Exam preparation: model answers
Exam preparation: model answers
Unit 1 The basic economic
problem: choice and the
allocation of resources
1.1
(a) Resources used to produce goods and services
are limited compared to our needs and
wants. This means our wants can never be
fully satisfied and therefore choices must be
made between what goods and services to
produce, how they are produced and who they
are produced for. That is, all societies must
choose how best to use their scarce resources.
For example, if we choose to use up scarce
resources in the production of cars those same
resources cannot be used to produce food.
This opportunity is foregone. Making a choice
between alternative uses of scarce resources
therefore always involves a cost in terms of
what we have to give up in return. The benefit
of the next best alternative foregone is the
opportunity cost of that decision.
(b) When people choose to go to work they are
giving up their leisure time. To compensate
them for loss of leisure most people will seek a
wage or salary. They will also choose between
different jobs or occupations depending on
how much each one pays and other factors
such as the number of hours they are required
to work, whether or not they have to work
unsociable hours, how long it takes to travel
to and from the workplace and how much it
costs, holiday entitlement, career prospects and
what the working conditions are like. Some of
these factors will matter more to some people
than others. For example, some people will
be willing to accept a low wage if a job offers
good career prospects and generous holiday
entitlements. Other people may not care so
much about these factors and instead simply
want to earn as much as they can, even if it
means working unsociable hours. Individuals
will therefore compare the opportunity costs
of different jobs before making their decision.
A person who chooses to take a low-paid job
because it offers generous holidays gains more
leisure time but may be giving up the benefit of
higher pay.
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Unit 2 The allocation of
resources – how the market
works; market failure
2.1
(a) In a market system consumers buy goods
and services to satisfy as many of their
wants as they can, and private sector firms
produce these goods and services to earn as
much profit as they can. What is produced
therefore depends on what consumers want
and are willing to pay for. Firms will allocate
the scarce resources of land, labour and
capital to produce those goods and services
consumers want in the cheapest way possible
so as to make as much profit as they can. The
profit motive of firms and the preferences of
consumers therefore determine how resources
are allocated in a market economy.
Changes in the market prices of different goods
and services act as signals to firms about how
to use resources. For example, if the market
price of a good is rising because consumers are
buying more then this will provide a signal to
producers to allocate more resources to produce
more of that product. Being able to sell more
to meet the increased demand and at a higher
market price means a firm can earn more profit.
(b) The government is a major employer, consumer
and producer of goods and services in many
countries. Governments will sometimes
intervene in markets for different goods and
services if these markets produce outcomes that
are undesirable and the decisions of producers
or consumers result in wasteful or harmful
activities. These market failures will reduce
economic welfare. This means other resource
allocations or market outcomes may be more
beneficial and economically worthwhile.
For example, consumers with little or no
money, perhaps because they are too old or
disabled to work to earn money, may be unable
to afford many basic goods and services. Private
sector firms are unlikely to produce many of
the goods and services they may need, such as
health care or products that aid mobility, simply
because it is not profitable to do so. Similarly,
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other goods or services such as street lighting, a
legal system and defence may not be provided
in free market economies because it will be
difficult for private firms to identify and collect
money from the individual consumers who
will benefit from them. This is because once,
say, street lighting, is provided it is difficult
to exclude consumers from the benefit of it,
whether they have paid for it or not. In all
these cases a government can use resources
to produce goods and services that are in the
public and economic interest, and distribute
them to people in the most need regardless of
their ability to pay. A government can pay for
the provision of such goods and services from
the tax revenues it collects.
High levels of unemployment among
workers can also be a big problem in many
market economies. Resources may become
unemployed if the products they produce are
no longer profitable. Government organizations
can therefore also provide employment for
many people to produce goods and services.
For example, in many countries water and
electricity supplies are provided by government
organizations because they are essential for
public and economic welfare. In this way a
government can more easily regulate service
quality, provision and prices charged to
different groups in society than it would be able
to if these services were provided by profit-
seeking private firms.
(c) Governments may also intervene in markets
by regulating the behaviours of producers to
achieve more desirable economic outcomes.
Governments may use laws that outlaw certain
activities, such as the production and sale
of dangerous drugs and weapons, and use
selective subsidies and taxes to affect market
supply and demand conditions.
In a market economy private firms and
individuals may fail to take account of the
impact their production and consumption
decisions can have on the natural environment.
A government may therefore introduce laws
or regulations to protect the environment. For
example, anti-pollution and dumping laws
can make it illegal to burn waste or dump
untreated waste into rivers and seas. Similarly,
competition laws can be used to outlaw anti-
competitive behaviours used by large powerful
firms to restrict competition and force up
market prices. Large firms found to be actively
restricting competition and acting against the
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public interest may be fined, be subject to price
controls or, in the case of monopolies, broken
up into smaller, competing firms.
Similarly, indirect taxes can also be imposed
on products that are considered harmful.
For example, high taxes on cigarettes and
alcohol can reduce consumer demand for
these products. Consumer demand for these
products will tend to fall as their after-tax prices
rise. Similarly, a government may change the
total amount of taxation in the economy to
affect the total or aggregate demand of goods
and services. If prices are rising rapidly in an
economy because total demand is rising faster
than supply, a government may increase direct
taxes on personal incomes to reduce consumer
spending. It may also raise interest rates to
reduce borrowing and encourage saving.
Selective subsidies can be used to influence
production decisions by offsetting costs. For
example, many governments are encouraging
the development of new technologies such as
renewable energy generation, bio-fuels and
electric vehicles that will help to boost economic
growth but in a more sustainable way. By
reducing the costs of production, subsidies can
increase output and employment, and help
to reduce market prices, thereby expanding
demand for new products and technologies.
2.2
(a) The market price for a good or service is in
equilibrium when the market demand for
that product is equal to the market supply.
At this price consumers are willing and able
to buy as much as producers are willing and
able to produce and sell. As a result, there
is no downward or upward pressure on the
market price.
In contrast, a disequilibrium price will be
unstable because market demand and supply
are not equal. If demand exceeds supply,
consumers are willing and able to buy more
than producers can produce so prices will
tend to rise as consumers compete to buy the
available supply. If supply exceeds demand,
prices will tend to fall as producers try to sell
their surplus output.
(b) There are two main reasons why many more
people travel by aeroplane today. First, real
incomes have risen in many countries so more
people can afford to travel more by plane.
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The demand for air travel has increased. More
and more people want to go on holidays these
days, and more often. Business air travel has
also increased.
Secondly, increased supply and competition
in air travel has reduced airfares. There are
many low-cost airlines around the world today
competing for air passengers with established
national airlines, and many more airport
destinations to fly to and from than previously.
We can use a diagram to show these changes
in demand and supply in the air travel market.
The diagram below plots airfares against air
travel per period, measured in air passenger
kilometers travelled between two countries. The
total market demand for air travel between the
two countries at every possible fare is plotted as
a downward sloping line or curve because the
demand for travel will tend to expand as fares
reduce. The market supply is an upward sloping
line because airlines will tend to supply more
flights and seats the higher the fare they can
charge passengers. The equilibrium fare (P) and
the quantity of air travel purchased from the
airline providers (Q) occurs where the market
demand curve (DD) crosses the market supply
curve (SS).
D D1 S S1
P1
P
Air fare
P2
S S1
D D1
Q Q1 Q2
Air passenger km per period
Increased demand for air travel due to rising
real incomes of consumers is shown as a
rightward shift in the market demand curve
to D1. If nothing else had changed the impact
would be to push up the equilibrium airfare
from P to P1, and the quantity of travel from
Q to Q1.
The increased supply of air travel provided by
airlines is shown as a rightward shift in the
market supply curve to S1. This has the effect
of reducing the equilibrium airfare from P1
to P2 and increasing the quantity of air travel
undertaken further from Q1 to Q2.
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(c) Price elasticity of demand refers to the
responsiveness of consumer demand for a
product to a change in its price. For example,
if the price of product rises and consumer
demand for it contracts significantly, so much
so that overall sales revenues fall, then the price
elasticity of demand for that product is said
to be elastic. In contrast, if consumer demand
contracts very little despite the rise in price, and
total revenues rise, then demand is said to be
relatively price inelastic.
Goods and services for which consumer
demand tends to be relatively price inelastic
tend to have the following characteristics.
• T
 hey are necessities, such as many basic
foods, and gas or electricity for power and
heating, which people cannot go without
even if their prices rise.
