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Constantine Ziogas
Economics
F O R T H E I B D I P LO M A
2nd edition
3
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Introduction for the student
n This book has been written specifcally or the student studying Higher or
Standard Level Economics or the IB Diploma Programme.
n The study guide is organized in boxes and bullet points, and also includes
tips to help your work. Explanations are provided or all points presented.
n Essay-style questions have been included to help you ensure that you have
covered all the material.
n The glossary covers every term ound in the syllabus and will be useul to
you both or reerence and as a revision source.
Constantine H. Ziogas
Contents
Scarcity
Economics as a discipline would not exist without scarcity. n ot to u nd ertake them . Th e people who d o so are called
This is the u nd am ental problem that all societies ace. I t reers en trepren eu rs. Entrepreneu rship reers to the willingness
to the excess o hu man wants over what can actu ally be and ability o certain ind ivid u als to take risks and to
prod u ced to u l ll these wants. H u man wants are u nlim ited . On m obilize the remaining actors o prod u ction.
the other hand , the m eans o u l lling these hu man wants are
lim ited becau se the resou rces available are lim ited . As a resu lt, Related concepts
choices have to be mad e. I n ad d ition to the id ea o physical capital alread y m entioned ,
For example, society cannot enjoy all the books and all the it is u seu l to inclu d e natu ral capital and hu man capital.
tables it wants becau se the nu m ber o trees requ ired to n Natural capital
prod u ce these two good s is lim ited . I t som eh ow has to d ecid e N atu ral capital can be thou ght o as natu ral resou rces
how many books and how many tables it wants to prod u ce. I which may be improved u pon or may be d epleted . Thinkin g
m ore tables are prod u ced then ewer books will be enjoyed and in term s o natu ral capital can easily accom m od ate another
vice versa. We d e ne as the opportu nity cost o a choice, the related concept, su stainability, which reers to the id ea o
valu e o th e next best alternative sacri ced . I , or exam ple, by preserving and even increasing or improving u pon the
giving (or m ore correctly, allocating) a tree to table prod u ction, available stock o natu ral resou rces.
one extra table is prod u ced bu t 2 5 books need to be sacri ced ,
n H uman capital
we say that the opportu nity cost o prod u cing one m ore table is
2 5 books. Labou r may also be improved u pon, in that the labou r orce
may becom e m ore prod u ctive. The term hu man capital
Resources (factors of production) reers to the ed u cation, training and skills em bod ied in the
labou r orce o a cou n try. Even i the size o the labou r orce
Resou rces are also reerred to as actors o prod u ction. They
o an economy is constant over tim e, th e stock o hu man
inclu d e all inpu ts u sed in the prod u ction o a good or service.
capital may increase.
They are typically separated into the ollowing ou r categories.
n Land and raw materials (natural resources) Other useful introductory terms
These are inpu ts into prod u ction that are provid ed by Social sciences: d isciplines that systematically stu d y hu man
natu re, or example agricu ltu ral and non-agricu ltu ral land , behaviou r rom d ierent perspectives. Econom ics, psychology,
orests, pastu res, m ineral d eposits, oil, natu ral gas, lakes anthropology, political science, sociology and history are all
and rivers. The world s land area and raw materials are consid ered social sciences.
lim ited . Som e resou rces, su ch as oil and coal d eposits, are
Models: sim pli ed and oten simplistic representations o
non-renewable: i they are u sed now, they will not be
reality. They are constru cted to stu d y a phenom enon and
available in the u tu re. Other resou rces, or example orests
throu gh it explain past observations and perhaps pred ict u tu re
(tim ber) and the stock o sh, are renewable.
ones. Evalu ating the appropriateness or u seu lness o a speci c
n Labour (human resources) m od el is not easy.
Labou r inclu d es all orm s o hu man inpu t, both physical N ormative economic statem ents: valu e ju d gm ents, opinions
and m ental, into cu rrent prod u ction. The labou r orce is, at and statem ents that cannot be alsi ed or proven rig ht or
any point in tim e, lim ited both in nu m ber and in skills. The wrong; statem ents that cannot be tested against act (d ata).
total nu m ber o people available or work is reerred to as Examples are: I nf ation is rising too ast or I ncom e d istribu tion
the labou r orce or working popu lation. is not air. Key phrases in normative statem ents inclu d e ou ght
n Capital to be, shou ld be, too m u ch, too little, is air, is u nair, and
Physical capital inclu d es manu actu red resou rces; in other so on.
word s, good s u sed to prod u ce other good s. The world has Positive econom ic statem ents: statem en ts that ca n be
a lim ited stock o capital (lim ited su pply o actories, alsi ed or proven , at lea st in prin ciple, rig h t or wron g . Th ey
machines, tools and other equ ipm ent). N ote that the ca n be tested a ga in st a cts (d ata ), or exam ple: A m in im u m
m eaning o capital in econom ics is d ierent rom that u sed wa g e policy will in crea se u n em ploym en t am on g u n skilled
in ord inary speech where people reer to m oney as capital. workers.
n Entrepreneurship Economic goods: good s and services that requ ire scarce
Entrepreneu rship is related bu t not id entical to resou rces to be sacri ced in ord er or them to be prod u ced .
managem ent. When a new ventu re is being con sid ered , Free goods: in contrast to econom ic good s, ree good s have a
risks exist. They involve the u nknown u tu re. Som eone m u st zero opportu nity cost o prod u ction. (There are very ew
assess these risks and make ju d gm ents abou t whether or real-world exam ples, perhaps sea water and air.) N ote that
1
Foundations o economics
good s available at a zero price are not ree in the econom ists Ceteris paribus: a Latin phrase that m eans all other things
sense i scarce resou rces have been u sed u p to prod u ce them . remaining constant.
Competitive market: a market where there are very many small Rationality: in econom ics rationality is taken to imply
f rm s, the good is hom ogeneou s (it is consid ered id entical pu rposeu l behaviou r and , m ore specif cally, u tility-maxim izing
across f rm s by consu m ers) and nothing prevents a new f rm consu m ers and prof t-maxim izing f rm s.
rom entering the market or an existing f rm rom exiting.
Three fundamental questions provid e answers to the three u nd am ental qu estions. For
exam ple, the market can d eterm ine:
Scarcity necessitates choice. As a resu lt all societies,
ind epend ently o their level o econom ic d evelopm ent or the n whether this good or that good will be prod u ced and in
econom ic system ad opted , m u st answer the ollowing three what qu antities
qu estions. n which prod u ction technology a f rm shou ld u se to prod u ce
n What (which good s and services) will be prod u ced and in a good or a service
what qu antities? n how m u ch in com e the owner o each actor o prod u ction
n H ow will each good or service be prod u ced (u sing, or will earn.
exam ple, a labou r-intensive or capital-intensive tech nology)? Econom ics is th e stu d y o ma rkets: their su ccesses and th eir
n For whom will good s and services be prod u ced ? (H ow will ailu res. Qu estion s o resou rce a llocation are in vestigated in
incom e be d istribu ted ?) econom ics. Taking th e exam ple given earlier, econom ics
investigates how many workers a nd h ow many trees will be
Cou n tries d evelop their own set o institu tions that answer
allocated to the prod u ction o tables, an d h ow many workers
these three qu estions. H ow these institu tions d o this d epend s
an d how many trees will be allocated to th e prod u ction o
on the econom ic system th e cou ntry has ad opted . An econom ic
books. Given a set o resou rces (that is, a specif c am ou nt o
system can be broad ly d ef ned as the institu tional ram ework
labou r a nd trees) th ere a re variou s possible a llocation s. Each
within which econom ic activity takes place. I t is easy to
allocation lead s to som e am ou nt o tables an d som e am ou n t o
distingu ish two extrem e cases bu t in the real world there are
books prod u ced an d consu m ed . N ot all o th ese allocation s are
many variations. The two extrem es are market econom ies and
best or society. Econom ics stu d ies the allocations that resu lt
com mand econom ies, and between these extrem es are m ixed
rom th e operation o th e ma rket m echan ism and th en
econom ies.
exam ines wh ether they answer th e three u n d am en tal
n A market economy is one where households and frm s, each qu estions in the best possible way or n ot. Som etim es we will
acting in their own sel-interest and through their interaction see that th e ma rket as a m echan ism su cceed s and resu lts in
in markets, provide answers to the three questions. the best possible answers or society to th ese qu estions. M any
n A command economy is one where the state provid es the other tim es, th e market as a m echanism a ils. When it a ils it
answers. au tomatically creates a role or th e governm ent to step in and
n A mixed economy is one where both markets and the state attempt to correct the market a ilu re. H owever, as we will
provid e the answers. see, th ere is no a priori g u arantee that the a nswers that
governm ents provid e are n ecessarily better a s g overnm ent
Central to the id ea o a market economy is the concept o a ailu re is also possible.
market. A market shou ld be thou ght as a m echan ism that can
2
Fou n d ati on
1 Microeconomics
s o econ om i cs
Explanation
Points outside the PPC These are unattainable combinations o output: more or better resources and/or improved technology would be
necessary to produce such combinations.
Points on the PPC These are attainable and ecient combinations as there is no waste o scarce resources.
Points inside the PPC These are attainable but inecient combinations as scarce resources are not being used, so they are wasted.
3
Foundations o economics
Central themes
n H ow much o a role should markets have and how much These points are not new. They only repeat what still is,
o a role should governm ent have? ater m ore than 2 0 years, perhaps the m ost wid ely u sed
M arkets can be consid ered as a m echanism lead ing to d ef nition o su stainable d evelopm ent: Developm ent that
som e allocation o scarce resou rces. There is no gu arantee m eets the need s o the present withou t comprom ising the
that the market ou tcom e is the best ou tcom e rom societys ability o u tu re generations to m eet their own need s.
point o view. For example, markets may lead to too m u ch n Given scarcity, should we only care about efciency or
pollu tion, or not enou gh libraries; they may lead to should equity also be a goal?
u nacceptably high rates o u nemploym ent or to inad equ ate I s there perhaps a trad e-o between these two g oals? What
health care or lower-incom e hou sehold s; they may lead to d o we m ean in econom ics by the term ef ciency? What
excessively risky lend ing practices by f nancial institu tions d oes equ ity m ean? There has been m u ch d ebate on
or to not enou gh basic scientif c research. On the other whether policies that prom ote equ ity hu rt or also prom ote
hand , even i th ere is a role or the governm ent to play, can ef ciency. Does the answer d epend on th e types o policy
we g u arantee that intervention will improve matters? What that are em ployed to ensu re equ ity?
is the extent and the type o in tervention that is necessary?
n I an economy grows, is there economic development?
At what cost?
I s there perhaps too m u ch attention being paid to how ast
n What is sustainability and why has it emerged as such
an econ omy grows? When d oes econom ic growth lead to
an important concept?
d evelopm ent? Can there be d evelopm ent with ou t growth ?
The concept is closely bu t not exclu sively related to the To what extent can one conf d ently claim that an ad vanced
environm ental eects o cu rrent patterns o prod u ction economy is a d eveloped economy? Shou ld we ocu s on
and resou rce allocation. The World Developm ent Report cou ntry totals or shou ld we pay closer attention to
2 01 0 states: variations within a cou ntry?
Developm ent that is socially, econom ically and
environm entally su stainable is a challenge,
even withou t global warm ing. Econom ic growth
is need ed , bu t growth alone is not enou gh i it
d oes not red u ce poverty and increase the
equ ality o opportu nity. And ailing to
saegu ard the environm ent eventu ally threatens
econ om ic and social achievem ents.
4
1.1 Competitive markets: demand and supply
M icroeconom ics is concerned with the ind ivid u al parts o the economy. I t is concerned with
the d emand an d su pply o particu lar good s, services and resou rces. I n other word s, it ocu ses
Markets
A market can be d ef ned as an institu tion which perm its market and the oreign exchange market are exam ples o
interaction between bu yers and sellers. I t can also be f nancial markets.
consid ered a m echanism that d eterm ines which good s and The interaction o consumers and producers (frms) in product
services will be prod u ced in an economy and so how scarce markets determine the market price o each product. Changes in
resou rces will be allocated . market conditions thereore result in changes in market prices.
Several d ieren t types o market exist beyond prod u ct markets These set o a chain o events leading to more or less o the good
where g ood s and services are being exchan ged . Factors o being produced and so to a new allocation o scarce resources.
prod u ction are trad ed in actor markets. The labou r market is To analyse how markets u nction we need to exam ine the
an example o a actor market. Th e stock market, the bond behaviou r o consu m ers and o prod u cers.
5
1 Microeconomics
A good is a normal good if: A good is an inferior good if: Figure 1.1.3 The effect of an increase in the price of a complement
an increase in income an increase in income There may also be changes in the price of substitutes. Two
leads to an increase in leads to an decrease in
good s are consid ered su bstitu tes if they are in competitive
its demand its demand
consu mption and consu m ers typically bu y one or the other as
or, more generally, or, more generally,
the good s satisfy the sam e need or want. Exam ples are coffee
if income and demand change if income and demand change
in the same direction in opposite directions and tea or Pepsi Cola and Coca Cola. I f a su permarket increases
the price of Pepsi Cola then it is expected that the d emand for
n Changes in the price of other related g ood s will have an Coca Cola will increase. More generally, if g ood X and good Y
impact on d emand . First lets consid er a chan ge in th e price are consid ered close su bstitu tes then an increase in the price of
of complements. Two good s are consid ered complem ents if good Y will lead to an increase in the d emand for X. Demand
they are often consu m ed together. For example, for many for X will shift to the right.
people coffee and su gar are complem ents becau se they
Price per unit (P)
D2 D1
D1 D2
0 0
Quantity demanded per period (Qd) Quantity demanded per period (Qd)
Figure 1.1.2 The effect of an increase in income on a normal good and on an inferior good
6
1 Microeconomics
Price per unit (P)
movement along
if the price of the good changes D(P)
the demand curve
We have a:
shift of the if any of the other factors affecting demand changes D( Y, Ps, Pc, T ) (where Y denotes income,
demand curve Ps stands for price of substitutes, Pc stands for price and T stands for tastes)
oer per period, ceteris paribus. Ceteris paribus m eans that all S
other actors aecting supply are assum ed constant.
The relationship between price per u nit and qu antity su pplied
per period is d irect (positive), m eaning that at higher prices
P2
prod u cers will be willing to oer m ore per period .
This positive relationship between price per unit and quantity
supplied per period o time is oten reerred to as the law o
supply. The law o supply states that i the price o a product
P1
increases then quantity supplied per period is expected to increase.
A supply curve shows the direct relationship between the price per
unit o a good and the quantity supplied per period. It is typically
upward sloping. Price per unit is measured on the vertical axis
and quantity supplied per period on the horizontal axis.
A su pply cu rve may reer to an individu al f rm or to the market.
The market supply curve is the horizontal sum mation o the 0 Q1 Q2
su pply curves o an individual f rm . This m eans that at each Q u a n tity su p p li ed p er p eri o d (Q s)
price we ad d the quantities su pplied by each f rm . So, i a
market consists o 1 00 identical frm s and each is willing to Figure 1.1.5 A typical market supply curve
7
1 Microeconomics
S2 S1
S2
S1
P2
P
P1
0 Q2 Q1 0 Q
Q u a n tity su p p l i ed p er p erio d (Q s) Q u a n ti ty su p p li ed p er p eri o d (Q s)
8
1 Microeconomics
costs and lead to an increase in su pply and a shit o the n Changes in expectations aect su pply. For exam ple, the
su pply cu rve to the right. expectation that the price will be higher in the u tu re may
cau se su pply o a good to d ecrease now, shiting its su pply
The supply decision is predominantly affected by changes in cu rve to the let.
production costs.
n Changes in other actors can be signifcant. For obvious
Production costs If the wages paid decrease, production reasons, weather conditions aect the supply o arm
can change if: costs will decrease and supply will products. Floods in Australia, a heat wave in Russia or drought
the price of an increase, shifting the supply curve to the
in Brazil will adversely aect the world supply o wheat,
input changes right (and vice versa)
technology If technology improves, production costs
changes will decrease and supply will increase, Supply curves may be drawn as straight lines or curved;
TIP
shifting the supply curve to the right they may or may not start from the vertical (or horizontal)
(and vice versa) axis. Typically, they are upward sloping.
productivity If productivity increases, production
changes costs will decrease and supply will decreasing it and shiting its supply curve to the let. A major
increase, shifting the supply curve to the accident, a terrorist act or a war may aect the supply o oil.
right (and vice versa)
an indirect tax If an indirect tax is eliminated, Shifts of supply versus movements along a
is imposed or production costs will decrease and
supply curve
eliminated supply will increase, shifting the supply
curve to the right (and vice versa) M any stu d ents make m istakes over this becau se th ey d o not
get into the habit o d istingu ishing between su pply and
a subsidy is If a subsidy is granted, production costs
granted or will decrease and supply will increase, qu an tity su pplied . Su pply changes (and on a d iagram th e
eliminated shifting the supply curve to the right su pply cu rve shits) when any d eterm inant other than the price
(and vice versa) o the good changes, ju st as in the case o d emand . For
example, a change in the price o a raw material will change
n A change in the price o a good that is jointly su pplied will su pply and shit the su pply cu rve to the right or to th e let.
have an eect on su pply. This is best u nderstood through Qu antity su pplied changes when the price o the good changes
an example. I a f rm prod uces m u tton it is jointly produ cing and resu lts in a m ovem ent along th e su pply cu rve. For example,
wool. I the price o m u tton increases in the market this f rm i the price o a good increases then it is qu antity su pplied that
will have an incentive to increase the qu antity su pplied o increases. Su pply and its graphical representation will n ot be
m utton, bu t at the sam e tim e the supply o wool will aected . There is only a m ovem ent along the su pply cu rve.
increase and its supply curve will shit to the right.
n A change in the price o a good in competitive su pply will movement along if the price of the good
the supply curve changes D(P)
have an eect. This is also best u nd erstood throu gh an
example. Assu m e a arm er with a f xed am ou nt o land u ses if any of the other factors
it to prod u ce lem ons and orang es. I the price o oranges affecting supply changes D(Pf,
increases then this arm er will have the incentive to Tech, Prod, Pj, Pc, Tx, Sub, etc.)
increase th e qu antity su pplied o oranges so the su pply o We have a: shift of the (where Pf denotes price of factors
lem on s will d ecrease, shiting that su pply cu rve to th e let. supply curve like labour, Tech stands for
technology, Prod for productivity,
n Changes in the size o the market (the nu m ber o f rm s) Pj for prices of jointly produced
aect su pply. As m ore f rm s join a market, or example, goods, Pc for goods in
su pply will tend to increase, sh iting the su pply cu rve to competitive supply, Tx for indirect
the righ t. taxes, Sub for subsidies)
Equilibrium
Price and output determination in a I t ollows that there will be no tend en cy or th e price to chang e
competitive market i there is neith er excess su pply n or excess d eman d in the
market. This requ ires that qu antity d eman d ed per period at
The price at which a good will be sold in a competitive market that price is equ al to qu a ntity su pplied . Th is price is th e
will be determined by the interaction between consumers and equ ilibriu m price a nd the correspon d in g qu an tity is the
producers; in other words, by the interaction o demand and supply. equ ilibriu m qu a ntity.
I at some price there is excess supply (i quantity supplied per A price is an equilibrium price if quantity demanded is
period exceeds quantity demanded) then the price will tend to drop. equal to quantity supplied, so there is neither excess
I at some price there is excess demand (i quantity demanded per demand nor excess supply.
period exceeds quantity supplied) then the price will tend to rise.
9
1 Microeconomics
We say that the market clears or that the market Reerring to Figu re 1 .1 .7, we can answer the ollowing qu estions.
is in equilibrium. n Cou ld P1 be the equ ilibriu m price?
At P1 consumers are willing to buy Qd1 units per period while frms
Price per unit (P)
S are willing to oer Qs1 units per period. Quantity supplied per period
is greater than quantity demanded. There is excess supply equal to
H F Qs1 2 Qd1 5 HF units per period which will create pressure or the
P1 price to all. Since excess supply creates a tendency or the market
price to all, it ollows that P1 is not an equilibrium price.
n Cou ld P2 be the equ ilibriu m price?
E
P At P2 consu m ers are willing to bu y Qd 2 u nits per period while
frm s are willing to oer Qs2 u nits per period . Qu antity
P2 demand ed per period is greater than qu antity su pplied . There is
J V
excess d emand equ al to 0Qd 2 2 0Qs2 5 JV u nits per period
which will create pressu re or the price to rise. Since excess
demand creates a tend ency or the market price to increase, it
ollows that P2 is not an equ ilibriu m price.
Qu antity d emand ed per period is equ al to qu antity su pplied
D
only at price P. At P there is neither excess d emand nor excess
0 Qd1 Q s2 Q Q d 2 Q s1
supply so the market clears. Price 0P is thereore the
Q u a n tity p er p erio d (Q )
equ ilibriu m price. I t is ou nd at the intersection E o the
Figure 1.1.7 The determination o equilibrium price in a competitive market demand and the su pply cu rves.
Changes in equilibrium
Changes in demand conditions I n Figu re 1 .1 .8, equ ilibriu m is initially at price P1 and qu antity
I a actor aecting d emand changes, then d emand will Q1 . I d emand increases rom D1 to D2 then, at the original
increase or d ecrease (and on a d iagram the d emand cu rve will equ ilibriu m price P1 , there will be excess d emand equ al to FH
shit to the righ t or to the let). A new equ ilibriu m will resu lt, as as qu antity d emand ed (Q9 ) exceed s qu antity su pplied (Q1 ).
at the original equ ilibriu m either excess d emand or excess Excess d emand in th e market creates pressu re on the price to
su pply will now exist. increase u ntil a new equ ilibriu m is established at P2 and Q2 .
n The d emand cu rve shits to the right. n The d emand cu rve shits to the let.
n At the original equilibrium price there will be excess demand. n At the original equ ilibriu m price there will be excess su pply.
n As excess d emand exists there will be a tend ency or the n As excess su pply exists there will be a tend ency or the
price to rise. price to d ecrease.
n Assu m ing typical d emand and su pply cu rves, a higher n Assu m ing typical d emand and su pply cu rves, a lower
equ ilibriu m price and a greater qu antity is expected . equ ilibriu m price and a smaller equ ilibriu m qu antity
is expected .
P/unit
P/unit
S1
S1
P2 J R
P1
F H
P1 P2
D2 D1
D1 D2
0 Q1 Q2 Q 0 Q Q2 Q1
Q / p eri o d Q/period
Figure 1.1.8 Eect o an increase in demand on market equilibrium Figure 1.1.9 Eect o a decrease in demand on market equilibrium
10
1 Microeconomics
I n Figu re 1 .1 .9, equ ilibriu m is initially at price P1 and qu antity n Assu m ing typical d emand and su pply cu rves, a higher
Q1 . I d emand increases rom D1 to D2 then, at the original equ ilibriu m price and a lower qu antity is expected .
equ ilibriu m price P1 , there will be excess su pply equ al to JR as
P/unit
qu antity su pplied (Q1 ) exceed s qu antity d eman d ed (Q9 ). Excess S2 S1
su pply in the market creates pressu re on the price to d ecrease
u ntil a new equ ilibriu m is established at P2 and Q2 .
I a actor aecting su pply changes, then su pply will increase or
d ecrease (and on a d iagram the su pply cu rve will shit to the
right or to the let). A new equ ilibriu m will resu lt as at th e P2
original equ ilibriu m either excess d emand or excess su pply will
now exist.
Supply increases J R
P1
These are the eects i su pply increases.
n Th e su pply cu rve shits to the right.
n At th e original equ ilibriu m price there will be excess su pply.
n As excess su pply exists there will be a tend ency or the
D1
price to d ecrease.
n Assu m ing typical d emand and su pply cu rves, a lower 0 Q Q2 Q1
equ ilibriu m price and a greater qu antity is expected . Q/period
S1
S2 I n Figu re 1 .1 .1 1 , equ ilibriu m is initially at price P1 and qu antity
Q1 . I su pply d ecreases rom S1 to S2 then, at the original
equ ilibriu m price P1 , there will be excess d emand equ al to JR as
F H qu antity d eman d ed (Q1 ) exceed s qu antity su pplied (Q9 ). Excess
P1
d emand in the market creates pressu re on the price to increase
u ntil a new equ ilibriu m is established at P2 and Q2 .
P2
Keep in mind that:
excess demand leads to an increase in price
excess supply leads to a decrease in price
also:
D1
an increase in demand increases both equilibrium price
and quantity
0 Q1 Q2 Q a decrease in demand decreases both equilibrium price
Q/period and quantity
Figure 1.1.1 0 Eect o an increase in supply on market equilibrium but:
an increase in supply increases equilibrium quantity but
I n Figu re 1 .1 .1 0, equ ilibriu m is initially at price P1 and qu antity
decreases price
Q1 . I su pply increases rom S1 to S2 then, at the original
equ ilibriu m price P1 , there will be excess su pply equ al to FH as a decrease in supply decreases equilibrium quantity but
qu antity su pplied (Q9 ) exceed s qu antity d eman d ed (Q1 ). Excess increases price
su pply in the market creates pressu re on the price to d ecrease
u ntil a new equ ilibriu m is established at P2 and Q2 . Both demand and supply change
I both d eman d and su pply cond itions in a market change,
Supply decreases it d oes n ot matter which one o th e two eects is hand led
These are the eects i su pply d ecreases. f rst. Either the eect on equ ilibriu m price or the eect on
n Th e su pply cu rve shits to the let. equ ilibriu m qu antity will be ind eterm inate u nless you know
either d iagram matically 2 or, algebraically (H L only) 2 by
n At th e original equ ilibriu m price there will be excess
h ow m u ch d emand and su pply changed . For example, i both
d emand .
d emand and su pply increase and their cu rves shit to the right,
n As excess d eman d exists th ere will be a tend ency or the you know or su re that the equ ilibriu m qu antity will be greater
price to increase. bu t the eect on equ ilibriu m price is u ncertain.
11
1 Microeconomics
The signalling and incentive role of relative The answer lies in the act that an increase in d emand will
au tomatically lead to excess d emand , and so a tend ency or the
price changes
market price to increase. This increase in market price is visible
Assu m e that, or a particu lar good , d emand and su pply to both prod u cers and consu m ers and each grou p will act in its
cond ition s are su ch that the equ ilibriu m price P1 and the own sel-interest. Th e increase in market price has signalling
equ ilibriu m qu antity Q1 are d eterm ined , as illu strated in power as it contains inormation that m ore o the good is
Figu re 1 .1 .1 2 . Q1 u nits o the good are prod u ced , with som e wanted and it also provid es an incentive to f rm s to react to
scarce resou rces allocated to its prod u ction. that inormation an d oer m ore o the good per period .
Assu m e now that preerences in society change an d that, or In Figure 1 .1 .1 2 , quantity supplied increases along the su pply
example, d emand or the good increases (a sym m etric analysis curve as price increases rom P to P9 . We say that there is an
hold s or a d ecrease in d emand ). N ow Q9 u nits are d emand ed extension o su pply rom point J to point J9 . At the sam e tim e,
bu t only Q1 are su pplied . Why and how will m ore o this good som e consum ers will be dropping out o the market or cutting
be prod u ced , and so ad d itional scarce resou rces allocated to back on their purchases as the increase in price lead s to a
and employed in its prod u ction? What m echan ism s will happen decrease in quantity demanded along the new demand
to gu aran tee that the changed preeren ces o society will be curve D2 . There is a contraction o demand rom point R to
satisf ed ? point R9 . As long as excess demand exists, the price will
continue to rise until price P2 is reached . Price P2 is the new
P/unit
equilibrium price where m ore units o the good (Q2 units) are
S1
produ ced and consu m ed. Since m ore units o this good are
produ ced, it implies that m ore scarce resou rces are channelled
into its produ ction.
The process leading to m ore o the good being produ ced and so
H m ore resou rces being channelled into its prod uction has com e
P2
J R abou t without the governm ent or any other entity intervening.
P
Prod u cers and consu m ers acting in their own sel-interest and
J R
P1 respond ing only to changes in relative prices ad ju st their
behaviour and are responsible or the new ou tcom e. I t is as i
an invisible hand gu id es their behaviou r. We will see later that
D2 this ou tcom e is also the best rom societys point o view, bu t
we m u st also realize that this analysis rests on som e very
restrictive assumptions that oten d o not hold.
D1
0 Q1 Q2 Q
The rationing function of free market prices
Q/period We have seen that prices have a signalling and incentive role
in a market economy. They also have a rationing u nction. I
Figure 1.1.12 The signalling and incentive unction o relative a market is ree then whoever is willing and able to pay the
price changes
market-d eterm ined price will end u p with the good .
12
1 Microeconomics
Market efciency
Consumer surplus wou ld be willing to pay or it at the m ost) and the price (what
th ey wou ld be orced to pay) is higher, at P d ollars.
You may be willing to pay $ 1 .00 or a cold sot drink at the
beach bu t it cou ld be that the price is only 75 cents. You will I t ollows that Q u nits are worth area (0QH F) to consu m ers as
obviou sly bu y it or 75 cents (as it is worth m ore to you than that is the am ou nt they wou ld have been willing to pay to
the price you have to pay). We say that you gained a consu m er enjoy all these u nits. Given a market price o P d ollars, they will
su rplu s o 2 5 cents. For the sake o the argu m ent, assu m e that end u p paying area (0QH P) to enjoy Q u nits, or the price per
a second u nit is worth 90 cents to you . You wou ld also bu y this u nit tim es the qu antity consu m ed . Consu m er su rplu s is
second u nit as it is worth m ore to you than the market price th ereore area (PH F), the d ierence between area (0QH F) and
you have to pay. Th e consu m er su rplu s you gained rom the area (0QH P).
second u nit is 1 5 cents. The consu m er su rplu s rom consu m ing On a diagram, consumer surplus is the area below the
both u nits is thereore equ al to 40 cen ts. You were willin g to demand curve and above the price line for the units of the
pay at the m ost $ 1 .90 or the two u nits (as m u ch as they were good consum ed.
worth to you ) and you end ed u p paying only $ 1 .5 0.
More generally, we d ef ne con su m er su rplu s as the d ierence Producer surplus
between how m u ch consu m ers are willing and able at the m ost A f rm may be willing to oer a u nit o a good or $ 2 .00. I the
to pay or som e am ou n t o a good , and what they actu ally end market price or the u nit is $ 3 .00 then it will certainly d ecid e to
u p paying. To be able to id entiy the consu m er su rplu s on a oer it. We say that th e f rm benef ted rom a prod u cer su rplu s
d iagram , it is necessary and u seu l to realize that a d emand o $ 1 .00. Assu m e that it wou ld have been willing to oer the
cu rve (and a su pply cu rve) can be read vertically. next u nit i the price was at least $ 2 .2 0. Since the market price
is $ 3.00 it wou ld also oer this u nit, gaining rom it a prod u cer
P/unit
S, MC
F
P
P F
D, MB
0 Q Q
Q/period H
P
Figure 1.1.13 Consumer surplus
13
1 Microeconomics
less to be willing to oer an extra unit. The m inim um it would Allocative efciency
accept is the cost o producing it. Later you will realize that the
Th e ol l owi n g q u esti on a ri ses: Gi ven su ppl y a n d d em a n d
supply curve is nothing but the marginal cost (MC) curve o
con d i ti on s or a g ood i n a m a rket, what i s th e opti m a l
the f rm .
am ou n t prod u ced a n d con su m ed o th i s g ood rom soci etys
So, or a f rm to be willin g to oer u n it Q in Figu re 1 .1 .1 4, the poi n t o vi ew? I t wou l d m a ke sen se or soci ety to wa n t a l l
lowest price requ ired is P d ollars (or d istan ce QH ), n ot a cen t u n i ts o a g ood tha t a re worth m ore tha n what th ey wou l d
less. I th e price was even slig htly less (say at th e level o th e cost to prod u ce.
grey d otted line), then th e f rm wou ld n ot have been willing to
D o we h a ve a m ea su re o wh a t ea ch extra u n i t o a g ood
oer that last u nit Q. I t wou ld be willin g to oer ewer u n its
i s wo rth to so ci ety? Ca n we d eterm i n e th e extra b en ei t
per period bu t not u n it Q. Equ ivalently, or the f rm to be
(th e m a rg i n a l ben ei t) th a t soci ety en j oys ro m ea ch extra
willing to oer u nit Q9 the least paym ent requ ired is P9 (or
u n i t o th e g oo d con su m ed ? Yes, we ca n . I t i s h ow m u ch
d istan ce Q9 F).
a t th e m ost con su m ers wou l d b e wi l l i n g to pa y to
I it so happens that th e market price is P d ollars per u nit, then en j oy i t. Th i s i s th e verti ca l d i sta n ce rom ea ch Q to th e
f rm s will be willing to oer per period all u nits u p u ntil and d em a n d cu rve.
inclu d ing u nit Q. They wou ld not be willing to oer u nit Q9 as
Do we have a m easu re o what is th e cost to society o
they wou ld requ ire m ore (P9 or d istance Q9 F) than they wou ld
prod u cing each extra u n it o a good ? Yes, we d o. I t is th e
get rom the market.
lowest am ou nt that f rm s wou ld be willin g to accept to oer
I t ollows that the m inim u m f rm s wou ld requ ire to be willing to each extra u n it o a good . Th is is the vertica l d istan ce rom
oer Q u nits is area (0QH J), which is the su m o all vertical each Q to the su pply cu rve, or th e marg ina l cost (M C) o
d istances u p u ntil u nit Q. Given a market price o P d ollars per prod u cing each extra u n it.
u nit, f rm s will actu ally earn area (0QH P) by selling Q u nits or
the price per u nit (P) tim es the qu antity oered (Q). So,
P/unit
prod u cer su rplu s is area (JH P), the d ierence between area S, MC
(0QH P) and area (0QH J).
On a diagram, producer surplus is the area above the $1 8.00
supply curve and below the price line or the units o the
good produced and sold.
$1 4.00 A
H
P/unit
$8.00 B
H S
$6.00
D, MB
E
P 0 Q Q Q Q
Q/period
Figure 1.1.1 6 Allocative efciency: where or the last Q produced, P 5 MC
and social surplus is maximized
14
1 Microeconomics
Condition or allocative efciency: the price (or marginal be properly u sed . Why? Becau se that u nit is worth to consu m ers
beneft) must be equal to marginal cost (that is, less than it wou ld cost to prod u ce it. I u nit QQ- were
P (5 MB) 5 MC) or the last unit produced. prod u ced , society wou ld have lost su rplu s rom its prod u ction
I t is easy to u nderstand why. Reerring to Figu re 1 .1 .1 6, society equ al to FH . I t wou ld have lost su rplu s equ al to area (JH F) rom
wou ld want u nit Q9 to be produ ced as it is worth $ 1 8.00 to th e prod u ction o all u nits QQ-.
consu m ers (this is the m ost they would have been willing to pay What i on ly Q0 u nits were prod u ced and or som e reason u nits
or it) which is m ore than the $ 6.00 it wou ld cost f rm s to Q0Q were not prod u ced and en joyed by society? Then society
prod u ce (as the m inim u m f rm s wou ld be willing to accept wou ld have lost the su rplu s represented by the area (ABJ) as all
to oer that u nit is $ 6.00). We cou ld say that i the market did u nits u p u ntil u nit Q are worth m ore than they wou ld have cost
indeed prod uce that u nit, society wou ld gain a surplus o to prod u ce.
$ 1 2 .00 rom unit Q9 . Sim ilarly or unit Q0, as it is worth m ore I , by prod u cing either less or m ore than Q u nits, a portion o
($ 1 4.00) than it wou ld cost to prod u ce ($ 8.00); society wou ld social su rplu s is lost, it ollows that by prod u cing exactly Q
gain a su rplu s o $ 6.00 rom u nit Q0. The sam e argum ent hold s u nits per period , social su rplu s is maxim ized .
up u ntil and inclu ding u nit Q which is worth to consu m ers as
Summary
m uch as it wou ld cost to prod u ce it; that is, P (5 MB) 5 MC.
I , or the last u nit prod u ced , P (5 M B) 5 MC, then allocative
What abou t u nit Q09 ? Society wou ld not want that u nit
ef ciency is achieved and social su rplu s is maxim ized .
prod u ced as this wou ld m ean that scarce resou rces wou ld not
15
1.2 Elasticity
16
1 Microeconomics
P/unit
P/unit
A PED
F PED > 1
P1
Pm PED = 1
M
PED = 0
P1 H 0 Qm B
Q/period
D
Figure 1.2.3 PED along a negatively sloped linear demand curve
0 Q1 Q1
I t makes sense. Responsiveness to a price change (that is, PED)
Q/period
will be higher, the higher the initial price o the good , so the
Figure 1.2.1 PED varies continuously even along a linear demand m ore expensive it is.
Reerring to Figu re 1 .2 .1 , i the initial price P1 is at point F, the
A common mistake is to consider that PED for a linear
P1
Q1 ( )
ratio ___ is bigger than i the initial price P1 was at point H . TIP
demand curve that is at 45 degrees to the axes is constant
I t ollows that even along a linear, negatively sloped d emand and equal to 1. The slope of such a curve is 1 but, as
cu rve, price elasticity varies continu ou sly. explained, slope is not elasticity.
Figu re 1 .2 .3 shows that as point A is approached , PED tend s to
inf nity as Q1 tend s to zero, while at point B price elasticity is Demand curves with constant PED
zero as P1 is zero.
The case of a perfectly inelastic demand curve: PED 5 0
I n this case the d emand cu rve is vertical at som e qu antity. Any
P/unit
Perfectly inelastic
PED = 0
0
Q/period
D
0 B Figure 1.2.4 Perectly inelastic demand curve (PED 5 0)
Q/period The perectly inelastic d emand cu rve (PED 5 0) is oten u sed
Figure 1.2.2 PED takes on all values rom ` to zero to d escribe the case o highly ad d ictive good s su ch as dru gs, or
to d escribe the ind ivid u al d emand or pharmaceu tical prod u cts
I t can be shown that at the m id poin t M o a linear d emand or which no su bstitu tes exist.
cu rve, price elasticity is equ al to 1 . Reerring to Figu re 1 .2 .3:
n within line segm ent AM , correspond ing to prices higher The case of a perfectly elastic demand curve: PED `
than Pm within th e segm ent APm , d emand is price elastic I n this case the d emand cu rve is horizontal at som e price. I t is
(PED . 1 ) u sed to d escribe the d emand that a perectly competitive f rm
aces. Su ch a f rm is so tiny in size compared with the market
n within line seg m en t M B, correspon d in g to prices lower
that it can sell any am ou nt at the going market price. I t is as i
tha n Pm with in the seg m en t Pm B, d eman d is price inelastic
it is acing a perectly elastic d emand at the market price.
(0 , PED , 1 )
17
1 Microeconomics
0
Q/period PED and the shape of the TR curve
I t ollows rom the above that there is a close relationship
Figure 1.2.5 Perectly price elastic demand curve (PED ` ) between PED and th e shape o the TR cu rve a f rm aces.
Focu sing on Figu re 1 .2 .7 a, which illu strates the typical, linear,
The case of a unitary elastic demand curve: PED 5 1
negatively sloped d emand cu rve, we realize that at zero
Th e d emand cu rve in this case is asymptotic to both axes
qu antity (poin t at the origin), TR are zero and at a zero price
(that is, it never tou ches either axis). The d emand cu rve is a
(point H ) TR are also zero. As price d ecreases (thinking o
rectangu lar hyperbola.
walking d own the price axis) rom point F to Pm , qu antity
d emand ed increases rom 0 to Qm . Since d emand or that price
P/unit
Al l a rea s bel ow th i s cu rve represen t th e reven u es o f rm s HL Def ne marginal revenu e (M R) as the extra revenu e
a n d a re eq u a l i n si ze. I n oth er word s, i n a u n i ta ry ela sti c rom selling one m ore u nit o ou tpu t. MR is the
d em a n d cu rve, a ch a n g e i n pri ce d oes n ot ch a n g e f rm s change in TR becau se o a change in Q, so it is the
tota l reven u es. slope o the TR cu rve. At Qm , where TR are at their
maxim u m , it ollows that M R is zero. I d emand is
Relationship between PED and total revenues a negatively sloped line then MR has d ou ble th e
slope. I n Figu re 1 .2 .8a thereore it will go throu g h
What will happen to f rm s revenu es (and hence to consu m er
ou tpu t Qm .
expend itu res) i there is a change in price? The answer d epend s
on PED. Total revenu es (TR) a f rm collects are the prod u ct o
the price per u n it tim es the qu antity sold (TR 5 PQ). I t is not Focu sing now on Figu re 1 .2 .7 b, which illu strates a u nitary
the sam e as prof ts, which are the d ierence between the TR elastic demand cu rve, we realize that any change in price will
collected and the total costs (TC) incu rred . lead to a percentagewise equ al change in the opposite
Con sid er the three possible cases. d irection o qu antity d emand ed , so that TR remain constant. I n
the bottom part o Figu re 1 .2 .7 b, th e TR cu rve is drawn as a
Case 1 : A change in price when PED . 1 (demand is price elastic).
straight line parallel to the qu an tity axis, illu stratin g that TR d o
A ch a n g e i n pri ce l ea d s to a ch a n g e i n th e opposite not change as ou tpu t varies.
d i recti on i n q u a n ti ty d em a n d ed . Wh en d em a n d i s pri ce
Lastly, Figu re 1 .2 .7 c illu strates the case o a perectly elastic
ela sti c, q u a n ti ty d em a n d ed cha n g es proportion ately m ore
d emand cu rve. This wou ld be the case o a f rm which cou ld sell
tha n pri ce, so th e ch a n g e i n q u a n ti ty h a s a bi g g er eect on
all it wants at the price P9 , say, or exam ple, 3.00 per u nit. I t
reven u es th a n d oes th e ch a n g e i n pri ce. So, i d em a n d i s
ollows that the TR cu rve is a rising straight lin e starting rom
ela sti c, tota l expen d i tu re ch a n g es i n th e sam e d i recti on a s
the origin as the revenu es rom one u nit sold will be 3.00, the
q u a n ti ty d em a n d ed . I P ri ses th en Q fa lls proporti on a tel y
revenu es rom two u nits sold will be 6.00, the revenu es rom
m ore, so TR wi l l fall. Bu t i P a l l s, th en Q rises
three units sold will be 9.00, and so on. I t will becom e clear
proporti on a tel y m ore, so TR wi l l rise.
that or a f rm to be able to sell as m u ch as it wants at the
Case 2 : A change in price when 0 , PED , 1 (d emand is sam e price, two cond itions m u st apply. The f rm m u st be tiny
price inelastic). compared to the market in which it operates. I n ad d ition, it
I n th i s ca se, pri ce ri ses proportion ately m ore th a n q u a n ti ty. m u st sell a good that consu m ers consid er id entical to the good
Th e ch a n g e i n pri ce h a s a bi g g er eect on TR th a n th e sold by all the other f rm s in the sam e market.
18
1 Microeconomics
P/unit
P/unit
F
>1
Perfectly
Pm =1 Unitary elastic PED = 1
elastic
Areas below equal to P D
total expenditures
0<<1
D D
0 Qm H 0 0
Q/period Q/period
TR Q/period TR TR
MR
TR TR
TR
0 Qm H 0 0
Q/period Q/period
Q/period
Figure 1.2.7 PED and the shape o the TR curve
19
1 Microeconomics
( )(
DQ x
____ prod u cts where XED is zero. For exam ple, i the price o
( )
1 1
Qx Py cheesecake rises or alls we expect th e d emand or iPhones to
%DQ
%DD y DP y
____
DQ
XED 5 ______x 5 ____ 5 ____x 3 ___1
DP y Qx
) remain u naected .
1
Py
Applications o XED
H ere, the sign d eterm ines how we interpret XED or a prod u ct: XED is u sed by policy makers to delineate (d escribe) markets.
n I XED . 0 then the two goods x and y are substitutes, I t helps to know the size o XED o d ierent produ cts, or
meaning that they are in competitive demand: i one becomes example to d ecid e whether m u fns and eggs shou ld be
more expensive then consumers will switch to the other. considered as belonging in the sam e market as breakast cereal.
n I XED , 0 th en the two good s x an d y a re complem ents, Firms can use XED to guide their pricing policy changes. Assume
m ea nin g that th ey are jointly d emand ed : i one becom es that the price o a substitute product decreases, or example. I
m ore expensive and people bu y it less, they will also bu y frms producing the good do not react, demand or it will probably
less o the other one. decrease. Or, i a complement becomes pricier then, assuming no
n I XED 5 0 then the two good s x and y are u nrelated . reaction, its producer should expect demand or it to contract.
n I t ollows that the u rther away rom zero XED is, the
stronger the relationsh ip between the good s. Conversely, Calculating XED
the closer (absolu tely) to zero XED is, the weaker the Assu m e that the price o good A increases rom $ 1 5 0.00 to
relationship between the two good s. $ 1 80.00 and , as a resu lt, qu antity d emand ed or good B
increases rom 1 .8 m illion u n its a week to 2 .5 2 m illion u nits a
Figu re 1 .2 .8a illu strates th e case o su bstitu tes in which XED is
week. What is the PED or good B when there are changes in
positive. I the price o coee increases rom P1 to P2 then we
the price o good A? H ow are these good s related ?
expect that the qu antity o tea d emand ed per period will
increase rom Q1 to Q2 as som e consu m ers will switch rom Applying the orm u la or XED:
drinking the now m ore expensive coee and will drink tea
( ) ( ) (
1
%DQ B
instead . N ote that this is not a demand curve as on one axis %DD A
DQB
DP A
PA
QB
(2 .5 2 2 1 .8)
1 80 2 1 5 0
1 50
XED 5 ______ 5 ____ 3 ___1 5 __________ 3 ____
1 .8 ) ( )
we have the price per u nit o one good and on the other the
qu antity d eman d ed per period o another good .
Figu re 1 .2 .8b illu strates the case o complem ents in which XED
0.72 1 50
( ) ( )
1 08
5 ____ 3 ____ 5 ____
30 1 .8 54 5 1 2
is negative. I the price o coee increases rom P1 to P2 then Sin ce XED is a positive valu e we conclu d e that A an d B are
we expect that the qu antity o su gar d emand ed per period will consid ered as su bstitu tes.
(a) (b)
Price of coffee
Price of coffee
P2 P2
P1 P1
0 Q1 Q2 0 Q2 Q1
Quantity of tea Quantity of sugar
Figure 1.2.8 Substitutes (XED . 0) and complements (XED , 0)
20
1 Microeconomics
DQ Income Income
___
inelastic elastic
Q
____
DY
___
DQ
DY ( ) ( )
Y
YED 5 1 , or ___ 3 ___1
Q1
Y1 Using a graph to illustrate YED
Sin ce YED is the ratio of the percentage changes in d emand There are two ways to illu strate YED on a graph . Th e ea sy bu t
and incom e levels, it follows that if both changes are rath er im precise way is to u se a typical d eman d cu rve d iagram .
positive (plu s sign) or if both are negative (m inu s sign) then I f YED is positive an d so th e good is normal, then an increase
YED is a positive nu m ber. For example, if an increase in in incom e will increase d eman d an d shift th e d eman d cu rve to
in com e lead s to m ore of a good being d emand ed or a drop in the righ t, while a d ecrease in incom e will d ecrease d ema nd
in com e lead s to less being d emand ed , then YED is a positive an d shift th e cu rve to th e left. I f YED is negative and so the
nu m ber. I f one change is positive (plu s sign) and the other is g ood is inferior, th en an increase in incom e will d ecrease
negative (m inu s sign), then YED is a negative nu m ber. For d ema nd an d shift the d ema nd cu rve to th e left, while a
example, if an increase in incom e lead s to a d ecrease in d ecrease in in com e will in crease d eman d and sh ift th e cu rve to
qu antity d emand ed , or a d ecrease in incom e lead s to an the righ t.
in crease in qu antity d emand ed , then YED is a negative With in th is fram ework, illu stratin g the ca se of a n in com e
nu m ber. elastic good an d a n in com e in ela stic g ood ca n be a problem .
We can d istingu ish between normal and inferior good s based I t may be accepta ble to illu strate th e in com e ela stic case with
on whether YED is positive or negative. a big sh ift to th e rig h t of th e d ema n d cu rve if in com e
increases a n d with a tiny sh ift to the rig h t if d eman d is
n I f YED . 0 the good is a normal good since d eman d
incom e in elastic.
increases (d ecreases) as consu m er incom e increases
(d ecreases): both incom e and d emand change in the sam e A better way to illu strate YED is by u sing an Engel cu rve, which
d irection. is ju st a graph with incom e on the vertical axis and qu antity
d emand ed on the horizontal axis. I f the cu rve is positively
n I f YED , 0 the good is an inerior good since d emand
sloped then YED is positive and the good is normal. I f the slope
d ecreases (increases) as consu m er incom e increases
is negative then YED is negative and the good is inferior. I f th e
(d ecreases): incom e and d emand chan ge in opposite
cu rve is vertical then YED is zero. All three cases are illu strated
d irections.
in Figu re 1 .2 .9.
Focu sing on normal good s, we can state the following.
Income ( Y)
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1 Microeconomics
Income ( Y)
elastic and incom e inelastic d emand as well as the case where Engel curve
YED 5 1 . YED = 1
To illu strate a prod u ct with incom e elastic d emand , draw a (at all points)
straig ht line Engel cu rve that cu ts the vertical axis, as illu strated
in Figu re 1 .2 .1 0.
Income (Y)
F
Y1
Engel curve
YED > 1
F
Y1
0 Q1
H Quantity demanded (Yd)
Optional material
0 Q1 I you are cu riou s why the above resu lts occu r, here is an
Quantity demanded (Yd) easy proo. Lets rearrange the YED orm u la as:
Figure 1.2.1 0 Income elastic demand (YED . 1 )
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1 Microeconomics
Applications o YED manu actu ring sector, or example cars, appliances and
u rnitu re, which carry a higher YED. Lu xu ry item s and services
Firms would like to know whether demand or their product is
are con sid ered to have an even higher YED so once hou sehold s
highly incom e elastic or m oderately incom e inelastic to help
have attained a certain stand ard o living, u rther increases
them better plan their investm ents. I an economy is growing and
in d iscretionary in com e are spent m ostly on vacation s, spa
incom es are increasing ast, then rm s producing highly income
treatm ents, expensive clothing and expensive cars. I n this
elastic products may have to invest now in expanding their
way the relative size o the primary sector and later o
capacity to be able to m eet the increased demand. Conversely,
manu actu ring sh rinks while that o services expand s. This is
arm ers growing, say, potatoes may think o switching to kiwi
the case or many bu t not or all cou n tries, with Germany and
ruit or to agro-tourism, which have a higher YED.
Au stralia being notable exam ples.
A govern m ent may also be in terested in knowing YED
in variou s sectors to plan ahead regard ing training or
Calculating YED
d isplaced workers. The econom ic signi cance and viability o
incom e in elastic sectors will shrink in the long ru n so som e Assu m e that per capita incom e in the preectu re o Corinth
workers in these sectors may lose their jobs and will need increases rom 2 5 ,000 per annu m to 33,75 0 and , as a
re-training. I n this sense, a growing econom y may su er rom resu lt, qu antity d emand ed or atty grou nd m eat d ecreases
increased (stru ctu ral) u nemploym ent and m ove away rom u ll rom 1 5 ,000 kg per week to 1 4,2 5 0 kg per week. What is the
employm ent. Also, as sectors prod u cing highly incom e elastic YED or atty grou nd m eat? I s the d emand or atty grou nd
prod u cts, or example services, will grow ast, employm en t m eat in the area o a normal good ?
need s will also grow ast. This m ean s that governm ents shou ld Apply the orm u la or YED:
plan ahead regard ing changes in school cu rricu la and
vocational schools, so as to avoid employm ent bottlenecks.
DQ
DY ( )Y1
Q1 ( ) (
1 42 5 0 2 1 5 000
3375 0 2 2 5 000
2 5 000
YED 5 ___ 3 ___ 5 ______________ 3 ______
1 5 000 ) ( )
Related to the above is the id ea that th e so-called sectoral 2 75 0 25 2 1 875 0
composition o ou tpu t o an econ omy changes throu gh tim e as 5 _____ 3 ___ 5 _______ 5 2 0.1 4
875 0 15 1 31 2 5 0
a resu lt o d iering YEDs. Many ood prod u cts have a low YED
Since YED has a negative valu e, atty grou nd m eat is
once a certain threshold level o incom e is reached . Any u rther
consid ered an inerior prod u ct in that area.
increases in incom e are m ostly spent on prod u cts rom the
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1 Microeconomics
P/unit
P/unit
S
S
Linear supply
Vertical supply
cutting vertical
PES = 0
axis: PES > 1
0
0 Quantity supplied (Qs)
Quantity supplied (Qs)
Figure 1.2.1 6 PES curve (PES . 1 )
Figure 1.2.13 Perectly inelastic supply curve (PES 5 0)
Lastly, i the linear su pply goes throu gh the origin th en PES is
P/unit
Horizontal supply,
innitely elastic
Linear supply
through the
origin: PES = 1 S
P S (at all points)
0
Quantity supplied (Qs)
S
cu rve d eterm ines whether PES is smaller than, equ al to
or greater than 1 , u se the sam e logic presented earlier
or YED.
Determinants of PES
n The tim e period d eterm ines PES. I n econom ics, tim e is
d istingu ished into the m om entary period (or market
Linear supply, period ), the short ru n and the long ru n. The d istinction is
cutting horizontal based on the extent to which ad ju stm ents can be mad e.
axis: 0 < PES < 1 I n the m om entary (or market) period no ad ju stm ents are
possible. I n the short ru n som e, bu t not all, ad ju stm ents are
possible. I n the long ru n all ad ju stm ents are possible.
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1 Microeconomics
I t ollows that in the m om entary ru n, su pply is perectly by m ore per tim e period to lower the ad d itional (marginal)
in elastic (vertical). I d emand or the prod u ct increases, qu antity cost o d oing so.
su pplied remains u nchanged . The increased d emand will be n Another d eterm inant o PES is whether it is possible to
expressed only as a higher price. Su pply is not at all responsive. store the good . I it is possible to store stocks then it may
I n the short ru n the increased d emand will be partially be possible to m eet an in crease in d emand by releasing
expressed as an increase in qu antity su pplied and partially as stocks, so f rm s can be m ore responsive in their su pply than
an increase in price. I n the long ru n, when all actors are i their good s are perishable or no stocks are held .
variable an d the f rm can even increase its scale o operations
n Mobility o labour is relevant. I, or example, labour is
(its size), ou tpu t cou ld expand even m ore. So, in the long ru n ,
occupationally or geographically immobile then it will be
su pply is typically expected to be m ore price elastic than in th e
more difcult to meet an increase in the demand or a product
short ru n.
than i labour is mobile between occupations or regions.
Figu re 1 .2 .1 8 illu strates the eect o tim e on the PES o a good .
The longer the tim e period , the greater the PES is expected to Applications of PES
be. I n the m om entary ru n it is vertical so that the PES is zero,
PES d eterm i n es th e exten t to wh i ch a n i n crea se i n d em a n d
while in the long ru n it may even be perectly elastic with f rm s
wi l l a ect th e pri ce a n d /or q u a n ti ty o th e g ood i n a
willing to oer m ore at the sam e price P9 (althou gh this wou ld
m a rket. Th e m ore pri ce i n ela sti c su ppl y i s, th e g rea ter th e
requ ire that cost cond itions d o not change).
i n crea se i n pri ce g i ven a n i n crea se i n d em a n d ; th e m ore
ela sti c su ppl y i s, th e g rea ter th e i m pa ct o a n i n crea se i n
P/unit
S1 S2 d em a n d on q u a n ti ty.
S3 Primary agricu ltu ral com m od ities, or example wheat and corn,
are characterized by low PES as their prod u ction is su bject to
long tim e lags. Think, or example, o a prod u cer planting at a
particu lar tim e bu t harvesting six m onths later. N on-agricu ltu ral
S4
primary prod u cts, su ch as m etals and m inerals, are also
characterized by low PES becau se o the associated steep
extraction costs. On the other hand , prod u cts rom the
P S5 manu actu ring sector are characterized by higher PES becau se
given a prod u ction plant, the extra costs o prod u cing
ad d itional u nits are typically low.
25
1.3 Government intervention
Indirect taxation
Taxes can be categorized as direct or indirect taxes. Indirect taxes Consequences o a specifc indirect tax
are taxes on goods and services and can be imposed on a specic
Assu m i n g typi ca l d em a n d a n d su ppl y cu rves, a n i n d i rect ta x
or an ad valorem basis. Specic or unit taxes are a xed am ount
wi l l m a ke th e g ood m ore expen si ve, wi l l d ecrea se th e
per unit o the good produced or consumed. For example, a tax o
am ou n t con su m ed a n d prod u ced a n d wi l l crea te reven u es
1 00 Indian Rupees per unit o a good is a specic tax. Ad
or th e g overn m en t. Prod u cers wi l l be ea rn i n g l ower
valorem taxes are a percentage o the price and so o consum er
reven u es both on a per u n i t ba si s a n d a s a tota l . Con su m er
expenditures. Value added tax (VAT) is an example o an ad
spen d i n g on th e g ood m a y i n crea se or d ecrea se, d epen d i n g
valorem tax which is expressed as a percentage, say 23%, o the
on PED.
price o the good.
More speci cally, and reerring to Figu re 1 .3.2 , the
Governm ents impose indirect taxes or a variety o reasons.
ollowing occu rs.
Typical reasons include revenue collection or an attempt to
decrease the consumption o goods. Governm ents need revenues n The market price rises rom P to Pc per u nit while the
to nance their expenditures and indirect taxation is one source equ ilibriu m qu antity d ecreases rom Q to Q9 per period .
o revenue. Som e goods are considered harmul and governm ents Ou tpu t and consu m ption o the good thereore shrink.
oten try to lim it their consumption; examples include cigarettes, n Prod u cers earn only Pp (5 h) per u nit sold , so their new
alcoholic drinks and petrol (gasoline). Another reason or average revenu e is less than the original, pre-tax price and
governm ents imposing taxes is that they wish to switch average revenu e P.
expend itu res away rom imports toward s d om estically prod u ced n Th e tota l reven u es th e prod u cers col lect d ecrea se rom
good s. One way o d oing this is by imposing taxes (known as a rea (0QeP) to a rea (0Q9 Pp). Con su m er expen d itu res m ay
taris) on imports. in crea se, d ecrea se or stay th e sam e, d epen d in g on th e
PED between poin t e a n d poin t h , a s th ere is a m ovem en t
Illustrating indirect tax on a diagram a l on g th e d em a n d cu rve oll owin g th e sh it in su ppl y.
An indirect tax can be consid ered as an add itional cost o Sin ce th e price con su m ers pay in crea ses, th eir
prod uction. As su ch it will tend to decrease the supply o a rm , expen d itu res on th e g ood will in crea se i d ema n d is
shiting the su pply cu rve let on a d iagram . I we recall that a price in ela stic.
su pply cu rve can also be read vertically and that it ref ects the n The governm ent collects tax revenu es equ al to area
extra (marginal) cost o prod ucing an extra u nit, then it shou ld (PphPc). This area is ou nd by m u ltiplying the tax per u nit
be clear that an ind irect tax will increase this extra cost, shiting (h) by the nu m ber o u nits sold (line segm ent 0Q9 , which is
the su pply cu rve vertically upwards by the am ount o the tax. equ al to segm ent Pp).
n Resou rces are m isallocated and a welare loss equ al to area
P/unit
St (eh) resu lts, u nless the tax is im posed to lim it prod u ction
(or, MC = MC + tax) o a pollu ting ind u stry or to cu rtail consu mption o a
h harm u l good , su ch as cigarettes.
S, MC
P/unit
f St
hf = tax/unit
S
Pc h
H
j
D P e
0 Pp f
Q/period
Figure 1.3.1 A specic indirect tax
26
1 Microeconomics
HL Tax incidence n M arket price will rise m ore and hence the consu m ers share
o the tax will be larg er, the less elastic is d eman d and the
Tax incid ence reers to wh o pays what proportion o a tax. For
m ore elastic is su pply.
example, i ater a $ 1 0.00 tax is imposed on a good its market
price increases by $ 9.00, then the incid ence on consu m ers was n M arket price will rise less and hence the prod u cers share
$ 9.00, while the incid ence on prod u cers was $ 3 .00 (or 9/1 2 will be larger, the m ore elastic is d emand and the less
and 3/1 2 respectively). elastic is su pply.
Figu re 1 .3.2 reveals that the market price d id not increase by n Equ ilibriu m qu antity will d ecrease less, the m ore inelastic
the u ll am ou nt o the ind irect tax im posed . The size o the tax d emand and su pply are (the m ore vertical arou nd the initial
is line segm ent h (the vertical d istance between the pre-tax pre-tax equ ilibriu m point).
and the post-tax su pply cu rves) while market price increased I t ollows that tax revenu e or the governm ent increases as
only by segm ent hj. I t ollows that the incid ence o this tax is elasticities d ecrease.
on both consu m ers and prod u cers: consu m ers and prod u cers
I t is arg u ed that a tax is oten u lly paid by con su m ers. H ow
share the tax. Tax incid ence on consu m ers is line segm ent
can that be th e case i the law o d eman d has alm ost u n iversal
jh (5 PPc) whereas tax incid ence on prod u cers is line segm ent
applica bility? The a n swer is that su ch cases a re a resu lt o
j (5 PPp).
frm s very oten being a ble to su pply greater qu a n tities per
Tax incid ence d epend s on PES and PED. The ollowin g period at the sam e price 2 later we will reer to th is a s
relationship hold s: consta n t retu rns to sca le 2 that is, acing h orizon ta l
(% of tax incidence on consumers) (perectly ela stic) su pply cu rves.
____________________________ PES
5 ____
(% of tax incidence on producers) PED I t is a com m on m istake to claim that i d emand is price inelastic
then the incid en ce o an ind irect tax alls m ostly u pon
To rem em ber the relationship ju st keep in m in d that i incid ence consu m ers. I PES happens to be lower than PED then it is
on consu m ers is in the nu m erator then PED is in the prod u cers and not consu m ers who will pay a bigger proportion
d enom inator. o the tax. So i, or example, PED 5 0.8 (price inelastic) while
Bearing in m ind that the two percentages on th e let raction PES 5 0.2 , then the incid ence on consu m ers will be smaller
m u st ad d u p to 1 00%, the interpretation o the above is (consu m ers will pay 2 0% o th e tax and prod u cers will pay
straightorward . 80% o the tax).
PED ` producers are burdened by he full amoun of he ax here is 100% of ax on producers and 0% on consumers
27
1 Microeconomics
Analysis of an ad valorem (percentage) tax Figu re 1 .3 .3 illu strates an ad valorem (percentage) tax. I nitially,
market d emand and market su pply are at D and S respectively
What i the tax is an ad valorem (a percentage) tax? Su ch a tax
with P the initial market price and Q the initial qu antity bou ght
is analysed in the sam e way as a specif c tax except that the
an d sold per period . Let an ad valorem (percentage) tax be
shit o su pply is not parallel bu t the wed ge (vertical d istance)
im posed , say, VAT at 2 3%.
wid ens at higher prices. Otherwise, the eects are id entical to
those o a specif c tax. The d ollar am ou nt o th e tax at each possible price is not
constant anym ore. This is why the vertical d istance between the
P/unit
0 Q Q
Q/period
Figure 1.3.3 Eects o an ad valorem (percentage) indirect tax, or
example VAT
Subsidies
A su bsid y is d ef ned as a per u n it paym ent to f rm s by the
P/unit
governm ent aim ed at lowering their costs and the market price, S
and at increasing prod u ction, consu m ption and f rm s revenu es.
I ts analysis is sym m etrical to that o an ind irect tax as once a
h
su bsid y is gran ted the governm ent is payin g (and not getting
paid ) a per u nit am ou nt o m oney to f rm s. Prod u ction costs are
lower by the am ou nt o the su bsid y so su pply shits vertically S(sub)
d ownward by that am ou nt (the marginal cost o prod u cin g
each u nit o ou tpu t is n ow lower). f
Governm ents grant su bsid ies or a variety o reasons. Typically,
they are granted when or som e reason it is consid ered
d esirable to make a particu lar good cheaper so that its hf = subsidy/unit
consu m ption increases and it becom es accessible to lower-
incom e hou sehold s. This inclu d es many health-care and
ed u cation-related prod u cts. Or g overnm ents may wish to
expand ou tpu t and consu mption o prod u cts that are
environm entally riend lier. Oten governm ents grant su bsid ies
to arm ers to increase their incom e becau se o certain D
characteristics o th e agricu ltu ral sector. Or it cou ld be that a 0
Q/period
su bsid y is u sed to make a particu lar good m ore competitive and
attractive abroad so that it penetrates oreign markets, or to Figure 1.3.4 A subsidy
lim it im ports o com petin g good s rom abroad .
In Figure 1 .3.4 the initial demand and supply conditions are Consequences of a subsidy
represented by curves D and S. The new supply ollowing the Assu m ing typical d emand and su pply cu rves, a su bsid y will
granting o the subsidy is at S(sub). The vertical distance h is make the good cheaper, will increase the am ou nt consu m ed
equal to the subsidy per unit and represents the decrease in costs an d prod u ced and will cost the governm ent m oney. Prod u cers
each frm enjoys once the subsidy is granted. I you remem ber will earn m ore revenu es both on a per u nit basis and as a total.
that the supply curve also represents marginal cost (MC) then Consu m er spend ing on the good may increase, d ecrease or
the new supply curve S(sub) is MC9 5 (MC 2 subsidy). remain the sam e, d epend ing on PED.
28
1 Microeconomics
More specif cally, ocu sing on Figu re 1 .3.5 , the market price errors. First, locate the new equ ilibriu m qu antity (Q9 in
consu m ers pay d ecreases rom P to Pc while the equ ilibriu m Figu re 1 .3.5 ). From point Q9 draw a line u p all th e way to the
qu antity increases rom Q to Q9 . Ou tpu t and consu mption o initial su pply cu rve S. This is line Q9 h. The prod u cers earn
the good thereore in crease. whatever consu m ers are paying (Q9 5 Pc) plus the su bsid y per
u nit h that the governm ent pays. They thereore earn Q9 1 h,
P/unit
Price controls
Price controls reer to cases where or som e reason the
P/unit
29
1 Microeconomics
30
1 Microeconomics
P/unit
Beore th e ren t control wa s im posed , equ ilibriu m ren t wa s at S
Re an d th e equ ilibriu m qu a n tity o ren ta l u n its was Qe.
Consu m er su rplu s is equ a l to a rea (1 1 2 1 4) an d prod u cer
su rplu s is equ a l to a rea (3 1 5 1 6). Social (or com m u n ity)
welare (or su rplu s) is thereore equ a l to a rea (1 1 2 1 4 1 f h Minimum price
P
3 1 5 1 6). (price oor)
31
1 Microeconomics
Application: setting a m inim um wage in the labour market Firm s d ema n d la bou r to prod u ce th e g ood s a n d services th ey
The sam e analytical ram ework can be employed to d escribe prod u ce. Th e d ema n d or la bou r is a d erived d ema n d . I t is
the eects o m inim u m wage legislation . I n Figu re 1 .3 .9 the n egatively sloped a s at h ig h er wag e rates f rm s will try to
vertical axis m easu res the m oney wage rate (W) per worker and su bstitu te ca pita l or la bou r. Workers oer th eir la bou r services
the horizontal axis d epicts the nu m ber o workers (L). to th e la bou r ma rket. Th e su pply o la bou r is u pwa rd slopin g
a s at h ig h er wa g e rates th e opportu n ity cost o leisu re
Wage rate (W)
S(L)
in crea ses (it becom es m ore expen sive or som eon e to sit
ou tsid e th e la bou r ma rket) so m ore in d ivid u a ls will su bstitu te
work or leisu re. I th e la bou r ma rket is com petitive th en
th e equ ilibriu m wa g e rate will be at We with Le in d ivid u als
h f Minimum em ployed .
W
wage
I th e governm ent n ow consid ers that the market d eterm ined
wage rate We is too low and d ecid es to set a m inim u m wage at
W9 , th en f rm s at W9 will want to hire ewer ind ivid u als than
We the nu m ber o ind ivid u als willin g to oer th eir labou r services.
At the higher wage rate W9 that the governm ent sets, L2
ind ivid u als are looking or a job while f rm s will hire only L1
workers. The excess su pply (su rplu s) o labou r L1 L2 (or line
segm ent h) represents u nemploym ent.
A m i n i m u m -wa g e pol i cy wi l l ben ef t som e workers: th ose
wh o wi l l en d u p wi th a j ob a t W9 i n stea d o We. I t wi l l
typi ca l l y crea te u n em pl oym en t (L1 L2 ) th ou g h , a n d wi l l
D(L) especi a l l y h u rt th e workers wh o wou l d h a ve h a d a j ob
wi th ou t th i s pol i cy bu t a re n ow l et wi th ou t on e, n am el y
0 L1 Le L2
i n d i vi d u a l s L1 Le.
Number of workers (L)
Figure 1.3.9 Minimum wage policy
32
1.4 Market ailures
HL Case 3: The existence o m onopoly power Case 4: The case where inormation is asym m etric
M arkets are oten not com petitive as rm s may possess I bu yers and sellers share d ierent sets o inormation then
signi cant m onopoly power. When m onopoly power is present, this may also lead to market ailu re. Certain types o
less than the socially optimal am ou nt o the good will be inormational ailu res also involve an externality aspect.
prod u ced and consu m ed so ewer than optimal resou rces will
be employed in its prod u ction.
We shou ld note here that the u nd erlying incom e d istribu tion in d o not pay or, respectively. Equ ivalently, an externality
a cou ntry may be very u nair. Since market d emand or any exists whenever there is a d ivergence between private and
good ref ects not ju st willingness to bu y a good bu t also the social costs o prod u ction or between private and social
ability to d o so, hou sehold s with a severe incom e constraint, bene ts o consu m ption. Externalities are also reerred to as
living, say, below the absolu te poverty line, may not exist even spillover eects.
in markets where the m ost basic prod u cts, su ch as ood , are An extern ality lead s to a market ailu re as either m ore or
bou ght and sold . Paraphrasing Sam u elsons am ou s expression, less than the socially optimal am ou nt is prod u ced or
these hou sehold s d o not have any d ollars to vote with. I t consu m ed . M arket orces alone ail to lead to an e cien t
ollows that even i the resu lting ou tpu t m ix is consid ered as resou rce allocation.
allocative e ciency, it may still be socially u nd esirable.
Externalities may arise in the prod u ction process, where they
are known as prod u ction externalities, or in the consu mption
Externalities as a source o market ailure process, in which case they are known as consu mption
An externality is present i an econom ic activity (prod u ction externalities. I they im pose costs on third parties th ey are
or consu m ption) im poses costs on, or creates bene ts or, consid ered negative externalities. I n contrast, i they create
third parties or which they d o not get compensated or, or bene ts they are consid ered positive externalities.
Relevant terms and defnitions resources that are sacriced, the costs o which are taken into
Marginal private costs (MPC) consideration by the rm, but also include any external costs that
M PC are d e ned as the costs o prod u cing an extra u nit o are not taken into consideration by rms in the orm o, say,
ou tpu t. They inclu d e wages, costs o raw materials and other pollution. In this case the MSC o production exceed the MPC and
costs that a rm takes into consid eration in its d ecision making should be drawn above the MPC (the supply) curve. This would
regard ing prod u ction. I t ollows that the su pply cu rve ref ects be the case o a negative production externality. I, though, a
the M PC o a (competitive) rm . production process creates benets or a third party (say, another
rm) then the MSC curve lies below the MPC (the supply) curve as
Marginal social costs (MSC) there is an external production beneft involved in the process.
These are dened as the costs o producing an extra unit o
output that are borne by society. They refect the value o all Marginal private benefts (MPB)
resources that are sacriced in the specic production process. MPB are d e ned as the bene ts the in d ivid u al enjoys rom the
This means that they include not just the labour and other consu mption o an extra u nit o a good . The willingness o a
33
1 Microeconomics
consu m er to pay or an extra u nit is d eterm ined by the extra by th e i n d i vi d u a l bu t i n a d d i ti on a ny ben e ts oth ers m ay
bene ts h e or she enjoys rom consu m ing that extra u nit. The en j oy a s a resu l t (extern a l ben e ts). I t ol l ows tha t th e M SB
d emand cu rve ref ects the MPB enjoyed rom consu m ing extra cu rve l i es a bove th e M PB (th e d em a n d ) cu rve. I , th ou g h ,
u nits o a good . i n d i vi d u a l s con su m pti on i m poses a cost on oth ers th en th e
M SC cu rve wi l l l i e bel ow th e M PB (th e d em a n d ) cu rve a s
Marginal social benefts (MSB) th ere i s a n extern a l cost o con su m pti on g en era ted by
Th ese a re th e ben e ts tha t soci ety en j oys rom ea ch extra th e process.
u n i t con su m ed . M SB i n cl u d e th e pri vate ben e ts en j oyed
MSC
f S, MPC pla n ts. Dem a n d , wh i ch a l ways ref ects th e M PB o bu yers o
h on ey, is id en ti ca l to M SB a s n o extern a l eects in th e
con su m pti on o h on ey a re a ssu m ed . Su ppl y o h on ey ref ects
For each level of output, th e M PC o h on ey prod u cers (that i s, th e costs th ey pay, su ch
h MSC lies above MPC so a s or la bou r a n d bees). Si n ce th e h on ey prod u cers
there is an external cost prod u cti on process en ta i ls extern a l ben e ts to a pple growers
of production equal to fh in th e orm o poll in ati on , it ol l ows that th e socia l costs o
h on ey prod u cti on a re lower tha n th e private costs th e
beekeepers con si d er. Th e M SC o h on ey prod u ction a re
th ereore lower tha n th e M PC by th e am ou n t o th e extern a l
D, M PB = M SB ben e t created .
