined by the potential size of the labour force, the
capital stock, productivity and discovery of natural resources.
Making links
Actual growth is the
increase in real GDP.
Real GDP is the output of
an economy, with
the effects of inflation
removed.
Potential growth is the
level of output that an
economy could produce at
a constant rate of inflation.
It is associated with a
rightward shift in the LRAS
curve.
The output gap is the
difference between actual
GDP (or growth) and
potential GDP (or growth).
The above concepts may be analysed using production possibility frontiers (see
Chapter 1, pages 15–18) and also using AD/AS analysis (see chapters 8 and 9).
In exams, you should be able to analyse actual and potential growth using both
of the approaches above.
Now test yourself
1 An increase in potential growth will cause a rightward shift in which curve(s)?
Answers available online
Factors that could cause
economic growth
Growth occurs when there is an increase in AD or in LRAS, meaning that
there is a new equilibrium real output at a level where more is produced.
Table 9.1 provides an overview of the causes of changes in AD and LRAS.
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9 Economic growth
Table 9.1 Causes of changes in AD and LRAS
Causes of changes in AD
Causes of changes in LRAS
Increase in consumption: caused by,
for example, higher real wages or cuts in
income tax or increase in value of assets
(the wealth effect)
Increase in investment: for example, in
infrastructure
Increase in investment: caused by, for
example, increased confidence, lower
interest rates
New technology: for example, use of
robots and artificial intelligence
Increase in government expenditure:
caused by, for example, political priorities
Increase in net migration: for example,
making it easier for people to immigrate
into the country
Increase in net exports: caused by, for
example, depreciation of the country’s
currency
Supply-side policies: these policies
would increase productivity (see
Chapter 10)
Exam tip
Investment is a component
of AD but influences
potential output so it also
affects LRAS.
Making links
Exam tip
In exams, you should be ready to consider the causes of economic growth in the
context of emerging and developing countries (see Chapter 19). You should consider
the relevance of the above factors in relation to particular countries.
Consumption relates to
spending on goods and
services in an economy. It
is neither an injection nor a
leakage. However, a change
in the marginal propensity
to consume will affect the
value of the multiplier.
Now test yourself
2 What happens to growth if there is an increase in investment?
Answers available online
Conversely, there may be factors that restrict or inhibit economic growth.
These might include:
✚ a lack of access to funds for investment
✚ corrupt governments
✚ currency instability or an overvalued exchange rate
✚ poor-quality human capital
✚ protectionism by other countries limiting free international trade.
The importance of international trade for
export-led growth
✚ International trade is very important for economic growth because
an increase in exports causes the AD curve to shift to the right, with
multiplier effects.
✚ Export-led growth is economic growth associated with an improvement in
the current account of the balance of payments.
✚ In order to stimulate exports, a country might employ the following
strategies:
✚ Engineer a depreciation of the exchange rate (e.g. by cutting interest
rates). This makes exports relatively cheap and imports relatively
expensive.
✚ Adopt policies to improve productivity and efficiency in export markets
(e.g. by providing incentives for investment in new technology).
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International trade is considered in Chapter 17. The benefits of free trade are considered
in that chapter — this analysis has particular relevance for export-led growth.
Export-led growth is also very significant as an explanation of growth in some
developing countries (see Chapter 19). In exams, you should be able to provide
examples of countries where this strategy has been successful or might be successful
in the future. You could start researching these now!
Now test yourself
3 Explain how an increase in exports affects economic growth.
9 Economic growth
Making links
Answers available online
Output gaps
Actual growth rates and long-term trends
in growth rates
✚ The actual growth rate of economic growth is the rate at which real GDP
changes from one year to another.
✚ The long-term trend rate of economic growth is calculated as the average
rate of economic growth over several years. It is determined by the increase
in productive capacity and is consistent with a stable rate of inflation.
Now test yourself
4 If growth rates change from 3.2% to 2%, what has happened to the level
of real GDP?
Answers available online
Positive and negative output gaps
A negative output gap
Price level
A negative output gap exists when actual growth rates are below potential
growth rates. This is shown in Figure 9.1 by the distance Y1 to YFE. Keynesians
believe these can persist in the long run. Assuming that the current
equilibrium level of real output in Y1 then there will be a negative output gap
of Y1 − YFE. Only if AD increased to AD2 would the output gap be closed.
AS
PL2
PL1
AD2
AD1
Y1 YFE Real GDP
Negative output gap
YFE is the full employment level of real output
109
Figure 9.1 Negative output gap using a Keynesian AS curve
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A positive output gap
✚ A positive output gap is when growth rates are higher than the economy
where the economy can produce more, but this cannot be sustained in the
long run. In the long run, the LRAS curve is vertical and the positive output
gap disappears. This is shown in Figure 9.2.
Price level
9 Economic growth
can sustain, i.e. higher than the long-term trend rate of growth.
✚ This can be shown on a classical LRAS curve as a temporary situation
LRAS
SRAS
PL2
AD2
PL1
AD
AD1
Y1
YFE
Y2
Real GDP
Negative Positive
output gap output gap
YFE is full employment real output
Figure 9.2 Positive and negative output gaps
Now test yourself
5 If the long-term trend rate of growth is 2.5% but actual growth is 0.7%, is there a
positive or negative output gap?
Answers available online
Problems of measuring output gaps
✚ Output gaps, then, are a sign that the country is not using its resources
efficiently, or at their maximum potential.
✚ In practice, it is very difficult to measure output gaps because of the
difficulty of measuring the level of potential output. All that is known is
actual output (as measured by real GDP) at a point in time.
✚ The potential level of real output depends on spare capacity, which is very
hard to estimate accurately. Reasons include:
✚ resources available are not suited to the needs of the economy
✚ production is relocated to other countries
✚ structural changes or major shocks to the economy may occur, causing
some productive capacity to be permanently lost.
Exam tip
There are many ways to
draw an output gap on a
diagram. Make sure that you
are confident in at least one
of these ways, e.g. drawing
a PPF curve where the point
of output is not on the PPF
but inside the curve.
Trade (business) cycle
Understanding of the trade cycle
✚ The rate of economic growth rarely stays constant over years.
✚ Instead, there may be some periods of rapid economic growth (a boom)
when the rate of growth is higher than its long-term trend.
✚ On the other hand, there may be some periods of very slow economic
growth (a slump) when the rate of growth is lower than its long-term
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9 Economic growth
trend. This could result in a recession (two consecutive quarters of
negative economic growth), as occurred in many countries in 2008 and
again in 2020.
✚ Between the boom and the slump there is a slowdown, and between the
slump and the boom there is a recovery.
Boom
th
n
Re
io
ce
s
sio
ess
Re
c o v ery
R ec
Grow
n
c o v ery
Trend
Re
Boom
Boo
m
Level of real output
Figure 9.3 illustrates the concept of the trade cycle.
Slump
Slump
Time
Figure 9.3 The trade cycle
Characteristics of a boom and a recession
Table 9.2 shows the key characteristics of a boom and a recession.
Table 9.2 Booms and recessions
Characteristics of a boom
Characteristics of a recession
Low unemployment
Rising unemployment rates
Less underemployment
More underemployment
Increasing living standards
Falling living standards
Increased levels of investment
Falling levels of investment
An increasing rate of inflation — if caused
by rising AD
A falling rate of inflation (because AD is
falling)
Increasing income inequality — if
associated with rising asset prices
Increasing income inequality — if
associated with higher unemployment
Investment is an increase
in the capital stock.
Making links
In exams, you should be ready to consider output gaps, booms and slumps in relation
to major economic events such as the Great Depression, the 2008 financial crisis (see
pages 121–122) and the COVID-19 pandemic.
You will need to be able to consider, for example, the characteristics of a deep
recession and also the measures taken by governments in response (see Chapter 10,
pages 121–122, and Chapter 21, page 244).
Now test yourself
6 If real GDP growth is 1% in the first quarter of 2020 and –0.5% in the second
quarter, is that a recession?
7 What would you expect to happen to unemployment during a boom?
Answers available online
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9 Economic growth
The impact of economic growth
Benefits of growth
On consumers
✚ Economic growth is associated with rising real incomes.
✚ Consequently, consumers are able to afford more goods and services,
leading to higher standards of living.
✚ Higher real incomes may help people to eat more healthily and lead to an
increase in life expectancy.
✚ Some research suggests that higher real incomes lead to an increase in
subjective happiness (see page 68).
On firms
✚ With higher real incomes and increased demand for goods and services,
firms are likely to benefit from increased profits.
✚ Consequently, shareholders are likely to enjoy increased returns.
On the government
✚ During a period of economic growth real incomes will be increasing. This
means that government tax revenues are rising, as workers are paying
more tax on their incomes, people are spending more so VAT revenues
will be rising, and firms will be paying more tax because their profits are
higher.
✚ The government could also use the increased tax revenues to reduce
income inequality.
On current and future living standards
Exam tip
✚ Economic growth may help to lift people out of poverty.
✚ Developing countries can gain foreign investment, foreign currencies
Inferior goods feature in
Theme 1 (see Chapter 2)
and will not be examined
directly in Theme 2, but you
can refer to them when
discussing the impact of
growth on some companies
where demand falls when
consumers have increased
income.
can flow into an economy, and there are likely to be improvements in
infrastructure of all types, from airports to mobile phone coverage.
Making links
The benefits of economic growth are revisited when considering emerging and
developing countries (see Chapter 19).
In exams, you should be able to show how economic growth may have significant
benefits to both developed and developing economies, and to offer critical
evaluation of whether the pursuit of growth should be a key objective of
macroeconomic policy.
Now test yourself
8 How might workers benefit from economic growth?
Answers available online
Costs of growth
On consumers
✚ There is a danger that rapid economic growth could lead to an increase in
the rate of inflation.
✚ If the rate of inflation is higher than the increase in wages then, in real
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✚ An increase in the rate of economic growth may be at the expense of
working longer hours, so increasing stress for workers and consumers.
✚ Economic growth and rising real incomes might not increase subjective
9 Economic growth
happiness after incomes have risen beyond a certain level (see page 68).
✚ Economic growth may be associated with an increase in health conditions
associated with higher incomes, e.g. obesity, diabetes.
Now test yourself
9 How might economic growth cause lower living standards?
Answers available online
On firms
✚ Rapid economic growth would cause an increase in demand for workers
and raw materials.
✚ This would cause an increase in wages and in the price of raw materials.
✚ Consequently, firms’ costs would increase, which could reduce their
profits.
On the economy
✚ On the balance of trade: higher incomes mean that people can afford to
import more, and the need of firms to export is no longer so pressing, as
higher profit margins can be made through selling at home rather than
abroad. Therefore, exports fall, imports rise and the balance of trade
deteriorates.
Evaluation: If there is export-led growth then an improvement of the
balance of trade is expected.
✚ On the distribution of income:
The distribution of income is a measure of the difference in incomes
between different groups in an economy. These groups can be
measured in a variety of ways but one common way is to compare the
highest 10% of income earners with the lowest decile.
✚ When the economy grows, those who benefit most may be those
who are already rich. For example, the manager or shareholders of a
business will enjoy the increased profits, whereas other employees, e.g.
cleaners or factory workers, may not receive an increase in wages.
✚
A decile is a 10% chunk of
an ordered set of data.
Evaluation: with continued growth, workers may lobby for higher incomes
and the rewards may trickle down to those on lower pay. Governments
may also have more tax revenues to redistribute to those on lower
incomes.
✚ On the environment: with increased economic growth there is frequently
an increase in external costs, e.g. air and noise pollution, overcrowding,
social dislocation and stress.
Evaluation: higher incomes may mean that the government has more
tax revenue to clear up environmental damage. For example, subsidies
may be given to firms producing electric cars or for investment in ‘green’
technology.
Exam tip
To evaluate a benefit of economic growth, link it directly to the point you have made.
For example, it may be argued that growth leads to higher real incomes. However,
these increases in real incomes may not be distributed evenly, i.e. most of the benefits
may go to owners of resources and not to unskilled workers.
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9 Economic growth
Making links
The balance of trade was introduced in Chapter 5 (page 78), and then applied in the
context of aggregate demand in Chapter 6 (pages 88–89). It is revisited in Chapter 17
(page 198) in the context of global trade. Consequently, in papers 2 and 3 of the exam
you should be able to apply this concept to different contexts.
Income distribution, inequality and poverty are further considered in Chapter 18. They
are relevant in many contexts, for example, economic development (Chapter 19), the
labour market (Chapter 15) and taxation (the role of the state in the macroeconomy,
Chapter 21). It is possible, therefore, that aspects of these concepts could be tested in
any of the three exam papers.
With reference to the environment, external costs were introduced in Chapter 3
(pages 50–51). This illustrates how this concept may be used in both microeconomic
and macroeconomic contexts, for example in Paper 3.
On current and future living standards
✚ In choosing to increase the rate of economic growth, an economy may
have to forgo current consumption.
✚ However, in the future living standards would increase as the PPF shifts
to the right. This was illustrated in Theme 1 using production possibility
frontiers (see pages 16–17).
Now test yourself
10 How might a government benefit from economic growth?
Answers available online
Summary
You should have an understanding of:
✚ the two ways to measure growth: actual and potential
✚ the many causes of growth, and how to analyse these
by looking at the forces acting on the components of
AD: C + I + G + (X – M) and the factors affecting LRAS.
✚ how output gaps may be positive (growth above trend
rate) or negative (growth below trend rate)
✚ the benefits and costs of economic growth.
Exam skills
This chapter develops and applies concepts introduced
earlier in this theme. Obviously exam questions could
involve testing of knowledge, application, analysis and
evaluation that have been considered previously. Given the
nature of the material covered in this chapter, it is worth
focusing on the particular quantitative skills that could be
tested. These include:
✚ QS2: calculate, use and understand percentages,
percentage changes and percentage point change. For
example, this is especially relevant in analysing data on
economic growth, productivity and output gaps.
✚ QS4: construct and interpret a range of standard
graphical forms. For example, you should be able to
draw an AD/AS diagram to illustrate an output gap and
be able to interpret a graph showing economic growth.
✚ QS9: interpret, apply and analyse information in
written, graphical, tabular and numerical forms. For
example, you may be required to analyse information
in a prose passage relating to the benefits and costs of
economic growth.
✚ QS10: distinguish between changes in the level of a
variable and the rate of change. This is particularly
relevant in analysing data on economic growth in terms
of the level of output and the rate at which output is
increasing (or decreasing).
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Exam practice
11.0
10.5
10.0
9.5
9.0
8.5
Bangladesh
8.0
7.5
9 Economic growth
%
1 Study Figure 1 and the extract below, and answer the questions that follow.
7.0
6.5
China
6.0
5.5
5.0
0.0
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
Figure 1 GDP growth (annual %) in Bangladesh and China, 2009–2018
Source: World Bank
Extract: Bangladesh’s economy
Bangladesh’s economy has been growing steadily since
2004. The economy has been driven by export-led
growth. Industries that have been important exporters
include textiles, shipbuilding, fish and seafood, jute and
leather goods. Bangladesh’s IT industry has contributed
significantly to economic growth: it exported $1 billion
worth of ICT products in 2019 and this is expected
to increase to $5 billion by 2021. The development of
the IT industry has been helped by investment from
multinational companies.
Bangladesh’s agricultural sector and money sent
back to Bangladesh from citizens living abroad have
both also helped to stimulate economic growth.
Further, the country has significant reserves of
natural gas.
With high rates of economic growth, Bangladesh has
benefited from an increase in life expectancy as well
as improvements in healthcare and education. GDP per
capita has increased, partly because of economic growth
but also because the population has been growing
at a slower rate. This has also helped to reduce the
proportion of the population living in poverty.
Economic growth has some downsides. Bangladesh is
the country with the highest air pollution in the world.
Its capital city, Dhaka, is the second most polluted
capital city. One reason is that petrol and diesel have
more sulphur than in other countries. Additionally, river
pollution has been increasing because many towns and
cities are sited on the banks of rivers and much rubbish
is discarded into them.
a) Explain what happened to the level of GDP in Bangladesh and in China between 2013 and 2018.
[5]
b) Examine the likely impact of rapid economic growth in Bangladesh on its output gap.[8]
c) Discuss the causes of economic growth in Bangladesh.
[12]
d) Discuss the likely benefits of economic growth in Bangladesh.
[15]
Answers and quick quizzes online
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10 Macroeconomic objectives
and policies
Possible macroeconomic
objectives
Key objectives
Figure 10.1 shows the main macroeconomic objectives of a government.
How these objectives are prioritised varies depending on the individual
government’s political concerns.
Greater
income
equality
Protection of
the
environment
Economic
growth
Macroeconomic
objectives
Balance of
payments
equilibrium
on current
account
Low
unemployment
Balanced
government
budget
Low and
stable rate of
inflation
Figure 10.1 Macroeconomic objectives
Policies adopted by governments in order to meet any one of these objectives
are likely to have an impact on the other objectives. Therefore, governments
must prioritise their most important objectives. Such decisions will determine
the opportunity cost in terms of other policies or objectives.
Now test yourself
1 What is the difference between a balanced government budget and the balance
of trade equilibrium?
Answers available online
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Distinction between monetary and
fiscal policy
There are two types of demand-side policy:
✚ Monetary policy: the manipulation of monetary variables in order to
influence the level of AD.
✚ Fiscal policy: the manipulation of government spending and taxation in
order to influence the level of AD.
Demand-side policy
is any deliberate action
taken by governments or
monetary authorities to
shift the AD curve.
Monetary policy instruments
Monetary policy involves the setting of monetary variables, the most
important of which are interest rates (cost of credit or the reward for saving)
and quantitative easing (QE), or asset purchases by the central bank. Until
2008 the main monetary policy instrument in most countries was the
interest rate.
Interest rates
The interest rate is the cost of borrowing money or the return received for
saving.
Use of interest rates to reduce aggregate demand
✚ If the rate of inflation is above its target level then the Bank of England’s
Monetary Policy Committee (MPC) may raise the base interest rate in order
to decrease AD.
✚ This means that C, I, and (X – M) tend to fall, and the AD curve shifts to the
left. There are multiplier effects, increasing the impact of the change.
Interest rate is the cost
of borrowing money or the
reward for saving.
Quantitative easing refers
to the buying of government
bonds or other financial
assets by the central bank
as a means of increasing
the money supply to
stimulate the economy.
10 Macroeconomic objectives and policies
Demand-side policies
The base interest rate
is the interest rate that the
central bank will charge
commercial banks for loans.
Price level
Figure 10.2 illustrates this.
AS
PL1
PL2
AD1
AD2
0
Y2
Y1
Real GDP
Figure 10.2 Deflationary monetary policy
Use of interest rates to increase aggregate demand
✚ If the rate of inflation is below its target level then the MPC may reduce the
base interest rates in order to increase AD.
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10 Macroeconomic objectives and policies
✚ This means that C, I, and (X – M) tend to rise, and the AD curve shifts to
the right. This causes an increase in the price level and an increase in real
output. There are multiplier effects, increasing the impact of the change
(this is illustrated in Figure 8.3, page 100).
Now test yourself
2 Explain three ways by which a reduction in interest rates affects aggregate
demand.
Answers available online
Asset purchases (quantitative easing)
This occurs when a central bank (in the UK’s case, the Bank of England) buys
government bonds or other securities in order to increase money supply in
the economy.
Figure 10.3 illustrates quantitative easing.
Expectations
↑ Total wealth
↑ Asset prices
(↓ yields)
↓ Cost of
borrowing
Bank of England
asset purchases
↑ Money in
the economy
↑ Spending
and income
Inflation at 2%
↑ Bank
lending
Figure 10.3 Quantitative easing
Source: https://www.bankofengland.co.uk
Use of quantitative easing to stimulate aggregate demand
✚ After 2008, many monetary authorities found that interest rates alone
could not stimulate AD. This was also true during the COVID-19 pandemic
because interest rates were already very low.
✚ Central banks, therefore, purchased long-term assets in the money or
capital markets. As demand for these assets increased, their prices rose,
which in turn meant the yield (interest rate) on them fell.
✚ Therefore, quantitative easing (QE) has the same impact as cutting interest
rates, but it has a direct effect on money markets.
Now test yourself
3 What effect does QE have on the supply of money?
Answers available online
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Fiscal policy instruments
health, education, defence, infrastructure and welfare benefits.
✚ There are two forms of taxation:
✚ Direct taxes (on incomes), such as income tax and corporation tax. A
rise in direct taxes might mean people have reduced disposable income
and reduced incentives to work.
✚ Indirect taxes (on spending), such as VAT. If indirect taxes are raised,
the cost of living increases, particularly for those on lower incomes
because the tax paid is a higher proportion of their income than for
those on higher incomes.
Use of fiscal policy to reduce aggregate demand
If the government wanted to reduce AD it would reduce government
expenditure and/or increase taxes. This would have a deflationary
(contractionary) effect on AD, with multiplier effects.
Use of fiscal policy to increase aggregate demand
If the government wanted to increase AD it would increase government
expenditure and/or decrease taxes. This would have a reflationary
(expansionary) effect on AD, with multiplier effects. You can show this by
shifting the AD curve on a diagram, for example Figure 8.3 (see page 100).
Now test yourself
4 What fiscal policy measures could be used to reduce aggregate demand?
Answers available online
Exam tip
When discussing demandside policies, don’t forget to
support your analysis with
an AD/AS diagram(s). The
explanation of the diagram
should be integrated into
your written analysis.
10 Macroeconomic objectives and policies
✚ Government (public) expenditure refers to spending on areas such as
Distinction between government budget
(fiscal) deficit and surplus
✚ If the government spends more than it receives in taxation, this is known
as a fiscal or budget deficit. This will lead to an increase in AD.
✚ If the government spends less than it receives in taxation, this is known as
a fiscal or budget surplus. This will lead to a decrease in AD.
Exam tip
Examiners tend to use the words ‘budget’ or ‘fiscal’ to mean the same thing, so do
not be alarmed if you are asked to explain a budget or fiscal deficit — your answer will
be the same. It means that the government is spending more than it is receiving in tax
revenues.
AD/AS diagram to illustrate demand-side
policies
✚ Policies designed to deflate the economy include increasing taxes and/or
reducing government expenditure.
✚ These would cause a reduction in AD, leading to a leftward shift in the AD
curve.
✚ This would result in a fall in real output and in the price level, as shown
previously in Figure 10.2 (page 117).
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The Bank of England’s role
10 Macroeconomic objectives and policies
The Monetary Policy Committee: role and operation
✚ The Monetary Policy Committee (MPC) of the Bank of England sets the base
interest rate.
✚ The MPC meets every month to look at factors that are likely to influence
the rate of inflation over the coming 18 months.
✚ At its monthly meeting, the MPC votes to determine whether to raise,
lower or leave the base interest rate unchanged.
✚ The MPC is required to use its monetary tools to meet the government’s
inflation target of 2%. This means that a rise in the average level of prices
of 2% is the desired level.
✚ If the 2% target is missed by 1 percentage point either side of the target
(i.e. outside the range 1–3%), the Bank of England is required to explain the
reasons why and how it intends to restore the rate of inflation to 2%.
Now test yourself
5 What is the target rate of inflation in the UK?
Answers available online
Demand-side policies in the Great Depression
and the 2008 global financial crisis
Inflation target — in the
UK the government tasks
the MPC with keeping
inflation low and stable.
At present, the inflation
target is 2%. However,
some economists have
suggested setting a target
for unemployment and/or
nominal GDP along with an
inflation target.
Making links
In exams, you need to
be able to apply both
deflationary and reflationary
demand-side policies in
a variety of situations/
countries. These policies
are considered again in
Chapter 21.
The Great Depression
The Great Depression occurred from 1929 through most of the 1930s and
affected many countries. It started with the Wall Street Crash in stock market
prices in October 1929. During this period, countries experienced a prolonged
recession that resulted in large-scale unemployment.
Policy responses in the USA
✚ The initial response of the US Government in 1929 was to do very little.
With unemployment increasing rapidly to over 7 million, President Hoover
did allow a limited public works programme. He also increased 900 import
tariffs by between 40% and 48%, which probably worsened the Great
Depression.
✚ When President Roosevelt came to power in 1933, unemployment had
reached 10 million. To address this he introduced his New Deal. This
involved a looser monetary policy, millions of dollars for infrastructure, a
larger public sector and price support for agriculture.
Evaluation: some argue that the New Deal, although large, was too little too
late, and that it was the money spent on the Second World War that finally led
to the end of the Depression.
Policy responses in the UK
✚ In 1925 the UK returned to the gold standard, which meant that the pound
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had to be maintained at a fixed value against gold. In order to do this,
deflationary policies had to be adopted.
✚ In 1931, deflationary policies (e.g. wage cuts in the public sector and tax
increases) were necessary to maintain the value of the pound. These
further depressed GDP.
✚ Eventually, in September 1931, the government left the gold standard,
which resulted in a 25% fall in the value of the pound. Monetary policy was
also eased with a reduction in interest rates.
✚ The UK introduced a 10% tariff on imports from most countries. However,
it cut interest rates and increased money supply.
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Now test yourself
6 How might the cut in public sector wages in 1931 in the UK have affected real
output?
Answers available online
The 2008 global financial crisis
The lessons learned from the Great Depression led to most governments
adopting reflationary demand-side policies in response to the global financial
crisis.
Policy responses in the USA
✚ Fiscal policy: tax cuts and increases in public expenditure amounted to
around $700 billion.
✚ Monetary policy:
✚
✚
Interest rates were cut from 5.25% in 2007 to 0–0.25% in 2008.
Quantitative easing: over the period 2008 to 2010 the Central Bank
(Federal Reserve) purchased $2.1 trillion of bonds in an attempt to
increase money supply and keep interest rates low.
Policy responses in the UK
Exam tip
It is very useful to have
a knowledge of major
previous and current
economic events so that
you can illustrate your exam
answers with real world
examples.
10 Macroeconomic objectives and policies
Evaluation: although GDP rose and unemployment fell, the recovery was
uneven. Only with rearmament at the end of the 1930s did the economy fully
recover.
✚ Fiscal policy:
The government followed expansionary fiscal policy between 2007 and
2010, which included buying shares in UK banks, a temporary cut in
VAT from 17.5% to 15%, and bringing forward £3 billion in investment.
✚ The budget deficit increased from 2.3% of GDP in 2007–8 to 11.3% of GDP
in 2008–9.
✚ However, from 2010, the UK adopted austerity measures aimed at
reducing the budget deficit.
✚ Monetary policy:
✚ Interest rates: the Bank of England cut the bank base rate from 5.75% in
November 2007 to 0.5% in April 2009.
✚ Quantitative easing: over the period 2009 to 2016, the Bank of England
bought £435 billion of government bonds in an attempt to increase
money supply and keep interest rates low.
✚ Evaluation:
✚ The authorities avoided using extreme measures early in the crisis.
However, in hindsight this meant that economies suffered more severe
recessions than might otherwise have been the case.
✚ QE may have helped to prevent a more severe recession, but some
economists argue that its main effect was to increase asset prices (e.g.
share prices and house prices). However, it did not cause inflation as
some had predicted.
✚
The 2020 COVID-19 pandemic
Policy responses in the UK and the USA
✚ The MPC in the UK purchased an extra £300 billon of government bonds as
part of its QE programme, bringing the total to £745 billion by June 2020.
✚ The Bank of England cut the base interest rate to 0.1%.
✚ Between March and November 2020 the UK Government announced
measures costing £280 billion to protect jobs and to stimulate the economy.
✚ In March 2020 the US Federal Reserve launched a $700 billion quantitative
easing programme and cut interest rates from a range of 1–1.25% to
0–0.25%.
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✚ Between March and May 2020 the US Government announced measures
costing $2 trillion to stimulate the economy.
10 Macroeconomic objectives and policies
✚ From this we can see that the US policy response to the global financial
crisis was far greater than that of the UK, and many argue this is why the
US economy recovered more quickly than the UK economy.
Now test yourself
7 a) Why might QE be expected to lead to an increase in the rate of inflation?
b) Suggest one reason why this did not occur in the years after the 2008
financial crisis.
Answers available online
Strengths and weaknesses of demand-side
policies
Table 10.1 summarises both the strengths and the weaknesses of demandside policies.
Table 10.1 Demand-side policies: strengths and weaknesses
Strengths
Weaknesses
According to Keynesian economics,
demand-side policies are the only way
to get a country out of demand-deficient
unemployment and stagnation, at least in
the short run.
According to classical economics,
expansionary demand-side policies only
cause inflation in the long run.
If the multiplier is large, they can have a
significant impact on growth.
The multiplier might be so low that they
have little effect.
If there is spare capacity, the economy can If there is no spare capacity, then supplygrow quickly.
side policies are needed instead in order
to achieve economic growth.
If used to control demand-pull inflation,
they can act quickly and solve the
problem.
If used to stimulate AD, the government
can end up running a huge budget deficit,
which adds to national debt.
Making links
Remember that in questions with the command words ‘examine’, ‘assess’, ‘discuss’,
‘evaluate’ and ‘to what extent’, the assessment objective ‘evaluation’ is being tested.
In your answers to these questions it is important to offer counter-arguments to the
points you make. This applies not only to demand-side policies, considered above, but
to a variety of other policy areas including:
✚ supply-side policies (see page 123)
✚ government intervention in markets (chapters 4 and 16)
✚ strategies influencing growth and development (Chapter 19, pages 218–220)
✚ macroeconomic policies in a global context (Chapter 21, pages 242–244).
Now test yourself
8 Under what circumstances might reflationary demand-side policies lead to
inflation?
Answers available online
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Supply-side policies
10 Macroeconomic objectives and policies
Distinction between market-based and
interventionist methods
Supply-side policies are designed to increase LRAS through measures to
increase the productivity and efficiency of the economy. Some of these
work through market forces while others involve direct intervention by the
government.
Market-based supply-side policies
✚ These policies work through the market mechanism.
✚ They relate to measures designed to:
increase incentives
✚ increase competition
✚ reduce bureaucracy/regulations.
✚
Interventionist supply-side policies
✚ These policies involve government intervention in the market to overcome
market failures.
✚ They relate to measures that involve government expenditure designed to
increase productivity.
Table 10.2 gives an overview of market-based and interventionist policies.
Table 10.2 Market-based and interventionist supply-side policies
Market-based policies
Interventionist policies
Increased incentives for workers, e.g. by
cutting income tax rates and benefits for
out-of-work members of the labour force
Improving the skills and quality of the
workforce (human capital), e.g. by
providing new vocational courses and
apprenticeships
Labour market reforms, e.g. reducing trade Incentives for investment, e.g. by offering
tax breaks for investment or by forcing
union power with laws to prevent strikes
banks to lend money
so that the labour market works more
efficiently
Reduction in corporation taxes (taxes
on profits) so that firms have a strong
incentive to invest more
Investment in infrastructure, e.g. in
green transport systems, new mobile
phone and internet technology
Increased competition, e.g. privatisation,
deregulation of markets to allow
competitors to enter the market, reduction
in tariffs (taxes on imports)
Finance for business start-ups, e.g. in the
UK, firms may apply for start-up loans
of between £500 and £25 000 to start or
grow the size of their businesses
Removing regulations that are preventing
firms from growing, e.g. removing
restrictions on mergers to allow these to
take place
Investment in new technology, e.g. in
artificial intelligence, the Internet of Things
(Alexa, Google Home), voice technology
An incentive, in this
context, is a measure
designed to motivate
workers or businesses,
e.g. higher pay for working
harder, more profits
if businesses are run
successfully.
Infrastructure is the
capital assets that are
designed to help an
economy to function
efficiently, e.g. motorways,
energy supply, internet
connection.
Now test yourself
9 Give an example of an interventionist supply-side policy designed to increase
productivity.
Answers available online
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✚ The impact of supply-side policies may be illustrated by a rightward shift
in the LRAS curve.
✚ Figure 10.4 illustrates the impact of supply-side policies using a Keynesian
AS curve.
✚ It can be seen that these policies would cause a rightward shift in the AS
curve, leading to a rise in real output and a fall in the price level.
Price level
10 Macroeconomic objectives and policies
Use of AD/AS diagrams to illustrate
supply-side policies
AS1
AS2
PL1
PL2
AD1
0
Ye
Y2
Real GDP
Figure 10.4 An increase in aggregate supply
Strengths and weaknesses of supply-side
policies
Table 10.3 summarises the strengths and weaknesses of supply-side policies.
Table 10.3 Supply-side policies: strengths and weaknesses
Strengths
Weaknesses
Economic growth can be achieved without
inflationary pressures building up.
If AD is very low (i.e. the economy is
operating on the perfectly elastic part of
the AD curve) then supply-side policies
would have no impact on real output.
Some supply-side policies help to increase
productivity, e.g. privatisation and
deregulation.
Interventionist policies might be very
expensive, e.g. new infrastructure projects
such as HS2.
Supply-side policies may be used to
achieve economic growth when there is
no, or limited, spare capacity.
Many supply-side policies take a
considerable time to work, e.g.
improvements in education and training,
infrastructure projects
They are less likely to cause a conflict with
other macroeconomic objectives.
Some supply-side policies, e.g. lower
welfare benefits and lower income tax
rates, might increase income inequality.
Exam tip
Note that supply-side
policies may not be
effective in increasing
productivity and in
increasing LRAS. For
example, they might take a
very long time to have any
impact on the economy, or
AD may be so low that they
do not affect it.
Exam tip
Note that cutting interest
rates can lead to increases
in AD and AS.
Now test yourself
10 Under what circumstances might supply-side policies be ineffective?
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Conflicts between objectives
There are many possible conflicts between the macroeconomic objectives
listed above. Below is a selection of possible trade-offs.
Conflict 1: inflation and unemployment —
the short-run Phillips curve
When the government tries to control the rate of inflation it is likely to try to
reduce AD.
✚ Less spending will mean less upward pressure on prices.
✚ The government might increase taxes or the MPC might increase interest
rates.
✚ The impact of these may reduce the rate of inflation but they will also
mean a fall in AD.
✚ Firms may start laying off workers because they are unable to sell all their
goods and services. As workers are laid off, incomes fall and so the cycle
continues.
✚ So, there appears to be a trade-off between the objective of controlling
inflation and unemployment because in trying to control inflation,
unemployment will rise.
This works in the other direction as well.
✚ If the government is trying to reduce unemployment it might start
spending more on training workers or subsidising firms to take on more
workers.
✚ This increased spending in the economy is likely to cause an increase in
the rate of inflation.
✚ This is because there is more money chasing the same amount of goods
and services.
A trade-off occurs when
an objective is achieved
only at the expense of some
other objective.
Exam tip
10 Macroeconomic objectives and policies
Conflicts and trade-offs
between objectives and policies
Be careful not to confuse
conflicts between
objectives, e.g. inflation
and growth, with conflicts
between policies, e.g. fiscal
expansion and monetary
contraction.
Inflation
(% per year)
The trade-off between inflation and unemployment is illustrated in the
Phillips curve in Figure 10.5. At Point A there is high inflation and low
unemployment, but if the government tries to move to Point B, it only reduces
the rate of inflation at the expense of a higher rate of unemployment.
A
10
B
5
0
3
6
Unemployment rate (%)
Figure 10.5 The Phillips curve
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10 Macroeconomic objectives and policies
Making links
The concepts of inflation and unemployment were introduced in Chapter 5 and then
were referred to in the AD/AS analysis in Chapter 8 and again in relation to output gaps
in Chapter 9.
In exams, you will be required to examine the significance of these variables in
considering the economic performance of developed economies (Chapter 5) and of
emerging and developing economies (Chapter 19).
Now test yourself
11 What does the Phillips curve show?
Answers available online
Conflict 2: economic growth and protection
of the environment
When an economy grows, standards of living tend to improve.
✚ However, there may be a conflict between enjoying a non-renewable
resource today and someone else enjoying it in the future.
✚ This is most important when considering those affected by damage to the
environment when we consume resources today.
✚ So, if our increased use of fossil fuels means that there is more global
warming, growth may not be as desirable as it first appears.
✚ Governments must make a choice, weighing up the welfare of today’s
generation with that of tomorrow to achieve sustainable growth.
Sustainable growth
is growth that does not
compromise the welfare of
future generations.
Making links
The concept of economic growth was introduced in Chapter 5 and the protection of
the environment was introduced earlier in this chapter (see page 116). Environmental
pollution was given as a specific example of external costs in Chapter 3.
In exams, you will be required to examine the significance of the link between
growth and the environment in the context of the standard of living in both
developed economies (see Chapter 5) and in emerging and developing economies
(Chapter 19).
Conflict 3: inflation and equilibrium on the current
account of the balance of payments
Controlling inflation should make a country more competitive internationally
and therefore lead to an improvement on the balance of payments.
✚ Exports become relatively cheap and imports relatively expensive.
✚ Therefore, controlling the rate of inflation should not conflict with dealing
with a balance of payments deficit on the current account.
✚ However, the actions required to control inflation can damage the current
account. For example, raising interest rates to reduce the rate of inflation
might have the effect of raising the exchange rate, which in turn makes
exports expensive and imports cheap.
✚ By contrast, contractionary fiscal policy — which might alternatively be
used to control inflation — tends to improve the current account because
people have less money in their pockets to purchase foreign goods.
Exam tip
Avoid confusing the
budget with the balance of
payments. A budget refers
to the government’s fiscal
position while the balance
of payments is a record of
the international flow of
funds.
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Making links
10 Macroeconomic objectives and policies
The concepts of inflation and the balance of payments were introduced in Chapter 5.
The link between these concepts is explored further in Chapter 17, in the context of
international competitiveness (see page 204) and in relation to exchange rates (see
page 201).
Now test yourself
12 How might deflationary (contractionary) fiscal policy affect the trade balance?
Answers available online
Conflicts between macroeconomic policies
Conflict 1: fiscal policy and monetary policy
Changes in the planned levels of spending and taxation by the government
(fiscal policy) have a direct impact on the MPC’s decision-making (monetary
policy).
✚ If the MPC believes that fiscal policy is too loose, e.g. government spending
is too generous relative to taxation, then it might seek to counterbalance
the effect on inflation by raising interest rates.
✚ If the MPC believes that fiscal policy is too tight, e.g. government spending
is low relative to taxation, then it might seek to counterbalance the effect
on inflation by cutting interest rates.
