Economics Final Exam Study Guide

Preface: How to Do Well on the IB Exam:

General Advice
o Start preparing well in advance. Do not wait until the last minute, or until this study
guide is complete.
o Know your key terms; you will need to define them. So, write out a glossary (or use the
glossary provided) and test yourself to check that you know the definitions.
o Know your graphs and practice drawing them out; it is not enough to look them over in
the textbook and expect to remember them. Make sure your labels are as accurate as
possible and you include correct relationships between plotted variables. To
understand the graphs, you need to understand the theory behind them.
o Know examples for all major topics that we cover; the examples should be as current
and relevant as possible, and should depend on the subject area you are focusing on
(recall your commentary articles and LDC projects as a starting point).
o When in doubt, do past papers without access to notes or your textbook (or write a
textbook yourself); you need to get a sense of timing and pacing on each set of
questions.
o The more specific you can get in your answers, without sacrificing efficiency or the big
picture, the better-quality your analysis will be.
o Do not avoid certain topics altogether; you will need to address every syllabus section at
some point; revise the main topics in the course. Do not rely on the hope that certain
topics will not appear on the exam.
o Practice your evaluation (more on this later).
Advice for Exam Papers:
o General Advice:
Points are allocated for defining key terms; never forget to do so (at least,
define the keywords of the question)
Always provide as many suitable graphs as you need to communicate your ideas
clearly. Accurately label all of the axes and curves and show correct
relationships between variables. If something shifts, use arrows to show the
shift.
Refer to your graphs in your text; they should not be a separate
component for the points.
More graphs are usually better than one busy graph that requires
some serious effort to decipher.
Draw your graphs as neatly as possible; if you have time, use pencil and
then shade in with ink to be able to make corrections.
Use colors (but not red) to show shifts in curves, if you are so inclined.
Make sure our diagrams are large enough to be accurately interpreted
and incorporate all necessary information.

Your graphs should not be redundant; every new diagram should

introduce a new concept that you had not previously examined in the
question.
A table may, in some cases (e.g. when evaluating tax regimes) also
count as a diagram, although you should avoid using one as your main
diagram whenever feasible.
When introducing a graph, you essentially commit to it; unless you
explain it within the framework of the question, you are likely to lose
marks.
Write like an economist: show off your skills in writing answers to exam
questions as precisely as possible.
Refer to examples whenever possible (this includes simple numerical examples,
but, when possible, your examples should come from real life and be as nonhypothetical and clear as possible).
If you are not sure as to what a question demands, skip the question; it is better
to be sure that you know exactly what the question demands than to take a
guess at what seems to be an easier question.
Stylistically, break your responses into paragraphs: a wall of text approach
may piss off some graders.
Dont come into the exam with ready-made answers; know your theory, but be
ready to tailor your responses to the demands of the question.
To structure your answer, define the key terms of the question as soon as
possible and explain them. Add some graphs, and you are probably mostly
done; without key terms, though, it is difficult to show understanding.
Otherwise, you are liable to go jumping from idea to idea, without getting
anywhere far in your response.
Do not make unsubstantiated assumptions- explain your reasoning whenever
feasible.
Link your written response to your diagrams and the specific demands of the
question.
Paper 1: The Essay
Worth 20% (25%) of the final grade at HL (SL). You have 4 questions to choose
from and need to do one in one hour.
All questions are divided into 2 sections:
o Part A: 10-mark short answer
o Part B: 15-mark detailed answer and evaluation
Carefully consider each question offered and make the right choice
based on what you know best from the syllabus.
o If no single question seems right, choose the question whose
evaluation you are more comfortable with (15 points > 10
points, obviously)

Read the question carefully, and write an answer that is clearly relevant
to the question. It is the quality, not the quantity, of your answer that
you are graded on.
If you are worried about digressing, plan before you write; if you dont
take too much time to plan, this will work in your favor. You are not
graded on grammar, but a clear approach, especially on the essay
component, is all-important.
Manage your time effectively and cover main points before entering
into too many details.
If at all possible, link parts A and B together (but keep them separate on
the page!)
As you are evaluating in Part B, include a conclusion at the end of your
essay. This helps to add structure to your answer, leads to greater
clarity and allows you to point-maximize.
Stick to the f*cking question. Dont start going off on a tangent by
applying all the vaguely-familiar theory you know.
Part A: Distinguishing between economic concepts or explaining a
particular concept/theory. You are graded on:
o Clear understanding of the specific demands of the question
o Relevant economic theory clearly explained and developed
o Relevant terms clearly defined
o Where appropriate, diagrams have been included and explained
o Where appropriate, examples have been used
o No major errors.
Part B: Evaluating a particular ec. policy/theory- a step beyond simple
explanation.
o You do not need to repeat definitions from Part A,but you may
need to define some more terms.
o If your graphs from part A are relevant, you can refer back to
them; however, if you will be extending your response to them,
it is best to redraw them and add the necessary info.
o If you are asked to distinguish between cyclical and structural
unemployment in Part A and then asked to evaluate policies
that reduce unemployment in Part B, you would need new
diagrams in addition to those from Part A to make a convincing
argument.
o To do well on Part B, you are graded on:
Clear understanding of the specific demands of the
question
Relevant economic theory clearly explained and
developed

Relevant terms clearly defined

Where appropriate, diagrams have been included and
explained
Where appropriate, examples have been used
Evidence of appropriate evaluation
No major errors.

Paper 2: Short Response:

Worth 20% of the final grade; HL only. You have 6 questions, you choose three,
you have an hour to answer the questions you choose.
You will be given reading time; use it to decide which questions you are
best prepared to answer and develop a plan of attack for each question.
Read the questions carefully so that you are sure which theory is the
most pertinent.
The short response questions are similar to Part A of Paper 1; you will
be asked to explain a concept/theory or distinguish b/w related
concepts.
Your answers should all include key definitions, diagrams and relevant
examples. Ask yourself whether you have put all of the above
components into your paper.
The odds that you will get a question that does not call for a diagram
(even a simple PPF) are very, very slim. Always include at least one
graph. The mark-scheme is the same as for Part A of the extended
response.
Work efficiently and manage your time well; take 20 minutes for each
answer. If you spend too long on the first two questions and fail to
answer the third, youre pretty much screwed.
If you feel the need, keep a watch by you when taking the test and do as
much practice as you can.
Paper 3: Data Response:
Worth 40% of the final grade (HL)/ 50% (SL). There are five questions available;
you are required to do three. You have two hours.
All 5 questions will follow the same format; there will be a set of data
(either an article or visual data, or both) and a set of four sub-questions:
o Part A: Definitions of two words in the text. Each definition is
two points; dont waste time writing verbose definitions.
o Parts B and C: Application of a specific piece of theory; worth 4
points each.
In the majority of cases, you should draw a graph;
sometimes the graph will be alluded to in the question,
and sometimes, you will need to decide on the right
diagram to use.

Be sure to label axes with the variables given in the text;

try to be as un-hypothetical as possible.
Carefully assess what the question is asking; you are
under the gun and should not write more than is
necessary to answer the question in Parts B and C.
Always make use of your text to support your theory;
also, make your diagrams large to not piss off your
examiner.
Very occasion, you may need to use the data to perform
a calculation of some sort and interpret your results.
o Part D: Application of information from the text and evaluation
of issues related to the text. This is worth 8 marks and is the
most important part of the question.
Dont forget the information from the text; use
quotations and data (when available) in your answers.
Also, the essential here is to evaluate (more on
evaluation below).
Your reading time is essential for Paper 3; skim the questions and
pinpoint those that you know the most about. Do not choose questions
based on definitions; it is much more important to be able to provide
good short answers and evaluation.
Annotate the text to make yourself familiar with the data.
Manage your time effectively; you have 40 minutes per question, so
keep on pace.
If you know your definitions and diagrams, parts A, B and C should be
quick, leaving you with a lot of time to evaluate.

How to Evaluate:
o You will be asked to evaluate in part B of your long response and part D of your data
response questions. Unless you can evaluate effectively, you will not score high.
On the other hand is a good indicator of what evaluation is, although, by
itself, such statements are too simplistic. You should:
Compare advantages and disadvantages of your issue or policy; this is a
step in the right direction, but not quite enough. You also need to make
a conclusion about the relative weight of your arguments and
counterarguments.
Identify the most important causes/consequences/arguments, and
present them as such, justifying your reasoning. If asked to evaluate the
consequences of a policy, explain several consequences and conclude
that the most important consequence is
o There is no single right answer to an evaluation question;
defend your decision with economic theory, however.

When evaluating a controversial issue, be familiar of the arguments and

counterarguments of the divergent viewpoints.
When evaluating advantages and disadvantages, state which outweighs
the other, explaining your reasoning for the decision.
When evaluating a normative proposition (e.g. protectionism is the best
way to protect domestic employment), you could explain the ways in
which protectionism could prevent domestic job losses, but also
consider why it might not be an effective solution for fixing the
problem. Depending on the length of the question, you can (and
should!) go into quite a few arguments and counterarguments.
If asked to evaluate an economys performance using data, you can
evaluate whether a country is achieving the standard macro. policy
objectives, assess the validity of the data, and examine the time-frame
in which the data figures.
When evaluating a text, keep an eye out for biases (e.g. strong freemarket tendencies of the author); if you comment on these, your
evaluation may become more effective.
Evaluation also includes a consideration of the ways in which an ec.
theory may not always be applicable to reality.
After giving a list of points, prioritize the arguments: make a conclusion
stating which point is the most (or least) significant and explain why.
o In your conclusion, summarize your most important arguments
from the body of the text; make sure your conclusion is specific
to the real-life situations (if on Paper 3) considered
Long-run vs. Short run: The long run consequences of a policy may be
very different from the short run consequences; you are evaluating if
you distinguish between the two time periods.
Consider the issue from the point of view of different stakeholders (for
example, domestic producers, foreign producers, consumers, high- and
low- income people, the govt).
Where Candidates Screw Up:
o Poor time management: you have a limited amount of time per paper; plan accordingly:
Paper 1: Take a few minutes to plan, and do not take too long answering the
Short Answer.
Paper 2: Choose the three questions that you will be answering during your
reading time, and manage your time such that you answer each question in
approx. 20 minutes.
Paper 3: Choose at least 2 of your questions during the reading time, and
choose the third when writing time begins, if necessary. Answer each question
in approx. 40 minutes.

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Reading the question carelessly: Dont base your entire answer on the few key words
that you see immediately, and dont spew random theory on the page; you are being
graded on specific understanding of the demands of the question, so you may get
marked down for inaccuracy even if your theory is essentially correct, in such a case.
Imprecise use of key terms: Learn correct and precise definitions, or risk getting marked
down. This is an economics class; thus, lay definitions will not get you very far.
Lack of examples/poor use of examples: To score high, include relevant real-life
examples; in Paper 3, refer to the data given to you in addition to your theory.
Lack of diagrams/poor use of diagrams: Quite self-explanatory; use a graph even if the
question does not specifically ask for one (99% of the time, there will be a graph that
will fit the question), and label your diagrams correctly.
Take enough space that your ideas are as clear as possible. of an IB page is an
appropriate size, with an explanation on the side.
Do not put your diagrams at the end of an answer or the end of the exam;
always include them where they are most relevant to your theory.
When in doubt, sketch your diagrams in pencil and then use ink, to avoid
making preventable errors.
Use a ruler; it makes your examiners life that much easier.
Learn the correct labels for diagrams; most significantly, dont mix up micro. and
macro. labels.
Also, choose your labels with respect of what you are trying to say, and
be as specific as possible without wasting time on labeling; if it saves
you time in your written answer, time spent labeling is not time wasted.
When you shift a curve, indicate the shift with your labels (e.g. D1->D2).
Do not invent innovative diagrams in the middle of the exam.
Use axes to provide information (e.g draw dotted lines from the equilibrium
points to the axes and note the variable; note this information in the written
explanation)
When you shift a curve, use arrows to show the direction of the change (both on
the graph and on the axes).
Make sure you understand the relationships that the diagrams show.
A theory may lend itself to a non-linear diagram (eg. a poverty cycle); draw such
a diagram neatly and clearly, and describe in words the relationship that the
diagram shows. Such diagrams should be used mainly for support (e.g. a
poverty cycle could be used with a PPF, but should not usually stand alone).
Ineffective Evaluation: See above, on evaluation.
Not following instructions: On Paper 3, use the information given to you in the text; to
help you, annotate the text (underline specific key phrases or statistics, for instance).
Abbreviating everything: Unsubstantiated abbreviations will not get you very far on the
exam; only use clearly-accepted abbreviations (e.g. MNC, GDP), and only abbreviate
after having written each term at least once in full.

`Making sweeping generalizations in your answers: Economic concepts are usually

composed of many aspects; if you generalize, odds are good that you will be
inaccurate/imprecise- for example, stating that all LDCs experience massive corruption
is factually inaccurate, while discussing the problems of aid without reference to types
of aid is imprecise, as many types of aid, with different problems, exist.
Using arrows instead of the words increase and decrease (or, in an earlier version of
this study guide, the symbols ^ (increase) and / (decrease): This practice is just lazy
writing.
Not explaining econ. relationships: A common mistake is to state that a change in one
econ. variable will lead to a change in another variable, but never explain why this is so.
Tell the story.
Try not to repeat yourself unnecessarily, as that represents a waste of your
precious time.

Chapter I: Introduction to Economics

Economics is a social science (a study of how people and societies interact with each other)
which is concerned with rationing systems and the allocation of scarce resources to fulfill
consumers infinite wants.
Although the Earth and all of its resources are finite (they will eventually deplete), the wants of
humans are infinite. We must use the finite resources to produce the goods and services that
we want/need; therefore, the quantity of goods and services that can be produced is finite, and
all of our needs and wants cannot be satisfied at once.
o Needs: goods and services that we must have to survive (e.g food, shelter, clothing)
o Wants: things that we would like to have, but which are not necessary to our survival
(e.g tablet computers to play Tetris on).
o Goods: physical objects that are tangible (can be touched); e.g. enriched uranium,
potatoes.
Specific types of goods include:
Capital (producer) goods: man-made goods used to produce other
goods, which are not bought for final consumption (e.g. hammers,
combine harvesters).
Consumer goods: Goods bought for final consumption.
o Consumer durables: Consumer goods that are consumed over
an extended period of time (e.g. TVs)
o Consumer non-durables: Consumer goods that are consumed
immediately, or over a short period of time (e.g. TV dinners).
o Services: intangible items that people may purchase (e.g healthcare)
There is a conflict between the finite resources available and our infinite needs and wantspeople cannot have everything they desire and some rationing system (an economy) for
allocating scarce resources must be in place.

All goods that have a price are relatively scarce (they are scarce relative to peoples demand for
them, and the price is there to ration them). For example, although cars are commonplace, they
are economically scarce because they have a price, which makes some people unable to afford
them, however much they may want one. Their ability to purchase a car is limited by the
amount of money they have and the cars price, which rations the available cars. Any
good/service that has a price and is being rationed is an economic good (as opposed to a free
good, such as atmospheric air (discounting externalities; clean air is not a free good, as there is
an opportunity cost involved in removing pollutants)). Therefore, scarcity in economics is
different from its everyday definition.
Since people do not have infinite incomes, they must choose whenever they purchase goods
and services as to how to allocate their finite financial resources and choose between
alternatives.
The above results in all economic decisions having an opportunity cost (the next best alternative
foregone when an economic decision is made). Opportunity cost: something that is given up to
have something else. Opportunity cost is never a monetary cost.
As long as economic resources are used in the production of a good/service, a cost is involved,
even if a price is not.
If a good/service has an opportunity cost it is relatively scarce and therefore, an economic good.
Free goods do not have an opportunity cost when they are consumed, as they are unlimited in
supply; e.g. we do not have to give up anything else in order to breathe. Free goods do not have
prices and are not relatively scarce.
Therefore, in economics, choices have to be made. These can be expressed as a series of three
questions (the basic economic problem):
o What should be produced and in what quantities, using our scarce resources? This has
to be decided for all economic goods.
o How should things be produced? There are many ways of producing things and different
combinations of resources that can be used (e.g. capital intensive vs. labor intensive,
organic farming vs. industrial farming)
o Who should things be produced for? Those who can afford them, or some other
allocation system? How will a nations GDP be distributed?
All rationing systems must answer these questions. There are two main rationing systems: the
free market and the planned economy. All economies, both in MDCs and LDCs, must answer
these questions (e.g. in a choice between military expenditure and a functioning healthcare
system- both in the US and in Somalia).
Factors of Production: the four resources that allow an economy to produce its output
o Land: the surface area of the Earth, as well as all natural resources coming from the
Earth (both basic raw materials and cultivated products). Some natural resources are
renewable; others are non-renewable.
o Labor: The human FoP- the physical and mental contribution of the existing workforce
to production. Investment in human capital (the value of the workforce) is also
classified as factoring into this FoP.

Capital: The FoP that comes from the investment in physical capital (man-made goods
used to produce other goods- this includes manufactured resources, tools, machinerye.g. hammers), and infrastructure: the large-scale public systems that are necessary for
a countrys economic activity, including a nations roads, railroads, hospitals, schools,
power plants and telecommunications, accumulated through investment, usually by the
government. Improving infrastructure would lead to increased potential growth and
probably development.
o Management (Entrepreneurship): The organizing and risk-taking FoP- entrepreneurs
organize the other FoPs to produce goods/services, using their personal finds and the
funds of investors in the hopes of making a profit (which is not guaranteed, and
investments may be lost- thus, risk is involved)
Production Possibility Curves are used by economists to show the concepts of scarcity and
opportunity cost, inter alia.
o A PPF shows the maximum combination of goods/serviced that can be produced in an
economy at a given time, if all resources are fully and efficiently employed and the state
of technology is fixed (the PPF represents potential output).
o A PPF illustrates a two-good economy and is displayed as a curved, convex graph; this
demonstrates the relationship that, as more of one good is produced, increasing
amounts of the other good must be sacrificed to produce each marginal unit of the good
being produced.
This relationship is due to a version of the Law of Diminishing Returns that
assumes that some FoPs are better adapted to the production of certain
goods/services than others; as a consequence, increased production of one
good will cause progressively larger decreases in the production of the other
good, as the resources that are least efficient at the production of the alternate
good (and thus contribute least to output) are diverted first.
If returns are constant, however, the PPF is a straight line; as resources
are transferred from one good to another, the amount of output
sacrificed in the production of one good and gained in the production of
the other is constant.
o On a PPF graph, if all FoPs are dedicated to building schools (at point X), Y schools will be
produced, but no roses will be produced. Point Y shows the opposite situation. At Point
Z, FoPs are shared between production of schools and roses; the points on the PPC
show the possible combinations of output. At full employment, it is impossible to
produce more roses without producing fewer schools; the opportunity cost of the roses
is the number of schools not built.
The PPC is a curve because not all FoPs used to build schools and grow roses are equally
efficient; as we move towards point Y, where fewer schools are built, it is unlikely that the
workers used to building schools will be very skilled at growing roses; at point Z, however, the
economy will be at its most productive, as workers will be able to specialize in the industry in
which they work most efficiently.

Thus, the PPF illustrates opp. cost: as the economy switches production from Good X to
Good Y, resources producing Good X are sacrificed to produce Good Y; the opp. cost of
an increase in Y is the foregone production of some units of X.
If an economy is producing within the PPF, not all FoPs are used or allocated efficiently. This is
always the case in reality, as some FoPs are always unemployed at any given time (especially
labor); therefore, in this situation, more of one good could be produced without producing less
of another.
Point W is inside the PPC and represents actual output. If there is a movement in the PPC from
W to A (towards the PPCs edge), actual growth has occurred
A point outside the PPC is unattainable unless the quantity/quality of FoPs, or the level of
technology, increases and the PPC moves outwards, or unless intl trade occurs.. Any outwards
movement of the PPC is an increase in potential output, and therefore, potential growth (eg.
due to increases in the quantity of raw materials, tech. improvements, improvements in
labor/capital productivity, etc). This does not also mean that actual growth has occurred, which
would require a movement of the current point of actual output towards the new PPC
A fall in the quantity of FoPs causes an inward shift of the PPC (e.g due to war/natural disasters)
Utility: a measure of usefulness and pleasure from consuming a product.
o Total utility: the total satisfaction gained from consuming a certain quantity of a
product.
o Marginal utility: the extra utility gained from consuming one additional unit of the
product. Marginal utility usually falls as consumption increases, up to a point where a
person may get sick or suffer side effects, in which case marginal utility would ultimately
become negative.
o In theory, the free market will work to maximize the utility of all private economic
agents.
o An interesting related point is that, while water is more essential than diamonds, people
are willing to pay rel. more for diamonds than for water; this is due to the scarcity of
diamonds and thus, their high marginal utility; however, while the marginal utility for
water tends to be rel. lower, the total utility is high, as far more diamonds than water
can be consumed.

Chapter 2: Rationing Systems and Additional Definitions

Economics is a large discipline that can be split up into various sections; there are a
number of ways in which this is done:
o Microeconomics and Macroeconomics
Microeconomics: The study of smaller, discrete economic agents and
their reactions to changing conditions (e.g. the study of how consumers
make decisions about demand and expenditure, how individual firms
make decisions on what to produce and how much, and how individual
industries are affected by government regulation)

Macroeconomics: The study of all economic activity in a national

economy (e.g. inflation, unemployment, and income distribution in an
economy)
Positive and Normative Economics:
Positive statement: A statement that is objective and can be proven
right or wrong by examining the facts (e.g. the unemployment rate at a
given time)
Normative Statement: A subjective statement based on opinion; cannot
easily be proven or disproven. Such statements often contain words
such as should, too little, too late, and require evaluation based
on theory.
Positive economics deals with questions that are capable of
being proven correct or incorrect
Normative economics deals with areas of the subject open to
belief, opinion and interpretation. While confidence is easier in
positive economics, it is more interesting to examine normative
questions (although conclusions may be misleading) (e.g.
business cycle theories)
Economics and Model Building:
Economists build models to test and illustrate their theories; these
models may be manipulated to see what the outcome will be if one of
the variables changes.
This method of holding all variables but one constant is known
as ceteris paribus, all else being equal in Latin. When
economists test the effect of one variable on another, they
need to be able to isolate the effect of one variable by assuming
no other variables have changed (e.g. when analyzing the effect
of a change in wages, they assume that taxes have not
increased). Economists nearly always make assumptions, which
it is important to be aware of.
o An example of an economic model is the circular flow
model, which shows the relationship between
households and firms in a national economy.
In the model, households serve two functions:
they consume goods and services, and are the
owners of the FoPs used to produce goods and
services.
Firms are the productive units in the
economy that turn the FoPs into
goods/services. Firms and households
combined represent the private sector:

the sector of the economy controlled by

private individuals.
Services are intangible products that
can be either consumed immediately
(e.g. a haircut) or over time (e.g.
insurance).
The circular flow model can also be
expanded to account for the public
sector (government), the net foreign
sector and the financial sector.
The government has a number of roles.
It is responsible for law and order,
national defense, adjusting the
economy to achieve economic policy
objectives, and directly providing
certain goods and services (e.g. water,
electricity, healthcare).
Rationing Systems (Economic Systems): Planned vs. Free-Market Economies:
o Economics is the study of rationing systems; since FoPs are relatively scarce, a
way of rationing the FoPs and the goods and services produced by them must
exist.
o In theory, two archetypes of rationing system exist:
Planned economies (e.g. North Korea):
In a planned (command) economy, decisions on what to
produce, how to produce, and who to produce for are
undertaken by a central body (the government). All resources
are collectively owned; government bodies arrange all
production, set wages and prices through central planning.
Decisions are made (theoretically) on the behalf and in the
interests of the people (the motive for production is social
welfare, as opposed to profit).
o In a pure planned economy, market forces are
nonexistent.
o In theory, planned economies allow the govt to
influence the distribution of income towards greater
equality and, by determining which goods are
produced, can prevent the production of sociallyundesirable goods.
The quantity of decisions to be made, data to be analyzed and
FoPs to be allocated is immense, making central planning
difficult. Because of the need to accurately plan for future

events, the task becomes near-impossible to complete

efficiently.
In many planned economies in the world today (e.g. China),
elements of the free market are becoming increasingly common
and even encouraged (e.g. the inflow of FDI)
Free-Market Economies (e.g. Hong Kong):
In a free-market (private enterprise or capitalistic) economy,
price (determined by supply and demand) rations goods and
services. All production is in private hands and market forces
set wages and prices in the economy. The economy should be
rel. efficient, with few surpluses and shortages.
Individuals make independent purchasing decisions in their own
self-interest (and seek to maximize their utility), and producers
(who seek to maximize profits) then decide whether they are
prepared to provide the products; their decisions are based on
the likelihood of profit.
o If demand changes, for instance, quantity supplied will
change to compensate. If tastes change for one
product vs. its substitute, shops will have a shortage of
the more popular product and a surplus of the less
popular product.
As a consequence, they will increase price for
the popular product, reducing QD, and raise the
price of the unpopular product, increasing its
QD.
Producers (ceteris paribus) will receive the
signal through the higher price that greater
profit can be made by producing the popular
good, and will therefore have the incentive to
prioritize production of the popular good over
the unpopular good.
FoPs will have been reallocated in favor
of the popular good.
Finally, the increased price rations the popular
good among consumers, as the good scarce
relative to consumer demand.
Thus, a change in consumer demand sends signals to producers
through price, which ultimately makes sure that the wishes of
consumers are met (in theory) as efficiently as possible. The
free market is therefore self-righting.

When consumers and producers work to their own self-interest

(theory goes), the market produces the best possible outcome
for both. Adam Smith referred to this concept as the invisible
hand of the market, and the notion has been used to justify
non-interventionist economic philosophies.
o The profit motive provides firms with an incentive to
reduce costs and be innovative.
o However, resources may sometimes take a long time to
be reallocated from the production of one product to
that of another, which will likely negatively impact the
stakeholders involved.
o The free market only maximizes community surplus if
there are no market failures or imperfections; however,
in practice, numerous forms of market failure exist.
In order for free markets to be effective, most of the following
conditions are often assumed to be necessary:
o Law and order
o Stable pol. systems, property rights, neutral legal
systems, currency stability.
o Trust in institutions and firms
o Social mobility
o Free access to information
In reality, all economies are mixed economies (some of the rationing
decisions are made by the govt, while some are made by market
forces); what is different is the degree to which an economy
incorporates free market vs. command policies.
There is a spectrum on which we can place countries.
Government intervention is essential in reality, as some dangers
exist to unrestricted free-market activity; however, the longterm trend since the mid-1970s has been towards a more
market-oriented allocation of resources (including privatization
of nationalized firms and incentives to increase the involvement
of the private sector).
Note that traditional economic systems still exist in some LDCs, and
involve activities such as gift-trading and barter
Some of the disadvantages of planned/free market economies include:
Disadvantages of a free-market economy:
o Demerit goods (goods that are harmful to people- e.g.
drugs) will be over-provided due to high demand, high
prices and a high profit motive

Merit goods (goods that provide often-intangible

benefits for consumers- e.g. healthcare) will be
underprovided, as they will only be produced for those
who can afford them (or not at all)
o Public goods (which are non-excludable and nonrivalrous) will not be provided at all, as there is no
incentive for private firms and individuals to shoulder
the high costs of provision given the relatively very
small private benefits of doing so.
o Resources may be used up too quickly and the
environment may be damaged by pollution, as firms
seek to profit-maximize and minimize costs.
o Prices for certain goods (e.g. agricultural commodities)
are often unstable, reducing firms ability to plan
effectively and potentially causing incomes to be
volatile.
o Some people will not be able to look after themselves
(e.g. the very old and very young), and will not survive.
o Large firms may grow to dominate industries, leading to
inefficiency, high prices and excessive power.
Disadvantages of a planned economy:
o Production, investment, trade and consumption, even
in a small economy, are too complicated to plan
efficiently, often leading to bureaucracy and
inefficiencies; resources will be misallocated, leading to
surpluses and shortages.
o Because there is no price system, resources will not be
allocated efficiently; arbitrary decisions will not be as
effective as supply and demand.
o Incentives may be distorted. Workers with guaranteed
employment and managers who gain no share of the
profits will have no incentive to work efficiently;
output/quality/variety of goods sold may suffer.
Due to lack of competition, production is
unlikely to be productively or allocatively
efficient.
o In practice, planned economies have tended to
encourage corruption, weak governance, loss of trade, a
lack of incentives, and policy conflicts.
o Governments might not share the same aim as the
people, but may implement unpopular/corrupt plans
through raw power.

 Transition Economies: Economies in the process of moving from a centrally planned

economic system towards a more market-oriented economic system (e.g. Poland, in the
1990s).
o Some countries that were once chiefly centrally planned (mostly in Eastern
Europe) have been moving towards a more market-oriented economic
structure. Some problems that these countries face have included increased
crime rates, initially inefficient/corrupt governments, collapse of inefficient
state-owned industries, difficult currency reform, and a reduction in
welfare/unemployment, as well as social security/healthcare benefits by the
government, as well as overall government expenditure.
Economic Growth:
o Gross Domestic Product = National Income = The total value of all final goods
and services produced in an economy in a given year.
o GDP can be found in three ways:
By looking at the value of the output of all goods and services by an
economys firms.
By looking at the total planned expenditure on goods and services by
consumers, firms, the government and the net foreign sector
By looking at the total incomes earned by households for allowing firms
to use their FoPs.
It is not pragmatically possible to measure the values of all FoPs used;
this method is not attempted.
o To not overstate the value of GDP when comparing between two or more years,
any increase in average price level caused by inflation is ignored; nominal GDP is
converted into real GDP. Real = having compensated for the effects of
inflation
o If real GDP increases from one year to another, the economy has grown (more
goods and services- more stuff- is being produced); however, if the population
has grown by the same proportion, per capita GDP (real GDP divided by
population) will not have increased. Thus, a more accurate statistic for
measuring economic progress is GDP/capita.
o Because it is an aggregate and a money measurement, economic growth tells us
little about the welfare of a country. A countrys economy may grow because of
expansion in military spending, for instance, and Joe on the street will not really
be better off.
o Economic growth, in the sense of an increase in real GDP is actual, as opposed
to potential growth (movement within the PPC towards its outer edge, as
opposed to outward shift of the PPC).
Economic Development:

Unlike growth, economic development measures welfare, or well-being, or the

quality of life, as defined by some agreed-on indicator (e.g. education, health
and social indicators) in addition to raw money figures.
The Human Development Index (HDI) is the most well-known development
index; it measures national income per capita, adult literacy, average years of
schooling and life expectancy at birth.
HDI is calculated for a country and gives a value between zero and one
(the maximum end of the scale)
HDI>.8: High Human Development
.5<HDI<.8: Medium Human Development
HDI<.5: Low Human Development
These boundaries are arbitrary and do not mean that there are
large differences between countries on either side.
Sustainable development:
Many economists believe that growth cannot be sustained indefinitely
into the future at current levels, as environmental degradation is
occurring and non-renewable resources are being used up at an
unsustainable rate. A possible solution to this issue is sustainable
development (development that meets the needs of the present
without compromising the ability of future generations to meet their
own needs). To develop sustainably, countries should manage and
conserve their resources and avoid harming the environment, as this
will prevent future growth. Countries should limit their growth, and
how they wish to achieve it, in the present to ensure healthy growth
prospects in the future.
At the same time, if LDCs are forced to achieve sustainable
development, their ec. growth could be slowed and the environmental
consequences of allowing low levels of income, in the medium to long
term, could be just as harmful, if not more so.

Chapter 3: Supply and Demand (The Market Forces)

Market: A place where buyers (demand) and sellers (supply) meet.
o In a free market, prices are determined directly and solely by interaction of demand and
supply; however, govts may intervene to manipulate the relationship between demand
and supply, and thus alter the allocation of resources.
A fall in price may be caused by a decrease in demand or increase in supply.
Demand: The quantity of a good or service that consumers are willing and able to purchase at a
given price, in a given time period.
o The operative phrase is willingness and ability- it is not enough for consumers to
merely want a given good/service (otherwise, economic theory dictates, demand would
be infinite at any price); they must also have the financial means to purchase it (the

ability to buy). This is known as effective demand and can be shown on a demand
curve.
The Law of Demand: As the price of a product falls, the quantity demanded (QD) of that product
will usually increase, ceteris paribus (all else being equal; that is, if price changes, but all other
factors, the determinants of demand, are assumed to remain constant).
o This relationship can be illustrated graphically or using a table (a demand schedule). As
a result of the Law of Demand, the demand curve is usually drawn as sloping
downwards.
o The QD of a good normally increases as the price falls (a fall in price usually leads to an
increase in QD). On the graph, price is placed on the y-axis, and quantity is placed on
the x-axis. This is counterintuitive, as price is the independent variable and QD is the
dependent variable (but is nonetheless necessary for the mathematics of HL
microeconomics to function). So, dont question it.
o When graphed from plotted data, demand curves are usually convex to the origin (due
to varying elasticity of demand); however, they are usually drawn as straight lines for
simplicity.
o A change in a goods price causes a change in QD and a movement along the existing
demand curve; this is in contrast to the effect of a change of the other determinants of
demand.
o The Law of Demand occurs for three reasons:
The Income Effect: When a products price falls, consumers real income (the
amount of goods and services that their income will buy) increases; thus, people
will be likely (more willing and able) to buy more of the product, as a larger
proportion of their income will now remain unspent after having purchased the
same quantity of the product as beforehand.
Due to the higher real income, consumers will have greater purchasing
power; if a good is normal, consumers will want to buy more of it due to
the income effect. However, if it is inferior, consumers will want to
switch to higher-quality substitutes as income rises.
o Thus, the income effect may act in opposition to the
substitution effect; however, the substitution effect is rel. larger
and consumers do end up demanding more at lower prices,
overall.
The Substitution Effect: When a products price falls, the product will become
rel. more attractive to people than other products whose prices have remained
unchanged; it is likely that consumers will buy more of the product as a
substitute for relatively more expensive products that were previously
purchased.
The Law of Diminishing Marginal Utility: Each extra unit of a good/service
consumed will eventually give less utility; thus, consumers will only be willing to
purchase more goods if they cost less.

This principle applies to the overall market demand curve, as it is a

summation of all individuals demand curves for the product in
question.
The Determinants of Demand:
o A number of factors determine demand and cause a left/rightward shift in the demand
curve. When examining determinants of demand, we always make the ceteris paribus
assumption; if we do not, the analysis becomes too complex and potentially unreliable
(this applies to most economic analysis, including that on your exam papers). The most
important determinants of demand are:
Income: There are 2 types of products to consider when determining how a
change in income affects the demand for a good/service. These are:
Normal Goods: For most goods, as income rises, demand for the good
at any price will rise (YED>0) and the demand curve will shift to the
right; these goods are called normal goods (e.g. newspapers). The size
of the shift in demand will depend on the YED of a good, with
necessities displaying smaller shifts than luxuries.
Inferior Goods: If a good is considered inferior, then demand for the
product will fall as income rises (the demand curve will shift left; less
will e demanded at any price) and the consumer begins to buy higherpriced substitutes in lieu of the inferior good (e.g. cheap wine,
supermarket brand products). When income reaches a certain point,
the consumer will only be buying the superior goods, and QD=0 (the
demand curve will disappear).
The Price of Other Products: There are three possible relationships between
products:
Substitute Goods: If products are substitutes for each other (the
relationship between them being competitive demand), a change in
price of one product will lead to an equidirectional (the opposite of
inverse; I invented the word) change in demand for the other product
(XED>0); if the price of a good rises, demand for its substitute will shift
right, and vice versa. This is because some consumers will switch from
the more expensive good to its relatively cheaper substitute (even
though the price of the substitute is unchanged, its QD changes because
of the shift in demand)
o Examples of substitute goods include tea and coffee, Coke and
Pepsi, HD-DVD and Blu-Ray, Xbox 360 and PS3
Complementary Goods: Complements are products that are often
purchased together (e.g. printers and cartridges, beer and pretzels) and
are said to be in joint demand. If products are complements of each
other, a change in price for one of the products will lead to an inverse
change in its demand; if the price of good rises, demand for its

complement will shift left (QD decreases) and vice versa. This is
because, if a good changes in price, consumers willingness and ability
to purchase its complements will be affected (even though the price of
the complement is unchanged, its QD changes because of the shift in
demand).
Both cases involve a movement along the demand curve for the product
under consideration, and a shift in the demand curve for its
complement/substitute.
Unrelated Goods: If products are unrelated, a change in the price of one
product will have no effect on the demand for another product (YED=0;
e.g. marijuana and sea anemones.
Tastes and Preferences: For the most part, this determinant is self-explanatory.
Marketing may alter consumers tastes and preferences, and firms attempt to
influence tastes to shift demand for their product right. A change in tastes in
favor of a product leads to more being demanded at any price.
Other (macroeconomic) factors may also influence demand for a good/service,
in addition to the ones above; these include:
Population size: if the population increases, the demand for most
products will shift right.
Changes in age structure of the population: If the age structure of the
economy changes, this will affect demand for certain products; an aging
population will result in increased demand for cardiac bypass surgery
and reduced (left-shifting) demand for skateboards.
Changes in Income Distribution: If income distribution becomes more
equal (e.g. via progressive taxation), the demand for normal goods
(0<YED<1) may increase (rightward shift in demand)
Changes in availability of credit: If the cost of borrowing money falls due
to a decrease in the interest rate, credit will be more widely available,
and consumption of durable goods (e.g. houses) will increase.
Government Policy Changes: Changes in direct tax rates (e.g. income
tax) will affect consumers disposable income, and hence, demand. In
addition, regulations mandating/banning/restricting use of certain
products (e.g. bike helmet laws, smoking restrictions) will affect demand
in related markets.
Seasonal changes: These will lead to changes in demand patterns in the
economy (e.g. demand for ice cream and beach towels falls in the
winter)
The (Very Simple) Distinction Between a Movement and a Shift in the Demand Curve:
o A change in the price of a good causes a movement along the existing demand curve (as
price is located on one of the axes of a demand graph); a change in any of the
determinants of demand will always cause demand to physically shift either left or right.

Exceptions to the Law of Demand:

o Giffen Goods (One of the two Bigfoots of economics; the other is a diseconomy of
scale): A unique type of inferior good, the QD of which rises as price rises.
The key to understanding Giffen goods is poverty; a Giffen good will necessarily
be a very inferior, necessity good (e.g rice and noodles in rural China). There is
much debate as to whether they exist (I personally believe they do not, at least
in the long run), and if they do, they are necessarily rare and will be eliminated if
poverty diminishes.
When the price of the Giffen good falls to the very poor (theory goes), they will
likely buy less of the good and use their increased real income to buy higherquality products, which they can now afford; likewise, if the price of the good
rises for the very poor, they will buy more of it as they are unable to afford
higher quality products (the Giffen good is a staple with no substitutes).
Thus, the income effect of a price increase may outweigh the
substitution effect, leading to the perverse demand curve.
However, this relationship can equally well be explained through the
properties of inferior goods (demand shifts left as incomes increase)
and the substitution effect (if prices of all foodstuffs rise, relative to the
real income of the poor, they will switch over from the more expensive
substitute foodstuffs to the staple good).
o Veblen Goods: Goods for which the QD increases as price rises due to snob value (e.g.
Louis Vuitton handbags). Some products get more popular as their price rises due, in
part, to conspicuous consumption: getting satisfaction from being seen by others to
consume more expensive products. As the price of a Veblen good rises, people with
high incomes begin to buy more of the product due to ostentation.
A typical Veblen good, when graphed, will resemble a sideways parabola. At
low prices, a Veblen good will have a normal demand curve (QD falls as price
rises); however, as price continues to rise, the good will ultimately achieve
snob value status, and further price increases will begin to cause QD to
increase.
o Expectations and the Bandwagon Effect
It is often argued that there are times where QD rises as price rises due to
expectations of what will occur to prices in the future. In some cases (e.g. house
prices, share prices) an increase in prices causes consumers to jump on the
bandwagon if they believe prices will rise in the future. However, this
relationship can also be explained (an explanation which I tend towards) by
progressive rightward shifts in demand.
A famous example of speculative demand in history was Tulipmania, in
1636 Holland.
Supply: The willingness and ability of producers to produce a given quantity of a good/service at
a given price in a given time period.

Again, the operative phrase is willingness and ability. It is not enough for producers to
be willing to produce a good/service; they must also have the financial means to do so
(the ability to supply); this is known as effective supply, which is shown on a supply
curve.
The Law of Supply: As the price of a product rises, the quantity supplied (QS) of the product will
usually increase, ceteris paribus.
o As a result of the Law of Supply, the supply curve of a product normally slopes upwards;
this relationship may either be illustrated using a table (supply schedule) or graphically.
Once again, price is on the y-axis, and quantity is on the x-axis. Supply curves are usually
curved and increase in steepness as price rises (due to differing values of PES, as well as
diminishing returns, because supply = marginal cost). However, for ease of analysis,
they are usually drawn as straight lines.
o As with demand, a change in the price of the product itself will cause a change in the QS
of the product and a movement on the existing supply curve (because at higher prices
there will be more potential profit to be made, granting an incentive to increase
production- in a PCM, producers will also e attracted to enter the market), while a
change in the determinants of QS will cause a left/rightward shift in the supply curve.
The Determinants of Supply: A number of factors determine supply and cause a left/rightward
shift of the supply curve. Whenever we examine any of the determinants, we make the ceteris
paribus assumption, to prevent analysis from becoming complex to the point where the precise
shift in supply due to any one determinant cannot be estimated. These include:
o Cost of FoPs: If the cost of an FoP increases (e.g. if wages increase), costs in the
industries using that FoP will increase, reducing the ability of firms to supply as many
units of the product at any price and shifting supply left. Conversely, a fall in production
costs will enable firms to increase supply, which shifts right.
Especially on ag. markets, costs will vary according to weather conditions. In
addition, better management can make FoPs mare productive, decreasing their
costs.
o Price of Substitutes in Production
Often, producers have a choice as to what they will produce (e.g. a physics lab
can create dark matter and antimatter using the same particle collider; a dairy
can make (rather more realistically) butter and cheese). If the price of a
substitute in production rises, due to increased demand, it may be that the
producer will be attracted by the higher prices and aim to supply more of the
substitute in production (XES>1).
This leads to a movement along the supply curve for the substitute in
production and a leftward shift in the supply curve of the original good
(and vice versa, if the price of the substitute in production decreases).
A rise in the price of a substitute of production causes an increase in QS
(q>q1); some producers will supply less of the original good, as they are
manufacturing the substitute in production; supply of the original good

shifts left (S>S1), even though the price of the original good remains
constant.
o Sometimes, goods will be produced jointly (e.g. beef and
leather, copper and silver); in this case, if a higher price leads to
an increase in the QS of beef, the supply of leather will shift
right, as more leather is now produced at any price.
o The State of Technology: Improvements in the state of technology in an industry should
cause supply to increase (shift right); if technology actually worsens (which is unlikely),
supply will shift left. This may happen as a result of natural disasters/war.
o New Firms Entering the market: If a firm enters the market, industry supply will
increase.
o The Aims of Producers: If firms choose to produce in a more environmentally
sustainable/socially responsible manner (e.g. by using environmentally-sourced raw
materials), their prod. costs rise, and the supply curve will shift left.
o Govt Intervention: In many cases, govts interfere in markets in ways that alter supply.
Examples include:
Indirect Taxes: Taxes on goods/services added to the price of a product.
Because they force up the price of a product at any price, supply shifts left by
the amount of the tax. Less of the product will be supplied at any price.
Subsidies: Payments made by the government to firms per unit of output
produced, decreasing production costs. This shifts the supply curve downwards
by the amount of the subsidy; more of the product will be supplied at any price.
The (Very Simple) Distinction Between a Movement and a Shift in the Supply Curve:
o A change in the price of a good causes a movement along the existing supply curve (as
price is located on one of the axes of a supply graph); a change in any of the
determinants of supply (e.g. an increase in rent) will always cause supply to physically
shift either left or right; more/less will be supplied at any price.

Chapter 4: Microeconomic Equilibrium

When demand and supply interact, a state of equilibrium results.

In economics, equilibrium occurs whenever the variables being studied are in a state of rest, in
the absence of outside disturbance. My laptop is in equilibrium on my desk until it is dropped
(and goes into disequilibrium, until it falls to the ground- a new equilibrium situation); economic
variables can change in an analogous way.
o Economists study the reasons for which equilibriums change and use the knowledge in
policymaking and evaluation to predict changes in equilibrium caused by certain actions.
On a standard demand and supply graph, equilibrium occurs at the price and output where
supply intersects demand; at that point, the amount of a product consumers are willing and able
to purchase is equal to the amount producers are willing and able to supply.
The equilibrium is often known as the market-clearing point, as it is the point where all output
produced in the market is sold, with no surpluses or shortages.

Once the market is in equilibrium, it will stay in equilibrium until an outside disturbance affects
demand and supply.
The equilibrium in a free market is self-righting: any attempt to move away from it without an
outside disturbance will result in it returning to its original position.
o If producers attempt to raise price above equilibrium, the quantity demanded will fall
and the quantity supplied will rise, as producers/consumers are more/less willing and
able to provide/purchase the product at the higher price. There is excess supply of Qd>Qs, as more is being supplied than demanded at the higher disequilibrium price.
To eliminate the surplus, producers will need to lower prices; as they do so,
quantity demanded (QD) will fall and quantity supplied (QS) will rise, until
QS=QD once again, at the equilibrium; the situation is therefore self-righting if
the price is raised for no external reason.
o Likewise, if producers decide to lower the price below the equilibrium price, the
quantity demanded will rise and the quantity supplied will fall, as consumers/producers
are more/less willing and able to purchase/provide the product at the lower price.
There will be excess demand (Qd->Qs) on the market; more is being demanded than
supplied at the existing price than at equilibrium.
To remove this shortage, producers will need to increase prices; as they do so,
QD will fall and QS will rise, until QS=QD at the equilibrium price once again (the
higher price rations the good). Once again, the situation is self-righting.
o In general, these trends explain the price mechanism: if demand for a product increases,
for instance, there will be excess demand at the old price; the price will rise, reducing
the QD and rationing the product, the higher price will act as an incentive for existing
firms to increase output, and firms outside the industry will receive the signal to join the
industry.
The Effect of Changes in Demand and Supply on Equilibrium:
o Equilibrium may be moved by any outside disturbance. In the case of supply and
demand, this would be a change in one of the determinants of supply or demand, which
would cause either curve to shift.
For instance, when incomes increase, demand for holidays will increase; ceteris
paribus, demand for holidays will shift right. When this occurs, price initially
stays at Pe (equilibrium price); thus, Qe units continue to be supplied, but QD
now increases to Q2; there is excess demand at the former equilibrium price.
To eliminate the shortage, price must rise until QD=QS once again at a new
equilibrium, at a price of (P1, Q1), where Q1 units are both demanded and
supplied.
Whenever demand or supply shift, the market will (if left alone) adjust to a new
equilibrium price.
Price Controls:
o Although it is relatively efficient, the free market does not always lead to optimum
outcomes for producers or consumers, or for society as a whole; the govt may feel that

the market equilibrium does not lead to a socially desirable outcome; thus, intervention
will focus on the adjustment of the price and/or quantity of a good towards a more
socially optimal outcome; there are issues of market failure implicated here.
Governments often intervene in individual markets in order to:
Establish maximum prices (price ceilings)
A government may set maximum prices below market equilibrium,
preventing producers from raising the price above the ceiling.
Maximum prices are usually set to protect consumers, normally in
markets for necessities and/or merit goods (goods that are beneficial to
society, but would be underprovided were the market allowed to
operate freely.
o Venezuela set max. prices in agri. And food markets to ensure
low-cost food for the poor; NYC set price ceilings on rent to
attempt to provide affordable housing.
o If a government were to establish a price ceiling in a market
with equilibrium (Pe,Qe), a problem would arise. At the price
ceiling (Pmax), Qd units are demanded, but only Qs units are
supplied; Qs>Qd- there is excess demand on the market.
If the government does not intervene further,
consumption of the product will actually fall (Qe->Qs),
despite the lower price.
o Due to the excess demand and shortages, black (parallel)
markets may arise, where the product is sold at a price
somewhere between official market price and equilibrium
price; queues may also form at shops and producers may have
to begin directly allocating and rationing their output. Since
these problems are unfair to consumers, the govt may need to
eliminate/reduce the shortage. Besides rationing the good,
which is inefficient and pol. unpopular, it has two options for
doing so:
Option I: It could attempt to shift demand left, creating
a new equilibrium at Pmax, but this would limit
consumption, which defeats the intention of the price
control.
Option II: It could attempt to shift supply right, until
equilibrium is reached at Pmax, with more supplied and
demanded than at equilibrium, through a variety of
ways:
The provision of subsidies to encourage
producers in the industry to produce mere

Direct provision of the product by the

government, which would increase the supply
(not very effective, as Stalin found, with
agricultural markets)
If the government has stocks of the product, it
an release some of the stocks onto the market;
this is impossible, however, with perishable
goods.
If the govt is able to shift the supply of the product
right, equilibrium will be reached at (Pmax, Qd);
however, this may well mean that the govt incurs a
cost, especially in the case of a subsidy, as well as an
opportunity cost (e.g. if the govt subsidizes the corn
industry, it may have to raise taxes or divert funds from
healthcare). In addition, this approach would nullify the
usefulness of the price control.
Establish minimum prices (price floors)
A govt may set a minimum price above equilibrium price, preventing
producers from reducing their sales price below the floor. Minimum prices are
set for one of two reasons:
To attempt to raise incomes for producers of goods/services that the
govt believes are important (e.g. agricultural products); they may be
helped because their prices are subject to many fluctuations, as well as
foreign competition.
o Agricultural producers in particular face two major problems:
the price of ag. goods have suffered a long-term decline, and
prices in the SR tend to be very unstable; this leads to unstable
incomes for farmers.
o Ag. prices in the SR are unstable because:
The necessary nature of food makes PED inelastic.
Because it is often difficult to keep stocks and crops
take a long time to grow, supply is inelastic in the SR.
Supply is vulnerable to sudden shifts (e.g changes in
weather patterns).
As demand for ag. products is inelastic, farmers earn
more in bad years than good ones; with a fall in supply,
prices, and thus revenues, increase.
To protect workers via minimum wages, to ensure that they earn
enough to maintain a reasonable standard of living.
o Minimum wage policies:
Aim to help the lower-paid

May increase incentives to work in the economy and

cause labor supply to increase
Theoretically will always cause disequilibrium
unemployment
The effect of min. wage policies on
unemployment depends on:
o How far above equilibrium the min.
wage is set.
o The wage-elasticities of supply and
demand for labor; the greater the
values of WED and WES, the greater the
impact of the min. wage on
unemployment.
Might deter FDI.
The increase in wages might, additionally:
Increase the demand for goods and services,
and thus for labor.
Increase labor morale and productivity.
If a government institutes a price floor on a market, price will rise (Pe>Pmin), which is theoretically intended to increase revenue for
producers (and will work, if PED is inelastic). However, a problem arises,
as, at Pmin, Qd is demanded, while Qs is supplied (Qd<Qs); we have a
situation of excess supply. If the govt does not intervene further,
consumption will fall (Qe->Qd), while the product will be more
expensive.
The excess supply causes problems, as producers will have surpluses
that they cannot get rid of; they will be tempted to contravene the price
controls and sell their stocks illegally for a lower price (between Pmin
and Pe).
To maintain the min. price, the govt will likely need to intervene by
buying up the surplus products at Pmin, thus shifting demand for the
product right until a new equilibrium is reached at (Pmin,Qs); the new
demand curve would be: D+govt buying.
The govt can then store the surplus, destroy it, or attempt to export it;
however, storage is expensive, destruction would be wasteful, and,
while selling abroad is usually possible, it often angers foreign
governments, who claim that products are being dumped on their
markets, harming local producers. In some cases, farmers are
guaranteed a min. price and paid to let land that could have been used
for production lie fallow; they are paid the price for the estimated

harvest and nothing is grown. This costs the same for the govt, but
avoids waste, dumping and storage costs.
There will be an opp. Cost involved whenever govts spend in a given
area; in this case, the cost of buying and storing surpluses must be paid,
and the govt may need to limit expenditure in another area or raise
taxes.
The min. price could also be maintained through quotas, which restrict
supply such that it does not exceed a certain quantity; this would keep
price at Pmin, but would limit the number of producers who would
receive that price.
o Quota: A physical limit to production set by the govt (e.g. EU
restrictions on fishing catch volumes).
o A quota may be graphed with a supply/demand diagram, with
supply being normal until some quantity below the equilibrium
quantity, and subsequently perfectly inelastic, as no more may
be produced past that point; in effect, supply will intersect
demand above market equilibrium, at a higher price Pmin and
lower quantity Qquota.
o The main advantage of a quota is that the total amount of the
quota may be subdivided into tradable permits for producers,
providing an incentive to keep output limited.
Also, the government could attempt to advertise the product to
increase demand for it, or, possibly, restrict imports of the product
through protectionist policies (increasing demand for dom. Products).
If govts protect firms via min. prices, problems are likely: firms may
think that they do not need to produce as efficiently as they should,
leading to inefficiency and resources being wasted; firms could also be
producing more of the protected product than they should, at the
expense of products they could produce more efficiently.
Institute price support/buffer stock schemes (e.g. the EU crop support
mechanism)
This action is undertaken by govts to stabilize prices, usually in markets for
commodities (essentially, raw materials), whose prices are usually unstable.
For instance, agricultural prices fluctuate according to season, plant
disease, weather, insects, etc.
Even if conditions are perfect, and there is a bumper crop, the largescale increase in market supply would depress prices, affecting the
incomes of all producers. Poor weather would drive prices up, but this
would only benefit those farmers who did not lose their crops.
Therefore, producers of ag. commodities face volatile prices.

The fluctuation in mineral prices is due to large changes in demand

caused by trends in the global economy. If world income grows,
demand for mineral rises, Increasing price for commodity producers (a
positive situation, as they gain more revenue). However, economic
downturns have a similarly large negative impact on mineral commodity
producers, as demand for their products falls.
Both demand and supply shifts cause instability in commodity markets,
making planning difficult for producers and possibly reducing standards
of living during economic downturns for producers and their societies.
To avoid these risks, a govt may wish to institute a buffer stock scheme,
in which a price band with a max. and min. price are set; the govt then
intervenes in the market whenever market forces cause the price of the
product to move outside of the band.
o If there is a bumper crop, supply will rise, and price will fall. If it
falls below the band, the government will buy up the excess
supply, increasing demand and causing price to return to within
the band. The surplus would have to be stored.
o If there is poor weather or pest problems, however, and supply
falls, increasing the price above the permissible band, there
would be excess demand (a shortage) of the product at the
maximum price; to rectify this, the govt will intervene by
releasing some of its stocks of the product and shifting supply
back right, such that the price returns within the band.
o There are many problems associated with a buffer stock scheme
(related to the problems of minimum price schemes). Buffer
stock schemes will only be effective with non-perishable goods,
which must still be stored appropriately; storage costs are likely
to be high. In addition, as technology continues to improve,
there may be persistent surpluses that must be bought by the
govt, putting financial pressure on the scheme, especially if few
bad seasons occur. Choosing the price band may also be
problematic, as producers will want it as high as possible,
leading to persistent surpluses.
The buffer stock scheme also entails administration
costs.
If the band is set too high (as is the case in the EU, due
to pol. pressure), the govt is constantly buying up
produce surpluses. The problem is likely to increase as
tech. improves and the equilibrium price decreases,
moving outside of the original price band.

To raise finances for the intervention, taxes may need

to be increased, and/or alternate spending projects,
which may be more important to society, may need to
be curtailed.
Institute guaranteed-price schemes:
In this scheme, the govt guarantees a price above equilibrium for
farmers, at which price farmers produce. The market clearing price for
the quantity produced is lower than the market equilibrium; thus, the
govt ends up paying a subsidy to farmers equal to the guaranteed price
minus the sales price.
o By allowing the market to clear, this system means that the
govt no longer needs to maintain stocks of crops.
Institute commodity agreements (eg. the International rubber Organization,
OPEC)
Commodity agreements are international buffer stock schemes for a
particular commodity; they are mainly instituted to help LDCs that are
dependent on the export of a few commodities for export revenue,
where low commodity prices can limit growth and development.
o The usual aim of a commodity agreement is for commodity
exporters to be able to control the supply, and thus the price, of
their commodities.
o Although several commodity agreements have been set up,
none has thus far been successful due to the above problems
and lack of cooperation among members; in addition, as
commodity agreements may result in higher prices for
consumers, they may decrease econ. efficiency.
Demand and Supply Issues:
o If supply exceeds demand along the full length of both curves (i.e. there is no
equilibrium), the good will not be produced- the highest price consumers are willing to
pay is lower than the minimum price producers need to supply.
o If the health service is nationalized, and free at the point where care is given, supply is
nevertheless fixed at a certain level (there is only a set number of medical
personnel/equipment available at any one time).
Given that there is no price, there is excess demand; the only way to ration
healthcare, then, is via planning and queues. As the population ages, the
problem of long waiting lists for operations will likely increase, especially since
new technology increases demand for as well as supply of operations, since
more treatment options become available.

Chapter 5: Elasticities

Elasticity: A measure of the responsiveness of one variable to a change in one of its

determinants.
o We may examine the elasticities of demand and supply in terms of our discussion of
microeconomics.
Elasticity of demand: A measure of how much the demand (or quantity demanded, depending
on the elasticity) changes when there is a change in one of the determinants of demand. There
are three significant elasticities of demand that we will consider:
o Price Elasticity of Demand (PED): a measure of how much the QD of a product changes
in response to a change in the products price.

PED is calculated using the formula:

. If you are like me

and cannot for the life of you remember the formula for % change, it is (for a
single variable):

If a firm decreases its price by 10% and sees an increase in QD of 15%, its
.

The negative value indicates that there is an inverse relationship between P and
QD (i.e. the demand curve slopes downwards, as we would expect it to); the
sign of an elasticity value gives us the nature of the relationship between the
two variables, but does not show the actual elasticity (which is given by the
number).
Because most demand curves are downward-sloping, economists usually
simplify matters by ignoring the negative sign and stating PED as a positive
figure; this is obviously not the case for Giffen and Veblen goods, however.
Thus, PED for the firm would be 1.5.
However, if the calculation results in a positive PED value, we deal with
a perverse demand curve.
The Range of Values for PED:
Possible values for PED range from 0 to infinity; the two extreme values
are theoretical, and the real values lie between.
If PED=0, a change in the products price will not cause any change in
the QD; the % change in QD would be 0, as would the value at the top of
the PED equation. As 0/x=0, PED=0, no matter the % change in price. A
demand curve with PED 0 is perfectly inelastic: completely unresponsive
to price changes; at any price, the QD will be fixed at Q.
If PED=infinity, the formula stops making mathematical sense, as we are
dividing by zero, so the relationship can best be explained graphically.
In this case, demand is said to be perfectly elastic; at the market price,
the demand curve extends forever and the QD is thus infinite.
o However, if price is raised or lowered, even by an infinitesimal
amount, QD will fall to 0, an infinite change; the value on top of
the PED equation would therefore be infinity. Since

infinity/n=infinity, PED will be infinite, no matter the percentage

change in price.
These extreme values for PED are, once again, purely theoretical and no
products on any markets (firm theory is a different matter) possess a
PED of zero or infinity. Most products have PED between the two
extremes; the range of PED values is usually split into three categories.
o Inelastic Demand: [0<PED<1]. If a product has price-inelastic
demand (e.g. alcohol, public transport), a change in the
products price will lead to a less-than-proportionate change in
QD. If the price of a product with inelastic demand is raised, QD
will not fall by as much; as a result, the firms revenue would
increase.
Graphically, inelastic demand curves are relatively
steeply-sloped. The changes in revenue resulting from
an increase/decrease of price anywhere along the
demand curve where PED<1 can be illustrated by
drawing revenue boxes; if this is done, it is clearly
shown that the revenue boxes before a price increase
(a+b) < (a+c), the revenue boxes after the price
increase.
The firm loses some revenue, as fewer units are being
sold due to lower consumer demand (lessened
willingness/ability to purchase), but this decrease is
more than made up for by the increase in price of all
units sold; the firms total revenue rises as a
consequence.
If a firm has inelastic demand and wishes to increase its
revenue, it should raise the price of the product.
o Elastic Demand: [1<PED<infinity]. If a product has price-elastic
demand (e.g. cars, TVs), a change in its price will lead to a
greater-than-proportionate change in its QD; thus, if price is
raised, QD will fall by relatively more, and the total revenue
earned by the firm (price of units sold x quantity of units sold)
will decrease.
Graphically, elastic demand curves are relatively
gradual-sloped. The changes in revenue resulting from
an increase in price anywhere along the elastic portion
of the demand curve may be shown using revenue
boxes; if this is done, it becomes evident that the
revenue boxes before a price increase (a+b)>(a+c), the
revenue boxes after a price increase.

The firm gains some revenue, as more units are being

sold due to higher consumer demand (increased
willingness/ability to purchase), but this increase
outweighed by the decrease in price of all units sold;
the firms total revenue falls as a consequence.
If a firm has elastic demand at the point at which they
are producing and wishes to increase revenue, it should
lower the price of its product.
o Unit Elastic Demand: [PED=1]. If a product has unit elastic
demand, a change in its price leads to a proportionate,
opposite, change in the QD. Thus, if price is raised by a certain
%, QD will fall by the same %, and vice versa.
o When PED=1 between two points, total revenue gained by the
firm (price x quantity) will not change.
A rectangular hyperbola (which is shown by any
function y=a/x, x>0, a>0) has unitary PED at every point;
price x quantity at any point is constant (the revenue
boxes have the same area; if the revenue does not
change when price changes, PED is necessarily = 1).
The Mathematics of Elasticity:
o Elasticity is empathically not a measure of the demand curves
slope; for a straight-line demand curve, PED falls as price falls.
PED is elastic on the top half of the demand curve, inelastic on
the bottom half of the demand curve, and unitary at the
midpoint between the demand curves x- and y- intercepts.
The value of PED decreases as we move down the
demand curve; this is logical as goods with a lower price
have relatively more inelastic demand than more
expensive goods, as they represent a smaller portion of
consumers real income. Consumers would be less
likely to defer the purchase of a pack of chewing gum
whose price has increased 5% than the purchase of a
Porsche whose price has increased by the same
amount.
Determinants of PED:
o Different products will have different values of PED (e.g. the
PED for gasoline may be 0.5, while the PED of a holiday package
might be 2.3), depending on a number of determinants, which
include:
The number and closeness of substitutes available: This
is the most important determinant of PED. The more
substitutes there are for a product, the more elastic

demand for the product will be. Also, the closer the
substitutes available, the more elastic the demand.
If there are a large number of brands of a
particular product, the increase in one brands
price would cause many consumers switching
over to a cheaper (almost identical) substitute.
Thus, the demand for a product that is highly
differentiated (as in an MCM) tends to be price
elastic.
Necessity of the product and how broadly it is defined:
Food is a necessary product: if we do not eat, we die;
therefore, the demand for food is very price inelastic.
However, if we define food more narrowly (e.g. fruit),
we would find demand to be more elastic, as there are
many alternatives (e.g. meat). If we divide fruit more
narrowly and consider the demand for kiwi, we will find
that it is even more price elastic, as consumers can
easily switch form one type of fruit to another. When
we consider kiwi produced by different plantations,
demand will be still more price elastic.
Necessity will vary from consumer to consumer;
different people have different tastes and
necessity is often subjective.
o For instance, kielbasa will have much
more inelastic PED in Poland than in
Saudi Arabia, where pork products
border on cultural taboo.
Necessity also includes the addictive effects
of drugs, as they are habit forming. For
alcoholics and chain smokers, alcohol and
cigarettes will have very inelastic demand.
The Time-Period Considered: As the price of a product
changes, it takes consumers time to change their
purchasing and consumption habits; thus, demand is
more price inelastic in the short run and more price
elastic in the long run.
For instance, if heating prices rise, there is
initially little consumers can do to avoid paying
the higher price, especially in winter-time;
however, as time passes, many consumers may
switch to alternate methods of generating heat;

for example, they may install wood or coalburning stoves. Thus, PED for central heating
may be inelastic in the short run, but more
elastic in the LR.
The Percentage of Income Spent on the Good: Goods
that d not represent a large proportion of consumers
income (e.g. salt) will have rel. inelastic PED, as
consumers will not be very receptive of price changes;
by contrast, durable goods and holidays represent a
greater % of income and households are more likely to
search for the best prices; these goods have more
elastic PED.

PED is used for:

o Determining pricing policy: if demand is price inelastic, firms will
increase price to increase revenue; if it is price elastic, firms will
decrease price to increase revenue.
o Firms can use PED for planning; by knowing the PED of their
product, firms can plan the quantity of goods to produce, the
number of people to employ, and the impact of price changes
on cash-flow.
o PED is used by firms wishing to price-discriminate, in setting the
appropriate price for each market segment.
o PED can be used to estimate the impact of a change in supply
on consumer spending, producer revenue, and income.
o PED and Taxation:
Governments need to be aware of the possible
consequences of indirect taxation (e.g. sales taxes) on
products; if the government taxes a product, its price
will rise and its QD will fall, which may affect
employment in the industry concerned. If the demand
for the product is price-elastic, the imposition of a tax
(and resulting price increase) will lead to a greater-thanproportionate fall in the QD of the product; the industry
in question will contract to a large degree and may be
forced to lay off workers, increasing unemployment in
the economy.
Since governments do not usually wish to
increase unemployment, they usually place
indirect taxes on products with inelastic
demand, such that the QD will not fall by a
significant amount, and the industry will not be
forced to lay off as many workers.