• T
 hey have few substitutes. For example, in
some countries electricity and gas supplies,
postal services and trains are provided by
single companies. They are monopolies and
have no competitors. Consumers must either
buy these services from these companies or
go without. Similarly, many people have to
travel to work each day by buses or trains.
If fares rise, they will still have to use them
to travel to work because there are few
other ways of getting there, even if there are
competing bus and train providers.
• P
 roducts like newspapers and matches do
not cost very much so even a relatively
big increase in their prices may not cause
demand to contract very much.
In contrast, products for which demand
is relatively price elastic tend to have the
following characteristics.
• T
 hey are luxury items and expensive,
such as cars and holidays. An increase in
their prices may cause demand for them to
contract significantly.
• T
 hey have many substitutes. For example,
a rise in the price of butter may cause an
increase in consumer demand for
margarine instead.
• S
 imilarly, consumers can choose between
many different makes of car. A rise
in the price of one make may cause a
big contraction in demand for them as
consumers turn to alternative makes. The
more time consumers have to shop around
to find lower-priced alternatives, the more
elastic demand is likely to be.
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(d) A company selling holiday tours would find
it useful to know if its sales revenues would
rise or fall if it increased or reduced its holiday
prices. For example, if a specific holiday tour
is proving unpopular and pre-booked seats of
aircraft and hotel rooms will be left unfilled,
then the company could lower the holiday
price to attract more holidaymakers and fill
these vacant places. This will be especially
important If the holiday company has already
paid air travel companies and hotels for these
places. To cover these costs and not make a
loss it must book more people on the tour. If
demand is price elastic, cutting the holiday price
will expand demand and overall revenues will
rise. This is why many holiday companies cut
their prices to fill empty spaces on holidays the
nearer it gets the date to the day of departure,
or during periods of relatively low demand at
the start and end of the holiday season when
many children are at school and families are
unable to travel.
However, if demand for the tour is price
inelastic then cutting price, even by a large
amount, is unlikely to create further bookings.
In this case it may be worth charging consumers
more for the holiday, because overall sales
revenues will tend to rise if
The price rise has little effect on demand. For
example, some rich people like to go on very
exclusive holidays, staying in luxury hotels
and travelling on first-class tickets. They do not
want lots of other people on the same holiday
and may be willing to pay a very high price to
ensure it remains exclusive. Despite it being
a luxury, rich people can afford to pay for
the holiday and increasing the price of it may
have little impact on their demand, so overall
revenues will rise.
2.3
(a) Resources, such as land, labour and capital
equipment, are the inputs to productive activity.
They are used to produce goods and services
to satisfy our needs and wants. Resources are
scarce relative to our wants and many are
not renewable. That means that once they
have been used up they cannot be replaced.
For example, some forecasters suggest if we
continue to consume goods and services in the
future at the same rate as we do today many
natural commodities, such as aluminium,
copper, lead, tin, zinc and timber from the last
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remaining rainforests, will have all gone within
the next 50 years. Similarly, many woodlands
and forests may have disappeared because
of our growing wants for houses and more
space for factories to produce yet more goods
and services. Rivers and seas may have been
polluted by industrial waste and many fish,
bird and animal species driven into extinction.
Conserving resources therefore involves
reducing or halting the rate at which we use up
natural resources in order to preserve them for
future generations. The opportunity cost may,
however, be fewer goods and services today.
(b) The direct beneficiaries of an urban development
project will be the developers and construction
firms who build and sell homes, shops, offices
and industrial units for a profit. It will also benefit
the employees who work for these companies by
providing them with jobs and incomes. People
and firms who buy or rent properties in the
development will also benefit, whether from
owning a new home or running a new business.
Some of these benefits may be financial, such
as reduced costs of home ownership, revenue
from the sale of additional products, etc. while
other may be non-financial, including increased
satisfaction from homeownership, improved
living environment, etc.
There may also be indirect benefits and
beneficiaries from the new development. For
example, other shops and businesses may benefit
from the increase in the local consumer base.
Local transport operators may also increase their
passenger numbers and fares. The government
may also secure an increase in tax revenue
from taxes on incomes and profits from the
increase in jobs and business opportunities, and
from indirect taxes from increase expenditure
on goods and services, for example from those
consumers buying additional households goods
for their new homes.
(c) Planning regulations may control what private
firms can build and where. For example,
regulations may restrict developments in areas
of natural beauty and may also restrict the
height of buildings. The government may also
reduce incentives to redevelop urban areas by
increasing taxes on developers or the urban
land they buy.
(d) Negative externalities may arise from the
development and exploitation of urban areas.
These impose external costs on others. For
example, noise and pollution levels may have
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been increased during the construction phase.
Similarly, many homes and communities may
be destroyed in the process and people forced
to move elsewhere or into smaller homes and
apartments in the new developments. Once
the area has been redeveloped there may be
more congestion because of the increase in the
number of residents and work places. Older,
nearby homes may suffer visual intrusion while
nearby shops may lose trade to shops in the
new retail parks. However, local consumers
may benefit from this increase in competition.
Unit 3 The individual as
producer, consumer and
borrower
3.1
(a) Above all euro notes and coins must be a
generally accepted medium of exchange if they
are to be a good form of money. This means all
producers are willing to accept the notes and
coins in payment for their goods and services,
consumers are willing to use the notes an coins
to make payment and receive change, and
employees will accept the notes and coins in
payment for their labour in the form of wages
or salaries.
Euro notes and coins must therefore also be a
good store of value. If hey did not hold their
value people and firms would be unwilling to
accept them as a means of payment, now or in
the future. To enable people and firms to accept
euros as a mean of making deferred payments,
the currency must be a good store of value.
Similarly, euros must provide an easy to
understand measure of value so people and firms
can agree on and compare the prices of different
goods and services and know how many notes
and coins they need to pay for them.
(b) Consumer price inflation will reduce the
purchasing power or real value of the euro. For
example, if inflation is 1% a product exchanged
for 1 euro last year will cost 1.01 euros this
year. This means a euro will buy less than it did
the previous year. Inflation therefore affects
the ability of the currency to be a good store
of value. When inflation is low the real value
of the currency will fall only slowly over time.
However, in a hyperinflation confidence in the
currency may be lost because it no longer holds
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its value and will also fail to provide a means
of deferred payment. As a result, the currency
may no longer be a generally acceptable
medium of exchange.
(c) A commercial bank can lend money to an
individual or firm in the form of fixed-term
repayable (personal or commercial) loan.
The interest rate on the loan may be fixed or
variable for the duration of the loan, which
will usually be paid off in monthly installments
including interest over the duration of the loan.
Long-period loans specifically for the purchase
of homes or commercial properties are known
as mortgages. To reduce the risk of default,
banks will normally insist that the home or
property the loan has been used to purchase is
secured against the loan so it can be sold in the
event the loan cannot be repaid.
(Other forms of lending include overdrafts and
credit cards.)
(d) A central bank holds the deposits of commercial
and other banks, and will transfer funds
between their accounts to settle the many
millions of cheque, debit card and other
payments made by their customers to the bank
accounts of other people and firms or even to
the government. If a bank runs short of money
to meet these payments it will need to borrow
money. It can do this by borrowing the shortfall
from other banks. However, if it is unable to do
so it may run out of money and be unable to
meet its liabilities. If depositors lose confidence
in the bank they may all want to withdraw
their savings and other deposits at the same
time. This will cause the bank to fail.
To stop this from happening the central bank
will lend money to the banking system if one
or more banks run into difficulties meeting
payments to customers, suppliers or other
banks, in order to prevent those banks from
running out of money and going bankrupt.
3.2
(a) The public sector consists of organizations
owned, controlled, financed and accountable
to the government. Occupations often found
in the public sector of an economy include the
armed forces, police and civil servants.
(b) Trade unions have a number of aims regarding
the welfare of their members. Their functions
include defending the right of employees
in disputes with employers, developing
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the skills of their members by providing
training and education programmes, and
collectively influencing government policy
and employment legislation. Some unions also
provide social and recreational amenities for
their members.
However, perhaps the most important
function of a trade union is collective
bargaining or negotiation with employers to
secure improvements in the wages, terms of
employment and working conditions of their
members. For example, unions may seek better
hours of work and improvements in holiday
entitlement, sick pay and pensions for their
members. Trade union members may take
strike action if negotiations fail.
Before trade unions existed, a worker had to
negotiate on his or her own for increased pay
and better working conditions with his or her
employer. With few rights, a worker could
face being sacked for asking. Trade unions,
however, can negotiate with and put pressure
on employers on behalf of all their members to
secure these aims.