When fiscal policy results in a large budget deficit, this has to be financed by
borrowing. Increased demand in the money markets for funds means that
there will be an upward pressure on interest rates. In turn, this will increase
the cost to the government of borrowing money. However, this may not be the
case if quantitative easing causes interest rates to remain low.
Conflict 2: monetary policy and supply-side policy
Changes in interest rates and other monetary policy decisions have a direct
impact on the costs of firms, therefore shifting the AS curve.
✚ If interest rates rise, it will cost firms more to produce, which might mean
that firms are willing to produce less at any particular price level.
✚ If interest rates fall, it will cost firms less to produce, which might mean
that firms are willing to produce more at any particular price level.
Now test yourself
Exam tip
Monetary policy is not
intended to influence the
supply-side of the economy,
but this is an impact the
MPC must take into account
when making its interest
rate decisions.
13 How might an expansionary fiscal policy affect interest rates?
14 Why do firms borrow money?
Answers available online
Conflict 3: supply-side policy and fiscal policy
Changes in most supply-side policies have a direct impact on government
spending, i.e. fiscal policy. For example:
✚ Improving education and health services in order to encourage people to
be more productive requires high levels of government spending.
✚ Increasing the length of education also means that governments won’t
receive money via taxes from income those students might have earned
had they been at work.
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10 Macroeconomic objectives and policies
In most cases:
✚ supply-side policies tend to increase the budget deficit in the short term
✚ supply-side policies can decrease the budget deficit in the long term, as
improved human capital means higher incomes that can be taxed by the
government.
However, some supply-side policies, such as reducing bureaucracy, are
unlikely to make a significant impact upon government spending (G) and
taxation (T).
Some supply-side policies, such as privatisation and cutting benefits, tend to
reduce the budget deficit. Privatisation is a one-off benefit, and cutting benefits
could increase long-term costs to the government because of the social
problems involved.
Making links
These policies were introduced earlier in this chapter on pages 123–124. They are also
relevant in consideration of the strategies influencing growth and development in
Chapter 19 (see page 218).
In exams, it is important to be able to apply these concepts in both developed and
developing economies, and to be able to differentiate between market-based and
interventionist supply-side policies.
Now test yourself
15 How might interventionist supply-side policy affect the budget deficit?
Answers available online
Exam tip
When assessing supply-side
policies, such as cutting
benefits, remember that
there are two sides to every
issue, and if you want to
earn evaluation marks, you
must weigh up both sides of
the argument.
Summary
You should have an understanding of the following:
✚ No objective can be achieved by governments without
some form of impact on other objectives. There
are seven major government economic objectives,
including control of:
1 growth
2 employment
3 inflation
4 balance of payments
5 fiscal balance
6 environmental sustainability
7 distribution of income.
✚ Some of these objectives are possible to achieve
together, but for some there is a trade-off, i.e. more
of one means less of another. You need to be able to
reason through the relationship between at least two
of these seven objectives.
✚ When a macroeconomic policy is applied, there are
direct effects, which may or may not be seen as a
successful outcome, and indirect effects, which may or
may not be beneficial.
✚ The government has to prioritise the objectives that
it believes are the most important at any one time,
and the economist tries to predict what the effects of
implementation will be on a wide range of variables.
No economic policy comes without costs — in addition
to knowing what the main macroeconomic policies
are (monetary and fiscal), you also need to know the
possible side effects.
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This part of the course lends itself to the use of
evaluative skills, not least because the priority given to
macroeconomic objectives and the use of policies involves
subjective judgements.
Given that this part of the course may be tested by
essays, it is worth considering the criteria for a Level 3 for
evaluation in an essay, for which up to 9 marks may be
awarded (out of 25):
Evaluative comments supported by relevant
reasoning and appropriate reference to context.
Evaluation recognises different viewpoints and
is critical of the evidence provided and/or the
assumptions underlying the analysis enabling
informed judgements to be made.
In the context of this chapter, examples of essays may
relate to the evaluation of fiscal policies, monetary policies
or supply-side policies. Alternatively, evaluation might be
required in essays relating to the evaluation of conflicts
between macroeconomic objectives.
Obviously, essays test all the assessment objectives, with
16 marks for knowledge, application and analysis, so it is
also important to ensure that:
✚ terms are explained precisely, e.g. reflationary fiscal
policy
✚ there is clear reference to the context in your answer,
e.g. the question could relate to a specific rate of
unemployment or of inflation
✚ there are clear step-by-step explanations, e.g. how an
increase in government expenditure would cause an
increase in AD with a multiplier effect, how this would
cause a rightward shift in the AD curve and how this
would lead to an increase in real output and in the price
level. This analysis should be supported with an AD/AS
diagram.
Exam practice
10 Macroeconomic objectives and policies
Exam skills
1 Study the material below and answer the questions that follow.
Table 1 German government expenditure and tax revenues
2010
2013
2016
2019
Total
government
revenue
€1 122 258
€1 264 688
€1 425 594
€1 608 567
Total
government
expenditure
€1 234 544
€1 263 544
€1 388 482
€1 558 779
Source: Eurostat
Extract: German fiscal stimulus, June 2020
In June 2020, the German Government announced a
fiscal stimulus of €150 billion. The main elements of the
package were the following:
✚ There would be a cut in the standard VAT rate from
19% to 16% and in the lower VAT rate from 7% to 5%
from 1 July to 31 December 2020. This measure will
result in lost tax revenues of €20 billion.
✚ There would be a €300 handout for each child in a
family.
✚ The subsidy for electric cars would be increased from
€3000 to €6000 for cars costing up to €40 000.
✚ There would be €50 billion for future investment.
a) With reference to Table 1, calculate the change in Germany’s fiscal balance between 2010 and 2019.
b) With reference to Table 1, examine the effect of the change in Germany’s fiscal balance on the circular
flow of income.
c) With reference to the extract, assess the likely effect of the cut in VAT on businesses.
d) With reference to the extract, discuss the impact of €50 billion for future investment.
e) Apart from €50 billion for future investment, discuss the likely impact of Germany’s fiscal stimulus on
its economy.
[5]
[8]
[10]
[12]
[15]
2 Greece, Italy and Spain have very high rates of youth unemployment.
Evaluate the use of supply-side policies as a means of addressing a problem of rising youth
unemployment.[25]
Answers and quick quizzes online
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11 Business growth
A firm is an organisation whose function is to combine resources (factors of
production) for the production and supply of goods and services.
Making links
Enterprise was considered as a factor of production in Theme 1 (see page 13) and
could be relevant in answering questions on its significance in a capitalist economy.
A firm buys and sells
products and/or services to
consumers, usually with the
aim of making a profit.
Size and types of firms
Why do some firms remain small?
✚ Size of market is very small: if the firm is operating in a specialist segment
of a market (sometimes referred to as a niche market) and demand is low
then the firm is likely to remain small.
✚ Limited access to finance: small firms might be regarded as high risk to
banks, making them unwilling to lend.
✚ Owner objective to retain control of the business: owners may want to
retain complete control of their businesses and so be unwilling to expand.
✚ Lack of economies of scale: there may be no incentive for a firm to grow
if there are no potential cost savings (see pages 149–150 for further
consideration of economies of scale).
✚ Individual, personalised services: nail bars, personal trainers and
osteopaths are examples of firms that are often small because they offer a
personal service and customers wish to deal with a particular person.
✚ Need for a dynamic, responsive, service-led firm: firms involved in design
are often small and quick to respond to the needs of larger firms that buy
in their services.
Economies of scale occur
when an increase in the
scale of production results
in a fall in long-run average
costs.
Now test yourself
1 Why are plumbing firms often small businesses?
Answers available online
Why do some firms grow?
✚ To benefit from economies of scale: larger firms often have lower costs
per unit of output in the long run. These are discussed in more detail on
pages 149–150.
✚ To increase market share: a larger firm has more market power and can
control prices and retain consumer loyalty. A larger market share also
means that the threat of competitors is reduced.
✚ To reduce risk: larger firms might diversify and produce a range of
products, so benefiting from economies of scope. Firms specialising in
one product face the risk that if demand falls, they may be forced out of
business. This could be a particular problem in times of recession.
✚ To meet managerial objectives: firms may wish to grow because the pay
and bonuses of managers are related to sales revenue. Also, managers
might seek the higher status of being part of a large organisation.
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Now test yourself
Answers available online
The divorce between ownership and control:
the principal–agent problem
✚ Shareholders (‘principals’) own most large businesses and they appoint
directors and managers (‘agents’) to control business on their behalf.
✚ Shareholders want to maximise profits (to maximise their dividends),
whereas managers might have different motives, such as wanting to
increase sales at the expense of profits.
✚ The principal–agent problem is when the aims of the principals and agents
diverge and conflict with each other.
The principal–agent
problem occurs when the
aims of a firm’s owners
diverge from those of the
managers, which may lead
to a conflict between the
aims and the policies of
these two groups.
11 Business growth
2 Why might a firm launching a new range of vegan foods wish to grow in size?
Private and public sector firms
The main objectives of the firm depend on whether it is in the private or
public sector.
Private sector firms are owned by private individuals or groups of private
individuals. They usually aim to make a profit, without which they may not
survive. The main types of private sector organisation are:
✚ sole proprietors
✚ partnerships
✚ joint stock companies (private and public)
✚ cooperative societies.
The private sector is the
part of the economy in
which the assets are owned
by individuals or groups,
and not the government,
e.g. Spire hospitals, which
are funded by private
payments from individuals
or companies.
Public sector firms are owned by the government. They can survive without
making a profit because the government can make up any shortfall in
revenues from taxation.
✚ UK public sector organisations include, for example, policing, education
and healthcare.
✚ Some public sector firms do aim to make a profit but tend to have other
aims that are more important, such as quality of service. For example,
Network Rail is funded through government grants and charges levied on
train operators that use the rail network, and via its commercial property
estate.
The public sector is the
part of the economy owned
by society as a whole and
regulated/provided by
the government, e.g. NHS
hospitals, which are funded
mainly through taxation.
Now test yourself
Exam tip
Remember that the private
sector includes public
limited companies, which
are owned by shareholders.
3 What is the key difference between a private sector firm and one in the public
sector?
Answers available online
Making links
In exams, private sector and public sector businesses may be linked to a consideration of
free markets, mixed economies and command economies in Theme 1 (see pages 20–23).
Profit and not-for-profit organisations
Profit organisations
These aim to make or maximise profit and include those discussed in the
previous section.
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Non-profit organisations
11 Business growth
✚ These are part of the private sector.
✚ Non-profit organisations are independent organisations whose purpose
is something other than to make private profit for directors, members or
shareholders.
✚ They include many different types of organisation, such as charities and
social enterprises. Examples in the UK include Divine Chocolate, the Motor
Neurone Disease Association and the World Wide Fund for Nature (WWF).
✚ They usually have to cover their own costs, and any surpluses are
ploughed back into the business.
Non-profit organisations
are private firms for which
the primary motive is not
profit, although they do
usually have to cover their
costs.
Business growth
Organic growth
Organic growth is the internal growth of a business, and not growth from
the businesses it acquired. A business can achieve organic growth by buying
new capital, taking on more workers or increasing the amount of hours
people work.
Organic growth refers to
the increase in output and
sales of a business using
internal resources.
Advantages and disadvantages of organic growth
Advantages
Disadvantages
Management has a sound knowledge of
the business.
Growth may be slower than through
mergers or takeovers.
The firm can respond to changes in the
market quickly.
It may decrease the competitiveness of
the business.
There is no need for restructuring.
The business might not take on new ideas
or people.
There is less risk than with growth through
a merger/s.
The firm might get too specialised in areas
that are becoming out of date.
An example of successful organic growth is Walmart. This company started
with the opening of one store in 1950. By 1995 it had a store in every US state
and some in Canada. In 2020 Walmart had over 11 000 stores in 28 countries.
This growth was achieved without mergers, but through a decision to achieve
higher sales by cutting prices.
External growth
Firms can also grow by buying out other firms, either by agreement (mergers)
or by taking them over (acquisitions), often referred to in combination as
M&A.
External growth involves
the expansion of a business
by merger or takeover.
However, there are financial risks because the firm might have to take on
debt to buy another firm.
There is also the risk of investigation by the Competition and Markets
Authority, the UK government organisation that exists to promote
competition and consumer interests.
Now test yourself
4 What is the difference between internal and external growth?
Answers available online
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Horizontal integration
✚ This is when firms merge at the same stage of the same production
process (see Figure 11.1).
✚ The firms may not make exactly the same product, and are likely to want
to increase the range of products they produce, or to be keen to get into
new markets around the world.
Car manufacturer
Car manufacturer
11 Business growth
There are three main ways in which a firm can grow externally, as described
below.
Figure 11.1 Horizontal integration
For example, in 2019, Fiat Chrysler and the Groupe PSA (owners of Peugeot)
agreed to merge. This merger was expected to generate savings and other
benefits of €3.7 billion without any factory closures.
Advantages and disadvantages of horizontal integration
Advantages
Disadvantages
To gain economies of scale.
Risk is focused on a narrow range of goods or services.
To increase market share.
Diseconomies of scale may occur (see Chapter 13, page 151).
To eliminate a competitor so enabling the firm to gain a
degree of monopoly power.
The share price of the firm being bought might rise, meaning
the buyout is very expensive.
A merger reduces the risk of being bought out by a rival
company.
Some workers might lose their jobs if the roles in the new
bigger firm are duplicated, e.g. head of human resources.
Increased revenue for the business as a result of having a
larger customer base.
Some workers might have to move or travel further.
Some assets might be sold off (e.g. duplicated capital
equipment), which might be wasteful.
Now test yourself
5 In 2019 there was a proposed merger between two of the world’s largest textbook
publishers, McGraw-Hill and Cengage. Identify two reasons why these companies
wanted to merge.
Answers available online
Vertical integration
✚ This is when firms merge at different stages of the production process.
✚ This can be broken down into two further types, backward vertical
integration and forward vertical integration (see Figure 11.2).
Commodity producers
Backward
Suppliers
Manufacturers
Retailers
Forward
Customers
Figure 11.2 Vertical integration
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11 Business growth
Starbucks is an example of a vertically integrated company because it owns
coffee bean farms and roasting plants, warehousing and distribution, and
retail outlets.
Backward vertical integration
This occurs when a firm merges with a supplier. The table below summarises
the advantages and disadvantages of this type of merger.
Exam tip
Remember that backward
vertical integration involves
integration back towards
the suppliers of raw
materials.
Advantages and disadvantages of backward vertical integration
Advantages
Disadvantages
Control over raw materials means supply and quality are
guaranteed.
The firm might not need to buy all the supplies.
Other firms might be prevented from getting the supplies.
The firm might not have specialist knowledge of production
— diseconomies of scale might set in.
The mark-up that a supplier makes can become profit for
the buying firm.
The firm might find it hard to adapt to changes in consumer
demand, e.g. buying a sugar plantation might be unhelpful if
demand shifts to artificial sweeteners.
Forward vertical integration
This means buying another firm in the same production process but closer
to the customer. For example, a brewery buying a chain of pubs engages in
forward vertical integration.
Advantages and disadvantages of forward vertical integration
Advantages
Disadvantages
Buying a retail outlet might guarantee that consumers
see a firm’s products at their best.
The firm on its own might not have a wide enough range or
choice for consumers.
The consumer may not be distracted by competition
from other products.
The firm might not have marketing and sales expertise.
Market research is more effective and the firm can
adapt in response to consumer preferences.
Risk of larger losses i.e. if demand for the final product falls.
Now test yourself
6 State whether the following are examples of forward or backward vertical
integration:
a) A car manufacturer buys a chain of car retailers.
b) A wine merchant buys a vineyard.
Answers available online
Conglomerate integration or ‘diversification’
This occurs when a firm buys another firm in a completely unrelated
business, i.e. the firm diversifies. For example, Honeywell is involved in a
wide range of markets including aerospace, building technologies, materials
technology and safety products.
Advantages and disadvantages of conglomerate integration
134
Advantages
Disadvantages
It spreads the risk — profitable areas can crosssubsidise loss-making areas.
There might be a lack of expertise in new areas.
Different products do well at different parts of the
business cycle.
Brands might become diluted.
Brands gain more recognition.
Differences in cultures may result in conflict and low productivity.
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Making links
11 Business growth
The size of firms in a country might have significance for productivity (see page 94)
and for the country’s international competitiveness (see page 204).
Constraints on business growth
Despite the potential benefits of growth for some firms, there may be
powerful constraints preventing a firm from growing.
✚ Government regulation: some firms are unable to grow because
governments might use regulations to ensure markets remain competitive
and to prevent the development of monopolies.
✚ Capacity constraints: a firm might have insufficient machinery to expand.
Linked with this point is the fact that the business may face a shortage of
finance for expansion. Further, labour constraints might be a problem. For
example, the firm might have difficulty in recruiting workers and/or there
may be a shortage of skilled labour.
✚ Market constraints: if demand is limited or if individual tastes have to be
satisfied, then large-scale production would be inappropriate. Further, the
existing competition in the market may deter a firm from expanding.
✚ Vision constraints: the owner’s attitude, e.g. a lack of ambition, might be
the key reason why a firm does not expand. Some firms like to ‘keep it in
the family’ by employing family members and avoid taking on people from
outside. This may make the firm easier to manage and workers might have
greater loyalty and be more productive.
✚ The state of the economy: if the economy was in recession, the owners
might think that demand would be limited and so there would be no point
in expanding.
Exam tip
Be prepared to provide
examples of the way in
which each of these factors
might inhibit the growth of
a firm.
Now test yourself
7 Petra runs a successful business as a hairdresser employing one other person.
Identify two factors that might explain why the business remains small.
Answers available online
Demergers
Demergers involve the separation of a large company into two or more
smaller companies. This might involve the dissolution of an earlier merger.
An example is Whitbread, which sold off the Costa Coffee chain after pressure
from some investors.
Reasons for demergers
✚ To focus on the core business: this might enable higher profits to be made
by developing that part to gain the benefits of specialisation.
✚ To increase profit: this could be achieved if under-performing or lossmaking parts of the business are sold.
✚ To raise finance: this would be possible by selling the shares in the new
company. The money raised could be used for investment in the core
business.
✚ To avoid diseconomies of scale: merged firms can be difficult to manage if
they involve different core activities.
✚ To meet demands of regulators: a firm might be required to spin off
part of its business by a regulatory authority as a means of increasing
competition.
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Impact of demergers
11 Business growth
✚ On businesses: demergers allow focus on the core business, raising funds
from selling part(s) of the business, and removing loss-making parts of the
business.
✚ On workers: there might be an increase in job security if loss-making parts
of the business are demerged, a reduction in conflict between cultures and
an increased focus on the business to enable it to be more profitable — but
some may lose jobs.
✚ On consumers: greater competition leads to lower prices. More focused
businesses are able to better meet consumer needs — but some parts of
the service might be limited. For example, when Lloyds TSB split into two
firms, some consumers were left without a local bank branch.
Now test yourself
Exam tip
8 How might the shareholders of a company benefit if there is a demerger of part of
the business?
Know some examples of
mergers and demergers
with reasons for each.
Answers available online
Summary
You should have an understanding of:
✚ why some firms remain small for sound economic
reasons, and why others wish to grow, with benefits to
many stakeholders
✚ how a firm’s motivation for growth depends on its type,
its market and the context
✚ the ways in which firms grow, which may be internal
(organic) or involve joining with other firms (external)
✚ why when firms grow beyond a certain point, costs
may start to rise (diseconomies of scale, for example)
and this is the main reason for splitting up (demergers).
Exam skills
Providing context in both analysis and evaluation is
important, and this is an area of the course that relies
heavily on real-world examples. Therefore, it would be
helpful to investigate some individual firms, mergers and
demergers of your own, so that you have examples to use
in essays. This also ensures that you are more informed
when answering data response questions. You will then
be better placed to tackle questions around the following
areas:
✚ The reasons why a firm might wish to grow in size
✚ The significance of the principal–agent problem
✚ The difference between private sector and public
sector businesses
✚ The advantages and disadvantages of the ways in
which firms might grow in size
✚ The rationale for, and impact of, demergers
Exam practice
1 AstraZeneca is a joint stock pharmaceutical company
founded in 1999 through the merger of Astra AB and
Zeneca Group. Zeneca was formed after the demerger
of Imperial Chemical Industries (ICI) in 1993.
a) Which one of the following arises from the
separation of ownership from control in joint stock
companies?
A Asymmetric information
B The principal–agent problem
C Demerger
D Diseconomies of scale
[1]
b) Explain two reasons why a demerger might take
place.[4]
2 A cocoa producer in West Africa takes over a chocolate
manufacturer.
a) Which type of integration does this illustrate?
A Horizontal integration
B Backward vertical integration
C A conglomerate merger
D Forward vertical integration
[1]
b) Explain two economies of scale that might result
from this integration.
[4]
3 ‘The advantages of size are so great that it is rational
for most small firms to aim to grow in size.’
To what extent do you agree with this view?
[25]
Answers and quick quizzes online
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12 Business objectives
Profit maximisation
It is usually assumed that firms try to make the most profit possible.
However, while all firms in the private sector have to make a profit in order to
survive, not all firms aim to maximise profits.
Profit maximisation can be viewed in two ways:
✚ It is the output at which the difference between the total revenue (TR)
and total cost (TC) is greatest, or price minus cost per unit, multiplied by
quantity, is greatest
or
✚ it is the point at which the revenue gained from selling one more unit
(marginal revenue (MR)) is exactly equal to the cost of producing one more
unit (marginal cost (MC)). In short, this is written as MR = MC.
Understanding why profits are maximised
when MR = MC
✚ If a firm sells one more unit and gets more money coming in than it costs
to make that unit, then it is rational for the firm to produce and sell that
unit. We say that the marginal profit is positive.
✚ By contrast, if in selling another unit the cost is greater than the revenue
received, then the marginal profit is negative and the firm would be
advised to reduce output.
✚ When the marginal cost equals the marginal revenue, the firm reaches
equilibrium. This means that there is no tendency for the firm either to
increase or decrease output because either of those options would reduce
the profitability of the firm.
✚ Profit maximisation does not mean that the firm is making the most
amount of revenue possible. This is in fact a different objective called
revenue maximisation (see page 138).
Making links
The assumption of profit maximisation, like that of utility maximisation (see Chapter 2),
is based on the assumption of rational behaviour. These assumptions need to be
examined critically, as well as the reasons for and implications of irrational behaviour.
Now test yourself
Exam tip
Profit is the reward for risk
taking, so it is rational that
the risk taker will want to
get the greatest reward
possible. Therefore, it is
assumed that private sector
firms aim to maximise
profits. In exams, however,
you should be prepared to
question whether this will
always be the case.
Total revenue (TR) is the
price multiplied by the
quantity sold.
Total cost (TC) is the cost
of producing a given level
of output. In the short run it
is calculated by adding the
total fixed cost to the total
variable cost.
Marginal revenue (MR)
is the change in TR from
selling one more unit of
output. It is the gradient of
the TR curve.
Marginal cost (MC) is the
extra cost of making one
more unit of output. MC
is always positive. It is the
gradient of the total cost
curve.
Marginal profit is the
extra profit gained from
selling one more unit. When
marginal profit is zero, the
firm is maximising profit.
Marginal profit = MR − MC.
1 If a firm is making maximum revenue, does that mean it is making the most
possible profit?
Answers available online
Making links
Profit maximisation is initially assumed to be the objective of firms in different
market structures, i.e. perfect competition, monopolistic competition, monopoly and
oligopoly. These are covered in Chapter 14.
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12 Business objectives
Now test yourself
Exam tip
2 Identify two ways of determining the profit maximising output.
Remember that marginal
revenue must be equal to
marginal cost to maximise
profits. If marginal revenue is
greater than marginal cost,
the firm can increase its
profit by increasing output.
Answers available online
Revenue maximisation
Revenue maximisation can be viewed in two ways:
✚ The output at which total revenue (TR) is at a maximum
or
✚ the output at which the marginal revenue (MR) gained from selling one
more unit is zero. This is shown in Figure 12.1 (see page 139), as the output
at which MR = 0 (Q1).
In this case, the firm cuts its price down to the point where the extra revenue
received from selling another unit is balanced by the reduced price on every
item it is already selling.
In certain circumstances revenue maximisation might be a rational objective:
✚ If a firm is going to have to dispose of all its stock, then effectively the
costs are not relevant. For example, supermarkets often sell goods that
have reached their sell-by-date at a discount because they are unable to
sell them on the following day.
✚ If a business is owned and managed by different people, there might be
different objectives. This is an example of the principal–agent problem
(see page 131). The owners might be the shareholders who want maximum
profit, but the managers’ bonuses might be paid according to the revenue
made by the firm.
✚ If a firm is about to be taken over by another firm it may be valued on the
basis of its revenue. Therefore, the firm might try to maximise its revenue
to ensure that the sale price is as high as possible.
Exam tip
In exams, it is important
that you have a clear
understanding of the
relationship between TR
and MR. See page 142 for a
detailed explanation of this
relationship.
Now test yourself
3 At the end of a day’s trading, a flower seller cuts the price of all the stock that will
spoil before the following day. What pricing strategy is this?
Answers available online
Sales maximisation
Sales maximisation can be viewed in two ways:
✚ The output at which total cost is equal to total revenue
or
✚ the output at which average revenue is equal to average cost.
This strategy occurs when a firm sells as much as possible subject to the
constraint that it at least makes normal profit (see page 153).
138
There are several reasons why a firm might follow a sales maximisation
strategy:
✚ To increase its market share and eliminate competitors by cutting its price:
this might be a short-run policy and in the long run the firm might want
to return to profit maximisation. This is shown in Figure 12.1, at output
Q where AC = AR. (Note: the derivation of the cost and revenue curves in
Figure 12.1 is considered in Chapter 13.)
✚ To avoid the attention of the competition authorities: the government is
often involved as a watchdog for private firms and if firms are seen to be
making a large amount of profit they may be subject to investigation.
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✚ To deter new firms from entering the market: a high level of profitability
Costs and
revenue
MC
AC
Exam tip
P1
Sales maximisation means
making as much output
as possible subject to the
condition of not making a
loss (AR = AC). Revenue
maximisation or sales
revenue maximisation
occurs at the output at
which MR = 0 and ignores
costs.
P
MR
AR
Q1
Q
Output
Figure 12.1 Sales maximising and revenue maximising outputs
12 Business objectives
might attract other firms into the market, so by cutting prices and selling
more, new entry is prevented.
Now test yourself
4 Why might a new entrant into the nail bar market adopt a sales maximising strategy?
Answers available online
Satisficing
Characteristics of satisficing
✚ This objective abandons the idea of maximisation.
✚ A satisficing firm is not attempting to maximise anything.
✚ Satisficing implies setting an acceptable level for each goal of the business
to be achieved simultaneously, e.g. for profit, market share, revenue,
environment.
✚ Satisficing occurs when businesses attempt to pursue several goals at the
same time.
Reasons to adopt the objective of satisficing
✚ The human intentions and the interaction of the people who run firms can
have a significant impact on output and pricing decisions.
✚ This objective is likely to be followed when there is a separation of
ownership and control in which shareholders and managers have
different, and perhaps conflicting, objectives.
✚ The characteristics of the owner or manager are reflected in the objectives
of the firm. For example, if a person wants to run a business with low risk,
the business might be kept small, producing just enough to make a certain
amount of profit to pay the costs.
✚ Firms may wish to keep profits down to avoid being taken over by other
firms. The managers might get satisfaction from being in control of their
own business, which is worth more than money.
✚ Some firms aim to make just enough profit to keep the shareholders happy
and then pursue other objectives. For example, a manager may choose to
go and play golf rather than sell a few more items.
A policy of satisfying the shareholders with sufficient profit is described as
profit satisficing.
Profit satisficing is
making enough profit to
keep shareholders happy,
after which managers can
pursue other objectives.
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Now test yourself
12 Business objectives
5 Why do some firms engage in satisficing?
Answers available online
Summary
You should have an understanding of:
✚ the condition necessary for profit maximisation,
which is the output at which MC = MR (see page 137)
✚ the condition necessary for revenue maximisation,
which is the output at which MR = 0
✚ the condition necessary for sales maximisation, which
is the output at which AC = AR
✚ why some firms might follow a satisficing policy by
setting minimum targets for a range of objectives.
Exam skills
Traditional economic theory suggests that consumers
aim to maximise utility while firms aim to maximise profit.
However, this specification encourages you to think
critically about these objectives and, in this theme, the
reasons why firms might not aim to maximise profits.
You need to be able to draw diagrams to identify the
output and price under each of the following conditions:
✚ Profit maximisation
✚ Revenue maximisation
✚ Sales maximisation
Note that firms following an objective other than profit
maximisation in the short run might nevertheless be
compatible with the goal of long-run profit maximisation.
Exam practice
1 A publisher launches a new magazine and sells it at a
50% discount for the first four issues.
a) Explain two reasons why a publisher might adopt
this policy.
[4]
b) Which one of the following is a necessary condition
for a firm to maximise its sales revenue?
A
B
C
D
Average cost equal to average revenue
Marginal revenue equal to marginal cost
Average cost equal to marginal cost
Marginal revenue equal to zero
[1]
2 Discuss reasons why a firm may change its objective
from revenue maximisation to profit maximisation. [12]
Answers and quick quizzes online
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13 Revenues, costs and profits
Revenue
Total revenue
✚ Total revenue (TR) is the amount of money a firm receives. If everybody
pays the same price, the formula is: price multiplied by quantity sold
(P × Q). For example, if I sell 200 doughnuts for 50p each, my total revenue
is £100.
✚ When we plot the TR curve we must consider whether the firm is a price
taker or a price maker.
✚ If the firm is a price taker, it is operating in a very (perfectly) competitive
market, and must accept the market-determined price whatever output it
produces. Therefore, its TR curve will be a straight line drawn through the
origin.
✚ If the firm is a price maker, it is operating in an imperfectly competitive
market. In this case the TR curve is a parabola shape. This means that as
the price falls the revenue will rise, but it rises more slowly each time that
price is cut, up to the point of maximum revenue. Further price cuts will
cause the TR to fall.
A price maker is a firm
that has sufficient market
power to influence the price
of the good it is selling and
faces a downward sloping
demand curve.
A price taker has to offer
its product at the same
price as everyone else.
Maximum revenue, or
revenue maximisation, is
the output at which total
revenue is at a maximum.
Figure 13.1 illustrates the TR for a price taker and a price maker.
Revenue
TR
Revenue
(b)
(a)
TR
0
Quantity
0
Quantity
Figure 13.1 Total revenue for a) a price taker and b) a price maker
Making links
Price elasticity of demand was initially considered in Theme 1, and it has applications
in many other areas of the course, e.g. in considering elasticity of demand for labour
(in Chapter 15), and in relation to the impact of exchange rate changes and the impact
of tariffs (Theme 4).
Now test yourself
1 Why is the total revenue curve a straight line drawn through the origin for a pricetaking firm?
Answers available online
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13 Revenues, costs and profits
Average revenue
Average revenue (AR) is the price the firm receives per unit sold. An AR
curve is the same as the demand curve. It is calculated by dividing TR by the
quantity sold:
AR = TR
Q
Since TR is P × Q, it can be seen that AR is the same as price:
AR = P × Q
Q
Just as with TR, the AR curve depends on whether the firm is a price taker or
a price maker:
✚ A price taker faces a horizontal demand curve, which is perfectly elastic. A
typical example is a fishing boat captain who brings his catch into port in
the mornings. The price he gets for his fish depends entirely on the
demand and supply for that type of fish at that particular port at that
time, and the fisherman has to accept the price offered.
✚ A price maker faces a downward sloping demand curve.
Exam tip
Note that in a perfectly
competitive market (see
Chapter 14) the firm has
to accept the marketdetermined price and so its
demand curve is perfectly
elastic. In practice, most
firms have some degree
of monopoly power and
therefore face a downward
sloping demand curve.
This means that these
firms control set prices or
determine the quantity they
produce.
Now test yourself
2 If a firm’s total revenue from selling 6000 units is £240 000, what is the price?
Demand is also known as
average revenue (AR).
Answers available online
Marginal revenue
✚ Marginal revenue (MR) is the change in total revenue from selling one
more unit of output.
✚ It is calculated by dividing the change in TR by the change in the quantity
sold:
MR = ΔTR
ΔQ
✚ For a firm that is a price taker, the MR is horizontal and is equal to the AR.
✚ For a firm that is a price maker, the MR curve is downward sloping. It has a
gradient twice as steep as the AR curve. It is less than AR because cutting
prices means losing money on items already sold. The reason is that when the
price is reduced, the firm loses money on all the items it is already selling.
✚ A typical example might be a price-making firm on a beach selling ice
creams, that has to set the price at £2 per ice cream. It finds it cannot
sell very many — say 20. The total revenue is £40. It cuts the price to £1
to increase its sales and sells an extra 20 ice creams. The MR is £20 from
selling 20 extra ice creams, but it loses £20 on the ice creams it could have
sold at £2 each. Its TR is still £40, and its MR is zero. The only difference
is that it has to sell more ice creams, which in fact costs it more, so it is
actually making less profit.
Exam tip
In drawing diagrams
remember to draw the
gradient of the MR curve
twice as steep as the
AR curve.
Figure 13.2 illustrates the AR and MR for a price taker and a price maker.
(b)
Costs and
revenues
Costs and
revenues
(a)
Making links
P
AR = MR
AR
0
142
Output
0
MR
Output
Perfectly elastic demand
was first considered in
Theme 1, page 30. It is also
relevant in considering
perfectly competitive firms
(see page 158).
Figure 13.2 Average revenue and marginal revenue for a) a price taker and b) a price maker
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3 A firm’s total revenue rises from £3000 to £3300 when it reduces its price from
£100 to £90 and sells 10 more units. What is the marginal revenue?
Answers available online
Price elasticity of demand and its relationship
to revenue
The formula for price elasticity of demand (PED) is:
% change in quantity demanded
% change in price
✚ The result is called a coefficient, meaning it is a number that goes with
other numbers and does not have any units of its own.
13 Revenues, costs and profits
Now test yourself
✚ PED has a range between zero (perfectly inelastic) to minus infinity
(perfectly elastic). The mid-point on a straight-line demand curve is
unitary elasticity (minus one) and it is here that marginal revenue is zero
(MR = 0).
✚ However, for most firms the demand curve is downward sloping.
✚ For a price-making firm, the TR curve is a parabola shape. What this
means is that as the price falls the revenue will rise, but it rises more
slowly each time that price is cut, up to the point of maximum revenue.
Eventually it reaches the point where revenue will not increase any more.
At that output the marginal revenue is zero, that is, MR = 0.
Example
Table 13.1 illustrates the relationship between TR, AR, MR and PED.
Table 13.1 The relationship between TR, AR, MR and PED
Output
Price = AR
(£)
TR
(£)
0
0
—
1
10
10
2
9
18
3
8
24
4
7
28
5
6
30
6
5
30
7
4
28
8
3
24
9
2
18
10
1
10
MR
(£)
PED
10
Elastic
8
Elastic
6
Elastic
4
Elastic
2
Elastic
0
Unitary
–2
Inelastic
–4
Inelastic
–6
Inelastic
–8
Inelastic
Using the data in Table 13.1, the TR, AR and MR curves are shown in Figure 13.3.
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Total revenue
25
20
15
TR
10
5
0
Price per unit
13 Revenues, costs and profits
Maximum TR
30
2
10
4
6
8
10
Output
Elastic
8
6
Inelastic
4
AR
2
0
–2
–4
–6
–8
MR
0
2
4
6
8
10
Output
per period
Figure 13.3 A graphical representation of the relationship between TR, AR and MR
Figure 13.3 illustrates the following key relationships:
✚ When demand is price elastic, MR is positive and TR moves in the opposite
direction to the price change.
✚ When demand is price inelastic, MR is negative and TR moves in the same
direction as the price change.
✚ When demand is unitary elastic, MR is zero and TR remains constant
when price changes.
Now test yourself
4 If demand for a product is price inelastic, should the firm raise or reduce its price if
it wants to increase its revenue?
Answers available online
Costs in the short run
✚ Costs are the payments that firms make for use of the factors of
production. Examples include rent, wages and interest.
✚ Included in costs is a reward for risk taking, which is known as normal
profit. This represents the amount the risk taker must receive to keep
resources in their current use. Normal profit is considered as a cost and it
is built into the average cost curve.
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Total cost
Total cost (TC) refers to the cost of producing a given level of output.
13 Revenues, costs and profits
Total costs consists of two components:
✚ Total fixed costs (TFC): these costs do not change directly with output.
Examples of fixed costs include rent paid for a factory building, business
rates and advertising.
✚ Total variable costs (TVC): these vary directly with output. Examples of
variable costs include raw materials such as cocoa beans used to make
chocolate, wages of workers on zero-hour contracts and energy costs for a
steel manufacturer.
Therefore:
TC = TFC + TVC
TFC = TC – TVC
TVC = TC – TFC
Cost
These total cost concepts are illustrated in Figure 13.4.
TC
TVC
TFC
Output
Figure 13.4 Total costs
Now test yourself
5 Why is normal profit regarded as a cost?
6 What is the difference between total cost and total fixed cost?
Answers available online
Average cost
Average cost (AC or ATC) is the cost per unit of output, i.e.:
Exam tip
AC = TC
Q
Be able to distinguish
between total and average
costs. Remember that total
costs will never fall and,
unless they are fixed costs,
they will always be rising.
Average cost initially falls as more is produced because the fixed cost is
spread out over more units of output. For example, if you are making
chocolate bars, the more you produce the more the cost of the factory is
spread out over the number of units produced.
Average fixed cost
Average fixed cost (AFC) is the fixed cost per unit of output.
Total fixed costs (TFC) are spread out as more is produced. Since fixed costs
do not change with output, then by definition fixed cost per unit must always
fall as output increases.
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AFC = TFC
Q
Average variable cost
Average variable cost (AVC) is the variable cost per unit of output.
It is calculated by dividing total variable cost (TVC) by the amount produced,
or quantity (Q), i.e.:
Exam tip
It is useful to remember the
initials of the average fixed
cost (AFC) by noting that
the words can be replaced
with ‘always falling curve’ —
initials AFC.