Cross-Elasticity of Demand (XED): A measure of the responsiveness of the demand for

one product (X) to a change in the price of another product (Y).
XED is calculated using the formula:

XED=

If a firm producing pizza finds that its demand has decreased by 5% as a

result of a competing burger stand lowering its prices by 10%, the XED

of its pizzas against the competitors burgers is XED=

The Range of Values for XED:

XED explains the relationship between products. Unlike PED, where
most products have a negative value of PED, the value of XED may be
positive or negative, and the sign is important, as it tells us the
relationship between the two products in question.
If XED is positive, the two goods in question are substitutes for each
other. Products that are close substitutes will have a higher positive
value than products that are more distant substitutes. Two brands of
the same product will have a high positive value for XED; a relatively
small increase/decrease in the price of one will lead to a greater-thanproportionate increase/decrease in demand for the competing good.
o Close Substitutes: XED>1
o Remote Substitutes: 0<XED<1
If XED is negative, the two products in question are complements;
products that are very close complements will have a lower negative
value than more distant complements (e.g. products bundled together
vs. products sold in the same shop). If there is a strong negative value
for XED, a small increase/decrease in the price of one product will lead
to a greater-than-proportionate decrease/increase in the demand of the
complement.
o Close Complements: XED<-1
o Remote Complements: -1<XED<0
Some products (e.g. horseshoes and hand-grenades) are not related
(except in Green Day songs); an increase in the price of one will have no
effect on the demand of the other; XED=0 and the two products are
considered unrelated.
Graphically, XED may be plotted with the price of good Y on the Y axis
and the QD of good X on the X-axis. In all cases, the graphs will reflect
the proportionality of the change in the demand of good X to the
change in the price of good Y; read them accordingly.
For strong substitutes, the demand curve for Good X
[D(x)] slopes upwards and is gradually-sloped.
For remote substitutes, D(x) slopes upwards and is
steeply sloped.

For strong complements, D(X) slopes downwards and is

gradually-sloped
For remote complements, D(x) slopes downwards and is
steeply-sloped.
Firms need to be aware of the XED for their products, as it is essential
that they know the probable impact of the demand for their products of
any price changes by competitors; likewise, they will want to know the
impact of any of their own price changes on the demand for the
competitors product.
o In addition, firms that produce complementary goods (e.g.
power tools and accessories) need to be aware of the effect of
the price changes that they make on one product on the
demand for the complements that they produce.
Income Elasticity of Demand (YED): A measure of the responsiveness of the demand of
a product to a change in consumers incomes. It is calculated using the formula:

YED=

If a consumers income increases by 10% and she increases her spending on

snowy-white cocaine by 20%, her YED for cocaine, YED=

The Range of Values for YED:

As with XED, the sign obtained from the equation is important, as it tells
us whether the product we are examining is a normal or an inferior
good. Recall that the demand for a normal good rises as income rises
and demand for an inferior good falls as income falls.
o For normal goods, YED is positive; demand increases as income
rises; the higher the figure (ignoring the sign), the greater the
relationship between demand and income.
If the % increase in QD is less than the % increase in
income 0<YED<1 and the good is income-inelastic.
If the % increase in QD is greater than the % increase in
income, YED>1 and the good is income elastic.
o Necessity goods tend to have low (positive) YED; the demand
for them will change little as income rises, as people feel that
they already have enough of the necessity good if they are
doing any better than subsisting, and will not increase
consumption.
o Superior goods (e.g. holidays abroad, yachts) are income-elastic
(YED>1); the demand for them increases significantly as income
rises. As people satisfy their needs, they begin to purchase nonessential products (wants; e.g. holidays), in greater numbers.
o Inferior (and Giffen) goods (e.g. supermarket-brand products,
public transport) have negative YED; the demand shifts left as

income increases, since people start to switch expenditure from

the inferior goods they had been buying to better-quality goods
that they can now afford (e.g. demand for supermarket-brand
detergent falls as incomes rise).
An Engel curve shows the relationship between income and the demand
for a product as incomes rise; as income in a country rises over time, the
demand for a normal good may initially increase, then become
constant, and finally begin to fall as consumers begin to buy superior
substitutes instead.
Uses of income elasticity:
o YED can determine what goods firms should produce/stock; as
the econ. grows, firms may wish to stop producing as many
inferior goods.
o Firms can use YED to plan production and employment
requirements as the economy grows.
o YED can help firms estimate any pot. changes in demand (e.g. if
incomes grow abroad, they may be able to expand into new
markets).
Price Elasticity of Supply (PES): A measure of the responsiveness of the QS of a product
to a change in its price.
PES can be calculated using the equation:
PES=

If the price at which a firm can sell its product increases (due to
increased demand) by 10%, and the quantity supplied of the product
increases (because the firm is willing and able to produce more of the
product at the higher price) by 15%, the PES of the firms product is
PES=

=1.5.

The value of PES will be positive in the overwhelming majority of cases.

The Range of Values of PES:
The possible range of values of PES spans from 0 to infinity. Unlike PED,
both extreme values occur regularly throughout the study of economics.
o If PES=0, a change in the price of a product will have no effect
whatsoever on the products QS. Thus, the % change in QS
would equal 0, as would the value at the top of the PES
equation. As 0/x=0, PES=0 no matter the % change in price. A
supply curve with PES=0 is referred to as perfectly elastic; it is
completely unresponsive to price changes. Thus, the supply
curve, when graphed, will be vertical at a given quantity of
output, regardless of the price.
In the very short run (a.k.a. the immediate time period),
it is impossible for firms to increase supply immediately,

regardless of the increase in price, and supply would be

perfectly inelastic until new FoPs could be employed;
thus, perfectly inelastic supply is possible in reality.
A PES value of infinity brings up the prickly issue of division by
zero, and can best be explained graphically. In this case, supply
is considered perfectly elastic; the supply curve extends forever
at market price and the QS is infinite. However, if price falls
below market price, even by the smallest amount, QS will fall to
0, an infinite change. Thus, the value on top of the PES
equation would be infinity; as infinity/x=infinity (though a
smaller infinity!), PES would be infinite regardless of the
percentage change in price.
In international trade, the supply of commodities (e.g.
wheat) available to a country for import is assumed to
be infinite- the consumers in the country can purchase
any quantity of the commodity that they wish, so long
as they are prepared to pay the world market price.
Thus, the market in the country will have a perfectly
elastic World Supply curve at the world price.
Regular products have PED values between 0 and infinity; we
will now examine these values , the range of which is usually
split into three categories:
Inelastic Supply [0<PES<1]: If a product has inelastic
supply, a change in its price leads to a less-thanproportionate change in its QS.
Elastic Supply [1<PES<infinity]: If a product has elastic
supply, a change in its price leads to a greater-thanproportionate change in its QS.
Unit Elastic Supply [PES=1]: If a product has unit elastic
supply, a change in its price leads to a proportionate
change in its QS.
Graphically, inelastic supply curves are steeply-sloped and
elastic supply curves are gradually-sloped.
Any supply curve that passes through the origin will
have PES=1 along its entire length, regardless of its
actual gradient, because the % change in price will
always be equal to the % change in QS. This is a
mathematical relationship that holds for all supply
curves passing through the origin.
Any supply curve that intersects the vertical axis will
have elastic PES along its entire length-the % change in

price will always be lesser than the % change in QS; this

is a mathematical relationship.
Any supply curve that intersects the horizontal axis will
have inelastic PES along its entire length- the % change
in price will always be greater than the % change in QS;
again, this is a mathematical relationship.

Determinants of PES:
Different products will have different values of PES (e.g. the supply of
soda may be elastic, while the supply of cotton will likely be inelastic). A
number of determinants influence the value of PES of a product. These
include:
o How much costs rise as output is increased: If total costs rise
significantly as a producer attempts to increase QS, it is likely
that the producer will not increase QS in response to a small
increase in price; thus, PES for the product will be relatively
inelastic; large price increases would be required In order for an
increase in QS to be worthwhile.
However, if total costs do not rise quickly as output
rises, the producer will be able to easily raise QS and
take advantage from the slow increase in costs to
benefit from higher prices, potentially making more
profits. TC will not rise quickly if a firm has significant
amounts of spare capacity and if the cost of FoP inputs
does not rise quickly as the firm uses more of them.
o Spare Capacity: If firms operate at full capacity, supply will be
price inelastic; the more spare capacity exists, the greater the
PES can be, as firms may increase output more easily in
response to a price change.
Ease of storing stocks: if it is easy to stock goods, if price
increases, a firm can sell its stocks, and thus supply may
be quite elastic, even in the SR; in the case of goods that
cannot be stored easily (e.g. francium), supply will be
more inelastic.
o Type of good: Time lags in the production of certain goods pay
make supply of them more inelastic (even perfectly inelastic),
even in the SR; this is esp. true for ag. markets.
o Number of producers on the market: the more producers there
are, the easier it is for the industry to increase output in
response to a price increase; industry supply will be more elastic
with a greater number of firms.
o Factor mobility: The easier it is for resources to move into the
industry, the more elastic supply will be.

Length of the production period: The quicker a good is to

produce, the more elastic the PES; mfg. supply curves tend to
be far more elastic than ag. supply curves.
The time period considered: The amount of time over which PES
is measured will affect its value- in general terms, the longer the
timespan considered, the more elastic supply will be.
In the very short run, firms cannot increase their supply
very much, if at all, as price increases, as they cannot
immediately increase the number of FoPs they employ;
PES will thus be very inelastic (generally approx. 0)
In the short run, firms will be able to increase the
quantity of some FoPs (eg. Raw materials, labor) but will
not be able to increase the quantity of all FoPs (e.g.
factory size and number of machines may be fixed).
Supply will be more price-elastic than in the immediate
time period (generally inelastic, however).
In the long run, firms are able to increase the quantity
of all FoPs they employ; therefore, supply will be much
more elastic (PES>1, generally).
Also, over time, firms can invest in training and
more equipment, and more firms can join the
industry, rendering supply more elastic.

Chapter 6: Indirect Taxation and Subsidies

When governments tax products or subsidize firms, demand and supply on the relevant markets
will be affected; we will now consider these effects and how they are influenced by the relative
price elasticities of the good in question.
The Effect of an Indirect Tax on Demand For, and Supply Of, A Product:
o Indirect tax: A tax imposed on consumers expenditure (e.g. taxes on alcohol). Indirect
taxes are placed on particular products, and must be paid by firms to the government
(although some of the tax burden will be passed on to consumers).
Indirect taxes increase costs for the firms in question and thus shift the supply
curve for the product left by the amount of the tax (e.g. $1, 10%). Due to this
shift, firms will be willing and able to supply less of the product at any price.
Two types of indirect taxes need to be considered:
Specific tax: a fixed amount of tax imposed on a product (e.g. $1/unit).
Graphically, specific taxes shift the supply curve upward by the same
amount (the amount of the tax) at any point along its length.
Ad valorem tax: An indirect tax on a proportion of the sales price of a
product (e.g. a VAT of 22.5% on consumer goods). Graphically, an ad
valorem tax shifts the supply curve by a progressively greater amount as

price increases (moving right along the supply curve); the new supply
curve begins to diverge from the old supply curve at higher prices,
because a proportion, rather than a fixed amount, of the price is handed
over to the government.
When an indirect tax is imposed on a product, it will affect consumers,
producers, the government, and the market as a whole. We can analyze supplyand-demand diagrams to answer the following questions:
What will happen to the products market price?
What will happen to producers revenue?
How much revenue will the government receive?
What will happen to market size, and thus employment?
If we assume that a government imposes a specific tax on a product with normal
supply and demand, we obtain the following (graphical) situation:
The market is initially in equilibrium where supply (S) = demand (D).
After the tax is imposed, S shifts left by the amount of the tax.
While producers would like to keep output constant at free-market
equilibrium output, while raising market price by the amount of the tax
(such that consumers shoulder the full burden of the tax), this would
result in a surplus (QS>QD) on the market.
To clear the surplus, price would rise until a new equilibrium is reached
(S+tax=D), at a higher price and lower QD than before the tax.
o Because price for consumers has risen, they shoulder part of the
burden of the tax (Pe->P1, the difference in price between the
two equilibriums).
o However, consumers do not cover the full burden of the tax;
therefore, producers are forced to pay a portion of the tax to
the government from the revenue that they had been receiving
before the taxs imposition; they now receive C per unit, where
C may be found by tracing a line from the old equilibrium
vertically downwards to the firms original supply curve (S).
The burden of the tax to producers is whatever cost
increase they cannot pass on to consumers; (Pe-C). In
total, producers pay tax equal to (P1-C) to the
government per unit produced.
Burden of taxation: The proportion of the tax
paid by the producer or the consumer.
Due to the tax, producer revenue falls from Pe x Qe to C
x Q1. Because market sales and market size decrease
(Qe->Q1 units), the level of employment in the industry
in question may be affected, as firms may be forced to
lay off workers.

o
o
o

The government receives tax revenue equal to (P1-C) x Q1.

If PED=PES, the burden of the indirect tax will be shared evenly
between producers and consumers.
However, the share of the tax burden for producers and
consumers will vary based on the relative values of PED and PES
for the product, as will government revenue and the effect of
the tax on market size.
On a market where PED for a product is relatively more elastic
than the products PES (where PED>PES), the imposition of a
specific tax will still shift S upwards by the amount of the tax.
While producers would like to pass on the full burden of
the tax to consumers by producing the equilibrium
quantity at a price increased by the amount of the tax,
they cannot do so, as a surplus ensues.
Due to the relatively elastic demand curve, price will
need to fall by more than half of the amount of the tax
before a new equilibrium is reached at (S+tax=D) and
the surplus is cleared.
In this case, producers cannot pass on much of the tax
burden to consumers, as the relatively elastic demand
signifies that too many consumers would stop
purchasing the product (and turn to substitutes) if the
price increases substantially.
Thus, the market price of the product increases by less
than half of the amount of the tax, and consumers
contribute less than half of the total amount of the tax
((P1-Pe) x Q1, or (P1-Pe per unit).
As a result, producers need to shoulder most of the tax
burden themselves. As producers need to contribute to
the tax using some of the revenue that they were
earning beforehand, they now only receive C per unit
sold (where C is the price corresponding to Q1 on the
firms supply curve prior to the tax).
Producers contribute the majority of the tax ((Pe-C) x
Q1, or (Pe-C) per unit).
As a consequence of the tax, producer revenue falls (Pe
x Qe -> C x Q1) by a larger amount (as a proportion)
than in the case where PED=PES.
Because fewer units are now sold due to elastic
demand, but the amount of the tax is the same
(assuming you have followed along from the previous
situation), the government receives tax revenue ((P1-C)

x Q1), which is lower than in the situation where

PED=PES.
The market size decreases from one producing Qe to
one producing Q1 units, again affecting employment in
the industry in question (on a greater scale than the
case where PED=PES).
Where PED>PES, the tax burden is greater on producers
than consumers due to the difference in the elasticities
values.
On a market where demand is relatively more price inelastic
than supply (PED<PES), the imposition of an indirect tax, which
shifts S left (S->S1), can easily be predicted.
While producers would like to pass on the full burden of
the tax to consumers by producing at the original
equilibrium output and raising the price by the amount
of the tax, this would create a surplus on the market,
which would only clear once price decreases, by less
than half of the amount of the tax, to a level where
(S+tax=D), at a new equilibrium.
Because demand is price-inelastic relative to supply,
and relatively few consumers would stop buying the
product if the price were raised, producers will be able
to pass on more than half of the burden of the tax to
consumers.
The price of the product for consumers would rise
substantially (Pe->P1); consumers will therefore
contribute a total of ((P1-Pe x Q1) towards payment of
the tax, which is a majority of the total tax.
Meanwhile, producers need to contribute the
remainder of the tax out of the revenue that they had
been receiving before the imposition of the tax. As a
result of the tax, producers only receive C per unit (C
being, once again, the point on the pre-tax supply curve
corresponding to the output level Q1. Thus, they
contribute ((Pe-C) x Q1, or (Pe-C) per unit) towards the
tax, while retaining revenue equal to (C x Q1).
The government receives tax revenue equal to ((P1-C) x
Q1, or (P1-C) per unit). As demand is relatively priceinelastic, consumers purchase relatively more units as a
result of the tax than they would in a market where
PED=PES; the government is thus able to earn high
revenue from the tax.

Market size decreases, as the market is producing Q1,

instead of Qe, units, which, as should be abundantly
clear by now, will affect the level of employment on the
market.
In this case, the burden of taxation will fall more heavily
on consumers than on producers.
o We may derive some general rules as to the incidence of
indirect taxes for consumers and producers from the above
situations:
1. On markets where PED=PES, the burden of an
indirect tax would be equal for producers and
consumers of the product.
2. On markets where PED>PES (demand is relatively
elastic), the burden of an indirect tax will be greater on
producers than on consumers.
3. On markets where PED<PES (demand is relatively
inelastic) for a product, the burden of an indirect tax
would be greater on consumers than on producers.
o Thus, governments tend to place indirect taxes on products
with relatively inelastic demand (e.g. cigarettes); as QD falls by a
less-than-proportionate amount to price, the government is
able to gain high revenue, while not causing large decreases in
employment (and possibly reducing negative externalities from
the production/consumption of the taxed products)
o Note that, when the govt increases taxes on products, revenue
will not increase if demand and supply are relatively elastic;
although the tax per unit is higher, the fall in the quantity of
goods sold reduces overall govt revenue.
o To maximize tax revenue, the govt can broaden the tax base
(i.e. tax more goods/services); by taxing more goods, consumers
will have a harder time finding cheaper alternatives, thus
making demand for the taxed goods more inelastic.
The Effect of a Subsidy on the demand for, and supply of, a product:
o (Unit) Subsidy: A specific amount of money paid by a government to a firm, per unit of
output produced (e.g. EU cotton subsidies).
o A government might subsidize a product for a number of reasons, of which the main
ones are:
1. To lower the price of necessities (e.g. food) to consumers. By imposing the
subsidy, the government hopes to increase consumption of the product by
allowing for a lower price.
2. To guarantee the supply of products considered necessary in the national
economy; either of goods classified as necessities (e.g. an emergency food

o
o

supply, electricity), or of products whose production guarantees the

employment of many people, to avoid the social and economic problems of high
unemployment.
3. To enable producers to compete with imports from abroad, protecting the
home industry.
4. Possibly, to protect cultural traditions that would be endangered if a
culturally-significant industry (e.g. wine-makers) were to decline.
If a subsidy is granted to producers on a given market, the supply curve for the product
will shift right by the amount of the subsidy, as the subsidy reduces firms costs,
rendering them more willing and able to supply more of the product at any price.
As with indirect taxes, the amount of the subsidy passed on to consumers through lower
prices, and the amount retained by producers, will depend on the respective values of
PED and PES on the market.
Although percentage subsidies may be occasionally granted, they are rare; hence, this
study guide will focus exclusively on unit subsidies and their effects.
Assuming that demand and supply are normal, the granting of a subsidy on a product
will shift S for the product right by the amount of the subsidy to S-subsidy.
Producers lower prices and increase output until a new equilibrium on the
market is reached (D=S-Subsidy), at a lower price (P2 vs. Pe) and higher output
level (Q1 vs. Qe) than the free-market equilibrium.
As a result of the subsidy, price does not fall by as much as the per-unit amount
of the subsidy (Pe->P2, which is higher than P1, the point on S1-subsidy
corresponding to the output level Qe).
Producer revenue increases ((Pe x Qe -> D x Q1), where D is the subsidized price
that the firms receive for producing a unit of output; D=P2+Subsidy).
While consumers pay P1 x Q1 for their purchases, the rest of the firms revenue
((D-P2) x Q1) is paid to them by the government through the subsidy on each of
the Q1 units produced; this is the total cost to the govt of the subsidy.
Obviously, the money for the subsidy cannot materialize out of thin air,
and there is an opportunity cost involved with the subsidy. The
government may need to either divert money from other expenditure
projects (e.g. infrastructure, education) or raise taxes.
As a result of the subsidy, consumers are able to purchase the original Qe units
at a lower price, saving them the expenditure ((Pe-P2) x Qe); however, due to
the lower price, they also purchase (Qe->Q1) additional units, spending (P2 x
(Q1-Qe)) extra.
Total consumer expenditure may either rise or fall, depending on the
relative savings and extra expenditure.
In a market where demand is relatively price elastic and supply is relatively price
inelastic (PED>PES), the subsidy will have the same overall effect: the supply curve will
shift right (S->S-Subsidy), and producers will lower prices and increase output until a
new equilibrium is achieved.

The price of the subsidy to consumers, however, will fall by less than half of the
amount of the subsidy. If the whole price were to be passed on, price would
need to decrease to P1 (at which point there would have been a shortage).
Producer revenue increases ((Pe x Qe -> D x Q1), where D is the subsidized price
that the firms receive for producing a unit of output; D=P2+Subsidy).
While consumers pay P1 x Q1 for their purchases, the rest of the firms revenue
((D-P2) x Q1) is paid to them by the government through the subsidy on each of
the Q1 units produced.
Again, both consumption of the product and producer revenue increase; the
consumers do not benefit from a large price fall, but, as demand is relatively
price-elastic, this nevertheless translates into a large increase in consumption.
Finally, in a market where demand is relatively price-inelastic and supply is relatively
price-elastic (PED<PES), a unit subsidy would, once again, cause supply to shift right by
the amount of the subsidy (S->S-Subsidy). The producer is able to lower prices and
increase output until a new equilibrium is reached where (S-Subsidy=D).
The price to consumers would fall significantly, by more than half of the amount
of the subsidy. If the whole subsidy were passed on, price would need to fall to
P1, which would, once again, provoke a shortage (excess demand).
Producer revenue rises as a result of the subsidy, from (Pe x Qe) to (D x Q1).
Consumers pay (P2 x Q1) for the product, while the government pays the
producers the remainder of their revenue ((D-P1 x Q1) in the form of the
subsidy.
Consumption of the product increases, as does producer revenue. While the
consumers benefit from a relatively large price fall, consumption increases by a
less-than-proportionate amount because demand is relatively price-inelastic.
We can derive a set of rules related to the effects of granting of subsidies on producers
and consumers in different markets:
On markets where PED=PES, the products price will fall by half of the amount of
the subsidy.
On markets where PED>PES, the products price will fall by less than half of the
amount of the subsidy.
On markets where PED<PES, the products price will fall by more than half of the
amount of the subsidy.
In all cases, consumption will rise and producer revenue will increase.
A number of issues need to be considered when a government grants a subsidy to an
industry; these include:
The opportunity cost of government spending on the subsidy in terms of
alternate expenditure projects.
Whether the subsidy would foster inefficiency among firms by allowing them to
be less competitive
Although a subsidy may lower prices for consumers, they might be paying the
same cost indirectly through higher taxes- how is the subsidy being funded?

Will the subsidy damage the sales of unsubsidized foreign producers? The
agricultural subsidies of the US and EU have been heavily criticized, as they lead
to over-production which severely reduces the ability of small farmers in LDCs
to compete on world markets and earn a living.
In addition, developed countries may often dump their products in LDCs
by selling them below their production costs (not to mention, below the
local market price); this is the point at which the Doha Round of WTO
negotiations has hit a brick wall (so much for a solution from there!)

Chapter 7: Costs, Revenue and Profit (A Lot of Definitions)

This chapter is an introduction to the Theory of the Firm, which studies the different types of
behavior for firms in the markets in which they operate, and the nature of competition in
different markets.
o The fundamental concepts of Firm Theory are costs, revenues and profits.
o In firm theory, all factors of production are assumed to be homogeneous (which is an
unrealistic assumption)
Cost Theory:
o Some Definitions:
The Short Run (SR): the period of time in which at least one FoP is fixed; all
production occurs in the SR.
The Long Run (LR): the period of time in which all FoPs are variable, but the
state of technology is fixed. All planning takes place in the LR.
The Very Long Run: Where the state of technology is variable.
The Very Short Run: Where all FoPs are fixed (and the supply curve for the
industry is perfectly inelastic)
o In the SR, a firm will not be able to quickly increase the quantity of its fixed FoPs. Often,
the fixed FoP is land, or some form of capital, but it may also sometimes be a highly
specialized type of labor (e.g. a fast-breeder reactor overseer).
If a firm wishes to increase output in the SR, it can only do so by applying more
units of its variable FoPs to the fixed FoPs it already possessing, while planning
ahead to change the number of fixed FoPs it has.
The length of the short run is dependent on the time it takes to increase the
quantity of the fixed FoP; this will vary between industries. Whereas a street
kebab seller may have cooking utensils (capital) as a fixed FoP, and its short-run
will be the time taken to run to the store and buy more utensils (3 hours), a
nuclear power company is constrained by the number of power plants that it
has; its short run may therefore last for years.
If a firm plans ahead to change its number of FoPs, all FoPs are assumed variable
as plans are being made- the firm plans in the long run.
As soon as the fixed factors are changed, the firm is back in the shortrun, though with a different number of fixed FoPs; the only way to

increase output would once again be through applying more units of

variable FoPs to the fixed FoPs.
Definitions and Equations Related to Cost Theory:
Total Product: the total output a firm produces using its fixed and variable FoPs
within a given time period (bear in mind that output in the SR can only be
increased by applying more units of the var. FoPs to the fixed FoPs; the x-axis of
the graph, when TP is plotted, is therefore quantity of *insert variable FoP
here+).
Average Product: the output produced, on average, by one unit of the variable
FoP. AP= , where V is the number of units of the variable FoP employed.

Marginal Product: the extra output produced by applying an extra unit of the
variable FoP to production. MP =

, where dTP is the change in total output

(units produced) and dV is the change in the number of units of the variable FoP
employed.
Productivity: Output/worker. Can be increased through more training, more
capital equipment, better management and improved technology
Total product, when graphed, never crosses the x-axis: you cannot
produce -554 fake plastic trees, for example.
The point of inflection (where the concavity changes) on the TP curve
occurs at the maximum point of the MP curve; ,after that point,
diminishing returns set in.
When the marginal is positive, the total increases; when it is negative,
the total falls.
When MP is above AP, the average gets pulled up (which makes
mathematical sense); conversely, where MP is below AP, the average is
dragged down; therefore, the maximum AP occurs where MP intersects
AP
The Law of Diminishing Returns is composed of two subcomponents:
The hypothesis of eventually diminishing marginal returns: As extra units of a
variable FoP are added to a given quantity of a fixed FoP, the output gained
from each additional unit of the variable FoP will eventually diminish.
The hypothesis of eventually diminishing average returns: As extra units of a
variable FoP are added to a given quantity of a fixed FoP, the output/unit of the
variable factor will eventually diminish.
Both hypotheses examine the same relationship from different angles; the entire
relationship is based on common sense. While adding units of a variable FoP will
initially make production more efficient; for example, because adding more units of
labor will allow workers to specialize in a particular task and therefore be more efficient
at that one task, at a certain point, production will start becoming less and less efficient
because, to use the limited quantity of fixed FoPs, the variable FoPs begin to get into
each others way (for example, at a countertop) and production therefore becomes less

efficient. However we measure diminishing returns (Dim. Marg. Returns/Dim. Avg.

Returns) inefficiency will eventually occur.
o The Law of Diminishing Returns is only effective in the short run, as it is assumed that at
least one FoP is fixed.
Short-Run Costs:
o Firms face different types of costs when producing their output of goods/services. We
can separate costs into several categories, depending on their origin:
Total costs: the complete costs of producing output. We use three measures:
1. Total fixed cost: the total costs of the fixed FoPs that a firm uses in a
given time-span. Since the number of fixed assets is constant in the
short-run, TFC is also constant and does not vary according to output.
o TFC=(# of fixed assets)(cost of each fixed asset)
2. Total variable costs: The total cost of the variable assets a firm uses
in a given time period. TVC increases as a firm uses more of the variable
FoP.
o TVC=(# of variable factors)(cost of each variable factor)
3. Total Cost: the total cost of all fixed and variable FoPs used to
produce a certain output)
o TC=TFC+TVC
Average costs: costs per unit of output; we use three measures:

1. Average Fixed Cost: Fixed cost/unit of output. AFC=

, where q is

the total output. Because TFC is constant, AFC always falls as output
increases.

2. Average Variable Cost: Variable cost/unit of output. AVC=

. AVC

tends to fall as output increases, and starts to rise again as output

continues to increase. This is due to the Law of Diminishing Average
Returns. As more of the variable FoPs are applied to the fixed factors,
output/unit of the variable factor eventually falls; thus, the cost/unit of
output eventually begins to rise
o AVC tends to be U shaped; on average, the variable factor
becomes more productive at first, then becomes less
productive; AVC falls when the var. FoP is more productive and
rises when the var. FoP is less productive.

3. Average Total Cost: Total cost/unit of output. ATC=AFC+AVC= . For

the same reason as AVC, ATC tends to fall as output increases, and start
to rise again as output continues to increase.

Marginal Cost: The increase in the total cost of producing an extra unit of
output. MC=

MC tends to fall as output increases, and start to rise again as output

continues to increase; this is due to the Law of diminishing marginal
returns. As more variable FoPs are applied to the fixed FoPs, the extra
output per unit of the variable factor eventually falls, and so the extra
cost/unit of output eventually begins to rise.
The ATC, AVC and MC curves are closely connected. Quite simply, MC
intersects AVC and ATC at the curves minimum points (this is
mathematically justified by the relationship between marginals and
averages (see above)). AFC falls as output increases, and (since it is the
gap between AVC and ATC), ATC and AVC converge as output grows.
Include these relationships in your graphs.
The MC curve is inversely related to the MP curve in the SR; when MC
increases, MP falls, and vice versa.
o When each marginal variable FoP is more productive, less of
their time (or man-hours, as the case may be) is needed to
produce an additional unit of output; assuming wages are
constant, marginal product will rise and marginal cost will fall
(and vice versa, when the variable FoP is less productive).
Overhead/Sunken Costs: Costs that entrepreneurs incur when opening a
business that they wont expect to regain when they leave the business (e.g
rent, raw materials, and depreciated capital- in general, whatever cannot be
sold if the business closes).
Typical costs faced by firms include raw materials, labor, depreciation of capital,
and the cost of capital.
Costs in the Long Run:
The long run is the planning stage; in the long run, entrepreneurs are free to
adjust the quantity of all FoPs used, and are only restrained by the level of
technology.
In the long run, we examine what happens to costs when all FoPs have been
increased to increase output. What we find is different in theory than in
practice.
In theory, the long-run avg. cost curve is an envelope curve (it
envelops all possible SRAC curves for a firm- an infinite number of
possible SRAC curves). A firm can only produce on one SRAC curve at a
time, however (production occurs in the SR).
o The lowest possible cost of producing the output occurs on the
SRAC curve that is tangent to the LRAC curve at its minimum
point (the point on SRAC is also a point on LRAC).

If demand increases and the firm wishes to increase output, it

can do so in the short run by employing more FoPs and moving
along SRAC; this may be at a lower or higher cost/unit than
before (due to diminishing returns). The firm will know that
they would be able to produce the output more cheaply,
though, by adjusting their fixed FoPs in the long run; when this
eventually occurs, the SRAC curve will shift towards a position
where it is more optimally situated on LRAC.
On each individual SRAC curve, the lowest possible cost of
producing the desired output will always be the point where
SRAC is tangent to LRAC (because LRAC is an envelope curve).
Therefore, readjustment of fixed FoPs to move along the LRAC
curve is in the interest of a firm that wants to produce at
minimum cost.
The envelope curve represents all the possible combinations of
FoPs that could be used to produce differing outputs for the
firm.
LRAC is the boundary between attainable and unattainable unit
cost levels for the firm; if possible, the firm will always like to be
producing at points on LRAC to minimize average costs;
however, this may only be possible in the LR.
Some more definitions:
Increasing returns to scale: when a given % increase in
all FoPs will lead to a greater-than-proportionate %
increase in output, reducing LRAC; thus long-run unit
costs fall as output increases
With increasing returns to scale, if the amount
of FoPs a firm uses is doubled, its output will
more than double.
Constant returns to scale: when a given% increase in all
FoPs will lead to a proportionate % increase in output,
keeping LRAC constant; thus, long-run unit costs are
held constant as output increases;.
Decreasing returns to scale: when a given% increase in
all FoPs will lead to a less-than-proportionate %
increase in output, increasing LRAC; thus, long-run unit
costs rise as output increases;.
Long-run costs may increase/decrease as output rises because
of:
Economies of Scale: Any decreases in AC caused by a
firm altering all of its FoPs to increase the scale of its
output; these lead to a firm experiencing increasing

returns to scale, but are not increasing returns to scale.

While returns to scale are an FoP/output issue,
economies of scale are an FoP/cost issue.
Although increasing returns to scale contribute
to economies of scale, the latter is a
relationship involving cost, rather than product.
With internal economies of scale, SRAC moves
downwards along LRAC as it shifts right; with
external economies of scale, the entire LRAC
curve shifts downwards.
A firm may benefit from a number of economies of
scale when expanding output:
Specialization: In small firms with few
managers, management often has to take on
roles for which the managers are not ideallt
suited, leading to higher unit costs; as firms
expand, their management may specialize in
areas such as production, finance and
marketing, and therefore become more
efficient.
Division of labor: breaking a production process
down into small, repetitive, efficient
subcomponents; as firms get bigger, they are
often able to divide labor up and reduce unit
costs (e.g. a factory organizing an assembly
line). Also, if a production process cannot be
subdivided, the cost/unit will be high if fewer
units are produced, and increasing output
would decrease unit costs in the LR.
Increased dimensions (spatial economies): if a
storage container is doubled in size, the volume
will more than double, making storage costs
cheaper/unit.
Linked processes: if machines produce at
differing output levels, buying more of a certain
type of machine to increase output may allow a
firm to synchronize production.
Risk-bearing economies: by diversifying into
multiple markets, a firm will likely face more
stable demand; sudden falls in demand in one
area will likely be offset by increases in demand

elsewhere. Demand is more predictable and a

firm need not keep high levels of stocks,
reducing stockholding costs.
Bulk buying: As firms increase in scale, they are
often able to negotiate larger discounts with
suppliers; this reduces input costs and thus,
their unit costs of prod.
Financial economies: large firms can raise
financial capital much more easily and cheaply
as smaller firms, as they are considered less of a
risk in terms of repayment, and may get lower
interest rates on loans.
Transport economies: large firms carrying out
bulk orders may be charged less for delivery
than smaller firms; as firms grow, they might
develop transport fleets, allowing them to cut
out the middleman (and the associated profit
margin) on transport.
Large machines: some machinery is too large
and expensive to be owned by small businesses
(e.g. a combine harvester for a small farmer).
While small businesses may have to hire out
such equipment, paying a profit margin, when
they need it, once they grow to a certain size, it
will be feasible for them to have their own
machinery, reducing unit costs of prod.
Promotional economies: Most firms attempt to
advertize their products; the costs of
promotion, however, tend not to increase by
the same proportion as a firms output (e.g.
firms may overdub ads for foreign markets). If a
firm doubles output, it is unlikely to double
advertizing expenditure, and the cost of
promotion/unit output falls; this situation
applies to other fixed costs as well (e.g.
insurance).
Diseconomies of Scale: Any increases in LRAC caused by
a firm altering all of its FoPs to increase the scale of its
output. Diseconomies of scale lead to a firm
experiencing decreasing returns to scale.

With internal diseconomies of scale, SRAC

moves upwards along LRAC as it shifts right;
with external diseconomies of scale, the entire
LRAC curve shifts upwards.
There are several sources of diseconomies of scale a
firm can experience:
Control and communication problems: As firms
grow in scale, the management will find it
harder to coordinate the firms activities, which
may lead to increases in unit costs due to
inefficiency; likewise, greater size may lead to
increased likelihood of communication
breakdowns as firms increase in size, also
eventually causing unit cost increases.
Alienation and loss of identity: As firms grow, it
may be that both workers and managers may
begin to feel alienated and lose their sense of
belonging and loyalty to the firm; if this
happens, it is likely that they will work less
efficiently, forcing up unit costs of production.
All of the above economies/diseconomies of scale relate to unit
cost increases/decreases encountered by a single firm; they are
internal (dis)economies of scale.
A further group of (dis)economies of scale are external
(dis)economies of scale, which occur at industry level and affect
unit costs of individual firms.
External economies of scale: If an industry grows in a
certain geographical area, universities may start
offering programs relating to the skills required in the
industry.
The graduates of the firms would be ready to
work in the industry, lowering training costs for
firms and making them more efficient.
Also, if many firms produce in one area, they
can share technology and resources, and
specialist suppliers could emerge.
If suppliers increase in size and benefit from
economies of scale, this will cause external
economies of scale for the industries they
supply.

External diseconomies of scale: when an industry

develops rapidly and intense competition between
firms for FoPs forces up prices of the FoPs, and thus the
unit costs of all firms in the industry.
Minimum Efficient Scale: The first level of output at which unit costs of
prod. are minimized.
SRAC curves are U shaped because of diminishing returns, which also
explains the shape of the AVC curve (dim. Avg. returns) and the MC
curve (dim. Mar. returns).
LRAC curves are U-shaped in theory due to the existence of
(dis)economies of scale
In reality, there has been no solid evidence of a firm being so large that
diseconomies of scale outweigh economies of scale in the long run;
actual long-run cost curves may be L-shaped.

Revenue Theory:
o Revenue: the income a firm receives from selling its products over a given time-span.
Revenue can be measured in several ways:
Total Revenue: The total amount of money a firm receives from selling
a certain amount of goods/services in a given timespan. TR=price X
quantity.
Average Revenue: The revenue a firm receives per unit of sales.
AR=

Marginal Revenue: The extra revenue a firm gains for producing one
additional unit of output in a given timespan. MR=

When output increases, two cases involving what happens to revenue as output
increases can be considered.
Revenue when price does not change with output (where PED is infinite):
If a firm does not need to (or cannot) lower prices as output rises and
wishes to sell more of its product, it faces a perfectly elastic demand
curve.
This situation is purely theoretical, but is used in models of PCMs and,
by extension, other market structures.
o A firm with perfectly elastic demand will be very small relative
to the industry, and is able to increase output without affecting
total industry supply, and therefore price, in any significant way.
The firm can sell all of its output at the same price.
o When graphed, if PED is perfectly elastic, price, AR, MR and
demand are all the same.
TR increases at a linear rate as output increases, as MR
is constant (Calculus, folks!)

Revenue when price falls when output increases (when the demand curve
slopes downwards/PED falls as output increases)- revenue graph for a
monopolistic firm.
In the case where price falls as output increases, TR, MR and AR show a
very different set of relationships.
If a firm wants to sell more units and is big enough to control the sales
price, it will need to lower the price if it wants to increase QD.
o The firm faces the demand curve for the industry, which is
downward-sloping.
o In a monopolistic market, D=AR, which falls as output rises,
since the price must be lowered to sell more units.
o MR also falls as output rises, but at a greater rate than AR (due
to calculus- integration, folks). The MR curve is twice as steeply
sloping as the AR curve and intersects the X axis at the midpoint
between the origin and where demand intersects the x axis; at
the point where TR is maximum and PED on the demand curve =
1.
o Proof: MR slopes twice as steeply as AR:
Assume (by Occams Razor) that the TR curve can be
modeled by the simplest curve that is concave
downward and symmetric around its maximum point,
p=-q(q-z)=-(aq^2-qz), where z is the intercept of AR with
the q-axis, as well as a zero of TR.
Taking the derivative of TR (MR): MR= -2aq+z.
Then, D=AR: p=-aq+z (where z is also the vertical
intercept of the demand curve, such that it is able to
slope downwards in the first quadrant; q=z, because of
the fact that AR is an average based on TR/output, and
must therefore cross the y-axis at the same point as MR
[mMR=-2a]=[2(mAR=-a)]. QED.
This relationship holds for all downward-sloping AR
curves and the MR curves associated with them.
MR is below AR because, to sell more products, the firm
must lower the price of all products sold, losing revenue
for those it could have sold for a higher price in order to
gain revenue from extra sales.
For a downward-sloping D curve, TR rises at first but
eventually starts falling as output increases. This is
because extra revenue gained from dropping the price
and selling more units is outweighed by the revenue
loss from the units that now need to be sold at a lower
price.

When MR is negative, TR will fall.

There are several important relations between PED, MR, AR
and TR. Knowledge of these relationships is used by firms trying
to assess the impact of a change in pricing on their revenue
If a firm raises price and PED<1, total revenue will
increase as the increase in price causes a relatively
larger fall in QD- the increase in price will more-thancompensate for the fall in QD; firms with inelastic PED
should raise price to maximize revenue
If the firm raises price and PED>1, the firm will lose
revenue as the increase in price will cause a prop.
Greater fall in QD; the increase in price will not fully
compensate for the fall in QD. Firms with elastic PED
should lower price to maximize revenue.
When PED=1, revenue is already maximized, and firms
wishing to maximize revenue should keep prices
unchanged
This technique can also be applied in reverse: the price
elasticity of a demand curve may be found by analyzing
changes in revenue as price changes

Profit Theory:
o Economists and accountants calculate profit in different ways. Both are in agreement
that profit is total revenue-total cost. However, economists also include the
opportunity cost of the owner of the firm in cost calculations; if the entrepreneur could
be making more money in alternative business ventures, and cannot cover their
opportunity cost in the long-run, economic theory assumes that they will close the firm
down and move on. The opportunity cost is the difference between a firms survival
and non-survival.
Total profit = total revenue total cost (incl. opportunity cost, fixed costs and
variable costs.
o If total revenue = total cost, a firm is making normal profit, and there is no incentive for
firms to leave/enter the industry.
Normal profit: The level of profit necessary to keep resources in their present
use in the LR.
o If total revenue > total cost, a firm is making abnormal profit (profit in excess of
operation costs + opportunity cost); there is an incentive for firms to enter the industry,
if they are able to.
o If total revenue < total cost, a firm is making a loss; since the opportunity cost is not
being covered, if a firm makes a loss in the long run, the entrepreneur will close down
the firm and move to the next-best occupation.
o We need to consider three different scenarios:
1. The Shut-down Price

Firms may continue to operate in the short run even if they are making
a loss; also, firms may shut down in the SR and reopen later. Let us
examine these two cases:
o A firm can shut down in the SR and produce nothing, employing
no FoPs to do so. Thus, it will only lose its total fixed costs
(which are unavoidable in the SR- e.g. rent, interest
repayments). Opportunity cost is counted as a fixed cost; it is
therefore not being covered either.
o This may be better than producing and not getting enough
revenue to cover variable costs (thus losing fixed costs as well
as those var. costs that have not been covered)
o If a firm fails to cover variable costs with the revenue that it
gains, it is better off shutting down in the SR, as the firm loses
more (fixed costs + part of var. costs) by producing than by not
producing (losing just the fixed costs).
o If a firm is barely covering its variable costs (and just losing the
fixed costs), they will lose the same amount whether they
produce or not. It is likely that the firm will remain in business
to maintain continuity of production, pleasing customers, and
to maintain employment of workers and usage of inputs,
pleasing workers and suppliers.
o If a firms revenue more than covers its variable costs, they
would lose more by not producing (loss of all of the fixed costs)
than producing (loss of some of the fixed costs) in the SR. The
firm would produce in the SR.
However, if a firm is making losses in the SR, it cannot
do so forever. Whether they continue producing or not
in the SR, the firms need to plan ahead in the LR to
change their combination of FoPs and devise a situation
where they may cover all of their costs and make
normal profits. If they still cannot do so, they will shut
down permanently.
o The Shut-Down Price: The level of price that enables a firm to
cover its var. Costs in the SR; the price where MC=AVC; if price
does not cover AVC, the firm will shut down in the SR.
On a graph, production would occur at the price where
MC=AVC , in this situation.
Many firms (especially businesses with seasonal
demand) will shut down in the SR at times when their
revenue will not cover their variable costs; this may
contribute to seasonal unemployment in the regions
affected.

The Break-Even Price: The price at which a firm is able to make

long-run normal profit (break even)- it will cover all costs,
including its opportunity cost.
The break-even price occurs where MC=ATC; if a firm cannot
cover average total costs in the LR, it will shut down
permanently.
In the SR, then, the firms supply curve is equivalent to the MC
curve (which represents the additional cost of producing an
extra unit of output; given a particular cost/price, the MC curve
shows how much is supplied) above the intersection with AVC
(the short-run shut-down price); above that price, the firm
would produce in the SR.
In the LR, the firms supply curve is equivalent to the
MC curve above the intersection with ATC (the breakeven price; if a firm cannot make at least normal profit
in the LR, it will not produce).
The Profit-Maximizing Level of Output
It is usually assumed that firms wish to maximize profits
as their main aim. If this is so, firms need to know what
output level to produce at in order for profits to be
maximal.
If a firm finds that, at its present output level, MC<MR,
it is clear that the firm could increase its profits by
producing more.
In a PCM (perfectly elastic demand curve), MC
intersects MR at 2 points. However, at the first point
where this occurs, losses are maximized and profits
minimized. Because MC>MR for every unit up until that
unit of output, the firm has made the greatest possible
loss. Between the 2 points of intersection, the firm
makes a profit from every unit as MR>MC; therefore, it
makes the greatest overall profit (so long as the profit
between Q1 and Q2 is greater than the initial loss, this
will be an abnormal profit- it can, however, also be a
loss) where MC=MR for the second time.
Because MC>MR again after the 2nd point of
intersection, every additional unit beyond that output
will be produced at a loss, and total profit will begin to
decline; in this case, the firm should scale back output if
it wants to profit-maximize.
To profit-maximize, firms will want to produce every
single output unit that contributes more (or an equal

amount) to total revenue than to total cost (therefore,

all units of output for which MR>MC; the firm will make
a profit on the sale of any such unit).
When the marginal revenue from selling a unit
equals the marginal cost of producing it, the
firm is either profit-maximizing or lossmaximizing (see above); no further profit or loss
can be made.
PROFIT IS MAXIMIZED WHERE MC = MR!
Because firms want to maximize, not minimize pofits,
we disregard the left portion of the MC curve in
diagrams, and only the profit-max output is shown.
If a firm wishes to maximize its profits, it should
produce at the output level where MC=MR from
below.
In a monopoly, profit is also maximized where MC=MR;
to find the price, we examine the D curve to see how
much consumers will be willing/able to pay for this
output.
To show profit on the diagram, an AC curve is added
(which intersects the MC curve at its minimum point).
The profit max. output is noted q and the price is noted
p; the profit per unit for producing q units is the
difference between AR and AC.
A revenue box can be drawn to show whether the firm
is making normal profit, abnormal profit, or a loss. This
will depend on the position of the AC curve, which can
be moved to show what we want.
In general (AR-AC)xTotal Output gives the total
profit made by a firm.
If AC intersects MC at an average cost lower than
market price, the firm makes abnormal profit; is this
occurs where AC=P, the firm makes normal profit; if it
occurs where AC>P, the firm makes a loss.
However, in reality, firms may not want to profit maximize (not everyone has studied, or
wishes to follow, conventional economic theory). Other aims followed by
entrepreneurs are:
Revenue maximization: entrepreneurs often see maximal revenue as a sign of
success; if this is so, they might wish to maximize revenue by producing where
MR=0. This will occur (by mathematics) above the profit-max output level.
This may be because:

Consumers value companies with increasing sales and are more

likely to buy from them; by contrast, consumers are rarely
aware of firms economic profit.
o Fin. institutions may be more willing to lend to firms with
increasing sales.
o Salaries of employees and managers may be linked to sales,
providing an incentive to revenue-maximize.
Sales maximization: likewise, entrepreneurs my gauge their success by their
sales volume. If this is so, they will produce above the profit-max output level
and not realize they can make more profit by charging a higher price and selling
less. Alternately, a firm may wish to increase SR sales to drive out competition
from a market and gain high market share. Having done so, they may attempt
to profit-maximize.
Large firms are also less vulnerable to takeovers and salaries of
managers and employees are often linked to the size of the firm.
Firms will sales-maximize by producing at the highest possible output
level consistent with long-run normal profit and being able to remain on
the market (i.e. where AR=AC).
Environmental aims: Entrepreneurs will sometimes be prepared to pay higher
prices for raw materials to ensure that they originate from an environmentallyfriendly source, or one where labor is not exploited. They may, for instance, buy
Fairtrade goods, at a higher cost, to support suppliers from LDCs (e.g. the Body
Shop, before being incorporated, attempted to sell products from animalfriendly sources).
Satisficing: There are theories that doubt whether most entrepreneurs profitmaximize in reality. It is argued that, if people own firms, they will work hard
enough to cover their own opportunity costs (make normal profit) but will not,
in most cases, push themselves further. Often, firms are not run by the people
who own them; while shareholders may own a firm, managers will run it.
This can lead to conflicting objectives. The managers (who generally
have much freedom in decisionmaking) would not have a strong
incentive to maximize the firms profits beyond a level that would
please the shareholders (who are often not well informed of the firms
performance) and allow them to retain their jobs. As a consequence,
they satisfice (portmanteau of satisfy and suffice).
o Typical objectives that managers are likely to pursue, instead of
attempting to profit maximize, include:
Salary maximization: As salaries are more often linked
to sales than to profit, managers may seek to maximize
either sales volume or sales revenue.

Employment maximization: This makes managers feel

more powerful and important; employment
maximization may be an aim for firms producing using
labor-intensive methods of production- e.g. Vietnamese
shoes factories- due to insufficient access to capital).
Investment: Again, this makes managers feel more
powerful (e.g. Mr. Waddells Super-Factory example).
Gaining additional benefits (e.g. new offices, first class
travel, multimillion bonuses while the firm files for
bankruptcy, etc.)
Alternately, a satisficing firm may attempt to reconcile the
interests of different groups within the organization; the overall
objectives of the organization will be a result of bargaining,
discussion, and negotiation between production units, unions,
workers communities, and departments.
The end result is likely to be a compromise which
reaches a satisfactory conclusion (or not- see Dilbert)
but which does not maximize anything; the firm aims to
satisfice these different groups and still function.

Chapter 8: Perfectly Competitive Markets

As a social science, economics relies on building models to try to explain how things work and
predict the possible outcomes of the economic situations being studied.
Perfect competition is a model used as a starting point to explain the theory of the firm; it is
theoretical and based on precise assumptions.
o Despite its theoretical nature, it is very important as it serves as the basis for further
models, if the theoretical assumptions underpinning it are relaxed.
This allows us to make more realistic models of real-life market structures.
Perfectly competitive markets are based on a set of assumptions. These are:
o The industry is made up of a very large number of firms
o Each firm is so small, relative to the industrys size, that it cannot alter its own output to
have a noticeable effect on the output of the industry as a whole; a single firm cannot
affect the supply curve of the industry and thus the price of the product- individual firms
must sell at the price set by supply and demand in the entire industry, if they wish to
maximize profit (by producing where MC=MR=Equilibrium Market Price). Individual
firms are price takers.
o The firms are all profit maximizers.
o The firms all produce homogeneous products- it is not possible to distinguish between
goods produced by the different firms in the industry; there are no brand names and no
marketing to attempt to differentiate goods from each other.

Firms are completely free to enter and leave the industry; firms already in the industry
cannot stop new firms from entering it and are free to leave the industry, if they so
choose. There are no barriers to entry or exit.
o All producers and consumers have perfect market knowledge- producers are fully aware
of market prices, costs in the industry and the workings of the market; consumers are
fully aware of market prices, quality of products, and availability of goods.
The level of technology is therefore constant, as producers are fully aware of
the technological improvements that their competitors put into place.
Resources are perfectly mobile; thus, firms cannot maintain a competitive
advantage over each other in the long-runl
Although the model is theoretical, come real markets come close to being PCMs; most notably,
agricultural markets.
o For example, wheat farms in the EU
There are some large wheat farms in the EU, which are small compared to the
entire wheat industry. An individual farm could increase its wheat supply to a
great extent before impacting overall EU wheat supply
A single farm cannot change wheat prices in the EU, as it cannot shift
the industry supply curve.
The farm has to sell at whatever the existing market price for wheat is.
Wheat is a commodity, and cannot be distinguished from one farm to
another (in theory).
However, although firms are relatively free to enter/eave the industry,
there are significant costs involved with either, which may affect firms
decisions.
o Also, it is unlikely that producers and consumers will have
perfect market knowledge (however open the flow of
information is); thus, the EU wheat industry is not a perfect
PCM (but comes close)
Demand curves for the industry and the firm in a PCM:
o Individual firms in a PCM are price takers; they must sell at the market price and cannot
affect the market price. We can therefore make assumptions about the demand and
supply curves for the industry and PCM firms.
A PCM industry will have normal demand and supply curves; we expect
producers to supply more, and consumers to demand less, at higher prices;
thus, demand slopes downward and supply slopes upward; equilibrium occurs
at point (P, Q) where D = S.
PCM firms have to sell at the industry price, P (they are price takers)- if they try
to raise prices, consumers will simply buy the good from another firm, since the
goods are homogeneous in looks and quality, and perfect information exists. If
they want to lower prices, on the other hand, they would be acting irrationally,
as they would not be able to maximize profits.

If a firm sells at the industry price, it can sell however much it wants; as
it increases output it does not affect the industry supply curve or alter
the goods market price.
If the firm can sell all that it wishes at price P (the equilibrium price), its
demand curve is perfectly elastic at that price. Thus, the firm has to
take the price set by the industry
Profit Maximization for a PCM Firm
o Firms maximize profits at the output level where MC=MR. When plotted on a diagram,
we can see that the firm takes the price P from the industry and, because demand is
perfectly elastic, P=D=AR=MR. Profit is maximized where MC = MR at output level/ unit
time q.
In a PCM, P=MC, because of profit maximization; MC is therefore equal to the
industry supply curve.
Although the scale of the price axis is the same for both firm and industry, this is
not the case for the output/unit time (quantity) axis- the quantity q is very small
compared to actual industry output, and would not register on the axes for the
industry (if it could, it would be large enough to shift the supply curve and alter
the industry price)
PCM Profit and Loss Situations only possible in the Short Run
o Short Run Abnormal Profits:
In this case (when plotted; see graph inset) the firms in the industry are making
abnormal profits in the short run; this could be caused by a SR increase in
demand or supply- they are more than covering their total costs, including opp.
costs.
If a firm sells at the industry price P and maximizes profits by producing where
MC=MR, the average cost C is lower than the average revenue P; the firm makes
an abnormal profit of (P-C)/ unit
o Short Run Losses
In this case (see graph inset) the firms in the industry are making short-run
losses (not covering their total costs).
If a firm sells at the industry price P and maximizes profits by producing at
MC=MR when AC is fully above the demand curve, the cost/unit exceeds the
average revenue; the firm makes a loss (C-P)/unit.
Although the firm is making a loss, it still produces at profit-max
output, as any other output would result in a greater loss; in effect, they
are loss-minimizing.
The Unsustainability of the Above Two Situations in the Long Run:
o If firms make either SR abnormal profits or SR losses, other firms begin to react and the
situation begins to change until long-run equilibrium is reached.
o SR Abnormal Profits to LR Normal Profits:

When a firm is making abnormal profits, the situation cannot continue very
long.
Since there is perfect market information and no barriers to entry, firms outside
the industry that could also produce the good will start to enter the industry,
attracted by the chance of making abnormal profits; because firms are relatively
small, this will have little initial effect- however, as more and more firms enter
the industry, attracted by abnormal profits, the industry supply curve will start
shifting right.
Thus, industry price will fall- because PCM firms are price-takers, the price they
charge will begin to fall, and their demand curves will shift downwards- the
abnormal profits will eventually be competed away.
At the point where firms are no longer making abnormal profits, AC = AR
because AR has shifted downwards. The firms are now making normal profits.
The entrepreneurs are satisfied as they cover their opportunity costs; however,
new firms are no longer attracted by abnormal profits and the industry is in long
r un equilibrium; no-one will enter or leave. In effect, the industry grows in size,
although the output of each individual firm contracts.
o SR Losses to LR Normal Profits:
Conversely, when a firm is making losses, it cannot continue to do so for long in
a PCM.
After a time, some firms in the industry will begin to leave because they are not
covering opportunity costs; at first, this will have no real effect, as the firms are
rel. small; however, over time, this will cause industry supply to shift left as
firms leave the industry, unable to make normal profit.
When this occurs, industry price will rise to ration the industrys output.
As the firms in the industry are price takers, the price they charge will
start increasing and their demand curves will shift up, reducing the
losses they have been making.
The process will continue as long as firms in the industry are making
losses- eventually, however, the industry supply curve reaches the point
where AR=AC (because the increase in price has been shifting the AR
curve upwards) Because revenue/unit = cost/unit, firms are now
making normal profits
o Entrepreneurs are now satisfied, as they are exactly covering all
costs, including opp. Costs- there would be no reason to leave
the industry, as the firm could not do better elsewhere.
However, no firms are making abnormal profits; the industry is
in long-run equilibrium, with no firms entering/leaving.
o The outcome is a decrease in the industrys size, and an increase
in the output produced by each individual firm in the industry.
Long-run equilibrium in a PCM

Thus, in the long-run, firms in a PCM will make normal profits; even if they were making
short-run losses/abnormal profits, the industry will adjust with firms entering/leaving
until a normal profit situation is reached.
o In this case, there is no incentive for firms to enter/leave the industry; equilibrium will
persist until either the industry demand curve or the costs faced by firms changes. If
this does occur, firms will either face abnormal profits or losses, and the industry will
again adjust, with firms entering/leaving until long-run equilibrium is restored.
Productive and Allocative Efficiency in a PCM
o Productive Efficiency- one of the measures used by economists to judge the efficiency of
a firm. A firm is productively efficient if it produces at the lowest possible unit cost
(average cost). At the output where AC=MC, a firm is able to produce at the most
efficient level of output (lowest average production cost)- this output level is known as
the productively efficient level of output. This is because MC always intersects AC at the
lowest point.
o If a firm is producing at productive efficiency (as in long run equilibrium in a PCM) they
are combining their FoPs as efficiently as possible and resources are not wasted through
inefficient use
o Allocative efficiency- also known as the socially optimum level of output.
Allocative efficiency occurs when firms are producing the optimal mix of goods
and services required by consumers.
While price reflects the value consumers place on a good and is shown on the
demand (average revenue) curve, marginal cost reflects the cost to society of all
the resources involved in producing an extra unit of the good, including the
normal profit needed for the firm producing to stay in business. If price > MC,
consumers would value the good more than it cost to make it; to achieve
allocative efficiency in this case, output should be expanded (in the opposite
case, where the cost to firms of producing a good/service is greater than the
products value to consumers, firms should restrict output)
If both sets of stakeholders arrive at the ideal combination, output will expand
to the point where price = MC
If MC>price, society will be using more resources to produce the good than
consumers value, and output will fall.
Allocative efficiency occurs when cost to producers = value for consumers
(MC=AR), assuming no external costs and/or benefits exist; this can be
established both for a firm in a PCM and for a monopoly.
Allocative efficiency is important to economists as if a firm is producing at an
allocatively efficient output level, assuming no externalities exist on the market,
it is in a situation of Pareto optimality, where it is impossible to make someone
better off without making someone worse off (this opens the doors for study of
market failure)

Dynamic Efficiency: Results from improvements in technical/productive efficiency which

occur over time (e.g. new production methods, new management methods). Dynamic
efficiency increases with innovation, R+D, and investment in human capital.
SR Productive and Allocative Efficiency in a PCM
o If a firm is making abnormal profits in the SR in a PCM, although they may produce at
the profit-max. level of output, where MC=MR and the Allocatively efficient level of
output, where MC=AR, they are not producing at the productively efficient output level
(where MC=AC)
o Likewise, if a firm is making SR losses in a PCM, although they produce at the lossminimizing output level MC=MR and the allocatively efficient output level MC=AR, they
are not producing at the productively efficient output level where MC=AC.
o However, if a PCM firm is making normal profits (in the long run), it will profit-maximize
at the lowest point of the LRAC curve; because we assume perfect market knowledge
exists, all firms will face the same cost curves, so they will all sell at the same price,
minimizing AC by producing where MC=AC. All PCM firms making normal profit thus
produce at the allocatively efficient level of output, where MC=AR.

Chapter 9: Monopolies

Assumptions of the model of a monopolistic market:

o There is only one firm producing the product so the firm IS the industry and shares the
industrys demand curve
o Barriers to entry exist, which prevents new firms from entering the industry and
maintains the monopoly
o In most cases, the monopoly will have developed high levels of brand loyalty via
branding and lack of significant competition.
o As a result of the barriers to entry, the monopolist will be able to make abnormal profits
in the LR (or a loss in the LR)
Whether a firm actually is a monopoly depends on how broadly an industry is defined.
Microsoft may have a near-monopoly on operating systems, but it does not have a monopoly on
all software. Likewise, a local shop has a monopoly on neighborhood sales, but it is not the only
shop in the world, and if the area is widened, the shop loses its monopoly.
The more important question is not whether or not a firm has a monopoly, but rather how much
monopoly power the firm has. To what extent is the firm able to set its own prices without
worrying about competition, and to what extent can it keep people out of the industry? The
strength of a firms monopoly power will depend on the number and closeness of competing
substitutes available. For instance, a metro company has a monopoly on underground travel,
but faces competition from other forms of public transport (buses, taxis, etc)
o Although not necessarily monopolies (they could be members of an oligopoly), firms
with over 25% of market share are assumed to possess market power.
Sources of monopoly power:

A monopoly may continue to be the only producer in an industry if it can prevent other
firms from entering the industry through barriers to entry. These include:
Economies of scale: As we know, firms gain cost advantages as their size
increases (known as economies of scale). Things such as specialization, bulk
buying, and financial economies may lead to cost savings and lower unit costs.
If a monopoly is large, it will experience economies of scale; any firm wishing to
enter the industry will probably have to start up relatively small and will not
have the economies of scale of the monopolist. Even if the new firm were to
start up at the same size as the monopolist, it would lack technical, managerial,
promotional and research and development economies of scale.
Without equal economies of scale, the would-be entrant into the
market would not be able to compete with the monopolist, who would
reduce price to the level of normal profits. At that price, the new
entrant would be making losses, as its AC would be higher. The lack of
economies of scale thus acts as a deterrent to firms that might want to
compete with the monopolist
Control over supplies :if a monopolist controls supplies in an industry, other
firms will not be able to enter.
Natural monopolies: Some industries (usually utilities; e.g. an energy company,
a landline phone company) are classified as natural monopolies, if there are only
enough economies of scale in an industry to support one firm This may be
shown graphically using a tilted LRAC curve.
In this case, the monopolist is the industry, and has demand curve D.
The position and shape of the LRAC curve the monopolist is facing is set
by the economies of scale the firm is experiencing; the minimum
efficient scale is ar an output higher than total industry demand. The
monopolist can make abnormal profits by producing an output between
the points of intersection of D and LRAC as AR>AC for that interval.
If another firm enters the industry, the firm takes demand from the
monopolist and the monopolists demand curve would shift left; as this
situation will be the same for both firms, the two firms would both be in
a position where neither can make normal profit; therefore, both will
shut down, because their LRACs would be above AR for any output
level.
o In this industry, LRAC, shaped by the monopolists economies of
scale, will only give abnormal profit if the monopolist can satisfy
all demand on the market; the market will only support one
firm. Real-life examples include utilities companies.
Legal Barriers: In some cases, a firm may be given a legal right to be the only
producer in an industry (to be a monopoly). This is the case with patents, which
give a firm the right to be the only producer of a product for a number of years

after its invention. When the patent expires, other firms will be allowed to
produce and sell the product. Patents exist to encourage invention; if
individuals/firms invest in research and development, only to find that they
were copied as soon as they succeeded, there would be little incentive to
innovate. However, if a firm knows that its invention will be temporarily
protected with a monopoly, they will be more likely to invest in R+D (in theory).
Patents, copyrights and trademarks are an example of intellectual
property rights- IP refers to creations of the mind; they guarantee the
creators of ideas the rights to own ideas. Patents are prevalent in the
pharmaceutical industry.
Another example of legal barriers is where a national government
grants the right to produce a good to a single firm, by setting up a
nationalized industry (e.g. a postal service, the Swedish Govts
monopoly on casinos in Stockholm) and banning other firms from
entering the industry, or selling the right to be the sole supplier to a
private firm (e.g. the right for a mobile firm to be the only mobile
service provider in an area, banning other firms).
Sunken costs: The higher the costs that firms need to pay when entering an
industry, without expecting to recoup them when leaving the industry, the
greater the disincentive for firms to enter the market and the higher the
barriers to entry.
Brand Loyalty: A monopolist may produce a product that has gained much
brand loyalty. The consumers think of the product as the brand (e.g. Garmin,
to Google). If brand loyalty is very strong, new firms may be dissuaded from
entering the industry as they feel that they will not be able to produce a product
sufficiently different to counteract the strong brand loyalty.
Product differentiation: By making their product seem very different from
competing products via marketing/branding, a firm can establish a monopoly
position.
Control over retail outlets so competitor cannot get their products to markets.
Anticompetitive behavior: A monopolist may attempt to stop competition by
adopting restrictive practices (both legal and illegal). For instance, a monopoly
should be in a position to start a price war if another firm enters the industry.
The monopoly can lower its prices to a loss-making level and should be able to
sustain losses for a longer time than the smaller entrant, forcing the firm off of
the market. The mere knowledge of this possibility may dissuade firms from
entering the market. Microsoft engaged in uncompetitive behavior by bundling
proprietary applications into the Windows OS, slowing growth of competing
services.
Demand and Profit-Maximizing Output in a Monopoly
The monopolist is the industry; therefore, the monopolists demand curve is the
industrys demand curve, which slopes downwards. The monopolist can control

either the output level or the price, but not both at once. It is not the case that
monopolists can charge what price they like and continue selling products; they
must lower price to sell more, and, because they are profit maximizers, they will
produce at the price corresponding to MC=MR (assuming that the monopolist
does not price discriminate)
In each case, the monopoly is gaining revenue from the sale of the extra
unit but losing revenue on the ones before, whose price has been
lowered; hence, MR is below AR along its entire domain.
Possible Profit Situations in Monopoly:
If a monopolist is able to make abnormal profits in the SR and has effective
entry barriers, other firms cannot enter the industry and compete away the
abnormal profits being earned. The monopolist is thus able to make abnormal
profits in the LR, as long as the entrance barriers hold out. This can be
illustrated graphically [See Inset]
A monopolist will NOT always earn abnormal profits. If it produces something
for which there is low demand, it will not earn abnormal profits. If a monopolist
makes SR losses, it has the option of shutting down temporarily (if it is not
covering variable costs) or temporarily continuing to produce. It would plan
ahead to see whether LR changes could be made so that it could at least earn
normal profits. If this is not possible, the monopolist will close down the firm
and the industry would cease to exist.
If AC>AR for all output levels, the firm will not cover costs in the LR. As nothing
can be done to rectify the situation, this is an industry where no firms are willing
to produce; i.e. there would be no industry.
Efficiency in Monopoly:
Unlike perfect competition, the monopolist produces at an output level where
neither Allocative nor productive efficiency is achieved. The monopolist
produces at a profit-maximizing level of output, which is restricted to force up
the price and to maximize profit. The productively efficient level of output
AC=MC and the allocatively efficient level of output of MC=AR are not attained.
Advantages and Disadvantages of Monopoly and Perfect Competition
Although both market forms are theoretical, economists debate the relative
merits and demerits of PCMs and monopolies.
Advantages of monopolies vs. PCMs
o Monopolies may be able to achieve large economies of scale
through sheer size. Monopolies do not have to be large, but if
the industry is large, the monopolist should gain substantial
economies of scale. If this pushes MC down, the monopolist
may be able to produce at a higher output and lower price than
in a PCM. The idea of relative price and output in a monopoly is
highly debatable.