0
Q/period
P/unit
S, M PC = M SC
Figure 1.4.1 a Negative production externality
For each level of output,
Figu re 1 .4.1 a illu strates the case o a rm in the cem ent MSB lies above MPB so
ind u stry em itting pollu tants into the atm osphere. Demand , there is an external benet
of consumption equal to fh
which always ref ects the M PB o bu yers, is id entical to M SB as f
no external eects in the consu m ption o cem ent are assu m ed .
Su pply o cem ent ref ects the M PC o cem ent man u actu rers
(that is, th e costs they pay, su ch as or wages, energy and MSB
materials). Since the prod u ction process entails external costs in h
the orm o pollu tion, it ollows that society sacri ces in the
prod u ction o cem ent m ore than the rm s consid er. Society D, MPB
sacri ces environm ental assets becau se o the pollu tion. The
M SC o cem ent prod u ction are thereore bigger than the MPC 0
Q/period
by the am ou nt o the external costs created . N ote that there is
no shit involved as many stu d ents incorrectly claim : the two Figure 1.4.1 c Positive consumption externality
cu rves, M PC and M SC, ref ect d ierent inormation.
Fi g u re 1 .4.1 c il l u strates th e m a rket or f u va ccin ati on s. I a
stu d en t vi si ts a d octor a n d g ets va cci n ated a ga in st f u i t i s n ot
P/unit
34
1 Microeconomics
S, MPC = MSC the market or vodka. When people consum e alcohol there is
always the risk o increased violence, o drunk driving, o lower
For each level of output, productivity at work and other negative eects. These are all
MSB lies below MPB so
external costs o drinking. The supply o vodka always refects the
there is an external cost
f of consumption equal to fh MPC o vodka producers. The MPC are identical to the MSC as no
external eects in the production process itsel are assum ed.
Demand or vodka refects the MPB o those who consum e the
D, M PB product. Since consumption o alcohol oten creates external
h costs to others in the orm o violence, accidents, lost productivity
at work, and so on, it ollows that the social benets o vodka
M SB consumption are lower than the private benets that individuals
0 enjoy when deciding whether to consum e alcohol or not. The
Q/period
MSB o alcoholic beverages are thereore less than the MPB by
Figure 1.4.1 d Negative consumption externality the am ount o the external costs created.
Demand: Supply:
always refects the MPB enjoyed by consumers: when drawing the always refects the MPC paid by rms: when drawing the supply curve
demand curve instead o simply labelling it D, label it D, MPB. instead o simply labelling it S, label it S, MPC.
I there is no externality in consumption then the benets enjoyed I there is no externality in production then the costs imposed on
by society are not any dierent rom the benets enjoyed by the society are not any dierent rom the costs paid by the rms
individuals consuming the good, so label the demand curve producing the good, so label the supply curve S, MPC 5 MSC.
D, MPB 5 MSB.
I, though, there is an externality in consumption then one o I, though, there is an externality in production then one o
two cases applies: two cases applies:
i there is an external benet then I there is an external cost then I there is an external cost then I there is an external benet then
the MSB curve lies above the D, the MSB curve lies below the D, the MSC curve lies above the S, the MSC curve lies below the S,
MPB curve MPB curve MPC curve MPC curve
(positive consumption externality) (negative consumption externality) (negative production externality) (positive production externality)
Impact of production and consumption Reer to Figure 1.4.2 . The market will lead to Q units o cement
externalities produced at a market price o P per unit. The socially optimal level
o cement output is less at Q* . Why? Because at Q* the MSB are
Impact of a negative production externality
equal to the MSC. For all units past Q* the marginal costs incurred
Prod u ction externalities arise on th e prod u ction sid e so we
by society exceed the marginal benets enjoyed by society, so units
ocu s on the market su pply in the d iagram . The d emand cu rve
Q* Q should not have been produced rom societys point o view.
ref ects both the M PB and th e M SB involved . The (competitive)
There is overproduction o cement, which is the market ailure in
market ou tcom e is always d eterm ined at the intersection o
this case. Area (eh) represents the welare loss as a result o the
market d emand and market su pply.
market ailure. Too much cement is produced at too low a price.
MSC
External cost
P/unit
D, MPB = MSB
D, MPB = MSB
0 Q* Q
Q/period
0 Q Q* Q/period
Overproduction of cement
(market failure) Underproduction of honey
(market failure)
Figure 1.4.2 Negative production externality
Figure 1.4.3 Positive production externality
35
1 Microeconomics
Assu m e that Figu re 1 .4.3 illu strates the market or honey. The exam ples. Alternatively, m erit good s can be d e n ed as good s
d emand cu rve ref ects both the MPB and the MSB that th e that governm ent wou ld like all m em bers o society to consu m e
consu mption o honey creates. The (competitive) market in ad equ ate qu antities ind epend ently o their incom e or even
ou tcom e is d eterm ined at the intersection o market d emand their preerences. I nd ivid u als may not be aware o the bene ts
and market su pply so that Q u nits o honey will be prod u ced at arising rom the consu m ption o the good becau se o lack o
a market price o P per u nit. inormation or myopic behaviou r (resisting change). This is why
The socially optimal level o honey output is more at Q* . Why? ed u cation is com pu lsory in many cou ntries u p to at least a
Because at Q* the MSB are equal to the MSC. For all units past certain level. N ote the paternalistic role o the state in this case.
unit Q the marginal benets enjoyed by society exceed the Analysis o merit goods is preerably but not necessarily
marginal costs incurred by society, so units QQ* should have been conducted within the positive consumption externality ramework.
produced rom societys point o view. The market leads to
underproduction o honey, which is the market ailure in this case. Impact of a negative consumption externality
Area (eh) represents the welare loss as a result o the market Fig u re 1 .4.5 illu strates the market or vod ka (bu t cou ld
ailure. N ot enough honey is produced rom societys point o view. represent the market or alcoholic drinks in general). The
externality arises when vod ka is con su m ed . The su pply cu rve o
Research and d evelopm ent (R&D) activities are con sid ered a
vod ka ref ects the M PC as well as the M SC o prod u cing vod ka.
sig ni cant exam ple o a positive prod u ction externality as the
The (competitive) market equ ilibriu m is d eterm ined at the
u nd er o the R&D program m e oten captu res only part o the
intersection o the market d emand and the market su pply so Q
retu rns generated .
u nits o vod ka will be prod u ced and consu m ed at a market
Impact of a positive consumption externality d eterm ined price P per u nit.
Figu re 1 .4.4 illu strates the market or f u vaccinations. Th e
P/unit
su pply cu rve ref ects the MPC as well as the M SC o prod u cing
S, M PC = M SC
vaccines. The (competitive) market equ ilibriu m is d eterm ined at
the intersection o the market d emand and the market su pply P*
so that Q vaccines will be prod u ced and consu m ed at a market Wel fa re
l o ss
price P per u nit. f
P
P/unit
The socially optimal level o vod ka consu m ption and prod u ction
P* is less at Q* . Why? Becau se at Q* the M SB are equ al to th e
MSB
M SC. For all u nits past u nit Q* the marginal bene ts to society
D, MPB o consu m ing vod ka are less than the margin al costs to society
0 Q Q* o prod u cing it. Units Q* Q shou ld thereore not have been
Q/period prod u ced and consu m ed rom societys point o view bu t they
are: market orces lead to overconsu mption and overprovision
Figure 1.4.4 Market or fu vaccinations o vod ka and this is the market ailu re in th is case. Area (eh)
Th e socially optimal level o prod u ction and consu m ption is represents the welare loss as a resu lt o the market ailu re. Too
m ore at Q* . Why? Becau se at Q* the MSB are equ al to the m u ch vod ka is consu m ed rom societys point o view.
MSC. For all u nits past Q the marginal bene ts enjoyed by
Demerit goods
society exceed the marginal costs o prod u ction incu rred by
Dem erit goods are a special class o goods that are dened
society. Units QQ* shou ld thereore have been prod u ced and either in term s o externalities generated and/or in term s o
consu m ed rom societys point o view bu t they are not: market inormational ailures involved. I the consumption o a good
orces lead to u nd erconsu m ption and u nd erprovision o creates very signicant negative externalities then the product is
vaccines and this is the market ailu re in this case. Area (eh)
reerred to as a dem erit good. Alcoholic drinks and tobacco
represents the welare loss as a resu lt o the market ailu re. N ot
products are good examples. Alternatively, dem erit goods can be
en ou gh vaccines are consu m ed rom societys point o view.
dened as goods o which governm ents would like to lim it
Merit goods consumption. Individuals may not be aware o the costs arising
Merit good s are a special class o good s that are d e ned either rom the consumption o the good because o lack o inormation
in term s o externalities generated and /or in term s o or myopic behaviour and the state takes a paternalistic role.
inormational ailu res involved . I th e consu mption o a good Analysis o demerit goods is preerably but not necessarily
creates very signi cant positive externalities then it is reerred conducted within the negative consumption externality ramework.
to as a m erit good . Ed u cation and health care are prim e
36
1 Microeconomics
Negative production externalities in tervention , cou ld correct problem s arising rom extern alities
Market-based solutions throu g h ba rgain ing and a system o bribes and com pensations
that wou ld make all parties in volved better o. Th e basic id ea
Indirect taxation
is that i th ere is an opportu nity to a chieve an im proved
The pioneering work recom m end in g governm ent interven tion in situ ation , private agents (people an d f rm s) will have the
the case o pollu ting f rm s is attribu ted to Pigou (1 92 0) wh en in cen tive to ma ke a greem en ts that wou ld lead to the
he proposed the imposition o an ind irect tax equ al to the size im provem en t. A hotel own er cou ld bargain an d agree with a
o the external cost generated by the f rm . The ind irect tax pollu tin g f rm nea rby that the hotel will pay that f rm a certain
wou ld in principle internalize th e externality in the sense that it am ou n t o m oney per yea r in exchang e or the f rm red u cin g
wou ld raise the f rm s prod u ction costs to the level o the social pollu tan ts to a pre-specif ed level. Both bu sin esses cou ld
costs created by its activity. This wou ld in d u ce the f rm to lim it ben ef t, or exam ple:
ou tpu t o whatever it prod u ced to the socially optimal level.
n i the agreem en t allows the h otel owner to charge
The principle u nd erlying this solu tion is reerred to as the
higher rates that will cover th e paym ents mad e to the
pollu ter pays principle and the tax is also known as a Pigovian
pollu ting f rm
tax or carbon tax.
n i these paym ents are greater than the lost prof t
Figu re 1 .4.6 illu strates the eect o im posing a Pigovian tax on
experienced by the f rm becau se o the lower level o
a pollu ting f rm in the cem ent ind u stry.
prod u ction.
P/unit
37
1 Microeconomics
and uel they can use, or example. In many cases direct con su m ers a n d o f rm s by in crea sin g th eir awa ren ess o th e
regulation may be the only realistic and cost-eective solution but extern a l costs o certa in a ctivities th ey u n d erta ke. By ma kin g
it may also lead to costly and inefcient outcom es. sch ool ch ildren awa re o th e ben ef ts o recyclin g tod ay th e
g overn m en t a im s at creatin g citizen s wh o will ma ke better
Advertising (or banning of advertising), moral persuasion or education ch oices a bou t su ch issu es in u tu re. Wh en pollu tin g f rm s a re
Th is is a d ieren t set o solu tion s wh ereby th e g overn m en t exposed , th e ba d pu blicity th ey receive may orce th em to a lter
attem pts to cha n g e th e preeren ces a n d pra ctices o th eir pra ctices.
Positive consumption externalities (merit goods) The subsidy increases supply o the good (or example
Market-based solutions vaccinations) to S(sub). The market price will consequently drop
to P* . Consumers will be willing to consume Q* at the lower price
Granting a subsidy
P* which is equal to the socially optimal level o consumption.
The governm en t can estimate the size o the external benef t
Again, estimating the proper size o the subsidy is not an easy task.
created an d grant a su bsid y equ al in size that wou ld lower
prod u ction costs and thereore price. The lower price will ind u ce Command and control solutions
higher levels o consu mption which cou ld equ al the socially Legislation and direct provision
optimal level, as illu strated in Figu re 1 .4.7. Wh en a governm ent consid ers that the external ben ef ts are
very sign if cant to the economy and that any positive price may
P/unit
38
1 Microeconomics
Negative consumption externalities The specifc tax h will decrease supply to S(tax). As a result, the
(demerit goods) market price o the good will increase to P* . The higher price will
lead to a decrease in the quantity consum ed to Q* , the socially
Market-based solutions
optimal level o consumption. Several issues arise with such a
Imposing indirect taxes solution. Again, the optimal tax is difcult to determ ine. Lets
An ind irect tax equ al to th e external costs o consu mption will take the examples o drinking and sm oking. Alcohol and tobacco
d ecrease su pply and so increase the price o the good . The are addictive so demand is quite price inelastic. This m eans that
higher price will ind u ce a lower level o consu m ption. I the size i the goal is to curtail consumption a very high tax will be
o the tax is correct, the socially optimal level o con su mption needed. H owever, not all consum ers are the sam e. Demand by
may be achieved . Figu re 1 .4.8 illu strates the case. higher-incom e individuals will even m ore price inelastic so their
consumption may not be aected at all. On the other hand, a
P/unit
Public goods as a case of market failure Few exam ples o pu re pu blic good s exist. A lighthou se, national
d eence and traf c lights are typical examples. I a lighthou se
A good is consid ered a pu blic good i it is characterized by the
is bu ilt and maintained on som e island no f sherman can be
ollowing two properties.
exclu d ed rom its benef ts. I the lighth ou se is u sed by one
n I t is non-exclu d able. This m eans that i the good becom es boat the am ou nt o its service available to other boats
available to even one consu m er it au tomatically becom es is the sam e (the marginal cost o one m ore boat u sing
available to all. N o on e can be exclu d ed rom consu m ing it. the service is zero).
n Consu mption o the good is non-rival (or non-d im inishable). Law and ord er in a town and price stability in an economy are
Th is m eans that each ind ivid u al s consu m ption o the good som ewhat d ierent examples bu t they satisy both criteria o
d oes not d ecrease the am ou nt available or all others. pu blic g ood s and their im plications are interesting . For
N on-excl u d a bi l i ty l ea d s to i n d i vi d u a l s h i d i n g th ei r tru e example, i it is sae or M egan to walk at night in a city then,
preeren ces a n d beh a vi n g a s ree-ri d ers beca u se th ey kn ow probably, it is sae or others. Also, i she walks saely there is
tha t th ey ca n en j oy th e g ood wi th ou t h a vi n g to pa y or no less saety available or others. I price stability exists or one
i t on ce i t becom es a va i la bl e or oth ers. N on-ri va l ry i n then it exists or all econom ic agents. Sim ilarly, i one benef ts
con su m pti on i m pl i es th a t th e m a rg i n a l cost o a n rom its existence then law and ord er can even be extend ed to
extra u ser i s zero. imply a u nctional institu tional ram ework, which is especially
important or a d eveloping economy and only a governm ent
The externality aspect o pu blic good s becom es apparent by
can provid e it.
realizing that i som eone provid es or maintains a pu blic good ,
even at a cost, he or she cann ot prevent others rom enjoying A d ieren t exam ple o a pu re pu blic g ood is broa d ca st
the benef ts. So i the private ben ef ts o provid ing a pu blic television a n d ra d io. Both pu blic g ood properties a re satisf ed .
good are small compared to th e social benef ts and the private A broa d ca st television program m e is n orma lly ava ila ble to a ny
costs are larger than the private benef ts, then the good will h ou seh old with a television (a private, sepa rate g ood ). Also,
not be su pplied at all. i on e person watch es th e program m e th ere is n o less o it
ava ila ble or oth ers to watch . I n terestin gly, television a n d ra d io
More generally, pu blic good s are a case o market ailu re
broa d ca stin g , d espite its pu blic g ood eatu res, is prod u ced
becau se private prof t-orien ted f rm s will not have the incentive
an d oered by private, or prof t com pa n ies. Th is is possible
to prod u ce and oer su ch good s and services throu gh the
beca u se broa d casters a re n ot sellin g th e program m es bu t th e
market. The market m echanism ails. Even thou gh there may be
ad vertisin g tim e, wh ich is both exclu d a ble a n d riva l.
suf cient d eman d or su ch a good , it will not be oered .
39
1 Microeconomics
P/unit
resources) MSC
The traged y o the com m ons was a term introd u ced by Garrett
H ard in (1 968). The id ea was simple. Assu m e a pastu re open to
all (the com m ons) with the ad jacent land own ed by a nu m ber S, MPC
o herd sm en, as in the ollowing illu stration.
P*
H1 H2
P
H6 Th e co m m o n s H3
D, MPB = MSB
H4
H5 0 Q* Q
Overshing Q/period
40
1 Microeconomics
HL Monopoly power as a source of market failure n practices that seem anti-com petitive are m onitored ; it cou ld
tax or f ne f rm s ou nd gu ilty o su ch practices or even break
Firm s with m onopoly power are able to restrict ou tpu t
these f rm s u p into smaller ind epend ent pieces.
below the com petitive id eal and charge a higher price lead ing
to a welare loss. A u ll analysis o m onopoly is given on A m ost eective way to red u ce d om estic m onopoly power o
pages 5 9-62 . frm s is throu gh liberalizing international trad e. Free trad e
automatically increases competition, lead ing to increased
Possible solutions ef ciency and lower prices. Bu t, one shou ld keep in m ind that
The governm ent shou ld en su re that competitive cond itions there may be very sign if cant d ynam ic benef ts arising rom
prevail in markets. I t shou ld ensu re that: the existence o su ch larg e m onopoly f rm s in the orm o
n n o m ergers or acqu isitions materialize that excessively aster rates o inn ovation, technological change an d econom ies
increase the m onopoly power o any f rm o scale.
41
1.5 Theory o the frm and market structure
HL I n general, the short ru n is d e ned as the tim e period d u ring the second worker simply copies the rst worker then d ou ble
which som e, bu t not all, ad ju stm ents can take place. I n the the u nits (2 x) will be prod u ced . Bu t since there is so m u ch
context o prod u ction theory, the short ru n is d e ned as that capital available to work with compared to labou r there is a lot
period d u ring which at least one actor o prod u ction is o room or labou r specialization to take place. The two
consid ered xed . Assu m ing two actors o prod u ction, capital workers may agree that one will be in charge o th e whole
(K) and labou r (L), it is typically capital that is assu m ed kitchen and the other o all the serving and o taking
constant in th e short ru n. This m eans that the total prod u ct cu stom ers paym ents. Ou tpu t will as a resu lt m ore than d ou ble.
(TP), which is another term or ou tpu t (Q), can change by Focusing on Figure 1.5.1 (a) output will be initially increasing at
varying the level o labou r given the level o capital. an increasing rate up until some unit o labour, say L1. You should
I n the short ru n the behaviou r o ou tpu t is d eterm ined by the notice that the tangent on the TP curve at point b is steeper than
law o d im inishing marginal retu rns. Th e behaviou r o short-ru n at point a. Since we have realized that marginal product is the
costs and the shape o short-ru n cost cu rves (d iscu ssed later) are slope o total product and this slope is increasing up until L1, it
a d irect con sequ ence o the behaviou r o ou tpu t and o the law ollows that the MP curve in diagram 1.5.1 (b) is rising up until L1.
o d im inishing marginal (and average) retu rns. At this point thou gh, ad d ing workers will still help increase
The marginal product o labour (MP) is dened as the extra output total prod u ct (the TP cu rve in d iagram 1 .5.1 (a) continu es to
produced by employing one more worker or, more generally, as the rise) bu t now it will rise at a slower rate (it becom es f atter and
change in output induced by a change in labour (L): f atter). Each extra worker contribu tes to the prod u ction o
DQ
MP L 5 ___
TP (Q)
(a) d
DL
e
So, or any u nit o ou tpu t Q, M P is the slope o the total c
prod u ct (TP) cu rve. TP
(b)
and the variable actor (labour) is assum ed hom ogeneous. So,
any dierences in returns (output) as m ore units o labou r are
employed are not because o dierences in workers abilities but
a result o the continuously changing ration o capital to labour.
That is why the law is also known as the law o variable
proportions. I capital and labour were perectly substitutable
actors in the produ ction process then the law would not hold.
An example will help you u nd erstand the logic o the law.
I magine a pizzeria equ ipped with ovens and other equ ipm ent,
tables and chairs, etc. The prem ises, ovens, tables, etc. are the
xed capital that exists. With zero workers working in this
pizzeria, ou tpu t per period will be zero. Zero workers will
0 L1 L2
prod u ce zero pizzas. N ow, i one worker is em ployed , then som e L
level o ou tpu t (som e nu m ber o pizzas) will be prod u ced per MP
period , say x u n its. The worker will have to d o everything: take
ord ers, prepare th e pizzas, serve the ood and take the m oney. Figure 1.5.1 Total product, marginal product and the law o diminishing
I two workers are em ployed then it shou ld be realized that i marginal returns
42
1 Microeconomics
pizzas bu t not as much as the previou s one. The bene ts o on th e tota l prod u ct cu rve. For exam pl e, th e avera g e prod u ct
m ore and m ore specialization are slowly exhau sted . The TP o la bou r a t L9 i s eq u a l to ou tpu t (wh i ch i s eq u a l to l i n e
curve still rises bu t now at a decreasing rate. Marginal seg m en t L9 H ) d i vi d ed by th e n u m ber o workers em pl oyed
product, wh ich is the slope o the TP cu rve, is thereore (l i n e seg m en t 0L9 ). Th i s rati o i s th e sl ope o th e ray (0H ). I t
positive but decreasing (dropping) between L1 and L2 . N ote ol l ows th at to d eterm i n e th e beh avi ou r o a vera g e prod u ct
that the slope o the total prod u ct cu rve is f atter at point c on e n eed s to exam i n e th e beh avi ou r o th e sl ope o th e ray
than at point b and that at worker L2 (point d ) its slope is zero rom th e ori g i n to su ccessi ve poi n ts on th e tota l prod u ct
(it is parallel to the horizontal axis) so marg inal prod u ct is zero cu rve. Th e sl ope o th i s ray i n crea ses u p to L9 a n d th en
in Figu re 1 .5.1 (b). d ecrea ses. I t i s steepest a t L9 so AP ha s a m a xi m u m at th at
Ater L2 workers are em ployed , labou r is too m u ch or the l evel o workers. N ote th at a vera g e prod u ct ca n n ever cross
am ou nt o capital available (the size and equ ipm ent o the th e h ori zon ta l a xi s a n d becom e n ega ti ve a s n ei th er Q n or L
pizzeria) so total prod u ct will start d eclining. There are so many ca n ever be n ega ti ve.
workers that they get in each others way. The contribu tion o
TP (Q)
each extra worker (the workers marginal prod u ct) is negative (a)
ater L2 workers are employed . M arginal prod u ct is negative
ater worker L2 : the marginal retu rns are now negative.
This shows that the law o d im inishing marginal retu rns hold s H TP
between L1 u nits o labou r and L2 u nits o labou r: ater worker
L1 total prod u ct contin u es to rise bu t at a d ecreasing rate; in
other word s, marg inal prod u ct is d ecreasing. N o rm will ever
employ m ore than L2 workers as there wou ld be too m u ch
labou r compared to capital. Sim ilarly, no rm will ever em ploy
ewer than L1 workers as there wou ld be too m u ch capital
compared to labou r. Distance L1 L2 is known as the econom ic
region o prod u ction.
0 L
L
Reer to Figure 1.5.1 (a) and (b). Draw the TP curve in three
AP
TIP (b)
steps: initially with a rising positive slope (rom zero to L1),
then with a decreasing positive slope (rom L1 to L2) then
with a negative slope (past L2). At each switch, drop a line to
the horizontal (labour) axes o both diagrams. You will have
determined points L1 and L2 in the bottom diagram. Here, sketch
the MP curve, remembering that it is the slope o the TP curve.
It rises up to L1 and right above L1 it starts to decrease. At L2
MP is zero so the curve crosses the horizontal axis.
(HL Math and Math Methods students: draw the MP as i you were AP
asked to sketch the frst derivative o the TP unction above it.)
0 L
Diminishing average returns L
One can also express the law o d im inishing retu rns in term s Figure 1.5.2 Total product, average product and diminishing
o the average prod u ct o labou r: as m ore and m ore u nits o average returns
labou r are ad d ed to a xed am ou nt o capital there is a point
beyond which average prod u ct o labou r d ecreases. I n The relationship between marginal and
Figu re 1 .5.2 this occu rs ater worker L9 . average product
The average prod u ct (o labou r) is d e ned as ou tpu t per u nit o I n general, the ollowing hold s.
labou r (per worker):
n I marginal is greater than average then average will rise.
Q
__ I marginal is less than average then average will drop.
AP L 5 n
L
n I marginal is equ al to average then average will be at
The average prod u ct o labou r is also reerred to as the a maxim u m .
prod u ctivity o labou r.
To u n d ersta n d th e relation sh ip, th in k o a stu d en t ta kin g a
Focu si n g on Fi g u re 1 .5 .2 , th e averag e prod u ct o la bou r a t series o tests in a n econ om ics cou rse. I in th e sixth test (th e
a ny poi n t on th e tota l prod u ct cu rve i s eq u a l to th e sl ope o marg in a l test) th e stu d en t ga in s a h ig h er gra d e tha n h is or h er
a stra i g h t l i n e (th e ray) drawn rom th e ori g i n to th a t poi n t
43
1 Microeconomics
MP, AP
th e stu d en ts avera g e will rise. I th e stu d en t receives a lower
gra d e tha n h is or h er avera g e gra d e to that poin t (in oth er
word s, i M , A) th en th e stu d en ts avera g e gra d e will a ll.
An d i th e stu d en t receives in th e sixth test exa ctly th e sam e
gra d e a s h is or h er avera g e to that poin t, th e stu d en ts avera g e
will n ot cha n g e.
Focu sing on Figu re 1 .5.3, f rst draw the inverse U -shaped
average prod u ct (AP) cu rve and then the marginal prod u ct (MP)
cu rve, making su re that on its way d own, the M P cu rve cu ts the
AP cu rve at its maxim u m point. AP
To th e l et o L9 , M P i s g rea ter th a n AP so AP sh ou l d be
ri si n g . I n d eed i t i s. To th e ri g h t o L9 , M P i s l ess th a n AP so
AP sh ou l d be d ecrea si n g a n d i n d eed i t i s. Si n ce beore L9 AP
0 L
i s i n crea si n g a n d ri g h t a ter L9 AP i s d ecrea si n g , i t ol l ows
Labour (L)
th a t a t L9 AP m u st be a t a m a xi m u m .
MP
Figure 1.5.3 Marginal and average product curves in one diagram
HL The meaning o the term economic costs next best alternative bu siness with the sam e risks, bu siness B,
then the m inim u m retu rn the entrepreneu r requ ires to keep the
To u nd erstand the m eaning o the term it is important to
1 .0 m illion invested in bu siness A wou ld be 80,000 per year,
rem em ber that resou rces are scarce in any economy so
otherwise he or she wou ld pu ll the f nancial capital ou t and
whenever a resou rce is u sed in the prod u ction o a good it is
instead invest it in bu siness B. The am ou nt o 80,000 is a
au tomatically not available to prod u ce other good s. I n oth er
prod u ction cost or bu siness A as withou t this retu rn the
word s, it is sacrif ced . From an econom ists poin t o view, the
entrepreneu r wou ld pu ll ou t his or her scarce u nd s and the
term econom ic costs reers to the valu e o all resou rces that
f rm wou ld not exist.
are sacrif ced d u ring the prod u ction process. I t implies that
econom ic costs inclu d e not only what are d ef ned as the
explicit costs production costs or which
explicit costs o a f rm (the explicit paym ents it makes or the
explicit payments are made,
u se o actors, also known as ou t-o-pocket costs) bu t also
or example wages
implicit costs. This term s reers to the valu e o resou rces the
f rm owns and th ereore it d oes not have to pay or bu t, rom Economic costs implicit costs production costs or actors
include: owned by the frm plus the
the econom ists point o view, these represent sacrif ced
minimum payment required to
scarce resou rces.
secure entrepreneurship
I mplicit costs also inclu d e the m inim u m reward that the scarce (which is known as normal
actor o entrepreneu rship requ ires to remain in that lin e o profts)
bu siness. This m inim u m reward is known as normal prof ts and
is an elem en t o econom ic costs. The id ea is that to secu re
entrepreneu rship in a bu siness activity, som e m inim u m reward Short-run costs
(paym ent) is necessary or the risk that is u nd ertaken. This As m en tioned earlier, the short ru n is a period o tim e d u ring
m inim u m is equ al to what cou ld be earned by the entrepreneu r which at least one actor o prod u ction is f xed . As a resu lt,
in the next best alternative available with the sam e risk. I this f rm s in the short ru n ace both fxed an d variable costs.
m inim u m reward d oes not materialize, then th e f rm will close
Fixed costs are costs that d o not vary when the level o
d own and the f nancial capital tied u p in it will be reed and
prod u ction varies and they are u navoid able. They exist and
m oved into the next best alternative project that com mand s the
have to be paid even i ou tpu t is zero. Examples typically
sam e level o risk. I it is d if cu lt to accept that this m inim u m
inclu d e ren t, interest on loans, insu rance costs, f xed contract
requ ired to attract and secu re the actor o en trepren eu rship is
costs, etc. Figu re 1 .5.4 (a) illu strates f xed costs as a line parallel
an elem ent o econom ic costs, rem em ber that or a f rm to be
to the qu antity axis. Figu re 1 .5.4 (b) below it illu strates average
able to u se the scarce actor o labou r, wages have to be paid
f xed costs. Since average f xed costs are d ef ned as f xed costs
which, o cou rse, are an elem en t o cost. For example, i an
d ivid ed by ou tpu t, it ollows that the average f xed costs
entrepreneu r is contemplating whether to start u p bu siness A
continu ou sly d ecrease as ou tpu t rises bu t they never becom e
by f nancially investing 1 .0 m illion and the entrepreneu r
zero. N ote that the areas beneath the average f xed costs (AFC)
knows that he or she cou ld be earn ing 80,000 a year in the
cu rve are all equ al to the f xed cost the f rm aces.
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1 Microeconomics
(b)
relationship between prod u ction and cost theory and so
between marginal prod u ct and marginal costs. Rem em __
ber that
i labou r is the only variable actor then wage costs ( w 3 L are
the variable costs:
__ __
DVC ( w 3 L) w (DL) __ DL
MC 5 ____ 5 _______ 5 ______
5 w 3 ___
DQ DQ DQ DQ
__
__ 1 __ 1 w
5 w 3 _____5 w 3 ___
5 ___
MP MP
DQ
___
DL ( )
So, MC will d ecrease when M P rises and M C will rise when MP
d ecreases (i.e. wh en d im inishing marginal retu rns start in
AFC prod u ction)
0
Output (Q)
VC
(a)
Figure 1.5.4 Fixed and average xed costs
Variable costs inclu d e costs that vary with the level o ou tpu t,
The output level Q1 here is
or example raw materials, components and labou r. Average equal to the output level Q1
variable costs (AVC) are d e ned as variable costs over the level in Figure 1.5.1 :
o ou tpu t. The average total cost (ATC) o prod u cing som e
When MP starts to decrease
level o ou tpu t is total costs over the level o ou tpu t and it is (i.e. law of diminishing marginal
the su m o the average variable and the average xed costs o returns kicks-in). MC start to
prod u cing that level o ou tpu t: ATC 5 AFC 1 AVC increase as VC start to increase
Marginal cost (MC) is dened as the additional cost o producing at an increasing rate.
an extra unit o output. This m eans it is the change in costs (total 0 Q1
Q
or variable) resulting rom a change in the level o output:
MC
(b)
DTC DVC
MC 5 ____ 5 ____ MC
DQ DQ
I t is the slope o the total cost (or the slope o the variable cost)
cu rve at each level o ou tpu t.
45
1 Microeconomics
The shape o variable and average variable costs in the will becom e smaller and smaller as ou tpu t increases becau se
short run AFC continu ou sly d ecreases and tend s to zero, as sh own in
Average variable costs are the ratio o variable costs over the Figu re 1 .5.7. As the level o ou tpu t increases the vertical
level o ou tpu t. I n Figu re 1 .5.6 (a) i ou tpu t is Q9 u nits then d istances between th e two cost cu rves becom es smaller and
variable costs are equ al to line segm ent Q9 H . Averag e variable smaller: (h) , (d e) , (ab).
Q9 H
costs are thereore equ al to the ratio ____ which is the slope o
0Q9
ATC, AVC
th e ray 0H . So, to d eterm ine the behaviou r o the AVC cu rve
one need s to check the behaviou r o the slope o the rays rom
th e origin to variou s su ccessive points on the VC cu rve. These b
slopes initially d ecrease u p to ou tpu t Q9 and then increase, ATC
giving rise to a U -shaped AVC cu rve. f AVC
h
VC
(a)
VC c
a d
0
Q
(b)
VC cu rve and the f xed cost (FC) cu rve. I n Figu re 1 .5.8 the TC
cu rve is shaped ju st like the VC cu rve except it has been shited
u p by the am ou nt o the f xed costs. So, the vertical d istance
between the TC cu rve and the VC cu rve is the sam e at all levels
o ou tpu t. Line segm ent ab 5 h 5 kj 5 u v and they are all
AVC
equ al to the f xed costs 0c.
TC, VC, FC
TC
k
VC
0 Q
Q h
u
Figure 1.5.6 Variable and average variable costs
b
The shape o the AVC cu rve is the m irror image o the average j
prod u ct (AP) cu rve. The ollowing d erivation also illu strates the
d irect relationship between prod u ction and cost th eory and in f
this case between AP and AVC: c FC
__
w 3 L)
(_______
__ __ a
VC L 1
AVC 5 ___ 5 5 w 3 __ 5 w 3 ____
Q Q
__
Q Q
__
L ( )
__ 1
___ w
___ 0
5 w3
AP 5 AP Q/period
46
1 Microeconomics
MC ATC
throu gh average at its m inim u m poin t.
AVC n I M , A then A will drop.
n I M . A then A will rise.
n I M 5 A then A will be at a m inim u m .
I n Figu re 1 .5.9, AVC d ecreases or all u nits o ou tpu t u p to
un it Q1 . MC m u st lie below it. For ou tpu t to the right o
un it Q1 since AVC is rising, M C m u st lie above it. Focu sing
on ATC, it shou ld be clear that or ou tpu t to the let o
un it Q2 , M C shou ld lie below ATC as ATC is d ecreasing. For
outpu t to the right o Q2 , M C shou ld lie above ATC as ATC
is rising.
HL The long ru n is d ef ned as that tim e period d u ring which all n I prod u ction is characterized by constant retu rns to scale
ad ju stm ents are possible. Within the theory o prod u ction it is then average (u nit) costs are constant, as ou tpu t is
the period d u ring which all actors are consid ered variable (or, increasing as ast as costs.
equ ivalently, no f xed actors exist). The f rm can thereore n I prod u ction is characterized by d ecreasing retu rns to scale
change its scale o prod u ction. I t can grow or it can shrink then average (u nit) costs are increasing, as costs are
in size. increasing aster than ou tpu t. The f rm is experiencing
I n the long ru n there are three possible eects on ou tpu t rom d iseconom ies o scale.
an increase in the level o u se o all actors.
I n Figu re 1 .5.1 0 a typical long-ru n average cost (LAC) cu rve is
n Increasing returns to scale: the percentag e increase in illu strated . Th e LAC cu rve shows the m inim u m average cost
ou tpu t is greater than th e percentage increase in all inpu ts. or which level o ou tpu t Q can be prod u ced in th e long ru n;
For example, d ou bling all actors o prod u ction m ore than that is, when th e f rm can change its size and choose the
d ou bles the level o ou tpu t Q. I n other word s, an increase in optimal scale.
all inpu ts by 1 % will lead to a greater than 1 % increase
in ou tpu t.
LAC, SAC
47
1 Microeconomics
size o a rm and ou tpu t increases. The d ownward section o a becau se, on the ou tpu t sid e, d istribu tion costs on a per
LAC cu rve illu strates EOS. Long-ru n average costs are constant u nit basis are u su ally lower or larger rm s.
in the horizontal section o the LAC cu rve where the rm is n Financial EOS may arise becau se a large rm can oten
characterized by constant retu rns to scale. Lastly, i the rm s borrow rom banks at lower interest rates.
size increases m ore then ater som e point, the LAC cu rve slopes
n M anagem ent EOS may arise becau se larger rm s can
u pward . Average costs increase as the scale o a rm and
employ specialists in each d epartm ent, or example a large
ou tpu t increases. The u pward sloping section o a LAC cu rve
su permarket will hire nan cial experts to man age its cash
illu strates DOS.
f ow on a d aily basis and a large d epartm ent store will hire
N ote at each level o ou tpu t (Q) correspond s the rm s speci c specialist bu yers.
size (and so a speci c short-ru n average cost cu rve: SAC) with
n Risk-related EOS may arise because a larger rm is oten more
which the rm can ach ieve the lowest possible average costs.
diversied, selling not one but many products, in not one but
For example, Q9 u nits o ou tpu t can be prod u ced both by a
in many markets (or even in many countries). Risks, and the
small rm with a sh ort-ru n average costs cu rve SAC1 and a rm
associated costs, are thereore better spread and m inim ized.
that is larger and has a short-ru n average costs cu rve SAC2 . Th e
lowest u n it cost with which this rm can prod u ce Q9 u nits is C2 External EOS
(equ al to line segm ent Q9 a) and this is achieved i the rm s Som etim es, as an ind u stry grows, u nit costs o the rm s
size increases. Point a belongs on the rm s LAC cu rve. com prising it may d ecrease. Typically this is a resu lt o sim ilar
rm s locatin g together in one area (reerred to also as
Draw the U-shaped LAC curve rather shallow, making sure agglom eration econ om ies). Why?
TIP
that on its decreasing region the SAC curves are tangent to H ere are som e reasons.
it on the let o their lowest points while on its rising section n A specialized labou r orce may d evelop and technical
the SAC curves are tangent to it on the right o their minima. Also schools, catering to rm s need s, may also be established in
note that the smallest size with which minimum average costs the area.
can be achieved in the long run is the frms minimum optimal
n Complem entary rm s may also be established .
(or minimum efcient) scale.
n Better transportation and telecom m u n ications networks
may d evelop.
EOS n M arketing o by-prod u cts may be possible.
These are d e ned as cost savings d u e to increased scale o
prod u ction. They can be d istingu ished into internal EOS and DOS
extern al EOS. I nternal EOS are cost savings d u e to actions o These are d e ned as increases in average costs d u e to
the rm itsel. External EOS are cost saving s originating rom increased scale o prod u ction. Firm s may becom e so big that
d evelopm ents ou tsid e the rm , or example becau se the u nit prod u ction costs start to rise. DOS can originate within a
ind u stry in which it operates grows. rm (internal DOS) or ou tsid e the rm (external DOS).
Sources of EOS Internal DOS
I nternal EOS can resu lt rom technical, marketing, Ater a point, size may becom e a problem . When rm s grow
managem ent, nancial or risk-related reasons. Speci cally, beyond a certain size then u nit costs may start increasing.
these can be as ollows. Possible reasons or this are as ollows.
n Technical EOS may arise: n M anagem ent problem s o coord ination, control and
becau se a rm that is large in size may be able to ad opt com m u nication associated with hu ge size may d evelop.
technologies o prod u ction sim ply not available or n M otivation may d ecrease.
smaller rm s, or example capital equ ipm ent (su ch as
n I n terd epend encies within a hu ge rm may lead to problem s
an assem bly line) is oten ind ivisible and thereore
i there are any hold u ps in any particu lar part o the rm .
u navailable or small rm s
becau se larger rm s oer m ore possibilities or labou r External DOS
specialization n Ater a point, congestion costs in an area may d evelop.
as a resu lt o the container principle (or the law o n As an ind u stry grows, actor prices (or exam ple or
d im ension s): cost savings may arise becau se volu m es materials or specialized labou r) may also start increasing as
rise aster than su races. For example, a storage tank a resu lt o the higher actor d emand .
that can store d ou ble the volu m e o som ething costs
less than d ou ble to manu actu re than a smaller tank. Revenues
This principle is related to blast u rnaces, pipes, tru cks Total revenu es (TR) are d e ned as the prod u ct o the price per
and o cou rse shipping transportation. u nit tim es the nu m ber o u nits sold , or:
n Marketing EOS may arise: TR 5 P 3 Q
becau se, on the inpu t sid e, a larger rm bu ys inpu ts in The behaviou r o total revenu es as a rm sells m ore u nits o
bu lk and so may secu re better prices rom su ppliers ou tpu t d epend s u pon whether the rm can sell m ore u nits at
(bu lk bu ying) the sam e price or whether in ord er or the market to absorb
m ore u nits it m u st lower the price.
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1 Microeconomics
Case 1 : The frm can sell more per period at the same price
Average revenue
I the f rm is extrem ely small in size compared with the market
and it sells a good that is id entical to the one sold by all the
other f rm s in the market then it will be able to sell m ore u nits
withou t lowering the market price. I n this case it will be as i it
is acing a perectly elastic (horizontal) d emand or its prod u ct,
as illu strated in Figu re 1 .5.1 1 .
P
P d, AR
0
Q
P d Figure 1.5.13 AR curve when a frm can sell more units at the same price
Figu res 1 .5.1 3 and 1 .5.1 1 are id entical: the d emand cu rve that a
f rm aces is always id entical to the f rm s AR cu rve.
M arginal revenu e (MR) rom the sale o Q u nits is d ef ned as
0 the extra revenu e earned rom an extra u nit o ou tpu t sold or,
Q
the change in revenu es g iven a change in ou tpu t. So:
Figure 1.5.11 Demand o a frm being able to sell more units at the
DTR
same price P9 MR 5 ____
DQ
Assu m ing that the price at which it can sell its ou tpu t is P9 ,
then its total revenu es will be: There are two ways to u n d erstand what th e M R cu rve will look
like. One way is to realize that i a f rm can sell extra u nits at
TR 5 P9 3 Q
th e sam e price (say, P9 ) then:
For example, i the price at which it can sell its ou tpu t is $ 5.00
n the M R rom selling an extra u nit will be o cou rse equ al to
per u nit then:
the price P9
TR 5 5 Q
n the MR curve will be a straight line at the price P9 , identical to
Figu re 1 .5.1 2 illu strates the total revenu e u nction or su ch a the demand curve it aces and its AR curve, as in Figure 1.5.1 4.
f rm . I t is a straight line that starts rom the origin becau se i it
sells zero u nits it will earn zero revenu es. The other way is to realize that M R is nothing bu t the slope o
the TR cu rve in Figu re 1 .5.1 2 . The slope o TR is a positive and
Total revenues
TR
P d, AR, MR
0
Output (Q)
Figure 1.5.12 Total revenues when the frm can sell more units at the 0
Q
same price
Figure 1.5.1 4 Marginal revenue when a frm can sell more units at the
Average revenu e (AR) rom the sale o Q u nits is d ef ned as the same price
revenu e per u nit o ou tpu t sold , or:
N ote that since AR in Figu re 1 .5.1 4 is constant it ollows rom
TR(Q)
_____ P3 Q the logic o marginal and average magnitu d es explained earlier
AR(Q) 5 5 _____ 5 P
Q Q that M R m u st equ al AR and m u st thereore also be constant.
It should be clear that AR is always equal to the price at which the
output is sold. Since the demand curve shows at which price each
quantity can be sold it ollows that the AR curve is always the
demand curve that the frm aces, as illustrated in Figure 1.5.1 3.
49
1 Microeconomics
Case 2: The frm must lower the price to sell more Determ ining the shape o the MR cu rve is m ore d if cu lt. I t is
I the f rm is large in size compared with the market or i it sells im portant to rem em ber that M R is the slope o TR and that
a good that is not consid ered id en tical to those sold by other since AR continu ou sly d ecreases, it m u st be that M R is less
f rm s then it aces a n egatively sloped d emand cu rve. (below on a d iagram ) than AR. So M R m u st cross the horizontal
Since AR is always equ al to the price at wh ich the good is sold axis at Q (see Figu re 1 .5.1 7 ).
(as shown earlier) the d emand cu rve aced by the f rm is also its
P, AR, MR
AR cu rve, as illu strated in Figu re 1 .5.1 5 :
P, AR
D, AR
D, AR 0 Q
TR Output (Q)
0 Q
Quantity (Q) MR
Figure 1.5.15 AR curve when a frm must lower price to sell more
Figure 1.5.1 6 TR curve when a frm must lower price to sell more
50
1 Microeconomics
HL The meaning o the term economic profts (p) have mad e in the next best alternative available with the sam e
risks. Other entrepreneu rs will want to join this market an d they
Econom ic prof ts are d ef ned as the d ierence between total
will i there is nothing to d eter their entry.
revenu es (TR) and total econom ic costs (TC) o prod u ction.
Lastly, i total revenu es are less than total (econom ic) costs
p(Q) 5 TR(Q) 2 TC(Q)
then the f rm is not making the m inim u m it requ ires to remain
The key to u nd erstand ing econom ic prof ts is to rem em ber th e in bu siness. I t may be making prof ts bu t these are less than the
m eaning o econom ic costs. Econom ic costs inclu d e not only entrepreneu r cou ld earn in th e next best altern ative (less than
explicit costs bu t also implicit costs. Rem em ber that implicit normal prof ts) so, in the long ru n when no f xed actors tie the
costs reer to the cost o u sing resou rces owned by a f rm or f rm u p, it will certainly exit and try to enter the next best
which it makes no explicit paym ent as well as the m inim u m alternative line o bu siness.
reward that the actor o entrepreneu rship requ ires to remain in
that line o bu siness, known as normal prof ts. The role o economic profts in a market
Since econom ic costs inclu d e the m inim u m prof t requ ired to economy
remain in bu siness, it ollows that i total revenu es are equ al to
Econom ic profts are the reward to entrepreneurship. They dier
total (econom ic) costs and the f rm is making zero econom ic
rom wages in that profts are not contracted, as wages are, but
prof ts it is not that the f rm is making no m oney! I t is making a
are a residual and so they may even be negative (losses).
prof t 2 the m inim u m it requ ires: normal prof ts.
Supernormal profts attract resources into an industry whereas
This means that i a frm is making zero economic profts it will losses ree up resources, allowing their use in other industries.
have no reason to shut down and exit the market as it is making Relative price changes coupled with supernormal profts and
as much as it would have been making in its next best alternative. losses drive resource allocation in a market economy. Striving to
I now it happens that total revenu es exceed total (econom ic) achieve profts results in less waste and thereore in greater
costs then the f rm is earning m ore than the m inim u m (normal (technical) efciency. Supernormal profts provide the incentive
prof ts) requ ired : it is making su pernormal (or, som etim es, and unding or frms to fnance expansion (investment).
abnormal) prof ts. These are prof ts over and above normal. Supernormal profts can also be used to fnance R&D
Entrepreneu rs are making in this market m ore than they cou ld program mes and so may lead to product and process innovations.
Goals o frms
HL Proft maximization extra revenu e collected rom selling one m ore u nit o ou tpu t
exceed s the extra cost o prod u cing that extra u nit. I that is
The working assu mption in econom ics is that f rm s aim at
th e case, then whatever the level o prof ts mad e at Q u nits
maxim izing econom ic prof ts (that is, maxim izing the d ierence
o ou tpu t, the f rm will be able to in crease these prof ts by
between total revenu es and total costs).
prod u cing that extra u nit. Bu t i prof ts can be increased , they
The condition or proft maxim ization are n ot at a maxim u m . I t ollows that i MR . M C then prof ts
I t can be shown that i a f rm wishes to maxim ize prof ts it m u st cannot be at a maxim u m as they can be increased . N ote that
choose an ou tpu t level Q at which: even i the f rm was making losses at the ch osen level o ou tpu t
MR 5 MC Q, it wou ld be able to d ecrease these losses by prod u cin g the
and the MC curve is rising extra u nit, so the chosen Q cou ld not have been the right (the
best or optim u m ) choice o ou tpu t.
Many stu d ents erroneou sly think that this cond ition m eans that
prof ts are zero, orgetting that the term marginal reers to one Case 2: MR , MC
m ore u nit, to the extra u nit. To realize why prof ts are maxim u m I th e f rm ha d ch osen a n ou tpu t rate Q at wh ich M R , M C,
when M R 5 M C one m u st consid er the alternatives. There are th en , by prod u ci n g on e u n i t less it wou ld n ot col lect th e
two alternatives. M R cou ld be either greater or less than M C. a ssociated reven u es bu t it wou l d n ot in cu r th e greater
a ssociated cost. I t ollows that, whatever th e level o prof ts,
Case 1 : MR . MC it wou ld increase th ese (or d ecrea se losses) by prod u cin g
Assu m e or the sake o the argu m ent that at the chosen level on e less u n it.
o ou tpu t Q, M R . MC. Read ing this careu lly m eans that the
51
1 Microeconomics
I t ollows rom the logic o this analysis that pro ts cannot be maxim ize revenu es is to choose that level o ou tpu t Q or which
at a maxim u m i M R . MC or i M C . M R. MR are zero. I MR are a positive nu m ber at som e level o
A rm shou ld neither increase nor d ecrease its ou tpu t rate i ou tpu t then by selling one m ore u nit the rm cou ld increase
M R 5 M C as at that level o ou tpu t pro ts are maxim ized (or revenu es so they were not at a maxim u m . This m eans that the
losses are m inim ized ). rm shou ld sell all u nits or which M R are positive u p u ntil that
u nit or which M R are zero.
Profts can be increased MR . MC MR , MC
(or losses decreased) Growth maximization
How? By How? By Firm s may also wish to maxim ize the volu m e o ou tpu t sold
i: increasing decreasing su bject to non-negative pro ts. By maxim izing growth the rm
output Q output Q
may be able to lower u nit costs, achieving EOS. A larger rm is
Profts can not be increased (or in better position to d iversiy into d ierent markets as well as
losses decreased); into d ierent prod u cts. The consequ ence o su ch d iversi cation
in other words, profts are MR 5 MC is an overall lowering o associated risks. The cond ition to
maximized and the MC curve is rising maxim ize the volu m e o ou tpu t withou t incu rring losses is that
(or losses minimized) at the chosen level o ou tpu t Q the average revenu e earned
i: shou ld equ al the average costs incu rred .
Why should the MC curve be rising? Satisfcing
To understand why at the chosen level o output Q at which MR The term satis cing was introd u ced by H erbert Sim on (rom
are equal to MC it m ust also be that the MC curve is rising, satisy and su ce). I t d escribes when, becau se o conf icting
consider the alternative (that MC were declining) and assum e objectives o th e variou s stakehold ers within a rm as well as
that the rm decided to produce one m ore unit o output. Prots inormational lim itations, it d oes not aim at maxim izing pro ts
would urther increase as the extra revenue would exceed the or revenu es bu t only strives to achieve at least som e pre-d e ned
extra cost incurred. It ollows that at the chosen output Q not m inim u m level o pro ts or revenu es.
only m ust MR equal MC but also the MC curve m ust be rising.
Corporate social responsibility
Other goals Firm s may d epart rom a strict ree-market, pro t-maxim izing
Goals other than pro t maxim ization inclu d e the ollowing. m od e o operation and pu rsu e objectives that are m ore closely
aligned to the interests o the wid er com m u nity in which th ey
Revenue maximization operate, both the local and global com m u nities. Ethical ways o
I t may be that a rm aim s at maxim izing revenu es. Revenu es d oing bu siness are ollowed and there is a sense o obligation
are d e ned as the prod u ct or the price per u nit tim es the to satisy long-term goals that inclu d e goals involving positive
nu m ber o u nits sold . Reerring to Figu re 1 .5.1 7 it shou ld be im pact on the lives o the workorce and their am ilies as well
clear that the cond ition that need s to be satis ed or a rm to as o society at large.
Market structures
HL I t tu rns ou t that resou rce allocation and e ciency n These rm s will prod u ce a hom ogeneou s prod u ct, m eanin g
consid erations are greatly aected by market stru ctu re. The that consu m ers consid er it identical across sellers. There
stru ctu re o a market (whether there are many, ew or one rm ) are ew exam ples o su ch prod u cts. They are m ostly ou nd
is important as it d eterm ines the cond u ct o rm s (or exam ple in the primary sector (arm prod u cts and m etals are
whether they have the power to set prices) and , consequ ently, examples).
their perormance (that is, whether e ciency is achieved in n N o entry (or exit) barriers will exist. An entry barrier is
resou rce allocation). anything that may d eter entry into a market.
Trad itionally, markets are split into ou r types, n am ely:
I n ad d ition, we assu m e:
n perect competition
n perect inormation available to all market participan ts
n m onopoly
n perect m obility o actors o prod u ction.
n m onopolistic competition
n oligopoly. Is the perectly competitive m odel realistic?
Very ew markets in the real world share the characteristics
Market stru ctu res are d istingu ished on the basis o the nu m ber
o perect competition. Why? First, EOS are very com m on,
o rm s in the market (whether there are many, ew or one
especially in the manu actu ring sector. Very oten large rm s
rm ), the type o prod u ct (hom ogeneou s or d ierentiated ) and
can prod u ce at a lower u nit cost than smaller rm s can . Firm s
whether entry barriers d o or d o not exist.
thereore have an incentive to grow either internally (throu gh
Perect competition investm ent in physical capital) or throu gh m ergers and
acqu isition s. This explains why large rm s are typically ou nd in
Characteristics
m ost ind u stries.
n I n perect competition there will be very many small rm s in
the market. Firm s also have the incentive to d ierentiate their prod u ct, or
exam ple by im provin g qu ality or changing its characteristics, in
52
1 Microeconomics
ord er to acqu ire som e d egree o m onopoly power. Monopoly price below the market determ ined level as it is, by assumption,
power is d ef ned as the ability to raise price (P) above marginal so small compared with the market that it can sell all it wants at
cost (MC). The Lerner ind ex o m onopoly power is given by the the going market price. Imagine a sandy beach representing a
ratio (P 2 M C) /P. A f rm that manages to prod u ce and sell market with each grain o sand being a frm . Even i one doubles
even a slightly d ierentiated prod u ct will ace a negatively its size and becom es as big as two grains o sand it would make
sloped d emand cu rve or its prod u ct, so it will be able to no dierence to the beach (the market). This implies that a
increase price withou t losing all cu stom ers. perectly competitive frm can sell m ore output per period at the
Firm s also try to create entry barriers so that they can maintain sam e price. So, it is as i it is acing a perectly elastic demand
any su pernormal prof ts in the long ru n. I n ad d ition , exit or its product at the going market price P.
barriers in the orm o su nk costs also are com m on. Su nk costs As a resu lt o this, the f rm s average revenu e (AR) and marginal
are costs that a f rm can not recover when it exits an ind u stry. revenu e (MR) are both equ al to the price P so that the AR cu rve,
I normation in the real world is not perect. There are cases the MR cu rve and the d emand the f rm aces or its produ ct
where inormation is asym m etric, as explained earlier. coincid e (Case 1 in the analysis o AR presented earlier).
Lastly, perect m obility seld om characterizes actors o This perectly competitive frm only has to decide how much
prod u ction. Labou r, or exam ple, oten su ers rom output to oer in the market per period given the prevailing
occu pational an d geographical im m obility. market P. I we assume that the frm is a proft maximizer, we know
the answer. It will choose that level o output q or which:
Why is it still useul to study perect competition?
MR 5 MC and the MC curve is rising.
Despite its lim itations perect competition is u seu l. I t is sim ple
and it is capable o su ccessu lly pred icting change. M ost The M C cu rve in Figu re 1 .5.1 8 (a) intersects the MR cu rve at
importantly, its ef ciency properties are consid ered d esirable, so point H which is right above ou tpu t q * . I t ollows that the f rm
it serves as a m od el again st which real world markets can be will choose to sell q * u nits per period at the market price P per
compared and perhaps, i necessary, corrected . u nit. The cost per u nit (the average cost) when prod u cing q *
u nits is given by the AC cu rve. Going u p rom q * toward the AC
Short-run equilibrium in perect competition: a case o cu rve we f nd point F and rom there we tu rn let and f nd that
supernormal profts the AC o prod u cin g q * u nits is C. Total revenu es collected are
Assum e a perectly competitive market, as illustrated in equ al to the nu m ber o u nits sold tim es the price per u nit or
Figure 1 .5.1 8 (b). Market orces, in other words market demand q * tim es P. This is the area o rectangle (0q * H P).
and market supply, determ ine the market price at P. Each frm in Tu rnin g to the cost sid e, bear in m ind that total costs are equ al
a perectly competitive market is a price taker, m eaning that to the nu m ber o u nits prod u ced tim es how m u ch it costs on
the market-determ ined price P is a given or each frm . Since the average to prod u ce each, or q * tim es q * F. This is the area
there are so many other frm s oering an identical product to o rectangle (0q * FC). Econom ic prof ts are d ef ned as th e
perectly inorm ed consum ers, one frm cannot increase the price d ierence between total revenu es collected and total costs o
above the market-determ ined level as no one would purchase prod u ction, so geom etrically on Figu re 1 .5.1 8 (a) they are equ al
even a single unit rom it. I t also has no incentive to lower the to shad ed area (CFH P).
P/unit
MC S
AC
H d, MR, AR
P P
>0
C
F
D
0 q* 0 Q
Q/period Q /period
53
1 Microeconomics
Econom ic prof ts or the typical f rm in this case are positive. their next best alternative. Firm s in perect competition will
The typical f rm in this market is making su pernormal prof ts. neither enter nor exit i each f rm ach ieves its assu m ed
This m eans that it is making m ore than the m inim u m requ ired prof t-maxim izing goal by prod u cing at that level o ou tpu t at
to com pensate or the resou rces employed and the risk taken which M R 5 MC (and the MC cu rve is rising ) and i the typical
(rem em ber this m inim u m requ ired has been d ef ned as f rm is makin g only n ormal prof ts (that is, zero econom ic
normal prof ts). prof ts). I n this situ ation, there is no reason or new f rm s to
enter the market or existing f rm s to exit. Th is requ ires that at
the chosen ou tpu t AR 5 AC.
A typical mistake students make is when they shade the
TIP I n Figu re 1 .5.2 0, the f rm will choose q * u nits to prod u ce as at
proft area. Make sure you correctly identiy on your diagram
the AC associated with the chosen level o output. Also, line that level o ou tpu t it achieves its goal and has no reason to
FC on Figure 1.5.18 (a) cannot be tangent to your U-shaped AC chang e anything. I n ad d ition, at q * AC and AR are equ al to
curve in the short run as MC is shaped like the Nike swoosh. q * F so the typical prof t-maxim izing f rm is making normal
prof ts (that is, zero econom ic prof ts). N o n ew f rm s will enter
and no existing f rm s have an incentive to exit. N othin g will
Short-run equilibrium in perfect competition: a case chang e u nless d emand or cost (technology) cond itions change
of losses in this market.
I t is not necessary or the typical perectly competitive f rm to
be making su pernormal or normal prof ts in the short ru n. I t H ow is long-run equilibrium achieved?
cou ld be making losses. Figu re 1 .5.1 9 illu strates this case. Assu m e, as illu strated in Figu re 1 .5.2 0, a perectly com petitive
I n Figu re 1 .5.1 9 (b) market d emand and market su pply are su ch market in which the typical f rm is making su pernormal prof ts.
that the equ ilibriu m price is d eterm ined at P. The f rm in Figu re As explained , this will ind u ce entry o new f rm s into the
1 .5.1 9 (a) takes the market d eterm ined price P which is equ al to ind u stry. As n ew f rm s enter, market su pply increases, shiting
its MR (an d AR) and selects its optimal level o ou tpu t at the the market su pply cu rve to the right and pu shing the market
intersection o M R and M C at q * . AC are equ al to q * F while price lower. This process (the entry o f rm s) will stop when
AR (price) is only q * H . This f rm is making econom ic losses there is no incentive or m ore f rm s to enter; that is, when
equ al to shad ed area (FH CP). econ om ic prof ts are driven to zero. Figu re 1 .5.2 0 illu strates this
situ ation. The market price in Figu re 1 .5.2 0 (a) has been driven
Long-run equilibrium in perfect competition to P. The typical f rm in Figu re 1 .5.2 0 (a) prod u ces q * u nits. At
Resou rces are attracted in to an ind u stry in which f rm s earn this level o ou tpu t total revenu es and total costs are equ al to
su pernormal prof ts as this implies that these f rm s earn m ore area (0q * FP).
than they wou ld in the next best alternative. On the other I n the case o short-ru n losses, illu strated in Figu re 1 .5.1 9,
hand , econom ic losses will ind u ce exit o f rm s rom the loss-making f rm s will exit, d ecreasing and shiting to the let
ind u stry as the resou rces they employ cou ld earn m ore in their the market su pply cu rve and pu shing market price and AR
next best alternative. I t ollows that i econom ic prof ts in an hig her. The process (the exit o f rm s) stops when AR becom e
ind u stry are zero neither entry nor exit will be observed , as f rm s equ al to AC, in other word s when the typical f rm is making
in su ch an ind u stry make ju st as m u ch m oney as they wou ld in normal prof ts (zero econom ic prof ts); that is, as m u ch as it
P/unit
MC
AC S
H
C
>0
d, MR, AR
P P
F
D
0 q* 0 Q
Q/period Q/period
54
1 Microeconomics
P/unit
MC
AC
F dd, MR, AR
P P
D
0 q* 0 q
Q/period Q/period
wou ld earn in the next best alternative. There is no reason or reein g u p sca rce resou rces. Ba n kru ptcy perorm s a m ost
m ore f rm s to exit, as illu strated in Figu re 1 .5.2 0. im porta n t rol e i n a m a rket econ om y a s i t m a kes sca rce
resou rces ava ila bl e a ga i n or u se i n oth er, m ore prod u cti ve
The long-run equilibrium condition in perect competition a rea s. O cou rse, wh eth er reed -u p resou rces m ay or m ay
Long-ru n equ ilibriu m requ ires that at the chosen ou tpu t rate q n ot be cha n n el led in to m ore prod u cti ve u ses a l so d epen d s
the typical f rm is maxim izing prof ts and that these econom ic u pon th ei r m obi l ity. I n a d d ition , th e a ected pa rti es
prof ts are zero (normal prof ts) so no entry or exit is ind u ced : (workers a n d own ers o ca pita l ) may a ce si g n i f ca n t
MR 5 MC (and the MC curve is rising) a d ju stm en t costs.
p(q) 5 zero.
Shutting down in perect competition
Rem em ber that price is always equal to AR and that in this Assu m e a loss-making f rm . Shou ld it shu t d own im m ed iately?
perectly competitive case (where the frm can sell as m uch as it The answer d epend s on whether it is operating in the long ru n
wants at the going market price) it is also equal to MR. Also, or in the short ru n.
since at the chosen output MC and AC are equal, it m ust be
that AC is at a m inim um . So, the long-run equilibrium cond ition Long run
in perectly competitive markets can be written as: I n the long ru n a loss-making f rm will shu t d own and exit the
q* : (P 5 AR) 5 MR 5 MC 5 AC market. I n the long ru n all possible ad ju stm ents have been
mad e and the f rm has no f xed actors, thereore it aces no
Role o profts and losses in resource allocation
f xed (and so u navoid able) costs.
N ote h ere th e role o prof ts a n d losses in a ll ocati n g a n d
re-a l locatin g sca rce resou rces in a ma rket econ om y. Prof ts
Short run
attra ct sca rce resou rces a s n ew f rm s en ter th e in d u stry
Shou ld a loss-making f rm shu t d own in the short ru n? I n
(a ssu m i n g n o en try ba rriers) wh i l e l osses orce f rm s to exit,
the short ru n som e actors o prod u ction are consid ered
f xed . This im plies that the f rm aces f xed costs. Fixed costs are
To illustrate long-run equilibrium in perect competition, u navoid able costs in the sense that the f rm m u st pay them
TIP
start by drawing a U-shaped AC curve or the typical frm even i it exits the market and prod u ces zero u nits o ou tpu t.
and then draw, using always a ruler, a horizontal tangent at
Th e key to wh eth er a l oss-m a ki n g f rm sh ou l d sh u t d own i n
its minimum. This line will be the demand (and MR and AR
th e sh ort ru n i s th a t i i t d oes th i s i t wi l l sti l l a ce a n d h a ve to
curves) this frm aces and so determines the price. Make sure
pay i ts f xed costs, or exam pl e m on th l y pa ym en ts or a n
the MC curve is drawn in such a way that it cuts the AC curve
ou tsta n d i n g ba n k l oa n . Wh eth er th i s f rm sh ou l d sh u t d own
at its minimum. At the intersection o the MR and the MC
i n th e sh ort ru n or n ot d epen d s on wh eth er th e l osses
curves drop a line to determine the equilibrium output o the
i n cu rred wh en th e f rm i s opera ti n g exceed or a re l ower th a n
frm. When you then draw the market diagram make sure the
th e f xed costs i n cu rred i i t sh u ts d own a n d exi ts. I th ese
market demand and supply curves intersect at the price you
u n a voi d a bl e f xed costs a re h i g h er th a n th e l osses a ced by
determined on the frst side diagram. You could start the other
prod u ci n g , th en i t sh ou l d rem a i n i n bu si n ess a s i t wi l l be
way around by frst determining the market equilibrium price
l osi n g l ess. O n th e oth er h a n d , i th ese u n a voi d a bl e f xed
and extending it all the way to the diagram o a typical frm.
costs a re l ower th a n th e l osses i n cu rred by operati n g th en i t
sh ou l d sh u t d own a n d exi t.
55
1 Microeconomics
MC ATC equ al to P. Given the MC curve illu strated , the prof t-maxim izing
a AVC f rm will choose to prod uce and sell q u nits per period.
AFC at
output q2
P/unit
b MC ATC
C F
H AVC
dd, MR, AR C
P
J
C
H
C J
d, AR, MR
P
F
0 q1 q2
Q /period
Figure 1.5.21 Shut-down rule or a perectly competitive
frm short-run analysis
0 q
Figu re 1 .5.21 illu strates a perectly competitive f rm operating q/period
in the sh ort ru n. As a resu lt, both the ATC and the AVC cu rves
Figure 1.5.22 A loss-making perectly competitive frm shutting down in
are present. The market price is d eterm ined at P which th is f rm
the short run
m u st take an d d eterm ine the optimal, prof t-maxim izing level o
ou tpu t. MR an d M C are equ al exactly above ou tpu t level q 1 . I t will be making a loss as ATC are greater than AR equ al to
This f rm is makin g losses. AR (price) is equ al to line segm ent area (FH CP). I it shu ts d own it will ace the u navoid able f xed
q 1 J while ATC are equ al to line segm ent q 1 F so per u nit losses costs ou nd by m u ltiplying the prof t-maxim izing level o ou tpu t
are equ al to d istance JF. Mu ltiplying this d istance by PJ (which q tim es the correspond ing average f xed cost H J. Fixed costs
is equ al to ou tpu t 0q 1 ) gives the loss area (JFCP), the shad ed aced i it shu ts d own are equ al to area (JH CC). These are less
rectangle. than the losses incu rred by prod u cing. Th is f rm s revenu es
(0q FP) are insu f cien t to cover its variable (operating) costs
We n eed to d eterm ine n ow the size o the (u navoid able) f xed
(0q JC). AR earned 2 P (or q F) 2 is less than the AVC
costs. Given that ATC 5 AVC 1 AFC so that AFC 5 ATC 2
incu rred q J. I t will thereore choose to shu t d own.
AVC it ollows that the vertical d istance at each ou tpu t level
between the ATC and the AVC cu rves is equ al to AFC. Shut-down rule
For example, at ou tpu t level q 2 the correspond ing AFC are
Long I TR , TC Shut down
d istance ab, the d ierence between ATC (q 2 a) and AVC (q 2 b).
run or i AR (5 P) , ATC and exit
We can com pare f xed costs and th e losses incu rred at that is, i p , 0
ou tpu t q 1 by calcu lating the f xed cost area u sing AFC at the
chosen ou tpu t level q 1 . M u ltiplying ou tpu t C9 H (5 0q 1 ) by FH Short i p , 0 Shut down
(the AFC at q 1 ) is area (H FCC9 ), the f rm s f xed costs, the black run and TR , VC and exit
ou tline rectangle. or, equivalently, i AR (5 P) , AVC
I n this case illu strated here, the loss-making f rm shou ld not i p , 0 Do not shut down:
shu t d own in the short ru n as the losses (JFCP) incu rred by but TR . VC wait until no fxed
operating are less than the f xed costs (H FCC9 ) it wou ld still or, equivalently, i AR (5 P) # AVC costs are incurred
ace i it shu t d own.
In the short run the decision to shut down or not boils down to
whether, by producing, the frm is making sufcient revenues to This is a tricky diagram to draw and needs some practice.
TIP
cover its operating (that is, variable costs). I its revenues more Start by drawing the U-shaped ATC and AVC curves ensuring
than cover its variable costs then it should not shut down as it will that their vertical distance (the average fxed costs) becomes
also be able to pay part o its fxed costs, whereas by shutting smaller and smaller as output increases. Make sure the MC curve
down it would be burdened by the ull amount o its fxed costs. (the Nike-swoosh curve) cuts through their minima on its way up.
I you want to illustrate the case o a loss-making perectly
Short-run shut-down rule competitive frm in the short run which will not shut down, choose
A loss-making f rm in the short ru n shou ld shu t d own i total a price between the minima o ATC and AVC and denote the line d,
reven u es are less than (total) variable costs or, equ ivalently AR and MR. Otherwise (i you want to show a frm which will shut
(d ivid ing by Q both sid es), i average revenu e (price) is less than down immediately and exit) choose a price below the minimum o
average variable cost (AVC). the AVC curve you drew. Remember that the vertical distance
So, at any price below the m inim u m AVC a loss-making perectly between ATC and AVC is the AFC corresponding to the chosen
competitive f rm shou ld shu t d own. This case is illu strated in proft-maximizing output so i you multiply it by this output you get
Figure 1 .5.2 2 . The market d eterm ined price is assu m ed to be P. the unavoidable fxed costs incurred.
56
1 Microeconomics
P/unit
I n the short ru n, the break-even price or a perectly competitive
MC, S
f rm lies above (that is, is greater) than the shu t-d own price
(which is at the m inim u m o the AVC cu rve) as AVC lies below j
ATC or all levels o ou tpu t. P3 MR3, AR3
AVC
I n the long ru n, the break-even price or a perectly competitive h
f rm is equ al to the shu t-d own price as both are equ al to the P2 MR2, AR2
m inim u m o the AC cu rve. (Rem em ber that in the long ru n f
P1 MR1, AR1
there are no f xed costs so there is no reason to d istingu ish
between ATC and AC.)
N ote, that there is another widely acceptable notion o the
break-even point. It reers to the level o output or which the frm
makes normal (that is, zero econom ic) profts. By setting TR equal
to TC and solving or Q you can fnd the break-even level o
output (that is, the output or which normal profts are earned). 0 q1 q2 q3
q /period
So, or a perectly com petitive f rm :
Figure 1.5.24 Short-run supply o a perectly competitive frm
In the short run:
Rem em ber that a su pply cu rve shows how many u nits a f rm
break-even price is P 5 min ATC will be willing to oer per period at each price, ceteris paribu s.
shut-down price is P 5 min AVC Reerring to Figu re 1 .5.2 4, i the market price was at P1 then
In the long run: the prof t-maxim izing perectly com petitive f rm wou ld oer q 1
u nits per period as its MR cu rve intersects the MC cu rve at
break-even price and shut-down price are P 5 min ATC
point . Sim ilarly, i the market price was at P2 then the
prof t-maxim izing perectly competitive f rm wou ld oer q2
Figu re 1 .5.23 illustrates the shu t-d own price as well as the u nits per period as its new MR cu rve intersects the MC cu rve at
break-even price in the short ru n or a perectly competitive f rm . point h. Lastly, i the market price was at P3 then the prof t-
maxim izing perectly competitive f rm wou ld oer q3 u nits per
P/unit
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1 Microeconomics
while the marg inal cost o prod u cing it is Q1 b (rem em ber that n Since market d emand is d e ned as the willin gness bu t also
the su pply cu rve is the MC cu rve). So u nit Q1 shou ld be the ability to bu y a good at each price, an d ability ref ects
prod u ced and in a perectly com petitive market it will be the level o incom e, it may very well be the case that market
prod u ced . I n act, all u nits worth prod u cing rom societys point d emand ignores very poor hou sehold s. (These will not have
o view are ind eed prod u ced . For the last u nit Q* prod u ced in a enou gh d ollars or eu ro, or exam ple, to express their
perectly competitive market, P 5 M C. willingness to consu m e even basic good s). So, to take one
Figu re 1 .5.2 5 (b) shows how social welare, which has been exam ple, the market may lead to a very lim ited am ou nt o
d e ned as the su m o consu m er and prod u cer su rplu s, is low-qu ality bread being prod u ced becau se m ost resou rces
maxim ized . Consu m er su rplu s is equ al to area (FP* E) and are em ployed in the prod u ction o higher-qu ality whole
prod u cer su rplu s is area (H EP* ). Their su m , area (H EF) is at wheat bread . There is no gu arantee, thereore, that perect
maxim u m since allocative e ciency is achieved . I any other competition lead s to a truly socially optim u m com bination
qu antity was prod u ced , social welare wou ld be less. o good s prod u ced .
n Perectly competitive rm s d o not have an incentive to
Technical (or productive) efciency in perect competition innovate. I t is not only that they may not be able to aord
I n the long ru n, rm s in perectly competitive markets are spend ing on R&D bu t they also know that their innovation
also techn ically e cient as they are orced to prod u ce with (a new prod u ct or a better process) wou ld be copied by the
m inim u m average costs. I n Figu re 1 .5.2 5 (a) long-ru n other rm s. Su ch investm ent wou ld be a waste o m oney.
equ ilibriu m ou tpu t q * is prod u ced by the typical rm with
n Perectly competitive ind u stries prod u ce u nd ierentiated
m inim u m average costs (AC) equ al to d istance q * z. Minimal
prod u cts. This lack o variety m ight be seen as a
waste o scarce resou rces is achieved . I n the long ru n, a rm
d isad vantage to the consu m er.
incu rring AC higher than q * z wou ld be orced to exit the
ind u stry as it wou ld be making losses. I t ollows that perectly n Price in competitive markets changes given any change in
competitive markets not only lead to the optimal prod u ct m ix d emand or cost (su pply) con d itions. These f u ctu ation s
bu t also scarce resou rces are not wasted . This explains why the increase u ncertainty and may d eter long-term investm ent in
perectly competitive market is oten consid ered the m easu rin g an ind u stry. I n contrast, the price stability oten ou nd in
rod against which other market stru ctu res are compared . oligopolistic markets may seem d esirable when plannin g
investm ent.