(c) An employee will choose between different
occupations by comparing their net advantages.
These will include the wages, hours of work,
working conditions, promotion or career
prospects, and other costs and benefits
associated with each job.
(d) The market or equilibrium wage rate for an
occupation will depend on labour demand
and supply conditions for that occupation.
Differences in labour demand and supply in
different occupational markets will therefore
explain wage differentials.
As wages rise the supply of labour will tend
to expand. However, as it becomes more
expensive to employ people, the demand for
labour will contract. At the equilibrium wage
rate the demand for labour will equal the
supply of labour. An increase in demand for
labour or a fall in its supply to an occupation
will therefore tend to push up the market wage.
In contrast, if labour demand falls or supply
rises, the market wage rate will tend to fall.
Highly skilled labour tends to be in relatively
short supply compared to unskilled workers
so the wage rates highly skilled employees can
earn will tend to be much higher. This explains
why, for example, doctors, lawyers and pilots
tend to earn far more than shop assistants and
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farm labourers. The supply of labour to such
professions also tends to be low because of the
amount of training people require before they
can enter these occupations. For example, it
takes doctors over six years to qualify to do
their job and up to 15 years, perhaps more, to
become a skilled surgeon.
Workers who are skilled and highly productive
will also tend to be in great demand compared
to less-productive workers. This is because they
will contribute more to output, revenue and
lowering average production costs than less-
productive workers. As a result of demand for
their labour being high, they will tend to earn
higher wages.
The demand for labour is a derived demand
because firms want labour to produce goods
and services that consumers want and are
willing to pay for. It follows that the more goods
and services demanded, the higher their market
price will be and therefore the more revenue
is generated from their sale, so the more the
demand for labour is likely to be.
Trade unions with significant bargaining
strength and who insist on full membership
by all workers in a particular firm, industry or
occupation may also be able to secure higher
wages for their members. This is because a
powerful union can restrict labour supply and
disrupt production through industrial action if
employers fail to meet their wage demands.
3.3
(a) No, the information provided cannot tell us
how much in total poor and rich households
spend on food. We will need data on average
household income to determine this. Richer
households will tend to spend more on food
in total although the expenditure is a much
smaller proportion of their incomes. For
example, if the average weekly income of a
poor household is just $500 then spending on
food may well be $150, i.e. 30% of $500. In
contrast, if the average weekly income of a rich
household is $4,000 then the household may
well spend $520 on food each week, i.e. 13%
of $4,000.
(b) The spending patterns of Ali and Faizal differ
will largely depend on their incomes, family
circumstances and tastes. Relative disposable
income after the deduction of any income taxes
will be a major factor. Because Faizal has been
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working for some time and has been promoted
to a senior position it is likely he earns more
than Ali who is just starting his first job. Faizal
may therefore spend more in total than Ali,
although the proportion of income spent may
be less than the proportion Ali spends, as he
will have to spend all or most of his income
meeting his basic needs for food, clothing and
rent for accommodation.
In contrast, Faizal may have his own home and
spend more on household goods and mortgage
repayments than Ali. Faizal may also be
married with young children and will therefore
spend more on food, health care, children’s
clothes, toys, family holidays and education.
Motoring and travel costs may also be higher in
the Faizal household than for Ali, who may not
be able to afford to own and run a car. If Ali is a
single young man he may send more on music,
fashionable clothing and going out with his
friends compared to Faizal.
(d) An increase in consumer spending can have
(c) People have many different motives for saving
that will be influenced by their income, age,
family circumstances, economic conditions and
taste. Saving allows a person to delay
spending and consumption, for example to
purchase an expensive product such as a car or
to fund the person’s retirement from work.
Income is a major determinant in saving
decisions. People on higher incomes will tend
to save a larger proportion of their incomes
than people on lower incomes. People on low
incomes will tend to spend most of their income
on meeting their needs, that is, spending
money on food and accommodation. They
will have little left over to save to fund future
consumption. Young people tend to earn lower
incomes and will spend more and save less than
middle-aged people. Older people may also
have low incomes and will fund their spending
from any savings they have made over time.
Middle-aged people are more likely to earn
more income but also save more to fund large
purchases in the future, such as a new car
or home, and to fund their retirement or to
cover possible future medical bills or periods
of unemployment.
As income taxes rise, disposable incomes
available for spending or saving will tend to fall.
As a result, people may save less to maintain
lifestyles and their previous levels of spending.
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Family circumstances will also influence saving
– people with young families may spend a lot
of their income on bringing up and educating
their children and have little left over for
saving. Economic conditions will also affect
motives for saving. When people are confident
that the economic situation is good and will
remain good in the future, they will feel more
secure in their jobs and may spend more and
save less. If confidence in the economy is low,
people will save more and spend less in case
they lose their jobs.
The interest rate, relative to the inflation rate,
will also influence saving. If inflation is higher
than the interest rate, people will spend rather
than save. If the interest rate is higher than the
inflation rate, people will tend to save more.
Finally, people have different tastes and habits
that will influence their spending and saving
over time.
widespread impacts on an economy. If, as a
result of the increase in consumer spending,
aggregate demand for goods and services in
the economy increases, producers will tend to
increase their output and to do so may need
to hire more labour. This will tend to reduce
unemployment and boost disposable incomes.
Producers may also experience an increase in
profits if the additional revenues exceed the
costs of expanding output.
As personal incomes and profits rise, the
government will tend to collect more in
direct taxes. Revenues from indirect taxes on
goods and services will also rise as consumer
sending increases. Government spending on
unemployment and welfare supports may
decrease at the same time as employment rises.
However, if the increase in consumer spending
is on imported goods and services domestic
firms and employment may not benefit. The
balance of trade may deteriorate and this could
place downward pressure on the exchange rate
of the currency of the economy. In turn this
will increase the prices of imported products.
Further, if the aggregate demand increases
at a faster rate than the aggregate supply can
expand, there may be a demand-pull inflation in
the economy as the general level of prices rise.
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Unit 4 The private firm as
producer and employer
4.1
(a) Most private sector firms aim to make as much
profit as they can from their operations. This
means maximizing the difference between
their total revenues and total costs. Profit is
calculated as the surplus of revenue from the
sale of goods and services and their cost of
production. If the production of an additional
unit adds more to revenue than it costs to
produce then total profit will rise. To maximize
their profit some firms will expand their scale
of production to reduce their average costs
of producing each unit. This may require
additional spending on plant and machinery
that will reduce profits in the short run.
However, in the longer term the increase in
output and revenues should help the firm
increase its profits.
(b) The increase in the number of customers and
therefore revenue from additional sales will
tend to boost profits. In contrast, the payment
of compensation to customers will add to costs
and will reduce profits. However, this will
only happen if compensation payments are
significant and this will therefore depend on
how satisfied customers are with the service
provided by the company. If the company is
confident of its ability to satisfy customers,
this is likely to further increase the number of
customers and therefore profits. However, if
the company fails to satisfy then a great deal
of compensation will be paid out and if this
exceeds the increase in revenue then profits
will fall.
(c) There are many different types of business
organization in a modern, developed economy.
They range from small, sole trader organizations
to large, multinational corporations. While
there are many more small, sole traders in
most economies it is public limited companies
that tend to be the most important both in
terms of their contribution to total output and
to employment. This is because they have
been able to greatly expand their scale of
production to supply the national and even
international markets. They are able to finance
this expansion not just from reinvested profits
and favourable debt finance but also by selling
shares through a stock exchange. The sale of
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shares raises permanent capital to expand these
companies. Nevertheless, small businesses
remain important in most economies because
they also provide jobs and incomes for many
people but also because many of the world’s
largest public companies started life many years
ago as sole traders or partnerships that have
been able to grown in size and scale over time.
Sole traders and partnerships tend to be small
businesses because they serve local markets that
constrain their growth. A sole trader or sole
proprietership is a business organization owned
and contolled by one person. A sole trader may
employ other people to work in the business,
but it will only ever have one owner. One of
the main drawbacks of owning and running
a sole trader is the fact that the owner has
unlimited liability. This means the owner will
be liable for all business debts in the event it
fails. Owners could therefore lose their perosnal
possessions to repay their businesses debts.
Many partners also have unlimited liability.
Most sole traders and partnerships also lack
the finance to expand. Partnerships are
popular in professions such as accountancy,
law, medicine and veterinary medicine. They
can be between two or more people who will
also tend to work in the partnership. However,
partnerships can also include sleeping or
limited partners who invest money in the
partnership but play no active role in running
it. Limited partners benefit from having limited
liability. If the partnership fails, their liability
for business debts is limited to the loss of their
original investment.