In a PCM, equilibrium price and quantity occur where

demand=supply; however, if the industry is a monopoly
with significant economies of scale, the MC curve may
be substantially below the perfect competition MC
curve (=the industry supply curve)
If this is the case, the monopolist, producing where
MC=MR, will produce a greater quantity than in a PCM
at a lower price.
o A second advantage may be that a monopoly will have higher
levels in research and development than a PCM; firms in a PCM
are relatively small, and so many cannot easily invest in R+D.
However, a monopolist making supernormal profits is in a
better situation to use the profits to fund R+D, which benefits
consumers, who have better products and more choice in the
LR, as products are no longer differentiated.
o Third, because of their size and possible cost-efficiency,
monopolies could be beneficial in terms of employment and the
production of goods for export.
o Fourth, by being able to offer products at greater output
volumes and more competitive prices than PCM firms,
monopolies can contribute to the disappearance of niche
markets for obsolete products; while this may not be a benefit
to firms producing the niche products, this can, in the long-run,
improve the level of technology in use in the econ.
Disadvantages of monopolies vs. PCMs
o If significant economies of scale do not exist in a monopoly, the
monopoly might restrict output and charge a higher price than
in a PCM. If this is the case, then the monopolist will produce
where MC=MR; however, this will occur below, and more
expensively, than the productively efficient level of output
(MC=Supply = AR=Demand) that would be achieved in a PCM.
Thus, often, higher prices and lower output would exist under a
monopoly.
o The high profits of monopolists may be seen as unfair, esp. by
competitive firms or those on low incomes. The scale of the
problem depends on the size and power of the monopoly; the
post offices monopoly is not as important as the nuclear power
plants monopoly. By contrast, firms in a PCM can only make
normal profits in the LR.
o The fact that firms in a PCM can gain abnormal profits in the SR
by becoming more efficient than other firms grants an incentive

for firms to innovate and be competitive; this incentive is

arguably absent in a monopoly.
There are three problems associated with monopolies vs.
perfect competition:
They are productively and allocatively inefficient
They can charge higher prices for lower output levels
They can exercise anticompetitive behavior to retain
monopoly power.
Thus, monopolies can act against the public interest. As a
result, all governments have laws to reduce monopoly power.

Chapter X: Monopolistic Competition:

Monopolistic competition is a theory of market structure that illustrates a market between the
two extremes of a PCM and a monopoly; it s a more realistic model that can more accurately
be applied to reality.
A monopolistically competitive market (MCM) is a market where many competing firms exist,
each with some degree of market power. The term monopolistic derives from the fact that
each firm in an MCM has some ability to set its own prices.
The theory of monopolistic competition assumes that:
o The industry is made up of a fairly large number of firms.
o Each firm in the industry is small relative to the industrys size; thus, the actions of one
firm are unlikely to greatly affect its competitors; the firms assume that they can act
independently of each other.
o Firms are completely free to enter and leave an industry; there are no barriers to entry
and exit (in reality, in a MCM, barriers to entry/exit will exist, but will tend to be fairly
low- the cost of renting out a venue and purchasing simple equipment, perhaps)
The only theoretical difference between a PCM and MCM is that, in an MCM, there is product
differentiation (when a good/service is perceived to be different from other goods/services in
some way). Products may be differentiated based on brand name, packaging, color,
appearance, design, quality, skill level required to use the product, and so forth.
o Examples of MCMs include the auto-repair industry in the UK, the plumbing industry,
electronics stores in NYC, and mom-and-pop grocery stores.
Although the assumptions of a MCM do not appear very different from those of a PCM, they
lead to a markedly different market structure; as products are differentiated, there will be some
degree of brand loyalty (some of the customers will be loyal to the product even if the price
goes up a little vs. competitors prices, perhaps because they believe that the higher price is a
sign of higher quality or skill).
o Due to brand loyalty, producers will have some element of independence when deciding
on price; thus, they are, to an extent, price makers, who can produce at any point along
a downward-sloping, albeit elastic, demand curve, owing to the availability of many
substitutes in consumption.

Graphically, a MCM in the short run resembles a monopoly, but has markedly more
elastic demand=AR curve. The MR curve is below AR and twice as steeply sloped; the
firm will produce at an output and price level corresponding to the profit maximizing
condition, MC=MR.
Possible Short-Run Profit and Loss Situations in an MCM:
o As in a PCM, it is possible for firms in an MCM to make abnormal profit in the SR; this
occurs when AC is below AR at the point where the profit-maximizing output level
occurs (where production takes place). The graph is analogous to a monopoly graph in a
similar situation, with the caveat that it examines the short run, rather than the long
run.
If, when the firm produces at the profit-maximizing level of output MC=MR, the
cost per unit (AC) is less than the selling price p, the firm makes abnormal profit.
It is also possible for an MCM firm to make losses in the SR; in this case, AC is
wholly above AR (the firm is losing money, on average, for every unit produced)
at the profit-maximizing output level MC=MR; however, this time its unit cost
(AC) at that point exceeds the price; the amount of loss incurred can be shown
using a revenue box.
Long-Run Equilibrium in Monopolistic Competition
o Whether firms are making SR losses or abnormal profits, because there are very low
barriers to entry/exit in the industry, there will be a long-run equilibrium, where all
firms in the industry make normal profits.
If the firms in the MCM are making abnormal profits, firms from outside the
industry will be attracted to the industry. Because no significant barriers to
entry exist, the other firms will be able to join the industry in the long run. As
they enter, they will take business away from existing firms, shifting their
demand (and, by extension, MR) curves left.
Conversely, if firms in the MCM are making SR losses, some of them will leave,
because the barriers to exit are also insignificant. The remaining firms will find
that demand for their product has increased (shifted right) as they start to pick
up business from the leaving firms.
Both of these situations can be illustrated graphically; remember,
though, to have both the D=AR and MR curves shift, to preserve the
relationship between them. Because of this characteristic, the shift is
not the standard shift that we have been seeing thus far; rather, it is an
increase (if demand shifts right) or decrease (if it shifts left) of the
PED along the entire D=AR or MR curve, coupled with an
upward/downward shift of the vertical/horizontal intercepts of the two
distinct curves; this will be determined by the fact that, in the long run,
demand needs to be tangent to AC at one point exactly, as this is the
point where the firms in the industry will be making normal profits.

As a result of these properties, it is not uncommon for similar shops spring up in

an area at around the same time (e.g. sushi bars in Warsaw). Attracted to high
consumer demand, compared to average cost, many caterers were attracted to
open new sushi bars after the success of the initial restaurants; eventually, the
demand for all sushi restaurants in Warsaw will be divided, and decrease;
however, as demand continues to be strong, more restaurants will open, with
each attempting to differentiate its product from that of competitors (e.g. by
staying open longer, offering theme nights, having live bands play, etc.- this
process is known as non-price competition.
Whatever the short-run situation, in the LR, firms in an MCM will end up making
normal profits (with AC tangent to AR at the profit-maximizing level of output;
at that point, cost/unit is exactly equal to the price/unit). Each firm is exactly
covering its costs, incl. its opportunity costs, and there is no incentive for firms
to enter or leave the industry (as external firms are aware that their entry will
lead to losses for all participants on the market, including themselves).
The table below examines how closely the sushi restaurants in Warsaw
represent a MCM:
Characteristics of Monopolistically
Sushi Restaurants in Warsaw
Competitive Markets
Very Large Number of Firms
Condition Met
Each Firm Very Small Relative to
Condition Met
Market Size
Goods are Differentiated
Condition Met (via different menus,
emphasis on different types of sushi)
No Barriers to Entry/Exit
Very low barriers to entry/exit (low
capital costs, little special expertise
required, large economies of scale are
unlikely, some brand loyalty
Perfect Information
Fairly open (through restaurant
guides, the Internet, etc), but not
perfect
Abnormal Profits Possible in the SR but More and more sushi restaurants will
not the LR
be set up as long as the existing ones
earn abnormal profit; the market will
eventually adjust towards normal
profit (although this may take more
time than the strict theoretical
definition of the long run)
Productive and Allocative Efficiency in an MCM
o We know that a firm is producing at a productively efficient output level if it produces
where at the lowest possible unit cost, where AC=MC (AC is minimized).
o Allocative efficiency is achieved at the output level where MC=AR (the socially optimum
level of output, assuming no externalities exist on the market)

In both the short run and the long run, an MCM firm producing at the profit maximizing
level of output will not produce at the productively efficient or the allocatively efficient
level of output. Instead, it will produce at a higher price and lower output than in either
of the optimal output situations.
Monopolistic Competition In Comparison with Perfect Competition:
o Unlike in a PCM, where firms are able to profit maximize while being productively and
allocatively efficient in the LR, MCM firms in the long run are neither productively nor
allocatively efficient.
However, although MCM firms do not produce where industry supply=MC
intersects industry demand=AR (nor do they produce at the lowest per-unit
cost, MC=AC), the inefficiency is not due to the firm using its market power to
artificially restrict output and increase price, as in a monopoly.
Rather, the inefficiency is the result of the tastes and preferences of
consumers, and their desire for variety. It is therefore hard to argue
that, even with Allocative inefficiency, consumers are worse off in a
MCM than in a PCM, as the difference is in the desire of consumers to
purchase differentiated products.
Rather than having perfect competition, where consumers pay lower
prices for a homogeneous product, MCMs allow consumers to have
choice; hence, they are prepared to pay more for the products.

Chapter 11: Oligopolies

o

An oligopoly is a market structure where a few firms dominate an industry (e.g. the US steel
industry).
o The industry does not necessarily need to have a small number of firms; however, the
key to an oligopoly is that a large share of the industrys output is produced by a small
number of firms.
What constitutes a small number is variable, but a common indicator of the
concentration of firms in an industry is known as the concentration ratio (CRx,
where X represents the number of largest firms- for instance, CR(4) expresses
the market share (or percentage of output) of the four largest firms in the
industry). The higher the %, the more concentrated the market power of the
four (or eight, although CR(4) is the most commonly-used measure) largest firms
on the market is.
While the lines between the concentration of market share/sales in different
industries and market forms are open to interpretation, a commonly-held view
is:
CR(4)=0- Perfectly Competitive Market
0<CR(4)<45- Monopolistic Competition
45<CR(4)<95- Oligopoly
95<CR(4)<100-De Facto Monopoly

CR(4)=100- Theoretical Monopoly

For instance, CR(4) in the US malt industry is 90%, even though there is a total of
160 malt-producing firms. In the frozen seafood industry, by contrast, CR(4) is
19%, with over 600 firms on the market; thus, the malt industry is an oligopoly,
while the seafood industry is in monopolistic competition.
Firms may gain greater market share quickly through takeovers and/or
mergers of other firms. We distinguish between three concepts:
o Horizontal integration: Mergers/takeovers between firms at the
same stage of the same prod. process; this leads to a firm
gaining market share in a single industry (e.g. a gas station
buying out a competitor).
o Vertical Integration: Mergers/takeovers between firms at
different stages of the same of the prod. process; depending on
the industry, this could lead to firms gaining market share
indirectly, by cutting out the middleman and thus gaining
economies of scale and being able to expand LR output (e.g. the
Big Three car companies buying auto parts factories).
o Conglomerate Integration: Mergers/takeovers between firms
performing distinct prod. processes (e.g. the modus operandi of
Unilever and Procter & Gamble); this does not directly lead to
greater market share in either industry, but may provide
stability benefits (risk-bearing economies of scale).
Oligopolies may be very different in nature. While some produce nearly
identical products (e.g. OPEC with gasoline), where the product is impossible to
differentiate, but the sellers are different, some produce highly differentiated
products (e.g. cars) and still others produce slightly-differentiated products, but
spend money on advertizing to convince consumers to buy their products (e.g.
cosmetics).
In most oligopolies, distinct barriers to entry exist; usually the economies of
scale or brand loyalty of the larger firms. However, this is not always the case,
and some oligopolies feature low barriers to entry (this effect is explained by
contestable market theory)
The key feature of all oligopolies is interdependence. Whereas, in PCMs and
MCMs, the firms are all too small relative to the industrys size to be able to
influence the market, oligopolies feature a small number of large firms
dominating the industry.
Because of the small number of firms, each firm needs to closely
consider its competitors actions. Interdependence tends to foster
collusion to avoid surprises and unwanted outcomes; if firms can
collude and act as a monopoly, they can maximize industry profits.

However, firms in oligopoly may also want to fiercely compete with

each other in a bid to gain the greatest market share.
Oligopolies tend to be characterized by price rigidity: prices in
oligopolies tend to change much less than those in PCMs. Even when
there are production-cost changes, oligopolistic firms often leave prices
unchanged.
Collusive and Non-Collusive Oligopoly:
Collusive Oligopoly: A situation where the firms in an oligopolistic market
collude to charge the same prices for their profits, in effect acting as a
monopoly, and divide up any abnormal profits that may be made.
There are two types of collusion:
o Formal Collusion: A situation where firms openly agree on the
price they will all charge (or, more rarely, on market share or
marketing expenditure).
A formally collusive oligopoly is often known as a cartel;
since formal collusion usually results in higher prices
and lower output for consumers, this is usually deemed
to be against consumers interest, and so collusion is
illegal in a majority of countries. If a countrys anti-trust
authority finds that firms have been engaging in anticompetitive behavior such as price-fixing agreements, it
will impose fines or attempt to break up the cartel.
However, formal collusion between governments is
much more difficult to regulate and may be tolerated;
the prime example is OPEC (the Organization for
Petroleum Exporting Countries), which sets production
quotas and prices on world oil markets.
o Tacit Collusion: A situation where firms in an oligopoly charge
the same price without formally colluding.
This is not extremely difficult; a firm may charge the
same prices as all other firms by examining the prices of
the dominant firm on the market, or of their primary
competitors; there are elements of game theory
involved, but it is not necessary for firms to
communicate to charge the same prices.
In both formal and tacit collusion, the firms behave like a monopolist (a
single producer), charge the monopoly price, make LR abnormal profits
(or a LR loss!), and share them according to market share (e.g. by setting
production quotas). Graphically, a collusive oligopoly is analogous to a
monopoly.

Oftentimes, the colluding firms erect barriers to entry via limit pricing:
charging the highest possible price without allowing entry; entry is
prevented as firms realize that, if they joined the industry, the price
would be driven down and they would make a loss.
o However, there is an incentive for individual producers (e.g.
Venezuela, in OPEC) to cut prices and exceed the quota to gain
additional profit at the expense of the other colluding countries.
Unless an effective policing mechanism is in place to
prevent firms in a CO from producing in excess of
production quotas, at lower prices, cartels tend to break
down due to the incentive to cheat.
o Collusion is likely if:
There are only a few firms, making it easier for them to
check on each other and share information.
Effective communication and oversight means that
attempts at cheating can be identified early on.
Stable cost and demand conditions mean that quotas
are easy to allocate and measure, and the policy is easy
to administer.
Similar production costs mean that firms are able to
make similar profits.
Non-Collusive Oligopoly: A situation where the firms in an oligopoly do not
collude, and thus must be aware of the reactions of other firms when making
pricing decisions.
The behavior of firms in non-collusive oligopoly is strategic behavior;
because they must take into account all of the possible actions of their
rivals in their planning. To explain how non-collusive oligopolists
behave, economists apply game theory (which is outside the scope of
the syllabus, but heres a Wikipedia article about it:
http://en.wikipedia.org/wiki/Game_theory).
o Assume that a firm in an NCO is deciding whether or not to
lower prices. If another firm in the NCO decides to lower prices
by an equal amount to compete, then both firms (assuming
they are identical) will have lost the same proportion of
revenue; neither would be in a strategic advantage over the
other.
If the competing firm did not lower prices, it would be
unable to compete against the original firm and thus
would lose revenue; the same would happen if the
competing firm were to lower its own prices.
Although the optimum strategy would be for both firms
to keep prices constant, if a firm decides to lower price

(hoping for an optimum outcome for itself),

competitors would also lower prices to deny the original
firm its strategic advantages; a price war may begin, and
both firms would lose revenue as the firms attempt to
undercut each other in an attempt to gain market
share. Hence, the firms are better off maintaining rigid
prices.
One explanation of the situation in a non-collusive oligopoly
(NCO) is the kinked demand curve; although this theory has
been questioned, it does a reasonable job at modeling a NCO
market.
The models fundamental assumption is that a firm only knows
one point on its demand curve; the point where it is producing
at any one time (shown on the graph as the point on the
demand curve where the upper, elastic portion of the demand
curve joins with the lower, inelastic portion of the demand
curve).
The reason why this point is graphed the way it is
involves strategic behavior and the reactions a firm
would get from competing firms in the NCO if it were to
raise its price.
If a firm raises its price, it is unlikely that
competitors will follow suit and raise theirs;
thus, a significant amount of demand would be
lost to the other firms. This implies that
demand would be rel. elastic above point A, as
a rel. small increase in price would lead to a
greater-than-proportionate increase in QD as
some consumers switch to the competitors
substitute products.
Conversely, if the firm were to lower prices, it is
likely that competitors would follow in an
attempt to retain market share. In point of fact,
they would attempt to undercut the first firms
price in an attempt to regain lost sales and gain
market share. Thus, demand would be more
inelastic below Point A; a decrease in price is
unlikely to lead to a large increase in QD.
Because of these expectations, the demand
curve will be kinked around Point A. The firm
will also possess a MR curve that bas a vertical

section (usually marked BC), as each part of the

MR curve must (mathematically) slope twice as
steeply as the two parts of the AR curve. The
rule of thumb to use is that MR must intersect
the horizontal axis at the midpoint between the
horizontal intercept of AR and the origin.
To draw the graph, first draw the bottom
portion of AR, then extend AR using a dashed
line towards the x-axis.
o Place Point A at some point along AR.
Draw the associated dashed MR curve
to the dashed AR curve; these curves
will serve as the basis for the bottom
portion of your graph.
o Fill in your dashed lines- draw an elastic
section of the demand curve from the Y
axis to point A, then extend the demand
curve to the X axis along your dashed
line.
o Likewise, approximate the MR curve to
a point directly below Point A, and
continue it vertically downwards
towards your dashed MR curve; the two
should meet at Point C.
o Finally, fill in the dashed MR curve
between C and the X axis.
The kinked demand curve explains why price
rigidity tends to occur in a non-collusive
oligopoly; there are three reasons:
o Firms are afraid to raise prices above
the current market price, as other firms
will not follow and they will lose sales,
and possibly profit.
o Firms are afraid to lower prices below
the current market price, as other firms
will follow, undercutting them and
creating a price war that may harm all
firms in the NCO (including the first firm
to lower prices)
o The shape of the MR curve means that,
if MC were to rise, MC could still = MR;
the firms, being profit maximizers,

would not change their prices or

outputs; this can be shown graphically.
Tf we assume that the firm is operating
where MC=MR on the lowest portion of
the vertical segment of MR, they are
profit-maximizing by producing as many
units as they could if marginal costs
were higher, at the same price that they
would be selling at, were MC at the
upper portion of the MR curves vertical
segment. MC could rise as high as the
top of the vertical MR segment and the
firm would still be profit-maximizing by
producing the same output and selling
it for the same price. Thus, even if costs
change significantly, the market is likely
to remain stable.
o

Non-Price Competition:
Because oligopolistic firms tend not to compete in terms of price (either
because they are colluding with each other or because the market structure
prevents large price fluctuations from occurring, or because they know that a
price war would imply a significant reduction in their profits), the concept of
non-price competition is all-important.
Many types of non-price competition exist; these include brand names,
advertizing, special features, competitions, celebrity promotion,
sponsorship, free delivery and after-sales service.
Oligopolies tend to have very high marketing and advertizing
expenditures, as firms try to develop brand loyalty and reduce PED for
their products. While this may be seen as a misuse of scarce resources,
and may mislead or create barriers to entry due to demand for
competing products becoming more inelastic and shifting left, as well as
due to the fact that advertisement increases entry costs for new firms, it
is also possible that the competition between oligopolistic firms grants
consumers increased choice.
The behavior that firms undertake to guard and expand market share
serves to increase barriers to entry for new firms; many of the branded
goods we consume daily are produced by MNC oligopolies (Coke, Pepsi,
Nike, Unilever, etc. etc.) that fiercely compete with each other on nearly
every significant market worldwide, even though most consumers are
not aware of the fact.

Price leadership models beyond the kinked demand curve model illustrate cases where a
single firm leads other firms in pricing decisions; the leading firm changes price, and
others follow (e.g. UPS and FedEx in the US). The decision to follow a price leader may
be clearly agreed upon between firms or may occur tacitly.
Dominant firm price leadership: The case where the industry price is set by the
leading firm on the market, which the smaller firms will be reluctant to
challenge, for fear of losing market share.
Barometric firm price leadership: The case where industry price is set by the firm
believed to predict future market conditions most accurately.

Chapter 12: Pareto Optimality, Price Discrimination and Contestable Markets (An Appendix to Firm
Theory)

Consumer and Producer Surplus:

o Any existing (unregulated) market for goods/services will feature a demand curve and a
supply curve and, economic theory assumes, production will take place where demand
meets supply, at some price p and quantity q (the exact values of which will be
determined by market forces.
However, because the demand curve slopes downwards, there will be
consumers who were willing and able to pay a higher price than the market
equilibrium price for the product (in fact, this applies to every consumer except
for the consumer willing and able to buy at the lowest price). Those consumers
who were prepared to pay more for the good/service do not have to pay more;
they pay the equilibrium price and keep whatever extra money they were
prepared to pay; as a result, they make a gain vs. their expectations.
Likewise, because the supply curve slopes upwards, at the market equilibrium
point, all sales but that of one marginal unit could be taking place at a lower
price, as some producers would be willing and able to supply their product at a
price lower than market equilibrium. This means that most producers will make
a gain vs. the lowest price they were prepared to produce the product for on
the output that they produce, as they sell for a greater price than what they
were willing to accept.
Therefore, at market equilibrium, both consumer surplus (the extra
utility (satisfaction) gained from consumers purchasing a product at a
lower price than they were willing to pay) and producer surplus (the
excess of actual earnings that a producer makes from a given quantity
of output, over and above the amount the producer would be prepared
to accept for that output) are maximized.
o We say that, at equilibrium, marginal private costs equal
marginal private benefits; thus, assuming no externalities, the
free market brings about allocative and social efficiency.

Graphically, consumer surplus is equal to the area under the demand

curve and above the equilibrium price, while producer surplus is equal
to the area above the supply curve and below the equilibrium price.
A mathematical note: market equilibrium occurs where marginal consumption
intersects marginal output, or, in firm theory terms, where average revenue
(representing the price per unit output at a given output level, which is
determined by and equivalent to the demand curve of the industry, is equal to
marginal cost (the extra cost to producers of producing an extra unit of output;
in effect, equivalent to the supply curve. Calculus, people. At least know the
basics.)
Price Discrimination: A situation where a producer sells the exact same produce to different
people at different prices (differential pricing).
o Price discrimination is a method for firms to convert consumer surplus into revenue.
o For instance, even though two seats on a plane may be identical to each other, a child
ticket is likely to be priced more cheaply than an adult ticket by the airline.
o In order for a firm to be able to price discriminate, three conditions must be met:
The producer must have some ability to set prices; therefore, the market must
be imperfect. The greater the price-setting ability of the producer, the easier it
is for price discrimination to occur; thus, it is most often found in monopolies
and oligopolistic markets, less often in oligopolistic competition, and never (be
definition) in a PCM, where perfect market information is available.
The consumers must have different PEDs for the product; if they do not, they
would not be prepared to pay different prices for the product and price
differentiation would not occur. By definition, a consumer with rel. inelastic
demand for a product will be more willing and able to pay a higher price than a
consumer with relatively elastic demand; PED is (among other things) a measure
of how important a product is to consumers.
The producer must be able to separate consumers, such that they are not able
to buy the product and sell it to another consumer (and partake in arbitrage). If
this were not the case, the consumers who can the product at a low price would
resell it to those who were paying the higher price, at some price between the
two prices; this destroys the producers ability to effectively price discriminate,
as a (black) market equilibrium is restored.
Producers may separate markers in a variety of ways, including:
o Time: Consumers are often willing to pay higher prices at
certain times than at others; for instance, early morning rail
travel might be a near-necessity for commuters, who will be
prepared to pay a higher fare than a slacker who works the
afternoon shift at McDonalds. The consumers PED is more
inelastic than that of the slacker; thus, the train company
charges higher profits during rush hour than during off-hours.

Age: Firms may charge different prices based on consumers

ages; children and the elderly are often charged lower prices
than adults. This is because the two groups have lower
incomes, and their PED is more elastic as a consequence.
o Gender: Firms may charge different prices for men and women.
Assuming that the firms are not sexist, but want to maximize
profits, they will charge lower prices for the gender that is less
interested, on the whole, in the activity in question, and
therefore have a more elastic demand (e.g. women being
charged lower ticket costs at sports games)
o Income: Firms may charge higher prices to consumers with
higher incomes, as the wealthier consumers are, the more
inelastic their demand for the product, which they can afford
more easily than poorer consumers.
o Branding: Some firms sell their products under their own brand
name, as well as under a supermarkets brand name, at a lower
price; although the products are identical, the supermarket
brand will have much less brand loyalty, and therefore, more
price-elastic demand.
o Geographical Distance: Firms often sell products at differing
prices based on geographical region; this is possible so long as
the cost of transferring the product (to partake in arbitrage) is
higher than the price differential; if this is so, consumers cannot
gain money by reselling the product in the region where the
price is higher, because they need to contend with transport
costs that erode their profit margin. For instance, CDs are sold
at a cheaper price in the US than in the EU, as PED for CDs
varies between the two regions, and transport costs between
the regions are greater than the price differential.
o Types of Consumer: Firms may sell at different prices to
different users (e.g. market traders charging tourists higher
prices than locals, museums offering lower entrance fees to the
unemployed, power companies discriminating between
industrial users and households). In all of these cases, the rates
reflect the differing PED of various groups of consumers.
If the above three conditions do not exist, price discrimination is impossible. It
is easy to confuse price discrimination (which relies on differing values of PED
among groups of consumers) with sales promotion. For examples, clubs may let
girls in for free in order to attract them to their particular club out of a desire to
attract guys to get crunk on their premises, rather than to take advantage of a
difference in PED between guys and girls (which might not exist).

There are three degrees (levels) of price discrimination that must be considered; these
are:
First-degree price discrimination occurs when each consumer pays the exact
price he/she is willing and able to pay for a product. This is how hagglers in a
bazaar (e.g. in Egypt) operate when trying to get the best price possible from
consumers. On a supply and demand graph, it can be shown that, if a firstdegree price discriminator (FDPD) is successful at bargaining with consumers
and sells his product at the highest price each consumer is prepared to pay, they
can increase their revenue from (equilibrium price x equilibrium quantity) to
(equilibrium price x equilibrium quantity + consumer surplus region).
By discriminating, the FDPD has eliminated the consumer surplus
region. Also, since the extra revenue received from each unit sold
above market equilibrium is exactly equal to the price of the unit,
D=AR=MR.
Second-degree price discrimination (SDPD) occurs when a firm charges
different prices to consumers depending on how much they purchase (e.g. bulk
buying, utility fees, cell-phone call fees).
Producers may charge a high price for the first x units, those that
consumers are expected to need to purchase, and then a lower price for
any extra units consumed. This can be shown graphically using a set of
revenue boxes along a demand curve; while the first units may be
priced at some price x, any subsequent units will be priced at the lower
price y; the resulting graph resembles a histogram, in effect.
Third-degree price discrimination (TDPD) occurs when consumers are identified
in different market segments, and a separate price that recognizes the different
values of PED on the market is charged for each individual market segment.
TDPD is the most common form of price discrimination. A typical situation of
price discrimination would be a business charging two separate ticket prices for
children and adults; graphs showing D=AR and MR curves (the latter twice as
steeply-sloping as their respective associated D=AR curves) for each market
segment may be drawn.
The children have more price-elastic demand (D(C)) than do the adults
(D(A)), as they have lower incomes. The management knows that they
will need to charge children less than adults. They can separate their
market into segments if the students need to show some form of
student ID before they are allowed to buy a cheaper ticket.
We assume that the firm in question wishes to profit-maximize; having
made this assumption, we may combine the two MR for both market
segments on one graph; MR(C+A) is shown as a kinked concave demand
curve (with a relatively inelastic upper portion and a relatively elastic
lower portion) on the combined graph. When the MC curve for the firm

as a whole is added to the graph, the profit-maximizing level of output

can be established.
o When the marginal cost (not the price) corresponding to this
output level is applied to the graphs of the individual market
segments, it becomes possible to determine the profitmaximizing position in each segment by tracing a vertical line up
to the demand curve from the point on the MR curve where
MC=MR for each market segment.
o We should find that profits are maximized if the firm sells
tickets at a higher price to the group with relatively priceinelastic demand, and at a lower price to the group with
relatively price-elastic demand.
In TDPD, a market may be broken up into more than two segments, but
the general principle is unchanged: there may be many prices and
discounts offered (e.g. senior citizen, veteran, etc.), but each will take
into account the differing PED of the relevant groups and all represent
TDPD.
Whatever the degree, price discrimination has both advantages and
disadvantages, depending on the firm and stakeholders in question.
The firm clearly benefits from price discrimination:
o Price discrimination allows a producer to gain a higher amount
of revenue from a given amount of sales; this occurs before
consumer surplus is eroded.
o Price discrimination may, over time, allow a producer to
increase the scale of output and benefit from economies of
scale, which could benefit everyone by lowering AC and price in
all market segments.
o Through price discrimination, a firm may be able to drive out
competitors from a market with elastic PED.
If a firm can price discriminate, it may use the profits
gained from its more price-inelastic market segment to
undercut competitors in the price-elastic market
segment by offering a lower price. This is especially
true in intl trade, where a firm may face inelastic
demand domestically and more elastic demand abroad.
Price discrimination may allow the exporter to
be very competitive on international markets.
According to the WTOs anti-dumping
stipulations for global trade, firms may not sell
(dump) their products abroad at below the
costs of production. However, exporting firms

are allowed to sell at prices lower than the

importing countrys domestic prices, thus
undercutting local competition on the market.
Consumers may also benefit from price discrimination:
o Price discrimination could allow some consumers to purchase
products that they would have not been able to afford
beforehand, when all consumers were paying the same price
and wealthier consumers were not paying part of the cost of the
service to poorer consumers.
Lawyers and doctors often charge wealthy consumers
large fees in order to be able to provide treatment to
the poor at little/no cost.
o Price discrimination allows some consumers to purchase a
product at a lower price than they would have had to pay, were
the producer not able to secure higher prices from others (e.g.
some of you will benefit from lower tuition because the
difference will be made up by tuition paid by foreign/out-ofstate students)
o Price discrimination usually increases total output in a market;
the product is more widely available.
o Price discrimination may lead to economies of scale, lower unit
costs, and thus lower prices for consumers in all market
segments (especially if the profits gained from PD are
reinvested into R&D).
However, consumers may also be disadvantaged by price
discrimination:
o Any consumer surplus on the market will be lost when price
discrimination is initiated
o Some consumers will pay more than the price that they would
have been charged in a non-discriminated market; this could be
seen as unfair, depending which groups are being affected.
Contestable Market Theory: An extension of the theory of market forms, focusing on the
probability that new firms will enter the market in the future, rather than what the current
market structure is.
o A firm may have a temporary monopoly in an industry, but if the likelihood that other
firms will be attracted to the industry in the future is high, the firm is likely to keep
prices low and make normal profits, in order to discourage entry by potential
competitors.
In theory, many contracted firms (our school cafeteria seems an insidious
exception) will be aware that, if a competitor offered lower prices, their

contractor could easily end cooperation with them, breaking their monopoly on
the small market granted to them by the contractor.
It is likely that the existing firm will keep prices reasonable and quality
high to discourage the possible entry of competing firms; the firm acts
as though it were in a competitive market, even though it is not.
Conversely, if there is little risk of competitors entering the industry due
to effective and long-term entry barriers, we can expect higher prices
and lower-quality goods.
Cont. Market Theory states that the likelihood of entry by competing firms onto
a market is mostly determined by their entry costs (costs a firm must pay to
establish itself in an industry- e.g. the cost of building offices and hiring
employees) and exit costs (the FoPs that cannot be sold for other uses if a firm
leaves an industry- also known as sunken costs of entry).
Whereas a travel agent, who can sell his office, would have very low exit
costs, a power plant will face much higher exit costs because of the
difficulty in selling their specialized (and possibly obsolescent)
equipment.
Contestable Market: A market where barriers to entry are low, firms entering
the industry and established firms face similar costs, and firms would be able to
get back their entry costs (less depreciation) when they leave the industry.
The lower the entry and exit costs, the more contestable a market will
be. If a market is contestable, the existing firm(s) (in a
monopoly/oligopoly, respectively) on the market are more likely to
charge lower prices than the SR profit-maximizing price; they would not
want potential competitors to enter the market and compete away
their products.
Thus it is potential, rather than actual, competition on markets that
leads to pricing and output decisions.

Chapter 13: Market Failure

Community Surplus:
o When a market is in equilibrium, with no external influences or effects, it is in a state of
Pareto optimality (a situation where it is impossible to make someone better-off
without making someone worse-off; this does not necessarily imply that everyone is
equal).
o If a market is Pareto optimal, it is also socially efficient (a situation where community
surplus is maximized).
Community surplus: the welfare
of society, composed of producer
surplus and consumer surplus.

On a market with no external

influences, community surplus is
maximized at the market
equilibrium where supply
intersects demand at some price
P and some quantity Q.
Given this market situation, there is no other combination of price
and quantity on the market that would lead to a more sociallyefficient outcome (greater community surplus).
Thus, the market is Pareto efficient and ultimately allocates
resources, such that no one could be made better-off without
making someone else worse off.
In theory, the free market usually leads to an optimum allocation of
resources and maximizes community surplus.
o As the supply curve is equivalent to the MC curve, and
represents the marginal cost of producing the product to the
whole community (given no externalities exist), we refer to it as
marginal social cost (MSC).
o The demand curve is determined by marginal utility (the benefit
to the whole community resulting from one extra unit of a
product; in a socially-efficient free market, demand equals
marginal social benefit (MSB).
Market Failure: Any situation where the free market fails to allocate scarce resources efficiently.
o In reality, markets are imperfect, for a variety of, as well as factors that prevent
resources from being allocated in a socially-optimal manner. If this is the case,
community surplus is not maximized; we refer to this as market failure.
o When markets fail, governments are usually expected to intervene in order to reduce
the market failure and move towards optimal resource allocation.
o The most important reasons for market failure, as well as the options that governments
have for correcting the relevant markets in those situations, are outlined below:
Imperfect Competition:
Monopolists, and other imperfect markets, restrict output to push
up prices and maximize profits (where MC = MR). Thus, they do not
produce at the socially efficient output level (where MC= AR). Any
imperfect market will fail to equate MSC and MSB; this may be
shown by drawing a simplified monopoly graph, with MC depicted
as a straight-line supply curve.
The market failure does not correct itself, as the monopolists
barriers to entry prevent competition and grant the firms in
question market power (ability to set prices).

Because profits are maximized where MC=MR, the level of

output produced will be lower than the socially-efficient level of
output, and the price of the good will be higher than the
socially-efficient price (at market equilibrium). As a result, there
is a loss of consumer surplus, shown by the triangle between
the free market price, the monopolists output level and the
demand curve, as well as a shift of producer surplus from the
area shown by the triangle between the free market price, the
monopolists output level and the supply curve, to the area (P1P0)xQ0.
Because community surplus has fallen from the maximum, the
market is no longer socially efficient, as Q1->Q* units are not
being produced (even though MSB>MSC), resulting in a welfare
loss equivalent to the sum of the two triangles; market failure
has occurred.
Governments may reduce this welfare loss by intervening in
several ways.
They may legislate to make markets more competitive,
by passing laws preventing takeovers or mergers that
give an individual firm more than a certain market
share. They may also take laws preventing mergers and
takeovers that would increase the market share of a
specified number of largest firms in an oligopoly beyond
a certain threshold.
They may regulate newly-privatized industries, which
are at particular risk of becoming monopolies, in terms
of price and quality of service provision, as well as
reduction of entry barriers and encouragement of
competition.
They may promote contestable markets by reducing the
administrative costs to entry/exit of new firms onto
markets.
They may set up regulatory bodies to investigate
markets where monopoly power is being used against
the public interest. These bodies are empowered to
take action (or recommend that the govt do so) if the
public interest is demonstrably harmed.
If the bodies find that monopolies have acted
against the public interest, the offending firms
could be split up into competitive parts, fined,
or their managers could face imprisonment.
Lack of Public Goods:

Public good: a good that is non-excludable and non-rivalrous, and

would therefore not be provided on the free market. If a good does
not have both of these characteristics, it is not a public good.
o Note that, for a private good, if one unit is consumed by one
person, it cannot be consumed by anyone else.
A pure public good is a good that is completely non-excludable and
non-rivalrous (e.g. flood defense, national defense)
o A good is non-excludable if it is impossible to limit its
consumption once it has been provided; for instance, a private
company building a flood barrier would also build it for
people who had not paid for it. This is known as the free-rider
problem; using economic logic, no individual will pay for a public
good, as they will hope that someone else will do it.
o A good is non-rivalrous if one persons consumption of it does
not prevent others from consuming it as well. Whereas, if a
person eats a bagel, no one else can eat the bagel and gain
utility from it, there is practically no limit to the number of
people a flood barrier in a certain area could protect.
The private benefit of public goods is likely to be very
small relative to their cost, although the total social
benefit of the public good will be large (most likely,
larger than the private cost).
Thus, there is no incentive for private individuals to
provide public goods; for the above reasons, public
goods would not be provided on the free market,
despite their benefits to society, which results in market
failure.
The notion of a public good is debated; a number of
goods considered public (e.g. lighthouses could
theoretically be provided on the free market to an
extent (e.g. street lighting, lighthouses) as they may
have large benefits for private individuals. These goods
are sometimes called quasi-public goods.
o Governments may attempt to reduce this market failure by:
Providing the public good themselves (usually the case
with natl defense, flood defense, roads and other
infrastructure). The use of taxpayer money to fund
provision distributes the cost among a large group of
people who would not have been prepared to pay
individually.
Subsidizing private firms, covering all costs, to provide
the good.

Under-Supply of Merit Goods:

Merit goods: goods that are considered to provide positive benefits
to both those who use them and society in general, and therefore
should be consumed to a greater degree. However, they will be
underprovided by the market and underconsumed.
o Public schools are merit goods, as are healthcare and sports and
entertainment facilities.
o Merit goods often, though not always, are assoc. with pos.
externalities; however, as the definition of a merit good
depends on social, rather than economic, factors, our views on
what a merit good is/is not may change over time.
o Governments will attempt to increase supply, and thus
consumption, of merit goods; the method will depend on the
relative importance of the merit good.
If the merit good is very important (eg. Education,
healthcare) the govt will usually provide it directly or
subsidize them such that they are available at no direct
cost to the consumer (or legislate such that
consumption of them becomes mandatory). The goods
still do have a cost; the cost, however, is shared among
taxpayers.
As merit goods decrease in importance, they will be
subsidized to a lesser degree; although sports and
entertainment facilities may be seen as providing
positive benefits to consumers and society, they are
relatively less important than education and healthcare,
and providers will likely receive smaller subsidies.
Over-Supply of Demerit Goods:
Demerit goods: Goods considered bad for both their consumers and
society as a whole, which the government would like people to
consume less of, or not at all. Demerit goods are oversupplied by
the free market, and thus over-consumed.
o Examples of demerit goods include hard drugs, tobacco,
alcohol, and child porn.
o Demerit goods are often, though not always, assoc. with neg.
externalities.
o Governments may attempt to reduce supply and/or demand for
demerit goods; if a demerit good is considered very harmful
(e.g. cocaine), the government will make them illegal; however,
they will not completely disappear, as black markets will arise,
due to the chance of making high profits by fulfilling the
demand for the goods.

Less harmful demerit goods will usually be taxed, with more

harmful goods (e.g. alcohol) being taxed rel. more than less
harmful goods (e.g. petrol).
In addition to the above solutions, as consumption of merit/demerit
goods is greatly influenced by consumer choices, education and
information can be effective solutions.
Externalities: Costs/benefits to
third parties incurred by the
consumption/production of a
good/service that are not
accounted for in the cost of the
good/service to firms and/or
private consumers.
If the effects of the externality are harmful, we refer to a negative
externality; there is an external cost that must be added to the
private costs of the producer/consumer to reflect the true cost to
society.
If the externalitys effects are beneficial, we deal with a positive
externality; there is an external benefit that the
consumption/production of a good/service would grant, were it
consumed/produced at a socially efficient output level.
MSC = Marginal Private Cost +- Marginal External [Cost/Benefit] of
production.
o If no externalities of consumption exist for a good, MSC = MPC;
the MPC is the private supply curve of the industry, based on
production costs.
MSB = Marginal Private Benefit +- Marginal External [Cost/Benefit]
of consumption. If no externalities of consumption exist, then
MSB=MPB; MPB is essentially the private demand curve of
consumers.
If no externalities exist in a market, MSC=MSB and we maximize
community surplus; the market is socially efficient. If externalities
exist, MSC =/= MSB at market equilibrium, and market failure
(inefficient allocation of societal resources) occurs.
o When analyzing externalities, we apply the ceteris paribus
assumption: to prevent our analysis from becoming too
complex, we focus on the effect of a single externality on the
market. Note, though, that the prod./cons. of a good/service
could have both neg. and pos. effects on third parties (e.g. a
beekeeping firm that causes some atmospheric pollution).

Externalities may be split into two broad categories. There is

considerable debate on the subject, but the Editor believes that
externalities of production are graphically equivalent to
externalities of consumption.
o Negative Externalities (External Costs) are incurred when the
production/consumption of a good/service creates external
costs that harm third parties.
o Firms, basing their decisions on private costs and benefits and
disregarding the negative external effects of the product, will
produce more output than is socially optimal.
These mainly relate (in production) to environmental
problems, such as a factory dumping pollutants into a
river, which indirectly harm local fishermen; the cost to
society is greater than the cost of producing the product
to the firm, which creates external costs over and above
its private costs. Although consumers may gain some
benefit from consuming the product, the externality
arises when we consider the costs to society (e.g. lung
cancer) that their consumption incurs. Thus, we
examine MSC, rather than MSB.
In consumption, negative externalities usually involve
health hazards or pollution; e.g. secondhand smoke
from cigarettes, air pollution and traffic congestion
from cars, noise pollution from airplanes.
To reduce the negative externality, less of the good in
question needs to be consumed, and the price of the
good should rise.
Graphically, this may be illustrated with the MSC curve
being above the MPC curve (MSC>MPC); this is because
there is an extra cost to society caused by the pollution
or health problems created by production/consumption
of the product, which is not factored into the costs of
the firms producing the product.
The firm, only interested in its private costs, will
produce at free market equilibrium (a higher output
than the socially optimum level Q*, where MSC=MSB;
thus, market failure occurs as societys resources are
misallocated: too much of the good is produced at too
low a price).
We thus have a welfare loss equal to the triangle
between MSC, MPC, Q* and Qe, as MSC>MPC for those
units.

In a free market, the situation would continue, as profitmaximizing firms will only consider their private costs; it
is up to the govt to rectify the problem. These include:
Taxing the offending firms to increase their
MPC towards the socially optimum output level.
If the tax exactly covers the MEC, the
government has internalized the externality; if
this is not the case, the tax will reduce the
welfare loss, but not eliminate it- the welfare
loss will simply occur at a lower level than in the
unregulated free market.
o If the government imposes a tax (e.g.
landfill taxes, pollution taxes, and
carbon taxes), MPC will shift towards
the socially optimum output level, while
raising the price to consumers.
o The government may gain significant
revenue (if PED for the product <1),
which may be used to correct some of
the negative effects of the externality.
However, when PED<1, taxes
do not manage to reduce QD by
a large amount; while
governments gain revenue, QD
does not fall to the socially
efficient level.
In addition, specific taxes are
often regressive; the incidence
of the tax lies more heavily on
poorer consumers than
wealthier consumers; income
inequality may be widened.
Also, if taxes are raised too
high, people will start looking
for other sources of supply; for
instance, buying cigarettes
abroad and illegally importing
them. Thus, a black market for
the product may form.
o Although taxes are seen as an effective
solution for negative externalities, use
of them may be problematic as it is

difficult to measure pollution (the size

of the externality), and thus the welfare
that can be regained by use of the tax,
accurately.
o It is also difficult to establish which
firms are the main causes of the
externality and to what extent each
firm should be penalized.
o If a firm imposes a tax on its products to
reduce neg. externalities, the prices of
the products rise; if the products are
exported, they will become less
competitive.
o Finally, taxes may not stop the negative
effects from occurring altogether, and
may invite black market activity and .
Legislating to ban the offending
product/activity, or restricting the offending
firms output in some way (eg. by setting output
quotas). This could involve laws enforcing
environmental standards for producers; to
meet standards, firms will need to spend
money, increasing MPC.
o However, a ban/restriction could lead
to job losses (which would heavily
affect shareholders and employees in
the industry) and decrease
consumption of the product, which may
sometimes have been valuable (e.g.
automobiles). Also, the cost of
establishing and policing laws may
outweigh the cost of the externality.
o Setting the level of a quota is difficult; it
is easy for govts to under/overestimate
the extent of the market failure and
thus not guarantee the soc. efficient
outcome.
o All forms of regulation tend to be
expensive, and some may be difficult to
enforce effectively.
o Even if fines/restrictions are imposed,
firms may be reluctant to limit pollution

if the private benefits of continued

pollution outweigh the cost imposed by
the regulation.
o Because habit-forming goods have
inelastic demand, governments can gain
much more revenue by taxing the
product than banning it.
o Also, bans tend to be politically
unpopular, and may jeopardize a
political partys reputation among, for
instance, smokers or drinkers. Even if
governments impose partial bans on
the activity (e.g. smoking bans in clubs),
the decisions are usually highly
controversial.
Issuing tradable emission permits for pollutants;
a market-based solution to negative
externalities of production (e.g. permits for air
pollution, fishing quotas). The permits are
issued by the govt and allow firms to pollute up
to a certain level; firms may buy, sell and trade
permits among each other.
o At present, tradable permits are one of
the main means of response to market
failure.
o The govt decides on a set optimal
level of pollution permitted per year
and splits this total into a number of
licenses, each allowing a given level of
pollution, which it allocates to different
firms (in effect, a quota on the amount
each firm may pollute).
o The market comes into effect; the firms
have an incentive to pollute little as
possible, as they may trade permits
with each other; thereby,
environmentally efficient firms gain
revenue, while heavily polluting firms
face high costs). Firms that pollute
below their allotted quota may earn
money by selling their unused permits
to polluting firms, which are in effect

charged for their high pollution levels.

This raises polluting firms MPC.
By selling permits, rel. efficient
firms may also be in a better
position to overcome periods of
lower activity/ short-term lossmaking; also, rel. efficient firms
may expand output by buying
permits from rel. less efficient
firms.
A problem with this solution is that it
does not lead to a reduction of
pollution below the allowable level.
Firms pay the costs of polluting, but
some firms may continue to pollute
heavily. The government must also
decide on an acceptable pollution level
and take on the difficult task of
regulating firms pollution levels, to
prevent fraud.
Tradable permits are used in the EU to
reduce greenhouse gas emissions, in
accordance with the Kyoto protocol, an
agreement to cut global emissions of
GHGs to 5% below 1990 levels. The
treaty has been ratified by 163
countries, not including the US or
Australia.
LDCs are not required to reduce
emissions, but they are in a
position where they can be
given tradable permits if they
implement GHG reduction
policies; developed economies
are allowed to meet their
carbon quotas by purchasing
permits from the LDCs that
have earned them.
Any such intl agreements to
limit pollution are politically
difficult, with negotiations
often taking a long time; also,

as the agreements are difficult

to enforce, there is an incentive
for countries to cheat.
Enforcing property rights (rights to own or use
assets); if individuals have the right to clean air,
for instance, and this right may be enforced
through courts, polluters may be forced to
reduce emissions and/or pay fines via the legal
system.
o This approach is only effective in
societies where prop. rights are easily
enforceable; this is often not the case in
LDC and centrally planned (and some
transition) economies.
Providing education as to the risks of
purchasing/consuming a certain product, or
funding negative advertisement against the
product to reduce demand and shift MPB left.
o However, this may be expensive,
although revenue from indirect taxes
may be used to fund the measures.
Also, such measures may not be as
effective as purely economic incentives
in reducing consumptions; for example,
some teens continue to smoke despite
education campaigns and seem
prepared to accept the dangers of
smoking.
Positive Externalities (external benefits): positive effects on
third parties resulting from the consumption/production of a
good/service. Again, we distinguish between externalities of
production
(e.g. employee training, which is a cost to the firm, but
provides benefits both for its efficiency and for that of
other firms in the industry, which do not need to spend
as much on training, if the workers are hired by them,
or the positive environmental effects of beekeeping);
society has gained relatively more from the training
than the firm has gained, and externalities of
consumption
(arising from the consumption of, for instance,
healthcare; if people are healthier, they will not pass on

illnesses to others and the economy as a whole will

become more productive).
Another important example: education, which
is tremendously valuable to any society, as well
as outdoor concerts, vaccinations and
deodorant.
In both cases, we illustrate a positive externality by showing
that the MPB to society is greater than the MSB for individual
consumers (and, by extension, producers) of the product. The
externality exists as there is an unrealized potential welfare gain
shown by the triangle bounded by MPB, MSB, Qe and Q*,
where MSB>MSC. Resources are misallocated because, were
consumption to increase (Q1-Q*) social welfare would increase.
The market fails as the true benefits to society are
underestimated by market agents acting in their private
interests (private individuals and firms fail to take into
account the marginal external benefit of the prod./cons.
of the product).
If a government wishes to reduce a positive externality by
increasing consumption (increasing output, as well as price, to
give firms an incentive to produce more of the product), it has a
number of options:
Subsidizing firms offering the good/service; if this were
to happen, prod. costs would be lowered until Q* is
achieved via MPC shifting right (the magnitude of the
shift depending on the subsidy per unit). For some
important goods (healthcare, education, national
defense), the subsidy may entirely cover all of the
consumers direct costs.
Direct free provision of the good/service is also
an option.
This solution is problematic as it is difficult for
the govt to estimate the subsidy level deserved
by each firm (a problem of information arises),
as well as the rel. costs, benefits and external
effects for stakeholders.
Also, the subsidy implies high costs (which may
render such a solution impossible in LDCs,
reducing their ability to benefit from the
reduced positive externalities), as well as an

opportunity cost in terms of govt spending in

other areas, which could be more valuable.
o In addition, if demand is price-inelastic,
the price decrease caused by the
subsidy will have a less-thanproportionate effect on consumption;
the effectiveness of the subsidy in these
cases may be limited.
Legislating and thereby making certain behaviors
mandatory (e.g. mandatory health checkups,
compulsory education until age 16); however, this
solution is likely to be ineffective unless the govt can
provide the services free of charge to consumers.
Providing vocational training through State-run training
centers/ apprenticeship programs.
The problem here is that the costs of the
solution would be high, the trainers may lack
the technical expertise of established firms, and
firms may be dissuaded from offering private
training.
Using positive advertizing to encourage consumers to
consume more of the product by informing them of its
benefits, thus shifting MPB right towards Q*.
There may be a high cost involved with the
advertizing, and, although the ads may be
beneficial in the LR, they may take time to be
effective, minimizing SR benefits.
Passing legislation mandating vaccinations, health
screenings or education; this will only succeed if the
govt provides the services free of charge. Consumers
often resent such laws, seeing them as an infringement
on their civil liberties.
The extent of the govt intervention will depend on the size of
the externality; in the case of merit goods
(education/healthcare) the potential benefits are usually
massive; economic growth largely depends on the productivity
of labor, which depends on the level of healthcare and
education of the workers.
Thus, a priority of govts is usually an effective system
for the provision of education and healthcare, whether
through direct provision or through a subsidized private
sector (which differs from country to country).

Other Causes of Market Failure:

These tend to be less significant
than the ones above, though still
have a tangible effect on markets.
Immobility of FoPs: In a theoretical perfect market, resources move
freely between producers, via changes in factor prices. In reality,
this does not happen as easily; there are shortages of FoPs and time
lags, which cause delays when resources are reallocated between
industries.
o For example, a service industry could be booming in one region,
and a mfg. industry declining in another. In theory, resources
will leave the mfg. industry for the service industry due to the
ability to make greater profit; however, workers may be limited
by the high costs of moving, and a lack of skills necessary for the
new jobs; alternately, they may not be aware that the new
opportunities exist due to lack of information.
o As a result of the occupational and geographical immobility,
structural unemployment occurs; factor costs are higher than
they theoretically should be, and there are unemployed
resources in certain areas.
o To correct this type of market failure, govts adopt supply-side
policies, increasing labor-market flexibility and/or creating jobs.
They will also encourage retraining schemes.
Imperfect Information: In theory, in a perfect market, both
consumers and producers will have perfect market knowledge; this
is not the case in reality. Decisions (e.g. pricing decisions) are often
made based on incomplete information, making it difficult to avoid
externalities and leading to market failure.
o This is especially true for durable goods, which consumers do
not often buy, and thus have less knowledge of (e.g. houses,
cars). Producers need to estimate demand over time, and thus
set an average price to cover various possibilities. This average
price may, at various times, be above or below market
equilibrium.
o Govts may attempt to improve the flow of information to
correct the market failure; this is, however, costly and may not
be possible for all markets.
Income Inequality: The free market often leads to large differences
in income between different groups in the economy; Pareto
optimality =/= equality. This is often seen as a market failure by
society, which may be rectified via progressive taxes, which

redistribute income in favor of poorer social groups, and transfer

payments to the benefit of lower-income groups.
Instability: The free market leads to instabilities in many markets; in
agriculture, for instance, shifts in supply due to natural occurrences
(e.g. the weather) can lead to major price changes.
o To avoid this, the govt may implement some form of price- or
income-support scheme.
o On a macro. level, the econ. often goes through cycles of
booms, recessions, troughs, and recoveries; the govt may use
demand-management policies to reduce this instability.
Short-Termism: On markets, short term decisions with severe longterm consequences are often made.
o The private sector is often blamed for pursuing short-term
profit, while causing long-term problems; firms may consume
resources in the short term at a rate that does not permit
sustainable growth and development in the future.
o The public sector (govt) may intervene in the workings of
markets in the short term to gain favorable political results
before elections, although such intervention may be against the
best interests of society. By intervening for political purposes,
they cause market failure.
In addition, regulatory agencies can be influenced by
the firms that they are intended to oversee (e.g. via
lobbying, campaign financing) and then operate on the
behalf of the firms, rather than the public interest.

Chapter XIV: Economic Growth: Measuring National Income

Whereas microeconomics (our focus thus far) was the study of individual markets,
macroeconomics is the study of a national economy.
o Macroeconomists are concerned with the allocation of a nations resources, as
concentrated around five main variables. These variables are at the core of
macroeconomics, and are associated with macroeconomic policy objectives; they are
given below:
Variable
Associated Policy Objective
Economic Growth (GDP)
Steady Rate of Increase of GDP;
desirable as growth is often associated
with higher living standards
Employment
Low Unemployment Rate; desirable
due to unemployments high social
costs
Price Stability
Low and Stable Inflation Rate; desirable
due to the high costs of inflation for the

achievement of other macro. goals

External Stability
Favorable Balance of Payments
Position; desirable due to the pot. high
LR costs of current account deficits.
Income Distribution
Equitable distribution of income;
desirable in terms of social justice and
potentially human development
o In macroeconomics, the most significant consideration is an economys total output
level, also known as the economys national income. This level of output may be
measured in several ways.
The Circular Flow of Income Model:
o We return to the simplified model of the national economy introduced earlier. In
the models basic form, there were two sectors: households (the people who buy
the nations output of goods/services and own all FoPs in the economy, and who are
paid by firms for the use of their FoPs) and firms (the institutions that hire FoPs from
households and use the FoPs to produce the nations output of goods and services.
o The main forms of payment by firms to households for each FoP are given below:
Land: Rent
Labor: Wages
Capital: Interest
Entrepreneurship: Profits
o These relationships may be illustrated using a simple double-loop circular flow diagram,
with households supplying FoPs, receiving payment for them, and purchasing
goods/services with the income received, and firms using the households FoPs to
produce goods and services, selling them to households and paying households for their
FoPs.
o This model is a simplification; in reality, households and firms do not follow this
simplified behavior pattern. Households (and firms) do not immediately spend all of the
income and profits received, as the model suggests. Rather, households can save some
of their income in banks or other financial institutions, foregoing current consumption
to allow for (increased) consumption in the future.
Saving is a leakage from the circular flow, as it is income received, but not used
to finance expenditure on goods and services.
If households do not buy the entirety of the firms output, the firms will have
unsold stocks of goods and will reduce their output to compensate, using fewer
FoPs and paying less income to households. Thus, saving will cause the amount
of income circulating in the economy to fall.
However, firms will have access to the savings of households by borrowing
money from financial institutions (e.g. by taking out a loan for capital).
They can use this money to increase their capital stock a thus, their
output; this increase in the capital stock is known as investment and
represents an injection into the circular flow; it involves income that

does not directly stem from household expenditure on goods and

services.
Investment allows the amount of income circulating in the economy to
rise.
o Even though adding investment and saving to the model makes it more realistic, the
mode is still limited; in reality, there are other sources of injections and leakages of
income (sectors) in the economy.
o If households import goods and services from abroad, some of their income leaves the
circular flow; imports are a leakage as they represent expenditure of income not
returning to firms.
Conversely, if people in foreign countries purchase a countrys exports of goods
and services, income is injected into the circular flow: exports represent an
income source not directly originating from domestic households. Exports will
not necessarily equal imports; most countries have trade imbalances.
o Likewise, households and firms (the private sector) are not the only active domestic
economic agent. The government (public) sector collects some of the income earned by
households and firms in the form of taxes; taxes are thus a leakage from the circular
flow. Governments spend money in the economy on infrastructure, education,
subsidies, healthcare, etc.
Government spending on goods and services represents an injection into the
circular flow. Government spending is not necessarily equal to tax revenue;
most governments will run deficits (spend more than they earn) to deliberately
influence the level of leakages and savings in the economy, thereby affecting
the level of national income.
Transfer payments (payments to individuals that are not a result of an increase
in output- e.g. unemployment benefits, social security) are a category of
government expenditure that is not included as an injection into the circular
flow.
Governments tax the income of households and transfer some of this
income to others; as we deal with an income transfer, rather than
income in exchange for output, this spending is not an injection.
o The circular flow model can be enhanced by factoring in the above three additional
sectors. However, even this model is a simplification of a complete economy. We can
draw several conclusions from the circular flow model:
The economy is in equilibrium where injections = leakages
If leakages rise, without a corresponding increase in output, GDP will fall
to a new equilibrium- less income will be circulating. Likewise, if
injections rise without a corresponding increase in output, the economy
will move to a new equilibrium.
Measurement of National Income

National income is usually measured using gross domestic product (GDP) (see
definitions, below). Three different methods are used to calculate GDP:
The output method: measures the actual value of all goods produced by firms in
an economy; this is calculated by summing the value added by all firms in the
economy. At every stage of a production process, we deduct input costs, such
that we do not double count inputs. The data is usually grouped according to
production sectors: the primary sector (agriculture and mining), the secondary
sector (mfg.) and the tertiary sector (services).
Alternately, the value of all final goods and services produced in an
economy could be summed, to obtain (theoretically) the same figure.
The income method: measures the value of all incomes earned by households
for the use of their FoPs in an economy. This typically includes:
Wages and salaries
Self-employed income
Trading profits
Rent, including imputed rent: the rental value of owner-occupied
housing is estimated and included.
Interest
Less stock appreciation (if stocks increase in value over the year, their
value becomes exaggerated)
The expenditure method: measures the value of all planned expenditure on all
goods and services in the economy, including:
Expenditure by households (consumption)
Expenditure by firms (investment)
Government expenditure
Net exports (spending by foreigners on exports domestic spending on
imports). Note that GDP will not directly decrease from an increase in
imports; however, neither will it rise. Thus, we also count export
expenditure as consumption of goods and services, to keep the
accounting clear.
Note that, if no one buys the goods that firms produce and firms have
unsold stocks, we count the stocks as if the firm had bought them itself.
Each approach measures national income differently by examining different
data sets. However, as they measure the same thing, the GDP values will
necessarily be equal.
GDP: The total value of all final goods and services produced in an
economy in a given year or the total value of all planned expenditure in
an economy in a given year (GDP=Y=AD+C+I+G+(X-M)).
The above definitions reflect the output and expenditure methods of
GDP accounting, respectively; both are correct and accepted.

In theory, regardless of the method used, accounting will result in the

same final figure; whether we call it national income, national
expenditure or national output.
o In practice, however, the data used to calculate each of the
three values will come from many different sources, leading to
inaccuracies and imbalances in the final values.
o Often, inaccuracies may result from the timing of data
collection; figures may need to be revised when more data
becomes available.

GDP versus GNP:

o A third definition of GDP, in addition to those above, is useful to draw comparisons
between GDP and GNP.
GDP (3): the total of all economic activity in a country, regardless of who owns
the productive assets.
If LG, a Korean MNC, begins production in Poland, the value of its
output will count towards the Polish GDP, as the production is carried
out on Polish territory.
Gross National Product (GNP): the total income earned by a countrys factors of
production, regardless of where the assets are located.
In the above example, LGs output will be recorded under Koreas GNP,
as Koreans, rather than Poles, can be said to own the firms assets
(GNP is an inherent simplification).
Thus, GNP= GDP + income earned from assets abroad [property income
from abroad] income paid to foreign assets earned domestically.
Note that income earned from assets abroad [property income from
abroad] income paid to foreign assets earned domestically is usually
known as net property income from abroad. Thus,
o GNP=GDP+ net property income from abroad.
GNP versus Net National Product (NNP):
o Over the course of a year, a countrys capital stock will depreciate (lose some of its
value), due to factors such as mechanical wear and tear as capital is used, obsolescence
of capital due to new technologies, and damage to capital. Capital gets used up;
however, GDP/GNP does not take this fact into account.
o The measure that does is NNP.
NNP = GNP capital depreciation.
o While NNP is a more realistic picture of a countrys true economic activity, it is very
difficult to measure depreciation in practice. Thus, gross figures are much more widely
used.
Nominal versus real GDP:
o In order to compare a countrys GDP from one year to the next, we need to compensate
for the fact that inflation will likely have increased prices in the economy; if this occurs,

the GDP value will be overstated. GDP will have risen, even if economic activity had
stayed constant.
o To get a true picture of economic activity over time, we adjust the nominal GDP ( the
GDP value at current prices) and adjust it for inflation using a GDP deflator (an
expanded version of the Consumer Price Index). The resulting value is known as real
GDP (GDP adjusted for inflation).
Real GDP = Nominal GDP adjusted for inflation
It is necessary to use real figures to compare GDP, or other economic variables,
over time, such that price changes do not distort the information.
GDP per capita:
o The easiest natl income statistic to measure; it is a measure of economic output per
person and a rudimentary indicator of economic welfare.
GDP per capita = total real GDP/ population size.
o While the total economic activity of a country is measured using the simple GDP figure,
GDP per capita is used as a starting point for judgment of the economic progress of a
country in comparison to other countries in terms of raising living standards (e.g. Chinas
GDP is larger than that of Canada, although China is far less developed and poorer;
the GDP/capita figures account for this fact).
Why National Income Statistics are Gathered:
o While definitions of national income statistics are straightforward, the task of data
collection, undertaken by natl statistics agencies, is complicated and expensive. Every
country has an agency that cooperates with the UN System of National Accounts,
gathering national income data which serves as:
An indicator of a governments progress in achieving economic policy objectives.
Economic growth (an increase in the real GDP of a country over time) is an
objective for many governments; analysts use natl income statistics to judge
the success of the govt in achieving its policy objective of increased growth.
Govts use the statistics to develop policies.
Economists use the data to develop economic models and predict future
economic trends.
Businesses use the data to forecast future demand.
If real data is used, economic performance over time may be evaluated.
Because rising GDP/capita is often associated with rising living standards, people
use natl income data as a basis for evaluating the quality of life/ standard of
living/ economic development of a countrys population.
Natl income statistics are often used as a basis for comparison between
countries.
Limitations of the Data:
o Given the usefulness of natl income statistics and their many applications, the possible
limitations of the data become significant in terms of their accuracy, suitability for
comparisons and appropriateness for evaluating living standards. Limitations include:

Inaccuracies: The data used to calculate natl income statistics comes from a
wide range of sources, including tax claims, output data and sales data. As a
result, figures become more accurate over time, as more data is collected.
Statisticians calculating national income attempt to make their data accurate;
while this is usually the case in developed countries, it is less so in LDCs, despite
work by the UN SNA to improve data collection methods and thus, the validity
of comparisons.
As the price of most goods has decreased over time due to tech. improvements,
the value of GDP may be shown to have decreased (ceteris paribus), even
though the quality of the goods (e.g. the number of features) may have
improved.
Regional variations: GDP/capita figures only report the total ec. activity of a
country per inhabitant; as a result, they mask regional inequities and may not
be an accurate indicator of the overall welfare of a countrys population.
Likewise, GDP/capita figures fail to account for inequitable income
distribution within a country; although GDP/capita may be high, a
majority of the income could be in the hands of a wealthy few.
Un(der)recorded Economic Activity and Informal Markets:
Natl income statistics can only account for officially-recorded economic
activity; they do not include DIY work or other work done at home, but
usually include the same work if it is done by a paid firm, even if the
output is identical.
o This is most significant in LDCs, where much economic activity
occurs informally and is unrecorded (e.g. subsistence
agriculture- farmers growing their own food). Although
estimates of this value are made, GDP figures are likely
undervalued, making comparisons difficult.
In addition to DIY and subsistence farming, a class of activities known as
the hidden economy goes unrecorded; this includes activities that are
off the books because they are illegal (e.g. drug trafficking, smuggling
of untaxed cigarettes from the Ukraine into Poland) as well as normally
legal activity that is done illegally (e.g. work done by illegal immigrants).
o In addition, some work is not recorded as people want to evade
paying a portion of their taxes. If there are high taxes on
tobacco (or other indirect taxes), smokers may buy their
cigarettes on the black market; likewise, high income taxes and
health and safety regulations provide an incentive for firms to
hire workers unofficially, and for people to understate their true
income by not declaring a proportion of their work.
o Statisticians try to estimate the size of the hidden economy in
each country (http://www.havocscope.com/). For the most

part, countries with high tax burdens have a higher amount of

hidden economic activity, but the fact that different degrees of
the hidden economy exist in different countries, as well as the
fact that they are estimates, increases the complexity of
accurate GDP calculation.
External Costs: GDP figures do not take into account the costs of resource
depletion; this is recorded as an increase in GDP, but there is no measure to
account for the loss of natural resources, or for the external costs of air/water
pollution and congestion, even though these factors will compromise the quality
of life as the economy grows.
Living costs: Raw GDP figures are difficult to use as an indicator of welfare, as
they do not reflect the cost of life within a given country; to somewhat
compensate for this disparity, economists may use Purchasing Power Parity
figures in a common currency (usually the US$), which account for cost
differences between countries.
However, if certain goods are produced on a local scale or are not
traded and lack international equivalents, fully accurate comparisons
may be impossible to make.
Quality of Life Concerns: GDP may grow if people work longer hours or take
fewer holidays, earning higher incomes but enjoying a lower quality of life. GDP
also does not account for community service/ volunteer work; even though such
activities are a social benefit, they may be discouraged in the pursuit of econ.
growth. Likewise, tougher pollution restrictions may reduce output but increase
quality of life.
Problems of Valuation: some output (e.g. natl defense, healthcare) does not
have a market price; while the value of the services is expected to be equal to
their cost, this figure may be over- or undervalued.
Composition of Output: A large portion of a countrys GDP may consist of goods
that do not benefit consumers (e.g. defense goods, capital)- if this is so, growth
may not lead to higher living standards.
In addition, GDP accounting does not take into account the physical
volume or quantity of the products produced, only their financial value;
thus, rel. high GDP figures might mask unemployment if most of the
GDP growth is a result of small, lucrative manufacturing or service
industries.
Likewise, GDP figures do not distinguish between expenditure on capital
goods, which allow for increased production and consumption in the
future, and consumer goods, which allow for increased consumption in
the present.
Problems of Comparison of GDP Statistics Between Countries:

The income figures of both countries need to be converted into a

common currency; as the value of the ER may frequently change
(usually more than once per year), it may be difficult deciding what ER
to use.
Accounting methods vary between countries, which can alter GDP
calculation methods.
It is important to consider inflation and nominal incomes; a country may
have lower nom. incomes, but lower prices.
Factors such as climate should be considered: while one country may
need to produce heating or irrigation, for instance, another may not
(e.g. Norway and Saudi Arabia)
The composition of output may vary greatly between countries, making
exact, point-by-point comparisons difficult.
Income distribution is likely to vary between the two countries.
Some economies have more barter trade and/or greater illegal markets
than others.

