Professional Documents
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Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This subject guide is for a 100 course offered as part of the University of London
International Programmes in Economics, Management, Finance and the Social Sciences.
This is equivalent to Level 4 within the Framework for Higher Education Qualifications in
England, Wales and Northern Ireland (FHEQ).
For more information about the University of London International Programmes
undergraduate study in Economics, Management, Finance and the Social Sciences, see:
www.londoninternational.ac.uk
This guide was prepared for the University of London International Programmes by:
O. Birchall, The London School of Economics and Political Science, assisted by D. Verry, The
London School of Economics and Political Science.
This is one of a series of subject guides published by the University. We regret that due
to pressure of work the authors are unable to enter into any correspondence relating to,
or arising from, the guide. If you have any comments on this subject guide, favourable or
unfavourable, please use the form at the back of this guide.
Contents
Introduction............................................................................................................. 1
Introduction to the subject area...................................................................................... 1
Aims of the course.......................................................................................................... 1
Learning outcomes......................................................................................................... 2
Overview of learning resources....................................................................................... 2
Route map to the guide.................................................................................................. 4
Study advice................................................................................................................... 6
Use of mathematics........................................................................................................ 7
Examination advice........................................................................................................ 7
Block 1: Economics, the economy and tools of economic analysis......................... 9
Introduction................................................................................................................... 9
Scarcity........................................................................................................................ 12
Rationality.................................................................................................................... 13
The production possibility frontier (PPF)......................................................................... 13
Opportunity cost and absolute and comparative advantage........................................... 15
Markets........................................................................................................................ 16
Microeconomics and macroeconomics.......................................................................... 18
A note on mathematics................................................................................................ 18
Models and theory........................................................................................................ 19
Criticisms of economics ............................................................................................... 22
Overview...................................................................................................................... 22
Reminder of learning outcomes.................................................................................... 23
Sample examination questions...................................................................................... 23
Block 2: Demand, supply and the market.............................................................. 25
Introduction................................................................................................................. 25
Equilibrium................................................................................................................... 26
Demand and supply curves........................................................................................... 27
Shifts in the demand and supply curves......................................................................... 28
Consumer and producer surplus.................................................................................... 29
Overview...................................................................................................................... 32
Reminder of learning outcomes.................................................................................... 32
Sample examination questions...................................................................................... 32
Block 3: Elasticity ................................................................................................. 35
Introduction................................................................................................................. 35
Price elasticity of demand ............................................................................................ 36
Cross-price elasticity of demand.................................................................................... 39
Income elasticity of demand......................................................................................... 40
Price elasticity of supply................................................................................................ 41
Incidence of a tax ........................................................................................................ 41
Overview...................................................................................................................... 43
Reminder of learning outcomes.................................................................................... 43
Sample examination questions...................................................................................... 43
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EC1002 Introduction to economics
Oligopoly................................................................................................................... 114
Game theory.............................................................................................................. 115
Models of oligopoly.................................................................................................... 116
Reminder of learning outcomes.................................................................................. 120
Sample examination questions.................................................................................... 120
Block 10: The labour market................................................................................ 123
Introduction............................................................................................................... 123
The factors of production............................................................................................ 124
Analysis of the labour market...................................................................................... 125
Labour supply............................................................................................................. 127
Labour market equilibrium ......................................................................................... 128
Disequilibrium in the labour market............................................................................ 130
Wage discrimination................................................................................................... 131
Overview.................................................................................................................... 131
Reminder of learning outcomes.................................................................................. 132
Sample examination questions.................................................................................... 132
Block 11: Welfare economics............................................................................... 135
Introduction............................................................................................................... 135
Equity and efficiency................................................................................................... 136
Distortion of the market.............................................................................................. 141
Sources of market failure............................................................................................ 141
Overview.................................................................................................................... 145
Reminder of learning outcomes.................................................................................. 145
Sample examination questions.................................................................................... 145
Block 12: The role of government....................................................................... 147
Introduction............................................................................................................... 147
Government functions................................................................................................ 148
Taxation..................................................................................................................... 148
Public goods............................................................................................................... 150
Merit and demerit goods............................................................................................ 151
Transfer payments and income redistribution............................................................... 151
Principles of taxation.................................................................................................. 153
Local government....................................................................................................... 155
Impact of globalisation............................................................................................... 155
Political economy........................................................................................................ 155
Overview.................................................................................................................... 155
Reminder of learning outcomes.................................................................................. 156
Sample examination questions.................................................................................... 156
Block 13: Introduction to macroeconomics......................................................... 159
Introduction............................................................................................................... 159
Macroeconomic analysis............................................................................................. 160
The circular flow of income......................................................................................... 160
Measuring GDP.......................................................................................................... 161
Overview.................................................................................................................... 164
Reminder of learning outcomes.................................................................................. 165
Sample examination questions ................................................................................... 165
Block 14: Output and aggregate demand........................................................... 169
Introduction............................................................................................................... 169
Components of aggregate demand: consumption and investment............................... 170
Equilibrium output...................................................................................................... 171
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EC1002 Introduction to economics
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EC1002 Introduction to economics
Notes
vi
Introduction
Introduction
1
EC1002 Introduction to economics
Learning outcomes
At the end of the course and having completed the Essential reading and
activities, you should be able to:
• define the main concepts and describe the models and methods used
in economic analysis
• formulate real world issues in the language of economic modelling
• apply and use economic models to analyse these issues
• assess the potential and limitations of the models and methods used in
economic analysis.
Primary textbook
Begg, D., G. Vernasca, S. Fischer and R. Dornbusch Economics. (London: McGraw
Hill, 2014) 11th edition [ISBN 9780077154516]. Referred to as BVFD.
The two supplementary textbooks below can be used to extend your
understanding and also provide an alternative approach which you may
find suits your own style. Although you are encouraged to make use
of these, you should check that you have a good understanding of the
material covered in the primary textbook and the subject guide, as this is
the required material for this course.
Supplementary textbooks
Lipsey, R.G. and K.A. Chrystal Economics. (Oxford: Oxford University Press,
2015) 13th edition [ISBN 9780198746577] international edition;
[ISBN 9780199676835] UK edition. Referred to as L&C.
Witztum, A. Economics. (Oxford: Oxford University Press, 2005)
[ISBN 9780199271634]. Referred to as AW.
The material contained in the two supplementary textbooks (where it
goes beyond that contained in BVFD and the subject guide) is not directly
examinable and you are not required to purchase these texts. However,
if you are able to access them, you will find them beneficial and they
will enhance your understanding of the text and this guide. Both have
certain key advantages, for example, L&C contains very clear explanations
and is structured in a very logical way, while AW provides a deeper
understanding of the core concepts both philosophically and in terms of
the analytical approach.
2
Introduction
One key aim of the guide is to encourage active engagement with the
material, as this is how you will really gain a good understanding. For
example, many of the models which will be covered in this course are
expressed graphically and the subject guide contains empty boxes where
you can practise drawing these graphs. It is very difficult to understand
and remember graphs just by looking at them, so you will need to practise
drawing them for yourself. For more complex graphs in later chapters,
you could even practise using blank paper and then, when you are
confident, draw the graph in the empty box in the subject guide. You are
also encouraged to actively undertake the other activities and questions
in the subject guide. Answers to these are available on the virtual learning
environment (VLE).
The subject guide and the primary textbook must be used together. The
guide will not make much sense without the textbook. Equally, do not be
tempted to neglect the guide and just focus on the textbook. You need to
be aware that the subject guide not only seeks to complement and clarify
the contents of the textbook, but also to extend it in certain places. For the
final examination, you will need to be familiar with the material in both
the textbook and the subject guide. The textbook chapters that are not
covered in the guide, and are not examinable, are: Chapters 11 (except
for section 11.9), 12, 26, 29. We hope that this guide will help you as you
work through the textbook and that you will find it useful in your studies.
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
• Electronic study materials: All of the printed materials which you
receive from the University of London are available to download, to
give you flexibility in how and where you study.
• Discussion forums: An open space for you to discuss interests
and seek support from your peers, working collaboratively to solve
problems and discuss subject material. Some forums are moderated by
an LSE academic.
3
EC1002 Introduction to economics
should be clear to the reader that this refers to Chapter 12 of the textbook
(BVFD).
Breakdown of readings for each block:
Microeconomics
Block 1 2 3 4 5 6 7 8 9 10 11 12
Chapter 1, 2 3 4 5 6; 7.1, 7.2 and 7.3– 8.1– 8.5– 9 10 13 14;
7–appendix 7.9 8.4 8.10 11.9
Macroeconomics
Block 13 14 15 16 17 18 19 20 21 22 23
Chapter 15 16, 17 18, 19 20 21 22 23 24 25 27 28
Specific topics and concepts to be covered are as follows: This differs from
the syllabus only in the order that topics are listed. The full syllabus can be
found in Appendix 1.
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EC1002 Introduction to economics
Macroeconomics
Introduction to macroeconomics: the problem of aggregation, the
circular flow of income, leakages and injections, national income accounting,
Block 13
depreciation, value added and the NNP = Y identity, real and nominal gross
domestic product (GDP).
Aggregate demand: actual and potential output, consumption, investment,
income determination, equilibrium, the multiplier, the paradox of thrift,
Block 14 consumption and taxation, the government budget, automatic stabilisers (the
financing of government), the multiplier and taxation, the role of fiscal policy,
imports and exports, the multiplier in an open economy.
Money and banking: the role of money, real balances, the liquidity
preference approach and the demand for money (liquid assets), commercial
Block 15
banks and the supply of money (banks and the various multipliers), central
banks and monetary control, equilibrium in the money market.
Monetary and fiscal policy: aggregate demand and equilibrium (IS),
Block 16 equilibrium in the money market (LM), the IS-LM model, monetary and fiscal
policies in a closed economy.
Aggregate demand and aggregate supply: Keynesian and classical
Block 17 assumptions regarding wages and prices, aggregate supply in the long-run and
the short-run, the effects of exogenous demand and supply shocks.
Inflation: inflation targeting, the Taylor rule, the quantity theory of money,
Block 18 the Phillips curve in the long-run and the short-run, stagflation and the role of
expectations, costs of inflation
Unemployment: types of unemployment, voluntary and involuntary
Block 19
unemployment, causes of unemployment, private and social costs, hysteresis
Exchange rates and the balance of payments: the foreign currency
Block 20 market, exchange rate regimes, the balance of payments, capital mobility, the
rate of interest and the price of foreign currency
Open economy macroeconomics: the effects of fiscal and monetary policies
Block 21
under fixed and floating exchange rates with and without capital mobility
Business cycles: trend path and business cycles, theories of the business
Block 22
cycle, real business cycles
Supply-side economics and economic growth: growth in potential
Block 23 output, the steady state, technological progress, capital accumulation,
convergence, endogenous growth, policies to promote growth
Study advice
The British education system, possibly more than others, and economics as
a subject, possibly more than others, both emphasise understanding above
rote learning (learning by heart). It is very difficult (if not impossible)
to do well in economics examinations simply by rote learning. A much
better strategy is to try to gain a good understanding of the concepts and
the models. Although this may involve more work in the short term, the
final outcome will be much better, and the examination much easier. For
example, many of the models we will cover can be summarised in a single
graph or set of equations. You will need to be able to use these graphs to
demonstrate the effects of changes in the economic environment to which
the model relates. This is very difficult to do well through memorisation,
but if you understand why the different lines of the graph are drawn
in that particular way or what a particular equation represents, then
adjusting the graph or modifying the equations will become a relatively
simple and straightforward exercise.