Evaluation o perectly competitive markets n The perectly competitive m od el is not compatible with
Even thou gh, in general, allocative and technical e ciencies increasing retu rns to scale; that, is with EOS. I EOS were
are d esirable properties, there are a nu m ber o caveats to keep present then this wou ld m ean that there wou ld be a cost
in m ind . ad vantage in larger size so the ind u stry wou ld end u p with
n There is no gu arantee that the good s prod u ced will be ew large rm s. The absence o EOS in perect competition
d istribu ted to the m em bers o society in the airest may imply that, ater all, price is higher than it wou ld have
proportions. There may be consid erable inequ ality o been i there were ew large rm s involved .
incom e in a society. So even i the right m ix o good s and
services is prod u ced som e may not enjoy any o them .
(a) (b)
P/unit
P/unit
MC F S, MC
AC
a
z d, AR, MR E
P* P*
b
H
D, MB
0 q* 0 Q1 Q*
q /period Q /period
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1 Microeconomics
P/unit
the price bu t not both, since the f rm is still constrained by
a negatively sloped d emand cu rve.
n A m onopoly f rm d oes not necessarily make hu ge prof ts. I t
MC
may even make losses; rem em ber that prof ts are a u nction
o the relative position o the d emand cu rve (the AR cu rve)
and the AC cu rve. P* F
AC
n A m onopoly f rm (and , m ore generally, any f rm acing a J
negatively sloped d emand cu rve) d oes not have a su pply
cu rve: the MC cu rve is not a su pply cu rve or su ch f rm s;
each ou tpu t rate correspond s to m ore than one possible C G
price as an inf nite nu m ber o M R cu rves may go throu gh
any point on the M C cu rve. Rem em ber that i we are u sing H
a su pply cu rve in a d iagram we are implicitly assu m ing a D, AR
perectly com petitive market.
0 Q* Qr Qsoc
n I t can be shown that i the d emand cu rve (the AR cu rve) is
Q /period
linear, the MR cu rve is also linear, has the sam e vertical MR
intercept and double the slope. (H L mathematics stu d ents: Figure 1.5.26 Monopoly: short-run and long-run equilibrium
express a lin ear d emand as P 5 a 2 bQ. TR are equ al to
P 3 Q or, su bstitu ting TR 5 (a 2 bQ)Q 5 aQ 2 bQ 2 . MR I n Figu re 1 .5.2 6, at Q* u nits o ou tpu t per period , prof ts are
DTR equ al to area (GFP* C). The d ierence between the average
is ____ or, or small changes in Q the f rst d erivative o the
DQ revenu e Q* F and the average cost Q* G is the prof t per u nit
d TR
total revenu e u nction, ____ 5 a 2 2 Q. The M R cu rve is which, i m u ltiplied by the nu m ber o u nits CG (equ al
dQ
linear, has the sam e vertical intercept with the linear to Q* ) gives u s the prof t area (GFP* C).
d eman d cu rve and d ou ble its slope.) Th is f rm is making su pernormal prof ts bu t since we can
n A m onopoly f rm can set th e price (it is a price setter an d assu m e that entry barriers exist, no new f rm s will enter th e
not a price taker); the d egree o m onopoly power is given ind u stry. I d emand cond itions, cost cond itions and the entry
by the d ierence between the price charged and MC barriers persist then this equ ilibriu m (P* , Q* ) will not chang e,
expressed as a proportion o price. so it is also a long-ru n equ ilibriu m cond ition .
n A prof t-m a xim i zi n g m on opoly f rm wil l n ever ch oose a rate N ote that i the monopolist aims at maximizing revenues instead
o ou tpu t Q that correspon d s to th e price in ela sti c o profts then it will choose that level o output at which MR 5 0,
seg m en t o th e d em a n d cu rve it a ces. I t wi ll a l ways locate which is at Qr where the MR curve crosses the horizontal axis.
below th e ela stic seg m en t. Th is is beca u se or prof t Efciency considerations and m onopoly
ma xim ization M R m u st equ a l M C bu t sin ce M C i s Allocative ef ciency is not achieved u nd er m onopoly. M onopoly
n ecessa rily a positive n u m ber i t ollows that M R m u st a l so is a case o market ailu re (as ou tlined earlier). Why?
be a positive n u m ber at th e prof t ma xi m izin g ou tpu t. M R
At th e level o ou tpu t Q* chosen by the m onopoly f rm s, price
is positive (it lies a bove th e Q a xi s) on ly or that set o
exceed s M C. Society wou ld valu e m ore u nits to be prod u ced . I n
ou tpu t rates that correspon d to th e ela stic reg ion o th e
Figu re 1 .5.2 6, society wou ld like to enjoy all u nits u p u ntil u nit
d ema n d cu rve.
Qsoc, which is valu ed as m u ch as it wou ld cost society to
n Th e prof t-maxim izing ou tpu t level is necessarily less than prod u ce (d istance JQsoc). Units Q* Qsoc are not prod u ced , so
the reven u e-maxim izing level o ou tpu t (where M R 5 0) society d oes not enjoy welare equ al to area (H JF). Social (or
59
1 Microeconomics
com m u nity) su rplu s is not maxim ized . Area (H JF) is the probable that the m onopoly rm will enjoy EOS. I ts cost cu rves
resu lting welare loss reerred to as the d ead weight loss. I t may be lower than those the smaller com petitive rm s ace, as
represents net valu e lost by society. This is a case where market illu strated in Figu re 1 .5.2 8. The technology available to the
orces lead to ine cient allocation o scarce resou rces. I t is a com petitive rm s lead to a set o short-ru n cost cu rves su ch as
market ailu re. SACc and MCc. On the other hand , the technology available to
Prod u ctive ine ciency also resu lts u nd er m onopoly. Why? the larger rm s may, as a resu lt o increasing retu rns to scale
Becau se the m onopoly rm is not orced to prod u ce with and EOS, lead to a d ierent set o cost cu rves, su ch as SACm
m inim u m average costs. At the chosen level o ou tpu t Q* and M Cm , located below those the com petitive rm s ace.
average costs are equ al to line d istance Q* G, which are greater
LAC, SAC
than m inim u m .
MCc SACc LAC
Lastly, H arvey Leibenstein coined the term X-ine ciency
or a d ierent type o ine ciency that som e very protected
m onopoly positions may lead to. X-ine ciency reers to the
internal slackness that characterizes som e m onopolies. This is MCm SACm
the case wh en , on a d iagram , the AC cu rve is not as low as it
cou ld have been given the available technology.
I s there a case in avou r o m onopoly and m ore generally, in
avou r o large rm s with m onopoly power?
The answer is yes. Assu m e a perectly competitive ind u stry with 0
a market su pply at S (also the MC cu rve) and market d emand Output (Q)
at D, as in Figu re 1 .5.27. Equ ilibriu m price will be at Pc and Figure 1.5.28 The lower cost curves enjoyed by the large rm as a result
equ ilibriu m qu antity at Qc. We have shown that this ou tcom e is o EOS
e cient. Assu m e now that som ehow this perectly competitive
I that is the case (and retu rnin g to Figu re 1 .5.27 ) then the
ind u stry is m onopolized , or exam ple one rm bu ys ou t all
m onopoly will have a new MC cu rve that cou ld be as low as
perectly competitive rm s, bu t that the prod u ction technology
MC. MC ref ects the id ea o EOS and is MCm in Figu re 1 .5.2 8.
remains u nchanged . The M C cu rve or the m onopoly rm
I th is is the case then the m onopoly may end u p prod u cing
remains at M C. The pro t-maxim izing m onopoly rm will now
even m ore (Q* * ) than the perectly competitive ind u stry at an
equ ate its MC with its M R and choose Q* u nits charging a
even lower price P* * .
price P* . We have established that this ou tcom e is ine cient.
The m onopoly rm restricts ou tpu t and raises price. Welare Perhaps, even m ore importan tly, a large rm with m onopoly
is red u ced . power may lead to a aster rate o technological ad vancem ent.
There are two reason s or su ch a d evelopm ent. First, su ch rm s
H owever, this resu lt rests on the rather u nlikely assu mption that
are in a position to keep their su pernormal pro ts becau se o
the larg er in size m onopoly rm employs the sam e technology
the existence o barriers so th ey are in a position to nance
that the small perectly competitive rm s employ. I t is very
R&D projects which lead to in novations, d e ned as new
prod u cts or n ew processes. I n ad d ition, assu m ing the m onopoly
P/unit
Barriers to entry
Barriers are d e ned as anything that d eters entry into an
ind u stry or that prevents exit rom an ind u stry. A barrier
D
increases the u nit cost o a potential entrant above the level
0 Q* Qc Q**
enjoyed by the incu m bent rm .
Q /period
MR
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1 Microeconomics
Types of entry barriers d esperately try to d ierentiate their prod u ct. I su ccessu l, this
Barriers can be classi ed into natu ral, state-created and lowers the PED o their prod u ct and perm its the rm to raise
rm-created barriers, as d escribed below. price. By d ierentiating its prod u ct and by prod u cing many
d ierent varieties the rm makes entry m ore d i cu lt. Kelloggs
Natural barriers: the case of a natural monopoly cereal prod u cts are a good example.
Oten, prod u ction technology is su ch that very signi cant EOS
Lastly, incu m bent rm s may d eliberately maintain excess
are present. As a resu lt, given market size, only ew or even only
prod u ctive capacity. Potential entrants know that the
one rm can pro tably co-exist. When only one rm can
incu m bent rm can easily increase ou tpu t, d epressing price to
pro tably exist in a market it is the case o natu ral m onopoly.
u npro table levels. A typical exam ple o this can be ou nd in
Figu re 1 .5.2 9 illu strates the point. I n this d iagram signi cant
cem ent rm s where, in ad d ition, transportation costs are high.
EOS are present as the LAC cu rve slopes d own ward throu ghou t
the length o the d emand cu rve that d e nes the relevant
market. Assu m e that initially there is only one rm in th is Monopolistic competition
market and that the pro t-maxim izing ou tpu t is at Q while the Characteristics
price at which these Q u nits will be absorbed is P. This rm is n Very many small rm s exist in the market (each rm has a
pro table and it enjoys pro ts equ al to ab per u nit. I now this very small share o the market).
market is equ ally shared by two rm s, each prod u cing and n The rm s prod u ce d ierentiated prod u cts. Dierentiation
selling (Q/2 ) u nits, then the total am ou nt en tering the market can be based on qu ality, d u rability, packaging, d esign or
will still be Q u nits and th e price will remain at P. Each rm now prod u ct service and can be real or imaginary.
is making a loss equ al to h per u nit. I t is m u ch too expensive n N o entry barriers exist.
to prod u ce (Q/2 ) u n its, as the d iagram illu strates.
I t is th e secon d cha racteristic that g ives su ch rm s a very
small d egree o m onopoly power. Sin ce the prod u ct is not
P/unit
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1 Microeconomics
En try will con tin u e u n til th ere is n o lon g er a n in cen tive or it normal there is no in centive or new f rm s to enter or or
to take pla ce. Th is will be th e ca se wh en su pern orma l prof ts incu m bent f rm s to exit. This d ef nes long-ru n equ ilibriu m .
a re com peted away a n d th e typica l m on opolistica lly
com petitive f rm is ma kin g on ly n orma l prof ts (that is, zero
Figure 1.5.30 is very tricky to draw. Either start by drawing
econ om ic prof ts). I , on th e oth er ha n d , th e typica l f rm wa s TIP
a wide U-shaped AC curve, ollowed by a relatively fat
ma kin g losses th en exit wou ld ollow, in crea sin g d ema n d
demand tangent to it and its corresponding MR; determine
(sh itin g it to th e rig h t a n d ma kin g it m ore price in ela stic)
the prot-maximizing output Q right below the point o tangency
u n til th ere is n o rea son or m ore f rm s to exit. Th is will be
o AC with AR; lastly careully draw the MC curve, making sure
wh en th e typica l f rm is ea rn in g ju st a s m u ch prof t a s it wou ld
that not only does it intersect MR right above the chosen output
ea rn in its n ext best a ltern ative (that is, wh en it is ea rn in g
Q but that it also cuts AC at its minimum. Alternatively, rst draw
n orma l prof ts).
a relatively fat demand curve and its corresponding MR;
Long-ru n equ ilibriu m will be achieved when the typical f rm in continue with a relatively fat MC curve and, lastly, the AC curve
su ch a market is maxim izing prof ts and these prof ts are zero that is both tangent to the demand curve above the MR 5 MC
(normal prof ts). intersection and has also a minimum on the MC curve.
P/unit
MC
Evaluation of monopolistic competition
In this market structure neither allocative nor technical (or
productive) efciency are achieved. Price exceeds marginal costs or
the last unit o output each frm produces in equilibrium.
AC Production does not take place with minimal average costs so that
monopolistically competitive frms operate with excess capacity.
F Each frm ends up with a scale o operation that orces it to
P*
produce less output than the one that corresponds to minimum
average costs. Restaurants typically have empty tables and one
does not have to wait long in a queue to rent a DVD or to buy uel.
Free entry and product dierentiation are responsible or this
result. In addition, since these frms cannot maintain profts in the
D, AR long run they are not in a position to fnance R&D projects and,
being small in size, they do not enjoy EOS.
On the other hand , as a resu lt o prod u ct d ierentiation and
0 Q* non-price competition, consu m ers enjoy a greater variety o
Q/period prod u cts, increasing the probability that they will f nd a closer
MR match to their preeren ces. Given ree entry and extensive
prod u ct d ierentiation, consu m ers will have very many, very
Figure 1.5.30 Monopolistic competition: long-run equilibrium close su bstitu tes to choose rom . Price cannot be m u ch higher
Figu re 1 .5.3 0 illu strates long-ru n equ ilibriu m in m onopolistic than marginal costs, which is another way o saying that the
competition as at the chosen level o ou tpu t Q* the f rm not m onopoly power each f rm enjoys is m inimal. As a resu lt,
only equ ates M R and M C, so maxim izing prof ts, bu t also these ou tpu t will not be too ar below th e socially optimal level.
econom ic prof ts are zero (normal prof ts) as AR and AC are Firm s are orced to ad vertise and to resort to other m ethod s
tangent and so equ al (to Q* F) right above them . Since the o non-price competition, thou gh. The hig her than m inim u m
typical f rm is maxim izing prof ts it is ach ieving its goal, so it u nit costs in su ch markets are oten interpreted as the cost
has no reason to change its ou tpu t. Since these prof ts are o variety.
HL Oligopoly complete picture o the market share enjoyed by the largest frm s
in the market. For example, the 5-frm CR (5 CR) is given by:
Characteristics
5
Few f rm s operate in the market.
n
5 CR 5 S i
n They prod u ce hom ogeneou s prod u cts (su ch as oil, steel or i =1
cem ent) or d ierentiated prod u cts (which inclu d e alm ost wh ere S i i s th e m a rket sha re o th e i th f rm i n th e m a rket (that
any ind u strial prod u cts, or exam ple cars, d etergents, i s, th e proportion o m a rket sa les it en joys). Th e m a rket sha re
appliances, air crat and banking or insu ran ce prod u cts. o a f rm i s th e proporti on o th e tota l m a rket sa les it en j oys.
n Signif cant entry barriers exist. A 4CR or 5 CR a bove 80% i m pli es a h i g h l y con cen trated
To determ ine the extent o concentration in a market a m a rket wh ere a ti g h t oli g opol y (or a m on opoly) is presen t.
concentration ratio (CR) is used which m easures the proportion CRs provid e n o in orm ati on a bou t th e si ze d i stri bu ti on o
o total sales accounted by the largest frm s in a market (or an f rm s, so a 5 CR that i s 1 00% cou ld be a m a rket with f ve la rg e
industry). Typically, m ore than one CR is calculated and f rm s o equ a l si ze ea ch with a 2 0% ma rket sha re, or a m a rket
presented. For example, researchers provide 4-frm , 8-frm and wh ere one f rm ha s 96% o th e m a rket a n d ou r f rm s have
20-frm CRs (or 3-frm , 5 -frm and 1 0-frm CRs) to provide a more th e rem ain i n g 4%.
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1 Microeconomics
MC
Interdependence is evident since the outcome o whichever policy
Gray chooses depends on how White will react, and vice versa. For
P f AC
example, ocusing on Gray and reading vertically, i it decides to
maintain price it could earn either 6.0 million o supernormal
Joint
profts or incur losses equal to 1.0 million depending on whether prots
White also maintains its price or decides to cut price. I Gray h
C
decides to cut price it could earn 1 0.0 million o supernormal
profts (i White maintains price) or just 3.0 million (i White also
cuts price). Symmetrically, this is true or White.
To determine the dominant strategy, each frm realizes that no
matter what the rival chooses, it is better o cutting price. For D, AR
example, Gray realizes that i White maintains price it is better that
Gray cuts price (Gray earns 1 0.0 million instead o only the 6.0 0 Q
MR Q/period
million it would earn it also maintained price) whereas i White
cuts price Grey too should cut price as it would then earn 3.0 Figure 1.5.31 Collusive behaviour where frms behave as a monopoly frm
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1 Microeconomics
How likely is it for a collusive agreement to collapse? rival. N ote that d emand below the kink d oes not have to be
Collu sive stru ctu res are u nstable becau se o the inherent price inelastic bu t only less price elastic than it is above it, as
incentive to cheat. Each m em ber wou ld preer others to abid e the existence o a positive seg m ent or MR illu strates above.
by the ou tpu t restricting agreem ent (the qu ota) while it
P/unit
d oesnt. The logic o this in centive is clear: i all f rm s except MC (upper)
one maintain their ou tpu t qu ota then the price o the g ood will
remain high. To the extent that price is higher than the MC o f
the d eector, it has the incentive to cheat and raise ou tpu t MC (lower)
above its qu ota. Since all m em bers have the sam e incentive, h
P*
su ch collu sive agreem ents oten collapse.
Collu sive agreem en ts are m ore likely to collapse:
n the greater the nu m ber o m em ber f rm s (as m onitoring
b
each others behaviou r becom es m ore d if cu lt) a c
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1 Microeconomics
HL Price discrimination (bu ying low and selling high) will gu arantee that eventu ally
one price will d om inate in both markets.
Price d iscrim in ation is a pricing policy that certain rm s ad opt
to increase their pro ts u rther. Formally, price d iscrim ination n Price elasticities o d emand between markets m u st d ier.
exists when a rm sells the sam e prod u ct at two or m ore Som e consu m ers m u st be prepared to pay m ore either
d ierent prices in two or m ore markets provid ed that the price becau se ewer su bstitu tes are available to them or becau se
d ierences d o not ref ect d ierences in th e cost o prod u ction they enjoy a higher level o incom e.
or provision. Examples inclu d e airline tickets; train and bu s
Third-degree price discrimination
ares; theatre and cinema ticket prices; telephone services; and
There are three types (or degrees) o price d iscrim ination. The
lawyers, private d octors and consu ltants ees. I n international
rst degree is only o theoretical interest as it assu m es that the
trad e, d u m pin g is also consid ered a orm o international price
rm can sell each extra unit at the highest price the consu m er is
d iscrim ination as it involves selling abroad at a lower price than
willing and able to pay, and so extracts and appropriates the
in the protected d om estic market.
entire consu m er su rplu s. Block price d iscrim ination, also known
Conditions allowing a frm to price discriminate as second-d egree price discrim ination, is when su ccessive blocks
N ot all rm s can practise price d iscrim ination. The ollowing o u nits o ou tpu t are sold at a lower prices. For example, a
cond itions m u st hold or eective price d iscrim ination to parking lot may sell the rst hou r o parking at $ 1 0.00, the
be possible. second and third hou rs at $ 5.00 each and extra hou rs at $ 2 .00.
n The rm m u st enjoy som e d egree o m onopoly power. I t The com m onest type o price d iscrim ination is third d egree,
m u st ace a negatively sloped d emand cu rve. Thereore, where the rm segm ents a market across som e characteristic
a perectly com petitive rm cannot practise price that on th e one hand takes ad vantage o d iering price
d iscrim ination. elasticities and on the other hand d oes not allow resale o the
good rom the cheaper to the m ore expensive market. For
n N o resale o the good (reerred to as seepage) rom the
exam ple, airlines price tickets bou ght a ew d ays in ad vance
cheaper to the pricier market shou ld be possible. The two
m u ch higher than i they were pu rchased a m onth or so in
markets m u st som ehow be separable otherwise arbitrag e
advance o a f ight. Since the consu m ers nam e is on the ticket,
65
1 Microeconomics
resale is not possible. By pricing tickets or the sam e f ight in As expected , the rm will charge the higher o the two prices in
this way the company tries to take ad vantage o the act that i the market with the relatively m ore price-inelastic d emand .
people d ecid e to travel and book a f ight only a ew d ays in
ad van ce, either they have very im portant bu siness to cond u ct When drawing the two demand curves make sure their
and ace ew i any alternatives or they are very wealthy and TIP
slopes dier substantially so that the resulting prices dier
the ticket expense is a small proportion o th eir incom e. On the signifcantly.
other hand , i people book a ticket a m onth in ad vance then
they are m ost probably travelling or pleasu re, so they have
many alternatives to choose rom . Demand or this speci c Consumers and price discrimination
f ight is qu ite price elastic. I n general, a price-d iscrim inating rm extracts and appropriates
part o the consu m er su rplu s. Prod u cers are better o and the
Figu re 1 .5.3 3 may look a bit com plicated bu t is actu ally a very
only risk they may ace is the possibility o bad pu blicity in
straightorward and convenient illu stration o third -d egree price
som e cases. Viewed d ierently, i they were not better o with
d iscrim ination. The two markets, A and B, are drawn sid e by
price d iscrim ination they wou ld not have ad opted it.
sid e. On the right-hand sid e the d emand or market A is drawn
as relatively price inelastic. This is the grou p o ind ivid u als with Consu m ers, on th e other hand , are generally worse o as part
the ewer su bstitu tes available and /or the higher incom es who o their su rplu s is transerred to prod u cers. There may be
are consid ering bu ying a ticket a ew d ays in ad vance o a situ ations, thou gh, where at least certain grou ps o consu m ers
f ight. On the let-hand sid e (qu antities are o cou rse not d o bene t. One cou ld be the grou p that pays the lower price, i
negative to the let o the origin) the d emand or market B is this is set below the single price that the rm wou ld have
drawn as relatively price elastic (f atter). This is the grou p o charged withou t price d iscrim ination.
ind ivid u als with m ore available su bstitu tes and /or lower Su ch a pricing policy may allow a rm to sell a greater volu m e
incom es who are consid ering bu ying a ticket a m onth in o ou tpu t and so grow in size. For example, rm s oten sell at a
ad van ce o a f ight. To avoid the d iicu lty o drawing accu rately higher price in their d om estic protected market and at a m u ch
the m irror image o an MC cu rve shaped like the N ike swoosh, lower price in world markets. I su ch a rm grows and enjoys, as
it is assu m ed that the extra cost o an extra ticket or the airline a resu lt, EOS which perm it it to d ecrease all prices charged ,
is constant and equ al to 0h, and we draw the M C cu rve then even consu m ers in its d om estic market will bene t.
horizontal to the Q axis. Pro t maxim ization requ ires that in Lastly, there are cases where selling a good wou ld be
each market MR is equ al to M C so that: u npro table at any sin gle price bu t the rm may becom e
MR( A) 5 MC and MR(B) 5 MC or MR(a) 5 MR(B) 5 MC pro table by price d iscrim inating and , throu gh this, allowing
consu m ers to enjoy the prod u ct.
This is the case at Q(A) in market A and Q(B) in market B so
that the rm will charge P(A) in market A and P(B) in market B.
P/unit
P(A)
Market B: Market A:
Tickets purchased Tickets purchased
a month in advance a few days in advance
(relatively price elastic demand) (relatively price inelastic demand)
P(B)
h
MC MC
D(B)
D(A)
Q(B) 0 Q(A)
Q/period Q /period
MR(B)
MR(A)
Figure 1.5.33 Price discrimination: third degree
66
1 Microeconomics: Questions
1 . Explain what extern alities are and how they may arise. 1 7. Explain, u sing the term s social su rplu s, marginal bene t
2 . Explain u sing d iagram (s) the welare loss arising rom the and marginal cost, the m ean ing o the term allocative
prod u ction or consu mption o a good responsible or the e ciency.
gen eration o negative externalities. 1 8. Analyse, u sing an appropriate d iagram , the role that
3. Distingu ish between marginal private and social costs as relative price changes play in the allocation o scarce
well as between marginal private and social bene ts. resou rces in a ree market economy.
4. Explain what price, incom e and cross elasticities o d emand 1 9. U sing an appropriate d iagram and examples, explain why
m easu re. market orces may prove insu cient to ad dress
environm ental concerns.
5. Explain why governm ents provid e su bsid ies, and d escribe
examples o su bsid ies. 2 0. Explain, u sing examples and an appropriate d iagram , why
d em erit good s are consid ered a market ailu re.
6. Explain why the price elasticity o d emand or many
primary com m od ities is relatively low while th e price 21 . Explain, u sing appropriate examples an d a d iagram , why
elasticity o d emand or manu actu red prod u cts is governm ents may choose to im pose price ceilings.
relatively high. 2 2 . Explain why governm ents impose price f oors and d escribe
7. Analyse the con cept o market ailu re as a ailu re o exam ples o price f oors.
markets to achieve allocative e ciency. 23. Distingu ish between m erit good s, d em erit good s and
8. Distingu ish u sing examples between private and pu blic good s.
pu blic good s. 2 4. Explain u sing examples why com m on access resou rces may
9. Explain u sing an appropriate d iagram the possible be overu sed and d epleted .
consequ ences o rent controls on the market or rental 2 5. Explain why the over-exploitation o land or agricu ltu re in
hou sing in a city o you r choice. less d eveloped cou ntries may pose a threat to
1 0. Explain why a governm ent may choose to establish a su stainability.
m inim u m wage. 2 6. Explain, u sing examples, why the global natu re o th e
11 . Explain why a governm ent may choose to su pport the price problem s threatening su stainability and th e lack o
o an agricu ltu ral prod u ct. ownership o com m on access resou rces lim it the
eectiveness o in d ivid u al governm ent responses and thu s
1 2 . Ou tline reasons or which a governm ent may choose to u se
requ ire international cooperation.
ood price controls.
27. Explain, u sing an appropriate d iagram , why the u se o
1 3 . Explain why the price elasticity o su pply or primary
ossil u els in prod u ction processes threatens su stainability.
com m od ities is relatively low while or manu actu red
prod u cts it is relatively high. 2 8. Describe the term s su stainability and com m on access
resou rces u sing appropriate examples or the latter.
1 4. Distingu ish between m ovem ents along th e d emand cu rve
and shits o the d emand cu rve, drawing appropriate 2 9. Explain, with reerence to the ree rid er problem , h ow the
d iagram s and provid ing exam ples related to the owner- lack o pu blic good s ind icates market ailu re.
occu pied hou sing market o you r cou ntry. 30. Explain the role o price elasticity o d emand and cross-
1 5. Distingu ish between m ovem ents along th e su pply cu rve elasticity o d eman d or bu sinesses making d ecisions.
and shits o the su pply cu rve, drawing appropriate 31 . Explain why negative externalities are an example o
d iagram s and provid ing exam ples related to a market or market ailu re.
an agricu ltu ral prod u ct o you r choice.
1 6. Distingu ish between speci c and ad valorem taxes u sing
appropriate d iagram s and examples.
67
1 Microeconomics: Questions
HL 1. Describe the term tacit collu sion inclu d ing reerence to 1 5. Explain how f rm s operating in d ierent market
price lead ership by a d om inant f rm . stru ctu res com pete.
2 . Explain why oligopolistic f rm s ace the d ilem ma to 1 6. Disting u ish, u sing d iagram s, the short ru n and long ru n
compete or to collu d e. equ ilibriu m positions or a perectly com petitive f rm .
3. U sing examples and an appropriate d iagram , explain the 1 7. Disting u ish, u sing examples, between m onopolistic
m eaning o the term natu ral m onopoly. com petition and oligopoly as market stru ctu res.
4. Explain the cond itions that need to be satisf ed or a f rm 1 8. Analyse the d ierences between a collu sive oligopoly and
to su ccessu lly ad opt price d iscrim ination. a non-collu sive oligopoly.
5. Explain, u sing d iagram s, u nd er what cond itions and in 1 9. U sing appropriate d iagram s, d istingu ish between the short
which market stru ctu res positive econom ic prof ts are ru n shu t-d own price and the break-even price or a perectly
u nlikely to persist in the long ru n. com petitive f rm .
6. Explain why the opportu nity cost o entrepreneu rship, 2 0. Disting u ish between the characteristics o perect
an elem ent o normal prof ts, is part o the econom ic costs com petition and m onopolistic competition.
o a f rm . 21 . Describe how a f rm operating in an oligopolistic market
7. Distingu ish between th e three types o retu rns to scale. m ight attempt to increase its market share.
8. Describe ou r actors giving rise to econom ies o scale. 2 2 . Explain the role o barriers to entry in perm itting a f rm to
9. Explain why interd epen d ence is responsible or the earn econom ic prof ts.
d ilem ma aced by oligopolistic f rm s as to whether to 23 . Explain, u sing examples, why market ailu re may occu r
compete or to collu d e. when one party in an econom ic transaction possesses m ore
1 0. Explain, u sing appropriate d iagram (s), how a perectly inormation than the other party.
competitive market will m ove rom a short-ru n equ ilibriu m 2 4. Explain, u sing d iagram s, why the prof t maxim izing choices
position to long-ru n equ ilibriu m . o a m onopoly f rm lead to allocative inef ciency and
11 . Ou tline the ways in which m onopoly power m ight arise. prod u ctive (technical) inef ciency.
1 2 . Explain how a m onopoly prod u cer is in a position to earn 2 5. Disting u ish between short-ru n average total cost cu rves
positive econom ic prof ts in the long-ru n. and long-ru n average cost cu rves u sing appropriate
d iagram s.
1 3. Explain how a concentration ratio may be u sed to id entiy
an oligopoly. 2 6. Describe three goals oth er than prof t maxim ization that
f rm s may pu rsu e.
1 4. Explain, u sing d iagram s, why both price elasticity o
d emand and price elasticity o su pply are necessary to
consid er in ord er to d eterm ine the incid ence o an ind irect
tax on consu m ers and prod u cers.
68
1 Microeconomics:
1 Microeconomics
Questions
1 . Discu ss whether governm ents shou ld always intervene in 1 7. Discu ss the im pact o im posing an ind irect tax on market
markets where signi cant externalities arise. ou tcom es.
2 . Evalu ate the u se o two market based policies to correct 1 8. Discu ss the consequ ences o imposing an ind irect tax on
the market ailu re arising rom negative externalities o the stakehold ers in a market.
prod u ction. 1 9. Explain, u sing appropriate d iagram s and exam ples, why
3. Evalu ate, u sing appropriate d iagram s wherever possible, social (com m u nity) su rplu s is not maxim ized i either m ore
govern m ent responses to correct the market ailu re arising or less than the allocatively e cient ou tpu t level is
in the case o m erit good s. prod u ced .
4. Discu ss, u sing d iagram s wherever appropriate, the 2 0. Discu ss why national policies may not prove su cient to
sig ni cance o price elasticity o d emand or both rm s and ad dress environm ental issu es and thu s why an eective
the governm ent. response to global environ m ental problem s requ ires
5. Explain, with the help o d iagram s, (i) how the market or internation al cooperation.
beer will be aected by a tax on hard liqu or su ch as whisky 21 . Discu ss the econom ic argu m ents relevant to a policy
and vod ka, (ii) how the market or oranges will be aected d ecision to im pose su bstantially higher levels o taxation
i arm ers can sell lem ons at a higher price, (iii) how the on the sale o alcohol, explaining reasons or which it may
d emand or red wine will be aected i its price d ecreases. not ind u ce signi cantly lower levels o consu mption.
6. Discu ss the consequ ences o provid ing a su bsid y on the 2 2 . Exam ine the possible consequ ences o a d ecision to impose
stakehold ers in a market. a price ceiling on basic ood stu .
7. Exam ine the implications or a bu siness o changes in the 23. Discu ss the consequ ences o imposing a price ceiling on
prices good s that are related to the one it oers. the stakehold ers in a market, inclu d ing consu m ers,
8. Evalu ate a policy response ad opted by a governm ent on a prod u cers and the governm ent.
market ailu re o you r choice. U se examples and , i possible, 2 4. Exam ine the position that consu m ers are necessarily
appropriate d iagram s. worse-o in a m onopoly market.
9. Exam ine the implications o d irect provision o pu blic 2 5. Contrast the u se o a market-based policy versu s
good s by governm ents. governm ent regu lation in markets or good s su ch as
1 0. To what extent d o tenants (i.e. h ou sehold s who rent an cigarettes and alcohol.
apartm ent) bene t rom rent controls? 2 6. Discu ss legislation and u nd ing or clean technologies as
1 1 . Discu ss the possible market ou tcom es o ad opting a possible solu tions to th e threats to su stainability.
m inim u m wage policy. 27. Evalu ate, u sing d iagram s, two possible governm ent
1 2 . Discu ss the consequ ences o im posing a price f oor on the responses to threats to su stainability.
stakehold ers in a market or su ch a prod u ct. 2 8. Compare and contrast carbon taxes and cap and trad e
1 3. Discu ss the consequ ences o im posing ood price controls schem es as possible solu tions to threats to su stainability.
on the stakehold ers o su ch markets. 2 9. Evalu ate carbon taxes and cap and trad e schem es as
1 4. Discu ss, u sing appropriate d iagram (s), the consequ ences on possible solu tions to th reats to su stainability.
the stakehold ers involved o provid ing a su bsid y to the 30. To what extent can the imposition o carbon taxes
prod u cers o an agricu ltu ral prod u ct. encou rage su stainability.
1 5. An alyse, u sing d iagram s an d with reerence to excess 31. Discu ss the im plications o d irect provision o pu blic good s
d emand or excess su pply, how changes in any three by governm ents.
d eterm inants o d emand resu lt in a new market 32 . Exam ine the view that governm ents can best red u ce
equ ilibriu m . sm oking (or, alcohol con su mption) by su bstantially
1 6. An alyse, u sing d iagram s an d with reerence to excess increasing taxes on cigarettes.
d emand or excess su pply, how changes in any three 33. Discu ss three policies that governm ents m ight implem ent
d eterm inants o su pply resu lt in a new market equ ilibriu m . to red u ce negative externalities associated with the
environm ent.
69
1 Microeconomics: Questions
HL 1. Evalu ate the d esirability o markets in which f rm s enjoy 1 2 . Contrast ormal/open an d tacit collu sion in oligopolistic
consid erable market power. markets.
2 . Explain (i) u sing an appropriate d iagram why price rigid ity 1 3. Discu ss the view that the greater the nu m ber o f rm s in a
is typical in oligopolistic markets, as well as (ii) why market the better o society is.
non-price competition is u su ally employed by su ch f rm s. 1 4. Contrast the sh ort ru n with the long ru n equ ilibriu m
3. U sing an appropriate d iagram , compare and contrast the positions o a f rm in a perectly competitive market.
equ ilibriu m positions o a prof t maxim izing m onopoly f rm 1 5. Compare and contrast th e characteristics o
and a revenu e maxim izing m onopoly f rm . m onopolistically competitive markets with perectly
4. Draw a d iagram to illu strate 3 rd d egree price com petitive markets.
d iscrim ination in airlines, explaining when the prices 1 6. Explain why price rigid ity and n on-price competition are
charg ed in th e two markets you chose will d ier m ore. typically encou ntered in oligopolistic markets. U se a
5. Explain, u sing appropriate d iagram (s), why, d espite the d iagram and examples to illu strate you r answer.
absence o su pernormal prof ts in a m onopolistically 1 7. U sing appropriate d iagram s, com pare and contrast th e
competitive market, f rm s achieve neith er allocative ef ciency ou tcom es in m onopolistic com petition and in
ef ciency, nor prod u ctive ef ciency. perect com petition.
6. Explain u sing an exam ple why f rm s will ch oose to operate 1 8. U sing appropriate d iagram s, com pare and contrast th e
in the lon g ru n d espite earnin g zero econom ic prof ts. short-ru n and long ru n equ ilibriu m o a prof t maxim izing
7. Careu lly d ef ne the long-ru n average total cost cu rve o m onopolistically competitive f rm .
f rm s and explain, u sing a d iagram , the reason or its 1 9. To what extent d o prod u cers and not consu m ers benef t in
typical shape. oligopolistic markets?
8. U sing appropriate d iagram s, compare and contrast the law 2 0. Exam ine the view that m onopoly is an u nd esirable market
o d im inishing marginal retu rns with the d ecreasing retu rns stru ctu re.
to scale.
21 . Discu ss two possible governm ent responses to problem s
9. Explain, u sing a d iagram , the shape o the perectly arising rom asym m etric inormation.
competitive f rm s average revenu e and marginal reven u e
2 2 . Discu ss two possible governm ent responses to the abu se o
cu rves and why, in the long ru n, a perectly competitive
m onopoly power.
f rm will make only normal prof ts
23 . To what extent is greater econom ic ef ciency achieved in
1 0. Explain, u sing a d iagram , why perectly competitive f rm s
perect com petition compared to m onopoly?
will be prod u ctively ef cient in the long ru n, thou g h not
necessarily in the sh ort ru n. 2 4. Explain why cartels are likely to collapse as well as the
cond itions that make su ch a d evelopm ent m ore likely.
11 . Shou ld governm ents always intervene to control
m onopoly power?
70
2.1 Macroeconomic goals
S E CTI O N 2 : M ACRO E CO N O M I CS
is on aggregate economic variables. Whereas microeconomics may be interested in explaining
why the price o corn is rising, macroeconom ics investigates why the average price level may
be rising. I n m icroeconom ics, the ocu s may be on how many workers a f rm will employ bu t
macroeconom ics exam ines the total level o employm ent and u nemploym en t in a cou ntry.
I n other word s, in macroeconom ics we zoom ou t o ind ivid u al markets and f rm s and look
at what is going on in the cou ntry.
Generally, governm ents and policy makers aim at ach ieving Unem ploym ent is also responsible or high hu man and
the ollowing. social costs, over and above the associated econom ic costs
n Satisactory and su stainable real (m eaning non-in ationary) it entails. I t is clear that aim ing or zero u nem ploym ent is
growth: total ou tpu t and incom e o the cou ntry or economy u nrealistic in a d ynam ic economy, one that is constantly
shou ld increase at an annu al rate that is consid ered changing. Bu t what is consid ered as an acceptable rate o
acceptable. We have to u se cau tion when evalu ating an u nemploym ent d iers rom cou ntry to cou ntry and rom
economys perormance with respect to growth rates, as period to period . As a very rou gh ru le, keep a 5 %
satisactory growth m eans d ieren t things to d ierent benchmark rate in m ind , rem em bering thou gh that su ch a
econom ies at d ierent tim es. I n general, or ad vanced rate may be consid ered u n acceptably high or certain
econom ies, satisactory growth is taken to m ean between cou ntries and u nrealistically low or others.
3% and 5 %. Anything less than 3% is typically n Long-run equilibrium in the balance o payments: the balance
characterized as weak growth and anything exceed ing 5 % o payments relates to the transactions o a country with the
is potentially in ationary. For d eveloping econom ies the rest o the world (exports, imports as well as investments to
range is between 5 % and 1 0% or the sam e reasons. I n and rom other countries) and by long-run equilibrium it is
ad d ition, this increase in total ou tpu t shou ld be su stainable meant that the oreign sector should not impose a constraint
(that is, it shou ld not com e at a heavy environm ental cost). on the countrys ability to achieve the three domestic policy
The central id ea o trad e-os in econom ics shou ld alread y objectives explained above. This goal is difcult to understand
be apparent. Faster growth may not only prove in ationary even on an intuitive basis at this point but the basic idea is
bu t also u n su stainable in term s o the accompanying that a country should be in a position to pay or its imports by
environm ental d egrad ation. maintaining a sufciently competitive export basis.
n Price stability (which implies low in ation and no d e ation): n Equ itable (m ean ing air) d istribu tion o incom e: it may be
or reasons that will becom e clear later, prices on the clear that equ itable d oes not m ean equ al bu t its precise
average (o good s and services bu t also o assets) shou ld m eaning is elu sive and su bject to interpretation. I the
not increase throu gh tim e too ast. When prices on the d istribu tion o incom e is not consid ered by the people
average increase rom one year to the next we say that them selves as air then the process is not su stainable. On
there is in ation. Bu t prices on the average shou ld not the other hand , i the ru its o econom ic growth are enjoyed
d ecrease either as the costs and risks o alling prices by m ore than a ew people, then there are benef ts that
(d e ation) are also u nacceptable. Price stability is u su ally may even help to accelerate the process.
consid ered to have been achieved i the in ation rate is
between 1 .5 % to 3 % annu ally as the m easu rem ent o To achieve:
in ation carries the risk o overestimating the tru e rate and
1 Satisfactory and sustainable real growth
near zero rates o in ation may actu ally be hid in g the
initial stages o d e ation. 2 Low levels of unemployment
n H igh levels o employm ent (low u nemploym ent): ensu ring Macroeconomic 3 Price stability
that whoever is searching or a job is able to f nd one is goals 4 Long-run equilibrium in the balance of
historically consid ered one o the m ost important objectives payments
o governm en ts. Given that resou rces are scarce, it becom es 5 An equitable distribution of income
clear what a terrible waste u nemploym ent implies.
The circular fow o income model good s and services) or m onetary ( ows o expend itu res on
good s and services, ows o incom es generated in the
The circu lar ow m od el is a simplif ed representation o how
prod u ction process).
the basic d ecision-making u nits o an economy (hou sehold s,
f rm s, the governm ent and , in an open economy, the oreign At the m ost basic level, where only hou sehold s and f rm s exist,
sector) interact. I t d escribes the ows between these u nits. it is u n d erstood that hou sehold s own all actors o prod u ction
These ows can be real ( ows o actors o prod u ction, ows o which they oer to f rm s. Firm s u se these actors o prod u ction
71
2 Macroeconomics
to prod u ce good s and services which they oer back to This latter expend itu re is an injection to the circu lar ow
hou sehold s. These ows are real ows and are illu strated below system . Where this injection com e rom ? The answer is that
in Figu re 2 .1 .1 . banks or f nancial interm ed iaries attract savings and then lend
f rm s the u nd s they need to f nance their investm ents.
H ou sehold s I t ollows that the ow in this system will neither increase nor
d ecrease i injections are equ al to withdrawals. I n this
simplif ed version o an economy, withou t governm ent and
withou t a oreign sector, the equ ilibriu m cond ition or national
Flow of incom e (Y) becom es:
Flow of
goods/services
factors I5 S
(ou tpu t ow)
I a governm ent is ad d ed then injections into the circu lar ow
will also inclu d e governm ent expend itu res (G) on d om estically
prod u ced ou tpu t. Dom estic ou tpu t in this m od el can be bou ght
Firm s
by hou sehold s and f rm s as well as the governm ent. On th e
Figure 2.1.1 other hand , part o the incom e generated in this economy may
not be spent as it leaks ou t o the circu lar ow o incom e in the
I n exchange or the u se o these actors o prod u ction f rm s orm o taxes (T).
oer paym ents to hou sehold s in the orm o wages, rents, The equ ilibriu m cond ition becom es:
interest and prof ts, the su m o which is d ef ned as incom e. So,
in the opposite d irection o the real ow o actors there is a I1 G5 S1 T
m onetary ow o actor paym ents, or o incom e. Th is is reerred Lastly, i we make this m od el m ore realistic and ad d a oreign
to as the incom e ow. Equ ivalently, in the opposite d irection o sector then we have one m ore sou rce o expend itu res on
the real ow o good s and services rom f rm s to hou sehold s d om estic ou tpu t, nam ely the expend itu res oreigners make on
there is a m onetary ow o expend itu res rom hou sehold s to it. N ow, not only d o d om estic hou sehold s, f rm s and the
f rm s or the good s and services enjoyed . governm ent spend on d om estic ou tpu t bu t also oreigners.
These expend itu res oreigners make on d om estic ou tpu t
H o u seh o l d s constitu te the export revenu es (X) o th e economy and they are
an injection to its circu lar ow system . On the other hand , part
o the incom e generated in this economy may now be spent on
oreign ou tpu t. This spend ing represents ou r imports (M) and is
Fl ow of Fl ow of a leakage (a withdrawal) to the circu lar ow.
fa ctor pa ym en ts exp en d i tu res
(i n co m e ow) (exp en d i tu re ow)
The equ ilibriu m cond ition becom es:
X1 I1 G5 M1 S1 T
A sim plif ed representation o the circu lar ow is also illu strated
Fi rm s in Figu re 2 .1 .3.
Gross domestic product (GDP) and gross tim e, u su ally a year or a qu arter (by actors o prod u ction
national income (GNI) resid ing in the cou ntry). Rem em ber the ollowing points.
GDP is perhaps the single m ost importan t macroeconom ic Only f nal good s and services are inclu d ed . I nterm ed iate good s
variable and it is d ef ned as the valu e o all f nal good s and (good s u sed in the prod u ction o other good s) are not inclu d ed .
services prod u ced within an economy over a certain period o Alternatively, in stead o trying to work ou t which good s are
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2 Macroeconomics
f nal, inclu d e the valu e-ad d ed contribu ted by each f rm in the an increase in ou tpu t o good s and services prod u ced or
cou ntry, where the valu e ad d ed is d ef ned as the d ierence whether it is d u e to an increase in prices (an increase in the
between the total revenu es collected by each f rm and the cost general or average price level; that is, d u e to in ation). I n other
o raw materials, services and components the f rm pu rchased word s, we cannot know to what extent the increase in the
to prod u ce the good or service. I all prod u ced good s and nom inal (or m oney) GDP f gu re record ed is real an d to what
services were inclu d ed , d ou ble-cou nting wou ld resu lt and extent it is in ationary. For exam ple, i GDP m easu red at
thereore overestimation o the tru e valu e o ou tpu t. cu rrent prices increased rom one year to th e next by 5.5 %, it
M easu rem ent o th e GDP o an economy d oes not in clu d e cannot be known what proportion o this increase is d u e to an
transactions involving u sed good s, f nancial transactions or ou tpu t increase and what proportion is d u e to in ation. I t cou ld
transer paym ents as these d o not represent contribu tions to be, or exam ple, that ou tpu t increased by, say, 4% (that is, real
cu rrent prod u ction o good s and services. GDP increased by 4%) and that the remainin g 1 .5 % was d u e to
price level increases (that is, to in ation), or it cou ld be that
GDP ou tpu t increased only by 0.5 % and prices by 5.0%.
The output, expenditure and income approaches So, nom inal GDP (m oney GDP or GDP at cu rrent prices) is a
There are three conceptu ally equ ivalent ways o arriving at th e m easu re o ou tpu t o a certain period valu ed at the prices
GDP f gu re or a cou ntry. These are: prevailing in that sam e period .
n the ou tpu t m ethod , where we ad d all d om estically Real GDP (or GDP at constant prices) is a m easu re o ou tpu t o
prod u ced f nal good s and services a certain year (say, year t) valu ed at the prices prevailing at
n the expend itu re m ethod , where we ad d all expend itu res som e reerence period (known as the base period or base year).
mad e on d om estically prod u ced f nal g ood s and services So, the ou tpu t o each good in year t is m u ltiplied by its price
n the incom e m ethod , where we ad d all incom es generated in that prevailed in the base year chosen.
the d om estic prod u ction process. Real GDP is thereore a m easu re o ou tpu t ater having isolated
Conceptu ally, the three m ethod s are equ ivalent, and with som e (or ad ju sted or) the eect o in ation. Real GDP f gu res re ect
m in or ad ju stm ents the f gu res arrived at throu gh each m ethod the volu m e o prod u ction, not the valu e.
are equ al. Th e valu e o all ou tpu t prod u ced d oes not becom e Def ne the GDP d e ator as the ratio o nom inal GDP to real
thin air bu t end s u p in pockets in the orm o wages, prof ts, GDP o a year tim es 1 00:
interest or rent (that is, as incom e to th e actors o prod u ction
nominal GDP
involved ). This incom e is then spent on ou tpu t. GDP deator 5 ___________ 3 1 00
real GDP
Each m ethod is u seu l becau se o the breakd own it perm its.
By manipu lating the above we arrive at:
The ou tpu t m ethod , or example, will give u s the share o total
ou tpu t accou nted or by each o the three sectors o an nominal GDP
real GDP 5 ___________ 3 1 00
economy as well as the ou tpu t o d ieren t ind u stries: GDP deator
output method: primary sector 1 secondary sector The GDP d e ator is a com prehensive price ind ex which
1 tertiary sector, or m easu res the average level o prices o all good s and services
industry 1 1 industry 2 1 industry 3 1 1 industry n inclu d ed in the GDP o a country.
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2 Macroeconomics
Per capita f gu res scale the variable or cou ntry size, making d eence, sacrif ces resou rces in this area that cou ld
com parisons between cou ntries m eaningu l. oth erwise have been u sed in the prod u ction o pro-
d evelopm ent good s.
Problems in GDP measurement
n I t ails to inclu d e the valu e o leisu re, a m ost important
GDP m easu rem en t is rau ght with problem s. Of cial GDP
good an ind ivid u al may enjoy. I t makes a big d ierence to
f gu res in many cou ntries u nd erstate the tru e level o econom ic
workers i their average workin g week is over 5 0 hou rs and
activity becau se o the existence o a large parallel (black or
they can seld om take tim e o, or i the workin g week is
shad ow) economy. I nd ivid u als in many cou ntries u nd er-report
only 35 hou rs.
their incom es to avoid taxation. A heavy tax bu rd en, especially
high marginal (top) tax rates may be responsible or this n I t ails to incorporate the valu e o the stream o services
tax-evad ing behaviou r. Som e prod u ctive activity may also be owing rom the accu m u lated social an d other capital o
illegal per se (involvem ent with dru gs, prostitu tion , etc.). an econ omy. Living stand ard s at any point in tim e are
Fu rtherm ore, d o it you rsel activities are not inclu d ed . I aected not ju st by cu rrent incom e bu t also by the stock o
I repair my car instead o taking it to the m echanic, the valu e o accu m u lated wealth. For example, the existence o a
the service I produ ce will not show up in of cial statistics. This high-qu ality and ree pu blic school system implies that
becom es an important issue in the case o many d eveloping hou sehold s with children may d evote m ore o their incom e
cou ntries becau se su bsistence arm ing (d ef ned as arm ing to to other good s and services.
eed ones am ily) is not inclu ded in GDP m easu rem ents and
The trade (or business) cycle
this leads to und erestimation o per capita incom e levels. Lastly,
The trad e or bu siness cycle is d ef ned as the short-term
data collection in many countries is poor and u nreliable.
u ctu ations o real GDP arou nd its long-term trend . Period s o
Comparisons over time and across countries using national expansion (boom s) are ollowed by period s o contraction
incom e statistics (recession or bu sts). The d owntu rns major characteristic is
For m eaningu l comparisons over tim e it is im portant that the increasing levels o u nemploym ent. I , on the other hand ,
eect o chan ging price levels is isolated . Real GDP or GN I expansion is too rapid it may give rise to in ationary pressu res.
m u st be u sed . I n ad d ition, i we are not ju st interested in the I d eally, stead y, su stainable, non-in ationary long-term growth
size o an economy then it is ad visable to u se per capita f gu res. is d esirable.
Con version o n ational incom e f gu res to a com m on cu rrency,
Real GDP
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2 Macroeconomics
I n figu re 2 .1 .4, between tim e t1 and t2 the econom y is in If actual output is greater than potential output then
recession. Real GDP is d ecreasing (technically, for at least two unemploym ent must be lower than the natural rate.
consecu tive qu arters), so the economy is registering negative If actual output falls short of potential output then
growth rates. At t1 it was at a peak (as well as at t3). At t2 it is unemployment is greater than the natural rate.
at a trou gh and it is abou t to enter recovery.
When actual output is not equal to potential output an
N ote that if th e growth rate is d ecrea sin g (from , say, 2 .1 % to output gap is present.
0.8%) rea l GDP con tin u es to in crea se bu t at a slower a n d
slower rate. Va riou s expressi on s a re u sed to d escribe th is
Make sure that ater you fnish drawing the trade cycle there
pha se, for exam ple th e econ om y i s l osin g steam , it is TIP
is only one level o real GDP corresponding to each time
pea kin g ou t or i t i s a pproa ch in g recessi on . An econ om y
period t. A common error is to draw it in such a way that at
a bou t to en ter recession is, i n Fi g u re 2 .1 .4, som ewh ere rig h t
each point t on the horizontal axis there are more than one
before a pea k.
corresponding levels o real GDP.
Time line
75
2.2 Introducing aggregate demand
and aggregate supply
Aggregate demand
Ag gregate d ema n d (AD) is a term that reers to total spen d in g n The interest rate eect: i the average price level increases
on d om estic g ood s a n d services per period o tim e. M ore then m ore m oney will be need ed to eectu ate a given level
precisely, AD is d ef n ed a s th e pla n n ed level o spen d in g on o transactions. I the su pply o m oney is f xed bu t the
d om estic ou tpu t at d ieren t avera g e price levels per period d emand or m oney increases then interest rates will
o tim e. increase, which d ecreases both consu mption and
Spend ing on ou tpu t ca n orig in ate eith er rom th e private investm ent expend itu res as people an d f rm s borrow to
sector (wh ich in clu d es h ou seh old s a n d f rm s) or rom th e pu rchase d u rables and capital good s respectively.
pu blic sector (th e govern m en t). Private sector spend ing n The trade eect: i the average price level increases then exports
in clu d es consu m ption expen d itu res (C) that h ou sehold s ma ke become less competitive abroad while imports seem more
a n d in vestm en t expen d itu res (I ) that f rm s make. Th e pu blic attractive at home so net exports, a component o AD, decrease.
sector expen d itu res are u su ally term ed g overn m en t As in all d iagram s, the u nction will not shit when a variable
expend itu res (G) in wh ich both cu rrent an d capital pu blic on either o the axes changes. So, i there is a chan ge in th e
spen d in g are in clu d ed . average price level there will be no shit in the AD cu rve bu t
Spend ing on d om estic ou tpu t can also origin ate rom abroad on ly a m ovem ent along it. Changes in national incom e cannot
as oreigners bu y d om estic good s an d services. These are the initiate a shit in the cu rve either. AD will shit only i a
exports (X) o an economy. Since thou gh part o the spend ing non-incom e actor ind u ces a change in any o its components.
that hou sehold s, f rm s and the governm ent makes is on oreign
good s, we m u st su btract imports (M ) to arrive at AD. So, AD is Components of AD
given by the relationship: Consumption expenditures
AD 5 C 1 I 1 G 1 (X 2 M) Consu mption expend itu res (C) are d ef ned as spend ing by
hou sehold s on d u rables, non-d u rables and services per period
AD 5 C 1 I 1 G 1 N X, where N X 5 (X 2 M) o tim e. Consu mption expend itu res d epend on the level o
Wh en pl otted a ga i n st th e avera g e pri ce l evel , AD i s interest rates (I R), on the d egree o consu m er conf d ence (CC),
n egati vel y sl oped i l l u strati n g , a s i n Fi g u re 2 .2 .1 , that a t a on the level o hou sehold wealth (W), on personal incom e taxes
h i g h er avera g e pri ce level , pla n n ed spen d i n g on d om esti c (PIT), on hou sehold ind ebted ness (H D) etc.
ou tpu t d ecrea ses. C 5 f (IR, CC, W, PIT, H D, ...)
The above simply states that consu mption expend itu res are a
Average price level (P)
u n ction o (that is, d epend on) the variables listed insid e the
parentheses.
More specif c d etails are as ollows.
N egatively sloped becau se of th e:
wea lth effect n Interest rates (IR): the interest rate can be simply defned as
tra d e effect the price paid per period or borrowing money on a
in terest rate effect percentage basis. I interest rates, or example, increase, then
consumption expenditures are expected to decrease, shiting
AD to the let or three reasons. First, borrowing to fnance
the purchase o consumer durables such as cars, appliances
and urniture will becom e m ore expensive so households will
AD = C + I + G + N X tend to cut down on such purchases. N ote that the housing
market will also be negatively aected as it will becom e m ore
Real ou tcom e/incom e ( Yr) expensive to fnance the purchase or construction o a house,
Figure 2.2.1 The AD curve but technically this expenditure is classifed under
investm ent. Second, higher interest rates make saving m ore
The AD cu rve is d ownward sloping bu t n ot or the sam e reasons attractive (saving is defned as incom e not spent). I people
that the d emand or a single good is d ownward sloping as on tend to save m ore then it automatically implies that they will
the vertical axis we have th e average price o all good s and not tend to spend less. Lastly, the single largest expenditure o a
o a single good . typical household is the purchase o its house. H ouseholds
AD is negatively sloped because o the wealth eect, the borrow rom banks to fnance this purchase through
interest rate eect and the trade eect. H ere are specif c details. specialized very long-term loans known as m ortgages. The
n The wealth eect: i the average price level increases the interest rate charged on such loans is oten adjustable,
real valu e o the m oney that people have in their pockets or m eaning that i market interest rates increase, mortgage
in bank accou nts, as well as the real valu e o other f nancial rates will also increase and so will the m onthly payments.
assets su ch as bond s, d ecreases. I people eel poorer they People who bought houses in the past with a m ortgage and
tend to spend less. still owe m oney will thereore have less m oney available every
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2 Macroeconomics
m onth to spend on goods and services, as they will need to n Bu siness conf d ence (BC): the greater the d egree o
pay a higher m onthly mortgage payment to the bank. I, or bu siness conf d ence in an econom y, the m ore willing f rm s
example, a amily m ust pay the bank $ 55 0.00 per m onth will be to invest and expand . Econom ic and political
instead o $ 5 00.00 then in a year it will have $ 600.00 less stability are necessary or a positive bu siness climate to
available to spend on goods and services. evolve and so or in vestm ents to take place. Keynes
n Consu m er conf d ence (CC): hou sehold s eeling secu re and consid ered the behaviou r o entrepreneu rs with respect to
conf d ent abou t their u tu re will tend to spend m ore. private investm en t d ecisions sim ilar to that o a herd
A stable and growing economy with low in ation and (im itation ) and , in his opinion, the observed instability o
u nem ploym ent will boost consu m er conf d ence and investm ents was d u e to these animal spirits. Expectations
avou rably aect hou sehold spend ing, shiting AD to the can be greatly chang ed by many u npred ictable actors,
right. On the other hand , u ncertainty over u tu re job lead ing to swings in the prevailing bu siness climate and so
prospects and insecu rity abou t ones u tu re incom e to changes in the level o investm ent spend ing.
ad versely aect present consu m ption. Spend ing on d u rable n Technology (T): ind u stries and sectors where technology
good s, su ch as cars and appliances, as well as on hou sing, ad vances at a rapid rate will register higher rates o
are greatly aected by consu m er m ood s. investm ent spend ing. Firm s in su ch ind u stries will be orced
n Wealth (W): the total valu e o a hou sehold s assets may to u nd ertake su ch spend ing in ord er to remain ahead or
aect the level o its spend ing. I , or example, wealth keep u p with rivals.
increases, then consu m ption will be positively aected . n Bu siness taxes (BT): changes in bu siness taxes aect the
A stock market boom or rising property valu es tend to expected prof tability o an investm ent project. An increase
increase spend ing and lower savings. AD will tend to in bu siness taxes will m ean that ewer investm ent projects
increase and shit to the right. pass the prof tability test and this will tend to d ampen
n Personal incom e taxes (PIT): I , or example, the governm ent investm ent and , consequ en tly, d ecrease AD.
increases PIT then d isposable incom e (Yd ), d ef ned as n Corporate ind ebted ness (CD): companies that are highly
incom e (Y) less su ch taxes (T) plu s transer paym ents (Tr) ind ebted will be very hesitant to take on m ore d ebt in ord er
will d ecrease (Yd 5 Y 2 T 1 Tr ). Lower d isposable incom e to make m ore investm ents.
as a resu lt o higher PIT will tend to d ecrease consu m ption
I n add ition to the above actors, th e ollowing are also thou ght
expend itu res and so d ecrease AD, shiting it to the let.
to aect investm ent spend ing in an econom y and so AD.
n The level o household indebtedness (H D): i private
n Public policy toward investm ent: governm ents oten attempt
(household) debt (rom taking out loans and /or rom paying
to inuence investm ent by oering tax incentives to frm s,
credit card charges) has accumulated, household spending will
subsidies, preerential loan term s, protection rom oreign
to decline as households will need to pay more and more to
competition, etc. N ote that the size itsel o the public sector
service their debt. This will put a damper on consumption
in an economy may inuence the growth o private
expenditures and so tend to decrease AD, shiting it to the let.
investm ent. Also rem em ber that institutions aect private
investm ents. A large bureaucracy (or red tape) and
Investm ent expenditures
complicated regulations will burden the operation o frms in
I nvestm ent expend itu res (I ) are d ef ned as spend ing by f rm s on
a country and negatively aect the rate o investm ent.
capital g ood s per period o tim e. I nvestm ent increases the stock
Investm ent levels are, ceteris paribus, higher in countries with
o capital o an economy. I nvestm ent is important both becau se
low levels o bureaucracy and with transparent econom ic and
o its short-ru n in u ence on AD and becau se in the long ru n it
business environm ents. Lastly, corruption adversely aects
aects aggregate su pply (AS) and so the rate o (actu al and
investm ent, especially oreign direct investm ent (investm ent
potential) growth o an economy. I nvestm ent spend ing is the
by m ultinational corporations in oreign countries).
m ost volatile component o AD. I nvestm ent expend itu res
d epend on the level o interest rates (I R), on the d egree o n The overall macroeconom ic environm ent: a sou nd
bu siness conf d ence (BC), on technology (T), on bu siness taxes macroeconom ic en vironm ent where policy makers ensu re
(BT), on corporate ind ebted ness (CD), etc. low in ation, low bu d get d ef cits, a su stainable pu blic d ebt
an d exible labou r markets u su ally lead s to higher rates o
I 5 f (IR, BC, T, BT, CD, ...) investm ent spend ing. A sou nd macroeconom ic environm ent
The above simply states that investm ent expend itu res are a lead s to h igher conf d ence level or bu sinesses.
u nction o (that is, they d epend on) the variables listed insid e n I ncom e and its growth : rising incom e lead s to rising
the parentheses. consu mption, which may in d u ce m ore investm ents as f rm s
Again, m ore specif c d etails ollow. may be orced to increase their capacity to m eet th e
increased d emand or good s and services.
n I nterest rates (I R): i interest rates increase, then investm ent
expend itu res by bu sinesses are expected to d ecrease, Government spending
shiting AD to the let. Borrowing to f nance the pu rchase Governm ent spend ing (G) is in many econom ies a large part o
o capital good s su ch as machines, tools, equ ipm en t and total spend in g on g ood s and services. Governm ent spend ing is
actories will becom e m ore expensive so f rm s will f nd that d istingu ished in to current spend ing on good s and services,
ewer possible investm ent projects are now prof table. Even capital (pu blic investm ent) spend ing which reers to spend ing
i a f rm u ses its own u nd s to f nance an investm ent on road s, ports, telecom m u nications, schools and other
project, the opportu n ity cost o u sing these u nd s instead o inrastru ctu re and also on transfer payments which basically
keeping them tied in banks or as bond s increases.
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2 Macroeconomics
reer to pension s and u nemploym ent benef ts. N ote that n Exchange rate (ER ): the exchange rate o a cu rrency is its
transer paym ents are not inclu d ed in national incom e since price expressed in term s o a oreign cu rrency. I , or
they d o not represent reward s to cu rrent prod u ctive eort. exam ple, the exchange rate d ecreases (d epreciates or
Governm ents spend to ensu re that ad equ ate am ou nts o pu blic d evalu es) then exports becom e ch eaper an d so m ore
and m erit good s and services are consu m ed , su ch as national competitive abroad while im ports becom e pricier and less
d eence, ed u cational services and health-care services. They attractive d om estically. As a resu lt, net exports are expected
spend to reg u late markets in their attem pt to gu arantee to increase, shitin g AD to the right.
prod u ct saety, environm ental stand ard s, competitive n Trade protection or changes in commercial policy (CP ): trade
cond ition s, etc. They may also spend to red istribu te incom e so protection or commercial policy reers to any policy that
that a socially acceptable m inim u m is gu aranteed . Su ch governments may implement to discriminate against oreign
spend ing inclu d es u nd ing state pensions, u nemploym ent suppliers. I, or example, trading partners lit trade barriers (or
benef ts, su bsid ies, d isability benef ts, or example. Lastly, example i they decrease taris, which are taxes on imports; or
governm ents spend to aect AD. An increase or d ecrease in eliminate quotas, which are quantitative restrictions on
governm ent expend itu res will cau se AD to increase or d ecrease, imports) then exports will increase and so will AD.
shiting to the right or to the let. This is part o what is known
So, i any o these actors change in the d escribed d irection, AD
as f scal policy. We may thereore conclu d e that econom ic and
will ten d to increase and shit to the right. Rem em ber thou g h
political priorities aect the level o governm ent spend ing .
that there is no a priori gu arantee that the expected change
N et exports will be signif cant or that it will even materialize, as each
N et exports (N X or X2 M ) a re d ef n ed a s th e d ieren ce component o AD is aected by many variables. So, i, or
between spen d in g by oreig n ers on d om estic ou tpu t m in u s example, interest rates d ecrease, we expect that consu mption
d om estic spen d in g on oreig n ou tpu t or, m ore sim ply, a s th e expend itu res will be positively aected bu t we cannot be
d ieren ce between export reven u es an d im port expen d itu res certain that this will ind eed happen, as perhaps the d ecrease in
per period o tim e. N et exports d epen d on oreig n in com e (Y ), interest rates is too small or hou sehold s happen to be very
th e exchan g e rate (ER ), th e level o tra d e protection or o pessim istic or highly ind ebted . This is why we qu aliy ou r
com m ercial policy (CP ) etc. conclu sion stating that consu mption will tend to increase.
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2 Macroeconomics
Aggregate supply
Aggregate su pply (AS) is d ef ned as the planned level o ou tpu t an economy. This is equ ivalent to a d ecrease in prod u ction
that d om estic f rm s are willin g to oer at d ierent average costs which will tend to shit the SRAS to the right. N ow
price levels per period o tim e. The shape o the AS cu rve is consid er the eect o an increase in th e price o oil. Since oil is
rather controversial in macroeconom ics as it re ects the the pred om in ant orm o energy, it will increase prod u ction
d ierent assu m ptions u sed by d ierent schools o thou ght. costs, shiting the SRAS cu rve to the let.
We will initially discuss what is known as the short-run aggregate Lastly, in a principally agricu ltu ral economy, temporary su pply
supply (SRAS) curve. The m onetarist or new classical m odel will shocks (su ch as generally poor weather, a d estru ctive hu rricane
ollow and, lastly, we will present the Keynesian m odel. or ood s) will have ad verse eects, d ecreasing SRAS and
shiting the cu rve to the let.
SRAS
The short ru n is d ef ned in econom ics as the tim e period d u ring Alternative views of AS
The monetarist or new classical AS
which not all ad ju stm ents have taken place. Within the
Accord ing to the m onetarist or new classical school o thou ght,
ram ework o an AS analysis this is taken to reer to f xed
an econom y will in the lon g ru n when all ad ju stm ents are
m oney wages: m oney (or nom inal) wages are assu m ed f xed
possible and m ore specif cally m oney wages have ad ju sted to
over the short ru n and u nable to ad ju st to changes in the
changes in the average price level prod u ce whatever its
average price level. Why? Two explanations may be oered . The
resou rces and tech nology allow it to prod u ce. I n the long ru n,
f rst rests on labou r contracts wh ich f x wages or relatively long
ou tpu t will be at its potential or natu ral level, which is
period s o tim e. The second explanation rests on the id ea that
consid ered the u ll employm ent level o ou tpu t or the
workers are slow to ad ju st th eir expectations o in ation (o a
economy. This level o ou tpu t in the long ru n is ind epend ent o
risin g average price level) and only ater som e tim e d o they
the average level o prices becau se m oney wages are assu m ed
realize that rising prices have aected their pu rchasing power.
to ad ju st u lly so that the real wage is constant.
Figu re 2 .2 .3 illu strates a m onetarist or new classical long-ru n
Average price level (P)
SRAS
aggregate su pply (LRAS) cu rve. I t is drawn vertical to show that
increases in the average price level will not ind u ce any increase
in real ou tpu t in the long ru n. Why? Becau se in th e long ru n,
B m oney wages will have ad ju sted and matched the increase in
P2
prices so f rm s prof tability will not have changed .
Money wages are
A
Average price level (P)
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2 Macroeconomics
The Keynesian version of AS section. Within su ch a set-u p, at u ll employm ent there is som e
Th e Keynesian version o the AS cu rve typically has th ree u nemploym ent, the natu ral or normal rate o u nemploym ent;
d istinct sections, as illu strated in Figu re 2 .2 .4. and ou tpu t can increase beyond that level, im plying that
u nemploym ent may all below that level. I t is perhaps ad visable
Average price level (P)
LRAS LRAS
AS AS
0 Yf Yf 0 Yf Yf
Real outcome/income (Yr) Real outcome/income (Yr)
Figure 2.2.5 Shiting AS over the long run
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2 Macroeconomics
Equilibrium
Short-run equilibrium
P2 a2
Average price level (P)
SRAS
P a
P1 a1
P AD2
AD1
0 Yp Y
Real outcome/income (Yr)
AD Figure 2.2.7 Returning to ull employment ollowing an increase in AD
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2 Macroeconomics
at its potential (u ll employm ent) level Yp and the average level the Keynesian ramework an economy may fnd itsel stuck at an
o prices is at P1 . Assu m e now that, or whatever reason, AD equilibrium level o real output with less than ull employment.
d ecreases and th e cu rve shits to the let to AD2 . The average N o endogenous orces exist that will restore ull employment.
price level will d ecrease to P and this will ind u ce f rm s to More specifcally, money wages are assumed sticky downwards
d ecrease real ou tpu t to Y as m oney wages in the short ru n are (the ratchet eect: money wages may increase but they do not
f xed , so prof tability is lower. Short-ru n equ ilibriu m is at poin t a easily adjust downwards). It ollows that within the Keynesian
at the intersection o AD2 with SRAS1 . Real ou tpu t is below its world, AD is the driving orce behind economic activity. Instead o
potential (u ll employm ent) level. The economy is characterized believing in supply creating its own demand (Says law rom the
by a defationary gap equ al to the d ierence between the classical school o thought, which included the intellectual athers
potential level o ou tpu t and the lower equ ilibriu m level o o monetarism and the new classical school), Keynes turned things
ou tpu t YYp. inside out, postulating that it is eective demand (which we call
AD) that determines the equilibrium level o real output in an
Average price level (P)
P2 a2
AD1
AD2
0 Y Yp
Real outcom e/incom e (Yr)
Section II Section III
Figure 2.2.8 Returning to ull employment ollowing a decrease in AD
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2 Macroeconomics
AS
level o real ou tpu t equ al to the u ll employm ent level o real
ou tpu t Y. I , or som e reason, AD increases and the cu rve shits
to AD2 then the economy will remain at its u ll employm ent
b
level o ou tpu t Y bu t the average price level will rise, proving
pu rely inf ationary. Distance ab in Figu re 2 .2 .1 0 is oten
AD2 consid ered to illu strate an inf ationary gap within the
a
Keynesian m od el.
AD1
0 Yf
Real outcome/income (Yr)
Figure 2.2.1 0 An infationary gap within a Keynesian AS diagram
83
2.3 Macroeconomic objectives
Low unemployment
An ind ivid u al is consid ered u nemployed i h e or she is actively are sacrifced. One way o viewing this cost is by examining the
searching or a job an d cannot f nd one. The u nemploym ent size o the distance between actual output and potential output
rate is the ratio o the nu m ber o u nem ployed over the size o in a business cycle diagram. This is reerred to as the output gap.
the labou r orce (also reerred to as the workorce or the Another way o visualizing this cost is through a diagram showing
working popu lation) tim es 1 00. The labou r orce inclu d es the a production possibilities curve (PPC) also known as a
employed and the u nemployed : production possibilities rontier (PPF) as unemployment implies
number of unemployed that the economy is operating inside the curve.
Unemployement rate 5 ___________________ 3 1 00 The governm ents f nances are also aected by u nemploym ent.
labour force
Tax revenu es collected are lower becau se o the lower incom es
and the resu lting d ecreased private spend ing. Governm ent
Measurement problems spend ing increases becau se o the u nem ploym ent benef ts paid
It is difcult to get an accurate estimate o the unemployment rate. to the u nemployed and the increased nu m ber o trainin g and
The ofcial unemployment rate may underestimate or overestimate re-training program m es that need to be implem ented .
the true level o unemployment in a country, as ollows.