Chapter 15: Introduction to Economic Development

While natl income statistics provide important information about the economic activity of a
country and form the basis for assessing the countrys economic growth, growth (an increase in
the real output of the economy over time) is a one-dimensional concept.
Traditionally, economists have assumed that increased output, along with the parallel processes
of industrialization, is equivalent to economic development (an increase on the quality of life in
an economy over time, as measured by [the HDI or some other development index]).
o This is not a reasonable/correct assumption, and a new field, developmental economics,
has arisen to take this fact into account. Developmental economics postulates that
econ growth does not equal economic development, a far more complex,
multidimensional (and subjective- economists have different views on the meaning of
development) concept.
Some of the objectives of economic development are reduced poverty, public
provision of education and healthcare, and the guarantee of civil liberties,
political participation, and law and order.
o Due to this multidimensionality, development is difficult to measure. Economists have
derived several ways to measure economic development, including:
The Human Development Index; the measure proposed by the UN
Development Program.
One of the aims of the HDI is to reemphasize that people and their capabilities
should be the ultimate criteria for assessing the development of a country,
rather than economic growth.
The HDI is an index composed of three variables representing
quantifiable development goals. These are:

A long and healthy life, as measured by life expectancy at birth

(assuming that those who live longer have benefitted from
greater health)
o Education, as measured by the adult literacy rate, as well as
primary, secondary and tertiary school enrolment.
o Standard of living, as measured by GDP/capita (converted at
PPP US$).
When combined, the three indicators give an HDI value between 0 and
1, with higher values representing greater development. Countries are
classified into three categories according to their HDI:
o High Human Development: HDI > .800
o Medium Human Development: .500 < HDI<.800
o Low Human Development: HDI<.500
How the HDI information is used:
o Prior to the establishment of the HDI, GDP/capita had been
used as a measure of economic development, under the flawed
assumption that higher GDP translated directly into higher living
standards.
o However, if we compare a countrys HDI ranking with its
GDP/capita, we may find that countries have not always been
successful in translating the benefits of GDP growth into
development.
While Norway has the worlds highest HDI, it is third in
terms of GDP/capita.
Conversely, while Saudi Arabia is ranked 44th for
GDP/capita, it is ranked 77th (!) for HDI. It has a
GDP/capita slightly higher than that of Argentina (which
is a high human development country) while being a
medium human development country.
Had we used the simple GDP/capita figure, we would
have made misleading conclusions about either
country. On the other hand, the HDI figure allows us to
compare how effectively countries have emphasized
human development in policymaking.
Other Development Indicators:
o HDI is not sufficient as a guide to a countrys econ.
development, but it is more adequate than the raw GDP figure.
However, the HDI excludes many other components of human
development, and is just an average that can mask inequalities
b/w urban and rural areas, men and women, and different
ethnic groups.

To address this fact, there are several other composite

indicators, as well as single indicators (indicators that measure
one variable) that attempt to measure the other dimensions of
devt. These include:
The Gender Related Development Index (GDI):
Along with HDI, the UNDP attempts to analyze
data to present HDI values for different groups;
one such measure is the GDI, which looks at
the same indicators as the HDI but considers
the discrepancies between men and women.
Gender inequality in a country will result in a
GDI figure that is lower than the HDI. The GDI is
essentially HDI adjusted for gender inequalities.
The Gender Empowerment Measure (GEM):
One aspect of devt is the creation of
opportunities, self-esteem and freedom for all
people; thus, it is valuable to measure whether
economic development in a country is helping
to create freedoms and opportunities for
women.
The UNDP therefore calculates the GEM, which
measures the extent to which women may
actively participate in politics and the economy.
The GEM examines the number and percentage
of women in leadership, managerial and
parliamentary positions, technical and
professional jobs (essentially, their participation
in the workforce and their share of GDP). A
high value (values range from 0 to 1) indicates a
higher level of gender empowerment for
women.
If a country has a high low GEM value in relation
to its GEM value, it is implied that the access to
basic needs, education and health is not
creating better opportunities for women.
The Human Poverty Index (HPI):
The UNDP also measures the level of
deprivation and poverty occurring in a country.
While HDI measures the achievements of a
country in three variables, the HPI focuses on
the proportion of people deprived of the

opportunity to reach a basic level in each area;

it is a composite index and examines indicators
comparable to those of the HDI; these are:
Development
Goal

HDI Measure

Equivalent
HPI Measure
Illustrating
Deprivation
in meeting
the Goal
Long and
Life
% of people
healthy life
expectancy
who do not
at birth
reach age 40
Education
Literacy and % of adults
school
who are
Enrolment
illiterate
Ability to meet GDP/Capita
% of pop.
basic needs
without
access to safe
water + % of
children who
are
underweight
for their age
While HDI represents development
achievements for an average inhabitant
of a country, HPI measures how evenly
the benefits of development are spread
within a country. HPI is expressed as a
%, with a higher % expressing a higher
level of deprivation and poverty.
Two countries may have very similar
HDI, but differing GDI values. This
would suggest that the benefits of
development are spread more evenly in
some countries than others.
The Lorenz Curve and Gini Coefficient:
o This is a measure of income inequality in an
economy; inequality can be graphed using a
Lorenz curve, which uses data about national
income collected from surveys and divided
into ascending shares of national income, and
presents them graphically; the share of total

GDP going to each class of households is

calculated.
The data can be presented using a Lorenz
curve, on which the X axis shows the
cumulative % of the total population, divided
into quintiles, while the Y axis shows the
cumulative $ of total income earned in the
economy.
The graph also features the line of absolute
equality, which indicates a perfectly equal
distribution of income (x% of the population
earns x% of the income).
o Each country has its own Lorenz
curve based on income data; the
further away a countrys Lorenz
curve from the Line of Absolute
Equality, the more unequal the
income distribution.
o An indicator that summarizes the
information given by the Lorenz
curve is the Gini coefficient
(derived from the Lorenz curve; it
is the ratio between the area
between the line of absolute
equality and a countrys Lorenz
curve to the area beneath the line
of absolute equality. The higher
the Gini index, the less equal the
distribution of income.
o Although a reduction in inequality
might be an important devt goal,
a countrys development progress
cannot be evaluated solely on the
basis of the Gini Coefficient.
While low-income countries tend
to have more income inequality
than high-income countries, there
is no hard-and-fast correlation
between the level of
development of a country (as
measured by HDI) and its Gini
index.

Also, it would be
incorrect to assume
that more equality is
necessary to raise living
standards. If GDP rises
and income inequality
remains the same, the
poorest will still receive
a larger amount than
they had previously
(they receive the same
percentage share of a
larger amount).
While the UNDP calculates the composite HDI based
on three key indicators, there are numerous single
indicators that measure different dimensions of
development, including:
Indicators to measure the ability to live a
long and healthy life:
Infant mortality rates
Under-five mortality rates
Maternal mortality rates
% of children underweight for their
age
Population with sustainable access
to an improved water source
Population with sustainable access
to sanitation.
Population undernourished
Number of one-year-olds
immunized against TB.
Number of doctors per 1000 of the
population
Indicators to measure ability to acquire
knowledge:
Enrolment in each level of
education.
Literacy rates
Internet users per 1000 people
Telephone mainlines per 1000
people

As a corollary: energy consumption

per capita.
The Genuine Progress Indicator: Another
View of Human Development:
For various reasons listed above,
GDP is not a good indicator of living
standards, and the emphasis for
development economics is
therefore the measure of human
development in less developed
countries.
The Genuine Progress Indicator (as
well as other related indicators,
such as the Net Economic Welfare
indicator) is an alternative measure
of welfare established specifically to
measure human development in
more developed countries; it
attempts to measure whether a
countrys growth (increase in the
value of the national output of
goods produced) has actually led to
greater welfare for the people. It
adds a measure of non-monetary
benefits, such as the benefits of
household and volunteer work, to
the GDP, and attempts to deduct
the many external costs of
economic growth from the GDP
figure. The deducted costs include:
o Environmental damage:
Air, water and noise
pollution
Loss of farmland
and natural
habitats
Resource depletion
Ozone depletion
o Social costs:
Family breakdown

Crime and personal

security costs
Loss of leisure time
o Commuting costs
o Cost of automobile
accidents.
While such variables are difficult to
quantify, the realization that rising
GDP does not correspond to rising
welfare means that economists
must look for ways to measure the
consequences of growth, such that
both MDCs and LDCs can aim for
equitable and sustainable growth.

Chapter 16: Aggregate Demand and Demand-Side Policies

The macroeconomic concepts of aggregate supply and aggregate demand may be treated as
extensions of the microeconomic concepts of supply and demand.
Aggregate demand (total planned expenditure on goods and services, at a given price level,
within a given period of time) is the foundation of macroeconomic analysis. Graphically, the AD
curve closely resembles the demand- curve; it is downward-sloping.
However, whereas the demand curve (a microeconomic concept) shows the relationship b/w
the price of a good and its quantity demanded for a single market, macroeconomics considers
the functioning of the economy as a whole. Thus, the AD curve is an aggregate of all goods and
services demanded.
The AD graph has a measure of the average price level of all goods and services in the economy,
instead of simply price, on the y-axis, and the total value of all goods and services in an
economy, adjusted for inflation (real national output=real national income=real national
expenditure= real GDP) instead of simply quantity on the x-axis; graphically, this is usually
labeled real output or real GDP.
The AD curve therefore shows the inverse relationship between the average price level and real
output in the entire economy of a country; at a lower average price level, more output is
demanded. However, the Law of Demand does not apply on an aggregate level; we can explain
the downward trend through:
o The Wealth Effect: While the nominal value of money is fixed, its real value is based on
the average price level. As the avg. price level decreases, the same nominal amount of
money will be able to purchase more of an economys output than had been previously
possible. As price level falls, consumers are wealthier, which encourages expenditure.
o The Interest Rate Effect: The quantity of money demanded in the economy is dependent
on the avg. price level; a high price level denotes that it takes a large amount of

currency to make purchases. Consumers thus demand large amounts of currency when
prices are high.
When average prices are low, consumers demand relatively little currency as it
takes a small amount of currency to make purchases. Thus, consumers keep a
large amount of currency in the bank, increasing the supply of loanable funds.
As a result, as the price level decreases, the interest rate on loans decreases,
increasing demand for investment and thus total national output.
o The Exchange-Rate Effect: This effect is related to the interest-rate effect; because,
when the avg. price level falls, interest rates fall, the currency decreases in value as
investors become relatively more likely to invest their financial capital abroad, as the
relative return on financial investment abroad increases. This causes a fall in the
domestic exchange rate relative to foreign currency; this means that it becomes
relatively more expensive to import, and exports become relatively more competitive
internationally. Thus, net exports rise as the price level decreases, causing AD to
increase at lower price levels; as domestic investment abroad increases, the balance of
payments remains neutral.
The differences in the graphs indicate the difference between the microeconomic demand curve
and the macroeconomic AD curve.
Thus, in constructing the AD curve, we examine demand from all possible sectors of the
economy; this gives us the components of AD, which comprise:
o Consumption: Total planned expenditure by consumers on dom. products.
In looking at consumer demand of goods, we distinguish b/w 2 types of goods:
Durable Goods: Goods used by consumers over an extended time
period (eg. cars, TVs, houses).
Non-Durable Goods: Goods used by consumers immediately or within
a rel. short timespan (e.g. Big Macs, toilet paper, newspapers).
o Investment: Total planned additions by firms to the capital stock of the economy.
Firms have three types of investment:
Replacement investment: Expenditure on capital in order to maintain
the productivity of existing capital
Induced Investment: Expenditure on capital in order to increase output
in response to higher demand in the economy
Autonomous Investment: Expenditure on capital in order to increase
output, independent of the level of demand in the economy.
o In general, firms will invest autonomy if the expected rate of
return from the investment exceeds borrowing costs; this
depends on expected costs, revenues, and productivity of/from
the capital.
We also distinguish between [optional, though useful]
Planned Investment: The level of investment that firms intend to
undertake at the beginning of the time period considered

Actual Investment: The level of investment which has occurred at the

end of the period. If firms fail to see their stocks, actual investment will
exceed planned investment
Capital Stock: All the goods in an economy that are man-made and used to
produce other goods/services (e.g. cars, computers, offices).
Thus, macroeconomic investment is not equivalent to financial
investment (the purchasing, sale and lending of assets); although this is
referred to as investment colloquially, it is actually saving, as income
leaves the circular flow.
o Government Expenditure:
May occur on a variety of levels (local -> federal), and represents spending on a
wide variety of goods and services, which commonly includes health, education,
security, transport, welfare and housing).
The amount of govt spending depends on the govts policy objectives.
o Net exports:
Exports: Domestic products purchased by foreigners.
When firms sell exports to foreigners, the export revenue enters the
country
Imports: Products purchased from foreign producers
When imports are bought, an outflow of imp. expenditure occurs.
Net Exports: Total planned export revenue less total planned import
expenditure in an economy (usually noted as (X-M).
The net figure may be either negative (export revenue is lower than
import expenditure) or positive (import expenditure is lower than
export revenue); however, in national income statistics, imports are also
added as consumption, to reflect the fact that imports most often
enter a country through domestic firms and/or the dom. govt, and that
the actual output of the economy is independent of the amount
imported.
Aggregate Demand can be summarized using the formula C+I+G+(X-M).
o When the avg. price level in the econ. falls (PL0->PL1), the level of output demanded by
consumers *C+, firms *I+, the govt *G+ and the net foreign sector *X-M] increases (Y1-Y2).
o Economists use different, equivalent labels for the x-axis (e.g. natl income, natl
expenditure, real GDP). Be consistent with whichever one you use and be sure to
distinguish between your label and quantity, which is a microeconomic concept in a
single market.
Changes in AD:
o A change in price level will cause a movement along the AD curve b/w real output levels;
a change in any of the components of AD will cause AD to shift left (AD falls, if the
component decreases) or right (AD rises, if the component increases).
Changes in the Components of AD:

Consumption changes are caused by:

Changes in income:
Income is the most sig. determinant of consumption; as incomes rise,
people have more money to spend on products, and consumption rises.
In a growing economy with rising GDP, consumption, and thus AD, will
increase.
Changes in interest rates:
Spending on non-durable goods is carried out with consumers income
(the day-to-day money earned); however, some of the money used to
buy durable goods consists of bank loans.
When people borrow money, they must pay interest on the loan to the
bank; the interest rate may be understood as the price of loanable
funds in the econ.
o If interests rates rise, borrowing will likely fall (as the cost of
borrowing rises). Consumption will fall, leading to a fall in AD.
o An example of interest rates affecting AD is the housing market;
to buy a house, consumers often take out mortgages. If interest
rates increase, mortgage repayments rise and people will be
able to spend a smaller prop. of their income on other goods
and services; consumption will fall.
o Also, if the IR rises, saving will become more attractive; people
would rather earn money by depositing their incomes in the
bank than spend on goods/services. Consumption will also fall
as a result.
o An increase in IRs leads, ceteris paribus, to a fall in consumption;
conversely, a fall in IRs leads to a rise in consumption, ceteris
paribus; it becomes rel. more attractive to purchase durable
goods and services using loaned funds and less attractive to
save money in banks, where the return on investment falls.
Also, mortgage repayments may fall, leaving more money to
spend on goods/services.
Changes in Wealth:
The amount of consumption depends on the amount of wealth
consumers have.
o Income: The money private individuals earn
o Wealth: The assets private individuals own, including physical
assets (e.g. housing, gold jewelry) and monetary assets (e.g.
govt bonds, shares in companies, bank savings).
Two main factors affect the level of wealth in the econ.:
o Changes in housing prices: As house prices rise across the econ.,
consumers feel more wealthy and will likely feel confident

enough to increase consumption by saving less/borrowing

more.
o Changes in the value of stocks/shares: Many consumers hold
shares in companies; if their value rises, consumers will feel
wealthier, encouraging them to spend more. They may also sell
the shares and use the earnings to finance consumption.
Changes in Expectations (Consumer Confidence):
If people are optimistic about their econ. future, they are likely to spend
more now (e.g. if they believe they can find better jobs soon due to the
booming economy, they will be more likely to take out a loan or use up
savings).
o High consumer confidence will likely lead to high consumption
levels.
However, if people expect econ. conditions to worsen, they will likely
reduce present consumption to save for the future.
If inflation is expected to rise, consumers will consume more in the
present, possibly causing an inflationary spiral.
Economists measure consumer confidence and use a consumer
confidence/sentiment index to summarize the results.
An increase in the index implies that confidence, and thus cons. and AD,
is rising.
Inflation: With inflation, the purchasing power of savings is reduced, and people
may have to save a greater prop. of their incomes if they wish to maintain a
given level of savings.
Consumers income: As income increases, consumers are likely to save more
and spend less out of each additional unit of currency received (marginal
propensity to consume is lower at higher incomes).
Discretionary vs. Contractual Savings: With contractual savings (e.g. a
retirement plan), consumers agree to save a certain amount each month; with
discretionary savings, consumers have the choice to save or not to save.
Relative incomes: Consumer expenditure will be influenced by their past
expenditure patterns, as well as those of their neighbors; in the short run, a
household will not scale back consumption if incomes decrease as it has become
accustomed to higher levels of spending and seeks to keep up with the
Joneses
Changes in exchange rates: an increase in the value of a countrys currency will,
ceteris paribus, make exports less competitive abroad, decreasing AD; the
converse is also true.
Income distribution: as income is redistributed more equitably, consumption
will likely rise as the low income groups MPC is rel. higher than that of
wealthier groups.

An interesting note (the paradox of thrift): If households try to save more of

their income, they may end up saving exactly the same amount as before; if
they save more of their money, AD decreases, leading a fall in the level of real
GDP. Although they save a greater proportion of their income, in a 2-sector
economy, their total savings will be the same total amt. as before (for
equilibrium, planned leakages must equal planned withdrawals, which remain
constant).

Investment changes are caused by:

Interest rates:
To invest, firms need money; while some of that money originates from
their Retained profits, some is borrowed; the level of borrowing is
affected by the interest rate.
If money is borrowed, an increase in borrowing costs will cause the
investment level to fall; also, if interest rates are high, firms may prefer
to save their retained profits to earn higher returns, rather than use
them for investment.
There is an inverse relationship between interest rates and the level of
investment; this can be shown on an investment schedule, which has
the interest rate on the Y axis and the investment level on the X axis.
o A decrease in interest rates will decrease the incentive to save
and borrowing costs (as there are now more projects with a
higher rate of return than the borrowing cost), leading to an
increase in borrowing and thus investment; an increase in IRs
will have the opposite effect.
Interest rates will depend on:
o How long the loan is for: longer-term loans constitute a greater
risk and are priced at higher IRs
o Risk: The riskier the project, the greater the IR charged will be
o The cost of setting up a loan; there are scale benefits for the
bank of setting up fewer large loans rather than more smaller
loans.
o Demand of loanable funds from:
Households, to buy consumer durables
Firms, to invest
the government, to finance a budget deficit
o Supply of loanable funds from:
Peoples willingness to save (and thus provide loanable
funds to banks)
Banks ability to lend (which may be affected by
minimum reserve requirements, etc.)

Changes in GDP:
As GDP rises, cons. tends to rise; if this occurs rapidly, the prod. capacity
of firms will be put under pressure, making it likely that firms will invest
in new capital to meet the increase in demand; this is induced
investment.
Investment accelerates as GDP rises (more on the accelerator effect
later).
Technological Change:
A dynamic economy will feature a quick rate of tech. change; to keep up
with tech. advances and remain competitive, firms will need to invest.
Expectations/ Business Confidence:
Businesses make investment decisions largely based on their future
expectations and confidence in the ec. climate.
o Firms are unlikely to invest to increase their pot, output if cons.
demand is likely to fall in the future.
o If businesses are confident about the ec. climate and expect
demand to rise, they will invest (autonomously) to increase
output and productivity and thus meet projected demand.
o Economists usually measure business confidence and publish
their results in the form of a business confidence index.\
Govt expenditure changes are caused by:
The amount and nature of govt spending depends on the aims of the govt; if
the govt has committed to subsidizing an industry, govt spending will rise, as
will happen if the govt decides to spend to correct market failure. Education
and healthcare improvements may see increased spending on schools and
clinics.
The govt may also deliberately pursue policies to adjust the level of AD in the
econ.
To perform both of these tasks, govts may run budget deficits (spend more
than they receive in revenue).
Alternatively, the govt may run a surplus, whereby its expenditure is
lower than its revenue. This often implies lower levels of expenditure,
and thus AD.
Net export changes are caused by:
Exports: Goods/services bought by foreigners.
If foreign incomes rise, their consumption of imports from Home will
rise; thus, domestic exports rise as foreign economies grow (this is
evident between China and Germany). Similarly, as foreign countries
grow, their investment expands; this will involve some measure of
imported capital, causing increases in dom. capital good exports.
Imports:

When a countrys GDP rises, increases in consumption will result; it will

necessarily be the case that some of those goods and services will be
imported.
Likewise, as GDP rises, investment is likely to rise. Part of the capital
goods (or components thereof) purchased will be imported; thus, as
GDP rises, so does import expenditure.
If GDP falls, there will be reduced spending on all goods and services,
including imports.
Thus, net exports depend on both domestic and foreign GDP growth trends.
Protectionist measures and other limits to the physical ability of consumers and
firms to import and export goods, as well as the countrys relative exchange
rate, will also affect net exports.

Chapter 16-A: Demand-Management Policies

Govt Demand Management Policies:

o Govts have two broad sets of policies available to influence the level of AD in the econ.
These are:
Fiscal Policy: The set of govt policies relating to its spending and taxation rates.
Both direct taxes (on income) and indirect taxes (on expenditure) can be
raised/lowered to alter the level of disposable income consumers
possess.
Govts use expansionary fiscal policy to increase AD and contractionary
fiscal policy to lower AD; this is known as a governments fiscal stance,
which will depend on the discretionary stabilizers that the government
has in place:
o Discretionary Stabilizers: Actions deliberately undertaken by the
govt to stabilize the econ (e.g. taxation rate changes, changes
in govt expenditure). To stabilize the economy, in a slump, the
govt will usually try to reflate the economy by increasing AD; in
a boom, it will usually try to deflate the economy by reducing
AD.
o Expansionary Fiscal Policy:
If the govt wishes to encourage increased
consumption, and thus AD, it can lower income taxes to
increase disposable income.
If a govt wishes to encourage greater investment, it can
lower corp. taxes to increase firms after-tax profits and
thus investment; this will also likely increase AD
Govts may increase their spending to improve or
increase public services; this has a direct effect on AD.
Govts gain revenue from:

Taxes
Privatization proceeds
Profits of nationalized industries
Dividends from govt shares in private
enterprises
Using Tax Changes Compared to Spending Changes:
Tax changes:
Can be introduced and have an effect quite
quickly
Tax cuts can increase incentive to invest and
work, and thus may have supply-side effects.
However:
o Tax changes are an indirect method; the
govt may not be able to predict how
consumers will react to a tax cut: they
may save most of the extra money
received.
Spending Changes:
Govt spending can be targeted at specific
industries/regions
Expenditure directly increases AD and has full
multiplier effects, compared to a tax cut, where
some of the money can be saved in the first
round of spending
However:
o There is a time lag before the budget
gets approved and spending actually
takes place; there may be a long delay
between the decision to increase
spending and implementation.
Spending is difficult to control, because:
o Some items of expenditure are difficult
to reduce (e.g. education, healthcare);
demand for them is constantly
increasing. People expect higher
standards; thus, it is pol. unwise to
crack down on these items.
o Factors beyond a govts control may
place an added burden on health
services or defense expenditure.

Commitments to other countries and

intl organizations (e.g. the EU) are not
easy to end.
Financing a Deficit: To finance its deficit, a govt can sell:
Treasury bills (short-term borrowing by the govt); the
bills are essentially IOUs which are redeemed after
three months.
Bonds: Longer term debt (longer-term IOUs)
The Central Bank can lend money to the govt.
If a deficit exists, the govt is putting more money into
the economy than it is taking out; this will increase the
money supply.
If, however, the govt sells debt to the non-bank
public, this will take excess money out again;
the overall effect may be neutral.
If the govt sells long-term debt to banks, their
liquidity will be reduced (as they have
exchanged cash for the bonds), which may
decrease lending, offsetting the increase in
money supply.
Treasury bills are so liquid that they will not
significantly affect lending; thus, money supply
will increase, if they are used.
The National Debt: The total debt of the govt, which grows
whenever the govt runs a deficit, as the govt is borrowing
more money.
The govt needs to pay back the national debt, plus
interest, from future revenues (eventually)
If the natl debt consists entirely of borrowing within
one country, the govt is simply transferring money
from one group to another. To pay off a group it owes
interest to, it borrows from another group; the money
remains within the economy.
If the govt borrows from abroad, the interest needs to
be paid to people outside of the country; thus, the natl
debt can become a burden.
Note that a problem of twin deficits (whereby a budget
deficit causes an external deficit) may arise, as increases
in govt spending and reductions in taxation will cause
an increase in import expenditure relative to export
revenue; this will not occur, however, if the econ. has

spare capacity and the increases in spending are met by

increases in dom. output.
As output increases, dom. incomes increase;
thus, the budget deficit will be able to be
funded from dom. savings.
Finally, if capital is not perfectly mobile, an
increase in govt spending will increase IRs,
increasing savings and reducing investment;
thus, private sector funds would be available to
fund the deficit.
Problems of Fiscal Policy:
Time lags: any changes in policy will take time to work
through the economy, by which point the policy may
not be needed and may actually be detrimental.
Fiscal policy may also be too inflexible in the
face of changing ec. conditions (e.g. spending
increases are straightforward enough, but
spending cuts may be highly unpopular).
Information problems: it is difficult to know the exact
position of the economy and the size of the multiplier
or accelerator.
Budget deficits could potentially lead to intl
indebtedness and/or higher tax rates in the LR.
Fiscal Drag: If the govt keeps spending and taxation
rates are constant, it will have a deflationary effect on
the econ.: as households and firms earn more, they will
end up paying more tax to the govt.
Crowding Out (See Chapter 20)
Consumption may not be sensitive to tax changes; e.g.
consumers may save any increases in disposable income
rather than spend a proportion of it.
Govt intervention often increases AD by too much/ too
little due to time lags and poor information; this can
destabilize the econ.
Keynesian Fiscal Policy:
The economy will not nec. be in equilibrium at full
employment output; govt intervention is required to
reach full employment when in a recession
Fiscal policy is more effective than mon. policy
By having a deficit, the govt can increase AD and
achieve Yf

Fiscal policy can be used to stabilize growth.

o Neoclassical Fiscal Policy:
Fiscal policy is not effective at fine-tuning the economy
Expansionist fiscal policy is inflationary
There is a need to reduce govt spending, borrowing
and taxation as a % of GDP
Mon. policy is more effective than fiscal policy.
Monetary Policy: The set of official policies governing the money supply and the
level of interest rates in an economy.
The level of money supply in the economy is not directly in the IB
syllabus; however, the effect of interest rates on AD is.
o Many different IRs exist in any economy; private commercial
banks may offer competitive financing (e.g. low mortgages).
Although banks are regulated by the govt, they are free to set
such rates themselves.
o Discount Rate (base rate, prime rate) The interest rate used as
a tool of monetary policy, at which a countrys central bank
offers liquidity to commercial banks.
The central bank is not a commercial bank; rather, it
acts as the govts banker and controls money supply in
an economy.
In some countries, the govt controls the CB;
however, in most developed countries, the CB is
an independent entity mainly responsible for
maintaining low and stable inflation rates in the
econ.
Changes in the discount rate are an important indicator
of overall mon. policy as they set the tone for all
borrowing and lending in the economy; to make a
profit, commercial banks will need to set their private
interest rates above the discount rate.
Even though the CB is largely independent, we usually
consider its activities part of a govts mon. policy.
Changes in the discount rate affect the level of AD in
the economy:
To increase AD, the central bank might lower
the DR, reducing the cost of borrowing and
increasing both cons. and investment; this is
expansionary (loose) mon. policy.

By contrast, to operate contractionary (tight

mon. policy and reduce AD, the CB will increase
the base rate.
Functions of the Central Bank:
Banker to the govt- provides an account for the govt
and manages the natl debt through the sale of bonds,
redeeming (buying back) debt when it has matured.
Pays interest for the govt on debt and holds debt itself.
supports fin. institutions as a lender of last resort,
providing liquidity when necessary.
Holds deposits and will lend funds to commercial banks
Controls the natl currency; usually the sole power to
issue currency. The actual quantity of currency is
dependent on how much people want to hold in bank
deposits/cash.
Agent for the govts ER policy; holds official currency
reserves and will buy and sell currency for the govt
Oversees the fin. system, licenses deposit takers in the
UK and regulates various fin. services.
Instruments and Objectives of Mon. Policy:
The objective of mon. policy is usually to control
inflation; because this relies on increases/decreases in
the interest rate, it is a demand-management policy
that also has ramifications for ec. growth.
In the early 1980s, govts mainly attempted to
do this by controlling banks lending; from the
mid-1980s, the govt has used the interest rate
as the main policy instrument; this is aimed at
controlling demand for, rather than supply of,
money.
Money is liquid, but does not earn a rate of return; if
people hold money, they do not earn interest. Thus,
the IR is the opp. cost of holding money; if the IR is high,
the desire to hold money will be reduced- if low, there
will be less incentive to switch out of money into other
assets.
The money supply (and thus, interest rate) is controlled
by:
Open-market operations: The CB selling govt
debt (treasury bills in the short term, bonds in
the long term), which the buyer pays for by

writing out a check on their banks. The banks

honor this check by paying the CB, reducing
their reserves, their ability to lend, and
increases the IR.
o Bonds have fixed returns per year; thus,
the lower the value of a bond, the
higher its return rel. to its value.
o If households and firms as if they have
too much liquidity (i.e. they are holding
too much money), they will want to
switch into bonds; this will increase the
price of bonds and lower their rate of
return. The process will continue until
the price of bonds has increased, and
the rate of return on bonds fallen, to a
point where there is not further desire
to switch away from money (both the
bond market and the money market are
in equilibrium).
Thus, if the interest rate is set
too high, there is excess money
supply, leading households to
buy bonds until a new
equilibrium is reached.
Likewise, if the IR is set too low,
there is excess demand for
money; households sell bonds,
leading to a fall in their price
and increase in their rate of
return, until both financial
markets return to equilibrium.
o If banks are left short of cash as a result
of OMOs, they may need to borrow
cash from the CB; as they are
competing for scarce loanable funds,
the interest rate increases, making
borrowing rel. more expensive.
o The CB may also change its discount
rate to affect overall interest rates. By
influencing interest rates, the CB also
influences demand for money.

Liquidity (reserve) ratios: By forcing a bank to

keep more funds in reserve, the CB can restrict
comm. bank lending, but banks may find ways
around the restrictions.
Funding: converting short-term govt debt into
longer-term debt; by exchanging long-term
debt with banks in return for short-term debt,
the CB reduces banks liquidity and ability to
lend.
Special deposits: banks can be forced to deposit
a certain % of their liabilities in the CB (often
without interest); the CB may also restrict how
much banks are allowed to lend (quantitative
controls) and who they are allowed to lend to
(qualitative controls)
Moral suasion: The CB can make it known
whether it would like more or less lending;
bankers often heed the CBs advice/wishes.
An increase in the money supply, due to any of
the above methods, will have the following
effects:
o On money markets:
If money supply (which is giveni.e. constant, as the level of
money in an economy is set by
central banks) increases, there
is excess liquidity at the old IRs;
households attempt to shed
this liquidity by moving out of
money into other bonds and
assets, bidding up the price of
bonds and reducing their return
(the interest rate).
The process continues until
bond prices are high enough,
and IRs low enough, that there
is no further incentive to move
out of money; the financial
markets are back in equilibrium.
o On capital goods markets:

The lower IR will increase the

amount of investment: as
borrowing costs have fallen,
more investment projects are
now profitable; the extent of
the increase in investment will
depend on the interest-rate
elasticity of investment.
On consumer markets:
When investment increases, so
does AD; if the econ. is below
Yf, output and employment will
increase.
By contrast, if the economy is at
Yf, an inflationary gap and
upwards pressure on prices will
occur, without a LR output
increase.
If prices do increase, so will
nom. GDP, increasing the
transactions demand for
money. This will in turn raise
interest rates and bring AD back
down (i.e. a one-off increase in
money supply will create forces
that reduce inflationary gaps
and hence inflation), assuming
that the money supply is held
constant and not increased
again; if the money supply is
increased at the same rate as
inflation, the price increases
can continue.
Thus, if demand for money
increases, households will
switch out of assets into
money, selling their bonds. This
reduces the price of the bonds
and increases their rate of
return (the IR); the process
continues until no further
incentive to move out of bonds

exists. Such a trend should

cause investment to fall, by an
amount determined by the
interest-elasticity of
investment, leading to a fall in
AD.
Problems of Monetary Policy and Using Interest rates:
Banks may hold reserves in excess of the minimum
reserve requirement, causing the policy to have no
impact on lending.
Attempts to curtail certain types of lending will lead to
more lending of a different type or by different
organizations (Goodharts Law)
Mon. policy can be undermined by disintermediation
(firms borrowing and lending directly to/from each
other, esp. when the CB intervenes on financial
markets)
Interest rates affect many factors at once; thus, IR
adjustments are often seen as a blunt macro. policy; a
CBs IR decisions apply to all institutions and aspects of
an econ.
Changes in IR are likely to affect the ER; using higher IRs
to discourage borrowing my increase the value of the
ER, making dom. firms uncompetitive.
Borrowing by households and firms is likely to be
affected.
Monetary policy may take years to take full effect;
unless the CB plans its policies carefully, the policies
impact may come too soon or too late.
However, because mon. policy is rel. easier to implement and
manage than fiscal policy, it is the preferred demand-side policy
for most govts; between approx. 1980 and 2008, the main use
of fiscal policy was perceived to be supply-side improvements
(tax incentives and reductions in benefits).
Thus, fiscal policy is likely to be more effective than mon. policy
if:
Money demand is interest-elastic (such that changes in
money supply have little effect on IRs)
Investment is interest-inelastic.
The above conditions closely reflect Keynesian views on
the economy. In general, govts following Keynesian
policies believed that:

Govt intervention via fiscal policy (often by

running a budget deficit) is often necessary to
bring the economy towards full employment; in
addition, they believed that fiscal policy could
be used to fine-tune the economy to stabilize
growth.
By contrast, govts influenced by neoclassical views of
the economy have believed that:
Fiscal policy was less effective than mon. policy,
and ineffective at fine-tuning the economy.
Expansionary fiscal policy is inflationary in the
LR; thus, govt spending, taxation, and
borrowing as a % of GDP should be reduced.

Chapter 17: Aggregate Supply

The supply side of the economy is important in macroeconomic analysis, as it shows the overall
prod. capacity of the economy.
Aggregate Supply: The total amount of goods and services that all industries in the economy
will produce at any given price level.
o AS may be seen as the sum of all supply curves of all of the industries in the economy.
o In macroeconomic analysis, we distinguish between short-run and long-run AS:
Short-Run AS:
o Graphically, the short run AS curve resembles a micro. supply curve in that it slopes
upwards; there is a pos. relationship b/w the price level and the output level a countrys
industries will supply. As with an AD diagram, price level is given on the y-axis while real
GDP is given on the x-axis.
At any given price level, industries will supply a certain output level. In the short
run (which is defined, in macroeconomics, as the time-period where FoP prices,
especially wages (the price of labor) are constant; thus, each SRAS curve is
drawn for a given nom. price level), if firms want to increase output level, firms
will face higher avg. prod. costs when producing a higher output.
To produce more, firms might have to provide incentives to workers for them to
be available to produce the output; this is usually done via overtime pay (which
is greater than regular wages; hence, avg. costs for firms rise)
By the Law of Diminishing Returns, marginal and avg. costs will rise as output
increases in the SR.
Thus, in the SR, an increase in output will cause AC to rise; industries
will pass this on to consumers via a higher price.
Hence, SRAS slopes upwards; an increase in output level (Y0->Y1) will be
accompanied by an increase in price level (P1->P2)
o Shifts in SRAS:

The SRAS curve shows the relationship between avg. price level and real output
in the economy (assuming ceteris paribus; i.e. factor costs are ass. to be
constant)
A change in price level causes a change in the output level and results in a
movement along SRAS; this is similar to the micro. supply curve, where a price
increase leads to an increase in QS, shown as a movement along the S curve)
Just as with the micro. S curve, a change in any other determinant of SRAS than
the avg. price level will cause the entire SRAS curve to shift; these shifts are
sometimes called supply-side shocks.
If SRAS increases, the SRAS curve shifts right; if SRAS decreases, the
SRAS curve shifts left.
The most straightforward explanation for supply-side shocks is that they
are factors that cause changes in prod. costs.
o As in micro. analysis, an increase in prod. costs causes an
increase in SRAS, while a decrease in prod. costs causes a
decrease in SRAS.
Prod. costs typically change as a result of the following:
o Changes in wage rates: Any increase in wages (for example, due
to new min. wage laws, or the occurrence of successful
collective bargaining in mfg. industries, where unions usually
lobby for good conditions and wages for workers) will lead to an
increase in prod. costs to firms, and thus a fall in AS.
o Changes in raw material costs: For a change to have an effect on
SRAS, we ass. a change in the price of significant, widely-used
raw materials has occurred. While an increase in bismuth prices
would affect rel. few industries (implying that aggregate prod.
costs in the economy may not increase by enough to affect
SRAS), a change in oil prices would affect almost all industries,
as oil is widely used in most prod. processes, and thus almost
certainly cause a shift in SRAS
o Govt taxes and subsidies may also affect SRAS (causing it to
shift left/right, respectively), if they are applied to the majority
of industries in the economy.
o Changes in import prices: If the capital/raw materials used by a
countrys industries are imported, a rise in import prices will
increase prod. costs.
This can occur due to changes in the ER of a countrys
currency (e.g. if the Euro falls in value, the import price
of the raw material/capital used by European producers
will become rel. greater, raising prod. costs in the
Eurozone).

Short-Run Macroeconomic Equilibrium:

o The economy will operate where AD=AS. At this avg. price level and output level, all of
the output produced by a countrys producers is consumed; thus, there is no incentive
for prod. to alter output or prices.
Long-Run Aggregate Supply
o Economists hold various theories as to the shape of the LRAS curve; there are two main
schools of thought regarding its appearance and function (the Keynesian school and
what is often called the neoclassical school- the term monetarist is applied,
sometimes erroneously, to this school, as well)
o The differing shapes of the LRAS curve lie at the basis of controversies concerning
appropriate govt economic policies b/w the two schools.
o Keynesian LRAS:
The Keynesian LRAS curve shows three possible phases; these are, in order of
increasing natl output:
The Depression Phase: In this view, LRAS is perfectly elastic at low levels
of ec. activity; producers in the econ. can raise real output without
incurring higher average costs (or increases in the avg. price level) due
to the existence of spare capacity in the economy.
o Spare Capacity: The existence of high levels of unused FoPs (e.g.
unemployed labor, underutilized capital).
o Firms can potentially produce far more than they are producing
at the moment. Should there be demand for increased output,
the unutilized FoPs can be employed to their full capacity (e.g.
idle machines can be put into use and unemployed workers
given jobs) at constant avg. costs
More can be produced at the same price level; workers
are willing to work at the given wage and marginal
product is constant; thus, MC is also constant.
The Transitional Phase: As the economy approaches its potential output
(Y(f)), the available FoPs in the economy become rel. scarce; as
producers continue trying to increase output, they will have to bid for
increasingly scarce FoPs.
o Higher prices of FoPs mean higher costs for prod, and the price
level will rise to compensate for the higher costs. In this region,
LRAS slopes upwards.
o The nearer the economy gets to full employment, the more
difficult it will be for firms to attract scarce resources, and the
greater the increase in costs (and thus the price level) for each
increase in output will be; AS becomes progressively more
inelastic.

The Full Employment Phase: As the economy reaches its full capacity
(Yf; the full employment level of output), it is impossible to increase
output any further, as all FoPs are fully employed; thus, LRAS is perfectly
inelastic at the economys potential output.
o The full-employment level of output is a tricky concept; full
employment does not mean that no unemployment exists;
rather, it is the output level where the efficiency of FoP use is
maximized.
In terms of unemployment, full employment connotes
that the number of jobs in an economy is equal to or
greater than the number of people actively seeking
work.
Neoclassical LRAS:
Neoclassical economists believe that LRAS is perfectly inelastic at the fullemployment output level; thus, the economys pot. output is dependent on the
quantity/quality of FoPs, rather than on the avg. price level.
The LRAS curve, in this view, is independent of price level; if the price
level rises or falls, long-run output does not change.
Shifts in LRAS:
As a countrys FoPs are constantly changing (usually, increasing in quantity or
quality), we should expect to see steady increases in its LRAS; this represents
pot. economic growth.
An outward shift in a countrys LRAS means that its prod. potential has
increased; thus, a rightward shift in LRAS is equivalent to an outward
shift of the countrys PPF.
This shift can be shown from both the Keynesian and Neoclassical
perspective; with the Keynesian perspective, note that LRAS shifts
directly right; it does not also shift downwards. As a result, in both
cases, the full employment output level should increase.
LRAS will shift right if there is an improvement/increase In the quality/quantity
of a countrys FoPs; e.g. tech. advancements may increase the productivity of
capital, improvements in education may increase the productivity of labor,
immigration may increase the quantity of labor, lower benefits may increase
incentives to work, lower nom. wages may increase incentives to hire,
investment due to lower interest rates may lead to a larger capital stock, and
discoveries of raw materials may increase the quantity of goods that can be
produced. All of the above factors will shift LRAS outward.
Supply-Side Policies: Govt policies that are put into place to increase the LRAS
of an economy.
The main goal of supply-side policies is to increase pot. econ. output by
increasing the quantity/improving the quality of FoPs.

We can divide the policies into two categories: market-oriented and

interventionist policies:
o Market-oriented supply-side policies:
These policies focus on allowing markets to operate
freely, with minimal govt intervention; these policies
are designed to increase the incentives for labor to be
more productive and efficient, and to increase the
incentives for firms to increase productivity. The most
prominent such policies include:
Reductions in income taxes: if people work
harder and make more money, they may need
to pay higher taxes as they attain higher income
levels.
o This may act as a disincentive to work; if
taxes are reduced, the incentive for
labor to work harder and be more
productive may increase, thus
increasing the economys pot. output.
o In addition, at lower avg. tax rates, the
opp. cost of not working, as opposed to
working, increases; more people will
therefore seek employment if dir. taxes
are lowered.
Reductions in corporate taxes: If businesses are
allowed to keep more of their profits, they will
have more money for investment; as
investment entails additions to the capital stock
of the economy, pot. output will increase.
o In addition, if businesses know that
they will be able to keep a larger share
of their profits, rather than give them to
the govt in taxes, they will have more
incentive to produce efficiently.
o It is interesting to note that, while
Keynesians focus on the
macroeconomic effects of taxation and
govt expenditure, neoclassical (supplyside) economists tend to focus on its
micro. effects (e.g. disincentives to
invest/work)

Reductions in trade union power: Trade unions

may often push wages up too high and
increase prod. costs to firms. Thus, a reduction
in union power will reduce the ability of unions
to negotiate disequilibrium wages and should
lower prod. costs for firms. This should cause
pot. output to increase.
o However, as the existence of unions
protects workers from exploitation,
reduced union power may result in
abuses of workers rights by firms.
o A note on unions: Trade unions are
organizations founded to represent
employees, protect their interests, and
bargain on their behalf; by joining a
union, employees gain increased
bargaining power and benefit from
collective bargaining.
o Unions will typically bargain over issues
such as pay, working conditions, and
training.
o Unions must decide whether to
maximize wages of existing workers
(which is likely to reduce employment),
maximize the total wage bill, or
maximize employment.
To simultaneously maximize
employment and wages, unions
must aim to increase
productivity, such that the
demand got labor shifts right;
they may do so by lobbying for
better working practices.
o Unions can affect the average real wage
rate by:
Improving productivity: By
negotiating for better
conditions and protecting the
workforce, unions may increase
output.

Using industrial power (e.g. the

threat of strikes) to force
employers to pay more.
Restricting supply of labor (e.g
through closed shops in
industries and firms; as only
union workers are allowed to
be employed under closed shop
conditions, labor supply
decreases and the wage rate
consequently increases).
o The power of trade unions in the
economy as a whole depends on:
The number of union members,
expressed as a proportion of
the total labor force.
The legal environment: govts
often take measures to reduce
union power (e.g. by making
them more accountable for
their actions and preventing
industrial action without a
secret ballot).
Reduction in govt expenditure; depending on
the degree to which crowding out effects the
economy, this should mean that less money
needs to be borrowed by the govt and more
remains available for the private sector;
however, this approach may end up harming
programs that benefit society (e.g. education,
healthcare).
Reduction/elimination of min. wages: Likewise,
it can be argued that because govt-set
minimum wages keep labor prices above their
free-market level, abolition of the minimum
wage would also lower prod. costs and thus
decrease LRAS.
o While this may lead to overall economic
growth, it will reduce living standards
for minimum-wage workers and is thus
often seen as a harsh policy.

Reduction in unemployment benefits: If the

unemployed are given generous benefits by the
govt, they may have less of an incentive to find
employment.
o Market-oriented supply-side
economists would recommend that
unemployment benefits be reduced to
encourage unemployed people to take
the available jobs in the economy; this
policy is only appropriate if jobs are
actually available.
Deregulation: If govts have heavily regulated
business operations, this may increase overall
prod. costs, reducing AS in the econ.
o A reduction in the number/severity of
regulations (deregulation) will lower
firms costs and increase AS; this will
especially be the case if regulations on
new firms entering the market are
decreased.
o However, this may include reductions in
regulations on employee safety or
environmental standards, which can
have severe neg. consequences for
workers and the environment.
Privatization: The sale of public, govt-owned
firms to the private sector, e.g by contracting
out (selling off public-sector activities to the
public sector), deregulation to allow for greater
competition, and sale of govt-controlled assets
to private shareholders.
o Examples of privatized industries
include British Airways, Japan Post, and
Telekomunikacja Polska.
o Arguments Against Privatization:
Privatization, if executed
poorly, may lead to the
replacement of state
monopolies with private
monopolies.

Privatized firms are often sold

below their value to ensure that
shares are sold.
To address these problems,
many countries have set up
watchdog bodies to monitor
privatized utility industries; the
utilities must meet the
conditions of their operating
license, which is intended
ensure that they are not
abusing their monopoly power;
prices of the services may also
be controlled.
If a nationalized monopoly is
divided into several more
competitive components, there
may be a loss of economies of
scale and a net increase in
costs/prices due to duplication
of resources.
When firms are privatized, the
govt can no longer directly
control the externalities arising
from their operation.
In industries that require high
levels of investment (e.g. coal
mining), private firms may not
be able to raise the funds
needed to expand capacity.
Arguments for Privatization:
Organizations run by the public
sector are often inefficient, as
the govt will usually finance
them despite any losses that
they make.
Privatization may be popular
with voters, who are able to
acquire shares cheaply.
As the govt no longer needs to
subsidize (ideally), public
spending is reduced.

Privatization provides a one-off

increase in govt revenue.
Privatization should encourage
competition and
competitiveness.
Organizations in the public
sector are often run for political
ends (e.g. to maintain high
employment), at the expense of
efficiency.
Shareholders may provide a
better method of control over
managers activities than the
govt; this leads to better
decision-making and increased
efficiency.
Increased share ownership may
encourage entrepreneurship.
Employees and managers in
newly-privatized firms will have
a greater incentive to innovate,
in order to remain competitive.
o According to market-oriented
economists, privately-owned profitmaximizing firms will be much more
efficient and productive than govt-run
firms; they will have more incentive to
increase pot. output.
All of the above market-oriented supply-side policies
emphasize the reduced role of the govt in the economy
and the importance of allowing all markets, esp. labor
markets, to operate freely. Their most significant
drawback is almost always the potential high cost in
terms of welfare of negatively affected workers, at least
in the short run.
Interventionist Supply-Side Policies:
These policies are based on the notion that the govt
has a fundamental role to play in actively encouraging
growth, and include:
Education and training: To consistently increase
the quality of labor, it is the responsibility of the
govt to ensure that ed. and training facilities

are geared to providing the skills and

knowledge necessary for a dynamic economy.
o This relates to both the skills and
knowledge needed by young people
entering the labor force and the
retraining of workers to help them
adapt to changing ec. circumstances.
o Such training can occur in schools,
universities, training institutions and
apprenticeship programs.
Research and development: It is important that
an economys firms be able to stay up-to-date
with tech. developments, develop new prod.
techniques and constantly seek improved prod
methods.
o All of the above may increase a
countrys pot. output, but all involve
extensive R&D spending.
o Govts may encourage R&D by firms by
offering tax incentive to innovative
firms (e.g. by allowing firms to not pay
taxes on the retained profits used for
R&D; this is known as a tax credit.
o Firms may be reluctant to spend on
R&D if they know that they will not be
able to benefit fully from their
spending; govts can thus encourage
R&D by guaranteeing IP rights (e.g.
patents, copyrights).
o Govts may also finance R&D directly in
public universities and research
facilities.
Provision of Infrastructure: The prod. potential
of an economy will be enhanced by improved
infrastructure (e.g. better transportation and
communications)
Encouragement of an entrepreneur culture (e.g.
via university degrees for management).
Workfare programs: A govt may opt to provide
the unemployed with simple, low paying jobs
which generally benefit society (e.g. garbage

disposal, basic construction) in lieu of providing

unemployment benefits for those who are able
to work; this avoids some of the pot. problems
with the disincentive effects of welfare
schemes.
Improved Information: Govts can finance trade
fairs to facilitate the sharing of expertise and
info. among a countrys firms.
All of the above interventionist policies have significant
costing implications and govts must consider the opp.
costs of such spending. The benefits of interventionist
supply side policies will likely be more evident in the
long term than in the short term.

Chapter 18: Macroeconomic Equilibrium

National income is equivalent to the output level that a country produces and is a key sign of the
economys health.
The actual output level, and its corresponding price level, are determined by the interaction of
AD and AS.
The equilibrium level of national output (macroeconomic equilibrium): The point where
AD=AS.
o Since we distinguish between SRAS and LRAS, we have both a short run and a long run
macroeconomic equilibrium.
o Macroeconomic equilibrium is closely related to unemployment and inflation, and the
associated policy objectives; joblessness and rapidly rising (or falling!) price levels are
significant macroeconomic problems.
o Short-Run Equilibrium Output: The economy is in SR equilibrium where AD = SRAS.
Graphically, this situation resembles the short-run equilibrium for an industry, although
the axis labels differ.
When an economy is in SR equilibrium, producing an output level Y at a price
level P, the output produced by all firms is exactly equal to total demand in the
economy; there is no reason for producers to alter output levels.
Because AD=AS, there is no inflationary/deflationary pressure
(upward/downward pressure on the price level). As long as AD and AS remain
constant, the economy remains in equilibrium.
o Long-Run Equilibrium Output: Occurs where AD = LRAS.
Given that economists disagree on the shape of the LRAS curve, we distinguish
between Keynesian and Neoclassical long-run equilibrium output.
Keynesian Long-Run Equilibrium Output:

As we know, long-run macro. equilibrium occurs where AD=AS.

According to Keynesians, the equilibrium level of output may
occur at various levels of real GDP.
Significantly, they believe that the economy can be in LR
equilibrium at an output level below the fullemployment level of natl income (Y(f)).
This will be the case if the economy operates where
there is spare capacity; in this view, the equilibrium
level of output depends mainly in the level of AD in the
econ.
If AD intersects the region of the LRAS curve where
spare capacity exists, the equilibrium output level will
occur at an output Y below Y(f) at a price level of P.
Keynesian LRAS can be perfectly elastic due to
the existence of spare capacity, with high levels
of unused FoPs (unemployed workers,
underutilized capital, etc.)
In this case, the equilibrium level of output will
occur below full-employment output; a
deflationary gap exists:
o Deflationary Gap: A situation whereby
the level of AD in the econ. is
insufficient to buy up the economys
potential (full-employment) output.
This case is also known as an
output gap and, though not
easily measurable, can be
shown as the distance from a
point inside a countrys PPF to a
point on the curve.
o In the Keynesian view, AD can increase
such that real output increases w/o any
consequent increase in price level.
o If AD intersects LRAS where the curve is
perfectly elastic (i.e. spare capacity
exists), and AD rises, real output will
initially rise with no corresponding
change in price level, as producers can
employ the unused FoPs to increase
output without corresponding cost
increases; thus, there is no inflationary
pressure.

If AD increases further, to the

transitional region on LRAS, the
economy begins to experience
inflationary pressure, as available FoPs
become scarcer and their prices are bid
up. The price level thus rises (P0->P1)
to compensate producers for higher
costs.
o If the economy operates at full
employment, and AD increases, the
outcome will be purely inflationary;
output does not increase, and the only
change is an increase in price level.
This is because it is impossible
for the econ. to expand output
further in the LR, given the
existing FoPs.
o An increase in AD on the fullemployment phase of LRAS will not
increase output; the econ. cannot
produce output beyond the fullemployment output level. The only
result is an increase in the avg. price
level. Thus, an inflationary gap occurs.
Inflationary Gap: A situation
where the level of AD cannot be
satisfied given the available
resources.
As a result, price level rises to
allocate the scarce resources
among the competing
components of AD: consumers,
producers, the foreign sector
and the govt.
Demand-Side Policies:
The Keynesian perspective of the different poss.
positions of the econ. leads to the conclusion
that the long-run equilibrium level of output
does not nec. occur at Y(f), and that the
economy can rest in equilibrium at an output
level below Y(f).

This implies that the govt has an

important role to play in the economy,
as it can intervene to steer the econ.
towards Yf via demand-side (demandmanagement) policies, mainly via fiscal
and monetary policy.
o Expansionary policies are used to
increase the equilibrium output level by
increasing AD; as increases in real
output imply increases in demand for
labor, such policies are intended to
reduce unemployment.
o Contractionary policies are used to
decrease AD to reduce inflationary
pressure caused by increases in the avg.
price level.
Neoclassical Long-Run Equilibrium Output:
o Acc. to neoclassical economists, the economy will always move
towards long-run equilibrium at Y(f). Thus, LR equilibrium
occurs where AD meets the vertical (perfectly inelastic) AS
curve.
Thus, any changes in AD will only affect the price level;
an increase in AD (AD1->AD2) causes price level to
increase (P1->P2) w/o any increase in real GDP.
In the neoclassical perspective, the transition from
short-run to long-run is significant.
Keynesians and neoclassical economists agree
on the shape of the SRAS curve, but neoclassical
economists argue that the economy will move
automatically (i.e. without govt intervention, as
neoclassical economists believe in free markets)
towards long-run equilibrium. In this view,
there may be a SR increase in output if AD
increases, but the econ. will always return to LR
equilibrium at full-employment output.
The neoclassical perspective can be shown
using a combination of the LR and the SR using
an AD/AS diagram. Initially, the econ is at longrun equilibrium at Yf, where AD=LRAS=SRAS.
o If AD increases (AD0->AD1) due to
changes in any of the determinants of

AD, output will increase along SRAS (Yf>Y1) in the SR (i.e. there will be an
inflationary gap- firms are producing
beyond their normal capacity output).
Acc. to neoclassical economists,
this is only possible in the SR;
output can increase along SRAS
if workers are paid overtime
wages as a short-term solution
to firms excess demand for
labor; however, as the econ.
was at full-employment output
to begin with, no unemployed
resources exist.
In attempting to increase
output, the firms in the econ.
compete for increasingly scarce
labor and capital and, as the
diagram shows, the increase in
AD causes price level to
increase(P1->P2).
The increase in the price level
means that prices in the entire
economy have, on average,
increased, as prices of the rel.
scarce FoPs used by firms to
produce the output now demanded
increase.
The rise in price level means that
the costs faced by firms will
increase as FoP (esp. raw materials,
labor and capital) prices have
increased.
When prod. costs rise, SRAS shifts
left (SRAS->SRAS1); although firms
were willing to supply a higher
output level due to the higher
prices that they received in the SR,
the higher cost of prod. means that
no real gain is made, and firms
reduce output back to Y(f). The

final result is that output returns to

Yf at the higher price level P2.
Assume the econ. is originally at
equilibrium where AD=SRAS=LRAS, at
output level Yf and price level P0. If AD
falls (AD->AD1) due to changes in any of
the determinants of AD, natl output
will fall (Yf->Y1), as will price level (P0>P1), as, with the old nom. wages and a
lower avg. price level, real wages will
have increased, ultimately leading to an
excess supply of labor. In the SR, the
economy will produce at less than Yf
(i.e. there will be a deflationary gap),
but the fall in price level means that FoP
prices in the economy have fallen.
Thus, firms prod. costs fall, and
this results in a rightward shift
in SRAS (SRAS1->SRAS2). The
shift will occur until the econ.
returns to long-run equilibrium
at Yf, at the lower price level
P2.
If FoP costs increase in the SR, SRAS will
shift left (SRAS->SRAS1) as prod. costs
have risen. The avg. price level rises
(PL0->PL1) while output contracts (Y0>Y1); this illustrates stagflation
(inflation combined with lower output
and employment).
Acc. to neoclassical economists,
if the govt does not intervene,
the econ. will return to LR
equilibrium; unemployment will
put downward pressure on
nom. wages, reducing costs and
causing SRAS to shift back to
SRAS(0) at the full employment
output level.
Keynesians, however, argue
that this adjustment is likely to
take a long time, as nom. wages

are sticky downwards. The

govt could also intervene by
increasing money supply
(lowering interest rates) and
thus boosting AD; this
reflationary action will cause
AD to shift right (AD->AD1),
causing the econ. to return to Yf
at a higher avg. price level (PL1>PL2).
The above three cases illustrate the
neoclassical perspective of long-run
macroeconomic equilibrium, with the
important conclusion that long-run
equilibrium output is always equal to Yf,
and that the economy will move
towards this equilibrium without govt
intervention as a result of market
forces.
Acc. to the model, an increase in AD will
be purely inflationary in the LR; thus,
there is no role for the govt to play in
trying to steer the economy towards Yf.
Although there may be deviations from
Yf in the SR, neoclassical economists do
not see a role for the govt in filling
these gaps; they recommend leaving
the econ. to market forces, rather than
using demand-side policies.

Changes in LRAS:
A countrys LRAS is based on the quantity/quality of its FoPs, which
change. Thus, Yf also changes. As potential growth occurs, LRAS shifts
right; the pot. output of the econ. increases.
o A country seeking to increase the rate of econ. growth and full
employment output will use supply-side policies to increase the
quantity/improve the quality of its FoPs. The impact of such
policies largely depends on the view of the econ. that one takes.
Keynesians believe that the impact of an increase in
LRAS will depend on the initial position of long-run
equilibrium of the economy. If the economy operates
where spare capacity exists, the increase in LRAS will
have no effect on equilibrium output.

The econ. is initially in equilibrium at Y below Yf;

an increase in LRAS increases the pot. of the
econ. to produce at a higher output level, but
the AD is insufficient to buy up this potential
and equilibrium will remain at Y.
While Keynesian economists do not
underestimate the importance of supply-side
policies in achieving growth, this emphasizes
the Keynesian view that the govt must
intervene if the econ. is operating below Yf.
Neoclassical economists believe that an increase in
LRAS will have an entirely favorable effect; there will be
an increase in the full employment income level (Yf>Yf1) and a fall in the price level (P->P1); this is why
Neoclassical economists are often called supply-side
economists.
Acc. to this view, supply-side policies are the
most effective way of achieving a countrys
marco. goals.
o Combining the two perspectives, a successful strategy for
sustained, stable ec. growth is a balance between demand-side
and supply-side policies, such that AD can be allowed to
increase, as long as increases in the supply-side of the economy
balance the increase out.
Most devd economies can only sustain 2-3% before
inflation accelerates; thus, govts may need to
moderate demand-side policies such that AD does not
become too high or too low, while using supply-side
policies to ensure that the growth caused by rising AD is
sustainable at low inflation rates.
Macroeconomics: Keynesian and Neoclassical Perspectives:
In general, Keynesian economists believe that:
o Markets, esp. labor markets, do not clear and are slow to adjust
without external intervention.
o An economy can be in equilibrium below Yf, if demand is
deficient, leading to involuntary cyclical unemployment.
o Govts can and should intervene to stabilize the economy if it is
below Yf.
o Fiscal policy is more effective than mon. policy, and control of
the economys growth to prevent excessive cyclical fluctuations
is the best way to achieve ec. growth.

Inflation is usually caused by cost-push and demand-pull

factors.
o The move from SRAS to LRAS is slow, as nom. wages are slow to
adjust.
In general, Neoclassical economists believe that:
o Markets adjust quickly and allocate resources effectively, and
expectations adapt very quickly.
o Economies tend towards Yf in the LR, as prices and wages
change quickly
o Inflation is generally caused by money supply growth in excess
of GDP growth; reducing the growth rate of money supply will
lead to lower inflation without more unemployment in the LR.
Inflation makes firms uncompetitive, discourages
investment, and thus must be kept under control; to do
so, govts must control the money supply.
Govts should limit intervention in the economy as a
whole to controlling inflation by limiting money supply
growth.
o The adjustment from SRAS to LRAS is quick; nom. wages are
quick to adjust.