6
Introduction
The textbook, which the subject guide accompanies, assumes that you
haven’t done any economics before and starts from the basics. It gives a
good explanation of all concepts and uses examples to make these new
concepts intuitive. It also includes material to stretch you, including
Maths boxes. You are required to really master this textbook, including
the Maths boxes and more challenging elements. If there are sections
which are difficult to understand at first, you may find that reading these
through several times is very helpful. In certain places, the subject guide
will also seek to extend the textbook if there are areas where it does not
go far enough. Although you will find the textbook approach of starting
at a fairly basic level very useful, you should expect the examination to
be quite rigorous. For example, examination questions are likely to be
similar to the ‘hard’ questions in the review questions at the end of each
chapter. In this way, we hope to help you really lay a firm foundation of
understanding in economics, and at the same time demonstrate the high
standard that is expected of you as University of London students.
Use of mathematics
Economic models can be expressed in various ways, in words, in diagrams
and in equations. Although this course mainly uses diagrammatic
representations accompanied by words, simple equations can also be
a concise way of expressing an economic model, and you will need to
become familiar with this approach. At this stage, the maths involved
will be limited to simple algebra and elementary calculus. Some basic
mathematical techniques and ideas will be also introduced in the first
block. It is important to work through the Maths boxes in each chapter,
as these often provide a step-by-step explanation of the mathematical
approach to the models covered. The subject guide will also provide
further explanations where we think this will be helpful. Economics is
becoming an increasingly technical subject and, although the level of
mathematics required for this course is quite basic, we hope that you
will become confident in taking a mathematical approach to analysing
economic issues.
Examination advice
Important: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Programme
regulations for relevant information about the examination, and the VLE
where you should be advised of any forthcoming changes. You should also
carefully check the rubric/instructions on the paper you actually sit and
follow those instructions.
Examination structure: The structure for the 2016–17 examination is
as follows:
• Part I
worth 50 marks
30 multiple choice questions covering the entire syllabus in
microeconomics and macroeconomics. Candidates should answer
all 30 multiple choice questions.
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EC1002 Introduction to economics
8
Block 1: Economics, the economy and tools of economic analysis
Introduction
This block covers the first two chapters of the textbook and is designed to
give you an introduction to economics and some help in starting to use
the tools of economic analysis. The concepts introduced in this block, such
as scarcity, opportunity cost and ceteris paribus (more on these below),
are absolutely essential to your understanding of economics. The more
thoroughly you work through the material in this block, the better your
foundation will be for all the material that follows.
So what is economics? The word ‘economy’ comes from two Greek words
– oikos (meaning house) and nemein (meaning manage) – its original
meaning was ‘household management’. Households have limited resources
and managing these resources requires many decisions and a certain
organisational system. The meaning of the word economics has developed
over time. Today, economics can be defined as the study of how societies
make choices on what, how and for whom to produce, given the limited
resources available to them. Furthermore, the key economic problem can
be defined as being to reconcile the conflict between people’s virtually
unlimited desires and the scarcity of available resources and means of
production.
These are the definitions provided in the core textbook (BVFD) and indeed
in many other textbooks. They are traditional definitions and have their
origins in an essay by Lionel Robbins (of the London School of Economics
and Political Science) written in 19321 in which he defined economics as 1
Lionel Robbins An
‘the science which studies human behaviour as a relationship between essay on the nature and
significance of economic
ends and scarce means which have alternative uses’.
science. (London:
It is important to realise that this definition is not without its critics. Macmillan, 1932, 2nd
The textbook does not pretend to discuss in any depth the definition edition 2014) p.16.
9
EC1002 Introduction to economics
Although the definitions above may appear abstract, economics deals with
phenomena you will be very familiar with from your daily activities, and
provides tools and a language to analyse these. While it is not the only
language available, we hope it will prove useful to you.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• recognise economics as the study of how society addresses the conflict
between unlimited desires and scarce resources
• describe ways in which society decides what, how and for whom to
produce
• identify the opportunity cost of a decision or action
• explain the difference between positive and normative economics
• define microeconomics and macroeconomics
• explain why theories deliberately simplify reality
• recognise time-series, cross section and panel data
• construct index numbers
• explain the difference between real and nominal variables
• build a simple theoretical model
• plot data and interpret scatter diagrams
• use ‘other things equal’ to ignore, but not forget, some aspects of a
problem in order to focus on core issues.
10
Block 1: Economics, the economy and tools of economic analysis
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapters 1 and 2.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapter 1; UK edition,
Chapter 1.
Witztum (AW), Chapter 1.
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EC1002 Introduction to economics
Scarcity
BVFD defines scarcity by saying: ‘a resource is scarce if the demand for
that resource at a zero price would exceed the available supply’. Since the
concepts of demand and supply have not yet been introduced to you, we
can also define scarcity by stating that the means available to society (its
labour force, its capital stock, its natural resources, its technology) are
insufficient to meet all the wants (or the desired goods and services) of the
people making up that society. This implies that for any one person to have
more of something, they or someone else must have less of something
else. In turn, this requires choice, both at the level of the individual agent
but also at the societal or collective level. How individuals and societies
cope with scarcity in relation to wants is central to economics. This course
concentrates on the market economy as the basic organisational principle
for coping with scarcity, but modified by governments to rectify market
shortcomings and to achieve distributional ends.
Opportunity cost
Related to scarcity is the concept of opportunity cost – one of the key
concepts in economic analysis.
To cement your understanding of opportunity cost, complete the following
activity on this concept.
Activity SG1.1
a. Let us change the details of the problem in concept box 1.1. Suppose that there
were no jobs in the campus shop. The only job available, and this is the alternative
to going to the beach with your friends, is to work at the local fast food restaurant
clearing tables and washing dishes. This job also pays £70, but because of its general
unpleasantness you wouldn’t do it unless you were paid at least £55. Should you go
to the beach or work at the fast food restaurant?
b. A high-end ladies fashion boutique purchases winter coats from a manufacturer at
a price of £300 per coat. During the winter the boutique will try to sell the coats at
a price higher than £300 but may not be able to sell all of the coats. Since they are
the latest fashion, no customers would be interested in buying the coats next season.
However, at the end of the winter, the manufacturer will pay the boutique 20% of the
original price for any unsold coats (and re-use the expensive fabrics they are made
from for the next year’s designs).
i. At the beginning of the year, before the boutique has purchased any coats, what
is the opportunity cost of these coats?
ii. After the boutique has purchased the coats, what is the opportunity cost
associated with selling a coat to a prospective customer? (You can assume the
coat will be unsold at the end of the winter if that customer doesn’t buy the coat).
iii. Suppose towards the end of the winter the boutique still has a large inventory of
unsold coats. The boutique has set a retail price of £950 per coat. The marketing
manager argues that the boutique should cut the price to £199 to try to sell
the remaining coats before they become unfashionable at the end of the winter.
However, the general manager disagrees, arguing that would mean a loss of £101
on each coat. Which makes more economic sense – the marketing manager’s
suggestion or the general manager’s argument?
often left to specialised courses. In each case, the authors demonstrate the
impact on the three key questions of what to produce, how to produce it
and for whom.
Rationality
► BVFD: read concept box 1.2.
The production possibility frontier is one of the most basic and important
concepts in economics. It shows all the combinations of goods that can be
produced if the means of production are fully employed. It will come up
again in Block 7 when we discuss the perfect competition model of market
structure, Block 11 when we discuss welfare economics and also in Block
23 when we discuss economic growth.
13
EC1002 Introduction to economics
14
Block 1: Economics, the economy and tools of economic analysis
Activity SG1.2
In the box below, draw a production possibility frontier, clearly marking the regions of
inefficient production, efficient production and unattainable production. Illustrate how the
slope of the PPF represents opportunity cost. Why is the frontier concave to the origin?
15
EC1002 Introduction to economics
Activity SG1.3
a. Putting cakes on the horizontal axis and T-shirts on the vertical axis draw Jennifer and
John’s production possibility frontiers for a 10-hour working day.
b. In what way do these PPFs differ from that drawn in Figure 1.4? Why?
c. Write down the equations of these production possibility frontiers, making T (T-shirts)
a function of C (cakes).
d. What is the interpretation of the slope of these PPFs?
e. In your diagram what represents Jennifer’s absolute advantage in producing both
goods?
f. In your diagram what represents John’s comparative advantage in making cakes?
Activity SG1.4
Suppose there are two countries (M and W) and two goods (shoes and hats). The table
gives the labour requirements to produce a unit of each output in each country.
Country M Country W
Shoes 10 labour hrs/unit of output 12
Hats 2 5
a. Which country has an absolute advantage in shoes? In hats?
b. Which country has a comparative advantage in shoes? In hats?
c. Assuming each country has 100 labour hours available, what will the total production
of shoes and hats be if each country specialises fully in the production of the good in
which it has a comparative advantage (presumably they would then engage in trade
with each other) compared to what they could produce in a situation with no trade if
they spent half their available labour on each good?
If you are interested in exploring these concepts in more detail you can
read Chapter 29 on Trade (which is optional and will not be covered in
this subject guide).
Markets
► BVFD: read section 1.4 and case 1.3 and complete activity 1.1.
Activity SG1.5
Classify the following statements as positive or normative:
•• Inflation is more harmful than unemployment.
_______________________________________________________________
•• An increase in the minimum wage to £8 per hour would reduce employment by
0.5 percentage points.
_______________________________________________________________
•• The government should raise the national minimum wage to £8 per hour to help
reduce poverty in society.
_______________________________________________________________
•• An increase in the price of crude oil on world markets will lead to an increase in
cycling to work.
_______________________________________________________________
•• A reduction in personal income tax will improve the incentives of unemployed people
to find paid employment.
_______________________________________________________________
•• Discounts on alcohol have increased the demand for alcohol among teenagers.
_______________________________________________________________
•• The retirement age should be raised to 70 to combat the effects of our ageing
population.
_______________________________________________________________
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EC1002 Introduction to economics
► BVFD: read the Summary and work through the review questions.
► BVFD: read Chapter 2.