For individuals who lose their jobs, the single m ost important
It may understate the true level o unemployment because o cost incurred is the lost income. Living standards o the
the existence o discouraged workers and o underemployed unemployed are adversely aected, especially i wages were the
individuals. The frst category o discouraged workers includes only source o incom e. Another cost or individuals is the loss o
individuals who would like to work and would happily accept a up-to-date skills. In certain proessions this may be very important
job oer but who have stopped actively searching or one because and the longer people remain unemployed the less employable
they have remained unemployed or too long and their past search they become as their human capital is eroded. Employers preer
eort was unsuccessul. Since they are demonstrating no eort in to hire individuals currently employed elsewhere as not only will
seeking employment they are not considered unemployed, so they their skills be up to date but also the risks created by asymm etric
are not included in the ofcial unemployment rate. The second inormation are avoided as the employer cannot know why the
category, the underemployed individuals, includes people who do unemployed lost their jobs in the frst place. Other possible
have a job (so are considered employed) but who are working as private costs o unemploym ent include the loss o sel-esteem
part-time employees ewer hours per week than desired. These are that oten results and the increased probability that the person
involuntary part-time workers. will resort to alcohol or drug abuse.
The of cial u nem ploym ent rate may overstate the tru e level o I u nem ploym ent is high and prolonged , society may experience
u nem ploym ent as som e ind ivid u als may inten tionally conceal a higher incid ence o crim e and violence and other negative
their tru e employm en t statu s eith er earing loss o transer externalities resu lting rom dru g and alcohol abu se. I
paym ents, su ch as u nem ploym ent benef ts, that are granted u nemploym ent is heavily concentrated in regions or in age
only to the u nemployed or becau se they are em ployed in illegal grou ps su ch problem s may becom e even m ore pronou nced .
activities su ch as gam bling or prostitu tion.
There may be som e benef ts arising rom m od erate
In general, during recessions the num ber o part-time workers and u nemploym ent. Many qu ote that u nion power weakens, so
o discouraged workers increases. Also, som e who were alsely there is red u ced wage in ation in the economy. I the real wage
claim ing to be unemployed in order to collect benefts may d ecreases then prof tability and com petitiveness o d om estic
actually becom e unemployed. As a result, actual or true f rm s increases. I ncreased geographical and occu pational
unemploym ent is m ore likely to be higher during the downturn o m obility is also m ention ed as a possible positive sid e eect o
the business cycle than the ofcial fgure suggests. Sym m etrically, u nemploym ent as workers are orced to relocate or change
during a boom actual unemploym ent may be lower than the occu pation. These benef ts m u st be viewed in context thou gh,
reported ofcial fgure as ewer people will become discouraged otherwise the harsh reality o u nem ploym ent may be d istorted .
or will be orced into accepting part-time positions when jobs are
plentiul. In addition, m ore people may continue reporting as Types and causes of unemployment
unemployed even though they have actually ound a job.
and policies to lower it
Remember that the reported ofcial unemployment rate does not
There are three main types o u nem ploym ent.
reveal any inormation pertaining to age, gender, ethnic or regional
disparities. Concerning demographic groups, unemployment n Seasonal unemployment is a resu lt o pred ictable
among young workers and minorities is typically the highest. It is variations in the d emand and su pply o labou r. Weather
thereore important to examine disaggregated unemployment data patterns are responsible or constru ction workers being laid
to get a better picture o the labour market o a country. o in th e winter and snow ski instru ctors in the su m m er.
Labou r su pply su rges in Ju ne every year as college and
Consequences of unemployment second ary school grad u ates start lookin g or a job. This
type o u nem ploym ent is expected and there is not m u ch a
Perhaps the biggest cost o unemployment is the opportunity cost
governm ent can d o abou t it. Unemploym ent statistics
o lost output. Goods and services that could have been produced
thou gh are oten corrected (season ally ad ju sted ) so that
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2 Macroeconomics
policy makers can d eterm ine tru e changes in N ote that labou r d eman d (LD) shows how many workers f rm s
u nemploym ent, not th ose d u e to the changing seasons. are willin g to hire at each wag e rate while labou r su pply (LS)
n Frictional unemployment reers to people in-between jobs shows how many workers are willing to oer their labou r
as it takes tim e to match a job seeker with an available job services at each wage rate. I nitially, we assu m e equ ilibriu m in
vacancy. This is u nemploym ent o a short-term natu re and is this specif c labou r market with the wage rate d eterm ined at
largely also u navoid able in an economy since people will the intersection o LD1 with LS. I au tomated processes or
always volu ntarily switch jobs, searching or better ones or shiting com parative ad vantage d ecrease labou r d emand to
relocating. Faster and better inormation abou t the labou r LD2 and m oney wages are sticky then d istance h may be
market will d ecrease bu t not elim inate rictional thou ght o representin g the resu lting stru ctu rally u nemployed .
u nemploym ent. Governm ents can m inim ize rictional Stru ctu ral u nem ploym ent, thou gh, may n ot be a resu lt o
u nemploym ent by ensu ring that job vacancies as well as m ismatches bu t o what are known as labou r market rigid ities.
the prof les o those available or work becom e kn own M inim u m wage laws and wages set throu gh collective
wid er and aster. bargaining between ind u stries and labou r are examples o
n Structural unemployment is perhaps the most serious type o labou r market rigid ities. They both resu lt in high er
unemployment since it is o a long-term nature. It represents u nemploym ent as wage rates are set above their equ ilibriu m ,
those remaining unemployed long ater recovery is under way market clearing level. I pension plans in one ind u stry are not
in an economy. An economy may be booming but structural easily transerred to another ind u stry then occu pational
unemployment will not decrease. It is the result o the m obility is hampered . Consid er a worker losing his job in
evolving structure o an economy because o rapid ind u stry A bu t prevented rom taking a job oer in ind u stry B
technological advancement or shiting comparative becau se he can not transer his pension rights. H e will end u p
advantage. The changing structure o an economy results in a u nemployed . Lastly, in stitu tional d isincentives are consid ered as
mismatch between the skills available among the cau ses o stru ctu ral u nemploym ent. Laws preventing f rm s
unemployed and the skills required by the labour market. N ew d ism issing employees except in certain circu m stances and high
technologies render certain proessions obsolete but at the u nemploym ent benef ts are examples.
same time create new job opportunities. For example, in some Elim inating stru ctu ral u nemploym ent is not possible in a
cases the Internet may have decreased the demand or shop d ynam ic econ omy as its stru ctu re is con stantly changing bu t
assistants but it has created new jobs or web designers and there are policies consid ered helpu l in red u cing it. Perhaps the
sotware engineers. But i the redundant shop assistant is not m ost important o these policies are related to acilitating the
trained in computer science then he or she may fnd it difcult training and re-training o those with non-marketable skills.
to get a job. Or, consider the case o an industry in a country Governm ents may d irectly provid e training program m es or they
losing its export markets to lower-cost oreign frms. I Korean may su bsid ize private provision o su ch program m es. They may
shipyards become more competitive then specialized workers also provid e low-interest loans to ind ivid u als willin g to enroll in
in other countries will lose their jobs. Lastly, the mismatch can su ch skill-creating cou rses who otherwise lack the necessary
also be geographic, with the unemployed clustered in one f nancing, as well as assistance to ind ivid u als willing to relocate
region o the country while job vacancies exist elsewhere. to ease their ad ju stm ent costs. Governm ents oer incentives in
the orm o tax breaks or wage su bsid ies to f rm s hiring
Fig ure 2 .3.1 is an illu stration o the stru ctu ral u nemploym ent
stru ctu rally and long-term u nemployed ind ivid u als. They also
resulting in som e specif c ind u stry i, or example, som e o the
revise school cu rricu la to prepare ind ivid u als better or the
f rm s are orced to shu t d own as a resu lt o increased oreign
labou r market.
competition or becau se o som e f rm s switching to au tomated
processes that rend er som e o the workers red u nd ant. I labou r market rigid ities are responsible or som e o the
stru ctu ral u nemploym ent in a cou ntry then th e obviou s solu tion
Money wage
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2 Macroeconomics
cost to society. Decreasin g workers protection may lead to the right-hand sid e o Figu re 2 .3 .2 the economys labou r market
labou r and social u nrest which may hamper growth instead o is illu strated . N ote that in Figu re 2 .3.2 the labou r market as a
accelerating it. Segm ents o the popu lation may becom e whole o a cou ntry is d epicted whereas Figu re 2 .3 .1 ocu sed on
marginalized and incom e d istribu tion m ore u nequ al, again with the labou r market relating to a specif c ind u stry. I n Figu re 2 .3.2 ,
ad verse eects on growth and d evelopm ent. labou r d eman d d ecreases rom DL1 to DL2 . M oney wages are
I t is worth noting that the policies that shou ld be em ployed to assu m ed sticky d ownward and so remain at w. Excess su pply
lower stru ctu ral u nem ploym ent are o a m icroeconom ic natu re. o labou r in the cou ntry resu lts equ al to d istance ab, re ecting
the resu lting cyclical u nem ploym ent.
Cyclical (or Keynesian or demand-defcient) Unemploym ent d u e to cyclical reasons is d ealt with u sing what
unemployment are called expansionary d emand -sid e policies. Eectively,
throu gh these policies the governm ent will attempt to close the
This type o u nemploym ent is d irectly related to the bu siness
d e ationary gap. The policies aim at increasing AD. They
cycle. H igher u nemploym en t will necessarily accompany a
inclu d e interest rate cu ts in the hope that hou sehold s and f rm s
recession becau se o the lower level o econom ic activity. A
will be convinced to spend m ore, as well as lower taxes and
d ecrease in AD will orce som e bu sinesses to shrink and others
increased governm ent expend itu res.
to close d own.
On the let-hand sid e o Figu re 2 .3.2 the d ecrease in AD is
Even though it sounds counterintuitive, a growing economy
shown rom AD1 to AD2 which resu lts in lower level o TIP
may over the long term suffer from higher structural
econom ic activity and lower real ou tpu t Y2 . The economy has
unemployment. This is because the different income
entered a recession. As a resu lt o the lower o econom ic
elasticities of demand of the different industries and sectors of
activity, f rm s d ecrease their d emand or labou r. Som e f rm s may
an economy will change its structure.
shrink, others may even shu t d own becau se o the recession. On
Money wage
Average price level (P)
SRAS SL
a b
w
AD1
AD2 DL2 DL1
0 Y2 Y1 Yf 0
Labour
Real outcome/income (Yr)
Figure 2.3.2 Illustrating cyclical unemployment
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2 Macroeconomics
weighted average as good s and services are not o equ al ch u nk o the typical consu m ers bu d get. Food prices, thou gh,
signif cance to the typical consu m er. The weight or each good are aected by weather and other rand om actors. For exam ple,
is the expend itu re on it expressed as a proportion o total a bad season will increase the price o m ost ood prod u cts
expend itu res mad e. The cost o pu rchasing the basket is while a good crop will d ecrease it. Oil prices are aected by
record ed and then expressed as an ind ex nu m ber. This m eans d ecisions mad e by the Organization o th e Petroleu m Exportin g
that u sing statistical criteria som e year is chosen to be the Cou ntries (OPEC), political d evelopm ents in cou ntries prod u cin g
base (or reerence) year and all other years are expressed as a and exporting oil and by specu lators. Oil prices may thereore
percentage o it. I t ollows that the price ind ex or the base year increase and d ecrease signif cantly or reasons u nrelated to the
will be equ al to 1 00. By expressin g a variable as an ind ex u nd am entals o an economy. This is why what is known as core
nu m ber we get rid o its u nits o m easu rem ent which makes in ation is estimated and reported . The core or u nd erlying rate
comparisons throu gh tim e easier. I we have constru cted the o in ation simply exclu d es ood and energy prices rom the set
consu m er price ind ex or period t and the consu m er price ind ex o prices comprising the basket o good s that the typical
or period (t 1 1 ) then the in ation rate o period (t 1 1 ) is consu m er pu rchases. As a resu lt, swings in ood and energy
given as the percentage change o these two price ind ices. prices that are u nrelated to the u nd am entals o an economy
N ote that a negative percentage change implies d e ation. are isolated , perm itting a m ore accu rate interpretation o the
CPI(t 1 1 ) 2 CPI(t) working s o an econom y.
Infation (t 1 1 ) 5 % D(CPI) 5 ________________ 3 1 00
CPI(t)
The producer price index
An alternative price ind ex that has certain ad vantages over the
Problems o measurement CPI is the prod u cer price ind ex (PPI ). The PPI inclu d es the prices
The typical con su m er is a f ctitiou s person. This person is both that prod u cers receive or good s (services are not inclu d ed ) at
you ng and old , lives both in a city and on a arm and is both all stag es in the prod u ction process, inclu d ing not ju st f nished
well o and relatively poor. As a resu lt, it is problematical to g ood s (su ch as price-scanning d evices and tractors) bu t also
u se the in ation rate f gu re to d eterm ine, or example, by how sem i-f nished and interm ed iate good s (su ch as ou r and steel)
m u ch a governm ent shou ld increase pension s, as old er people as well raw or cru d e materials (su ch as coal and cru d e oil). The
consu m e m ore health care an d less entertain m ent than a main ad vantage o the PPI over the CPI is that it picks u p and
you nger ind ivid u al. Since the patterns o consu mption across sign als price chang es that the typical consu m er will ace beore
d ierent d em ographic grou ps d ier, the price d ierences those changes actu ally materialize. I n this sense chan ges in the
experienced by each grou p will not be accu rately re ected by PPI are consid ered lead ing ind icators o u tu re consu m er
the nation al or of cial in ation rate o the cou ntry. in ation rates.
Th ere a re a l so severa l oth er m ea su rem en t probl em s o a m ore
tech n ica l n atu re. Th e wei g h ts u sed to con stru ct th e avera g e The GDP defator used as a comprehensive
price l evel a re f xed . As a resu lt, th e eect on th e i n ati on measure o price movements
rate o a n i n crea se i n th e pri ce o a pa rti cu la r g ood i s
Th e GDP d e ator (see pa g e 69) m ea su res pri ce cha n g es o a l l
overestim ated . Even th ou g h con su m ers wi ll swi tch away rom
g ood s a n d servi ces i n clu d ed i n a cou n trys GDP. I t i s i n th i s
i t a n d pu rcha se oth er ch ea per su bsti tu tes, i ts si g n i f ca n ce (i ts
sen se broa d er a n d m ore u seu l tha n th e CPI or th e PPI or
weig h t) in th e con stru cti on o th e avera g e wi l l be th e sam e. I n
m ea su ri n g th e overa l l cha n g es i n th e pri ce l evel. I t i n clu d es
th i s way, th e of cia l i n ation rate m ay overestim ate tru e
n ot on l y con su m er g ood s a n d services bu t a lso i n vestm en t
i n ation . Th i s i s reerred to a s th e su bsti tu ti on bia s. N ew
g ood s a n d servi ces, g overn m en t g ood s a n d servi ces a s wel l a s
prod u cts a re n ot im m ed iatel y ta ken i n to a ccou n t i n th e
g ood s a n d servi ces sol d to orei g n ers. I t d oes n ot, th ou g h ,
con stru cti on o th e avera g e pri ce l evel. I t took a ew yea rs or
i n clu d e pri ces o i m ported g ood s a n d servi ces wh i ch d o
th e pri ce o m obil e ph on e servi ces to en ter th e typica l ba sket
eatu re i n th e ba sket o g ood s a n d servi ces that th e typi ca l
o g ood s a n d services in ma ny cou n tri es. Th i s i s reerred to a s
con su m er bu ys, a n d th i s is con si d ered a d isa d va n ta g e. Th e
th e n ew prod u ct bi a s. Pri ces rom n ew reta i l ou tlets su ch a s
G DP d e ator i s typica ll y u sed to a d ju st m on ey (or n om i n a l )
on li n e stores (or exam ple Am a zon ) or m ega a n d d i scou n t
G DP or price cha n g es.
stores m ay n ot be su f ci en tly sam pl ed . Sin ce th ese reta i l
ou tlets u su a ll y have l ower pri ces, th e of cia l in ati on rate
m ay overestim ate tru e i n ation . Th i s i s reerred to a s th e n ew Consequences o infation
reta il ou tlet bia s. I m proved qu a li ty o g ood s a n d servi ces m ay n I n a ti on i n crea ses u n certa i n ty i n bu si n ess, m a ki n g i t
n ot be properl y a ccou n ted or i n th e con stru ction o th e even m ore d i f cu l t or f rm s to ju d g e a n d d eci d e wh eth er
avera g e pri ce level . A better version o a prod u ct m ay be 1 0% a n i n vestm en t proj ect wi l l or wi l l n ot be prof ta bl e. Th i s
m ore expen sive bu t m ay la st 5 0% m ore tha n th e old er i s m ore so th e ca se i i n a ti on i s va ri a bl e. H ow a st wi l l
versi on , ren d eri n g i t eecti vely ch ea per. Aga i n , th e of cia l wa g es a n d prod u cti on costs ri se i n th e u tu re? H ow
i n ation rate m ay overestim ate tru e i n ati on . Th i s is reerred m u ch wi l l i t be possi bl e to sel l th e g ood or i n on e, two
to a s th e qu a li ty bia s. or th ree yea rs ti m e? H ow a st wi l l pri ces o su bsti tu tes
a n d com pl em en ts i n crea se? Th e i n crea sed u n certa i n ty
Core (or underlying) infation m ea n s th a t f rm s wi l l u n d erta ke ewer i n vestm en ts.
Sl ower ra tes o i n vestm en t spen d i n g wi l l sl ow d own
The CPI is aected signif cantly by changes in (resh) ood
econ om i c g rowth a n d so, i n th e l on g ru n , em pl oym en t
prices and energy prices. Spend ing on ood item s together with
ra tes m a y d ecrea se.
spend ing on gasoline and heating oil represent a signif cant
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2 Macroeconomics
n I n ation also rend ers exports less competitive in oreign Consequences o defation
markets. As a resu lt, the export sector shrinks, making it
n The biggest risk o d e ation is that the economy may enter
m ore d if cu lt to earn the necessary oreign exchange to
a d e ationary trap. A viciou s circle may start, with d e ation
pay or imports, which will tend to increase as oreign
creating m ore d e ation.
good s will also becom e m ore attractive. Trad e im balances
will wid en. Pressu re on the cu rrency to d epreciate will be n De ati on in d u ces con su m ers to d elay pu rcha ses sin ce th ey
exerted which cou ld u rther aggravate in ation as imports com e to expect u rth er pri ce d ecrea ses. As a resu l t, AD
will becom e m ore expensive. d ecrea ses even m ore, pu sh in g even l ower th e avera g e
pri ce level .
n H ou sehold s on f xed m on ey incom es (su ch as wage earners
and pensioners) su er a d ecline in their pu rchasing power. n De ation d ecreases f rm s revenu es, squ eezing their prof t
I ncom e d istribu tion may worsen. margins and orcing them to cu t d own on costs. Wages all
and red u nd ancies ollow. Som e f rm s are orced to go
n I actu al in ation proves higher than expected in ation
bankru pt. AD shits u rther to the let.
then borrowers will gain at th e expense o lend ers. The
m oney they will be paying back to lend ers will be worth n The real valu e o ou tstand ing d ebt increases. I nd ebted
less than expected at the tim e o the loan. consu m ers becom e hesitant to make pu rchases and
ind ebted f rm s h esitan t to make investm ents. AD d ecreases
n I n a ti on a l so tra n sers pu rcha si n g power rom th e peopl e
even m ore and so d oes the average price level.
to th e g overn m en t, a cti n g a s a n a d d i ti on a l ta x i th e ta x
bra ckets o a progressi ve i n com e ta x system d o n ot a d ju st n Since the real valu e o ou tstand ing d ebt increases, som e
i n l i n e wi th i n a ti on . Assu m e th a t som eon e ea rn s 1 0% hou sehold s and som e f rm s cannot service their loan s.
m ore i n com e wi th i n a ti on a l so at 1 0%. I n rea l term s Banks accu m u late bad loans (loans that are not repaid ),
th i s i n d i vi d u a l i s n ot better o bu t h e or sh e m ay be so the risk o a banking crisis with repercu ssions on th e real
m oved to a h i g h er ta x bra cket wi th a m u ch h i g h er economy increases.
m a rg i n a l ta x ra te, so i n rea l term s wi l l pa y proporti on a l l y n As AD alls it is not only the average price level that alls
m ore ta x th a n beore. bu t also real ou tpu t, lead ing to higher u nem ploym ent.
n I n ation, in general, may red istribu te national incom e rom n Easy m onetary policy is a policy u sed by a central bank to
the poor to the rich since the orm er have ewer choices to stim u late econom ic growth by lowering interest rates bu t,
hed ge against in ation and , in ad d ition, they cannot when there is d e ation, the central bank cannot u se this
borrow easily. The wealthy have the necessary collateral to policy to re ate the economy as (nom in al) interest rates
borrow rom the banking system and proceed to invest in cannot d ecrease below zero. Expansionary f scal policy may
assets (or example land or gold ) the valu e o which is also prove ineective as hou sehold s may preer to save and
expected to rise aster than in ation. On the other han d , postpone spend ing. Even sitting on cash earn s a real rate
the real valu e o m oney d eposited in a typical savings o retu rn, m eaning that with alling prices it will bu y m ore
accou n t d ecreases. in the u tu re.
n Th e ef cien cy o th e price m echa n ism is lost beca u se n H owever, exports becom e m ore competitive abroad and AD
in ation d i storts th e sig n a llin g a n d in cen tive power o may increase as a resu lt o a rise in net exports.
relati ve price cha n g es. A con su m er or a f rm witn essin g
th e price o g ood X risin g ca n n ot be su re that it tru ly is Types and causes o infation and o defation
becom in g relatively m ore expen sive a s th e person or f rm Throu gh th e AD/AS d iagram it shou ld be clearly realized that
ca n n ot kn ow wh eth er th e prices o oth er sim ila r g ood s any actor that persistently increases AD or lead s to an ad verse
have in crea sed by th e sam e percen ta g e or n ot. I th ey shit in AS may lead to an increasin g price level (that is, to
have, th en th e relative price o th e g ood in qu estion ha s in ation). The orm er is known as d emand -pu ll in ation and th e
n ot cha n g ed a n d n o su bstitu tion process sh ou ld kick in . latter as cost-pu sh in ation, even thou gh once an in ationary
With in ation (wh ich is u n ba la n ced , m ea n in g that prices process begins it is d if cu lt in practice to d istingu ish between
a re n ot a l l ri sin g at th e sam e rate) th is becom es the two.
im possible to d eterm in e, con u sin g d ecision s o con su m ers
a n d o f rm s a n d lea d in g to in ef cien cy in th e a llocation Demand-pull infation
o sca rce resou rces. I n th i s sen se, in ation i s n oise. I n the case o d emand -pu ll in ation the extent o the
n Keep in m ind that m ild in ation red u ces the real wage in ationary eect resu lting rom the increase in AD d epend s on
costs o f rm s, so it may help their competitiveness. This is how steep the AS cu rve is, in other word s on how close to the
especially important in a world where m oney wages d o not u ll employm ent or potential level o real ou tpu t the economy is
easily ad ju st d ownward s becau se o contracts an d operating. The closer to the potential level o real ou tpu t (that
resistance o labou r u nions. is, the steeper AS is) the greater the eect on the average price
level o AD increasing.
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2 Macroeconomics
Average price level (P)
SRAS
Remember that increases in AD will aect not only the
TIP
average price level but also real output. A rise in real output
and in employment may accompany demand-pull infation.
Cost-push infation
Figu re 2 .3.4 illu strates cost-pu sh in ation as the average price
level is shown to increase rom P1 to P2 ollowing a shit to the
P2 let o AS (an ad verse su pply shock) rom AS1 to AS2 .
AD2
AD1
0 Y1 Y2
Real outcome/income (Yr)
Figure 2.3.3 Demand-pull ination
P2
I n Figu re 2 .3.3 d emand -pu ll in ation is illu strated , employing a
generic SRAS cu rve. Keep in m ind that, in the lon g ru n, any P1
increase in AD is pu rely in ationary as the LRAS cu rve is
vertical at the potential level o ou tpu t. Within the m onetarist
or new classical m od el any increase in real ou tpu t and
correspond in g d ecrease in u nemploym ent will be short lived
since m oney wages will ad ju st. Within the vertical section o a AD
typical Keynesian-style AS cu rve an increase o AD will also
0 Y2 Y1
prove pu rely in ationary. I n the Keynesian m od el an increase in
AD may not prove in ationary i the economy is in a d eep Rea l ou tcom e/in com e (Yr)
recession and is operating on the horizontal section o the Figure 2.3.4 Cost-push ination
AS cu rve.
Causes o cost-push infation
Causes o demand-pull infation Any actor that is responsible or a d ecrease in AS and a shit o
An increase in any component o AD may prove responsible or the AS cu rve to the let may lead to cost-pu sh in ation. Perhaps
d emand -pu ll in ation. Demand -pu ll in ationary pressu re may the m ost com m on cau se o cost-pu sh in ation is a rise in the
originate rom a rapid increase in consu m ption and investm ent price o oil. Oil is still the pred om inant orm o en ergy or f rm s
expend itu res cau sed by excessively optim istic and con f d ent so a su stained and sharp increase in its price will increase
hou sehold s and f rm s. Su rging exports may also exert u pward prod u ction costs across the board and so increase prices. More
pressu re on prices. Export growth may accelerate, as a g en erally, rising com m od ity prices can create cost-pu sh pressu re
resu lt o an u nd ervalu ed or d epreciating cu rren cy or aster as com m od ities are prod u cts u sed as inpu ts in manu actu ring .
growth abroad .
Poweru l labou r u nions may also create cost-pu sh pressu re as
M ost oten, governm ents are responsible or d emand -pu ll they may be in a position to achieve or their m em bers m oney
in ation. Pro igate governm ent spend ing and poorly d esigned wage increases higher than any prod u ctivity gains. Eectively,
tax-cu ts, especially beore elections, may increase AD too ast this increases prod u ction costs or f rm s and so increases prices.
and create in ation.
A d eva lu ation (or a sha rp d epreci ation ) o th e cu rren cy
I n ationary expectations them selves are a com m on cau se o ren d ers im port pri ces h ig h er. Th e avera g e price level wil l
continu ing in ation. I prices are expected to continu e clim bing a u tom atica lly i n crea se a s th e typica l ba sket o g ood s a n d
then f rm s and workers with pricing power will increase their services con su m ed in clu d es im ported prod u cts. Th is may lea d
prices and wages to keep ahead o the gam e, ad d ing to the workers to d ema n d h ig h er wa g es, in i ti atin g a wa g e-pri ce
in ationary spiral. spira l. Also, i d om estic f rm s rely or th eir prod u ction process
Perhaps the single m ost important cau se o ination is excessive on i m ported raw m ateria ls a n d in term ed iate prod u cts th en
m onetary growth. The easiest way to understand this is by prod u ction costs will i n crea se, wi th th e sam e eect on pri ces.
qu oting Milton Fried mans am ous saying that ination exists An increase in ind irect taxation will increase prod u ction costs
when too m uch m oney chases ater too ew goods and so and so increase prices. This wou ld be a one-o increase in the
ination is a purely m onetary phenom enon. I the m oney supply average price level so it wou ld hard ly qu aliy as a cau se o
increases aster than output then part o the resulting increased in ation (a sustained increase in prices) u nless it led to
spending will maniest itsel in the orm o rising prices. d emand s or higher wages and an in ationary spiral began.
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2 Macroeconomics
Lastly, a prod u ctivity slow-d own may initiate cost-pu sh in ation I nterest rates are set by the central bank o a cou ntry and
as prod u ction costs wou ld increase. Su ch a d evelopm ent wou ld chang es o interest rates (and /or o the m oney su pply) are
typically requ ire som e u navou rable institu tional change. reerred to as m onetary policy. An increase in interest rates
(known as tight m onetary policy) makes borrowing rom banks
Stagnant GDP or even alling GDP will accompany cost-push m ore expensive or hou sehold s and bu sinesses. I t also makes
TIP saving m ore attractive and it leaves am ilies with ad ju stable
infation.
m ortgage loans with less to spend every m onth as their
m onthly bank installm ent to pay o their m ortgage will be
Causes o defation
hig her. The bottom line is that private spend ing is expected to
Figu re 2 .3 .5 illu strates a case o d e ation since the average
d ecrease (or to slow d own). Figu re 2 .3 .6 illu strates the eect o
price level is shown to d ecrease rom P1 to P2 as a resu lt o
con tractionary policies on in ation.
d ecreasing AD rom AD1 to AD2 .
AS
P2
P1
P
P2 P1
AD2
AD1
AD
AD1
AD2 0 Y1 Y Y2
0 Y2 Y1 Real outcome/income (Yr)
Real outcome/income (Yr) Figure 2.3.6 Dealing with demand-pull ination
Figure 2.3.5 Deation
Given AD1 and AS the average price level is at P1 . As a resu lt
De ation can be cau sed by continu ing d ecrease in AD, oten o d emand -pu ll in ation, AD wou ld increase rom AD1 to AD2
the resu lt o a signif cant d om estic crisis, su ch as a banking an d the price level all the way to P2 . I contractionary f scal
crisis or a crisis related to governm en t d ebt. Typically, interest an d /or tight m onetary policies are ad opted then the hope is
rates have alread y been driven d own to zero as a resu lt o that AD will not increase as ast all the way rom AD1 to AD2
u nsu ccessu l attem pts by the central bank to in crease private bu t wou ld increase on ly to AD. The price level will rise bu t not
spend ing and the governm ent has little room to spend m ore as m u ch. I n ation will be lower.
and boost AD. N ote thou gh that whereas real ou tpu t wou ld rise to Y2 it will
De ation may also resu lt rom AD rising slower than originally now, as a resu lt o the contractionary policies employed , rise
expected . Optim istic f rm s may have overinvested in new on ly to Y9 . Ou tpu t will increase bu t not as ast, so the
capacity, lead ing to a large shit to the right o AS. I AD ails cost o d ecreasing in ation is slower econom ic growth,
to rise as ast then a d ecreasing average price level may resu lt. even recession.
Policies to deal with demand-pull infation Policies to deal with cost-push infation
I n the case o d emand -pu ll in ation , policy makers m u st Th e pol i cy respon se i s l ess obvi ou s i n th e ca se o cost-pu sh
attempt to d ecrease (or, m ore correctly, slow d own the increase) in ati on . I t m ay seem that pol ici es that a i m at i n crea si n g
o AD in the econom y. Spend ing in the economy m u st be AS (su ppl y-si d e poli cies) a re i n ord er bu t th ese poli cies a re
restrained . I t ollows that the governm ent may d ecrease its own d if cu lt to a d opt a n d i m plem en t a n d ta ke a l on g ti m e to have
expend itu res (f scal restraint). Governm ent expend itu res are a ny eects. For exam ple, pol icy m a kers m ay try to d ecrea se
a com ponen t o AD, so i they d ecrease then AD will also th e power o la bou r u n i on s or th ey may i n i tiate pol ici es that
d ecrease. Taxation may also increase as higher d irect taxes will a i m at m a ki n g prod u ct m a rkets m ore com petitive. Th ere i s n o
d ecrease d isposable in com e and so consu mption expend itu res. d ou bt that a ppropriate su pply-si d e poli cies a re a l ways h elpu l
The policy m ix o d ecreasing governm ent expend itu res and to con ta i n i n ation sin ce by sh iti n g AS to th e rig h t a ny
increasing taxation is reerred to as contractionary or in crea se in AD wi ll be a bsorbed with ou t th e avera g e
d e ationary f scal policy and will be evalu ated later. pri ce l evel ri si n g . N on-in ati on a ry growth wi ll th ereore
Policy makers cou ld try to restrain private spend ing be a ch i eved .
(consu mption expend itu res by hou sehold s and investm ent Becau se o the d if cu lties related to policy initiatives that
expend itu res by f rm s) throu gh an increase in interest rates. try to increase AS even i in ation is cost-pu sh in ation, it is
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2 Macroeconomics
contractionary d emand managem ent policies that are Policy makers respon d by in crea sin g in terest rates (tig h t
employed by policy makers. The typical im m ed iate real-world m on eta ry policy) in a n attem pt to keep th e avera g e price level
response to any in ationary pressu res em erging in an economy at P1 . I th e policy is su ccessu l a n d th e in crea sed borrowin g
is or policy makers to tighten m onetary policy (that is, to costs lea d to a d ecrea se in spen d in g by h ou seh old s an d f rm s
increase interest rates, making borrowing m ore costly). th en AD will d ecrea se an d sh it let rom AD1 to AD9 ,
ma in ta in in g th e price level sta ble at P1 . I n ation will have
Average price level (P)
HL The Phillips Curve o their unit costs (mark- up pricing) it seem ed sensible to
explore how the annual in ation and unemploym ent rate were
The original Phillips Curve related. The right-hand sid e o Figure 2 .3.8 illustrates what was
Sin ce the early 1 960s and u ntil the m id -1 970s econom ists ound by many empirical studies in the 1 960s. I nation and
relied on an em pirical resu lt that Alban W. Phillips, a N ew unemploym ent were inversely related. I unemploym ent
Zealand econom ist at the Lond on School o Econom ics, mad e decreased then ination increased, while i ination d ecreased
in 1 95 8. H is work, th e Phillips cu rve, becam e one o the m ost unemploym ent would increase. The negatively sloped curve on
am ou s relationships in macroeconom ics. I t showed that there the right-hand side o Figure 2 .3.8 is the original Phillips curve.
was a stable trad e-o between the in ation rate and the I this inverse relationship was stable then g overnm ents cou ld
u nemploym ent rate o an economy. perhaps exploit it. The Phillips cu rve was consid ered as
H is original empirical (statistical) work exam ined U K data on the presenting policy makers with a m enu o choices. They cou ld
annual percentage change in m oney wages and the annual achieve a lower u nem ploym ent rate bu t at the cost o higher
unemployment rate over a period o 96 years (rom 1 861 to in ation, or they cou ld achieve lower in ation bu t at the cost o
1 957). The let-hand side o Figure 2 .3.8 shows what he ound: higher u nem ploym ent. The issu e was to d eterm ine the
that the percentage change in m oney wages and the politically d esired com bination o the two variables and then
unemployment were inversely related. I unemploym ent was low throu gh d emand -sid e policies policy makers cou ld achieve it.
(reerred to as a tight labour market) then m oney wages rose a This statistically d eterm in ed relation ship was compatible with
lot as employers were orced to bid up wages to fnd employees, the ru ling Keynesian theory. Rem em ber that the Keynesian
In contrast, i unemployment was high (a slack labour market), perspective stressed the importance o AD in the d eterm ination
then m oney wages increased by just a little, or even decreased, o equ ilibriu m incom e. I AD increased then real ou tpu t wou ld
as frm s could hire workers without having to oer m ore or even increase and so u nem ploym ent wou ld d ecrease. Bu t this rise in
by oering less than last years prevailing m oney wage. AD wou ld also lead to in ationary pressu res. So, as shown on
Moving rom wage ination to price in ation was the next step. the righ t-hand sid e o Figu re 2 .3.8, i policy makers were to
Since wages typically orm a big proportion o production costs su cceed in red u cing u nem ploym ent rom U 1 to U 2 then
and since frm s in the real world oten set prices as a percentage in ation wou ld increase rom p1 to p2 .
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2 Macroeconomics
Ination rate ()
2
1
+
Phillips
curve
0 U2 U1
Unemployment
Unemployment rate (%)
rate (%)
Figure 2.3.8 The original Phillips curve
The breakdown of the Phillips curve A1 to point A2 which is characterized by rising prices and by
Since the late 1 960s the original Phillips curve relationship suered lower real output and higher unemployment as the same point
both empirical and theoretical setbacks. Ination and illustrated on the right-hand side diagram o Figure 2 .3.1 0. The
unemployment were both increasing in the 1 970s in the USA adverse supply shock resulted in stagation and analytically this
and in other advanced economies. The term stagation was is shown with a shit to the right o the Phillips curve.
coined, implying recession together with rising ination. The But beyond this empirical reutation o the original Phillips curve
original inverse relationship had collapsed and traditional there came a theoretical attack. Milton Friedman and Ed Phelps
Keynesian analysis, relying on the importance o shits in AD to (both Nobel Laureates; 1 976 and 2 006 respectively)
explain movements in output and prices, ound it hard to explain independently made a distinction between a short-run Phillips
what was going on. Stagation implied higher ination and higher curve (SRPC) and a long-run Phillips curve (LRPC) and claimed that
unemployment and this suggested that the Phillips curve was not in the long run the Phillips curve was vertical at the equilibrium
stable but shited out and to the right, as illustrated in Figure 2.3.9. rate o unemployment (the natural rate introduced earlier which
I n Figu re 2 .3 .9 the Phillips cu rve is shiting ou tward s throu gh corresponds to the potential level o real output o an economy
tim e. Point A2 on Phillips cu rve PC2 illu strates a both a hig her where the LRAS is vertical). Thereore, they claimed, any trade-o
rate o u nem ploym ent and a h igher rate o in ation compared between ination and unemployment could exist only in the short
with Phillips cu rve PC1 and point A1 . run. This became known as the PhelpsFriedman critique and the
H ow could this happen? One explanation was that AS had shited theory as the expectations-augmented Phillips curve.
let in the 1 970s. The oil price shocks at this time increased I a governm ent tried to lower unemploym ent below its natural
production costs o frms across the board. Back then the US or equilibrium rate using expansionary policies (that is, by
economy relied much more on manuacturing than it does these increasing AD) it would succeed only temporarily and at the cost
days. The price shocks shited AS on the let-hand side diagram o o permanently higher ination. The short run trade-o between
Figure 2 .3.1 0 rom AS1 to AS2 . Equilibrium has shited rom point ination and unemploym ent was only because workers suer
Ination rate ()
AS2 AS1
P2 A2
A2
P1 A1
A1
PC2
PC1 AD
0 Y2 Y1
Unemployment rate (%) Real Output/Income (Yr)
Figure 2.3.9 Stagation and the outward shiting o the Phillips curve Figure 2.3.1 0 Stagation as a result o adverse supply shocks
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2 Macroeconomics
rom m oney illusion: they orm their expectations about ination and the economy has moved to point A2 on the fgure. Workers are
adaptively (m eaning that they orm their expectations about slow to realize that ination is actually higher than previously at
next years ination by looking at past ination rates) so they are 2 .0%, so the real wage is lower. But when their expectations adjust
slow to realize that ination accelerates and does not remain the they will demand higher money wages, increasing the real wage
same as a result o the expansionary policies pursued. or frms back to its original equilibrium level. The SRAS curve o
the economy will have decreased and shited to the let. Firms will
Ination rate (%)
Economic growth
Econom ic growth exists i a countrys real GDP increases through
Units of good Y
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2 Macroeconomics
with the unemployment rate remaining the same i the number o Poten tial ou tpu t has increased rom Yp1 to Yp2 , shiting the
unemployed increases at the same rate as the labour orce. In this economys LRAS cu rve rom LRAS1 to LRAS2 . The actors that
case, though, there would also be a shit o the curve outwards. cou ld be respon sible or su ch d evelopm ents inclu d e all the
Econom ic growth can also be illu strated throu gh an ou tward s actors that cou ld sh it a PPC ou tward s bu t, in ad d ition, any
shit o the PPC, as illu strated in Figu re 2 .3.1 3. actor that may d ecrease the natu ral rate o u nemploym ent.
I n the long ru n , econom ic growth is achieved when the
Units of good Y
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2 Macroeconomics
higher incom es and m ore spend ing. Tax revenu es rom both benef ts bu t it also creates very signif cant costs. The
d irect and ind irect taxation will thereore au tomatically possible benef ts can best be u nd erstood throu gh the
increase (that is, withou t the governm ent imposing any new so-called environm ental Ku znets cu rve (associated with
taxes). M ore m oney owing into the governm ents coers Gene Grossman) which shows that there is an inverted
perm its f nancin g o m ore governm ent projects, not only U -shaped relation ship (that is, a hu mp-shaped cu rve)
withou t the governm ent resorting to higher taxation bu t between certain environm ental costs (su ch as water
also withou t it incu rring any ad d itional borrowing costs. pollu tion, air pollu tion and d eorestation) and per capita
n Econom ic growth can both im prove and worsen incom e incom e levels o cou ntries. Th e basic id ea is that as per
d istribu tion. I t can alleviate incom e inequ ality as it perm its capita incom es increase, pollu tion increases, bu t som e
govern m ent a red istribu tion o incom e rom the wealthy to threshold level o incom e exists. Beyond this thresh old , not
the poor. Red istribu tion can be d irect by perm itting the only is there sign if cantly increased d emand or a cleaner
establish m ent o a social welare net su ch as pensions and environm ent by the popu lation, bu t there are also m ore
u nemploym ent benef ts or perm itting an increase in su ch resou rces available to expend on clean er technologies. The
benef ts. I t can also be ind irect throu gh spend ing on issu e here is that ou tpu t growth not only requ ires the u se o
poverty alleviation program m es (to increase agricu ltu ral m ore natu ral resou rces bu t also lead s to m ore em issions
prod u ctivity; to im prove sanitation; to improve basic and wastes that may exceed the earths carrying capacity,
inrastru ctu re, etc.) as well as on im proved health an d rend ering growth u nsu stainable. The environm ental
ed u cation acilities that increase hu man capital and labou r Ku znets cu rve provid es an optim istic view in the sense that
prod u ctivity. Unortu nately, econom ic growth oten lead s to it claim s that econom ic growth d oes not u navoid ably harm
higher incom e inequ ality. There is no gu arantee that he the natu ral habitat bu t it is strongly criticized in many
benef ts o growth will be airly d istribu ted . I growth is respects. First, it may empirically hold or local externalities
driven by only a hand u l o ind u stries; i it is concentrated (that is, or ind oor hou sehold pollu tion which d oes d ecrease
in certain regions; i it relies only on certain skills or i it is ater som e relatively low per capita in com e level) bu t it
jobless then many may be let ou t and incom e inequ ality d oes not seem to hold or many d ispersed externalities su ch
in the cou ntry may wid en. as carbon em issions. Also, d ierent pollu tants behave
d ierently across cou ntries and across incom e levels. I n
n Econom ic growth aects trad e. I the growth is export
ad d ition, with global pollu tion levels still rising, wealthier
driven (that is, i it is a resu lt o growing exports as in the
cou ntries may choose not to prod u ce bu t to import
case o China) then it will d ecrease any trad e d ef cit or lead
pollu tion-intensive good s. I n general, the eect o econ om ic
to a trad e su rplu s. I , thou gh, it is driven by d om estic
growth on the environm ent is a u nction o the scale o
d emand then the resu lting higher incom e levels may be
prod u ction , the composition o prod u ction (whether
respon sible or a wid ening trad e d ef cit as part o the
changing tastes lead to the prod u ction o ewer pollu tion-
higher incom es will be spent on imports.
intensive good s) and the techniqu es o prod u ction (whether
n Th ere are also consequ ences or su stainability: the eect o less pollu tion-intensive technologies are em ployed ).
econom ic growth on th e environm ent may entail certain
The ou rth macroeconom ic goal is to ensu re that incom e Income inequality can also be described through the Lorenz curve
d istribu tion is equ itable. Equ itable d oes not m ean equ al. I t and its degree can be measured through the Gini coefcient.
m eans air. Bu t airness is an elu sive concept and it m eans
d ierent things to d ierent people. Unequ al ownership o The Lorenz curve and the Gini coefcient
actors o prod u ction may be responsible or incom e inequ ality I n Figu re 2 .3 .1 5 popu lation (incom e recipients) is plotted on
as well as a d istorted institu tional ram ework that is tilted in the horizontal axis in cumulative percentages (that is, rom
avou r o certain social grou ps and grants them exclu sive poorest to richest hou sehold s). So at, say, the 2 0% point, we
privileges and preerences. have the poorest 2 0% o th e popu lation and at the 40% point,
we have the poorest 40% o the popu lation. On the vertical
Indicators o income inequality axis we m easu re the percentag e o incom e received by each
percentage o the popu lation.
Inequality ratios
I n com e in equ a lity ca n be d escribed u sin g in equ a lity ratios. The Lorenz cu rve shows the proportion o national incom e
Th ese exam in e th e ratio o (d isposa ble) in com e o th e top earned by each incom e grou p. For example, the poorest 2 0%
1 0% (d ecile) over th e bottom 1 0% o th e popu lation (a lso o people in Figu re 2 .3.1 5 receive only 5 % o national incom e.
kn own a s th e in terd ecile P90 to P1 0 in com e ratio) or o th e N ote that 1 00% o the popu lation will o cou rse receive 1 00%
top 2 0% (qu in tile) over th e bottom 2 0% (qu in tile). I n com e o national incom e. Also note that the d iagonal is th e line o
in equ a lity ratios in th e world o th e h ig h est to th e lowest equ ality (perectly equ al incom e d istribu tion).
d ecile ra n g e ca n ra n g e between rou g h ly 5 to 40: th e top 1 0% The u rther away rom the d iagon al, the m ore u nequ al the
may ea rn 5 to 40 tim es m ore tha n th e bottom 1 0% o th e d istribu tion o in com e is. The closer to the d iagonal, the m ore
popu lation . I n Den m ark th e f g u re in th e m id -2 000s wa s th e equ al the d istribu tion o incom e is. I incom e d istribu tion
lowest at 2 .72 . worsens in a cou ntry it m eans that the Lorenz cu rve m oves
u rther away rom the d iagonal.
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2 Macroeconomics
A m ore equ itable d istribu tion may help accelerate growth and
prom ote hu man and econ om ic d evelopm ent in many ways.
55% n The very poor will be able to aord access to cru cial
40% A B resou rces, su ch as ed u cation and m ed ical care, so the
am ou nt and qu ality o prod u ctive resou rces available to
20% a cou n try increases. Better ed u cation and health improves
1 0%
labou r as prod u ctivity will be hig her.
5% n The propensity o the poor to consu m e is higher than that
0% 20% 40% 80% 1 00% o the rich so red istribu tion will increase AD, especially or
Population (cumulatively ranked) basic good s and services.
poorest to richest n Social tensions will be lower, so governm ents can m ore easily
Figure 2.3.15 The Lorenz curve and the Gini coefcient undertake important econom ic reorm s requiring a high
degree o consensus within the population. I people eel
The Gini coefcient measures the degree o incom e inequality in that they enjoy the ruits o econom ic growth then they will
a population. It is the ratio o the area between the Lorenz curve be willing to work harder and sacrifce m ore now in order or
and the diagonal over the area o the hal square in which the them or their children to enjoy m ore at a later date. They will
curve lies. The Gini coefcient is the ratio o the area between the be willing and able to save m ore, allowing higher rates o
Lorenz curve and the diagonal over the area o the hal-square or, investm ent and so growth. Fewer social tensions decrease
ocusing on Figure 2 .3.1 5, area (A) divided by area (A1 B): uncertainty and risks or dom estic and oreign investors.
area (A) Tru st increases am ong the popu lation so the cost o
Gini coeicient 5 ___________
n
area (A 1 B) econom ic transactions d ecreases. More econom ic activity
will take place so growth will accelerate.
The Gini coef cient can vary rom 0 (d enoting perect equ ality:
each person gets the sam e incom e) to 1 (d en oting perect On the other hand , consid er the ollowing.
inequ ality: all incom e goes to the share o the popu lation with n An excessively equ al incom e d istribu tion cou ld lower
the highest incom e). econom ic ef ciency. I t cou ld lower the incentives or people
Range o values o Gini: (0,1 ) to work hard and or risk taking. I n this way, growth may be
u nd erm ined .
Typically, highly unequal incom e distributions are distributions
with a Gini coefcient between 0.50 and 0.70. Som e
The role o taxation in promoting equity
representative values o this coefcient are: Brazil 0.57, Zim babwe
0.50, Argentina 0.49, U ganda 0.46, the U SA 0.38, the U K 0.34, Direct and indirect taxes
Australia 0.30, Austria 0.27, and Denmark and Sweden at 0.23. Direct ta xes are ta xes on in com e, on prof ts an d on wea lth .
The Organisation or Econom ic Co-operation and Developm ent The chara cteristic o a d irect ta x is that its bu rd en can n ot be
(OECD) average in the mid-2 000s was around 0.31 . sh ited on to an other en tity. I n d irect ta xes in clu d e taxes on
g ood s a nd on expen d itu res a nd th ey have been d iscu ssed
Keep in m ind that oten what matters m ost is not the level o earlier. Th e bu rd en o a n ind irect tax ca n be sh ited on to a
incom e d istribu tion bu t the d irection o chang e (that is, d ieren t en tity.
whether incom e d istribu tion is becom ing m ore or less u nequ al).
Progressive, proportional and regressive taxation
Poverty To explain the d ierence between these types o taxes it is
Absolute poverty is defned by the minim um incom e necessary to important to d ef ne the marginal tax rate (MTR) and the
satisy basic physical needs; the 2 008 World Bank international average tax rate (ATR).
poverty line is set $ 1 .2 5 (purchasing power parity PPP) per day.
The M TR is the percentage taken by the governm ent on the last
Relative poverty m easu res the extent to which a hou sehold s d ollar earned , or the extra tax paid as a resu lt o extra incom e
incom e alls below the national average. earned .
Causes and consequences of poverty The ATR is the ratio o the tax collected over incom e earned or,
Poverty locks ind ivid u als into a viciou s poverty cycle or trap. m ore generally, the ratio o the tax collected over the tax base.
Low incom e is both a cau se and a consequ ence o poverty. As a The tax base reers to whatever is taxed , or example incom e,
resu lt o their low incom e, these ind ivid u als hu man capital is spend ing, prof ts and wealth.
very low. They cannot aord the opportu nity cost o schooling.
Th eir savings are non-existent, so they are not in a position to MTR ATR
invest in physical capital and (in d eveloping cou ntries) they are DT
MTR 5 ___
T
ATR 5 _
orced in their eort to su rvive to d eplete or d estroy any natu ral DY Y
capital they may have access to. Low hu man, physical and
natu ral capital implies low prod u ctivity, which in tu rn lead s to A progressive tax system is one in which ind ivid u als with
low incom e, closing the cycle. higher incom es pay proportion ately m ore so the ATR rises as
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2 Macroeconomics
incom e rises. I n a progressive incom e tax system the M TR is Measures to promote equity
greater than the ATR. (Rem em ber that i the average increases Short-run solutions
it ollows that the marginal is greater than the average.) U su ally governm ents resort to a m ixtu re o progressive incom e
A proportional tax system is one in which all individuals pay the taxes cou pled with a system o transer paym en ts. Transer
sam e proportion o their incom e independently o the level o paym ents inclu d e pensions, u nemploym ent benef ts, d isability
their incom e. In a proportional tax system the ATR remains ben ef ts, child allowances and su bsid ies. By taxing hou sehold s
constant as incom e rises so the MTR is equal to the ATR. A at with higher incom es m ore heavily than those with lower
rate (proportional) incom e tax exists in several countries, such as incom es and spend ing m ore on transer paym ents, nation al
Latvia, Russia, and Estonia, and is being considered by many incom e may be red istribu ted in an attempt to satisy the equ ity
others. I t presents many ad vantages to the progressive incom e g oal. Social health insu rance and a system o pu blic ed u cation
tax system s that m ost countries have. Disincentives are lower, is u su ally part o a package that aim s at eectively increasing
adm inistrative costs are lower, the system is simple and m ore the incom e o the lower-incom e strata.
transparent and it is potentially even airer, as loopholes do not
exist which usually higher-incom e household s take advantage o. Long-run solutions
I n the long ru n, the m ost eective rou te to a m ore equ itable
A regressive tax system is one in which poorer ind ivid u als pay
incom e d istribu tion is by im proving the qu ality and access to
a greater proportion o their incom e. I n a regressive tax system
ed u cation an d health-care services or the m ost d eprived
the ATR d ecreases as incom e rises so the MTR is less than the
incom e grou ps. Schools, health-care centres, im proved
ATR. I nd irect taxes are proportional with respect to expend itu re
inrastru ctu re that inclu d es better road s, as well as sanitation
bu t regressive with respect to incom e. This is why ind irect
and clean water su pplies will all contribu te to an increase in
taxation on ood and basic good s is lower than in other
h u man capital. A healthier popu lation with better ed u cation,
system s, or set at zero.
training and skills will increase labou r prod u ctivity and lead to
In Figure 2 .3.1 6 the horizontal axis m easures the tax base (say, h igher incom es. The importance o a air ju d icial system , better
incom e) and the vertical the am ount o tax paid. A proportional institu tions in general and lower corru ption shou ld not be
tax system is illustrated by any straight line through the origin. In u nd erestimated .
a progressive tax system the slope o the line is increasing while
in a regressive tax system the slope o the line is decreasing. Progressive tax Proportional tax Regressive tax
A tax is progressive: A tax is proportional: A tax is regressive:
Tax paid
Progressive
if the ATR constant
97
2.4 Fiscal policy
Fiscal policy is a d emand -sid e policy. Demand -sid e policies attempt to increase or d ecrease
AD (or, m ore precisely, to slow d own the increase o AD) in ord er to aect real ou tpu t
(growth), employm ent an d the in ation. Later we will see that these sam e policies are also
u sed to correct a trad e im balance and are reerred to as expend itu re-changing policies.
Fi sca l pol i cy reers to th e m a n i pu la ti on o th e l evel o g overn m en t expen d i tu res (G )
a n d /or g overn m en t reven u es (T) i n ord er to i n u en ce AD a n d , th rou g h th i s, econ om i c
va ri a bl es su ch a s rea l ou tpu t a n d g rowth , em pl oym en t a n d i n a ti on .
Sources of revenue and types of expenditures n A bu d get su rplu s exists i governm ent revenu es or incom e
(T) exceed governm ent expend itu res (G).
Governm ents typically earn m ost revenu es rom d irect and
ind irect taxation. They may earn also revenu es rom the sale o n A balanced bu d get exists i governm en t expend itu res (G)
good s and services (or example, revenu es rom the sale and are equ al to governm ent revenu es or incom e (T).
export o oil are a major sou rce o governm ent reven u es or
The public (national or government) debt
cou ntries prod u cing and exporting oil). The proceed s rom the
Assum e the ormation o a n ew cou ntry in, say, 2 006. Assu m e
sale o governm ent-owned assets, su ch as state-owned
that its governm ent in 2 006 had spent 1 5 0 m illion o its own
enterprises that are then privatized or governm ent land , are
d ollar cu rrency and had collected 1 2 0 m illion d ollars. I t
also one-o revenu es.
incurred a bu d get d ef cit equ al to 3 0 m illion d ollars. Assu m e
Spending is classif ed into current spending, capital expenditures now that in 2 007 it had spent 1 80 m illion d ollars and had
and transer paym ents. Current expenditu res include wages and collected in tax and other revenu es 1 70 m illion d ollars. I n 2 007
salaries o public sector employees as well as spending on it record ed a bu d get d ef cit equ al to 1 0 m illion d ollars. I ts
consu mables (day-to-day item s) such as stationery. Capital pu blic d ebt is at 40 m illion d ollars. I in 2 008 it spent
expenditures reer to public investm ent spending. These 21 0 m illion d ollars and collected in tax and other revenu es
expenditures inclu de all spending on inrastructure, or example 21 5 m illion d ollars, it record ed in 2 008 a bu d get su rplu s
spending on the construction o roads, harbou rs, hospitals and o 5 m illion d ollars. I ts pu blic d ebt will now stand at 35 m illion
schools. Transer paym ents represent transers o m oney rom d ollars. The pu blic d ebt is d ef ned as the the cu m u lative total
one grou p to another and as such are not inclu ded in the o all governm ent borrowings less repaym ents or the su m o all
calculation o GDP bu t are part o incom e redistribution policies. m oney owed by a governm ent at a point in tim e. Bu d get
Transer paym ents inclu de social security (welare) expenditures, d ef cits or su rplu ses and the pu blic d ebt are thereore n ot the
or example pensions, unemploym ent benefts, disability sam e bu t they are linked , as the pu blic d ebt grows when the
paym ents and scholarship grants. governm ent ru ns a bu d get d ef cit and shrinks wh en it ru ns a
bu dget su rplu s.
The budget outcom e
The relationship between the size o governm ent expend itu res
and governm ent incom e (tax revenu es) d eterm ines whether The public (national or government) debt should not be
TIP
there is a bu d get d ef cit, a bu d get su rplu s or a balanced conused with a countrys external debt. The external debt
bu d get. H ere are specif c d ef nitions. reers to what a country (public and private sector) owes to
n A bu d get d ef cit exists i governm ent expend itu res (G) oreigners and is denominated in oreign exchange.
exceed governm ent revenu es or incom e (T).
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2 Macroeconomics
LRAS
SRAS
AD2
AD1
Y1 Y2 Yf
Real outcome/income (Yr)
Figure 2.4.1 Expansionary fscal policy
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2 Macroeconomics
I there is a d e ationary gap then expansionary f scal policy will pressu res, requ ires contractionary f scal policy. The governm ent
increase AD rom AD1 to AD2 . The resu lt is higher real ou tpu t m u st d ecrease governm ent expend itu res and increase taxes so
bu t also in ationary pressu res. I , thou gh , the economy is at its that AD d ecreases.
potential ou tpu t and AD increases as a resu lt o re ationary The d ecrease in governm ent expend itu res (G) will d irectly
f scal policy rom AD3 to AD4, then no lastin g increase in real d ecrease AD (or slow d own its increase) while an increase in
ou tpu t will resu lt. Any increase in real ou tpu t will be temporary. d irect taxes will d ecrease d isposable incom es, lowering
I n the long ru n, real ou tpu t will retu rn at its poten tial rate at con su mption (C) and so AD.
the cost o higher in ation. Expansionary f scal policy will not
I n a d ia gram , AD will sh it let, a lleviatin g in ation a ry
have su cceed ed in increasing real ou tpu t.
pressu res (sh own a s a d ecrea se in th e avera g e price level) bu t
a lso riskin g a con traction o th e econ om y (that is, a lower level
Contractionary (deationary) fscal policy o ou tpu t a n d a h ig h er rate o u n em ploym en t). Th e risk o
On the other hand , an overheating economy, d ef ned as an con tra ction d epen d s on th e sha pe o th e AS cu rve a cin g th e
economy where AD is rapid ly increasing, creating in ationary econ om y.
How? G and/or T G and/or T
Why is AD An increase in G directly increases AD; A decrease in G directly decreases AD;
aected? a decrease in T will increase Yd and so C and AD an increase in T will decrease Yd and so C and AD
Possible Higher infation; Slow down in growth or even a recession; increased
costs wider trade decit; crowding out unemployment
Note: The shape o the AS curve is crucial in evaluating the impact on an economy
1
k 5 _________
(1 2 MPC)
where M PC is the marginal propen sity to consu m e d ef ned as
the extra spend ing ind u ced by extra incom e:
DC
MPC 5 ___
DY
Since whatever is not spent on d om estic ou tpu t is either spent
G on imports, or saved or paid as taxes to the governm ent, k is
Multiplier effect also equ al to:
1
k 5 __________________
AD3 (MPM 1 MPS 1 MRT)
AD2
AD1 MPM is the marginal propensity to import, M PS is the margin al
propen sity to save and M RT is the marginal rate o tax. They
0
Real outcome/income (Yr) are d ef ned respectively as the extra spend ing on im ports, the
Figure 2.4.4 The Keynesian multiplier eect
extra savings and the extra taxes paid rom extra incom e
earned and th ey represent th e withdrawals (leakages) in ou r
Assu m e that a governm ent wishing to close a d e ationary gap circu lar ow o incom e m od el.
em ploys expansionary f scal policy and d ecid es to increase its
expend itu res by som e am ou nt, say, DG (the d ierence between The logic o the Keynesian m ultiplier
the new level o spend ing and the original level o spend ing). Why will national income increase by m ore than the increase in
AD will au tomatically increase by DG and shit rom AD1 to governm ent expenditures? The explanation rests on two ideas.
AD2 , as in Figu re 2 .4.4. Bu t accord ing to the m u ltiplier eect, First o all, one persons spending is automatically som eone elses
the process will not end there. AD will continu e to increase and income. In addition, as the circular ow diagram (see Figure 2 .1 .3
shit to the righ t all the way to AD3 . on page 68) clearly illustrates, econom ic activity takes place in
successive rounds. An example will help clariy the point. Assum e
The m u ltiplier eect states that an increase in governm ent
that the governm ent decides to increase expenditures by 1 0
expend itu res will lead to a greater chang e in incom e:
m illion and hires unemployed workers to dig holes and bury
1 00
2 Macroeconomics
1 01
2 Macroeconomics
0
S of Rea l ou tcom e/in com e (Yr)
loanable funds Figure 2.4.6 The crowding-out eect
1 02
2 Macroeconomics
will not allow d isposable incom e to d ecrease as ast in a At tim e t1 the economy starts to recover. At tim e t2 real ou tpu t
recession, slowing d own the d ecrease in con su mption and AD. has grown above the (thick black) trend line that re ects
Figu re 2 .4.7 illu strates the point. potential ou tpu t. An in ationary gap em erges. Real ou tpu t
wou ld have grown to Y withou t the au tomatic stabilizing eect
Real GDP
Real GDP
Figure 2.4.7 How automatic stabilizers mitigate an economic downturn The upturn is milder as a result of
the automatic stabilizing effect of
The economy enters recession at tim e t1 . Real GDP begins to progressive taxes
Y
d ecrease. At tim e t2 , as a resu lt o the au tomatic stabilizing The trend line
eect o u nem ploym ent benef ts and progressive taxes, real Y (potential output)
ou tpu t alls on ly to Y whereas it wou ld have d ecreased to Y
withou t their existence. Th e d owntu rn is m ild er.
Assu m e now an economy starting to overheat as AD is growing
aster than AS. An in ationary gap is em erging. Real ou tpu t is
growing above potential ou tpu t. H ere, progressive taxes will d o
their trick as they increase aster than incom e, slowing d own
the in crease in d isposable incom es and so the spend ing power
0 t1 t2
o hou sehold s and f rm s. AD will not be in creasing as ast as it
Time
wou ld have had taxes not been progressive. The existence o a
progressive tax system cools o the economy, relieving it to an Figure 2.4.8 How automatic stabilizers cool-o an overheating economy
extent rom the bu ild -u p o in ationary pressu res. The u ptu rn o
the bu siness cycle is m ild er, as Figu re 2 .4.8 illu strates.
Impact o fscal policy on potential output cru cial in increasing labou r prod u ctivity. An increase in labou r
and LRAS prod u ctivity translates to aster long-ru n growth and so a higher
level o potential ou tpu t.
N ot all governm ent expend itu res are the sam e. A d istinction
in trod u ced earlier was between cu rrent spend ing, capital I t can be argu ed that a d ecrease in tax rates may u nleash m ore
spend ing and transer paym ents. An increase in cu rrent work and investm ents as incentives cou ld be positively aected .
spend ing and transer paym ents is u nlikely to have an im pact To the extent that lower taxes provid e the incentive or m ore
on potential ou tpu t bu t that d oes not hold tru e or pu blic work and investm ents, potential ou tpu t can also increase. On
in vestm ent (capital) spend ing. Lets take the exam ple o th e other hand , tax revenu es have to be su f cient and
governm ent expend itu res on inrastru ctu re, which can be equ itably shared so that the f nancing o necessary governm ent
d ef ned as physical capital that creates signif cant positive expend itu res d oes not requ ire m ore and m ore borrowing which
externalities in lowering the overall cost o econom ic activity may prove u nsu stainable.
and so potentially having a h igh social rate o retu rn. This type Lastly, pru d ent f scal managem ent may ind irectly aect
o expend itu re can increase an economys potential ou tpu t and potential ou tpu t and long-ru n growth . The term is elu sive bu t it
shit its vertical LRAS to the right. The constru ction o an is generally consid ered to m ean that bu d get d ef cits are not
im proved road system , o a necessary brid ge or harbou r, or o a excessive and that the national d ebt d oes not grow at
better system o telecom m u nications has the potential to u nsu stainable rates. As explained earlier, high-bu d get d ef cits,
expand the prod u ctive capacity o an economy. O cou rse, we especially i they are not incu rred in a d eep recession, can lead
shou ld keep in m ind thou gh that a brid ge to nowhere is ju st a to in creased interest rates and the crowd ing ou t o private
waste o scarce resou rces. sector investm ent and consu mption. An u nsu stain able national
Expend itu res on schools and health care can increase and d ebt, as a resu lt o pro igate governm en t spen d ing and an
im prove the stock o h u man capital an economy has available. ineective tax system , may lead to d eau lt with hu ge costs on
More and better primary schools, second ary schools and th e real econom y.
colleges as well as m ore an d better health -care centres are
1 03
2 Macroeconomics
Possible strengths o expansionary fscal policy the ad m inistrative lag (it takes tim e or the governm ent to
d ecid e, or exam ple, exactly how m u ch it need s to spend
n Fiscal policy is d irect: any increase in governm ent spend ing
and on exactly what projects, as well as to have the
will au tomatically increase national in com e by at least as
package approved by the parliam ent or congress)
m u ch, i not m ore, as it is a component o AD.
the execu tion or impact lag (it takes tim e or whatever
n A d ecrease in taxes to re ate an economy as part o an
policy response was chosen to have eects on the
expansionary stim u lu s plan may also have benef cial su pply-
economy, especially since the cu m u lative im pact o the
sid e eects as lower taxes may im prove the incen tives to
m u ltiplier is long).
work and to invest.
n Large defcit spending may increase national debt to
n I n an economy in d eep recession (or d epression ) in terest
unsustainable levels and may orce signifcant tax increases
rates may be at or close to zero, so m onetary policy is
in the uture (so, in a sense, the cost o such a policy is
totally ineective; in su ch a case policy makers have only
shited on to uture generations) or may even lead to deault.
f scal policy to tu rn to.
n There is also the chan ce that i an expansionary f scal eect
n I the institu tional ram ework o the economy is equ ipped
continu es or longer than requ ired th en in ationary
with u nem ploym ent benef ts and a progressive incom e tax
pressu res may arise.
system then policy makers have the benef ts o bu ilt-in
stabilizers. n Expansionary f scal policy and d ef cit spend ing may end u p
crowd ing ou t private investm ent and thereore be less
n I the increased governm ent expend itu res o a stim u lu s
eective. The resu lting bu d get d ef cit m u st som ehow be
package in clu d e spend ing on in rastru ctu re (or example
f nanced . Governm ent borrowing rom f nancial markets
road s, brid ges, harbou rs or telecom m u nication s; that is,
may drive interest rates u p and , as a resu lt, private
physical capital typically f nanced by governm ents that
investm ent will d ecrease (and so will consu m ption
create very signif cant positive externalities d ecreasing
expen d itu res). I this d ecrease in private spend ing matches
transaction costs across the board ), along with health and
the increased governm ent spend ing, the crowd ing ou t is
ed u cation then a positive su pply-sid e eect will also resu lt.
said to be com plete and f scal policy is totally ineective.
n I th e in crea sed g overn m en t expen d itu res o a stim u lu s
n Fiscal policy su ers rom an expansionary bias becau se
pa cka g e in clu d e spen d in g on th e d evelopm en t o green
politicians are oten irresponsible and preer to spend m ore
tech n olog ies th en an a d d ition a l lon g -ru n ben ef t will be
and tax less rather than spend ing less and taxing m ore
th e im provem en t o th e en viron m en t, a llowin g su sta in able
becau se the orm er maxim izes their sh ort term re-election
growth .
chances.
n Expansionary f scal policy may also lead to a wid ening
HL n I the governm ent expend itu re m u ltiplier is greater trad e d ef cit. A higher level o in com e will lead to m ore
than one then it is also a very poweru l tool to imports absorbed . I the average price level increases then
help a lagging economy recover. The Chie exports will shrink as they becom e less competitive and
Econom ist o Presid ent Obamas Cou ncil o imports will rise as they becom e relatively m ore attractive
Econom ic Ad visors, Christina Rom er, estimates the than d om estic good s.
U S governm ent expend itu re m u ltiplier at 1 .6. I n n Contractionary f scal policy to f ght in ationary pressu res is
general, the size o f scal m u ltipliers d epend s on oten d if cu lt to employ. Societies u su ally d o not welcom e
specif c characteristics o each economy with m ore d ecreases in spend ing related to social welare or in
open econom ies (those, or example, with ew ed u cation and health or even in d eence program m es.
restrictions on trad e) having larg er m u ltipliers I n creasing taxation beyon d a point will ad versely aect
than less open econom ies. incentives in the economy.
n An increase in governm ent expend itu res as part o an
expan sionary f scal policy cannot be easily reversed i policy
Possible weaknesses o fscal policy makers realize that it lead s to overheating: or exam ple, it is
n There are signif cant tim e lags associated with f scal policy not easy to stop the constru ction o a brid ge.
that may even en d u p d estabilizing instead o stabilizing an
economy. Specif cally, we can break d own the overall lag
HL n The governm ent expend itu re m u ltiplier may even
rom the m om ent an econom ic problem is encou ntered to be less than one as som e econom ists claim .
the m om ent the policy switch has an im pact into:
the d etection lag (it takes tim e to collect and evalu ate
d ata in ord er to d etect a problem )
1 04
2.5 Money and monetary policy
Money
Money is d ef ned as anything generally acceptable as a m eans They pay interest to savers and are paid interest rom borrowers.
o paym ent. I nothing serves this u nction, then we have a Their prof tability to a large extent d epend s on the d ierence
barter economy, where good s are exchanged or g ood s. Barter (the spread ) between the two interest rates. I nterest is what is
requ ires d ou ble coincid en ce o wants and implies extrem ely earned when lend ing m on ey and what it costs to borrow m oney
high transaction costs or ind ivid u als who will thereore preer and typically is expressed on an annu al basis and as a
to avoid specialization in ord er to m inim ize d epend ency on percentage. There are very many interest rates d epen d ing on
exchange. I ntrod u cing m oney perm its specialization to take who borrows or lend s, how m u ch is borrowed or lent, the level
place, expand ing dramatically the prod u ction possibilities in o risk involved , etc. The central ban k, as will be explained later,
both a static and d ynam ic sense. can in u ence market interest rates.
I t is im portant to u nd erstand that lend ing by com m ercial banks
Functions of money is perorm ed by the stroke o a pen. N owad ays, its actu ally
n M on ey is a m ed iu m o exchange: it is acceptable as a m ore like a compu ter click o a m ou se. The bank issu es a loan
m eans o paym ent in market transactions. to a bu siness by opening u p a accou nt allowing chequ es to be
n I t is a u nit o accou nt: it serves as a yard stick, with which written or the bu siness (that is, a cu rrent accou nt). N ote
valu es can be m easu red , expressed and com pared . thou gh that or every $ 1 .00 cash d eposited by a cu stom er in a
bank, cred it can be extend ed by a m u ltiple which is greater, the
n I t is a store o valu e: people may hold their wealth throu gh
smaller the cash drainage (the u se o cash ) in the econ omy.
tim e in the orm o m oney (m oney at rest).
This is known as a ractional reserve system : com m ercial banks
n M on ey provid es a stand ard o d eerred paym ents: it allows need on ly to keep as reserves (in their vau lts or in th eir d eposits
inter-temporal con tracts; it serves as a link between the at the central bank) a raction o the total valu e o loans
past, present an d u tu re. (cred it) they have issu ed . This is becau se at any point in tim e
only som e cu stom ers will requ ire to be paid in cash (by cash ing
The banking system their chequ es); m ost transaction s (in term s o valu e) involve the
The m od ern banking system is known as a two-tier system transer o ch equ es, the compu ter cred iting o one accou nt
since it comprises com m ercial banks and a central bank. and the d ebiting o another.
1 05
2 Macroeconomics
hold m oney at each level o interest rates will increase, shiting d iscou nt rate which is the interest rate at which com m ercial
the d emand or m oney to the right. banks can borrow i they need to rom the central bank.
I the central bank wants to d ecrease the m oney su pply and
Interest rate (r)
Ms
Ms3 Ms1 Ms2
r3
r1
r2
Md
Money (M)
Money (M)
Figure 2.5.2 The money supply (exogenous and fxed by the central bank)
Figure 2.5.3 Interest rate determination by the central bank
Th e central bank can aect the size o the m oney su pply as Given a m on ey d eman d M d a n d m on ey su pply at M s1 th e
ollows. ma rket in terest rate will be d eterm in ed at r1 . I th e cen tra l
n I t can change the requ ired reserve ratio. Com m ercial banks ba n k wish es or som e reason to lower in terest rates it ca n
need to keep only a raction o the m oney d eposited in in crea se th e m on ey su pply to M s2 . I t ca n d o th is by d ecrea sin g
their vau lts and can lend ou t the rest. They need to d o that th e requ ired reserve ratio, lowerin g its d iscou n t rate or
to ensu re that they are su f ciently liqu id to m eet their con d u ctin g open market pu rcha ses o (ou tsta n d in g ) bon d s.
obligations to d epositors. I the central bank increases the Th e in terest rate in th e m on ey market will d ecrea se to r2 . On
requ ired reserve ratio then they will be able to lend ou t less th e oth er ha n d , i or som e rea son th e cen tra l ba n k wish es to
so the m oney su pply will d ecrease, shiting the cu rve in in crea se in terest rates it ca n d ecrea se th e m on ey su pply to
Figu re 2 .5.2 to the let. M s3 . Th is ca n be d on e by in crea sin g th e requ ired reserve ratio,
n The central ban k can change the d iscou nt rate. There are ra isin g its d iscou n t rate or con d u ctin g open ma rket sales o
very many interest rates in an economy. One su ch rate is the (ou tsta n d in g ) bon d s. Th e in terest rate in th e m on ey ma rket will
in crea se to r3 .
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2 Macroeconomics
Monetary policy
Monetary policy is, together with fscal policy, a demand-side pricier and th ereore less competitive abroad and imports m ore
policy. It aims to aect economic variables such as real output attractive d om estically, d ecreasing net exports.
and growth, employment and ination. I the goal is to increase N ote that the term qu antitative easing reers to pu rchases
AD then the central bank will adopt easy or loose (expansionary) by the central bank o long-term bond s so that the m oney
monetary policy, increasing the money supply and, through this, su pply increases.
lowering interest rates. This would typically be the policy choice
or an economy in recession or about to enter one (that is, when a Evaluation of monetary policy
deationary or recessionary gap is present). I the goal is to
Central banking is both an art and a science: the tim ing o an
decrease AD (or to slow down its increase) then the central bank
interest rate chang e, the statem ents issu ed by the central
will adopt tight or contractionary monetary policy, decreasing the
banker and the size o the interest rate change are all cru cial
money supply and, through this, increasing interest rates. This
or the su ccess o any policy change. There are very many
would typically be the policy choice or an overheating economy
actors that d eterm ine the extent to which a policy response
(that is, when an inationary gap is present).
will or will not be su ccessu l. I n general, m onetary policy is
extensively u sed throu ghou t the world to regu late the strength
Easy or loose monetary policy o total spend ing on d om estic good s and services.