The Business Cycle:

o In MDC economies, we generally observe a pattern where periods of rising growth are
followed by periods of slowing and sometimes falling growth; this is known as the
business cycle (trade cycle)
Business Cycle: The periodic fluctuations in a countrys econ. activity measured
by changes in real GDP.
The phases of the business cycle are known as boom, recession, trough
and recovery; while the fluctuations are highly irregular in practice, we
illustrate the business cycle using a standard periodic cycle.
In the recovery phase, AD increases and the scale of total output
expands. Consumption and investment rise, resulting in higher levels of
AD and GDP.
o To meet the increased AD, firms take on more workers; thus,
unemployment falls. The newly-employed workers spend their
incomes on durable goods and the process repeats itsekd.
However, capacity constraints in the econ. will
eventually slow down growth rates and lead to
inflationary pressure.
o GDP will reach its highest level at the peak of the cycle (the
boom). However, demand for money for investment will likely
increase interest rates; the combination of higher inflation and

higher interest rates will ultimately cause consumption and

investment to fall.
This is the beginning of the recession phase of the cycle.
Recession: Two consecutive quarters of negative GDP
growth (i.e. falling real GDP).
During a recession, consumption and investment fall;
falling AD will lead to firms laying off workers- thus,
unemployment rises.
If more people are unemployed, still less
consumption will occur; low levels of demand
result in low inflation rates, and potentially
deflation.
At some point, the contraction will come to an end; this is
known as the trough phase. Output cannot continue to fall
indefinitely, as there will always be some employed people to
maintain a given level of consumption, foreigners will demand
exports, govts will run deficits in order to spend, and people
will be able to use savings to finance consumption.
The low demand for money will lead to low IRs; thus,
AD will eventually increase, the economy will enter the
recovery phase, and the cycle will perpetuate.
The second diagram is at a higher level of real GDP than the
first, and each boom is higher than its precedent. This
illustrates the fact that economies go through periodic real GDP
fluctuations around their long-term potential growth trend (in
the simplified diagram, the periodic actual output curve
increases symmetrically along the potential growth rate).
The periodic growth fluctuations are known as the
actual output line, while the economys long-term
potential is shown as a steady rise in output (the
potential growth rate that the economy can sustain
over time; this is not sustainable development!)
Output gap: The difference between pot. and actual
output.
Output gaps may be negative or positive. If
negative, the economy is producing below pot.
output and unemployment is likely to be an
issue; if positive, the economy is producing
above pot. output (i.e. beyond capacity) and
inflation is likely to be an issue.
o This relationship illustrates the possible
short-run tradeoff between inflation

and unemployment in
macroeconomics.
When operating below
potential, unemployment will
be a problem, while, when
operating above potential,
inflationary pressure (a rising
rate of inflation) will occur.
There are no straight answers as to the length and magnitude of a
typical business cycle; one theory (among many) speculates that a
countrys business cycle may be related to its electoral cycle (the
political business cycle theory).
o Acc. to the theory, a govt will stimulate the econ. with
expansionary policies to create a boom before an election, and
put into place less-popular contractionary policies after having
been elected.
Such policies are often criticized, as they can widen the
magnitude of the cycle, with higher unemployment and
inflation levels than there would be, were the economy
left on its own.
In addition, the political business cycle, though
compelling, is likely not the only explanation for the
occurrence of business cycles; another theory is the
multiplier/accelerator model.
o In practice, it is difficult to tell which phase of the business cycle
the economy is in, as the various indicators of a countrys
economic health are not synchronized with the business cycle,
and it is therefore difficult to establish causal relationships
between the various indicators. We distinguish between:
Leading indicators: Give an indication that an
expansion/contraction may occur in the future (e.g.
business confidence, house purchase trends)
Coincident indicators: Show when an
expansion/contraction is occurring (e.g. sales data)
Lagging indicators: Follow the expansion/contraction
(e/g/ unemployment; firms are reluctant to lay off
workers until they are convinced that the economy is in
a recession, and are slow to re-hire workers until they
are convinced that the econ. is recovering).
Business Cycles and International Economics:
o During an expansionary phase, when GDP is rising, an economy
tends to purchase more imports of goods/services, as income is

a major det. of consumption, and consumption rises as incomes

rise; much of what consumers purchase is likely to be imported.
Even if the final products are produced domestically,
they will most likely be produced with
subcomponents/raw materials of foreign origin.
Thus, as incomes rise, import spending is likely to rise.
Also, as inflationary pressure builds during an
expansion, the process of a countrys exports rise,
making its exports less competitive on world markets
and usually leading to a fall in export revenue.
Thus, in an econ. expansion, import expenditure rises
and export revenue may fall, worsening the balance of
trade in goods and services and potentially the curr. acc.
balance.
During a contractionary phase, the opposite occurs; import
spending may fall as people can afford fewer imported
goods/services; exports may become more competitive
internationally due to lower prices, which usually leads to
greater export revenues; thus, the curr. acc. balance may
improve.
Four of the five macroeconomic policy objectives of govts are
linked to the business cycle; as it is difficult to achieve all of the
goals simultaneously, there exists conflict b/w policy objectives,
thus:
Goal:
Expansion:
Contraction:
Ec. Growth
Achieved: GDP
Not achieved: GDP
rises
falls
Low Unemployment Achieved: more
Not achieved:
workers are
workers are laid
needed to
off when less
produce the
output is
growing output
demanded
Low and Stable
Not achievedAchieved: inflation
Inflation Rates
inflationary
falls
pressure builds
Favorable Balance of Not usually
Achieved: the curr.
Payments Position
achieved- the
ac. improves.
balance of trade
usually worsens

The Multiplier:
o If the govt decides to fill a deflationary gap by increasing expenditure, the final increase
in AD will exceed the amount initially spent.

Any increase in AD will result in a prop. larger increase in natl income, assuming
spare capacity exists.
This is explained by the multiplier effect, which is closely related to the circular
flow model of natl income.
Govt spending and private investment are injections into the circular flow; any
injections are multiplied through the econ. as people receive a share of the
income and spend a portion of what they receive.
If a govt spends $100 million building schools, the money goes to many people as
payment for the FoPs that they provide; this includes income for labor provided on the
project (e.g. by plumbers and architects) as well as payments to providers of capital and
raw materials (e.g. concrete, steel, minerals, water and electricity).
The $100 million ends up as income for those who provided the FoPs for the
construction project; these people can either save the income, spend some of it
on foreign goods/services, pay some to the govt as taxes, and spend the rest on
dom. goods and services.
In the first three cases (all three withdrawals from the circular flow), the
income leaves circulation; the money that is spent within the economy
becomes the income of a new set of consumers, who behave the same
way: pay some as tax, spend some on imports, save some, and spend
the rest on dom. goods/services.
During each round of spending, some income is withdrawn from the
circular flow and some is re-spent.
If the govt spends $100 million on the economy and the marginal
propensity to withdraw (the proportion of every additional unit of
income received that consumers will spend on imports, pay as taxes, or
save; MPW=marginal propensity to save + marginal rate of taxation +
marginal propensity to import) is 40%.
o Thus, the remaining income (60% of all additional income) is
spent on dom. goods and services; this is known as the marginal
propensity to consume:
Marginal Propensity to Consume: The proportion of
every additional unit of income received that
consumers will spend on dom. goods/services.
o In our example, when the govt spends its $10^8, it goes to
architects, plumbers, capital suppliers, etc, who cause a leakage
of $4x10^7 from the circular flow via imports, taxes and savings.
The rest is spent on a wide range of dom. goods and services
(e.g. food, clothing, entertainment, repairs).
The recipients of this $60 million behave likewise, with
40% ($3.6x10^7) remaining in the circular flow and
being re-spent and the rest leaking from the circular

flow. This process continues until, after an infinite

number of rounds of spending, there is no income from
the original injection in circulation.
The final addition to GDP, once the money has been
spent and re-spent, amounts to $250 million (2.5x the
value of the original expenditure). Thus, the multiplier
in our example = 2.5; any injection into the circular flow
would contribute 2.5x its amount to GDP.
The multiplier may be found using a series of formulas,
using the values of the marginal propensity to consume
or the marg. prop. to withdraw.

In an economy with mpc=0.5, the multiplier is

equal to 1/.25 = 4; if $50 000 is invested, GDP
will increase by $200 000, in total.
Any change in withdrawals from the circular flow will
alter a countrys multiplier; if taxation rates increase,
the multiplier will decrease, if savings rates decrease,
the multiplier will increase, and if mpm falls, the
multiplier will increase (and vice versa, in all of the
above cases).
The multiplicative effects of a round of spending can be
shown using an AD/AS diagram, with progressively
smaller rightward shifts in AD.
If a govt plans to intervene to fill a deflationary gap, it
must be aware of two things:
An estimate of the gap between equilibrium
output and Yf.
An estimate of the value of the multiplier, such
that it can judge the increase in AD necessary to
inject into the economy such that the gap is
filled.
o Determinants of the size of the
multiplier:
If the economy is open, rather
than closed, consumers will
purchase imports, reducing the
amt. of money passed on at
each stage of the mult. process;
i.e. MPC decreases, reducing
the multiplier.

Interest rates: Higher IRs may

encourage more saving and less
spending, reducing the
multiplier.
Tax rates: With higher tax rates,
more of each pound is given to
the govt and less is spent on
dom. goods/services, reducing
the multiplier.
Marginal propensity to import
depends on:
Relative prices of UK and
foreign goods: to a large extent,
this will be dependent on the
ER.
Quality of the goods and
services produced dom. and
abroad.
Incomes (both domestic and
foreign)
Interest rates: If overseas rates
are high, domestic residents
will want to save abroad and
money will leave the economy;
as the currency will decrease in
value, however, import
expenditure may eventually fall
to compensate.
Speculation: If people think the
dom. currency will fall in value,
thet will sell it now and buy
foreign currency (and vice
versa).
The difficulties in estimating either of these
values illustrate a limitation of govt fiscal policy
aimed at managing AD in the econ.

The Accelerator Effect:

o Firms must always engage in replacement investment to replace capital that is
depreciating.
Depreciation: The loss of value by capital equipment over time

Assuming that firms are working at full capacity and spending a constant amount on
investment to maintain the level of existing capital, a rise in GDP will cause investment
to accelerate.
Income is a determinant of consumption; thus, when GDP rises, ceteris paribus,
consumer demand will rise. If firms are producing at capacity, but wish to
increase output to meet rising demand, they will need to increase the level of
investment to increase capacity; thus, they will have the incentive to invest in
new capital equipment to meet the increase in demand.
This is known as induced investment; firms are induced to buy new
equipment to expand capacity. Induced investment is also counted as
net investment, as it represents investment beyond the level needed to
replace depreciated capital.
o Gross investment: The total level of investment.
o Net investment: Investment which causes an increase in the
capital stock, rather than simply replacing depreciated capital.
Assume that a firm manufactures bongs, with an annual demand of 200
000 units/year, and operates 20 machines to meet this demand. Each
machine costs $20 000, and the firm must replace 1/10 of its machines
per year due to depreciation (the level of technology, and thus the
capital/output ratio, is assumed to be constant and capital is assumed
to be homogeneous). For a more realistic example, take dishwasher
and steel-manufacturing firms with Illinois.
o If AD rises such that demand for bongs rises by 5% to 210 000
units, the firms existing machinery is not able to produce the
extra amount of bongs; thus, if the firm wishes to meet this
demand, it will need to invest in new capital.
o To maintain the original capital/output ratio of 10:01, the firms
will need a total of 21 machines. Usually, the firm spends $40
000 on machines to replace depreciated capital; due to
increased demand, however, the firm is induced to invest in one
additional machine; thus, investment rises by 50% to $60 000
worth of capital. A reasonably small (5%) increase in demand
has led to a 50% increase In investment; investment thus
accelerated when demand rose.
o Conversely, if the level of demand faced by a firm begins to
stagnate, the demand for investment will decrease, even if the
demand for bongs is still increasing, because fewer new
machines in induced investment are needed to supply the
output.
As this will mean that capital producers face severe
cutbacks in demand, thereby likely losing significant
amounts of revenue, they may be forced to lay off

workers, whose demand for bongs will fall. If demand

for bongs falls by enough that QD returns to its original
level, the bong producer would no longer partake in
induced investment, and the capital producer would
need to lay off increasingly more workers.
In addition, if demand falls by enough that the
firm has excess unused capital (which the
model assumes is not initially the case), they
may not need to partake in replacement
investment, either, reducing the revenue of the
capital producer to 0.
If this cycle continues, the economy is likely to go into a
recession, with falling levels of income due to lower
revenues in both the bong-making and capital-making
firms. However, because some replacement investment
will eventually need to occur, the recession will
eventually end as firms begin investing in capital again.
Likewise, as the induced investment is subject to the
multiplier effect, any increases in induced investment
will affect GDP still further. This is known as the
multiplier/accelerator effect and can explain the upward
momentum in the recovery phase of the business cycle
(the same relationship in reverse, as explained above,
can also explain the movement of an economy into a
recession caused by falling AD).
Thus, the level of induced investment will be dependent
on the rate of change of natl income: when GDP rises
rapidly, firms will want to meet increasing demand by
expanding their capacity; however, when GDP growth
rates fall, businesses will no longer need to add to
capacity; investment will return to the original
replacement level.
On an AD/AS diagram, the crucial relationship to note is
the effect of increased (or slowing!) GDP growth on
interest rates; in the first case, AD will shift to the right
by progressively larger amounts as demand for
investments rises. In the latter case, however, AD will
shift right by prog. smaller amounts as investment stalls
and may eventually shift left as the econ. enters a
recession.
Limitations of the Accelerator Model:

Firms often have stocks; if demand increases, they can release stocks, rather
than produce more after having invested.
The capital goods industry may not be able to increase supply; even if firms
want to buy more machines, they may not be able to, esp. in the SR.
With tech. changes, the capital/output ratio may change and firms may not
need to invest as much as before
Firms need to be convinced that the increase in demand is long-term;
otherwise, they may be reluctant to invest and will try to meet demand using
overtime.

Chapter 19: Inflation and Deflation

Inflation
o One policy objective that a govt can pursue is price stability (a low and stable inflation
rate)
o Inflation: A persistent increase in the avg. price level in the economy, as measured by
the Consumer Price Index.
The operative word is persistent; a single increase in prices is not inflation, as
inflation is a sustained increase in the price level. Inflation is NOT simply an
increase in the price of a particular good/service.
We recognize several types of inflation:
Creeping inflation: slowly increasing inflation rates (e.g 5%->6%)
Strato-inflation: High rates of inflation (e.g. 10%-50%).
Hyperinflation: Extremely high inflation rates (e.g. thousands of %;
Hungary in 1945).
o Costs of inflation:
The reason that govts wish to have low inflation rates is b/c there are several
significant neg. consequences of high levels of inflation, which include:
Loss of purchasing power: If the inflation rate is 3%, the avg. price of all
goods and services in the economy has risen by 3%; if incomes remain
constant, consumers will be unable to buy as many goods/services as
they had before the increase in avg. price level.
o There is a fall in real income; thus, there is a decrease in the
purchasing power of income, due to inflation.
o If incomes are linked to the inflation rate, such that workers are
offered cost-of-living increases in line with rising inflation,
they may not face a fall in real income; this is the case for many
jobs, esp. if strong unions exist.
o However, many jobs do not offer the security of inflation-linked
incomes, either b/c workers are on fixed incomes or b/c they
are self-employed.

Inflation reduces the purchasing power of their

incomes, and thus their living standards; income may
be redistributed in a way that runs counter to govt
policy.
o Inflationary expectations are important, in this case; even when
peoples incomes are linked to inflation, they can be neg.
affected if the actual inflation rate is higher than the expected
rate (e.g. if inflation is predicted at 1% and is actually 2%,
workers with inflation-linked incomes that rise 1% will still
suffer a loss of purchasing power).
Decrease in the value of money, reducing its effectiveness as a:
o Medium for exchange: people become less willing to exchange
their goods/services for money, reducing the effectiveness of
markets.
o Store of value: With inflation, money loses value at a greater
rate; people will become less willing to hold on to money, often
purchasing assets instead, reducing the supply of loanable
funds available for investment.
o Unit of account: With inflation, it becomes more difficult to
measure the value of products in terms of money
o Standard of deferred payment: If money decreases in value,
people will be less willing to accept it as payment after a job is
completed, as it will be worth less by that time; this occurrence
will have neg. ramifications for ec. growth.
Detrimental effect on saving: If money is saved in a bank at a nominal
interest rate lower than the inflation rate, the real interest rate
(interest rate adjusted for inflation; i.e. nominal interest rate minus
inflation rate) will be negative; the savings would lose purchasing power
over time.
o In this case, consumers would be better off spending their
money than saving it, as it will have lost some purchasing
power.
o Thereby, inflation discourages saving; if people do save money,
rather than spend on consumption, they might buy fixed assets
(e.g. land, gold), whose value is not as strongly affected by
inflation.
Thus, there are fewer savings available for investment
in the economy, which has neg- implications for ec.
growth.
Detrimental effect on interest rates: Commercial banks earn money by
charging interest on loans. If there is a high inflation rate, banks raise

nominal IRs (thereby deterring consumption and AD) to ensure that the
real IR that they receive remains positive.
Detrimental effect on intl competitiveness: If a country has higher
inflation rates than its trading partners (ceteris paribus), its exports will
be less competitive and imports from lower-inflation trading partners
will become rel. more attractive; this may lead to lower export revenue
and higher import expenditure, worsening the trade balance, and may
worsen unemployment in export industries and dom. industries
competing with imports.
Uncertainty: Firms may be discouraged from investing not only due to a
fall in availability of savings and higher nom. interest rates, but also due
to uncertainty as to future price and cost changes; this will negatively
impact ec. growth.
Labor unrest: This may occur if workers feel that their wages/salaries
are not keeping pace with inflation, and may cause disputes b/w unions
and mgmt.
Shoe-leather and menu costs: With inflation, it is likely that consumers
will need to search for good returns on their savings to protect their
earnings from inflation; these are known as shoe-leather costs. Menu
costs are the added costs to firms of changing prices in advertisements
and displays.
Many of the costs of inflation depend on whether inflation is
anticipated or unanticipated; volatile inflation makes it difficult for firms
and individuals to plan and predict costs in the short and medium term.
o With volatility, businesses and households will take steps to
protect their interests; this will likely result in reduced rates of
growth combined with increases in unemployment, as
consumption and production are reduced to safe levels.
Deflation: A persistent fall in the avg. price level in the economy.
o Two broad explanations for a fall in the price level exist, which economists use to
classify good deflation and bad deflation:
Good deflation: The situation where deflation occurs as a result of supply-side
improvements and/or increased productivity.
An AD/AS diagram can be used to show that an increase in LRAS can
result in an increase in real output and a fall in avg. price level.
o If the real output level increases, we can add. that there is a
lower level of unemployment as more workers are needed to
produce the higher output level.
Bad deflation: The situation where deflation is caused by deficiencies in AD.
Another simple AD/AS diagram may illustrate that a fall in AD will cause
a decrease in price level as well as a decrease in real output.

If real output decreases, it is ass. that unemployment levels will

rise, as firms need fewer workers to satisfy the lower demand.
Both causes of deflation will lower the avg. price level; however, the first is pos.
as it results in an increase in real GDP and a fall in unemployment, while the
second is neg. as it results in a fall in real output and a rise in unemployment.
DO NOT confuse deflation with a falling inflation rate; again, this is where it pays off to
know your calculus. Inflation is the situation where the first derivative of the avg. price
function is positive; i.e. avg prices are increasing, deflation occurs when the first
derivative of the avg. price function is negative (i.e. falling prices), and disinflation
occurs when the inflation rate is falling (i.e. the rate at which the rate at which prices
are changing is falling; the second derivative of the average price level function)
When disinflation occurs, prices fall at a lower rate than they had been falling at
previously.
Costs of Deflation: Although consumers may be pleased, at first, to see falling prices,
many problems are associated with a persistent fall in the price level; it may well be
that the costs of deflation exceed those of inflation. Costs include:
Unemployment: The single greatest issue associated with deflation; if AD is low,
businesses are likely to lay off workers, which may lead to a deflationary spiral:
if prices fall, consumers will put off the purchase of durable goods as they will
want to wait until prices drop still further. This is known as deferred
consumption and is rational- to an extent.
Deferred consumption will further reduce AD; if households become
pessimistic about their ec. future, cons. confidence will fall. Low cons.
confidence will likely further depress AD, and a deflationay spiral will
perpetuate.
Deleterious effect on investment: Where deflation exists, businesses make less
profit, or make losses, as their nom. costs rise, while nom. prices are constant in
the SR; this may lead to layoffs.
In addition, business confidence will likely be low, which will likely
result in reduced investment. This has neg. implications for future ec.
growth.
Costs to debtors: Anyone who has taken a loan (including mortgages for
housing) suffers due to deflation as the value of their debt rises. If profits are
low, it may be too difficult for businesses to repay loans, and many
bankruptcies may occur; this will further worsen business confidence and may
perpetuate a deflationary spiral.
The danger of a liquidity trap(a situation where monetary policy- either
decreases in the IR or increases in money supply- fails to stimulate an economy)
occurring increases, as expectations of falling returns on investment, as well as
decreased consumer and business confidence, make consumers and producers
less willing to take out a loan, even when IRs fall significantly (a large-scale
decrease in interest-rate elasticity of investment occurs).

Due to these costs, govts will often want to reduce deflation; the most
common way that this is done is through expansionary demand-management
policies, used to stimulate consumption, lending, or govt expenditure. In brief,
any policy that encourages consumers to spend, rather than save, their money
should reduce deflation by causing AD, and thus avg. price level to rise; this can
be shown on an AD/AS diagram.
Causes of Inflation:
o These can be divided into three main types; these are:
Demand-Pull Inflation: Inflation that occurs as a result of increasing AD in the
economy, usually due to expansionary govt policies and/or increased consumer
spending (e.g. due to increased cons. confidence).
When illustrated on a Keynesian AD/AS diagram, this can occur when
the economy approaches Yf and AD increases (due to changes in any of
its determinants), or when the economy is at Yf and AD increases.
o If there is a small amount of spare capacity in the econ. an
increase in AD will cause both price level and real output to
rise.
o At full employment, where no spare capacity exists, the
economy cannot expand output to meet increasing AD; in this
case, any increase in AD will be purely inflationary, as FoP prices
are bid up by competing producers, but no further goods can be
produced using the total FoPs.
o In each case, an increase in AD pulls up the avg. price level; the
reasons for the increase could be due to changes in any
components of AD; for instance, due to a high level of cons.
confidence, causing consumption to increase, or due to rising
demand for a countrys exports due to rising GDP abroad, or
due to an increase in govt expenditure, etc.
Cost-Push Inflation: Inflation that occurs as a result of an increase in prod.
costs.
An increase in prod. costs causes SRAS to shift left (SRAS1->SRAS2, if
one were to graph it), resulting in an increase in avg. price level and a
fall in real GDP.
o The causes of cost increases derive from the respective costs of
a countrys FoPs.
Increases in inflation due to increases in labor costs are
referred to as wage-push inflation.
Increases in the costs of dom. capital, components or
raw materials (e.g. due to suppliers gaining monopoly
power via mergers and takeovers) also increase firms
prod costs, creating cost-push pressures.

If a govt places indirect taxes on important raw

materials, cost-push inflation may also occur.
Inflation due to increases in the costs of imported
capital, components or raw materials is referred to as
import-push inflation.
A fall in the value of a countrys currency,
whether intentional or due to market forces,
can cause import-push inflation, as a lower ER
renders imports of capital, raw mats. and
components more expensive, increasing prod.
costs for most firms.
Inflationary Spirals (Demand-Pull and Cost-Push Inflation Combined)
Regardless of the source of the price level increase, inflation is
problematic as it tends to perpetuate itself. This can be shown using an
AD/SRAS diagram.
If AD increases due to increased wealth in the econ. (e.g. due to rising
house prices) then, if the econ. is near full employment, the increase in
AD leads to demand-pull inflation and a rise in avg. price level (p1->p2).
o The higher price level means that costs of FoPs, and thus prod.
costs, rise. Also, because of price level increases, workers will
negotiate higher wages, further increasing prod. costs.
As a result of cost-push pressures, SRAS will shift left
(SRAS1->SRAS2), further raising the price level (p2->p3).
This is not the end of the cycle: higher nom. wages may
give households the illusion that they have more
spending power and encourage increases in
consumption, further increasing AD (AD2->AD3) and
price level (p3->p4); the inflationary spiral perpetuates
itself.
Inflation due to excess mon. growth:
Monetarist economists (an offshoot of the Neoclassical school) have
identified a further cause of inflation. Quoth Milton Friedman (an
adherent to this view): Inflation is always and everywhere a monetary
phenomenon.
o Monetarists believe that the link between money supply and
AD is not only indirect via IRs and investment, but also direct
(i.e. given excess liquidity, households and firms spend more on
goods/services)
o Monetarists argue that excess increases in the money supply by
govts are the leading cause of inflation (while rising costs and
AD can cause temporary bursts of inflation, a long-term price

increase can only be sustained if the money supply is

expanding).
If money supply increases (which can be shown on a loanable
funds diagram), the interest rate (price of money) will
decrease, encouraging higher consumption of durable goods
and investment and thus causing AD to rise.
Acc. to monetarists, if the income velocity of circulation (the
avg. number of times that one unit of currency must be spent in
one year to buy up the economys output) and the number of
transactions of final products are constant, then the quantity of
money and avg. price level are directly related; i.e. an increase
in money supply will cause an increase in avg. price level.
IVC will be constant if the rate at which money is spent
does not change by much over time.
The number of transactions on final products will be
constant when the econ. is near Yf, which implies that
the output level and thus number of transactions in the
econ. cannot rise significantly, esp. in the LR.
As monetarism is a branch of Neoclassical economics, we use
the neoclassical AD/AS diagram to illustrate this point. As
money supply increases, AD shifts right (by a relatively large
amount, as investment is, for monetarists, interest-elastic and
not vulnerable to changes in expectations); because the econ.
rests in equilibrium at Yf in the LR, increases in AD due to
increases in money supply are purely inflationary, causing pricelevel increases (P1->P2).
The Keynesian response to this theory is that the IVC can
change (with more money circulating, people will be more likely
to hold on to money) and that an increase in money supply
could lead to greater output, rather than be purely inflationary
(i.e. when spare capacity exists).

Reducing Inflation:
o The appropriate inflation-reduction policies depend on the type of inflation; as demandpull inflation is caused by excess AD, an appropriate response would be a reduction in
AD; the govt could use deflationary fiscal policy (increase taxes and lower govt
expenditure) and/or deflationary mon. policy (raise interest rates and contract money
supply).
There are problems associated with such policies; first, they are highly pol.
unpopular- the electorate is unlikely to be happy to accept higher taxes if their
disposable income and level of cons. is reduced.
A reduction in govt spending will harm a number of groups in the
country, which may reduce pop. support for the govt.

Higher IRs will also harm debtors (anyone who has taken out a
loan/mortgage in the economy), as repayments on the loans will
increase- a further cause of the policies unpopularity.
Thus, a govt concerned about re-election will be reluctant to combet
inflation using those methods.
However, mon. policy is carried out by central banks which, in most
industrialized countries, are independent bodies whose main goal is the
maintenance of a low and stable inflation rate.
o In many countries, the CB sets an explicit target rate of inflation
and uses changes in IRs to keep inflation within the targeted
range.; other central banks, incl. the ECB and the Fed, have
implicit target inflation rates; thus, the target rate that the CBs
choose is not officially stated.
Central banks are usually independent because govts tend to use mon.
policy to pursue SR pol. objectives, which may result in persistently high
inflation rates as govts running for reelection are reluctant to adopt
contractionary policies (eg. raise IRs) to fight inflation.
o As a result of greater CB independence and inflation targeting,
many countries have successfully avoided high inflation rates.
o Targeting inflation, whether implicitly or explicitly, s beneficial
as it reduces inflationary expectations; as long as people have
faith in the CBs ability to contain inflation, they will not expect
higher inflation rates and will not make demands for wage
increases out of line with predicted inflation rates.
This will keep labor costs from rising explicitly, thus
suppressing cost-push inflationary pressure.
o The more independent the CB, the more likely it is that prices
will be stable.
If inflationary pressure builds up and inflation rises, one
solution is an increase in IRs. CBs keep a close watch on
signs of inflation and are ready to raise IRs to reduce
inflationary pressure; while a govt may be reluctant to
do so, a CB can make the pol. unpopular choice as it is
appointed, rather than elected.
o In the past, price and wage controls were used to control
inflation (this strategy was, in fact, effective, if executed
correctly; e.g. in Nazi Germany under Schacht); however, it is
very unpopular nowadays as it involves direct govt intervention
on markets.
Specifically, the goal of this policy was to control price
and wage growth rates. However, the policies could be

easily circumvented via illegal markets, extra benefits

for workers, overtime and holiday-pay fraud, prevented
firms for attracting the labor they needed through
higher wages, and caused industrial relations problems,
as well as sudden surges in wages and prices (pot.
causing inflation) when the policies were loosened
If inflation is due to high import costs, increasing the value of
the currency will reduce import prices and demand for dom.
exports; however, this strategy may have consequences for
dom. employment.
Nowadays, mon. policy is considered the most effective
demand-management policy and IR changes are seen as the
best weapon against inflation.
Fiscal policy may not be as effective as mon. policy in
fighting inflation as it is difficult for govts to lower
spending or taxes due to their commitments to the
public; even if this were possible, it would take a long
time for the cuts to have any effect on price level.
If inflation is of a cost-push nature, deflationary
demand-side policies may reduce avg. price level, but
they will also lower real GDP and likely cause
unemployment to rise.
In this case, demand-mgmt policies are less
effective than supply-side policies. However, if
inflation occurs, it is often difficult to
distinguish demand-pull from cost-push factors,
and policymakers will likely attempt a range of
solutions; indeed, a balance between the two
types of policies is desirable, as increased
output produced at a lower cost allows an
economys prod. capacity to expand without
causing accelerating inflation.
Monetarists, who believe that inflation is
caused by excess monetary expansion, see a
plain solution: the money supply should not
increase by more than the increase in real GDP
(if GDP rises by x%, the money supply should
also rise by x%).
o If the growth of money supply exceeds
GDP growth, too much money chases
too few goods, and prices will rise to
allocate the scarce output. It is in

practice difficult for govts and/or CBs

to control the money supply in the
economy; the ways in which this is
possible are discussed above (Chapter
16).

Measurement of Inflation:
o It is necessary to have some accurate measure of the increase in avg. price level. The
most-commonly-used statistic that measures inflation is the Consumer Price Index
(occasionally referred to as the Retail Price Index).
Not all prices change by the same amount over a given time-period; e.g. the
price of sugar may increase by 15% while wood prices may rise by 2%. Neither
measurement is representative of the rate of change of average prices in the
econ.
Although the exact statistical methods of measuring inflation differ
between countries (e.g. some countries may consider indirect taxes and
mortgage repayments, while others may not), the central concept is the
same: statisticians choose a representative basket of consumer goods
and services and measure how the price of this basket changes over
time. When the price of the basket increases, the implication is that
the avg. price level has risen.
o A representative basket of goods and services does not
include all goods and services consumed; the number of data
makes measurement of inflation by that method impossible.
o Instead, the countrys statistical agency compiles a list of the
typical cons. goods/services consumed by the avg. household.
The items are grouped into categories, and their prices
are measured each month to calculate the change in
the price of the basket.
It is changes in the avg. price of the basket of goods and
services that are reflected by the CPI. The index is
weighted by the proportion of the average consumers
income spent on each category to account for the
varying degrees of necessity/importance of the
goods/services.
For instance, changes in housing,
transportation and food prices are weighted
much more heavily than changes in clothing
and recreation prices.
The weight given to each category represents
the proportion of the typical households
income that is spent on goods/services from

that category; this will invariably affect CPI

calculations.
The components and weighting of the basket
are determined by household surveys and will
change along with consumption patterns, with
items being added and removed.
The baskets price is measured by collecting
prices form retail outlets throughout the
country, and a natl avg. price (the CPI) is
determined; thus, changes in CPI reflect the
headline inflation rate (the most commonly
used measure of inflation in a countrys
economy).
Problems Involved with Measurement of Inflation:
Measuring inflation using the CPI has one major limitation: while the basket of
products used represents the consumption patterns of the typical household,
this measure will not be applicable to all people; purchasing habits vary greatly.
For instance, the cons. pattern of a family with children will be very
different from that of an elderly couple or that of a Bachelor Frog.
Inflation within a country may vary by region; although regional
inflation figures are published, the national measure is by far the most
widely-used, although it may not accurately reflect conditions in a part.
area.
o If the natl avg. is used as the basis for wage negotiations or
pension changes, these might not accurately reflect living costs
in certain regions and for certain groups.
o This will be harmful if the group has a higher cost of living than
suggested by the natl avg and benefit those whose living costs
are less than the natl avg.
Errors in data collection may limit the accuracy of the final results; because
collecting the prices of all goods bought by households in all possible locations
is impossible, it is necessary to take sample items from a sample of cities and
retail outlets.
The multiple sampling will likely lead to inaccuracies; the larger the
sample, the more accurate the results, but thorough measurements
entail a significant time investment and financial cost.
Statisticians try to account for changing cons. habits by making changes to the
basket; items are added and removed to be more representative of typical
demand patterns.

However, the adjustments take a good deal of time, and if the items in
the basket are changed, the ability of analysts to draw comparisons in
price levels between time periods becomes more limited.
This is complicated by changes in quality of goods over time: when a
computer company upgrades a computer, for instance, the quality of
the product improves, and its price may rise to reflect the
improvement.
o If the computer is in the CPI basket, the price change will
contribute to a higher estimated inflation rate, even though the
product had been altered.
Countries measure inflation in different ways and include different
components, pot. making intl comparisons problematic.
Prices may change for non-sustained reasons. For instance, seasonal
variations in the prices of food or volatile commodity prices may lead to
anomalous and misleading changes in CPI.
o Statisticians attempt to avoid such distortions by identifying a
core rate of inflation that uses the data from the CPI but omits
food and energy prices.
The CPI only measures changes in consumer prices, but other price
changes are also important in judging the progress and prospects of an
economy.
o Thus, economists also measure changes in prices for producers
and commodity prices (one such specific measure is the GDP
deflator, used to adjust the natl income of a country for
inflation). These measurements provide economists with a
forecast of possible cost-push pressures.

Chapter XX: Unemployment

A low level of unemployment is one of the main macro. goals of any govt. Unemployment s a
significant issue, and a low and falling unemployment rate is usually seen as a sign of improved
econ. health.
There are several key points and issues associated with unemployment that are worth
mentioning:
o Unemployment essentially means joblessness, although the actual definition is far
more nuanced.
o A change in the unemployment rate of even 0.1% is considered newsworthy.
o The unemployment rate is affected by the rate of job creation in the econ.
o The number of jobs created will vary between industries (e.g. mfg., services) and
demographics (e.g. men, women).
o While a country will publish a natl unemployment rate, the rates in different regions
will vary from the natl avg.

Many factors, incl. raw material costs, ERs and intl ec. conditions, will affect the
unemployment rate.
o The unemployment rate will affect wage rates.
Unemployment: The incidence of people of working age who are without work, available for
work, and actively seeking employment.
o Unemployment Rate: The number of people who are unemployed expressed as a
percentage of the total labor force [Note: NOT the population].
o Total Labor Force: The economically active population: those who are of working age
and are either employed or actively seeking employment.
The working age, which varies b/w countries, is the specified age at which
people are legally allowed to start work and receive retirement benefits.
Anyone outside of this age is not part of the workforce.
Students currently in school, as well as stay-at-home parents, retirees and those
who choose not to work, or are unable to work, do not actively seek
employment; thus, they are not part of the workforce.
Although they do not have jobs, these groups are not considered
unemployed, as they are not seeking employment and thus not in the
labor force.
As a result, it is difficult to measure the size of the labor force and the
unemployment rate. Each country has its own natl system for measuring
unemployment; information is usually gathered from natl censuses and
surveys, along w/ admin. records and soc. security info.
There may be inaccuracies in such data, and the specific definition of
unemployment is inconsistent from country to country.
o For instance, unemployment may be based on the people
registered as unemployed (labor force survey; e.g. in Austria), or
as the number of people receiving unemployment benefits
(claimant count; e.g. in Belgium).
In the UK, unemployment is defined as those who are
in receipt of unemployment benefit and who are able to
undertake any suitable work, excluding groups such as
school-leavers and members of the labor force over 60
who are unemployed but not in receipt of
unemployment benefits.
o Even with those approaches, accurate measurement of true
unemployment rates is difficult; e.g. the incentive to register as
unemployed will depend on the availability and size of
unemployment benefits.
A person who is not entitled to any benefits has no
incentive to register as unemployed.

In addition, the statistics omit the incidence of

discouraged workers: those who have been
unemployed for long enough that they have given up
searching for a job, are no longer eligible for benefits,
and are no longer part of the labor force.

Distribution of Unemployment:
Besides the measurement difficulties, a further limitation of the unemployment
rate is the fact that, as it is a natl average, the official unemployment rate
(much like the headline inflation rate) is likely to gloss over inequalities among
different groups in the econ.
The national rate, therefore, is not an entirely accurate basis for making
conclusions about different groups of people.
Some of the typical disparities that exist among different groups of
people in a country include:
o Geographical disparities: Unemployment will likely vary quite
markedly among regions in a country, as most countries have
regions that are more prosperous than others; inner city
unemployment, for instance, is likely much higher than
suburban unemployment.
o Age disparities: Unemployment rates in the under-25 age group
are usually higher than natl averages due to frictional
unemployment.
o Ethnic differences: Ethnic minorities often face higher
unemployment rates than the natl avg; this may be due to
differences in educational opportunities, language/cultural
barriers or, in some cases, discrimination and prejudices from
employers.
o Gender disparities: Unemployment rates among women tend to
be much higher than rates for men in many MDCs due to
differences in education, employer discrimination, or other
social factors.
Costs of Unemployment:
Govts prioritize the reduction of unemployment levels b/c employment
represents a sig. cost to the econ. The costs of unemployment increase the
longer people are unemployed; the costs below are those of long-term
unemployment
The associated costs can be broken down into categories:
Costs of unemployment to the unemployed themselves: The
unemployed face several major costs. First they receive less income
than they would if they were employed, even assuming that they qualify

for unemployment benefits; if no benefits are available, the situation is

even worse.
o A reduction in income implies a lower living standard for the
unemployed and pot. also for their families.
o The costs worsen the longer the people are unemployed; it is
likely that a person who remains unemployed will become
increasingly dejected and suffer from stress, and pot. anxiety
and depression. Erosion of mental health can lead to
relationship breakdowns and, on a broader level, higher suicide
rates.
Costs of unemployment to society: the social costs of unemployment
are most apparent in areas with high levels of poverty, high crime and
vandalism rates, increased gang activity, etc. While these problems are
not entirely due to unemployment, researchers have found correlations
between them and high unemployment rates.
Costs of unemployment to the econ. as a whole: A PPF can be used to
show the key econ. problem created by unemployment: if actual output
is less than pot. output because some portions of the labor force are
unemployed, the economy is foregoing poss. output, operating at a
point within the PPF.
o This loss of output, and income to the unemployed, will neg.
affect the econ. as a whole. For instance, there is an opp. cost
involved in govt spending on unemployment benefits.
If the unemployed, who have lower incomes, pay less
direct tax and consumer fewer goods (which are
indirectly taxed), the govt loses pot. revenue;
consumption also falls, decreasing AD and possibly
beginning a positive feedback cycle.
Thus, the govt may need to spend more money to
resolve the soc. problems created by unemployment,
which is in itself costly.
Factors Affecting the Level of Unemployment:
At any given moment, a number of people will be unemployed; this is referred
to as the pool of unemployment.
This pool will be in a constant state of change, as, at any time, some
people become unemployed, while others gain employment.
o The level of unemployment depends on the relationship
between these two trends. If more people are becoming
unemployed than gaining jobs, the unemployment level will
rise; if more jobs are created, and more people are taking up
jobs than losing jobs, unemployment will fall. These

movements are known as inflows and outflows into/from the

pool of unemployment.
Inflows into the pool of unemployment:
People who have lost their jobs
People who have resigned
People who have left school but not yet found
work
People trying to return to work after having left
it (e.g. stay-at-home parents returning to the
workforce)
Immigrants who have not yet found work.
Outflows from the pool of unemployment:
People who find jobs
People who retire
People who go (back) into education
People who choose to stay at home and look
after family.
Emigrants to other countries
People who give up the search for jobs.
[Note: Other than the first point, the people are
no longer listed as unemployed because they
have left the labor force: they are no longer of
working age, available for work and actively
seeking employment
o The inflows and outflows to/from the pool of unemployment
affect the supply of labor in an economy at a given time; this,
along with demand for labor, will determine employment and
unemployment levels in an econ.
Causes of Unemployment:
Unemployment may be classified in two broad categories, which relate closely
to the causes of unemployment. These categories are equilibrium and
disequilibrium unemployment; to analyze each type, an understanding of the
macroeconomic labor market is necessary.
The labor market for an economy can be shown using a diagram, on which the
Y-axis represents the price of labor, as measured by the avg. real wage rate.
Average real wage rate: The avg. level of wages, adjusted for inflation.
The X-axis represents the total quantity of labor in the economy; thus, the labor
market represents demand and supply for all labor in the economy.
Demand for labor is a derived demand, as firms only demand labor due
to demand for the actual goods and services that they produce.

Thus, the demand curve, which is curved and slopes downwards, is

called the aggregate demand for labor, as it includes the demand for all
labor involved in the prod. of an economys output, rather than that for
a specific type of worker. ADl includes demand for assembly line
workers, school directors, porn stars, etc.
The ADl curve shows the total demand for labor at any given avg. wage
rate; the curve slopes downwards because, at a lower wage level,
producers are more willing and able to take on more labor, and the QD
for labor thus increases.
o As the wage level increases, firms attempt to reduce the
amount of labor that they use by laying off less-necessary
workers and/or exploiting capital-intensive prod. methods.
o ADl will shift right if:
Labor, on average, becomes more efficient and thus less
expensive (e.g. through increased use of capital, better
training, and more effective management).
If AD rises in the economy; i.e. if consumers, other
firms, the govt, or foreigners demand more of an
economys output.
The aggregate supply of labor curve shows the total number of an
economys workers that are willing and able to work in the econ. at any
given wage rate; as the avg. wage rate increases, more people are
willing to work; thus, ASL slopes upwards and is curved.
o ASl is determined by:
The flexibility of labor markets: how easy it is for firms
to hire/fire employees.
The size of the labor force (thus, the population size,
the working age, and the retirement age; note that this
does not preclude some unemployment from
occurring).
Working conditions and job security in the economy
(this cuts both ways: with better working conditions and
job security, people will be more willing and able to
supply their labor, but firms may be less willing or able
to employ the workers due to the probable increase in
costs).
The degree of information about jobs in the economy
The ability of workers to take on particular jobs within
the economy (e.g. there may be too many coal miners
in the economy, or too few IT geeks).

Wages and job conditions in other countries which

workers can emigrate to.
Attitudes to work (e.g. attitudes towards women (and
gays!) serving in the military).
Tax rates on the incomes of employees.
Note that an individual taking on a job incurs an opp.
cost in the form of foregone leisure time; the decision
whether or not to work will depend on the income and
substitution effect. For example, if average real wage
rates increase,
The opportunity cost of leisure rises, as employees give
up more money for every hour they are not working
than they had been beforehand. Workers will, to an
extent, substitute leisure for work.
As more money is earned for every hour worked, an
employee may feel that he or she can now work less
hours and still earn a satisfactory amount of income.
Usually, the substitution effect outweighs the income
effect and people will want to work more hours when
the wage increases; however, in practice (not shown by
the ADl/ASl model), the income effect outweighs the
substitution effect at high real wage rates and people
may decide to work less when the wage increases; this
would create a backward-sloping ASl curve.
The labor market is in equilibrium where ADl=ASl; although it resembles
any micro. supply and demand model, it is a macro. model, as it
describes aggregates in the econ. The equilibrium wage rate is
established by the interaction of ADl and ASl and usually noted We.
In practice, labor markets are imperfect to some degree, due to several
reasons, listed below; these reasons are potential causes of
unemployment:
o Imperfect information: Workers may not know what jobs are
available
o Immobility: workers may not be able to move from one job to
another due to occupational or geographical immobility. We
distinguish between:
Occupational immobility: the situation where people
cannot move from one job to another because they lack
the right skills or do not know that the job exists.
Geographical immobility: The situation where workers
have difficulties moving between jobs in different parts
of the country (e.g. because they may have children in

education, family and friends in their current location,

or moving is too expensive due to removal costs and
housing prices).
o Employers may not be profit maximizers; they may pay more
than they need to. Also, employees may not be rational in
the economic sense: they may stay with a company which offers
lower wages than other firms out of loyalty.
o There may be monopoly buyers (monopsony in a particular type
of labor; e.g. Springfield Nuclear Power Plant and reactor
technicians) or monopoly sellers (closed-shop unions) on labor
markets in the economy.
o Exploitation: The situation where employees are paid less than
their value; this often occurs if many employers in strong
bargaining positions exist in the economy (e.g. if they are
monopsonists-the major employers in significant industries).
The labor market is a key element of the econ. and its ability to clear,
which depends on the flexibility of wages, is important; if AD falls and
there is an excess supply of labor, in a perfectly competitive world, nom.
wages will fall and the labor market will clear; the econ. will remain at
Yf. However:
o Unions may fight any decrease in wages.
o Wages are often negotiated in advance and may take time to
fall; if wages do not fall, there could be extended periods of high
disequilibrium unemployment.
o While neoclassical economists believe that nom. wages and
prices are flexible, and thus the econ. tends towards full
employment, Keynesians believe nom. wages and prices are not
always flexible and labor markets, as well as the economy as a
whole, do not necessarily clear; the economy may be in
equilibrium below Yf.
Disequilibrium unemployment (sometimes known as involuntary unemployment): A
situation where some condition prevents the labor market from clearing (reaching
equilibrium); this form of unemployment is considered involuntary as workers are
willing and able to accept jobs at the given real wage rate, but no job is available for
them.
Two types of disequilibrium unemployment exist:
Real-Wage (Classical) Unemployment: Disequilibrium unemployment
caused by trade unions, minimum wages and govt intervention
interfering with the labor market (e.g. unemployment as a result of
Pennsylvanias min. wage law.
o This form of unemployment reflects the neoclassical view that,
if unions negotiate wage rates above equilibrium, or if govts set

wages above equilibrium at the enforced wage level W1, ASl >
ADl and unemployment (Qd->Qs) is created.
In effect, this situation represents a surplus of labor on
the market; unemployment is caused by there being
more workers that seek jobs than firms are willing and
able to hire at the imposed wage rates. The unions or
the govt prevent the market from clearing.
o Solutions to real-wage unemployment: The solution to real
wage unemployment is clear; if unions are preventing labor
markets from clearing, the govt could reduce their ability to
negotiate higher wages; if the min. wage prevents the barket
from clearing, it could be reduced or abolished. Both of the
above represent supply-side policies.
Several problems with these solutions exist. First,
reduction of union power may be difficult. Further,
such policies would, in effect, harm low-income workers
the most; while high income workers are largely
unaffected, the reduction of minimum wages will
reduce income and living standards for min. wage
workers.
The policy could thus worsen income inequality
in the econ.
Cyclical (demand-deficient) unemployment: Disequilibrium
unemployment caused by cyclical downturns in the economy (e.g
layoffs during the 2008 Recession).
o As the econ. moves into a period of slowing/neg. growth (e.g. a
recession), AD tends to fall as consumers spend less on
goods/services; thus, ADl will also fall as firms scale back
production.
o If the labor market is initially in equilibrium with an equilibrium
wage level We, and the econ. slows down, ADl shifts left as
firms reduce their output (ADl->ADl1).
If labor markets functioned perfectly, the avg. real wage
would fall (We->W1); however, this is not the case as
wages are sticky downwards; while wages can easily
increase, it is less likely that real wages will fall.
This is due to several reasons: firms realize that
paying lower wages will lead to discontent and
reduced motivation among workers, which
would reduce productivity and would be
undesirable; in addition, firms may not be able

to reduce wages due to labor contracts and

union power.
o Thus, wages will likely remain stuck up
at We, ASL will exceed ADl, and
unemployment (Qs->Qd) will be
created.
o This form of unemployment is
sometimes called Keynesian
unemployment, as Keynes observed
that, when an econ. operates well
below Yf, high unemployment is a likely
occurrence.
o Solutions to cyclical unemployment: As the problem is due to a
low level of AD, the solutions to this type of unemployment are
expansionary demand-side (fiscal or monetary; increasing govt
expenditure, lowering direct taxes or interest rates) policies by
the govt which aim to provide more jobs.
Equilibrium Unemployment (sometimes known as voluntary unemployment):
The situation where unemployment exists, despite the labor market being in
equilibrium (i.e. no cyclical or real-wage unemployment is occurring).
This occurs as other types of unemployment occur even when the labor
market is in equilibrium. At labor-market equilibrium, the number of
job vacancies is the same as the number of people seeking work.
o Where there is no disequilibrium unemployment, then, the
economy is at full employment in terms of labor.
o However, while jobs exist, people may be unwilling/unable to
take the available positions.
o Arguably, all equilibrium unemployment is voluntary, as:
Frictional unemployment is voluntary, because people
have decided to search or another job.
Seasonal unemployment is voluntary because people
have chosen to take a job in which they are only
seasonally employed; they could take other work in the
off-season.
Structural unemployment is arguably voluntary if
workers who have left a job in a declining industry are
unwilling to accept a job at a lower wage rate in another
industry.
Although not equilibrium unemployment, real-wage
unemployment may be seen as voluntary as workers or
unions have decided to push up wages and
volunteered some workers for unemployment.

o
o

To illustrate this situation, we introduce a new curve to our

labor-market diagram, showing the total labor force.
While the ASl curve shows the number of people willing and
able to work at every given wage rate, there will be, at any
given time, more people looking for jobs than people who are
willing and able to take the jobs available.
While, at We, Qe people are willing and able to take
jobs, unemployment equal to the distance between ASL
and TLF at We (Qe->Q1) exists.
What the diagram shows is that, because no labor-market
disequilibrium exists, jobs are available, but (Qe->Q1) people
are unwilling/unable to take them.
For instance, even if job vacancies in the service
industry exist, unemployed assembly-line workers are
unable to accept the jobs as they lack the necessary
skills; alternatively, if jobs are available at McDonalds,
unemployed bankers might be unwilling to take them
out of pride. Finally, jobs may be available in an
industry, but imperfect information could restrict
unemployed peoples access to them.
In each of the above cases, the unemployed
workers are unable (the assembly-line workers)
or unwilling (the bankers) to take the available
jobs.
The ASL and TLF curves converge at higher wage rates; this is
common sense- at low wage rates, fewer workers are willing to
work; some people would rather be unemployed than take the
available jobs.
As the real wage rate rises, more people are willing to
take the available jobs and the gap b/w the two curves
decreases.
Natural Unemployment: The sum of the three main types of
equilibrium unemployment (frictional unemployment, seasonal
unemployment, and structural unemployment).
An economy is at full employment when the only
employment that exists is natural unemployment.
The common feature to all three types of natural
unemployment is that jobs exist, but people are
unwilling or able to take them.
The solutions to each type of nat.
unemployment are thus designed to increase
the willingness and ability of the unemployed to

take the available jobs. As a result, ASl will shift

right.
o These solutions are thus labor marketoriented forms of supply-side policies,
as they are designed to improve
quality/increase quantity of labor.
Again, we distinguish b/w
market-oriented and
interventionist supply-side
policies. The interventionist
policies rely on govt
involvement on labor markets,
while the market-oriented
policies emphasize the
importance of allowing the
labor market to function freely
without intervention.
Frictional Unemployment: The short-term
unemployment that occurs when people are in between
jobs, or have left education and are waiting to take up
their first job (e.g. college graduates looking for a job).
This type of unemployment is clearly natural, as
it is natural for people to leave jobs in the hope
of finding better ones. Thus, it is not generally
seen as a neg. outcome in a dynamic economy.
If people leave a job, the ass. is that they will
find a job where they can be more productive;
as soon as such members of the LF get a job,
they will be able to contribute more to the
econ.
Solutions to frictional unemployment:
o Although frictional unemployment is
not a serious problem in an economy,
as it is short-term in nature, govts may
act to reduce this level of
unemployment if they believe that
people remain unemployed for an
unacceptably long time.
Some economists argue that
people have little incentive to
find a job if the unemployment

benefits available to them are

generous and allow them to
take their time when looking.
Thus, free-market economists
argue that govts should lower
unemployment benefits to
encourage unemployed
workers to take the available
jobs, rather than allow them to
wait for a better one to come
along.
If unemployment benefits were
reduced, the unemployed
workers may become more
willing to work, thus shifting ASl
right.
o Sometimes the frictionally unemployed
remain out of work because they are
not aware of existing vacancies. In this
case, frictional unemployment can be
reduced by improving information flows
between employers and the
unemployed via job fairs, news papers,
the Internet, and employment
counselors; this represents a more
interventionist solution.
Seasonal Unemployment: Unemployment caused by
demand for certain types of workers falling at certain
times of the year.
This is a natural occurrence in many countries
(e.g. many construction workers are laid off
during the winter in Poland, and farmers cannot
harvest crops during winter). Seasonal
unemployment is common in tourism: ski
instructors will be unemployed in the summer
and many lifeguards will be unemployed in the
winter.
Solutions to seasonal unemployment:
o Such unemployment can be reduced by
encouraging workers to take different
jobs in the off season; for example.

via reduced unemployment benefits

and greater information flows.
Structural Unemployment: Unemployment caused
when changes in the structure of an economy cause a
permanent fall in demand for a particular type of labor
(e.g. the collapse of the Walloon coal industry).
This is by far the worst type of equilibrium
unemployment, but is natural in a growing
economy, where newer, dynamic industries
(e.g. IT, services), will replace jobs in the mfg.
sector (e.g. coal mining), causing
unemployment.
Structural unemployment is harmful as it results
in long-term unemployment: people who lose
their jobs in one area lack the skills to take the
newly-created jobs (they lack the occupational
mobility to change jobs).
In addition, jobs may be created in one type of
the country, while unemployment is
concentrated in another region. If structural
unemployment occurs on a rel. small scale (e.g.
Flint, MI), it is known as regional
unemployment, and the workers lack the
geographical mobility required to seek
employment elsewhere.
Several causes of structural unemployment
exist:
o New technologies can make certain
types of labor unnecessary. By
definition, automation reduces demand
for labor (e.g. ATMs largely replaced
human bank tellers). This is known as
technological unemployment.
o Demand for a part. type of labor may
fall due to lower-cost labor abroad. For
instance, there is less demand for auto
workers in the US as a result of
competition with foreign manufacturing
plants whose costs are lower, resulting
in higher unemployment in the US auto
industry.

Changes in consumer tastes can lead to

a fall in demand for a part. type of
labor; e.g. people in some areas, when
given the choice, tend to consume
alternatives to fossil fuel energy due to
the neg. externalities involved with
fossil fuel combustion; as demand for
fossil energies has fallen in those
countries, unemployment in coal
mining has increased.
Interventionist solutions to structural
unemployment: The key to these solutions is
increasing the occupational mobility of people,
such that they become more able to take
available jobs.
o A long-term solution is educating
people to be more occupationally
flexible- as people in MDC economies
will often have to change jobs several
times in their lives, an ed. system
teaching the skills required to adapt to
rapidly changing ec. conditions would
reduce structural unemployment.
o Another strategy to improve occ.
mobility is expenditure on retraining
programs to help workers acquire the
skills necessary to find new, stable jobs.
Govts could also subsidize
firms that provide training for
their workers.
o Govts could provide information about
job vacancies and help the unemployed
with job applications in industries that
they are unfamiliar with.
o If jobs exist in some regions but not
others, govts might provide
subsidies/tax breaks to encourage
unemployed people to move to those
areas, enhancing geographical mobility.
o Govts (e.g. Germany, Austria) can
support apprenticeship programs that

teach pot. workers the skills needed to

enter the LF.
o These solutions have two main
disadvantages: first, they likely involve a
high opp. cost as govts will have to
forego spending in other areas or raise
taxes to afford the strategies.
Second, the policies are not
very effective in the short term.
Market-Oriented Solutions to Structural
Unemployment- the key to this set of solutions
(mainly supply-side policies) is increasing
incentives for people to take up available jobs:
o Market-oriented solutions for structural
unemployment broadly resemble those
for frictional unemployment: if govts
reduce unemployment benefits or
income tax, the unemployed may have
a greater incentive to take up available
jobs, by increasing the opp. cost of not
working (this is only effective, however,
if jobs that meet their skills do, in fact,
exist)
o Market oriented economists feel that
govt intervention and labor regulations
reduce labor market flexibility and
discourage firms from hiring workers.
They would argue that deregulation of
labor markets (e.g. by loosening
hiring/firing regulations by loosening
legislative barriers) would create an
incentive for firms to hire more
workers, thereby reducing
unemployment.
The govt could legislate, for
instance, to reduce barriers to
people accepting jobs (e.g.
closed-shop factories).
o The cost of such policies falls on two
groups. First, those who lose
unemployment benefits will have lower

living standards, and the policy may

increase income inequality in the econ.
Second, labor market
regulations are often put into
place to protect workers from
unfair treatment (e.g. being
fired w/o due cause) and grant
them decent working
conditions (e.g. reasonable
hours, vacation time,
occupational safety). If labor
markets are deregulated,
working conditions for labor
may worsen.
Although unemployment might
fall and GDP might rise, there
may be a high cost to the
workers themselves; again, this
can contribute to income
inequality, where the benefits
of growth are not shared by all.
Solutions to Regional Unemployment:
o This set of policies, which aims to
reduce unemployment and increase
incomes in depressed regions/areas,
contains varying degrees of marketoriented and interventionist elements,
and includes:
Subsidies and tax concessions:
are often used to encourage
new firms into the area and to
encourage existing firms to hire
more people.
Provision of facilities in
depressed areas (e.g. better
infrastructure)
Adjustment of tax rates such
that firms in richer areas are
taxed rel. more than those in
less wealthy areas, creating an
incentive to divert production,

and thus employment, to

depressed regions.
Regulation: the govt can make
it more difficult for firms to
expand in wealthier areas and
easier for them to expand in
poorer areas.
Creation of enterprise zones
(e.g. in Detroit): small districts
in urban areas, which provide
major incentives for firms
setting up there (e.g. tax
exemptions, less bureaucracy)
Relative Effectiveness of Demand-Side and Supply-Side Policies in Reducing
Unemployment:
The solutions to unemployment are dependent on the type of
unemployment; if an economy is experiencing cyclical unemployment
due to an econ. downturn, demand-management policies would be
suitable.
o Several concerns relating to such policies arise: in order to use
expansionary fiscal policy, govts may need to run budget
deficits, spending more than their intake in revenues.
This is not nec. a problem, esp. in the SR, but may lead
to fiscal problems in the LR.
If govts reduce taxes, consumers will not spend all of
their additional disposable income, rendering the
increase in AD rel. lower than with an expenditure
increase, esp. as consumer confidence is usually low in a
recession, making saving rel. attractive; this tends to
depress AD.
If govts lower IRs to encourage spending, there is no
guarantee that consumption and/or investment will
increase, esp. if there is low business confidence, as is
often the case in a recession.
Even when successful, there will likely be a lag before
these policies come into full effect; it is possible that AD
will increase after the economy had recovered, causing
the stimulus to be inflationary.
Another problem with the solutions is that, even at Yf,
there will still be natural unemployment, which is best
countered by supply-side policies.

Using demand-side policies against natural

unemployment would be unsuccessful, as the
economy is producing near Yf at full
employment, rendering any further AD
increases inflationary.
In practice, it is difficult for policymakers to distinguish
b/w the diff. types of unemployment, esp. as an
economy usually suffers from several types of
unemployment at once.
Thus, govts usually use a mix of demand-side
policies (to manipulate interest rates, narrowing
business cycle fluctuations and reducing output
gaps) alongside supply-side policies (to ensure
that labor is skilled and flexible enough to adapt
to changing ec. conditions, such that LRAS and
ASl continuously shift right).
Neoclassical and Keynesian Views of Unemployment:
o Neoclassical economists believe that nom. wages and prices are
flexible and adjust quickly, so that the real wage is at the right
level to quickly achieve LR equilibrium in the labor market,
which clears quickly and is either at or approaching Yf, even
during periods of slowed or falling ec. growth.
Thus, all employment is voluntary, acc. to this view.
o Keynesians believe nom. wages are slow to adjust (e.g. due to
money illusion, fixed contracts, or a desire by employers and
workers for LR wage stability); thus, the real wage may not
adjust to clear the labor market, leading to some involuntary
(cyclical/demand-deficient) unemployment.
Acc. to Keynesians, the issue of downward wage
stickiness in a recession could take a long time to
resolve itself, justifying govt intervention on labor
markets.
Crowding Out: A situation where govt expenditure financed by real borrowing from a fixed
supply of loanable funds (i.e. deficit expenditure financed by loans) causes a decrease in privatesector consumption and investment (e.g. [arguably] the UK public sector in the 1960s).
o As the money supply is fixed, by borrowing money through the sale of bonds and
treasury bills to fin. institutions (who then sell them to potential savers), the govt
increases demand for the loanable funds in the economy. Supply of loanable funds
(which represents the total amount of savings available to fin. institutions in the econ.)
is perfectly inelastic; thus, the only effect of the increase in demand for loanable funds
by the govt (D0->D1) is an increase in the interest rate (i1->i2); thus, the price of

money, and therefore, the cost of borrowing money to consume durable goods/invest,
increases.
On an investment schedule, it is clear that the higher interest rate will decrease
firms willingness and ability to invest (as the cost of investment- the interest
rate- rises (I0->I1)).
The higher interest rate causes AD to decrease (this may be shown on
an AD/AS diagram, with an initial increase in AD followed by a
subsequent, smaller fall in AD); while the govt attempted to stimulate
AD by increasing govt expenditure, the higher IR caused interestsensitive private investment to fall (private investment was crowded
out).
The extent to which crowding out occurs is (surprise, surprise) hotly
contested.
o Keynesians believe that investment is motivated mainly by the
need to replace depreciated capital and match increases in
consumer demand. As firms have little choice in either task,
investment is interest-inelastic and an increase in IRs will
decrease investment by a less-than-proportionate amount. AD
will not be greatly affected.
In addition, because, below full employment, firms can
fall back on stocks of products and reserve capital,
Keynesians argue that crowding out is unlikely to occur
below Yf.
o Neoclassical economists, on the other hand, argue that firms
tend to invest autonomously, choosing to expand their capacity
and scale of output to become more competitive, and thus
defer investment until interest rates fall, as they seek to
minimize costs.
Thus, investment is interest-elastic; an increase in IRs
will reduce investment by a greater-than-proportionate
amount, AD will significantly decrease (perhaps to the
point where the increase in govt spending is fully
canceled out), and thus crowding out is a major
problem of increased govt spending.
Economists have suggested two further forms of crowding out:
Physical crowding out: If an economy is near its prod. capacity, increased
spending on govt projects could see resources (esp. labor) diverted from the
private sector to the public sector (the neoclassical school would argue that this
effect causes an efficiency loss)
Psychological crowding out: A situation where the private sector worries about
what it sees as too much govt intervention in the econ.- fearing future tax
increases, the private sector may delay/cancel certain projects.

Chapter 21: Phillips Curves

Two major macroeconomic policy objectives are low and stable inflation rates and low
unemployment levels. As should be utterly predictable by now, there is much debate as to the
relationship between these two ec. problems.
The Phillips Curve: An economic model which suggests that there is an inverse relationship
between the inflation rate and the unemployment rate in the economy.
o The original Phillips curve presented the argument that there was an inverse
relationship between the rate of change of nominal wages (wages not adjusted for
inflation) and the rate of unemployment.
The reasoning behind the model was that, at low unemployment rates, firms
would need to pay higher wages to attract labor. Conversely, if unemployment
was high, workers would be competing with each other to obtain the available
jobs, keeping the level of nom. wages offered rel. low.
During an econ. expansion, when more output is demanded and more workers
are needed, wages rise more quickly than they would in the case of a
contraction in ec. activity and lower AD.
The rate of change of money wages could actually become negative- wages
could fall at high unemployment rates as workers would be willing to accept the
higher wages rather than remain unemployed.
The relationship was later adapted using data from many countries and revised
to establish an inverse relationship b/w the inflation rate and unemployment
rate of the economy, due to the fact that, as wages represent a large share of
firms costs, wage changes contribute directly to changes in the price level.
The resulting Phillips curve can be inexactly approximated by the
equation y=(1/x)-1, with the inflation rate on the Y axis and the
unemployment rate on the X axis
o In the short run, a Phillips Curve will intersect the horizontal axis
at the natural rate of unemployment.
This graph shows a tradeoff between inflation and unemployment; the
inflation rate would need to rise in order to achieve a fall in
unemployment, and vice versa; as one variable decreases, the other
increases.
o Thus, if a govt aims to reduce unemployment, this can be done
at the expense of a higher inflation rate; if the govt wishes to
reduce inflation, it will need to allow the unemployment rate to
increase.
In theory, an economy could operate at any point along
its Phillips curve, with govt intervention managing the
economys position acc. to its policy objectives.
o AD/SRAS diagrams can be used to illustrate the tradeoff;
assume the econ. is initially at equilibrium at real output Y and

price level P. If the govt wishes to increase employment, it

could use demand-side policies to cause AD to increase (AD0>AD1).
The policies will result in an increase in output (Y->Y1),
which is produced by hiring more workers; thus,
unemployment is ass. to fall.
The converse of this change is a higher price level (P>P1, i.e. increased inflation *as the govt must spend
some money to boost AD, and the higher levels of
demand increase prices]).
In addition, workers could become more
confident b/c the econ. is doing well, and it may
become more difficult for employers to find
new employees; thus, cost-push inflation could
also occur due to higher employment).
This follows the relationship set out by the Phillips
curve, and can be plotted on a Phillips curve as a
movement along the curve towards higher inflation
rates.
The existence of a clear inflation/unemployment
tradeoff was supported by data until the 1970s; since
then, however, the incidence of stagflation (rising
inflation without corresponding decreases in
unemployment; e.g. in England, 1973-75) due to oil
price shocks and factor costs (which led to increased
use of expansionary policies by the govt to reduce
unemployment, setting off an inflationary spiral) began
to suggest that the relationship was no longer valid;
according to the PC, inflation and unemployment could
not worsen simultaneously.
Long-Run Phillips Curves:
Monetarist economists criticized the original PC as, according to their analysis,
no tradeoff between inflation and unemployment is possible in the long run.
This is consistent with the Neoclassical view of LRAS, which shows that
the econ. will automatically tend towards long-run equilibrium at Yf.
Assume that the econ. is in LR equilibrium at point A, where SRPC (a
short-run Phillips Curve) intersects the economys vertical LRAS at a
given time.
o Assume also that the labor market is in equilibrium, such that
the only existing unemployment is natural. Assume inflation is
constant.