To raise enough finance needed to invest in
large-scale production a small firm will have to
become a limited company. A limited company
is owned and financed by its shareholders
although it will be managed day to day by a
board of directors elected by the shareholders.
Because a company is a separate legal entity
from its owners the company shareholders
have limited liability. Companies raise finance
by selling shares – privately if a private limited
company or publicly on the global stock market
for a public limited company.
4.2
(a) Factors of production are the inputs to
productive activity. The goods and services they
produce are the outputs. Economists classify
productive resources into land (all natural
8

resources), labour (physical or mental efforts
by people) and capital (man-made resources
like machinery and computers used to produce
other goods and services). Entrepreneurs will
combine and organize these resources into
firms to produce goods and services. Enterprise
is therefore recognized as economists as another
factor of production. Enterprise refers to the
business know-how entrepreneurs have that is
necessary to organize production successfully.
Productive resources or factors of production
are scarce relative to human wants for goods
and services.
(b) Most small firms are one-person businesses
called sole traders, or partnerships. Many may
be new start-ups and will start small. This
is because they usually lack the finance or
capital they need to grow and operate a larger
organization. Many, however, may prefer to
remain small because growing large can often
mean the original owners lose control of their
businesses. To raise enough finance needed to
invest in large-scale production a small firm
may have to become a limited company and
sell shares in the ownership of the company.
However, the cost and capabilities of modern
technologies, such as computers, mobile phones
and other equipment, has allowed many firms
to remain small in terms of the size of their
premises and workforce.
Small firms also tend to serve local markets and
can offer their customers personalized services,
specialist or made-to-measure products that
larger firms would find too difficult or costly
to make. The size of their markets will also
constrain the ability of small firms to grow.
(c) A firm that buys a smaller competitor that uses
similar factors of production, and presumably
also similar processes, is an example of
horizontal integration. A firm that buys another
firm that supplies it with the raw materials and
other inputs for its production is an example of
backward vertical integration.
(d) A takeover or merger between two or more
firms at the same stage of production and
producing the same products is called horizontal
integration. This can increase the scale of
production, efficiency and market power of the
new firm. Average costs tend to fall as the scale
of production increases as a result of economies
of scale. For example, the new firm can spread
its fixed costs over a much larger output and
may be able to borrow money more cheaply
from the banking system to buy more efficient
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machinery. In turn this may result in lower
prices for consumers. However, there may be
reduced choice and higher prices for consumers
if the merger significantly reduces competition
and creates a powerful monopoly able to
control market supply.
Lateral integration or conglomerate merger
occurs between firms producing different goods
and services. This diversification means the
new firm can enjoy risk-bearing economies.
This means it can continue in business if there
is a sudden fall in the demand for one of its
products because it produces different products
for different markets.
Vertical integration occurs between firms at
different stages of production. For example,
a car manufacturer may integrate with a tyre
manufacturer and a car retailer so it can be
guaranteed a steady and secure supply of tyres,
and prime retail locations to sell its cars.
However, takeovers and mergers to create
much larger enterprises can create less rather
than more efficient firms. They can experience
problems if they try to expand their size and
scale of production too much and too quickly.
Productivity may fall and average costs will rise
as a result of diseconomies of scale.
For example, managing a large firm can be
difficult especially if the firm has factories or
offices spread over many different locations
producing many different types of products
and has many different layers of management.
This can cause communication breakdowns
and disagreements between different managers
in different parts of the organization and at
different levels in the management hierarchy.
Decision-making will be slowed down, and it
may take longer for decisions to be acted on by
employees at the bottom of the organization.
Similarly, a large firm can experience
shortages of labour and materials that will
slow down production and increase costs.
Large firms may also find it difficult to
continually attract new customers because
their products are too standardized and they
have outgrown their market.
4.3
(a) Factors of production are resources used to
produce goods and services to satisfy our needs
and wants. Productive resources are scarce
relative to human wants for goods and services.
9

Economists typically group productive
resources into land (all natural resources),
labour (physical or mental efforts by people)
and capital (man-made resources like
machinery and computers used to produce
others goods and services).
Entrepreneurs will combine and organize these
resources into firms to produce goods and
services. Enterprise is therefore recognized as
economists as another factor of production.
Enterprise refers to the business know-how
entrepreneurs have that is necessary to organize
production successfully.
(b) A monopoly is a firm that has significant
market power over the supply of a particular
product because it has a controlling market
share. It may use this market power to restrict
market supply in order to force up the market
price and earn abnormal profits, over and
above what it might expect to earn in a more
competitive market.
This means a monopoly can be a price maker in
the absence of competition. In contrast, firms
in a perfectly competitive market are price
takers. In this type of market there are no entry
barriers and so many competing firms that no
one firm has any market power over supply or
price. Firms must accept the equilibrium market
price resulting from market demand and supply
conditions. If a firm did try to raise its price
above the market price it would lose custom
to rival producers and soon go out of business.
Similarly, a firm would be unable to lower its
price below the market price without losing
money unless it was able to produce much
more cheaply than other firms. Even if it did,
it could not do so for long as other firms would
soon find out how this was done and use the
same methods to lower their own production
costs. Subsequently, market price would fall.
(c) Firms can expand their scale and market shares
through internal growth or external growth.
Internal growth or organic growth involves
a firm expanding its scale of production
through the purchase of additional equipment,
increasing the size of its premises and hiring
more labour if needed. To finance this growth
the owners will need to use the profits of the
firm, borrow money from banks and other
lenders or sell shares in the ownership of their
business to other investors. To sell shares a firm
must become a joint-stock company.
External growth in the size of firms is more
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common. It involves one or more firms joining
together to form a larger enterprise. This
is known as integration through merger or
takeover. A merger occurs when two or more
firms agree to form a new company together.
A takeover occurs when one company acquires
ownership and control of another company
through the purchase of its shares.
A takeover or merger between two or more
firms at the same stage of production and
producing the same products is called horizontal
integration. This can increase the scale of
production and market power of the new firm,
possibly forming a monopoly.
Because of its size a monopoly can enjoy
significant cost advantages or economies of
scale such as the ability buy materials it needs
in bulk at a discount and to attract low-cost
finance. Some of these cost advantages may be
passed on to consumers as lower prices.
A monopoly may also invest more in the
research and development of new products
and processes that can increase the availability
and variety of different types of products,
and promote economic and possibly more
sustainable growth. This is because a monopoly
does not face competition and therefore the
profits it could earn from new developments
will not be competed away.
However, a monopoly may not necessarily be
advantageous for its customers, shareholders
or an economy. A monopoly may use its
market power instead to restrict competition
and market. Consumers will face higher prices,
reduced choice and possibly reduced service
levels and product quality. Many governments
around the world have therefore introduced
laws and regulations to control monopolies in
the private sector that act against the public
interest. Governments must therefore employ
scarce resources paid for from tax revenues to
monitor and regulate monopoly behaviour.
These scarce resources could have been put to
other more productive uses instead.
In addition, because a monopoly faces little or
no competition and earns abnormal profits it
may make less effort than a competitive firm
to ensure its resources are used in the most
efficient way.
However, despite an absence of direct
competition a monopoly may still face
competition from firms overseas or from firms
10

selling products that can satisfy similar wants.
For example, a monopoly provider of air or
railway services could still face competition on
some routes from providers of bus, coach or
boat services. Similarly, a monopoly may still
behave as if it does face competition and charge
low competitive prices because new firms could
otherwise be attracted by higher prices to enter
the market it dominates and compete for its
sales. A market is said to be contestable market
if barriers to entry are low and new firms can
enter a market easily to compete.
Unit 5 Role of government in
an economy
5.1
(a) In a mixed economy there is a private sector
and a public, or government owned and
controlled, sector. Both will own and hire
resources to produce goods and services.
In a market economy, private sector producers
supply consumers with the goods and services
they want to earn a profit. Changes in market
prices provide signals to producers about what
consumers want and what is profitable. If
consumer demand for a product is increasing
the market price of that product will tend to
rise. As price rises, profits will rise and firms
will respond by expanding their supply of
the product.
However, resources will only be employed in a
market economy if it is profitable for firms to
do so. This means there could be higher levels
of unemployment and some goods and services
may be underprovided or not provided at all,
especially to those consumers least able to pay
for them. Private firms may also fail to take
account of the impact of their production on
the natural environment and will also supply
harmful products, such as hard drugs and guns,
if it is profitable to do so.