A note on mathematics
In discussing the tools of economic analysis, this chapter, perhaps
surprisingly, has little to say in general terms about the role of mathematics
in economics. In its methods and approaches, if not its subject matter,
economics today is almost unrecognisable from the subject taught under
the same name 60 or 70 years ago. Of course, one wouldn’t expect the
subject to stand still, but in this case the change has been dramatic. Today,
top universities require a high level of mathematical competence of their
students, even at undergraduate level (and even higher at postgraduate
level) while a cursory scan of the top economics journals might give the
impression that the subject is a branch of mathematics. It isn’t. Correctly
used, mathematics in economics is a tool – a means to an end not an
end in itself. Nevertheless, some have argued that the pervasiveness of
mathematics in modern economics has had damaging consequences both
on the development of the subject (with concentration on topics that lend
themselves to mathematical analysis and relative neglect of those that don’t)
and on the ability of economists to communicate with non-economists,
often including those responsible for formulating economic policy.
Whether or not these criticisms are correct, it is highly unlikely that the
trend towards greater reliance on mathematical tools is likely to be reversed
in the near future. For those of you pursuing the subject beyond the
introductory level you will need to be prepared to use considerably more
18
Block 1: Economics, the economy and tools of economic analysis
Activity SG1.6
Index numbers: work through the following example to help you understand how index
numbers are calculated. Say we want to calculate inflation (a Retail Price Index) for
four specific goods. The index for each good is set at 100 for the first year. Work out the
percentage price change in each good (the first one is filled in for you).
TOTAL 400/4
Overall index 100
The change in the overall index is the average rate of inflation. What was the rate of
inflation for these four products?
Inflation between year 1 and 2 __________________________?
However, the products in the price index are not equally important and should not be
given an equal weighting in the calculation of the index. That is why Weighted Index
Numbers are often used.
Of the four products above, which do you think represents the lowest proportion of a
family’s total spending? Which represents the highest?
If toothpaste represents a small proportion of each family’s total spending, then we should
make the price change for toothpaste have a much smaller overall effect on the price index. To
do this we weight each price change to give it more or less importance in the overall index.
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EC1002 Introduction to economics
This has been done in the table below – see if you can complete the last column:
TOTAL 10 1,000/10
Overall 100
index
Activity SG1.7
You got a job in the year 2012 with a salary of £25,000. In 2014, you receive a £3,000
increase in your salary. CPI in 2014 with base year 2012 is 108. Calculate your real
income in 2012 and 2014 as well as the percentage changes in your nominal income and
your real income.
► BVFD: read sections 2.6 and 2.7 and complete activity 2.1.
These sections, and 2.9 below, turn to the use of empirical evidence in
economics. They begin to give an intuitive feel for econometrics, the
application of statistical and mathematical techniques, often with the help
of computers, to economic data, in order to test hypotheses and/or forecast
20
Block 1: Economics, the economy and tools of economic analysis
Activity SG1.8
Use the following functions to draw diagrams in the boxes below:
Slope = Slope =
Intercept = Intercept =
In economics, a Latin term is often used to indicate that other factors are
held constant, this term is ceteris paribus, which means ‘other things the
same’. This has to do with the conditions under which a theory holds. For
example, the market for one product is often studied under the assumption
that prices of other products are held constant. The purpose of this is not
to say that such factors are unimportant, but rather to focus on one effect
at a time. If many factors are allowed to vary simultaneously, the effects of
these can be difficult to disentangle. This section illustrates a technique of
showing the effect of two variables (fares and income in Figure 2.7) in a
two dimensional diagram. When we study the demand for a good we will
21
EC1002 Introduction to economics
Criticisms of economics
► BVFD: read section 2.10 and case 2.1.
22
Block 1: Economics, the economy and tools of economic analysis
23
EC1002 Introduction to economics
Wine Cheese
Samuel 6 4
Roberto 2 3
a. Samuel has an absolute advantage in both products and a
comparative advantage in cheese.
b. Roberto has an absolute advantage in both products and a
comparative advantage in cheese.
c. Roberto has an absolute advantage in cheese and a comparative
advantage in wine, while the opposite is true for Samuel.
d. Samuel has an absolute advantage in both products and a
comparative advantage in wine.
e. Roberto has an absolute advantage in both products and a
comparative advantage in wine.
24
Block 2: Demand, supply and the market
Introduction
The previous block introduced economics as ‘the study of how societies
make choices on what, how and for whom to produce, given the limited
resources available to them’ and described how societies adopt various
institutional arrangements to answer these questions as best they can. In
the societies we all live in, the role of the market is very important as a
means of answering these questions. Markets bring together buyers and
sellers and the mechanism of prices operates to coordinate the quantities
sellers wish to sell with the quantities buyers wish to buy. This chapter
examines demand and supply and the way they interact within markets to
determine quantities and prices.
The focus of this chapter, the demand and supply model, is perhaps the
‘iconic’ model of economics. Like all models it has its shortcomings and
knowing when it is appropriate to the analysis of a particular problem,
and when it is not, is something of an art. Some of the strengths and
weaknesses of this basic model will become clearer in subsequent chapters
of the text and blocks in this guide, but first you need to become familiar
with the basic workings of the model. Also postponed until later is the
analysis of the behaviour of individual consumers and individual firms
which lie behind demand and supply curves. It would also be possible to
start with the behaviour of these individual agents and then derive the
market demand and supply curves, however, experience suggests that
the power of supply and demand analysis in showing how prices and
quantities respond to changes in the economic environment can also be
experienced without all the detailed foundations being in place (as long
as they provided subsequently) and that this approach is often more
motivating than the reverse sequencing. The blocks of the subject guide
therefore follow the order of the textbook in firstly presenting the demand
and supply model and then showing later how demand and supply curves
are derived from the behaviour of individual consumers and firms.
Demand is the quantity of a product that buyers wish to purchase at any
given price, while supply is the quantity of a product that suppliers are
willing to sell at any given price. Demand and supply come together in a
market and this determines the price and quantity of goods sold. This will
be described in more detail in this chapter. Since we have all bought (and
maybe also sold) goods before, many of these ideas are quite intuitive.
Nonetheless, it is important to become familiar with the language
economists use to explain these ideas and the way that economics deals
with them. Graphical analysis is very important in economics and you will
need to become very comfortable with drawing demand and supply curves
and using them to demonstrate changes in various influential factors. You
will hopefully find this a very useful tool of analysis.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• define the concept of a market
• draw demand and supply curves (and inverse demand and supply
curves)
25
EC1002 Introduction to economics
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 3.
Further reading
Lipsey and Chrystal (L&C), Chapter 2.
Witztum (AW), sections 2.1 and 4.1.
Equilibrium
► BVFD: read sections 3.1–3.3.
26
Block 2: Demand, supply and the market
(Note: Although these lines are straight, they are still called demand and supply curves).
Activity SG2.2
The direct demand function and direct supply function can be used to easily find the
equilibrium quantity and price. Use the following curves to find the equilibrium price and
quantity for noodles:
QD= 30 – 3/4P
QS= 5 + 1/2P
Equilibrium Price = Equilibrium Quantity =
27
EC1002 Introduction to economics
Activity SG2.3
Find the inverse demand and supply functions using the direct demand and supply
functions in the table below.
Activity SG2.4
For each event in the following table, identify whether this relates to demand or supply, in
what direction the curve would shift, and the effect on price and quantity. If you draw a
graph for each example, you will also see the movement along the other curve, resulting
in the new equilibrium price and quantity. The first line has been completed for you.
28
Block 2: Demand, supply and the market
29
EC1002 Introduction to economics
Activity SG2.5
Multiple choice questions
1. The only four consumers in a market have the following willingness to pay for a good:
£120
Supply Curve
£100
£80
£60 Equilibrium
£40
0 100 Quantity
30
Block 2: Demand, supply and the market
3. Here you see Anthony’s demand curve for football matches (you can treat the demand
curve as being approximately linear).
P
£8
£6
0 6 10 Q
Activity SG2.6
Price floors and ceilings result in a loss of consumer and producer surplus, this is called a
deadweight loss. Can you calculate how much consumer and producer surplus is lost
due to the price ceiling in the diagram below? Has there also been a transfer of surplus
between consumers and producers?
Price
£120
£100
Supply Curve
£80
Demand Curve
£20
0
50 100 Quantity
Figure 2.3: Loss of producer and consumer surplus due to a price ceiling.
► BVFD: read the summary and work through the review questions.
31
EC1002 Introduction to economics
Overview
Buyers and sellers come together in a market and exchange goods and
services. Demand (from buyers) and supply (from sellers) are key concepts
of economic analysis. Demand curves display the quantity that buyers
wish to buy at each price and generally slope downwards – demand is
higher when the price is lower. Supply curves display the quantity that
sellers wish to sell at each price and generally slope upwards – sellers
are prepared to sell more when the price is higher. The market clears
(and equilibrium is achieved) at the point where the demand and supply
curves intersect. Understanding what demand and supply curves represent
and what makes them shift is the most fundamental lesson from this
block. Price changes are represented by a movement along a curve,
shifts in the curves indicate changes in other factors, such as the price of
complements or substitutes or changes in consumers income (for demand
curves) and changes in technology and input prices (for supply curves).
Shifts in the demand or supply curves change the equilibrium price and
quantity. Inverse demand and supply curves (where price is expressed as
a function of quantity) can be useful for graphing the curves. The block
also introduces consumer and producer surplus and the fact that price
controls lead to a reduction in consumer and producer surplus, whereas
free markets optimise consumer and producer surplus. You need to be able
to calculate consumer and producer surplus and the loss involved due to
price controls.
Price
£50
Supply Curve
Excess supply
£40 Price Floor
£20
0
10 20 30 Quantity
34
Block 3: Elasticity
Block 3: Elasticity
Introduction
The concept of elasticity is very important in microeconomics – here we
devote a whole block to it! Elasticity has to do with responsiveness, for
example: how much does the quantity demanded of a good respond to
a change in the price of that good? For some goods, such as life-saving
medicine, people’s demand will not fall much even if the price increases
substantially, while for other goods, such as a particular chocolate bar,
the demand will respond to price much more, since if the price of one
chocolate bar goes up, people will generally be quite happy to purchase
another one (or a different kind of snack) instead. This chapter uses many
examples to make the concepts more intuitive, and also relies on graphs
and simple equations. Make use of the exercises in this block and in the
textbook to really master this concept and its applications.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• describe how elasticities measure the responsiveness of demand and
supply
• define and calculate price elasticity of demand
• indicate the determinants of price elasticity
• describe the relationship between demand elasticity and revenue
• recognise the fallacy of composition
• describe how cross-price elasticity relates to complements and
substitutes
• define and calculate income elasticity of demand
• use income elasticity to identify inferior, normal and luxury goods
• define and calculate elasticity of supply
• describe how supply and demand elasticities affect tax incidence.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 4.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapter 2; UK edition,
Chapter 3.