The monetarists state that the SRPC is ineffective due to

rational expectations. That is, people expect inflation to
remain constant and negotiate pay increases based on
the expected rate.
If the govt decides to reduce unemployment through
expansionary demand-side policies (e.g. increases in
govt expenditure), AD would increase, as would
demand for labor and wage rates. To ration the rel.
scarce natl output, however, the inflation rate would
also rise.
In the SR, unemployment would fall as workers
who were unprepared to take jobs at prior
wage levels become attracted by what they
believe to be higher wages, and the econ.
moves left along SRPC (an increase in
employment at the expense of inflation); in
addition, labor becomes cheaper, in real terms,
for firms, who hire more workers.
However, these are higher nominal wages; real
wages have not risen, and workers may actually
be worse-off than previously in real terms. The
workers have thus suffered from money illusion.
o When the workers realize their wages
have not actually risen, they leave their
jobs and unemployment goes back to
the natural rate, though at a higher
inflation rate- alternately, if workers
demand wage increases in line with the
new inflation rate, firms may need to
lay off workers in an attempt to cut
costs;
o The econ. does not return to its initial
position; now that inflation is higher,
people expect prices to continue rising
at the higher rate and negotiate pay
increases accordingly.
o As a result, SRPC shifts upwards such
that the econ. is in LR equilibrium
where the Natural Rate of
Unemployment=SRPC. Unemployment
has returned to the natural rate at a
higher inflation rate

This shift only happens in the LR

due to money illusion,
expectations of inflation at the
earlier rate, and labor contracts
in the SR.
Any renewed attempt to use demandside policies to reduce unemployment
below the natural rate will only lead to
higher inflation and a move to another
SRPC further up at the intersection of
the NRU and the prevailing inflation
rate.
To maintain employment above the
NRU, the govt would need to
progressively increase inflation so that
employees would be fooled; for
money illusion to be effective in the LR,
it is assumed that employees must have
adaptive expectations and base their
view on future inflation rates on what
has occurred in the past.
However, according to the
monetarists, employees
expectations are rational and
based on a prospective
estimate using all information
available to them at the
moment; for example, if
workers believe that the govt
will reduce inflation in the
future, they will reduce wage
demands quickly; thus, the
economy returns to long-run
equilibrium within a rel. short
timespan.
Natural rate of unemployment: The
rate of unemployment consistent with a
stable rate of inflation.
For this reason, the NRU has
also been referred to as the
NAIRU (the non-accelerating
inflation rate of

unemployment); the rate of

unemployment at which
inflation is correctly
anticipated, and the labor
market is in equilibrium.
As long as govts do not use
expansionary fiscal policy,
inflation will not accelerate at
the NRU; however, if such
policies are used, inflation wll
accelerate.
The Long-Run Phillips Curve is vertical at the
natural rate of unemployment; thus, it is
functionally equivalent to the LRAS curve in
analysis.
o At any time, there may be a SR tradeoff
b/w inflation and unemployment, but
the economy will always return to the
NRU in the LR.
o Govts cannot reduce the NRU via
demand-side policies; thus, the NRU is
the unemployment rate that occurs
when the econ. is at Yf and the labor
market is in equilibrium.
o This is not to say that long-run
unemployment rates cannot be
reduced altogether; rather, the key
point is that supply-side, rather than
demand-side policies, are the key to
reducing NRU.
Supply-side policies will shift
LRPC left (LRPC->LRPC1); this is
equivalent to a rightward shift
in LRAS or an outwards shift in
the PPF of a country.
This confirms our earlier
conclusions about reduction of
unemployment: although
demand-side policies can
reduce cyclical unemployment,
they do not affect, in the LR,
frictional, seasonal and

structural unemployment
(components of NRU).
Although estimates of the NRU are
made, their accuracy is uncertain;
however, the rate varies over time and
between countries.
Differences b/w countries are due to
supply-side factors (e.g. the size of
unemployment benefits, union power,
labor regulations, wage-setting
practices).
Countries with more benefits
and greater regulation tend to
have higher NRU; thus, marketoriented supply-side policies
are often recommended to
reduce NRU.

Chapter 22: Distribution of Income

One of the characteristics of free-market economies is unequal income distribution (e.g. the CEO
of a company will likely earn more than his secretary).
Inequality occurs to different extents in different countries; the reasons for differences in
income and consequences of inequality are multiple, and are the subject of massive political,
economic, etc. debate.
It is often argued that large amounts of income inequality are unfair; people with low income
will experience rel. low living standards and fewer opportunities than those with high income.
o Indeed, some may live in absolute poverty (a state where they do not have access to
the basic necessities to sustain life).
o Others may live in relative poverty (a state where their living standards are well below
some specified average for their country; this is often characterized by an inability to
take part in the typical activities of society).
o One reason for low incomes is socioeconomic: being born into a low-income household
and experiencing little opportunity (e.g. education, adequate healthcare, the ability to
wait until adulthood before finding employment) to escape the conditions associated
with poverty.
Another reason is low human capital, which keeps people in low-paying jobs;
unemployment may also cause low incomes. All of the above causes are heavily
debated.
Further, labor market conditions, differences in bargaining power, certain tax
and benefit structures (i.e. regressive taxation, lack of benefits), discrimination

(both positive and negative), household composition, the low earnings of the
unemployed and differing levels of qualifications also cause income inequality.
Even if income inequality is seen as unfair, standard economic theory shows that higher
income serves as an incentive for people to work harder; if people did not believe that
their work would allow them to increase their human capital/efficiency and grant them
the opportunity to earn higher incomes (the argument goes), this would negatively
affect the supply-side of the economy, resulting in lower overall ec. activity levels.
Pure economic theory will not give an answer as to how much inequality is
acceptable/desirable; this is a normative issue. However, it is true that market
economies do lead to income inequality, and that govts may use fiscal policy to affect
income distribution in an economy. This may be done through:
Taxation:
Governments at all levels impose numerous taxes for numerous
reasons.
o Taxes may serve to reduce the consumption of goods that
create neg. externalities, reduce the consumption of imports
and protect local industries, manage the level of AD in the
entire economy, or- significantly- change the distribution of
income.
Direct taxes: Taxes on the income/wealth of individuals, or on firms
profits.
o The various forms of taxable household income include
employment income, interest on savings and dividends on
shares; social security contributions are also direct taxes.
o Some of this income is directly collected from employers, while
some is charged based on annual tax returns.
Thus, theoretically, such taxes are unavoidable, as
households and firms are obliged to declare their full
income to the govt and be taxed on it accordingly.
Indirect taxes (expenditure taxes, consumption-based taxes, e.g. the
Goods and Services Tax, the VAT, excise taxes): Taxes which the
consumer pays to the seller or producer of a product, who then pays
the tax to the govt.
o In theory, indirect taxes are avoidable, as consumers may
choose whether to buy the good in question or not, and in what
quantities.
o Governments vary indirect tax rates on different goods and
services, with necessities and merit goods (e.g. bread) taxed at
much lower rates than luxury products and demerit goods (e.g
alcohol).

We can classify the above two tax systems into three categories, depending on
their effect on distribution of taxpayers incomes:
Progressive Taxes: A system whereby, as income rises, a greater
proportion of income is paid in tax (e.g. tax systems in the US and
Australia).
o Many govts use progressive taxes as the main way of
redistributing income from higher to lower earners; usually,
there is a certain threshold below which income is not taxed.
Very low-income people may oftentimes not need to pay any
direct tax.
o If income moves beyond this minimum, however, an increasing
percentage of income will be paid to the govt, with larger
percentages being taken in tax at higher incomes.
It is important to note that we deal with a marginal tax
rate for each income bracket in the prog. tax system: a
person with an income of $ 100 000 might not be taxed
anything for the first $ 10 000, and subsequently be
charged increasing rates on all income which falls within
subsequent tax brackets. This results in an average tax
rate that is lower than the marginal tax in the highest
bracket ones income falls under.
However, the average tax rises as income rises; thus,
the tax is progressive.
o Note that, in reality, most progressive tax systems are much
more complex than simple brackets. The biggest complication
stems from tax deductions and the calculation of taxable
income.
Tax deductions allow people to reduce their taxable
income if they spend on particular things, or partake in
particular activities.
For instance, if a worker commutes to work, the govt
might deduct commuting costs from his taxable income,
reducing the amount of tax that he pays, to encourage
people to find work and to reduce unemployment;
however, the precise mechanics of tax deductions vary
from country to country.
o A prog. tax means that higher income people pay higher taxes,
and can lead to redistribution of income to the less well-off.
Regressive Tax: A system whereby, as income rises, the proportion of
income paid in tax (avg. tax rate) falls.
o Specific taxes are an example of a regressive tax rate; a $1
cigarette tax will represent a larger share of the real income of a

construction worker than that of a bank manager. The tax is

regressive as a higher proportion of income is paid at lower
incomes.
o Regressive taxes may be a good source of govt revenue and
discourage consumption of demerit goods, but they can worsen
income inequality.
Proportional Tax: A system whereby the proportion paid in tax is
constant for all income levels (e.g. the Estonian tax system).
o Many countries are attempting to introduce proportional direct
taxes, where the same % of tax is paid at all income levels; there
are several advantages of the policy:
First, taxation is usually a hugely complex process, with
much room for error and manipulation; thus, govts
may earn less revenue than predicted as people find
ways to evade paying taxes.
Second, taxes may have a disincentive effect on
working; it is possible that high tax rates discourage
people from working harder, moving into higher-paying
jobs and taking risks, as they will be reluctant to pay
higher taxes on their gains.
If taxes were constant, a supply-side incentive
to work, and therefore, to increase labor
supply, would be created (the argument goes).
Transfer Payments: a policy whereby the govt uses tax revenue to redistribute
income and provide assistance to different groups in the economy to improve
living standards.
While transfer payments are not included as income in GDP accounting
as they do not represent payment for the prod. of a good/service, they
are payments made to increase the income of particular groups in the
economy.
Examples include child support, pensions, unemployment benefits and
subsidies to producers.
Other Govt Policies to Affect Income Distribution:
Minimum wage policies are used to ensure workers are paid what is
determined to be a fair wage; govts may also legislate that firms pay
social benefits, such as some level of medical insurance or pensions, to
workers. Both of these policies redistribute income from firms to
workers.
o In addition, govt-sponsored training programs are help workers
find gainful employment and thus improve their living
standards.

Evaluation of Income Redistribution Policies:

o The question of income redistribution is loaded; while many agree that the govt is
responsible for ensuring a reasonable standard of living for citizens, this is a problematic
issue for many reasons, including the debate as to what constitutes a reasonable
standard.
o Neoclassical economists tend to argue against active govt intervention in income
redistribution, as it interferes with market forces and may result in inefficiencies; this
view argues that optimal resource allocation occurs in free markets; thus, govt taxation
should be minimized. Arguments for this view include that:
If firms need to pay social security and insurance for workers, this will provide a
disincentive in terms of hiring and contribute to unemployment.
High taxes may discourage entrepreneurship and possibly encourage
entrepreneurs to leave a country in search of more favorable tax environments.
High taxes have negative effects on overall ec. growth due to their disincentive
effects, whereas lower taxes would encourage ec. activity, leading to an overall
increase in output that would benefit everybody.
If people lose unemployment benefits when they begin work and are taxed on
their income, their total income falls when they start working, creating a
disincentive to work.
o In general, this view does not hold that the govt has no role in the economy; rather, it
argues that taxes should be limited to financing the obligations of the govt to maintain
property rights, reducing the effects of market failure, providing an adequate security
system and judiciary and promoting competition, rather than redistribution of income.
o A good tax system should:
Have horizontal equity: people in the same circumstances pay the same amount
Have vertical equity: taxes should be fair in terms of rich and poor
Be cheap and simple to administer
Be difficult to evade and convenient to pay
Be easily understood by taxpayers
Have limited disincentive effects on working
o If GDP starts to grow, the prog. tax system acts as an automatic stabilizer; as more
people will now be paying a higher rate of tax; thus, the level of disposable income is
less than it would be without a govt- this will dampen the effects of the boom; simply,
transfer payments will reduce the effects of a recession. When incomes fall, some
people will be entitled to benefits which will keep consumption and incomes above freemarket levels.
As the marginal rate of taxation increases, however, the multiplier will decrease;
any change in injections will have a smaller cumulative effect.
The Laffer Curve:
o The view that higher taxes create a disincentive effect and ultimately negatively affect
govt revenues may be illustrated using a Laffer curve, which shows the relationship
between direct tax rates (on the x-axis) and govt revenues (on the y-axis).

A Laffer curve is concave downwards along its full length and displays two prominent
characteristics:
If the direct tax rate is 0%, the govt would gain no money in tax revenue; thus,
tax revenue is 0 at a 0% tax rate.
If the direct tax rate is 100%, there would be no incentive to work and thus no
income for the govt to tax; thus, tax revenue would also be 0 at a 100% tax
rate.
The points in between demonstrate the view that higher direct taxes will
eventually cause people to work less hard (or not at all; high taxes may
discourage work altogether for certain individuals), thus earning less income
and paying less in taxes. According to this theory, an initial increase in the direct
tax rate from 0% will increase tax revenue, but further increases will eventually
cause tax revenue to fall.
It follows that, if tax rates are above the rate corresponding to the
maximum tax revenue, the govt could increase revenue by lowering the
direct tax rate. This would encourage people to work harder, and firms
to expand, as they would keep a greater share of their earnings.
The model suggests that there is an optimum tax rate at which govt
revenue is maximized; this level will vary from country to country, and is
not usually 50% (the tradeoff between revenues and disincentives is not
proportional.

Chapter 23: Reasons for International Trade

International trade: the exchange of goods and services between countries.

There are a number of significant gains from international trade that economists emphasize:
o Lower prices: The main gain from trade, and main reason for trade, is the ability to buy
goods at a lower price than the domestic price; consumers benefit by gaining access to
cheaper products and producers may purchase raw materials and semi-mfg. at a lower
cost; this should lead to an increase in economic efficiency.
Prices may be lower in some countries than others due to access to natural
resources, differences in quality and availability of labor, capital, and the level of
technology. The lower prices can be explained by comparative advantage
theory.
o Greater choice: Trade allows consumers to have a greater variety of products; they now
have access to products produced internationally, in addition to the domestic market.
o Differences in resources: Different countries possess different resources; to acquire the
resources that it needs to produce its output, but does not possess (e.g. gold, rare earth
metals, oil), a country may have to trade and import the commodities they lack. To do
so, they will also need to export goods and services to gain foreign currency with which
they can buy the required resources.

Some countries (e.g. Japan) have few natural resources, and are dependent on
trade for growth, and economic survival and well-being; they have to import
most natural resources. However, they are able to fund this by maintaining high
export levels.
o Economies of Scale: When firms begin to produce for an international market, the
market size, and thus demand, will increase, and the level of production and output will
increase to compensate.
The increased production levels should lead to economies of scale being
achieved; production should become more efficient (or, at least, not become
less efficient). Also, expanded production allows for increased specialization;
when firms are large, individuals may specialize in narrow, specific tasks (e.g.
Head of Accounting), and should become more knowledgeable and efficient at
those tasks.
Larger production units may also lead to greater division of labor (where
a production process is broken down into a number of small, simple,
repetitive steps that workers (or robots!) can specialize in, thereby
achieving a high level of efficiency.
In addition, if countries specialize in the production of certain
commodities (e.g. petrochemicals in Bahrain), there will be cost benefits
(technical economies of scale) from acquiring knowledge and expertise;
this is known as moving down the learning (LRAC) curve
Trade, and with it, larger markets and production units, should enable
production in a countrys export industries to become cheaper and
more efficient in the LR, make producers more competitive, and lead to
a reduction in LRAC.
o Increased Competition: Trade may lead to increased competition, as domestic firms are
forced to compete with foreign firms. This should lead to increased efficiency and
innovation, and could likely lead to increased quality, variety, and a lower cost of goods
and services for consumers.
o There are political, social, and cultural gains to be made from increased trade bringing
countries closer together; this is perhaps most visible with the European Union.
Putting together the above six points, it is clear that there are large-scale gains to be made from
trade; it is fair to conclude that, for the reasons listed above, trade can be a major contributor to
a countrys econ. growth.
Where trade will occur is dictated by comparative advantage theory, which attempts to
determine which goods a country should produce for export and which it should import, to gain
the maximum benefits from trade.
o Absolute Advantage: A country is said to have an absolute advantage in the prod. of a
good/service if it can produce it using fewer overall resources than another country.

If two countries produce two goods with the same amount of resources, the
country with the greater output in any one good has the absolute advantage in
that good.
Reciprocal Absolute Advantage: A situation where either of the countries
trading has an absolute advantage in the production of one product
In this case, the question of which goods should be imported and which
exported by each country is straightforward: the countries should
specialize in the products they have an abs. adv. in; this will maximize
the amount produced by each country and, after trade, both countries
will gain.
o Assuming constant returns to scale, doing so will cause output
in both countries to double, in excess of the prior output; total
output of both products should rise, following specialization.
Comparative advantage: a situation where a country can produce a good at a lower
opportunity cost than another country; that country has to give up fewer units of the
alternate good in producing a certain good than its trading partner.
Comparative advantage theory is used where the relatively more
straightforward reciprocal absolute advantage theory is inapplicable.
It has been mathematically proven that trade could be beneficial for both
countries, even if one had the abs. adv. in the production of all products being
traded. Comparative advantage theory is based on the opportunity cost of
production.
In a case where one country produces both goods traded more efficiently (in
terms of resources) than its trade partner, it will most likely not have a
comparative advantage in the production of one of the products; they would
have to give up more units of one of the goods than the producer with the
absolute disadvantage in order to increase output of the other good
Thus, absolute advantage does not imply that a country necessarily has
a comp. adv. In the production of a good/service.
According to comp. adv. theory, each country should specialize in the good that
it has the com. adv. in; each country will then consume the amount of output
that they wish and trade the remainder for the alternate product.
Assuming the two countries trading face different opp. costs, then, if
they specialize acc. to comp. adv, both should be able to consume at
some point outside their PPFs (i.e. beyond what had been possible
before trade was occurring).
This situation can be illustrated using simplified linear PPF curves for each
country. If the scale of the axes is the same, and one country has the abs adv. in
the prod. of both goods, the comp. adv. for the better producer occurs where
the distance between the PPCs is largest, while the comp. adv. for the less
efficient producer occurs where the distance between the PPCs is smallest.

This is not a mathematical justification (which would rely on the relative

gradients of the lines, as it is the gradients of the lines that show the
respective opp. costs, which are assumed to be constant); it is simply a
useful trick for graphing comp. adv.
Assume that two countries are trading in TVs; they also produce cotton.
The opp. cost of producing 1 TV for Country A is 3 units of cotton; the
opp. cost of producing 1 TV for Country B is 2 units of cotton. Both
countries will benefit from trade if the ratio of exchange between TVs
and cotton is anywhere between 1TV=2 units of cotton and 1TV=3 units
of cotton; between the two countries, production will be maximized if
trade occurs at the midpoint of these two ratios; i.e. if 1TV is traded for
2.5 units of cotton, and 1 unit of cotton is traded for 2/5 TV.
o In each country, the opportunities for the second good are
reciprocal to those for the first good (in our example, 1/3:1 and
:1, units of cotton: TV, respectively).
Comparative advantage theory is effective only if the opp. costs faced by the
countries are both different; if the countries face the same opp. costs (if the
PPFs had the same gradient), there would be no reason for trade to occur.
Comparative advantage is largely based on a countrys access to FoPs; a country
that possesses good-quality arable land may have a comp adv. in agricultural
products, a country with much low-skilled labor may develop a comp. adv. in
labor-intensive mfg, and a country with numerous universities and educated
labor may develop a comp. adv. in Ponzi schemes. A country with favorable
climate and nice beaches (which counts as land, rather than climate. Silly
book.) may develop a comp. adv. in tourism.
The abundance of a given FoP will make its cost relatively lower than
that of other FoPs, allowing the opp. cost of the goods and services
produced using the FoP to be lower than in other, less well-endowed
countries.
Comp. Adv. Theory is based on several assumptions, which tend to limit its
applicability to the real world. These include:
As in PCMs, it is ass. that producers and consumers have perfect market
knowledge and are aware of where the lowest-priced goods are
purchasable.
It is assumed that there are no transport costs; however, this is
evidently not the case in reality, and the existence of transport costs can
erode a countrys comp. adv, reducing its competitiveness and the
potential gains from trade.
It is often assumed that the model is limited to 2 goods producing 2
products; however, this is not always true: the theory may be extended
to more countries and products, and it is still possible to determine

where the comp. adv. lies, and the use of computer programs facilitates
multi-country, multi-product analysis.
It is assumed that costs do not change and returns to scale are constant
(with no economies or diseconomies of scale); however, the existence
of economies of scale would likely increase a countrys comp. adv, as
relative prod. costs fall by ever more, whereas the existence of
diseconomies of scale may eventually undermine some of the gain to be
made from trade.
The model does not take into account the external costs/benefits of the
production of the two countries output.
It is assumed that no barriers to trade exist; this is clearly not the case in
reality, as govts often use tariffs, subsidies, quotas and administrative
measures to restrict imports from abroad.
It is ass. that the goods being traded are homogeneous (e.g. bananas,
uranium-238). However, problems arise with differentiated goods (eg.
consumer durables), as the differences in the products design render
proving that a country has a comp. adv. in their production much more
difficult.
It is ass. that FoPs stay within the country (but are perfectly mobile
within each country); however, it may be the FoPs, rather than the
goods, that move between countries; for instance, MMCs in developed
countries might outsource production to LDCs by investing capital,
enabling prod. of goods there rather than exporting finished products
produced domestically. Labor may also migrate from low- to high-wage
countries.
Despite its limitations, comp. adv. theory is at the core of intl trade theory and
is effective at explaining patterns of trade. Countries that specialize in
production of goods in which they have a lower opp. cost than other countries
can maximize their potential gains from trade.

Chapter 24: Free trade and Protectionism:

Free Trade: A situation where trade between countries occurs when no protectionist barriers to
trade put into place by govts or intl organizations exist. Goods and services are allowed to
move freely across borders.
Arguments for Protectionism:
o Although there are clear benefits to trade for the countries involved, countries do not
trade freely, and protect their economies from imports, for several reasons, the
arguments for which are not always valid. Some of the arguments for protectionism
include:
Protecting domestic employment: At any time in an economy, some industries
are in decline (sunset industries), as they cannot compete with foreign

industries. If the industries are relatively large, their collapse would lead to high
structural unemployment, and govts often attempt to protect the industries to
avoid the unemployment.
However, the argument is not very sound, as it is likely that the
protectionism will only prolog the industrys continued decline.
Although there will be SR social costs, it could be better to let the
resources employed in the industry move into expanding sectors of the
economy. However, often, the neg. externalities of a rapidly declining
major industry may be great enough that a govt feels obligated to
intervene and protect the market.
Protecting the economy from low-cost labor:
It is often said that the main cause of declining domestic industries is
the low-cost labor of exporting countries, and that the economy should
be protected from imports produced in countries where labor costs and
wages are much lower.
o While trade may greatly benefit the economy as a whole, the
benefits are often spread widely, while the costs in terms of job
losses tend to be concentrated in a few industries; the job
insecurity in mfg. industries in the West is due to workers fears
that they will lose their jobs to workers in emerging markets;
thus, unions may lobby vigorously for protection against foreign
imports.
o It is especially likely that the govt will protect industries seen as
traditionally important, despite the economic circumstances
having changed.
For instance, the US steel industry often negotiates
favorable tariffs to protect itself against steel imports
from Asia.
However, this argument is uneconomic, as it goes against the theory of
comp. adv, as it means that domestic consumers pay higher prices than
they should and that production in the protected economy would be at
an inefficient level. The country wishing to export would lose trade,
leading to economic harm, and the importing country would lose out on
some of the benefits of trade and specialization.
o Comparative advantage changes over time, and countries that
presently have the comp. adv. in the prod. of a good are
unlikely to retain it indefinitely into the future (for instance, the
US did once have a comp. adv. in steel). As relative factor costs
in different countries change, it is important that resources
should move as freely as possible from sunset industries,
where comp. adv. is declining, to industries where it is growing.

Supply-side policies focusing on labor markets emphasize the

importance of making labor flexible enough to adapt to
changing economic conditions, putting some responsibility on
govts to help workers who have lost their jobs due to increased
competition from foreign countries with a comp. adv. in the
production of labor-intensive goods.
Protecting infant (sunrise) industries: Many govts argue that industries that are
just developing do not have the economies of scale of their larger competitors
abroad. The domestic industry would not be competitive against imports until it
can gain the cost advantages of economies of scale. Thus, the industry may
need to be protected against imports until it becomes large enough to compete
on an equal footing.
However, this argument may be flawed: most devd countries have
ready access to expansive financial capital markets and thus large
amounts of financial capital (especially since the advent of
globalization); thus, it is possible that there is no basis for the notion
that industries in devd countries would set up in a relatively small way,
and thus not benefit from economies of scale.
o With access to capital markets, it is difficult to assume that
industries would not be founded at the most efficient possible
size; e.g. Saudi Arabia has expanded into petrochemicals
through partnerships with leading MNCs; the resulting factories
are some of the worlds largest, and benefit from extensive
economies of scale.
o However, for LDCs, which often lack access to sophisticated
capital markets, the infant industry argument for protectionism
is justifiable. However, whether they are politically powerful
enough to implement protectionist measures without
complaints from developed countries and the WTO is
debatable.
Avoiding the risks of overspecialization: Govts may wish to limit
overspecialization, as it means that a country could become dependent on the
export of one or two products; any change in world markets (for instance,
changes in technology reducing the demand for a commodity, the introduction
of new products, or abrupt changes in supply and demand) for the products
might seriously impact the countrys economy. Alternately, a govt may want to
avoid the possible diseconomies of scale that could arise due to excessive
specialization of a countrys industries.
This is especially the case in LDCs, which are often forced to overspecialize in a select few export commodities (primary products); the
introduction of synthetic materials, for instance, and the over-supply of

textiles on the world market (which reduced prices) severely harmed

Bangladeshs textile industries at one point.
This point is relatively unarguable; it does not promote protectionism,
but rather, points out the potential risks of overspecialization for natl
economies.
Strategic reasons: Govts often argue that certain crucial industries need to be
protected, as they would be needed for strategic purposes in the case of a war
(e.g. agriculture, steel, power generation); the argument goes that these
industries would need to be protected to stay competitive.
This argument may be valid to an extent, if the risk of war does exist;
however, it is usually overstated: it is unlikely that many countries will
be cut off from all supplies if they go to war. The argument may be
mostly an excuse for protectionism.
Political reasons: Govts may occasionally wish to limit trade with certain
countries as a form of pol. punishment (e.g. for irreconcilable ideological
differences); however, unless the sanctions are followed through by multiple
countries, this form of punishment may not be very effective. In addition, if the
sanctions are too harsh, it is the people in the country being punished, in
addition to the offending govt, who may be harmed.
Anti-dumping measures:
Dumping: the selling by a country of large quantities of a product on
foreign markets at a price below the cost of its production (e.g. EU
exports of subsidized dairy products to LDCs in Africa).
o The EU often dumps its agricultural surpluses on LDC markets,
harming local producers by lowering their revenue. Where
countries can prove that they have suffered severe economic
harm from dumping, they are allowed by WTO rules to impose
anti-dumping measures to reduce the damage.
However, it is difficult to prove that a foreign industry
has been guilty of dumping; in addition, a govt that
subsidizes a dom. industry may be itself guilty of
dumping, as the price at which the subsidized goods are
exported does not reflect dom. producers production
costs.
If dumping does occur, then, a negotiated settlement
between govts, rather than protectionist measures,
may be the better solution.
There is always the risk that protectionism may incite
retaliatory measures by foreign governments, further
reducing the benefits to consumers in producers in all
countries involved.

Protecting product standards: A country may wish to impose safety, health, or

environmental standards on imported products, to ensure that the imports
match the standards of domestic goods and to reduce the effect of negative
externalities and/or demerit goods on the dom. economy (e.g. the EU ban on
hormone-injected US beef).
This argument is valid as long as the concerns themselves are valid;
however, many of the reasons given for bans when standards are not
met are simply veiled protectionist measures (e.g. US cattle farmers
have complained that EU authorities had no conclusive evidence that
the hormone-treated beef constituted a health risk for consumers).
Where product standards are disputed, the exporting country may
resort to retaliatory protectionism and trade sanctions to protect its
position on the market.
Raising government revenue: In many LDCs, tax collection is difficult, and govts
impose tariffs (import taxes) on products to gain revenue; according to the IMF,
approx. 15% of all revenue of the LDCs originates from import duties.
This is not as much an argument for protectionism per se, but a means
of gaining revenue; in effect, the import duties represent a tax for
consumers in the country who purchase imports.
Correcting a balance of payments deficit: Govts sometimes impose
protectionist measures to reduce import expenditure and thus improve a
balance of trade deficit, whereby a country spends more on imports of products
than it earns from its exports of products.
This is only effective in the SR, and does not address the actual problem,
reducing the symptoms, though not the root cause of the deficit. If
countries do so, they are likely to invite retaliatory protectionist
measures from the countries that they export to.
Arguments against protectionism:
o These are closely related to the reasons for trade (discussed above), and include:
Protectionism may raise the cost of purchasing imports for domestic consumers
and producers.
Protectionism leads to less choice for consumers, and therefore decreased
economic efficiency.
Competition would lessen if foreign firms were kept out of a country; dom. firms
may become inefficient and uncompetitive without an incentive to minimize
costs; likewise, innovation may be reduced.
Protectionism distorts comp. advantage, leading to an inefficient allocation of
world resources; specialization is reduced, decreasing the pot. level of the
worlds output.
Governments may choose target industries for protection based on political
aims, rather than the best interests of the national economy.

Protectionism may incite retaliatory measures/trade wars from competitors

abroad.
For the above reasons, protectionism may hinder economic growth.
Types of protectionism:
o A number of methods to protect a dom. economy from imports exist. To examine them,
it is worth considering a countrys situation if it were trading freely in a particular
commodity (e.g. marijuana). We may then consider how different protectionist
measures will alter the free trade situation.
If there is no foreign trade, domestic farmers would produce Qe ounces of weed
at the equilibrium price Pe. If the market is open and trade occurs, the situation
changes; consumers may import as much weed as they want, if they are
prepared to pay the world price. Thus, the supply curve faced by importers
(S(world)) is perfectly elastic and assumed, in our case, to be below equilibriumotherwise, no importing would occur).
With free trade, the market price of weed decreases to Pw (the world price); at
this price, dom. producers are only prepared to supply Qs tons of weed;
however, the quantity demanded (Qd)of weed would be higher; the excess
demand would be satisfied by (Qs->Qd) units of imported grass. Domestic
consumers get to smoke (Qe->Qd) more weed than at autarkic equilibrium, at a
lower price.
The different protectionist measures that the govt could employ on the weed
market include:
Protective tariffs: indirect taxes charged on imported goods.
As we have seen, any tax placed on a good shifts its supply curve
upwards (left) by the amount of the tax; in the case of a tariff, world
supply will shift upwards, as it is foreign producers, rather than dom.
producers, who are being taxed.
o Before the tariff is imposed, Qd tons of weed are consumed at
the world price Pw. Domestic production was Qs and imports
were (Qs->Qd).
o When the tariff is imposed, S(world) shifts upwards by the
amount of the tariff, raising the market price (Pw->Pw+Tariff).
As the price has risen, total QD falls (Qd->Qd1).
o Domestic producers are able to increase production (Qs->Qs1);
their revenue increases from (Pw x Qs) to (Pw+t x Qs1). Foreign
producers supply the rest (Qs1->Qd1). They receive Pw+t, but
must pay the tariff to the govt; thus, their revenue falls (Pw x
(Qs->Qd)) to (Pw x Qs1-> Qd1), and the govt receives tariff
revenue ((Pw -> Pw1) x (Qs1-> Qd1).
o Importers must pay a higher price for the imported good; in the
case of weed, the higher price will be passed on to hash
brownie bakers and joint manufacturers that buy the imported

weed. If a country imposed a tariff on clay, the price of clay

bongs for consumers would rise as well, as the tariff would
cause producers prices to rise. If the bong-maker is an
exporter, the tariff will reduce the competitiveness of their
exports abroad.
o Tariffs are the usual anti-dumping measure; if a country proves
that dumping has occurred, it can place a tariff on the imported
goods to raise their prices, eliminating the cost advantages of
the foreign producer.
o There are two further outcomes:
(Qd1->Qd) ounces of weed are no longer demanded;
consumers keep the amount k that they would have
spent on the weed, but there is a dead-weight loss of
consumer surplus [welfare] f (the triangle between D,
Qd and Qd1), as the weed is no longer consumed.
After the tariff, (Qs->Qs1) tons of weed are produced by
rel. inefficient dom. producers, as opposed to efficient
foreign producers; while the foreign producers would
produce this quantity for a minimum revenue (Qs->Qs1
x Pw), the domestic producers require a revenue of
(Qs->Qs1 x Pw+S, where S is the supply curve at any
given point on the interval). This additional region
represents a misallocation of world resources and a loss
of world efficiency; this is another deadweight welfare
loss.
Quotas: Physical limits on the quantity or value of goods that can be imported
into a country (e.g. the EUs import quotas on Chinese mushrooms). The
imposition of a quota is graphically similar to the imposition of the tariff,
although the mechanics are rather different:
o Before the quota was imposed, Qd tons of weed are consumed
at the world price Pw. Domestic production was Qs and imports
were (Qs->Qd).
o When the quota is imposed, S(world) shifts upwards by an
amount that reflects the limit on imports from abroad; for
instance, S(world) will increase until imports from abroad are
limited to (Qd1->Qs1 units), raising the market price (Pw>Pw+Quota), to clear the excess demand that arises. As the
price has risen, total QD falls (Qd->Qd1).
o Domestic producers are able to increase production (Qs->Qs1);
their revenue increases from (Pw x Qs) to (Pw+q x Qs1). Foreign
producers supply the rest (Qs1->Qd1); they are unable to
import more than the amount of the quota. They receive Pw+q

for their output; their revenue thus changes to (Pw x (Qs->Qd))

to (Pw+q x Qs1-> Qd1); this is usually a decrease in revenue, but
theoretically does not have to be. The govt receives no
revenue from the quota.
o Once again, there are two areas of dead-weight welfare loss
incurred by the quota:
(Qd1->Qd) ounces of weed are no longer demanded;
consumers keep the amount k that they would have
spent on the weed, but there is a dead-weight loss of
consumer surplus [welfare] f (the triangle between D,
Qd and Qd1), as the weed is no longer consumed.
After the quota, (Qs->Qs1) tons of weed are produced
by rel. inefficient dom. producers, as opposed to
efficient foreign producers; while the foreign producers
would produce this quantity for a minimum revenue
(Qs->Qs1 x Pw), the domestic producers require a
revenue of (Qs->Qs1 x Pw+S, where S is the supply
curve at any given point on the interval). This additional
region represents a misallocation of world resources
and a loss of world efficiency; this is another
deadweight welfare loss.
Subsidies: payments by the government to firms in a particular industry, per
unit of output (e.g. US export subsidies for cotton). If the govt subsidizes firms
to increase their competitiveness, the domestic supply curve will shift
downwards by the amount of the subsidy. Continuing with our weed example,
the effect of a subsidy for dom. weed producers is:
Before the subsidy was granted, Qd tons of weed were consumed at the
world price Pw. Domestic production was Qs and imports were (Qs>Qd).
When the subsidy is granted, S(domestic) shifts downwards by the
amount of the subsidy to S(d)+Subsidy. The market price remains at
P(w); thus, QD remains constant.
However, dom. producers are able to increase production (Qs->Qs1), as
they now receive Pw+subsidy per unit produced. Their revenue thus
increases from (Pw x Qs) to (Pw+s x Qs1). Foreign producers supply the
rest of the weed (Qs1->Qd), receiving ((Qs1->Qd) x Pw) in revenue. The
govt pays the subsidy, equal to (Pw->Pw+s x Qs1).
o As with a tariff, (Qs->Qs1) tons of weed are produced by rel.
inefficient dom. producers, as opposed to efficient foreign
producers; while the foreign producers would produce this
quantity for a minimum revenue (Qs->Qs1 x Pw), the domestic

producers require a revenue of (Qs->Qs1 x Pw+S, where S is the

supply curve at any given point on the interval). This additional
region represents a misallocation of world resources and a loss
of world efficiency; this is another deadweight welfare loss.
o However, there is no consumer surplus loss, as the market price
of weed does not change. Consumers are indirectly affected by
the opportunity cost in terms of govt spending on projects
besides the subsidy and potentially higher taxes, if the subsidy is
funded from tax revenue.
Voluntary Export Restraints (VERs): agreements between exporting and
importing countries in which the exporter limits the quantity of exports below a
certain level; this is usually done to avoid legal restrictions and retaliatory
protectionism in the importing country. VERs are now illegal, but could have
been reached at government or industry level.
Administrative Barriers: When goods are imported, there is usually a fair
amount of red tape that has to be undertaken. If administrative processes are
difficult or time-consuming, they can act as a barrier to imports. For instance,
making importers fill out mountains of paperwork before their goods can cross
the border will slow down imports and raise costs for the importer, as will a
large amount of required legal work, or the designation of specific ports of entry
for products that may e difficult to reach or more expensive.
Health, safety and environmental standards: If restrictions are placed on the
types of goods permitted for sale on domestic markets, or on the methods used
in manufacture, and the regulations apply to imports, they may act as a barrier
to trade. While it is important that countries are able to guarantee the quality
of the products sold and prevent the entry of unhealthy/unsafe goods, it is
important that they be legitimately concerned with product standards, rather
than simply protecting dom. industries.
Also, LDC exporters may find it difficult to pass muster with product
standards, as they may find it difficult or prohibitively expensive to gain
the certification required to prove that they meet the standards. The
costs of certification may make it difficult for such countries to
successfully exploit their comp. adv.
Embargoes: Complete bans on all imports from a given country, which act as an
extreme version of a quota and usually serve as political punishment. Complete
embargoes are rare; more commonly, countries impose economic sanctions
against an offending country, limiting the exports/imports of key products as
political punishment, or to exert political pressure.
Exchange Controls: govts will occasionally place limits on the amount of money
which can be exchanged for foreign country; however, this tends to not be very
effective, as illegal currency markets arise.

Nationalistic Campaigns: Govts will sometimes run marketing campaigns to

encourage people to buy dom. goods instead of imports (e.g. the Buy American
campaign in the US), in order to increase demand for dom. goods and preserve
domestic jobs; this is essentially moral suasion- the government links
consumption of imports to domestic job losses.
The World Trade Organization: an international organization that sets the rules for global trade
and resolves trade disputes between member-states. The WTO succeeded the General
Agreement on Tariffs and Trade in 1995 and now has 153 member-states. The WTO/GATT,
among other things, is credited with reducing the average manufacturing tariff from a post-War
high of 40% to around 4%.
o All WTO nations are required to confer most favored nation status to one another;
thus, usually, trade concessions granted by one WTO country to another must also be
granted to all other WTO members.
o Aims of the WTO: The WTO aims to increase international trade by lowering trade
barriers among member-states and providing a forum for negotiation; the WTOs
functions include:
Administration of WTO trade agreements
Handling trade disputes among member-states
Monitoring natl trade policies
Providing technical assistance and training for LDCs
Cooperating with other intl organizations
o The WTO operates on a system of trade negotiation rounds, which originally (under
GATT) were mainly related to tariff reduction, but later included issues such as antidumping legislation and, most recently, development goals.
o The current round of negotiations is the Doha Round or Doha Development Agenda,
which mainly covers agricultural tariffs, other tariffs, trade and the environment, antidumping, subsidies, competition policy, government transparency and intellectual
property.
No conclusive agreement has yet been reached in the eight years of
negotiations; negotiations have been suspended several times due to an
inability to decide upon fundamental issues. There are two key concerns:
The US and EU are being urged to reduce their agricultural subsidies to
improve market access for LDCs.
Devd countries want the larger LDCs to lower their barriers to imports
of MFGs.
Despite a consensus that these measures will increase growth worldwide, there
has been no success at reaching a compromise thus far.
Evaluation of the WTO: Success or Failure?
o This is a contentious question, and IB wants us to know both sides of the debate. Let us
summarize the arguments of the proponents and critics of the WTO (I deleted most of
my snarky comments- make your own minds up!):
The WTO claims that its work is beneficial in numerous ways:

The system helps to promote world peace; the freer trade is, the less
likely it is for countries to enter into conflict (tell that to the 1914
European empires).
Disputes are handled constructively, and there is a forum for discussions
to take place.
Rules make trade easier, and small countries have an equal say, gaining
from collective bargaining with the larger countries.
Free trade reduces living costs for most consumers
Freer trade grants consumers more choice of products, and better
quality of products.
Trade raises incomes and stimulates growth.
The system encourages good government.
However, critics of the WTO have raised a number of important objections to
the claims:
The WTO supposedly operates on a consensus basis, with equal
decision-making power for all members; however, many important
decisions get made in informal negotiations between wealthier nations;
LDCs are often excluded from crucial decision-making.
The WTOs decisions may not be fully effective, as many MDCs have
shifted to subtler forms of protectionism, including subsidies and
administrative barriers, to protect domestic firms.
Many LDCs cannot afford to participate in all negotiations or even to be
represented at the WTO; their interests are not represented.
The WTOs General Agreement of Trade and Services calls for the
privatization of crucial services (merit goods and natural monopolies),
including: childcare, care for the elderly, sanitation, park maintenance
and postal services. Low-paid workers and poor communities will be
less able to afford these services, and will consequently suffer.
Free trade may not improve the life of ordinary people, being instead
skewed towards benefitting the wealthy.
WTO treaties can be seen as biased towards the interests of MNCs and
rich nations; for instance:
o Rich countries are allowed to maintain high tariffs and quotas in
certain products, stopping LDC imports.
o Agriculture is heavily protected in MDCs, while LDCs are
pressured to open their markets, usually resulting in lower
revenues among local firms, which face higher costs and are
unable to compete against imports from MDCs.
o IP regulations ban LDCs from incorporating technology
originating in MDCs into their systems; this is slowing, for
example, the fight against AIDS.

The increasing number of non-tariff barriers (e.g anti-dumping

legislation) that favors MDCs in allowing them to protect against
foreign imports.
In the quest for free trade, health, safety and environmental issues are
often abandoned, to the detriment to society and the environment;
animal rights activists have also accused the WTO of encouraging
behavior such as inhumane animal trapping, overfishing, and industrial
agriculture.

Chapter 25: Economic Integration

Economic Integration: a process whereby countries coordinate and link their economic policies.
o As the degree of economic integration increases, international trade barriers decrease
and fiscal and monetary policies become more closely harmonized.
Globalization: the increased integration of national economies into global (trans-national)
markets, prompted by liberalized capital and trade flows, advances in information technology,
and decreases in intl transport costs.
o Globalization has been occurring for centuries, but notably increased in pace since the
1980s due to the emergence of modern communication systems and the expansion of
MNCs, and the growth rate of world trade far exceeds, at present, the growth rate of
world output.
Multinational corporations: Companies that produce in more than one country; they have
played the crucial role in the process of globalization by taking advantage of differences in costs
between countries when producing (e.g. Procter&Gamble, Unilever, BP, Vodafone).
o MNCs may produce components of a product in several countries where production is
cheapest, assemble it in yet another country, and sell it halfway across the world (the
process of integrated international production).
o MNCs are associated with foreign direct investment: long-term overseas investment by
firms. The contribution of MNCs to globalization and global ec. growth, including in
LDCs, cannot be overestimated.
Trading Blocs: groups of countries that join together under some form of agreement to increase
trade between themselves and/or gain economic benefits from cooperation on some level; this
process is economic integration.
o We may distinguish between 6 primary stages of economic integration:
1. Preferential Trading Areas: trading blocs that give preferential access to
certain products from certain countries, usually through the reduction, though
not elimination, of tariffs.
The EU and many of its former colonies participate in a PTA agreement,
wherein the EU guarantees regular supply of raw materials and the
former colonies gain preferential access to EU markets and access to
price-stabilizing funds for commodity markets.

2. Free Trade Areas: Agreements made between countries, where the countries
agree to trade freely amongst themselves, but are able to trade with countries
outside the FTA however they wish.
Thus, members of a free trade area may retain contradictory trade
policies towards countries outside the FTA, while maintaining free trade
amongst themselves; this means that they can maintain differing levels
of tariffs, and enter into separate FTAs and embargoes, independently
of each other.
An example of an FTA is NAFTA, established in 1995 between the US,
Canada, and Mexico; following a series of staggered tariff reductions,
nearly all trade in NAFTA is now tariff free, and production processes
have become more specialized in each of the three countries as a result.
o Other examples include EFTA (the EU + Iceland, Norway,
Switzerland and Liechtenstein) and the South Asia Free Trade
Agreement.
FTAs are politically straightforward, as they do not infringe on the ability
of member-states to freely conduct economic policy, but
administratively complex, as MNCs outside the free trade area may
abuse the system by establishing factories in countries where entry
barriers for semi-manufactured goods are lowest (or simply importing
through countries where they face the lowest tariff barriers), and thus
avoiding the higher tariffs that they would have needed to pay when
directly exporting to the products final destination, leading to a
decrease in tariff revenue. While this is usually illegal, it is difficult and
expensive to police in practice.
3. Customs Unions: Agreements between countries, whereby the countries
agree to free trade among themselves, as well as common external tariff
barriers against any importers.
If a country outside a customs union wishes to import into the customs
union, it faces the same tariff barriers (agreed upon by all customs
union members) no matter which country the goods enter from.
Thus, customs unions are administratively simple, as it is more difficult
for external exporters to take advantage of differences in protectionist
measures, but politically complex, as the common tariff barriers must
be decided on by the unions members.
All common markets and economic and monetary unions are also
customs unions; thus, the EU is a customs union, as is East African
Community (Kenya, Uganda and Tasmania) and Mercosur (in South
America).
4. Common Markets: Customs unions with common policies on product
regulation, which allow for free movement of products, capital and labor.

The best-known example of a common market is the EU; however, a

second common market that is presently being established is the
Caribbean Community, which unites 15 member-states, and will
eventually include an economic and monetary union.
5. Economic and Monetary Union: A common market with a common currency.
The best-known example is the Eurozone, consisting of EU countries
that have adopted the Euro.
6. Complete Economic Integration: The final stage of economic integration,
where the member-states would relinquish individual control over economic
policy, enter full monetary union, and completely harmonize fiscal policy; the
EU is moving towards this form of integration.
Evaluation of Trading Blocs:
o The extent of the advantages and drawbacks of trading blocs is largely dependent on
the degree of economic integration.
The benefits of belonging to a trading bloc resemble those of free trade, and
include greater market size, larger export markets, economies of scale (as firms
operate in a larger market and may be able to increase output and sales and
reduce unit cost), increased competition, lower prices for consumers, (possibly)
greater bargaining power and better external trading conditions for members of
the trading bloc, and greater choice and efficiency.
With reduced barriers to trade and freer movement of people and capital, skills
and knowledge may spread more quickly.
A consolidated social, regional and monopoly policy may allow member-states
to harmonize their ec. activity to a greater degree than was poss. beforehand.
The consequences are likely to not be even; some domestic producers will gain
more from the trading bloc than others.
The large market size may attract FDI from outside the trading bloc, especially
from countries that would like to expand their presence on the market in the
future.
Trading blocs may foster increased political stability and cooperation, and trade
negotiations are easier between trading blocs than individual states.
However, while trading blocs foster trade creation among members, they also
discriminate against non-member producers, which may stall WTO negotiations
(as seen with the Doha Round). This may, in turn, foster the creation of more
trading blocs, which may undermine free trade rules and limit the potential
global gains from liberalized trade; in addition, trade diversion may occur if
common external tariffs are in place.
This will disadvantage LDCs more than MDCs, as LDCs usually lack
international bargaining power.

In addition, the cost of administering the trading bloc may be high, and,
as firms within the trading bloc expand, it is possible, though unlikely,
that they will encounter diseconomies of scale.
In addition, it is possible that firms in countries entering the trading bloc
may find themselves uncompetitive, go out of business, and cause
structural unemployment in the SR
Finally, as member-states may be expected to pay contributions
towards the administration of the trading bloc, the decision to pursue
greater ec. integration may be pol. unpopular.
Obstacles to Economic Integration:
o When economic integration occurs, there are various reasons why countries may be
disadvantaged; these include:
Economic integration reduces a countrys political sovereignty; if integration
reaches the customs union stage, political decisions begin to be made by a
central, transnational body, reducing the power of the domestic government
(e.g. the European Parliaments directives for member-states); this is politically
unpopular, and may rile up nationalists.
Economic integration reduces economic sovereignty; if integration reaches the
stage of a customs union, economic decisions begin to be made centrally.
Governments and citizens may not wish to relinquish their right to make
decisions on economic matters, such as interest rate changes.
Integration into a common market may force a country to change its
economic policies; several EU countries have had to reduce taxes in
order to encourage workers to remain employed domestically, due to
the low opportunity cost of finding work in member-states with lower
taxes.
The greater the level of econ. integration, the more control member-states
relinquish over polit. and econ. affairs.
Trade Creation and Trade Diversion:
o Trade Creation: A situation where a countrys accession to a customs union leads to
transfer of production from high-cost to low cost producers; an advantage of greater
economic integration (e.g. Mexico benefitting from increased trade and specialization
thanks to NAFTA).
If a country has a comparative advantage in the production of a good, but is
constrained by high tariff barriers, (returning to our free-trade diagrams) it
exports a reduced (Qs1->Qd1) ounces of marijuana into the customs union,
while the customs union produces (0->Qs1) ounces of marijuana itself; on
entering the customs union, the tariff is removed, and the exporter can make
full use of its comparative advantage in marijuana production. This leads to an
increase in exports to (Qs->Qd) and a decrease in the importers production to
Qs ounces. Trade is created because (Qd->Qd1) more ounces of weed are now

consumed, leading directly to an increase in consumer surplus equal to the

consumer welfare-loss triangle.
There is a movement from high- to low-cost producers, as Qd->Qd1
units of weed are now being produced by the relatively more efficient
country. Although the importing countrys producers may have lost out,
there is a world welfare gain as fewer resources are misallocated.
This is usually a two-way process; it is highly likely that imports of other
products that the customs union has a comparative advantage in (e.g.
cocaine) will increase with freer trade.
Trade diversion: The situation where the entry of a country into a customs union leads
to production of a good/service transferring from low-cost to high-cost producers; a
disadvantage of increased economic integration (e.g. the relative decline of Vietnamese
imports in Poland due to Polands entry into the EU).
Let us assume that our favorite drug-country has been producing meth, and also
importing meth from Methtopia, which has the comparative advantage in the
drug. However, once it joined the customs union, Marijuania had to place a
tariff on Methtopian exports, because the EU had one in place.
Before entry into the customs union, Marijuania would produce Qs units of
meth domestically and import the rest (Qs->Qd). However, once the new tariff
is established upon its entry into the CU (as is required by the agreement),
Methtopian meth becomes more expensive than meth from the customs union;
thus, Marijuania will now produce (Qs1) units of meth itself and import the rest
(Qs1->Qd1) units from the customs union.
Overall QD of meth will decrease by (Qd1->Qd) units, leading to a loss of
consumer surplus (our usual shaded triangle).
There is also a movement from low-cost to high-cost meth producers, as (Qs>Qs1) units of meth, formerly produced by rel. efficient Methtopian producers,
are now produced by rel. inefficient Marijuanian producers. Although
Marijuanian producers will have gained, a global welfare loss will occur due to
resource misallocation.
Moreover, the production of (Q2->Q2) units of meth has been diverted
to the rel. inefficient customs union, increasing the scale of trade
diversion and global welfare loss; this is a disadvantage of economic
integration.

Chapter 26: Exchange Rates

Exchange rate: The value of one currency In terms of another currency (e.g. 1 euro = 3 PLN
means that the price of Euro in PLN is 3 PLN)
o It is the external value of a currency (what the currency is able to buy abroad); the
internal value of a currency is concerned with dom. expenditure and depends on the
price level.

Currencies are traded on the foreign exchange market (Forex), the worlds largest market in
terms of cash movements; Forex includes trading of foreign currencies b/w govts, central
banks, commercial banks, financial institutions and MNCs.
o People and import/ export firms will buy currencies from banks and foreign exchange
offices to conduct international transactions. Foreign exchange brokers will in turn be
used by banks to supply needed currencies and to cash-in unneeded currencies. Finally
the central banks of trading countries may intervene on the currency market by adding
to the foreign reserves in order to adjust the exchange rate.
Exchange rate systems:
o A number of different exchange rate systems operate worldwide; the way a country
manages its exchange rates is known as its exchange rate regime, of which there are
three main types; these are:
o Fixed exchange rates: An exchange rate regime where the value of the currency is fixed
(pegged) to the value of another currency, the average value of several currencies, a
commodity, or a selection of commodities (e.g. the Argentinan Peso).
As the value of the variable the currency is pegged to changes, the government
is obliged to adjust the currencys value accordingly.
Deciding on and maintaining the currencys peg is usually the role of a countrys
central bank (or government). If the value of a currency in a fixed ER is raised,
we speak of a revaluation of the currency; if it is lowered, we deal with a
devaluation; these terms are specific to fixed ER regimes and are only used in
reference to changes in fixed ERs.
Note that currencies always change in value rel. to other currencies; the
pound can appreciate against the yen, for instance, but depreciate
against the dollar.
The usual mechanism for a fixed ER regime is similar to a buffer-stock
scheme; the currency is allowed to float within a very narrow range of
values, and the central bank intervenes by buying/selling its own
currency on the foreign exchange market when its currency leaves the
band set by the peg.
o The Central Bank may also manipulate interest rates to
encourage/discourage investment in the country (which will
affect upward/downward pressure on the ER)
o In the long run, governments might intervene using fiscal
policies, supply-side measures and protectionism to adjust
national income in order to increase or decrease exports and
citizens propensity to import.
The central bank could also borrow from the
International Monetary Fund. The IMF was created to
aid countries having difficulty keeping a stable exchange
rate. When a countrys currency falls, and the central

bank runs out of foreign exchange to buy up the home

currency, the central bank can borrow funds from the
IMF to get over the crisis
o To discourage speculation (e.g. George Soros in the UK, in
1992), governments/central banks do not publicize the limits of
the peg, but they do exist.
A further, less effective, mechanism for a fixed ER is a straightforward
peg, where the dom. currency is fixed at a certain rate to a foreign
currency.
o Using this method, it is very difficult for govts to settle on a
suitable ER that limits the scale of currency black markets;
however, the strategy is theoretically very simple, and is often
used in LDCs.
Floating Exchange Rates: An exchange rate regime where the value of a currency is
determined solely by supply of, and demand for, it on Forex; there is no govt
intervention to influence the currencys value (e.g. the US Dollar, since 1971).
In a floating exchange rate system, perfect information is an important issue.
Graphically, the market for a currency is illustrated as a supply-and-demand
diagram, with price of Currency X in Currency Y on the vertical axis (make sure
to get your labels right). The demand and supply curves are normal; demand
slopes downwards and represents the demand for the local currency by holders
of the foreign currency, and supply slopes upwards, indicating the supply of the
local currency, originating from its citizens and assets.
The exchange rate is set by market equilibrium, where QS=QD.
If a currency in a floating ER regime increases in value, we refer to an
appreciation of the currency; if it decreases in value, we deal with a
depreciation of the currency; these terms are specific, and limited to
changes in a currencys value under a floating ER regime; do not confuse
the terms with devaluation and revaluation, which are not applicable in
this case.
If a currency appreciates against another currency (for sake of
argument, the Zloty against the Euro), the price of Eurozone goods in
Zlotys decreases (though their value remains the same); this means that
the purchasing power of the Zloty has risen, and a given amount of
Zlotys may now buy relatively more Eurozone goods.
Conversely, in the Eurozone, the appreciation of the Zloty against the
Euro is simultaneous with a depreciation of the Euro against the Zloty;
the two movements are exact mirrors of each other (which is only
logical; changes in one exchange rate will be met by inverse changes in
the other ER.
Causes of a free-market change in exchange rates:

Several factors will influence demand and supply on currency

markets; using our Euro and Zloty example, let us examine the
demand for Zlotys by Euro-holders outside of Poland. Euroholders will buy PLN on Forex in order to:
Buy exports of Polish goods and services, and travel to
Poland
Invest in Poland (long-term capital movements, usually
through FDI or portfolio investment)
Save money in Polish banks and fin. institutions
Speculate on the Zloty in the hope that the currency will
increase in value in the future; these are short term cap.
movements known as hot money.
Thus, demand for the Zloty (which is to a very large extent a
derive demand) will rise if:
Demand for Polish goods and services increases; for
example, if:
Polish inflation rates are relatively lower than
Eurozone inflation rates (OK, ridiculous
example, due to the EU; in fact, pretend Poland
is not in the EU for this section), making Polish
goods and services relatively cheaper than EU
products.
An increase in incomes in the EU, which shifts
AD right, increasing demand for imports from
Poland, occurs.
A change in tastes in the EU in favor of Polish
products, occurs (e.g. due to better quality,
increases in foreign incomes, or increases in
tourism).
Polish investment prospects improve (e.g. due to sound
public finance practices by the Polish govt); note that
slow growth will have the opposite effect, as it is often
seen as a sign of ec. weakness)
Polish interest rates increase, making saving more
attractive in Poland than in EU fin. insts.
EU speculators think that the Zloty will rise in value in
the future, so they purchase it now; if they are correct,
they will be able to resell the Zlotys when they are
worth more and make a financial gain.

An increase in demand for the Zloty will shift the currencys

demand curve right, causing the Zloty to appreciate; each Zloty
can be exchanged for a larger amount of Euros.
o The elasticity of demand for a currency is dependent on the PED
for dom. goods and services; the more elastic this value of PED,
the more elastic the demand for the currency.
Supply of the Zloty on Forex (continuing with our example) will be
determined by a converse set of factors; the Zloty will be supplied when
Poles wish to:
o Buy Eurozone goods and services and travel to the Eurozone
o Invest in Eurozone firms (both FDI and portfolio investment)
o Save money in Eurozone banks and fin. institutions
o Make money by speculating on the Euro, in the hope that it will
increase in value.
In all of the above cases, Poles will need Euros, and will need to
exchange PLN to acquire Euros, increasing PLN supply on Forex; thus,
supply increases of PLN on Forex will be caused by:
o Poles increasing demand for EU goods/services, exchanging
more PLN for Euros; this could be due to:
Polish inflation rates being rel. higher than those in the
EU, making EU products relatively less expensive than
domestic products.
An increase in incomes, and thus AD, in Poland, which
increases Polish demand for imports from the EU (inter
alia).
A change in tastes in favor of EU products in Poland
(e.g. because EU products are of better quality, or Polish
incomes rise, or Polish tourism to the EU increases).
o An improvement in US investment prospects
o An increase in EU interest rates, making saving rel. more
attractive there than in Poland
o Speculators in Poland thinking that the Euro will gain in value
against the Zloty; they sell PLN now and buy Euros- if they are
correct, they will be able to buy US$ again when they are less
expensive, and thus make a financial gain.
If the supply of PLN on Forex increases, the supply curve for PLN will
shift right and the Zloty will depreciate; each zloty will be exchangeable
for a smaller amount of Euros.
Managed Exchange Rates: Exchange rate regimes where the government maintains a
band of in which the currency is allowed to fluctuate (much as in a fixed ER), but with
the band set at an arbitrary level. The government/central bank is free to adjust the

band (realign the currency) in the long run, if either upward or downward pressure on
the band becomes too intense (in which case, the currency is fundamentally over- or
undervalued), to account for changing economic conditions.
This ER regime exists because completely fixed rates cause a problem of
inflexibility, since economies have different fundamentals such as growth rates
and inflation rates.
In the long run it could be very costly for a country with a weakening currency to
defend its links with other countries.
o In reality, no currency is fully fixed or free-floating, and all ER regimes exist on a
spectrum; even where governments try to be non-interventionist, the currency may
sometimes be subject to severe fluctuations and the monetary authority will feel
obliged to intervene.
Likewise, frequent changes in a floating ER cause uncertainty and reduced
business confidence, and govts may be forced to intervene to stabilize the
exchange rate; thus, most free-floating ER regimes are, in reality, dirty float ER
systems, with some govt intervention.
Advantages/Disadvantages of High/Low ERs:
o The actual level of the ER will influence the economic situation of a country; hence,
governments intervene to influence the value of the ER. The respective
advantages/disadvantages of a high/low ER are:
Possible advantages of a high ER:
Downward pressure on inflation: If the value of an ER is high, the price
of finished imported goods and imported semi-mfgs, raw materials and
component will be rel. low; this will lead to lower costs/prices for
firms/consumers. The lower import prices will put pressure on
domestic producers to be competitive and keep prices low.
More imports can be bought: If the value of the ER is high, each unit of
the currency will buy more foreign currency; thus, more foreign
products (including visible imports and services- e.g. tourism) can be
bought.
As import prices will fall rel. to export prices, (ceteris paribus) an
improvement in the terms of trade (though not the balance of trade)
will occur.
Increased efficiency of domestic producers: The high ER will threaten
their intl competitiveness; they will be forced to lower costs and
become more efficient to remain competitive. While this may result in
layoffs and unemployment, there are other means by which efficiency,
and thus greater econ. productivity (potential growth) can be achieved.
Possible Disadvantages of a High ER:
Damage to Export Industries: If the value of the ER is high, export
industries may have difficulties selling their products, whose prices will

be rel. high, abroad; this could lead to unemployment in those

industries.
Damage to Domestic Industries: With greater levels of (now rel.
cheaper) imports being purchased, dom. producers may find that the
increased competition lowers demand for their products; this may
further increase unemployment as firms scale back.
o It is difficult for govts to predict and plan for the effects of the
high ER, as the consequences are likely to be asymmetrically
distributed across industries and regions in the economy.
Possible Advantages of a Low ER:
Greater Employment in Export Industries: If the value of the ER is low,
exports will be rel. less expensive and thus more competitive abroad,
leading to greater employment in export industries.
Greater Employment in Dom. Industries: The low ER will make imports
increasingly expensive; this may encourage dom. consumers to
purchase relatively cheaper dom. produced goods, rather than imports;
this may also boost employment.
Possible Disadvantages of a Low ER:
Inflation: A low value of the currency will make imported final products,
as well as raw materials and components, more expensive; this will
increase costs of production for firms as well as prices for consumers,
leading to higher prices in an economy and, in all probability, inflation.
Thus, a high value of a currency may be good to fight inflation, but may cause
unemployment problems (and possibly hinder growth), while a low value of a
currency will increase employment, but may worsen inflation. Conflict between
policy objectives, people.
Government Measures to Intervene on Forex:
o Governments may wish to intervene on currency markets and influence the value on
their currency for several reasons; they may wish to:
Lower the ER to reduce unemployment
Raise the ER to combat inflation
Maintain a fixed ER
Avoid large fluctuations in a floating ER
Achieve rel. ER stability to improve business confidence
Improve a balance of trade deficit (where spending on imported products
exceeds revenue received from exports of products).
o Whatever the case may be, there are two main methods for governments to manipulate
the ER of their currency:
Using reserves of foreign currencies to buy and sell its own currency: If a govt
wishes to increase its currencys value, it can use its foreign reserves to buy its

own currency on Forex, increasing demand for the currency and forcing up the
ER.
Likewise, if a govt wishes to lower the value of its currency, it can buy
foreign currencies on Forex using its own currency; to do so, the govt
uses its own currency, increasing its supply on Forex. This causes the ER
to be forced down.
Changing interest rates: If a govt wishes to increase its currencys value, it can
raise interest rates in the country; this will make dom. interest rates rel. higher
than foreign interest rates and should attract fin. investment from abroad; to
put money into the country, investors will need to buy the local currency,
increasing the demand for it, and thus, the ER.
Likewise, if a govt wishes to lower its currencys value, it may lower
interest rates in the country, making dom. interest rates rel. lower than
those abroad and making fin. investment abroad rel. more attractive; to
invest abroad, local investors would need to buy foreign currencies,
exchanging their own currency and increasing its supply on Forex,
lowering the ER.
Advantages and Disadvantages of Fixed/Floating ERs:
o Whichever ER regime a country operates, there will be associated advantages and
drawbacks; these include:
Advantages of a fixed ER:
A fixed ER should reduce uncertainty for all econ. agents in a country;
businesses will be able to plan ahead, knowing that predicted costs and
prices for intl trade and export will not change by much; this should
encourage investment and trade in the econ.
If ERs are fixed, inflation may have a harmful effect on demand for
imports and exports; thus, the govt will have an incentive to take
sensible measures to keep inflation as low as possible, in order to
maintain business competitiveness on foreign markets; in addition,
firms will have an added incentive to keep costs as low as possible in
order to be competitive.
In theory, the existence of fixed ERs should (by definition) reduce
speculation on foreign exchange markets; however, in reality, this has
not always been the case, as speculators have destabilized fixed ER
systems for speculative gain.
Drawbacks of a fixed ER:
The govt is compelled to maintain the fixed exchange rate; as the main
way of doing so is through manipulation of interest rates and control of
money supply, if the ER is in danger of falling, the govt will need to
increase interest rates to increase demand for the currency. This will,
however, have a deflationary effect on the economy, lowering demand

and increasing unemployment; the policy objective of low

unemployment may need to be sacrificed.
To keep the ER fixed and instill confidence on Forex, the govt will need
to maintain a war chest of foreign reserves to ensure that it can
defend its currency by buying and selling foreign currencies.
Setting the level of the fixed ER is not simple; many variables, which will
change over time, need to be considered. If the rate is miscalculated,
export firms may not be competitive abroad; if this is so, the ER may
need to be recalculated, but this will again involve difficulties in
estimation.
A country that fixes its ER at an artificially low level may create
international disagreement; a low ER will give the countrys exports an
advantage on world markets, which may be seen as unfair trade. This
may lead to economic disputes or retaliatory protectionism.
Meanwhile, an ER that is fixed at an artificially high rate is likely to
reduce the competitiveness of dom. firms.
Under a fixed ER, mon. policy becomes more difficult; any change in IRs
is likely to lead to unwanted inflows/outflows of currency and put
pressure on the currency (e.g. if the govt tries to control the money
supply, the resultant higher IRs will encourage inflows on the cap. acc.
and increase the money supply again.
o Thus, deflationary fiscal policy (e.g. higher taxes, lower
spending) may be the only policy option available to govts for
curing demand-pull inflation; lower demand will also reduce
demand for money and thus IRs, leading to capital outflows
which reinforce the contractionary fiscal policy but may put
pressure on the currency. The same situation in reverse applies
for expansionary fiscal policy.
Advantages of a floating ER:
Because the ER does not need to be maintained at a certain level,
interest rates are freed up as a dom. mon. demand-side policy tool (e.g.
for controlling inflation).
In theory, a floating ER is self-adjusting, and will keep the current
account balanced; for instance, if there is a current account deficit,
demand for the currency is low, as export sales are most likely low, and
its supply is high, as demand for imports is likely relatively high.
o This should mean that, in the long run, the market will adjust, as
the ER will fall. As a consequence, exports should become
relatively less expensive and more competitive, imports
relatively more expensive, and the current account balance

should right itself, if the Marshall-Lerner condition

(PED(exports)+PED(imports)>1) is met.
Because foreign reserves are not needed to stabilize the currency, it is
not necessary to maintain high levels of foreign exchange or gold.
Imported inflation is prevented: if one country has higher inflation,
then, under a fixed ER system, its trading partner becomes more
vulnerable to import-push inflation via higher import prices, as the
currency is not self-writing (e.g. China, in recent years).
A floating ER possibly reduces speculation, as the risk of large losses
may deter speculators.
In a floating ER, an increase in money supply will reduce IRs, boosting
dom. expenditure and leading to outflows of currency on the cap. acc.,
and thus a fall in the value of the currency, which will boost exports,
leading to a further increase in AD.
o Alternatively, a contractionary mon. policy will increase IRs and
reduce AD; the higher IRs will lead to capital inflows and cause
the currency to appreciate; this further reduces AD. Thus, in a
floating ER regime, monetary policys effectiveness is amplified.
Disadvantages of a floating ER:
Floating ERs tend to cause uncertainty on intl markets; businesses
attempting to plan for the future may find it difficult to accurately
predict costs and revenues (although businesses may hedge against ER
movements by buying/selling currencies in the future in forward
currency markets to reduce the risk). Investment is more difficult to
assess, and volatile ERs will reduce intl investment levels, as risk/return
calculation becomes more difficult.
In reality, more factors than demand and supply for products and
investment affect floating ERs; such factors include speculation, govt
intervention and unplanned world events (e.g. the Japanese earthquake
and tsunami). Thus, they do not necessarily self-adjust to correct
current account problems; in particular, speculation may lead to largescale ER changes.
Govts are permitted looser controls over their economies (e.g. they do
not have to ensure that do. inflation is in line with that of other
countries to ensure that their firms are competitive, as their currency is
free to depreciate)
A floating ER may worsen existing inflation rates; if a country has high
inflation relative to other countries, its exports will be less competitive
and its imports more expensive; demand for the currency, and thus the
ER will fall to compensate-while its goods will become competitive
again, at least initially, this could lead to even higher import prices of

finished goods, raw materials and subcomponents, which may

exacerbate cost-push inflation.
Fiscal policy is less effective in a floating ER regime, as contractionary
fiscal policy reduces income, and thus demand for money and IRs,
leading to an outflow on the cap. acc. This in turn causes a depreciation
of the ER which raises AD. The same situation in reverse applies for
expansionary fiscal policy.
Advantages/Disadvantages of a Single Currency/Monetary Union:
o Since 1999, the Eurozone is an example of a monetary union; all existing EU members
are eligible to join the Eurozone if they meet certain economic and monetary
requirements. New EU members must take action to eventually adopt the Euro.
o Specifically, to join the Eurozone, countries must:
Have inflation rates no more than 1.5% above those of the three countries in
the EU with the lowest inflation.
Have interest rates on long-term bonds at no more than 2% above the average
of the three countries with the lowest interest rates.
The budget deficit should not exceed 3% of the GDP at market prices.
The national debt should not exceed 60% of the GDP at market prices.
The exchange rate must have been stable for the preceding two years, with no
realignments or excessive intervention.
o The European Central Bank manages the Euro; there are several advantages and
disadvantages to participating in the Eurozone.
Advantages of a monetary union:
A single currency reduces transaction costs and facilitates
administration, as countries within the Eurozone do not need to
exchange currencies, and pay commission, when trading.
Within the Eurozone, businesses no longer need to worry about
exchange rate fluctuations and thus changes in rel. costs and prices; this
reduces risk and increases business confidence among member-states.
It is easier for firms to compare prices between members of a monetary
union, as they do not need to constantly convert figures using the latest
ER data.
Firms within the monetary union are forced to control inflation or risk
becoming uncompetitive.
Firms within the monetary union gain increased access to markets, due
to the removal of all barriers to trade (including currencies); firms may
now benefit from significant economies of scale.
FDI may be attracted to the monetary union due to lower transaction
costs, reduced uncertainty, and large size of the common singlecurrency market.
Drawbacks of a monetary union:

With a single currency, a single body sets interest rates for all memberstates; thus, individual countries lose their ability to set interest rate
levels and adopt an independent mon. policy, leading to a loss of
sovereignty over monetary policy.
The benefits of a monetary union may be spread unevenly within a
country, which could potentially worsen income inequality.
In a mon. union, it is not possible for one country to depreciate/devalue
its currency to ease a balance of trade deficit; all countries are required
to maintain the same ER against non-member states.
There is a cost of transition from national currencies to a single currency
for governments, who need to physically change currencies, as well as
firms (menu costs) and potentially, regional unemployment; however,
this is mostly a one-off cost.
Purchasing-Power Parity Theory: An economic theory that argues that, in the long run, ERs
should move towards a level that would equalize the prices of an identical basket of products in
the two countries being compared; it equates the LR exchange rate with relative inflation rates
in each country.
o The theory states that ERs will be in LR equilibrium where the rate allows people in
different countries to buy the same basket of goods with an equal amount of money
(this comes down to the Law of One Price: in an efficient market, identical products will
have the same price).
o Assume that the actual ERs between two countries are equivalent to the PPP ERs (e.g. if
a Big Mac can be bought for L1 in the UK and $1.8 in the US, the ER is L1=$1.8). If,
because of inflation, prices rise by more in the UK than in the US, the PPP exchange rate
will decrease, and theory suggests that the actual exchange rate will eventually also
decrease, as UK Big Macs will have become more expensive (note, though, in reality,
that we will not be dealing with a single good. Just a silly example)
There would be rel. increased demand for US imports in the UK, and the supply
of L on Forex should increase; likewise, demand for UK goods in the US should
decrease, and demand for the L should fall; the pound should depreciate
relative to the $ until the PPP ER is reached.
o If inflation rises by x% in a country, the currency should fall in value by x%, ceteris
paribus.
o PPP theory is useful in drawing comparisons between countries; however, it is simplistic
in the sense that ERs are not only affected by demand and supply for/of products; in
reality, speculation, business confidence, govt intervention and world events may mean
that the theoretical long run is never achieved, due to the accumulation of short-run
fluctuations. The actual ER is unlikely to ever reach the optimum PPP ER.