AVC = TVC
Q
Average and marginal costs are illustrated in Figure 13.5.
Cost
13 Revenues, costs and profits
It is calculated by dividing total fixed cost (TFC) by the amount produced, or
quantity (Q), i.e.:
Making links
Average variable cost is
important in considering
whether or not a firm
should close down in the
short-run (see page 160).
MC
AC
AVC
Output
Figure 13.5 Average and marginal costs
Now test yourself
7 Are business rates a fixed cost or a variable cost?
Answers available online
Marginal cost
The marginal cost (MC) is the cost to the firm of making one more unit of
output.
It is calculated by dividing the change in TC by the change in output, i.e.:
MC = ΔTC
ΔQ
The gradient of the TC curve is the MC.
The relationship between average cost and
marginal cost
✚ When marginal cost is below average cost, it means the cost of producing
146
the next unit is less than the average cost of producing a unit. Therefore,
this extra unit produced brings down the AC, although the AC will not fall
as much as the MC.
✚ When marginal cost is above average cost, it means the cost of producing
the next unit is more than the average cost of producing a unit. Therefore,
this extra unit produced causes AC to rise.
✚ The MC curve, therefore, cuts the AC curve at its lowest point, as shown in
Figures 13.5 and 13.6.
Exam tip
When drawing the AC and
MC curves, note that the
MC always cuts the AC
curve at its lowest point (as
shown in Figure 13.5).
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Imagine you are playing a game of cricket and the average
batter’s score is 23. You go out to bat and you are having
a bad day, caught for a golden duck and you are out.
Your score is nil. It is also the marginal score, and your
score pulls down the average for your team. It won’t pull
everyone down to your score, but it will shave a bit from
the team average as a whole.
Suppose you score 23? Your marginal score is the same
as the average, so the average remains the same. But if
you have a fantastic innings, and you make 72, then your
marginal score will pull up the batting average. It is exactly
the same relationship with MC and AC. If the cost of
producing one more is less than the average, then the AC
falls. If the marginal is the same as the average, then the
average remains the same, and if the marginal is greater
than the average then the average will rise.
Figure 13.6 illustrates this. Notice that when MC is below
AC the marginal cost could be falling or rising, but average
cost will still fall.
Cost
Relationship between the average and the
marginal cost
MC
AC
13 Revenues, costs and profits
Example
Output
Figure 13.6 The relationship between marginal cost
and average cost
Now test yourself
Exam tip
8 If average cost is falling, can marginal cost be rising?
The gradient of the cost curve
shows the increase in the
cost of producing one more
unit. Because the cost curve
is always rising (or zero), MC
is always positive (or zero),
so you will never see MC as
a negative number.
Answers available online
Derivation of the short-run cost curves from
the assumption of diminishing marginal
productivity
The law of diminishing returns
The short run is the period
of time in which at least one
factor is fixed.
The law states that as more variable factors are added to fixed factors of
production, the increase in output will eventually fall.
It is only applicable in the short run because it assumes that at least one factor
of production is fixed.
✚ To be able to picture the law of diminishing returns in your mind, imagine
a farmer with an orchard of 200 apple trees.
✚ The farmer measures his marginal product in terms of baskets of apples.
These increase as he hires more labourers to pick the apples.
✚ The fixed factor is the orchard, the variable factor is the workers. When
an additional worker is taken on, more than double the quantity of apples
may be picked because of the teamwork and cooperation involved. In other
words, the marginal product increases and marginal cost falls.
✚ However, with additional workers being employed, the increase in output
starts to decline, i.e. marginal product falls and marginal cost increases.
This is because the apples are harder to pick as they are higher up the tree.
✚ When the employment of an additional worker causes a fall in marginal
product, it is said that diminishing returns set in. It only operates in the
short run, because in the long run the farmer can plant more apple trees.
The law of diminishing
marginal returns states
that as more units of a
variable factor are added to
a fixed factor, the increase
in output (or marginal
product) eventually falls.
Marginal product is the
extra output when one
more unit of the variable
factor is added.
A fixed factor is a factor
of production, such as the
size of your apple orchard,
which cannot be changed in
the short run.
Now test yourself
9 Why is the law of diminishing returns only relevant in the short run?
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Total product (TP) is the total output of a firm in a given period of time.
Average product (AP) is the unit of output produced per unit of a variable
factor of production. It is calculated as follows:
AP = TP
Q
Marginal product is the change in output resulting from employing one more
unit of the variable factor. It is calculated as follows:
Making links
Note the similarity between
the law of diminishing
returns and the law of
diminishing marginal utility
(see page 26).
MP = ΔTP
ΔQ
The relationships between AP, MP, AC and MC are illustrated in Figure 13.7.
Output 0Q1 is the point of diminishing returns, i.e. the point at which the
marginal product starts to fall.
Y
Average product and
marginal product
13 Revenues, costs and profits
The law of diminishing returns and short-run
cost curves
AP
MP
0
Q1
Q2
AVC and MC
Y
0
Quantity
of labour
X
MC
AVC
Q1
Q2
Quantity
of output
X
Figure 13.7 The relationships between average product, marginal product,
average cost and marginal cost
The following are key relationships that can be derived from Figure 13.7:
✚ When MP is rising, MC is falling and when MP is falling, MC is rising.
✚ When AP is rising, AVC is falling and when AP is falling, AVC is rising.
✚ It can, therefore, be seen that the cost curves are a mirror image of the
product curves.
Now test yourself
10 If marginal product is above average product, will the average product be rising or
falling?
11 At what point on the average cost curve does the marginal cost curve cut the
average cost curve?
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13 Revenues, costs and profits
The relationship between the MC curve and the AC curve is explained in
exactly the same way as the relationship between MC and AVC. This is
because the only difference between AVC and AC is the average fixed cost,
which has absolutely no relationship with MC.
The relationship between short-run and long-run
average cost curves
✚ In the short run there are some fixed factors of production so, as
Costs
explained above, the short-run average costs are determined by the law of
diminishing returns.
✚ In the long run, however, all resources are variable, enabling new, larger
production facilities to be built. The long-run average cost (LRAC) curve
is derived by drawing it at a tangent to the short-run average cost (SRAC)
curves SRAC1, SRAC2, SRAC3 and SRAC4. This is illustrated in Figure 13.8.
✚ Therefore, a long-run average cost will show what the long-run cost of
producing each output will be.
SRAC1
SRAC2
SRAC3
Making links
SRAC4
0
LRAC
Long-run average costs
are relevant when
considering economies and
diseconomies of scale (see
below).
Output
Figure 13.8 The relationships between short-run average cost curves and long-run
average cost curves
Now test yourself
12 What is the key difference between the short run and long run in economics?
Answers available online
Costs in the long run
Economies of scale
✚ Economies of scale occur when an increase in the scale of production
results in a more than proportionate increase in output, so causing a fall in
long-run average costs.
✚ Economies of scale, therefore, are a long-run concept, since a change in the
scale of production implies that all resources are variable.
✚ When a firm is experiencing economies of scale, long-run average costs
fall as output increases.
✚ Internal economies of scale arise when a firm grows larger and it benefits
from lower long-run average costs (see below).
✚ External economies of scale arise when a whole industry grows larger
and firms in that industry benefit from lower long-run average costs (see
page 151).
Internal economies of
scale occur when the
long-run average costs of
production decrease as a
firm increases in size.
External economies
of scale occur when the
long-run average costs of
production decrease for
firms as the whole industry
increases in size.
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13 Revenues, costs and profits
Examples of internal economies of scale
The following are examples of internal economies of scale:
✚ Technical economies: doubling the dimensions of any object increases the
volume by eight times. Therefore, a larger warehouse, or a larger shop can
hold much more per square metre.
✚ Marketing economies: as a firm grows bigger, the cost of advertising is
spread out over a larger number of potential customers. For example, a
national advert would not be suitable for a small or regionally based firm.
✚ Commercial economies: large firms can bulk-buy from their suppliers.
Because they buy a large amount at a steady rate they are likely to get
better deals. For example, Walmart pays a very low price to its suppliers
and that is how it keeps prices low.
✚ Managerial economies: larger firms can increase efficiency by employing
highly skilled and more experienced managers, who specialise in
managing particular parts of the business.
✚ Financial economies: large firms can issue shares on the stock market
and can do deals with lenders to borrow at a lower rate of interest.
Since they have more collateral, large firms are regarded as a lower
risk than small firms because they hold more assets that can be sold
to pay off a debt.
✚ Risk-bearing economies: large firms can spread risks by diversification.
They can sell a wider range of goods or sell in a wider range of markets, e.g.
by selling in different countries.
Now test yourself
Exam tip
In exams you should be
able to apply these internal
economies of scale to
particular industries or firms.
Diversification by a firm
involves increasing the
range of goods it sells or the
markets in which it sells as a
means of reducing risk.
13 What is the difference between internal and external economies of scale?
14 A firm decides to expand output and sell not only in the UK but also in the Far East.
What type of internal economy of scale is this?
Answers available online
Minimum efficient scale
The minimum efficient scale (MES) is the output at which a firm’s long-run
average cost curve stops falling. Or it can be viewed as the minimum output
at which internal economies of scale are fully exploited. This is shown in
Figure 13.9.
Average cost (£)
ATC for a
small firm
ATC for a
medium firm
ATC for a further
expanded firm
The minimum efficient
scale (MES) is the output
where the long-run average
costs first reach a minimum.
ATC for a
large firm
22
20
Long-run
average cost
18
0 1000
20 000
Minimum
efficient scale
40 000
80 000
Quantity
Figure 13.9 Minimum efficient scale
150
✚ In Figure 13.9, the minimum efficient scale is at 20 000 units. This is the
optimum size if it correlates with the total demand or market size.
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size distribution of firms in an industry and on its concentration ratio (see
page 162).
✚ Between the range of the minimum and the point just before the long-run
average costs start to rise, there may also exist constant returns to scale,
where the average unit costs of production remain unchanged as output
increases.
Now test yourself
15 If the dimensions of a container lorry are doubled, what happens to its volume?
Answers available online
Constant returns to
scale occur when an
increase in the scale of
production results in
an exactly proportional
increase in output.
Consequently the LRAC
curve will be horizontal.
Diseconomies of scale
Diseconomies of scale occur when long-run average costs increase as output
increases. There are various sources of diseconomies of scale:
✚ X-inefficiency: see also page 157. As a firm increases in size, administration
costs may increase disproportionately. Further, a lack of competition for a
large firm may mean that costs are allowed to rise.
✚ Poor communication: the lines of communication between managers and
workers may become complex. As a result, workers may experience delays
in getting the information they require at an appropriate time.
✚ Demotivation: large businesses tend to be impersonal and workers may not
feel valued. This could result in an increase in absenteeism or employees
not working efficiently. Consequently, productivity is likely to decrease.
✚ Poor co-ordination: large firms can become difficult to manage, especially
if they are operating in different countries with different cultures,
time zones, languages and hours of working. Co-ordinating production
decisions across a large organisation can be very difficult, with the result
that productivity may fall and average costs increase.
Diseconomies of scale
occur when an increase
in the scale of production
results in a less than
proportionate increase in
output, so causing a rise in
LRAC.
13 Revenues, costs and profits
✚ The minimum efficient scale has an important bearing on the number and
External economies of scale
External economies of scale arise when a whole industry grows larger and
firms in that industry benefit from lower long-run average costs.
✚ External economies of scale cause the LRAC curve of the firm to move
downwards without any action by the firm itself as the industry grows.
✚ External economies of scale are an example of the external benefits of
production (see page 52) that arise when an industry grows in size.
Types of external economies of scale
✚ Improvements in transport that benefit all firms in a particular industry,
e.g. Crossrail, HS2.
✚ Skilled labour may be attracted to an area that gets a reputation for
specialising in a particular service, e.g. Tech City in East London attracts
those with IT skills. This reduces training and recruitment costs for all
firms in that industry.
✚ New methods of production, e.g. in the hospitality industry, iRobot Roomba
is a machine that can do vacuum cleaning by itself, so benefiting hotel chains.
✚ Firms based in Tech City in East London are benefiting from super-fast
broadband, new transport links and excellent publicity from the government,
which make it cheaper and more effective for any firm that is based there.
Now test yourself
16 If diseconomies of scale have set in, should the firm increase or decrease output?
17 Explain why 5G broadband is an example of an external economy of scale.
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13 Revenues, costs and profits
External diseconomies of scale
As the industry grows, external diseconomies of scale may set in. External
diseconomies of scale would cause the LRAC curve of the firm to move
upwards without any action by the firm itself as the industry grows.
Types of external diseconomies of scale
✚ There might be higher costs, e.g. rents on offices, if many firms want to
locate in a particular region.
Making links
External diseconomies of
scale are an examples of
external costs of production
which were covered in
Theme 1, pages 50–51.
✚ Congestion could occur if an industry located in a particular area grows
rapidly. This would increase the costs of transporting raw materials and
finished goods.
✚ As the industry grows, demand for resources needed by that industry
increases. Consequently, any one firm in the industry will face higher unit
costs for resources such as labour, raw materials and machinery.
Profit
What is meant by profit?
Profit is the reward for risk taking. It is the difference between revenue and costs.
Profit maximisation
✚ Profit maximisation occurs where the firm cannot increase its profits,
Costs and revenues
whether by increasing or decreasing price or output.
✚ It is best explained using marginal analysis. For this, you must first
understand the key terms marginal cost (MC), marginal revenue (MR) and
marginal profit (MP) (see page 137).
✚ The profit maximisation point is MR = MC. In other words, the output at
which profit maximisation occurs is that at which the cost of making one
more unit is exactly equal to the revenue gained from selling that unit.
✚ This formula (MC = MR) can be rearranged to give marginal profit:
MR − MC = 0. Therefore, profits are maximised when marginal profit is zero.
✚ Another way of looking at profit maximisation is the output at which the
difference between TR and TC is greatest.
✚ When MR = MC, the gradients of the TC and the TR curves are the same.
Because these are concave to each other this must also be the point at
which they are furthest apart. This is illustrated in Figure 13.10.
Making links
Profit maximisation will be
considered in relation to
firms in different market
structures in Chapter 14.
Profit maximisation
Total revenue (TR)
slope = marginal revenue
Total cost (TC)
slope = marginal cost
Profit
Quantity
Total profits
Quantity
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Figure 13.10 Profit maximisation
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MC = MR. At a lower output, MR is greater than MC. There is more profit to
be made by increasing output.
✚ Likewise, consider the situation if a firm is producing at an output higher
than MR = MC, i.e. when MC > MR. The cost of making another unit is more
than the revenue received from selling it. Therefore, if the firm reduces
production it would increase its profit.
It follows that a logical decision for the firm would be to operate at MR = MC,
and the reasoning behind this is called marginal analysis.
Exam tip
It is important to use
marginal analysis in exams
as will become evident
in considering profit
maximisation in different
market structures.
Now test yourself
18 What should a firm do if marginal revenue is greater than marginal cost if it is
aiming to maximise profit?
Answers available online
13 Revenues, costs and profits
✚ Consider the situation if a firm produced at a different output than
Normal profit, supernormal profit and losses
Normal profit
Making links
✚ This is the minimum necessary to keep the risk-taking resources in their
Normal profit is an example
of opportunity cost, a
concept first introduced
in Theme 1, page 14. It is
relevant in many other
contexts e.g. comparative
advantage (pages 188–189).
current use. Therefore, it represents an opportunity cost.
✚ It is built into the AC curve, and represents the cost of use of the
entrepreneurship factor of production.
✚ Normal profit occurs when AC = AR or TC = TR.
✚ It does not act as a signal for other firms to enter the market, nor does it
cause firms to want to leave the market.
✚ The size of normal profit varies according to the level of risk involved,
and the other investment opportunities available at the time. A business
‘upcycling’ furniture probably does not need much profit to stay in that
line of business — just enough to prevent the owner finding a job working
for someone else. But for an oil exploration firm with a 20-year investment
cycle, normal profits will need to be much higher, because the risks are
much greater.
Supernormal profit
✚ This is profit above the minimum required to stay in business.
✚ It is the difference between TR and TC or between AR and AC.
Loss
✚ A loss occurs when a firm’s total costs exceed revenues, TC > TR, or the
average cost of production is greater than the price per unit.
✚ The break-even level of output occurs when TC = TR, and/or AC = AR. The
firm will stay in business here because it is earning normal profit.
✚ However, a firm does not automatically shut down when making a loss. If
a firm is covering its average variable costs it will stay in business in the
short run. Therefore, the point where P = AVC, and any price below that, is
the point at which it will shut down. This point is often referred to as the
shut-down point.
Now test yourself
19 What happens when marginal profit is zero?
Answers available online
The break-even level
of output is where no
supernormal profits or
losses are made. In other
words, it is that output at
which total cost is equal to
total revenue and average
cost is equal to average
revenue.
The shut-down point
is where price is equal to
average variable cost (AVC).
If AVC is not covered then
the firm will close down in
the short run.
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Costs
13 Revenues, costs and profits
Figure 13.11 illustrates the break-even and the shut-down points for a
business.
MC
Zero-profit point
Profit zone
AC
AVC
Shut-down point
Operating but making a
contribution to fixed costs,
so the firm continues in
business in the short run
Shut-down zone
Output
Figure 13.11 Break-even and shut-down points on the average cost and revenue
diagram
Summary
Table 13.2 summarises the definitions, formulae and explanations that you need to know for the theory of individual
firms.
Table 13.2 Market structures: key terms and concepts
Term
Formula
Explanation
Productive efficiency
MC = AC
Minimum point on AC, lowest cost per unit
Allocative efficiency
P = MC
Price charged maximises social welfare, taking into account
consumer and producer surplus
Normal profit
TR = TC or AR = AC
Return to the entrepreneur is built into the cost curve, which
is just enough profit to keep the entrepreneur in this function
Profit maximisation
MR = MC
Marginal profit is zero, or the vertical difference between TR
and TC is at a maximum
AC = AR
Highest level of output consistent with normal profit
or
Sales maximisation
TR = TC, when costs
cross revenue from
below
Revenue maximisation MR = 0
Maximum total revenue. Selling another unit adds the same
to total revenue as the amount lost from units being sold at
a lower price
Price taker/perfectly
elastic demand
AR = MR
TR is a straight line going through the origin, AR and MR
horizontal. Price elasticity of demand is infinite
Price maker/monopoly
AR > MR
AR downward sloping, MR twice gradient. The firm has
some degree of price-setting power
Break-even
AR = AC
Firm covers costs and makes only normal profit
Shut-down point
AR = AVC
Firm covers AVC only, makes a loss. If price is above this but
below AC there is a loss but the firm contributes to AFC so
carries on in the short run
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Exam skills
.
With regard to knowledge you need to ensure that you
know:
✚ the precise definitions of each of the cost and revenue
concepts
✚ the precise formulae for calculating each of the cost
and revenue concepts
✚ the basic diagrams for illustrating each of the concepts.
You require the following quantitative skills:
✚ QS4: construct and interpret a range of standard
graphical forms.
✚ QS6: calculate cost, revenue and profit (marginal,
average, totals).
✚ QS8: make calculations of elasticity and interpret the
result.
✚ QS9: interpret, apply and analyse information in
written, graphical, tabular and numerical forms.
Exam practice
1 A firm changes its output level from sales maximisation
in the short run to profit maximisation in the long run.
a) Refer to the table below. Which of the following
combinations will be the result in the long run? [1]
Output
Price
A
Lower
Lower
B
Lower
Higher
C
Higher
Lower
D
Higher
Higher
b) Suppose total revenue was £30 000 when the firm
was maximising sales. When it changes to the profit
maximising output, total revenue falls to £27 000 and
total cost is £24 000. How much does profit change
when the firm changes from the sales maximising
output to the profit maximising output?
[2]
c) Based on the information in the table above, would
you expect demand to be price elastic or price
inelastic as the firm moves from the sales maximising
output to the profit maximising output?
[2]
2 There was a significant fall in the price of oil in the first
quarter of 2020. This affected manufacturers of plastic
that use oil in the production process.
a) Explain the impact of this fall in the price of oil on
the total, average and marginal cost of producing a
given amount of plastic.
[4]
b) Which of the following must be true about the
relationship between average and marginal cost?
A When marginal cost is rising, average cost must
be rising.
B When average cost is falling, marginal cost is
above average cost.
C When marginal cost is below average cost,
average cost is falling.
D When average cost is rising, marginal cost is
constant.[1]
13 Revenues, costs and profits
This chapter has introduced the cost and revenue
concepts that you will be using in Theme 3. You require
knowledge and quantitative skills.
3 The following list illustrates some of the main costs of
running a hotel.
✚ Business rates
✚ Wages of senior employees
✚ Security services
✚ Yearly maintenance contract fees, e.g. internet,
telephone plans
✚ Advertising, sales and marketing costs
✚ In-house services, e.g. newspapers, entertainment
✚ Interest on loan
✚ Food, drinks, house-keeping cleaning supplies
✚ Guest room amenities
✚ Guest room, restaurant and banquet linen
✚ Laundry operations
a) With reference to the list above, explain the
difference between fixed costs and variable costs
for a hotel.
[5]
b) Suppose the hotel’s total costs are £2.6 million.
Its variable costs are 40% of its total costs. If its
revenues are £1.14 million, examine whether it
should remain in business.
[8]
Answers and quick quizzes online
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14 Market structures
Efficiency
Efficiency measures how well resources are used, that is, the output relative
to some other factor, such as the cost of resources used.
Allocative efficiency
✚ Allocative efficiency occurs where the price equals the marginal cost of
Costs and revenue
production. If price is P2 then this is point Ae in Figure 14.1. It means that
people are paying the exact amount it costs to produce the last unit.
✚ The best way to consider this is the situation where it is not true: if people
are prepared to pay more than it costs to produce the last unit then it
would be better in terms of consumer satisfaction to produce more units
— because consumers are prepared to pay more than the cost of producing
the last unit.
✚ By contrast, if the consumer satisfaction from the last unit is less than the
cost of making the unit then production should be cut back, as consumers
do not appreciate the costs involved.
MC
P1
AC
Ae
P2
Pe
P3
B
AR
Q MR
Output
Figure 14.1 Productive efficiency and allocative efficiency
Productive efficiency
✚ Productive efficiency occurs where a firm operates at the output at which
average cost is lowest, i.e. the lowest point on the average cost curve (point
Pe in Figure 14.1).
✚ At the lowest point on the average cost curve, marginal cost will be equal
to average cost (see page 147).
✚ If the price is equal to average cost, then this is the lowest price the
customer can enjoy. So in terms of consumer surplus (that is, welfare
to the consumer) and effective use of factors of production, this is the
optimum output.
✚ However, there is very little incentive for a firm to operate at productive
efficiency and certainly no incentive to lower the price this far.
156
Here is an example. You are making chocolates to sell in a market. Productive
efficiency occurs when you get the average costs down to a minimum — you
spread out the fixed costs, and the rising labour costs do not yet outweigh the
falling overheads. Allocative efficiency occurs if you stop making the product
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Now test yourself
1 If price = marginal cost, is this productive or allocative efficiency?
Exam tip
Remember to draw the
MC curve going through
the lowest point of the AC
curve. If you have drawn
it correctly, MC = AC at
productive efficiency, the
lowest point on the AC
curve.
Answers available online
Dynamic efficiency
Dynamic efficiency arises when the firm uses its resources more efficiently
and productively over time. This contrasts with allocative and productive
efficiency, which are concerned with the most efficient combination of
resources at one point in time, i.e. static efficiency.
Dynamic efficiency may be achieved through:
✚ innovation, resulting from research and development that leads to the
development of new products
✚ investment in new production processes
✚ investment in human capital through training
✚ improvements in working practices and labour relations.
14 Market structures
when the cost of making the last one is equal to the amount people will pay
for the last chocolate on your stall at the end of the day. If it is a perfectly
competitive market, these two points will be exactly the same in the long run.
But usually productive efficiency kicks in at a lower output than allocative
efficiency, as demand curves are downward sloping. Compare points for
productive efficiency Pe and allocative efficiency Ae on Figure 14.1.
Dynamic efficiency is
concerned with an increase
in productive efficiency
over time which is related to
technological advances and
innovation.
X-inefficiency
✚ This occurs when costs rise because there is a lack of competitive pressure
in a market.
✚ It could occur in markets such as monopoly or in firms owned or
Costs and revenue
subsidised by the public sector. In the latter, there is little incentive for
firms to minimise costs. If wages and employment are not dependent on
revenues, the workers might not work as hard to raise the volume of sales.
✚ This lack of competitive pressure can lead to managerial or organisational
slack.
✚ X-inefficiency results in an upward shift in the average cost curve (see
Figure 14.2).
Actual AC
Lowest
possible AC
Output
Figure 14.2 X-inefficiency
Now test yourself
2 Why is X-inefficiency unlikely in a highly competitive market?
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14 Market structures
Efficiency in different market structures
Market structures are the ways in which firms are competing, and they range
from monopoly (no competition) to perfect competition. These are discussed
in full below, but Table 14.1 is a useful summary of the efficiency concepts
relating to the market structures you will study:
Table 14.1 Market structures: efficiency concepts
Market structure
Productively efficient Productively efficient Allocatively efficient Allocatively efficient
in the short run?
in the long run?
in the short run?
in the long run?
Perfect competition
No
Yes
Yes
Yes
Monopolistic
competition
No
No
No
No
Oligopoly
No
No
No
No
Monopoly
No
No
No
No
In the following section different market structures will be considered. These
structures range from very competitive markets (perfect competition) to
monopoly (single seller), see Figure 14.3. If a firm sells products very similar to
those of other firms, it operates in a relatively competitive market. But if it has
a unique product or there are strong barriers to entry, it operates with some
market power, also known as monopoly power.
More competitive
Perfect
competition
Monopoly
Less competitive
Figure 14.3 Spectrum of competition
Perfect competition
The characteristics of perfect competition
Perfect competition is a model of an extreme form of competition. In this
model, certain assumptions hold:
✚ There are many buyers and sellers. Neither buyers nor sellers can
influence the price. We say they are price takers, and firms face a
horizontal demand curve, AR = MR.
✚ The goods sold are homogeneous.
✚ There are no barriers to entry or exit (see pages 170–171).
✚ There is perfect knowledge or information, e.g. about production
techniques and sources of cheap raw materials.
✚ All firms aim to maximise profits, MR = MC.
Exam tip
Perfect competition is an
idealised model but it is
useful as a standard against
which the more realistic
market structures may be
assessed.
Now test yourself
3 What is the price elasticity of demand for a perfectly competitive firm?
Answers available online
Short-run profit maximising equilibrium
✚ In a perfectly competitive market, the market price is determined by the
interaction of supply and demand.
✚ Since there are many firms in the industry each individual firm is a price
158
taker and so faces a perfectly elastic (horizontal) demand curve. This is
illustrated in Figure 14.4.
✚ In Figure 14.4, the price is above the average costs of production. Therefore,
the firm is making supernormal profit. This is shown by the area shaded
in yellow.
Making links
Price determination in
competitive markets was
introduced in Theme 1
(see pages 38–40) and is
relevant in other contexts
e.g. wage determination
(see pages 174–175).
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PC firm
Price
S (industry)
MC
14 Market structures
Price
PC industry
MR = D = AR = P
AC
AVC
P
Supernormal profit
D (industry)
Q
Quantity
Quantity
Figure 14.4 Perfectly competitive industry and firm, in the short run with
supernormal profits being made
Long-run profit maximising equilibrium
✚ The supernormal profit being made by firms acts as a signal to other
firms to enter the industry. Consequently, this supernormal profit will be
competed away in the long run. This is illustrated in Figure 14.5.
The single firm is a price taker
Costs and
revenue
Price
The industry is the price maker
S
MC
(Normal profits
only in the long run)
S1
P
p
P1
p1
AC
A
AR = MR
AR1 = MR1
D
Q
Q1
Quantity
(industry)
q1
q
Quantity
(firm)
Figure 14.5 Long-run equilibrium under perfect competition
✚ The entry of new firms into the industry causes the market supply curve
to shift to the right. Consequently, there is an increase in market supply
from Q to Q1 and a fall in the market price from P to P1.
✚ Note that the individual firm now faces a lower price (and also that output
falls from q to q1). This is because at lower prices the firm will want to
operate at a slightly lower output (MC is lower because MR is lower).
✚ With the decrease in the market price, firms will now make only normal
profit (AR = AC).
Now test yourself
4 Why will a perfectly competitive firm make only normal profit in the long run?
Answers available online
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When a perfectly competitive firm is making a loss, average cost will be
higher than average revenue at the profit maximising (loss minimising)
output. This is illustrated in Figure 14.6.
D
S
A firm
Price/Cost
A market
Price
14 Market structures
Firms making a loss in the short run
MC
ATC
P = D = AR = MR
P
Eq
Quantity
Q1
Quantity/Output
Figure 14.6 Perfectly competitive firm with short-run losses being made
Does the firm in perfect competition automatically
shut down in the short run when it makes a loss?
✚ Since there are no barriers to exit, it may seem sensible for the firm to
leave the industry straight away.
✚ A perfectly competitive firm has fixed costs in the short run. These have to
be paid even if the firm shuts down immediately. The question for the firm
is whether a larger loss will be made by shutting down completely (paying
the fixed costs) or waiting until the fixed costs become variable.
✚ To discover what the firm should do, it needs to look at the shut-down
point. This occurs when the price the firm receives covers its average
variable costs (AVC).
✚ If the firm more than covers its AVC then it is making a contribution to
the fixed costs of production. However, if it cannot even cover its AVC, it
is better to shut down straight away, since it would make less of a loss if it
does not produce at all.
A real-world example of this would work as follows:
✚ Suppose you are running a theatre company that is looking for venues to
run the show. The venues have to be paid whether the show runs or not
and they are a fixed cost. The actors are variable costs — if you don’t put
on the show (and you give them enough notice) you will not have to pay
for them. You try selling tickets and realise you are not going to make a
profit. Should the show go on? If you have sold enough tickets to pay for
the actors then you should run the show, as you will pay a contribution
towards the fixed cost of hiring the venue. But if you have not even sold
enough tickets to pay for the actors, it is better for you if they stay at home.
From short-run loss to long-run equilibrium
✚ Some firms leave the industry, so causing a leftward shift in the market
160
supply curve and, therefore, a decrease in the industry output. In turn this
causes a rise in the market price.
✚ For the individual firms that remain in the market, the price will rise and
their output will also rise. This is because there are fewer firms in the market
and each one makes just a little more, allowing MC to rise as MR rises.
Remember that for profit to be maximised MC must always be equal to MR.
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Now test yourself
Answers available online
Monopolistic competition
The characteristics of monopolistically
competitive markets
The model of monopolistic competition is very close to that of perfect
competition, with the main exception being differentiated products. This
means that the firms have some price-setting power, and the demand curve
is downward sloping (the firms have a little market power).
14 Market structures
5 Would a firm carry on producing even if it was making a loss?
The following characteristics apply:
✚ There are many buyers and sellers.
✚ The goods sold are differentiated.
✚ Firms are price makers facing a downward sloping demand curve.
✚ There are low barriers to entry or exit (see pages 170–171).
✚ All firms aim to maximise profits, MR = MC.
✚ In these market structures there is some brand loyalty but no strong brand
names.
Now test yourself
6 What is the main difference between perfect competition and monopolistic
competition concerning the nature of the goods being produced?
Answers available online
Short-run profit maximising equilibrium
✚ The individual firm faces a downward sloping demand (AR) curve. This is
twice as steep as the MR curve (see Figure 14.7).
✚ This means the firm has some market power, some influence over price.
Costs and revenue (£)
The short run
MC
A
P
AC
B
C
0
AR
Q
MR Output
Figure 14.7 Monopolistically competitive firm, with short-run supernormal profits
being made
✚ It can be seen from Figure 14.7 that the average revenue (AR) is above
the average costs (AC) of production. Therefore the firm is making
supernormal profit. This is shown by the area ABCP.
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Long-run profit maximising equilibrium
enter the industry. There are no barriers to entry, so nothing will stop
other firms entering.
✚ Therefore, in the long run supernormal profit will disappear and the firm
will only make normal profit (see Figure 14.8).
The long run
Costs and revenue (£)
14 Market structures
✚ In the long run the supernormal profit acts as a signal to other firms to
MC
Exam tip
AC
P
A
AR
0
Q
Output
MR
To draw the long-run
equilibrium output start
with the AR, MR and MC
curves. Then determine the
profit maximising output
and price. Finally draw the
AC curve so that it is at a
tangent to the AR curve
at the profit maximising
output.
Figure 14.8 Long-run equilibrium under monopolistic competition
✚ Note that in Figure 14.8 the AC and AR curves are tangential at the profit
maximising output. This is because it is only where AC and AR meet that
normal profit exists, so AR will keep shifting until the curves touch just
this once (and don’t cross).
Now test yourself
7 Do firms operating under the conditions of monopolistic competition make profit in
the long run?
Answers available online
Oligopoly
Oligopoly is a word of Greek origin: oligo means ‘a few’ and poly means ‘sellers’,
so an oligopoly is when a few firms are dominating the market (although
there may be many firms in the market).
Characteristics of oligopoly
These key characteristics apply:
✚ There are high barriers to entry and exit.
✚ There is a high concentration ratio.
✚ The firms are interdependent. This means that the actions of one firm are
dependent on the actions of another. A firm’s decisions on price, output
and other competitive activities, such as the level of advertising, can have
an immediate effect on the behaviour of other competitors.
✚ There is product differentiation, such as the level of advertising, design,
quality and reliability of the product.
✚ The firm faces a downward-sloping demand curve.
Concentration ratio is the
proportion of the market
supplied by the largest firms
in that industry.
Interdependence means
that the actions of one
agent depend on the
actions of another.
Now test yourself
8 What is meant by interdependence?
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Answers available online
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Concentration ratios and their significance
✚ Market power is most effectively measured using a concentration ratio.
✚ The n-firm concentration ratio measures the proportion of the market
14 Market structures
supplied by the largest n firms.
✚ The UK industries with the highest five-firm concentration ratios (CR 5)
are as follows:
✚ Sugar: 99%
✚ Tobacco products: 99%
✚ Confectionery: 81%
✚ Man-made fibres: 79%
✚ Soft drinks and mineral waters: 75%
Example
Table 14.2 US car manufacturers: market share in 2019
Car manufacturer
Market share (%)
General Motors
16.9
Ford
14.1
Toyota
14.0
FCA/Chrysler
13.0
Honda
9.5
Nissan
8.6
Others
23.9
What is the 5-firm concentration ratio?
Exam tip
Answer
67.5. (This is calculated from the sum of the market shares of the largest five
companies: 16.9 + 14.1 + 14.0 + 13.0 + 9.5.)
✚ A high concentration ratio implies that the industry is dominated by a few
firms that have a high degree of monopoly power to exploit consumers.
✚ In contrast, a low concentration ratio implies that the industry is
competitive. Consequently, individual firms in the industry have very
limited ability to exploit consumers.
There is an ‘f-rule’ to help
you decide whether a firm is
operating in an oligopolistic
market: ‘Five or Fewer
Firms control Fifty per cent
of the market’. That is, if the
concentration ratio is above
50% then there is likely to
be an oligopoly.
Now test yourself
9 What is meant by stating that a particular industry has a 5-firm concentration ratio
of 90%?
Exam tip
Answers available online
Reasons for collusive and non-collusive behaviour
Collusive behaviour may occur in oligopolistic markets because:
✚ it enables the firms to increase their profits
✚ firms do not believe that their collusion will be discovered by the regulator.
Non-collusive behaviour may occur if there is:
✚ no trust between the firms in the market
✚ a possibility of new entrants in the market
✚ there are high penalties for being found guilty of collusion.
Overt and tacit collusion
Collusion refers to agreements among sellers to raise or fix prices and to
reduce output in order to increase profits. Given that firms in oligopolistic
markets are interdependent there is a great temptation for them to collude.
Two types of collusion are:
In exam questions the
smallest, least significant
firms are grouped under the
title ‘other’. Many students
count ‘other’ in their
calculation, as the total of
‘other’ might well occupy a
bigger section than some of
the biggest firms. Be careful
not to include ‘other’ in your
calculation.
Collusion occurs when
firms collaborate with other
firms in the market.
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14 Market structures
✚ Overt collusion: any form of direct contact between firms is defined as
overt or explicit collusion. There is a formal agreement (written or verbal)
among firms to control the market by fixing prices, allocating customers or
rigging bids for contracts. It is illegal, and easier to detect than tacit
collusion.
✚ Tacit collusion: this can result from situations where firms act individually
but jointly exercise market power with other competitors, for example, by
following the market leader in raising prices. In other words, there is an
implicit (unspoken) agreement with nothing in writing. This is also illegal
but very hard for the competition authorities to control.
Making links
Collusion by firms would
give the firms involved
monopoly power (see pages
165–166).
Now test yourself
10 A finance director in a firm e-mails her counterpart in a competing firm and asks
her what price rises are being planned for the Christmas period. What sort of
collusion is this?
Answers available online
Cartels
A cartel is a form of overt collusion. It is a formal agreement between a
group of producers that limit output in order to manipulate prices. Cartels
might also engage in collusive bidding for contracts and dividing the market
between the firms involved.
A cartel involves firms
acting as a monopoly
through an agreement.
Price leadership
In some markets the dominant firm acts to change prices and others will
follow. This is because if other firms try to make changes, this could set off a
price war or other sorts of retaliation. The large firm becomes the established
leader.
Now test yourself
11 What might limit the success of a cartel in raising prices?
Answers available online
Game theory
Game theory is used to analyse and evaluate the actions of firms in oligopoly.
It is a set of ideas that looks at the strategies firms use to make decisions, for
example on prices or levels of advertising.
Simple pay-off matrix
Two petrol stations, R and Q, are situated on the high street leading out of
town. The price one charges is highly dependent upon the price charged by
the other, and vice versa, as shown in the pay-off matrix in Figure 14.9.
Q
High price
High price
£100
£160
0
£160
A pay-off matrix is a
simple two-firm, twooutcome model.