Witztum (AW), Chapter 2 section 2.4.
35
EC1002 Introduction to economics
The formula for calculating price elasticity of demand (PED) is important and
also quite intuitive:
Price elasticity of demand = [% change in quantity] /
[% change in price]
As explained in Maths 4.2 this can be expressed using delta notation as:
∆Q P
PED =
∆P Q
where Q refers to quantity demanded and P to price. ∆ always means ‘change
in’, such that ∆Q means ‘change in quantity’.
If the quantity demanded changes a lot in response to a change in price, we
say demand is responsive (or sensitive) to the price change, and the
demand is elastic. If the price can change a lot without really affecting the
quantity demanded, we say that demand is unresponsive (or insensitive)
to the change in price and demand for that product is inelastic.
• Demand is elastic if the elasticity is more negative than –1.
• Demand is inelastic if the price elasticity lies between –1 and 0.
This is represented in the sketch below:
elastic inelastic
−∞ −1 0
Figure 3.1: Defining elastic and inelastic demand.
When PED=0 demand is said to be perfectly inelastic and when PED=–∞
we say demand is perfectly elastic.
While economists often discuss the absolute value of the elasticity (so if this
is between zero and 1, demand is said to be inelastic, and if it is greater than
1, demand is said to be elastic) we recommend you not to lose track of the
sign of the elasticity. As we shall see below for other elasticities (cross-price
elasticity, income elasticity), the sign has important implications. Nonetheless,
you will often see positive numbers for own-price demand elasticities – this is
a shorthand and does not necessarily imply that the law of demand has been
violated.
The Greek letter eta (ε) is often used to denote elasticity. For example, ε = 0
means that the price elasticity of demand is equal to zero and quantity
demanded will not change at all in response to a change in price.
Activity SG3.1
Consider your own buying habits. Rank the items below in terms of how responsive your
demand for these goods is to a change in their price:
36
Block 3: Elasticity
There are various ways of calculating elasticity. Arc elasticity (Maths 4.1)
is used to find the elasticity between two different points of a demand
curve, in such a way that it is equal whether you analyse the change in
price as an increase or a decrease.
Point elasticity, on the other hand, describes the elasticity at a certain point
on the demand curve. Maths 4.2 on point elasticity uses calculus, however,
it also explains that the derivative of the direct demand function gives
the slope of the direct demand function at a given point. If the function is
∆Q
linear, the slope is constant for the whole curve, and corresponds to ∆P in
the PED
formula above. The slope of a curve is straightforward and something you
can easily use without any knowledge of calculus.
One thing to be careful of is whether you are using the direct or the
inverse demand function (remember Block 2). For an inverse demand
function, use the inverse of the slope. For a direct demand function, you
can use the slope directly. That should be easy to remember!
That means that for an indirect demand function, the point elasticity is:
PED = 1/s * (P/Q), where s is the slope. For example: P = 20 – Q/2 is an
indirect (or inverse) demand function. The slope of this is dP/dQ = –1/2.
In this case, you would use PED = (1/–0.5) *(P/Q) = –2*(P/Q).
On the other hand, Q = 40 – 2P is a direct demand function. The slope of
this is dQ/dP = –2. (To check that the slope of the direct demand function
∆Q
is equal ∆P
to note that if P = 5, Q = 30. If P = 10, Q = 20. Therefore
∆Q -10
∆P
= 5
= –2). In this case you would use PED = –2*(P/Q).
If you want to express the elasticity as a positive number, you will need to
use the absolute value (or just multiply the negative number by the minus
one, which is the same thing).
Activity SG3.2
Part A: Calculating an arc elasticity
Given the following information, calculate the elasticity of demand for the following
goods, expressing the elasticities as positive numbers
37
EC1002 Introduction to economics
Price
£20
At X, PED =
At Y, PED =
X
£16
At Z, PED =
Y
£10
Z
£5
8 20 30 40 Quantity
Activity SG3.3
The following table identifies some factors which act as determinants of demand
elasticity. Fill in the fourth column, which has been left blank, with a concrete example.
38
Block 3: Elasticity
Activity SG3.4
Use the boxes below to draw demand curves appropriate to each heading:
ε= ε=
Activity SG3.5
Total spending is the same as the firm’s revenue. Use the data below to decide, if you
were a manager, whether or not to make the price change in the following cases (you can
ignore costs for the purposes of this activity and just assume that an increase in revenue
is a good thing and a decrease in revenue is bad). For each case, calculate the demand
elasticity (using the arc method), decide whether or not to make the change, and then
check your answer by calculating total revenue before and after the price change.
a. Increasing the price from £6 to £7 will lead to a fall in sales from 10,000 to 8,000.
b. Increasing the price from £8 to £10 will lead to a fall in sales from 15,000 to 12,500.
c. Decreasing the price from £20 to £18 will lead to an increase in sales from 6,000 to
8,000.
Unlike the case of a downward sloping demand curve where PED was
always negative, the cross-price elasticity can be positive or negative
depending on how the goods are related in consumption (whether they
are substitutes or complements). The cross-price elasticity of demand is
negative for complements and positive for substitutes. If the price of good i
increases, people will demand less of good j if it is a complement to good i,
and more of good j if it is a substitute for good i. What would be the value
of the cross-price elasticity between two goods if they were completely
unrelated?
Activity SG3.6
Multiple choice question
A Bordurian lawyer explains: ‘Smoking is a Bordurian tradition. If you had coffee, you had
cigarettes; if you had cigarettes, you had coffee’. According to this statement, the cross-price
elasticity of the demand for coffee with respect to the price of cigarettes in Borduria is:
a. positive
b. negative
c. zero.
Activity SG3.7
Classify the following goods, based on their (hypothetical) income elasticity:
Activity SG3.8
For the following direct supply function, calculate and interpret the PES when Q = 10
and P = 2.5.
Direct Supply Function: QS = 5 + 2P
PES =
Activity SG3.9
Initially, the price of a tennis racket is £20. Demand is 30 and supply is 50. If the price
falls by £5, the quantity demanded rises to 40, the quantity supplied rises to 40, and the
quantity demanded of white cotton t-shirts rises from 70 to 100. Using the arc method,
calculate the own-price demand elasticity and the elasticity of supply for tennis racquets;
and the cross-price demand elasticity for white cotton t-shirts. Are white cotton t-shirts a
complement or substitute to tennis racquets?
Own price elasticity =
Cross-price elasticity =
Elasticity of supply =
Substitute or complement?
► BVFD: Examine Table 4.11 – this provides a simple but helpful summary
of the chapter up to section 4.8.
Make sure that you also understand section 4.7 which brings together own-
price, cross-price and income elasticities with reference to inflation.
Incidence of a tax
► BVFD: read section 4.9. 1
This is summed up in an
expression which holds
The key point of this section is that the incidence of the tax is not related for small taxes, but which
we do not prove here:
to the person who physically pays the money to the government. Rather,
whichever party (consumers or producers) is less price sensitive (either in ∆D PES
=
demand or supply) will bear the greater share of the burden of the tax.1 ∆ S
PED
Suppose demand were perfectly inelastic, how would the burden of a sales In words, the ratio of
tax be shared between consumers and producers? the change in the price
the consumer pays (the
It is important to realise that a sales tax drives a wedge between the price demand price) to the
paid by consumers (sometimes called the demand price) and the price change in the price that
received by producers (the supply price). In a simple supply and demand the producer receives
diagram in the absence of taxes these two prices are, of course, the same. (the supply price) is
equal to the ratio of the
Another point to consider is why goods such as cigarettes and fuel are price elasticity of supply
taxed so heavily. This isn’t only a question of improving health or reducing to the price elasticity of
pollution – consider the PED of these goods and the implications for demand.
government tax revenues of taxing goods such as these.
41
EC1002 Introduction to economics
Activity SG3.10
Let’s put Maths box 4.4 into practice using a numerical example. If:
QD = 30 – 4P
QS = –6 + 8P
t = 0.375 where t is a specific tax that has to be paid by suppliers.
Calculate
i. the equilibrium quantities with and without the tax
ii. the increase in the price paid by consumers and the fall in consumer surplus
iii. the fall in the price received by suppliers and the fall in producer surplus
iv. the tax revenue received by the government
v. the deadweight loss of the tax.
Activity SG3.11
Multiple choice question
Here you see the football fans’ demand curve d for televised football matches together
with the Football Association’s (FA) supply curve s for such matches. The market for
televised matches clears where the two curves cross, hence when 10 matches are
televised for £6 each. Suppose now that the Government introduces a tax of £4 per
televised match. The figure shows that the number of televised matches falls from 10 to
6. For these 6 matches fans pay £8 but the FA earns only £4 as the difference goes into
the government’s coffers.
£8
£6
d
£4
£2
42
Block 3: Elasticity
► BVFD: read the summary and work through the Sample examination
questions.
Overview
This block describes the concept of elasticity, explores how to calculate
elasticities and discusses the implications. Conceptually, elasticity has to
do with responsiveness, usually how much demand or supply responds to
a change in price or income. You need to know how to calculate arc and
point elasticities. The type of elasticities you need to be familiar with are
as follows: own-price demand elasticity (elastic if more negative than –1,
unit elastic if –1, inelastic if between –1 and 0; though in practice these
are often expressed as positive numbers using the absolute value), cross-
price demand elasticity (generally positive for substitutes and negative for
complements), income elasticity of demand (negative for inferior goods,
larger than 1 for luxury goods) and supply elasticity (positive since the
supply curve slopes upwards). Elasticity has implications for total spending
on a product (which from the company’s perspective is simply revenue):
If demand is elastic, a fall in price leads to an increase in revenue. It also
has implications for tax incidence – the more price insensitive side of the
market (be it buyers or sellers) will bear a greater burden of the tax.
43
EC1002 Introduction to economics
Long-response question:
1. a. Discuss the meaning of elasticity and the various types. What
determines the price elasticity of demand for a certain good? Who
is likely to find this information useful?
b. Assume that the market demand for barley is given by:
Q=1,900 – 4PB + 0.1M + 2PW
Where Q is the quantity of barley demanded, PB is the price of
barley, M is income (say per capita income of consumers) and
PW is the price of wheat. The prices of wheat and barley are each
200 (say £s per tonne) and M is 1,000. The slopes for barley
demand, wheat demand and income are –4, 2 and 0.1 respectively.
44
Block 3: Elasticity
45
EC1002 Introduction to economics
Notes
46
Block 4: Consumer choice
Introduction
This block introduces another two fundamental concepts in
microeconomics: indifference curves and the budget constraint. Indifference
curves illustrate a consumer’s preferences, while the budget constraint
shows what it is possible for them to consume, given a limited budget and
the prices they face. Put together, these concepts are used to determine the
consumer’s consumption decisions. In this way, we can see how the demand
curves you learned about in Block 2 are derived.