Chapter 27: Balance of Payments and the J-Curve Effect

The Balance of Payments Account: A record of the value of all transactions between the
residents of one country and the residents of all other countries in the world over a given period
of time (usually one year, although monthly figures are also collected).
o The balance of payments shows a countrys payments and receipts from its relations
with other countries, and is usually subdivided into two parts, listed below; as their
names vary, the most common names will be used.
The Current Account: A measure of the flow of funds from trade in goods and
services, plus all other flows of income; it is usually subdivided into three parts:
The Balance of Trade in Goods (The Visible Trade Balance, the
Merchandise Account Balance, the Balance of Trade): A measure of the
revenue received from exports of tangible (physical) goods (e.g. boxes
of Mac n Cheese, hair driers) minus the expenditure on imported
tangible goods over a given timespan; it includes trade in all tangible
goods.
o Exports: When an international transaction relating to goods
and services leads to an inflow of money into a country.
o Imports: When an international transaction relating to goods
and services leads to an outflow of money from a country.
o Balance of Trade Surplus: A situation where export revenue
exceeds import expenditure (e.g. Germany).
o Balance of Trade Deficit: A situation where import expenditure
exceeds export revenue (e.g. the US, for the past 30 years).
o The Balance of Trade will be affected by increases/decreases in
the value of the economys currency; see the discussion on the
Marshall-Lerner Condition, below.
o In addition, any changes in the balance of trade will affect AD,
as import expenditure and/or export revenue (the two
components of Net Exports) will have risen/fallen.
Conversely, in a country with high marginal propensity
to import, an increase in AD will significantly increase
import expenditure, moving the curr. acc. towards a
deficit.
The Balance of Trade in Services (the invisible balance, the services
balance, net services): A measure of the revenue received from the
export of services (e.g. tourism, banking, and exotic dancing) minus the
expenditure on imports on services over a given timespan.
o An Italian tourist on holiday would be spending money that
amounts to an invisible export for the host country (money
coming in) and an invisible import to the Italian economy
(money leaving).
Net income flows- usually split into two sections:

Net investment incomes (net factor income from abroad): A

measure of the net monetary movement of profit, interest and
dividends entering and leaving a country over a given timespan
as a result of financial investment (from) abroad.
If domestic firms have foreign branches, any profits
being repatriated count as a credit to the current
account balance; likewise, profits remitted by foreign
firms operating within the country would count as a
debit to the current account.
If domestic residents and institutions invest in foreign
financial institutions, any interest on the financial
investments will be a credit towards the current
account; likewise, any outgoing payment of interest to
foreign investors will count as a negative item.
If domestic residents and institutions purchase shares in
foreign companies, any dividends received on the
shares will be a current account credit; likewise, any
dividends paid by domestic firms to foreign
shareholders would count as a current account debit.
o Net Transfers of Money (Current Transfers, Net Unilateral
Transfers from Abroad): Payments made between countries
when no goods/services change hands- at a govt level, this
includes foreign aid and grants; at an individual level, it includes
remittances of earnings by foreign workers to their home
country or private gifts sent between people in different
countries.
Current Account Balance = Balance of Trade in Goods + Balance of
Trade in Services + Net Income Flows
Any of these accounts, as well as the entire current account, may be in
surplus/deficit at any one time (e.g. there could be a deficit on the trade
balance but a surplus on net income flows); the current account balance
is an overall balance of all of its components.
The Capital Account: A measure of the buying and selling of assets between
countries; it measures the net change in foreign ownership of domestic assets.
The capital account is sometimes referred to as the financial account or
subdivided into a financial account and a capital account; for simplicity,
IB refers to the buying and selling of all assets internationally as the
current account.
Capital Account Surplus: The case where foreign ownership of dom.
assets rises more quickly than dom. ownership of foreign assets; thus,
more money enters than exits a country.

Capital Account Deficit: The case where domestic ownership of foreign

assets grows more quickly than foreign ownership of domestic assets;
thus, more money leaves than enters a country.
Assets: Property that can be owned and has value- including land, real
estate, govt bonds, treasury bills, bank deposits, shares, foreign
currency, derivatives, etc.
o Assets can be classified in several ways; for instance, we
distinguish between:
Assets that represent ownership; e.g. purchasing
property, businesses, or stocks and shares- in all cases,
the asset is expected to have a positive return in the
future by increasing in value over time- the investment
is not necessarily repaid, and a pos. return is not
guaranteed; the buyer of the asset takes a risk.
Assets that represent lending: e.g. treasury bills, bonds,
savings deposits- in these cases, the investor lends
money in order to purchase the asset, expecting a
positive return (interest) on the investment and
eventual repayment; these assets represent borrowing
and lending on an intl scale.
Foreign direct investment (investment by MNCs in
another country)
Portfolio investment: Investment in stocks and shares
Other investment (e.g. currency transactions)
o The capital account also includes changes in the official reserve
account (the stores of gold and foreign reserves kept by
governments); it is movements into and out of this account that
ensure that the balance of payments will always balance out to
zero; the official reserve account will show the degree of govt
intervention on exchange rate markets.
If there is a surplus on all other accounts combined, the
official account total will decrease; if there is a deficit on
all other accounts combined, the official reserve
account will increase; it is net changes in the official
reserve account over the timespan considered that
balance the accounts.
For instance, if, at the given ER, there is excess demand
for a currency, the govt will need to sell the currency to
keep the ER constant. This is entered as a negative
number under official financing on the curr. acc.
Likewise, if at the given ER there is excess supply of the
currency, the govt will need to buy the currency to

keep the value constant; this is entered as a pos.

number under official financing.
If there is no official financing, demand for a currency
will always equal supply of the currency (i.e. inflows =
outflows), and the official reserve account balances out
at zero.
In a free-floating ER regime, this item will
automatically balance the curr. acc. with the
cap. acc; the ER automatically changes until the
supply of the currency equals the demand for
the currency.
In a fixed ER regime, govt intervention will
ensure that this item balances the curr. acc.
with the cap. acc.; if the govt is ineffective in
doing so, the two accounts will balance through
unofficial (illegal) foreign exchange markets.
o In reality, the accounts will never perfectly balance, as too many
individual transactions occur for measurement to be exact;
some transactions will be unrecorded when figures are put
together- thus, a balancing item (a.k.a. net errors and
omissions/ statistical discrepancy) will be used to ensure that
the accounts balance.
As more data becomes available, trading accounts are
revised and the balancing item decreases in size.
The total capital account balance should be the inverse
of the current account balance; the balance of
payments should always sum up to zero (thus, if there is
a current account surplus, the capital account must be
in deficit, and vice versa; one account effectively pays
for the other.
One result of sustained economic growth is usually
increasing demand for imports of goods and services;
thus, economic growth may cause the current account
to worsen: a country will need to borrow heavily from
abroad (either literally or by attracting investment)
from abroad to finance its international expenditure;
this may not be sustainable indefinitely.
Consequences of Current and Capital Account Imbalances:
A deficit or surplus in the capital or current account will have economic
consequences that we can consider:

Consequences of a current account deficit: If the current account is in

deficit, the cap. acc. will need to be in surplus to balance out the deficit.
This has one of three implications:
o Foreign reserves may be used to increase the cap. acc. and thus
regain balance with a curr. acc. deficit- if reserves are taken
from the official reserves account, they are a pos. entry into the
cap. account; however, no country can fund long term curr. acc.
deficits indefinitely from its reserves, which will eventually run
out.
o A high level of buying of assets for ownership can be used to
fund the curr. acc. deficit- foreign investors may purchase dom.
assets (including property, shares and firms); inflow into the
cap. acc. funds the curr. acc. deficit.
As it is a sign of foreign confidence in the dom.
economy, it is not usually assumed harmful; however, if
foreign ownership of dom. assets becomes too great,
economic sovereignty may be endangered, and if
confidence decreases, foreign investors may abruptly
withdraw their assets elsewhere (more so with hot
money than long-term investment).
Selling the assets would result in an increase in the
supply of the dom. currency and a decrease in its value.
o The deficit may be financed by high lending from abroad; if this
is so, high interest rates will need to be paid, causing short-term
economic harm and further increasing the curr. acc. deficit in
the future.
Also, private and public lenders may withdraw their
money and place it elsewhere if investment prospects
worsen, leading to massive selling of the currency and a
sharp fall in the ER.
Consequences of current and cap. account surpluses: If the capital
account is in surplus, the following is likely:
o A curr. acc. surplus allows a country to have a cap. acc. deficit
by building up its official reserve account or purchasing assets
abroad; however, one countrys surplus is anothers deficit,
which may lead to protectionism from countries with trade
deficits.
o A curr. acc surplus usually causes the currency to appreciate on
Forex as it implies an increase in demand for the currency
(however, at the same time, demand for exports is relatively
low, so this may be a moot point). If this occurs, at least in the

SR, imports will become cheaper, reducing inflation, but

exporters will be harmed by higher prices.
One countrys surplus is anothers deficit; the country
with the deficit may introduce protectionist measures,
possibly harming dom. industries.
Dutch Disease Effect: If a country generates a curr. acc.
surplus by exporting natural resources (e.g. natural gas
in Holland, North Sea oil in Britain), the increase in
foreign demand for the natural resources may cause the
ER to appreciate, making dom. companies less
competitive.
If the ER is fixed, a curr. acc. surplus will increase the
dom. money supply (a surplus means that there is
excess demand for the currency, so the authorities must
sell currency); the increase in the money supply could
lead to inflation.
A cap acc. surplus, based on the purchase of assets for ownership is
almost always a positive outcome and allows a current account deficit
(and more gains from importing products); however, if the cap. acc.
surplus is based on high levels of borrowing from abroad (usually as a
matter of necessity, to fund a current account deficit), the economy
may be in serious trouble due to debt and interest repayments.
The Magnitude of a Current Account Deficit/Surplus:
Two ways of interpreting the magnitude of a curr. acc. deficit/surplus exist; first,
its total value may be considered (e.g. a deficit of $109 billion); however, the
figure becomes more meaningful when placed into context with the countrys
GDP- a current account deficit of a given size would mean much less to the US
than to Burkina Faso, for instance. The burden of the deficit depends on ability
to pay; this is not as great a concern when a country has a curr. acc. surplus,
although possible problems with the appreciation of the currency may arise in
the SR.
The major problem is when current account deficits reach a certain % of
a countrys GDP and become difficult to manage effectively.
Methods of correcting a persistent current account deficit:
Although a current account deficit may be based on cyclical factors in the shortterm, a sustained current account deficit is most likely caused by structural
factors within the economy in question.
For instance, an economy may produce goods un-competitively (at a rel.
higher opp. cost than competitors), or may produce goods that are not
demanded by dom. consumers and/or foreign consumers (e.g. nuclear
weapons).

This is usually more of a problem under a fixed ER regime,

compared to a floating ER regime; in a floating system, the
external value of the currency falls, making exports competitive
again. By contrast, in a fixed system, the deficit would need to
be offset by inflows on the cap. acc. or govt intervention to buy
up excess currency (which cannot continue indefinitely, as the
countrys foreign reserves are limited).
When govts attempt to correct a current account deficit, they may adopt two
sets of policies:
Expenditure-switching policies: any govt policies that attempt to divert
consumption of imports towards dom. produced goods; if successful,
import expenditure will fall and the curr. acc. deficit will improve.
This is accomplished through:
o Depreciation/devaluation of the currency: If the govt adopts
policies to reduce the ER, exports should become cheaper and
imports- more expensive; depending on the PED of imports and
exports (the Marshall-Lerner Condition applies) the curr. acc
should improve as export revenues rise and import expenditure
falls.
Although a depreciation of the currency is assumed to
occur as an automatic response to a curr. acc. deficit in
a free-floating ER regime, a govt operating a fixed ER
regime will need to determine the amount the currency
needs to be devalued; this may lead to inefficiency if
the government mis-estimates the appropriate amount
by which the currency should decrease in value.
o Protectionist measures: the govt may attempt to restrict
imports via quotas, tariffs, embargoes, and
administrative/health and safety barriers. If the price of
imports rises and/or they become less widely available (the two
go hand in glove; the rationing function applies), domestic
consumers will switch a portion of their expenditure towards
domestic products, away from imports.
However, govts are often reluctant/unable to use
protectionist measures as they may incite retaliation
and violate WTO agreements; also, protectionism
reduces competition and encourages inefficiency- it is
not a viable long-term solution.
Expenditure-Reducing Policies: any govt policies that attempt to
reduce overall expenditure in the economy, shifting AD left; if this
occurs, expenditure on all products (including imports) should fall, and

the curr. acc. deficit should improve. The size of the fall in imports will
depend on marg. prop. to imports.
o However, a conflict between policy objectives arises; deflating
the economy may reduce the current account, but will also lead
to a fall in growth rates and employment; thus, it is a difficult
decision to make. Examples of this policy type include:
Deflationary fiscal policy: Increasing direct tax rates
and/or reducing govt expenditure; both are pol.
unpopular and a govt may be reluctant to adopt such
policies.
Deflationary mon. policy: Increasing the interest rate
and/or reducing money supply. The higher interest rate
should attract foreign investment, as foreigners put
money into fin. institutions, attracted by higher rates;
this will cause a cap. acc. improvement, which will
offset the curr. acc. deficit; however, this policy will also
be pol. unpopular as higher interest rates will increase
domestic debt repayments.
The higher borrowing costs due to higher interest rates
may act as a disincentive to dom. investment and limit
pot. growth.
In some cases, supply-side policies may be beneficial in correcting a
curr. acc. deficit, by expanding the potential output of a country,
increasing productivity, improving the quality of output, and
encouraging investment, innovation and competition by reducing
protectionist barriers, thus allowing the economy to produce its exports
in a more competitive manner.
In most cases, a package of policies will be used to manage a curr. acc
deficit; for instance, a depreciation of the currency will cause consumers
to switch consumption to dom. goods; however, if dom. industries are
near full capacity, they cannot produce enough in response to the
policy, resulting in inflation.
o Thus, the govt may intervene by deflating the economy
(expenditure-reducing) to provide capacity for expenditureswitching to occur; the two policies are complementary.
The econ. costs of reducing a curr. acc. deficit suggest the importance of
preventing its occurrence; to avoid these costs, many govts actively
promote exports (e.g. via official trade missions and advertizing), hoping
to develop new markets.
The Marshall-Lerner Condition:

In theory, if a countrys currency decreases in value, exports will increase (they become
less expensive abroad) and imports will decrease (they become more expensive
domestically); this should improve a countrys curr. acc, but this is not always the case.
The effect of a price change on expenditure and revenue depends on PED;
export prices may fall due to depreciation of the currency and, acc. to the Law
of Demand, QD will increase; however, whether export revenues increase
depends on foreigners PED for exports.
Likewise, the price of imports will rise if a currencys value falls; according to the
Law of Demand, QD will fall, but whether this will lead to decrease in import
expenditure depends on PED for imports.
The Marshall-Lerner Condition tells us how successful a
depreciation/devaluation of a countrys ER will be at improving a curr. acc.
deficit in the balance of payments.
The Condition states that: reducing the value of the ER will only be successful if
the total of the PED for exports and imports is greater than one;
A fall in the exchange rate will reduce a curr. acc. deficit if:
o PED(exports)+PED(imports)>1
This can be explained via price elasticity of demand; if demand for
exports was price inelastic and price fell due to a fall in the ER, the QD of
exports would increase by a less-than-prop. amount, leading to a
decrease in export revenue.
o Likewise, if the price of imports rose due to a fall in the ER, and
demand for imports was price inelastic, the QD of imports
would decrease by a less-than-prop. amount, increasing import
expenditure; both factors would worsen the curr. acc. deficit.
One of the determinants of PED is the timespan being considered;
demand becomes more elastic over time. This applies to demand for
imports and exports.
o Based on actual data, in almost all cases, short-run PED values
for exports and imports are lower than long-run values; this
corresponds to theory.
o Whereas few countries meet the Marshall-Lerner Condition in
the SR, most would meet the condition in the LR.
The J-Curve Effect:
o If a govt faces a curr. acc. deficit, it may reduce the ER of its currency to make exports
rel. less expensive and imports rel. more expensive; if this happens and the MarshallLerner condition is met (PED(exports)+PED(imports)>1), the curr. acc. deficit will
improve.
This is not the case in the SR and the curr. acc. deficit worsen before it
improves; this is known as the J-curve effect, which shows the effect of the
lowering of an ER on a curr. acc. deficit over time.

If the govt lowers the ER, the price of exports will fall, but, because of imperfect
communication, other countries will not immediately realize that export prices
have fallen; also, other countries may be locked into contracts for
goods/services with suppliers that cannot be broken quickly.
Thus, PED(exports) will be inelastic in the SR and export revenue will fall
by prop. more than the increase in QD, increasing the curr. acc. deficit
(this can be plotted on a graph).
Likewise, import prices will have risen, but purchasers of imports will
take time before they switch to domestic substitutes; they may also be
tied into contracts and will need to wait until they expire before moving
on to other suppliers.
o Thus, in the SR, PED (imports) will also be inelastic and import
expenditure will rise, as prices rise by prop. more than the
decrease in QD, further contributing to the worsening of the
curr. acc.
However, PED for exports and imports increases over time; after q
certain time where the curr. acc. worsens, PED for exports and imports
will increase to a point where the Marshall-Lerner Condition is satisfied,
as cons. and prod. abroad will switch to the cheaper imports from
Home, and as dom. consumers change their expenditure patterns
toward dom. goods/services; henceforth, the less expensive exports and
more expensive imports should decrease import expenditure and
increase export revenue and improve the curr. acc. balance.
By the same token, a balance of payments surplus may be reduced via a
revaluation/appreciation of the currency (along with removals of import
controls and expansionary demand-side policies, which increase
demand for imports).
Note that, in the very long run, the curr. acc. could worsen again, a the
higher import prices could cause cost-push inflation and make dom.
goods/services uncompetitive abroad. Thus, a depreciation/devaluation
of the currency may only be a temporary solution to long-term curr. acc.
deficits.
Also, one countrys surplus is anothers deficit: if a depreciation leads to
a fall in import expenditure, the country that produced the imports will
suffer falling GDP; if Home exports to those countries, its exports may
also suffer. Falling income levels may reduce inflationary pressure in
those countries, making goods from Home appear more expensive and
poss. mitigating some of the benefits of the ER policy.

Chapter 28: Terms of Trade

Terms of trade are a distinct concept from the balance of trade in visible goods, discussed
earlier; it is easy to confuse the two, but do not do so.
Deteriorating terms of trade are one of the major problems faced by LDCs; this has a specific
meaning in context, and does not simply mean that they experience difficulty in trade.
Terms of Trade: An index that shows the value of a countrys average export prices relative to
their avg. import prices;
o

Terms of Trade=

The weighting of the idices of avg. export and import prices reflects the rel.
importance of diff. goods and services to the countrys export rrevnue and
import expenditure.
Assume the ToT index is initially set at 100.
o If export prices rise and import prices stay constant, or if export
prices rise by prop. more than import prices, or fall by prop. less
than import prices, there is an improvement in the ToT; a
countrys exports will buy more imports than they had in the
past (this has been the case, for instance, in India, as the
economy has progressed to exporting manufactures and,
increasingly, services).
o Conversely, if import prices rise and export prices remain
constant, or if export prices fall by prop. more than import
prices, or rise by prop. less than import prices, there is a
deterioration in the TOT; a countrys exports will buy fewer
imports than they had in the past (e.g. the economy of Chad).
o Note that the terms improvement and deterioration are
relative; a country may face deteriorating terms of trade for a
time and still face a net long-term improvement in the ToT. In
addition, whether a deterioration or improvement in the ToT is
good or Bad will depend entirely on the relative
composition of a countrys exports and imports (the terms in
themselves are unnecessarily loaded).
o If the ToT improve, a given quantity of exports will buy more
imports than before. We usually refer to a basket of standard
export and import products; if the price of a basket of exports
falls (ceteris paribus), the country will need to sell more exports
to keep imports constant.
Short-Run and Long-Run Causes of Changes in a Countrys ToT:
o Short-run changes in the ToT may be caused by:
Changes in the conditions of demand and supply if the demand curve for
exports shifts, the price of exports will change. This will likely be in response to
prices of competitive goods in other countries, which affect export

competitiveness, changes in income (and thus AD) in importing countries, and

changes in tastes and preferences for the products exported.
Likewise, changes in supply will also affect export prices; if a number of
countries experience increased supply of a product (e.g. because of
good weather conditions, wine prices dropped in Australia), its price will
fall. The effect of such a change on the ToT depends on the overall
importance of the good as an export.
Changes in rel. inflation rates: If inflation rates in one country are higher than in
another, their export prices will begin to rise; although this causes an
improvement in the ToT, the countrys exports become less competitive.
Changes in ERs: a change in the value of a countrys currency will cause a change
in export prices rel. to import prices; this will occur either due to market forces
or via govt intervention on Forex.
o Long-run changes in the ToT are mainly caused by:
Income changes- rising incomes, esp. in MDCs, lead to increased demand for
secondary and tertiary products (manufactured goods and services), whose YED
tends to be elastic; this affects the rel. prices of the products; the ToT of MDCs,
which produce more secondary and tertiary products, tend to improve rel. to
the ToT of LDCs, many of which are dependent on primary product exports,
which usually have inelastic YED. The result is a change in world trade patterns.
Long-run improvements in productivity will lead to gradually deteriorating ToT,
as real prices will not rise significantly; however, the countrys exports would be
more competitive abroad and the result will be positive, if demand for exports is
elastic.
Elasticity of Demand for Imports and Exports:
o The concept of elasticities is very relevant to the discussion of ToT; to effectively analyze
ToT changes, we must consider the PED for imports and exports.
PED for exports (the measure of the responsiveness of the QD of exports to a
change in price):

PED

If demand for exports is price-elastic, a change in avg. export prices will

lead to a greater than proportional change in their QD; this would be
good for a country with falling export prices, since QD would rise by
prop. more than the decrease in price and export revenue would thus
increase.
o Most exports are price-elastic in the long run (PED(exports)>1);
however, this is not the case for most commodities (e.g. oil,
coffee, sugar, rice, copper, rubber, cotton, etc.)
PED for imports (the measure of the responsiveness of the QD of imports to a
change in price):
PED

If demand for imports is price-inelastic, a change in import prices will

lead to a less-than-proportionate change in demand for them; this
would harm a country with falling import prices, as QD of imports would
fall by rel. more than the increase in price, causing revenue to decrease.
o Most imports are price-elastic (PED(imports)>1), especially in
the long-run; however, commodity imports tend to have
inelastic PED.
How beneficial is an improvement in the ToT?
o An improvement in the ToT is not necessarily a positive outcome, as it may affect a
countrys current account balance in adverse ways. The outcome will depend on the
reason for the improvement; possible reasons for improvement include:
Increase in demand for a countrys exports:
A number of factors may increase demand for a countrys exports.
o If prices in other countries rise, domestic exports become rel.
more competitive.
o If incomes abroad rise, the countries demand for domestic
exports (imports, from their perspective) will rise.
o Consumers tastes and preferences may change in favor of
domestic exports.
When demand increases, average export prices rise, while the quantity
of exports demanded and supplied also rises. This leads to an
improvement in the ToT and an increase in total export revenue. In
addition, this will improve the current account balance.
o Thus, an improvement in the ToT, when caused by an increase
in demand for exports, leads to an improvement in the curr.
acc. balance.
Higher export prices caused by dom. inflation:
Rel. export prices may rise if a country is experiencing relatively higher
inflation than its trade partners. If this is so, the ToT will improve;
whether or not the ToT improvement leads to an improvement of the
curr. acc. balance depends on the PED of the countrys exports.
o Assume that the demand curve is normal and has the usual
relationship with MR and TR. The value of PED on a demand
curve falls as price falls; there will be an inelastic and an elastic
region on the demand curve (and demand will be unitary elastic
where MR = 0).
If demand for exports is price-inelastic (price is on the
lower half of the demand curve), an increase in price
will cause a less-than-prop. decrease in QD and export
revenue will rise; this can be illustrated using revenue
boxes and will improve the curr. acc. balance.

Thus, an improvement in the ToT, when caused

by inflation, causes an improvement in the curr.
acc. balance when export demand is priceinelastic.
If demand for exports is price-elastic (price is on the
upper half of the demand curve), an increase in price
will cause a greater-than-prop. decrease in QD; total
export revenue will fall. Again, this can be illustrated
using revenue boxes; this will depreciate the curr. acc.
balance.
Thus, an improvement ToT, when caused by
inflation, causes a depreciation in the curr. acc.
balance when export demand is price-elastic.
Hence, we can draw two conclusions about real-world
situations:
PED for most exports tends to be elastic; for the
majority of exported products, there is much
intl competition; thus, demand tends to be
elastic . In general, commodities face inelastic
demand; as a result, most MDCs will likely be on
the elastic portion of their demand curve for
exports.
Even if demand is on the inelastic portion of the
demand curve, if rel. high inflation rates
continue, export prices will eventually move
into the elastic region of the demand curve.
Overall, then, an improvement in the ToT due
to inflation usually causes a deterioration in the
curr. acc. balance.
The Significance of Deteriorating ToT for LDCs:
o Deteriorating Terms of Trade: A situation where avg. export prices fall relative to
average import prices.
o Although there are vast differences LDCs, most (though not all) LDCs are dependent on
the export of one or two commodities for export revenue and foreign exchange. The
degree to which this occurs varies, however:
While the % of Chads export revenue from primary products is 95%, this figure
is as low as 22% for Cape Verde, which exports services (tourism).
We distinguish between non-oil exporting LDCs (e.g. Mail, Ethiopia), oilexporting LDCs (e.g. Angola, Yemen), manufactures exporting LDCs (e.g.
Bangladesh, Nepal) and services-exporting LDCs (e.g. Cape Verde, the Maldives).

Thus, the problems facing different groups of LDCs come from differing
sources; we will focus on the problems facing non-oil exporting LDCs
that mainly export commodities; some of their growth and devt
barriers are related to ToT.
There has been a long-run downward trend in commodity prices since the early
1970s, due to:
Increases in the supply of commodities, mostly caused by technological
improvements (e.g. agricultural yields have risen exponentially over the
last century due to fertilizers, pesticides, mechanization, botanical
research and GMOs). Technology has allowed for the extraction of
more minerals and more efficient mining techniques.
The advent of synthetic replacements for natural commodities (e.g.
synthetic rubber, plastics, man-made fabrics) has led to a slow increase
in demand for the commodities concerned.
As LDCs have become richer and incomes have risen, demand for
commodities has not greatly changed; their YED is inelastic. At the
same time, as incomes rise, demand for mfg. and services (which tend
to have more income-inelastic demand) increases; thus, demand for
commodities has risen by less than demand for other products.
Ag. policies in MDCs have harmed world ag. markets- price support
schemes in the EU and US have led to rel. high prices there and
overproduction by local producers; subsidies have also led to
overproduction. The surplus crops are sold on world markets, pushing
down ag. prices. Therefore, LDCs often accuse MDCs of dumping ag.
products on the world market to the detriment of the LDCs ag.
industries.
The tech. improvements of the last 50 years have led to miniaturization
of products (e.g. large computers being replaced by laptops and iPads).
Miniaturization and improvements in plastics have led to a fall in
demand for commodities traditionally used to produce and package
manufactured products.
As a result, over time, demand for commodities has increased by rel. less than
supply of commodities; there has not been a fall in demand for commodities,
but the combination of low YED, increased use of synthetic substitutes and
miniaturization have led to rel. small increases in demand.
Meanwhile, ag. policies in MDCs and tech improvements have led to
large increases in commodity supply; as a result, average commodity
prices have fallen.
Because the ToT index is based on a weighted avg. index of export
prices, countries dependent on commodities will see a fall in the index
of export prices and a deterioration in their ToT.

The consequence of the deterioration in the ToT is a worsening of the

current account, because demand for commodities tends to be priceinelastic, overall. Although demand for a commodity from a single
source may be quite elastic, as many alternate producers exist, the
commodity as a whole has very few substitutes and is a necessity for
the production of some products.
o In addition, as supply is also rel. inelastic for most commodities
(due to time-lags in production and/or difficulties in the
efficient extraction of capital-intensive minerals), any shift in
supply or demand can lead to major changes in commodity
prices, and thus price volatility and large-scale changes in the
ToT.
This can be shown on a revenue box diagram: the fall in average export
prices when PED <1 leads to a fall in export revenues.
We may also consider the effect on imports: if export prices fall, import prices
rise relative to the price of exports (i.e. deteriorating ToT). The imports of LDCs
are usually necessities (e.g. raw materials, manufactured components, capital,
food), which are not always available domestically but are required for growth;
thus, demand for them is price-inelastic; in addition, as these products tend to
have higher YED than do commodities, their prices are likely to increase at a
high rate relative to the decrease in commodity prices.
On a revenue-box diagram, a rise in import prices when demand is
inelastic leads to an increase in export expenditure.
The deterioration of the ToT of LDCs that depend on commodity exports has
several harmful effects:
LDCs have to sell increasingly more exports to maintain import
expenditure constant; this is harmful enough, but to do so, LDCs must
increase supply of exports, depressing commodity prices further in a
vicious spiral.
Many LDCs are heavily indebted; falling export prices and thus export
revenue increase the difficulty of debt servicing, leafing, in extreme
cases, to countries needing to increase borrowing and going further into
debt to pay off debt.
o This vicious spiral is related to the previous one: to repay their
debt, many LDCs have to increase output of the commodities
they have a comp. adv. in, increasing supply and depressing
price.
To increase supply of commodities and thus export revenue, some LDCs
have overused their resources, resulting in neg. externalities (e.g.
erosion, deforestation, desertification); this is not sustainable in the
long run.

To produce more commodities, LDCs need to purchase capital from

abroad, as they usually cannot produce it domestically. However, since
import prices are relatively high, this is usually difficult without going
into debt; thus, it may not be possible for an LDC to even increase
commodity output significantly.
While the overall trend in commodity prices over the past 50 years has been a
decrease, there have been occasional short-run upward movements in most
commodity prices.
Although petroleum, being more highly demanded than other
commodities, is a unique case, the short-term upswings in price for
most commodities can be explained by the growing world economy and
increased demand from newly-industrializing countries.
These trends may give some short-term benefits to commodityexporting LDCs, although the sustainability of the price increases in the
LR is uncertain.
The upswings also demonstrate the volatility of commodity prices; as a
consequence, commodity exporters are vulnerable to external
circumstances, and their export revenues can fluctuate significantly,
making effective govt planning for the future difficult.
Not all LDCs are the same, and not all LDCs depend on commodity
exports; however, deteriorating TOT also adversely effects
manufactures-exporting LDCs, which depend heavily on the export of
labor-intensive textiles, whose prices are also decreasing, for export
revenue; they also experience deteriorating ToT, although their prices
tend to be more stable.
The oil exporters have benefited from the overall increase in oil prices;
given that demand for oil is inelastic, their export revenues have
increased (whether or not this has led to increased development is a
different matter.

Chapter 29: Characteristics of LDCs

Devt economics is an extremely important, growing field in economics. The UN recently

estimated that 80% of the worlds population lived in developing countries.
There is a fundamental distinction between economic growth and economic development,
which informs the definition of developing/less developed countries (LDCs).
As a starting point of devt, we need to consider what makes a country an LDC.
Common Characteristics of LDCs:
o It would be useful for economists if all LDCs displayed the same characteristics; if this
were so, it would be easy to classify them and develop solutions to their problems.
Although this is not the case in reality, development economists have come up with a
list of common characteristics of most, though not all, LDCs; these include:

Low living standards, characterized by low (real) incomes (per capita),

inequality, poor health (low life expectancy) and inadequate education (low
levels of literacy):
In LDCs, low living standards tend to be experienced by most of the
population. The main indicators of low living standards are very high
poverty rates (very low incomes), high levels of inequality, poor housing,
low health standards, high infant mortality rates, malnutrition, and lack
of access to education.
Low levels of productivity (output/person):
These are common in LDCs, mostly due to low education, standards, low
levels of health in the workforce, lack of investment in capital, and lack
of access to technology.
High pop. growth rates and dependency burdens:
LDCs tend to have higher birth rates that, on average, are more than
double the rates in MDCs. This is a potential problem as, when pop.
growth rates exceed GDP growth rates, GDP/capita falls (which is
indicative of greater poverty levels)
o Crude birth rate: The annual number of live births per 1000 of
the population; the world average is 20.15, but this number
approaches 50 in some LDCs; most MDCs have figures below
15/1000.
High crude rates in LDCs translate into high dependency rations; as
many children are born, there are many people aged less than 15 in
LDCs. Those of working age (between ages 15 and 64) need to work to
support a larger population of children than those of similar age in
MDCs.
o However, MDCs also have larger proportion of the population
above age 64, who also need to be supported by the workforce.
o Dependency Ratio: the percentage of those who are nonproductive, usually those below 15 and 64 , expressed as the
percentage of those of working age (between 15 and 64); thus:
Dependency Ratio:
.
o

MDCs tend to have lower dependency ratios than LDCs, due to

the high % of the population below age 15; however, they tend
to have low % of the population above age 64, due to low life
expectancy at birth caused by poor healthcare.
In some LDCs (e.g. Uganda), dependency ratios are
particularly high due to the death toll from HIV/AIDS.
High and Rising Unemployment and Underemployment Rates:

LDCs tend to have rel. high unemployment and underemployment

levels, usually (officially) between 9% and 16% of the workforce;
however, it is difficult to measure unemployment accurately in an MDC
economy, let alone in an LDC. Thus, we must consider three additional
groups in the unemployment figures:
o The discouraged unemployed: Those who have been
unemployed for so long that they have given up the search for a
job and no longer appear in the statistics.
o The hidden unemployed: those who work for a few hours per
day on a family farm/business/trade and therefore do not
appear as unemployed in the statistics.
o `The Underemployed: Those who would like full-time work, but
can only find part-time employment, often informally and
illegally; low wages and output/worker are the usual
consequences of underemployment in an econ.
o Only when the above groups are combined can the full extent of
unemployment in LDCs begin to be understood; although
accuracy is impossible, a reasonable estimate of unemployment
in most LDCs is around 40%.; the high birth rates in LDCs only
stand to worsen the situation over time.
Substantial dependence on agricultural and commodity exports: This issue is
prevalent in LDCs and has everything to do with deterioration terms of trade; it
is discussed in Chapter 28, above.
Prevalence of imperfect markets and limited information:
The trend in LDCs in the last 20 year has been towards market-oriented
growth (the Washington Consensus), which has been promoted by
the IMF and World Bank; however, this is problematic as, while marketled strategies work rel. well in MDCs with efficient markets, many LDCs
face imperfect markets and market knowledge.
LDCs lack many of the factors necessary for market efficiency. They
lack:
o A functioning banking system, which enable and encourages
savings and investment (a necessary prerequisite for growth,
acc. to the Harrod-Domar Model).
o An effective legal system, which ensures that business takes
place in a fair and structured way.
o Many LDCs lack transparency in government, often leading to
inefficient governance and potentially high levels of corruption.
o Adequate infrastructure, which would enable commodities and
finished products to move around the country, and onto intl
markets, efficiently and at low cost.

Accurate information systems for producers and consumers,

often leading to imperfect information, resource misallocation,
and misinformed economic decisions.
Dependence and Vulnerability in intl relations:
In almost all cases, LDCs are dominated by devd countries due to the
polit. and econ. power of the MDCs; in addition, they are dependent on
MDCs for trade, investment, aid, and access to technology.
o Thus, it is not possible for most LDCs to isolate themselves from
world markets. For these reasons, LDCs are vulnerable
internationally, and are often dominated and harmed by the
decisions of devd countries, which they cannot contest.
o As a consequence, LDCs only account for 20% of the volume of
intl trade; this figure is inflated by high oil prices.
o Some economists argue that LDCs should begin to negotiate in a
bloc, much like a trade union, and gain from collective
bargaining.
o All of the above characteristics of LDCs are also barriers to growth and, possibly, devt.
Diversity among LDCs:
o Despite the usefulness of a list of common characteristics, no two LDCs are the same;
LDCs display diversity in a number of areas:
Resource endowment:
There is a tendency to assume that all LDCs are poorly endowed with
physical and human resources; this is not necessarily the case, however.
While human resources are often undernourished, poorly educated and
low-skilled (there are low levels of human capital), physical resource
endowment varies immensely among LDCs (e.g. Angola possesses oil
and diamonds, and Bangladesh has no significant natural resources after
the replacement of jute by synthetic textiles, yet both are LDCs).
o However, a lack of physical resources does not imply that a
country cannot be successful; Japan and Singapore both have
few resources, yet both are economically powerful. Much
depends on how the LDCs resources are maintained and used.
Historical background:
A large proportion, though not all, LDCs were once colonies of MDCs
(e.g. Rwanda has been colonized, while Ethiopia has not, excepting a
brief period before and during WWII); however, the impact of this trend
on LDCs varies greatly; much depends on the duration of colonization
and whether independence was achieved peacefully or violently. Some
countries (e.g. Singapore) have benefitted from colonization, while
others (e.g. D.R. Congo) have not.

It is unarguable that the historical differences b/w LDCs set

them apart from each other socially, politically and
economically.
Geographic and Demographic Factors:
LDCs vary greatly in terms of geographical and population size; some
LDCs (e.g. China, India) are huge, with large populations, while others
(e.g. Nauru, Swaziland) are small and have small populations. It is not
the case that all LDCs have large populations (compare China to
Djibouti, for instance).
Ethnic and religious breakdown:
LDCs have a wide range of ethnic and religious diversity; high levels of
diversity within a country may increase the risk of political unrest and
conflict (e.g. the Rwandan Genocide, the Tamil rebellion in Sri Lanka).
However, some LDCs are relatively ethnically and religiously
homogeneous (e.g. Morocco).
The structure of industry:
It is often assumed that all LDCs depend on the production and export
of primary products; while this may often be true, and a large number
of LDCs are typical in this respect, other countries (e.g. Bangladesh and
Nepal) export mfg. products, and a group of others (e.g. Cape Verde)
mainly export services (tourism).
Per capita income levels:
It is often assumed that all LDCs have very low GDP/capita; however,
there are marked differences in /capita income between LDCs.
Mauritius has a GDP/capita 20.5 times that of Sierra Leone, yet is still
considered an LDC.
Political Structure:
LDCs have very different political structures from one another,
including:
o Democracies (e.g. Brazil)
o Monarchies (e.g. Brunei)
o Military Rule (e.g. Myanmar)
o Single party states (e.g. Syria)
o Theocracies (e.g. Iran)
o Transitional political systems, as a result of conflict/civil war
(e.g. Somalia)
Many sub-structures exist within the above broad
structures; e.g. democracies can be subdivided into
presidential systems, parliamentary republics, etc.
Because the political systems of LDCs are so diverse, it is
difficult to establish universal solutions for human devt.

To conclude, while some common characteristics among LDCs exist to a certain extent, there are
also significant differences; it is risky to generalize and imply that all LDCs are the same.

Chapter 30: Sources and Consequences of Growth and Development

Econ. growth is often confused with econ. development; also, just because a factor causes
economic growth does not imply that economic devt will improve; it is possible that the quest
for growth may lead to a reduction in development (e.g. workers working longer hours, or in
more dangerous conditions).
We need to consider the sources and econ. consequences of growth, and the main sources of
development, in order to be able to discuss barriers to growth and devt and strategies to
promote growth and devt.
Economic Growth:
o The distinction between potential and actual growth is of key importance:
Potential Growth: A situation where the quality/quantity of a countrys FoPs
increases; this causes a rightward shift of LRAS and an outward shift of the PPF
Actual Growth: A situation where more real output is produced; this causes a
movement towards the curve on a PPF and an increase in real output on an
AD/AS diagram.
Sources of Economic Growth: The sources of growth broadly fall under four
headings, as follows:
Natural Factors:
o Anything that increases the quantity/quality of an FoP will lead
to potential growth; increasing the quantity of land available is
difficult, although the Netherlands and Singapore have been
quite successful in doing so via land reclamation.
o However, this will only have a small effect on total land area,
and thus productive capacity, unless the land area is small to
begin with (e.g. Singapore, where land reclamation led to a land
increase of 20%; if the same increase were to have occurred
across the strait, in Malaysia, the total increase in land through
landfill would increase land area by 0.03%).
o Natural factors will largely determine a countrys comparative
advantage in the production of agricultural vs. non-agricultural
goods and services; the better-endowed a country is in certain
natural factors (e.g. soil, climate), the more resources it can
commit to agriculture before suffering from diminishing returns.
o Most countries attempt to improve the quality of their natural
FoPs, rather than quantity (e.g. via fertilizers, more efficient
zoning, improved ag. techniques, irrigation, and vertical
expansion of cities- e.g. Hong Kong).
Human Capital (Labor) Factors:

The quantity of labor can be increased either by encouraging

pop. growth or increasing immigration levels; however, most
LDCs would not want to increase pop. size (as, although a larger
population increases productive potential, it often reduces
GDP/capita, esp. when human capital is low) and, even if they
were, the process is long-term.
o Most emphasis is thus placed on improving the quality of labor,
mainly via improved healthcare and education (e.g. through the
development programs in Mali), vocation training and retraining
programs. In addition, the provision of clean water and
sanitation can greatly improve the health (and thus quality) of
human capital; these actions, however, entail an opp. cost for
the govt in terms of alternate spending projects (e.g.
investment in physical capital/infrastructure).
o In addition, encouragement of entrepreneurship (eg. through
higher-education scholarships or decreased bureaucracy) can
also contribute to ec. growth.
Physical Capital, Social Capital and Technological Factors:
o Econ. growth may be achieved by improving the
quantity/quality of physical capital (e.g. factory buildings,
machinery, shops, vehicles) or social capital (e.g. schools, roads,
hospitals, houses)
In LDCs, physical capital investment is often centered on
the agricultural sector, which suffers from volatile prices
and deterioration terms of trade.
o The quantity of physical capital is dependent on savings rates,
dom. investment, govt involvement, and FDI; the quality of
capital is improved via higher education, R&D and access to
foreign tech. and expertise.
o By definition, investment involves foregoing some portion of
current consumption for increased consumption in the future;
growth may thus be achieved by encouraging savings and
investment.
Tech. change and investment tend to go hand in hand,
as firms gain the incentive to upgrade their capital
stock.
o We refer to two concepts (as with the Accelerator effect):
Capital Widening: A situation where extra capital is
used with an increased amount of labor, but capital-toworker ratios remains constant. Thus, total production
will rise, but productivity (output/worker) will remain
constant.

Capital Deepening: A situation where the amount of

capital per worker increases, often as a result of tech.
improvements. Capital widening results in increases in
productivity as well as total production.
o Advancements in physical capital enabling (improved)
extraction of primary products (e.g. improved oil drilling
techniques)may be very important for growth, as they will
increase the quantity of an FoP (in effect, land).
Institutional Factors:
o Certain institutional factors are a prerequisite for meaningful ec.
growth. These essential factors include adequate banking and
legal systems (to provide the savings and environment
necessary for high levels of investment to occur), a good
education system, infrastructure, and political stability (internal
and external); some of these factors are also sources of ec.
devt. Burkina Fasos attempt to reform the legal system could
lead to growth via an improvement of institutional factors.
In many LDCs, investment opportunities do not exist for
small businesses run by the poor, and savings may leave
through capital flight rather than be channeled into
investment opportunities, hindering efforts to reduce
poverty.
o To achieve ec. growth, the promotion of entrepreneurship and
organizing factors is also necessary.
Consequences of Ec. Growth: The consequences of higher levels of growth may
be pos. or neg., and include the following:
Higher incomes: Higher growth rates lead to (ceteris paribus) higher
GDP/capita, which should, to an extent, improve living standards for the
population; the end effect will depend on the level of income equality.
o Higher GDP will benefit many, due to higher incomes and higher
living standards; however, some groups may see little to no
improvement in income.
Improved Ec. Indicators of Welfare:
o Historically, ec. growth has clearly led to higher averages in
terms of econ. indicators of welfare (e.g. life expectancy,
schooling, literacy rates)- this might not be the case for all
sectors of the population.
In most countries that have experienced ec. growth, HDI
has increased; there is a positive association between
growth and HDI. Although other factors aside from
GDP/capita contribute to an improvement in HDI, there

is evidence suggesting that one consequence of growth

may be an improvement in welfare, as defined by HDI.
Note that ec. growth is cumulative: a country with a
slightly higher LR potential growth trend may be far
ahead of other countries in terms of national income
within several decades; this is the main cause of the
inequity between countries worldwide.
However, in the short term, newly industrializing LDCs
are capable of achieving much higher growth trends
than MDCs, as the new industries are developed from
scratch, at rel. low levels of income, which can be
quickly increased.
If the rate of population growth exceeds the rate of GDP
growth (as is often the case in LDCs), GDP/capita may
actually fall, resulting in a decrease in HDI and
connoting a decrease in ec. welfare.
Higher govt revenues:
o Even if tax collection is rel. inefficient (the case in many LDCs),
increased GDP should lead to increased govt tax revenues; if
this is so, the govt will be in a better situation with the
provision of infrastructure and essential services (e.g.
education, healthcare).
Creation of inequality:
o Usually, economic growth achieved via market-oriented
initiatives leads to increases in inequality along with GDP
increases (the rich get richer and the poor, relatively poorer).
Even if the poor receive slightly more income, the gap between
rich and poor usually grows (as does the cost of living, which
may significantly worsen the situation of the poor), as the rich
receive most of the gains. Over time, this may be accentuated,
and the concept of a trickle-down effect (higher spending by the
rich eventually benefitting the poor) is especially voodoo
economics in LDCs, even more so than in MDCs.
In order for growth to occur, a high-income sector of
the population with rel. high marg. prop. to save must
emerge to finance investment; it is unlikely that all, or
the majority, of the population of a growing LDC will
belong to that sector; this trend is a direct cause of
income inequality in industrializing LDCs.
Low levels of human capital in certain regions or
demographics, which lead to an inability of some

sectors of the population to contribute to economic

growth, may also worsen income inequality in LDCs.
Neg. externalities and lack of sustainability:
o In both MDCs and LDCs, the quest for ec. growth often leads to
neg. externalities, such as pollution; as incomes rise, car and
airplane usage increases, and more goods are imported over
long distances.
o This behavior creates neg. externalities of cons. and prod. (the
market prices of the goods do not reflect the full social and
environmental costs of the goods).
o Deforestation caused by clear-cut agriculture, logging, and use
of natural wood for fuel, soil degradation, over-farming,
hazardous waste buildup from factories and landfills, water and
air pollution, overpopulation, and loss of biodiversity are all
consequences of growth (however, it can be argued that lack of
growth is equally harmful, and that the only satisfactory
solution is sustainable development)
Sector change: As incomes rise, the economy is likely to produce more
products that are rel. income elastic (e.g. high-tech manufactured
goods, IT services); thus, the composition of the economy will likely
change over time from agriculture/low-skilled manufactures-based
production towards a more diversified balance of goods and services
that requires high human capital and higher incomes.
o Urbanization: In order for these changes to occur, production
will become more concentrated in urban areas due to external
economies of scale and incomes being rel. higher in cities than
in rural areas (causing migration of former rural workers), which
will grow in size and population.
Climate Change:
o As economies grow, so does demand for energy; factories and
houses all consume energy and, to meet this demand, huge
increases in fossil fuel consumption have occurred.
Along with rising pollution levels, fossil fuel
consumption results in large-scale greenhouse gas
emissions, contributing to global warming.
Although the exact consensus is uncertain, the
Intergovernmental Panel on Climate Change concluded
that mean global temperatures could decrease by 1.55.8 degrees Celsius by 2100.
The net effect of climate change is very negative; there
may be massive destruction of habitats and ecosystems

due to their inability to adjust to changing climate

patterns.
The human effects of climate change will most affect
LDCs, and include:
Increased precariousness of access to safe
water sources; even now access to safe water is
not guaranteed for over 1 billion people.
Tropical diseases may spread further north
The frequency and intensity of droughts in
many Asian and African LDCs, and flooding will
likely become intensified in temperate and
humid regions.
Food production in the tropics and subtropics
will likely suffer; although agriculture could get
easier in the extreme north and south, this is
not guaranteed to improve food security
worldwide.
Millions of people may be displaced by rising
sea levels; this includes coastal areas and lowlying island nations (e.g. Nauru)
The concept of uneconomic growth has gained some
prominence lately; it is said to occur when increases in
production come at an expense in resources and wellbeing greater than the value of the items made.
Based on the definition, growth based on
current consumption patterns is unsustainable
and uneconomic; we may refer to a sort of
intergenerational inequity, whereby current
generations use up disproportionately many
non-renewable resources and create negative
externalities that will likely compromise living
standards of future generations.
Sources of Economic Development: Some factors are sources of economic
development, while also contributing to growth:
Education:
o Improvements in education improve the well-being of the
population, both of the educated themselves and society as a
hole (education provides external benefits).
o Although it leads to a more efficient workforce, it also has
further benefits; with increased education, people are better
able to read and communicate, increasing the likelihood of

reform, political participation and social change;. Changing

attitudes may lead to the realization of several development
aims, including the following:
Improvements in the role of women in society: Women
are empowered by education, and high correlations
between womens education, child survival rates, and
decreasing fertility rates.
Fertility rate: the number of live births per 1000
women of child-bearing age.
The role of women in society is hugely
significant to devt, and the promotion of the
political, social and economic role of women is a
major devt objective.
Improvements in the level of health: Improvements in
education and literacy rates improve health levels in
society; as people, esp. women, are able to
communicate more fully, they become increasingly
aware of some of the health risks that they face, as well
as of healthcare opportunities available to them.
Individuals may read and be informed about
diseases such as HIV/AIDS and the danger of
poor sanitation and nutrition.
In addition, they are able to learn about
opportunities for preventive measures such as
water filtering and inoculations.
Healthcare:
o Greater healthcare levels, esp. when combined with greater ed.
opportunities, will improve levels of ec. devt. Although many
factors affect life expectancy, there is a strong correlation,
supported by HDI figures, between healthcare and life
expectancy.
Although many factors can affect a single outcome, it is
unsurprising that countries that spend a higher prop. of
GDP on healthcare tend to have a higher life
expectancy.
This may be seen when comparing the % of GDP spent
on healthcare and life expectancy at birth in Australia
and Syria; Australia, which spends 9.55 of 590 billion
USD on healthcare, has significantly higher life
expectancy than Syria, which spends 5.1% of 60 billion

USD on healthcare; also, HDI is much higher in Australia

than in Syria.
We may also observe a close correlation between life
expectancy and education, but this trend may be
difficult to fully justify given the many other possible
variables involved.
Infrastructure: the essential facilities and services that are necessary for
economic activity (e.g. roads, airports, sewage treatment, water
systems, railways, telecommunications and other utilities).
o Improvements in infrastructure will lead to increased growth as
well as devt; e.g. better roads allow children to get to school,
and goods to be transported at lower cost to potential buyers.
o If it is universal, sewage treatment improves public health, as
does an adequate water system; any improvement in
infrastructure will, in some way, improve quality of life.
Political stability:
o Politically stable countries are more likely to attract FDI and aid,
and domestic savings and profits are more likely to remain in a
more stable country.
Increased access to FDI could contribute more to
growth than devt, but increased access to aid will
increase devt.
With pol. stability, citizens are more likely to have an
input in the political system; govt planning is likely to
be more structured and long-term, and the law will
likely be more enforceable.
All of the above factors will lead to higher living
standards for the population.

Chapter XXX: Barriers to Growth and Development

Many barriers to growth and devt hold back the economic progress of LDCs. They are most
easily understood when separated into several categories; however, many of the barriers are
very closely interconnected.
Some of the barriers to economic progress are barriers to economic growth, some are barriers
to development, and some hinder both.
We can break down barriers to growth and development into:
o Institutional Barriers:
Insufficient Provision of Education:
One of the Millennium Development Goals is to ensure that, by 2015,
children everywhere, boys and girls alike, will be able to complete a
course of primary schooling.

While progress in provision of education, esp. at the primary level, has

been made, over 115 million children of primary school age still do not
attend school worldwide.
o 80% of these children are in Southeast Asia and Sub-Saharan
Africa.
Provision of education is vastly expensive, and funding may not be
sufficiently available in the countries affected.
o In addition, there may be large disparities in access to ed. within
a country, with urban areas receiving a greater share of ed.
funding than rural areas.
o Family economic conditions may prevent children from going to
school, if the parents cannot afford to educate their children
and/or the children are needed to earn an income as child
laborers to support their families.
o For the most part, it is children from poor households and
families where the mother received no formal education who
do not attend school.
o Secondary school enrolment tends to be much lower than
primary school enrolment, because of the increasing necessity,
as children mature, of earning an income (the single greatest
obstacle to school attendance),
This is a barrier to both growth and development, as education is an
important development aim, and an uneducated workforce tends to be
inefficient (quality of labor is relatively low)
Insufficient Healthcare Systems:
LDCs have made much progress in terms of training medical personnel,
building clinics and hospitals, and providing immunizations and public
health services (e.g. sanitation, improved access to safe water).
Infant mortality rates have fallen worldwide, life expectancy has
increased, more children are immunized than ever before, and maternal
mortality rates are falling.
Nonetheless, LDCs still need to achieve considerable progress in
providing healthcare, as a large disparity between LDCs and MDCs
exists.
o For instance, low life expectancy at birth in Niger, Nigeria, and
Namibia is indicative of a lack of adequate healthcare
provisions.
This is a barrier to both growth and development, as the health of the
population is an important development goal and an unhealthy
population is more likely to contract diseases (quality and possibly
quantity [in the long run] of labor decreases).

Lack of Infrastructure:
One of the greatest barriers to growth (and devt) facing LDCs is lack of
essential infrastructure.
o Infrastructure: The essential facilities and services necessary for
ec. activity to occur. We can identify certain forms of
infrastructure that LDCs are likely to lack in sufficient quantities:
Transport infrastructure:
Roads
Railways
Seaports
Airports
Public Transport
Pavements (Improved roads)
Public Utilities:
Electricity
Gas
Water supply
Sewers
Public Services:
Police Service
Fire Service
Education infrastructure
Health infrastructure
Waste disposal
Communication Services:
Postal system
Telecommunications
Radio/Television
o The lack of any of the above will harm the ability to achieve ec.
growth by constraining the economys supply side; if goods
cannot be transported internally due to poor roads, or exported
due to the lack of a seaport, trade, and thus growth, is limited.
o If power supplies are intermittent and unreliable, production is
harmed.
o If communication channels are poor or nonexistent, the ability
to coordinate and plan ec. activity is limited.
Due to limited infrastructure, resources may be poorly
used or misallocated.
o Limited infrastructure also hinders devt prospects; poor roads
and transport may make access to schools and hospitals difficult

(although this is not the only obstacle in terms of education and

healthcare).
An underdeveloped communications network limits the
ability of people to learn about and participate in wider
communities (including political parties and trade
unions).
The availability of gas and energy is important to
households in terms of cooking and food preservation,
while sanitation and safe water are crucial for public
health to improve.
Weak institutional framework:
Another major barrier to growth is the inadequacy of the legal
framework necessary to support ec. activity; we can consider two main
areas:
o The legal system:
In many LDCs, the legal system is ineffective; where this
is so, contracts cannot be created and enforced and
property rights cannot be upheld.
Property rights: A basket of legal rights that
allow people to own and benefit from private
property, if the law supports them. They
include:
o The right to own assets (e.g. land,
buildings)
o The right to establish the use of assets
(e.g. being able to add sanitation to a
house)
o The right to benefit from assets (e.g. by
renting out land)
o The right to sell assets
o The right to exclude others from using
or taking over assets.
If a person cannot guarantee his/her ownership
of property, they will have no incentive to
improve the property, as the property can be
lost and the investment- wasted.
If property rights cannot be enforced, as in
many LDCs, investment and growth will be
severely reduced (however, property right
enforcement is not a silver bullet for economic
growth).

The Financial System:

Developed and independent financial institutions are
necessary for growth to occur; they are, however, often
underprovided in LDCs.
Most LDCs have dual financial markets:
The official market is small and usually
dominated by foreign commercial banks that
often have an outward-oriented emphasis for
operations and restrict lending to foreign
businesses.
The unofficial markets are illegal and
unregulated; their main operation is to lend
money at high interest rates to those desperate
and poor enough to need to borrow it.
Microcredit initiatives offer a potential solution
to this discrepancy, and a possible way to
reduce this barrier to growth and development.
Saving is necessary (according to common sense and
the Harrod-Domar Growth Model) for funds for
investment to be available; investment is necessary for
sustained growth.
Saving is difficult enough in countries with high
poverty rates, but becomes near impossible if
no place to save money that is safe and offers a
high rate of return exists.
Where fin. institutions are weak and
untrustworthy, people with investment income
tend to buy assets (e.g. livestock) or invest their
money outside the country (capital flight).
Fin. services are necessary for development, as well (at
they allow the poor to manage their assets and allow
them to increase in value). Thus, the difficulties
associated with saving and borrowing are a significant
barrier to both growth and devt, and make it very
difficult for low-income people to escape poverty.
Ineffective Tax Structure and Informal Markets:
Tax revenue provides govts with the means to finance nec. public
services (e.g. education, healthcare)and improve the economys
infrastructure.
If the govt does not receive enough tax revenue, it will not eb able to
perform its obligations effectively.

It is difficult for govts to collect tax revenue in LDCs; there are several
reasons for this.
o First, due to tax exemptions and inefficiency and corruption in
the administration, less than 3% of people in LDCs pay income
tax, vs. 60-80% in MDCs.
Second, corporate tax revenues tend to be low, as there is relatively
little corporate activity in LDCs (although it is rising) and LDCs often
offer tax incentives to encourage domestic corporate activity and
attract FDI.
Third, the main sources of revenue in LDCs are export, import and
excise taxes, as they are rel. easy to collect at the moment where goods
pass borders.
o However, it is only possible to gain much tax revenue in this way
if a country is heavily involved in foreign trade.
o The WTO, with its emphasis on liberalized trade, has negative
implications on countries that gain significant revenue from
tariffs.
Finally, tax systems in LDCs tend to be inefficient, byzantine and
corrupt; when combined, these elements mean that people can often
evade the taxes they owe.
In addition, in LDCs, much ec. activity occurs on informal markets (the
size of informal markets as a % of GDP is far greater in MDCs than in
LDCs); informal markets are growing worldwide.
o Large informal markets also lead to decreased tax revenues for
govts in LDCs.
If incomes are not recorded, as they are earned
informally, no tax will be paid on the incomes.
Lower tax revenues make it more difficult for
govts to promote growth and achieve devt
aims.
o Further, workers in informal markets tend to be unprotected,
and are poorly paid, with low job security, poor working
conditions and no social care.
o Productivity on informal markets tends to be low; workers are
often low-skilled rural migrants with low human capital.
Political Instability and Corruption:
These are barriers to both growth and development.
o Political instability causes uncertainty and, in extreme cases,
complete econ. breakdown (as an example, consider the civil
wars in Sudan that have caused significant deaths and
displacement of the population).

The conflicts have led to poor economic performance,

high poverty rates and low living standards for the
majority of the population.
With conflicts, the likelihood of attracting FDI and aid
decreases.
Several LDCs, mostly in Africa, are experiencing armed
conflicts along ethnic, religious and political lines; the
death toll, damage to infrastructure, loss of investment
and aid and political instability have all severely harmed
growth and devt in those countries.
Corruption: The dishonest exploitation of power for personal
gain.
Corruption is a major challenge for growth and devt,
and is most prevalent where:
Govts (esp. dictatorships) are not accountable
to the people.
Govts spend large amounts of money on largescale capital investment projects
Official accounting practices are not wellformulated or controlled.
Govt officials are not well-paid
Elections are not well-controlled or nonexistent (i.e. there is no democracy)
The legal structure is weak
Freedom of speech is lacking
Many of these conditions are found in LDCs, which may
explain the high level of corruption most LDCs
experience.
Forms of corruption include fraud, bribery, extortion,
patronage and nepotism.
Corruption is likely to have several negative effects on
growth and devt:
Electoral corruption means that the wishes of
the people are not heeded. If a government
that has not been voted on by the majority is in
power, it is unlikely to adopt policies that will
benefit the people.
Corruption reduces the effectiveness of the
legal system; if people can buy their way out
of trouble, there will be an incentive to act
illegally.