I an economy is abou t to enter recession or i it alread y is
n I t is consid ered rather exible as the central bank can alter
su ering negative growth rates and a d e ationary gap then the
interest rates oten.
central bank may d ecrease interest rates (r) (or, equ ivalently,
d ecrease the m oney su pply) in an attem pt to increase AD and n I nterest rates can be altered grad u ally or increm entally (by
so ou tpu t and employm ent. H ow d oes it work? H ow are lower 0.2 5 % at a tim e).
interest rates expected to re ate a ailing economy? I t is hoped n The central bank can also easily reverse any d ecision i it
that AD will increase becau se consu mption expend itu res, becom es clear that a policy reversal is in ord er.
investm ent expend itu res and net exports will tend to rise.
On the other hand , it is also characterized by several problem s.
Consu m ption expend itu res o hou sehold s may in crease as
n M ost importantly, spend ing o both hou sehold s and f rm s
borrowing to f nance the pu rchase o d u rables (or exam ple cars
d oes not only d epend on interest rates. Consu m ption and
or hou sehold appliances) becom es cheaper so hou sehold s may
investm ent expend itu res d epend on a host o other actors.
spend m ore on these good s. Also, m onthly paym ents on
The d egree o con su m er and bu siness conf d ence is
ad ju stable m ortgage loans will d ecrease so hou sehold s will
extrem ely im portant in d eterm ining the response o
have m ore available to spend in general. Lastly, the lower rate
hou sehold and bu siness spend ing to a change in in terest
o retu rn will make saving a less attractive option so
rates. The d egree o hou sehold and f rm ind ebted n ess is
hou sehold s will tend to spend m ore.
also o param ou nt im portance. For example, lets say the
I nvestm ent spend ing by f rm s may also increase as borrowin g central bank lowers interest rates in an attempt to prevent
costs to f nance pu rchases o capital good s (or example a recession. I bu sinesses are pessim istic and /or i
machin es, tools and other equ ipm ent) and expansions (su ch as hou sehold s are alread y bu rd ened by heavy d ebts there is
new actories) are lower. Also, lower interest rates im ply that no gu arantee that they will be convinced to borrow and
the opportu nity cost to f rm s o u sing their own past retained spend m ore, and the policy may ail.
prof ts to f nance investm ents is also lower.
n Also, i the borrowing rate is alread y too low (close to zero)
Lastly, as a resu lt o lower interest rates, the exchange rate will then it can not be lowered any u rther as negative interest
tend to d epreciate (see the section on exchange rates later) so rates d o not make any sense (see Figu re 2 .5.1 and consid er
exports will becom e m ore com petitive abroad and imports less the liqu id ity trap case where m oney d emand becom es at,
attractive d om estically, increasin g net exports and so AD. that is, inf nitely elastic).
n Ju st like f scal policy, m onetary policy is characterized by
Tight monetary policy
potentially d estabilizing tim e lags. Th ese tim e lags may be
Assu m e an overheating econom y in which in ation is becom ing shorter than those characterizing f scal policy bu t they are
a problem and an in ationary gap is orm ing. The cen tral bank still variable in length, creating u ncertainty as to the
may increase interest rates (or, equ ivalently, increase the m oney su ccess o any policy change.
su pply) in an attempt to d ecrease AD. AD is expected to
n Und er a f xed exchange rate system m on etary policy is
d ecrease as higher interest rates will work in the opposite
ineective. I nterest rate changes have to be u sed only to
d irection to the one d escribed when an easy or loose m onetary
ensu re that the exchange rate remain s f xed at the chosen
policy is ad opted . With tight m onetary policy, borrowing costs
will increase or both hou sehold s and f rm s, m onthly loan level. This will becom e clear in a later section.
repaym ents or many types o loans will increase and saving n Tod ay, f nancial markets are largely global so m ost f rm s
will becom e m ore attractive. Spend ing by hou sehold s and f rm s and even hou sehold s can and d o borrow rom anywhere in
is thereore expected to slow d own or even d ecrease. The the world . These d evelopm ents weaken the eectiveness o
exchange rate will also tend to appreciate, rend ering exports any d om estic m onetary policy ch oice.
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2 Macroeconomics
By r (or, by Ms through open market purchases o bonds, By r (or, by Ms through open market sales o bonds,
How?
lower required reserves or a decrease in the discount rate) higher required reserves or an increase in the discount rate)
Why is AD By lowering interest rates the central bank hopes that C and I By increasing interest rates the central bank hopes that C and
aected? and NX will and so AD will I and NX will and so AD will
other variables also aect the decision to spend; nancial markets are global; there is a lower interest rate limit beyond which it
But
is ineective (the liquidity trap); it is ineective under a xed exchange rate regime, etc.
On the monetary policy is fexible, gradual and easily reversible; in addition, i the central bank is independent, monetary policy is less
other hand yielding to political pressure and manipulation
Supply-side policies aster rate o technological advancem ent will increase labour
Su pply-sid e policies are policies that aim at increasing the productivity and so the LRAS o an economy.
prod u ction sid e o an economy and so aggregate su pply, N ote that all o the above public investments imply an increase
shiting the LRAS cu rve to the right. in governm ent expenditures and as such will also have a
Su pply-sid e policies attem pt to enhance the institu tional short-run eect on AD, increasing it and shiting it to the right
ram ework o an economy, increase the qu an tity and improve beore the LRAS is positively aected and also shits to the right.
the qu ality o actors o prod u ction, as well as im prove n I m proving the institu tional ram ework is a su pply-sid e
incentives. They may be d istingu ished into interventionist and policy. The institu tional ram ework o an economy inclu d es
pro-market policies. I n th e orm er, the governm ent takes on an the laws, the regu lations, the cu stom s and trad itions within
active role, whereas in the latter the role o the governm ent is which econom ic activity takes place. They d ef ne th e ru les
su pposed to be m inim ized in ord er to u nleash the powers o o the gam e. I m provin g the in stitu tional ram ework o an
the ree market. economy im plies improving the capacity o the economy to
prod u ce. Unortu nately, there is no u niqu e set o laws, ru les
Interventionist supply-side policies and regu lations that can be transplan ted to any economy
n I nvestm ents in hu man capital, inclu d ing investm ents in and prove optimal. Movem ents that red u ce bu reau cracy,
ed u cation and health care, are one example. I nvestm ents in increase transparency and accou ntability, simpliy processes
primary and second ary ed u cation yield the high est social and proced u res, and red u ce corru ption are, in general,
rate o retu rn, the resu lting external benef ts are the h ighest
consid ered to be steps in the right d irection.
and investm ent ensu res that all children have access to
ed u cation. I nvestm ents in better h ealth-care services mad e n I n d u strial policies are cham pioned by policy makers who
available to the general popu lation also help increase the consid er governm ent intervention and gu id ance necessary
stock o hu man capital o an economy. An increase in or the prod u ctive capacity o an economy to increase. This
hu man capital lead s to increased labou r prod u ctivity, so to grou p consid ers market orces inad equ ate to gu id e f nancial
an increase in the prod u ctive capacity and th e potential capital and investm ents to their m ost prod u ctive u ses and
ou tpu t o an economy. The LRAS will sh it to the righ t. so believe that governm en t is necessary to d o the job and
pick winners (that is, ind u stries and f rm s to su pport as
n I nvestm ents in in rastru ctu re will also boost the su pply sid e. they are thou ght to have the m ost potential or growth).
Bu ild you rsel a road to get rich is not an exaggeration as Su bsid ized low interest loans, tax breaks an d tax
a better transportation system creates massive positive allowances and protection rom oreign com petition are
externalities. I nrastru ctu re reers to physical capital that som e o the m easu res employed . Som e su ccessu l as well as
governm en t typically bu t not necessarily f nances which u nsu ccessu l d eveloping cou ntries have ad opted su ch
d ecreases the costs o econom ic activity and creates sizable m easu res. M any, i not all, ad vanced econom ies have also
external benef ts. Road s, railways, harbou rs, airports and
employed su ch policies in varying d egrees.
telecom m u nications all serve to lower prod u ction costs o
all econom ic agents in a cou ntry. Pro-market supply-side policies
n Investm ents in technology are another example. In their The m easu res inclu d ed in this grou p are m easu res that the
attempt to increase AS, governm ents und R&D projects. su pply-sid ers espou se. Su pply-sid ers are a grou p o econom ists
Provision o basic R&D is responsible or signifcant positive who are known or their oten extrem e pro-market id eas and
externalities that a private frm would not be able to capture. biases. Their basic principle is less governm ent and m ore ree
Markets alone would lead to ewer R&D projects being an d u nettered markets. Their id eas inclu d e the ollowing .
undertaken, which implies a slower rate o technological n Policies related to the labou r market inclu d ing polices that
progress. Labour productivity does not only depend on the try to make it m ore exible. Som e examples are policies
level o human capital (education and training) but also on aim ed at:
the quality and the level o technology em bodied in the lowering or even abolishing the m inim u m wage
physical capital that employees work with. It ollows that a
1 08
2 Macroeconomics
1 09
2 Macroeconomics
11 0
2 Macroeconomics: Questions
1 . Describe the circu lar ow m od el o an open econom y and same actors that are responsible or shiting the production
explain the m eaning o the term s incom e ow and possibilities curve (or, rontier) o an economy outwards?
expend itu re ow. 1 7. Distingu ish between the reasons the Keynesian
2 . Explain how the size o the incom e ow within th e circu lar aggregate su pply cu rve is u pward sloping (section I I )
ow m od el d epend s on the relative size o the with drawals and the reasons the M onetarist short ru n aggregate
(or, leakages) and the injections. su pply is u pward sloping .
3. Ou tline the d ierence between GDP and GN I as well as 1 8. Explain the impact o an increase in aggregate d emand
between nom inal and real valu es o these m easu res o within the M onetarist /N ew Classical an d the Keynesian
econom ic activity. analytical ram ework.
4. Explain why the in com e approach, the ou tpu t approach 1 9. U sing appropriate d iagram (s), explain the m echanism that
and the expend itu re approach in m easu ring national gu arantees, within the Monetarist /N ew Classical
incom e are equ ivalen t. ram ework, how any gap (in ation ary or d e ationary) will
5. Explain the m eaning and signif cance o the term au tomatically close.
green GDP. 2 0. Explain the role o aggregate d emand within the Keynesian
6. U sing an appropriate d iagram , d istingu ish between the ram ework o analysis and contrast it with its long ru n role
phases o the bu siness (or, trad e) cycle and explain th e in th e M onetarist /N ew Classical ram ework.
m eaning o the term long term growth tren d , id entiying 21 . Compare and contrast the sign if cance o shits o the
it on you r d iagram . aggregate d emand within the Keynesian and the
7. What is th e d ierence between the d emand or a prod u ct M onetarist /N ew Classical ram ework.
and aggregate d emand ? Explain two reasons or which 2 2 . Explain what prevents real ou tpu t retu rning to its u ll
aggregate d emand is negatively sloped . employm ent (or, potential) level ollowing a d ecrease (or,
8. Def ne any three o the ou r components o aggregate an increase) in aggregate d emand within the Keynesian
d emand and explain, or each o these three components ram ework.
chosen , one actor that may increase it and thu s lead to a 23. Explain why a d e ationary gap requ ires governm ent
rightward shit in the AD cu rve. intervention within the Keynesian perspective bu t d oes not
9. Def ne the term consu m ption expend itu res and explain within the M onetarist /N ew Classical perspective.
three actors that may increase their level in an economy 2 4. Explain how th e u nemploym ent rate is calcu lated as well
and thu s increase aggregate d emand . as the d if cu lties in m easu ring u nemploym ent.
1 0. Def ne the term investm ent expend itu res and explain 2 5. Describe u sing examples the types o u nemploym ent
three actors that may increase their level in an economy d istingu ishing between the cau ses o each type.
and thu s increase aggregate d emand . 2 6. Explain u sing d iagram (s) the cau se o cyclical
11 . Def ne the term governm ent expend itu res and explain the u nemploym ent.
three types that these expend itu res are typically classif ed 27. Explain u sing d iagram (s) the cau se o stru ctu ral
into as well as actors that may increase their level in an u nemploym ent.
economy and thu s increase aggregate d emand .
2 8. Distingu ish between in ation, d isin ation and d e ation.
1 2 . Def ne the term net exports and explain three actors that
2 9. Explain how in ation and d e ation are m easu red .
may increase their level in an economy and thu s increase
aggregate d emand . 30. Explain the problem s o m easu ring in ation.
1 3 . Explain why the short ru n aggregate su pply within the 31 . Explain why core in ation is importan t to m onitor.
M onetarist /N ew Classical ram ework is u pward sloping 32 . Explain what a producer price index m easu res and why it
and su ggest two reason s it may shit to the let. is u seu l to m easu re it.
1 4. Explain the d istinction between the short ru n aggregate 33. Explain the cau ses o both d emand pu ll and cost pu sh
su pply and the long ru n aggregate su pply within th e in ation.
M onetarist /N ew Classical ram ework. 34. (H L only) Explain the view that the short ru n Phillips cu rve
1 5. Explain each o the three d iscreet sections o a typical may shit ou tward s.
Keynesian aggregate su pply cu rve. 35. Explain the m ean ing o the term natu ral rate o
1 6. Explain actors that may shit the Monetarist /N ew Classical u nemploym ent and its relationship to the M onetarist /
long run aggregate supply curve right. Are these exactly the N ew Classical id ea o potential ou tpu t.
111
2 Macroeconomics: Questions
36. Def ne econ om ic growth and , u sing appropriate d iagram s, 54. Explain both the d irect and ind irect channels throu gh
d escribe variou s ways it may be achieved . which f scal policy may impact on long term growth.
37. Explain the signif cance (or, role) o d ierent types o 55. Ou tline the typical role and responsibilities o a Central
investm ent (in natu ral, physical and hu man capital) or Bank.
econom ic growth and illu strate u sing an appropriate 56. Explain how the level o interest rates in an economy is
d iagram . d eterm ined , d escribing how the Central Bank can aect
38. Explain the role o prod u ctivity gains in the process o the m oney su pply.
econom ic growth. 57. Explain u sing appropriate d iagram (s) how easy m onetary
39. Does equ ity and equ ality in the d istribu tion o incom e policy can in u ence macroeconom ic aggregates su ch as
m ean the sam e thing? Explain. in ation, employm ent and ou tpu t, with special emphasis
40. Explain why markets may lead to increased incom e on the shape o aggregate su pply (note that this cou ld
inequ ality. easily be also a part (b) long essay qu estion as it is qu ite
d emand ing).
41 . Explain two ways th e d istribu tion o incom e may be
d escribed . 58. Explain u sing appropriate d iagram (s) how tig ht m onetary
policy can in u ence macroeconom ic aggregates su ch as
42 . Explain how inequ ality in the d istribu tion o incom e is
in ation, employm ent and ou tpu t (note that this cou ld
typically m easu red .
easily be also a part (b) long essay qu estion as it is qu ite
43. Distingu ish between absolu te an d relative poverty. d emand ing).
44. Explain possible cau ses o poverty. 59. Describe the channels throu gh which looser (easier)
45. Explain possible consequ ences o poverty. ( / tigh ter) m onetary policy can help close a d e ationary
46. U sing examples, d istingu ish between d irect and ( / in ationary) gap.
ind irect taxation and explain the role o each type in 60. Explain what is m eant by the expression in ation
d istribu ting national incom e (or, ... o d irect taxation in targeting when reerring to the mand ate o a Central
red istribu ting incom e). Bank.
47. Distingu ish between progressive, proportional and 61 . Su ppl y sid e pol ici es m ay be o a n i n terven ti on ist n atu re
regressive taxes, provid ing examples o each and or m ay be m a rket ori en ted . Ou tl i n e th e m ea n i n g o th i s
illu strating with an appropriate d iagram (last point not in statem en t, expla in i n g th rou g h a n a ppropriate d ia gram
syllabu s). th ei r a im .
48. Explain, u sing examples, how governm ent expend itu res 62 . Def ne the term inrastru ctu re and explain the im pact o a
and transer paym ents may be u sed to red istribu te incom e. d ecision to improve a cou ntrys inrastru ctu re both in the
49. Distingu ish, u sing examples, the sou rces o governm ent short term and in the long term .
revenu e and the types o expend itu res a governm en t makes 63. Def ne the term hu man capital and explain why many
and com m ent on the possible bu d get ou tcom e. cou ntries make signif cant investm ents to increase its stock.
50. Explain u sing a nu m erical example the relationship 64. What d o we m ean by the expression ind u strial policies?
between bu d get d ef cits/su rplu ses that a governm ent ru ns List three exam ples that may be consid ered part o an
and the pu blic d ebt o a cou ntry. ind u strial policy initiative and explain their impact on
51 . Explain u sing appropriate d iagram (s) how expansionary aggregate d eman d and long ru n aggregate su pply.
f scal policy can in u ence macroeconom ic aggregates 65. Ou tline any two interventionist su pply sid e policies
su ch as in ation, employm ent and ou tpu t, with special explaining both th eir short term impact on aggregate
emphasis on the shape o ag gregate su pply (n ote that this d emand and their potential im pact on long ru n impact on
cou ld easily be also a part (b) long essay qu estion as it is aggregate su pply.
qu ite d emand ing ). 66. Explain how two d ierent types o market-based su pply-sid e
52 . Explain u sing appropriate d iagram (s) how contractionary policies are expected to aect the long ru n aggregate
f scal policy can in u ence macroeconom ic aggregates su ch su pply o an economy.
as in ation, employm ent and ou tpu t (note that this cou ld 67. Analyze how labou r market reorm s may aect the
easily be also a part (b) long essay qu estion as it is qu ite su pply-sid e o an economy.
d emand ing).
68. Analyze how policies to encou rage com petition may aect
53. Explain how au tomatic stabilizers may help to stabilize the su pply-sid e o an economy.
overall econom ic activity. U se a d iagram to illu strate
69. Analyze how incentive-related policies may aect the
you r analysis.
su pply-sid e o an economy.
11 2
2 Macroeconomics: Questions
1 . To what extent can national incom e statistics be u seu l in 1 3. Discu ss the consequ ences o econom ic growth on living
d eriving conclu sions concerning changes in living stand ard s, u nemploym ent, in ation, incom e d istribu tion,
stand ard s o a cou ntry throu gh tim e or comparisons o the balance o paym ents and su stainability.
living stand ard s between cou ntries at a point in tim e? 1 4. Evalu ate possible governm ent policies employed to
2 . Exam ine the impact o an increase (and , separately, a red istribu te incom e with special reerence to how ef ciency
d ecrease) in aggregate d emand on short ru n an d long ru n issu es are aected .
equ ilibriu m within the Monetarist /N ew Classical. 1 5. Evalu ate the eectiveness o expansionary f scal policy,
3. Exam ine the impact o an increase (and , separately, a taking into consid eration the Keynesian Monetarist/N ew
d ecrease) in aggregate d emand within the Keynesian Classical viewpoints as well as short ru n versu s long ru n
analytical ram ework. consid erations.
4. Exam ine why an increase in aggregate d emand may have 1 6. Evalu ate the eectiveness o contractionary f scal policy,
d ierent implications concerning in ation ary pressu res taking into consid eration the Keynesian Monetarist/N ew
within the Keynesian and the M onetarist /N ew Classical Classical viewpoints as well as short ru n versu s long ru n
ram eworks o analysis. consid erations.
5. (H L only) Explain, u sing an appropriate d iagram , the 1 7. Evalu ate the eectiveness o easy m on etary policy, taking
m eaning and signif can ce o the Keynesian m u ltiplier into consid eration the Keyn esian Monetarist/N ew
ou tlining the actors that may increase its size. Classical viewpoints as well as short ru n versu s long ru n
6. Discu ss econom ic consequ ences o u nem ploym ent. consid erations.
7. Discu ss personal and social consequ ences o 1 8. Evalu ate the eectiveness o tight m onetary policy, taking
u n employm ent. into consid eration the Keyn esian Monetarist/N ew
Classical viewpoints as well as short ru n versu s long ru n
8. Evalu ate policies to d eal with d ierent types o
consid erations.
u n employm ent.
1 9. Discu ss the strengths and weaknesses o market-based
9. Discu ss possible con sequ ences o in ation.
su pply-sid e policies.
1 0. Discu ss possible con sequ ences o d e ation.
2 0. Discu ss the strengths and weaknesses o interventionist
11 . Evalu ate policies to d eal with d ierent types o in ation. su pply-sid e policies.
1 2 . (H L only) To what extent (or, d iscu ss whether) a trad e-o
exists between in ation and u nemploym ent u sin g
appropriate d iagram (s).
11 3
3.1 International trade
th bfs d
S e cti o n 3 : i n te r n ati o n al e co n o m i cS
n I t perm its specialization o scarce resou rces wh ich lead s to Figu re 3.1 .1 may be u sed to illu strate the welare gains rom
high er levels o ou tpu t and so higher levels o consu m ption. ree trad e. The market or good X is shown and initially no
Throu g h trad e cou ntries can consu m e com binations o trad e is assu m ed . This cou ld be the resu lt o prohibitive trad e
good s ou tsid e their prod u ction possibilities cu rve (PPC). barriers that perm it no imports rom abroad (known as th e
n Free trad e d ecreases the power o d om estic m onopolies by au tarky case).
exposing them to international competitive orces. The
11 4
3 International economics
HL Absolute and comparative advantage A country has a comparative advantage in the production o a good
i it can produce it at a lower opportunity cost (that is, by sacricing
The qu estion that arises is in which good s shou ld each cou ntry
ewer units o another good compared to another country).
specialize? Accord in g to Ad am Sm ith, m u tu ally bene cial trad e
is based on the principle o absolu te ad vantage. A cou ntry may
Units of good Y
be m ore e cient in the prod u ction o som e com m od ities and 20
less e cient in the prod u ction o others relative to an other
nation. Each cou ntry shou ld specialize in the prod u ction o the
good in which it has an absolu te ad vantage.
A cou ntry has an absolu te ad vantage in the prod u ction o a
good i it can prod u ce m ore o it with the sam e resou rces or,
equ ivalently, i it can prod u ce a u nit o it with ewer resou rces
than another cou ntry. I n absolu te ad vantage the absolu te
resou rce cost o prod u cing a good is relevant. 9
Units of good Y
20
0 18 20
Units of good X
8 I n Figu re 3.1 .3, Cou ntry G rey can prod u ce 1 8 u nits o good X
or 9 u nits o good Y at the m ost, whereas Cou n try Black can
prod u ce 2 0 u nits o good X or 2 0 u nits o good Y. Cou ntry
Black has an absolu te ad vantage in the prod u ction o both
good s as it can prod u ce m ore o both.
0 14 18 Since their PPCs are not parallel, their opportu nity cost ratios
Units of good X d ier. This m eans there is room or specialization and m u tu ally
bene cial exchange.
Figure 3.1.2 Absolute advantage
Cou ntry G rey has a comparative ad vantage in th e prod u ction o
O n a d i a g ram , th e cou n try wi th th e PPC u rth er ou t on a n good X an d Cou ntry Black has a comparative ad vantage in the
a xi s h a s th e a bsol u te a d va n ta g e i n th e prod u cti on o th e prod u ction o good Y. G rey shou ld specialize and export good X
g ood m ea su red on th a t a xi s. I n Fi g u re 3 .1 .2 Cou n try G rey while Black shou ld specialize and export good Y.
h a s a n a bsol u te a d va n ta g e i n th e prod u cti on o g ood X H ow d o we know that Cou ntry G rey has a com parative
(i t ca n prod u ce 1 8 u n i ts wi th th e sam e resou rces wh i l e ad vantage in the prod u ction o good X?
Cou n try B la ck ca n prod u ce on l y 1 4 u n i ts). Cou n try Bla ck h a s
First, we can see this as Cou ntry G rey's PPC is f atter. On a
a n a bsol u te a d va n ta g e i n th e prod u cti on o g ood Y
gu re with two linear PPCs, the cou ntry with the f atter PPC has
(2 0 u n i ts i n stea d o 8 ). Cou n try G rey sh ou l d th ereore
the com parative ad vantage in the prod u ction o th e good on
speci a l i ze i n a n d export g ood X a n d i m port g ood Y, a n d
the horizontal axis, while the other cou ntry has the
vi ce versa or Cou n try B la ck.
comparative ad vantage in the prod u ction o the other good .
I a cou ntry happens to be absolu tely m ore e cient in the
We can also calcu late the opportu nity cost o prod u cing good X
prod u ction o both good s then, accord ing to the principle o
by each cou ntry.
absolu te ad vantage, there is no reason or it to specialize and
engag e in trad e. This wou ld be the case in a d iagram where the For Cou ntry G rey: I it prod u ces 1 8 u nits o good X it cannot
PPCs d o not intersect. prod u ce (that is, it m u st sacri ce) 9 u nits o good Y, so (d ivid ing
both sid es by 1 8) in prod u cin g 1 u nit o X it m u st sacri ce
I n 1 81 7, David Ricard o showed that absolu te ad vantage is not
9
___ 1
necessary or m u tu ally ben e cial specialization and trad e to or __ u nits o good Y.
18 2
take place. Even i a cou ntry is absolu tely at a d isad vantage in
the prod u ction o every g ood com pared with an other cou ntry For Cou ntry Black: I it prod u ces 2 0 u nits o X it cannot prod u ce
(that is, its PPC is insid e th e other cou ntrys PPC) there is still (that is, it m u st sacri ce) 2 0 u nits o Y, so (d ivid ing both sid es
room or m u tu ally bene cial trad e. by 2 0) in prod u cin g 1 u nit o X it sacri ces 1 u n it o Y.
Accord ing to Ricard o only comparative ad vantage is necessary. M ore generally, the opportu nity cost o prod u cing the good on
Each cou ntry shou ld specialize an d export those g ood s that it the horizontal axis is the slope o the PPC:
can prod u ce at relatively lower cost. Relative costs are what Y
Opportunity cost of producing the good on the horizontal 5 ___
matter and not absolu te costs. X
11 5
3 International economics
N ote that i the PPCs are parallel, as in Figu re 3.1 .4, then there n no tran sport costs
is no room or specialization and m u tu ally bene cial trad e n perect competition in all markets
becau se the opportu nity cost ratios are equ al.
n ree trad e (n o trad e barriers).
Units of good Y
20
Criticisms of the principle of comparative advantage
The above assu mptions d o not accu rately ref ect real world
cond itions. These assu mptions are the basis or the criticism s
o the com parative ad vantage m od el an d its pred ictions. The
criticism s are as ollows.
Costs o prod u ction need not be constant. They may be
decreasing, in which case the gains rom specialization may
even be greater. I ncreasing retu rns to scale in prod u ction and
10
the resu lting EOS are very oten the case in the real world .
Labour and the other actors o production suer rom both
occupational and geographical immobility. It may not be costless
or even possible or a country to specialize. Real adjustment costs,
such as unemployment or certain regions or groups, will result
when a country responds to a shit in its comparative advantage.
Transportation costs do exist in the real world and, depending on
the ratio o weight to value, will decrease the scope o oreign trade
0 10 20 opportunities. Note though that transport costs have dramatically
Units of good X decreased since the advent o the container in shipping.
Figure 3.1.4 No room or mutually benecial specialization and trade Perect com petition is not com m on at all. Large rm s with
monopoly power and EOS d om inate world trad e.
Sources of comparative advantage Trade barriers are also a reality which prevents world trade fows
The ultimate determ inants o a countrys comparative advantage rom refecting comparative advantage conditions among nations.
include dierences in actor endowm ents and dierences in
For these and other reasons the actu al pattern o trad e f ows
technology. Dierences in the quantity and quality o actors o
does not u lly ref ect com parative ad vantage. Still, comparative
production available include dierences in the stock o natural
advantage is a m ost u seu l concept in u nd erstand ing and
capital and its productivity, dierences in the stock o human
explaining m u ch o what is going on in the world o trad e.
capital and its productivity and dierences in the stock o
physical capital and its productivity. Dierences in technology
Limitations of the theory of competitive advantage: summary
are maniested indirectly as technology is embodied in the
physical capital available (it is inside the machines available) increasing returns to scale and so EOS exist
and aects the productivity o human capital. Limitations labour suffers from occupational and geographical
of the immobility so it may be costly to specialize
In addition, comparative advantage and trade fows can be aected
theory of
by movements in the exchange rate (the price o a currency transportation costs exist, limiting the scope for trade
comparative
expressed in terms o another). For example, i the exchange rate advantage perfectly competitive conditions are rarely
rises (appreciates) then exports become less competitive. Changes are that approximated
in the relative infation rates also aect competitiveness. For trade barriers exist, limiting the scope for trade
example, i average infation in country X is 8% while in country B
it is 4%, the goods and services produced by country X will become Comparative advantage is a dynamic concept
relatively more expensive over time. This worsens their Comparative ad vantage is a d ynam ic concept as it can and
competitiveness and causes a loss in comparative advantage. d oes change over tim e. Governm ents can and historically have
Export subsidies can also be used to create an articial comparative prom oted policies that help to create a com parative ad vantage
advantage or a countrys products US cotton producers, in speci c ind u stries. A governm ent cou ld invest in ed u cation,
recipients o massive state subsidies, provide a good example. increasing the stock o hu man capital and raising labou r
Lastly, non-price actors can lead to the creation or the loss o prod u ctivity and lowerin g average costs in speci c ind u stries.
comparative advantage and competitiveness (such as product I t cou ld create avou rable investm en t cond ition s or private
design, reliability, quality o ater-sales support). Export sales o rm s by ensu ring price stability (low inf ation), long-ru n
German capital goods, or example, are not easily aected by an equ ilibriu m in the exchange rate and , m ore generally, a
appreciating euro as their reputation is excellent in oreign markets. cond u cive bu siness environm ent. I t cou ld also import
Assumptions on which the principle of comparative technology by attracting oreign d irect investm ent (FDI ) in
advantage rests high -tech sectors.
These assu m ptions are: An example o a cou ntry that d id not rely on a static
n constant (average and marg inal) costs o prod u ction interpretation o comparative ad vantage bu t instead created a
ref ected in the linear PPCs we draw com parative ad vantag e in several other areas is Korea. I it had
relied on its original com parative ad vantage, it wou ld have still
n perect actor m obility within each cou ntry (bu t, im m obility
been an exporter o rice.
between cou ntries)
11 6
3 International economics
The World Trade Organization The WTO is criticized on several grou nd s. I t is accu sed that it is
controlled by the rich nations, especially the U SA, and that it
The World Trad e Organization (WTO) was set u p in 1 995 and
d oes not su ciently consid er the need s and problem s o th e
has 1 53 m em ber cou ntries, replacing another international
d eveloping world . For example, agricu ltu ral prod u cts rom
organization known as the General Agreem ent on Taris and
d eveloping cou ntries d o not have ree access to the U S market
Trad e (GATT). GATT was orm ed in 1 948 when 23 cou ntries
bu t the U SA insists that the poor open u p their markets to U S
signed an agreem ent to red u ce taris.
good s and , especially, services. I t is claim ed that the WTO is too
The WTO is an international in stitu tion aim ing at prom oting poweru l, trying to orce nations to change policies, laws and
ree trad e by persu ad ing cou ntries to abolish im port taris and regu lations by d eclaring them in violation o its ru les. I t is
other barriers. I t has becom e closely associated with charged that d oes not consid er th e possible ad verse eects o
globalization. I t ensu res that trad e ru les are ad hered to, it trad e liberalization on workers, on the environm ent and health
settles trad e d ispu tes between cou ntries and it organizes trad e or on child labou r. Lastly, som e consid er that it lacks
negotiations. WTO d ecisions are nal and every m em ber m u st transparency in its d ecision making on trad e d ispu tes as it is
abid e by its ru lings. So, when the U SA and Brazil are in d ispu te closed to the m ed ia and the pu blic.
over rozen orange ju ice, it is the WTO wh ich acts as ju d ge and
On the other hand, even i the benets o reer trade have not been
ju ry. The WTO empowers its m em bers to enorce its d ecisions by
shared equally, many believe that the trade liberalization eorts o
im posing trad e sanction s against cou ntries that have broken
the WTO have improved living standards across the globe.
the ru les.
The WTO: summary of key points
was set up in 1995 as a successor o the GATT (1948).
has 153 member countries.
The WTO promotes trade liberalization.
sets trade rules and ensures that they are ollowed.
is the arbitrator o trade-related disputes.
biased in avour o US and European Union interests.
inconsiderate to the needs o developing countries.
Criticisms of the WTO include that it is
paying insufcient attention to increasingly important issues such as child labour, health,
the environment and workers rights.
Does trade protection make sense? in the case o a war; in other word s, or strateg ic reasons.
The weapons and aerospace ind u stries as well as the ood
I the bene ts rom ree trad e are so many and , as shown
ind u stry are oten classi ed as being o su ch strategic
earlier in Figu re 3.1 .1 , n et welare increases with ree trad e, why
im portance. The valid ity o this argu m ent is d ou btu l, at
d o so many cou ntries restrict trad e and em ploy variou s d egrees
least or cou ntries belonging in wid e strategic and /or
o trad e protection? Why is managed trad e so com m on?
political alliances.
The sim ple answer is that not all parties involved gain rom ree
n Trad e barriers are also em ployed to restrict im ports o dru gs
trad e. There are grou ps that are worse-o. Free trad e creates
an d other harm u l su bstances or to pu t pressu re on and
winners and losers.
weaken politically u nriend ly cou ntries (em bargoes).
In Figure 3.1.1 the increase in the consumer surplus exceeds the
n Som e cou ntries resort to trad e protection to preserve a way
decrease in the producer surplus. The winnings o the winners are
o lie or cu ltu ral id entity as part o a broad er social
greater than the losses o the losers. The problem in the real world
strategy. For exam ple, the television stations in many
is that there is no guarantee that the losers will be compensated.
cou ntries ace restrictions on the hou rs o program m es
I n ad d ition, the winnings rom ree trad e are spread over a very broad cast in oreign langu ages.
large nu m ber o people (consu m ers) each getting a very small
n Trade barriers also exist to ensure that certain minimum saety
ad d ition to his or her incom e while the resu lting losses are
and health standards are met. The goal is purportedly to
spread over a m u ch smaller nu m ber o ind ivid u als (prod u cers)
protect the public but oten such standards are a pretence
each su ering a signi cant cu t in their incom e. I t ollows that
losers have a big incentive to pu t u p a ght again st ree trad e. through which domestic producers are protected.
To ensu re that th e ad ju stm ent costs or the losers are small, Economic arguments in favour of trade protection
governm ents oten ju d ge that som e level o trad e protection n A very com m on argu m ent in avou r o restricting trad e is to
is necessary. protect d om estic jobs. M any claim that ree trad e d ecreases
employm ent as ch eaper and better-qu ality oreign prod u cts
N on-economic arguments in favour of trade protection f ood the d om estic market, orcing d om estic rm s to shu t
n Governm ents oten erect trad e barriers to ensu re that a d own. Foreign cheap labou r is oten blam ed or in creasing
cou ntry is sel-su cient in the prod u ction o cru cial good s
rates o u nemploym ent.
11 7
3 International economics
These claim s m u st be careu lly evalu ated . First, higher as well as by all Asian export achievers, in varying d egrees.
d om estic wages d o not necessarily imply higher labou r Bu t it also su ers rom potential major drawbacks. H ow
costs as labou r prod u ctivity is important. I d om estic wages d oes a governm ent pick a winner? I t may be d i cu lt to
are higher becau se o hig her labou r prod u ctivity then d eterm ine which ind u stry qu ali es or su ch treatm en t. I a
labou r costs may be lower than abroad , so there is no m istake is mad e, will it be possible or the governm ent to
reason to ear imports. I , thou gh, the higher d om estic reverse its cou rse and withdraw its su pport? Rem oving the
wages are not a ref ection o higher labou r prod u ctivity protection cou ld be ercely resisted by the in d u stry
then the d om estic ind u stry has a comparative stakehold ers. I trad e protection is not lited th en we have
d isad vantage. Theory then su ggests that labou r and other the case o the perpetu al inant. There is an inherent risk
resou rces sh ou ld be channelled to other, m ore e cient o making the in d u stry over-reliant on state su pport,
u ses. Workers and owners o capital, and perhaps whole slu ggish and ine cient.
regions, will have to ace real ad ju stm ent costs and o
cou rse will resist these changes. They will try to blam e n I d u mping is su spected (which is selling abroad at a price
oreigners or their pligh t and will d emand protection. below average costs or lower than the d om estic price) then
I nstead o protection thou gh, which will red u ce the even the WTO allows a cou ntry to impose taris (taxes on
incentive to restru ctu re and ad ju st, other policies cou ld be imports which in this case are reerred to as anti-d u mping
ad opted to sm oothen the transition, especially or d isplaced d u ties) on the exporting ind u stry. An investigation ollows
workers. N ote that in the case o poorer d eveloping and i d u mping is proved th en trad e protection is perm itted
cou n tries shiting resou rces rom one u se to another may be to ensu re a level playing eld .
alm ost im possible withou t som e governm ent assistance Du mping is not easy to prove, thou gh. The qu estion arising
which itsel cou ld be too costly to implem ent. I n su ch a relates to rm s average costs. I t cou ld be that the oreign
case, trad e liberalization shou ld proceed grad u ally. Also, rm is m u ch m ore e cient, so it has m u ch lower u nit costs
i employm ent in a whole region relies on the d istressed o prod u ction. Or it cou ld be that the oreign rm is illegally
ind u stry with ew or no employm ent alternatives or the being su bsid ized by its governm ent, creating an arti cial
popu lation, then the liberalization process m u st be grad u al. cost ad vantage. I n the orm er case there is no case o
n Another com m on argu m ent in avou r o protection is to d u m ping whereas in the latter there is. As anti-d u mping
im prove a trad e d e cit. A trad e d e cit exists i the valu e o d u ties are au tomatically im posed when d u mping is
im ports o good s and services (the im port bill) is greater su spected u ntil the issu e is investigated and a verd ict is
than export revenu es. The id ea is that trad e protection will reached , many ind u stries cry d u m ping to gain tim e in
rend er imports m ore expensive and thereore less attractive. ord er to restru ctu re and , they hope, becom e m ore e cient.
Spend in g on imports will thereore d ecrease, shrinking and n Another argu m ent is the strategic trad e policy argu m ent.
correcting the trad e im balance. Accord ing to this, in a ram ework o international
There are several potential problem s with th is argu m ent. oligopolies (where ew large rm s d om inate world markets)
First, it invites retaliation rom trad ing partners as any a governm ent can tilt the balance and the pro ts away
im provem en t in the trad e balance com es at their expense. rom oreign com petitors and toward s d om estic rm s by
Second , restricting oreign prod u cts into the cou ntry lowers u sing trad e policies. The governm ents assistance can be in
oreign incom es and , consequ ently, oreign consu m ers the orm o su bsid ies, grants, loans at below market interest
ability to bu y ou r exports. Third , and m ost importantly, su ch rates and taris. The classic example is the aircrat
a policy d oes not treat the root cau se o a wid ening trad e manu actu ring in d u stry, with Boeing and Airbu s
d e cit problem . The ballooning trad e d e cit may be the m onopolizing the world market and where each sid e
resu lt o d om estic prod u cts being u ncom petitive: d om estic accu ses the other o massive governm en t assistance. I n
good s and services are u nable to penetrate oreign markets other cases (typically in high-tech ind u stries), where there
(so that exports d ecrease) and th ey are not the choice o are rst m over ad vantages (implying that rm s that are
d om estic hou sehold s which nd it cheaper to bu y imports rst to su cceed will d om inate th e world ind u stry), the
instead (so that imports rise). H igh inf ation, stru ctu ral assistance cou ld take the orm o setting ind u stry stand ard s
rigid ities and u ncompetitive d om estic markets, as well as in avou r o d om estic rm s.
issu es o poor qu ality, reliability, d elivery, d esign or The problem with strategic trad e policy is that it carries the
marketing may be the real reasons behind a growing trad e risk o d estabilizing trad e d ispu tes an d retaliation as it is a
im balance. I n these cases trad e protection will not prove beggar thy neighbou r policy. I one cou ntry su cceed s then
helpu l bu t may possibly prove d etrim ental as it will d elay another cou ntry necessarily ails. There is also the risk o
the ad option o appropriate ad ju stm ent policies. protecting the wrong ind u stries.
n Governm ents may decid e to erect import barriers to assist n Ta ri s (ta xes on i m ports) provi d e a g overn m en t wi th
the growth o certain indu stries in their initial stages o reven u es. Ta x system s i n certa i n d evel opi n g cou n tri es
developm ent. Once these industries acquire the necessary a re i n eecti ve, m a ki n g i t d i cu l t or th ei r g overn m en ts
know-how and achieve EOS they will be able to m eet to col l ect su ci en t reven u e to n a n ce pro-d evel opm en t
international competition. At this point protection should be a cti vi ti es. Si n ce poi n ts o en try i n to a cou n try a re ew,
rem oved. This is the well-known inant industry argum ent. ta xi n g i m ports to col l ect reven u e m ay be a la st resort
This argu m ent also n eed s to be careu lly evalu ated . I t is th a t ca n n ot be g i ven u p. I th i s i s th e ca se th en tra d e
ind eed theoretically sensible and the policy has been u sed l i bera l i zati on m u st be g ra d u a l to en su re th a t th e
by all d eveloped econom ies in the past, inclu d ing the U SA, provi si on o ba si c g overn m en t servi ces i s n ot i n terru pted .
11 8
3 International economics
Arguments in favour of trade protection: summary n Dom estic rm s will not be exposed to the technological
ad vancem ents em bod ied in im ported capital good s.
Economic it will protect jobs rom oreign competition.
arguments in n Only special interest grou ps bene t rom trad e protection,
it can correct a trade defcit.
favour of trade with society at large worse o in the long ru n. Owners and
it will protect against possible dumping. workers o protected ind u stries an d their stakehold ers are
protection
are that it can enhance government revenues. better o at the expense o all others.
Other arguments in the inant industry argument. n Trad e protection is responsible or d irectly u nprod u ctive
favour are the strategic trade policy argument. pro t-seeking (DU P) activities, a term introd u ced by
Bhagwati (1 989), which inclu d es activities su ch as rent and
Arguments against trade protection revenu e seeking and tari and qu ota evasion that take
n Trad e protection breed s ine ciency as d om estic rm s are place in response to an existing trad e barrier and lead to
exposed to less competition and are aced with captive the u se and waste o real resou rces.
d om estic markets. n Consu m ers an d rm s are aced with lim ited options to
n Less com petition im plies greater d om estic m onopoly power. choose rom . The red u ction in choice is a cost as bu yers
(consu m ers as well as rm s) have to settle or their second
n Greater m onopoly power or d om estic rm s implies higher or third choice. U tility d ecreases or hou sehold s while
prices, d istortion o the signalling power o the price com petitiveness d ecreases or rm s.
m echanism and m isallocation o scarce resou rces.
n H igher prices or im ported and d om estically prod u ced Arguments against trade protection: summary
consu m er good s imply a d ecrease in consu m er su rplu s and it breeds inefciency.
lower pu rchasing power or hou sehold s and so constrained
it limits competition and increases
ability to express d emand or all other good s and services
monopoly power.
in the economy. Th is cou ld have negative eects on ou tpu t
and employm ent levels. it is responsible or misallocation o scarce
resources.
n H igher prices or d om estic rm s importing interm ed iate
prod u cts (prod u cts u sed in their own prod u ction process) it leads to higher prices or consumers.
Arguments against
imply higher prod u ction costs and so a d ecrease in it increases the production costs o frms
trade protection are
aggregate su pply and cost-pu sh inf ationary pressu res. I importing intermediate goods.
that
these d om estic rm s happen to be export-oriented their it increases the possibility o retaliation.
competitiveness in international markets will be erod ed , it limits awareness o frms to technological
hu rting their sales and ad versely aecting overall progress embodied in imported capital
employm ent levels in the economy. Trad e protection u su ally goods.
d estroys m ore jobs than it preserves or creates.
it is responsible or DUPs.
n Trad e protection may ind u ce retaliation (tit or tat). I the
it limits options to consumers and frms.
trad e rictions escalate then a trad e war may resu lt, in the
long term , in hu rting all parties involved .
S
Trad e protection can take variou s orm s. The m ost com m on
orm s are: taris, qu otas, volu ntary export restraints, su bsid ies
and regu latory barriers (prod u ct stand ard s), as well as a host o
other m easu res su ch as antid u mping d u ties, exchange controls,
non-au tomatic im port au thorization (import licenses) etc.
Rem em ber that non-tari barriers inclu d e those barriers that
d o not d irectly aect the price o the good .
B C
Tariffs P Sw
A tari is d e n ed as a tax imposed on imports aim ed at 1 2 3 4 J
A
restricting their f ow into the cou ntry and at protecting P Sw
F H
d om estic prod u cers. I t has been the m ost com m on orm o
protection. I t may be speci c or ad valorem . A tari will tend to D
raise the d om estic price and d om estic prod u ction while
0 Q1 Q3 Q4 Q2
lowering the am ou n ts consu m ed and imported . These eects
Q /period
are illu strated in Figu re 3 .1 .5.
Figure 3.1.5 Eects o a tari (small country case)
11 9
3 International economics
u nit tim es that nu m ber o u nits imported . The tari per u nit is Sd
line segm en t P9 P (equ al to segm ent BF) and th e volu m e o
imports is Q3Q4 (or segm ent FH ). S = (Sd + Quota)
Exam ining the changes in social welare that resu lt rom the Su pply of th e g ood in th e
Quota = d om estic m a rket d id n ot
imposition o the tari we realize that: in crea se! I t wa s in n itely
250 units ela stic at Sw a n d n ow it is
D(producer surplus) 5 plus area (1 )
on ly S. Rem em ber th e
D(consum er surplus) 5 minus area (1 1 2 1 3 1 4) qu ota restricts im ports.
H E The qu ota d ecrea ses
Area (3 ) represents the tari revenu es collected , so it cannot be P
su pply in th e d om estic
consid ered a welare loss as this m oney can be spent on 1 2 3 4 m arket from Sw to S.
schools and health care centres, or example. P Sw
B C F R J
So: D(social welfare) 5 minus area (2 1 4)
D
A tari lead s to a net welare loss equ al to areas (2 ) and (4). A
Area (2 ) represents the resu lting prod u ction ine ciency while 0 Q1 Q3 Q4 Q2
area (4) represents the resu lting consu mption ine ciency. 200 700 Q /period
units units
Area (2 ) ref ects prod u ction ine ciency becau se the cost o
d om estically prod u cing u nits Q1 Q3 (which is equ al to area Figure 3.1.6 Eects o a quota
Q1 Q3BA, th e su m o all the margin al costs o prod u cing these
Let the world price or som e good be at P. At price P, d om estic
u nits) is greater than what it wou ld have cost the cou ntry to
rm s are willin g to oer Q1 u nits per period (say, 2 00
import these u nits at the world price 0P (which is equ al to area
thou sand tons o rozen orange ju ice per period ) while d om estic
(Q1 Q3FA), the prod u ct o u nits Q1 Q3 tim es the world price).
consu mption will be Q2 u nits (say, 700 thou sand tons). The
Area (4) ref ects consu mption ine ciency. U nits Q4Q2 are now volu m e o im ports will be Q1 Q2 u nits or, in this example, 5 00
not consu m ed by d om estic consu m ers as a resu lt o the tari thou sand tons o rozen orange ju ice).
even thou gh these u nits are valu ed by consu m ers m ore than
Let the governm ent now impose a qu ota o 2 5 0 thou sand tons
what it wou ld cost them to import. These u nits are worth area
o rozen orange ju ice in an attem pt to protect d om estic
(Q4CJQ2 ) to consu m ers, which is the su m o how m u ch
prod u cers. N o m ore than 2 5 0 thou sand tons o imported rozen
consu m ers wou ld be willing to pay or each o these u nits. They
orange ju ice may enter the d om estic market.
wou ld have cost only area (Q4Q2 JH ) to im port.
Prior to the qu ota, d om estic consu m ers aced an in nitely
elastic su pply o rozen orange ju ice Sw as they were oered
Remember that despite the welare loss a tari may make
TIP whatever am ou nt they wished at the world price. We are
sense. It is a source o government revenue that may be
again assu m ing a small cou ntry so that the world price remains
impossible to replace. Also, the adjustment costs or the
u naected no matter how m u ch the small cou ntry d ecid es
displaced workers may in some cases be prohibitively high.
to bu y.
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3 International economics
Ater th e im position o th e qu ota , at th e u n chan g ed world i m port bi l l rom th e poi n t o vi ew o th e i m porti n g cou n try)
price P, a s well a s at a ny oth er price a bove it, su pply o rozen a re bi g g er th a n i a n eq u i va l en t ta ri wa s i m posed a n d m ay
ora n g e ju ice in th e d om estic market will be con stra in ed to even be g reater th a n wh a t th ey wou l d ha ve been u n d er ree
whatever am ou n t d om estic prod u cers o rozen oran g e ju ice tra d e. Wi th ree tra d e th ei r export reven u es were eq u a l to
a re willin g to oer plu s th e 2 5 0 th ou san d ton s o rozen a rea (Q 1 Q2 J B) wh erea s wi th a q u ota a ppropri ated by th e
ora n g e ju ice that can n ow on ly be im ported . orei g n exporter th ey a re a rea (Q3 Q4EH ), wh i ch cou l d be
I t ollows that the new eective su pply o rozen orange ju ice is g rea ter. Th i s possi bi l i ty m i n i m i zes th e proba bi l i ty o
at S, which is parallel to the right o the d om estic su pply cu rve reta l i ati on .
Sd by the am ou nt o the qu ota, in th is case by 2 5 0 thou sand
tons (m ore precisely, the new su pply is the line ABFS). At each The quota diagram is one o the most difcult to draw and
price above P, the am ou nt o rozen orange ju ice available to TIP
is a source o many avoidable mistakes. An easy way to do
d om estic consu m ers will equ al to whatever qu antity d om estic the job is to draw a ree trade diagram, determine the
prod u cers are willing to oer plu s the 2 5 0 thou sand tons qu ota amount o imports under ree trade (Q1Q2 in Figure 3.1.5) and
o rozen orange ju ice. fnd the midpoint o this segment (conveniently assuming that
At price P, the total qu antity su pplied will equ al Q1 u nits o the quota is set at hal the ree trade level o imports). Do not
d om estic rozen orange ju ice plu s the 2 5 0 thou sand tons o the label this new point! Very lightly trace with your pencil (so that
qu ota equ al to d istance BF. At that price P thou gh, qu antity you can erase it later) a line up to Sw to determine the point
d emand ed is greater an d equ al to Q2 u n its. Excess d emand rom which you draw a parallel to the domestic supply curve Sd
equ al to d istance FJ u nits per period will resu lt. Since we are (in Figure 3.1.5 the point you determine on Sw is point F). This is
im plicitly assu m ing perectly competitive markets, the d om estic the new eective supply curve S9 . Lastly, rom the intersection o
market price or rozen orange ju ice will rise u ntil it reaches P9 . S9 and your demand curve D (point E in Figure 3.1.5) determine
Price P is the new equ ilibriu m price in the d om estic market the new equilibrium price P9 .
becau se at that price the total am ou nt su pplied to the market
by both d om estic and oreig n prod u cers is equ al to the qu antity
d om estically d emand ed by consu m ers. M ore specif cally, at P 9 Quotas: summary of effects
d om estic prod u cers oer Q3 tons (or d istan ce P9 H ), consu m ers increase the domestic price o the protected good.
bu y Q4 tons (or d istance P9 E) and the d ierence o Q3Q4 tons increase domestic production o the good.
(or d istance H E) is mad e u p o the im ported rozen orange ju ice
decrease consumption o the good.
which is equ al to the 2 5 0 thou sand tons qu ota.
decrease consumer surplus by area (1 1 2 1 3 1 4) in
A qu ota thereore increases the d om estic price o the protected
a typical quota diagram.
good as well as d om estic prod u ction while it red u ces d om estic
con su mption and , o cou rse, the volu m e (qu antity) o imports. increase producer surplus by area (1) in a typical quota
diagram.
Exam ining the changes in social welare that resu lt rom the
im position o the qu ota we realize that: create quota rents equal to area (3) which are typically
Quotas pocketed by oreign frms (but the domestic government
D(producer surplus) 5 plus area (1 ) may also collect these).
D(consumer surplus) 5 minus area (1 1 2 1 3 1 4) lead to production inefciency equal to area (2) in a
D(social welfare) 5 m inus area (2 1 3 1 4) typical quota diagram.
Area (3) is known as qu ota rents and represents m oney lead to consumption inefciency equal to area (4) in a
typically earned by the oreign exporting f rm s wh ich can now typical quota diagram.
export the prod u ct at a h igher price. Area (3 ) may also end u p are responsible or a welare loss equal to area (2 1 3 1 4)
in the hand s o oreign governm ents. I t is even possible that the in a typical quota diagram (assuming that the quota rents are
m oney that area (3) represents end s u p in the hand s (th e collected by oreigners).
coers) o the d om estic governm ent i, or example, it au ctions
o the qu ota licenses. Voluntary export restraints (VERs)
Area (2 ) again represents the resu lting prod u ction inef ciency Setti n g u p VERs i s a orm o tra d e protection that is a sl ig h tl y
while area (4) represents the resu ltin g consu mption in ef ciency, d i eren t versi on o i m posin g q u ota s. VERs a re a greem en ts
as explained in the case o a tari. between a n exportin g a n d a n im porti n g cou n try li m iti n g th e
The eects o a qu ota are the sam e as those o an equ ivalen t m a xi m u m am ou n t o exports i n a g i ven peri od . Th e d om esti c
tari with one exception: the tari revenu es area (3 ) now (im porti n g ) g overn m en t a sks th e oreig n g overn m en t to
represents qu ota rents which are u su ally collected by oreigners restrict th e exports o th e g ood ; th e term vol u n ta ry i s
and represent an ad d itional welare loss. m islea d in g sin ce th e req u est i s rea ll y a d ema n d a n d i t i s
m a d e clea r that u n l ess th e oreig n g overn m en t vol u n ta ri ly
Th e exi sten ce o q u ota ren ts h el ps expla i n wh y q u ota s a re
com pli es, m ore restri cti ve protecti on ist ba rri ers wi ll be
oten i m posed i n stea d o ta ri s even th ou g h th e a ssoci a ted
i m posed . Th e eects a re si m ila r to that o a q u ota so a rea (3 )
wel a re l oss i s bi g g er. Forei g n ers a re ha ppi er a s th ey u su a l l y
m ay sti ll en d u p in th e pockets o orei g n ers, m a ki n g i t l ess
pocket th ese ren ts. I th e orei g n exporti n g f rm s pocket th e
costl y tha n i a ta ri wa s i m posed .
q u ota ren t, th en th ei r export reven u es (a n d eq u i va l en tl y, th e
1 21
3 International economics
Why have cries for trade protection been example, has accu sed the Chinese o achieving export
increasing? penetration as a resu lt o keeping their cu rrency (the yu an or
renm inbi) u nd ervalu ed .
A growing number o developing countries (especially China) have
achieved rapid, export-led growth. Export success by these Exchange rate instability has ad d ed risk and u ncertainty to
countries means deep import penetration in Europe and the USA. trad e and since it can lead to su d d en shits in comparative
Protectionist response is expected rom those groups most ad vantages it may lead to calls or protection or d om estic
aected. ind u stry. M any claim that the choice is between managed trad e
or managed exchange rates.
Large trad e im balances between large trad ing nations (the
m ost prom inent example being that between the U SA and O cou rse, risin g u nemploym ent has always been a reason or
China) have strained relationsh ips between these cou ntries and d emand ing increased trad e protection. Recessions and
have led to variou s protectionist m easu res. The U SA, or u nem ploym ent always pu t political pressu re on governm ents to
lim it job threatening im ports.
1 22
3.2 Exchange rates
The exchange rate o a cu rrency is d e ned as the price (or the valu e) o a cu rrency
expressed in term s o another cu rrency.
For exam ple, on 7 April 2 01 1 , 1 .00 EU R 5 1 .38 U SD. One need ed 1 .38 U S d ollars to
pu rchase 1 eu ro. This au tomatically m eans that one need ed 0.73 eu ro to bu y 1 U S d ollar
as 0.73 is the inverse o 1 .3 8.
1 23
3 International economics
I t shou ld be ad d ed that central banks may also bu y or sell a A tra d e d e cit creates pressu re
cu rrency as part o th eir exchange rate policy. for th e exchan g e rate to
d epreciate as it lea d s to excess
Demand and supply of currency: summary su pply for th e cu rren cy
S for euros
($/euros)
Price of euros expressed in $
The demand and the supply o a currency in the oreign Dista n ce AB represen ts th e
(M of EU1 7)
exchange market refects international trade fows as well as EU 1 7 tra d e d e cit at e1
cross-border investment and speculative fows A B a n d th e resu ltin g excess
e1 su pply of eu ros
Demand or the Supply o the currency
E Dista n ce H F represen ts th e
currency refects refects e* EU 1 7 trad e su rplu s at e2
the value o its exports the value o its imports e2 an d th e resu ltin g excess
More H F
o goods and services o goods and services d em a n d for eu ros
specically:
as well as the infow o as well as the infow o D for euros A tra d e su rplu s creates pressu re
investments into the investments into the (X of EU1 7) for th e excha n g e rate to
country. country. 0 appreciate as it lea d s to excess
Euros per period dema n d for th e cu rren cy
I n Figu re 3 .2 .1 the market or British pou nd s sterling (GBP) is
Figure 3.2.2
illu strated against the U S d ollar (U SD).
At the exchange rate e1 the su pply o eu ros is equ al to d istance
e1 B and ref ects the valu e o imports into the EU 1 7 while the
Price of GBP
(in USD; $/GBP)
1 24
3 International economics
Second, whether a depreciating currency will increase the value o I nitially, assum e that demand and supply or the Australian
exports (that is, export revenues) depends on the price elasticity o d ollar are equal so that the exchange rate against the U S dollar
exports. The lower-priced exports will denitely increase the volume is at point e on the vertical axis. Australias trade in good and
(quantity) o exports per period but whether their value (revenues) services is balanced (we are assum ing there are no investm ent
actually increases or not depends on their PED. f ows). I there is growing demand or Australian exports then
d emand or AU D will shit to D ref ecting the growth in export
Causes o changes in the exchange rate d emand (X X). At the original exchange rate e there is a trade
The demand and the supply o a currency in the oreign exchange (current account) surplus equal to distance AB and excess
market refect trade fows and investment fows between d emand or Australian dollars in the market. This m eans there is
countries. Trade fows reer to exports and imports o goods and pressure on the Australian dollar to appreciate all the way to e.
services. This means that the rst actor that may change the I n Figu re 3 .2 .4 we assu m e increased d emand in Au stralia or
exchange rate o a currency is a change in exports or in imports. imported good s and services.
S of AUD
1 25
3 International economics
in dollars ($/rupiah) Figu re 3.2 .6 illu strates the eect o higher inf ation in
Price of Indonesian rupiah expressed
S1 for rupiah
(M1 ) I nd onesia on its cu rrency, the ru piah. I n itially, the ru piah
S2 for rupiah against the d ollar is at e1 .
(M2 > M1 )
Th e h ig h er in f ation in I n d on esia will have a n a d verse eect
on its exports a s th ey will becom e less com petitive abroa d a n d
th ereore d ecrease, d ecreasin g th e d ema n d or th e ru pia h rom
D1 to D2 .
e1
At the sam e tim e inf ation will m ean that I nd onesians nd
oreign prod u cts m ore attractive. I mports will tend to increase,
e2 lead ing to m ore ru piahs being su pplied in the oreign exchang e
market, shiting the su pply o ru piahs rom S1 to S2 . The ru piah
will ten d to d epreciate to e2 .
D for rupiah I nf ation in an economy will tend to d epreciate a cu rrency.
(X)
Changes in cross-border investment (capital) fows
0
Rupiah traded per period Th e excha n g e rate is also a ected by cross-bord er in vestm en t
Figure 3.2.5 Eect o a growing economy on the exchange rate an d specu lative f ows. For Am erican s to bu y EU 1 7 bon d s or to
set u p a n ew rm in th e EU 1 7 rst th ey n eed to g et th eir
In Figure 3.2 .5 the price o the Indonesian rupiah is initially han d s on eu ros. I , on th e oth er ha n d , EU 1 7 bon d s d o n ot
assumed at e1. I Indonesian growth accelerates then Indonesians seem a s attra ctive a nym ore th en h old ers o EU 1 7 bon d s will
incomes are rising so their consumption expenditures will rise. This wa n t to g et rid o th em to switch to, say, British bon d s. Th ey
means that they will also buy more oreign products. will sell eu ros to bu y pou n d s sterlin g , so th e su pply o eu ros
I nd onesians will have to su pply m ore o their cu rrency, th e will in crea se.
ru piah, in the oreign exchange market to bu y th e necessary
I nvestm en t f ows in clu d e portolio investm ents (the bu ying and
d ollars they need to bu y m ore im ports. Su pply o the ru piah will
selling o bond s and stocks and o other nancial assets) and
shit to the righ t to S2 as imports are now greater (M2 M1 ).
FDI , which reers to investors establishing a presence in a
As a resu lt, the ru piah will tend to d epreciate to e2 . This is a oreign cou ntry either by setting u p a new rm or by acqu iring
very interesting resu lt that is seem ingly cou nterintu itive. controlling share o an existing d om estic rm .
A growing economy may witness a d epreciatin g cu rrency.
Mu ch o these capital f ows are short term and specu lative in
n Factors that may aect trade fows include changes in natu re. Cu rrency specu lation is also inclu d ed in this section.
relative infation rates. I inf ation in a cou ntry accelerates These transactions are inclu d ed in the nancial accou nt o the
it m eans that prices in that cou ntry are rising on the balance o paym en ts o a cou ntry.
average aster than previou sly. As a resu lt, its prod u cts
Bea r in m in d that n ot a ll cou n tries have u lly libera lized th eir
will be less com petitive abroad while imported good s and
n a n cia l a ccou n t. Th is m ea n s that oreig n in vestm en t may be
services will seem m ore attractive d om estically.
con strain ed . M any econ om ies lim it th e types o oreig n
Foreign d emand or its exports will d ecrease and so will the in vestm en t f ows th ey perm it a s som e o th ese in vestm en ts
d emand or its cu rrency in oreign exchange markets. I n may prove very d estabilizin g . Sh ort-term specu lative ca pita l
ad d ition, d om estic d emand or oreign prod u cts (imported may su d d en ly be with drawn , lead in g to a su d d en sharp
good s and services) will increase, increasing the su pply o d epreciation a n d , con sequ en tly, to ad verse rea l eects on th e
its cu rrency in oreign exchange markets (as m ore oreign econ om y. Th ere is a lot o d iscu ssion on th e d esirability o su ch
exchange will be need ed to pay or these im ports). private ca pita l in f ows (reerred to also as h ot m on ies or
ootloose u n d s, or obviou s rea son s) especia lly or
d evelopin g cou n tries.
in dollars ($/rupiah)
Price of Indonesian rupiah expressed
S1 for rupiah Factors aecting cross-bord er capital f ows are explained below.
(M1 ) S2 for rupiah n Factors that may aect investment fows include changes
(M2 > M1 )
in relative interest rates. I in terest rates in a cou ntry
e1
d ecrease, then d om estic bond s as well as savings d eposits
d enom in ated in the d om estic cu rrency will be less attractive
to oreign investors. As a resu lt, not only will d emand or
that cu rrency d ecrease bu t also there will be an increase
in the su pply or that cou ntrys cu rrency as investors will
e2
sell their assets to bu y cu rrencies and bond s o other
cou ntries. The eect o lower interest rates will be a
D1 for rupiah tend ency or the cu rren cy to d epreciate.
(X1 )
D2 for rupiah
(X2 < X1 )
0
Rupiah traded per period
Figure 3.2.6 Eect o higher infation on the exchange rate
1 26
3 International economics
S1 for euros I the u tu re prospects o this growing economy are good (i, in
in dollars ($/euro)
Price of euros expressed
S of won e1
(Korean imports
and outows of
capital from Korea)
e2 D2 for TL
D1 for TL
e1
0
Turkish lira traded per period
D2 for won
Figure 3.2.9 Currency speculation and the exchange rate
D1 of won (Korean exports
I n Figu re 3 .2 .9 cu rrency specu lation increases the d emand or
and investments into Korea)
the Tu rkish Lira rom D1 to D2 , lead ing it to appreciate rom e1
0 to e2 . I n this way, expectations can oten be sel-u l lling.
Won traded per period
1 27
3 International economics
Government intervention
Fixed exchange rate systems Remember that in a fxed exchange rate system we use the
H ow does a fxed exchange rate system work? terms devaluation and revaluation.
A xed exchange rate system is dened as a system in which the The exchange rate will be maintained at the d esired level e*
exchange rate is set by the government at some desired level only i au thorities som ehow manage to in crease d emand or
(usually against a major currency, say, the US dollar) and is then the cu rrency to D2 . H ow cou ld they d o this? One obviou s
maintained at that level through intervention in the oreign option is or the central bank o cou ntry A to enter th e oreign
exchange market by the central bank. H ow is the exchange rate exchange market an d start bu ying FH u nits o its cu rrency per
maintained at the set level? What can and should the government period u sing its oreign exchange reserves, or example pou nd s
or the central bank do to maintain the rate at the desired level i, sterling or eu ros. What this really m eans is that the central
or example, there are pressures or it to devalue? bank is increasin g d emand or cu rrency A rom D1 to D2 .
H ow d o they work? To d eend the cu rrency, the central bank can also increase
interest rates. This wou ld be the next lin e o d eence as oreign
Currency A pegged
against the dollar at e* exchange reserves are lim ited and the central bank cannot go
on sellin g, or exam ple, eu ros orever to bu y its own cu rrency:
S of A rises to S2 because
ination makes imports
there will com e a point when it has no m ore eu ros let to sell.
in terms of currency B)
Price of currency A (expressed
seem more attractive, The higher interest rates in cou ntry A will attract nancial
S1 of A creating an excess capital rom abroad as d om estic bond s and d eposits in cu rrency
S2 of A
supply that will push A
below e* , unless: A will earn a higher rate o retu rn, so will be m ore attractive.
Foreigners will bu y cu rrency A in the oreign exchange market
central bank of A
starts buying HF units
in ord er to bu y cou ntry As bond s or make d eposits in cu rrency
e* H F
of A per period articially A. H igher interest rates im pose a real cost on the economy,
increasing demand for thou gh, as growth in cou ntry A will slow d own and
it to D2
u nemploym en t will increase.
or instead the central
The governm ent may also resort to o cial borrowing o oreign
D2 for A bank could increase
interest rates inducing exchange in an attempt to maintain the cu rrency at e* . This
D1 for A greater demand borrowing to d eend the cu rrency cannot con tinu e or long,
for A by investors
0 (i.e. inducing capital thou gh, as repaym ent will impose sig ni cant u tu re costs on an
Units of currency A inows). econ omy. Alternatively, the governm ent may try to lim it
traded per period pressu re on the cu rrency to d evalu e by restricting imports into
Figure 3.2.1 0 Fixed exchange rates the cou ntry and in this way restricting the su pply o its cu rrency
in the oreign exchange market.
I n Figure 3.2 .1 0 it is assum ed that currency A is pegged against, Lastly, it can also restrict access to oreign exchange, reducing the
say, the U S dollar at e* . I demand and supply orces are at D1 supply o its currency in the oreign exchange market. Exchange
and S1 the exchange rate will be at e* so there is no reason or
controls may lead to a parallel (black or shadow) market.
the authorities to intervene. Assum e now that supply or
currency A increases to S2 , perhaps as a resu lt o accelerating On th e oth er ha n d , i th ere a re orces pu sh i n g u p th e
dom estic infation which induces residents to switch to m ore cu rren cys va l u e th e cen tra l ba n k wi l l sell i ts cu rren cy, bu yin g
attractive imports. As m ore o the currency will be supplied in U S d olla rs i n th e oreig n excha n g e m a rket, or i t m ay l ower
the oreign exchange market (supply o A, say, shits to S2 ) there d om esti c i n terest rates. N ote that both opti on s in crea se th e
will be excess supply or the currency equal to FH per period at m on ey su pply, so m ay lea d to a ccelerati n g in f ati on a ry
e* , putting pressure on the currency to devalue. pressu res in cou n try A.
1 28
3 International economics
Managed exchange rate systems On the other hand, keeping the currency overvalued may be part
Managed foat o a policy to com bat infationary pressures. Export demand,
I n a managed exchang e rate system the govern m ent tries to which is part o aggregate demand (AD), will decrease, cooling
d ecrease exchange rate m ovem ents withou t keeping exchange o the economy. I n addition, cheaper imports also help. First,
rates rigid ly xed . The central bank period ically intervenes i the cost o living o the popu lation is lower (as the typical
au thorities consid er the exchange rate m oving in a d irection or consum ers basket o goods includ es imports). Also, it orces
a speed that is consid ered u nd esirable. U su ally there is an dom estic import-competing industries to cut costs, increasing
implicit targeted band within which exchange rate m ovem ents their eciency and keeping their own prices low. Lastly,
prod uction costs o dom estic rm s using imported inputs remain
are consid ered acceptable, bu t it is not annou nced .
low. With infation contained, the country can keep interest rates
I ntervention involves bu ying and selling the cu rrency in oreign low, which spu rs investm ent and growth. These are som e o the
exchange markets or o manipu lating interest rates to ind u ce benets the U S economy has enjoyed as a result o the U S dollar
the d esired capital f ows, as d escribed earlier when d iscu ssing being overvalu ed in relation to the Chinese yuan (as the Chinese
xed exchange rates. have been accused o keeping their currency undervalued). U S
Maintaining disequilibrium exchange rates export demand may have been hurt but there have been also
som e very signicant side-bene ts that cannot be overlooked.
Keeping the currency overvalued
Sometimes countries try to keep the exchange rate o their currency Keeping the currency undervalued
overvalued. This means that they try to maintain it at a level above Som etim es cou ntries try to keep the exchange rate o their
the ree market equilibrium level. Why would policy makers decide cu rrency u nd ervalu ed . This m eans that they try to maintain it at
on something like this and what are some o the consequences? a level below the ree market equ ilibriu m level. Why wou ld
M any d eveloping cou ntries have in the past tried to keep their policy makers d ecid e on som ething like this and what are som e
cu rrency overvalu ed as part o an im port su bstitu tion strategy o the consequ ences?
which will be explained in m ore d etail later. The basic id ea is An u nd ervalu ed cu rrency au tomatically im plies cheaper exports.
that they were trying to shit ou t o agricu ltu re and into This is the biggest ad vantage o su ch a policy. The oreig n price
manu actu ring by su bstitu ting d om estic prod u ction or imports. o a cou ntrys good s and services is pu shed lower. Exports gain
They erected trad e barriers to protect their inant ind u stries a competitive ad vantage. The increased export penetration an d
and at the sam e tim e kept their exchang e rate overvalu ed . This resu lting export revenu es increase AD and , throu gh the export
sou nd s absu rd becau se when the exchang e rate increases then m u ltiplier, accelerate growth. Und ervalu ed cu rrencies have
imports becom e cheaper. Bu t the goal was to lower the price o sign i cantly contribu ted to the spectacu lar exportled growth
imported machines and other inpu ts (that is, the price o
that several d evelopin g cou ntries have ach ieved .
capital good s and raw materials that wou ld d ecrease the
prod u ction costs o the new ind u stries). The trad e barriers Su ch a bene t d oes have its costs. First, the export su ccess rom
wou ld be u sed to keep ou t o the cou ntry any good s that cou ld keeping the cu rrency u nd ervalu ed creates trad e rictions with
be consid ered su bstitu tes in the eyes o d om estic bu yers, trad ing partners. One cou ntrys export su ccess m eans that
allowing the growth o the d om estic inant ind u stries. import-competing ind u stries o the trad ing partner will su er
and the d istress cau sed will increase the cries or retaliation
This may make sense but at the same time the overvaluation o and trad e protection. Another risk o su ch a policy is that it
the currency acted as a tax on exports because exports became may resu lt in inf ationary pressu res. To keep the cu rrency
more expensive abroad. In the case o traditional primary export u nd ervalu ed in the ace o growing export d emand requ ires
commodities (or example coee) or which the price was massive selling o a cu rrency in the oreign exchange market. To
determined in commodity markets and was quoted in US dollars, keep the yu an u nd ervalu ed , China m u st sell yu an bu ying U S
armers earned ewer units o domestic currency or each US dollar d ollars. The resu lting increase in the m oney su pply may prove
o their exports as a result o the overvaluation. The bottom line inf ationary and in the lon g term u nd erm ine the export su ccess
was that an overvalued exchange rate hurts the export sector. and growth o the cou ntry.