A prisoner’s dilemma is a
model used in game theory
to question whether firms
might not collude, even if
it appears that it is in their
best interests to do so.
0
£100
R
Low price
Low price
Game theory is the study
of strategies used to make
decisions.
£80
£80
Figure 14.9 Simple pay-off matrix: the prisoner’s dilemma
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✚ If R and Q agree to charge a high price, they can make supernormal profits per
Without collusion both firms will end up with £80 each. This explains why
it is in the interests of both firms to form a cartel, but also why there is an
incentive for it to be broken.
Types of price competition
✚ Price wars: these occur when price cutting leads to retaliation and other
firms cut prices, meaning the original firms again want to cut prices to
increase their sales.
✚ Predatory pricing: this involves cutting prices below the average cost of
production (this can also mean prices are below average variable costs). It is
a short-term measure only, and once other firms have been forced out of the
market the firm raises prices back up again. This is almost always illegal.
✚ Limit pricing: this involves cutting the price to the point that deters new
entrants from entering the market. It may also be used to discourage
incumbent firms (the ones already in the market) from expanding. This
may or may not be illegal, depending on the specific cases looked at by the
competition authorities.
Making links
Price competition and
non-price competition
are relevant when
considering international
competitiveness (see pages
204–205) and the balance of
trade (see page 78).
14 Market structures
hour of £100. R sees more money can be made and decides to undercut Q.
✚ R then gets £160 and Q gets nothing.
✚ Q is very unhappy so Q cuts prices too. Both firms find they get only £80 each.
Types of non-price competition
Non-pricing strategies refer to methods used by firms to compete without
changing the price of their products. These include:
✚ advertising and branding
✚ design and quality
✚ reliability
✚ service — good customer service and after-sales service may lead to repeat
sales
✚ loyalty cards and free gifts.
The aim of these strategies is to increase demand and to make demand less
price elastic.
Now test yourself
Exam tip
Use economic theory in
discussing these types of
non-price competition e.g.
advertising is designed to
increase brand loyalty so
making demand less price
elastic. The more economic
theory you use in your
answer, the more marks you
can earn.
12 What pricing policy could incumbent firms use to deter the entry of new firms into
the industry?
Answers available online
Monopoly
✚ A pure monopoly exists where there is only one firm supplying a good or
service.
✚ However, the legal definition of monopoly in the UK is that a firm supplies
at least 25% of the market.
A pure monopoly involves
one firm supplying the
market.
Characteristics of monopoly
✚ There is one firm in the market.
✚ There are high barriers to entry and exit.
✚ Firms face a downward sloping demand curve.
In a legal monopoly, one
firm dominates 25% or more
of the market.
Profit maximising equilibrium of a monopolist
Since there are high barriers to entry, a monopolist can make supernormal
profits in both the short run and the long run, as shown in Figure 14.10.
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The long run
Costs and revenue (£)
Costs and revenue (£)
14 Market structures
The short run
MC
A
P
AC
MC
AC
P
A
B
C
AR
AR
0
Q
0
Q
MR Output
Output
MR
Figure 14.10 Short- and long-run equilibrium for a monopolist
The profit maximising output is Q and the price is P. Therefore the
supernormal profit per unit is AB and total supernormal profit is CPAB.
Now test yourself
13 Why can a monopolist make supernormal profits in the long run?
Answers available online
A stakeholder is any
person or group that has
a vested interest in a firm.
These include consumers,
suppliers, owners (e.g.
shareholders), the
government (receivers of
corporation) and other firms
already supplying in the
market.
Benefits and costs of monopoly
There may be advantages to many stakeholders when a monopoly exists
(see Table 14.3).
Corporation tax is a tax
on profits.
Table 14.3 The benefits and costs of monopoly for stakeholders
Benefits of monopoly
For consumers Innovation: a monopoly may use its profits to
develop new and better products.
Lower prices: a monopoly may be able to
produce at lower average cost than firms
competing in the same industry. Therefore, prices
might be lower.
Costs of monopoly
Less choice: large firms keep to the brands that
make the most profit.
Higher prices: monopolists can restrict supply
and raise prices to maximise their profits.
Lower quality: firms with no competition might
not have the incentive to produce high-quality
goods.
X-inefficiency: results in higher costs for the
business and higher prices for the consumer.
For workers
Better job security: facing no competition,
monopolies are likely to have a steady demand for
their goods and services.
Higher pay and/or perks for the workers:
higher profits might mean that the firm can afford
to pay higher wages to its workers.
For
governments
Weak bargaining power: if a worker is not
happy, it might not be easy to transfer to a similar
company. Wages might also be kept down for this
reason.
Profits used to replace workers with
machinery: if this happens then jobs will not be
any more secure than in competitive industries.
Tax avoidance: monopolies, especially if they are
Higher tax revenue: large firms pay higher
transnational companies, can find it easy to avoid
rates of corporation tax. The more profit the
monopoly makes, the more the firm will pay in tax. paying tax.
Lower unemployment: monopolies might have
many competitors outside the country. Monopoly
power helps to keep jobs within the country. This
may also improve the balance of payments.
Higher rate of inflation: without competition
monopolies might raise prices. This could lead to
an inflationary wage-price spiral.
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Costs of monopoly
A secure outlet for suppliers: if a company
makes car tyres then a monopoly car producer
could ensure a steady demand for tyres.
Exploitation: small computer outlets, for
instance, have no choice over range and price
when dealing with Apple products.
Consistent quality: firms that buy from monopolies Overdependence: a supplier may have few other
outlets for its products. Therefore, its success is
might be more likely to have consistent quality. It is
not worth a monopoly taking any risks with the quality dependent on the success of the monopoly.
of a well-known brand, as there is too much to lose.
Now test yourself
14 Why might governments want to limit the power of monopolies?
14 Market structures
For other
firms, e.g.
suppliers
Benefits of monopoly
Answers available online
Price discrimination
Price discrimination occurs when a firm with some degree of market power
charges more than one price for the same good or service. It is usually easier for a
monopolist to use price discrimination because it is the only firm in the market.
Exam tip
Do not confuse price
discrimination with the
more common product
differentiation, where
different prices are charged
for slightly different
products. For example,
meals for children are half
price at Ikea — but the
meals are much smaller
than the adult meals.
Conditions necessary for price discrimination
In the model for price discrimination there are four conditions:
✚ Market power: the firm must be able to set prices, i.e. it will be facing a
downward sloping demand curve.
✚ Ability to separate markets: the firm must be able to identify different
submarkets and be able to keep them separate, i.e. it must be impossible
for consumers to move between the submarkets.
✚ Price elasticities of demand must be different in the different markets:
this condition is necessary so that the firm can charge different prices in
different submarkets.
✚ The cost of keeping the markets separate is less than the increased profits
gained from price discrimination: if this is not the case then there would
be no point in charging consumers different prices in different markets.
Now test yourself
15 Would price discrimination be possible if price elasticity of demand was the same
in each submarket?
Answers available online
Diagrammatic analysis of price discrimination
Costs and revenues
Market A
Market B
Combined market
P1
Pc
X
P2
Z
Y
AC = MC
AR = D
AR = D
0
0
Q1
MR
MR
MR
Q2
0
AR = D
Qc
Quantity
Figure 14.11 Price discrimination in two separate submarkets, A and B, with the firm
as a whole shown in the third set of axes
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14 Market structures
✚ Figure 14.11 shows two separate submarkets, one with relatively inelastic
demand (Market A) and one with price elastic demand (Market B), as well
as the combined market.
✚ To simplify the analysis it is assumed that average cost (AC) is constant.
Therefore, AC will be equal to marginal cost (MC). Consequently, the
AC = MC curve will be a horizontal line.
✚ In the combined market, MC is equated with MR to give a single profit
maximising price of 0Pc with an output of 0Qc, and a total profit equal to
the shaded area Z is earned.
✚ The marginal cost of production is projected back from the combined
market as a horizontal line to enable the monopolist to find the profitmaximising points, i.e. where MC = MR in each of the individual markets,
A and B.
✚ Therefore, in Market A, the profit maximising output will be 0Q1 and the
price will be 0P1 while in Market B the profit maximising output will be 0Q2
and the price will be 0P2.
✚ It can be seen that the price is higher in Market A (in which demand is
relatively inelastic) than in Market B (in which demand is relatively elastic).
✚ Since supernormal profit is determined by the difference between average
revenue and average cost, area X represents the total profit for Market A
and area Y represents the total profit for Market B.
✚ In this case it is clear that price discrimination results in an increase in
supernormal profit because area X + area Y is greater than area Z.
Exam tip
Always make sure the price is
higher in the market in which
demand is inelastic and
lower in the market in which
demand is elastic.
Benefits and costs of price discrimination to
consumers and producers
Table 14.4 summarises the advantages and disadvantages to consumers and
producers of price discrimination.
Table 14.4 The benefits and costs of price discrimination for consumers and
producers
For consumers
Benefits of price discrimination
Costs of price discrimination
Lower prices (and higher consumer surplus) for
those in the market where demand is elastic
Higher prices (and lower consumer surplus) for
those in the market where demand is inelastic
Helps consumers who would otherwise be unable
to afford the product
Creates a more unequal distribution of income:
consumers pay higher prices while shareholders
gain higher dividends
Consumers may benefit from better-quality goods
and services
For producers
Higher revenues and profits
Enables firms to finance research and investment
May enable the firm to provide a product or
service that would be unprofitable without price
discrimination
Cost involved in preventing seepage between
markets might outweigh extra revenue gained
from price discrimination
Might create a poor image of the company
May enable the firm to spread demand from peak
times to off-peak times, e.g. for airlines and trains
Now test yourself
16 Identify the main reason why a firm might use price discrimination.
Answers available online
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Natural monopoly
than if there were two or more firms.
✚ It is characterised by continuously falling long-run average cost and
marginal cost curves.
✚ The optimum size of the plant size is large relative to the demand for the
product.
✚ Consequently, there is room for only one firm to fully exploit the available
economies of scale.
✚ In other words, the minimum efficient scale (see pages 150–151) is only
reached at high levels of output.
✚ Typically, industries such as electricity generation, water supply and
telecommunications are regarded as natural monopolies.
Making links
Natural monopoly is
often used as a reason
for nationalisation (see
page 183).
14 Market structures
✚ This is a market in which one firm can supply the market at lower cost
Now test yourself
17 What happens to the long-run average cost curve for a natural monopoly?
Answers available online
Monopsony
A pure monopsony is a firm that is the sole buyer of resources or supplies.
Many firms have some degree of monopsony power, which means firms have
some control over their suppliers.
Table 14.5 summarises the benefits and costs of monopsony power.
Table 14.5 The benefits and costs of monopsony power
Benefits of monopsony
Costs of monopsony
Power in buying means the firm can
make more profits, as suppliers cannot
overcharge.
Suppliers can be squeezed out of
business.
Lower buying costs might be passed on to
the consumer in lower retail prices.
Choice for consumers could be limited, as
monopsony acts as a barrier to entry for
new firms.
Higher profits of monopsony can be used
to invest and innovate.
Higher profits of monopsony can result in
inequality.
Monopsony power can give power to
buyers in the face of monopoly supply
of resources. For example, cosmetic
producers such as L’Oréal can charge
very high prices for their products but
supermarkets can force their suppliers to
cut their costs.
Competition authorities might investigate
monopsony firms.
Exam tip
You do not need to be
able to draw or interpret a
monopsony diagram in your
exam, although you might
find one more efficient than
just using words. Any valid
economics you use can
earn credit, even if it is not
required in your course.
Exam tip
Now test yourself
18 What is the difference between monopoly power and monopsony power?
Answers available online
You need to know the
possible benefits and costs
of monopsony power, in the
context of data provided.
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14 Market structures
Contestability
Characteristics of contestable markets
Contestability is a measure of the ease with which firms can enter or exit an
industry. Contestable markets display the following features:
✚ Low barriers to entry or exit
✚ New firms entering or leaving the market
✚ Low sunk costs
✚ Low levels of supernormal profits
✚ Low levels of collusion or other signs of oligopoly
A low degree of contestability in an industry may be characterised by the
following features:
✚ There are high barriers to entry and exit.
✚ There are high sunk costs (barriers to exit), which are the key reason for
low contestability. Any costs that cannot be recouped if the firm leaves the
industry reduce contestability.
✚ A high concentration ratio may be a sign that contestability is low.
Sunk costs are
unrecoverable costs,
i.e. costs that cannot be
recovered if the firm closes
down.
Now test yourself
19 Would you expect supernormal profits to be high in a contestable market?
Answers available online
Exam tip
Ensure that you can distinguish between competitiveness, contestability and
concentration. For example, it should be noted that a high level of competitiveness
could be a sign that barriers to entry are low, but a low level of competitiveness does not
necessarily imply low contestability. Even a monopoly can be contestable, but no other
firm may wish to enter the industry because profits are low.
Barriers to entry and exit
Barriers to entry are any obstacles that prevent a firm from setting up or
extending its reach into new markets.
Types of barriers to entry
170
There are three main types:
1 Artificial (strategic) barriers: some are deliberately imposed and can be
seen by the regulators as illegal anti-competitive measures, e.g.:
✚ Predatory pricing
✚ Limit pricing
✚ Brand loyalty
✚ Loyalty schemes
✚ Switching costs, i.e. costs involved in switching suppliers
2 Natural (structural) barriers: many barriers to entry exist simply due to the
nature of the business or the market, for example:
✚ Economies of scale
✚ High start-up costs — this may involve specialist machinery
✚ Ownership of key resources
3 Legal barriers: some barriers to entry are imposed by the authorities, in
cases where too much competition might be seen as working against the
interest of the consumer. These include the following:
✚ Patents
✚ State-owned franchises, such as the rail network
✚ Licences to allow firms to operate, such as 5G licences
Making links
Barriers to entry are
particularly relevant in
determining the market
structure in which firms
operate (discussed in this
chapter) and affect the
amount of supernormal
profit a firm can make (see
page 153).
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Types of barriers to exit
Exam tip
Make sure you can evaluate
whether a market is
contestable or not. If you
are provided with some
data you should be able to
give evidence on both sides
of the argument.
Let’s take an example of a nail bar owner who is making a loss. She can sell
the shop, but this might be difficult in a recession. She may be unable to sell
her specialised equipment. Further, the reputation that the nail bar owner has
built up over the years would be sold on with the firm.
14 Market structures
Barriers to exit are often referred to as sunk costs. These are irretrievable
costs that cannot be recovered if the company leaves the market. The
following are examples of sunk costs:
✚ Advertising: these are costs that have been incurred by the firm in
promoting its products that cannot be recovered if the firm exits the market.
✚ Costs of closure: these could include redundancy costs, loans and costs of
terminating contracts early.
✚ Specialised machinery: it is unlikely that this could be transferable to other
industries, so it would be a barrier to exit.
Now test yourself
20 What is the impact of sunk costs on contestability?
Answers available online
Summary
You should have an understanding of:
✚ the four main types of efficiency to consider at A-level:
✚ allocative efficiency, where the price is equal to
marginal cost
✚ productive efficiency, at the lowest point of the
average cost curve
✚ dynamic efficiency, where costs are minimised in
the long run
✚ falling X-inefficiency, where firms see costs fall as
the threat of competition drives them down
Different market structures exhibit these efficiencies to
different degrees. In general, the more the competition
and contestability, the more efficient the market —
although there are many important exceptions to this.
✚ the four main market structures for firms selling goods
✚
✚
✚
✚
✚
that you need to know: perfect competition, oligopoly,
monopoly and monopolistic competition
a market structure showing the market conditions
where there is one powerful buyer, monopsony
how game theory can be used for your analysis of
oligopoly because the firms in this market structure are
interdependent
contestability, which is a measure of the ease with which
firms can enter or exit a market, and is concerned with
barriers to entry and exit, and sunk costs
how if the barriers to entry are extremely high, the firm
is likely to be a monopolist or an oligopolist
how if the barriers to entry are low, the firm is operating
in a fairly contestable market, and might be in
monopolistic competition or, in the case of no barriers to
entry and exit, the market is perfectly competitive.
Exam skills
In this chapter you should have developed some important
quantitative skills. Those tested in this part of the course are:
✚ QS4: construct and interpret a range of standard
graphical forms.
For example, you must be able to draw diagrams to
show price and output equilibrium points and be able
to show whether supernormal profits or losses are
being made.
Also, you must be able to show what happens when
there is an increase or decrease in demand (shift AR and
MR) and what happens where there is a change in costs
(shift AC and MC if there is a change in variable costs,
and shift just AC if there is a change in fixed costs).
✚ QS6: calculate cost, revenue and profit (marginal,
average, totals).
For example, you may have to calculate the profit
maximising output from the data provided.
✚ QS9: interpret, apply and analyse information in
written, graphical, tabular and numerical forms.
For example, you may be given a passage about a
monopolist facing an increase in demand and then be
required to show the impact on its price, output and
supernormal profit.
While you have already practised QS4 and QS9, of
particular significance in this chapter is QS6 — it is really
important that you can draw accurate diagrams and apply
them in unfamiliar contexts.
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14 Market structures
Exam practice
Table 1 Return flight from London to Sydney in 2020
1 Table 1 shows the price of a return flight from London
to Sydney in 2020.
Any person who travels by air frequently will know
that numerous different prices may be charged for the
same flight. Several factors affect the price charged,
including the following:
✚ When you want to travel (as illustrated in Table 1).
✚ When you book, i.e. how long you book before you
travel.
✚ The type of ticket — typically a flexible ticket is
more expensive than one with more restrictions.
✚ How frequently you fly — for example, frequent
flyer schemes enable members to acquire points
for each flight and later use the points to claim a
free bonus flight. This may be seen as a discount
that is not available to people who do not fly
frequently.
Date
Price
Monday 6 August
£717
Friday 9 October
£1250
a) Using examples from the data provided, explain
what is meant by price discrimination.
[5]
b) Examine the conditions necessary for an airline
to use price discrimination.
[8]
c) Discuss the benefits of price discrimination to
an airline. Illustrate your answer with a price
discrimination diagram.
[15]
2 Many local water companies are monopoly suppliers
of water to all citizens in that region.
Evaluate the benefits of a monopoly to the firm
and consumers. Illustrate your answer with an
appropriate diagram.
[25]
3 Study Figure 1 and answer the questions that follow.
Applied Materials
18.8%
Other
19.5%
Hitachi High Tech
2.1%
Screen 2.1%
KLA-Tencor
6.4%
ASML
17.6%
Tokyo Electron
16.7%
Lam Research
16.8%
Figure 1 Semiconductor equipment market share, 2018
Source: Seeking Alpha
a With reference to the figure above, what is the
5-firm concentration ratio in the market for
semiconductor equipment?
A 89.3%
B 76.3%
C 53.2%
D 44.1%
b Explain two characteristics of markets dominated
by a few firms.
[4]
Answers and quick quizzes online
[1]
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15 The labour market
The demand for labour
Features of the demand for labour
✚ The demand for labour is the amount that firms are willing to pay for a
certain amount of workers.
✚ It is a derived demand, based on what the output the workers can produce
can earn for the firm. The market for labour is often referred to as a factor
market because it is the price of resources used to make other goods and
services.
✚ The price of workers is the wage, and the demand varies inversely with wage.
Derived demand means
that the demand for labour
is dependent on demand for
the final goods and services
that the workers produce.
Factors influencing the demand for labour
✚ The level of consumer demand for the final product: if the demand for
hand sanitiser increases then more workers will be required to produce it.
✚ The productivity of labour: for example, new robotic methods in farming
mean that workers are more productive, so farmers may be prepared to
pay their remaining workers more.
✚ The price of the product: if there is an increase in the price of the product
following an increase in demand then more workers are likely to be
employed. The extra output made by any one worker multiplied by the
price that it can be sold for is called the marginal revenue product, and is a
key determinant of wages in competitive markets.
✚ The cost of capital (a substitute for labour): firms may choose to replace
labour with machinery (capital) if it is cheaper, more efficient or more
reliable.
✚ Wage rate relative to the price of capital: if the wage rate increases relative
to the price of machinery in, say, the textile industry, then the demand for
textile workers is likely to fall.
Marginal revenue
product is the additional
revenue generated by the
extra output from employing
one more worker.
Now test yourself
1 The demand for labour is often seen as a product of the marginal physical product
of a worker (what is actually made) and the price that the product is sold for. What
happens to the demand for labour if the price of the product rises?
Answers available online
The supply of labour
The supply of labour varies in direct relationship with the wage rate. More
people are willing to work, and for longer hours, when wages rise.
Factors influencing the supply of labour to a
particular occupation
The supply of labour is
the number of workers
willing and able to work at
any given wage.
✚ The size of the population: this may be influenced by birth rates in the
past but also by the levels of net migration. For example, the UK’s exit from
the EU has resulted in a shortage of workers to pick fruit and vegetables.
This is mainly because farm workers from Eastern Europe are no longer
eligible to enter the UK.
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15 The labour market
✚ The quality and content of education and training: many engineering
firms face shortages of workers because too few people have been trained
in the relevant skills.
✚ Income tax rates and out-of-work benefits: if income tax rates are reduced
then people of working age and the unemployed might have more
incentive to take jobs. Similarly, a reduction in out-of-work benefits would
encourage the unemployed to take jobs.
✚ The strength of trade unions: if trade unions are strong then they might
be able to restrict the supply of workers into a particular occupation, for
example, by insisting that a person is a trade union member.
✚ Government regulations: one way that the supply of labour may be
restricted is through occupational licences that set regulations for training
and entry standards. Only licensed workers are allowed to work in these
occupations. The use of these licences is increasing in the UK, covering
occupations ranging from estate agents to mainline train drivers.
✚ Opportunity cost of leisure (the next best alternative for the workers).
Now test yourself
2 How might an increase in income tax rates affect the supply of labour to the
finance industry?
Answers available online
Making links
Factors influencing
demand and supply were
first introduced in Theme
1 (see pages 25–26 and
pages 34–35). In this case,
specific factors affecting
demand and supply of
labour are considered.
Exam tip
One of the most common
errors is to confuse demand
and supply factors. This is
because demand for labour
is determined by firms while
the supply is determined by
the availability of workers.
Market failure in the labour market
Two forms of market failure that may occur are as follows:
✚ Geographical immobility of labour: some workers find it hard to move to
different places to seek and find work. This may be due to family ties, the
cost of travel or the cost of accommodation.
✚ Occupational immobility of labour: some workers find it hard to move
between jobs because they lack the appropriate skills or training. In a
dynamic economy, some jobs may become obsolete, for example, when
workers are replaced by machines. Also, the skills set required for jobs will
change as new occupations emerge and old ones disappear.
Making links
Market failure was
introduced in Theme 1
(see page 49). It is relevant
in other areas of the
course e.g. monopoly (see
pages 165–167) and in
the financial sector (see
pages 229–230).
Now test yourself
3 House prices are significantly higher in London than in Newcastle-upon-Tyne.
Which type of immobility of labour does this cause?
Answers available online
Wage determination
Wage determination in competitive markets
✚ The wage rate is the price of labour, that is, where the demand and supply
of labour meet, in competitive markets.
✚ If wages are too high, labour supply will be high but labour demand will
be low — there is excess supply leading to unemployment. To clear the
market, workers will have to accept lower wages or go without a job,
meaning the wage rate will tend to fall to the market clearing wage rate.
✚ If wages are lower than the equilibrium, labour demand will be high but
supply will be low — there is excess demand and therefore there will be a
labour shortage. The deficit will not disappear until wages rise, and firms
will have to pay workers more (demand contracts) to convince people to
work (supply expands).
174
This is illustrated in Figure 15.1.
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Wage
Price determination was
introduced in Theme 1,
pages 38–40. This is simply
an application to the labour
market.
S = AC
We
15 The labour market
Making links
D
0
Qe
Q (Labour)
Figure 15.1 The determination of the wage rate in a competitive market
Now test yourself
4 How might a decrease in the immigration of workers from the EU affect the wage
rate of workers in hotels and restaurants in the UK?
Answers available online
Wage determination in non-competitive
markets
✚ If the firm has monopsony power then it can ‘exploit’ the workers and
force wages down. In this case an employer will pay the employee less
than the value the worker adds to the firm.
✚ Conversely, workers may have significant power relative to the employer.
A powerful trade union might have a degree of monopoly power, and
therefore might be able to force wages above the free market level.
Current labour market issues
The labour market is constantly changing with the result that the issues
are also subject to change. What follows are some of the issues facing many
economies at the time of writing:
✚ Unemployment: the disruption to many economies following the COVID-19
global pandemic resulted in many businesses going bankrupt, causing
large-scale unemployment. Recovery from the effects of the pandemic
may take many years.
✚ Ageing population: many countries are facing ageing populations with
the result that their dependency ratios are increasing. This means the
proportion of dependants is rising relative to the number of workers. The
UK dependency ratio increased from 51.4 in 2010 to 56.4 in 2018.
✚ Gig economy: in the gig economy workers earn all or part of their incomes
from short-term contracts under which they are paid for individual tasks,
assignments or jobs. Examples include people working for companies such
as Uber and Deliveroo. These businesses use internet and smartphonebased applications to both hire and assign workers. Despite offering
flexibility, these jobs offer no security and no certain incomes.
✚ Zero-hour contracts: some workers might have permanent contracts
but might not be guaranteed a set number of hours each week. While
flexibility might be an advantage to both employers and employees, the
workers have no stable income from week to week.
✚ Low productivity: the UK has suffered from low productivity growth since
the 2008 financial crisis.
Making links
Unemployment was first
considered in Theme 2,
pages 74–77 and is relevant
in other macroeconomic
contexts, e.g. impacts
of globalisation (see
pages 186–187).
Dependency ratio is an
age-population ratio of
dependants (those younger
than 15 or older than 64) to
the working-age population
(those aged 15–64). Data
are shown as the proportion
of dependants per 100
working-age population.
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15 The labour market
✚ Artificial intelligence (AI) and robotic technology: the rapid developments
in AI and robotic technology are having profound impacts on the labour
market. Some jobs are disappearing while other new occupations are
appearing. Some argue that unemployment might increase significantly
and suggest that a universal basic income (UBI) for all citizens should be
introduced.
✚ Discrimination: there are many forms of discrimination including gender,
race, age and religion. Evidence of discrimination is often difficult to
secure but, to the extent to which it exists, it may impact the economy in
terms of productivity and economic growth.
Exam tip
Follow the news to keep up
to date with current labour
market issues — which
is a specific item on the
specification. Obviously
many issues have arisen
from the Covid-19 pandemic
that could form part of an
examination question.
Now test yourself
5 Identify two reasons why a firm might employ a worker on a zero-hour contract.
Answers available online
Government intervention in the labour market
Minimum wages
✚ Many countries have a national minimum wage (NMW), which is the
minimum firms are allowed to pay their workers, by law.
✚ The UK now has the National Living Wage (NLW), a premium paid to the
over-25s. This is a way to ‘make work pay’.
Figure 15.2 illustrates the possible impact of the introduction of an NMW.
W
S = AC
W1
We
Making links
D
0
Q2
Qe
Q1
QL
Minimum wages are an
application of minimum
prices (see Chapter 4,
page 60).
Figure 15.2 The effect of the introduction of a national minimum wage
✚ In perfectly competitive markets, a minimum wage, set at W1, results in a
wage above the market equilibrium wage, We.
✚ The higher wage results in an extension of the supply of labour to Q1 but to
a contraction in demand to Q2.
✚ This leads to an excess supply of labour of Q1–Q2, who will be unemployed.
✚ This is called ‘real wage’ or classical unemployment. Up to 2020 there was
little evidence that the NMW caused this type of unemployment.
Now test yourself
6 Why might a national minimum wage have no effect on unemployment?
Answers available online
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Possible advantages
Possible disadvantages
Might prevent exploitation
Might cause unemployment
Might reduce poverty
Might be inflationary if it leads to higher
costs that are then passed on by firms in
higher prices
Might eliminate the unemployment trap,
where it is financially better not to go to
work and to rely on state benefits
15 The labour market
Advantages and disadvantages of a national minimum wage
Might not reflect regional differences in
the cost of living
Maximum wages
✚ A maximum wage is an upper limit or ceiling placed on how much a
worker can earn in a given time period.
✚ A maximum wage has been suggested by some people who want to reduce
the rate at which the top earnings are racing away from the median
income. Two targeted groups are bankers and rugby union players.
Figure 15.3 illustrates the possible impact of the introduction of a maximum
wage that is below the free market wage.
W
S
The median income is the
income level in the middle
of a list of ranked incomes
i.e. it is the mid point
between what the highest
50% of earners are paid
and what the lowest 50% of
earners are paid.
We
Max
wage
Making links
D
0
Q1
Qe
Q2
Maximum wages are an
application of maximum
prices (see Chapter 4,
page 59).
Q
Figure 15.3 The effect of the introduction of a maximum wage
✚ In perfectly competitive markets, a maximum wage will result in a wage
below the market equilibrium wage, We.
✚ This lower wage will result in a contraction of the supply of labour to Q1
but an extension in demand to Q2.
✚ This leads to an excess demand for labour of Q1–Q2.
Advantages and disadvantages of a maximum wage
Possible advantages
Possible disadvantages
May reduce income inequality
May lead to a shortage of certain types
of worker, e.g. if top footballers have
their wages capped in the UK, they might
choose to go and play abroad
May prevent the top 1% of earners
‘creaming off’ the profits in the business
May allow higher wages to be earned by a
wider group of the workers
Can destroy incentives, e.g. if a bank
needs to be transformed, it needs to
attract the top businesspeople in the field,
and capping wages means they will not be
attracted to the job
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15 The labour market
Now test yourself
7 Suggest one reason why maximum wage controls might be ineffective in reducing
inequality.
Answers available online
Public sector wage setting
The government is a major employer. For example, the NHS employs
1.2 million workers. Through the government’s own policy on public sector
wages it directly determines the wages received by the workers in the public
sector.
Policies to tackle labour market immobility
Measures to reduce occupational immobility of labour
✚ Training and retraining schemes
✚ Apprenticeships
✚ Improvements in job information
✚ Reduce regulations, licensing or educational requirements
Measures to reduce geographical immobility of labour
✚ Provision of affordable housing
✚ Subsidies towards removal expenses
✚ Improvements in transport
Now test yourself
Occupational immobility
of labour refers to
obstacles that prevent
workers from changing their
type of occupation to find
work.
Geographical immobility
of labour refers to
obstacles that prevent
workers from moving from
one area to another to find
work.
8 Suggest one reason why improvements in training may not reduce the
occupational immobility of labour.
Answers available online
The price elasticity of demand for labour
The wage or price elasticity of demand for labour refers to how responsive the
demand for labour will be to changes in wages. It is estimated to be −0.4 in the
UK.
✚ If the price elasticity of demand is relatively elastic (−1 to infinity), there
will be a more than proportionate increase in job losses if wage rates
increase.
✚ If the price elasticity of demand is relatively inelastic (0 to −1), there will be
a less than proportionate fall in job losses resulting if wage rates increase.
Determinants of the elasticity of demand for labour
Key factors include:
✚ Labour costs as a proportion of the total costs of a business: the demand
for labour tends to be inelastic if labour costs are a small proportion of
total costs.
✚ The price elasticity of demand for the final output produced by a business:
if demand for the final product is price elastic then it is likely the price
elasticity of demand for labour will be elastic.
✚ The ease and cost of factor substitution: if it is relative easy and cheap to
replace labour with machinery then demand for labour will be elastic.
✚ The time period under consideration: demand for labour may be more
elastic in the long run than in the short run as businesses deploy new
labour-saving technology.
Making links
Price elasticity of demand
was first introduced in
Chapter 2, page 27 and has
many other applications
throughout the course.
See indirect taxes (pages
43–45), price discrimination
(pages 167–168) and the
Marshall-Lerner condition
(pages 202–203).
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Now test yourself
15 The labour market
9 How would an increase in labour costs as a proportion of a firm’s total costs affect
the elasticity of demand for labour?
Answers available online
The price elasticity of supply of labour
The wage or price elasticity of supply of labour to an occupation measures the
responsiveness of labour supply to a change in the wage rate.
✚ If the price elasticity of supply is relatively elastic (1 to infinity), there will
be a more than proportionate increase in supply of workers if wage rates
increase.
✚ If the price elasticity of supply is relatively inelastic (0 to 1), there will
be a less than proportionate increase in supply of workers if wage rates
increase.
Determinants of the elasticity of supply of labour
Key factors include:
✚ Level of skill required for an occupation: in low-skilled occupations, labour
supply is elastic because a pool of labour is available to take the job — at
least when there is some unemployment. In contrast, if a long period of
training is required then supply is likely to be relatively inelastic.
✚ Level of educational qualifications required: for example, since 2015 a
nurse requires a degree in the UK. This requirement is likely to have made
the supply of nurses less elastic.
✚ Ease of migration: when the UK was in the EU there was freedom of
movement of labour between member states. This made supply more
elastic than in the current situation in which there are more restrictions
on migration.
✚ Time: in the short run, supply of labour tends to be inelastic because
workers may have contracts requiring them to give notice before they are
allowed to leave their jobs.
✚ Degree of mobility of labour: if workers are both geographically and
occupationally mobile then the supply of labour will be relatively elastic.
The significance of these elasticities is that we can use them to explain wage
differentials and changes in wage rates. The higher the elasticities, the lower
the wages tend to be.
Now test yourself
10 How would an increase in education requirements affect the elasticity of supply of
labour?
Answers available online
Making links
Price elasticity of supply
was first introduced in
Chapter 2, pages 35–37.
Exam tip
Use a selection of demand
and supply of labour
diagrams to explain wage
differentials. Remember
to use the slope of the
demand and supply curves
to illustrate elasticities.
Summary
You should have an understanding of:
✚ the fact that in competitive labour markets, wages are
determined by the demand and supply of labour
✚ how market failure means that governments often
want to intervene to influence some wages and labour
immobility.
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15 The labour market
Exam skills
The labour market provides an opportunity for synoptic
assessment — that is tested in Paper 3. The last parts of
the two questions in Paper 3 always require an evaluation
of microeconomic and macroeconomic factors/effects/
influences.
Economic ideas are carefully selected and applied
appropriately to economic issues and problems
covering both microeconomic and macroeconomic
factors. The answer demonstrates logical and
coherent chains of reasoning.
The last part of the criteria required to secure a Level 4
mark for knowledge, application and analysis states:
To develop these skills, practise questions relating to
the labour market that could have microeconomic and
macroeconomic implications, such as the increased use
of robots.
Exam practice
1 Despite high levels of unemployment, there are severe
skill shortages in some occupations such as engineering.
a) Which one of the following is most likely to cause
the supply of labour to be inelastic?
A High qualifications and a long period of training
are required for the job.
B Immigration controls are relaxed leading to an
increase in workers.
C The demand for the product is inelastic.
D There is a large pool of unemployed people
with high skills and qualifications.
[1]
b) Explain two causes of the geographical
[4]
immobility of labour.
2 In the USA in April 2020 the number of people
unemployed was 23 million out of a labour force of
156.5 million.
a) Calculate the unemployment rate for the USA in
April 2020.
[2]
b) Explain one factor affecting the demand for
labour in a particular industry.
[2]
c) Which one of the following best describes the type
of unemployment resulting from the COVID-19
pandemic?
A Demand-deficient
B Structural
C Seasonal
D Frictional
[1]
3 Evaluate the possible microeconomic and
macroeconomic effects of the increase in
unemployment in the UK following the COVID-19
pandemic.[25]
4 Evaluate the possible microeconomic and
macroeconomic benefits for the UK economy of
the increase in workers on zero-hour contracts.
[25]
Answers and quick quizzes online
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16 Government intervention in
product markets
Competition policy refers to the set of rules and powers that are used
to increase competition within markets. Competition authorities, the
government’s means of intervening in markets, take increasingly strong
action to control mergers and monopolies, promote competition, and
protect suppliers and employees. The following are examples of competition
authorities:
✚ The Competition and Markets Authority (CMA) in the UK — has the power
to fine a firm up to 10% of its annual worldwide group turnover and ban it
from holding directorships for up to 15 years
✚ The Federal Trade Commission in the USA
✚ The European Competition Commission
These organisations aim to promote the interests of the consumer: prices,
profit, efficiency, quality and choice.
Types of government
intervention
To control mergers
✚ The CMA will investigate proposed mergers if the business being taken
over has a UK annual turnover of at least £70 million or the combined
businesses have at least a 25% share of the market. For example, the CMA
blocked a proposed merger between Sainsbury’s and ASDA in 2019.
✚ The CMA can also force firms to demerge. For example, Lloyds TSB was
forced to split into separate firms in 2013.
To control monopolies
The regulator looks at aspects of monopoly behaviour and has the following
means of addressing problems it uncovers:
Exam tip
Price regulation
The government regulates prices in several industries. Several examples are
outlined below:
✚ OFGEM, the energy regulator, has set a price cap for energy since 2019.
The price cap is a limit on the unit rate and standing charge that energy
suppliers can charge for standard variable tariffs.
✚ OFWAT sets the wholesale price controls for water and sewage companies
every 5 years.
✚ The ORR regulates half of all rail fares. Regulated fares have to rise on
average by RPI inflation plus 1% each year.
Now test yourself
1 Suggest one possible disadvantage of price caps for energy.
Answers available online
Consider how each of these
measures might affect the
behaviour of businesses;
and on their revenues, costs
and profits. You should
be able to illustrate these
effects with diagrams.
Making links
Price caps are related to
maximum price controls
(see page 59).
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16 Government intervention in product markets
Profit regulation
The government can set a maximum percentage profit relative to a firm’s
assets. The problem here is often that the firm has no incentive to be efficient
in its capital spending.
Quality standards
The government can control the quality of provision of services by setting out
quality standards. For example, the Care Quality Commission sets standards
for hospitals and care homes while children’s homes are regulated by The
Children’s Homes Regulations. This is made more effective by giving a limited
franchise period, which is not renewed if quality is unacceptable.
Performance targets
Businesses may be set specific measurable targets, for example, for the
proportion of first class post arriving the next day. Similarly, rail companies
may be set targets for train punctuality, which ensures passengers can get
refunds for late arrivals of trains.