After studying the demand curve in Block 2, it is important to realise that
this curve is the direct result of the assumptions of rationality and individual
decision making as discussed in Block 1. This block, on consumer choice,
draws on the idea of opportunity cost as well as individual preferences to
derive the demand curve.
You will need a good understanding of the intuition behind the models
in this block. It is important that you gain a good grasp of them, because
we use an equivalent set of concepts in analysing how firms make their
production decisions (Block 5), and they are also used to determine
household’s labour supply (Block 10). As well as this, you will also need
to practise drawing the graphs in this chapter, since they will help to
understand the concepts, and since you may need to be able to reproduce
them for your exam. In particular, practise drawing the income and
substitution effects for normal and inferior goods, since many of the key
concepts are summarised in these graphs.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• define the relationship between utility and tastes for a consumer
• describe the concept of diminishing marginal utility
• describe the concept of diminishing marginal rate of substitution and
calculate the marginal rate of substitution (MRS)
• represent tastes as indifference curves
• derive a budget line
• explain how indifference curves and budget constraints explain
consumer choice
• describe how changes in consumer income affect quantity demanded
• describe how a price change affects quantity demanded
• define income and substitution effects
• show how the market demand curve relates to the demand curves of
individual consumers.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 5 including the appendix.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapter 3; UK edition, Chapter 4.
Witztum (AW), Chapter 2.
47
EC1002 Introduction to economics
Utility
The concept of ‘utility’ was introduced by Jeremy Bentham, in his 1789
book Principles of morals and legislation. He defined it as follows: ‘By utility
is meant that property in any object, whereby it tends to produce benefit,
advantage, pleasure, good, or happiness, (all this in the present case comes
to the same thing) or (what comes again to the same thing) to prevent the
happening of mischief, pain, evil, or unhappiness to the party whose interest
is considered.’ The philosophy of ‘utilitarianism’ (the ‘greatest happiness
principle’) was invented by Bentham and has been very influential. The
textbook defines utility much more simply as ‘the satisfaction consumers
get from consuming goods’ (p.84). As you can read in the appendix to
Chapter 5, in the 19th century, economists believed that utility levels could
be measured, and used a unit of measurement called ‘utils’. Nowadays,
economists assume that utility is not measurable in this way, however, utility
is still a useful concept that underlies much of microeconomics.
Marginal utility
As discussed in Block 1, consumers and firms make decisions at the
margin. This idea is very important in relation to utility. The marginal
utility of a good or service is the extra utility a person gains from
consuming one more unit of that good or service.
Activity SG4.1
Linking the shape of the indifference curves to the assumptions regarding consumer tastes.
The various assumptions that lie behind indifference curves are reflected in certain
aspects of the shape of the curve. Match the assumption to the characteristic of the curve
and explain why.
48
Block 4: Consumer choice
25
20 b
15 c
d e
10 f
T
5
0 5 10 15 20 25 30 35
Food
Figure 4.1: The marginal rate of substitution is the slope of the indifference
curve.
Table 4.1
You should remember from Block 3 that Δ (delta) means change.
Examining the movement from a to b and b to c etc. gives us a good
approximation of the slope of various sections of the curve. An even more
accurate way is to examine the change in utility due to a one unit change
in either of the goods: this gives us the marginal utility of each good at
a point on the curve. In fact, the MRS is given by –MUC/MUF, (i.e. the
marginal utility of clothing at a certain point on the indifference curve,
divided by the marginal utility of food at that point, multiplied by –1).
We will come back to this again at the end of the block (as it is covered in
more detail in the third part of the appendix and Maths A5.1).
49
EC1002 Introduction to economics
Figure 5.5 on p.90 of BVFD also helps to illustrate this idea, showing
indifference curves for people with different tastes. The glutton is more
willing to substitute films for food than the weight-watching film buff and
has a higher MRS. Drawing a tangent to any part of their indifference
curves shows that the slope of the gluttons indifference curve is steeper –
reflecting his higher MRS between meals and films.
The slope of a typical indifference curve gets steadily flatter as we move to
the right, reflecting a diminishing marginal rate of substitution.
For example:
Clothing
A
b
Food
Figure 4.2: Changes in the slope of an indifference curve reflect a diminishing
marginal rate of substitution.
The slope of the tangent A shows the MRS of food for clothing at point a.
Similarly, the slope of the tangent B shows the MRS at point b. We can see
that the slope flattens as we move from a to b, reflecting a diminishing
MRS. At point a, the person has quite a lot of clothing and is willing to
substitute a fair bit of this for a certain amount of food. At point b, the
person has much less clothing but quite a lot of food and is only willing
to substitute a very small amount of clothing to gain the extra amount of
food. Going back to table 4.1, you can also see the diminishing MRS, as
the amount of clothing the person is willing to substitute for 5 additional
units of food continues to fall.
Activity SG4.2
Draw a map of indifference curves, marking out bundles and comparing them to each
other based on the following story: Mark likes jeans and cowboy boots. He is indifferent
between a bundle with 3 pairs of jeans and 2 pairs of cowboy boots (bundle A) and
a bundle with 2 pairs of jeans and 4 pairs of cowboy boots (bundle B). However, he
would prefer to have a bundle with 4 pairs of jeans and 5 pairs of cowboy boots (bundle
C). He is also indifferent between a bundle with 2 pairs of jeans and 1 pair of cowboy
boots (bundle D) and a bundle of 1 pair of jeans and 3 pairs of cowboy boots (bundle
E), although these last two options are his least preferred options. How do you think he
would feel about a bundle with 3 pairs of jeans and 3 pairs of cowboy boots?
Remember:
•• An indifference curve shows all the consumption bundles yielding a particular level of
utility.
•• Any point on a higher indifference curve is preferred to any point on a lower
indifference curve.
50
Block 4: Consumer choice
Indifference map
Budget constraint
Activity SG4.3
The slope depends only on the relative prices of the two goods. Draw budget constraints
for the following three price combinations, assuming a total income of £120.
A: PX = £12
PY = £20
B: PX = £10
PY = £20
C: PX = £12
PY = £15
You should be familiar with the general form of the budget constraint used
in this section, (i.e. where pX is the price of good X, pY the price of good Y, x
the quantity of good X, y the quantity of good Y and M the money income
available to the consumer). Note that the first term on the left-hand side
of this equation is the consumer’s expenditure on X and the second term
is expenditure on Y. Since we assume that the consumer spends all her
income on these two goods, the amount spent on the two goods sums up
to M which is her income. One important point from this Maths box is that
the slope of the budget constraint is given by –pX /pY i.e. the price ratio.
51
EC1002 Introduction to economics
The figure in this Maths box shows how you can represent a general case,
where you don’t have specific quantities and prices. The intercepts will
then be M/PY and M/PX respectively. This is likely to be how you will draw
a budget constraint most often.
Step 1 Step 2
Preferences Budget Constraint
(What the individual wants to do) (What the individual can do)
Step 3
Decision
(Taking constraints into account, the individual attempts
to reach the highest level of satisfaction)
Decision rule
The point which maximises utility is the point at which the consumer
reaches the highest indifference curve that the budget constraint allows.
For the ‘standard’ indifference curves we have been looking at, this
decision rule says that the consumer should choose the consumption
bundle where the slope of the budget line and the slope of the indifference
curve coincide. In other words, it is the point at which the indifference
curve is tangent to the budget constraint.
► BVFD: read the first part of the appendix for Chapter 5 of, the material in
the appendix applies whether or not utility can actually be measured.
52
Block 4: Consumer choice
Good Y
M/Py
u0
M/Px Good X
Figure 4.4: A budget constraint and an indifference curve.
MUX/PX=MUY/PY has the intuitive interpretation that the marginal utility
derived from the last pound spent on X must be equal to the marginal
utility of the last pound spent on Y. Otherwise the consumer would adjust
their consumption pattern and increase their utility.
Imagine that MUX/PX > MUY/PY. This implies that the consumer derives
more utility from the last pound spent on good X than the last pound spent
on good Y. In this case, by consuming one pound more of good X and one
pound less of good Y, they can increase their utility level without spending
any more money. The consumer should continue to adjust their spending
in this way until MUX/PX=MUY/PY.
It is important to understand the intuitive explanation of the consumer’s
decision, as well as being familiar with the relevant equations and graphs.
Activity SG4.4
Jeremy has £M and wants to buy some combination of books and shoes. Books cost PB
each and shoes cost PS per pair. Both of these goods are normal goods to him. Describe
graphically and in equations how he will decide on an optimal combination of the two
goods which will maximise his total utility. What is the intuition behind this?
53
EC1002 Introduction to economics
Activity SG4.5
Draw budget constraints and possible indifference curves for the following scenario:
Susan buys cabbages and carrots. Cabbages cost £1 per kilo and carrots cost £0.80 per
kilo. Her income falls from £20 to £16. Carrots are a normal good, but cabbages are an
inferior good.
Activity SG4.6
Page 98 contains a suggestion of two diagrams you should draw to check your
understanding, complete this in the boxes below:
54
Block 4: Consumer choice
Activity SG4.7
For a choice between Good X and Good Y, complete the graphs below, clearly indicating the
income and substitution effects in each case. You will find figures 5.14 and 5.16 helpful for
this activity, and you might want to repeat it a few times on a separate sheet of paper until
you are really comfortable with these concepts. The following order is generally best:
1. Draw the original budget line and indifference curve.
2. Draw the new budget line.
3. Draw the hypothetical budget line parallel to the new budget line and tangent to the
original indifference curve. This gives you the substitution effect.
4. Draw the new indifference curve (where you place this depends on what type of good it
is). This gives you the income effect.
NB: The method used in the textbook and in this activity to break a price change into
income and substitution effects follows an approach suggested by the economist John Hicks
and the effects are known as the Hicksian substitution and income effects. There is also an
alternative approach following the economist Eugen Slutsky. If you are interested to know
more about this, it is explained in AW 2.3.1. However, you are only required to know the
Hicksian approach (as in BVFD) for this course.
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EC1002 Introduction to economics
Activity SG4.8
Derive the individual demand curve from the information in figure A. Can you now explain
why the demand curve is downward sloping?
A
Sunglasses
e4 Price-consumption curve
e3
e2
e1 (Price per sandwich = p3)
0 x1 x2 x3 x4 Sandwiches
B
Price per Sandwich
0 Sandwiches
Figure 4.5: Deriving the individual demand curve.
► BVFD: read the second part of the appendix: deriving demand curves.
This explains why, for normal goods, a fall in price leads to an increase in quantity
demanded, due to both substitution and income effects.
y
P
with the relative price ( P ) where x is the good on the horizontal axis and
x
y the good on the vertical axis. This enables us to give further intuition to
the price at any given quantity and to the whole demand curve.