1 29
3 International economics
Comparing and contrasting fexible and xed n Governm ents lack the policy d iscipline that a xed
exchange rates exchange rate system imposes. A cou ntry may thereore be
m ore prone to inf ation. For example, easy m onetary policy
I n general, the ad vantages o one system can be consid ered to accelerate growth cou ld be m ore easily ad opted by a
d isad van tages o the other. governm ent even i it m eans that the resu ltin g growth will
Advantages o fexible exchange rates be inf ationary.
n Policy makers are ree to u se m onetary policy. For example,
they can u se easy m on etary policy to boost th e economy as Disadvantages o exible exchange rates: summary
not only is the cu rrency allowed to d epreciate bu t Disadvantages increased uncertainty hurts trade and
d epreciation may lead to an increase in net exports, a o exible cross-border investment fows.
com ponent o AD. exchange rates a government may be more prone to adopt
n A trad e (m ore generally, a cu rrent accou nt) d e cit or are that infationary policies or short-term gains.
su rplu s may be au tomatically corrected . A trad e d e cit
im plies that m ore o the cu rrency is su pplied than Advantages o fxed exchange rates
d eman d ed in the oreign exchange market. The excess n Less u n certainty and exchange rate risk m eans that rm s
su pply will d epreciate the cu rrency and , assu m ing proper engaged in in tern ational trad e can easier pred ict th eir
elasticities, the valu e o exports will rise and import export revenu es or import bill. Portolio investors avoid
expend itu res will drop. There is thereore less need or the exchange rate risk which cou ld lower their retu rn rom any
governm ent to ad opt costly contractionary d eman d -sid e investm ent. A xed exchange rate regim e may even lead to
policies which slow d own growth and increase m ore FDI as the valu e o repatriated pro ts d epend on
u nemploym ent i there is a wid ening trad e d e cit. exchange rate m ovem ents. This will m ean that the volu m e
n Exchang e rate ad ju stm ents throu gh tim e are u su ally o exports and im ports is higher and m ore cross-bord er
sm ooth and continu ou s, so cu rrency crises are avoid ed . investm ents will resu lt.
n On the one hand , there is less specu lation as there is no n Since infation is not compatible with a xed exchange rate
exchange rate target that may be perceived by specu lators system, governments cannot easily pursue expansionary scal
as u nd am entally u nd ervalu ed or overvalu ed and thereore policy that may prove infationary: xed exchange rates impose
eventu ally impossible to d eend . Bu t, i the u nd am entals o scal discipline on governments. In addition, rms are orced
an economy (or example inf ationary pressu res) point to a to be ecient and keep their costs and prices down to
weakening cu rrency, specu lators may start selling th e maintain whatever competitive advantage they have.
cu rrency en masse, lead ing to a u nnecessarily sharper n Fixing the exchange rate has oten been a policy choice or
d ecrease in its valu e. governm ents d eterm ined to cu rb inf ation in high-inf ation
n There is less need or the central bank to carry large oreign econom ies.
exchange reserves as there is no need or it constantly to
intervene to maintain the exchange rate at a xed parity. Advantages o fxed exchange rates: summary
there is less uncertainty and exchange rate risk
Advantages o oating exchange rates: summary increases the volume o trade and cross border
policy makers can use monetary policy to Advantages o investments.
achieve domestic goals. fxed exchange policy discipline on governments as infationary
trade imbalances are in principle automatically rates are that growth is not an option.
Advantages o corrected. they provide a policy option to curb high
oating infation.
exchange rate adjustments are smooth and
exchange rates
continuous.
are that
typically, less speculation exists. Disadvantages o fxed exchange rates
n The governm ent is d eprived o m onetary policy as a tool to
there is less need or the central bank to keep
oreign exchange reserves. aect d om estic econom ic activity. M onetary policy may be
u sed only to ensu re that th e exchange rate remains xed .
Disadvantages o fexible exchange rates n The governm ent is also d eprived o exchange rate policy to
n Since in a foating system the exchange rate bobs up and d eal with d om estic objectives.
down, oten in an very unpredictable manner with any world n Even the u se o ref ationary scal policy is constrained as
economic or political development capable o aecting it, bu d get d e cits need to be som ehow nanced and a
there is a lot o uncertainty in the oreign exchange market. nancing a large bu d get may lead to either a aster growth
Exporters and importers as well as investors ace signicant in the m oney su pply or hig her interest rates.
exchange rate risks against which they can only partially n Devalu ation or revalu ation can prove d isru ptive as they
hedge. As a result, both the volume o international trade in imply an abru pt realignm ent o th e cu rrency.
goods and services and the volume o cross-border portolio
n To avoid the need to resort to d evalu ation a trad e d e cit
investments are negatively aected. Smaller rms especially,
m u st be corrected by ad opting contractionary scal policy
with ewer resources available to protect themselves against
to lower national incom e and import absorption. Bu t this
such risks, will drop out o the market.
m eans slower growth or even ind u cing a recession with
u nemploym ent increasing.
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3 International economics
n Central banks m u st maintain large oreign exchange market and maintain the parity. This involves a high
reserves to be able to intervene in the oreign exchange opportu n ity cost as reserves earn either no or low interest.
Disadvantages o fxed exchange rates: summary
the government cannot use monetary policy to achieve domestic goals.
the government is deprived o an exchange rate policy.
the use o expansionary fscal policy is restrained as fnancing a defcit may aect the money supply
Disadvantages o fxed or interest rates.
exchange rates are
exchange rate adjustments are abrupt and potentially disruptive.
trade defcits are not automatically corrected requiring use o painul contractionary fscal policy.
the central bank may maintain large oreign exchange reserves.
Purchasing power parity (PPP) PPP theory may be helpu l to orecast the lon g-ru n valu e o a
cu rrency bu t its u seu lness to pred ict short-ru n variations is very
Econom ists oten use the concept o PPP to help predict long-run
strongly d ou bted . N ot only will it take a long tim e or the
m ovem ents in the oreign exchange value o a currency. PPP is a
equ ilibriu m valu e as d e ned to be reached bu t, in ad d ition,
m easure o the equilibrium value o a currency, dened as the
there are many oth er econ om ic orces that may keep the valu e
exchange rate towards which the currency will m ove over tim e.
The PPP rate is the rate that will equate the cost o purchasing away rom equ ilibriu m .
the sam e basket o goods in two countries. Overall, empirical su pport or PPP is m ixed , as exchange rates
d o not n ecessarily m ove toward s their long-ru n equ ilibriu m
I a currencys market exchange rate is presently below its PPP
valu e. Why? The basket o good s and services consu m ed by the
value, PPP advocates will argue that the currency is undervalued
typical con su m er in each cou ntry d iers su bstantially and also
and will thereore tend to appreciate in the uture. For example,
inclu d es non-trad ed good s (su ch as haircu ts or real estate). I
consider a basket o goods and services purchased by the typical
given the market exchange rate, real estate is cheaper in the
consumer in two countries. Assum e that it can be bought in
other cou ntry we cannot import land , bu ild ings and hou sing
Europe (EU 1 7 ) with 1 00.00 whereas one needs $ 1 60.00 to
rom it. Trad e barriers and transport costs also d ecrease the
buy it in the U SA and that the market exchange rate is 1 .00 5
scope o trad e bu t, m ost importan tly, exchange rates are highly
$ 1 .47. One may argue that the dollar is overvalued and will tend
to depreciate (or, equivalently, that the euro is undervalued and inf u enced by capital f ows.
will tend to appreciate). An Am erican could go to the oreign PPPs are still u sed as conversion actors. PPPs shou ld be u sed
exchange market and purchase 1 00.00 with only $ 1 47.00 and instead o market exchange rates as conversion actors (to a
buy the sam e basket o goods and services in Europe or which single cu rrency, u su ally th e U S d ollar) o GN I and per capita
he or she would need $ 1 60.00 to buy in the U SA. The theory GN I gu res, in ord er to incorporate cost o living d ierences
thereore suggests that in such a case U S imports o goods and that will make cross-cou ntry com parisons o these variables
services will rise. But, as m ore U S dollars will be oered in the m ore m eaningu l. Care shou ld be taken that the PPP valu e u sed
oreign exchange market to buy the necessary euros, the U S in the conversion accu rately ref ects recent and tru e cost o
dollar will be pushed down (and the pushed euro up) until the living d ierences.
U S dollar alls (the euro rises) to 1 .00 5 $ 1 .60.
1 31
3.3 The balance o payments
The balance o paym ents is d e ned as a record o all rom the sale o goods and services is greater or smaller than
transactions o a cou ntry with the rest o the world over a import expenditures on goods and services over a period then
period o tim e, u su ally a year. we have a current account surplus or de cit respectively.
Transactions which lead to an inf ow o cu rrency en ter the
accou nt with a plu s sign and are known as cred it item s whereas The capital account
those that lead to an ou tf ow o cu rrency enter with a m inu s The capital accou nt inclu d es the ollowing.
sign and are called d ebit item s. n I t inclu d es capital transers receivable and payable, su ch as
The balance o paym ents is d ivid ed into three major the provision o resou rces or capital pu rposes by one party
components, the cu rrent accou nt, the capital accou nt and the withou t anything o econom ic valu e being su pplied as a
n ancial accou nt. The su m o these by constru ction equ als zero. d irect retu rn to that party. Debt orgiveness is also inclu d ed
The balance o paym ents balances. in capital transers.
For the same reason a households monthly budget must balance: n I t also inclu d es the acqu isition and d isposal o non-
Assume Zoi earned $2,000 and spent $ 2,300 in January. This is prod u ced , non- nancial assets su ch as sales and pu rchases
not possible unless she drew on her savings and/or borrowed a o intangible assets (patents, copyrights, trad emarks,
total o $ 300. I these $ 300 dollars are added to her income then, ranchises and leases, etc.).
since all her expenditures were necessarily somehow nanced, her
budget or January was balanced. I more currency fowed out o a Typically, the capital accou nt is small and o m inor importance.
country to pay or imports and investments than fowed in rom
exports and investments then this dierence must have been The fnancial account
somehow nanced. Foreign exchange reserves decreased and/or The nancial accou n t inclu d es investm ents and assets, as
ocial borrowing took place in sucient amounts to balance her ollows.
external account. n FDI exists when a resid ent in one cou ntry acqu ires control
or a sig ni cant d egree o inf u ence on the manag em ent o
The current account a rm in another economy. I t m ostly reers to m u ltin ational
The cu rren t accou nt inclu d es the ollowing three accou nts. corporations.
n The goods and services account which inclu d es exports n Portolio and other investments reer to the acqu isition
and imports o good s (physical m erchand ise) and exports and sale o stocks and bond s as well as changes in loans
and imports o services. The d ierence between export and d eposits. When a resid ent o Egypt bu ys stocks o
revenu es and import expend itu res is the balance o trad e in Tu rkish companies or bu ys Tu rkish bond s then an ou tf ow o
good s and the balance o trad e in services respectively. m oney is record ed in the Egyptian nancial accou nt and an
Trad able services inclu d e transport, constru ction, postal and equ al inf ow o m oney in the Tu rkish on e. N ote that the
cou rier services, insu rance and pension services, nancial next year, when the Egyptian resid ent receives d ivid end s
services, com m u nication services, compu ter services, and interest paym ents rom the investm ents, the inf ow o
personal and bu siness travel, etc. m oney will be record ed in the Egyptian cu rrent accou n t as
n The primary incom e account which inclu d es the a receipt o in com e and the equ al ou tf ow o m oney in the
d ierences between primary incom e received rom abroad Tu rkish cu rrent accou nt as a paym ent o incom e.
and payable abroad . Primary incom e inclu d es pro ts, n Reserve assets (ofcial reserves) inclu d e assets that the
interest and d ivid end s (PI Ds) rom portolio and d irect central bank hold s to nance balance o paym en ts n eed s
investm ents, compensation o employees (wages and and to intervene in the oreign exchange market in ord er to
salaries) and the retu rn s rom renting natu ral resou rces (or aect the exchange rate.
example rom granting shing, grazing, m ining, and orestry The cu rrent accou nt is equ al to th e su m o the capital and
rights). N ote that this d ierence (net incom e rom abroad ) nancial accou nts. I t is th e inclu sion o changes in reserve
is what d istingu ishes GDP rom GN I in macroeconom ics. assets (that is, in o cial reserves that orce the balance o
n The secondary income (or current transers) account which paym ents always to balance). I t wou ld be impossible over a
includes unilateral current transers with nothing received in speci c period o tim e (say, a year) or m ore cu rrency to f ow
return, or example workers remittances, donations, transers out o a cou n try than had f owed in the sam e period u nless
related to international cooperation between governments som ehow this d e cit was nanced : either by drawing on oreign
(such as receipts and paym ents to EU institutions), ood aid exchange reserves and /or by o cial borrowing. Since we ad d
and emergency aid ater natural disasters. the nan cing o a d e cit as a d ecrease in oreign exchange
reserves assets (and /or as o cial borrowing) in the nancial
The sum o net exports o goods and services, net incom e and accou nt, the balance o paym ents accou nt will necessarily
net current transers over a period is d ened as the current balance. Con versely, i over a period m ore cu rrency had f own
account balance. I this is positive we say that there is a current into a cou ntry than f own ou t o a cou ntry then o cial reserves
account surplus. I it is negative we say that there is a wou ld in crease and /or o cial lend ing wou ld take place or th e
current account decit. I we ocus only on the exports and
overall balance o paym ents to balance.
imports o goods and services we can say that i export revenu es
1 32
3 International economics
U n ortu n a tel y th ere a re a l wa ys errors a n d /or om i ssi on s. a poten ti a l probl em i i t i s wi d en i n g a n d exceed s between
N ot on l y i s esti m a ti on o cred i ts a n d d ebi ts i n to a n d ou t o a 5 % a n d 6 % o th e cou n trys G DP.
cou n try i m preci se bu t th ere a re a l wa ys u n record ed i l l eg a l I t also d epend s on the reason s or which it exists. More
cross-bord er a cti vi ti es, or exam pl e i n vol vi n g d ru g s or speci cally it d epend s on whether it is temporary or persistent
wea pon s. As a resu l t, th e ba la n ce o pa ym en ts a ccou n t d oes (also reerred to as u nd am ental).
n ot ba la n ce d espi te th e i n cl u si on o th e o ci a l n a n ci n g
Tem porary d e cits are short term being either o a transitory
(reserves) i tem . To ba la n ce th e a ccou n ts a rti ci a l l y th e
natu re (or example becau se o a crop ailu re) or o a reversible
ba la n ci n g i tem i s i n cl u d ed wi th th e sam e m a g n i tu d e bu t
natu re (or example as a resu lt o a boom ing economy). I n the
th e opposi te si g n o th e error i tem . I th e ba la n ci n g i tem
latter case, a short-term cu rrent accou nt d e cit implies an
i s la rg e th en th i s i s a n i n d i ca ti on o poor d a ta col l ecti on
im provem ent in living stand ard s as the nation is consu m ing
a n d sta ti sti ca l servi ces a n d /or o i l l eg a l sa l es or pu rch a ses.
m ore than it is prod u cing. A strong and growing econom y
Is a current account defcit a problem? typically record s trad e d e cits as a resu lt o the increased
As explained earlier, a rising cu rrent accou nt d e cit will exert im port absorption (assu m ing o cou rse that growth was n ot
pressu re on the exchange rate to d epreciate (in a f oating export led in the rst place, as in the case o, say, China). Also,
exchange rate system ) or d evalu e (in a xed system ). Why? a d eveloping economy in the process o establishing certain
Becau se rising oreign import d emand m ean s that resid ents are ind u stries may initially be orced to rely on imported capital
oering in the oreign exchange market m ore o th eir cu rrency good s, lead ing to trad e d e cits.
while d ecreasing export revenu es m eans that oreigners are On the other hand , u nd am ental or persistent im balances are
d emand ing less o the cu rrency in the market. I su pply o a ch ronic. They tend to last or a long tim e and they are the
cu rrency increases and /or d emand or it d ecreases the cu rrency resu lt o stru ctu ral problem s o the economy. These are ind eed
will tend to d ecrease in valu e. seriou s as they ref ect a sick econ omy. To u nd erstand the issu e,
Beyon d th i s eect on th e exch a n g e ra te th e q u esti on consid er an economy with chronic inf ation, u ncompetitive
rem a i n s wh eth er a cu rren t a ccou n t d e ci t i s or i s n ot a prod u ct markets an d rigid labou r markets. Export
probl em . Th e a n swer i s i t d epen d s. Fi rst o a l l , i t d epen d s on com petitiveness will be erod ed and export revenu es will shrink
th e si ze o th e d e ci t. To d eterm i n e th e i m porta n ce o a while spend ing on im ports will in crease as many d om estic
cu rren t a ccou n t ba la n ce (d e ci t or su rpl u s) we a l ways express hou sehold s will tu rn to better and cheaper imports. A
i t a s a proporti on o G DP so th a t th e si ze o th e econ om y i s balloon ing cu rrent accou nt d e cit will resu lt.
sca l ed ou t. Typi ca l l y a cu rren t a ccou n t d e ci t i s con si d ered
HL Implications o a persistent current On the other hand , borrowing in volves u tu re repaym ent o
account defcit the capital plu s interest. This implies that in the u tu re
part o national incom e m u st be d iverted away rom
A cu rren t accou nt d e cit m u st be som ehow n anced and d om estic u ses toward s the repaym ent o past borrowing.
it is this nancing that may create u tu re problem s in the This incom e cou ld have been u sed to nance increased
economy. The bottom line is that the economy is not consu mption expend itu res, increased investm ent
earning enou gh oreign exchange rom its exports and expend itu res or increased governm ent spend ing on, say,
incom e earnings rom abroad to nance its imports. social capital ormation. I n ad d ition, since repaym ent o
Ru nning d own oreign exchang e reserves may only su ch borrowing m u st be mad e in oreign exchang e it
continu e or short period s o tim e becau se these reserves m eans that u tu re oreign exchange earnings rom exports
are lim ited . The remaining options are ew. A su rplu s is will need to be d iverted away rom the pu rchase o imports
requ ired in the com bined capital and nancial accou nts o consu m er and capital good s. I the economy is not
and it may resu lt either rom the sale o d om estic assets growing ast enou gh to nance these obligations then
(su ch as bu sinesses, stocks or property) to oreigners or these d evelopm ents will jeopard ize any u tu re growth
rom borrowing rom abroad . prospects o the economy. Living stand ard s o the
Selling assets requires willing buyers. Bu yers are willing to popu lation will d ecrease. Also, i the lend ing is o a
buy dom estic assets i the u ture prospects o the economy short-term natu re (rom hot m oney inf ows) then there is
look good and/or i the selling price is exceptionally low. I the risk o a su d d en exod u s o th is capital with the
the uture growth prospects o the economy look good then resu lting sell-ou t sharply d epreciating the cu rrency.
the sale o assets does not have to signal a problem . For More importantly, a m ou ntin g oreign d ebt creates
example, oreigners will buy shares or acquire companies snowballin g eects on an economy. Foreigners will be
because they expect growth in sales and thereore high willin g to lend only at higher and higher interest rates to
dividend s and high prots. But since we are d iscussing here com pensate or the ad d ition al risk they ace. H igher
a persistent current account de cit problem , any sale o interest rates imply su rging interest costs thou gh,
assets m ust be a result o very low sale prices. The assets worsening th e oreign d ebt problem . As the risk o the
sold to oreigners can be both sizeable and o signicance cou ntry d eau lting increases, its cred it rating by
(or example sale o signi cant natural resources, sale o international cred it rating ag en cies su ch as M ood ys cou ld
banks or o large industries) so such a developm ent carries be d owngrad ed . This tighten s th e squ eeze on the cou ntry
the threat o loss o econom ic sovereignty. as su ch a d evelopm ent will u rther increase interest rates.
1 33
3 International economics
I t shou ld be clear that an u n su stainable cu rrent accou nt Alternatively, policy makers cou ld in stead resort to trad e
d e cit cannot and will not last orever. Som e ad ju stm ent protection which will rend er imports m ore expensive. Taris
process eventu ally will restore balance. Bu t ad ju stm ent may and qu otas, or exam ple, increase the price o imports and
be abru pt and very u npleasant. Correcting a cu rrent accou nt lower import spend ing. Dom estic hou sehold s and rm s will
d e cit may requ ire expend itu re-red u cing or expend itu re- su bstitu te d om estic prod u cts or imports, d ecreasing the
switching policies an d /or su pply-sid e policies. cou ntrys import bill.
Su ch protectionist policies create trad e rictions and invite
Methods to correct a persistent current retaliation rom aected exporting nations. I n ad d ition, they
account defcit ru n again st WTO m em bership ru les. I they are implem ented
Expenditure-reducing policies then ine ciency increases as resou rces are m isallocated . The
These inclu d e policies that d ecrease the level o AD. The goal cou ntry su ers the costs o trad e protection.
is to red u ce the level o national incom e and so d ecrease N ote that certain expend itu re-red u cing policies may also end
spend ing on im ports. u p switching expend itu res. For example, a tight m onetary
Policies that d ecrease the level o AD inclu d e contractionary policy will d ecrease national incom e and so d ecrease
scal policy and tight m onetary policy. Since th e d ecrease in im ports, ind u ce capital inf ows which cou ld help nance the
AD will also d ecrease inf ation, the export sector may bene t cu rren t accou nt d e cit bu t also d ecrease inf ation, lead ing to
rom increased competitiven ess. All in all, shrinking imports increased international competitiveness. On the other hand ,
and perhaps rising exports will help narrow the cu rrent it may lead to an appreciation o the cu rrency, hu rting
accou nt d e cit. exporting ind u stries.
N ote thou gh that su ch an ad ju stm ent policy com es at a high Supply-side policies
cost. Growth will su rely slow d own or even tu rn negative. Solu tions o a m ore long-ru n natu re inclu d e certain su pply-
I ncom es and ou tpu t will d ecrease. Firm s will contract or shu t sid e policies aim ing at increasing the com petitiveness o the
d own and u nem ploym ent will su rge. economy and especially o the export sector. Rem em ber that
a persistent cu rrent accou nt d e cit may be a resu lt o
Expenditure-switching policies
u ncompetitive prod u ct markets characterized by a h igh
These are policies aim ing at switching spend ing away rom
d egree o m onopoly power and o rigid labou r markets with
im ported good s and services toward s d om estically prod u ced
hig h labou r costs and low labou r prod u ctivity. Su pply-sid e
good s and services. To ind u ce su ch a switch, imports have to
policies can prove u seu l to restore the competitiveness o an
becom e m ore expensive and thereore less attractive.
ailing economy and cu re a u nd am en tal d isequ ilibriu m in the
A d evalu ation (or a rapid d epreciation) o the exchange rate cu rren t accou nt.
is one su ch policy choice. I the price o a cu rrency d ecreases
On the other hand , su pply-sid e policies have their drawbacks,
then oreign good s and services (imports) becom e m ore
expensive in d om estic cu rrency. I n ad d ition, exports will which have been d iscu ssed earlier (see page 1 08).
becom e ch eaper abroad and may rise in valu e. Both eects
will tend to correct the oreig n d e cit. Policies to correct a persistent current account defcit: summary
A potential risk o a rapid d epreciation or d evalu ation o the include policies that decrease AD,
Expenditure-reducing
cu rrency is that inf ation may accelerate. Why? First, a rise in or example contractionary scal
policies
and monetary policies.
export d emand will tend to increase AD, shiting it to the
right. The rapid d epreciation will also increase im port prices include devaluation, as well as
Expenditure-switching
and increase the cost o living. I this d evelopm ent initiates a increased trade protection that
policies
rise in wages then a wage-price inf ationary spiral may ollow. renders imports more expensive.
I n ad d ition, d om estic prod u ction processes that requ ire the include decreasing domestic
u se o im ported raw materials and /or interm ed iate prod u cts monopoly power, increasing labour
Supply-side policies
will experience an increase in their prod u ction costs so market fexibility and improving
cost-pu sh inf ation may ollow. incentives.
1 34
3 International economics
HL Is a current account surplus a problem? growth this may pose a seriou s risk. The d e cit cou ntry may
su d d enly ad opt highly protectionist policies, blockin g ou t
Rem em ber a cu rrent accou nt su rplu s exists i the su m o net
imports which cou ld grind growth o the exporting su rplu s
exports o good s and services plu s net incom e and net cu rrent
transers is positive. I t is acceptable, even th ou gh not strictly cou ntry to a halt.
speaking correct, to say that it exists when export revenu es I t is also argu ed that i the cu rrent accou nt su rplu s is the resu lt
rom the sale o good s and services over a period o tim e o trad e barriers erected in key markets o the econ omy then the
exceed s the im port bill. su rplu s cou n try is not u lly exploiting its comparative
I n general, one may argu e that i the su rplu s is small or ad vantage and is ine ciently employing its scarce resou rces.
transitory it is not consid ered an issu e. Also, i it is part o a On the other hand , given that comparative ad vantage is not a
growth and d evelopm ent strategy known as export-oriented static bu t a d ynam ic concept that cou ntries can, and shou ld try
growth its bene ts may exceed its costs bu t, still, a persistent to change, this argu m ent is signi cantly weakened . The trad e
cu rrent accou nt su rplu s d oes involve risks or an economy protection policies employed may help the cou ntry d evelop
which shou ld be ad dressed . competitive ind u stries.
First, a persistent su rplu s implies that the economy is Perhaps the m ost seriou s problem associated with a persistent
consu m ing insid e its prod u ction possibilities. From a static and wid ening cu rrent accou nt su rplu s is that it pu ts pressu re on
point o view th is implies that living stand ard s are lower than the exchange rate to appreciate. This is even m ore seriou s i the
they need be bu t rom a d ynam ic point o view this argu m ent trad e su rplu s is m ostly d u e to one export, or exam ple oil or
may be tu rned on its head . Foreign markets can and have natu ral gas. The appreciation m eans that all other exports
proved an engine o long-ru n growth and d evelopm ent or becom e less and less competitive in oreign markets and as
many cou ntries. The m ost prom inent recent examples inclu d e resu lt su er (this is reerred to as the Du tch d isease). On the
Japan, the ou r East Asian Tigers (H ong Kong, Taiwan, other hand , the appreciation pu ts pressu re on rm s to cu t d own
Singapore and Sou th Korea), Malaysia, Thailand , Vietnam and , on waste and becom e m ore e cient.
o cou rse, China and I nd ia. Lastly, i the cu rrent accou nt su rplu s is the resu lt o the cou n try
M ore im portantly, large bilateral trad e su rplu ses carry the risk o keeping its cu rrency u nd ervalu ed then , as explained earlier, the
retaliatory protection ist m easu res by the d e cit cou ntry. To the cou ntry ru n s th e risk o inf ation.
extent that the su rplu s cou ntry relies on oreign d emand or its
HL The Marshall-Lerner condition and The proo need s som e elem entary calcu lu s bu t this may serve to
the J-curve eect illu m inate the cond ition.
Devalu ation im plies that the oreign price o exports d ecreases I we express the German trad e balance in U S d ollars, then a
and the d om estic price o im ports increases. This o cou rse sharp d epreciation o the eu ro will make U S Abercrom bie and
assu m es that the d om estic price o exports d oes not change nor Fitch shirts pricier in eu ros even thou gh their U S d ollar price is
d oes the oreign price o imports. So i, or example, Germany constant. Let PED(M ) 5 0 so that exactly the sam e qu antity o
exports BM W cars to the U SA and imports Abercrom bie and Abercrom bie and Fitch shirts is bou ght in Germany. With their
Fitch shirts rom the U SA, we are assu m ing that the eu ro price U S d ollar price the sam e and the qu antity d emand ed and
o BM W cars d oes not change nor d oes the U S d ollar price o imported the sam e, im port expend itu res expressed in U S d ollars
an Abercrom bie and Fitch shirt. will necessarily remain the sam e.
With exports more competitive abroad and imports less attractive Germanys trad e balance will im prove i export revenu es
domestically, we expect that export revenues will increase and (expressed in U S d ollars) increase. Since the d epreciation o the
import expenditures will decrease. So i a country has a current eu ro mad e the U S d ollar price o BM W cars in N ew York lower,
account decit this will improve. Such a development rests though Germanys export revenu es in U S d ollars will increase i the
on the size o the PED or exports and the PED o imports. Why? qu antity o cars d emand ed by Am ericans increase by
Because the behaviour o revenues and expenditures when price proportionately m ore, so that PED(X) 1 .
changes depends on PED. The su m o the two elasticities wou ld thereore exceed 1 . I t
ollows that i the M arshall-Lerner cond ition is satis ed then the
The Marshall-Lerner cond ition states that or d evalu ation or a
German trad e balance, ollowing a sharp d epreciation o the
sharp d epreciation o a cu rrency to improve, a cu rrent accou nt
eu ro, will improve.
d e cit the su m o the PED or imports and the PED or exports
m u st be (absolu tely) greater than 1 .
1 35
3 International economics
Why are PED for exports and PED for imports low
1 36
3.4 Economic integration and trade liberalization
Regional trading blocs or agreements Dismantling o trad e-related barriers within a trad ing block will
increase competition between the rm s o m em ber cou ntries,
The regional approach to trad e liberalization reers to
which is consid ered a positive ou tcom e, bu t at the sam e tim e
agreem ents am ong governm ents o two (bilateral) or m ore
certain ine ciencies may arise as a resu lt o taris being
cou ntries to liberalize trad e. They d o this by red u cing or
lowered or elim inated only between m em bers. Rem em ber that
elim inatin g taris and other trad e barriers and perhaps
preerential trad ing agreem ents are d iscrim inatory while WTO
coord inating other trad e-related activities while keeping
m u ltilateral agreem ents are non-d iscrim inatory.
protectionist barriers with ou tsid ers. There are ou r types o
regional trad ing arrangem ents: ree trad e areas, cu stom s
Regional trading blocs: summary
u nions, com m on markets and econom ic (and m onetary) u nions.
members eliminate or agree to phase out
n Two or m ore cou ntries can orm a free trade area i taris
A ree trade area trade barriers between them but each
and non-tari barriers between m em bers are abolished or is ormed i member country maintains its own external
agreed to be phased ou t, bu t each m em ber cou ntry tari to nonmembers.
maintain s its own taris on imports rom n on-m em ber
A customs union is ree trade area members agree to adopt a
cou ntries so that no com m on trad e policy exists toward s
ormed i common external tari.
non-m em bers. N AFTA (the U SA, M exico and Canad a) are
EFTA (I celand , N orway, Liechtenstein and Switzerland ) and members o a customs union additionally
A common market
the best kn own examples. agree to permit the ree fow o actors o
is ormed i
production.
n A customs union is a ree trad e area where m em bers
ad d itionally establish a com m on tari and agree to oth er members o a common market additionally
An economic
harmonize certain macroeconomic and
trad e policies with non-m em ber cou ntries. Examples union is ormed i
regulatory policies.
inclu d e:
members o an economic union agree to
n MERCOSU R, set u p in 1 991 , in which Argentina, Brazil, A monetary union
adopt a common currency and establish a
Paragu ay and U ru gu ay are u ll m em bers is ormed i
common central bank.
1 37
3 International economics
Monetary union whatever good or service they are looking or. This increases
competition, orces ine cient prod u cers to becom e m ore
I m em bers o an econom ic u nion ad opt a single cu rrency and
e cient and prices gravitate toward s the lowest oered in
tran ser the responsibility o m on etary policy to a com m on
the u nion.
central bank then they have also established a m onetary u nion.
I n 1 999 a su bset o cou ntries o the Eu ropean Union ad opted a n Exchange rate risk and o the resu lting u ncertainty costs are
com m on cu rrency, the eu ro. The eu rozone in 2 01 1 has 1 7 elim inated . Flexible exchange rates are oten very volatile
m em ber cou ntries. and even i an exchange rate is pegged it may always
revalu e or d evalu e. This implies increased u n certainty or
Ad vantages are m ostly o a m icroeconom ic natu re and inclu d e
rm s engaged in exports and imports o good s and services
the ollowin g.
as well as or investors bu ying and selling stocks and
n There are lower transaction costs as cu rrency conversions bond s. They cannot be su re what the exchange rate will be
are not necessary. Every tim e an ind ivid u al or a bu siness at a u tu re d ate and even thou gh there are nancial
has to exchange one cu rrency or another, a ee has to be instru m ents that help them hed ge against exchange rate
paid to the bank. This cost is elim inated or any volatility they are still costly, especially or smaller rm s.
transactions within a m onetary u nion. A single cu rrency encou rages m ore trad e and a greater
n There is greater price transparency, wh ich makes volu m e o investm ent within m em ber cou ntries.
comparisons o prices o good s, services and resou rces n A grou p o cou ntries with a com m on market and a com m on
m u ch easier. Bu yers (consu m ers a well as rm s) are able to cu rrency will enjoy greater inf u ence and bargaining power
spot qu ickly the lowest price available in the market or in world aairs.
1 38
3 International economics
On the other hand , here are som e possible d isad vantages, expend itu res and taxes, the available d egrees o reed om
m ostly o a macroeconom ic natu re, o m onetary u nion. are lim ited as scal irresponsibility within a m onetary u nion
n M em ber cou ntries are d eprived o an ind epend ent can create havoc. Rem em ber that bu d get d e cits and
m onetary policy. Since there is one cu rren cy and on e central pu blic d ebts have to be nanced som ehow so that scal
bank there is one m onetary policy or all m em bers. This and m onetary policies are not ind epend ent as they may at
one size ts all approach may make thing s very d i cu lt or rst seem .
som e m em bers i bu siness cycles are asynchronou s. This is n Mem bers lose econom ic sovereignty. I a cou ntry is d eprived
a ancy term that ju st m eans that when one economy is o an ind epend ent m onetary policy, i it cannot exercise an
boom ing and overheating another may be losing steam ind epend ent exchange rate policy and i its scal nances
and abou t to enter recession. Theory d ictates that the have to be aligned with other m em bers, th en it has
orm er shou ld tighten m onetary policy, in creasing interest transerred at least part o its econom ic sovereignty ou tsid e
rates, while the latter sh ou ld loosen m onetary policy, the cou ntry. This has been a major argu m ent or many
d ecreasing interest rates. I they are m em bers o a m onetary Eu ropean Union cou ntries again st ad opting the eu ro.
u nion, m ost probably the smaller cou ntry will su er.
Advantages and disadvantages of monetary union: summary
n M em bers a re d epri ved o a n i n d epen d en t exch a n g e ra te
lower transaction costs as currency conversions
pol i cy. A cen tra l ba n k i s respon si bl e or con d u cti n g are unnecessary.
m on eta ry a n d exch a n g e ra te pol i cy. B ei n g a m em ber o a
si n g l e cu rren cy a rea d epri ves a cou n try th e possi bi l i ty to Possible greater price transparency, acilitating price
advantages of a comparisons.
d eva l u e or sh a rpl y d epreci a te i ts cu rren cy to boost i ts
exports i n a recessi on , or to d o th e opposi te i n th e a ce monetary union no exchange rate risks and associated
o m ou n ti n g i n f a ti on a ry pressu res. N ot on l y i s th ere n o include uncertainty costs.
exch a n g e ra te to m a n i pu la te between m em bers (wh en greater negotiating and bargaining power in
tra d e between m em bers i s proba bl y th e bi g g est), bu t world aairs.
on e m em ber a l on e ca n n ot i n f u en ce th e extern a l va l u e no independent monetary policy.
Possible
o th e com m on cu rren cy a s th ere i s a n i n d epen d en t
disadvantages no exchange rate policy.
cen tra l ba n k.
of a monetary limited room or independent fscal policy.
n There is lim ited room or pu rsu ing ind epend ent scal policy. union include
Even thou gh each governm ent can manipu late its own loss o economic sovereignty.
1 39
3.5 Terms of trade
HL Meaning and measurement showing that this cou ntry can import two o the machines by
The term s o trad e (TOT in the equ ations below) o a cou ntry exporting one ton o coee.
are d e ned as the ratio o the average price o exports over
the average price o imports, expressed as ind ex n u m bers Changes in the terms of trade
tim es 1 00. I the term s o trad e increase throu gh tim e it is reerred to as a
Average price of exports expressed as an index number avou rable m ovem ent (an improvem ent) in the sense that now
____________________________________________
TOT 5 Average price of exports expressed as an index number 3 the cou ntry can attain a greater volu m e o imports with the
TOT = Average price of imports expressed as an index number 3 1 00
Average price of imports expressed as an index number sam e exports (or, equ ivalently, the sam e volu m e o imports with
1 00
a smaller volu m e o exports). For example, i the price o a ton
The term s o trad e thereore m easu re the volu m e o im ports o coee increases to $ 3 0,000 then the term s o trad e
attainable by a u nit o exports. They show the volu m e o increase to 3/1 m eaning that a ton o coee bu ys three o
oreign good s that can be bou ght by a cou ntry by exporting a the machines in world markets and not ju st two.
given am ou nt o d om estic ou tpu t. They ref ect the rate at which I the term s o trad e d ecrease over tim e this is reerred to as an
one cou ntrys good s exchange or those o another cou ntry. u navou rable m ovem ent (a d eterioration or a worsening) in the
A cou ple o examples will illu strate the above points. On a sense that now the cou ntry can attain a smaller volu m e o
personal everyd ay basis, i the price o a pizza is $ 1 2 .00 and imports with the sam e exports (or, equ ivalently, the sam e
the price o a cheesebu rger is $ 2 .00 then the ratio volu m e o imports with a greater volu m e o exports). For
Price o a pizza example, i the price o a ton o coee d ecreases to $ 1 0,000
__________________ 12
5 ___ 3 6 then the term s o trad e d ecrease to 1 /1 m eaning that a ton
Price o a cheesebu rg er 2
o coee now bu ys one o the mach ines in world markets
shows that you can exchange 6 cheesebu rgers or 1 pizza. You and not two.
shou ld realize im m ed iately that even thou gh it is a ratio o An i n crea se in th e term s o tra d e (a avou ra ble m ovem en t)
prices, it shows the rate at wh ich qu antities can be exchanged . wi ll occu r i th e avera g e price o exports ri ses relativel y to th e
N ow assu m e that we are reerrin g to international trad e and price o i m ports, a n d vi ce versa . An d ecrea se i n th e term s o
that a cou ntry exports coee and imports a certain type o tra d e (a n u n avou ra bl e m ovem en t) wi ll occu r i th e avera g e
machine. Fu rther assu m e that th e price o a ton o coee is price o exports ri ses relativel y to th e price o i m ports, a n d
$ 2 0,000 and the price o these machines is $ 1 0,000 each. Th e vi ce versa . By u si n g th e word relati vel y we avoi d havin g to
cou ntrys term s o trad e are m en tion a l l th e possi ble ways that a ra cti on m ay in crea se or
2 0,000 d ecrea se in va lu e.
2 5 2
TOT 5 ______ 3 __
1 0,000 1
HL Causes of changes in the terms of trade (raw materials) will lead to an increase in the average price
One m u st be careu l as to the cau se o any change in the term s o Australian exports. Australias term s o trade will increase
o trad e as it aects the interpretation o the eects. For (assum ing no change in the average price o its imports).
exam ple, it makes a big d ierence whether export prices rise as This is a avourable m ovem ent. On the other hand , or
a resu lt o increased d emand or a cou ntrys exports, or as a cou ntries importing raw materials, their term s o trade will
resu lt o an appreciation o the exchange rate. decrease (deteriorate; experience unavourable m ovem ent)
to the extent that the average price o all imports is aected.
n Take the case o changes in the world d emand or a
cou ntrys exports or imports. I the world d emand or a n N ow lets look at changes in the world su pply or a
cou ntrys exports increases (d ecreases) then, ceteris paribu s, cou ntrys exports or imports. A change in the world su pply
its term s o trad e will increase (d ecrease): there will be a will aect the price o a prod u ct. For example, i
avou rable (u navou rable) m ovem ent. I th e world d emand technological progress or higher prod u ctivity or red u ced
or a cou ntrys imports increases (d ecreases) then, ceteris inpu t costs increase the su pply o a good that a cou ntry
paribu s, its term s o trad e will d ecrease (increase): there will exports then its price will drop and its term s o trad e will
be an u navou rable (avou rable) m ovem ent. d ecrease (worsen). N ote that we are implicitly reerring to a
cou ntry with signi cant concentration o its exports in one
Let's, consider Australia. I t predom inantly exports
or ew prod u cts or prod u ct grou ps, or example agricu ltu ral
com m odities (they make up 80% o goods it exports).
prod u cts. For importers o the prod u ct or prod u ct grou p
A su rge in the world demand or com m odities
their term s o trad e increase (im prove).
1 40
3 International economics
Or, consider a decrease in the world supply o an export (or n Changes in the relative rates o in f ation will aect the
an import). A good example is the case o commodity term s o trad e. I prices in an economy are increasing aster
agreements which aimed at restricting exports to increase than th ey are abroad , then the average price o its exports
their world price. Oil is in a similar category as the will be increasing aster than the average price o its
Organization o the Oil Producing and Exporting Countries im ports. Ceteris paribu s, this m eans that the term s o trad e
(OPEC) is a cartel which typically, but not always, restricts oil o the cou n try with the h igher inf ation are improving.
exports o members to push the world price o oil up. The n When a large cou ntry imposes taris and other trad e
terms o trade o oil exporters increase (a avourable barriers this can improve its term s o trad e. A large cou n try
movement) but given oils signicance as an energy input, the is d e ned as a cou ntry that is in a position, throu gh its
terms o trade o importing countries will decrease (worsen). d ecisions, to aect the world price o a prod u ct. Assu m e
n Changes in the exchange rate will result in changes in the that a large cou ntry imposes a tari on a prod u ct it im ports.
terms o trade. I a the external value o the currency changes The d om estic price o this prod u ct will rise bu t at the sam e
then the terms o trade are aected as export prices and tim e the resu lting d ecreased d emand or it will tend to
import prices change. For example, assume an appreciation (or, d ecrease its world price. The d ecrease in the d emand in the
in a xed exchange rate system, a revaluation). Since exports im porting cou ntry was big en ou gh to ad versely aect world
become pricier and imports cheaper, the terms o trade are d emand or the prod u ct. The large cou ntry has managed to
aected. They will increase (that is, a avourable movement im prove its term s o trad e as the average price o its imports
will take place); conversely, or a depreciation (or devaluation). has d ecreased .
Consequences o changes in the terms o trade in determ ining the eect on the trade balance. For example,
i the term s o trade o a country have increased because o an
Consequences or the trade balance in goods and services appreciation, then prices o exports rise. Exports becom e less
(current account) competitive abroad and m ore dicult to sell. The volum e o
A change in the term s o trad e will aect the trad e balance o a exports alls. The country will earn m ore oreign currency only
cou ntry as it im plies that export and /or import prices have i the volum e o exports drops by proportionately less (that is, i
changed . For example, to d eterm ine whether a trad e d e cit will the demand or its exports is price inelastic; sim ilarly or imports).
improve or wid en it is importan t to d eterm ine whether the The Marshall-Lerner condition enters this discussion.
cau se o the change in the term s o trad e has aected the
n I the su m o the Price elasticity o d emand (PED) or
average price o exports and the volu m e o exports in the sam e
exports an d the PED or imports o a cou ntry exceed u nity
or opposite d irections (or, sym m etrically, whether the average
then an appreciation will d ecrease a trad e su rplu s (that
price o imports and the volu m e o im ports have m oved in the
is, narrow it).
sam e or opposite d irections).
n On the other hand , a d epreciation wh ich lowers export
The d iscu ssion is sim ilar to the d iscu ssion in m icroeconom ics o prices and makes imports m ore expensive will d ecrease
whether an increase in th e price o a good will increase or (worsen) the term s o trad e. H owever, i the su m o the
d ecrease the revenu es o a rm . I the increased price is a resu lt PED or exports and the PED or imports o a cou ntry
o an increase in the d eman d or the good , then both th e price exceed u n ity, then the d epreciation will d ecrease a trad e
and the qu an tity (volu m e) increase, so revenu es u nam bigu ou sly d e cit (that is, narrow it).
increase. I the increased price is a resu lt o a d ecrease in
su pply (and so a m ovem ent along the d emand cu rve), then Lastly, an im port tari imposed by a large cou ntry will, ceteris
qu antity (volu m e) will d ecrease and price elasticity will paribu s, tend to improve its trad e balance as both the world
d eterm in e the answer. I d emand is price elastic then the price o the good will d ecrease and the volu m e o its imports.
increase in price will d ecrease reven u es whereas i it is price Long-term consequences
inelastic the in crease in price will d ecrease revenu es. A long-term d eterioration in a cou ntrys term s o trad e m eans
Retu rning to trad e f ows, i an improvem ent in the term s o that the cou ntry will have to export ever-increasing volu m es o
trad e is the resu lt o an increase in world d emand or th e good good s to attain the sam e volu m e o im ports. I t implies that a
then price and qu antity (volu m e) m ove in the sam e d irection, unit o its exports com mand s a smaller slice o world ou tpu t.
so export reven u es increase. A trad e d e cit (ceteris paribu s) will The d istribu tion o world incom e (ou tpu t) changes against the
narrow (or a trad e su rplu s will grow). I the improvem ent is a cou ntry experiencing the worsening term s o trad e.
resu lt o a d ecrease in world su pply that increased export prices
then qu antity (volu m e) o exports d ecreases so the eect on Terms o trade and developing countries
export revenu es (or the import bill) d epend s on PED. I it is
price inelastic, as in the case o oil, then export revenu es o Short-term fuctuations
OPEC m em bers will increase and their trad e su rplu ses will grow M any d eveloping cou ntries specialize and export a narrow set
(and the import bill o oil importers will also increase, with their o primary prod u cts, while they import m ostly manu actu ring
trad e d e cits wid ening). sector prod u cts. Su pply in the short ru n o primary agricu ltu ral
com m od ities is typically very low and can be consid ered or
A change in the term s o trade as a result o exchange rate
analytical pu rposes as perectly inelastic (that is, vertical). This
m ovem ents aects prices and volum es (quantities) o tradables
is the resu lt o the lon g tim e lags that characterize th eir
in the opposite direction, so again price elasticities are important
prod u ction. Demand or m ost com m od ities is also very price
1 41
3 International economics
inelastic as they lack close su bstitu tes. Given that ou tpu t o technological ad vancem ents in agricu ltu re and as a resu lt o
agricu ltu ral prod u cts is aected by rand om and u ncontrollable massive su bsid ies granted to arm ers in d eveloped cou ntries
actors, su ch as weather cond itions, it ollows that prices o by their governm ents.
su ch exports are qu ite volatile. On the other hand , world d emand or agricu ltu ral com m od ities
The resulting short-term fuctuations o the term s o trade o has not increased as ast. The reason or this is that incom e
developing countries exporting a narrow range o agricultural elasticity o d emand (YED) or ood prod u cts is low.
com m odities creates high uncertainty both or producers and the This long-term d ecline o the term s o trad e o many d eveloping
governm ent. Uncertainty over export prices and, consequently, cou ntries signi ed a shrinking slice o world ou tpu t and incom e
export revenues hurt planning and deter productivity, enhancing or these cou ntries to enjoy. Distribu tion o world incom e
investments as arm ers are araid that they may not be in a becam e m ore u nequ al. Developm ent based on primary sector
position to pay back any bank loans they take. exports was consid ered a d ead -end . Decreasing export earnings
Flu ctu ating export revenu es m eans that oreign exchange may orced these cou ntries to try to prod u ce m ore and m ore which,
not always be enou gh to nance the pu rchase o necessary given th e competitive stru ctu re o these markets, pu shed prices
imports o ood , capital or interm ed iate prod u cts. even lower.
Foreign d ebt paym ents may be impossible to make, requ iring Short-ru n instability and long-term d ecline in export earnings
m ore borrowing. Growth and d evelopm ent becom e even m ore were responsible or low rates o investm ent, u nstable
d i cu lt to achieve. employm ent and increased poverty, as well as environm ental
d egrad ation becau se o m ore intensive cu ltivation o land ,
Long-term deterioration d eorestation and soil erosion.
Developing cou ntries specializing in and exporting a narrow
The long-term d ecline in the term s o trad e o many d eveloping
range o agricu ltu ral com m od ities have over th e long term
cou ntries is the principal argu m ent in avou r o ind u strialization
su ered a d eterioration o their term s o trad e. World prices o
and d iversi cation. The logic behind import su bstitu tion,
su ch prod u cts have in general d ecreased over the long term
in d u strialization and export prom otion as growth and
becau se su pply has in general grown aster than d emand .
d evelopm en t strategies rests on the long-term d eterioration o
World su pply has dramatically increased , both as a resu lt o
the term s o trad e o many d eveloping cou ntries.
1 42
3 International economics: Questions
1 . Explain the gains rom trad e that a cou ntry may expect. 1 3. Distingu ish, u sing real world exam ples, between an
2 . Explain u sing appropriate d iagram s absolu te and appreciation an d a revalu ation o a cu rrency (or, between a
com parative ad vantage. d epreciation and a d evalu ation o a cu rrency).
3. Describe the possible sou rces o com parative ad vantage or 1 4. Describe a xed exchange rate system and explain the
cou ntry X. actions requ ired to maintain cu rrency X xed .
4. Describe the objectives and u nctions o the WTO as well 1 5. Explain how a man aged exchange rate system operates.
as som e o the criticism s it aces. 1 6. Ou tline (or, d escribe) the role o th e balance o paym ents.
5. Explain, u sing an appropriate d iagram , the eects on 1 7. Distingu ish between cred its and d ebits in th e balance o
d ierent stakehold ers o a tari imposed on g ood X. paym ents, illu strating with examples (rom the extract).
6. Explain, u sing an appropriate d iagram , the eects on 1 8. Explain th e ou r components o the balance o paym ents
d ierent stakehold ers o a qu ota (or, o a VER) im posed on provid ing an example rom each.
good X. 1 9. Explain th e d ierence between a cu rrent accou nt d e cit
7. Explain, u sing an appropriate d iagram , the eects on and a cu rrent accou nt su rplu s.
d ierent stakehold ers o the governm ent granting a 2 0. Explain (u sing examples rom the extract) two components
su bsid y to the d om estic prod u cers o good X. o th e capital accou nt.
8. Describe ad m inistrative (regu latory) barriers to trad e. 21 . Explain th e three (main) components o the nancial
9. Discu ss argu m ents in avou r o trad e protection. accou nt provid ing an exam ple or each.
1 0. Discu ss argu m ents against trad e protection. 2 2 . Explain th e m eaning o the expression cu rrent accou nt
1 1 . Explain, u sing an appropriate d iagram and an example, balance.
how the valu e o a cu rrency is d eterm ined in a f oating 23. Exam ine how the cu rrent and the nancial accou nts are
(f exible) exchan ge rate system . interd epend ent.
1 2 . Describe, u sing an appropriate d iagram , two actors that 2 4. Explain th e pressu re on the exchange rate o a cu rrency o
may be consid ered responsible or an appreciation/ a sizeable cu rrent accou nt d e cit (or, su rplu s).
d epreciation (or, revalu ation/d evalu ation) o cu rrency X.
1 . Com pare and contrast a xed exchange rate system with a 9. Evalu ate the eect o d ierent types o trad e protection.
f oating exchange rate system . 1 0. Evalu ate the possible econom ic consequ ences o a chang e
2 . Com pare and contrast the d ierent types o trad ing blocs. in the valu e o a cu rrency.
3. (H L only) Discu ss the real-world relevance and lim itation s 1 1. (H L only) Evalu ate the eectiveness o the policies to
o the theory o comparative ad vantage. correct a persistent cu rrent accou nt d e cit.
4. Discu ss the argu m ents in avou r o trad e protection. 1 2 . Exam ine the possible consequ ences o overvalu ed and
5. Discu ss the argu m ents against trad e protection. u nd ervalu ed cu rrencies.
6. (H L only) Discu ss the implications o a persistent cu rrent 1 3. Exam ine how the cu rrent accou nt and the nancial
accou nt d e cit. accou nt are interd epend en t.
7. (H L only) Discu ss the possible consequ ences o a rising 1 4. (H L only) Exam ine the eects o changes in the term s o
cu rrent accou nt su rplu s. trad e on a cou ntrys cu rrent accou nt.
8. Discu ss the possible ad vantages and d isad vantages o a
m onetary u nion or its m em bers.
1 43
4.1 Economic development
Dfg grwh ad d
S ecti o n 4 : D evelo pm en t eco n o m i cS
Developm ent is a m u ltid im ension al qu alitative concept that Econom ic growth, on the oth er hand , is a pu rely qu antitative
reers to an improvem ent in living stand ard s in an economy concept. Growth reers to increases in the real GDP (total
encom passing material consu mption, ed u cation and health, as ou tpu t) o an economy throu gh tim e. Growth and d evelopm ent
well as environm ental concerns. Developm ent involves poverty are related bu t at the sam e tim e very d ierent. Growth d oes not
red u ction, in creased employm en t opportu nities or the necessarily imply d evelopm ent. A cou ntry may grow withou t
ind ivid u al and a m ore equ itable d istribu tion o incom e. any d evelopm ent objective being achieved . The United N ations
Developm ent ocu ses attention on the ind ivid u al and on the Developm ent Program m e (U N DP) has d escribed ou r types o
three d im ension s o well-bein g, which are: growth to avoid , d e ned as:
health: the ability to live a long and healthy lie jobless, where employm ent opportu nities or the poor d o
n ot expand
ed u cation: the ability to read , write and acqu ire knowled ge
ru th less, where incom e inequ ality wid ens
incom e: com mand over the incom e need ed or a d ecent lie.
u tu reless, where natu ral resou rces are wasted and the
The term su stainable d evelopm ent ocu ses attention on impact on the environm ent is neglected
intergenerational equ ity alon g with environm ental, social and
voiceless, where ind ivid u al empowerm ent lags behind .
econom ic issu es. A wid ely accepted d e nition is: d evelopm ent
which m eets the need s o the present withou t comprom isin g On the other hand , d evelopm ent typically necessitates growth.
the ability o u tu re generations to m eet th eir own need s. Even thou gh som e lim ited improvem ent in living stand ard s may
A d evelopm ent process is typically consid ered u nsu stainable be achieved withou t any growth taking place, long-term
when insu cient attention is paid to the environm ental progress on the d evelopm ent ront requ ires that d eveloping
consequ ences as well as to th e resu lting changes in the cou ntries grow.
d istribu tion o in com e. I gnoring these d im ensions threatens to
reverse any progress mad e.
1 44
4 Development economics
1 45
4.2 Measuring development
Per capita income fgures Relying on per capita incom e also conceals useul
inormation on the composition o output. Two econom ies
Per capita GN I or per capita GDP represent m easu res o per
with equal per capita incom e levels may dier with respect to
capita incom e. The d ierence between GDP and GN I is that
living standards because o dierent output m ix. A country
GN I exclu d es in com es earned d om estically by oreign actors
that spends a large proportion o its GDP on, say, deence,
(which are paid abroad , or example the pro ts o m u ltinational
devotes resources there that could have been used otherwise
corporations) bu t it inclu d es incom es earn ed abroad by
in the production o pro-developm ent goods. The value o
nationals o the cou ntry. Per capita incom e gu res are
leisure, a very important good an individual may enjoy, is
compu ted by d ivid ing GN I or GDP o a cou ntry by the m id -year
not included in the calculation o GN I or GDP. As pointed out
total popu lation o the cou ntry. U su ally, per capita incom e
in Section 2 , it makes a big dierence to workers i the
gu res are in so called PPP (pu rchasing power parity) d ollars,
average working week is over 5 0 hours and they can seldom
som etim es reerred to as international d ollars, which have the
take a holiday, or i the working week is only 35 hours and
sam e pu rchasing power over GDP as a U S d ollar in the U S. The
everyone enjoys our weeks paid leave every year.
id ea behind u sin g PPP as a conversion actor, and n ot the
market exchange rate, is that cost o living may d ier Lastly, per capita incom e d oes n ot inclu d e the valu e o the
su bstantially between cou ntries and market exchange rates d o stream o services f owing rom the accu m u lated social and
not necessarily ad ju st to captu re these d ierences. other capital o an economy that ind ivid u als enjoy. Living
stand ard s at any point in tim e are n ot aected ju st by
The World Bank u ses per capita GN I to d eterm ine the
cu rrent incom e bu t also by the stock o accu m u lated
ollowing incom e classi cations: low incom e was d e ned as
wealth. For exam ple, as m entioned in Section 2 , the
$ 975 or less in 2 008; m id d le incom e was $ 976 to $ 1 1 ,905 ;
existence o a high-qu ality and ree pu blic school system
and high in com e was $ 1 1 ,906 or m ore. A u rther d ivision at
implies that hou sehold s with children may d evote m ore o
GN I per capita $ 3 ,85 5 is mad e between lower-m id d le
their incom e to good s an d services not related to ed u cation.
incom e and u pper-m id d le incom e econom ies.
This classi cation is u seu l and may provid e u s with som e Despite these and oth er shortcom ings, per capita incom e
inormation on the level o d evelopm en t o a cou ntry as there is remains the best single ind icator o d evelopm ent available bu t
a positive correlation between per capita incom e and social m u st be employed with cau tion in any analysis.
welare. Few wou ld qu estion that N orway is m ore d eveloped
than Zim babwe. Bu t since growth in per capita incom e d oes Other single indicators
not necessarily imply improved living stand ard s, classi cation Single ind icators o the level o d evelopm ent o a popu lation
based on per capita incom e is also rau ght with problem s. inclu d e the ollowing.
U sing per capita incom e may mask very signi cant d ierences H ealth-related ind icators may be u sed , su ch as health
between cou ntries. expend itu re per capita; lie expectancy at birth (years);
These are some issues to be aware o when using per capita inant m ortality (per 1 ,000 live births); m ortality o children
income gures to determine the level o development o countries. aged u nd er ve years (per 1 ,000); malnu trition prevalence,
Per capita incom e ails to incorporate incom e d istribu tion weight and /or height or age (o children u nd er ve years
consid erations. Per capita incom e is ju st a simple average old ); birth s attend ed by skilled health sta (% o total);
provid ing no inormation on whether incom e is equ itably or maternal m ortality ratio (per 1 00,000 live births);
very u nequ ally d istribu ted . im m u nization, DPT and m easles (% o children aged
U sin g per capita incom e gu res d oes not take into accou nt between 1 2 and 23 m onths); im proved sanitation acilities
the valu e o the environm ental d egrad ation oten (% o popu lation with access); prevalence o H I V (% o
associated with increased prod u ction. The pressu re on popu lation aged between 1 5 and 49 years); physicians (per
agricu ltu re to prod u ce m ore ood prod u cts is responsible or 1 0,000 people); hospital bed s (per 1 0,000 people).
soil erosion and the bu rn ing o orests. I nd u strialization is Ed u cation-related ind icators may be taken into accou nt,
also oten accom panied by massive m igration rom ru ral to su ch as literacy rate (% o people aged 1 5 years and old er);
u rban areas, lead ing to heavily pollu ted and congested m ean years o sch ooling (o people aged 2 5 years and
cities. Em issions rom ind u stry and increased energy old er); expected years o schooling (years); expend itu re per
requ irem ents also d ecrease the qu ality o lie. stu d ent, primary, second ary and tertiary (% o GDP, per
Per capita incom e gu res ail to inclu d e non-marketed capita); pu pilteach er ratio, primary; ratio o girls to boys in
su bsistence prod u ction which may be relatively signi cant primary and second ary ed u cation (%); school enrolm ent,
in som e low-incom e cou ntries. N on-marketed su bsistence primary, second ary and tertiary (%); trained teachers in
prod u ction reers to ood s and other good s and services primary ed u cation (% o total teachers).
prod u ced by a am ily or its own consu m ption . More Other ind icators inclu d e newspaper circu lation per 1 ,000
g enerally, per capita incom e gu res ail to inclu d e th e size popu lation, energy con su mption per capita, percentage
o parallel (black or shad ow) econom ies in d eveloping o GDP d erived rom each sector o the economy and
cou ntries. u rban popu lation.
1 46
4 Development economics
An excellent sou rce o cu rrent d ata on health, ed u cation and (U N DP, 2 01 0).
other d evelopm ent-related ind icators are the statistical tables at
Being an average it may conceal important d ierences within a
the en d o th e World Developm ent Report pu blished annu ally
cou ntry. Wom en and ru ral popu lations as well as the very old
by the World Bank (www.d ata.world bank.org).
and the very you ng oten su er d isproportionately bu t this is
not illu strated throu gh the H DI . I n ad d ition, environm ental
Composite indicators concerns are not ad dressed . I t is possible or a cou ntry to have
N o single ind icator is powerul enough to illustrate satisactorily a high H DI and be u nsu stain able, u nd em ocratic and u nequ al .
the complex issue o developm ent. It is thereore preerable to
N ote that three new composite ind icators were introd u ced by
rely on several indicators synthesized into a single variable.
th e U N DP in 2 01 0 captu ring m u ltid im ensional inequ ality (the
A nu m ber o com posite ind ices have been d evised . They inequ ality-ad ju sted H DI , known as th e I H DI ), gend er d isparities
in tegrate econom ic, social and even political aspects o (the gend er inequ ality ind ex) and extrem e d eprivation (the
d evelopm en t. The m ost wid ely qu oted and u sed composite m u ltid im ensional poverty ind ex).
in d icator is the hu man d evelopm ent ind ex (H DI ). The H DI
The I H DI is a m easu re o hu man d evelopm ent that takes
m easu res average achievem ents o a popu lation in term s o
into consid eration the extent o inequ ality in the cou ntry.
health, ed u cation and access to good s and services and was
Und er perect equ ality the H DI and th e I H DI are equ al.
d evised as a simple rival to GN P concentrating only on
I nequ ality in the d istribu tion o health, ed u cation and
longevity, basic ed u cation and m inimal incom e. The H DI
incom e lowers the H DI o an average person in a society
su cceed ed in challenging the hegem ony o growth-centric
below the aggregate H DI o the cou ntry (based on the
thinking (that is, it was su ccessu l in d isplacing per capita
U N DP H u man Developm ent Report, 2 01 0).
in com e as a su m mary m easu re o d evelopm ent).
The gend er inequ ality ind ex attempts to reveal d ierences
The health dim ension o the H DI is captured by lie expectancy
in the d istribu tion o achievem ents between wom en and
at birth. In 2 01 0 the indicators used to m easure progress in
m en in a cou ntry. Oten wom en and girls are d iscrim inated
education have been revised and now include the m ean years o
against in health, ed u cation and in the labou r market,
schooling o people aged 2 5 and older and the expected years
which negatively aects their reed om s.
o schooling that a child o school entrance age could expect to
receive i prevailing patterns o enrolm ent were to stay the sam e The m u ltid im ensional poverty ind ex replaces the hu man
(instead o adult literacy and gross enrolm ent rate). Access to poverty ind ex. I t complem ents m oney-based m easu res o
goods and services is m easured by per capita incom e which in poverty by consid ering m u ltiple d eprivations and their
2 01 0 has also been revised and now reers to GN I per capita in overlap. Low level o incom e is bu t one d im ension o the
PPP dollars, replacing GDP per capita. The reason or the change poverty experienced by people in many cou ntries o the
to GN I is that in a globalized world it is preerable to ocus on world poverty extend s to other d im ensions su ch as poor
the incom e o the residents o a country as this incom e may health and nu trition, low ed u cation and skills, inad equ ate
signifcantly dier rom dom estic production. livelihood s, bad hou sing cond itions, social exclu sion and
lack o participation. The m u ltid im en sional poverty ind ex
Major drawbacks o the H DI inclu d e:
shows th e nu m ber o people wh o are poor (su ering a
a reliance on national averages which conceals skewed given nu m ber o d eprivations) and the nu m ber o
d istribu tions in the variables inclu d ed within a popu lation d eprivations with which poor hou sehold s typically stru ggle.
the absence o a qu antitative m easu re o hu man reed om
1 47
4.3 The role of domestic factors in the process
of development
Domestic factors
Education and health Microcred it, on the other hand , ocu ses on making available
very small loans to the very poor, helping them to start a small
Labour productivity is dened as output per worker, or the
bu siness or expand an existing one or m eet an em ergency
quantity o goods and services a worker can produce per hour o
arising rom d isease, thet or bad weather. The pioneer o
work. It critically depends on the education, skills and training o
m icro nance is Banglad eshi econom ist Mu ham mad Yu nu s who
workers as well as on the type o capital they use in the
created the Gram een Bank several d ecad es ago. Yu nu s won the
production process. Growth in productivity is the key to long-term
N obel Peace prize or his eorts in 2 006. The N obel Com m ittee
growth which in turn is a prerequisite or developm ent.
ad opted the view that red u cing the gap between the rich and
I nvestm ents in hu man capital ormation are necessary to the poor is necessary to d ecrease conf ict in the world .
achieve higher labou r prod u ctivity, aster long-term growth and
Many m icro nance loans have been oered to wom en who
improved living stand ard s. Better health and ed u cation
have not only shown that th ey spend the m oney careu lly and
increase labou r prod u ctivity and allow ind ivid u als to have
prod u ctively bu t also that they are m ore likely to pay the loans
m ore, better and higher-paid employm ent opportu nities. Better
back. Lend ing m oney to wom en has helped them in their
ed u cation and health are also responsible or n u m erou s
empowerm ent. Their participation in su ch program m es gives
extern al bene ts (both are the m ost im portant exam ples o
them greater bargaining power and enables them to take part
m erit good s). Rem em ber too that achieving better health and
in am ily d ecision making while it also increases their m obility.
ed u cation are them selves d evelopm ent goals.
Micro nance has been consid ered to play a signi cant bu t
Appropriate technology rather lim ited role in the d evelopm ent process o nation s.
Microcred it has lately com e u nd er attack: m ost borrowers d o
Growth is necessary or any long-term progress in d evelopm ent
not appear to be clim bing ou t o poverty, and a sizable
bu t not all types o growth d o lead to d evelopm ent. The
m inority is getting trapped in a spiral o d ebt, accord ing to
technology employed d eterm ines whether any acceleration in
stu d ies and analysts ( New York Times , 2 01 1 ).
growth will translate into hu man d evelopm ent gains or not.
I n general, technologies can be d istingu ished into capital- Women and their empowerment
intensive or labou r-intensive. Capital-inten sive prod u ction
Policies that aim at improving gend er equ ity have been ou n d
processes rely m ostly on the u se o physical capital (on
to improve hu man d evelopm ent. N ot on ly will d eprived girls
machines) whereas labou r-intensive prod u ction processes rely
an d wom en bene t rom su ch policies bu t also the growth and
m ostly on the u se o labou r (on workers). Rem em ber that in
d evelopm ent process will accelerate: H u man d evelopm en t i
many prod u ction processes there is no choice: you cannot
not engend ered , is end angered .
constru ct a labou r-intensive oil re nery.
There are numerous routes through which this can be
Since in m ost d eveloping cou ntries labou r is the relatively
accomplished. Educating girls is considered one o the most
abu nd ant actor o prod u ction, it ollows that appropriate
signicant investments or a developing country as it results in
technologies are labou r-intensive. A labou r-intensive technology
even greater, gender-specic benets. An educated mother
translates to in creased employm ent and incom e generation or
will enjoy higher earning ability outside the home or each extra
the popu lation o the cou ntry and an exit rom poverty. On the
year o schooling. She will have ewer children so will create
other hand , capital-intensive technologies lead to what is
conditions or capital deepening (which means more capital will
reerred to as jobless growth, which is a type o growth that
be available per worker), resulting in even higher long-term
d oes not lead to improved living stand ard s.
productivity and output gains. H er children will be healthier and
she will make sure that her children are also educated, creating a
Credit and microcredit virtuous circle. Educating women decreases mortality in children
The im portance o cred it and m icrocred it institu tions lies in the younger than ve years old, decreasing the costs o health-care
simple act that typically, i you cannot borrow, you cannot intervention.
make any investm ent in physical, natu ral or hu man capital. I t
Lastly, better and m ore ed u cated wom en can lead to higher
ollows that a u n ctional cred it system is vital in breaking the
wom ens participation in the labou r orce as well as in politics,
poverty cycle explained earlier.
allowing them to inf u ence policy.
Cred i t i n sti tu ti on s i n d u ce peopl e to save, a s th ey oer n ot
on l y sa ety or wh atever i n com e peopl e d o n ot spen d bu t
a l so a ra te o retu rn . Ba n ks a l l ow peopl e to borrow m on ey
th a t ca n be u sed to i n crea se th ei r h u m a n ca pi ta l or to sta rt a
sm a l l bu si n ess, wh i ch m ay en a bl e th em to brea k th e poverty
cycl e. U n ortu n a tel y, a u n cti on a l cred i t system i s n ot en ou g h
a s very oten i t i s a l so th e a bsen ce o wel l-d e n ed property
ri g h ts th at preven ts poor peopl e rom borrowi n g rom
com m erci a l ba n ks.
1 48
4 Development economics
The distribution of income corru ption is consid ered a major obstacle to the d evelopm ent
process as it increases the costs o d oing bu siness an d it
H igh and risin g incom e in equ ality is consid ered a major barrier
d istorts ef ciency. Tru st between econom ic agents increases,
to econom ic d evelopm ent. I t ollows that policies aim ing at
also d ecreasing the cost and increasing the likelihood o d oing
red u cing incom e inequ ality and making growth inclu sive will
bu siness, another necessary con d ition or growth to accelerate.
encou rage d evelopm ent. Poverty red u ction d epend s not only on
A m ore equ itable d istribu tion o incom e will d ecrease the
incom e growth bu t also on how incom e is d istribu ted : poverty is
nu m ber o the very poor so that m ore people will have access
red u ced and d evelopm ent is ach ieved i there is growth
to ed u cation and health resou rces and so becom e m ore
accompanied by narrowing incom e inequ ality.
prod u ctive m em bers o society. The probability o civil u n rest
A m ore equ itable d istribu tion o incom e will make it easier to will be lower, d ecreasing the risks or investors and lead ing to
reach consensu s am ong d ierent popu lation grou ps. This is a m ore d om estic an d oreign in vestm ent spend ing in the cou ntry.
necessary cond ition or a governm ent to be willing and able to Lower incom e inequ ality may accelerate savings and resu lt in
u nd ertake su ccessu lly the requ ired institu tional and econ om ic m ore investm ent and greater d emand or locally prod u ced
reorm s that accelerate growth. Lower incom e inequ ality good s and services, which may increase incom e and u rther
d ecreases the prevalen ce o corru ption in a cou ntry and d ecrease inequ ality.
1 49
4.4 The role of international trade
trade-relaed barriers
Barriers to primary export-led growth Prices received or many primary prod u cts have d ecreased
throu gh tim e. For exam ple, technology and an increase in
Overspecialization on a narrow range o primary exports cannot
the nu m ber o coee-prod u cing cou ntries have pu shed
eectively lead the way to econom ic d evelopm ent. H ere are
d own the world price or coee.
som e o the reason s or this.
Agricu ltu ral exports have to ace the trad e protection that
Demand or m ost primary exports is incom e inelastic and, as
ad vanced econom ies (the U SA, the Eu ropean U nion an d
a result, markets or such products in high-incom e countries
Japan) grant their arm ers in the orm o su bsid ies. The
do not grow ast enough to help accelerate growth.
resu lting inability to access these markets is a m ore general
barrier d eveloping cou ntries ace. This statem ent d oes not
HL The term s o trade o cou ntries exporting primary ind iscrim inately apply to all d eveloping cou ntries, thou gh,
products will deteriorate in the long run. They will as many alsely believe. I t mainly applies to the so called
need to export a greater volu m e o primary Cairns Grou p o d eveloping cou ntries, which inclu d es
exports to be able to import one u nit o Argentina, Brazil, Chile, Colom bia, Costa Rica, I nd onesia,
manuacturing goods. H owever, this will only lead M alaysia, Philippin es, Sou th Arica, Thailand and U ru gu ay
to a urther decrease in the price o these primary which are m ostly m id d le-incom e cou ntries with a strong
products as m ost o these markets are competitive. comparative ad vantage in agricu ltu re. I t ollows that th e
Export earnin gs may exhibit signi cant year-to- main bene ciaries o liberalizing trad e in agricu ltu re wou ld
year f u ctu ations as prices o arm prod u cts are be this grou p o cou ntries. The least d eveloped cou ntries as
aected by the weather an d other rand om d e ned by the U N (which inclu d e all cou ntries in Su b-
actors. This may m ean that d om estic aggregate Saharan Arica; Aghanistan, Banglad esh, Bhu tan,
d eman d becom es u nstable and investm en t Cam bod ia, Lao, Mald ives an d N epal in Asia; and H aiti in
spend ing is m ore risky. Cen tral Am erica) will actu ally be hu rt by this liberalization,
Primary exports may be dom inated by a ew the main reason or th is being that m ost o these cou ntries
m ultinationals and m iddlem en so that linkages are net ood importers and elim ination o agricu ltu ral
with the rest o the economy may prove ineective. su bsid ies will translate into higher ood prices or them .
The strategy of protection: import-substitution com petition im poses on rm s were totally absen t. I n
industrialization (ISI) som e ca ses, low-qu a lity, h ig h -cost a n d h ig h -priced g ood s
were prod u ced .
I n the 1 95 0s it was thou ght that the problem o d evelopm ent
was a stru ctu ral problem in that d eveloping cou ntries relied The overvalu ed exchange rate acted as a tax on trad itional
too heavily on the primary sector and d id not have a primary exports as arm ers earned less d om estic cu rrency or
manu actu ring sector. The creation o an ind u strial base to each d ollar o primary exports. Poverty or larg e segm ents o
su bstitu te d om estically prod u ced manu actu red good s or the popu lation thereore in creased . I n som e d eveloping
imports becam e known as I SI . The good s targeted were cou ntries the I SI strategy created a privileged lite which
non-d u rable manu actu red good s (or example textiles) that becam e m ore and m ore poweru l as the ind u strial sector grew.
were simple to prod u ce and were or d om estic consu mption. I n many cases, the protective trad e barriers were never
Trad e barriers were erected to protect the newly established elim inated . I n ad d ition, the newly established ind u stries were
d om estic rm s. These barriers wou ld stay in place u ntil the oten capital-intensive, employing inappropriate technologies
rm s grew su ciently in size and acqu ired the necessary which led to jobless growth as m inimal employm ent
know-how to lower average costs. Trad e barriers were red u ced opportu nities were created . Rem em ber that jobless growth is a
when the rm s were able to compete with imports and su rvive type o growth to avoid as d evelopm ent d oes not ollow.
within the d om estic markets.