Now test yourself
2 Why do governments want to increase competition in markets?
Answers available online
To promote competition and contestability
Promotion of small businesses
The UK Government has taken various measures to promote small
businesses, which should increase both competition and contestability:
✚ Start-up loans of up to £25 000
✚ Venture capital schemes that can help to raise finance
✚ Tech Nation — providing programmes to support UK tech industries
✚ Tax relief for small businesses
Exam tip
In exams you should be able
to discuss the advantages
and disadvantages of
each of these types of
government intervention.
Deregulation
✚ Deregulation is the reduction or elimination of direct controls in an
industry. The aim is to create more competition in a market.
✚ Examples of deregulation in the UK include the postal services,
telecommunications, energy and buses.
Competitive tendering for government contracts
✚ Competitive tendering is when government uses private sector businesses
to build major projects or to provide services by inviting suppliers to bid or
‘tender’ for the work.
✚ The bid with the lowest price usually wins the contract, although factors
related to quality, timeliness and efficiency are considered.
✚ The process forces suppliers to compete with the aim of ensuring that the
taxpayer will gain better ‘value for money’.
✚ Examples of projects include the building of new schools and roads.
✚ Examples of services contracted out include hospital cleaning, the
management of sports centres and refuse collection.
Deregulation reduces or
removes the legal barriers
to entry in an industry
in order to increase
competition and efficiency.
Competitive tendering
is when firms are invited
to bid to run a service or
undertake a project.
Privatisation refers to the
transfer of a state controlled
enterprise to the private
sector, usually through
the sale of shares in the
business.
Privatisation
✚ Privatisation refers to the selling of public sector businesses to the private
182
sector.
✚ The action can force the firm to increase efficiency because it can no
longer rely on government subsidy.
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✚ The competition from other firms might act as a spur to reduce
Now test yourself
3 How does deregulation increase competition?
Answers available online
To protect suppliers and employees
Restrictions on the monopsony power of firms
✚ Firms in a strong position as sole buyers (monopsonies) may face
regulation to ensure that their suppliers are not exploited.
✚ For example, the Groceries Code Adjudicator (GCA) independently ensures
that large supermarkets treat their direct suppliers lawfully and fairly,
investigates complaints and arbitrates in disputes.
Nationalisation
✚ A government can bring firms into the public sector to protect workers and
other firms that rely on the failing firm.
✚ In recent years several rail franchises have been brought back into public
ownership because they have been unable to make a profit. In 2020 the
railways were renationalised on a temporary basis as a result of Covid-19.
Now test yourself
4 Identify two possible reasons why a government might nationalise a firm
or industry.
Nationalisation is when
private firms are taken into
public or state ownership.
The government may
purchase all the privately
held shares.
16 Government intervention in product markets
X-inefficiency.
Answers available online
The impact of government
intervention
Possible benefits of government intervention
✚ Prices and choice: if the measures succeed in promoting competition
between firms then prices should be reduced resulting in an increase in
consumer surplus. The increased competition should also result in an
increase in choice for consumers.
✚ Profit: companies might face a fall in supernormal profit if the measures
are effective.
✚ Efficiency: increased competition will provide an incentive for firms to
reduce costs and to find ways to reduce waste practices.
✚ Quality: if the measures are effective in increasing competition then firms
will have an incentive to improve the design and quality of their products.
Limits of government intervention
✚ Regulatory capture: this means that the regulated industries are able to
Exam tip
gain influence over their regulator. The result is that the regulator acts in
the interest of the industry concerned rather than of consumers. Therefore,
regulatory capture may be regarded as a form of government failure.
✚ Asymmetric information: this could make it difficult for the authorities to
investigate and discover anti-competitive practices, because the people
operating the businesses are likely to know much more about the market
than the regulators. Refer to page 55 for an explanation of asymmetric
information.
You should understand
the functions of the
Competition and Markets
Authority (CMA) and be able
to refer to at least one case
where the CMA has had a
significant impact on firms.
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16 Government intervention in product markets
Now test yourself
5 What is the difference between symmetric information and asymmetric
information?
Answers available online
Summary
You should have an understanding of:
✚ how governments intervene in markets either to
increase competition or to prevent action that would
reduce the level of competition
✚ how, where increased competition will not improve
the welfare of consumers, the government may use
regulation, using direct controls to ensure that firms
behave in the interests of consumers and other
stakeholders.
Exam skills
This part of the course lends itself to the use of evaluative
skills, not least because government intervention
might lead to government failure (which was covered in
Theme 1). It is worth reminding yourself of the criteria for a
Level 3 mark for evaluation in an essay:
Evaluative comments supported by relevant
reasoning and appropriate reference to context.
Evaluation recognises different viewpoints and
is critical of the evidence provided and/or the
underlying assumptions underlying the analysis
enabling informed judgements to be made.
In the context of this chapter, one example is the
importance of the regulatory period. Regulation is imposed
on firms for a period of time. The longer the regulatory
period, the longer the firm can adapt to the controls and
make profits within the parameters set. However, if the
period is too long, the firm might not be forced to make
more efficiency savings.
Exam practice
1 Read the extract below and answer the questions that follow.
Extract: Firms fined for breaking competition law
It is very difficult to detect cartels, mainly because
customers are unlikely to know of their existence.
Agencies such as the Competition and Markets Authority
(CMA) are helped in their ability to detect cartels by
a reduction in sanctions for cartel members that
co-operate with the competition authorities.
companies agreed with each other to place bids that were
deliberately intended to lose the contract. These bids
affected 14 contracts with a variety of customers, ranging
from a City law firm to a further education college, over a
period of over 10 years. As a result, customers could be
overcharged or receive poorer quality services.
The best outcomes are secured by deterring firms from
forming cartels in the first place. In the UK, the existence
of severe penalties helps in this process:
✚ A business can be fined up to 10% of its worldwide
turnover and sued for damages.
✚ Those involved can be fined or sent to prison for up to
5 years if found guilty of being party to cartel activity.
✚ Company directors can be disqualified from being a
director for up to 15 years.
The five companies formally admitted that their actions
constituted a breach of competition law. They agreed to
pay fines totalling over £7 million after admitting being
involved in cartel behaviour. The largest fine was levied
on the office design specialist Fourfront, which had to
pay £4.1 million for 10 instances of collusion.
The CMA investigated a number of firms involved in
the refurbishment of offices. It found that five firms had
colluded on the prices they would bid for contracts. The
Source: https://www.gov.uk/government/news/
5-office-fit-out-firms-to-pay-7-million-fine-for-breakingcompetition-law
In 2015, one company, JLL, brought the anti-competitive
behaviour to the CMA’s attention and escaped a fine as
a result.
a) Explain why collusion is likely in an oligopolistic market.
b) With reference to the extract, discuss how a cartel enables the firms to increase their supernormal profits.
c) With reference to the extract, discuss reasons that might make it difficult for the CMA to uncover the
existence of a cartel.
[5]
[12]
[15]
Answers and quick quizzes online
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17 International economics
Globalisation
From a purely economic perspective, globalisation refers to the increased
economic integration between countries. Globalisation is not a new
phenomenon but the pace of globalisation increased significantly in the 50
years up to the financial crisis of 2008.
With the election of Donald Trump as President of the United States in 2016,
globalisation slowed as a result of an increase in protectionism. Then the
coronavirus pandemic in 2020 caused a complete disruption of global trade
and will almost certainly have major implications for globalisation. Indeed, it
is likely that this will accelerate the process of deglobalisation.
The following are key characteristics of globalisation:
✚ Increased trade as a proportion of GDP: world trade increased at a faster
rate than world GDP up until the 2008 global financial crisis. However, this
has been less evident since then, as shown in Figure 17.1.
6.0
5.0
Key
Trade
Average trade growth 2000–18
GDP
Average GDP growth 2000–18
Globalisation refers to
the increased integration
between countries
economically, socially and
culturally.
Foreign direct
investment (FDI) occurs
when a company in one
country establishes
operations, e.g. a factory,
in another country or when
it acquires physical assets
or a stake in an overseas
company.
4.0
3.0
2.0
1.0
0.0
2011
2012
2013
2014
2015
2016
2017
2018
2019P
2020P
Figure 17.1 World trade and global GDP growth rates
Source: WTO
✚ Increased foreign direct investment (FDI): the trend in FDI inflows is
illustrated in Figure 17.2. An increase in FDI is regarded as an indication
of an increase in the integration of economies as global companies spread
their production facilities to other countries.
2500
2000
Key
Transition economies
Developed economies
Developing economies
World total
1500
1000
500
0
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
Figure 17.2 FDI inflows, global and by group of economies, 2008–18 and projection
for 2019 (US$ billions)
Source: https://unctad.org/en/pages/newsdetails.aspx?OriginalVersionID=2274
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17 International economics
✚ Increased capital flows between countries — these have increased as
cross-border acquisitions and mergers of companies have grown in
different countries.
✚ Increased movement of people between countries.
Making links
Specialisation was introduced in Theme 1 (see pages 18–19) and could be relevant
in answering questions on its significance in a capitalist economy. Also in Paper 3 of
the examination you need to be aware of both the micro and macro implications of
specialisation and the division of labour.
Now test yourself
1 Identify two factors that could limit globalisation.
Answers available online
Capital flows refer to all
the money moving between
countries as a consequence
of investment flows into
and out of countries around
the world.
Exam tip
Although globalisation may
be interpreted very broadly,
you should focus on its
economic aspects when
answering questions in the
exams.
Causes of globalisation
The following are causes of globalisation:
✚ A decrease in transport costs: for example, containerisation resulted in
economies of scale (see Chapter 11, pages 149–150) and falling long-run
average costs.
✚ A decrease in the cost of communications: especially as a result of the
internet.
✚ A reduction in world trade barriers: engineered by the General Agreement
on Tariffs and Trade (GATT) and its successor, the World Trade
Organization (WTO).
✚ The opening up of China and the collapse of communism in Eastern
Europe.
✚ The growth of trading blocs (see pages 193–194).
✚ The increased importance of global companies or transnational companies
(TNCs): TNCs have undertaken much FDI, which frequently involves
moving manufacturing to a country where production costs are lower — a
practice known as offshoring.
Offshoring refers to
companies transferring
manufacturing to a different
country.
Impacts of globalisation
✚ On living standards: with lower trade barriers and increased trade,
countries can specialise in producing goods in which they have a
comparative advantage (see pages 188–190). This results in higher world
output and, therefore, an increase in living standards.
✚ On a country’s trade balance: a country that does not have a competitive
advantage may come to rely increasingly on imports. This would cause a
deterioration in its trade balance because imports would be rising relative
to exports.
✚ On inequality: there is evidence that globalisation has resulted in
increased inequality within some countries. One reason for this is that
the demand for unskilled labour has decreased in developed countries,
so increasing the earnings gap between the highest-paid and lowest-paid
workers. However, inequality between countries has fallen over the last
40 years.
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be used on public services such as health and education or for
infrastructure. However, some global companies engage in a form of tax
avoidance referred to as transfer pricing.
✚ On producers: firms will be producing on a larger scale and so will benefit
from economies of scale and higher profits. Further, technology transfer
is likely to occur — that is, when TNCs invest in other countries, they
are likely to bring modern technology with them. Similarly, TNCs are
likely to introduce modern managerial techniques designed to increase
productivity. In turn, both these may be adopted by local producers,
resulting in increased productivity. However, local producers who are
uncompetitive may be forced out of business.
✚ On consumers: consumers can expect lower prices (increased consumer
surplus) and greater choice.
✚ On workers: workers can expect increased employment opportunities.
However, TNCs might exploit workers in developing countries by paying
low wages for long working hours. Also, if there is more migration of
unskilled workers from developing countries to developed countries, the
workers in developed countries may face little increase in their real wages.
✚ On the environment: there will be increased external costs. Increased
trade will increase road and air transport and associated noise and air
pollution. Further, FDI by countries in search of raw materials may result
in exploitation and depletion of resources.
✚ On supply chains: globalisation has made supply chains lengthier and
more complex. The coronavirus pandemic in 2020 exposed the weaknesses
of this, and many countries, led by the USA, are trying to shorten them by
encouraging production in their home countries.
Transfer pricing is the
price one part of a company
charges for the products
and services it provides to
another part of the same
company. This system
enables TNCs to declare
profits in the country in
which corporation tax is
lowest.
Consumer surplus refers
to the difference between
consumers’ willingness to
pay for a product and the
market price.
External costs refer
to costs to third parties
who are not party to the
transaction. They are
not reflected in the price
mechanism.
Now test yourself
Exam tip
3 Identify two possible disadvantages of globalisation.
Notice that some of the
benefits of globalisation
are similar to those of free
trade.
Answers available online
17 International economics
✚ On public finances of governments: tax revenues will increase, which may
Making links
The impacts of globalisation affect variables that have been introduced in previous
parts of the course. For example, living standards (see page 68) and the trade balance
(see page 78) were considered in Theme 2 while consumer surplus (see pages 42–43)
and externalities (see pages 50–53) were examined in Theme 1. These examples
illustrate the interconnectedness of economics, and being aware of these connections
can help you to write more balanced answers in examinations.
Specialisation and trade
Absolute advantage
Absolute advantage implies that a country can produce more of one product
than another country can with the same amount of resources.
Figure 17.3 illustrates a situation in which Country A has an absolute
advantage in the production of rice and Country B has an absolute advantage
in the production of cars.
Absolute advantage
occurs when a country
can produce more of, say,
two products than another
country with the same
quantity of inputs per unit
of time.
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Rice
17 International economics
Country A
Country B
Cars
Figure 17.3 Country A has an absolute advantage in rice and Country B has an
absolute advantage in cars
In this case, it is clear that each country could benefit by specialising in the
product in which it has an absolute advantage.
Comparative advantage
If a country has a comparative advantage it can produce a good with a lower
opportunity cost than that of another country.
David Ricardo demonstrated that trade between two nations can be beneficial
to both if each specialises in the production of a good in which it has a
comparative advantage (even if one has an absolute advantage in both
products). The crucial requirement is that there must be a difference in the
opportunity cost of producing the products.
One country has
comparative advantage
over another in the
production of a good if it
can produce it at a lower
opportunity cost.
The law of comparative advantage
Exam tips
Assumptions include the following:
✚ Constant returns to scale, which would imply that the PPFs are drawn as
straight lines
✚ No transport costs
✚ No trade barriers
✚ Perfect mobility of factors of production between different uses
✚ Externalities are ignored
The law of comparative
advantage is not only
fundamental to an
explanation of international
trade, but it also applies
to specialisation and the
division of labour.
Now test yourself
4 What is the difference between absolute advantage and comparative
advantage?
Answers available online
Comparative advantage illustrated
diagrammatically and numerically
Some of these assumptions
are unrealistic and so
could be used in evaluating
the law of comparative
advantage.
Be careful to avoid confusing
absolute advantage and
comparative advantage.
The best way to understand comparative advantage and its potential benefits
is through an example.
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Country
Maize
Smartphones
Figure 17.4 illustrates the principle of comparative
advantage.
A
50 000 and
25 000
B
20 000 and
20 000
Total
70 000 and
45 000
Maize
Comparative advantage
To determine whether trade will be worthwhile, the
opportunity costs must be calculated:
100 000
Opportunity cost
of producing 1 kg
of maize
Opportunity cost
of producing 1
smartphone
A
1
2
2
B
1
1
Country
Country A
40 000
Country B
17 International economics
Example
Answer
40 000 50 000
Smartphones
Figure 17.4 Country A has an absolute advantage in
both products
In our example, countries A and B both produce two
products, maize and smartphones. Suppose they can both
produce the following amounts of these products with the
same quantity of resources:
Country
Maize
Smartphones
A
100 000
or
50 000
B
40 000
or
40 000
Clearly, Country A has an absolute advantage in the
production of both maize and smartphones. If each
country devotes half its resources to the production of
each product then output would be as follows:
From the table, it can be seen that Country A has a
comparative advantage in maize (because the opportunity
cost is lower) while Country B has a comparative
advantage in smartphones.
If Country A specialises in maize by devoting 80% of its
resources to maize production with just 20% devoted to
smartphones, and Country B devotes all its resources to
smartphone production, the outputs will be as follows:
Country
Maize
Smartphones
A
80 000 and
10 000
B
0 and
40 000
80 000 and
50 000
Total
It can be seen that specialisation has resulted in a 10 000
increase of maize production and a 5 000 increase in
smartphone production.
For trade to be beneficial, the terms of trade (see page 192)
must lie between the opportunity cost ratios. In this case,
the terms of trade must lie between 1 and 2 kg of maize
for 1 smartphone.
Now test yourself
5 Would a country benefit from specialisation and trade even if it has an absolute
advantage in all the products it produces?
Answers available online
Making links
The above analysis illustrates an application of opportunity cost, a concept that was
introduced in Theme 1 (see page 14). In examinations you should check for occasions
when employing this concept would be relevant.
Opportunity cost is the
sacrifice of the next best
alternative that has been
forgone when a choice is
made.
Terms of trade measure
the price of a country’s
exports relative to the price
of its imports.
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Limitations of the law of comparative advantage
17 International economics
✚ Free trade is not necessarily fair trade (i.e. the rich countries might exert
their monopsony power to force producers in developing countries to
accept very low prices).
✚ The law of comparative advantage is based on unrealistic assumptions
such as constant costs of production, zero transport costs and no barriers
to trade.
✚ If the opportunity costs were the same, there would be no benefit from
specialisation and trade.
Monopsony refers to a
sole buyer of a product
or service. In this case,
monopsony power refers
to the buying power of rich
developed countries.
Now test yourself
6 Would it be beneficial for two countries to trade with each other if the opportunity
cost ratios were the same?
Answers available online
Advantages and disadvantages of
specialisation and trade
Advantages
Disadvantages
Higher living standards and increased
employment would result from an
increase in world output.
There is a deficit on the trade in goods
and services balance if a country’s
goods and services are uncompetitive.
There are lower prices and, therefore,
higher consumer surplus and increased
choice.
There is a danger of dumping — firms in
countries with surpluses of goods might
‘dump’ them on other countries. This could
cause local producers to go bankrupt.
In the long run, the country could then
become dependent on imports.
There is a transfer of management
expertise and technology.
There will be increased unemployment in
some countries (resulting from the above
factors).
There are economies of scale (see
page 149).
There is an increased risk of contagion and
disruption resulting from problems in the
global economy.
There is a reduction in the power of
domestic monopolies.
TNCs may become global monopolies and
exploit consumers.
There could be unbalanced
development — only those industries
in which the country has a comparative
advantage will be developed, while others
will remain undeveloped. This could cause
sectoral imbalance, which could limit
economic growth.
Exam tip
In considering the
advantages of international
trade, it is important to refer
to theory, e.g. the law of
comparative advantage.
Trade balance (trade
in goods and services
balance) refers to the value
of exports minus the value
of imports.
Dumping occurs when a
product is sold in a foreign
country for less than the
cost of making the product.
Under the rules of the WTO,
this practice is illegal.
Sectoral imbalance
refers to an imbalance in
the three main sectors of
the economy — primary,
secondary and tertiary.
Developing countries face further possible disadvantages of free trade:
✚ Infant industries may be unable to compete and go out of business.
✚ Monopsony power of firms in developed economies might force producers
in developing countries to accept low prices for their products.
✚ Declining terms of trade occur for countries dependent on primary
products.
Now test yourself
190
7 From the perspective of consumers, identify two advantages and two
disadvantages of free trade.
Answers available online
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The following are key factors influencing patterns of trade between countries:
✚ Changes in comparative advantage (see above)
✚ The growth in exports of manufactured goods, especially from low wage
countries to developed economies
✚ The growth of global supply chains (see page 187)
✚ The increased importance of emerging economies as trading partners
✚ The growth of trading blocs and bilateral trading agreements (see
pages 193–194)
✚ Changes in relative exchange rates
Figure 17.5 illustrates changes in the share of world exports by region between
2008 and 2018. Asia’s share of total world exports increased by 6 percentage
points between 2008 and 2018.
2018
2008
4
4
4
17 International economics
Patterns of trade
6
3
3 2
6
38
41
14
13
28
34
Key
Europe
CIS
Asia
North America
South and Central America
Middle East
Africa
Figure 17.5 Share of exports of goods by region in 2008 and 2018
Source: WTO World Trade Statistical Review 2019
Now test yourself
8 Suggest three reasons why developing countries’ share of world trade has
increased.
Answers available online
Making links
Exchange rates were introduced in Theme 2 (see pages 88–89) as one of the
influences on the net trade balance. This concept is significant in this theme in
relation to international competitiveness, the balance of payments economic
development and as a macroeconomic policy. In Papers 2 and 3 of the examination,
be prepared to discuss the significance of this concept in a variety of contexts.
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17 International economics
Terms of trade
The terms of trade measure the price of a country’s exports relative to the
price of its imports.
Calculating the terms of trade
Terms of trade =
index of export prices
index of import prices
× 100
Example
Assume that Year 1 is the base year in Country A. Calculate the terms of trade in
Year 2 if export prices rise by 8% and import prices decrease by 2%.
Answer
Terms of trade =
108
× 100 = 110.2
98
Factors influencing a country’s terms of trade
✚ The country’s rate of inflation relative to other countries
✚ The country’s productivity relative to that of other countries
✚ Tariffs
✚ The country’s exchange rate
The effect of an increase in a country’s terms
of trade
✚ Higher living standards: the country can import more for a given quantity
of exports.
✚ A deterioration in the current account of the balance of payments:
although an increase in the terms of trade is referred to as an
‘improvement’ because of its implications for living standards, such an
increase would cause a decline in the competitiveness of its goods and
services.
A decrease in a country’s terms of trade would have the reverse effects of
those described above.
Exam tip
Note that the concept of
the terms of trade is also
relevant when discussing
primary product dependency
in developing countries, see
pages 214–215.
Making links
The terms of trade involves the use of index numbers, which were introduced in
relation to the Consumer Price Index in Theme 2 (see pages 69–71).
In exams, you need to be able to calculate and interpret index numbers in a wide variety
of contexts, so ensure that you have a firm understanding of how these may be used.
Now test yourself
9 Calculate the terms of trade in Year 2 resulting from the following changes,
assuming that the base year is Year 1:
a) A 20% increase in the price of exports combined with a 10% increase in the
price of imports
b) A 10% fall in the price of imports combined with a 10% increase in the price of
exports
10 What is the likely effect of a fall in the UK’s terms of trade on its living standards?
192
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What is a trading bloc?
A trading bloc is a group of countries, usually within a geographical region,
designed to significantly reduce or remove trade barriers between member
countries.
The world is now increasingly divided into trade blocs, most of which are in
specific geographical regions. Examples include:
✚ The Common Market for Eastern and Southern Africa (COMESA)
✚ The Southern African Development Community (SADC)
✚ The Comprehensive and Progressive Agreement for Trans-Pacific
Partnership (CPTPP)
✚ In November 2020 the Regional Comprehensive Economic Partnership was
signed. This includes all 10 countries from the Association of Southeast
Asian Nations (ASEAN) bloc and five of its major trading partners:
Australia, China, Japan, New Zealand and South Korea.
Trading blocs are groups
of countries that agree
to reduce or eliminate
trade barriers between
themselves.
Exam tip
17 International economics
Trading blocs and the World
Trade Organization
It is useful to know
examples of trading blocs
so you can include these in
your answers.
Now test yourself
11 What is the key characteristic of a trading bloc?
Answers available online
Types of trading blocs
Trading blocs or regional trade agreements take several forms, including the
following:
✚ Free trade areas: in these trading blocs, trade barriers are removed
between member countries but each member can impose trade
restrictions on non-members.
✚ Customs unions: there is free trade between member countries combined
with a common external tariff on goods from countries outside the
customs union.
✚ Common markets: these have the same characteristics as customs
unions but include the free movement of factors of production (e.g. labour)
between member countries.
✚ Monetary unions: these are customs unions that adopt a common
currency. The eurozone is an example of such a monetary union.
Now test yourself
Exam tip
12 What is the difference between a free trade area and a customs union?
Ensure that you understand
the differences between the
four types of trading blocs
identified above.
Answers available online
Costs and benefits of regional trade
agreements/trading blocs
Costs
What follows are the costs of regional trade agreements:
✚ Trade diversion: in most trading blocs there are tariffs and/or other
restrictions on imports from outside the bloc. Consequently, trade may be
diverted away from low-cost producers outside the bloc to high-cost
producers within the bloc.
Trade diversion occurs
when trade is diverted from
a more efficient exporter
towards a less efficient
producer.
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✚ Distortion of comparative advantage: trade barriers against non-members
17 International economics
are likely to cause a decrease in specialisation and a fall in world output.
In addition, there are various costs associated with monetary unions such as
the eurozone:
✚ Transition costs: these are one-off costs associated with changing menus,
price lists and slot machines when the currency is introduced.
✚ Loss of independent monetary policy: countries no longer have control of
their own interest rates. In the eurozone’s case, the European Central Bank
(ECB) controls monetary policy.
✚ Loss of exchange rate flexibility: individual members of the eurozone no
longer have their own currencies.
Benefits
The benefits of regional trade agreements include:
✚ Trade creation: the removal of trade barriers between member countries
results in increased trade between them.
✚ Increase in foreign direct investment (FDI): TNCs gain unrestricted access
in selling goods to consumers in the bloc.
✚ Increase in economic power: a large trading bloc might be in a better
position to negotiate trade agreements with other countries and
trading blocs.
Trade creation is trade
created as a result of the
formation of a free trade
agreement between a
group of countries that have
established a trading bloc.
In addition, monetary unions may enjoy further benefits including:
✚ Elimination of transactions costs: these are costs involved in changing
currencies when goods are imported or exported.
✚ Price transparency: consumers have the ability to compare prices more
easily across national borders.
✚ Elimination of currency fluctuations between member countries: this
could encourage increased investment by businesses.
Now test yourself
13 Under what circumstances might a) trade creation and b) trade diversion occur?
Answers available online
The role of the World Trade Organization in
trade liberalisation
The World Trade Organization (WTO) now has 188 members. The key roles of
the WTO are:
✚ to promote free trade — this is achieved through various rounds of talks
✚ to settle trade disputes between member countries.
Possible conflicts between regional trade
agreements and the WTO
Regional trade agreements restrict trade with non-member countries, which
conflicts with the aims of the WTO. However, both the number and the size of
these regional trade agreements have been increasing, so they have played an
important role in promoting free trade.
Now test yourself
14 Why might a new customs union conflict with the key objective of the WTO?
Answers available online
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Reasons for restrictions on free trade
Some of the reasons for restricting free trade include:
✚ to correct a deficit in the trade in goods and services balance
✚ to prevent dumping
✚ to reduce unemployment
✚ to reduce the risk of disruption resulting from problems in the global
economy
✚ to prevent sectoral imbalance: international specialisation based on
free trade means that only those industries in which the country has a
comparative advantage will be developed
✚ to limit the monopoly power of global companies.
Dumping is when a
product is sold abroad
at below average cost or
below the price charged to
domestic consumers.
Protectionism is methods
of restricting free trade.
Developing countries may have particular reasons for restricting trade,
including:
✚ to protect infant industries
✚ to limit monopsony power of firms in developed economies.
17 International economics
Restrictions on free trade
Now test yourself
15 Why might protectionism against dumping be justified?
16 Explain why a developing country might use protectionist policies.
Answers available online
Making links
The reasons for protectionism include the concepts of monopoly (see pages 165–167)
and monopsony (see page 169) that were examined in Theme 3. In examinations, be
prepared to use microeconomic concepts in a macroeconomic context — this may be
especially important in Paper 3.
Types of restrictions on free trade
Examples of trade barriers are shown in Figure 17.6.
Tariffs
Quotas
Types of
trade barriers
Subsidies to domestic
producers
Non-tariff barriers
Figure 17.6 Types of trade barrier
Tariffs
Tariffs and customs duties are taxes placed on imports that artificially raise
the price of imported goods. Figure 17.7 shows the impact of a tariff on a
particular product, both on domestic output and on the level of imports.
Tariffs are taxes on
imported goods.
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Price
17 International economics
D
Domestic supply
L
P2
R
P1
0
A
World supply + tariff
M
V
E
W
T
F
B
World supply
Quantity
Figure 17.7 The effects of a tariff on steel
Table 17.1 summarises the effects of the tariff on steel, with reference to
Figure 17.7.
Table 17.1 The effects of the tariff on steel
Before tariff is imposed
After tariff is imposed
Price paid by consumers
P1
P2
Domestic output
0A
0E
Imports
AB
EF
Tax revenue
Zero
LMWV
Net welfare loss
Zero
RLV and WMT
Quotas
Quotas are limits on the physical quantity of a product that may be imported.
As with tariffs, the price to domestic consumers will increase and domestic
output will rise.
Quotas are limits on the
quantity of a product
imported.
Subsidies to domestic producers
Price per unit
Subsidies are government grants to a firm which reduce costs of production,
so causing the supply curve of domestic producers to shift to the right.
Figure 17.8 illustrates the impact of subsidies.
Sd (domestic
supply)
D
Sd + subsidy
P1
0
World
supply
X
Y
Z
Quantity per week
Figure 17.8 The effect of a subsidy
196
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Before subsidy
After subsidy
Exam tip
This analysis is essentially
the same as that for
subsidies covered in
Theme 1. However, it is
given a global context by
including world supply.
Price paid by consumers
P1
P1
Domestic output
0X
0Y
Imports
XZ
YZ
It can be seen that the effect on imports is similar to that of tariffs, but in
this case the price of imports does not change and the government does not
receive any tax revenue. Indeed, this method involves public expenditure to
finance the subsidies to domestic producers.
Non-tariff barriers
Given that WTO agreements have reduced tariffs, countries have resorted to a
wide range of alternative methods to restrict imports. These include:
✚ health and safety regulations
✚ environmental regulations
✚ labelling of products
✚ bureaucracy, e.g. requiring importers to complete a vast number of forms.
All these may raise the cost of imports and/or deter foreign companies from
attempting to export goods to the country imposing the restriction.
Now test yourself
17 How might quotas affect consumers?
Making links
Tariffs and subsidies to
domestic producers are
an application of indirect
taxes, minimum prices
and subsidies, which were
considered in Theme 1 (see
page pages 57–58 and 60).
17 International economics
The effects of a subsidy to domestic producers, with reference to Figure 17.8,
are summarised in the table below.
In exams, you should be
able to draw the appropriate
supply and demand
diagrams to illustrate tariffs
and subsidies to domestic
producers.
18 Why might a government use non-tariff barriers as a means of restricting imports?
Answers available online
The impact of protectionist policies
✚ On consumers: tariffs and quotas result in higher prices and a reduction in
both consumer surplus and consumer choice.
✚ On producers: domestic firms face less competition and have less incentive
to produce at lowest average cost. Further, protectionist policies may cause
retaliation by other countries, who might impose tariffs on imports.
✚ On governments: if tariffs are imposed, a government would receive tax
revenue. This might help reduce a fiscal deficit or increase a fiscal surplus.
✚ On living standards: protectionism distorts comparative advantage. This
means that specialisation is reduced, resulting in lower output.
✚ On equality: tariffs are indirect taxes and so may cause an increase in
income inequality because they take no account of a person’s income.
Exam tip
Understanding the
disadvantages of
protectionism can help in
evaluating the benefits of
free trade.
Making links
Indirect taxes were first covered in Chapter 4 (see pages 57–58). Equality is an
issue to be considered in Chapter 18 and the impact of indirect taxes on equality is
covered more fully in Chapter 21 (see page 239). This illustrates that tariffs have both
microeconomic and macroeconomic implications. It is important to consider this when
answering questions in Paper 3 of the examination.
Now test yourself
19 How might a government justify using protectionist policies to reduce imports?
Answers available online
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17 International economics
The balance of payments
There are two main components of the balance of payments accounts: the
current account and the capital and financial account.
The current account
The current account consists of several elements, the most important of
which are:
✚ the trade in goods balance — value of goods exported minus value of
goods imported
✚ the trade in services balance — value of services exported minus value of
services imported
✚ the primary balance (investment income) — income earned from assets
owned overseas (interest, profits and dividends) minus income paid to
foreigners for assets owned in the UK
✚ the secondary balance (current transfers) — payments received from
foreign institutions and citizens minus payments paid abroad (e.g. taxes
and social security contributions, foreign aid).
The sum of the above items gives the current account.
✚ If the result is negative, there is said to be a current account deficit.
✚ If the result is positive, there is said to be a current account surplus.
Now test yourself
20 How is it possible for a country’s deficit on its trade in goods balance to increase
but its current account deficit to decrease?
Answers available online
The balance of payments
is a record of all financial
transactions between one
country and those in the
rest of the world.
The current account of
the balance of payments
shows a country’s day-today transactions with other
countries.
Exam tip
Remember that the
balance of payments is
concerned with external
balance (related to trade
and financial transactions
between countries).
The capital and financial account
This part of the accounts is concerned with changes of ownership of the
UK’s foreign financial assets and liabilities. It comprises several elements,
including:
✚ foreign direct investment — investment by foreign companies into the UK
minus investment by UK companies abroad
✚ portfolio investment in shares and bonds — purchase of UK shares and
bonds by foreigners minus purchase of foreign shares and bonds by UK
citizens
✚ short-term capital flows, often referred to as hot-money flows —
hot-money flows into the UK minus flows out of the UK to other
countries
✚ changes in foreign currency reserves.
The capital and financial
accounts of the balance of
payments show long-term
investments and short-term
capital flows.
Causes of deficits on the current account
These include:
✚ relatively low productivity
✚ the relocation of many manufacturing industries from developed
countries to countries where labour costs are significantly lower, such
as China
✚ an increase in the country’s exchange rate against that of other countries
✚ continuous economic growth, resulting in an increase in imports.
198
Exam tip
The balance of payments
is a set of accounts and
so it must balance each
year. Therefore, if there
is a current account
deficit, there must be a
corresponding surplus on
the capital and financial
account.
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Causes of surpluses on the current account
17 International economics
Current account surpluses could be caused by the opposite of the above
points.
Making links
The components of the balance of payments were outlined in Theme 2 (see
page 78). As shown, a more detailed analysis and understanding of this concept
is required in this theme. In exams, you should be able to use this deeper
understanding to explain how changes in variables such as the exchange rate, real
incomes and the degree of protectionism impact on the various components of
the balance of payments.
Now test yourself
21 For each of the following, state whether they would be part of the current account
or financial account and whether they would have a positive or negative impact on
the UK’s balance of payments:
a) The UK importing painkillers from India
b) A decrease in tourists to the UK from China
c) Investment by JCB into a new factory in Brazil
d) Scottish whisky exported to the USA
e) Dividends paid to US shareholders as a result of profits made by AXA, a UK
insurance company
Answers available online
Measures to reduce a country’s imbalance on
the current account
Measures to reduce a current account deficit:
✚ Expenditure-reducing policies: these include deflationary fiscal and
monetary policy, which would reduce aggregate demand and, in turn, lead
to a reduction in imports.
✚ Expenditure-switching policies: these include tariffs, quotas and export
subsidies (see pages 196–197).
✚ Devaluation/depreciation of the country’s currency (see page 202).
✚ Supply-side policies are often viewed as the most effective way of
reducing current account deficits for some countries. These could
include:
✚ reduction in corporation tax
✚ improved infrastructure
✚ provision of superfast broadband
✚ training and education
✚ a reduction in regulation and red tape
✚ a reduction in employers’ national insurance contributions
✚ improved/subsidised childcare provision.
A current account surplus could be reduced by using the opposite of the above
expenditure-reducing and expenditure-switching policies.
Now test yourself
22 Explain how demand-side policies might be used to reduce a current account
deficit.
Answers available online
Expenditure-reducing
policies are designed to
reduce aggregate demand,
e.g. deflationary fiscal and
monetary policy.
Expenditure-switching
policies are policies
designed to alter the
pattern of a country’s
expenditure between
domestic and imported
goods and services.
Exam tip
When considering how a
country might reduce its
current account deficit, the
context is of key importance.
For example, countries that
are part of the EU cannot
unilaterally raise tariffs
or give subsidies to firms
unless they are acting under
an EU agreement.
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Global trade imbalances arise when some countries run persistent and
large current account deficits, such as the USA and the UK, while others run
persistent and large current account surpluses, for instance China, Germany
and many oil-exporting countries. These differences in current accounts are
often associated with differences in savings ratios.
Figure 17.9 illustrates current account balances for selected countries from
2000 to 2018.
%
17 International economics
Significance of global trade imbalances
Global trade imbalances
occur when some countries
have large current account
deficits while other
countries have large current
account surpluses.
10
8
Germany
6
4
2
China
0
–2
USA
–4
–6
UK
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
Figure 17.9 Current account imbalances of selected countries, 2000–18
Source: World Bank
A persistent current account deficit may be undesirable because:
✚ it could indicate that the county’s goods and services are uncompetitive
✚ in turn, this may result in an increasing rate of unemployment
✚ ultimately the country may be forced to borrow foreign currency from
other countries or from the International Monetary Fund (IMF) (see
page 225)
✚ further, under a system of floating exchange rates, it could result in a
depreciation of the exchange rate.
On the other hand, a current account deficit may not be regarded as a major
problem if:
✚ it is caused by imports of capital goods
✚ it is only a short-run problem
✚ it can be financed easily by inflows into the financial account.
Similarly, a persistent current account surplus may be undesirable because:
✚ it could result in inflation, since aggregate demand will be increasing
✚ it may imply that living standards are falling, since there are less goods
and services available for domestic consumption
✚ it could cause an appreciation in the value of the country’s currency,
making the country’s goods and services less competitive
✚ it might cause other countries to impose restrictions on imports.
Now test yourself
23 Explain two advantages of a country having a current account surplus.
Answers available online
Exchange rates
200
The exchange rate is the rate at which one currency exchanges for another, or
the value of one currency in relation to other currencies. One currency may
also be valued against a basket of other currencies weighted according to their
relative importance in world trade. This is called the trade-weighted index.
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Exchange rate systems
forces, i.e. by the forces of supply and demand.
✚ Fixed: in this case the country’s currency is fixed against those of other
currencies.
✚ Managed: this is essentially a floating exchange rate but one which is
subject to intervention by the Central Bank in the foreign exchange market
in order to influence the exchange rate of the country’s currency.