Corruption leads to unfair resource allocation; if

contracts go to the highest bidder, rather than
the most efficient producer, market failure
occurs and resources are being misallocated;
corruption often shields inefficient produces by
protecting them from competition.
Bribes increase businesses costs, both in cash
terms and in terms of management negotiation
time; this will lead to higher prices.
Corruption reduces trust in an economy; as a
result, countries may experience difficulties
attracting FDI, which is often diverted to less
corrupt countries.
Corruption increases the risk of contracts being
violated; this acts as a deterrent to investment,
both domestic and foreign.
Corruption encourages the diversion of funds by
officials to capital projects where bribes are
more likely; this tends not to be in important
areas (education and healthcare, mostly), and
thus reduces the quality of the govts services
for the population.
Corruption often means that officials will
disregard regulations (e.g.
construction/environmental laws); this can be
harmful to individuals and the country as a
whole.
o Conversely, a corrupt govt could
impose regulations that are to the
disadvantage of the people of a country
for political reasons.
The monetary gains from corruption are often
moved out of the country; this is a form of
capital flight and reduces the capital available
for dom. investment.
The constant paying of bribes reduces the ec.
well-being of ordinary citizens.

Unequal Income Distribution:

Although all countries have income inequality, the gap between the rich
and the poor is generally greater in LDCs than in MDCs.
High income inequality can be a barrier to growth for several reasons:

There tend to be low levels of saving, as the poor save a very

small proportion of their incomes.
Low savings lead to low investment and low growth.
o The rich tend to dominate politics and the economy; thus,
policies in favor of the rich tend to be followed and pro-poor
growth (growth that leads to a reduction in some agreed
measure of poverty) may not occur.
o High income inequality in LDCs tends to result in the rich
moving large amounts of funds out of the economy (capital
flight).
o Also, a large % of goods purchased by the rich are imports,
whose consumption does not help the dom. economy.
o Thus, although we often link income inequality to low levels of
development, it can also lead to low growth.
International Trade Barriers:
Overdependence on primary products, adverse terms of trade, and the
consequences of a narrow range of exports:
While the share of mfg. produced by LDCs as a % of world trade is
growing, many LDCs are dependent on primary products for much of
their export revenues.
o When commodity prices are rising, this may be beneficial, as it
will increase growth rates and, if the revenues are used to
finance education, healthcare and infrastructure, can set off a
positive cycle in terms of growth and devt.
o However, if prices fall, the economies experience deteriorating
ToT; current account deficits will increase and it will be difficult
for the LDCs to finance current expenditure and necessary
imports.
Unless they can change the pattern of their export
trade, the countries that are dependent on a narrow
range of primary exports will find it difficult to gain
much growth through trade.
Regardless of the types of goods exported, if a country is dependent on
a narrow range of exports, if faces ec. vulnerability and uncertainty.
o Economic growth in a country reliant on tourism, for instance,
will be damaged if terrorism damages the global tourist trade.
A country specializing in one or a few products will also be vulnerable to
natural disasters, crop diseases, and other factors outside of its control.
o LDCs dependent on low-skilled MFG exports were harmed when
China joined the WTO and sharply increased textile supply on
world markets, driving down prices.

Protectionism in intl trade:

Protectionism: Any economic policy aimed at supporting dom.
producers at the expense of foreign producers.
Protectionist measures by MDCs against exports from LDCs may be very
harmful; if the measures prevent the LDCs from exploiting their comp.
adv. and exporting to MDCs, their ability to gain export revenue and
foreign exchange will be severely hindered.
Protectionism in primary product markets is especially harmful to LDCs;
for instance, massive US cotton subsidies encourage farmers to produce
more, depressing world cotton prices and exporting their surplus to
LDCs that do not benefit from subsidies.
o This is immensely damaging for LDC producers and markets, as
the lowered world price decreases the ability of local producers
to gain revenue.
o Other markets affected by large-scale subsidies include dairy,
corn, sugar, grains and rice.
o As the products are sold at lower prices than their unsubsidized
prod. costs, dumping occurs; small scale farmers in LDCs are
deprived of the ability to earn a living- a significant barrier to
devt.
o An important related issue is tariff escalation:
Tariff escalation: A situation where the rate of tariffs on
goods increases with the degree that the goods are
processed.
An importing country can thereby protect its processing
and mfg industries by putting lower tariffs on imports of
raw materials and components and higher tariffs on
processed and finished goods.
In extreme cases, the MDCs import the low-tariff raw
materials, process them, adding value to the goods, and
export the finished products.
Tariff escalation is a significant issue for LDCs in terms of
access to markets as it creates a disincentive in terms of
diversification towards processing raw materials
domestically, instead of exporting them; the higher
tariffs will make the exported processed goods
uncompetitive.
Tariff escalation can trap LDCs as exporters of
raw materials; the EU partakes in tariff
escalation on rice markets, whereby the tariff

on milled rice is nearly twice as high as that on

un-husked rice.
o Not surprisingly, the EU mostly imports
husked rice (2/3 of all rice imports),
with imports of the rel. more expensive
processed rice being much lower.
o Thus, tariff-escalation is successful in
reducing the imports of the more
processed good; the final processing of
the rice is thus done within the EU.
o Since processing and marketing add the
highest value to the product in terms of
the selling price, the EU makes the
largest gains from rice production
(rather than the LDC suppliers).
o Ideally, the LDC producers would like to
diversify into processing rice (through
vertical integration), but the tariff
escalation removes the pot. benefits.
o Tariff escalation is common on sugar,
meat, fruit, coffee, cocoa and tobacco
markets.
o

International Financial Barriers:

Indebtedness:
A major barrier to growth and devt in LDCs, especially due to the need
to repay the debt or face escalating compound interest. Indebtedness is
covered in more detail in Chapter XXXIII)
Capital Flight:
Capital Fight: A situation where money and other assets flow out of a
country to seek a safe haven abroad; LDCs (e.g. Zaire, now the Dem.
Rep. of Congo) have suffered heavily from capital flight since the 1970s.
Three main causes of capital flight common to many LDCs exist:
o If the dom. fin. markets are unsafe and citizens feel that their
capital would not be safe in dom. fin. institutions, they will
move it abroad to a more reliable country.
o Corruption in govts leads to the siphoning off of funds, both
dom. funds and FDI, and the removal of those funds to
numbered accounts abroad.
o Currency instability encourages citizens to move money out of
the country and into an economy with a more stable currency.

The repatriation of profits by MNCs arguably constitutes capital

flight, as the money sent out by the companies cannot be used
internally.
Capital flight has many harmful effects on LDC
economies
If money is outside a country, it cannot be used
to develop the country.
If money is outside a country, it cannot be taxed
and the govt loses pot. tax revenue.
Capital flight reduces govts ability to pay
employees decent wages, which forces the
employees towards corruption and bribetaking.
Increases in capital flight lead to greater
poverty, and thus social unrest and pol.
instability.
In many cases, LDCs lose more resources through
capital flight than they do through debt repayment; for
example, Africa is actually a net creditor with the world;
the value of accumulated assets that left Africa via
capital flight exceed the total value of Africas external
debt.
Another form of capital flight is human capital flight (brain
drain); the emigration of talented and educated individuals
from one country to another.
The usual cause of brain drain are better employment
opportunities and higher living standards abroad.
Emigration is sometimes forced by dom. unrest,
lack of dom. opportunities, and low heath and
safety standards.
o Iraq and Iran suffer heavily from human
cap. flight due to political instability.
Brain drain typically occurs in profession where a
university education is needed (e.g. engineers, doctors,
scientists)
Human capital flight represents an investment in higher
education that gives no return to the country where the
education was funded
It also means that valuable personnel are not
available domestically to promote growth and
devt and results in lower dom. tax revenue.

On the other hand, emigrants from LDCs often

send back money (remittances), which can
greatly help recipient families escape poverty.

Non-Convertible Currencies:
Many LDCs have non-convertible currencies (currencies that are only
usable domestically and are not accepted for exchange on Forex); e.g.
the Egyptian Pound.
o Most LDCs operate a fixed ER regime, where the dom. currency
is pegged to a more acceptable currency (usually the US$) at a
certain rate. However, LDCs usually lack the foreign reserves
and expertise to maintain the peg, leading to an over- or
undervalued currency (and thus, again, non-convertibility at the
official ER)
Thus, a black market for the convertible currency will
usually arise, which may be very harmful for the
economy; in some cases (e.g. Zimbabwe), the dom.
currency may become almost unacceptable
domestically, damaging local and intl trade.
o Non convertibility reduces likelihood of trade; traders and
foreign investors would be taking a greater risk dealing with the
LDC and are likely to go elsewhere to do business.
Social and Cultural Barriers:
A number of social and cultural barriers to growth and devt in LDCs
exist; it is, however, difficult to be general about them, as cultural
traditions vary from region to region and emphasize different sets of
moral codes and values; in addition, the extent of their effect is
relatively subjective (e.g. one cannot make a truly strong case that
dietary taboos are harmful to the growth of any one economy).
o Some points, however, are almost universal and rel.
unarguable:
Certain cultures disapprove of discussing sex, especially
with the young (this ranges from red-state America to
Mali and Uganda).
This may lead to a lack of appropriate advice in
countries where HIV/AIDS is epidemic, slowing
progress in combating the disease.
In many LDCs, especially in Africa, lack of
knowledge about HIV/AIDS is a major devt
barrier.

In all but 2 LDCs, women have a lower literacy rate than

men, spend less time in school in all but 14, and earn,
overall, significantly lower incomes than men.
In most societies, religious, social and cultural
traditions make the role of women very
different (usually, inferior) to that of men.
As women are expected to marry, raise
children, work in the home, etc. their potential
for ec. activity is limited.
Deprivation of ed. is a major barrier to devt for
women, as is the loss of freedom to seek
employment outside of the family.
The greatest untapped resources in the world,
then, may be women. Thus, many NGOs focus
on women as a devt priority.
o Increasing the number of educated
women will expand a countrys labor
force, allowing pot. output to increase.
In addition, some people may distrust banks and
financial institutions, and thus be reluctant to save.

Poverty Cycles:
o Poverty is usually measured in two ways:
Relative poverty: A situation where a person does not reach some specified
level of income (e.g. 50% of average annual earnings).
The level of relative poverty in a country will depend on this specified
level of income, which will depend on who is setting it; the figures are
thus prone to being altered for political purposes (e.g. a govt
attempting to show a fall in poverty by setting the level of 40% of the
median income, an opposition party attempting to embarrass the govt
by stating the level at 60% of the median income).
Thus, the whole concept is relative and, to some degree, subjective
Absolute poverty: A situation where a person does not receive enough income
to purchase the basic necessities for survival.
The absolute poverty line is the level of income sufficient to purchase
items such as basic clothing, food and shelter.
This enables us to make worldwide comparisons, if we first use PPP
exchange rates to account for varying living costs.
The abs. poverty line used by the World Bank is $1 (PPP)/day; if a
person is below this level, they are considered to be in absolute poverty.
o The World Bank has also issued figures for $2 (PPP)/day.

Many of the barriers to growth and devt are connected in a cyclical fashion; thus,
countries may be caught in poverty traps.
Poverty trap: Any linked combination of barriers to growth and devt that forms
a cycle that is self-perpetuating unless it can be broken.
A typical poverty trap is the poverty cycle (development trap).
A poverty trap that illustrates how low incomes perpetuate low
incomes, causing low growth, is given below:
o Low incomes (lead to)
Low levels of savings and very high MPC (lead to)
Low levels of investment (lead to)
o Low ec. growth (leads to)
Low incomes (etc.)
A poverty trap that illustrates how low incomes perpetuate low
incomes, harming economic devt, is shown below:
o Low incomes (lead to)
Low levels of ed. and healthcare (lead to)
Low levels of human capital (lead to)
o Low productivity (leads to)
Low incomes (etc.)

Chapter XXXII: Growth and Development Strategies

Do not confuse models and strategies for economic growth and devt (in particular, do not give
growth models in the place of development strategies).
Growth models, growth strategies and devt strategies are very different from each other:
o Growth models: Theoretical frameworks that explain how growth has occurred in the
past, and suggest ways by which growth can be achieved.
o Growth strategies: Economic policies and measures designed to increase GDP
o Devt Strategies: Ec. policies and measures designed to improve the standard of living in
a country (i.e. increase the level of human devt)
Ec. growth does not translate directly into devt, but if it can generate extra income for govts,
firms and people, it may lead to devt, depending on how the income is used.
Growth Models
o The Harrod-Domar Growth Model:
The Harrod-Domar growth model is used by economists to identify factors
affecting the GDP growth rate.
At its simplest, the model states that the ratio of GDP growth is determined by
the natl savings ration and the capital-to-output ratio in the econ. Thus:

Capital to Output Ratio: The expenditure on capital as a ratio of the

output gained from capital.

More sophisticated versions of the model also account for

capital depreciation, stating that a greater rate of depreciation
will lower growth rates.
If the model is correct, we can say that the rate of ec. growth may be
increased by one of two factors:
o Increasing the savings rate in the economy: if savings rise, econ
theory suggests that this can lead to an increase in investment;
as this increase represents a greater capital stock, which in turn
should lead to greater real output and greater GDP.
Since a prop. of the increased income will be saved, we
will have a cycle, which should lead to increased
growth, thus:
Increased incomes (lead to)
o Increased savings (lead to)
Increased capital stock (leads
to)
Increased Output (leads to)
Increased Incomes (etc.)
Although the theory is relevant when applied to MDCs,
there are problems when it is applied to LDCs- in
theory, all a country needs to do to achieve growth is
increase the savings ratio (as a greater numerator in our
formula results in a greater overall value)
However, raising savings ratios in LDCs is
difficult; most LDCs have very low MPS due to
poverty, as people spend most of their incomes
on consumption of necessities
o Furthermore, weak and insecure local
fin. institutions imply that the income
that people do have is spent on assets
(e.g. land, livestock)
o In some cases, savings leave the
country through capital flight and profit
repatriation.
o This combination of weak fin.
infrastructure, high consumption and
capital flight makes it difficult to
increase savings rates in LDCs
o Reducing capital/Output ratios in the economy (increasing the
efficiency of capital use: As this measure would decrease the

denominator, the theory suggests that this measure will

increase the growth rate.
However, increasing capital efficiency is never easy, esp.
in LDCs, due to a shortage of educated and skilled labor
(made worse by brain drain), as well as deficient
infrastructure (e.g. poor roads in Cameroon) and
possibly cultural factors, all of which imply that new
capital will not be used efficiently.
In addition, it is possible that the addition of
capital to an economys productive facilities will
eventually incur diminishing returns.
Moreover, a lack of skilled managers means
that entrepreneurship will be limited, which is
likely to limit efficiency.
Due to low incomes, R&D is likely to be
underfunded in LDCs, thereby reducing
efficiency, and access to foreign technology (a
further way of reducing capital/output ratios) is
expensive and thus often unavailable to LDCs.
In addition, due to capital flight and the
existence of other determinants of AD than
investment, many countries that experience
growth do not benefit from increased savings.
The Lewis Model (Structural Change Model, Dual Sector Model):
The main focus of the model is on structural change: the movement of a
traditional agrarian economy, with a small mfg. sector, towards a more modern
structural balance with greater mfg. and service sectors.
The model ass. that a large ag. sector with a surplus of labor and a small,
productive mfg. sector exist.
o The surplus labor in the ag. sector is not productive and thus
moves to the mfg. sector, attracted by wages that are higher
than in the ag. sector, but which are fixed, as labor supply is
high.
o Entrepreneurs in the mfg. sector will make profits as their prices
are above the fixed wage rates; the theory ass. that the profits
will be reinvested, increasing the (homogeneous) capital stock.
o Thus, the prod. capacity of the mfg. sector will increase and
demand for labor will grow; more workers will be employed
from the surplus ag. labor, entrepreneurs profits will increase
and be reinvested, and the cycle will perpetuate until all surplus
ag. labor is employed in the mfg. sector

o
o

A structural change has taken place away from the traditional

agrarian model and towards industrialization.
The Lewis Model presents, in a simplified manner, the process
of industrialization undergone by the current MDCs; however,
there are limitations to its use as a model for growth in LDCs;
these include:
The model ass. that entrepreneurs will keep adding
homogeneous capital; however, it is likely that
entrepreneurs would actually invest in tech. advanced,
labor-saving capital; this will reduce the increases in
employment.
While the Lewis model claims that this will slow
the pace of growth, in reality, the increased
levels of capital may actually contribute to
growth (see the Harrod-Domar Growth Model).
The model ass. that all profits are reinvested; however,
capital flight is a common problem in LDCs and it is
likely that a large % of the profits will leave the
economy, reducing investment and slowing growth.
The model ass. that a pool of surplus rural labor exists;
however, urban migration and the promise of jobs in
cities mean that in many LDCs, there is high urban
unemployment and little surplus of labor in rural areas;
thus, the model seems to fail in practice.
The model ass. that mfg. wage rates are constant;
however, the influence of collective bargaining,
imposed wage scales and higher wages offered by MNC
tends to lead to wage increases, even where there is
unemployment; this may reduce profits level and the
ability to reinvest.

Growth Strategies:
o Export-Led Growth:
Export-Led Growth: An outward-oriented growth strategy, based on openness
and increased intl trade.
Growth is achieved by increasing exports and export revenue, as a
leading factor in an economys AD.
This, in turn, should lead to higher incomes and, eventually, growth of
domestic industries in addition to growth of export industries.
The country concentrates on producing/exporting products that it has a
comp. adv. in.

To achieve export-led growth, it is ass. that a country will need to adopt

policies which include:
o Liberalized trade: opening domestic markets to foreign
competition, in order to gain access to foreign markets in
return.
o Liberalized capital flows; reduced FDI restrictions
o A floating ER
o Investment in provision of infrastructure to allow trade to occur
o Deregulation and minimal govt intervention.
This list of policies associated with export-led growth is largely
theoretical; in reality, countries that adopt an outward-oriented
strategy do not nec. adopt all of these policies.
LDCs usually export commodities and/or mfg. (although some export
tourist services). There is a crucial distinction between the export of
commodities and mfg. as an engine for growth:
o Many LDCs depend on commodity exports for export revenue;
however, commodity prices (with the exception of oil some
metals) have suffered long-term price decreases due to
increases in supply and rel. smaller increases in demand.
This, combined with protectionism in MDCs, means that
export-led growth based on commodity exports is
unlikely to succeed.
o The focus of ELG is usually on increasing mfg. exports; the
Asian Tigers (Singapore, Indonesia, South Korea, etc.) largely
owe their success to this strategy.
These countries were extremely successful in exporting
products based on low-cost labor, in which they had a
comp. adv.
Over time, the countries composition of
exports has shifted from low-skilled laborintensive mfg. towards more sophisticated
goods requiring capital intensive prod. methods
and more highly skilled workers; improvements
in ed. systems were essential to this change.
While ELG may seem like an obvious route to success in achieving ec.
growth, there are a number of problems associated with the strategy:
o The success of the Asian Tigers since the mid-1960s has led to
increased protectionism in MDCs against mfg. from LDCs;
unions and workers in MDCs argue that they cannot compete
with imports from low-wage LDCs and that free trade was unfair
to them.

They often lobby their govts to put tariffs and quotas

on the lower-priced goods. Price increases due to
tariffs effectively remove the comp. adv. of the
exporting LDCs; tariff escalation also reduced the ability
of the LDCs to export processed goods/services, forcing
many to export primary products and lower-skilled mfg.
instead.
The theoretical assumptions of the requirements for
export-led growth were not nec. met in the countries
that had been successful with the strategy.
Many economists have argued that the role of
the state in successful export-led growth is vital
and that minimizing govt intervention is not
the best way to proceed.
In the Asian Tigers, govts played an important
role by providing infrastructure, subsidizing
output via low credit terms from central banks,
and promoting savings and tech. improvements.
In addition, govts adopted policies that
protected dom. industries that were not yet
able to compete on export markets; this
illustrates the infant industry argument for
protectionism.
This is an area of debate, and, while many
economists agree that govt intervention in the
Asian Tigers was vital, others argue that state
intervention actually slowed growth rates.
If countries attempt to kick-start export-led growth via
FDI, the MNCs may become too powerful in a country,
leading to problems. The role of MNCs and FDI will be
discussed later.
Free-market export-led growth may worsen income
inequality within a country; if this is so, ec. growth may
occur at the expense of devt.
According to World Bank statistics, the LDCs that have globalized
following 1980 (e.g. Argentina, China, India, Mexico), becoming more
fully integrated in the intl economy via trade and capital-flow
liberalization (thereby becoming outward-oriented economies) have
experienced annual growth rates much higher than those in the LDCs
that have pursued inward-oriented strategies.

Import-Substitution Industrialization: An inward-oriented growth strategy that states

that a country should, whenever possible, produce goods domestically instead of
importing them.
This should mean that the dom. industries producing the goods will be able to
grow, as will the economy, and the country will be competitive intlly as its firms
gain economies of scale.
This strategy is the opposite of ELG and is not supported by economists who
promote the advantages of free trade according to comp. adv. as the most
effective growth strategy.
For the strategy to work, the following needs to occur:
The govt needs to organize the selection of goods to produce
domestically; historically, this has involved labor-intensive, low-skilled
mfg. (e.g. clothing, shoes).
Subsidies need to be granted to encourage dom. industries.
The govt needs to implement a protectionist system with tariff barriers
to restrict imports from abroad.
The advantages and disadvantages of ISI include:
Advantages:
o ISI protects jobs on dom. markets, as foreign firms are
prevented from entering and competing.
o ISI protects local culture and traditions by limiting foreign
influence on the econ.
o ISI protects the economy from the power, and possible harmful
influences, of MNCs.
Disadvantages:
o ISI may only protect jobs in the SR; in the LR, growth may be
lower due to decreased efficiency, which may lead to lower jobcreation rates.
o ISI means that a country does not enjoy the benefits of comp.
adv. and specialization, and thus produces inefficiently instead
of importing from rel. efficient foreign producers (trade
diversion occurs)
o ISI may lead to dom industry inefficiency due to the lack of
competition to stimulate competitiveness and R&D spending.
o ISI may lead to high inflation rate due to dom. AS constraints
o ISI may incite retaliatory protectionism from other countries.
The main countries to adopt ISI were in Latin America (esp. Brazil, Mexico and
Argentina); some former colonies in Africa and Asia (e.g. Kenya) also initially
adopted ISI strategies.
The policies showed some success in the 1960s-70s, but started failing in the
early 1980s, due to govt overspending and thereby indebtedness and an

inability to repay their loans; by the mid-1980s, many of the ISI countries were
forced to turn to the IMF for help.
The Washington Consensus:
Washington Consensus: A set of 10 common policy reforms seen by the IMF,
World Bank, and US Treasury Department as necessary for ec. growth in the
1990s.
Latin American countries seeking ec. help with the IMF were strongly
encouraged to adopt the policies, which included,
o Fiscal discipline (balanced budgets)
o Redirection of expenditure from subsidies to basic ed. and
healthcare.
o Lowering of marg. tax rates and broadening on the tax base.
o IR liberalization
o Trade liberalization
o A competitive (i.e. floating) exchange rate
o Liberalization of FDI inflows
o Privatization
o Deregulation
o Securing of Property rights
By the end of the 20th Century, the Washington Consensus reforms were
increasingly criticized by numerous economists.
o Critics of the Washington Consensus claim that the reforms
allow MNCs easy access to cheap labor markets in LDCs; thus,
MNCs may produce cheap products which are sold for high
prices in MDCs.
While the MNCs make high profits, the workers in LDCs
gain rel. little.
According to this view, the Wash. Consensus has not led
to high ec. growth in Latin America; instead, there have
been ec. crises and increased debt.
The policies have led to increased income
inequality and (it could be argued) exploitative
working conditions, thus working against the
goal of ec. devt.
Recently, many Latin American countries (e.g.
Venezuela) have become very critical of the
Wash. Cons. and moved back towards an ISI
growth strategy, which seems to have brought
some success in terms of growth,
Foreign Direct Investment:
FDI: Long term investment by private MNCs in countries overseas.

FDI usually occurs via MNCs building new facilities or expanding existing
plants in foreign countries (known as greenfield investment).
Alternatively, MNCs merge with or acquire existing firms in foreign
countries.
Approximately 80 000 MNCs with 730 000 affiliates operate worldwide.
FDI flows rapidly increased in the 1990s, a sign of the significant role
that FDI has played in world ec. integration and globalization.
o FDI flows fell sharply in 2001 and 2008, due to recessions, but
they rebounded shortly afterwards, largely due to an increase in
flows to LDCs (which accounted for 36% of all FDI inflows in
2004).
o There are imbalances in the levels of FDI inflows worldwide;
while China received 9.4% of all FDI inflows in 2004, Africa as a
whole received only 2.8%.
o The US is the largest recipient of FDI (14.8% of all inflows),
followed by the UK and then China.
MNCs are attracted to LDCs for several reasons:
o The countries may be rich in nat. resources (e.g. oil, minerals),
which MNCs have the tech. and expertise to extract. The top
FDI recipients in Africa (Angola, Nigeria, Sudan) are all wellendowed in resources.
o Some LDCs (Brazil, China, India) represent huge and growing
markets; if MNCs are located directly in the markets, they have
much easier access to a large number of pot. consumers. With
rising incomes, demand for consumer goods rises and MNCs
wish to be there to satisfy the demand.
o Labor costs are much lower than in MDCs; lower prod. costs
allow firms to sell their final products at lower prices and make
higher profits
o Govt regulations in many LDCs are less severe than those in
MDCs, making it easier for companies to set up and significantly
reducing prod. costs.
Many LDC govts also offer tax breaks to attract FDI;
over the past 15 years, both MDCs and LDCs have
adopted policies favorable to FDI (e.g. decreases in
corporate tax rates).
o The possible advantages and drawbacks of LDCs receiving FDI
from MNCs include:
Possible Advantages of FDI:
From the Harrod-Domar Growth Model, a nec.
condition for growth are increased savings;

LDCs, however, often suffer from savings gaps,

which may be filled by FDI; this may lead to ec.
growth.
MNCs provide employment and, often, ed. and
training; this may improve the skill levels and
managerial capabilities of the workforce.
MNCs allow LDCs greater access to R&D, tech.
and marketing expertise, which may enhance
industrialization.
Increased employment and incomes may have a
multiplicative effect on GDP growth in the host
country.
The host country may gain tax revenue from the
MNCs profits, which can be used to achieve
more growth through investments in
infrastructure or improvements in public
services (which may also lead to ec. devt)
If MNCs buy existing companies in LDCs, they
theoretically inject foreign capital into the
economy and increase AD
In some cases, MNCs may improve the phys. or
financial infrastructure of an economy, or act as
a spur for the host govt to do so in order to
attract FDI.
MNCs may provide lower prices for products
and more choice in the host country; they may
be able to provide necessities that are
unavailable domestically, and they will usually
produce more efficiently than domestic
nationalized firms (e.g. the govt mining
monopoly in Burkina Faso).
Thus, there are vast gains to be made from FDI; China is
a case in point:
Although treating FDI in isolation from other
variables is difficult, FDI most likely played a
major role in Chinas ec. growth since 1978,
when China began attempts to attract FDI as a
growth strategy.
Much of Chinas export volume is produced by
foreign firms. Through joint ventures with
MNCs, Chinese firms have grown rapidly and

successfully, and China is now the source of a

large outflow of FDI.
As china grows, so does its demand for natural
resources; thus, much of Chinas outgoing FDI is
investment in resource extraction.
Possible Drawbacks of FDI:
Although MNCs provide employment, they
often bring in their own management teams
and use the cheap low-skilled labor for basic
production, offering little to no ed. and training.
o This limits host countries ability to gain
new technologies.
Sometimes, MNCs may become too powerful
within a country due to their size, and gain large
tax breaks and/or subsidies, reducing pot. govt
income in LDCs.
o MNCs may also have too much
influence internationally; their incomes
and size allow them to influence WTO
and IMF policy decisions.
MNCs practice transfer pricing, whereby they
sell goods and services between divisions and
subsidiaries of the company in different
countries to take advantage of differing corp.
tax rates.
o Thus, LDCs that have lowered tax rates
to attract FDI gain little revenue from
their policies, and MDCs also lose pot.
tax revenue.
o This represents a large total revenue
loss to govts, as approx. 1/3 of world
trade is composed of sales between
different branches of firms.
o Govts have laws to prevent firms from
abusing their ability to use transfer
pricing to minimize tax payments, but
these are difficult to monitor and
enforce, esp. in LDCs.
MNCs may situate themselves in countries
where environmental legislation is ineffective,
reducing their private costs while creating

external costs; while this is good for the MNC, it

harms the environment of the host country.
o Likewise, MNCs may set up in countries
with weak labor laws, allowing
exploitation of local workers via low
wage rates and poor working
conditions.
MNCs may enter a country in order to extract
natural resources (e.g metals, minerals- copper
mining firms in Bolivia), strip the resources and
leave.
o This may lead to unrest as host country
nationals see the profits from their
resources sent out of the country to
foreigners.
MNCs may employ capital-intensive prod.
methods to make use of abundant natural
resources; this will not greatly improve
employment in the host country.
o It is argued that MNCs should use
appropriate technology, where
production methods are aligned with
the available resources, allowing for
growth that directly benefits lowincome people by providing
employment and incomes.
o Since LDCs usually have a large supply
of cheap labor, the argument goes that
labor-intensive prod. methods would be
more appropriate.
o In addition, the goods that many MNCs
produced are intended solely for export
markets, as local demand for them is
negligible; thus, the direct benefits of
increased output might not take effect
in the LDC.
In most cases, when MNCs buy host-country
firms, the owners of the purchased firms are
paid in shares from the MNC; thus, the actual
money is unlikely to be used in the LDCs
economy.

MNCs may repatriate profits, transferring them

back to the firms country of origin; this may
represent a form of capital flight.
While FDI is a pos. factor for ec. growth, the main
concerns with FDI relate to the poss. neg. effects of
MNCs on sustainable devt.
The extent to which MNCs can contribute to
sust. devt. depends on the type of investment
and the ability of host govts to appropriately
regulate the MNCs behavior and use the
benefits of the investment to achieve devt
aims.
The main concerns related to MNC activity have
always been possible exploitation of workers,
child labor, the possible inability of workers to
unionize, and business practices leading to
present or pot. environ. damage.
The existence of the Internet and global NGOs,
however, is making it difficult for MNCs to
conceal activities that contribute to these
problems from the public.
As most MNCs do not want to be seen as a
source of problems and want to promote their
image, firms are increasingly likely to develop
.corporate social responsibility policies, to show
that they are acting responsibly and e and
promoting sust. devt. Companies regularly
publish and advertize their CSR policies, in
particular, as related to human rights, employee
rights, env. protection and community
involvement.
o The extent to which these policies are
actively carried out and their actual
effects on workers, the environment,
and host communities is uncertain;
however, the policies are usually a step
in the right direction.

Development Strategies:
o Fairtrade Organizations:
In many LDCs, low world prices for commodities, high profits for middlemen,
tariff escalation and poor working conditions render it impossible for many poor

workers to earn a living income; in addition, the rules of the international

trading system are generally in favor of MDCs, which can compete easily due to
economies of scale and have been able to maintain key tariff barriers.
Fairtrade schemes are an attempt to ensure that food (and occasionally smallscale mfg.) producers in LDCs receive a fair deal when selling their products.
If consumers are aware of the harsh/unfair conditions facing producers, they
may be willing to buy from sources that pay a fair price to producers.
Fairtrade Labeling Organization International coordinates Fairtrade programs in
over 20 countries; the schemes aim to help poor farmers and landless workers.
Fairtrade Labeling has led to the rapid expansion of the Fairtrade
movement since the 1980s.
In this system, products can be certified (and labeled, giving consumers
confirmation that the producers of the products they purchase were
paid a fair price) if they meet FLO standards.
FLO regularly certifies hundreds of producers and firms in over 50
African, Asian and Latin American LDCs, and offers fair trading
conditions to over one million workers, farmers and families.
The criteria for a good to be FLO approved are as follows:
o The product must reach the trader through as few
intermediaries as possible (preferably, none).
o The product must be purchased at or above the Fairtrade
minimum price: a guaranteed price that covers costs of
sustainable production (prod. costs plus the provision of a living
income)
o The producer receives a premium if the product is certified as
organic.
o The trader must commit to a log-term contract, granting the
prod. security.
o The prod. has access to credit from the trader, on request, of up
to 60% of the purchase price.
o Where ag. goods are involved, the product must come from
sources managed democratically; if it comes from plantations,
the workers must benefit from intlly recognized employment
standards including unionization, and there must be no use of
child labor.
o The producer must produce the good using sustainable farming
methods.
o The trader must pay a Fairtrade premium to the producer; the
producers use the funds to aid local community development by
funding projects of their choice (usually education, healthcare

o
o

or other social schemes); the producers are accountable to FLO

for appropriate use of the funds.
Fairtrade certified products include many ag. goods, incl.
bananas, cocoa, coffee, fruit, honey, rice, sugar, tea and wine;
non-food products include cotton, cut flowers and sports balls.
Although the price of Fairtrade products may sometimes be
higher than that of products from standard sources, many
consumers are willing to pay in order to contribute to better
conditions for LDC producers.
Sales of Fairtrade products are increasing internationally, as
firms become more aware of their increasing popularity.
As Fairtrade emphasizes the provision of a living income,
security, proper working conditions, sustainable prod. and local
community devt, it is a strategy that leads to devt as well as
growth.

Microfinance Schemes:
In LDCs, the poor find it almost impossible to access trad. banking and fin.
systems due to a lack of assets to use as collateral, unemployment, and a lack of
savings.
If they are able to borrow money, it is often through black markets, at
exorbitant interest rates.
Microfinance schemes are specifically geared towards low-income borrowers;
they provide small loans, savings accounts and often insurance to the poor.
Microcredit: The provision of small loans to those who lack access to
trad. sources of finance.
o Microcredit schemes were originally developed in LDCs, in the
mid-1970s (e.g. the Grameen Bank in Bangladesh).
o Usually, micro-credit is given to the poor to allow them to start
up micro-enterprises (small-scale businesses- e.g. market stalls,
rice wine-making facilities).
o The loans give protection against unexpected occurrences and
seasonal problems, and help families gain a regular income,
start to gain wealth and thus, escape poverty, without
encumbering the poor with much debt; interest on microloans
tends to be low, although some for-profit microcredit
enterprises charge interest rates in excess of 60%, and
occasionally 100%.
Microcredit is often given along with financial and
technical education programs centered around the
needs of the recipients, which increase the level of
human capital

With microcredit, local economies in MDCs can become more

diversified and more resilient with respect to market changes
and deteriorating ToT.
Women are the main recipients of micro-credit, as they are a
better credit risk; they are more likely to pay back loans.
Women are usually responsible for caring for children; thus, any
reductions in womens poverty will translate into welfare
improvements for children,
Microfinance has allowed more poor children to go to
school.
In addition, when women take loans and begin to earn
an income, their socioeconomic status increases.

Chapter XXXIII: Aid and Indebtedness

(Foreign) Aid: Any assistance iven to a country that would not have been provided via normal
market forces.
Aid may be provided to LDCs in order to:
o Help people who have experienced natural disasters or war
o Help LDCs achieve ec. devt
o Create/strengthen pol./strategic alliances
o Fill the savings gap that exists in LDCs and thus encourage investment
o Improve the quality of human capital in an LDC.
o Improve tech. levels
o Fund specific devt projects
o Create markets to export to in the future (the economic reason for aid)
Many ways to categorize aid exist, although we draw an immediate distinction between two
forms:
o Official Aid: Aid organized by a govt or official govt agency
o Non-Official Aid: Aid organized by a non-government organization (e.g. Oxfam).
We can also classify aid under two main headings, as well as by types of aid that come under
both headings. The headings are, respectively:
o Humanitarian Aid: Aid given to alleviate short-term suffering caused by events such as
wards, natural disasters, or wars (e.g. relief efforts after the Haiti earthquake).
Humanitarian aid can take sev. forms, but is usually presented as grant aid
Grant aid: Aid provided as a gift (often in the short term) which does
not have to be repaid by the recipient.
The three main forms of humanitarian grant aid are:
o Food aid: The provision of food from donor countries or money
to pay for food, incl. money paid for transport, storage, and
distribution of the food.

Medical Aid: The provision of medical services and products

from donor countries, as well as money to facilitate med.
services (e.g. NGOs that provide antiretroviral drugs).
o Both forms of grant aid may be classified as official or nonofficial, depending on their origin.
Development Aid: Aid given in order to alleviate poverty in the LR and improve the
welfare of individuals.
Devt aid given by natl governments and intergovernmental organizations is
often referred to as Official Devleopment Assistance (ODA)
Official Development Assistance:
o [Informal Definition]: Aid provided by govts on concessional
terms, sometimes in the form of grants, and sometimes as Soft
loans
o [Formal Definition]: Flows to LDCs provided by official agencies,
incl. state and local govts, or by their executive agencies, each
transaction of which meets the following criteria:
It is administered with the promotion of ec. devt and
welfare of LDCs as its main objectives
It is concessional in character and consists of a grant
element of at least 25% (calculated at a 10% discount
rate).
o Bilateral aid: ODA provided directly by individual govts to LDCs
via official aid agencies (e.g. USAID).
o Multilateral Aid: Aid provided by intergovernmental
organizations (e.g. the IMF, UN agencies, the World Banks
International Bank for Reconstruction and Development), the
funds for which are provided by MDCs.
The intergovernmental agencies decide where the aid is
most needed and where it would be most effectively
used.
For instance, the World Bank IBRD grants soft
loans to LDCs in support of specific devt
projects, incl. provision of education,
healthcare, improvements in ag., pollution
reduction, and improvements in infrastructure.
Such loans are often conditional: the recipient
country may need to agree to certain policy
changes before receiving the loan (e.g.
environmental regulations, tariff reduction)

In 1970, the UN General Assembly adopted a resolution

agreeing that MDCs should spend 0.7% of their GDP on ODA.
However, in 2011, many countries are still far from this target.
Types of ODA:
Soft loans (concessional loans, long-term loans):
Loans that are usually repayable by the LDC over a long
time period (10-20 years).
The loans are sometimes repayable in foreign
currency, sometimes in local currency, and
sometimes in a combination of the two.
LDCs would prefer loans repayable in their local
currency, as they would not need to use
valuable, and scarce, foreign currency.
Soft loans tend to have very low interest rates
and be repayable over a longer time-period
than a standard commercial loan.
Soft loans may come via official (bilateral or
multilateral) or non-official aid, although the
latter is by far the rarer type.
Tied Aid: Grants/loans given to an LDC on the condition
that the funds be used to buy products from the donor
country.
Project Aid: Money given for specific projects in LDCS,
often given as grant aid (which requires no repayment);
e.g. aid for the construction of wells in Ghana.
The projects are usually intended to improve
infrastructure, and the aid funds are often
supplied to LDCs by the World Bank.
Technical Assistance (Sometimes classified as a subset
of project aid): Aid intended either to raise the level of
technology in LDCs by bringing in foreign technologies
and technicians who can instruct on its use, or to raise
the quality of human capital by providing training
facilities and expert guidance, or offering scholarships
such that managers and technicians can study abroad
(e.g. US assistance with farming techniques in Malawi).
Commodity Aid: Grant aid given to countries to
increase productivity in LDCs by providing funds to
purchase commodities incl. consumer items, semi-mfg.
goods and industrial raw materials.

Approx. 25% of the aid to Bangladesh takes this

form and provide necessities (e.g. chemicals,
fertilizer, concrete, steel, pumps, and capital
equipment).
Most forms of devt aid fall under the official (both
bilateral and multilateral)/non-official binary.

Concerns about Aid:

While humanitarian aid is generally seen as necessary and important in
alleviating short-term suffering, research suggests that no sig. correlation b/w
the level of aid given to a country and the GDP growth rate exists.
There are several concerns as to the use of aid as a means of poverty reduction:
In many LDCs, the govt in power may not nec. have the welfare of the
maj. of the pop. at heart; thus, when aid is received, it often goes to a
small sector of the population (usually wealthy city dwellers and/or
high-ranking officials).
o In the majority of cases, the benefits of untargeted aid do not
work their way through the economy; the trickle-down effect is
particularly ineffective in LDCs.
o Where there is extreme corruption, aid often leaves the country
via capital flight almost as soon as it enters.
o In addition, if the aid money props up such govts, a transition
towards a more democratic use of pol. and econ. power may be
slowed.
Aid is sometimes given for pol. reasons rather than being given to
countries where it is most needed; it is argued that MDCs often give aid
to the countries that are of pol. or econ. interest to them.
o As a result, the poorest countries in the world often receive less
aid than people in middle-income countries (for instance, Japan
has given aid to Nicaragua and St. Kitts and Nevis to influence
their vote in favor of a repeal of commercial whaling bans).
Tied aid is generally not as effective as untied aid; the LDC is unable to
look for the least expensive goods/services, but has to buy (usually)
more expensive goods/services from the donor country, which fosters
inefficiency.
o Tied aid creates no employment or extra output in the LDC, as
no expenditure takes place there; the imports may also harm
dom. producers, if they replace dom. products.
Tied aid is often pol. motivated, and arguably
represents a veiled subsidy to producers in the donor
country; the provision of tied aid, however, has fallen

within the past decade, and it is now illegal in some

countries (e.g the UK).
While short-term food aid provision during a famine may be
essential, long-term provision of large quantities of food may
reduce ag. prices in the LDC and worsen local farmers ability to
earn an income.
A potentially more effective policy to help farmers in
LDCs would be the reduction of ag. subsidies in MDCs,
which exceed total aid flows by a factor of 6.
LDCs may become dependent on aid in the LR, reducing their
incentive to innovate and poss. fostering a welfare mentality,
whereby LDCs believe that aid will always be available to them.
In reality, if govts need to reduce their own deficits, aid
expenditure is often one of the first items of spending
to be cut, and is thus often unreliable for LDCs.
Aid may prop up inefficient policies and agencies (e.g. corrupt
legal institutions) that hamper economic progress in the long
run.
Aid may sometimes maintain uncompetitive industries
in a recipient countrys economy, leading to resource
misallocation.
Some LDCs have industries that could quickly become
competitive on intl markets; in their case, it may be better to
concentrate on opening the markets to trade in order to gain
greater growth rates through exports.
Some economists argue that aid is skewed in favor of
industrialization, which may cause income and development
gaps between industrial workers and trad. ag. workers; in
addition, aid-fueled industrialization that is too rapid may cause
significant neg. externalities.
Aid is often only available if the LDC agrees to adopt certain ec.
policies; donors have argued that aid will only be effective if
given to countries that adopt the sound ec. policies of the
Washington Consensus (market-oriented liberalization,
privatization, and deregulation), said to promote ec. growth.
These policies may be more in the interests of MDC
govts and MNCs than in the interests of LDCs, and the
policies may worsen income inequality, as well as
reduce social safety nets and levels of public services,
however.
People and govts in MDCs may be showing signs of aid
weariness; they are beginning to believe that problems in their

own economies may be more important than those of LDCs; this

may reduce aid flows over time.
o Aid, esp. official aid, may not always get where it is needed due
to corruption, inefficiency, lack of information and capital flight.
o If technical assistance is not provided, LDCs may lack the
necessary skills and knowledge to carry out aid projects
efficiently.
o Loan repayments on fin. aid may lead to massive indebtedness
in LDCs.
o Despite the above concerns, in the poorest LDCs, private
investment is often not an option and aid may be the only
solution; wars, low human capital, corruption and lack of
infrastructure often render attracting foreign investment
impossible.
In these cases, directly targeted aid, esp. from NGOs
(which are usually less pol. motivated), may be the only
viable option for achieving growth and devt; however,
aid will not be effective in the LR without responsible
governance that emphasizes economic progress.
Non-Governmental Organizations:
o NGOs have come to play a major role in intl devt- although it is difficult to generalize
about NGOs due to their diversity in size, nationality, outlook, goals, income, and
success, most NGOs operating internationally aim to promote (sustainable) human devt
and humanitarian ideals.
They often work to provide emergency relief after natural disasters or provide
long-term devt assistance.
Examples of intl NGOs include Oxfam, the Mercy corps, Greenpeace, Amnesty,
and Mdecins sans frontires.
NGOs carry out two main activities: planning and implementation of specific,
targeted policies in LDCs and lobbying to influence public policy in areas such as
poverty reduction, workers rights, human rights, and the environment. Some
NGOs concern themselves with one of the above activities, while some carry out
both via fund- and awareness-raising.
This can result in public pressure on govts to affect the amount and
emphasis of official aid given, and may influence consumers spending
patterns such that better working conditions and sust. devt are
promoted (e.g. encouraging consumption of Fairtrade products).
As NGOs involves themselves directly with issues in the field, they can
develop a deeper understanding of the challenges facing the poor than
many official aid donors have.

Thus, they can combat poverty directly, often working in areas

where official aid does not reach, with groups that may be
isolated from official aid (e.g. stateless refugees).
Much of the work of NGOs focuses on direct cooperation with
the poor to enhance their human capital.
This may be accomplished via literacy programs, health
education, AIDS prevention programs, ag. extension
schemes, microcredit offerings, immunization and
vocation training.
Many NGOs focus on women in particular; raising
womens incomes and status is a major milestone for
achieving overall ec. devt.

Indebtedness:
o A high level of debt repayments that LDCs need to make on previously-borrowed
money is a major barrier to growth and devt in developing countries.
o To understand indebtedness, it is worth examining the historical causes of the Third
World Debt Crisis.
Before the 1970s, the level of borrowing by LDCs was low and tended to consist
of bilateral official soft loans at low interest rates.
In 1973, OPEC steeply raised oil crisis, leading to a massive increase in oil
revenues in oil-exporting countries (and tore apart many mixed economies
based on Keynesian principles, though that is a different story).
The revenues (known as petro-dollars) were deposited in Western
comm. banks; IRs fell sharply as the supply of loanable funds greatly
increased.
To make profits, the banks needed to lend the OPEC money to third
parties; however, the money supply was so great that the usual
borrowers did not take the full amount; thus, banks offered loans to
LDCs, which began to borrow money at regular interest rates, rather
than the prior soft rates. The loans were only repayable in hard
currencies, rather than the local currencies of the LDCs.
o The key to the Third World Debt Crisis was (according, at least,
to this left-leaning editor) that commercial banks wished to
continue making profits throughout the 1973-75 recession
without considering the consequences of their actions to
lenders (much like credit cards were offered for free to
unemployed college students in the lead-up to the 2008
Financial Crisis). Thus, although the banks lent huge sums, they
did not monitor the moneys destination and use.
Unfortunately, little of the money was spent on devt;
most LDC govts of the time were corrupt and/or

dictatorial, and the money went into large, failed

infrastructure projects (e.g. highways in the Sahara
desert), armaments, and private bank accounts of
dictators, generalissimos, and corrupt officials.
Although borrowing in LDCs grew at an alarming rate,
they managed to keep up with payments throughout
the 1970s, as high inflation rates worldwide made real
interest rates low.
Also, world demand for commodity exports was rel.
high, as were export prices; thus, LDCs had enough
foreign reserves on hand to manage repayments.
However, in 1979, OPEC increased oil prices again,
which contributed to a second worldwide recession;
this contributed to a sharp fall in demand for
commodities.
For sev. reasons, incl. falling commodity prices,
many LDCs found it very difficult to service their
debt and, in 1982, Mexico defaulted on its
loans- it was no longer able to pay the debt plus
interest.
o This sparked fears of a contagion effect
on intl credit markets, esp. as several
other LDCs followed Mexico in
defaulting; in response, the IMF made it
official policy to lend to countries that
needed a bailout, on the condition
that they adopted structural adjustment
policies, which included:
Encouraging trade liberalization
by lifting import/export barriers
Encouraging primary product
(esp. ag. and mineral) exports.
Devaluing the currency.
Encouraging FDI
Privatization of nationalized
industries.
Reducing govt expenditure to
ensure that govt budgets were
balanced
Austerity measures (reductions
in social expenditures)

Charging for basic services (e.g

ed./healthcare).
Removing subsidies and price
controls
Improving governance
(decision- and policymaking
processes) and reducing
corruption levels.
These policies reflect the views
of the Washington Consensus;
as such, many are supply-side
policies. The IMF has argued
that demand-management
policies are difficult to organize
effectively in LDCs.
However, after having come
under more recent criticism,
SAPs have also emphasized the
need for more efficient and
progressive tax systems, where
the wealthy are expected to
contribute a share of their
incomes and assets.
The SAPs were heavily criticized by
many devt economists and LDC govts;
although they may have successfully
reduced inflation, improved the
efficiency of markets in LDC economies,
lowered budget deficits, reduced public
ownership of firms and reformed ER
policies, serious costs (esp. to the poor)
were involved, including:
Reduction in govt-provided
services (e.g. education,
healthcare), which could
potentially lead to unrest,
economic disruption and falling
growth rates due to decreasing
AD, at least in the SR.
Increasing unemployment
Falling real wage rates

Increased prices of necessities

following removal of subsidies.
Due to the above, many LDCs
experienced de-development, as
reflected by higher malnutrition,
declining school attendance, and
increasing infant mortality.
Although the SAPs may have led to
long-term growth, the short-term costs
to the poor were tremendous.
In addition, the SAPs represent a rather
formulaic approach to ec. growth, and
do not reflect other possible paths to
ec. progress.
At present, many LDCs still suffer from
indebtedness, leading to debate about
the importance of debt relief; many
argue that LDCs debts should be
reduced/canceled.
One reason in favor of debt relief
relates to the inability of many LDCs to
service debt (pay back the original debt
plus interest); some countries are failing
to meet interest repayments, not to
mention the original debt (e.g. Nigeria
borrowed $17 billion, paid back $18
billion, and owes $34 billion); this debt
escalation is widely considered unfair.
Another reason is that debt servicing
reduces the ability of govts to spend on
other areas of the econ, a case of opp.
cost that is detrimental in two ways:
First, it slows ec. growth (e.g. as
govts lack the funds to invest in
infrastructure).
Second, it slows devt, as govts
cannot afford provision of
essential services (e.g. Malawi
spends more on debt servicing
than on healthcare provision).

Debt relief will release money,

enabling govts to finance devt
objectives
This relationship can be
illustrated using a spending
possibilities line, a simple
diagram similar to the PPF.
If a govt has a given amt. of
revenue, it must choose b/w
competing uses of the money,
which include debt servicing,
infrastructure investment, and
human capital investment via
ed. and healthcare expenditure.
The SPL has debt servicing on
one axis and expenditure on
human capital on the other
axis; if a govt is granted debt
relief, it will move along its SPL
away from debt servicing and
towards human capital
investment.
A further reason for debt relief involves
odious debt (debt incurred by a regime
and used for purposes that do not
reflect the peoples interests.
As dictators in LDCs have used much of
the borrowed money for individual
purposes, providing few real benefits to
residents (who need to repay the debt),
much of the debt incurred by LDCs
technically qualifies as odious debt.
The argument goes that the
lenders of the money (comm.
banks, intl fin. institutions, and
MDCs) were equally at fault in
making the loans. As such, they
should not expect repayment.
Economists have suggested that intl
debt is associated with boomerangs
that come back to hit MDCs; debt
creates problems for MDCs in terms of

worldwide environmental damage, drug

imports, higher taxes, higher
unemployment, illegal immigration and
higher conflict levels.
Thus, it is argued that MDCs
would benefit from debt relief,
as well, allowing them to
experience higher growth rates.
In addition, rising incomes in
LDCs create demand for MDC
exports; thus, MDCs may also
benefit from debt relief.
In 1996, the IMF and World Bank
launched the Highly Indebted Poor
Countries Program, which works with
the poorest debtor countries to reduce
their external debt; the majority of the
40 countries involved are in Africa.
As with the SAPs, assistance via HIPC is
contingent upon the govts in the
countries in question meeting certain
agreed ec. goals, which are still closely
based on Washington Consensus
policies and controversial.
Debt relief can be extremely effective in
promoting growth and devt; however,
it is not a silver bullet for assuring the
success of LDCs.

Market-Led vs. Interventionist Growth Strategies

o To conclude, we examine the weaknesses of market-led and interventionist growth and
devt strategies.
o As always, the same two schools of thought come into conflict; Keynesian and
Neoclassical economists have differing views on the role of govts in achieving intl econ.
progress.
o Market-led growth strategies (free-market policies, neo-classical policies, neoliberal
policies): Policies designed to minimize the role of govts and maximize the free
operation of markets.
Examples include export-led growth, growth via FDI, privatization, deregulation,
and the World Bank and IMFs SAPs and Poverty Reduction Strategy Papers.
o Interventionist growth strategies: Policies implicating the active role of govts and
manipulation of the workings of markets to achieve ec. growth.

o
o

Examples include ISI, protectionism, ER intervention, regulation, nationalization

of industries and govt promotion of certain export industries and products.
For about 30 years since the end of WWII, the main emphasis in terms of growth and
devt strategies was govt planning over the long term.
However, outside of MDCs, the policies were often difficult to implement and did not
lead to entirely sustained growth and devt, because of problems that arose:
Public sectors in many LDCs (esp. India and China) grew too large, leading to red
tape, overstaffing, and inefficiency; together with growing pol. instability, this
provided opportunities for the growth of corruption.
The many nationalized industries tended to be loss-making and inefficient, and
sometimes led to hidden unemployment.
Govt spending tended to be excessive, leading to large budget deficits and thus
the need for borrowing and increases in money supply, causing high inflation
rates.
Much of the expenditure was on unsuccessful large infrastructure
projects.
In the 1980s, a movement towards free-market, supply-side govts in MDCs saw a
realignment of govt policy and a change in paradigms on the best way to achieve
growth and devt in LDCs; along with ec. policy changes in MDCs, the change of direction
was influenced by:
The Third World Debt Crisis: As many LDCs needed to borrow money from the
IMF, which would only grant loans on the condition that LDCs implemented
SAPs, to avoid defaulting on loans, many LDCs adopted market-based policy
initiatives.
The transition of the USSR and satellite states towards market-based economies
(early 1990s) had two effects:
First, it acted as a signal that central planning was not effective as a
growth and devt strategy
Second, it removed fin. support for several LDCs aligned with the
Eastern Bloc, forcing them to seek support elsewhere (often, with the
IMF and World Bank)
The perceived success of the Asian Tigers (Japan, Singapore, Taiwan, Hong Kong,
S. Korea), who appeared to have successfully adopted export-led growth and
encouraged FDI, influenced thought on the ways to achieve high growth rates.
Thus, LDCs were encouraged to reduce the role of the govt in their economies and
adopt a more outward-oriented approach to ec. growth, generally including:
Freeing up dom. markets by eliminating price controls and subsidies, and
increasing competition.
Liberalizing intl trade by eliminating trade barriers and encouraging FDI.

Specializing according to comparative advantage; for most LDCs, this meant

specialization in primary products, which incurred the risk of deteriorating terms
of trade.
Privatizing nationalized industries.
Reducing govt expenditure to eliminate budget deficits.
However, as time progressed, a number of problems with the adoption of a purely
market-oriented approach have arisen:
Infrastructure is unlikely to be created via a market-based approach and most
LDCs lack the infrastructure to adopt such an approach, which would require
some future planning and govt intervention.
Although MDCs promote trade liberalization, they do not liberalize all trade;
protectionism in MDCs renders it difficult for LDCs to compete on a fair basis.
In recent years, LDCs (led by the BRIC bloc) have been cooperating with
each other to gain influence in trade negotiations.
The success of the Asian Tigers did not occur w/o govt intervention; the govts
in question were very interventionist in specific areas, esp. in infant industries
that needed protection before being able to compete on world markets.
The Asian Tigers also invested significant amounts of money into ed.
and healthcare, which is nowadays discouraged by World Bank and IMF
policies.
Although a market-based approach may lead to high growth in the LR, the poor
suffer SR costs, as unemployment rises, as do prices of necessities, and the
provision of public services falls.
As the measures will neg. affect low-income people worse than other
groups, income inequality will worsen.
Free market strategies tend to be concentrated on the urban, mfg. sectors of an
economy, increasing the divide b/w urban and rural areas, as well as rural
poverty, and leading to rural-urban migration, which has created large slums in
many major LDC cities due to a lack of employment opportunities for
uneducated workers in urban areas.
Govts may liberalize capital flows, but pol. instability means that many
countries are unable to attract the FDI necessary to fill savings gaps and achieve
growth.
Thus, solutions to growth and devt will lie in a combination of approaches which will
vary between countries. As the IMF discovered, a one-size-fits-all policy, esp. one that
is ideologically-motivated, is generally ineffective.
To conclude, we summarize some of the conditions believed to be necessary for both
ec. growth and ec. devt in LDCs by many economists:
Trade justice, such that LDCs trade on a fair basis with MDCs and are not
hampered by protectionist policies.
Debt relief, to release funds for investment in phys. and human capital.

Free operation of dom. markets, but only once the markets have reached a
competitive size and are sufficiently supported by infrastructure, high-quality
labor, and tech. and managerial expertise.
Encouragement of political stability and good governance and elimination of
corruption.
Effective, targeted aid that leads to pro-poor growth, such that aid flows are
directed at policies which encourage growth leading to a fall in poverty.

Appendix 1: IB Economics Markscheme Glossary

Abnormal profits (HL) see supernormal profits
Actual growth is an increase in real output for an economy over time. It is measured as an increase in
real GDP.
Aggregate demand is the total spending in an economy consisting of consumption, investment,
government expenditure and net exports.
Aid is
official aid is provided to a country by another government or governmental organization such
as UN or EU.
tied aid is granted on the condition that it is used to buy goods or services from the donor
country.
Allocative efficiency (HL) exists where price is equal to marginal cost (or marginal social cost) and
resources are allocated in such a way that neither too much nor too little is produced from societys
point of view.
Anti-dumping is government legislation [= the imposition of tariff] against the selling of imported goods
at a price below their production costs
Appreciation is an increase of the value of the currency, expressed in terms of another currency, in a
floating exchange rate system.
Average costs (HL) is the total cost divided by the quantity produced.
Business cycle is the periodic fluctuations in real national income/output/GDP around the productive
potential or long term trend of the economy. Its stages are slump/trough, recovery/expansion, boom
and recession.
Centrally planned economy is an economic system where resources are allocated by the government or
a central planning authority
Comparative advantage (HL) implies that one country is able to produce a good at a lower opportunity
cost than another.

Consumption is spending by individuals and households on domestic consumer goods and services over
a period of time.
Current account (balance) is a record of the revenues earned from the export of goods and services and
the expenditure on imports of goods and services.

current account deficit is where the value of total imports of goods and services are greater
than the value of total exports of goods and services
current account surplus is where revenues from the exports of goods and services are greater
than the spending on the imports of goods and services.
Cross elasticity of demand is the responsiveness of the demand for one good to a change in the price of
another good.
Crowding out (HL) is a situation where the government spends more (government expenditure) than it
receives in revenue (mainly taxation), and needs to borrow money, forcing up interest rates thereby
reducing investment and consumption
Demand is the quantity of goods and services that consumers are willing, and able to buy at each
possible price (over a given period of time).
Depreciation is a fall in the value of one currency against another currency in a floating exchange rate
system.
Developing countries are characterized by

low per capita income

high rates of poverty
low standard of living
low HDI ranking/value

Dumping is the selling of a good in another country at a price below its cost of production.
Economic growth increased real output for an economy over time and it is measured by an increase in
real GDP OR it is an increase in the potential output of the economy where the PPC shifts outwards.
Economic development is a broader concept than economic growth involving welfare improvements to
the standard of living including health, education and shelter.
Economies of scale (HL) are a fall in long run unit costs that comes about as a result of a firm increasing
its scale of operations.
Equilibrium price is the market-clearing price, set where Demand equals Supply.

Exchange rate is the price of one currency expressed in terms of another, preferably with an example.
Externalities are .
negative externalities they are costs to a third party caused by the production, or consumption
of a good (or service) or that they occur when MSC is greater than MSB in the market for a good
or service.

Factors of production are the four types of resources used in the production process: land, labor, capital
(and possibly entrepreneurship / management / enterprise).
Fiscal policy is the use of government spending and taxation to to shift the AD curve.
Floating exchange rate is where the exchange rate (i.e. price of one currency in terms of another)
changes according to the market forces of demand and supply.
Foreign direct investment is the establishment of production units by multinational companies in a
foreign country.
Free good is unlimited in supply and has no opportunity cost
Free trade exists where there is trade between different countries without government
intervention/regulation.
Free trade area is an agreement whereby there is free trade among member countries, but each
member can maintain its own trade barriers in trade with non-member countries
GDP or national output is the total value of all final goods and services produced in an economy in a
given time period (usually one year).
GDP per capita is a measure of real output/ income/ expenditure in the economy in one year
per head of the population.
real GDP or real output is the value of all final domestic goods and services, adjusted for
inflation.
Gini Coefficient is a measure of inequality in the distribution of income.
Human resources are the labor force of a country.
Import substitution policies are designed to encourage the domestic production of goods, rather than
importing them. The strategies encourage protectionism.
Income elasticity of demand is the measure of the responsiveness of demand of a good or service to a
change in income.

Indebtedness is the amount of money that a country owes to other countries and/or international
institutions.
Indirect taxation is an expenditure tax or a tax levied on goods and services imposed by the
government.

Infrastructure involves essential facilities and services such as roads, airports, sewage treatment,
railways, telecommunications and other utilities typically provided by the government.
Inflation is a sustained increase in the general or average level of prices.
Inflationary gap refers to inflationary pressure created by the current (or SR) equilibrium being above
the full employment (or LR) equilibrium.
Informal markets refer to markets in which economic activity is not officially measured/ recorded.
Interest rates is the price of capital or the price of borrowed/loaned money, usually expressed as a
percentage.
Investment is expenditure by firms on capital equipment and is an injection into the economy.
Inward-oriented policies see import substitution
Managed exchange rates is a system where the exchange rate is determined by market forces, but the
government/Central Bank intervenes from time to time in order to keep it within a certain band (=
range).
Market is the interaction between buyers and sellers in order to exchange goods or services (to make an
economic transaction).
Market economy is an economy where resource allocation is determined mainly by market forces of
demand and supply.
Maximum price is the upper limit imposed by the government below which the price may not fall. A
maximum price is usually set below the equilibrium to aid relatively poor consumers.
Merit goods are goods or services with strong positive externalities] that would be under-provided by
the market and so under-consumed.
Minimum price is the lower limit imposed by the government below which the price may not fall. A
minimum price is usually set above the equilibrium to aid farmers.
Monetary policy is a demand-side policy with the Central Bank using changes in the money supply or
interest rates to affect AD.

Monopolistic competition is a market when there are many buyers and sellers, producing differentiated
products, with no barriers to entry.
Multinational corporations are companies that have productive units in more than one country.
Multiplier (HL) is the ratio of the induced change in national income to the increase in the level of
injections and it is equal to the reciprocal of the mps + mpt + mpm.

NGOs are non-government organizations that exist to: promote sustainable economic development
and/or humanitarian ideals.

Nominal is the value of an economic variable that has not been adjusted for the effects of inflation.
Normal profit (HL) is the amount of revenue needed to cover the total costs of production, including the
opportunity costs.
(Official) foreign (currency) reserves are reserves of foreign currencies held by the Central Bank or the
government of a country.
Oligopoly is a market where few large firms dominate the industry, with at least one other characteristic
such as interdependency of firms, high barriers to entry, homogeneous or differentiated product with
example, imperfect information.
collusive oligopoly is where a few firms act together to avoid competition by resorting to
agreements to fix prices or output.
Opportunity cost is the cost of an economic decision in terms of the next best alternative foregone.
Poverty cycle involves low incomes which lead to low savings and low investment which ensure low
incomes in the future.
Potential growth is an increase in the potential output of an economy through an increase in the
quantity/quality of resources
Price elasticity of demand is a measure of the responsiveness of quantity demanded to a change in the
price of the good.
Price discrimination (HL) exists when a producer charges a different price to customers for an identical
good or service.

Product differentiation (HL) is where a producer attempts to distinguish her product from those of
competitors, with the aim of making demand less price elastic.
Productive efficiency (HL) exists when production is achieved at lowest cost per unit of output. This is
achieved at the point where average total cost is at its lowest value.

Progressive tax is where the higher the level of income, the higher the percentage of taxation that is
paid (or the higher the average rate of taxation).
Property rights give people a legal right to own property/assets.
Quotas are import barriers that set limits on the quantity or value of imports into a country.

Real price is the nominal price of a good or service adjusted for inflation.
Recession is at least two consecutive quarters of negative economic growth.
Resource allocation is concerned with how resources (land, labor, capital and management) are
distributed in an economy.
Regressive taxes is where the proportion of income paid in tax falls as the income of the taxpayer rises
or where the average rate of tax falls as income rises.
Unemployment is people of working age (those in the labor force) actively seeking work at the current
wage rate but cannot find one.
unemployment rate is the number of workers without a job, who are willing and able to work,
expressed as a percentage of the workforce.
Subsidy is a payment made by the government to producers in order to reduce the costs of production
or to increase output.
Supernormal profits (HL) refer to a situation where all costs, including opportunity cost, are more than
covered by revenue, OR profits that are above the level that is sufficient to keep the firm in an industry.
Supply is the willingness and ability of producers to produce a quantity of a good at a given price (in a
given time period).
Supply-side policies they are policies designed to shift the AS curve to the right. They may include tax
cuts, reductions in welfare payments, promotion of training etc.
Sustainable development is the development needed to meet the needs of the present generation
without compromising the ability of future generations to meet their own needs.
Structural unemployment is long term unemployment that occurs when there is a mismatch between
the skills of unemployed workers and the jobs available or that exists as a result of rigidities in the labor
market.
Tariff is a tax on imports.
Terms of trade deterioration is where the average price of exports falls relative to the average price of
imports, or making it more expensive to buy imports, in terms of exports that need to be sold.

Trade cycle: see Business cycle

Tradeable permits are permits to pollute, issued by a governing body, which sets a maximum amount of
pollution allowable. Firms may trade these permits for money.
Wage is the payment for labor/working

real wage is the payment for labor/working adjusted for inflation.

World Bank is an international organization whose main aims are to provide aid and advice to
developing countries, as well as reducing poverty levels.
World Trade Organization is an international body that encourages the reduction of trade barriers
between its member nations.