Export promotion: outward-oriented strategies
Typically, the exchange rate was kept overvalu ed so that prices
o necessary im ported materials and interm ed iate prod u cts I n som e East Asian cou ntries, inclu d ing those known as the
(machines and other manu actu red inpu ts) u sed by the in ant ou r East Asian Tigers (Korea, Taiwan, H ong Kong and
ind u stries were arti cially low. Singapore), the stru ctu ral change that the I SI strategy
represented was ollowed by an attempt to export the simple,
Several problem s a re a ssociated with a n in wa rd -orien ted
non-d u rable, manu actu red good s these cou ntries had been
strategy. Sin ce th e d om estic in d u stry had its own ca ptive
prod u cing or their d om estic market. These, and later other
ma rket to sell its prod u cts, it n ever ha d th e in cen tive to
d eveloping cou ntries, ad opted an ou tward orientation.
becom e e cien t. Th e price a n d cost d isciplin es that
1 50
4 Development economics
I n this process, the role o the state varied am ong cou ntries bu t, im ports which are the exports o the d eveloping cou ntries.
in all o them , it played a signi cant, com plem entary role. I t A d eep recession in the U SA or in Eu rope, thou gh, will be
provid ed gu id ance and assistance to the private rm s bu t only costly as it will slow d own the process, especially i
i they achieved speci c perormance stand ard s typically d om estic d emand is weak an d the governm ent is not in a
associated with export targets. These rm s were orced to position to ad opt expansionary scal policy. I n response to
prod u ce low-price, high-qu ality good s in ord er to continu e to the 2 008 global crisis China was able to ad opt a hu ge
enjoy any state su bsid ies or cheaper loan s rom banks. scal stim u lu s program m e, bu t not all cou ntries were able
Export prom otion is not su cient to prom ote d evelopm ent and to d o the sam e.
to ensu re the su stainability o the process. The state in these Ou tward -oriented growth m u st su ccessu lly overcom e the
cou ntries invested heavily in ed u cation, slowly creating a m ore barriers created by trad e protection in d eveloped cou ntries.
prod u ctive labou r orce with higher skills. The state also Outward-oriented strategies may lead to worsening incom e
ensu red that th e ru its o econom ic growth were enjoyed by all. distribution as the rural sector may be let behind. A larger
This m eant that these cou ntries avoid ed the costs associated share o national incom e will accru e to those involved in the
with rising incom e inequ ality. export sector. It ollows that only i there are redistributive
The rst Asian cou ntry to initiate su ch an approach to the policies in place will d evelopm ent ensue (u sing the term
growth and d evelopm ent problem was Japan. I t was ollowed redistributive policies in its broad sense here that is,
by the ou r East Asian Tig ers (and other cou ntries, su ch as including spend ing on better health and education).
Malaysia, I n d onesia, Thailand and Vietnam , have been ad d ed The drive to produ ce cheaply or export markets may lead
to th is list). China and I nd ia are th e cu rrent stars o the export- policy makers to ignore the costs o environm en tal
or ou tward -oriented strategy. d egrad ation. This is very evid ent in China where export-
driven growth is seriou sly d amaging the natu ral resou rce
Advantages of outward-oriented strategies
base o the cou ntry and generating major environm ental
Focu sing initially on the prod u ction and export o simple,
costs, u nd erm ining the su stainability o the cou ntrys
manu actu red non-d u rable good s changed the stru ctu re
long-term growth and d evelopm ent prospects.
o these econom ies. Employm en t opportu nities increased
or the ru ral m igrants, as th ese ind u stries were m ostly Achieving outward-oriented growth orces policy makers to
labou r -intensive. keep the exchange rate articially undervalued to provide an
extra competitive edge to their exports, risking not only rising
The export revenu es earned alleviated problem s with the
protectionist sentim ent abroad but also infation at hom e.
balance o paym ents as they were u sed to nance the
importation o necessary interm ed iate and capital good s. Focu sing on ou tward -oriented growth may lead policy
There was less d anger o the economy ru n ning into oreign makers to postpone the creation o a social saety net that
exchange and oreign d ebt problem s. Rising export wou ld inclu d e state pensions and health insu rance, as the
reven u es also increase aggregate d emand (AD), so they can growth process d oes not rely on the ability o the
u el growth in ou tpu t and incom es. popu lation to spend on d om estic good s and services.
Focu sing on the larger export markets orced rm s to grow
in size and acqu ire econom ies o scale (EOS). This is Preferential trading agreements
especially important or small cou ntries. Regional integration am ong d eveloping cou ntries is oten
Firm s were orced to learn m ore abou t manu actu ring their reerred to as sou thsou th in tegration. Originally, in the 1 960s
prod u cts m ore e ciently. I nternational competition and 1 970s, d eveloping cou ntries had attempted to create a
provid ed the stim u lu s. The state also invited technical nu m ber o preerential trad ing agreem ents as a way o red u cing
assistance rom abroad bu t it u su ally lim ited contracts so the cost o I SI throu gh opening their markets to other
that they lasted no m ore than three years, orcing d om estic d eveloping cou ntries. A bloc wou ld increase the size o the
rm s to learn the necessary technology. Operating potential market or each exporting rm and so it wou ld lead
su ccessu lly in world markets enabled rm s to acqu ire the to EOS. Any complem entarities in prod u ction wou ld also help
marketing, nancial, managerial and , m ost importantly, red u ce costs and allow specialization. The regional agreem ents
entrepreneu rial skills. Exposu re to world competition since the 1 990s are reerred to as new regionalism and are
allowed a local entrepreneu rial class to evolve and matu re. part o a broad er trad e liberalization schem e where export
Throu gh varying d egrees o state gu id ance these econom ies prom otion is eatu red as the growth and d evelopm ent strategy
slowly shited their comparative ad vantage and prod u ction o choice.
to m ore sophisticated and com plex manu actu red prod u cts Exam ples o preerential trad ing agreem ents am ong d eveloping
and later to knowled ge-based an d technology-intensive cou ntries inclu d e the Latin Am erica Free Trad e Association
prod u cts. Their econ om ies thereore d iversi ed and were (LAFTA), orm ed in 1 961 ; MERCOSU R, a cu stom s u nion am ong
m ore insu lated rom ind u stry-speci c risks. Argentina, Brazil, U ru gu ay, and Paragu ay orm ed in 1 991 ; the
Asia-Paci c Econ om ic Cooperation (APEC), a grou p o 21
Possible disadvantages of outward-oriented growth nations that bord er the Paci c Ocean, established in 1 989 and
Since the growth process is driven by exports, it d epend s on prom oting reer trad e and cooperation am ong its m em bers; the
how ast the ad vanced econom ies are growing. I th eir Econom ic Com m u nity o Central Arican States (ECCAS),
incom es are rising ast then they will be absorbing m ore established in 1 983 and inclu d in g Bu ru nd i, Cam eroon, Central
1 51
4 Development economics
Arican Repu blic , Chad , Congo, Equ atorial Gu inea, Gabon , H ere are som e reasons many attempts at regional cooperation
Rwand a, So Tom and Prin cipe; and the Econom ic Com m u nity am on g d eveloping cou ntries have ailed or have resu lted in
o West Arican States (ECOWAS), established in 1 975 , with 1 6 lim ited su ccess.
m em ber cou ntries. The stru ctu re o prod u ction and o trad e in d eveloping
Possible benef ts o increased regional cooperation am ong cou ntries lacks a su f cient complem entary natu re. The
d eveloping cou ntries inclu d e: sim ilarity o their econom ies has resu lted in m ore trad e
increased trad e creation as a resu lt o the resu lting d iversion than trad e creation.
expand ed market M any attem pts have encou ntered sign if cant organizational
the possibility o EOS that may lead to m ore exports ou tsid e and ad m inistrative problem s.
the bloc Political rivalry both between and within cou ntries and lack
greater political and bargaining power in negotiations with o com m itm ent have also prevented progress.
d eveloped econom ies Transaction costs are oten high d u e to the high share o
a d ecreased level o d epend ence on d eveloping cou ntries raw materials and non-d u rables in these cou ntries m u tu al
markets. trad e. There are high tran sport costs, especially since
inrastru ctu re is poor (or example, th ere are ew road s).
1 52
The role of foreign direct investment
4.5 and the multinational corporation
Foreign direct investment (FDI) high levels o hu man capital and labou r prod u ctivity
FDI is long-term investm ent where a rm based in one cou ntry low labou r costs (low wages cou pled with high labou r
establishes a presence in another cou ntry. I t may either reer to prod u ctivity)
investm ent in new acilities (d e novo or green eld qu ality o physical inrastru ctu re (or example road s and
investm ent) or it may reer to acqu iring controlling percentage ports) and inormational inrastru ctu re
o the shares o existing local companies. The key characteristic proxim ity to a major and growing market area with high
o FDI is that the investor has control o the acqu ired asset. and or growing levels o incom e
FDI lead s to the creation o m u ltinational corporation s. m em bership in wid er ree trad e areas or trad ing blocs;
A m u ltinational corporation is a rm which has established , avoid ance o taris
throu gh FDI , prod u ction or other operations in m ore than
natu ral resou rce end owm ents (and their geographical
one cou ntry.
d istribu tion) inclu d ing climate
Why do multinational corporations invest cu ltu ral sim ilarities.
in developing countries?
The obviou s reason or corporations to expand into other
Does the presence of multinational
cou ntries is that by d oing so they are able to increase their corporations accelerate growth
sales and /or d ecrease their costs so that they increase their and development?
pro ts. Arguments in support of multinational corporations
M ost FDI f ows into d eveloped cou ntries (abou t 70% o the FDI can be seen as a way o llin g in gaps between:
total in 2 009) and m ost o it f ows ou t o d eveloped cou ntries the target level o investm ent spend ing in a cou ntry and
(abou t 88% in 2 009). Flows into d eveloping cou ntries have the actu al level o investm ents that d om estic savings can
been alm ost stead ily increasin g thou gh. Som e o the m ost nance
important explanations or the expansion o a m u ltinational
the target level o oreign exchange and the actu al level
corporation into d eveloping cou ntries are listed below.
d erived rom net export earnings, oreign aid and private
Th e m u ltinational corporation is involved in extraction o rem ittances not only will the inf ow o private oreign
natu ral resou rces su ch as oil, copper or bau xite, which m u st capital partly nance a cu rrent accou nt d e cit bu t i the
be d one at location. oreign-owned enterprise generates a f ow o export
I t is attem pting to lower its prod u ction costs. For example, earnings it can also help over tim e
or many prod u ction processes (especially stand ard ized the target tax revenu es requ ired to nance projects aim ed
ones) labou r costs are oten lower in d eveloping cou ntries at growth and d evelopm ent and the actu al revenu es
than the m u ltinational corporations hom e cou ntry. collected .
Th e m u ltinational corporation is attem pting to bene t rom
I n add ition, m u ltinational corporations may:
slacker regu latory ram eworks.
create greater levels o employm ent, provid ing job
M u lti n ation a l corporati on s d o n ot expa n d in d i scri m in ately opportu nities to the local popu lation
i n to d evelopi n g cou n tri es. A d eta il ed exam i n ati on o a n n u a l
provid e training and skill creation to the local workorce
FDI i n f ows revea l s that som e d evelopi n g cou n tri es recei ve a r
m ore FDI tha n oth ers. Ch in a , Bra zi l a n d M exi co attra ct th e help by provid ing access to managem ent and
m aj ori ty. organizational skills
So, why d o som e d evel opi n g cou n tri es attra ct m u ch m ore FDI prove to be a vehicle or aster transer and d iu sion o
tha n oth ers? What a ctors a ct a s pu ll a ctors i n to a speci c technology.
d evel opi n g cou n try? Th e ol lowin g li st h el ps to a n swer th ese
qu esti on s. N ote that som e o th ese a ctors m ay a l so expla i n Arguments against m ultinational corporations
why com pa n ies expa n d a n d becom e m u lti n ation a l. Th e M u ltinational corporations may hu rt d om estic rm s by
a ctors a re: elim inating competition and by im porting interm ed iate
prod u cts rom overseas a liates instead o bu yin g these
stable macroeconom ic environm ent
rom d om estic su ppliers
stable political environm ent
Repatriation o pro ts, paym ent o royalties an d
pu blic policy, inclu d in g tax treatm ent and ease importation o interm ed iate good s may lead to problem s
o pro t repatriation with the balance o paym ents as m ore oreign exchange
weak regu latory system s f ows ou t o the cou ntry.
en vironm ental laws, regu lations and their enorcem ent The tax contribu tion o m u ltinational corporations may be
clearly d e n ed property rights and a secu re legal ram ework consid erably less than it shou ld be as a resu lt o tax
concessions, investm ent allowances and transer pricing
extent and power o labou r u nions
(which arti cially red u ces their incom e).
1 53
4 Development economics
1 54
The roles of foreign aid and multilateral
4.6 development assistance
Some aid-related facts they are hot, inertile, inested with malaria and oten landlocked,
making it hard to increase productivity without help to deal with
The total annu al f ow o aid in 2 01 1 am ou nts to 0.31 % o
such endemic problems. N either ree markets nor democracy, in
d onors GN I . This is d own rom 0.3 4% in 1 990 and
Sachs opinion, will do very much or them.
signi cantly lower than the 0.7 % target which was rst set
in 1 970 and has been repeated ly re-end orsed . On the other side o the debate, William Easterly, co-d irector o
the Developm ent Research Institute and Proessor o Econom ics
I n 2 01 0 the largest d onors by volu m e were the U SA, the
at N ew York University, argues that aid does m ore harm than
U K, France, Germany an d Japan. Denmark, Lu xem bou rg,
good. It is oten wasted instead o being spent productively. It
the N etherland s, N orway and Swed en continu ed to exceed
may prevent people rom devising their own solutions to the
the U N s ODA target o 0.7 % o GN I .
speci c problem s they ace. Aid oten corrupts or is granted to
The largest rich cou ntries give less per person than smaller corrupt autocrats and underm ines local institu tions. I t is
cou ntries. typically ragm ented am ong too many donor countries and is
Only six d eveloped cou ntries (I reland , Lu xem bu rg, the thinly spread over too many sectors with a lot o overlapping
N etherland s, Swed en, N orway and the U K) provid ed nearly and conusion.
1 00% u ntied aid . (Tying aid is consid ered to lim it the Som e aid program m es help m ore than others. I t is not easy to
eectiveness o aid .) d eterm ine which ones prom ote d evelopm ent goals and which
I n 2 008 total o cial aid f ows rom OECD cou ntries ones u nd erm ine them . One recent approach ad opted by J-PAL
(inclu d ing d ebt relie) reached a record high o $ 1 2 8.7 (Poverty Action Lab) at Massachu setts I nstitu te o Technology
billion (OECD d ata) while since 1 95 0 it has totalled $ 2 .3 (M IT), u nd er the d irection o Esther Du f o an d Abhijit Banerjee,
trillion 2 006 d ollars (Easterly and Pgu tze, 2 008). is to try to nd ou t by u sing rand om ized control trials, ju st as
M ost aid goes to those who need it least; the rich er 40% o the eectiven ess o a dru g is evalu ated in m ed icine.
the d eveloping world s people get twice as m u ch aid per The ollowing points provid e a platorm or d iscu ssing the
person than the poorer 40%. eectiveness o aid .
Accord ing to the U N DP, d evelopm ent aid is inad equ ate in
Effectiveness of aid
am ou nt and oten inappropriate in orm .
Aid can be eective:
when it is narrowly targeted to speci c pro-d evelopm ent
Evaluating the impact of aid on development projects and objectives
The debate on the role o aid in the development process is highly
when it is not tied to bu ying prod u cts rom d onor cou n tries
polarized. Jerey Sachs, UN adviser and director o Columbia
Universitys Earth Institute, argues that massive inusions o aid are m ost importantly, when it is reinorced by appropriate
needed to break the poverty cycle and considers aid a powerul d om estic policies and institu tions in a non-corru pt
determinant o long-term growth. Poor countries are poor because governm ent environm ent.
1 55
4 Development economics
Aid can be ineective: when it is given on the basis o strategic and political
when it is given to cou ntries with corru pt governm ents consid erations
when it ind u ces cou ntries to postpone improvem ents o when the technologies transerred and the ad vice given are
macroeconom ic cond itions inappropriate.
when it replaces d om estic saving s and trad e f ows as
vehicles or d evelopm ent
1 56
4.7 The role o oreign debt
Foreign or external d ebt is u su ally d e ned as d ebt owed to non-resid ents o a cou ntry. I t is
the total am ou nt o m oney that a cou ntry owes to oreign entities which is repaid in oreign
exchange. Foreign entities inclu d e oreign governm ents, com m ercial banks and m u ltilateral
institu tions.
1 57
The balance between markets
4.8 and intervention
Development as a separate sub-discipline o economics did not exist beore the 1 950s. Beore
that little attention was paid to poor countries. The League o Nations 1 938 World Economic
Su rvey inclu d ed one paragraph on Sou th Am erica. This was a m ore complete coverage than
poor countries in Arica or Asia had, since there was no reerence to them at all. The
industrialization o the Soviet Union (through planning, orced saving and investment)
changed all this.
The role of the state and of the market On the other hand , an eective state is requ ired to achieve
The role o the state in the d evelopm ent process resem bles a d evelopm ent or these reasons.
pend u lu m . I t shited rom the heavy-hand ed intervention in the I n rastru ctu re, which is necessary or growth and
1 95 0s and 1 960s when the problem o d evelopm ent requ ired d evelopm ent, is a pu blic good in the sense that the private
state planning and was red u ced to the solu tion o a system o sector will not provid e it.
equ ations. I t swu ng all the way to the grad u al d im inu tion o An appropriate institu tional environm ent is necessary or
the role o the state in the 1 970s and 1 980s, when markets markets to operate. At the very least the state has to protect
were conerred a central role (or example with privatization property rights and gu arantee the ru le o law.
and trad e liberalization) with increased attention paid to
Basic ed u cation and health care create very signi cant
getting the u n d am entals right (achieving, or exam ple, low
positive externalities and wou ld be u nd erprovid ed i let to
bu d get d e cits and low inf ation).
the market.
A growing consensu s is now being orm ed which consid ers the
The market cannot gu arantee an equ itable d istribu tion o
role o th e state and o the market complem entary. As the ocu s
incom e between ind ivid u als, grou ps, regions or tim e.
has been shiting toward s hu man d evelopm ent any policy,
wheth er macroeconom ic or m icroecon om ic in natu re, has to be The market cannot gu arantee eective protection o the
ju d ged with respect to its eect on the least privileged environm ent.
seg m ents o society. I t is necessary to create a stable macroeconom ic
M arkets and prices are important or these reasons. environm ent or econom ic activity to grow.
They provid e signals or the allocation o resou rces. Markets and the state shou ld be partners in the process o
They create incentives. growth and d evelopm ent. The private sector shou ld provid e the
necessary vigou r and the state the ram ework within which
They perm it choice.
econom ic activity can take place, rectiying market ailu res and
Pro t-oriented entrepreneu rs can spot opportu nities and au gmenting the resou rces available.
u se resou rces e ciently.
Competition lead s to lower prices and better qu ality and
orces rm s to innovate.
1 58
4 Development economics: Questions
1 . Distingu ish between econ om ic growth and econom ic 1 0. (H L only) Explain why the long term path o the term s o
d evelopm ent explaining that d evelopm en t is broad er trad e o a cou ntry may act as a barrier in its growth and
than growth. d evelopm ent process.
2 . Explain actors that may assist accelerating the growth 11 . Describe the natu re o FDI and o MN Cs.
process o an economy. 1 2 . Explain why MN Cs expand into d eveloping cou ntries.
3. Explain why growth is typically a necessary bu t not a 1 3. Describe the characteristics o d eveloping cou ntries that
su cient cond ition or a cou ntry to d evelop. rend er FDI inf ows m ore likely.
4. Su g gest two characteristics that many d eveloping 1 4. Explain the m ean ing o the term oreign aid making
cou ntries share. reeren ce to the variou s types and orm s o aid that exist.
5. Explain the m eaning o the term poverty trap 1 5. Describe the role o N GOs in the d evelopm ent process.
(or, poverty cycle).
1 6. Explain reasons or which a d eveloped cou ntry may extend
6. Ou tline the cu rrent statu s o the Millenniu m aid to a d eveloping cou ntry.
Developm ent Goals.
1 7. Ou tline the m eaning o oreign d ebt and explain the
7. Explain the d ieren ce between GN I and GDP as well as constraints it may impose in the d evelopin g process.
between GDP (or, GN I ) g u res and GDP (or, GN I ) at
1 8. Explain why good governance is consid ered a necessary
PPP d ollars.
precond ition or a cou ntry to d evelop.
8. Explain the components o the H DI and why the later is
a better ind icator o d evelopm ent than per capita
incom e levels.
9. Explain how (i) overspecialization, (ii) price volatility o
com m od ities and (iii) inability to access international
markets may obstru ct the process o growth and
d evelopm ent.
1 . Com pare and contrast the GDP per capita gu res an d the 1 0. Discu ss the lim itations o interventionist policies on
GN I per capita gu res or econom ically m ore d eveloped d evelopm ent.
cou ntries an d econom ically less d eveloped cou ntries. 11 . Discu ss the view that econom ic d evelopm ent may best be
2 . Com pare and contrast two health ind icators or achieved throu gh a complem entary approach, involving a
econom ically m ore d eveloped cou ntries and econom ically balance o market oriented policies and governm en t
less d eveloped cou ntries. intervention.
3. Com pare and contrast two ed u cation ind icators or 1 2 . Evalu ate each o the ollowing as a m eans o achieving
econom ically m ore d eveloped cou ntries and econom ically econom ic growth and econom ic d evelopm ent. a. I m port
less d eveloped cou ntries. su bstitu tion b. Export prom otion c. Trad e liberalization
4. Com pare and contrast the H DI gu res or econom ically d. The role o the WTO e. Bilateral and regional preerential
m ore d eveloped cou ntries and econom ically less trad e agreem ents f. Diversi cation.
d eveloped cou ntries. 1 3. Evalu ate the impact o oreign d irect investm ent (FDI ) or
5. Com pare and contrast the extent, natu re and sou rces o econom ically less d eveloped cou ntries.
o cial d evelopm ent assistance to two econom ically less 1 4. Evalu ate the eectiveness o oreign aid in contribu tin g to
d eveloped cou ntries. econom ic d evelopm ent.
6. Com pare and contrast the roles o aid and trad e in 1 5. Exam ine, u sing appropriate d iagram s where relevant, how
econom ic d evelopm ent. the ollowing actors contribu te to econom ic d evelopm ent.
7. Discu ss the positive ou tcom es on d evelopm ent o a. Ed u cation and health b. The u se o appropriate
market-orien ted policies. technology c. Access to cred it and m icro-cred it d. The
empowerm ent o wom en e. I ncom e d istribu tion .
8. Discu ss the negative ou tcom es on d evelopm ent o
market-orien ted strategies. 1 6. Exam ine the cu rrent roles o the I MF and the World Bank in
prom oting econom ic d evelopm ent.
9. Discu ss the streng ths o interventionist policies on
d evelopm ent.
1 59
5.1 Microeconomics
Remember that you are allowed to use a graphic display calculator (GDC) and this can
be very useful.
S e cti o n 5 : Q u an ti tati ve i S S u e S i n H L PaP e r 3
Linear demand functions price d ecreases, the su pply cu rve becom es steeper. Rem em ber
the convention to place the ind epend ent variable (price) on the
A linear d emand cu rve has the orm : Q d 5 a 2 bP
vertical axis.
This simply states that qu antity d emanded per period is
The question paper will provide the two axes with numbers on
inversely related to price re ecting the law o d emand , and that
them. Choose any two convenient prices within the range given
the d emand cu rve is a straight line rom the northwest to the
on the vertical axis and fnd the quantity supplied or each. Just
sou theast on you r paper.
substitute the values or P in the supply unction. You will have
The term a is a constant while the term 2 b is the slope o th e determined two points on your paper which you simply connect.
u nction. Use a sot pencil and then go over the line with a black ink pen.
I the term a increases, the d emand cu rve shits to the right, Remember that you are allowed to use a GDC calculator but plot
ind icating that d emand has increased . I the term a d ecreases, the inverse o the linear supply unction you are given. Only
the d emand cu rve shits to the let, ind icating that d emand has positive numbers or price and quantities make sense.
d ecreased .
I the absolu te valu e o the coef cient o price increases then Equilibrium price and quantity
the d emand cu rve you will have plotted on the graph paper The equ ilibriu m cond ition requ ires that qu antity d emand ed per
becom es atter, whereas i the absolu te valu e o the coef cien t period is equ al to qu antity su pplied per period . You will have
o price d ecreases the d emand cu rve becom es steeper. I this three equ ations: the d eman d equ ation, the su pply equ ation
seem s su rprising rem em ber that the convention we have, since an d the equ ilibriu m cond ition (given below as (1 ), (2 ) and (3 )
the work o Alred Marshall, is or the ind epend ent variable respectively) and you will have three u nknowns (the price, th e
(price) to be on the vertical axis. qu antity d emand ed and the qu antity su pplied ):
I you are asked to plot a d emand u nction, f rst f nd the P
(1 ) Q d 5 a 2 bp
intercept by pu tting in zero or qu antity d emand ed in you r
u nction, and then f nd the Q intercept by pu tting in zero or (2 ) Q s 5 c 1 d p
price. Connect the points. I nitially, u se a sot pencil and once (3) Q d 5 Q s
you are su re you have d one it right, go over the lin e with a
black pen. Th e qu estion paper will provid e you with the two Pu t (1 ) and (2 ) into the equ ilibriu m con d ition (3 ) and solve or
axes or the graph with nu m bers on them , so you au tomatically price. Pu t the equ ilibriu m price you f nd into either the d emand
have the relevan t range o valu es or su ch u nctions. I , or or the su pply equ ation to f nd equ ilibriu m qu antity.
example, the horizontal axis (qu an tity demand ed ) on you r exam For example:
paper goes u p to 1 2 0 and you have calcu lated the horizontal
Q d 5 60 2 2P
intercept to be 5 00, you have probably mad e a m istake! Also
rem em ber that only positive nu m bers or price and qu antities Q s 5 4P (here, the constant c is zero)
make sense. Qd 5 Qs
Also keep in m ind that you are allowed to u se a GDC
calcu lator. M ost, or example the Casio x9860GI I , allow you Su bstitu ting the d emand and the su pply equ ations in the
to enter th e d emand (or any) u nction and ask to plot its equ ilibriu m cond ition:
inverse. (Rem em ber that the axes are inverted with P on the 60 2 2 P 5 4P
vertical and Q on the horizontal.) M ake su re you practise u sing
a GDC calcu lator a lot to avoid errors. 60 5 6P
P 5 10
Linear supply functions
By putting the equilibrium price 1 0 into the supply equation we
A linear su pply cu rve has the orm : Q s 5 c 1 d P fnd that the equilibrium quantity is 40. Double check your answer
This simply states that qu antity su pplied per period is d irectly by also substituting the value 1 0 or P into the demand equation.
related to price re ecting the law o supply, and that the su pply I you pu t into the d eman d and su pply u nctions any price
cu rve is a straig ht line rom the sou thwest to the northeast on greater than 1 0 (the equ ilibriu m price), qu antity su pplied will
you r paper. be greater than qu antity d emand ed and their d ierence will be
Th e term c i s a con sta n t wh i l e 1 d i s th e sl ope o th e u n cti on . the excess su pply resu lting at that price. For exam ple, i you pu t
I c increases, the su pply cu rve shits to the right, ind icating the price 2 0 into the d emand u nction, qu antity d emand ed will
that su pply has increased . I c d ecreases, the su pply cu rve shits equ al to 2 0 u nits, wh ereas i you pu t 2 0 into the su pply
to the let, ind icating that su pply has d ecreased . u n ction, qu antity su pplied will be 80 u nits. Qu antity su pplied
exceed s qu antity d emand ed by 60 u nits, which is the excess
I the coef cient o price in creases, the su pply cu rve plotted on
su pply resu lting at a price o 2 0.
th e graph paper becom es atter. Whereas i the coef cient o
1 60
5 Quantitative issues in HL Paper 3
I you pu t into the d emand and su pply u nctions any price less Rem em bering that in the post-tax su pply u nction we su bstitu te
than 1 0 (the equ ilibriu m price), qu antity d emand ed will be (P 2 t) or the term P we m u st solve now the equ ation s:
greater than qu antity su pplied and their d ierence will be the
Q d 5 60 2 2 P
excess d emand resu lting at that price. For exam ple, i you pu t
the price 5 into the d emand u nction, qu antity d emand ed will Q s 5 4(P 2 3)
equ al 5 0 u nits, whereas i you pu t 5 into the su pply u nction,
Solving the system will yield the new market price that
qu antity su pplied will be 2 0 u nits. Qu antity d emand ed exceed s
consu m ers will pay Pc 5 1 2 and the new equ ilibriu m qu antity
qu antity su pplied by 3 0 u nits, which is the excess d emand
Q9 5 36.
resu lting at a price o 5.
This is how the table m ight look:
Indirect taxes
P0 10
An indirect tax is a tax on goods or services. For the quantitative
part o the exam you need to ocus only on specifc taxes (that Q0 40
is, a specif c dollar am ou nt per unit o the good). I you do not Pc 12
care about the logic o the problem , the easiest way to deal with
Q9 36
such a tax is to rewrite you r supply equation substituting the
term P with (P 2 tax). So, i the su pply equation is: Pp 5 (Pc 2 tax) 5 9
2
Q s 5 4P 12 2 10 5 2 (consumers pay __3
Incidence on consumers
of the tax)
and a $ 3.00 tax per u nit is imposed , rewrite it as:
1
10 2 9 5 1 (producers pay __
3 of
Q s 5 4(P 2 3) Incidence on consumers
the tax)
The n ext step is to equ ate the d emand with the new su pply Initial revenues and P0 3 Q 0 5 10 3 40 5 400
cu rve to f nd the n ew market price. Su btracting the tax rom the expenditures TR0
new market price you ju st calcu lated will give you the new, net
o tax, price that prod u cers earn. N ote that beore the tax was Post-tax producer revenues Pp 3 Q9 5 9 3 36 5 324
imposed , the market price was also the average revenu e earned Post-tax consumer Pc 3 Q9 5 12 3 36 5 432
by f rm s whereas ater the tax is imposed , the average revenu e expenditures
earned is the net o tax market price ou nd by su btracting the
Tax revenues collected by t 3 Q9 5 3 3 36 5 108
tax rom the new market price.
government
I you have alread y plotted the original d emand and su pply
cu rves on graph paper, you can ju st shit the su pply cu rve Area of a triangle is
1
__
vertically u pward s by the am ou nt o the tax to f nd the new 2 (base 3 height).
market price and the new market qu antity and to answer a lot Since the vertical intercept of the
o other related qu estions. Initial consumer surplus demand curve is 30, the height of
Rem em ber that an ad valorem tax (say a 1 5 % VAT or sales tax) the consumer surplus triangle is
will not lead to a parallel shit o the su pply cu rve bu t the new (30 2 10) 5 20. The base is the
su pply cu rve will create a wed g e with th e original one (their quantity 40 so CS 5 400.
vertical d istance will be increasing). (10 3 40)
Initial producer surplus Similarly: _________
2 5 200
H ere is som e ad vice on solving ind irect tax problem s.
Solve algebraically beore plotting on the graph paper to (30 2 12) 5 18 is the new height
en su re that you r calcu lations are precise. New consumer surplus and 36 is the base so consumer
(18 3 36)
Avoid ing u sing P1 and P2 . I nstead ad opt m ore m eaningu l surplus is _________ 5 324
2
sym bols like Pm or Pc or the new higher market price (9 3 36)
New producer surplus ________
consu m ers pay ater the tax, and Pp or the net o tax price 2 5 162
prod u cers earn (their new average reven u e). Initial social welfare 400 1 200 5 600
Write d own all the relevant inormation in a table as this
New social welfare 324 1 162 1 108 5 594
will help you with any ad d itional calcu lations you are asked
to make. 600 2 594 5 6 or
(40 2 36) 4
For exam ple, assu m e that d emand and su pply are given by: Welfare loss (12 2 9) 3 _________
2 5 3 3 __
2
Q d 5 60 2 2 P 5 6 (the area of the triangle)
Q s 5 4P
Denoting the orig inal equ ilibriu m price by P 0 and the original Subsidies
equ ilibriu m qu antity by Q 0 we have alread y ou nd that: A su bsi d y i s a paym en t to prod u cers a i m ed a t l oweri n g
prod u cti on costs a n d so m a rket pri ce a n d i n crea si n g
P0 5 1 0
prod u cti on a n d con su m pti on o th e g ood . Th e ea si est way to
Q 0 5 40 d ea l wi th su ch a su bsi d y i s to rewri te you r su ppl y eq u a ti on
1 61
5 Quantitative issues in HL Paper 3
1 62
5 Quantitative issues in HL Paper 3
this price into the d emand and then into the su pply u nctions price in to th e d ema n d an d th en in to th e su pply u n ction s
helps u s d eterm ine the qu antity d emand ed Q d and the qu antity h elps u s d eterm in e th e qu an tity d ema n d ed Q d a n d th e
su pplied Q s : qu a n tity su pplied Q s :
Q d 5 46 Q d 5 32
Qs 5 2 8 Qs 5 5 6
so that a shortage equ al to Q d 2 Q s 5 1 8 u nits resu lts. so that a su rplu s equ al to Q s 2 Q d 5 2 4 u nits resu lts.
You may be a sked to ca lcu late th e chan g e in con su m er You may be asked to calcu late the change in consu m er
expen d itu res. Con su m er expen d itu res a re ou n d by m u ltiplyin g expend itu res. Consu m er expend itures are ou nd by m u ltiplying
th e price pa id tim es th e a ctu al n u m ber o u n its bou g h t. the price paid tim es the actu al nu mber o u nits bou gh t.
Rem em ber that th e sh ort en d o th e ma rket always preva ils, so Rem em ber that the short end o the market always prevails, so
that i on ly 2 8 u n its were ma d e availa ble by f rm s at th e that i only 32 u nits were d emand ed by consu m ers at the
ma xim u m price set it is im materia l that con su m ers were m inim u m price set it is im material that f rm s were oering in
d ema n d in g 46 u n its. the market 5 6 u nits.
I nitially consu m er expen d itu res were 1 0 3 40 5 400 whereas I nitially, consu m er expend itu res were 1 0 3 40 5 400 while
ater the maxim u m price is set they will be 7 3 2 8 5 1 96. ater the m inim u m price they were equ al to 1 4 3 32 5 448
The change is thereore 1 96 2 400 5 2 2 04. This m eans that (or exam ple d ollars or eu ros). N ote that these expend itu res are
consu m er expend itu res d ecreased by 2 04 (or example d ollars greater than the expend itu res made at the lower price. Since
or eu ros) which makes sense as both the price is lower and the the price paid increased , the qu an tity pu rchased will have
qu antity consu m ed is less. Consu m er expend itu res in this case d ecreased (law o d emand ) so that consu m er expend itu res may
are equ al to total revenu es prod u cers collect. have increased , d ecreased or remained the sam e d epend in g on
the price elasticity o d emand (PED) or the good . What we
Price foors have here is a m ovem ent along a demand cu rve. Since in this
A pri ce oor or m i n i m u m pri ce (or pri ce su pport) i s a pri ce example th e higher price paid resulted in higher expend itu res
set by th e g overn m en t a bove th e eq u i l i bri u m pri ce. Th i s by consu m ers, it im plies that PED is less than one (d emand is
i m pl i es th a t q u a n ti ty d em a n d ed i s l ess th a n th e q u a n ti ty price inelastic).
su ppl i ed so th a t excess su ppl y, reerred to i n th i s ca se a s a I n the case o a m in im u m price, the governm ent m u st intervene
su rpl u s, resu l ts. and bu y rom prod u cers at the prom ised m inim u m price the
You may be asked to calcu late the resu lting su rplu s. You wou ld su rplu s created . I t ollows that produ cers earn not only what
ju st have to su btract the qu antity d eman d ed rom the qu antity consu m ers spend on the good bu t also what the governm ent
su pplied at the m inim u m price by su bstitu ting it into both the spend s to bu y the su rplu s. Rem em ber prod u cers sell all o what
su pply and the d emand equ ations. they have prod u ced : som e to consum ers and th e rest to the
governm ent. So prod u cers earn the prod u ct o the price set
U sing the sam e d emand and su pply cond itions:
($ 1 4 or whatever) tim es the total am ou nt su pplied (5 6 u nits),
Q d 5 60 2 2 P that is, $ 1 4 3 5 6 5 $ 784. The governm ent expend itu res in
the case o a m inim u m price are the prod u ct o the su rplu s
Q s 5 4P
(2 4 u nits) pu rchased tim es the m inim u m price prom ised ($ 1 4),
with or $ 1 4 3 2 4 5 $ 33 6.
Total, marginal and average product N otice that equ ation (1 ) has three term s so i you know any
two you can solve or the third . For example, i f ve workers can
You may be asked to calcu late rom a table (with em pty cells)
prod u ce an average o 1 2 0 shirts per d ay then each worker can
or rom a graph, total, marginal and average prod u cts. This is
prod u ce on average 2 4 shirts per d ay. Average prod u ct
an easy task i you rem em ber exactly what each concept m eans
120
and the orm u la one can u se. is ____ 5 2 4 shirts per worker per d ay. Or, i you know that the
5
To calcu late average prod u ct (o, say, labou r) you need to d ivid e average prod u ct per worker per d ay is 2 4 shirts and that the
total prod u ct (TP, or in other word s, Q) by the nu m ber o f rm employs f ve workers you can f nd the total averag e
workers u sed (L) or: produ ct which is 5 3 2 4 5 1 2 0 shirts per d ay.
TP To calcu late marginal prod u ct (o, say, labou r) you need to
AP L 5 ___ (1 ) rem em ber that marginal m eans extra (ad d itional) so that
L
1 63
5 Quantitative issues in HL Paper 3
marginal prod u ct (MP) is the change in ou tpu t ind u ced by a to the total product o two workers to calculate the total product
change in the n u m ber o workers employed . I t is equ al to the o three workers (which is equal to 300 1 2 00 5 500 units).
ratio o the change in ou tpu t prod u ced over the change in N ow that you have the total product or three workers it is easy
labou r employed . I the chan ge in th e nu m ber o workers is to calculate the average product when three workers are
1 (that is, you have d ata on the ou tpu t o 0, 1 , 2 , 3, 4, etc. employed by dividing total product by the num ber o workers,
workers) then marginal prod u ct is ju st the change in ou tpu t: 5 00
or ____ 5 1 66.67 u nits per worker per period .
DQ 3
DTP
MP L 5 ____ 5 ___ ,
DL DL
Total, marginal and average cost
and , i DL is always 1 , then M P 5 DQ 5 Q 2 2 Q 1 (2 ). Th e sam e l og i c expla i n ed a bove or th e ca l cu la ti on o tota l
N ote rom equ ation (2 ) that it ollows that M P 1 Q 1 5 Q 2 , so prod u ct, m a rg i n a l prod u ct a n d a vera g e prod u ct h ol d s
i we kn ow that th e ma rg in a l prod u ct o, say, th e f th worker or ca l cu la ti n g tota l , m a rg i n a l a n d a vera g e costs (TC,
is 2 5 a pples (per period ) an d that with ou r workers total M C a n d AC).
prod u ct is 1 00 apples, th en tota l prod u ct with f ve workers will The d ef nitions (orm u las) to rem em ber inclu d e:
be 2 5 1 1 00 5 1 2 5 a pples. Th is is very u seu l to rem em ber
wh en com pletin g su ch ta bles. TC 5 FC 1 VC (1 )
For example, consid er the table below. ATC 5 AFC 1 AVC (2 )
TC FC VC
Labour or Output (Q) or Average Marginal ATC 5 ___, AFC 5 ___, AVC 5 ___ (3)
Q Q Q
number of total product product (AP) product (MP)
workers (TP) DTC DVC
MC 5 ____ or, since DFC 5 0 M C 5 ____ (4)
(L) DQ DQ
0 0 2 2 i DQ 5 1 then :
1 (0 1 120) 5 ( ____
1 ) 5 120
120 120 MC 5 TC2 2 TC 1 TC 1 1 M C 5 TC 2 (5 )
120 MC 5 VC2 2 VC 1 VC 1 1 M C 5 VC 2 (6)
2 (2 3 150) 5 150 (300 2 120) 5
300 180 These may look d if cu lt bu t they are extrem ely easy. Equ ation
(1 ) states that total costs (TC) are the su m o f xed and variable
3 (300 1 200)5 ( ____
3 ) 5 166.67
500 200 costs (FC and VC). I n the lon g ru n, sin ce there are no f xed costs
500 total costs are variable costs.
4 640 ( ____
4 ) 5 160
640
(640 2 500) 5 You d erive equ ation (2 ) by d ivid ing all term s o equ ation (1 ) by
Q (the level o ou tpu t) to arrive at per u nit o ou tpu t (that is,
140
average) costs. I t states that average total cost (ATC) is the su m
5 (5 3 135) 5 135 (675 2 640) 5 o average f xed costs (AFC) plu s average variable costs (AVC).
675 35
The equ ations labelled (3) are u seu l as each has three term s
6 (675 1 0) 5 ( ____
6 ) 5 112.5
675 0 so, i two o them are known you can solve or the third term .
675 Rem em ber that f xed costs are f xed as the level o ou tpu t
increases bu t average f xed costs continu ou sly d ecrease as the
Assume that the table originally contains only the cells given in level o ou tpu t increases.
black on white above and that you are asked to calculate the The equ ations labelled (4) state that marginal cost (MC) is the
remaining (shaded) cells. The calculation required and the result change in either total or variable costs d ivid ed by the change in
or each cell is given in shaded cells. N ote two things: i no (zero) ou tpu t.
workers are employed neither the marginal nor the average can
Equ ations (5 ) and (6) are m ost u seu l as they state that i we
be calculated as they are m eaningless concepts; also, in each
know that the total costs (or variable costs) o produ cing, say,
row, only one number is needed to calculate the other two. For
eight u nits is $ 2 00.00 and that the marginal cost o the ninth
example, or three workers you are only given that the marginal
u nit is $ 2 2 .00 then the total costs (or variable costs) o
product o the third worker is 2 00 units o output. But since you
prod u cing nine u nits is $ 2 00.00 1 $ 2 2 .00 5 $ 2 2 2 .00. This is
have calculated that the total product o two workers is 300
m ost u seu l when asked to complete cost tables.
units, you just need to add the extra output rom the third worker
1 64
5 Quantitative issues in HL Paper 3
I n the table below you are g iven only the total cost o
prod u ction (in black on white) and you may be asked to f ll in
the rest o the table. The answers are in the shad ed areas.
Or, consid er the table below where only a ew entries were Total, marginal and average revenue
provid ed (th ose in the white cells). H ere are a ew hints to help. The log ic behind the calcu lations o total, average and
When ou tpu t is zero, variable costs are zero as no variable marginal revenu es is once again exactly th e sam e as the logic
actors are u sed . I the marginal cost o the f rst u nit is 1 5 0 beh ind prod u ct and cost u nctions. The orm u las are:
(d ollars) the variable cost o prod u cing one u nit is 1 5 0 (d ollars)
TR P3 Q
and by d ivid ing by 1 all average costs are ou nd . I the average AR 5 ___ 5 ______ 5 P (1 )
Q Q
total cost when prod u cing 2 u nits is 2 2 5 then the total cost is
(2 3 2 2 5 ) or 45 0 and given that the f xed costs are 1 00, the DTR
MR 5 ____ (2 )
variable cost o two u nits is 35 0. I the variable cost o DQ
prod u cing two u nits is 35 0 and the variable cost o prod u cin g
And , i DQ 5 1 , then :
1 u nit is 1 5 0 then the marginal cost o prod u cing the second
u nit is (35 0 2 1 5 0) 5 2 00 (d ollars) and so on. M R 5 DTR 5 TR 2 2 TR 1 so TR 1 1 MR 5 TR 2
1 65
5 Quantitative issues in HL Paper 3
1 66
5.2 Macroeconomics
Measures o economic activity I t also ollows that the remaining 2 0 cents were paid in tax,
saved and /or spent bu t on imports. The m u ltiplier may
You may be asked to calcu late nom inal GDP rom sets o
th ereore be written as:
nation al incom e d ata, u sing the expend itu re approach. I n this
case you ju st ad d (C 1 I 1 G 1 X) and then su btract im ports 1 1
k 5 __________________ 5 _____ , where
(M). Oten in su ch exercises stu d ents are given ad d ition al d ata (M RT 1 M PS 1 MPM ) M PW
as sm oke to conu se them . I gnore the ad d itional d ata. I asked
M RT is the marginal tax rate (the extra tax paid ou t o an extra
to f nd the per capita GDP (or GN I ) ju st d ivid e GDP (or GN I ) by
d ollar earned ), MPS is the ad d itional savings ou t o an
popu lation.
ad d itional d ollar earned and MPM is the ad d itional spend ing
You may be asked to calcu late GN P or GN I rom d ata. GN P is on imports ou t o an ad d itional d ollar earned :
GDP plu s incom e rom abroad m inu s actor (or property)
in com e rom abroad or plu s net actor (or property) incom e DT DS DM
MRT 5 ___, M PS 5 ___ and MPM 5 ____
rom abroad . DY DY DY
DW
Lastly, you may be asked to calcu late real GDP or GN I u sing a and MPW is the marginal propensity to withdraw, or ____.
DY
price d e ator. A price d e ator is a price ind ex. Divid e GDP (or
GN I ) by the GDP d e ator and m u ltiply the resu lt by 1 00. Once Continu ing the previou s exam ple, i people are taxed 1 2 cents,
again, the relationship has three term s so i any two are save 3 cents and spend on imports 5 cents ou t o each
provid ed you can solve or the third one. ad d itional d ollar earned then:
M RT 5 0.1 2 , M PS 5 0.03 and MPM 5 0.05
The Keynesian multiplier
so that MPW 5 0.2 0 (their su m ).
The Keynesian m u ltiplier states that the change in incom e is a
m u ltiple o the change in any injection: The m u ltiplier k is thu s equ al to:
1
__________ 1 1
D Y 5 k D J, where J 5 (G, I , X) 5 ________ 5 ___ 5 5
(1 2 MPC d ) (1 2 0.8) 0.2
I t ollows that i any two term s are given you can solve or the
third one. or u sing the MPW f gu re d irectly:
I n ad d ition, 1
___
5 5
0.2
1 D Cd
k 5 __________ , where MPC d 5 ____
(1 2 M PC d ) DY I th e g overn m en t in crea ses spen d in g by 1 5 0 billion , th en
n ation al in com e will in crea se by (5 3 1 5 0) 5 75 0 billion .
MPCd is the ad d itional spend ing on d om estic good s rom
Or i, or exam ple, th e g overn m en t wa n ts n ation a l in com e to
ad d itional incom e. So, i you are told that rom an extra d ollar
in crea se by 1 .2 trillion th en g overn m en t expen d itu res sh ou ld
(wh ich has 1 00 cents) people spend 80 cents it ollows that
1 .2
rise by ___ 5 2 40 billion .
80 5
MPC d 5 ____ 5 0.8.
1 00
The unemployment rate d en om inator in th e calcu lation o the u nem ploym ent rate as
they are not inclu d ed in the labou r orce.
You may be asked to calcu late the u nemploym ent rate rom a
set o d ata. Th e u nemploym ent rate is a percentage. I t is the
nu m ber o u nem ployed expressed as a proportion o the labou r The infation rate
orce: You may be asked to calcu late the in ation rate rom a set o
d ata. The in ation rate is also a percentage. I t is the
nu m ber o u nem ployed
Unem ploym ent rate 5 __________________ 3 1 00 percentage change in the average price level between two
labou r orce
period s o tim e, u su ally between two years. The average price
Again, you have a relationship with three term s so i any two level is given by a price ind ex.
are given you can solve or the third one. The labou r orce is not Typical price ind ices inclu d e the consu m er price ind ex (CPI or
the sam e thing as th e popu lation o a cou ntry. I t inclu d es the retail price ind ex) and the prod u cer price ind ex (PPI ). I we
employed and the u nemployed individ u als, so given a total d en ote by P t the CPI at period t and by P (t 2 1 ) the CPI the
popu lation f gu re, the nu m ber o those u nwilling and /or previou s period (so that i t is 2 009 then (t 2 1 ) is 2 008) th en :
u nable to work are exclu d ed . Babies, old er people as well as
Pt2 P (t2 1 )
people within the working age popu lation who are neither I n ation rate in t 5 % DP 5 _______ 3 1 00
working nor actively searching or a job are not part o the P (t2 1 )
1 67
5 Quantitative issues in HL Paper 3
So i the CPI or 2 008 was calcu lated at 1 5 8.2 and the CPI or You cou ld ca lcu late th e in ation rate in 2 01 3 a s th e
2 009 was at 1 65.6 then in ation in year-on-year in ation in percen ta g e cha n g e in th e cost o livin g between 2 01 3 an d
2 009 was:
(1 46 2 1 3 5 )
2 01 2 : ___________ 3 1 00 5 8.1 5 % an d , sim ila rly, th e
1 65.6 2 1 58.2
____________ 7.4 1 35
3 1 00 5 _____ 3 1 00 5 0.0467 3 1 00 5 4.68%
1 58.2 1 58.2
(1 5 8.5 2 1 46)
in ation rate in 2 01 4: ____________ 3 1 00 5 8.5 6%
N ote that i th is percen ta g e wa s n egative th en th ere was 1 46
d e ation . Rem em ber that i you were to ca lcu late in ation or, Or you cou ld constru ct the consu m er price ind ex u sing 2 01 2 as
say, two con secu tive years a n d th e resu lts were positive bu t the base year:
th e rate wa s sma ller in th e secon d yea r th en th ere wa s
1 35
d isin ation (that is, prices con tin u ed to in crease bu t at a price ind ex or 2 01 2 (base year) 5 ____ 3 1 00 5 1 00
1 35
d ecrea sin g rate).
1 46
You m a y be a sked to con stru ct a wei g h ted pri ce i n d ex u si n g price ind ex or 2 01 3 5 ____ 3 1 00 5 1 08.1 5
1 35
a set o d a ta provi d ed . Th i s i s very ea sy. You wi l l be g i ven a
l i m i ted n u m ber o g ood s (say, th ree to f ve), th ei r pri ces i n 1 5 8.5
price ind ex or 2 01 4 5 _____ 3 1 00 5 1 1 7.41
two or m ore peri od s (typi ca l l y m on th s or yea rs) a n d th e 1 35
n u m ber o u n i ts o ea ch g ood th at th e typi ca l h ou seh ol d a n d th en ca lcu late th e in ation rate or 2 01 2 a s th e
(con su m er) pu rcha sed in th e ba se peri od or reeren ce peri od percen ta g e cha n g e in th e price in d ices between 2 01 3 a n d
(m on th or yea r). Th ese a re th e wei g h ts o ea ch g ood .
1 08.1 5 2 1 00
Rem em ber th at g ood s d o n ot ca rry th e sam e wei g h t i n th e 2 01 2 : ____________ 3 1 00 5 8.1 5 %
1 00
ca l cu lati on o th e avera g e pri ce l evel or o th e ca l cu la ti on o
th e cost o th e ba sket o g ood s pu rch a sed . Th e wei g h t o an d then the in ation rate or 2 01 4 as the percentage
ea ch g ood i n you r si m pl e ca l cu lati on o th e wei g h ted change in the price ind ices between 2 01 4 and
a vera g e i s th e n u m ber o u n i ts o ea ch g ood pu rch a sed .
1 1 7.41 2 1 08.1 5
So, to calcu late the cost o each basket o good s in each period 2 01 3: _____________ 3 1 00 5 8.5 6%
1 08.1 5
you ju st m u ltiply the price o each good d u ring the period
tim es the nu m ber o u nits consu m ed by the typical consu m er Growth
and ad d the expend itu res across good s. To convert the cost You may be asked to calculate the rate o econom ic growth
(say, d ollars) arrived at to a price ind ex d ivid e the cost o the between two years rom a set o data. This is a straightorward
basket in each year by its cost in the base year chosen and percentage change calculation assum ing proportional growth in
m u ltiply by 1 00. To calcu late the in ation rate o a year f nd discrete tim e. Denoting the growth rate in year t as g t and real
th e percentage between the two price ind ices compu ted . GDP o year t as yt we arrive at:
Rem em ber it is the percentag e change o the price ind ex o one (yt 2 y(t 2 1 ) )
period with respect to its valu e in the previou s period . The next g t 5 ___________
yt
example will help you und erstand .
The ollowing table has the prices o three good s in som e Rem em ber that to calcu late real GDP rom nom inal (or m oney)
economy between 2 01 2 and 2 01 4. GDP or GN I d ata you ju st d ivid e nom inal GDP by the GDP
d e ator and m u ltiply by 1 00.
Year Price of X Price of Y Price of Z
2012 6.00 0.50 3.00 Equity
The role of taxation in promoting equity
2013 6.60 0.60 3.10
You may be asked to calcu late the margin al tax rate (MRT) and
2014 6.80 0.75 3.40 the average tax rate (ATR) rom a set o d ata. Rem em ber that
the M RT is the extra (ad d itional) tax paid rom an extra d ollar
We assu m e that the basket o the typical consu m er con tains
o incom e (or, rom an extra d ollar o the tax base; that is,
1 0 u nits o good X, 3 0 u nits o good Y and 2 0 u n its o good Z.
whatever is taxed , or example expend itu re, wealth and
Constru ct a weighted price ind ex or all three years assu m ing
bu siness prof ts). The ATR is the ratio o the tax paid over
that 2 01 0 is th e base year and calcu late the in ation rate or
incom e (or, m ore generally, the tax base). Assu m ing the typical
2 01 3 and 2 01 4.
case o an incom e tax:
First calcu late the cost o the basket in each year. Th e cost or
DT T
2 01 2 will be: M RT 5 ___ and , ATR 5 __
DY Y
(6.00 3 1 0) 1 (0.5 0 3 30) 1 (3 .00 3 2 0)
5 60.00 1 1 5.00 1 60.00 5 1 35.00 I the ATR is increasing as incom e (or, m ore generally, the tax
base) is increasing then the tax is progressive. I t ollows that
The cost or 2 01 3 will be: MRT . ATR.
(6.60 3 1 0) 1 (0.60 3 30) 1 (3 .1 0 3 2 0) I the ATR is constant as income (or, more generally, the tax base) is
5 66.00 1 1 8.00 1 62 .00 5 1 46.00 increasing then the tax is proportional. It ollows that MRT 5 ATR.
The cost or 2 01 4 will be: I the ATR is d ecreasing as incom e (or, m ore generally, the tax
base) is increasing then the tax is regressive. I t ollows that
(6.80 3 1 0) 1 (0.75 3 30) 1 (3.40 3 2 0) MRT , ATR.
5 68.00 1 2 2 .5 0 1 68.00 5 1 5 8.5 0
1 68
5.3 International economics
Floating exchange rates Assu m e that U S$ 1 .00 5 I N R44.69 and the item is an
Abercrom bie and Fitch shirt that sells or U S$ 70.00. I ts price in
H ere you may be asked to calcu late the valu e o one cu rrency in
INR INR
term s o another cu rrency. I N R is its price in U S d ollars tim es ____ or, $ 3 ____ so that the
$ $
Keep in m ind that i the exchange rate o currency in term s o $ cancels ou t:
currency is e, then the exchange rate o currency in term s o INR
the price o the shirt in U S d ollars 5 $ 70.00 3 44.69 ____
1 $
will be __
e . For example i 1 .00 5 $ 1 .44 then $ 1 .00 5 0.69. 5 I N R3,1 2 8.3
You may be asked to calcu late the exchan ge rate or linear Lastly, you may be asked to calculate the change in the value o
d emand and su pply u nctions and to plot th e cu rves. The a currency rom a set o data. H ere keep in m ind that i currency
process is id entical to th e d eterm ination o the equ ilibriu m depreciates by x% compared with cu rrency then currency
price and ou tpu t or a good an d the plotting o the linear has not appreciated by x% compared with currency . I the
d emand and su pply u nctions. dollar d epreciates against the euro by 1 0% then the euro has
Or, you may be asked to calcu late the price o a good in not appreciated against the dollar by 1 0%. You will need to
d ierent cu rrencies u sing exchange rates. For example, i you calculate the inverse o the exchange rates given and then fnd
are given the price o an item in, say, U S d ollars and you want the percentage change. I the euro was $ 1 .00 and appreciated
to calcu late it in I nd ian ru pees (I N R) you m u ltiply the price o to $ 2 .00 it appreciated by 1 00%. The dollar depreciated by
INR 5 0% as it was 1 .00 and it went down to 0.5 0.
the item in d ollars tim es the ____ exchange rate.
$
The structure of the balance of payments To f nd the f nancial accou n t balance rom its com pon ents you
ad d net d irect investm ent abroad , net portolio investm ent and
H ere you m ay be a sked to ca l cu late el em en ts o th e ba la n ce
net other investm ents and reserve assets together.
o paym en ts rom a set o d ata . You ju st n eed to rem em ber a
ew th i n g s. The su m o the capital and f nancial accou nts m u st equ al the
cu rrent accou nt balance.
To f nd the balance on any item you m u st su btract paym ents
(d ebits) rom receipts (cred its). I the resu lt is a positive nu m ber Thereore, the su m o the capital, f nancial and cu rrent
you have a su rplu s in that item , while i it is negative you have accou nts m u st equ al zero. I the su m is not zero it is becau se o
a d ef cit. errors and om issions.
To f nd the cu rrent accou nt rom its com ponents you ad d net
exports o good s, net exports o services, net incom e an d net
cu rrent transers together.
1 69
5 Quantitative issues in HL Paper 3
The meaning of terms of trade year. I t ollows that the ind ex nu m ber valu e or any variable in
the base year is equ al to 1 00.
You may be asked to calcu late the term s o trad e o a cou ntry.
The term s o trad e (TOT in the equ ation below) are the ratio o For example, assu m e a cou n try that exports only coee and
th e average price o exports over the average price o im ports o imports only laptops. You are given the price o coee and the
a cou ntry expressed as ind ex nu m bers tim es 1 00. price o laptops between 2 01 0 and 2 01 4 as well as the
revenu es in m illions o U S d ollars rom its coee exports. You
average price o exports
TOT 5 ___________________ 3 1 00 are also told that 2 01 1 is the base year. You may be asked to
average price o im ports
calcu late the term s o trad e and to express export revenu es as
An index num ber is a num ber that has no units o m easurem ent an ind ex nu m ber (to f ll in the colu m ns in grey in the table).
and because o this it allows comparisons. You may be given the First you calcu late export prices as an in d ex nu m ber by d ivid ing
average price o exports and o imports o a cou ntry or a the export price in each year by the export price o the base
nu m ber o years or you may be told that a cou ntry exports only year (2 01 1 ) and then m u ltiplying by 1 00. Do exactly the sam e
one product, say oil or coee, and imports only one good, say calcu lation to d eterm ine import prices as an ind ex nu m ber.
tractors or computers, to make things simpler. Rem em ber that in the base year the valu e o an ind ex nu m ber
To convert each average exports price into an ind ex nu m ber you is 1 00. To f nd the term s o trad e in each year d ivid e the ind ex
will need to d ivid e it by the average export price or the what is o export prices by the ind ex o import prices and m u ltiply by
chosen as the base year (or reerence year) and m u ltiply the 1 00. Rem em ber that the term s o trad e in the base year are
resu lt by 1 00. You will d o the sam e to convert each average equ al to 1 00.
imports price into an ind ex nu m ber. Throu gh this you are To express export revenu es as an ind ex nu m ber d ivid e export
expressing the average price o exports (or o imports) or each revenu es in each year by export revenu es in the base year and
year as a percen tage o its average price in the chosen base m u ltiply the resu lt by 1 00.
Year Price of Average exports price Price of Average imports Terms of trade (TOT) Export Export revenues as an
coffee as an index number a laptop price as an index PX
___ revenues index number
per ton (USD) number PM 3 100 (USD
(USD) millions)
Summary
I you know:
X2 2 X1
(1 ) that the percentage change in X is _______ 3 1 00
X1
1 70
5 Data response sample questions
Chinese and US trade negotiators convene in as well as concerns over the qu ality and saety o Chinese
Washington mad e toys, ood s and other prod u cts. The latter, accord ing
to Chin ese manu actu rers, are nothing m ore that an excu se
1 . I n a U S-Chinese trad e d ispu te over tire imports the World or U S trad e protection .
Trad e Organization (WTO) recently ru led in avou r o the
U S. The d ecision conclu d ed that the U S had complied with 4. Tension is also hig h as a resu lt o the U S complaint that
global trad e ru les when last year it imposed taris as h igh China is maintaining its cu rrency, the Yu an, artif cially
as 35 percent on Chinese tires that are u sed in both undervalued in ord er to u nairly assist its exporting f rm s.
passenger cars and light tru cks. The WTO ru ling relied on Since m id -2 008 the Yu an had been u nof cially f xed to the
a special provision that the U S trad e negotiators had U S d ollar. I n 2 009 the valu e o U S exports to China
secu red when China joined the WTO. Specif cally, the U S am ou nted to $ 7 7.4 billion whereas Chinese exports to the
reserved the right to impose taris i it consid ered that U S U S, its second biggest trad ing partner, were signif cantly
jobs were at risk as a resu lt o a su d d en and sharp increase higher reaching $ 2 2 0.8 billion . The U S trade defcit has
in imports rom China. recently narrowed as a resu lt o the recession ind u ced
d ecrease in U S d emand .
2 . The WTO verd ict was hailed as a major victory or the U S
and especially or Am erican companies and workers. The 5. On the other hand , the Chinese governm ent has its own
2 009 d ecision to impose taris on tires im ported rom grievances over U S econom ic policy. I t claim s that th e
China was also a consequ ence o signif cant pressu re rom loose m onetary policy that the U S Fed eral Reserve Bank
th e United Steelworkers Union and several other U S (the U S Central Bank) has ad opted to help re ate the
lobbying grou ps. Am erican economy has erod ed the valu e o Chinas hu ge
d ollar reserves.
3. The ru ling coincid ed with the preparations or a
Washington m eeting o U S and Chinese trad e of cials to Lastly, Chinas massive selling o its own cu rrency in th e
d iscu ss trad e and exchange rate issu es. Trad e rictions oreign exchange market, to help keep the Yu an low, has
between the two cou ntries inclu d e everything rom steel, increased in ationary pressu res at hom e as the m oney
tires and pou ltry to Chinese taris on raw materials exports su pply is increasing ar too ast.
(a) (i) Def ne the term recession ind icated in bold in the text (a) (i) Def ne the term undervalued (cu rrency) ind icated in
(paragraph 4). [2 marks] bold in the text (paragraph 4). [2 marks]
(ii) Def ne the term trade defcit ind icated in bold in the (ii) Ou tline two objectives o the WTO (paragraph 1 ).
text (paragraph 4). [2 marks] [2 marks]
or:
(b) Explain u sing an appropriate d iagram why the tari (b) Explain how easy U S m onetary policy is consid ered
ru ling o the WTO is consid ered a major victory or the responsible or d ecreasin g the valu e o the d ollar reserves
United States and particu larly or Am erican workers and China is hold ing (paragraph 6). [4 marks]
bu sinesses (paragraph 2 ). [4 marks] (c) Explain how a U S recession may narrow the U S trad e
(c) Explain u sing an appropriate d iagram how the Chinese d ef cit (paragraph 4). [4 marks]
are maintaining their cu rrency artif cially u n d ervalu ed .
[4 marks]
or:
(d) U sing inormation rom the text/d ata and you r (d) U sing inormation rom the text/d ata and you r
knowled ge o econom ics, evalu ate possible consequ ences knowled ge o econom ics, exam ine possible econom ic
o China maintaining the yu an u nd ervalu ed . [8 marks] eects on the U S and China o a d ecision to perm it the
or: yu an to rise. [8 marks]
1 71
5 Data
Data response
response
sample
sample
questions
questions
Question 2
Study the extract below and answer the questions that follow.
Brazils current account defcit widens in 201 0 estimated to be the equivalent o about 3% o Brazil s GDP.
1 . I n 2 01 0 Brazil s current account defcit increased to 5. Brazil s Central Bank annou nced in its qu arterly report that
$ 47.5 billion as a resu lt o rising imports, a rapid ly GDP grew by 7.3 percent last year as a consequ ence o
appreciating Real (Brazil s cu rrency) and its ad verse eect increased d eman d , cheap loans and investm ents. A su rvey
on the cou ntrys exports. Years o stable and continu ou s o econom ists expects Brazil s growth to slow d own to
growth is responsible or higher import absorption while 4.5 percent this year. The Central Bank signaled that it
oreign m u ltinational corporations with an established may also start tightening m onetary policy next m onth
presence in Brazil repatriate their prof ts taking ad vantage as in ation is projected to increase aster than orig inally
o the higher valu e o the Real. expected .
2 . Rising in ows rom oreign direct investm ent in to Brazil
u lly f nanced the cu rrent accou nt d ef cit. I n 2 01 0
Brazil ears international currency war
m u ltinationals invested $ 48.5 billion into Brazil u p rom 6. Brazilian Finance Minister Ed u ard o M antega claim ed in an
$ 2 5.9 a year earlier. interview that an international cu rrency war has begu n as
3. Decreasing exports and rising imports o good s as a resu lt g overn m ents are intervening in oreign exchange markets
manipu lating their cu rrencies. Mantega consid ers this
o the strengthening o the cu rrency narrowed Brazil s
tactic a d irect threat to Brazil as it erod es its
trade surplus rom $ 2 5.3 billion in 2 009 to $ 2 0.7 billion
this year. The cu rrency has appreciated rou ghly by 30% com petitiveness. Governm ents d eliberately weaken their
against the U S d ollar since th e beginning o 2 009. cu rrencies to improve trad e balances by rend ering their
exports m ore competitive and red u cing the attractiveness
4. In the m eantim e, oreign direct investm ent inows continue o im ported prod u cts. The ad vanced cou ntries are seeking
to increase and are predicted to rise to over $ 5 0 billion in to d evalu e their cu rrencies, said the Finance M inister,
2 01 1 . A $ 7.1 billion investm ent involving the Chinese group pointing u nm istakably to the United States, Japan and
Sinopec and Brazil s Repsol is responsible or the increased Eu rope. Su ch policies artif cially strengthen trad e
fgure this m onth. This trend in direct investm ent inows com petition and risk an abru pt policy reversal toward s
m ust continue as the current account defcit is projected increased trad e protection.
to urther widen to $ 64 billion in 2 01 1 . This fgure is
(a) (i) Def ne the term current account defcit ind icated in (a) (i) Def ne the term oreign direct investment ind icated in
bold in the text (paragraph 1 ). [2 marks] bold in the text (paragraph 2 ). [2 marks]
(ii) Describe a managed exchange rate system (ii) Def ne the term trade surplus ind icated in bold in the
(paragraph 6). [2 marks] text (paragraph 3). [2 marks]
or:
(b) U sing an appropriate d iagram explain how a d ecision (b) Explain whether each o the ollowing is registered as a
by Brazil s Central Bank to increase interest rates may cred it or a d ebit item in Brazil s Balance o Paym ents:
aect the Real (paragraph 6). [4 marks] g reater oreign travel by Brazilians (paragraph 1 )
(c) Exam ine the relationship d escribed between Brazil s the $ 7.1 billion transaction involvin g the Chinese
cu rrent and f nancial accou nts (paragraph 2 ). [4 marks] grou p Sinopec and Repsol Brazil (paragraph 4)
or: i ncreased overseas prof ts rem ittances by
(b) Explain u sing an exchange rate d iagram how weakening m u ltinationals (paragraph 1 )
cu rrencies may boost exports and improve trad e balances consu mption o m ore im ports (paragraph 1 )
(paragraph 6). [4 marks] [4 marks]
(c) Explain the expected eect on Brazil s term s o trad e o (c) (H L only) U sing a proper J-cu rve eect d iagram , explain
the appreciation o the Real (paragraph 3). [4 marks] whether ollowing the appreciation o the Real the
or: Marshall-Lerner cond ition or Brazil has com e into eect
(paragraph 3 ). [4 marks]
(d) U sing inormation rom the text/d ata and you r (d) U sin g inormation rom the text/d ata and you r
knowled ge o econom ics, evalu ate th e possible knowled ge o econom ics, exam ine possible reasons or
econom ic consequ ences o the appreciation o the which oreign d irect investm ent has been owing in to
Real on Brazil s economy. [8 marks] Brazil. [8 marks]
or:
1 72
55Quantitative
Data response
issues
sample
in HLquestions
Paper 3
Question 3
Study the extract below and answer the questions that follow.
The East African Community strategy to no need to convert cu rrencies in the oreign exchange
accelerate growth market tran saction costs will be signif cantly red u ced . The
elim ination o taris and other trad e barriers has alread y
1 . Bu ru nd i, Kenya, Rwand a, Tanzania and U gand a are enhanced trad e ows between the f ve m em ber states.
m em bers o the East Arican Com m u nity (EAC) which rom Greater tran sparency will perm it d irect price comparisons
Ju ly 2 01 0 has evolved rom a cu stom s u nion to a com m on boosting com petition and ef ciency. M em bers are also
market. The total popu lation o this regional trad ing bloc expected to benef t rom the greater bargaining power they
exceed s 1 2 5 m illion people while com bined GDP is rou ghly will enjoy in political and econom ic negotiations.
$ 75 billion.
4. On the other hand , d oing bu siness in the region has n ever
2 . As a resu lt o the ormation o a com m on market, trad e been easy. Poor infrastructure as well as high levels o
and investm ent ows insid e the bloc will increase while corru ption bu rd en bu sin esses with ad d itional costs. Sizable
foreign direct investment will also be attracted . By 2 01 2 investm ents in u pgrad ing road s and transport system s as
m em bers also plan to establish a m onetary u nion ad opting well as in d evelopin g su f cient and reliable power
th e East Arican Shilling as a com m on cu rrency. The generation acilities are expected to red u ce prod u ction
Com m on M arket agreem ent signed at the end o 2 009 has costs and thu s to accelerate growth or all f ve m em ber
alread y attracted signif cant investm ents rom Japan, states. On the other hand , erad icating corru ption may
China and I nd ia. prove m u ch m ore complex. For exam ple, even thou gh
3. Establishing an East Arican M on etary Union will prove region al taris have been elim inated since 2 005 m ore
ad van tageou s to investors who are expected to actively than 2 0% o cu rrent shipping costs rom Rwand a to Kenya
seek bu siness opportu nities in the region. As there will be are attribu ted to bribes an d corru ption.
(a) (i) Def ne the term infrastructure ind icated in bold in th e Or:
text (paragraph 4). [2 marks] (a) (i) Def ne the term foreign direct investment (paragraph 2 ).
(ii) Def ne the term GDP ind icated in bold in the text [2 marks]
(paragraph 1 ). [2 marks] (ii) Ou tline th e d ierences between a cu stom s u nion and a
(b) Explain two possible reasons or which signif cant com m on market (paragraph 1 ). [2 marks]
investm ents rom Japan, Chin a and I nd ia are alread y (b) Explain u sing an appropriate d iagram h ow elim inating
attracted into the EAC (paragraph 2 ). [4 marks] taris aects trad e ows o the cou ntries involved
(c) Explain u sing appropriate d iagram (s) the possible short (paragraph 3). [4 marks]
term an d long term impact o increased and im proved (c) U sing an appropriate d iagram explain the expected eect
inrastru ctu re in any o the EAC econom ies (paragraph 4). on an econ omy o a d ecrease in the level o corru ption
[4 marks] (paragraphs 4 and 5 ). [2 marks]
(d) U sing inormation rom the text/d ata and you r knowled ge (d) U sing inormation rom the text and you r knowled ge o
o econom ics, evalu ate the prospect o the East Arican econom ics d iscu ss the possible ad vantages and
Com m u nity establishing a m onetary u nion as a m eans o d isad vantages o signing a m onetary u nion or the EAC
achieving econom ic growth and econom ic d evelopm ent. m em ber cou ntries. [8 marks]
[8 marks]
1 73
5 Data
Data response
response
sample
sample
questions
questions
Question 4
Study the extract below and answer the questions that follow.