Now test yourself
24 Under a system of floating exchange rates, would a country’s currency appreciate
or depreciate if there was a significant increase in its exports?
Answers available online
17 International economics
✚ Floating: under this system the exchange rate is determined by market
Revaluation and appreciation, and
devaluation and depreciation
✚ A revaluation is when a country decides to increase the exchange rate of
its currency under a system of fixed exchange rates.
✚ An appreciation refers to an increase in the exchange rate of a country’s
currency under a system of floating exchange rates.
✚ A devaluation is when a country decides to decrease the exchange rate of
its currency under a system of fixed exchange rates.
✚ A depreciation refers to a decrease in the exchange rate of a country’s
currency under a system of floating exchange rates.
Factors influencing floating exchange rates
Figure 17.10 illustrates the factors that can influence floating exchange rates.
Factors influencing exchange rates
Relative
inflation
rates
Relative
interest
rates
Current
account
balance
Foreign
direct
investment
Speculation
Figure 17.10 Factors influencing exchange rates
✚ Relative inflation rates: if a country has a higher inflation rate than its
competitors, its purchasing power will fall relative to its competitors and,
in the long term, it is likely that its value will fall. This may be explained in
terms of purchasing power parity, see page 67.
✚ Relative interest rates: if a country has much higher interest rates than
others, this may attract money into its banks from abroad, causing
increased demand for the currency and so causing its value to rise.
✚ Current account balance: if a country experiences an increase in its current
account deficit, the supply of its currency is increasing relative to the
demand for it. This would result in a depreciation in its currency.
✚ Foreign direct investment: a country which is a net recipient of FDI will
experience an increased demand for its currency, so causing its value to
appreciate.
✚ Speculation: speculation arises for a number of reasons, e.g. the expected
state of the economy. Greater pessimism about the future state of the
economy would cause the country’s exchange rate to depreciate.
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17 International economics
Making links
Floating exchange rates is another application of supply and demand analysis, an
area covered in Theme 1 (see pages 39–40). In exams, you should be able to use this
analysis to explain why an exchange rate appreciates or depreciates.
Now test yourself
25 If speculators expect a country’s economy to experience a boom then what is
likely to happen to its exchange rate?
Answers available online
Government intervention in currency
markets
✚ Foreign currency transactions: if the aim is to reduce the exchange rate of
the country’s currency then the central bank would sell its currency on the
foreign exchange market. This increase in supply of the domestic currency
would cause a fall in its value.
✚ Interest rates: to reduce the exchange rate of the country’s currency, the
central bank would reduce the base interest rate. This would make it less
attractive for foreigners with cash balances to leave them in that country,
so causing an increase in supply of the currency on the foreign exchange
market and so causing a reduction in its value.
✚ Quantitative easing: although the intended effect is to stimulate the
domestic economy, there is evidence that QE has had an indirect effect of
causing a depreciation of the exchange rates of countries using this policy.
Now test yourself
26 Explain how a central bank might use interest rates to bring about a depreciation
in the value of its currency.
Answers available online
Competitive devaluation/depreciation
To improve rates of economic growth, a country could try to engineer
a depreciation in its exchange rate with the aim of improving its net
trade balance (exports – imports). If other countries follow suit then
a ‘currency war’ might break out. Ultimately, currency wars could
result in increased protectionism as a means of gaining a competitive
advantage.
A currency war occurs
when nations seek to
deliberately depreciate the
value of their domestic
currencies in order to
stimulate their economies.
Impact of changes in exchange rates
The current account of the balance of payments
A devaluation/depreciation would cause:
✚ a decrease in the foreign currency price of a country’s exports
✚ an increase in the domestic price of its imports.
These two factors would cause an increase in the competitiveness of the
country’s goods and services, and an improvement in its balance of payments
on the current account.
202
However, this will only happen if the Marshall–Lerner condition holds. This
states that the current account of the balance of payments will only improve
if the sum of the price elasticities of demand for exports and imports is less
than –1.
The Marshall–Lerner
condition states that a
depreciation or devaluation
of the currency will only
lead to an improvement in
the trade balance if the sum
of the price elasticities of
the demand for imports and
exports is less than –1.
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+
Time
The J-curve effect is when
a country’s trade balance
initially worsens following a
devaluation or depreciation
of its currency and only
improves in the long run.
Making links
–
X
Y
Figure 17.11 The J-curve effect
In the short run, a devaluation/depreciation might cause a deterioration in
the current account of the balance of payments (i.e. from point X to point Y in
Figure 17.11) because:
✚ the demand for imports might be price inelastic if firms have stocks or if
they are tied into contracts
✚ the demand for exports might be price inelastic because consumers take
time to adjust to the new, lower prices.
The effect of a depreciation/
devaluation depends on
price elasticities of demand
(for imports and exports),
an area covered in Theme 1
(see pages 27–31). In exams,
you should be able to apply
these concepts to explain
the impact of exchange
rate depreciation and
appreciation.
17 International economics
Current account of the balance of payments
Further, there may be different effects in the short run and in the long run, as
illustrated by the J-curve effect, shown in Figure 17.11.
Consequently, it will only be in the long run, when these factors are no longer
relevant, that there would be an improvement in the current account of the
balance of payments.
Now test yourself
27 Under what circumstances might an appreciation of a country’s currency lead to
an improvement in its current account balance?
Answers available online
Economic growth and employment/unemployment
In terms of aggregate demand/aggregate supply (AD/AS) analysis, a
devaluation/depreciation should lead to an increase in AD because net
exports should rise, causing a rise in real output. In turn, this would lead to an
increase in employment and a fall in unemployment.
Rate of inflation
The increased price of imported commodities and raw materials would cause
an increase in costs of production, so leading to cost-push inflation. Further,
the increase in AD described above could also cause an increase in the rate of
inflation.
Foreign direct investment flows
A depreciation in the value of the Japanese yen would make it cheaper for, say,
a US company to invest in Japan because a dollar would be worth more in yen
than before the depreciation.
Now test yourself
28 How might an appreciation of a country’s currency affect its unemployment rate?
Answers available online
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17 International economics
International competitiveness
International competitiveness is a measure of a country’s advantage or
disadvantage in selling its products in international markets at a price and
quality that is attractive in those markets. Two types of competitiveness may
be distinguished:
✚ Price competitiveness
✚ Non-price competitiveness
International
competitiveness
measures the cost of
a country’s goods and
services exports relative to
those of other countries.
Measures of international competitiveness
International competitiveness is measured in a variety of ways, including the
following:
✚ Relative unit labour costs: according to the OECD, unit labour costs (ULC)
measure the average cost of labour per unit of output and are calculated as
the ratio of total labour costs to real output.
✚ Relative export prices: a country’s export prices relative to those of its
major competitors are significant for competitiveness.
✚ The Global Competitive Index (GCI): this is a composite index based on
a range of indicators including macroeconomic stability, labour market
efficiency, infrastructure, health and primary education.
Unit labour costs
measure the average cost
of labour per unit of output
and are calculated as the
ratio of total labour costs to
real output.
Factors influencing international
competitiveness
Competitiveness may be affected by a variety of factors, including the
following:
✚ Unit labour costs: this measures the average cost of labour per unit
of output. An increase in labour costs higher than the rise in labour
productivity may cause a decrease in the economy’s cost competitiveness.
It is calculated as the ratio of total labour costs to real output.
✚ Productivity: labour productivity is defined as output per unit of labour
input or output per worker per hour worked.
✚ The real exchange rate: this is the nominal exchange rate adjusted for
changes in price levels between countries. It may be calculated as follows:
real exchange rate =
nominal exchange rate × domestic price level
foreign price level
There will be a depreciation in the real exchange rate of sterling if the price
of domestic (UK) goods and services increase while those in the foreign
country (USA) remain constant.
✚ Labour taxes or subsidies: employers’ national insurance contributions
are regarded as a tax on jobs and so could reduce the competitiveness of a
country’s goods and services.
✚ Government laws and regulations: these include environmental and
health and safety regulations, employment protection and a national
minimum wage.
✚ Research and development (R&D): this might result in technological
advancement and increased productivity.
Making links
Productivity is a key concept that you will have met already in many parts of the
course, for example, the division of labour (see pages 18–19) and supply and demand
analysis (see pages 34–35) in Theme 1, aggregate supply (see page 94) and economic
growth (see page 108) in Theme 2, and the labour market (see page 173) in Theme 3. In
exams, therefore, be prepared to use this concept in both micro and macro contexts.
It could be especially important in exam questions in Paper 3.
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29 How might each of the following affect the competitiveness of a country’s goods
and services?
a) A depreciation in its exchange rate
b) A reduction in employer national insurance contributions
c) An increase in the national minimum wage
d) An increase in expenditure on research into new technology
Answers available online
The significance of international
competitiveness
Benefits of being internationally competitive
Problems of being internationally uncompetitive
An improvement in the current account of the balance
of payments
A deficit on the current account of the balance of payments
A reduction in unemployment
An increase in unemployment
An increase in economic growth because an increase in net
exports will cause an increase in AD and have a multiplier
effect on national income
A depreciation in the country’s exchange rate (under a
system of floating exchange rates), leading to an imported
inflation
17 International economics
Now test yourself
Now test yourself
30 What is meant by a country being ‘internationally competitive’?
Answers available online
Summary
You should have an understanding of:
✚ globalisation: its meaning, causes, costs and impacts
✚ absolute and comparative advantage
✚ the advantages and disadvantage of specialisation
and trade
✚ factors influencing the patterns of trade
✚ the terms of trade
✚ trading blocs: their types, and costs and benefits
✚ the World Trade Organization
✚ types of and reasons for restrictions on free trade
✚ the meaning and components of the balance of payments
✚ the causes of current account deficits and surpluses
✚ the significance of current account imbalances and
measures to correct them
✚ fixed, floating and managed exchange rates
✚ devaluation and depreciation, and revaluation and
appreciation of currencies
✚ factors influencing the exchange rate of a currency, and
the impact of changes in exchange rates
✚ measures of international competitiveness
✚ factors influencing international competitiveness, and
its significance.
Exam skills
In the context of the terms of trade, an understanding
of index numbers is essential. This is one of the nine
quantitative skills that form 20% of the overall assessment.
This skill is described as follows:
QS5: calculate and interpret index numbers
In addition, QS2 is relevant:
QS2: calculate, use and understand percentages,
percentage changes and percentage point changes
You will have studied index numbers previously, for
example, in relation to the Consumer Price Index (see
pages 69–71), but note that they may be used in a variety
of contexts (e.g. index of production, index of growth in
world trade) so it is important that you can interpret these
as well as doing calculations when required.
Other quantitative skills are also required in this chapter.
Examples include:
✚ QS1: calculate, use and understand ratios and fractions
(for comparative advantage, see pages 188–189).
✚ QS4: construct and interpret a range of standard
graphical forms, e.g. in relation to tariffs (see
pages 188–189) and exchange rate determination.
✚ QS9: interpret, apply and analyse information in
written, graphical, tabular and numerical forms (this
could apply to any part of this chapter).
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17 International economics
Exam practice
1 Between January 2020 and March 2020 the value of the
US dollar appreciated against the Australian dollar from
US$1 = AUD$1.40 to AUD$1.74.
a) Calculate the percentage increase in the exchange
rate of the US dollar against the Australian
dollar between January and March 2020.
[2]
b) Explain the likely impact of an appreciation of
the US dollar on the price of Australian wine
[2]
imported to the USA.
c) Which one of the following is likely to cause an
appreciation of the US dollar?
A An increase in inward investment into the USA
B A rise in US inflation above that of its main
competitors
C An increase in interest rates in other major
economies
D An increase in tourism by US citizens to
other countries
[1]
2 Study Table 1 and answer the questions that follow.
a) Given the information in Table 1, calculate the
country’s current account balance in 2019.
[2]
Table 1 Components of the current account on the
balance of payments, 2019
$ billions
Exports of goods
34.5
Imports of goods
48.7
Exports of services
29.7
Imports of services
19.3
Net primary income
−28.9
Net secondary income
−25.9
b) Explain what is meant by ‘primary income’
in Table 1.
[2]
c) Which one of the following is likely to cause a
deterioration in the UK’s trade in goods balance?
A An increase in real incomes of the UK’s major
trading partners
B An increase in the UK’s income tax rates
C An increase in the UK’s productivity rate
D An increase in the UK’s inflation rate
[1]
3 Read the extract below and answer the questions
that follow.
Extract: End of globalisation
Globalisation is associated with trade liberalisation, a
decrease in the cost of transport and communications
(especially the internet), the opening up of former
communist economies and the growth of developing
economies. As a result, interdependence between
economies has increased significantly. Between 2003
and 2019 China’s share of global output increased from
4% to 16%.
Supporters of globalisation argue that it has helped raise
real incomes, especially in developing economies. In
turn, the number of people living in absolute poverty
has been reduced by nearly 36% since 1990. However,
globalisation has been associated with increased risks
such as cyber-attacks. Further, the danger of contagion
has increased so that a major economic or medical crisis
in one area of the world can have an impact globally, as
illustrated by the 2008 global financial crisis and the 2020
COVID-19 pandemic.
Globalisation helps to explain why nearly every major
car plant in the UK shut down in the first few months of
2020. These car plants depend on sales and components
206
a) Explain the key features of globalisation.
[5]
b) With reference to the information provided and
your own knowledge, examine two advantages
of globalisation for developing countries.
[8]
c) With reference to the extract, discuss the likely
benefits of a decrease in globalisation.
[12]
d) With reference to the extract and your own
knowledge, evaluate the likely microeconomic
from around the world. When sales of cars fell
dramatically and the supply of components stopped, the
car manufacturers were forced to shut down.
COVID-19 caused a major disruption to supply chains.
Consequently, firms tried to find alternative suppliers
at home, even if they were more expensive. This
reshoring had already begun as a result of factors such
as increased protectionism, 3D printing, automation,
and the demand for customisation and quick delivery.
For businesses, a further benefit is that reshoring brings
greater certainty of supplies.
Particular problems associated with the decline in
globalisation relate to countries that are dependent on
tourism and higher education. These service sector
industries are important for foreign currency earnings in
these countries.
A trade war between the USA and China started in 2018,
resulting in the USA imposing tariffs on Chinese goods
and China imposing tariffs on American goods. However,
by mid-2020 there were moves to reduce these tariffs
after an agreement had been reached.
and macroeconomic effects of the trade war
between the USA and China between 2018
and 2020.
e) Evaluate the likely microeconomic and
macroeconomic impact of COVID-19 on
countries dependent on tourism.
[25]
[25]
Answers and quick quizzes online
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18 Poverty and inequality
Poverty
Distinction between absolute poverty and
relative poverty
✚ Absolute poverty is defined in terms of the minimum amount of resources
a person needs to survive, including food, shelter, clothing, access to clean
water, sanitation, education and information.
✚ Relative poverty is measured in comparison with other people in a country
and varies between countries. People are considered to be in relative
poverty if they are living below a certain income threshold in a particular
country.
Absolute poverty
occurs when a person has
insufficient resources to
meet basic human needs,
e.g. food, shelter, clothing.
Measures of poverty
Absolute poverty
In October 2015, the World Bank updated the international poverty line to
US$1.90/day and this is the measure up to 2020. This measure preserves the
real purchasing power of the previous one (of $1.25 a day in 2005 prices) in the
world’s poorest countries.
Relative poverty —
people are classified as
relatively poor in a country
if their incomes are below
the average income.
Relative poverty
The median income is
the income that divides the
income distribution into two
equal groups, half having
income above that amount,
and half having income
below that amount.
A poverty line is set, which is a percentage of average income. Commonly,
these poverty lines range from 40–70% of household income. In the EU, people
falling below 60% of median income are said to be ‘at risk of poverty’.
There are some problems with the concept of relative poverty, including the
following:
✚ It is highly subjective.
✚ It changes over time.
✚ It cannot easily be used to make international comparisons.
Other measures of poverty
✚ The United Nations Human Poverty Index: there are two indices, the first
of which, HPI-1, is a measure of deprivation in the poorest countries of
the world, whereas HPI-2 is more relevant to developed countries. Both
of these are composite measures that combine components such as life
expectancy, literacy rates, long-term unemployment and relative income.
✚ Ratio method: poverty is measured by calculating the proportion of income
spent on basic necessities such as food or energy.
Exam tip
Ensure that you know
the difference between
absolute poverty and
relative poverty.
Making links
The different concepts of poverty are important in the discussion of both developing
economies and developed economies. In exams, it is really important to understand
that absolute poverty is an example of positive economics whereas relative poverty
is dependent on value judgements and is, therefore, an example of normative
economics. These concepts were considered at the start of the course in Theme 1
(see pages 11–12).
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18 Poverty and inequality
Causes of changes in absolute poverty
and relative poverty
Absolute poverty and relative poverty might change as a result of changes in
a range of factors including:
✚ the level of indebtedness
✚ the state of the economy and real
✚ the level of unemployment
incomes
✚ health or education
✚ distribution of income.
✚ access to public services
Now test yourself
1 If absolute poverty is falling, will relative poverty be falling also?
2 Identify two factors that could cause a reduction in absolute poverty.
Answers available online
Inequality
Distinction between wealth inequality and
income inequality
✚ Income is a flow concept, e.g. the money earned by a person over a period
of time. Therefore, income inequality refers to the unequal distribution of
earnings between individuals.
✚ Wealth refers to the stock of assets a person owns. Therefore, wealth
inequality refers to the difference in the value of stocks of assets owned by
individuals.
Measurements of income inequality
The Lorenz curve
The Lorenz curve is a
graphical representation of
income distribution.
Cumulative % of income
Figure 18.1 illustrates a Lorenz curve.
100
90
80
70
60
50
40
A
30
20
B
10
0
10
20
30
40
50 60 70 80 90 100
Cumulative % of population
Figure 18.1 The Lorenz curve
It can be seen that the Lorenz curve plots the cumulative percentage of
the population against the cumulative percentage of total income. The 45º
line represents perfect equality. The curved lined represents the income
distribution for a particular country.
Now test yourself
3 How would an increase in inequality be illustrated on a Lorenz curve diagram?
208
Answers available online
Exam tip
As with all diagrams, it
is important to label the
axes of the Lorenz curve
correctly.
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To determine the degree of inequality, the Gini coefficient may be calculated.
The following formula indicates how this may be done:
G=
A
A+B
In Figure 18.1, point A represents the area between the diagonal line and the
Lorenz curve and B represents the area under the Lorenz curve. The Gini
coefficient will have a value between 0 and 1, with 0 representing absolute
equality (the 45º line) and 1 representing absolute inequality (i.e. the Lorenz
curve would lie along the horizontal and vertical axes).
The Gini coefficient is
a numerical calculation
of inequality based on
the Lorenz curve with a
value of zero being perfect
equality and a value of 1
representing perfect
inequality.
The Gini coefficient may also be expressed as a percentage:
G=
A
A+B
× 100
18 Poverty and inequality
The Gini coefficient
Causes of income inequality and wealth
inequality within countries
A variety of factors may cause inequality within a country, including:
✚ globalisation (see pages 185–187)
✚ differences in education, training and skills
✚ differences in wage rates in different occupations
✚ strength of trade unions
✚ degree of employment protection
✚ the level of welfare benefits
✚ the progressiveness of the tax system (see page 235).
Now test yourself
4 Identify two factors that influence wealth inequality.
Answers available online
Causes of income inequality and wealth
inequality between countries
Income and wealth inequality between countries may be caused by
differences in:
✚ natural resources
✚ geography, e.g. whether a country is land-locked or close to large markets
✚ history, e.g. the impact of colonialism on a country’s economic growth
✚ the degree of political stability
✚ macroeconomic policies
✚ the amount of foreign direct investment (FDI) attracted by different
countries
✚ the degree of trade liberalisation
✚ the degree of technological change.
Making links
Income and wealth were first introduced in Theme 2 (see page 97). Inequality is relevant
in many areas including the labour market in Theme 3 and, from Theme 4, globalisation,
developing and developed economies, taxation and public expenditure. In answering
data response questions or essays in this area, it is important to use the information
provided (or your own knowledge) to develop an argument supported by evidence.
Exam tip
Make sure that you are
able to distinguish between
income and wealth.
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This is illustrated by the Kuznets curve, as shown in Figure 18.2.
Inequality
18 Poverty and inequality
Impact of economic change and development
on inequality
Income per capita
Figure 18.2 The Kuznets curve
✚ This shows that when the economy is at an early stage of development and
primarily agricultural, incomes are relatively evenly distributed.
✚ Industrialisation results in increased inequality but at some point it starts
to decrease.
✚ However, in the 30 years before the 2008 financial crisis there was
evidence that inequality in many advanced economies was increasing.
Significance of capitalism for inequality
A capitalist economy system is characterised by the split between, on the one
hand, the owners of the resources required for producing and distributing
goods and, on the other, the working class, who sell their labour to the owners
of resources in exchange for wages. Typically, the owners of resources will
have more wealth and income than workers, so contributing to inequality.
Now test yourself
5 Why is inequality inevitable in a capitalist economy?
A capitalist economic
system is usually
described as a free
market economy in which
resources are owned by the
private sector and prices
are determined by supply
and demand.
Answers available online
Summary
You should have an understanding of:
✚ absolute poverty
✚ relative poverty
✚ the measures of absolute and relative poverty
✚ the causes of changes in absolute and relative poverty
✚ the distinction between wealth and income inequality
✚ the measures of inequality: Lorenz curves and Gini
coefficients
✚ the causes of income and wealth inequality within
countries and between countries
✚ measures to reduce inequality.
Exam skills
The ability to interpret data, whether in numerical or prose
form, is very important in this topic. Having interpreted the
data, it is then important to be able to apply the relevant
tools of economic analysis, such as making relevant
deductions and doing diagrammatic analysis.
The quantitative skills that are particularly important include:
✚ QS3: understand and use the terms mean, median and
relevant quantiles (e.g. proportions of the population in
different income brackets).
✚ QS4: construct and interpret a range of standard
graphical forms (e.g. drawing a Lorenz curve diagram —
see page 208).
✚ QS9: interpret, apply and analyse information in
written, graphical, tabular and numerical forms (this
could apply to any part of this chapter — see exam
practice question below).
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Exam practice
55
50
45
Peru
40
For many years Norway has enjoyed high and
increasing living standards. In 2018 its GDP per capita
PPP (at constant 2017 international $) was 63 333.
This compared with an average of $45 186 for OECD
countries.
Norway’s Gini coefficient is just 0.27, the lowest in the
world.
35
30
Norway
25
0
Extract B: Norway
2006
2008
2010
2012
2014
2016
2018
Figure 1 Gini coefficients for Peru and Norway, 2006–18
Source: World Bank
Extract A: Peru
For many years Peru had one of the lowest GDPs per
capita in South America and one of the highest Gini
coefficients. However, in the 1990s it reduced trade
barriers and encouraged foreign direct investment.
Since then there has been economic growth in most
years and between 2009 and 2019 GDP per capita
increased each year. This resulted in a 75% reduction
in absolute poverty. Also, the Gini coefficient fell
from 0.53 in 1999 to 0.43 in 2018.
Nevertheless, the health, education and
transportation systems remained poor while crime
and corruption increased. Absolute poverty remains
a serious problem, especially in areas that are home
to indigenous communities.
With regard to wealth inequality, the richest quintile
of Peru’s population enjoys over 50% of the nation’s
wealth. In contrast, the poorest three quintiles own
only 25% of the country’s wealth.
Norway has a $1 trillion wealth fund, which was
originally set up to invest profits from North Sea oil
and gas. Some of this has been invested in education
and in innovation. Given its Gini coefficient, it is
surprising that Norway does not have a national
minimum wage. However, 70% of its workers are
covered by collective agreements that set minimum
wages. In addition, 54% of workers are members of
trade unions, compared with just 11% in the USA and
25% in the UK.
18 Poverty and inequality
%
1 Study the material below and answer the questions
that follow.
Norway’s educational standards are very high when
measured by international tests. The state provides
early childhood education and care for children aged
under six. It also provides large subsidies for childcare
and sets maximum prices for childcare.
a) Explain how the Gini coefficient is calculated.
b) Illustrating your answer with a Lorenz curve
diagram, examine the differences in inequality
between Peru and Norway.
c) Discuss the possible causes of differences in
inequality between Peru and Norway.
d) Evaluate measures by which a government
could help to reduce inequality in a country
such as Peru.
[5]
[8]
[12]
[25]
Answer and quick quizzes online
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19 Emerging and developing
economies
Measures of development
The Human Development Index
The Human Development Index (HDI) is a composite measure that is used
in the United Nations Development Report, and which consists of three
elements:
✚ GDP per head, which is measured at purchasing power parity.
✚ Health, which is measured in terms of life expectancy at birth.
✚ Education, which is measured in terms of mean years of schooling at
age 25 and expected years of schooling at age 4.
Making links
Economic growth was covered in Theme 2 and relates primarily to changes in real
incomes. By itself it does not give an accurate measure of economic development.
This is why it is necessary to use other measures of development.
Economic development
is a multidimensional
and subjective concept
that measures social and
economic progress. It
includes improvements
in health and education;
reducing absolute
poverty; reducing income
inequalities and increasing
employment opportunities.
In exams, you need to be able to interpret HDI indices and make comparisons
between countries.
Advantages and limitations of using the HDI
Advantages of the HDI
Limitations of the HDI
It is a broader measure than GDP per
capita.
It is too narrow, as it only comprises three
aspects of development.
It is used to make comparisons of
development between countries.
It is an average measure and so disguises
disparities and inequalities within
countries.
According to the United Nations
Programme, the three essential
contributors to development are for
people to:
It is only concerned with long-term
development outcomes.
Exam tip
Be sure that you can
distinguish between
economic growth and
economic development.
lead a long and healthy life,
to acquire knowledge, and to
have access to the resources
needed for a decent standard of
living.
These are captured in the HDI.
Other indicators of development
Given the deficiencies of the HDI as a measure of development, some
economists argue that a range of other indicators should be considered. Some
of these are included in Figure 19.1.
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Energy consumption per person
Mobile phones per thousand of population
Other indicators
of development
The proportion of male population employed in agriculture
The proportion of population with access to clean water
Exam tip
The degree of inequality
When discussing economic
development, it is useful
to know a range of
development indicators.
The degree of democracy
The proportion of people entitled to civil rights
Figure 19.1 Other indicators of development
Now test yourself
1 Why might the three elements of the HDI not give a true indication of
development?
19 Emerging and developing economies
The proportion of population with internet access
Answers available online
Factors influencing growth and
development
The impact of economic factors in different
countries
Figure 19.2 summarises a number of factors that affect growth and
development.
Non-economic
factors, e.g. poor
governance,
civil wars,
corruption
Primary
product
dependency
Volatility of
commodity
prices
Absence of
property
rights
Education/skills
Savings gap
Factors
influencing
growth and
development
Foreign
currency gap
Demographic
factors
Infrastructure
Access to
credit and
banking
Debt
213
Figure 19.2 Factors influencing growth and development
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19 Emerging and developing economies
Primary product dependency and volatility
of commodity prices
Many developing countries still depend on primary products for export
income. Therefore, their economies are vulnerable to the changing global
prices of these commodities. Consequently, primary product dependency can
hamper economic growth and development.
Primary product
dependency occurs in
countries where the value
of production of primary
products accounts for a
large proportion of GDP,
exports and employment.
There are two broad types of primary product:
✚ Hard commodities are usually those that are mined or extracted, e.g.
copper.
✚ Soft commodities are usually agricultural goods, e.g. rice.
For countries dependent on primary products, there are various issues:
✚ Extreme price fluctuations: since both the supply of, and the demand for,
primary products tend to be inelastic, any change in the conditions of
supply or demand causes large price fluctuations.
✚ Fluctuations in producers’ revenues resulting from price fluctuations:
these make it more difficult to plan investment and output.
✚ Fluctuations in foreign exchange earnings: revenues from exports
of primary products also fluctuate, making it more difficult for the
government to plan economic development.
✚ Protectionism: by developed countries.
✚ Shortages of supplies for domestic consumption: cash crops are usually
exported, meaning that there is little left for domestic consumption.
✚ Finite supplies of hard commodities.
✚ Appreciation of the currency: demand for a particular commodity will
cause an increase in demand for the country’s currency.
✚ Falling terms of trade: see page 192 and also the Prebisch–Singer
hypothesis below.
Now test yourself
2 Why might producers of primary products in developing countries face fluctuating
incomes?
Answers available online
Making links
Primary product
dependency draws together
many concepts previously
considered, such as supply
and demand analysis to
explain price fluctuations,
from Theme 1. In exams,
you should be able to
apply these concepts in
the context of economic
development.
The Prebisch–Singer hypothesis
According to this hypothesis:
✚ The demand for many primary products tends to be income inelastic
whereas the demand for many manufactured goods is income elastic.
✚ Therefore, as real incomes rise, the demand for manufactured goods will
increase at a faster rate than the demand for primary products.
✚ As a result, the prices of manufactured goods rise more quickly than the
prices of primary products.
✚ Consequently, the terms of trade of developing countries fall relative to
those of developed countries.
Exam tip
This area of the
specification involves many
concepts introduced earlier
in the course, e.g. elasticity
of demand and the balance
of payments.
However, some criticisms of the Prebisch–Singer hypothesis include the
following:
✚ The developing country may have a comparative advantage in the primary
product.
✚ The real price of primary products might increase over time with rising
world incomes and population.
✚ Foreign direct investment (FDI) has significantly increased in recent years
in countries dependent on primary products.
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Making links
19 Emerging and developing economies
Income elasticity of demand was a concept covered in Theme 1 (pages 212–213). This
concept may be used in considering many other issues in Theme 4, including the
promotion of tourism in developing countries, the goods and services that might yield
high tax revenues, and the impact on imports of rising living standards.
Making links
The terms of trade were considered earlier in this theme (see page 182) and this
concept is linked to income elasticity of demand, which you studied in Theme 1 (see
pages 212–213). In exams, you will need to be able to interpret the terms of trade
(which are index numbers) and be able to explain the significance of income elasticity
of demand for the terms of trade in developing countries.
Now test yourself
3 Suggest one reason why a country producing mangoes and kiwi fruit might not
suffer from falling terms of trade.
Answers available online
Savings gap: the Harrod–Domar model
Exam tip
The Harrod–Domar model illustrates the problem of how countries with a low
GDP per head will experience low savings ratios. Low savings mean that it
will be difficult to finance investment and, therefore, capital accumulation
will be limited. This translates into low output and low GDP, as illustrated in
Figure 19.3.
In exams it is useful to
include models to support
your analysis and be ready
to offer a critical appraisal
of them.
Low incomes
and output
Low capital
accumulation
Low savings
Low investment
Figure 19.3 The Harrod–Domar model
However, this model may be criticised for the following reasons:
✚ It focuses on physical capital and ignores the significance of human
capital.
✚ It assumes a constant relationship between capital and output.
✚ The savings gap may be filled by means other than domestic savings, e.g.
from FDI.
Now test yourself
4 Why might a savings gap hinder economic development?
Answers available online
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Foreign currency gap
19 Emerging and developing economies
Developing countries may face shortages of foreign currency. Some of the
most significant causes are identified in Figure 19.4.
Dependency on exports
of primary products
Dependency on imports of oil
and manufactured goods
Causes of foreign
currency gap
Capital flight (transfer of cash
or assets to another country)
Interest payments on loans
from foreign countries
Capital flight occurs when
individuals and countries
decide to transfer cash
deposits to foreign banks,
or to buy shares in overseas
companies or assets in
foreign countries.
Figure 19.4 Causes of foreign currency gap
For these reasons, the country may have insufficient foreign currency to
purchase imported capital goods, which are needed to increase its productive
capacity.
Demographic factors
✚ Thomas Malthus predicted that famine was inevitable because population
grows in geometric progression whereas food production grows in an
arithmetic progression. In countries where population growth is greater
than the growth of GDP, then GDP per head would decline.
✚ Ageing populations result in smaller working populations, the latter of
whom have to support much larger proportions of elderly people. This is
already a significant issue for countries such as Japan, Italy, Portugal and
Germany.
Now test yourself
5 How might the foreign exchange gap limit economic development?
6 Identify one benefit and one disadvantage of a rapidly rising population for a
developing economy.
Answers available online
Debt
Some causes of debt in developing countries are identified in Figure 19.5.
Primary product dependency
(if terms of trade are falling)
Interest payments on
debt – especially if loans were
taken out when interest rates
were low
Causes of debt
Loans for major investment
projects or military equipment
216
Depreciation of currency
(increasing the burden of debt)
Figure 19.5 Causes of debt
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Now test yourself
19 Emerging and developing economies
7 What would be the effect of an increase in interest rates on a developing country’s
debt burden?
Answers available online
Access to credit and banking
This is important both for new entrepreneurs who need to borrow money to
finance their start-up expenses and for existing businesses that may need
money to finance expansion and for cash-flow reasons.
Infrastructure
✚ A country’s infrastructure refers to the physical and organisational
structures and facilities that are required for the efficient operation of a
society and its enterprises.
✚ If a country’s infrastructure (e.g. roads, rail and electricity generation) is
poor, it is likely to deter both domestic investment and FDI.
Education/skills
If the school enrolment ratio is low then the levels of literacy and numeracy
are likely to be low. In turn:
✚ the productivity of the workforce is likely to be low
✚ this will act as a deterrent to FDI.
Absence of property rights
✚ Hernando de Soto has argued that a strong market economy depends
critically on property rights and the rule of law.
✚ Property rights involve assigning ownership (property) rights to
individuals. For example, if a person owns assets then it will be easier for
them to secure a bank loan because they have collateral.
✚ These rights would need to be protected by the rule of law.
Making links
Many of these factors are supply-side constraints that may be relevant in both
developing and developed economies. In exams, you should be able to explain factors
that might hinder economic growth in either context. For example, if the transport
infrastructure is poor then this would not only raise costs for firms but make it difficult
to trade, so limiting growth and development.
Property rights refer to
the exclusive authority to
determine how a resource is
used, whether that resource
is owned by government
or by individuals. In other
words, property rights are
ownership rights.
Now test yourself
8 Why is a good education system important for economic development?
Answers available online
The impact of non-economic factors in
different countries
Poor governance, political instability and civil wars
If there is weak or inefficient government then it is unlikely that resources
will be allocated efficiently. Further, government failure may occur, that
is, intervention by the government in the economy might result in a net
welfare loss.
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19 Emerging and developing economies
Civil wars can have a devastating effect on the infrastructure of the country,
deter investment and so hinder growth and development.
Corruption
Corruption is undesirable if it causes:
✚ an inefficient allocation of resources
✚ an increase in the costs of doing business in the country
✚ a decrease in FDI
✚ capital flight.
Strategies influencing growth
and development
Figure 19.6 indicates a number of strategies that might be adopted to promote
growth and development.
Market-orientated
strategies
Interventionist
strategies
• Trade liberalisation
Other strategies
• Development of
human capital
• Industrialisation
• Removal of government
subsidies
• Protectionism
• Development of
primary industries
• Floating exchange rates
• Infrastructure
development
• Fair-trade schemes
• Microfinance schemes
• Privatisation
• Joint ventures
• Debt relief
• Promotion of FDI
• Managed exchange rates
• Development of tourism
• Aid
• Buffer stock schemes
Figure 19.6 Strategies to promote growth and development
Market-orientated strategies
Trade liberalisation
Price
Trade liberalisation refers to the removal of trade barriers. Consequently,
it results in an increase in trade and the associated welfare benefits of, for
example, lower prices and increased consumer surplus. This is illustrated
in Figure 19.7.
D
Trade liberalisation refers
to the removal or reduction
of barriers to free trade
(such as tariffs) between
countries.
Domestic supply
P1
L
M
World supply + tariff
P2
R
V
U
T
0
Y
W
X
Z
World supply
Quantity
Figure 19.7 The effect of trade liberalisation
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After the tariff has been eliminated, the price falls to P2, domestic supply
falls to 0Y and imports rise to YZ.
✚ In turn, this is likely to encourage FDI.
Now test yourself
9 Give one advantage and one disadvantage of trade liberalisation as a means of
promoting economic development.
Answers available online
Promotion of FDI
FDI may be encouraged by a variety of measures, including:
✚ trade liberalisation
✚ deregulation of capital markets
✚ measures to make it easier and cheaper for global companies to build
factories in developing countries
✚ tax incentives.
Removal of government subsidies
19 Emerging and developing economies
✚ At the original price of P1, domestic supply is 0W and imports are WX.
Subsidies to domestic producers might result in an inefficient allocation of
resources because competition (e.g. from imports) is reduced and so there is
less incentive for firms to minimise costs.
Floating exchange rate systems
A system of floating exchange rates might result in a depreciation of the
exchange rate, which would make the country’s goods and services more
internationally competitive.
Microfinance schemes
✚ These schemes are a means of providing extremely poor people with small
loans (microcredit) to help them engage in productive activities or to grow
their tiny businesses.
✚ The main clients of microfinance are women (97% of clients), the selfemployed, small farmers in rural areas, and small shopkeepers.
✚ However, microfinance schemes have been criticised because of the high
interest rates charged on loans and because they have not been very
successful at creating prosperous businesses in the long run.
Privatisation
Since the profit motive and competition are characteristics of firms operating
in the private sector, it is argued that privatised firms will be more efficient
than those run by the state.
Now test yourself
10 What constraint on economic development does microfinance help to solve?
Answers available online
Interventionist strategies
Development of human capital
Human capital refers to the skills, knowledge and talents of the workforce and
it includes the idea that there are investments in people, such as education
and training, which increase an individual’s productivity.
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Protectionism
19 Emerging and developing economies
Protectionist policies include tariffs, quotas and, in particular, subsidies to
domestic producers (see Chapter 17).
Managed exchange rates
Under a system of managed exchange rates (see page 201), the central bank
could engineer a depreciation of the country’s currency, so increasing the
competitiveness of its goods and services.
Infrastructure development
Investment in infrastructure tends to be very expensive but is vital to a
country’s economic development and prosperity. Such projects may be
funded publicly, privately or through public–private partnerships.
Promoting joint ventures
In a joint venture, the foreign investor and a local partner business establish a
jointly owned firm to conduct operations in the host country.