56
Block 4: Consumer choice
y1 A
Indifference curve
x
x1 10
Px
4 A/
x1 x
57
EC1002 Introduction to economics
The market demand curve is the horizontal addition of the demand curves
of all the individuals in that market. In the following activity we assume
that there are only three consumers, but the method can be applied to
much larger numbers; in such cases kinks in the market demand curve
would tend to be smoothed out.
Activity SG4.9
Complete the fourth graph, showing the market demand curve. Why might the three
consumers have different demand curves?
PRICE
PRICE
PRICE
PRICE
Consumer 1 Consumer 2 Consumer 3 Market demand
12 12 12 12
8 8 8 8
4 4 4 4
0 7 2 4 6 5 10
58
Block 4: Consumer choice
Activity SG4.10
Draw the indifference curves for perfect complements together with a budget line. Now
draw a new budget line for a change in the price of one of the goods. Indicate the income
and substitution effects (if any) of the price change.
Perfect complements
Activity SG4.11
Barbara likes peanut butter and jam together on her sandwiches. However, Barbara is very
particular about the proportions of peanut butter and jam. Specifically, Barbara likes 2
scoops of jam with each scoop of peanut butter. The cost of ‘scoops’ of peanut butter and
jam are 50p and 20p, respectively. Barbara has £9 each week to spend on peanut butter
and jam. (You can assume that Barbara’s mother provides the bread for the sandwiches.)
If Barbara is maximising her utility subject to her budget constraint, how many scoops of
peanut butter and jam should she buy?
Activity SG4.12
Suppose that a consumer considers coffee and tea to be perfect substitutes, but he requires two
cups of tea to give up one cup of coffee. This consumer’s budget constraint can be written as 3C
+ T = 10. What is this consumer’s optimal consumption bundle?
Figure 4.8 below replicates Figure 5.21 from the textbook, but includes
indifference curves for the case where the consumer starts at e’. If the
consumer receives a cash transfer, they may move to point c, where their
utility level is indicated by the curve u1. However, if they receive food
stamps (a transfer in kind), they cannot choose point c, and may move
instead to the feasible point B. At point B, their utility level is indicated by
the curve u0. This is clearly lower than the utility level the consumer could
have reached with a cash transfer. Furthermore, point B is not a tangency
solution: the slope of the indifference curve is not equal to the slope of the
budget constraint. This shows that non-tangency solutions may sometimes
arise from government policy, and also reaffirms the conclusion made
by the textbook: ‘In so far as people can judge their own self-interest …
people are better off, or at least no worse off, if they get transfers in cash
rather than transfers in kind’ (p.108).
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EC1002 Introduction to economics
Films c
u1
A u0
B
e’
F F’ Food
Figure 4.8: Transfers in cash and in kind. Figure adapted by author from BVFD.
Activity SG4.13
Calculate the optimal quantity of each of two goods (x and y) and the consumer’s total
utility given px = 1, py = 2, M = 80, and U(x,y) = xy, where MUx = y and MUy = x. How
would you represent this graphically?
► BVFD: read the summary and work through the review questions in
Chapter 5.
Overview
This block started by introducing utility and indifference curves, as
well as the budget constraint. Indifference curves represent consumer
tastes, while the budget constraint shows the possibilities open to the
consumer, given their limited budget. Putting these together, we learned
the decision rule that determines consumer choice, under the assumption
that consumers maximise utility. In particular, we saw that consumers
will chose the bundle of goods such that MUX/PX = MUY/PY. Expressed
graphically, this means that the highest reachable indifference curve is
tangent to the budget constraint. We then explored how their choices are
affected by changes in income and prices, looking in particular at income
and substitution effects of a price change. This helped us identify normal
and inferior (and Giffen) goods. We also further examined complements
and substitutes. Understanding how consumers make choices lets us see
what lies behind the – individual and market – demand curves. Finally, the
analysis of budget constraints and indifference curves also made it possible
to evaluate the relative benefits of cash transfers versus transfers in kind.
60
Block 4: Consumer choice
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EC1002 Introduction to economics
Long-response questions
1. a. Susan buys bread rolls and cheese. One bread roll costs £1 and
cheese costs £3 per 500g block. Susan has £12 income to spend on
bread and cheese.
i. Draw Susan’s budget constraint and a possible indifference
curve. Explain the assumptions behind the shape of the
indifference curve you have drawn.
ii. If the price of bread falls to £0.80 per loaf, how will this affect
her purchases? Answer in words and graphically, clearly
indicating income and substitution effects of the price change.
iii. If Susan only enjoys bread and cheese when she has 500g of
cheese for every bread roll that she eats, draw her indifference
curves. How much bread and cheese should she buy to
maximise her utility? Assume Susan has £12, one bread roll
costs £0.80 and cheese costs £3 per 500g block.
b. Now let’s assume that Susan grows 100 potatoes each year and
all of her income comes from selling them. She spends all of her
income each year consuming potatoes and other goods. For Susan,
potatoes are a Giffen good, in that if her income is fixed in some
way (i.e. ignoring the fact that she sells potatoes and just fixing her
income at some value) her consumption of potatoes will rise when
their price rises. The price of potatoes falls and she consumes more
potatoes. Taking into account the fact that her income actually
comes from selling potatoes, explain how the last statement can be
consistent with those that precede it.
2. I consume two goods, ice cream and biscuits. I shop once a week,
spending £100, at either Sainsbury or Tesco (two well-known UK
supermarkets). Interestingly, I’ve noticed that the bundle I purchase
when I visit Tesco costs more at Sainsbury. Similarly, the bundle I
purchase when I visit Sainsbury costs more at Tesco. And yet, I find
that I get the same utility from shopping at either store (i.e. the
Sainsbury shopping bundle gives me the same utility as the Tesco
shopping bundle). Explain how it is possible for all of these statements
to be true. (Hint: draw a single indifference curve and have me
maximise utility given a £100 budget and different prices in the two
stores).
62
Block 5: The Firm I
Introduction
The two most important concepts in microeconomics are demand and
supply. In the previous block, we saw what lies behind the demand curve
and how this is driven by consumer preferences and the constraints
imposed by their budgets. In this and the following blocks, we will explore
what lies behind the supply curve. Basically, supply depends on the
technology available to firms, the cost of inputs, and the market structure
the firm operates in (e.g. the number of other sellers, which affects price
and revenue at each level of output). This block provides an introduction
to the analysis of the firm.
Many of the concepts introduced in this block are quite straightforward,
especially the early material in Chapter 6 of BVFD. Although you will need
to be familiar with this to have a context for the more detailed analysis, you
should concentrate your attention on the material from Chapter 7 (especially
the appendix) and the later parts of Chapter 6. Numerical examples are
provided in the block to help you calculate the firm’s optimal level of output.
You should also practise representing these concepts graphically.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• distinguish between economic and accounting definitions of cost
• describe the relationship between revenue, cost and profit
• describe the production function
• identify the point of diminishing marginal returns
• demonstrate how the choice of production technique depends on input
prices
• use isoquants and isocost curves to derive the firm’s total cost curve
• calculate marginal cost and marginal revenue
• find the profit maximising level of output, given the firm’s demand
curve and total cost curve.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 6; Chapter 7 sections
7.1, 7.2 and appendix.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapter 4; UK edition,
Chapter 5.
Witztum (AW), Chapter 3.
to derive the firm’s total cost curve. It also shows how the demand curve
facing the firm can be used to derive the firm’s total revenue curve. Profit
is equal to revenue minus cost, thus through understanding the firm’s
revenue and costs, we can find the profit function. The block concludes by
introducing the concepts of marginal cost and marginal revenue. Providing
that it is profitable for the firm to operate at all, it will choose its level of
production such that marginal cost and marginal revenue are equal.
► BVFD: read section 6.1–6.3, including concepts 6.1 and 6.2 and case 6.1.
Activity SG5.1
What is the economic cost of studying for an undergraduate degree?
Q=f (K,L)
The total output curve (also known as the total product curve), shown in
Figure 7.2 of the textbook, is a reduced form of the production function
for the short-run, when only one input is allowed to vary and the other is
held fixed. We can find this curve by ‘slicing’ the hill in Figure SG5.1 above
vertically at the level K0. The reduced production function Q = ƒ (L, K0), is
thus a vertical section of the hill.
Activity SG5.2
Describe how the phrase ‘too many cooks spoil the broth’ can demonstrate the law of
diminishing returns.
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EC1002 Introduction to economics
Activity SG5.3
Define the following terms and give a formula for (b) and (c):
a. total product
b. average product
c. marginal product.
Activity SG5.4
Complete the following table:
The point where marginal product reaches a maximum is called the point of diminishing
marginal returns. At what quantity of labour does diminishing marginal returns set in?
Graph the Total Product curve in the upper section and the marginal and average product
curves in lower section of the boxes below:
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Block 5: The Firm I
The appendix to Chapter 7 starts with isoquants. ‘iso’ (or ‘ίσο’ using Greek
letters) is a Greek word which means equal. Isoquant means equal
quantity, isocost means equal cost. An isoquant is very similar to an
indifference curve – while an indifference curve shows different
combinations of goods which generate a certain level of utility, an isoquant
shows different combinations of inputs which generate a certain output.
Read about isoquants on pp.166–67.
Activity SG5.5
Based on the production function: Q(L, K) = L0.5 * K0.5 , where Q is output, L is
labour and K is capital, fill in the blanks below and draw isoquants for the three output
levels on a large graph on a separate piece of paper, or using scatter plots in Excel.
(NB: remember x 0.5 = √x).
On the isoquant reflecting an output level of 10 units – what is the MRS between labour
and capital when labour changes from 4 to 5 units?
To find the optimal combination of labour and capital, the second tool we
need to use is called the isocost line, the line showing all combinations of
labour and capital (these being our two inputs in the current example)
which generate the same total cost, given the prices of the two inputs–
read about the isocost line on pp.167–68. It is worth pointing out that
on p.167, the textbook uses the term ‘cost function’ for the C=wL+rK.
However, this term is usually reserved for the equation showing cost as a
function of output, not input. Given that there are only two inputs, L and K
with prices w and r respectively C=wL+rK is an identity (something that is
always true) – this is how we define total cost.
Activity SG5.6
If r = £2/hr and w = £12.50/hr, draw three isocost lines onto the diagram you created in
Activity SG5.4 for when cost is equal to £50; to £100; and to £150. What is the optimal
(i.e. the least-cost or cost-minimising) combination of labour and capital for an output
level of 10? What is the cost?