A. India: Time to rethink crutches or exports that not only shou ld inrastru ctu re im prove to allow
exporting f rm s bu t also that the governm ent shou ld
1 . I nd ias export perormance in Decem ber 2 01 0 highlights
sim pliy proced u res and cu t d own on red tape. Will it m ove
several interesting d evelopm ents. First o all, it
in the right d irection?
d em onstrates that the exchange rate is not anym ore the
single m ost important d eterm inant o the cou ntrys export
perormance. Whether I nd ian exports penetrate oreign B. Rupee rises on und infows
markets d oes not only d epend on a cheap cu rrency. 5. Expectations that I nd ias economy will continu e to register
I nternational competitiveness relies m ore on increased strong growth as well as relatively high interest rates have
prod u ction ef ciency o I nd ian f rm s as well as on several been responsible or increased oreign investm ent as well
im proved non-price actors. as or the appreciation o the I n d ian ru pee. The Reserve
2 . Second ly, I nd ias export su ccess d oes not anym ore rely on Bank o I nd ia (its central bank) orecasts that the economy
the perormance o a ew commodities or on low valu e- will grow this year by 8.5 %. The interest rate has been set
ad d ed manu actu res. Past governm ent policies to d iversiy at 6.2 5 % by the RBI and is th e second highest ater
the composition o exports as well as their d estination I nd onesia in the region . Analysts thu s expect that oreign
(su ch as the Look East policy initiative or the ocu s on appetite or I nd ian assets will remain strong as the interest
Arican and Sou th Am erica) are paying o. And even rate d ierential will attract d ollar investors.
thou gh growth in ad vanced econom ies is slu ggish many
em erging econom ies are growing ast. C. Cotton prices to hit clothing exports
3. Third ly, rapid ly increasing export revenu es are narrowing this year
I nd ias trad e and cu rren t accou nt d ef cits. The gap between 6. Accord ing to a recent report, rising cotton prices as well as
export revenu es and import expen d itu res had wid ened the appreciation o the ru pee cou ld harm exports o the
d u ring the f rst hal o the cu rrent year to $ 3 5.4 billion or I nd ian clothing sector. As a resu lt o these d evelopm ents
3.7 % o I nd ias GDP as a resu lt o a sharp rise in imports. export revenu es o clothing exporters cou ld d ecrease
The size o this d ef cit was then consid ered by many lowering their prof tability. The report ad d s that d espite
analysts as increasingly u nsu stainable. improving export d emand in key markets the U S and
4. Thu s, the recently registered strong perormance o export Eu rope ru pee appreciation has im paired the competitive
revenu es which are now growing aster than im port ad vantage previou sly enjoyed by the I nd ian clothing
expend itu res is a m ost welcom e d evelopm ent. I t also exporters against their Asian rivals.
points to the sig nif cance o the export sector an d su gg ests
(a) (i) Def ne the term exchange rate ind icated in bold in (ii) Outline two typical unctions o a Central Bank, such
the text (paragraph 1 ). [2 marks] as the Reserve Bank o India (paragraph 5 ). [2 marks]
(ii) Def ne the term growth ind icated in bold in the text or:
(paragraph 5 ). [2 marks] (a) (i) Def ne the term commodities ind icated in bold in th e
or: text (paragraph 2 ). [2 marks]
(a) (i) Def ne the term appreciation ind icated in bold in the (ii) Def ne the term GDP ind icated in bold in the text
text (paragraph 6). [2 marks] (paragraph 3). [2 marks]
(b) Explain u sing an appropriate d iagram how econom ic investm ents may have aected the I nd ian ru pee
recovery in the western world may aect I nd ias (paragraph 5 ). [4 marks]
aggregate d emand (paragraph 2 ). [4 marks] (c) With reerence to the concept o price elasticity o
(c) Explain how greater prod u ction ef ciency and improved d emand , explain how I nd ias cotton export revenu es may
non-price actors may increase the competitiveness o d ecrease ollowing an appreciation o the ru pee
I nd ias exports (paragraph 1 ). [4 marks] (paragraph 6). [4 marks]
or: or:
(b) Explain the implication or I nd ias term s o trad e o the (b) Explain u sing an appropriate d iagram how relatively
ru pee appreciation m ention ed in paragraph 5. [4 marks] high interest rates have aected the Indian rupee
(c) Distingu ish the term s trad e and cu rren t accou nt d ef cits (paragraph 5 ). [4 marks]
m entioned in paragraph 3 . [4 marks] (c) U sin g an appropriate d iagram explain how the
or: d evelopm ent in cotton prices aects the d om estic
(I nd ian) price o clothing (paragraph 6). [4 marks]
(b) Explain u sing an appropriate d iagram how I nd ias
expected growth ou tlook and its im pact on oreign
1 74
55Quantitative
Data response
issues
sample
in HLquestions
Paper 3
(d) U sing inormation rom the text/d ata and you r or:
knowled ge o econom ics, d iscu ss the view that econom ic (d) U sing inormation rom the text/d ata and you r
d evelopm ent may best be achieved throu gh a knowled ge o econom ics, evalu ate export prom otion as a
com plem entary approach involving a balance o market m eans o accelerating growth and econom ic
oriented policies and governm ent intervention. d evelopm ent. [8 marks]
[8 marks]
or:
(d) U sing inormation rom the text/d ata and you r
knowled ge o econom ics, exam ine d iversif cation as a
m eans o accelerating growth and econom ic
d evelopm ent. [8 marks]
1 75
5 Data
Data response
response
sample
sample
questions
questions
Question 5
Study the extract below and answer the questions that follow.
More Kenyans to access banking service Philippines: Micro credit gains ground
1 . A new agent banking m od el is soon to be introd u ced by 4. Th e poor who need to borrow oten pay extrem ely in ated
the Central Ban k o Kenya (CBK) which will hopeu lly interest rates as they are orced to resort to the inormal
su cceed in bringing banking services closer to the banking system . An alternative or these people are m icro
popu lation. Fou r commercial banks have been granted a cred it institu tions. N ot only d o the very poor in cases o
license to cond u ct agent banking bu siness. A physical m ed ical or other em ergencies u se su ch in stitu tions, bu t
presence accord ing to the agent banking m od el is not also many small hou sehold based entrepreneu rs who
requ ired in the areas where these banks are planning borrow to f nance short term need s o their small
to oer their services. This signif cantly lowers the bu sinesses.
costs o expand ing. 5. M icro cred it may help alleviate poverty bu t it is not a
2 . The services oered by an agent ban k are the sam e as cu re-all an swer. Despite aim ing to help the very poor, loan
those oered by a real bank and inclu d e, am ong others, recipients still m u st satisy som e m inim u m requ irem ents.
cash d eposits and withdrawals, transer o u nd s as well as For example, poor ind ivid u als hoping to set u p a small
loans. Petrol station owners, villag e town wholesalers, bu siness m u st d em onstrate that they are capable to
su permarket owners and post of ces are examples o the manage it.
prof les o banking agents in this m od el. Micro credit 6. I n the Philippines, the market or su ch m icro cred it
institu tions are also expected to becom e agents, as not institu tions d ef nitely exists as abou t 40 percent o ru ral
only d o they satisy the requ irem ents bu t they also have h ou sehold s are very poor. Su ccess o su ch institu tions
the experience. involves signif cant risks sin ce the prod u ctivity o the
3. Access to banking institu tions is consid ered highly targeted poor larg ely d epend s on agricu ltu re. I t ollows
benef cial, especially since this m od el wou ld perm it a that targeted in rastru ctu re su ch as arm to market road s
banking presence in ru ral and rem ote areas o the cou ntry. and irrigation system s are necessary to increase their
At this point only 23 percent o the cou ntrys ad u lt capacity to repay their loans. Micro cred it and improved
popu lation hold s a bank accou nt while 34 percen t has no inrastru ctu re thu s go hand in hand : both are need ed to
access to ormal f nancial services with many orced to increase agricu ltu ral prod u ctivity and incom es and the one
resort to the inormal banking sector. These are exactly the withou t the other is inad equ ate to ad dress the problem o
ind ivid u als targeted by the proposed agent banking ru ral poverty. M ore generally, m icro cred it requ ires
m od el and by m icro cred it institu tions. I ncreasing access to com plem entary strategies that aim to increase the incom e
banking institu tions will in crease savings and investm ents. earning capacity o the loan recipients. Only then will it
As a resu lt, growth and d evelopm en t o poverty stricken, becom e eective and su stainable in the long ru n.
ru ral and rem ote areas will hopeu lly accelerate.
(a) (i) Def ne the term commercial bank ind icated in bold in (c) Explain two possible problem s associated with the u se o
the text (paragraph 1 ). [2 marks] inormal banking system s (paragraphs 3 and 4).
(ii) Def ne the term micro credit ind icated in bold in the [4 marks]
text (paragraph 2 ). [2 marks] (d) U sing inormation rom the text/d ata and you r knowled ge
(b) Su ggest two strategies that may improve the capacities o o econ om ics, exam ine how expand ed access to cred it may
benef ciaries to earn incom es and repay their loans contribu te to econom ic d evelopm ent. [8 marks]
(paragraph 6). [4 marks]
1 76
Glossary
Abnormal prots (see Supernormal prots) Anti-monopoly regulation Laws and agreements between two countries.
Absolute advantage A country is said to regulations that aim to restrict monopoly Bilateral aid Aid rom one government to
have an absolute advantage in the power and monopoly practices in markets. another through some kind o national
production o a good i it can produce Appreciation An increase in the exchange aid agency.
more o it with the same resources; or, the rate within a fexible (foating) exchange Birth rate The average number o live
same amount using ewer resources. rate regime. births in a year or every 1,000 population.
Absolute poverty Measures the number o Appropriate technology Technology that Bottlenecks (in production) Used to
people living below the minimum income employs the relatively abundant actor o explain the upward sloping section o the
necessary to satisy basic physical needs; production o a country. Keynesian aggregate supply (AS) curve
the 2008 World Bank international poverty Asymmetric inormation Exists when one (section 2) which reers to the act that as
line is set at $1.25 purchasing power parity side o a market knows more than the aggregate demand (AD) increases, some
(PPP) per day. (See also Purchasing other side does. industries being characterized by very low
power parity (PPP) theory.) Automatic stabilizers Reers to the price elasticity o supply (PES) reach their
Accounting costs Production costs or which income-induced changes o progressive capacity level o output beore others .
a rm makes explicit monetary payments. income taxes and o unemployment Branding A type o rm-created barrier to
Actual and potential growth Actual benets on the governments budget that entry which reers to the eorts rms make
growth reers to increases in real GDP tend to stabilize the business cycle. to establish the brand name image o their
through time; potential growth reers to a Average xed costs (AFC) Fixed costs goods in order to render demand or those
shit outwards o the production on a per unit o output basis; xed goods more price inelastic and deter entry
possibilities rontier or curve. costs divided by the level o output; o new rms.
Ad valorem tax An indirect tax expressed average xed costs continuously decrease Break-even output That level o output or
as a percentage o the price o a product, as output increases. (See also Fixed costs.) which the total revenues (TR) o a rm are
or example VAT. Average household A ctitious household equal to the total costs (TC) o production
Administrative trade barriers determined through surveys that possesses so that prots are zero.
(or, regulatory trade barriers) the average characteristics o the population Break-even price The price at which a rm
Government or administrative regulations or and that is used in the construction o the is earning zero economic prots (that is,
requirements that result in a lower level o consumer price index (CPI). normal prots) which or a perectly
imports into a country. Average product (o labour) Output per competitive rm is the minimum o its
Adverse selection A problem arising when worker and used as a common measure o average total costs (ATC).
inormation in a market is asymmetric and labour productivity. Budget decit Exists i government spending
the seller knows more about the Average revenue (AR) Total revenues (TR) (G) exceeds government (tax) revenues (T).
characteristics o the good being sold than divided by output; AR is always equal to Budget surplus Exists i government (tax
the buyer. The buyer would be better o price and diagrammatically is identical to and other) income (T) exceeds government
trading with someone selected at random the demand curve a rm aces. expenditures (G) .
rom the general population than with Average tax rate The ratio o the tax Business condence The degree o
this seller. paid over the tax base, or example optimism or pessimism characterizing
Aggregate demand (AD) Total planned income or spending. businesses which aects their decisions
spending on domestic goods and services Average total costs The total costs on investment spending.
at various possible average price levels per incurred on a per unit o output basis. Business cycle The short-run fuctuations
period o time. (See also Total costs.) o real GDP around its long-run trend.
Aggregate supply (AS) The planned Average variable costs (AVC) Variable Business taxes Taxes on rms prots.
level o output at various possible price costs on a per unit o output basis; Cap and trade schemes A solution to
levels that rms are willing to oer per variable costs divided by the level o pollution externalities that aims at
period o time. output. (See also Variable costs.) creating a market or pollution permits by
Aid Any fow o capital (grants or loans) Balance o payments (BOP) A record o limiting (capping) the number issued
rom developed to developing countries all transactions o a country with the rest (making them scarce and valuable) and
that is non-commercial rom the point o o the world over a period o time. It is then permitting rms to trade these in the
view o the donor and or which the terms broken down into the current account, the open market.
are concessional (that is, the interest rate capital account and the nancial account. Capital Produced means o production
is lower than the market rate and the Balance o trade Reers to the dierence (tools, machines, equipment, actories, etc.).
repayment period longer). between the value o exports and the Capital account o the balance o
Allocative eciency Exists when just the value o imports o goods (physical payments (BOP) An account o the
right amount rom societys point o view merchandise) over a period o time BOP which records unilateral transers
has been produced. It requires that or the (sometimes services are also included). o capital, such as the orgiveness o
last unit produced, price is equal to its Balanced budget When government a countrys debt by the government
marginal cost (MC) or, more generally, expenditures (G) are equal to government o another country as well as transers
that marginal social benet (MSB) is equal tax and other revenues/income (T) o non-produced, non-nancial assets
to marginal social cost (MSC). Barrier to entry Anything that deters such as natural resources, contracts,
Anti-dumping duties Taxes (taris) that entry o a new rm into a market, or leases and licences, marketing assets
bring the import price o the good that is example a patent. (and goodwill).
being dumped closer to the price Basic economic questions The what, Capital fight Reers to nancial capital
charged by domestic rms in order to how and or whom questions that all exiting a country legally or illegally and
avoid injury to the domestic industry in economies must somehow answer. fowing into saer and more protable
the importing country. Bilateral agreements Preerential trade nancial centres.
1 77
Glossary
Capital fows Investment fows per period o it is dicult to exclude individuals rom Contractionary scal policy Decreases in
time into and out o a country. These include deriving benets rom their use and which government spending and/or increases in
portolio and oreign direct investments. are rival in consumption, or example taxes aimed at decreasing aggregate
Capital gains tax A tax on the gains rom shing grounds and orests. demand (AD).
the sale o stocks (shares). Common market A orm o economic Contractionary monetary policy (see
Capital (government expenditures) integration whereby members move orward Tight monetary policy)
Reers to public investment spending, or to establish not only ree trade in goods and Core infation A measure o infation that
example spending by the government on services but also ree movement o actors o excludes volatile oil and ood prices.
inrastructure such as on the construction production. Corporate social responsibility A possible
o roads, harbours, hospitals and schools. Common-pool resources (see objective o rms that aims at creating and
Carbon tax A tax on polluting emissions Common-access resources) maintaining an ethical and environmentally
that aims at orcing polluters to pay the cost Comparative advantage A country is said responsible image or them.
o their action (polluter pays principle); a tax to have a comparative advantage in the Corporate indebtedness The total
on the carbon content o ossil uels. production o good X i it can produce it at a amount o money that rms owe to banks
Cartels Formal collusion o oligopolistic lower opportunity cost (that is, by sacricing and other holders o their debt and which
rms agreeing to behave as i they were a ewer units o good Y) compared with is considered a actor that may aect their
monopoly by restricting output in order to another country. decision to undertake additional
x price at a higher level. Competitive supply I a rm can produce investment spending.
Central bank An institution responsible or dierent goods with the same inputs then Cost-push infation Infation resulting
monetary and exchange rate policy which these goods are in competitive supply. rom adverse supply shocks shiting
provides banking services to the government Complementary goods or aggregate supply (AS) to the let; usually,
and to commercial banks and which is complements Goods that are consumed rising commodity prices are responsible,
considered the lender o last resort. jointly, or example coee and sugar. especially oil prices.
Centrally planned (command) economy Composite indicators o development Credit item (in the BOP) Any item that
Reers to an economy in which the state Indicators o development that are based leads to an infow o money into a country,
determines prices and output o goods and on more than one economic variable, or or example exports o goods and services
services. example the Human Development Index. or oreigners purchasing domestic bonds.
Ceteris paribus All other actors remaining Concentration ratio A measure o Cross-price elasticity o demand
constant. concentration based on ratio (CR) in an (XED) The responsiveness o the demand
Circular fow model An economic model industry where typically the sales o the or a good to a change in the price o
showing the major interrelationships and largest n rms are expressed as a percentage another good.
fows, real and monetary, between the o total industry sales; or example the Crowding-out The idea that expansionary
major players (decision-making units) o our-rm CR expresses the sales o the scal policy was not as eective as
an economy. largest our rms as a proportion o total Keynesian theory claimed because decit
Closed economy An economy that does industry sales. spending required nancing which would
not engage in international trade (exports Concessional loans Loans granted to a lead to increased interest rates and so
and imports). country usually by a multilateral institution, reduced private sector spending.
Collusive oligopoly When oligopolistic or example the IMF, with a longer Current government expenditures
rms ormally or tacitly agree to x price or repayment period and with an interest rate Spending by the government on wages and
to engage in other anti-competitive below the market rate (known as sot loans). salaries o public sector employees as well
practices. Constant returns to scale A production as spending on consumables (day-to-day
Commodities Primary sector agricultural and technology where a 1 % increase in all items) such as stationery.
non-agricultural products used as inputs in inputs leads to a 1 % increase in output (so Current account (o the BOP) Records
the manuacturing process and traded in that unit costs are constant). the value o exports and imports o goods
international markets, or example coee, Consumer condence The degree o and services o a country in a period o
cotton, tin, zinc and copper). optimism or pessimism characterizing time. A current account surplus exists i the
Commodity agreements Agreements households which aects their spending value o exports o goods and services
between producers to coordinate decisions. exceeds the value o imports. This applies
commodity exports in order to stabilize Consumer expenditures Spending by conversely or a decit. More precisely, the
prices. Either a production (export) quota households on durable and non-durable current account includes visible trade and
system is operated (such as the goods and services per period o time. invisibles. The latter include trade in
I nternational Coee Agreement) where Consumer price index (CPI) A weighted services and net investment income as well
producers (exporting countries) agree to average o the prices o the goods and as net transers.
limit the amount exported, eectively services that the typical consumer aces, Current account decit When import
orming a cartel; or a buer stock system expressed in index number orm. expenditures on goods and services exceed
(or example or cocoa or rubber) may be Consumer surplus The dierence between export revenues over a period o time; more
operated. Commodity agreements usually how much a consumer is willing and able to precisely, when the sum o net exports o
collapse because o nancing problems. pay at the most or some amount o a good goods and services plus net income rom
Commodity concentration o exports and what he or she actually ends up paying. investments plus net transers is negative.
When one or very ew products are Consumption (see Consumer expenditures) Current account surplus When export
responsible or a large percentage o the Consumption externality When the revenues exceed import expenditures on
export revenues o a developing country, consumption o a good imposes costs or goods and services over a period o time;
or example copper and nitrates or Chile. creates benets or third parties or which more precisely, when the sum o net exports
Common-access resources Common-access the latter do not get compensated or do o goods and services plus net income rom
(or pool) resources are resources or which not pay or. investments plus net transers is positive.
1 78
Glossary
Customs unions A orm o regional Demerit goods Consumption o such goods Easy monetary policy When the central
economic integration whereby two or more creates very signicant negative externalities bank decreases interest rates (or increases
countries abolish taris (and other on society so governments try to decrease or the money supply) to increase aggregate
barriers) between them and establish a prohibit their consumption. Typical examples demand (AD) in an economy and thereore
common external barrier toward non- include alcohol, tobacco and illegal drugs. overall economic activity.
member countries. Demographic actors Factors pertaining Economic costs The value o all resources
Cyclical (demand-decient or Keynesian) to the characteristics o a population in a sacriced to produce a good.
unemployment Unemployment that is a country, or example the average age o a Economic development A sustainable
result o insucient aggregate demand population. increase in living standards that implies
(AD) and o sticky money wages. Cyclical Depreciation (o a currency) A decrease increased per capita income, better
unemployment rises as an economy moves in the exchange rate within a foating education and health as well as
deeper into recession. (fexible) exchange rate system. environmental protection.
Death rate The average number o deaths Deregulation Policies that lower or eliminate Economic good Goods whose production
in a year or every 1,000 population. government regulations on the operation o involves the sacrice o scarce actors o
Debit item (in BOP) Any item that leads to an industry and which may have a positive production.
an outfow o money rom a country, or supply-side eect on the economy. Economic loss A rm is making economic
example imports o goods and services or Determinants o demand Factors other losses i its revenues are insucient to
domestic residents purchasing oreign bonds. than the price o a good that may aect its cover all economic (that is, both implicit
Debt burden Signies the impediment to demand and shit it, such as changes in and explicit) costs; negative economic
the growth and development process o a income, tastes and prices o related goods. prots.
country that a high external debt creates. Determinants o supply Factors other Economic models Simplied representations
Debt rescheduling Reers to agreements than the price o a good that may aect o economic reality, typically but not
between a debtor country and its creditors its supply and shit it, such as changes in necessarily expressed in mathematical orm,
to deer debt service payments, to extend the price o inputs or the level o aiming at acilitating comprehension o
maturities on all outstanding debt and technology available. complex economic phenomena and at
perhaps even to reduce debt-service Devaluation (o a currency) A decrease deriving alsiable hypotheses.
obligations in order to provide the debtor in the exchange rate within a xed Economic prots The reward o
with debt relie. exchange rate system. entrepreneurship. They are dened as the
Debt servicing Payment o interest and Dierentiated product Products which are (positive) dierence between total revenues
principal o a debt (o a country or an similar but not identical across sellers in an (TR) and total economic costs (TC).
individual). industry. They are considered by consumers Economic union A orm o regional
Decile One o the ten equal parts o a as close but not perect substitutes. economic integration where members o a
requency distribution. Direct taxation Taxation on income customs union decide to integrate urther
Decreasing returns to scale A production and wealth. by harmonizing taxation and other
technology where a 1 % increase in all inputs Diseconomies o scale (DOS) Reers to economic policies and even establishing a
leads to a smaller than 1 % increase in increases in average costs (AC) as a result o common currency.
output (so that unit costs rise; diseconomies increased size o the rm; see also Economies o scale (EOS) Economies o
o scale DOS). decreasing returns to scale. scale exist i average costs decrease as the
Defation Reers to the case where the Disguised unemployment (see Hidden size (scale) o the rm increases.
average level o prices is decreasing unemployment) Education indicators Single variable or
through time. Defation implies negative Disinfation Disinfation exists when the composite indicators that aim at
infation rates. rate o infation decreases which means summarizing an aspect or the level o
Defationary gap A defationary gap is that prices continue to rise but at a education o a country, or example the
present i equilibrium (actual) real output decreasing rate. adult literacy rate or primary education
alls short o the level corresponding to the Disposable income Income ater completion rate.
ull employment level o output as a result subtracting direct taxes and adding transer Eciency Reers, in general, to non-
o insucient aggregate demand (AD). payments which can be spent or saved. wasteul use o scarce resources. (See also
Demand The relationship between various Distribution o income A representation Allocative eciency, Productive eciency
possible prices and the corresponding o what proportion o national income is and Technical eciency.)
quantities that an individual or the market enjoyed by dierent segments o a Elasticity Generally, the responsiveness o
is willing and able to buy per period o time, population; a requency distribution an economic variable to a change in some
ceteris paribus. The individual demand showing groups o people classied by other economic variable. For example,
reers to an individual consumer whereas levels o national income. price elasticity o demand (PED).
the market demand reers to the whole Diversication (o exports) A policy Emergency relie aid (see Humanitarian
market and diagrammatically it is the initiative to move away rom commodity aid)
horizontal summation o the individual concentration o exports. When a country, Empowerment o women In the US
demand curves. instead o relying on only a ew denition the term has ve components:
Demand-pull infation Infation resulting commodities to export, tries to export a womens sense o sel-worth; their right to
rom aggregate demand (AD) rising aster bigger variety o goods and services. have and to determine choices; their right
than aggregate supply (AS). Dominant rm Typically the largest in size to have access to opportunities and
Demand-side policies Policies aimed at rm in an oligopoly which may set prices resources; their right to have the power to
infuencing the level o aggregate demand that other tacitly ollow. control their own lives, both within and
(AD) in order to aect growth, employment Dynamic eciency When a rm enjoys outside the home; and their ability to
and infation. They include scal and economies o scale (EOS), leading to aster infuence the direction o social change to
monetary policy. rates o innovation (new products and create a more just social and economic
new processes). order, nationally and internationally.
1 79
Glossary
Entrepreneurship The willingness and Expenditure-changing and expenditure- Fixed exchange rate system A system
ability o certain individuals to organize switching policies Expenditure changing: where the exchange rate is set at a level or
the other three actors o production and demand management policies that will within a range by the government and is
to take risks. lower aggregate demand (AD) and thereore then maintained there through central
Equilibrium A market is considered to be in national income and so reduce imports and bank intervention (specically, through
equilibrium i there is no tendency or a trade decit. Expenditure switching: buying and selling the currency in the
change. This will be the case i quantity policies that will try to switch expenditure oreign exchange market and/or
demanded per period equals quantity away rom imports and towards domestic manipulating the interest rate).
supplied and the market clears (that is, products by making imports relatively more Floating (fexible) exchange rate
quantity demanded equals quantity expensive and thereore undesirable, or system A system where the exchange
supplied and so neither excess demand example through devaluation or through rate is determined solely through the
nor excess supply exist). the imposition o taris. interaction o demand and supply or the
Equilibrium price The price at which a Expenditure fow Within the circular fow currency with no government (central bank)
market clears (that is, at which quantity diagram o a closed economy without intervention.
demanded equals quantity supplied and government it reers to the monetary fow Food price controls Maximum prices
so neither excess demand nor excess rom households to rms that refects their imposed by some governments on ood
supply exist). spending on domestic output per period. items which are set below the ree-market
Equilibrium quantity The quantity that Explicit costs Also reerred to as out-o- equilibrium prices and which aim at
corresponds to the equilibrium price in a pocketcosts o production. (See also protecting the vulnerable.
market. Accounting costs.) Foreign debt The amount o money that a
Equity Reers to airness in the distribution Export promotion A growth policy that country owes to oreign entities that
o income. aims at using export demand as the include oreign governments, commercial
Excess demand Excess demand exists when vehicle o growth and that is oten banks and multilateral institutions and
at some price the quantity demanded is contrasted to import substitution. which is repaid in oreign exchange.
greater than the quantity supplied, exerting Export subsidy A payment granted by a Foreign direct investment (FDI) When
pressure on the market price to increase. government to domestic rms to multinational corporations establish a new
Excess supply Excess supply exists when at strengthen their competitiveness against rm or acquire controlling interest in an
some price the quantity supplied is greater oreign producers. existing one in a oreign country. It is
than the quantity demanded, exerting Export-led/outward-oriented growth distinct rom portolio investment as in FDI
pressure on the market price to decrease. A strategy stressing export markets in the the investor has control over the asset.
Exchange rate The price o a currency belie that the resulting increase in Foreign exchange reserves The value o
expressed in terms o another currency. aggregate demand (AD) and in oreign oreign exchange holdings at the central
The number o units o a oreign exchange earnings, together with the bank o a country.
currency required to buy a unit o the aster transer and diusion o technology Free goods Goods that do not have an
domestic currency. and all other trade-related eciency opportunity cost, or example sea water.
Excise tax An excise tax is an indirect tax benets, will accelerate the growth and Free market economy Reers to an
(that is, a tax on goods or on expenditure); development process o an economy. economy in which markets alone, in other
strictly speaking it is a tax levied on a Externalities When an economic activity words the interaction o buyers and sellers,
specic commodity or group o creates benets or imposes costs or determine prices and output.
commodities in contrast to a sales tax third parties or which these do not pay Free rider problem A consequence o
which is levied on all commodities (US use). or, or do not get compensated or, non-excludability in the case o public
Exit (rom a market) When a rm or rms respectively. goods: it reers to the ability o all
shut down and cease operations in a market. Factor endowments The actors o individuals to benet rom a good or
Exit barriers Costs that a rm incurs production (land, labour, capital and service once it becomes available to one.
upon exit. entrepreneurship) o a country. Free trade Reers to international trade that
Expansionary scal policy Reers to Factors o production The land (natural is not subject to any type o trade barriers.
increases in government expenditures capital), labour, human capital, physical Free trade area (agreement) An
and/or decreases in taxes aiming at capital and entrepreneurship an economy agreement that is ormed when two or
increasing aggregate demand (AD) and has at its disposal. more countries abolish taris (and other
economic activity. Fertility rate The average number o live barriers) between them while maintaining
Expansionary monetary policy (see Easy births per 1,000 or all women between existing barriers to non-members.
monetary policy) 1 5 and 44 years old. Frictional unemployment Reers to
Expectations The present perception o Financial account Records the portolio people in between jobs. It is a orm o
decision-making units concerning the uture and oreign direct investment (FDI) into unavoidable unemployment as people are
state o aairs in an economy, a market or and out o a country over a period o time constantly moving between jobs in search
the value o an economic variable. as well as changes in reserve assets. o better opportunities. Better and aster
Expected variables The uture value o a Fiscal policy Reers to the manipulation o inormation concerning the labour market
variable as perceived presently. the level o government spending (G) and can lower this type o unemployment.
Expenditure approach Reers to one o the o taxation (T) in order to aect aggregate Full employment The term has come to
three ways o measuring national income demand (AD). reer to the situation where there is
whereby expenditures by households, rms, Fixed costs Production costs refecting the equilibrium in the labour market and so any
oreigners and the government on domestic use o xed inputs which are independent unemployment remaining is not demand-
goods and services over a period o time o the level o output and exist even i decient. Any increase in total output
are added (the other two methods are the output is zero; their existence signals that beyond the ull employment level will prove
output method and the income method). the rm operates in the short run. infationary and temporary.
1 80
Glossary
Game theory A branch o mathematics with Hidden unemployment Unemployment that Income elasticity o demand
many applications in economics that is not refected in ocial unemployment (XED) The responsiveness o demand
analyses in a stylized orm situations where statistics which includes, or example, to a change in income.
interdependence o outcomes exists. discouraged workers, involuntary part-time Income, expenditure and output
Gini coecient A measure o income employees and workers orced into early method Three conceptually equivalent
inequality within a population that ranges retirement and which causes the ocial methods o measuring overall economic
rom zero (perect equality) to 1 (or 1 00) in unemployment statistic to understate the activity. The output method includes all
the case o absolute inequality. true level o unemployment in an economy. nal goods and services produced within a
Goals o rms Prot maximization is the Homogeneous product A product that period o time; the income method adds all
working assumption but several other consumers consider identical (a perect incomes that this production process
behavioural assumptions have been also substitute) across all rms o an industry. generates (wages, prots, interest and
proposed by theorists. Sales (revenue) Household indebtedness The amount o rents); the expenditure method sums all
maximization, growth maximization, money households owe typically to banks the expenditures made or the purchase o
satiscing theories, corporate social rom past borrowing. these nal goods and services produced.
responsibility as well as managerial Human capital The education, training and Income fow Within the circular fow diagram
theories are among the alternatives. experience embodied in the labour orce o o a closed economy without government it
Government budget (or national an economy. reers to the monetary fow rom rms to
budget) An estimate o government Human development Expanding peoples households that refects payments by the
expenditures and government (tax and choices and the level o wellbeing they rms to households or the use o actors o
other) income or a uture period. achieve: material consumption as well as production.
Government debt (see Public debt) better health and better education. Increasing returns to scale A production
Government ailure When government Human development index A composite technology where an increase in all inputs
policies aiming at correcting a market measure o development that ocuses on by 1 % leads to an increase in output by
ailure ail to do so as a result o three dimensions: health, education and more than 1 %; increasing returns to scale
unintended consequences, measurement income. It uses lie expectancy; mean years lead to economies o scale (EOS).
problems, biases, etc. o schooling o people aged 25 and older; Indebtedness Within a development
Government revenue Also reerred to as expected years o schooling that a child o ramework the external (oreign) debt o
government income; it includes tax and school entrance age can expect to receive i a country. The money a developing
other revenues a government collects. prevailing patterns o enrolment stay the country owes to oreigners including
Grants (aid) Flows o nancial aid to same; and per capita GNP based on governments, multinational institutions
developing countries that do not have to purchasing power parity dollars (PPP$). (See and commercial banks.
be repaid to the donor country. also Purchasing power parity (PPP) theory.) Indirect taxation A tax on goods or on
GDP The value o all nal goods and Humanitarian aid Aid provided or expenditure on a per unit basis or as a
services produced within an economy over humanitarian reasons to countries percentage o the price.
a period o time, usually a year. suering rom a natural disaster (or Industrial policy A set o interventionist
Green GDP An attempt to correct GDP by example an earthquake), amine or war. supply-side policies whereby the
accounting or the detrimental eect o Implicit costs Production costs or which government supports with subsidized
production on the environment. Green GDP no explicit payment is made by the rm loans, preerential tax treatment as well as
is estimated by subtracting rom GDP the and which include the opportunity cost o other methods certain specic industries
cost o natural resource and environmental using resources the rm owns as well as thought to exhibit high growth potential
depletion. normal prot, the minimum return required and to create signicant positive spillovers
Gross national income (GNI) (see Gross or the rm to remain in business. or the whole economy.
national product) Import substitution/inward-oriented Inant industry argument The argument
Gross national product (GNP) GNP equals growth A growth strategy in which that the only way a developing country can
GDP plus income rom abroad minus income domestic production is substituted or create a competitive domestic industrial
paid abroad. imports in an attempt to shit production sector is i it blocks all competing imports
Growth Reers to increases in the real GDP away rom the primary sector and with prohibitive taris until it becomes
(the total output) o a country through industrialize. suciently ecient.
time. Can be distinguished into actual and Incentive unction o prices Reers to the Inerior goods Goods or which demand
potential. idea that changes in the relative price o a decreases ollowing a rise in consumers
Growth maximization An alternative to good will induce producers to oer more or income.
the short-term revenue maximization goal less o it in the market as their prot Innitely price elastic demand
where managers are assumed to seek to margin will be aected. A limiting value o price elasticity o
maximize the growth in sales revenue Incidence (burden) o taxation Reers to demand (PED) which implies that the rm
(that is, the growth rate o demand or the who ends up paying a tax (tax shiting). An is a price taker and aces a horizontal
rms output) and the capital value o the indirect tax imposed on a rm may eventually demand or its product at the going
rm over time. be partially or wholly paid by consumers. market-determined price.
Health indicators Single variable or Income approach Reers to one o the Innitely price elastic supply A limiting
composite indicators that aim at three ways o measuring national income value o price elasticity o supply (PES) which
summarizing an aspect or the level o health whereby incomes earned by all our actors implies that the rm is willing to oer as
o a country, or example lie expectancy at o production (namely, wages, prots, much as the market demands at some price
birth, incidence o tuberculosis per 1 00,000 interest and rents) over a period o time are and that the rm is characterized by constant
people. added together to arrive at an estimate o returns to scale so that average costs (AC) are
Heavily indebted countries Developing national income or GNP. The other two constant and equal to marginal costs (MC).
countries acing an unsustainable debt methods are the output method and the Infation Reers to a sustained increase in
burden. expenditure method. the general price level.
1 81
Glossary
Infation rate The percentage change in Invisible balance Invisibles in the balance Legal barriers (to entry) Reers to
the average price level, measured by some o payments include exports and imports o state-created barriers to entry, or
price index, between two time periods; or services, net income rom investments example patents and licenses.
example i the infation rate o a country (prots, interest and dividend receipts and Linear demand When demand is a
or 2011 is 3.2% it means that prices in payments) and net transers (ocial and straight line (and not a curve) as price is
2011 increased on the average by 3.2% private remittances). raised to the rst power; the general orm
rom 201 0. I it is negative it implies J-curve eect Following devaluation, a is Qd 5 a 2 bP.
defation. I it is positive but decreasing trade decit will typically worsen beore it Long run (in macroeconomics) When
through time there is disinfation. starts improving (tracing the letter J money wages can ully adjust to a change
Infationary gap A gap is present i through time) as the Marshall-Lerner in the average price level so that the real
equilibrium (actual) real output (temporarily) condition is not satised in the short run. wage remains xed at its equilibrium level.
exceeds the level corresponding to the ull Joint prots The prot measure that cartel Long run (in market structure) When
employment level o output. members aim at maximizing, behaving as i not only are incumbent rms achieving
Inormal markets Markets in which they were a monopoly. their prot-maximizing goal but in addition
economic activity is not ocially registered, Joint supply Two goods are jointly supplied there is no entry or exit o rms as either
recorded or regulated by the government. i the production o one automatically is prots are normal or because o the
Street vendors in many cities are typically responsible or the production o the other. existence o barriers.
part o the inormal sector o an economy. Kinked demand curve An oligopolistic Long run (in production and cost
Inormal sector (see Inormal markets) model developed by P. Sweezy where in a theory) When all actors o production
Inrastructure Physical capital, typically (usually non-collusive) set-up it is assumed are considered variable so no xed actors
nanced by governments, which acilitates that i one rm decreases price the rival exist. The rm can thereore change its
economic activity as it lowers production rm will ollow but i it raises price the scale o operations.
and transaction costs and is responsible or rival will not ollow. This asymmetric Long-run aggregate supply (LRAS) Within
the creation o sizable positive externalities. response gives rise to a kinked demand the monetarist or new classical perspective,
The road system, the rail system, harbours, curve. The model shows that in an the LRAS is a vertical line at the economys
airports and telecommunications that a oligopoly, even i cost conditions change, potential level o output illustrating that in
country has are typical examples. prices remain sticky. the long run (when money wages are
Injections Within the circular fow model the Labour The human eorts used in the assumed fexible and can ully adjust to
term reers to spending on domestic output production o goods and services. price level changes) the level o real output
that is exogenous (that is, independent o Labour market fexibility The ability o a is independent o prices.
the level o domestic income). It includes labour market to adjust ast and ully to Long run average cost curve (LRAC)
private investment spending, government changes in labour demand and labour A locus o points that show the minimum
spending and exports. supply conditions. unit costs a rm will incur to produce a
Innovations Reers to new or improved Labour market reorms Reorms related to certain level o production when it can
products or processes as well as new the operation o labour markets that aim at change all actors o production.
marketing and organizational methods. increasing labour orce participation, Long-run Phillips curve A vertical line at
Institutional actors Reers to the laws and lowering unemployment and improving the non-accelerating infation rate o
regulations o product, labour and capital overall fexibility o the labour market. These unemployment suggesting the idea that
markets in a country; more generally reers reorms are oten but not exclusively centred there is a rate o unemployment
to the legal and regulatory ramework around the labour unions, minimum wage compatible with any rate o infation as
within which economic activity is conducted. laws, employment protection legislation, long as this does not accelerate and that
Interdependence In an oligopolistic size and duration o unemployment in the long run there is no trade-o
setting the term reers to the act that the benets, etc. between infation and unemployment that
outcome o any action o a rm depends Land Natural resources that an economy is policy makers can exploit.
on the reaction o rival rms. endowed with. Loose monetary policy (see Easy
Interest The reward o the actor o Law o demand As the price per unit o a monetary policy)
production capital. The payment made or product rises, quantity demanded per time Lorenz curve A diagrammatic illustration
using borrowed money over a period o time. period decreases, ceteris paribus. o how national income is distributed
Interest rate The price paid or borrowing Law o diminishing marginal returns within the population o a country.
money over a specied period expressed A short-run law o production which states Luxury goods Usually reers to goods with
as a percentage (or, the reward or lending that as more and more units o a variable a high income elasticity o demand (YED);
or parting with money). actor (or example labour) are added to a that is, with YED greater than 1.
International credit rating An evaluation xed actor (or example capital) there is a Managed exchange rate system
o a countrys credit worthiness (that is, its point beyond which total output will Usually reers to a foating system in
ability to repay debt) prepared by continue to rise but at a decreasing rate or, which authorities (central banks)
specialized agencies such as Moodys. equivalently, that marginal product will intervene whenever they consider the
Investment Spending by rms on capital start to decrease. movement o the exchange rate
goods, or example machines, tools, Law o supply As the price per unit undesirable.
equipment and actories; the change in increases, the quantity that a rm is willing Managerial theories o the rm
the stock o capital o an economy through to oer per period rises, ceteris paribus. A collection o alternatives to the
time. Investment expenditures in national Leakages Within the circular fow model prot-maximizing behavioural assumption
income accounts include not only xed the term reers to income not spent on stemming rom the separation o
capital expenditures by rms but also domestic output but being withdrawn ownership rom management in the
inventory investment and residential rom the circular fow, namely savings, modern corporation. Here managers are
housing investment. taxes and spending on imports. assumed to pursue their own objectives
1 82
Glossary
such as power and prestige, salaries, status Market success When market orces demand (AD) and so infation, output and
and job security. This approach is mostly (demand and supply conditions) alone lead employment.
connected to Baumol, Marris and to socially ecient outcomes meaning that Monetary union An economic union where
Williamson. just the right amount o a good is members also adopt a common currency
Marginal benet The extra benet enjoyed produced rom societys viewpoint and so and monetary policy conducted by a
rom consuming an extra unit o a good. scarce resources are allocated in the best common central bank, or example the
Marginal cost The extra cost incurred rom possible way. 1 7 eurozone countries.
the production o an extra unit o a good. MarshallLerner condition A condition Money demand A relationship showing at
Marginal private benet (MPB) The stating that devaluation will improve a trade each interest rate how much money
extra benet enjoyed by the consumer rom decit i the sum o the price elasticities o (non-interest bearing assets) economic
consuming an extra unit o a good. demand or exports and imports exceeds agents wish to hold given the level o
Marginal private cost (MPC) The extra unity. Since this condition is typically not national income (also reerred to as
cost incurred by a rm rom producing an satised in the short run the trade decit liquidity preerence).
extra unit o a good. initially worsens, giving rise to the J-curve Money supply The total amount o money
Marginal product (o labour) Marginal eect. in circulation in a country; money supply
product o labour is the extra output rom Maximum price (price ceiling) A price set includes all coins and notes plus money in
one more unit o labour. It is thus the by an authority (the government) below the current (chequing) accounts
change in output rom a change in labour. equilibrium determined price (the market Monopolistic competition Exists when
This is the slope o the total product curve. price) aiming at protecting (low-income) there are very many small rms in a
Marginal propensity to consume The extra consumers. market, no entry or exit barriers and a
consumption induced rom extra income. Merit goods Goods whose consumption dierentiated product.
Marginal propensity to import The extra creates very signicant positive externalities Monopoly Exists when there is one rm, a
spending on imports induced rom extra to society. As a result, governments oten unique product and high entry barriers.
income. want even the poor or the ignorant to Monopoly power The ability o a rm to
Marginal propensity to save The extra consume sucient amounts o these raise price above marginal cost (MC): that
savings induced rom extra income. goods. Typical examples include basic is, the level that would prevail in
Marginal propensity to tax (see Marginal education, basic health care, museums, etc. competition; the Lerner index o monopoly
tax rate MTR) Microcredit schemes Very small loans to power is given by the ratio o the dierence
Marginal revenue (MR) The extra revenue the very poor in developing countries that o price charged less MC expressed as a
rom selling one more unit o output: it is are used to help them start or grow small proportion o price (P). This is equal to zero
the change in total revenues (TR) rom a businesses and meet emergency expenses. in perect competition as in perect
change in output. This is the slope o the Microcredit pioneer Muhammad Yunus and competition, P = MC.
TR curve. the Grameen Bank in Bangladesh won the Moral hazard Moral hazard arises when
Marginal social benet (MSB) The 2006 Nobel Peace Prize. economic agents, consumers or rms, as a
extra benet enjoyed by society rom the Millennium development goals result o asymmetric inormation do not
consumption o an extra unit o a good. (MDG) Following the 2000 Millennium bear the ull cost o their actions and so
Marginal social cost (MSC) The extra Summit these are eight development goals become more likely to take such actions.
cost incurred by society rom the that all UN member states have agreed to Movement along a curve The case in any
production o an extra unit o a good. achieve by 201 5. The MDG are: ending diagrammatic representation o an economic
Marginal tax rate (MTR) The tax paid on extreme poverty and hunger; achieving relationship between two variables when one
the last dollar o income earned. universal primary education; promoting o these two variables changes.
Marginal utility The extra satisaction a gender equality; reducing child mortality; Multilateral aid Aid dispensed through
consumer derives rom consuming an extra improving maternal health; combating multilateral organizations, such as the IMF
unit o a good. HIV/AIDS, malaria and other diseases; or the World Bank.
Market A process or an institution through ensuring environmental sustainability; Multilateral development
which potential buyers and sellers o a developing a global partnership or assistance (see Multilateral aid)
product interact. development. Multinational (or transnational)
Market clearing price That market price Minimum price (price foor) A price set corporations (or enterprises)
or which quantity demanded is equal to by an authority (the government) above Corporations that have established a
quantity supplied per period. No excess the equilibrium determined price, usually presence and manage acilities in more
demand or supply exists at such a price. in order to protect producers. Note that the than one country. A result o oreign direct
Market equilibrium Exists when there is expression is also used in cases o collusive investment (FDI).
no tendency or the market price to oligopoly and it reers to the minimum Multiplier eect (expenditure
change; it requires that neither excess price at which these rms have agreed to multiplier) The (Keynesian) idea that a
demand nor excess supply exists so that sell the product. rise in injections (G, I, X) will lead to a
quantity demanded equals quantity Minimum wage A wage set by the greater increase o national income. Fiscal
supplied per period. government above the equilibrium ree policy is thus a powerul tool to lit an
Market ailure When market orces market money wage that aims at protecting economy out o a recession.
(demand and supply conditions) alone ail workers; the lowest money wage employers National debt (see Public debt)
to allocate scarce resources eciently, can legally pay. National vs. domestic (output or income)
meaning that either too much or not Mixed economy Reers to an economy in National aggregates ocus on the nationality
enough o a good is produced or consumed. which economic decisions are determined o actors independently o their location,
Typical cases include the existence o by both market orces and by the state. whereas domestic aggregates ocus on
monopoly power; o externalities and o Monetary policy The manipulation o location independently o the nationality o
public, merit and demerit goods. interest rates in order to aect aggregate the actors o production involved.
1 83
Glossary
Nationalization The transer o privately Non-price rationing Rationing mechanisms Per capita (GDP or income) or per
owned rms (assets) to the state. that are not based on the use o a ree head The GDP (or national income) o a
Natural capital Reers to the resource o market price but on other methods such as country divided by its population.
land but it implies that land is not a xed sellers preerences or rst come-rst served. Perect competition Exists when there are
endowment but that it can both increase Non-produced non-produced assets very many small rms, no entry or exit
or improve, or decrease or be destroyed by Non-nancial, non-produced assets include barriers and a homogeneous product; also,
human activities and policies. land, patents, leases as well as transerable perect inormation and perect actor
Natural monopoly A natural monopoly is contracts and Internet domains. mobility. There are ew examples, mostly
said to exist i the available production Non-rivalness A characteristic o public ound in agriculture.
technology in relation to the size o the (and quasi public) goods which means that Perect resource mobility When nothing
market is such that two rms cannot i a good or service is consumed by one, the hinders the fow o actors o production
protably coexist; typically, a result o very amount available or the rest does not rom one use to another.
signicant economies o scale (EOS). diminish; also a characteristic o common- Perectly inelastic demand A limiting
Natural rate o unemployment (NRU) access (pool) resources (non-subtractability). case when price elasticity o demand (PED)
or non-accelerating infation rate o Normal goods Goods or which demand is equal to zero, implying that a change in
unemployment (NAIRU) The natural increases ollowing an increase in price leads to no change in quantity
rate o unemployment is dened as the consumer income. demanded so that the demand curve is
equilibrium rate o unemployment, that is, Normal prots The minimum reward vertical at some quantity.
the unemployment that exists at the real required by a rm to remain in business Perectly inelastic supply A limiting case
wage rate that equates the number o that compensates or the risk incurred by when price elasticity o supply (PES) is
workers that rms are willing to hire with the entrepreneur (normal prot is thereore equal to zero, implying that a change in
the number o workers who are willing to an element o economic costs as without it price leads to no change in quantity
accept a job oer. It is also the the rm would not secure the actor o supplied so that the supply curve is vertical
unemployment compatible with any rate production entrepreneurship). at some level o output; quantity oered is
o infation as long as it does not Normative (economic) statement thereore independent o demand and
accelerate. The long-run Phillips curve is A value judgement, an opinion; usually price. Typically, this is the case or many
vertical at this rate o unemployment. spotted by words such as ought to be, agricultural products in the (very) short run
Necessities A loose term reerring to basic, air or unair. or when a service is constrained by the
day-to-day goods and services with a low Ocial aid Aid rom governments or amount o capital available, or example in
income elasticity o demand (YED). multilateral institutions (organizations) the case o hotel services, or seating
Negative externalities Arise when an such as the World Bank. available in a sports stadium or concert hall.
economic activity, production or Ocial development assistance (see Personal income taxes A direct tax levied
consumption, imposes costs on third parties Ocial aid) on the income o a person.
or which these do not get compensated. Oligopolistic interdependence Phases o the business (or trade) cycle)
Net exports The dierence between the Interdependence exists when the outcome The alternating periods o growth and
value o exports and imports o goods and o any action o an oligopolistic rm contraction o an economy (o real GDP);
services over a period o time. depends on the reaction o the rival rm(s). usually, our phases are distinguished: the
Net investment Gross investment minus Oligopoly Exists when there are ew upturn (expansion or boom), the peak, the
capital consumption (depreciation). interdependent rms, entry barriers and downturn (recession or contraction) and the
Net national product Gross national either a homogeneous or a dierentiated trough. Recovery and slow down may be
product (GNP) minus depreciation. product. included as separate phases.
Nominal variable (or value) Nominal Open economy An economy that engages Phillips curve An empirically derived
variables are measured in monetary units in trade (that is, it exports and imports inverse relationship between the rate o
and the eect o infation has not been goods and services). The degree o infation and the rate o unemployment: a
accounted or. openness is measured by the ration o the decrease in unemployment will result to an
Non-collusive oligopoly When sum o exports and imports expressed as a increase in infation and vice versa.
oligopolistic rms compete through price proportion o GDP. Physical capital The term is used to
or non-price competition. Opportunity cost (o an action) The distinguish the term capital rom the terms
Non-excludability A characteristic o value o the next best alternative sacriced. human capital and natural capital and reers
public goods which means that i a good Output approach Reers to one o the to so-called produced means o production.
or service becomes somehow available to three ways o measuring national income Pigovian tax Taxes levied on polluters
one individual it automatically becomes whereby production (output) is summed (polluter pays principle) equal to the
available to all. across all industries over a period o time. external cost o pollution which not only
Non-governmental organizations (NGOs) The other two methods are the expenditure internalize the externality but also
Organizations usually independent o method and the income method. generate revenues or the government.
governments and typically aiming at Output fow Within the circular fow Polluter pays principle The idea behind
designing and implementing development- diagram o a closed economy without Pigovian taxes; the principle according to
related projects. An example is Oxam which government, it reers to the real fow o which polluters should pay the cost o
is concerned with poverty alleviation. goods and services rom rms to their actions or the cost o measures to
Non-price competition Competition households over a period o time. reduce pollution, according to the size o
typically ound in oligopolistic markets Overspecialization A case where a the damage inficted on society.
that is not based on price cutting but on country concentrates production and Portolio investments (in the nancial
other methods such as advertising, exports in only one or in a very limited account o the BOP) Reers to the
provision o volume discounts or o range o products which exposes it to acquisition o stocks and bonds and o
extended guarantees. higher risks. other nancial assets by oreign investors
1 84
Glossary
which do not provide them with ownership Price maker (or price searcher) Any Production possibilities curve (rontier
or management rights; international rm acing a negatively sloped demand or boundary) Shows the maximum
investment that covers investment in equity curve. amount o good Y an economy is able to
and debt instruments. Price mechanism A mechanism that produce or each amount o X it chooses to
Positive (economic) statement An impersonally and with minimum cost produce i it ully and eciently employs
(economic) statement that can (at least in conveys under certain assumptions all the all o its scarce resources with its given
principle) be tested against data. For necessary inormation to market level o technology.
example, unemployment in Australia has participants and allocates societys scarce Productive eciency When production
decreased since 2006. resources to their best use. takes place with minimum average (unit)
Positive externalities A positive externality Price rigidity (in oligopoly) A eature o costs, implying that production takes place
arises i an economic activity creates a oligopolistic markets where rms oten do with minimal resource waste (also
benet to a third party or which it does not not change prices even i market demand technical eciency).
pay. They can arise either in the production or cost conditions change, preerring to Prot maximization The assumed goal o
or in the consumption o a good. adjust quantities or ear o initiating a the typical rm. Firms will choose that
Potential output The level o output an price war. level o output or which economic prots
economy can produce in the long run when Price support (see Minimum price) are maximum, which requires that
money wages are fexible and the labour Price taker A perectly competitive rm marginal revenue (MR) is equal to
market is in equilibrium so that only which who is so small compared to the marginal cost (MC) and that MC is rising.
natural unemployment is present. At the market that it cannot infuence market Prot repatriation Prots earned by
potential level o output, the long-run price by its output decisions. multinationals and sent back home.
aggregate supply (LRAS) is vertical. The Price war Reers to the case where Progressive, proportional and
long-term growth trend line in a business oligopolistic rms compete through regressive taxation Progressive tax
cycle diagram also illustrates potential successive price cuts. system: when a higher-income household
output. It is also reerred to as the ull Price-elastic demand Demand is pays proportionately more than a
employment level o output. considered price elastic i a change in price lower-income household. Proportional tax
Poverty (cycle) A vicious circle in which leads to a proportionately greater change system: when a higher-income household
low incomes leading to poverty are in quantity demanded. pays proportionately the same as a
responsible or low savings which are able Price-inelastic demand Demand is lower-income household. Regressive tax
to nance limited investments, leading to considered price inelastic i a change in system: when a higher-income household
low income levels. price leads to a proportionately smaller pays proportionately less than a lower-
Price ceiling Reers to a maximum price change in quantity demanded. income household.
(that is, a price usually set by the Primary products Agricultural and Project aid Flows o aid targeting the
government below the ree market price non-agricultural products traded in world realization o specic projects, such as
and above which sellers cannot charge). markets and used as inputs in the construction o public
Price controls Reers to both maximum and manuacturing. inrastructure capital.
minimum prices (that is, cases where the Primary/secondary/tertiary sector The Property rights Legal ownership rights
government intervenes and sets the price primary sector reers to agriculture, mining, over an asset. Property rights are part o
because it considers the market-determined orestry and shing; the secondary sector the institutional ramework o an economy.
price as either too high or too low. reers to manuacturing (industry) and Public debt The sum o all past
Price defator A price index used to convert construction whereas the tertiary sector (accumulated) budget decits less surpluses;
nominal GDP or nominal GNP/GNI to real reers to services. the total o what a government owes.
GDP/GNI which is based on the prices o Prisoners dilemma A simple non- Public goods Goods which are non-
all domestically produced goods and cooperative game illustrating strategic excludable and non-rival. Since they are
services; more generally price defators interdependence and that lack o non-excludable consumers have the
permit comparisons o the true change in a coordination leads to suboptimal incentive to conceal their preerences and
variable such as GDP ree rom the solutions. behave as ree riders. Public goods are a
infuence o price changes. Private sector The private sector o an case o market ailure and typical examples
Price discrimination When a rm economy includes households and rms. include national deence, law and order,
charges or the same product two or Privatization The transer o state-owned trac lights, lighthouses, etc.
more dierent prices in two or more assets (rms) to the private sector. Public sector The state, the government.
markets and the price dierence is not a Producer price index (PPI) A price index Purchasing power parity (PPP) theory
result o dierences in production or that tracks the selling prices received by A theory o long-run equilibrium exchange
provision costs. domestic producers or their output. rate determination: in the absence o trade
Price elasticity o demand (PED) The These prices are also reerred to as barriers, transportation costs and
responsiveness o demand to a change wholesale prices. cross-border capital fows and i all goods
in price. Producer surplus The dierence between were tradable then the market exchange
Price elasticity o supply (PES) The what a rm earns and the minimum it rate would gravitate towards its PPP value
responsiveness o supply to a change requires to oer a given amount o a good. (that is, it would refect cost-o-living
in price. Production costs The value o resources dierences).
Price foor (see Minimum price) sacriced or the production o a good or Quintile One o the ve equal parts o a
Price leadership When in oligopolistic service. requency distribution.
markets tacitly colluding rms ollow the Production externalities Externalities Quota A quantitative restriction o imports.
price changes initiated by some industry arising in the process o production. These The term is also used to reer to the
leader (known as dominant rm or could be either positive or negative amount o output a cartel member is
barometric price leadership). externalities. assigned when joint prots are maximized.
1 85
Glossary
Rationality The assumption that all assumed to maximize revenues (sales) Slope o a demand curve Assuming a
consumer behaviour is purposeul and obeys choosing that rate o output or which linear demand unction it is the coecient
certain assumptions concerning preerences. MR = 0. o the term P; note that i this coecient
Rationing unction o equilibrium Sales maximization (see Revenue becomes absolutely larger the curve
prices The ability o ree-market maximization) becomes fatter as the axes in economics
equilibrium prices to ration the available Satiscing An alternative to prot are reversed.
quantity to whoever values it the most and maximization where, because o conficting Slope o a supply curve Assuming a
is willing and able to pay the price. objectives o the various stakeholders linear supply unction it is the coecient
Rationing system A mechanism employed within a rm and inormational limitations, o the term P; note that i this coecient
to allocate goods to consumers. The price rms only strive to achieve at least some becomes absolutely larger the curve
mechanism is an example o a rationing pre-dened minimum level o prots or becomes fatter as the axes in economics
system. revenues. are reversed.
Real GDP GDP ater adjusting or infation. Scarcity The idea that human wants exceed Social (or community) surplus The sum
Real GDP measures the volume o output the ability to produce goods and services o the consumer surplus and the producer
produced in an economy over a year. rom our limited resources to satisy these surplus.
Real variable An economic variable wants; illustrated by the mere existence o Social science The set o scientic
expressed in terms o goods and so a production possibilities rontier. disciplines that systematically study
adjusted or infation. Seasonal unemployment Unemployment human behaviour rom dierent
Recession An economy is in recession i due to seasonal variations o demand, or perspectives.
real GDP is decreasing or at least two example construction workers who are Sot loans Loans granted at concessionary
consecutive quarters (negative growth unemployed because o extremely cold terms. The interest rate charged is lower
rate); in the USA the NBER determines weather. than market interest rates and the
when the economy enters recession and its Shit o a curve A curve in a diagram may repayment period is longer. An example o
decision is based on more variables. shit i there is a change in a variable that such loans is oreign aid.
Refationary scal policy (see is not represented in either o the two Specialization When a actor o production
Expansionary scal policy) axes; or example, in a demand curve is employed in the production o only one
Regional economic integration When diagram with price and quantity good or even a part o a good.
countries become members o regional demanded on the two axes, the curve may Specialization results in increased levels o
trading blocs; more generally, the shit i income changes. output.
elimination o trade and investment Short run (in macroeconomics) When Specic tax An indirect tax (a tax on a
barriers among a group o countries. money wages are assumed xed so that a good) that is set as a xed amount per unit.
Regional preerential trade agreements change in the average price level aects Speculation The buying and selling o
Trade agreements among a group o oten the real wage and induces a change in oreign exchange (or more generally an
but not necessarily geographically real output by rms. asset) in order to prot rom dierences in
neighbouring countries that reduce trade Short run (in market structure) The time its price.
barriers on a reciprocal and preerential period during which the number o rms in Stagfation Stagnation (zero or negative
basis or only the members o the group. a market is not xed but may change as a growth) and rising or high unemployment
Regulation Direct government intervention result o supernormal prots or losses. at the same time.
in the operation o markets aimed at Short run (in production and cost Stagnation Stagnation exists when growth
infuencing the behaviour o rms with theory) The time period during which in real GDP is either negative or negligible
respect to decisions on pricing, market some but not all adjustments are possible; or a number o years.
entry and exit, competition, product in production, it is when at least one xed Stakeholders All parties that have a direct
standards, etc. actor o production exists. or indirect interest in an organization or
Regulatory ramework The set o Short-run aggregate supply (SRAS) who could be aected by its actions and
regulations within which a market, an Within the monetarist or new classical decisions.
industry or the economy as a whole perspective, SRAS is an upward sloping State-owned enterprises (SOE)
operates. curve illustrating that i the average price Nationalized rms (that is, rms whose
Relative poverty Reers to households level increases rms will be oering more ownership rests with the state).
with income below the national average; output because money wages are assumed Strategic interdependence In a game
the proportion o a population that is poor xed and so prot margins increase. theoretic ramework, the act that each
in comparison with the consumption or Shortage When, as a result o price being players welare and pay-o depends not
income level o the general population. xed by an authority below the competitive only on his or her actions but also on the
Rent The income or the services o a piece ree-market equilibrium level, quantity actions o other players.
o land collected by its owner. demanded exceeds quantity supplied. Structural unemployment Unemployment
Rent control A maximum price or rent Shut-down-rule A loss-making rm in the that persists way past recovery and is a
ceiling on what landlords can demand or short run will shut down and exit only i result o the changing structure o an
payment on residential housing set below the price (average revenue, AR) is less than economy as well as a result o labour-
the ree-market determined rent. the average variable cost (AVC). In the market rigidities.
Resource allocation The appointment o long run it will shut down i it is making Subsidy A payment made by the government
scarce resources to dierent uses or the losses. to rms aiming at lowering costs and price
production o dierent goods and services. Signalling unction o relative price and thus raising production and
Revaluation An increase in the exchange changes Relative price changes within a consumption o the product as well as rms
rate (the price o a currency) within a xed ree competitive market set-up convey revenues.
exchange rate system. inormation to participants concerning the Substitute goods Two goods that can
Revenue maximization An alternative to existence o excess demand or supply satisy the same need or a consumer
prot maximization where the rm is which induces a change in their behaviour. which are thus in competitive consumption
1 86
Glossary
and or which cross price elasticity o (AD) and so decrease infationary pressures Tragedy o the commons A term
demand (XED) is positive. in the economy. introduced in 1 968 by Garrett Hardin that
Supernormal (abnormal) prots Time lags (in economic policy) Reers to reers to users o a commons (a common-
Anything above the minimum prot the time that elapses rom the moment a pool resource, or example a pasture)
required by a rm to remain in a certain problem arises in an economy to the time a where in his original analysis the process
business. policy choice has an eect; can be inevitably leads to the destruction o the
Supply The quantity that a rm is willing to distinguished into the detection lag, the resource (or example overgrazing o the
oer per period o time at a given price, administrative lag and the impact or pasture) on which the users depend.
ceteris paribus. execution lag. Transer payments Payments o the
Supply shocks Reers to sudden changes Total costs The costs incurred or the government to individuals that do not
and shits in the short-run aggregate production o Q units o output. Total costs refect contribution to current production.
supply (SRAS) typically as a result o a are equal in the short run to xed costs Examples o transer payments include
sudden change in the price o oil (as oil is plus variable costs. unemployment benets and pensions.
the predominant orm o energy or rms) Total product Total product is the output Typical consumer (see Average
or, more generally, o commodities. derived rom a specic combination o household)
Surplus When, as a result o price being inputs. Underemployment When individuals are
xed by an authority above the competitive Total revenues (or sales revenue) employed but are working less than they
ree-market equilibrium level, quantity The product o the price per unit times the would have wanted to or in positions
supplied exceeds quantity demanded. number o units sold by a rm in a time below their skills.
Sustainable development Development period. Underlying infation (see Core infation)
that meets the needs o the present Tradable (marketable) permits (or Underprovision and overprovision o
generation without decreasing the ability licences) A market-based solution to the merit and demerit goods When market
o uture generations to meet their own problem o pollution-emitting rms where orces lead to less than the socially optimal
needs. Typically it implies development the government determines the maximum amount being produced or consumed (in
that does not result in environmental acceptable level o pollution and then the case o merit goods) or to more than the
degradation. issues to rms permits (rights to pollute a socially optimal amount being produced or
Tacit collusion Tacit or inormal collusion is certain amount) which are tradable. Firms consumed (in the case o demerit goods).
said to exist when oligopolistic rms have the incentive to engage in active Unemployment Exists when individuals
coordinate their behaviour (without any trading until a new allocation o permits who are actively searching or a job cannot
communication between the parties being emerges with the total level o pollution nd one.
necessary) so that it resembles that o a the same but with minimal amount o Unemployment rate The number o
single dominant rm and the outcome that production sacriced. unemployed individuals expressed as a
o explicit collusion. Trade balance The dierence between the proportion o the labour orce.
Tari A tax on imports as a result o which value o exports and imports o goods (and Unitary price elasticity o demand
the domestic price o the product rises, the services) per period. I the value o exports When a change in price leads to a
level o domestic production rises, the level exceeds the value o imports then a trade proportionally equal change in quantity
o domestic consumption drops and the surplus is recorded. Conversely, a trade demanded so that price elasticity o
volume o imports is restricted. A tari also decit is the case i the value o imports o demand (PED) is 1. I PED is 1 throughout
generates revenues or a government. goods (and services) exceeds that o exports. the length o a demand curve then the
Tax incidence (See Incidence (burden) Trade creation The increased trade as a demand curve is a rectangular hyperbola.
o taxation) result o lower trade barriers in a regional Unitary price elasticity o supply When
Technical eciency (see Productive trading bloc where a less-ecient member a change in price leads to a proportionally
eciency) now imports a good rom a more-ecient equal change in quantity supplied so that
Terms o trade The ratio o the average member instead o producing it itsel. price elasticity o supply (PES) is 1. I PES is
price o exports over the average price o Trade cycle (see Business cycle) 1 throughout the length o a supply curve
imports expressed as an index number Trade diversion The inecient rise in trade then the supply curve is linear and goes
times 1 00. It shows the volume o imports within a regional trading bloc whereby a through the origin.
attainable with a unit o exports. less-ecient member imports a good rom Variable costs Production costs that refect
Terms o trade: improving I the terms o another member, instead o importing it the use o the variable actors o production;
trade ratio rises it shows that a greater rom a truly more-ecient non-member. to produce more the rm needs more
volume o imports is now attainable by a Trade fows Exports and imports o goods variable inputs so variable costs increase.
unit o exports. and services per period. Voluntary export restraints A orm o
Terms o trade: worsening Trade liberalization Reers to policies trade protection which is similar to a
(or deteriorating) I the terms o trade aiming at decreasing or eliminating trade quota as it also reers to a quantitative
ratio decreases it means that ewer imports barriers. restriction but in this case the exporting
can now be attained by a unit o exports. Trade protection Reers to policies that rms agree to limit the volume o exports
Tied aid Aid that has to be used to buy the aim at restricting the fow o imports into a o a good, typically to avoid worse trade
donors products (oten unnecessary or low country and/or creating an articial protection.
priority and/or more expensive); advantage to exporting rms. Wage stickiness A eature o labour
considered a actor partially explaining the Trading blocs A orm o economic markets where money wages do not easily
weak link between aid and development. integration where a group o countries decrease because o labour unions
Tight monetary policy A central bank is decreases trade barriers among them while and contracts.
employing tight monetary policy i it maintaining barriers to non-members. The Wages The reward o the actor o
increases interest rates (decreases the arrangement may take the orm o a ree production labour.
money supply) in order to decrease (or slow trade agreement, a customs union, a Wealth The value o all assets owned by an
down the increase in) aggregate demand common market or an economic union. individual minus whatever he or she owes.
1 87
Glossary
Weighted average An average where countries which aims at urther liberalizing Zero economic profts Exist when total
each element does not carry the same trade through conducting multilateral trade revenues are equal to total (economic)
signifcance in the calculation. negotiations and at regulating trade and costs. Since normal profts are included in
Welare (or deadweight) loss Reers to which is the arbitrator o all trade-related (economic) costs, it ollows that a frm
decreases in producer and/or consumer disputes. It was established in 1 995 earning zero economic profts is making
surplus as a result o either more or less and grew out o the General Agreement just enough to remain in business (that is,
than the socially optimal level o output on Taris and Trade (GATT). it is making as much as it would have been
produced and consumed. X-inefciency Reers to the internal making in its next best alternative).
Withdrawals (see Leakages) slackness that oten characterizes
World Trade Organization (WTO) An entrenched monopoly frms. The term was
international organization with 1 53 member introduced by Harvey Leibenstein.
1 88
Index
absolu te ad vantage 1 1 5 1 6, 1 69 costs
ad valorem (percentage) taxes 2 8 d im inishing average retu rns 43
ad vertising 3 8, 3 9 econom ic costs 44, 51
aggregate d emand (AD) 76 law o d im inishing marginal retu rns 423
consu mption expend itu res 767 long-ru n costs 4751
governm ent spend ing 7 78 opportu nity costs 1 69
investm ent expend itu res 7 7 short-ru n costs 427
net exports 78 cred it 1 48
see also d emand cross-price elasticity o d emand (XED) 2 0
aggregate su pply (AS) 79 cu rrent accou nt 1 32
alternative views o AS 7980 d e cit 1 33 4
shits in long-ru n aggregate su pply (LRAS) 80 expend itu re-red u cing policies 1 34
short-ru n aggregate su pply (SRAS) 79 expend itu re-switching policies 1 34
see also su pply su pply-sid e policies 1 34
allocative e ciency 1 41 5 , 578 su rplu s 1 35
assets 37 cu stom s u nions 1 37
reserve assets 1 3 2
asym m etric inormation 33 , 41 d ebt
oreign d ebt 1 57
balance o paym ents 1 3 2 , 1 69 pu blic (national or governm ent) d ebt 98
capital accou nt 1 3 2 d ef ation 86, 88, 91
cu rrent accou nt 1 32 cau ses 90
cu rrent accou nt d e cit 1 33 4 d emand 5 6
cu rrent accou nt su rplu s 1 35 changes in d emand cond itions 1 01 1
nancial accou nt 1 3 23 law o d emand 5
J-cu rve 1 35 , 1 36 shit actors 67
Marshall-Lerner cond ition 1 3 5 6 see also aggregate d emand
banking system 1 05 d em erit g ood s 36, 38
interest rate d eterm ination by central bank 1 06 d eveloping cou ntries
break-even price 57 d epen d ence on exports o primary com m od ities 1 45
bu siness cycle 745 d epen d ence on primary sector 1 45
per capita incom e levels 1 45
cap and trad e schem es 37 popu lation 1 45
capital 1 term s o trad e 1 41 2
capital accou nt 1 32 u n employm ent and u nd erem ploym ent 1 45
circu lar f ow o incom e m od el 71 2 d im inishing retu rns 423
com mand econom ies 2 d iseconom ies o scale (DOS) 47, 48
com m on access resou rces 401 d isinf ation 86
com m on markets 1 37
com m u nity su rplu s 1 4 East Arican Cu stom s Union (EACU ) 1 37
comparative ad vantage 1 1 5 1 6, 1 69 econom ic activity 71 2
competitive markets 2 m easu res o econom ic activity 725 , 1 67
d emand and su pply 1 01 1 , 1 603 econom ic costs 44, 51
market e ciency 1 31 5 econom ic d evelopm ent 1 44
price and ou tpu t d eterm ination 91 0 composite ind icators 1 47
price m echanism 1 2 d eveloping econom ies 1 41 2 , 1 45
complem ents 6 d om estic actors 1 489
consu m er price ind ex (CPI ) 867 single ind icators 1 467
consu m ers 5 sou rces o long-term growth 1 44
consu m er su rplu s 1 3 econom ic good s 1
price d iscrim ination 66 econom ics 1
corporate social responsibility (CSR) 5 2 central them es 4
u nd am ental qu estions 2
1 89
Index
1 90
Index
1 91
Index
M u ltid im ensional Poverty I nd ex (MPI ) 1 47 primary com m od ities versu s manu actu red prod u cts 1 9
M u ltilateral Debt Relie I nitiative (M DRI ) 1 57 ranges o PED 1 6
m u ltinational corporations (M N Cs) 1 53 4 TR cu rves 1 81 9
price elasticity o su pply (PES) 2 3 4
natu ral capital 1 applications o PES 2 5
natu ral resou rces 1 calcu lating PES 2 5
non-governm ent organizations (N GOs) 1 5 6 d eterm inants 2 45
non-price competition 645 graphs 23 4
normative econom ics statem ents 1 ranges o PES 23
N orth Am erican Free Trad e Area (N AFTA) 1 37 price f oors 31 2 , 1 63
price m echanism 1 2
o cial d evelopm ent assistance (ODA) 1 5 5 6 primary incom e accou nt 1 32
oligopoly 623 prod u cer price ind ex (PPI ) 87
collu sive and non-collu sive oligopoly 63 4 prod u cers 78
gam e theory and interd epen d ence 63 prod u cer su rplu s 1 3 1 4
kinked d emand cu rve m od el 64 prod u ction possibilities cu rves (PPCs) 2 4
non-price com petition 645 pro t
opportu nity costs 1 69 econom ic pro ts 51 , 1 66
pro t maxim isation 51 2
per capita incom e 1 45 , 1 46 property rights over assets 37
perect com petition 5 23 pu blic (national or governm ent) d ebt 98
allocative and prod u ctive e ciency 578 pu blic good s 33, 39 40
break-even price 57
evalu ation o markets 5 8 qu estions 67, 69, 1 1 1 1 3, 1 43, 1 5 9
long-ru n equ ilibriu m 5 45 higher level qu estions 68, 70
short-ru n equ ilibriu m 53 4 qu otas 1 2 01
shu tting d own 5 5 6
su pply cu rves 57 raw materials 1
see also com petition reserve assets 1 32
Phillips cu rve 91 3 resou rces 1
Phillips, Alban William s 91 com m on access resou rces 401
popu lation 1 45 retu rns to scale 47
positive econom ic statem ents 1 revenu es
poverty 96 PED and total revenu es 1 8
M u ltid im ensional Poverty I nd ex (M PI ) 1 47 revenu e maxim isation 5 2
preerential trad e agreem ents 1 379, 1 51 2 total revenu es (TR) 1 81 9, 485 0, 51
price break-even 57 total, marginal and average revenu e 1 65
price ceilings 2 931 , 1 623
price controls 2 9 satis cing 5 2
maxim u m price (price ceiling) 2 931 scarcity 1 , 33
m inim u m price (price f oor) 31 2 second ary incom e (cu rrent transers) accou nt 1 3 2
price d iscrim ination 65 sh ort-ru n aggregate su pply (SRAS) 79
cond itions allowing price d iscrim ination 65 sh ort-ru n costs 427
consu m ers 66 shu t-d own ru le 5 6
th ird -d egree price d iscrim in ation 65 6 sh u tting d own 5 5 6
price elasticity o d emand (PED) 1 61 9 social sciences 1
applications o PED 1 9 social su rplu s 1 4
cross-price elasticity o d emand (XED) 2 0 su bsid ies 2 8, 38, 1 61 2
d emand cu rves 1 61 7 consequ ences 2 89
d emand cu rves with constant PED 1 71 8 trad e protection 1 2 2
d eterm inants o PED 1 9 su bstitu tes 67
exports 1 36 su pply 78
imports 1 3 6 changes in su pply cond itions 1 1
incom e elasticity o d eman d (YED) 21 3 shit actors 89
PED and total revenu es 1 8 see also aggregate su pply
1 92
Index
1 93
OXFORD IB STUDY GUIDES
Economics
Author
F O R T H E I B D I P LO M A 2nd edition Constantine Ziogas
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