Advantages and disadvantages of joint ventures
Advantages
Disadvantages
Reduction in the costs and risks
Possible loss of control of technology and
expertise to the local partner
Less vulnerability to hostile actions if there
is political instability
Possibility of the partners having different
strategic interests
Joint venture refers to
an enterprise undertaken
jointly by two or more firms
which retain their distinct
identities.
Making links
Several policies outlined
above were first introduced
in Theme 2 as supply-side
policies. In exams, you
should be prepared to
apply these in a variety of
contexts.
Buffer stock schemes
The key features of buffer stock schemes include:
✚ a ceiling price — the maximum price which would be allowed
✚ a floor price — the minimum price which would be allowed
✚ a buffer stock, which involves the storage or release of stocks in order to
reduce price fluctuations to the agreed limits.
Price
Figure 19.8 illustrates the operation of a buffer stock scheme.
S3
D
a
S2
S1
b
Ceiling price
E
P1
A buffer stock scheme
is designed to reduce price
fluctuations and involves
the buying and selling of
stocks to maintain price
within agreed limits.
Permitted price
fluctuations
x
Floor price
y
D
Exam tip
0
Quantity
Figure 19.8 Operation of a buffer stock scheme
✚ In Year 1, the equilibrium price is P1 so no action is required because the
price is within the permitted price range.
✚ Suppose supply is S2 in Year 2, then, to prevent the price from falling below
220
the floor price, xy would be removed from the market and stored in a
buffer stock.
✚ If supply fell to S3 in Year 3, then, to prevent the price rising above the
ceiling level, ab would be released from the buffer stock.
It is more straightforward
to use the diagram in
Figure 19.8 to explain how
a buffer stock system
operates — the perfectly
inelastic supply curves
make it easier to identify
the amounts that need
to be added or sold from
the stockpile.
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Criticisms of buffer stock schemes
in years of shortage.
✚ There are storage costs.
✚ There is the potential for one of the members to cheat.
Making links
Minimum and maximum
prices were introduced in
Theme 1 (see pages 59–60).
In exams, you need to be
able to use these concepts
in relation to buffer stock
schemes.
Now test yourself
11 What form of infrastructure is likely to be especially important to developing
countries in the 2020s?
12 What is the main aim of a buffer stock scheme?
Answers available online
Other strategies
Industrialisation: the Lewis model
Lewis’ structural change (dual sector) model considers many developing
countries at an early stage of development to have two sectors:
✚ a primarily subsistence agricultural economy, characterised by low
productivity, with a large proportion of the population living in rural areas
✚ a small modern industrial sector, characterised by high productivity,
monetary exchange and people living in urban areas.
19 Emerging and developing economies
✚ If the floor price is set too high, there will be surpluses each year.
✚ If the ceiling price is set too low, there may be insufficient stocks available
Lewis’ view is that economic development can only occur if there is
industrialisation. This is illustrated in Figure 19.9.
Manufacturing
sector
Su
rp
lus
lab
ou
r
Savings reinvested:
capital growth
s
plu
r
Manufacturing
sector
ou
lab
r
Su
Traditional
agricultural
sector
Surplus labour
Savings reinvested:
capital growth
Manufacturing
sector
Figure 19.9 The Lewis structural change (dual sector) model
The key features of the Lewis model are as follows:
✚ There is a transfer of surplus labour from the low-productivity agricultural
sector to a higher-productivity industrial sector.
✚ The marginal productivity of agricultural workers would be zero or close to
zero because of the excess supply of workers. This analysis is based on the
law of diminishing returns (see pages 147–148).
✚ Therefore, the opportunity cost of the transfer of workers from the
agricultural to the industrial sector would be zero or close to zero.
✚ Industrialisation requires investment, which increases productivity and
profitability and results in higher wages, so attracting workers from the
rural areas.
✚ Increases in the savings ratio and in profits as a proportion of GDP result in
increased investment, so further increasing economic growth.
Marginal productivity
is the change in output
resulting from the addition
of one more unit of the
variable factor.
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Criticisms of the Lewis model
✚ Profits made by transnational companies (TNCs) may be repatriated to the
19 Emerging and developing economies
foreign owners.
✚ The assumption of surplus labour in the agricultural sector and full
employment in the industrial sector is contradicted by the evidence, e.g.
the favelas in South America.
✚ Agriculture and primary products have formed the basis of growth and
development in some countries.
Now test yourself
13 Identify three problems associated with industrialisation.
Answers available online
The development of tourism
The expansion of tourism has strong attractions for developing countries but
also some potential drawbacks, as identified in the table below.
Advantages and disadvantages of tourism for developing
countries
Possible advantages
Possible disadvantages
Source of foreign exchange: tourism enables
a country to earn foreign exchange from the
expenditure of foreign travellers in the developing
country.
Adverse effect on the current account of the balance of
payments because:
✚ imported capital goods are required for the building of hotels
and equipment
✚ imported food and gifts are demanded by tourists
✚ profits may be repatriated to foreign shareholders of global
companies.
Investment by global (transnational)
companies: investment in hotels and associated
services will have a multiplier effect on GDP.
Overdependence on tourism: investment in tourism may be at
the expense of the development of other industries. This could be a
problem if tourism declines in the future.
Improvement in infrastructure: global companies
may help to finance new roads and houses as part of
agreements to allow them to build hotels.
External costs: tourists may cause an increase in waste and
pollution, destruction of ancient monuments, and water shortages
for local people.
Employment opportunities: tourism is labour
intensive and so may provide employment for the
local population.
Employment may be low-paid and seasonal: many tourist
jobs are relatively low-paid, e.g. cleaners. Further, tourism in some
countries is critically dependent on the seasons, so there may be
little work in the off-season.
Increased tax revenues: these may be used to
reduce absolute poverty, improve public services
and redistribute incomes.
External shocks such as pandemics and terrorism: the
COVID-19 pandemic in 2020 had devastating effects on tourism in
both developed and developing countries. Terrorist incidents have
affected tourism in countries such as Egypt, Kenya and Tunisia.
Demand for tourism is income elastic: when
real incomes are rising, demand increases more
than proportionately.
Fluctuations in demand: these may be associated with the
trade cycle since demand for tourism is likely to be income elastic,
especially for exotic holidays.
Changes in fashion: tourism is subject to changes in tastes,
Preservation of natural heritage: the income
earned from tourism may enable a country to preserve preferences and fashions, as well as climate change.
its biodiversity, ecosystems and geological structures.
Making links
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In exam questions on tourism (as with other topics) it is important to apply economic
concepts rather than to write generalised answers. In this case, several concepts from
themes 1 and 2 are relevant, e.g. factors influencing demand, income elasticity of
demand, externalities, employment and the balance of payments.
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Now test yourself
19 Emerging and developing economies
14 Tourism accounts for about 12% of Tanzania’s GDP. Identify three problems for a
developing country that is heavily dependent on tourism.
Answers available online
Development of primary industries
Some countries have achieved rapid rates of growth and development as a
result of development in their primary sectors. This approach to economic
development may be appropriate if:
✚ the demand for the primary products being produced is income elastic
✚ the country has a comparative advantage in the production of primary
products
✚ FDI is attracted by the existence of primary products.
Fair-trade schemes
The primary aim of fair-trade schemes is to guarantee that producers receive
a fair price for their products.
Advantages and disadvantages of fair-trade schemes
Advantages of fair-trade schemes
Disadvantages of fair-trade schemes
Producers receive a price higher than the market price
for their products.
The extra money available to spend on development projects
may be very small.
Producers can use increased revenues to improve the
quality of products.
Some poorer or remote farmers are unable to join the scheme,
while others will be working for larger producers who are
excluded from many fair-trade product lines.
Extra money is available to spend on development
programmes, e.g. education and health.
Distortion of market forces — the artificially high prices
encourage existing producers to increase output and new
producers to enter the market.
Producers are protected from wildly fluctuating prices,
enabling them to plan investment and output.
There is little incentive for producers to improve the quality of
their products.
A certification of Fairtrade is based on normative views.
A significant proportion of the higher price for fair-trade goods
goes to the profits of the retailers rather than to the producers.
Now test yourself
15 What is one benefit for a producer of being part of a fair-trade scheme?
Answers available online
Aid
✚ Aid refers to the voluntary transfer of resources from one country to
another or to loans given on concessionary terms, i.e. at less than the
market rate of interest.
✚ Official development assistance (ODA) relates specifically to aid provided
by governments.
The purpose of aid
✚ To reduce absolute poverty in the long run.
✚ To provide emergency, short-term relief following natural disasters or
extreme weather events, or for refugees following a civil war.
Types of aid
✚ Tied aid: this is aid with conditions attached. For example, there might be
a requirement to buy goods from the donor country or the aid might be
given in return for political and economic reforms.
Exam tip
Remember that aid is a
transfer of money/resources
from one country to another
(usually undertaken by
governments, international
institutions or charities)
whereas foreign direct
investment is undertaken by
companies whose aim it is
to make a profit.
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✚ Bilateral aid: this is aid given directly by one country to another.
✚ Multilateral aid: this is aid provided by individual countries but channelled
19 Emerging and developing economies
through organisations such as the World Bank to developing countries.
Advantages and disadvantages of aid
Advantages of aid
Disadvantages of aid
It reduces absolute poverty and inequality.
Aid reinforces the dominance of developed economies over
developing economies.
It can fill the savings gap.
Corruption — aid may be diverted by governments/agencies for their
own uses.
It can fill the foreign exchange gap.
Aid may be misdirected: in 2018, not one of the five poorest countries
in the world was among the main recipients of UK aid.
It provides funds for investment.
There is a danger that a dependency culture will result.
It improves human capital.
Aid may distort market forces.
Developed countries benefit if aid results in
increased incomes in developing countries
so enabling them to buy more goods from
developed economies.
Interest must be paid on concessional loans, i.e. loans at below the
market rate of interest.
Donor countries may exert political influence over recipient countries.
Debt relief
Debts are usually owed to all or to some of the following: the IMF, the World
Bank, governments, and banks in developed countries.
The Heavily Indebted Poor Countries initiative
✚ The Heavily Indebted Poor Countries (HIPC) initiative was devised by the
IMF and World Bank in 1996 and enhanced in 2005 by the Multilateral Debt
Relief Initiative (MDRI).
✚ It is aimed at reducing the external debt of the poorest countries of the
world to sustainable levels.
✚ The initiative helped to achieve the 2015 goal of halving absolute poverty
by 2010.
✚ By 2018, 37 countries had approval for debt-reduction packages under the
HIPC initiative.
Arguments for debt cancellation
In addition to the arguments for aid (see ‘Advantages of aid’ in the table
above), the following may be added:
✚ There is increased business confidence, leading to an increase in
investment.
✚ Environmental gains: conditions might be attached to the cancellation of
debts.
Arguments against debt cancellation
In addition to the arguments against aid (see ‘Disadvantages of aid’ in the
table above), the following may be added:
✚ It takes a long time to agree a debt cancellation programme.
✚ There is a moral hazard problem.
✚ There may be corruption.
✚ There could be an adverse impact on financial institutions and their
shareholders in developed countries.
The moral hazard
problem occurs when
the person/firm/country
taking the risk may not
be the one who bears the
consequences of that risk.
Now test yourself
16 Why might aid result in a ‘dependency culture’?
17 How does aid differ from foreign direct investment?
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The World Bank (International Bank for
Reconstruction and Development)
✚ The original role of the World Bank or International Bank for
Reconstruction and Development (IBRD) was to provide long-term loans for
reconstruction and development to member nations that had suffered in
the Second World War.
✚ In the 1970s, its role changed to setting up agricultural reforms in
developing countries, giving loans and providing expertise.
✚ The World Bank imposes structural adjustment programmes (SAPs), which
set out conditions on which loans are given. The aim is to ensure that
debtor countries do not default on the repayment of debts.
✚ SAPs were based on free market reforms. However, they have been
criticised because they did little to help the world’s poor, since they
increased inequality and resulted in social and political chaos in many
countries.
✚ Following these criticisms, the World Bank now focuses on poverty
reduction strategies, with aid being directed towards countries adopting
sound macroeconomic policies, healthcare, broadening education, and
local communities rather than central governments.
19 Emerging and developing economies
International institutions
The International Monetary Fund
The International Monetary Fund (IMF) was founded in 1944 with the
objective of increasing international liquidity and providing stability in
capital markets through a system of convertible currencies pegged to
the dollar. It also lends to countries with temporary balance of payments
deficits on current account in order to stabilise their economies, and achieve
economic growth.
Membership and finance
✚ There are currently 189 members of the IMF.
✚ When a country joins, it is required to pay a quota that is broadly based on
the relative size of the country in the world economy (calculated in terms
of its GDP).
✚ Up to 25% of this quota or subscription must be paid in the Special
Drawing Rights or currencies that are generally acceptable, such as the US
dollar, the pound sterling, the yen or the euro.
Impact of the 2008 global financial crisis
Following the financial crisis, the IMF:
✚ increased lending
✚ provides forecasts, analysis and advice to individual countries.
Impact of the 2020 COVID-19 pandemic
By the end of July 2020 the IMF had secured $1 trillion in funds to lend to
members who were experiencing severe financial difficulties as a result of the
pandemic.
Non-government organisations
✚ Non-government organisations (NGOs) are organisations that operate
independently of governments.
✚ They are usually non-profit organisations.
✚ The work of NGOs has brought community-based development to the
forefront of strategies to promote growth and development (i.e. the focus
has moved away from state-managed schemes).
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Now test yourself
19 Emerging and developing economies
18 How might the IMF help a country with a very large current account deficit?
Answers available online
Summary
You should have an understanding of:
✚ measures of economic development
✚ the factors influencing growth and development
✚ strategies influencing growth and development
✚ international institutions.
Exam skills
In the context of emerging and developing economies you
need to be able to demonstrate a range of skills, including
the ability to apply concepts that you have met in previous
parts of the course. Therefore, this topic is another area
that could be tested for synoptic assessment in Paper 3.
Consider, for example, how the following areas have both
micro- and macroeconomic implications:
✚ Primary product dependency (e.g. income elasticity of
demand and balance of payments)
✚ Volatility of commodity prices (e.g. supply and demand
elasticities and balance of payments, and public finances)
✚ Protectionism (e.g. supply and demand analysis relating
to a particular industry, and the balance of payments,
economic growth and employment)
In addition, the following quantitative skills are particularly
relevant:
✚ QS11: understand composite indicators (e.g. the
Human Development Index — see page 212).
✚ QS5: calculate and interpret index numbers (e.g. the
terms of trade — see page 182).
Exam practice
1 Study the material below and answer the questions that follow.
Table 1 Estimated benefits of China’s Belt and Road Initiative (BRI)
Benefits
Reduction in travel times across the corridors
12%
Increase in international trade
2.7–9.7%
Increase in real GDP
Up to 3.4%
Reduction in number of people in absolute poverty
7.6 million
Extract A: Possible impact of the BRI
In 2013, China proposed the Belt and Road Initiative (BRI)
as a means of improving connectivity across continents.
The land and sea routes cover more than 100 nations
in Asia, Africa and Europe. Two-thirds of the global
population was likely to benefit from the new networks,
which would influence global economic development in
the coming decades.
The BRI involves significant infrastructure investment in a
range of areas. These include tourism, mining, transport,
energy and information technology. The cost of this
investment could amount to US$5 trillion. Around 3 000
projects had been started by the middle of 2019.
226
Over 5 billion people will be affected by the BRI and the
countries involved account for one-third of global GDP
and trade. It is asserted that the BRI will bring significant
benefits, including the following:
✚ There would be a significant fall in absolute poverty in
many of the countries involved.
✚ International trade, investment and economic growth
would increase.
✚ Transport costs would be reduced, e.g. transporting
goods by train instead of by sea cuts transport time
in half.
✚ China would gain access to natural resources.
However, there are some criticisms of the BRI, including
the following:
✚ There would be external costs in terms of
environmental damage.
✚ Corruption has caused Malaysia to cancel some BRI
projects.
✚ The BRI represents a form of colonialism, with
potential exploitation of the countries involved.
✚ It creates unsustainable debt. For example, building
the Lao PDR part of the Kunming–Singapore Railway
could cost around US$6 billion. This represented 40%
of Laos’s GDP in 2016.
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More than 2 600 companies from different sectors were
involved in BRI-related projects by the middle of 2019.
Many of the companies that will benefit are some of
China’s largest state-owned enterprises (SOEs). They
are investing in various infrastructure projects including
roads, railways and ports.
A high proportion (about 89%) of BRI projects have
been implemented by Chinese companies or through
joint ventures. One example is a $10 billion project in
Malaysia to build a deep-sea port and a cruise terminal.
This project is being undertaken by a local company, KAJ
Development, and several Chinese firms.
Similarly, the US company General Electric and the
German engineering and electronics giant Siemens AG
have set up joint ventures with Chinese companies in
China and in BRI countries. These companies provide
Chinese firms with technology support, equipment
supply and finance.
a) With reference to Table 1 and Extract A, explain the
difference between absolute poverty and
[5]
relative poverty.
b) With reference to Extract B, examine two
possible benefits of joint ventures.
[8]
c) With reference to Extract B, discuss the impact
on the profits of the Haier Electronics Group of the
Chinese exporters will also benefit from the BRI,
particularly those who produce clothes, electronic
items and domestic appliances. One of China’s largest
producers of home appliances, Haier Electronics Group,
has built industrial parks and manufacturing plants in 18
countries. Six of their industrial parks are in BRI countries
including Vietnam, Pakistan and Russia. This investment
meant that Haier now has a 32% share of the home
appliances market in Pakistan. In 2018, Haier generated
RMB10.1 billion in revenues from South Asia, Southeast
Asia and the Middle East.
Haier did, however, face a major problem in Pakistan
because many of its major cities regularly suffer from
electricity blackouts. It is estimated that the country’s
power shortages are responsible for a 7% annual loss
in GDP. This issue has been partly addressed by the
US$40 billion that has been spent on new coal-fired
power stations.
19 Emerging and developing economies
Extract B: Companies benefiting from the BRI
increase in demand for its goods. Illustrate your
[12]
answer with an appropriate diagram.
d) With reference to the information provided,
evaluate the microeconomic and
macroeconomic benefits of the BRI.
[25]
Answers and quick quizzes online
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20 The financial sector
Financial markets
A financial market covers any marketplace where buyers and sellers
participate in the trade of assets such as equities, bonds, currencies and
derivatives. Therefore, the financial sector provides the means of channelling
funds to households, firms and governments.
Capital
market
Foreign
exchange
market
Financial
markets
Money
market
Exam tip
This section relates to
other parts of the syllabus
including, for example,
demand-side policies,
especially monetary policy
instruments and the role
of the Bank of England
(see pages 117–118) in
Theme 2, macroeconomic
policies in a global context
(see pages 242–244) in
Theme 4, and market
failure and government
failure (see pages 49 and
62–64) in Theme 1.
Derivatives
market
Figure 20.1 Financial markets
As shown in Figure 20.1, the key financial markets include:
✚ Capital markets: these enable individuals and institutions to trade
financial securities, so enabling organisations and firms in both the
private and public sectors to gain long-term finance. Two examples are
stock markets and bond markets:
✚ Stock markets allow investors to buy and sell shares in limited
companies.
✚ Bond markets are markets for loans to companies or governments.
✚ Money markets: these are markets for short-term loans such as treasury
bills and certificates of deposit.
✚ Derivatives markets: derivatives are financial instruments, e.g. futures
contracts whose price depends on the value of the underlying asset.
✚ The foreign exchange (FOREX) market: this is the market in which
currencies are traded.
Now test yourself
1 Why are capital markets important to businesses?
Answers available online
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The role of financial markets
20 The financial sector
The following are key functions of financial markets:
To facilitate saving
Financial institutions enable households and businesses to save money by
providing a range of accounts with varying degrees of risk and rates of interest.
To lend to businesses and individuals
Financial institutions enable the connection between households and
businesses which have savings with those that need to borrow.
To facilitate the exchange of goods and
services
The financial system handles millions of transactions every day. These allow
people to:
✚ make payments in shops and online
✚ receive wages, welfare payments from the government and other incomes
✚ settle debts.
To provide forward markets in commodities
and contracts
✚ Essentially, forward markets set the price of an asset, e.g. a commodity
such as wheat, or of a financial instrument, e.g. a foreign currency for
future delivery.
✚ Forward contracts may be used for both hedging and speculation. A
hedge is an investment to reduce the risk of adverse price movements in
an asset.
To provide a market for equities
✚ An equities or stock market is one in which stocks and shares are issued
and traded.
✚ A stock market gives companies access to capital and investors a share of
ownership in a company.
Now test yourself
2 Which financial market provides a means for the buying and selling of currencies?
Answers available online
Making links
The functions of money
were considered in Theme 1
(see page 20). In exams,
you will not only need to
understand the significance
of these but also the
functions of financial
markets.
Market failure in the financial
sector
Asymmetric information
This is a situation in which one party involved in a financial contract has less
information than the other party.
The following are examples of asymmetric information:
✚ The financial market for health insurance relies heavily on accurate
information, but those seeking insurance generally have better
information about their own health than the health insurance providers.
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✚ In the banking industry, relatively few investors understood the risks
associated with derivatives traded prior to the 2008 financial crisis.
20 The financial sector
✚ In the stock market, there are differences in knowledge between buyers
and sellers regarding the productivity and profitability of companies.
Moral hazard
✚ Before the 2008 global financial crisis some bankers engaged in trading
highly risky securities to enhance their bonuses. In the event, these risky
loans resulted in huge losses, which were so great that the UK Government
had to rescue some banks, such as RBS.
✚ This could create a further moral hazard (and government failure) because
banks might continue to engage in risky behaviour in the knowledge
that the government would bail them out if they were in danger of going
bankrupt.
Speculation and market bubbles
Between 2000 and 2007 interest rates were low, credit was easy to obtain
and asset prices were increasing. This period also saw banks create £1
trillion of new money, accompanied by a doubling of debt. Indeed, there
was a ‘herd effect’, which resulted in people buying assets in the hope of
future capital gains, even though these were unjustified in terms of their
real worth.
Market bubbles occur
when an asset e.g. shares
or houses, are traded at
prices considerably higher
than their intrinsic value.
They are usually followed by
a crash, when prices fall.
Externalities
The activities of agents in the financial markets could cause asset bubbles, for
example, in the housing market. This could be an external benefit to people
who own houses but would be an external cost to those wishing to get onto
the property ladder.
Market rigging
✚ One example of market rigging was that of the Libor rate. This is a
benchmark interest rate based on the rates at which banks lend unsecured
funds to each other on the London interbank market.
✚ In another case, the Financial Conduct Authority accused traders at HSBC
of colluding with traders from at least three other firms in an attempt to
manipulate the lowering of the sterling–dollar rate.
Market rigging is a
form of collusion in which
parties illegally fix prices to
achieve higher profits at the
expense of consumers or
other parties.
Making links
Market failure was introduced in Theme 1 (see Chapter 3). In this context not only
asymmetric information and externalities are considered but also other possible
market failures. In exams, it is important to be able to apply these concepts in the
context of the financial sector.
Now test yourself
Exam tip
It is important to be able to
apply the concepts in this
section (many of which have
been covered previously) to
a variety of contexts.
3 How might genetic and lifestyle tests reduce market failure in the health insurance
industry?
Answers available online
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Implementation of monetary policy
Central banks are responsible for implementing government monetary policy,
which may involve inflation targeting with the use of interest rate policy and
quantitative easing (see Theme 2).
Banker to the government
From the beginning, the Bank of England was the government’s banker,
which means that it manages the government’s accounts and arranges loans
to the government. However, with the decision to grant the Bank operational
independence in 1997, responsibility for government debt management was
transferred to the new UK Debt Management Office in 1998.
20 The financial sector
The role of central banks
Banker to the banks — lender of last resort
A central bank is usually willing to offer loans to financial institutions that
are experiencing financial difficulties and are unable to obtain the necessary
funds elsewhere, so helping to maintain the stability of the banking and
financial system.
The scale of the 2008 financial crisis meant that a number of governments,
including those in the UK and Ireland, had to bail out banks to keep them
afloat.
Making links
In exams, you should be able to discuss monetary policy, introduced in Theme 2 (see
pages 117–118), in both UK and international contexts. For example, you should be
able to discuss the response of central banks to the 2008 global financial crisis and to
the 2020 COVID-19 pandemic.
Now test yourself
4 What action could a central bank take to prevent a bank from failing?
Answers available online
Role of regulation in the banking industry
Since April 2013, the UK has had two new financial regulators:
✚ the Prudential Regulation Authority (PRA), whose main function is to
ensure the stability of firms involved in financial services such as banks,
building societies, credit unions and insurers
✚ the Financial Conduct Authority (FCA), which is the City’s behavioural
watchdog and is designed to protect consumers, to promote competition
and to maintain stability in the financial services sector.
The Bank of England has also gained direct supervision of the whole of the
banking system through its Financial Policy Committee (FPC). The main
objective of this committee is to identify risks and weaknesses across the
UK financial system. If risks are increasing, it might ask banks to raise more
money from shareholders as a buffer in case of a liquidity problem.
Some aspects of regulation
✚ Britain’s biggest banks were required to separate retail banking operations
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20 The financial sector
✚ The Bank of England subjects the UK’s biggest banks to tests to measure
whether they would survive a financial shock.
✚ Regulators in the UK, the USA and the EU have fined banks more than
$9 billion for rigging Libor, which underpins over $300 trillion worth of
loans worldwide.
Exam tip
You will not be required to
have detailed knowledge of
bank regulations.
Now test yourself
5 Give one reason why regulation of retail banks is necessary.
Answers available online
Summary
You should have an understanding of:
✚ the role and main functions of financial markets
✚ sources of market failure in financial markets
✚ the role and main functions of central banks.
Exam skills
This chapter develops some of the concepts introduced earlier in the course and
applies them to the context of the financial sector.
Therefore, to answer questions for this part of the specification you need to draw on
material that you have studied previously, in particular, market failure in Theme 1 and
monetary policy in Theme 2.
Exam practice
1 a) A bank makes risky loans to borrowers who have poor credit ratings in the
knowledge that the Central Bank will bail it out should the loans not be repaid.
This is an example of which type of market failure?
A Asymmetric information
B Market bubble
C Moral hazard
D Market rigging
[1]
b) Explain two effects of a bank going bankrupt.
[4]
2 Explain two ways by which a central bank could reduce the risk that retail
banks go bankrupt.
[4]
3 In 2020, many hotels, restaurants and retailers that were locked down during
the COVID-19 pandemic were unable to obtain loans from banks.
Evaluate the effects of the refusal of banks to lend money to businesses.
[25]
Answers and quick quizzes online
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21 The role of the state in the
macroeconomy
Public finance
There are three aspects to be considered:
✚ Public expenditure, i.e. spending by the state
✚ Taxation, i.e. money raised by the government for expenditure by the state
✚ Fiscal deficits (public sector borrowing) and national (public sector) debt
These are illustrated in Figure 21.1.
The key elements of public expenditure are closely associated with the
objectives of public expenditure, which are summarised in Figure 21.2.
Provision of
public goods
Current
expenditure
Public
expenditure
Capital
expenditure
As a means of
managing the
economy (part
of fiscal policy)
Objectives
of public
expenditure
Transfer
payments
Direct
taxation
Public
finance
Taxation
Indirect
taxation
Public sector
borrowing
Defence and
internal security
Provision of
goods yielding
external benefits
or where there are
information gaps
Redistribution
of income
To deal with
external costs
from production
and consumption
Public sector
net borrowing
Public sector
net debt
Figure 21.1 Key elements of public finance
Figure 21.2 Objectives of public expenditure
Public expenditure
There are three broad elements of public expenditure:
✚ Capital expenditure: this refers to long-term investment expenditure on
capital projects such as HS2, new schools and new motorways.
✚ Current expenditure: this relates to the government’s day-to-day
expenditure on goods and services, for example wages and salaries of civil
servants, and drugs used by the NHS.
✚ Transfer payments: these are payments made by the state to individuals
without any exchange of goods or services. They are used to redistribute
income. UK examples include Universal Credit and state pensions.
Now test yourself
1 How does capital expenditure differ from transfer payments?
Answers available online
Public expenditure
relates to expenditure by
central government, local
authorities and public
sector organisations.
Exam tip
Remember that the term
‘public expenditure’ is
expenditure by the state/
government — it is not
spending by the public!
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21 The role of the state in the macroeconomy
The changing size and composition of public
expenditure in a global context
The changing size of public expenditure
Several factors affect the size of public expenditure, including the following:
✚ The level of GDP: as GDP increases, a government is likely to have more tax
revenues to finance public expenditure.
✚ Demand for public services: demand for many public services such as
health and education is income elastic.
✚ Size and age distribution of the population: a rising population places
increased demands on public expenditure, for example on education
and healthcare. An ageing population also increases the need for public
expenditure, for example on pensions and healthcare.
✚ The state of the economy: when the economy is in recession, public
expenditure is likely to rise because of automatic stabilisers.
✚ Interest on the national debt: if national debt has been increasing and if
interest rates are high then there will be an increase in public expenditure
on financing the national debt.
✚ The rate of inflation: in nominal terms, public expenditure will inevitably
increase during periods of inflation, not least because many benefits are
index linked, i.e. linked to the rate of inflation.
✚ Political priorities: for example, the government might wish to improve
public services.
Now test yourself
2 Why did public expenditure increase so much during the COVID-19 pandemic?
Answers available online
The changing composition of public expenditure
£ billion
Figure 21.3 shows how public expenditure was distributed in the UK in
2019–20.
850
214.0
700
550
500
40.2
24.8
101.2
Debt interest
Other welfare
State pensions
Investment
450
400
101.3
Other public
services
350
47.0
Defence
89.6
Education
29.0
Health
300
250
200
150
In exams, you should be
able to apply concepts
such as income elasticity
of demand (Theme 1), GDP
and the rate of inflation
(Theme 2), and the size
and age distribution of the
population (Theme 4) in
your answers.
Tax credits
(personal)
650
600
Making links
Key
Other spending
800
750
Automatic stabilisers
are changes in government
spending or in tax revenue
that occur automatically,
without deliberate
government action.
63.5
100
50
0
234
130.1
2019–20
Figure 21.3 UK government expenditure, 2019–20
Source: Office for Budget Responsibility
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21 The role of the state in the macroeconomy
Social protection (which includes the range of benefits), health and education
have increased as a share of total government expenditure in recent years,
partly because of:
✚ increased payments for housing benefits as a result of rising rents
✚ increased expenditure on tax credits
✚ the ageing population
✚ an increase in the number of children of school age.
The 2020 COVID-19 pandemic caused a very large increase in public
expenditure, not least on the furlough scheme that paid 80% of the wages of
over 8 million workers in mid-2020.
Now test yourself
3 Identify two areas of public expenditure that might also be expected to increase as
a proportion of GDP in the future. Explain your reason.
Answers available online
The significance of differing levels of public
expenditure as a proportion of GDP
Productivity and growth
If a country’s public expenditure is a relatively high proportion of GDP, then its
productivity and economic growth rates may be relatively low because of the
absence of the profit motive and competition in the public sector.
Living standards
The impact depends critically on the composition of public expenditure, for
example the proportion of public expenditure spent on transfer payments and
on health relative to the amount spent on defence.
Crowding out
Structural deficits could imply that the size of the public sector is increasing,
which could cause resource or financial crowding out.
Level of taxation
If public expenditure is a high proportion of GDP then it is likely that taxation
will also be a high proportion of GDP.
Equality
Much research suggests that higher public spending is associated with greater
equality, for example in Sweden and Denmark. However, this is not always
the case because some countries have both high public spending and a
significant degree of inequality.
Making links
Productivity and living standards were considered in Theme 2 while inequality was
considered early in this theme. In exams, you should be prepared to apply these
concepts to the context of taxation and public expenditure.
Resource crowding
out occurs when the
economy is operating at
full employment and the
expansion of the public
sector means there is a
shortage of resources in the
private sector.
Financial crowding out
occurs when the expansion
of the state sector is
financed through increased
government borrowing.
This causes an increased
demand for loanable funds,
which drives up interest
rates and crowds out
private sector investment.
Now test yourself
4 How might ‘crowding out’ affect productivity?
Answers available online
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Taxation
21 The role of the state in the macroeconomy
Figure 21.4 summarises the main objectives of taxation.
As a means
of managing
the economy
(part of
fiscal policy)
To raise
revenue to
finance public
expenditure
Defence
and internal
security
Objectives
of taxation
To influence
the pattern of
expenditure
To redistribute
income
To internalise
external costs
Figure 21.4 Objectives of taxation
Progressive, proportional and regressive taxes
✚ Progressive taxes are taxes in which the proportion of income paid in tax
rises as income increases.
✚ Proportional taxes are taxes in which the proportion of income paid in tax
remains constant as income increases.
✚ Regressive taxes are taxes in which the proportion of income paid in tax
falls as income increases.
% of income paid in tax
Figure 21.5, where A is a progressive tax, B is a proportional tax and C is a
regressive tax, shows the relationship between the proportion of income paid
in tax and taxable income for the above categories of tax.
C
Exam tip
For precision, when you
are explaining progressive,
proportional and regressive
taxes, always consider what
happens to the proportion
of income paid in tax as
income rises.
A
B
0
Taxable income
Figure 21.5 Categories of taxation
Now test yourself
5 How does a progressive tax differ from a proportional tax?
236
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Direct and indirect tax rates
✚ Direct taxes are taxes on income and wealth.
✚ Indirect taxes are taxes on expenditure.
Table 21.1 indicates some of the main direct and indirect taxes in the UK.
Table 21.1 Direct and indirect taxes in the UK
Direct taxes
Indirect taxes
Income tax: a progressive tax levied at
three rates: 20%, 40% and 45%
Value Added Tax (VAT): an ad valorem
tax, i.e. a percentage of the price of the
product
Corporation tax: a proportional tax on
company profits, set at 19% in 2020
Excise duties: usually specific taxes, i.e.
a set amount per unit of the product
Capital gains tax: a tax on the increase
in value of assets between the time they
were bought and the time they were sold,
e.g. on shares and investment property
Tariffs: taxes on imports
To determine whether a tax
is direct or indirect, consider
whether it is levied directly
on a person’s income or on
their expenditure.
£ billion
Figure 21.6 shows the main sources of tax revenue and other sources of
government revenue for the UK.
850
54.7
Key
Other receipts
700
96.1
Other taxes
650
Capital taxes
550
30.7
28.4
31.3
36.3
500
58.2
800
750
600
Fuel duty
Business rates
Council tax
450
400
21 The role of the state in the macroeconomy
Exam tip
136.6
Corporation tax
350
VAT
300
Income taxes
250
200
150
339.1
100
50
0
2019–20
Figure 21.6 UK public sector receipts, 2019–20
Source: Office for Budget Responsibility
Making links
Indirect taxes were introduced in Theme 1 (see pages 43–45) in a microeconomic
context. In this theme, they are considered in a macroeconomic context. For the
Paper 3 examination you may need to discuss indirect taxes in both contexts.
Now test yourself
6 Which tax is levied on company profits?
Answers available online
Exam tip
Remember that VAT is a
percentage of the price of a
product and is not based on
income. Therefore it is not a
proportional tax.
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Effects of changes in direct tax rates
An increase in income tax rates might cause a disincentive to work because:
✚ the unemployed and those currently ‘inactive’ would be less willing to
take jobs
✚ workers currently employed may be less willing to do overtime, more
likely to reduce their working hours, more likely to retire early and less
willing to apply for promotion.
Tax revenues
Increases in tax rates might cause tax revenues to fall. This may be explained
using the Laffer curve, as shown in Figure 21.7.
Tax revenue ($ bn)
21 The role of the state in the macroeconomy
Incentives to work
R
S
0
T
V
Tax rate (%)
Figure 21.7 The Laffer curve
When the tax rate is increased up to point T, tax revenues increase. However,
a further increase in the tax rate from T to V causes a fall in tax revenue from
R to S. Several reasons might explain this phenomenon, including:
✚ increased disincentives to work
✚ an increase in tax avoidance, which is legal
✚ an increase in tax evasion, which is illegal
✚ a rise in the number of tax exiles.
Now test yourself
7 Identify two reasons why an increase in income tax rates might cause a fall in tax
revenue.
Answers available online
Income distribution
An increase in income tax rates will make the tax system more progressive,
so making income distribution more equitable.
Real output and employment
Higher rates of income tax would cause a fall in disposable income, a fall in
consumption and a fall in aggregate demand (AD). The disincentive effects
of higher rates of income tax might also cause a fall in aggregate supply (AS).
Consequently, there would be a fall in real output and employment.
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The fall in AD following higher income tax rates would cause a fall in the
price level. This may be partially offset by any fall in AS but the impact of the
leftward shift in the AD curve is likely to be more significant.
The trade balance
An increase in income tax rates would reduce disposable income. In turn,
this would cause a fall in consumption, resulting in a decrease in imports.
Consequently, there should be an improvement in the trade balance.
Foreign direct investment flows
An increase in direct taxes is likely to deter inward foreign direct investment
(FDI). Further, an increase in income tax rates is also likely to deter inward FDI
because disposable income would fall, causing a decrease in consumption.
Exam tip
Analyse tax changes with
reference to aggregate
demand and aggregate
supply.
Making links
Changes in direct taxes (and indirect taxes) have implications for economic growth,
unemployment, the rate of inflation and the balance of trade, which were explained
in Chapter 5; for inequality, a concept covered in Chapter 18; and for foreign direct
investment, which was considered in the context of globalisation (see page 185).
In exams, you need to think laterally so that you are able to consider the
interrelationships between changes in a variable and its impact on different
aspects of economic performance.
21 The role of the state in the macroeconomy
The price level
Now test yourself
8 How might an increase in income tax rates affect the trade in goods balance?
Answers available online
Effects of changes in indirect tax rates
Incentives to work
Exam tip
An increase in the VAT rate might cause an incentive to work more because
workers will try to maintain living standards by working longer hours.
Tax revenues
If the VAT rate is increased then tax revenues will almost certainly increase
because VAT is applied to most goods and services.
In Paper 3 of the
examination you might be
required to consider both
the microeconomic and
macroeconomic effects of a
change in indirect taxation.