In a mixed economy, a government can
intervene to correct failures of the market
system, for example by banning the sale of
guns, taxing other harmful products to reduce
their consumption, and providing goods and
services that people need and the economy will
benefit from although they are unprofitable for
private firms to supply.
(b) Most governments have a number of
macroeconomics objectives for their economies
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and will use their economic policies in an
attempt to achieve them.
For example, to achieve low and stable price
inflation a government may increase interest
rates and cut public spending when an
economy is overheating. High inflation erodes
the purchasing power of incomes and causes
people hardship, especially those on low fixed
incomes. It also increases production costs for
many firms.
In contrast, a government may cut taxes and
increase its own spending when unemployment
is high and rising in an attempt to boost
jobs and achieve a high and stable level of
employment. If there is high unemployment,
many people will suffer hardship from a loss of
income and total output will be lower than it
could otherwise be. In addition, a government
may have to spend more on welfare payments
to support the unemployed and their families.
This means the government may have raise
taxes on businesses and working people. This
will reduce their incomes and spending on
goods and services. High levels of employment
therefore help to increase output, incomes,
consumer demand and living standards.
Governments also aim to grow the size of their
economies over time. Fulfilling an objective to
achieve long-term economic growth will help
to expand employment opportunities, increase
the availability of goods and services, lower
inflation and improve living standards.
(c) Fiscal policy involves using the general level of
taxation and public expenditure to influence
total or aggregate demand in an economy.
Monetary policy also seeks to influence
consumer and business spending decisions
through changes in interest rates.
Price inflation may be the result of aggregate
demand for goods and services rising faster than
aggregate supply in an economy, increasing
production costs which producers pass on
to consumers in higher prices. Governments
concerned with controlling demand-pull
inflation can cut public spending on goods
and services and/or raise taxes, for example
on incomes, to reduce disposable incomes and
expenditure. This is called a contractionary
fiscal policy.
A contractionary monetary policy involves
raising interest rates. This will increase the cost
of borrowing money and make saving more
attractive. If people and firms borrow less
11

money to spend, and consumers save more
of their incomes as a result of the increase in
interest rates, then this will also help reduce
total demand and pressures on prices. However,
firms usually borrow money to invest in new
capital and therefore higher interest rates may
reduce investment and the potential for future
economic growth.
In contrast, when unemployment is high
or rising, a government may use its fiscal
and monetary policy instruments to expand
aggregate demand for goods and services.
This will involve cutting taxes, raising public
expenditure and/or lowering interest rates.
Firms should respond by expanding output and
employing additional resources, including labour.
Increasing total demand in the economy
may also encourage firms to invest in new
production facilities and equipment. This
will help to boost their productive scale and
therefore the rate of growth in the economy.
Cuts in taxes on profits may also encourage
more firms to invest in new capital and new
businesses to be created. Lowering income
taxes can similarly motivate more people to
seek employment and increase motivation and
productivity among those already in work.
These combined effects will also help to grow
the total output and size of the economy.
5.2
(a) Direct taxes are taxes on the incomes, profits
and wealth of individuals and organizations. For
example, payroll taxes are taken directly from
wages and salaries. Corporation tax is a tax on
company profits and property taxes are levied on
the value of homes or commercial buildings.
Indirect taxes include tariffs and excise duties
added to the prices of goods and services. They
are normally imposed on producers who will
then pass on as much of the tax as they can to
their consumers in higher prices. Value added
tax is levied as a percentage of the retail price of
many products. Excise duties are fixed amounts
of tax added to the retail price of goods such as
cigarettes, alcohol and petrol.
(b) A reduction in the general level of taxation in
an economy can help to expand the aggregate
demand for goods and services. A cut in income
taxes will increase disposable incomes and in
turn consumer spending may rise. As demand
expands, firms may increase their output and
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employ additional resources, including labour.
This will help to reduce unemployment.
Boosting total demand in the economy
may also encourage firms to invest in new
production facilities and equipment. This will
expand their productive scale and therefore the
rate of growth in the economy. Cuts in taxes
on profits may especially encourage investment
in new capital and new firms to be created.
Lowering income taxes can similarly motivate
more people to seek employment and increase
motivation and productivity among those
already in work. These combined effects will
also help to grow the total output and size of
the economy.
However, while cuts in taxation can boost
growth and employment, there is also a risk
that the balance of trade will deteriorate as
consumers increase spending on imports. If
total demand expands faster than supply, there
may also be a demand-pull inflation.
(c) Unemployment is a waste of resources. If more
people were in work more goods and services
could be produced to satisfy more consumer
needs and wants. Expanding employment
opportunities can therefore make better use of
available scarce resources to boost output and
increase economic welfare.
An increase in the number of people in
employment will also reduce hardship,
crime and cut public expenditure on welfare
payments, allowing the government to either
reduce taxes or re-allocate public spending to
other worthwhile projects.
The government may also increase in
popularity if more people are in work and
prosperity is rising.
(d) Unemployment can have both economic and
emotional costs. People who lose their jobs
will lose their income and may have to rely on
charity or government benefits. Unemployed
people can also lose their working skills if
they are unemployed for a long period of
time and, without retraining, they may find it
even harder to find work. They may become
depressed, possibly even ill, and it may also put
a strain on other family members and health-
care services. Some unemployed people may
lose their homes if they cannot meet their
mortgage repayments and some may even be
drawn into crime.
12

Income and output in the economy will also
be lower than it could otherwise be if there is
a high level of unemployment. Government
spending may also have to rise or be diverted
from other areas to provide welfare benefits
such as income support, low-cost housing and
health care for the unemployed.
This means people in work will either have
to pay higher taxes to pay for the additional
welfare payments and benefits, or government
spending on other public services or
investments, such as on new schools or roads,
will have to be cut.
Unit 6 Economic indicators
6.1
(a) Price inflation refers to a sustained or
continuous increase in the prices of goods and
services in an economy. This does not mean
every price will be rising at the same rate, or
that every price will necessarily be rising. Some
may be falling but overall, when taken together,
the general level of prices will be rising.
Most governments aim to keep price
inflation low and stable and will collect price
information in order to measure progress.
Clearly it will be difficult and expensive to
collect information on all the prices of all
goods and services in an economy
So governments will often measure inflation
by collecting price information on a sample, or
basket, of different goods and services. The ones
chosen will normally be those a ‘typical’ family
or household purchase. The prices of this typical
‘basket’ will then be monitored at a selection of
different retail outlets and online retailers. This
price information will then be used to compile
a consumer price index (CPI) or retail price
index (RPI). These are very similar measures of
the rate of consumer price inflation or changes
in the cost of living in an economy: they
differ only in the range of different products
selected for their baskets and the population
of consumers and retail outlets sampled. For
example, an RPI usually includes mortgage
interest charges whereas these are typically
excluded from a CPI.
The proportion of total household expenditure
spent on each type of good or service is used
to weight their prices to reflect the importance
of each product in the basket. So, for example,
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if on average households spend twice as much
on food products as they do on clothes then
changes in food prices will be weighted twice
as much as changes in the prices of clothes in
the index because an increase in the price of
food by say 10% will have a bigger impact on
household costs than a 10% increase in the
price of clothes.
A price index expresses the change in the
weighted average price of the basket of goods
and services as the movement in a single
number. The weighted average price of the
basket in the first year of measurement, or base
year, is given the index number 100. Then,
if on average the prices of all the goods and
services in the same basket rise by 10% over
the following year, the price index at the end of
the second year will be 110.
(b) In addition to low and stable inflation, in most
modern macro-economies governments have
objectives to encourage economic growth
in the national output and income of their
economies, and maintain low and stable levels
of unemployment.
Economic growth involves an increase in the
real output of a country, generally measured as
its gross domestic product (GDP). A sustained
growth in real GDP means that each year
the economy will have produced more goods
and services than the previous year, and the
total income of the economy will be higher
even after allowing for the impact of inflation
on prices and the purchasing power of that
income. Economic growth can therefore raise
living standards and economic welfare. Higher
real incomes allow people to buy more goods
and services they need and want, and for the
economy to invest more in schools, health
care, roads and other infrastructure. However,
economic welfare will also depend on what
goods and services are produced, what impact
they may have on the environment, and
how the increased income is distributed. For
example, if the increased output and income is
created by increased production that damages
the environment, and if the additional income
generated by growth is only shared among a
few very rich people, then economic welfare for
most people will not have improved and may
even have reduced.