Equation A7 has an intuitive explanation, namely, that the firm must buy
resources such that the last pound spent on K adds the same amount of
output as the last pound spent on L. This can be easily seen by further
rearranging the equation such that:
–r/w = –MPK/MPL (A7)
–r/MPK = –w/MPL (A7b)
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EC1002 Introduction to economics
In the case of consumer choice, the budget line was fixed at the consumer’s
budget, and the consumer maximised their utility by choosing the
combination of goods which put them on the highest possible indifference
curve. For the firm, for a given level of output, the firm minimises cost by
choosing the combination of inputs that puts them on the lowest possible
isocost line. As such, the isoquants together with the isocost curve can be
used to derive the firm’s total cost function at different levels of output.
Read about this on p.168.
Activity SG5.7
Use the information below to draw isoquants and isocost lines and find four points on the
firm’s total cost curve.
Rental rate of capital = £2 per hour
Wage = £2 per hour
Cost levels: £12, £16, £20 and £24.
Output combinations:
Qx = 25 Qx = 50 Qx = 75 Qx = 100
Capital Labour Capital Labour Capital Labour Capital Labour
A 1 8 2 10 3 10 4 10
B 2 5 3 6 4 7 5 8
C 3 3 4 4 5 5 6 6
D 5 2 6 3 7 4 8 5
E 8 1 10 2 10 3 11 4
Productive efficiency
The fact that the total cost curve shows the least-cost method of producing
each output level implies that the points on the long-run total cost curve
are productive efficient. It is important to note that every point on a firm’s
average total cost curve is, by definition, productive efficient – not just the
minimum point. Productive efficiency occurs when a certain quantity of a
good is produced at the lowest possible input cost. Saying the same thing
in a different way – productive efficiency means that the firm is obtaining
the maximum possible output from its inputs.
Activity SG5.8
A firm Sam’s Lamps has the production function Q(L, K) = L*K. Given labour of 5
and capital of 7, are they producing efficiently by producing 12 units? What level
of production is the productive efficient level? What reasons might there be for not
producing efficiently? Now suppose that Sam’s Lamps has decided to produce 100 lamps
and the price of labour is £5 per unit and the price of capital is also £5 per unit. The firm
decides to employ 50 units of capital and 10 units of labour. Is this efficient? Hint: with
this production function the marginal product of labour is equal to K and the marginal
product of capital is equal to L.
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Block 5: The Firm I
K K
a
80
40 a
b b
35 Q = 50 35 Q = 50
25 200 L 25 200 L
(a) Production function with limited (b) Production function with abundant
input substitution opportunities input substitution opportunities
Activity SG5.9
To produce a subject guide, one author and one computer are perfect complements in
production. One author and two computers would not be more productive. Two authors
is more productive – but (probably) only if they each have a computer. Draw the relevant
isoquants for this case. Now imagine that there is a machine that does exactly the same
thing as a human in regards to the production of a certain good. Labour and capital will
be perfect substitutes in production in this case. Draw the relevant isoquants for when the
inputs are labour and this type of machine.
Having used isoquants and isocost lines to derive the total cost curve, we
can now come back to section 6.4. Table 6.3 on p.124 contains data for
a certain firm – we can use this to graph the firm’s total cost function, as
follows:
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EC1002 Introduction to economics
140 TC
120
100
Pounds 80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10
Output
10
5
0
0 1 2 3 4 5 6 7 8 9 10
Quantity
140
120 X TR
100
Pounds
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10
Output
Figure 5.5: Total revenue.
For example, point X on the demand curve shows the firm will sell 7 units
of output at £15, generating revenue of £105. Point X on the total revenue
curve therefore shows the combination of 7 units of output and revenue of
£105.
Putting the total cost and total revenue curves together allows us to find
the profit function (profit as a function of output). For example, when
total cost and total revenue are equal, profit is zero. At 6 units of output,
the gap between the two curves is greatest, and this is the highest point on
the profit curve, showing a profit of £27.
70
Block 5: The Firm I
140 TC
120
100 TR
Pounds
80
60
40
20
0 Output
0 2 4 6 8 10 12
Profit
140
120
100
80
Pounds
60
40
20
0 Output
–20 0 2 4 6 8 10 Profit 12
► BVFD: read section 6.5, section 6.6, Maths 6.1 and Maths 6.2.
Marginal analysis
Marginal analysis is one of the key analytical tools in economics. We
have already covered marginal utility in the previous block. This section
introduces marginal cost and marginal revenue. ‘Marginal cost’ (MC) is the
change in total economic cost due to the production of one more unit of
output. ‘Marginal revenue’ (MR) is the change in total revenue due to the
sale of one more unit of output. At the profit maximising level of output,
marginal cost and marginal revenue are equal.
Both maths boxes involve calculus, which helps to simplify the analysis.
You should work through these maths boxes to understand the principles
they are expounding.
Activity SG5.10
If the firm faces the demand curve: P = 25 – 2Q:
a. fill in the blanks in the table below
b. draw the marginal cost and marginal revenue curves
c. find the profit maximising output level for this firm. How much profit is the firm
earning at that point? Assume output must be in integers.
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EC1002 Introduction to economics
5 55
6 65
7 78
8 93
9 110
10 130
► BVFD: read the summary and work through the review questions.
Overview
As well as providing an introduction to the basic unit of production – the
firm – this block has demonstrated what lies behind the firm’s production
decisions. Using isoquants and isocost curves, the firm can determine the
least-cost combination of inputs to produce a given quantity of output. From
there, the firm’s total cost curve can be derived. It is assumed that firms
pursue a goal of profit maximisation, and one key point from this block is
that Profit = Revenue – Cost. Knowing the demand curve it faces, the firm
can derive its revenue curve, and since it knows both revenue and cost, the
profit-maximising level of output can easily be found. At this level of output,
we have also seen in this block that marginal cost and marginal revenue
are equal. Marginal analysis is a very useful tool in economic analysis, as
we have seen here in the case of the firm. As the textbook also clarifies, the
economic analysis of the firm provides a useful model for understanding
firms’ behaviour – it is not meant to be a practical system for real world
firms to follow, rather, it provides an analytical framework which helps
explain the behaviour of individual firms and the market as a whole.
Number of workers 0 1 2 3 4 5 6
Output of pies 0 10 26 36 44 49 52
Note: Pies are sold competitively at £3 each. Labour is the only
variable input and costs £14 per worker. Capital costs are £80. These
are short-run and long-run costs and productivities (i.e. there is no
possibility of using different production techniques or combinations in
the long run).
Using the information above, which describes the number of pies
produced as a function of the number of workers at Shakespeare’s
Pies, and focusing just on the decision to hire workers (ignoring
the shut-down condition and just trying to pick the best number of
workers), Shakespeare’s Pies maximises its profit if it hires:
a. 1 worker
b. 3 workers
72
Block 5: The Firm I
c. 5 workers
d. 6 workers.
2. Anita owns a grocery shop. These are her annual revenues and costs:
Revenues £250,000
Supplies £25,000
Electricity and heating £6,000
Employees’ salaries £75,000
In addition to the above, Anita pays herself a salary of £80,000. If she
closed her shop she could rent out the land and building for £100,000.
Due to her experience at running her own shop the local supermarket
would offer her a job and pay her £95,000.
a. Anita’s revenue exceeds her economic costs so she should continue
running her business.
b. Anita’s economic costs exceed her accounting costs so she should
shut down her business.
c. Anita’s economic costs exceed her revenue so she should shut
down her business.
d. Anita’s salary is less than what the supermarket would pay so she
should shut down her business.
3. Choose the statement which is false:
When long-run costs for a firm are at a minimum
a. The ratio MPL/MPK = wage / rental.
b. MPL = MPK.
c. The extra output we get from the last dollar spent on an input
must be the same for all inputs.
d. The firm’s production is economically efficient.
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EC1002 Introduction to economics
Q P TC TR MR MC π
0 5 5
1 5 10
2 5 13
3 5 14
4 5 16
5 5 19
6 5 23
7 5 28
8 5 34
74
Block 6: The Firm II
Introduction
As in Block 5, we assume that firms attempt to maximise profit and profit
is equal to revenue minus cost. This block extends the analysis of the
firm’s costs – from total cost to fixed and variable costs, average costs as
well as marginal costs, and the relationships between all of these. While
the previous block looked at diminishing marginal returns (a short-run
concept), this block includes a discussion of increasing, constant and
decreasing returns to scale (a long-run concept). The following blocks will
provide more detail on the firm’s revenues, which are linked to the market
structure in which the firm operates. This current block shows how the
supply curves of individual firms are determined, while the following block
(Block 7) will continue this story by explaining how the market supply
curve is found (this depends on the number of firms in the market, which
is a crucial aspect of market structure – the topic of Block 7).
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• identify fixed and variable factors in the short-run
• analyse total, average and marginal cost, in the short-run and long-run
• draw the relevant cost curves and explain why they have certain
shapes
• define returns to scale and their relation to average cost curves
• describe how a firm choses output, in the short-run and the long-run
• describe the relationship between short-run cost and long-run cost.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 7, sections 3 to 9.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapter 4; UK edition,
Chapter 5.
Witztum (AW), Chapter 3.
The first few sentences of this section state that the firm’s production
function can be translated into a relationship between cost of production
and output. In the jargon of economic theory there is a ‘duality’ between
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EC1002 Introduction to economics
Output
Output
TP
decreasing
marginal increasing
increasing
returns marginal
marginal
returns returns decreasing
marginal MP
returns
L L
Cost
Cost
costs costs
increase increase MC
TC
at a at a
decreasing decreasing
rate costs rate costs
increase increase
at an at an
increasing increasing
rate rate
Q Q
Figure 6.1: Relationships between total and marginal product and total and
marginal cost.
The top left figure shows the total product curve, which is initially
displaying increasing marginal returns and then displays decreasing
marginal returns after the dotted line. This is a mirror image of the total
cost curve depicted in the figure below it. When marginal returns are
increasing, costs are increasing at a decreasing rate, and vice versa. The
slope of the TP curve gives the marginal product, while the slope of the
TC curve gives marginal cost. The total product curve is also related to
the marginal product curve (top left figure). The marginal product curve
displays increasing marginal returns by increasing up to a maximum point,
and then falling when marginal returns are decreasing. The marginal
cost curve below is the mirror image of the marginal product curve
and demonstrates the rate of change of costs more explicitly – it falls
when costs are increasing at a decreasing rate and rises when costs are
increasing at an increasing rate.
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Block 6: The Firm II
Activity SG6.1
This section introduces various cost curves – practise these in the boxes below as
indicated:
STC, SVC, SFC SATC, SAVC, SAFC, SMC
Activity SG 6.2
Why does the SMC curve cut the SAVC and SATC curves at their minimum points?
Provide an intuitive answer.
This maths box provides formulas for the various short-run costs based on
a short-run total cost function. You need to remember that:
• Total cost = Fixed cost + Variable cost
• Marginal cost is the change in total cost as quantity produced changes
• Average costs are calculated by dividing the cost by the quantity
produced; this applies to average fixed cost, average variable cost and
average total cost.