Income distribution
Research by the ONS suggests that the impact of VAT is broadly regressive.
Therefore, an increase in VAT would cause income distribution to become
less even.
Real output and employment
A higher rate of VAT would cause a fall in real income, which would cause a
fall in consumption and a fall in AD, leading to a reduction in real output and
employment. For businesses, the higher VAT rate would raise costs, so causing
a fall in AS, which would lead to a reduction in real output and employment.
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21 The role of the state in the macroeconomy
The price level
The short-run effect of an increase in indirect taxes is to increase the price
level. However, it should be remembered that taxes are a leakage from
the circular flow, so higher indirect taxes will cause a decrease in AD and,
therefore, a fall in the price level in the longer term.
The trade balance
In January 2020, the UK Government decided that tariffs on carpets and
household sewing machines that were set at between 5.7% and 9.7% would be
abolished from January 2021, and that tariffs on a range of other goods would
be reduced. If demand for these products is price elastic then the value of
imports would increase and AD would fall.
FDI flows
If a government of a country raises its indirect taxes significantly, then
global companies may be deterred from investing in that country because
the tax rise might lead to a reduction in the domestic demand for the
company’s goods.
Now test yourself
9 What is the likely effect on income inequality if VAT is increased on electricity
and gas?
Answers available online
Public sector finances
Automatic stabilisers and discretionary fiscal
policy
Automatic stabilisers
✚ Automatic stabilisers are changes in government expenditure and tax
revenue that occur as GDP rises or falls without any change in government
policy.
✚ In a recession, unemployment increases, so the government spends more
on unemployment benefits and other means-tested benefits. Such an
increase in government expenditure is automatic.
✚ Further, tax revenues will fall because less people are working and
therefore revenue from income tax will be less.
✚ Meanwhile, VAT receipts will be lower because consumer spending is lower.
✚ In addition, there will be a fall in corporation tax receipts because
company profits will be lower.
Automatic stabilisers
are designed to offset
fluctuations in a nation’s
GDP without intervention by
the government.
Discretionary fiscal
policy occurs when the
government intervenes in
the economy by changing
taxes or government
expenditure.
Discretionary fiscal policy
Discretionary fiscal policy involves deliberate changes in public expenditure
and taxation by the government in an attempt to influence the level of
economic activity (see page 119).
Now test yourself
10 In 2020, the UK Government agreed that if companies furloughed employees they
could apply for a grant that covered 80% of their usual monthly wage costs, up
to £2500 a month. Is this an automatic stabiliser or an example of discretionary
fiscal policy?
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✚ A fiscal deficit implies that public expenditure is greater than tax revenues.
✚ The national debt is the cumulative total of past government borrowing.
Exam tip
Remember that the fiscal (budget) deficit relates to excess public expenditure over
taxation in a year whereas the national debt is the cumulative total of government
borrowing over time.
Distinction between structural and cyclical
deficits
✚ The government’s finances change in line with the trade cycle; in other
words, they would usually be expected to deteriorate when the economy
is in recession. These are referred to as cyclical deficits. A cyclical deficit is
not regarded as a serious problem because it should disappear when the
economy returns to its trend growth rate.
✚ However, a structural deficit remains even when the economy is operating
at a normal, sustainable level of employment and activity.
Now test yourself
11 Why might public finances improve during a period of rapid economic growth?
The national debt is
the total sum owed by a
government to holders of
government bonds (giltedged securities). In other
words, it represents the
total of a government’s
outstanding debt that it has
accumulated over time.
The cyclical deficit is that
portion of a country’s budget
deficit which reflects changes
in the economic cycle.
The structural deficit
is the fiscal deficit that
remains when the economy
is normal, or when the
output gap is zero.
21 The role of the state in the macroeconomy
Distinction between the fiscal deficit and the
national debt
Answers available online
Factors influencing the size of fiscal deficits
The size of the fiscal deficit depends on factors that are similar to those which
affect public expenditure. Some of the key factors are listed below.
✚ State of the economy
✚ Political priorities
✚ Demographic factors
✚ External shocks
✚ Efficiency of tax collection
✚ Amount of tax evasion and tax avoidance
Note that, in a particular year, a country’s fiscal deficit may be reduced as
a result of one-off factors such as privatisations or auctions of telecoms
spectrum.
Now test yourself
12 How might an increase in the proportion of the population aged over 65 affect
the size of the UK’s fiscal deficit?
Answers available online
Factors influencing the size of national debts
✚ Fiscal deficits/surpluses
✚ Wars
✚ Economic crises such as the 2008 financial crisis or the 2020 COVID-19
pandemic
✚ Measures adopted by the government which create immediate and
long-term obligations
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Now test yourself
21 The role of the state in the macroeconomy
13 Suggest two reasons that might justify running a large fiscal deficit.
Answers available online
The significance of the size of the fiscal
deficit and national debts
The fiscal deficit as a proportion of GDP is more significant than the absolute
size of the fiscal deficit because it gives a better indication of the ability of the
country to finance the debt and eventually to repay it.
A persistent structural fiscal deficit and an increasing national debt might
cause the following:
✚ Loss of the country’s AAA credit rating, which could mean higher interest
rates when it borrows money
✚ Crowding out (see page 235)
✚ Inflation, because net injections will be increasing
✚ A fall in confidence, leading to a fall in FDI
✚ Rising interest payments on the national debt
✚ Places an increased burden on future generations.
However, a structural deficit and rising national debt caused by significant
investment on infrastructure and/or on education or health may not be
regarded as a serious problem because such expenditure would increase longrun aggregate supply.
Making links
Government expenditure (an injection into the circular flow of income) and taxation (a
withdrawal from the circular flow of income) were considered in Chapter 8 along with
their implications for the multiplier.
In exams, you should be able to consider the possible implications of changes in these
variables for the level of economic growth as well as for other economic variables
such as the rate of inflation.
Now test yourself
14 What might be the opportunity cost of an increasing national debt?
Answers available online
Macroeconomic policies in a
global context
Use of fiscal policy, monetary policy,
exchange rate policy, supply-side policies
and direct controls
✚ Changes in fiscal policy involve changes in public expenditure and
242
taxation whereas monetary policy involves changes in interest rates and
the money supply. Their use was examined in Chapter 10 and then earlier
in this chapter. It should be noted that the distinction between monetary policy
and fiscal policy is becoming increasingly blurred as a result of quantitative easing.
This may have implications for central bank independence.
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✚ Exchange rate policy involves deliberate manipulation of the exchange rate
21 The role of the state in the macroeconomy
in order to influence the competitiveness of a country’s goods and so affect
its level of economic activity. Managed exchange rates were discussed in
Chapter 17, page 202.
✚ Supply-side policies involve measures to increase efficiency, productivity
and international competitiveness. Their use was examined initially
in Chapter 10 and also in Chapter 19 (in the context of developing and
emerging economies).
✚ Direct controls involve government intervention to control prices or wages
in an economy. For example, they are used to control the increase in
energy prices in the UK, some food prices in Venezuela, and rents in some
German cities.
Measures to reduce fiscal deficits and national debts
To reduce a fiscal deficit, a government could:
✚ reduce public expenditure and/or
✚ increase taxes
✚ implement policies to increase economic growth. Some economists argue
that these policies would have the effect of reducing the fiscal deficit and
national debt as a proportion of GDP.
Now test yourself
15 Why might deflationary fiscal policy not cause a fall in the fiscal deficit?
Answers available online
Measures to reduce poverty and inequality
To reduce poverty and inequality, a government could:
✚ improve the quality of education and training for the poor
✚ make the tax system more progressive
✚ increase inheritance taxes
✚ increase the number and range of means-tested benefits
✚ implement measures to reduce unemployment
✚ introduce or increase the national minimum wage/National Living Wage.
Now test yourself
16 Identify one measure to reduce poverty and one measure to reduce inequality.
Answers available online
Changes in interest rates and the supply of money
✚ The impact of changes in interest rates and money supply is discussed in
Theme 2.
✚ Usually, central banks make independent decisions about changing interest
rates in the light of inflationary expectations in their own countries.
However, in October 2008, in response to the global financial crisis, central
banks agreed a co-ordinated half-a-percentage-point cut in interest rates.
✚ Quantitative easing is designed to make it easier and cheaper for
businesses to borrow from banks. However, according to the quantity
theory of money, this may cause inflation. Further, it could cause a
depreciation in the country’s exchange rate.
✚ Modern monetary theory (MMT) suggests that an economy with its own
currency can accumulate as much debt as it wishes because the central
bank can always increase money supply to pay the interest on the national
debt. While this might be feasible in the short term, problems may arise
if interest rates and the rate of inflation increase. On the other hand,
inflation may not occur if there is sufficient spare capacity in the economy.
The National Living Wage
is a wage high enough for
workers to have a normal
standard of living, i.e. to
be able to afford everyday
things like food, transport
and paying bills.
Quantitative easing
involves the central bank
buying securities from
financial institutions, which
has the effect of increasing
the money supply.
The quantity theory of
money states that there is
a direct and proportionate
relationship between
changes in the money
supply and the price level.
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21 The role of the state in the macroeconomy
Measures to increase international competitiveness
Policies used to eliminate a balance of payments deficit on current account
(see page 199) would also be relevant as a means of increasing international
competitiveness.
Making links
Most of these macroeconomic policies were first introduced in Chapter 10 and
supply-side policies have been applied in Chapter 19.
In exams, you need to be able to apply these policies to any context, for example, to a
country with low productivity or facing a severe economic downturn.
Exam tip
Now test yourself
17 Identify two policies that could be used to increase the non-price competitiveness
of a country’s goods.
Answers available online
Subsidies may not be a
relevant policy if the World
Trade Organization or the
trading bloc to which the
country belongs outlaws
them.
Use and impact of macroeconomic policies
to respond to external shocks to the global
economy
External shocks to the global economy may take a variety of forms. Four
examples are given in Table 21.2.
Table 21.2 External shocks and the impact on policies
External shock
Possible macroeconomic policies
Possible impacts of policies
A sudden increase in global
oil or commodity prices in
general
Increase in interest rate
Reduction in consumption, investment,
exchange rate appreciation leading to fall in AD
and in the rate of inflation
A financial crisis causing a
decrease in confidence in
the banking system
Decrease in interest rate; quantitative
easing; public expenditure to prevent
banks going bust; fiscal stimulus, e.g.
cutting VAT
Should stimulate AD but impact depends on
business and consumer confidence — if this is
low then impact will be small
Bursting of asset price
bubbles, e.g. global crash in
house prices
Decrease in interest rate, quantitative
easing
Aimed at reducing mortgage interest
repayments and increasing liquidity, and so
stimulating AD; policies are designed to reduce
the impact of negative wealth effect; impact
will depend on factors such as the success of
policies, degree of home ownership
Contagious diseases such as
the 2020 COVID-19 pandemic
Monetary stimulus, e.g. decrease
in interest rate; quantitative easing;
loans to firms underwritten by the
government
Policies aimed at limiting the fall in AD by
preventing firms going bust and a steep increase
in unemployment
Fiscal stimulus, e.g. employment
subsidies; increased public expenditure
on health and on industries severely
affected, e.g. transport
Impact depends on how long pandemic lasts,
magnitude, range of measures, and business
and consumer confidence
Now test yourself
18 What policies might be appropriate if there was a global recession caused by a
pandemic?
244
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The regulation of transfer pricing
It has proved very difficult for governments to control transfer pricing,
see page 187, although attempts are being made to seek international
agreement to ensure that global companies pay a fair amount of tax in each
of the countries in which they operate. For example, tax payable on turnover
in each country might be levied.
Limits to government ability to control global
companies
Global companies may:
✚ be ‘footloose’, i.e. they can move easily from one country to another in
search of the lowest wage and other costs
✚ have a monopoly on technological and intellectual property
✚ threaten to withdraw investment.
Making links
The significance of transnational (global) companies was considered in Chapter 17
(see pages 186–187).
21 The role of the state in the macroeconomy
Measures to control global companies’
operations
Now test yourself
19 What is the main problem facing governments wanting to raise taxes from global
companies?
Answers available online
Problems facing policy-makers when
applying policies
Inaccurate information
✚ Forecasts are notoriously inaccurate, e.g. of the future rate of inflation.
This also applies to costs of major projects, like HS2.
✚ Estimates of past data for a variety of indicators are frequently revised
significantly in subsequent years, e.g. GDP and balance of payments on
current account.
Risks and uncertainties
Risk is present when future events occur with measurable probability,
whereas uncertainty is present when the likelihood of future events is
indefinite or incalculable. Uncertainties cannot be eliminated or insured
against.
Inability to control external shocks
Most of the external shocks described in Table 21.2 (see page 244) are difficult
to predict and, consequently, to allow for when applying policies. Therefore,
policies being followed may no longer be appropriate.
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21 The role of the state in the macroeconomy
Now test yourself
20 Identify three reasons that might make it difficult to determine the most
appropriate policies to deal with a global pandemic.
Answers available online
Summary
You should have an understanding of:
✚ public expenditure: current, capital and transfer
payments
✚ reasons for the changing size and composition of public
expenditure as a proportion of GDP
✚ the significance of differing levels of public expenditure
as a proportion of GDP
✚ taxation: progressive, proportional and regressive
taxes; direct and indirect taxation
✚ the effects of changes in direct and indirect tax rates
✚ the distinction between fiscal deficits and national
debts, and factors influencing their size
✚ macroeconomic policies in a global context.
Exam skills
As with the last chapter, some concepts previously
introduced are developed more fully in this chapter. The
material covered in this chapter is mainly macroeconomic
and so will be tested primarily in Paper 2 and in Paper 3 as
part of synoptic assessment.
As you have now reached the end of the course you
should have developed key skills to perform well. You
should remember those listed below when answering
questions in examinations. Examples from this chapter are
included.
✚ Knowledge skills: ensure terms are explained
precisely, identify key points, be able to draw basic
diagrams and label them accurately (e.g. definitions
of fiscal deficit, national debt, automatic stabilisers,
discretionary fiscal policy).
✚ Application skills: to score good application marks
you need to relate your answer to the context provided
and/or provide relevant examples. In the latter case
there might be a requirement to refer to a developed or
developing economy of your choice in essays. Generic
answers score few marks for this skill. Application
marks are also allocated to calculations. An example
from this chapter would involve the interpretation of
data on public finances.
✚ Analysis skills: ensure that your arguments are
developed in stages (a coherent chain of reasoning).
Analysis developed in this way scores higher marks
than two-stage explanations. If required or appropriate,
include a diagram to support your analysis — and
ensure that you explain it (e.g. use of AD and AS
diagrams to illustrate the impact of changes in fiscal
and monetary policy).
✚ Evaluative skills: to score good marks for evaluation
in essays it is important to make the point and explain
it using reasoned analysis as well as relating it to the
context of the question. For example, in considering
the effectiveness of an increase in income tax it could
be argued that this would reduce consumption and
therefore AD. However, this would not be the case if
other elements of AD increased.
Exam practice
1 a) In 2019, Ireland raised the VAT rate in the tourism
and hospitality industry from 9% to 13.5%. If the
demand for tourism and hospitality is price elastic,
what would be the effect on Ireland’s tax revenues?
A Rise by 4.5%
B Rise
C Remain constant
D Fall
[1]
b) Explain the likely effect on income distribution
of an increase in VAT on food.
[4]
2 Namibia moved up six positions in the 2019 Global
Competitiveness Report rankings.
a) Which of the following is most likely to cause
an increase in a country’s international
competitiveness?
A An increase in health and safety regulations
B An increase in trade barriers
C An increase in the skills of the workforce
D An increase in environmental regulations
b) Explain two reasons why a depreciation of
a country’s currency might not increase its
international competitiveness.
[1]
[4]
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3 Read the following material and answer the questions that follow.
Real GDP growth rate (%)
Unemployment rate (%)
Fiscal deficit (% of GDP)
2017
2020
2017
2021
2017
2020*
Germany
2.8
–8.8
3.8
4.6
1.2
–9.1
Italy
1.7
–14.0
1.3
10.7
–2.4
−12.8
Spain
2.9
–14.4
17.2
21.1
−3.0
−12.5
UK
1.9
–14.0
4.4
10
−2.4
–14.2
* Note: data for 2020 are forecasts
Extract: Impact of COVID-19 pandemic on UK public finances
Forecasts by the Treasury, the Office for Budget
Responsibility and the Bank of England suggested that in
2020, UK GDP would decline by between 8.6% and 14%.
However, this would be followed by an increase in GDP
of between 6.1% and 10.3% in 2021. Obviously this could
have a significant impact on unemployment, which could
increase by over 2 million, or 10% of the workforce, in 2020.
The public finances will be significantly affected by
the economic shock of the coronavirus outbreak. It is
difficult to predict the overall impact of the pandemic
and economic shutdown for the fiscal deficit in 2020–21
but one estimate is that it will be around £400 billion.
This reflects both the increase in public expenditure and
fall in tax revenues. Much will depend on the length of
the lockdown, whether there are further lockdowns,
how many businesses survive and the number of
unemployed. If there is long-term economic damage to
the economy then the structural deficit will increase.
Further, the national debt is expected to increase from
about 85% of GDP in 2019 to 100% of GDP in 2020–21.
Some of the increase in the budget deficit will be
the result of ‘automatic stabilisers’. For example,
unemployment benefits payments will rise, mitigating
the decline in household incomes and moderating the
slowdown.
In addition, the government provided a package of tax and
spending measures (discretionary fiscal policy), including:
✚ the Job Retention Scheme, under which workers of
any employer placed on the scheme could keep their
job, with the government paying 80% of their wage,
capped at £2500 per worker each month
✚ the Self-Employed Income Support Scheme under
which the self-employed received a taxable grant
worth 80% of their average income over the period
2017–19, up to £2500 per month
✚ increased funding for the NHS and other public services
✚ a holiday from business rates in 2020/21 for those
businesses in the retail, hospitality or leisure sector.
21 The role of the state in the macroeconomy
Table 1 Growth rates, unemployment rates and fiscal balances in selected countries
Source: https://researchbriefings.files.parliament.uk/
documents/CBP-8866/CBP-8866.pdf
Government support to the economy was largely aimed
at ensuring that the effect on the economy and the
budget deficit is temporary, rather than permanent.
a) With reference to Table 1, explain how an
increase in the UK’s fiscal deficit might affect its
national debt.
[5]
b) With reference to Table 1, examine the impact
of COVID-19 on output gaps in Germany
and Spain.
[8]
c) With reference to the information provided,
discuss the costs of the expected rise in
unemployment.[12]
d) With reference to Table 1 and your own
knowledge, discuss the view that a country’s
budget deficit should be reduced as quickly as
possible.[15]
e) Evaluate the likely microeconomic and
macroeconomic effects of increasing taxes to
reduce a country’s fiscal deficit.
[25]
Answers and quick quizzes online
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Glossary
Glossary
248
Term
Definition
Page
Absolute advantage
When a country can produce more of one product than another country can
with the same amount of resources.
187
Absolute poverty
When a person has insufficient resources to meet basic human needs.
207
Actual growth
The increase in real GDP.
107
Ad valorem taxes
A tax that is imposed as a percentage of the price of a product.
44
Asymmetric information
One party in a transaction has more or superior information compared to another. 55
Automatic stabilisers
Changes in government spending or in tax revenue that occur automatically,
without deliberate government action.
224
Balance of payments
A record of all financial transactions between one country and those in the rest
of the world.
197
Base year
Used to compare price levels in different time periods – it is given the number 100.
70
Behavioural economics
A method of economic analysis that applies psychological insights into human
behaviour to explain economic decision making.
46
Break-even level of
output
Where no supernormal profits or losses are made. In other words, is it that
output at which total cost is equal to total revenue and average cost is equal to
average revenue.
153
Buffer stock scheme
Designed to reduce price fluctuations and involves the buying and selling of
stocks to maintain price within agreed limits.
220
Capital and financial
accounts
The balance of payments shows long-term investments and short-term capital
flows.
197
Capital flight
When individuals and countries decide to transfer cash deposits to foreign
banks, or to buy shares in overseas companies or assets in foreign countries.
216
Capital flow
All the money moving between countries as a consequence of investment flows 186
into and out countries around the world.
Capitalist economic
system
Described as a free market economy in which resources are owned by the
private sector and prices are determined by supply and demand.
210
Cartel
A form of overt collusion. It is a formal agreement between a group of
producers that limit output in order to manipulate prices.
164
Ceteris paribus
When the effect of a change in one variable is considered, it is assumed that all
other variables are held constant.
11
Classical approach
The economy is self-adjusting if markets are free from government intervention.
If there is unemployment, wages fall until people can find work and full
employment is restored.
93
Collateral assets
Used as security for a loan.
98
Collusion
When firms collaborate with other firms in the market.
163
Command economy/
One in which resources are allocated by the state.
centrally planned economy
21
Comparative advantage
One country has comparative advantage over another in the production of a
good if it can produce it at a lower opportunity cost.
188
Concentration ratio
The proportion of the market supplied by the largest firms in that industry.
162
Constant returns to scale
An increase in the scale of production results in an exactly proportional
increase in output (the LRAC curve will be horizontal).
151
Consumer Price Index
The measure of inflation used for inflation targeting in the UK; it measures the
weighted average of items on which people spend their money.
69
Consumer surplus
The difference between consumers’ willingness to pay for a product and the
market price.
42, 187
Corporation tax
A tax on firms’ profits.
87, 166
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The measure of the responsiveness of quantity of one product (Y) to a change
in the price of another product (X).
31
Currency war
When nations seek to deliberately depreciate the value of their domestic
currencies in order to stimulate their economies.
202
Current account
The balance of payments shows a country’s day-to-day transactions with other
countries.
197
Current account deficit
The balance of payments occurs when more money is flowing out of the
country than is flowing in.
79, 198
Current account surplus
The balance of payments occurs when more money is flowing into the country
than is flowing out.
79, 198
Cyclical deficit
A proportion of a country’s budget deficit which reflects changes in the
economic cycle.
241
Decile
A 10% chunk of an ordered set of data.
113
Demand
How much is demanded at each price over a certain period of time.
24, 142
Demand-side policy
Any deliberate action taken by governments or monetary authorities to shift the
AD curve.
117
Dependency ratio
An age-population ratio of dependants (those younger than 15-64). Data are
shown as proportion of dependents per 100 working-age population.
175
Derived demand for
labour
The demand for labour is dependent on demand for the final goods and
services that the workers produce.
173
Discretionary fiscal policy When the government intervenes in the economy by changing taxes or
government expenditure.
240
Diseconomies of scale
An increase in the scale of production results in a less than proportionate
increase in output, so causing a rise in LRAC.
151
Disposable income
84
The household income available from employment, private pensions,
investments and welfare benefits after direct taxes such as income tax, national
insurance contributions and council tax has been deducted.
Diversification
A firm involves increasing the range of goods it sells or the market in which it
sells as a means of reducing risk.
150
Division of labour
When the work is split up into small, specialised tasks.
18
Dumping
A product is sold in a foreign country for less than the cost of making the
product; under the rules of the WTO, this practice is illegal.
190
Dynamic efficiency
An increase in productive efficiency over time which is related to technological
advances and innovation.
157
Economic decline
A decrease in the productive capacity of the economy indicting a decrease in
real output.
17
Economic growth
An increase in the productive capacity of the economy indicting an increase in
real output.
16
Economically inactive
People not in education, employment or training and who are not actively
seeking work within the last 4 weeks and who are unavailable for work within
the next 2 weeks.
75
Economies of scale
When an increase in the scale of production results in a fall in long-run average
costs.
130
Emigration
People exit a country for long-term stay.
76
Equilibrium
A balancing point where there is no tendency to change.
99
Equilibrium (price and
quantity)
Determined by the interaction of the supply and demand curves. The
equilibrium price and quantity would not change unless there was a change in
the conditions of demand and supply.
38
Excess demand
The quantity demanded is greater than the quantity supplied at the existing price.
39
Excess supply
The quantity supplied is greater than the quantity demanded at the existing price.
39
Exchange rate
The price of one currency in terms of another.
89
Expenditure-reducing
policies
Designed to reduce aggregate demand.
199
Glossary
Cross elasticity of
demand (XED)
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Glossary
250
Expenditure-switching
policies
Designed to alter the pattern of a country’s expenditure between domestic and
imported goods and services.
199
External benefits
Benefits in excess of private benefits that affect third parties who are not part
of the transaction.
52
External costs
The costs in excess of private costs that affect third parties who are not part of
the transaction.
50, 187
External economies of
scale
The long-run average costs of production decrease for firms as a whole industry
increases in size.
External growth
External growth involves the expansion of a business by merger or takeover.
132
Externalities
Costs and benefits to third parties who are not directly part of a transaction
between producers and consumers.
50
Factors of production
Resources of a country, which include land, labour, capital and enterprise.
13
Financial crowding out
When the expansion of the state sector is financed through increased
government borrowing. This causes an increased demand for loanable funds,
which drives up interest rates and crowds out private sector investment.
235
Firm
An organisation whose function is to combine resources (factors of production)
for the production and supply of goods and services.
130
Fiscal policy
The government’s position or set of decisions on government spending and
taxation.
88
Fixed factor
A factor of production which cannot be changed in the short run.
147
Fixed incomes
For many groups, such as university students and pensioners, their income is
fixed so they do not usually enjoy wage increases in line with inflation. They
suffer when the cost of living rises.
72
Foreign direct investment When a company in one country establishes operations in another country or
(FDI)
when it acquires assets or a stake in an overseas company.
185
Free market economy
It refers to an economic system in which prices are determined by supply and
demand with no government intervention.
20
Free rider problems
Once a product is provided, it is impossible to prevent people from using it and,
therefore, impossible to charge for it.
54
Game theory
The study of strategies used to make decisions.
164
GDP per capita
Total GDP divided by population; it provides a better indicator of living
standards.
66
Gini coefficient
A numerical calculation of inequality based on the Lorenz curve with a value of
zero being perfect quality and a value of 1 representing prefect inequality.
209
Global supply chains
Worldwide networks of companies and their suppliers, manufacturers,
warehouses, distribution centres and retailers. The supply chain involves the
acquisition of raw materials, which are then transformed, manufactured and
delivered to customers.
80
Global trade imbalances
Some countries have large current account deficits while other countries have
large current account surpluses.
200
Globalisation
The increased integration between countries economically, socially and
culturally.
185
Government failure
When government intervention results in a new welfare loss.
62
Human capital
It refers to the knowledge and skills of a workforce that determine its
productivity. Human capital may be improved by education and training.
75
Immigration
People enter a country for long-term stay.
76
Incentive
A measure designed to motivate workers or businesses, e.g. higher pay for
working harder, more profits if businesses are run successfully.
123
Incidence of tax
How the burden of a tax is distributed between different groups, e.g. producers
and consumers.
44
Income
A flow of money.
97
Income elasticity of
demand (YED)
The measure of the responsiveness of quantity demanded of a product to a
change in real income.
32
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A number shown relative to another number in percentage terms, so the actual
figures are removed and only the relative difference is shown.
70
Indirect taxes
Taxes on expenditure.
43
Inflation target
In the UK, the government tasks the MPC with keeping inflation low and stable. At
present, the inflation target is 2%.
120
Infrastructure
Capital assets that are designed to help an economy to function efficiently, e.g.
motorways, energy supply, internet connection.
123
Injections
Additions to the circular flow of income. These inputs comprise investment,
government spending and export income.
98
Interdependence
The actions of one agent depend on the actions of another.
162
Interest rate
Cost of credit (borrowing) or the reward of saving.
85
Internal economies of
scale
The long-run average costs of production decreases as firm increases in size.
149
International
competitiveness
The degree to which a country’s goods and services can be sold on
international markets.
72, 204
Investment
An increase in the capital stock.
111
J-curve effect
When a country’s trade balance initially worsens following a devaluation or
depreciation of its currency and only improve in the long run.
203
Jobseeker’s Allowance
Money paid to people who are willing and able to work but are not currently in
employment.
74
Joint venture
An enterprise undertaken jointly by two or more firms which retain their distinct
identities.
220
Keynesian approach
The economy may be in equilibrium with unemployment, and governments may
need to stimulate AD to achieve long-term growth and employment.
93
Labour force
Those aged 16 and over who are either employed or unemployed.
74
Law of diminishing
marginal returns
As more units of a variable factor are added to a fixed factor, the increase in
output (marginal product) eventually falls.
147
Legal monopoly
One firm dominates 25% or more of the market.
165
Long run
A time period in which all factors of production can be varied.
37
Lorenz curve
A graphical representation of income distribution.
208
Marginal analysis
This involves consideration of the impact that small changes have on the
current situation; the rational decision maker will only decide on an option if the
marginal benefit exceeds the marginal cost.
15
Marginal cost (MC)
The extra cost of making one more unit of output. MC is always positive; it is the
gradient of the total cost curve.
137
Marginal product
Extra output when one more factor of output is added.
147
Marginal productivity
The change in output resulting from the addition of one more unit of the variable 221
factor.
Marginal profit
The extra profit gained from selling one more unit. When marginal profit is zero,
the firm is maximising profit
Glossary
Index number
137
Marginal profit = MR – MC.
Marginal revenue (MR)
The change in TR from selling one more unit of output. It is the gradient of the
TR curve.
137
Marginal utility
The change in total utility from consuming a unit of a product.
26
Market failure
When the forces of supply and demand (market forces) do not result in the
efficient allocation of resources.
49
Marshall-Lerner condition
States that a depreciation or devaluation of the currency will only lead to an
improvement in the trade balance if the sum of the price elasticities of the
demand for imports and exports is less than -1.
202
Maximum price
The price, usually set by the government, which makes it illegal for firms to
charge more than a certain price for a given quantity of a product.
59
Maximum revenue/
revenue maximisation
The output at which total revenue is at a maximum.
141
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Glossary
Median income
The income level in the middle of a list of ranked incomes, i.e. it is the midpoint
between what the highest 50% of earners are paid and what the lowest 50% of
earners are paid.
177
Migration
The movement of people from one country to another. Immigration, emigration
and the overall balance between the two in a country is called net migration.
76
Minimum efficient scale
(MES)
The output where the long-run average costs first reach a minimum.
150
Minimum guaranteed
price
The price, usually set by the government, which is guaranteed to producers.
60
Mixed economy
A combination of a free market economy and a command economy.
21
Money
Anything that is used as a means of exchange for goods and services.
20
Monopsony
A sole buyer of a product or service.
190
Moral hazard problem
When the person/firm/country taking the risk may not be the one who bears
the consequence of that risk.
224
Multiplier
The process by which a change in an injection (government expenditure,
investment or exports) causes a more than proportionate change in national
income.
101
National debt
241
The total sum owed by a government to holders of governments bonds. It
represents the total of a government’s outstanding debt that it has accumulated
over time.
National Living Wage
A wage high enough for workers to have a normal standard of living.
243
Nationalisation
When private firms are taken into public or state ownership. The government
may purchase all the privately held shares.
183
Net exports
The difference between the value of exports and the value of imports.
89
Non-profit organisations
Private firms for which the primary motive is not profit, although they do usually
have to cover their costs.
132
Non-renewable resources
Resources are those where continued consumption will eventually result in their 14
exhaustion.
Normative economic
statements
Subjective statements based on value judgements and cannot be proved or
disproved.
12
Offshoring
Companies transferring manufacturing to a different country.
186
Opportunity cost
The next best alternative that is forgone when a choice is made.
14, 189
Organic growth
Organic growth refers to the increase in output and sales of a business using
internal resources.
132
Output gap
The difference between actual GDP (or growth) and potential GDP (or growth).
107
Pay-off matrix
A simple two-firm, two-outcome model.
164
Positive economic
statements
Objective statements based on evidence or facts that can be proved or
disproved.
11
Potential growth
The level of output that an economy could produce at a constant rate of
inflation. It is associated with a rightward shift in the LRAS curve.
107
Price elasticity of
demand
This measures the sensitivity of the quantity demanded of a product to a
change of its own price.
27
Price elasticity of supply
The measure of the responsiveness of quantity supplied for a product to change 35
in its price.
Price maker
A firm that has sufficient market power to influence the price of the good it is
selling and faces a downward sloping demand curve.
141
Price taker
Has to offer its product at the same price as everyone else.
141
Primary product
dependency
Occurs in countries where the value of production of primary products
accounts for a large proportion of GDP, exports and employment.
214
Principal-agent problem
When the aims of a firms’ owners diverge from those of the managers, which
may lead to a conflict between the aims and the policies of these two groups.
131
Prisoner’s dilemma
A model used in game theory to question whether firms might not collude, even 164
if it appears that it is in their best interests to do so.
252
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Direct benefits to producers and consumers for producing and consuming a
product.
52
Private costs
The direct costs to producers and consumers for producing and consuming a
product.
50
Private sector
The part of the economy in which the assets are owned by individuals or
groups, and not the government.
131
Producers’ surplus
The difference between the price the produces received and the cost of supply
(in other words, profit).
42
Production possibility
frontier
The maximum potential output of an economy when all resources are fully
employed.
15
Profit satisficing
Making enough profit to keep shareholders happy, after which managers can
pursue other objectives.
139
Property rights
The exclusive authority to determine how a resource is used, whether that
resource is owned by government or by individuals. Property rights are
ownership rights.
217
Protectionism
Methods of restricting free trade.
195
Public expenditure
The expenditure by central government, local authorities and public sector
organisations.
223
Public goods
Those goods that have the two key characteristics of being non-rivalrous
(amount available does not fall after one person’s consumption) and nonexcludable (cannot prevent anyone from consuming them).
54
Public sector
The part of the economy owned by society as a whole and regulated/provided
by the government.
131
Purchasing power
parities (PPP)
Used to compared GDP in different countries and take into account the cost of a 67
‘basket of goods’ that could be bought in each of the countries being compared.
Pure monopoly
Only one firm is supplying the good or service.
Quality of life
A measure of living standards that takes into account more than just income (or GDP). 67
Quantitative easing
Central banks buying securities from financial institutions, which has the effect
of increasing the money supply.
243
Quantity theory of money
There is a direct and proportionate relationship between changes in the money
supply and the price level.
243
Quotas
Limits on the quantity of a product imported.
196
Real
This means inflation has been taken into account. Real values are sometimes
referred to as ‘constant’ prices. If inflation is left in the figures they are known
as ‘nominal’ or ‘current’.
66
Real GDP
The output of an economy, with the effects of inflation removed.
107
Real terms
Figures where inflation has been taken into account.
72
Recession
When an economy has two consecutive quarters (lasting three months) of
negative economic growth.
66
Relative poverty
People are classified as relatively poor in a country if their incomes are below
the average income.
207
Renewable resources
Resources that can be replaced naturally after use and whose stock levels can
be maintained at a certain level.
14
Resource crowding out
When the economy is operating at full employment and the expansion of the
public sector means there is a shortage of resources in the private sector.
235
Scarcity
Resources are finite but wants are infinite, thereby creating scarcity where
choices must be made.
13
Sectoral imbalance
An imbalance in the three main sectors of the economy – primary, secondary
and tertiary.
190
Short run
A time period in which there is at least one fixed factor of production.
37
Shut-down point
Where price is equal to average variable cost (AVC). IF AVC is not covered then
the firm will close down in the short run.
153
Social benefits
The sum of private benefits and external benefits.
52
Social costs
The sum of private costs and external costs.
50
Glossary
Private benefits
165
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Glossary
Spare capacity
Where there are unemployed resources in an economy.
93
Specific taxes
A set amount per unit of the product.
44
Stakeholder
Any person or group that has a vested interest in a firm, including consumers,
suppliers, owners, the government and other firms already supplying in the market.
166
Structural deficit
The fiscal deficit that remains when the economy is normal, or when the output
gap is zero.
241
Subjective happiness
A measure of how people feel about themselves.
68
Subsidy
A grant from the government that has the effect of reducing costs of
production.
45
Sunk costs
Unrecoverable costs, i.e. costs that cannot be recovered if the firm closes down.
170
Supply
How much is supplied at each price over a certain period of time.
34
Supply of labour
The number of workers willing and able to work at any given wage.
173
Sustainable growth
Growth that does not compromise the welfare of future generations.
126
Symmetric information
Both parties in a transaction have the same information.
55
Tariffs
Taxes on imported goods.
195
Terms of trade
Measures the price of a country’s exports relative to the price of its imports.
189
The law of diminishing
marginal utility
As consumption of a product is increased, the consumer’s utility increases, but
at a decreasing or diminishing rate.
26
Tight monetary policy
Designed to reduce the rate of inflation by (1) raising interest rates, (2) reversing
quantitative easing and (3) changing the criteria for giving loans to make it more
difficult for firms and consumers to borrow money.
73
Total cost (TC)
The cost of producing a given level of output. In the short run, it is calculated by
adding the total fixed cost to the total variable cost.
137
Total revenue (TR)
The value of goods sold by a firm; it is calculated by multiplying price by quantity 30, 137
sold.
Total utility
The amount of satisfaction a person derives from the total amount of a product
consumed.
26
Tradable pollution permits Rights to sell and buy actual or potential pollution in artificially created markets.
61
Trade balance/trade
in goods and services
balance
The value of exports minus the value of imports.
190
Trade creation
Trade created as a result of the formation of a free trade agreement between a
group of countries that have established a trading bloc.
194
Trade diversion
When trade is diverted from a more efficient exporter towards a less efficient
producer.
193
Trade-off
When an objective is achieved only at the expense of some other objective.
125
Trading blocs
Groups of countries that agree to reduce or eliminate trade barriers between
themselves.
193
Transfer pricing
The price one part of a company charges for the products and services it
provides to another part of the same company. This system enables TNCs to
declare profits in the country in which corporation tax is lowest.
187
Unit labour costs
The average cost of labour per unit of output and are calculated as the ratio of
total labour costs to real output.
204
Utility
The level of satisfaction a consumer receives from the consumption of a
product or service.
24
Wealth
A stock of assets.
97
Wealth effect
The effect on spending when asset prices change.
85
Weights
70
The proportion of income spent on items. They are used to ensure that the
percentage change in price reflects the impact on the average family in terms of
spending.
Withdrawals
Leakages out of the circular flow of income. These comprise savings, taxation
and the money spend on imports.
98
254
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