The more people there are in work the more
goods and services they can produce and
the more income they can earn to support
13

themselves, their families and others through
the tax they pay to their government to fund
public spending. Higher levels of employment
can therefore help economic growth. In
contrast, high levels of unemployment will
result in lower national output and income.
It will also mean that overall tax revenues
collected by government from wages will be
lower but public spending may potentially
be higher to pay social security benefits to
the unemployed.
All countries suffer some unemployment as
people change or move between jobs, but
this is generally short-lived. This is called
frictional unemployment. High and prolonged
unemployment caused by an economic
recession or structural change in an economy
is, however, a big cause for concern for many
governments. Cyclical unemployment can rise
as consumer demand for goods and services
falls during a recession and firms cut back
production and their demand for labour as a
result. Structural unemployment occurs when
the industrial structure of an economy changes
significantly and entire industries may shut
down, leaving many workers unemployed
and their skills redundant so they will find
it difficult to get new jobs in new industries.
For example, many manufacturing workers
were made unemployed in many developed
countries during the 1980s and 1990s as their
manufacturing industries declined or became
more capital intensive.
Governments also try to encourage trade and
secure a favourable balance of international
transactions, and some may have additional
objectives such as reducing poverty and
inequalities in income and wealth, and
protecting the environment.
(c) Just because oil prices are high does not
necessarily mean they will be inflationary.
Although oil prices are high they may be stable.
That is, they are not rising and therefore not
putting additional pressure on price inflation.
Secondly, if oil prices are high consumers may
have to spend more of their income on oil
products such as petroleum and heating oils,
leaving them less to spend on other goods and
services. The fall in demand for these other
goods and services may help to reduce demand-
push inflation.
Rising oil prices, however, may be inflationary
if they add to the cost of producing oil products
and other goods and services that use oil,
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including the manufacture of plastics and
paints, and the provision of bus and other
transport services. Producers faced with rising
costs of buying oil or oil products will attempt
to pass these costs on to their consumers in
higher prices for their goods and services. This
results in a cost-push inflation. Consumers
may react to these rising prices by seeking
wage increases from their employers if they
are in work. This will also increase pressure on
production costs and cost-push inflation.
(d) Price inflation may be the result of demand
for goods and services rising faster than their
supply in an economy, increasing production
costs which producers pass on to consumers in
higher prices, and/or from rising import prices.
In turn we refer to these types of inflation as
demand-pull inflation, cost-push inflation and
imported inflation.
A government that is concerned with
controlling a demand-pull inflation can use
contractionary or deflationary fiscal policy. A
contractionary policy involves cutting public
spending on goods and services and raising
taxes to reduce total or aggregate demand
in the economy. However, this may in turn
cause an increase in unemployment and lower
growth in the real output of the economy.
A deflationary monetary policy involves
raising interest rates, which raises the cost of
borrowing money and also makes saving more
attractive. If people and firms borrow less
money to spend, and consumers save more
of their incomes as a result of the increase in
interest rates, then this will help reduce the
total demand for goods and services in an
economy and reduce demand pressures on
prices. However, firms usually borrow money
to invest in new capital and therefore higher
interest rates may reduce investment and the
potential for economic growth.
Higher interest rates can help increase the value
of the exchange rate of the national currency
against other currencies. An appreciation in the
exchange rate will make imports cheaper to buy
and reduce an imported inflation. However,
it will also make exports more expensive to
overseas consumers. As a result, overseas
demand for exports may contract and could
result in rising unemployment as exporting
firms cut back their production in response.
Cost-push inflation can often be the result
of rising import prices for materials and
14
 Exam preparation: model answers

components purchased from other countries, information on all products at all places of sale.
but it can also be due to rising wage costs as Instead the prices of a sample of goods and
workers demand wage rises not matched by an services are monitored over time at a sample of
increase in their productivity. A government different retail outlets to compile a price index.
may react by holding down the wages of the The sample of goods and services will normally
workers it employs in the public sector. It may be those a ‘typical’ family or household
also use deflationary fiscal and monetary policy purchase.
because other workers will wish to spend their
A price index expresses the change in the
higher wages on goods and services and this will
average price of the basket of good and services
put upward pressure on prices. This can involve
as the movement in a single number, or index.
raising taxes on wages and/or raising interest
The average price of the basket in the first year
rates so workers with loans such as mortgages on
of measurement, or base year, is given the index
their homes will have to use their higher wages
number 100. Then if, on average, the prices of
to pay more in interest charges instead.
all the goods and services in the same basket rise
A government can also try to control inflation by 5% over the following year, the price index
by using supply-side policy instruments at the end of the second year will be 105.
to increase the productive potential of the
(c) Cyclical unemployment occurs when consumer
economy. Increasing the aggregate supply of
demand for goods and services falls during an
goods and services to meet increased levels of
economic recession. The reduction in demand
total demand can reduce inflationary pressures
leads to a cut in production and an increase in
caused by rising demand. It can also help
unemployment. As people lose their jobs and
reduce production costs as the productivity of
incomes, demand falls further. In very serious
resources is increased. Supply-side policies can
recessions, there can be a high proportion of
be used by a government to stimulate incentives
people unemployed with very few opportunities
to work and enterprise and to remove barriers
to get work and earn incomes. This type
that restrict competition, international trade
of unemployment is a real concern for the
and higher levels of productivity. For example,
government although economies will come out
a government may lower taxes on businesses
of recession in time and the rise in consumer
to increase incentives to enterprise. It may
demand will lead firms to increase their output
use competition policy to regulate or break up
and demand more labour.
monopolies that might otherwise restrict the
market supply of their goods or services to force Structural unemployment is by far the most
up prices. A government may also introduce serious form and results from long-term
laws to control the power of trade unions to changes in the structure of the economy as
strike and to force up wages. Improvements entire industries close down because of a lack
in education and training can also help teach of demand for their goods and services. People
workers new and improved skills. employed in these industries will not be able to
use their skills elsewhere and they can become
occupationally immobile and unemployed
6.2 for very long periods. This can have a serious
(a) A reduction in unemployment as a result of more impact on particular regions within a country
employment opportunities will help to boost total with high levels of unemployment compared
output in the economy and increase standards with levels in other regions. Retraining
of living as more people are in paid productive workers can help them move into other jobs
activity. As unemployment falls government if they are available. In some cases workers
spending on unemployment and welfare benefits will have to leave the region in order to seek
will also fall, allowing the government to fund employment elsewhere. New industries will
other projects or lower taxes. also need to be encouraged to develop. In many
developed countries, structural unemployment
(b) Price inflation is a sustained increase in the
has occurred as the economies have moved
general level of prices of goods and services in
from labour-intensive production, such as in
an economy.
agriculture or coal mining, to capital-intensive,
Inflation can be measured by monitoring service-based industries.
prices over time. However, it will clearly be
(Other types of unemployment include frictional,
very difficult and expensive to collect price
seasonal, technological and voluntary.)

15
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(d) Most governments have four main
macroeconomics aims; low and stable inflation;
high employment; economic growth and a
favourable and stable balance of payments.
These objectives can prove difficult to achieve
all at once and policy aims may conflict. For
example, measures to increase aggregate
demand during an economic recession to
reduce unemployment could create inflationary
pressures and boost consumer demand for
imports making the balance of international
payments less favourable. Faster economic
growth in the national output may also create
more pollution and waste, possibly conflicting
with any environmental objectives. Similarly,
raising taxes or interest rates, and cutting
public expenditure to reduce price inflation by
lowering total demand, may result in lower
growth and more unemployment.
Failure to control inflation, lower
unemployment or achieve economic growth
can have costly implications for an economy.
How severe these are and the importance
people and a government attaches to them will
determine which problem the government will
target with its policies.
Unemployment is a waste of resources and
if more people are in work more goods and
services can be produced to satisfy more
consumer needs and wants. Expanding
employment opportunities can therefore
make better use of available scarce resources
to boost output and increase economic
welfare. An increase in the number of people
in employment will also reduce hardship,
crime and cut public expenditure on welfare
payments, allowing the government either to
reduce taxes or re-allocate public spending to
other worthwhile projects. However, high rates
of inflation can also create significant problems.
Inflation erodes the purchasing power of
incomes and causes hardship, especially
those on low fixed incomes. It also increases
production costs for many firms. If it becomes a
hyperinflation it can destroy confidence in the
currency and entire economy.
However, increasing taxes and/or interest
rates, and cutting public expenditure to control
price inflation by reducing aggregate demand
may however result in lower growth and
more unemployment.
Economic growth is an important objective
because it involves expanding the total output
of the economy. This means more goods and
services, business and employment opportunities
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and income, all of which raise living standards.
If growth is slow, unemployment is likely to
remain high and living standards will remain
poor for many and fail to increase at the rate
of economies experiencing faster growth rates.
Worse still, if there is negative economic growth,
output, employment, incomes and living
standards will fall.
However, choosing which is the most
important objective to target will mean a
government accepts there are trade-offs. This
may not necessarily be the case. Indeed, some
economists argue there need not be any policy
conflicts and that sound fiscal management
of public spending and taxes combined with
sensible supply-side policies can achieve low
inflation, high employment and healthy
economic growth over the long term. It can also
stabilize or improve the balance of international
trade. This is because expanding the supply
side of the economy will increase employment
opportunities, increase output and reduce
prices, also making goods and services more
competitive on international markets. Further,
if people expect price inflation to remain low
and stable in the future then they are less likely
to push for big wage increases to compensate.
If they did, this would raise production costs
and reduce profits. Similarly, firms will tend
to invest more in new capital and product
development because they are more confident
of making a good long-term return.
Unit 7 Developed and
developing economies
– trends in production,
population and living
standards
7.1
(a) Useful indicators of the standard of living in
different economies may include income or
GDP per person. However, average income per
person tells us very little about how evenly
incomes are distributed or what and how much
people can buy with their incomes, their access
to health care and education, their security or
the quality of their environment. Therefore
a better measure is to look at the number
of people living in poverty, for example, by
measuring how many people have to live
on less than $1 or $2 per day. Average life
expectancy from birth and adult literacy rates
16

also tend to be lower in developing economies
than in more-developed economies so will
provide useful indicators of living standards.
(Other indicators may include percentage of
the workforce in agriculture, ownership of
consumer goods, access to safe drinking water,
proportion of children who are underweight or
who die at birth.)
(b) Many people in the least-developed countries
can live in absolute poverty. This refers to their
inability to afford basic necessities needed to
live successfully, such as food, water, education,
health care and shelter. The scale of absolute
poverty can be measured by the number of
people living below a certain income threshold,
usually less than $2 a day. This is often the result
of not enough jobs being available, low levels
of education and skills, and a lack of capital
to invest in industry, health care, schools and
infrastructure, such as roads, power grids and
modern communications networks. This holds
back economic growth in these economies.
Many less-developed countries lack basic
industries and services. If incomes and
therefore consumer demand are low there is
little incentive for firms to set up factories and
shops. If workers are uneducated and lack skills
then industry may be unable to employ them.
These factors make production and trade more
difficult. Costs of production will be higher and
revenue potential lower compared to locations
in more-developed economies.
Instead many people in developing countries
work on small farms producing only enough
food for themselves and their families to live
on. Farming methods are usually poor and they
produce very little surplus to sell. Slow economic
growth combined with high birth rates means
the available output has to be shared between
more and more people over time.
Unstable and corrupt governments, and wars
with neighbouring nations or between different
tribes or religious groups, have often blighted
the development of some less-developed
countries and therefore confined many people
in their populations to continued poverty.
(c) The standard of living in a developing country
may be improved in a number of ways.
Underemployment of people is a major cause
of poverty and may be tackled by improving
education and training so that more people can
enter the workforce. By improving the quantity
and quality of education available to children
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from poor families it will increase their job
prospects and earning potential once they leave
school or college. Better education about family
planning may also help reduce birth rates and
improve living standards.
A government may be able to fund these and
other programmes targeted to help the poor,
including providing low-cost housing, free
health care and direct income support, by
increasing taxes on the richest households.
Increasing public spending on developing the
economic infrastructure can also provide jobs
but also support the development of industry
and trade. Extending road, communications
and power networks, and the development of
container ports and airports will assist economic
development and overseas trade. Attracting
more foreign visitors and selling more goods
and services overseas will bring more money
into the economy and provide jobs.
However, governments in less-developed
economies will often lack the capital and other
resources they need to reduce poverty in their
countries. Increasing borrowing from overseas
governments and banks can provide funds but
can be expensive. Some developing countries
have borrowed so much that they have been
unable to meet loan repayments and interest
charges. Instead governments of developing
countries can seek to attract inward investment
from overseas firms to develop industry and
infrastructure, import new technologies, provide
jobs and teach employees new, more advanced
skills. Offering subsidies and tax incentives to
multinational firms may help to do this.
Similarly, governments can seek to attract
overseas aid from foreign governments and
aid agencies. This aid can be in the form of
grants of money but can also take a number
of other forms such as food, medicines, expert
advice and technical assistance, for example
helping people to improve their farming
methods or teaching them how to start up and
run a small business. Aid can also take the
form of debt relief. Because of the problems
debt has caused in many less-developed
countries, a number of poor countries have
received partial or full cancellation of their
loans from foreign governments, the IMF
and World Bank. This will release them from
meeting future loan repayments and high
interest charges and they can use this money
to fund economic development and poverty
reduction projects instead.
17

7.2
(a) The rate of growth of a population will be
determined by the birth rate, death rate and
net migration. If the birth rate is high and the
death rate is low the natural rate of increase in
the population will be rapid. If immigration into
a country exceeds emigration from the country
then the population will also rise.
(b) The populations of many developed countries
are ageing. This means the average age of
their population is rising as both birth and
death rates have fallen and remain low. This
means more people are living longer and fewer
children are being born. These features are
associated with higher levels of development,
including modern health care, education
and high levels of female participation in the
workforce. In some developed countries birth
rates have fallen below death rates so their
populations are shrinking.
The age and sex distribution of a population
of a developed economy can be displayed on a
population pyramid. Along the bottom axis is
the number or percentage of males to the left of
the vertical axis, and to the right the number or
percentage of females. The vertical axis shows
age in ascending ranges. The pyramid for a
developed country therefore tends to be narrow
at the base as birth rates are low and it bulges in
the middle due an increasing number of people
reaching middle age or above.
In contrast, the pyramid for a developing
country tends to be much wider at its base and
narrow at the top. This is because both birth
and death rates are relatively high. This means
there are more children and young adults than
older people. The average of the population will
therefore be relatively low. High birth and death
rates are associated with low levels of economic
and human development in a country.
Developing countries also tend to lose people
of working age to more developed countries
because they can earn more and enjoy a higher
standard of living in more developed countries.
(c) If governments of developing countries have
allocated large amounts of public expenditure
to developing new hospitals and to providing
health education programmes this will reduce
the amount of money available to other public
projects or result in higher taxes. If taxes have
to rise this could reduce aggregate demand in
their economies and result in firms cutting back
their production and employment. Incomes
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and living standards may fall further in these
countries that already have a relatively low
level of economic development and welfare.
Increasing direct taxes on people with low
incomes will also have the effect of creating
more hardship.
Instead of spending more on hospitals and health
education programmes, the government could
spend more on infrastructure developments,
such as new roads, ports and airports, and on
programmes to develop workforce skills. These
will help to expand the productive potential of
the economy and increase employment. In turn,
higher standards of living and education among
the population may reduce the spread of such
diseases as HIV/AIDS.
The same governments could instead decide to
cut taxes to boost consumer demand required
to stimulate private sector investments in an
industrial base and services sector to expand the
choice and availability of goods and services in
their economies. Many people in developing
countries lack access to even basic and essential
foodstuffs and other goods and services.
Unit 8 International aspects
8.1
(a) Trade restrictions or barriers can take a number
of forms. For example, tariffs are taxes placed
on the prices of imported goods to make them
more expensive for consumers to buy. This
should reduce demand for imports. Similarly, a
quota limits the volume of particular products
that can be imported. The limit on their supply
will also tend to push up their price.
Governments can also increase costs on
exporters and slow down the flow of imports by
introducing complex and unreasonable quality
controls, standards and licensing requirements.
For example, a government may set arbitrary
and excessive quality standards on imported
goods so many fail and can be rejected. Or it
may keep changing product labelling and other
regulations so that exporters are unable to keep
up with new requirements.
(b) Reducing or removing trading restrictions
between countries should help to increase
international trade by lowering the cost of trade
and improving market access. A developing
country may immediately see an increase in its
visible exports to other countries and this will
18

improve its balance of trade. Wages and salaries
are still relatively low in many developing
economies and this enables many of their firms
to produce goods and services far cheaper than
those in more developed economies. An increase
in demand for their products in international
markets will therefore improve revenues and,
as a result, exporting firms are likely to expand
their production. Output, employment and
national income are likely to rise, thereby helping
to boost domestic consumer demand for goods
and services. However, some of the increase in
consumer spending may be on imports. The
lifting of trade restrictions will increase consumer
choice in developing countries and allow them to
access a wider variety of goods and services from
overseas. As imports of goods and services rise,
the balance of payments on current account may
deteriorate but the final outcome will depend
on by how much exports expand, the degree
of international competition, and which trade
barriers were removed or reduced and which
ones remain in place.
Longer term, because the lowering of trade
restrictions allows consumers in developing
economies to import many more of the
products they need and want from overseas,
it will enable firms in these economies to
specialize in the production of the goods and
services they are best able to produce. The
ability to re-allocate resources more efficiently
in a developing economy should further expand
output, employment and income and living
standards should rise.
As the incomes and purchasing power of
consumers in developing countries expands it
also creates opportunities for foreign firms to
increase their international sales. An increasing
number of business organizations are already
moving some or all of their business units to
these countries to benefit from their low wages
and their growing consumer markets. This
inward investment can bring new technologies,
jobs and skills into developing countries and
will help to expand the productive potential
of their economies. However, the arrival of
multinationals in a developing economy can
also create more competition for local firms.
(c) International trade enables economies to
specialize in the production of those goods and
services their natural, human and man-made
resources are best able to produce because they
have an absolute or comparative advantage. They
can then trade their surplus outputs with other
countries to obtain the other goods and services
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they need and want. Through specialization
and trade therefore, output, incomes and living
standards will be much higher.
However, a country can overspecialize by
producing too narrow a range of goods and
services. If there is a fall in demand for the
products a country specializes in, or another
country becomes more efficient in their
production, that country can lose significant
trade. Many domestic firms may be forced to
close and many jobs and incomes will be lost.
Overdependence on overseas producers
to provide many of the goods and services
individual and business consumers need and
want in a country may also be risky. Overseas
producers may abuse this market power to
restrict supply to force up prices and their
profits. Problems with weather patterns or
industrial disputes overseas will also hold
up supplies that may be vital for continued
production in the countries’ many industries.
The economic risks of overspecialization can
therefore be high and a country may therefore
try to encourage the development of wider
range of industries to reduce them. This will
require it to use trade barriers against producers
from other countries that are more efficient in
the production of these products in order to
protect its domestic firms and jobs.
Trade barriers may be effective in protecting
new, infant or sunrise industries, such as those
involving new technologies, from overseas
competition. This will give new firms the
chance to develop, grow and become globally
competitive with the potential to provide
many more jobs and incomes in the future.
They may not otherwise get the chance to
develop and grow if they are quickly eliminated
by competition from lower-cost economies
overseas. Providing them with protection from
overseas competition may allow them to grow
to take advantage of economies of scale and
become internationally competitive. The danger
is that infant industries may continue to require
protection from cheaper imports even when
they have become established. Trade barriers
will also restrict consumer choice and other
countries may also retaliate with trade barriers
of their own which can harm the industries the
country is trying to protect.
It is therefore difficult to argue conclusively
whether it is better for a country to produce
many products and protect its markets from
international trade or whether it is better to
19

try to achieve specialization in some products
only. It will depend on which strategy secures
the most economic advantage and gains. Both
strategies involve potential gains but also losses
in terms of consumer choice, employment,
incomes and growth.
8.2
(a) A rate of exchange is the rate at which one
currency can be exchanged for another on the
global foreign exchange market. It is therefore
the market price of one currency in terms of
another currency, in this case, the price of the
Japanese yen in terms of the US dollar.
The rate of exchange of the yen in terms of the
US dollar will be determined by the demand
and supply conditions for the currencies on the
global foreign exchange market. An increase in
demand for one of the currencies will tend to
increase its rate of exchange. A fall in supply
will have the same effect. In contrast, a fall in
demand for, or rise in the supply of, one of the
currencies will put downward pressure on its
exchange rate. If the value or exchange rate of
the yen against other currencies was fluctuating
less than the US dollar it means that demand
and supply conditions for the yen were more
stable than those for the US dollar.
(b) As discussed in (a) above, the exchange rate of
a currency in terms of another currency will
depend on market demand and supply conditions
on the global foreign exchange market.
An increase in the demand for a currency,
for example because consumers are buying
more goods and services from the country or
countries trading in that currency, will increase
its exchange rate against other currencies. A
rise in the value of one currency against others
is referred to as an appreciation in the exchange
rate. This is shown in the diagram below. As
demand for the Japanese yen rises (from DD to
D1D1) the rate at which 1 yen exchanges for
US dollars rises (from $ to $1).
Price of 1 yen in terms of $
D D1
$1
$
S D
Q1
Quantity of yen traded per period
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In contrast, if the global market supply of the
yen rises, for example because Japanese firms
are investing more overseas and therefore
selling yen to buy overseas currencies, the
exchange rate of the yen will fall. This is
referred to as depreciation in the exchange rate.
(b) If a currency is ‘gaining strength’ it means
the currency is appreciating in value against
others. This has a number of implications for an
economy. This is because a rise in the value of
a currency will increase the cost of its exports
on international markets but lower the price of
imported goods and services.
For example, if 1 US dollar exchanges for 8
Japanese yen then a car exported from the
Japan to the US for 5,000 yen will cost $625 in
the US economy. If the US dollar appreciates
to $1 = 10 yen then the same car will now cost
$500 on import to the USA. As a result, demand
for Japanese cars in the USA may rise. This
may be at the expense of a fall in sales of US
cars, which may result in a reduction in output
and employment in US car manufacturers. The
increase in demand for imports from Japan will
also cause the US balance of trade to deteriorate.
In contrast, a machine exported from the US to
Japan priced at $1,000 will rise in price in Japan
from 8,000 yen to 10,000 yen following the
appreciation in the US exchange rate against the
yen. If Japanese demand or US goods is price
elastic then demand for the US imports will fall.
US exporters will suffer a decline in sales and,
if the fall in demand is prolonged, are likely to
cut back their production and employment as
a result. The fall in employment and incomes
could cause a fall in demand for goods and
services in the USA that is more widespread, and
this could reduce economic growth.
However, the outcome may be more complex
depending on the type and volume of goods
and services traded. For example, if Japanese
demand for US imports is price inelastic
then the fall off in demand for imports from
the USA may be relatively small. Further,
if US producers rely heavily on imports of
S
components and materials from overseas to
make their products then their costs will fall.
This will boost their profits and may provide
them with an incentive to expand their scale
of production. The reduction in import costs
may also be passed in part onto US consumers,
thereby expanding domestic demand.
D1
Q2
20
 Exam preparation: model answers

(c) A country has a deficit on its balance of (Other measures may include contractionary
payments on current account if international fiscal and monetary policies to restrict demand
payments for visible and invisible imports and for imports. However, these measures will also
transfers overseas exceed credits from foreign tend to reduce total demand in the economy
countries for visible and invisible exports and including for domestically produce goods
inward transfers. This means the country is and services.)
losing income and there will be less available
for residents to spend on domestic goods and
services. Domestic firms that experience a fall
in demand for their products may cut back
production and reduce their demand for labour,
resulting in higher unemployment. To pay for
recurrent annual deficits a country may need
to borrow money from overseas. Total debt will
rise and more income will have to be used each
year to pay interest charges. This will add to the
amount of money flowing out of the economy
and reduce over time the amount of money
it has to invest in new productive activities or
spend on domestically produced products. Not
surprisingly, the government of the country
may seek to overturn a deficit. It may do this in
a number of ways.
For example, the government could introduce
trade barriers to make overseas products
more expensive and difficult to import, for
example by placing a tariff or excise duty
on their imported price or by restricting the
amount that can enter the country through a
quota or embargo. If demand for the imports
is price elastic, the increase in their prices will
cause demand for them to fall significantly as
consumers switch their demand to domestic
products. This will help to correct a deficit.
However, trade barriers restrict consumer
choice, will increase inflation and business costs
and are likely to cause overseas trading partners
to retaliate with trade restrictions of their own.
Alternatively, the government could simply
do nothing because the deficit should correct
itself over time as the exchange rate adjusts. If
there is a deficit more of the national currency
is being supplied internationally to pay for
imports than is being demanded from overseas
consumers to buy that country’s exports. The
value of the exchange rate will therefore fall
on the global foreign exchange market. This
will make imports more expensive to buy while
reducing the prices of exports sold overseas. As
a result, domestic demand for imports should
fall and overseas demand for exports should rise
until the current account balance is restored at
a new lower equilibrium exchange rate.

21
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