Activity SG 6.3
Find the short-run fixed cost, variable cost, marginal cost, average fixed cost, average
variable cost and average total cost for the short-run total cost function STC = M + aQ2,
for which the first derivative is 2aQ.
•• short-run fixed cost
•• variable cost
•• marginal cost
•• average fixed cost
•• average variable cost
•• average total cost.
This section discusses how the firm chooses its level of output in the short
run. Two points are important: firstly, the firm chooses the output level
where marginal cost is equal to marginal revenue. Secondly, the firm
must check whether the price it receives at this output level enables it to
generate a profit, to cover all of its costs, to cover only its variable costs
and perhaps contribute a little towards the fixed costs, or not even cover
its variable costs. This will show the firm if it should produce at all in the
short run.
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EC1002 Introduction to economics
We now move on to the long run, and will examine production, costs
and the output decision as we did for the short run. The contents of this
section should be familiar to you already because we covered the appendix
of Chapter 7 in the previous block and this material is a descriptive version
of what is in the appendix. Read through carefully and make sure you are
familiar with these ideas, including the concept of factor intensity.
Activity SG6.4
How does the switch in technique in the final sub-section of section 7.5 relate to the
analysis of a change in factor prices using isocost lines and isoquants (See Figure 7.A4)?
Activity SG6.5
Draw the long-run cost curves in the boxes below as marked:
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Block 6: The Firm II
► BVFD: read section 7.7, cases 7.2 and 7.3 and Maths 7.3.
If five workers and five machines can produce 1,000 soft toys, how many
soft toys could be produced if we employed 10 workers and 10 machines?
This question has to do with returns to scale in production. Does doubling
inputs result in more than double, less than double or exactly double the
original output? This will tell us if there are increasing, decreasing or
constant returns to scale.
Some textbooks, but not BVFD, make a semantic distinction between
returns to scale in production and economies of scale in costs. Thus,
on the production side if there are constant returns to scale then a doubling
of all inputs leads to a doubling of output; and with increasing (decreasing)
returns to scale a doubling of all inputs more (less) than doubles output
(see Maths box 7.3). As long as input prices are held constant then the
relationship between returns to scale in production and economies of scale
in costs is straightforward: if doubling inputs more than doubles output then
cost per unit of output is smaller at higher output. However, if input prices
change as output increases or decreases then the effect of these changes, as
well as underlying scale effects in production, will affect average costs. The
fact that BVFD equates the two concepts implies an underlying assumption
that input prices are not changing as output increases or decreases.
The figure to the right demonstrates varying returns to an increase in
inputs at different levels of input. First let us describe what is meant by
the ‘composite input’ on the x-axis. This is a combination of labour and
capital where the proportions of each are held constant. Thus, for example,
if we double labour, we also double capital and the capital–labour ratio
remains the same. A change in scale doesn’t have to do with changing
the composition of inputs, but rather with changing the amount that is
employed.
Composite Input
Figure 6.2: Long-run production function.
We can now see how this curve demonstrates initially increasing, then
constant, and finally decreasing returns to scale. The vertical bars rising
up from the x-axis are evenly spaced. However, the quantity of output
generated from these input levels varies greatly. At low levels of input,
increasing the units of input increases the level of output more than
proportionally, representing increasing returns to scale. At high levels of
inputs and outputs, the opposite is the case, since increasing the level of
inputs increases the level of outputs less than proportionally, representing
decreasing returns to scale.
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EC1002 Introduction to economics
Section 7.7 discusses some real-world reasons behind returns to scale and
discusses why firms may face a U-shaped long-run average cost curve. You
should understand the reasons why LRAC may fall initially, be constant for
some time, and then increase.
Activity SG6.6
Increasing returns to scale can be expressed as saying that a certain increase in inputs
leads to a more than proportional increase in output. Equivalently, it can also be
expressed by saying that a certain increase in output requires a less than proportional
increase in inputs. Use this idea and the following isoquant map to derive a production
function (with a composite input on the horizontal axis), assuming that the level of output
represented by each successive isoquant increases by an equal amount each time.
X7
X6
X5
X4
X3
X2
X1
X0
L
Figure 6.3: Returns to scale: the relationship between increases in inputs and
increases in output.
The relationship between the level of input and the level of output is
discussed further in AW Section 3.1.2 (which the above activity is based
on).
The only difference to the analysis of the output decision in the short run
is that there are no fixed and variable costs, since all inputs are variable
in the long run. For this reason, the concept of it being worthwhile to
produce as long as variable costs are more than covered has no relevance
and the firm simply choses its output level where MR = LMC, and then
checks if this is profitable using the LRAC curve.
The firm’s long-run supply curve is its marginal cost curve
above the average cost curve. The firm will supply the output at
which LMC is equal to MR, provided that price is not less than the firm’s
LRAC.
The short-run cost curve shows the costs for when one input is fixed at a
certain level. If it were fixed at a different level, the short-run cost curves
would also be different. For example, if the level of capital was fixed at a
higher level, short-run costs for producing a given level of output may be
lower, if each worker is more productive with more capital to work with.
There is a different short-run cost curve for each quantity of the fixed
input. This is sometimes described as a family of short-run cost curves. In
the long run the firm chooses the plant size with the lowest average cost
for any given level of output. The LAC includes one point (assuming there
are a large number of feasible plant sizes) from each SAC (not necessarily
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Block 6: The Firm II
the minimum point of the short-run curve, as the text explains). The long-
run average cost curve can be described as an envelope of these short-run
curves.
Activity SG6.7
Draw six short-run average cost curves, each with a single point of tangency to a long-run
average cost curve showing increasing, constant and then decreasing returns to scale.
► BVFD: read the summary and work through the review questions.
Overview
This block introduces the distinction between the short run (when one
factor of production is fixed) and the long run (where all inputs are
variable). The production function, which summarises the technical
possibilities faced by the firm, can be used to derive the firm’s total cost
curve. Short-run total cost is equal to short-run fixed cost plus short-
run variable cost. Average costs are found by dividing cost by quantity
produced. Average cost is falling if marginal cost is below average cost,
and rising if marginal cost is above average cost. The short-run marginal
cost curve reflects the marginal product of the variable factor (usually
labour). It cuts the SATC and SAVC curves at their minimum points.
In the short run, the firm choses its output level where MC = MR, but
only produces at all if the price received at this level of output at least
covers all variable costs and makes some contribution to fixed costs. The
long-run total cost curve represents the economically efficient (least-
cost) production method for each level of output when all inputs can be
varied. The long-run average cost curve is usually U-shaped, representing
increasing, constant and then decreasing returns to scale as output rises.
In the long-run, the firm supplies the output at which MR = LMC as long
as the price is no less than LAC at that level of output. The LAC curve is an
envelope of many SAC curves which all touch the LAC at just one point.
This block showed how the short-run and long-run supply curves of an
individual firm can be found. The following block contains the derivation
of the short-run and long-run industry supply curves for different types
of industries. This block provides a detailed introduction to costs. The
following blocks will also look more in detail at revenue, in relation to the
market structure in which the firm operates.
You need to be able to reproduce the output curves and cost curves
covered in this block. Since there are quite a few, the best way to do this
is to understand what they mean, why they have certain shapes, and
how they are related to each other. Approaching this with understanding
(rather than memorisation) will be an easier and more effective method in
the long run. Furthermore, the examination will test your understanding
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EC1002 Introduction to economics
of these cost concepts (rather than just your capacity for memorisation).
The output and cost curves you need to know for this block are
summarised below. This is a good chance to practise them and make sure
you understand what they represent, where they come from, and how they
are related to each other.
TP MPL
(labour on horizontal axis)
82
Block 6: The Firm II
Number of workers 0 1 2 3 4 5 6
Output of pies 0 10 26 36 44 49 52
Note: Pies are sold competitively at £3 each. Labour is the only
variable input and costs £14 per worker. Capital costs are £80. These
are short-run and long-run costs and productivities, i.e. there is no
possibility of using different production techniques or combinations in
the long run.
Refer to the information above which describes the number of pies
produced as a function of the number of workers at Shakespeare’s
Pies and the note, which highlights that capital costs (fixed costs) are
£80 in the short and the long run. Assuming wages and prices don’t
change, Shakespeare’s Pies should:
a. shut down immediately
b. stay open in the short run but shut down in the long run
c. stay open in the short run and the long run
d. shut down in the short run but reopen in the long run.
2. If short-run average total cost equals short run marginal cost, then:
a. Short-run average total cost is at a minimum.
b. Short-run marginal cost is at a minimum.
c. Both a. and b. are correct.
d. Neither a. nor b. are correct.
3. Which of the following statements best summarises the law of
diminishing marginal returns?
a. In the short run, as more labour is hired, output diminishes.
b. In the short run, as more labour is hired, output increases at a
diminishing rate.
c. In the short run, the amount of labour a firm will hire diminishes
as output increases.
d. As more labour is hired, the length of time that defines the short
run diminishes.
4. Let the production function be q=ALaKb where q is output, L is labour
and K is capital. The function exhibits increasing returns to scale if:
a. a + b = 1
b. a + b > 1
c. a + b < 1
d. cannot be determined with the information given.
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EC1002 Introduction to economics
84
Block 6: The Firm II
d
8
Q4=?
c
4
Q3=?
2 b
Q2=?
1 a
Q1=?
1 2 4 8 L
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EC1002 Introduction to economics
Notes
86
Block 7: Perfect competition
Introduction
Our study of microeconomics now looks in greater depth at different
types of market structure, which refers to the economic environment
in which buyers and sellers in an industry operate. It is generally
defined according to four characteristics: the size and number of buyers
and sellers, the extent of substitutability of different sellers’ products,
the extent to which buyers are informed about prices and available
alternatives and the conditions of entry/exit. Although BVFD covers the
two extremes of market structure, perfect competition and pure monopoly,
in one chapter, this subject guide devotes a block to each, enabling some
issues to be covered in a bit more depth.
In perfect competition (Block 7), there is an infinite (or very large)
number of firms and free entry and exit, whereas in monopoly (Block 8),
there is a single firm which supplies the whole market, and very large
barriers to entry into the market. While many real-world firms do not fit
neatly into these two extremes, it is nonetheless worthwhile to study them
first, partly because they do approximate some real-world markets (see
below for examples), but also because they provide a benchmark that is
very useful for comparison with other market structures which are more
commonly encountered in the real world. Perfect competition is a desirable
market structure in terms of maximising the welfare of market participants
and for this reason is often used by economists as a kind of first-best
standard in order to evaluate the welfare losses caused by deviations from
the competitive ideal. The subsequent block (Block 9) will introduce other
market structures (monopolistic competition and oligopoly) which sit on
the continuum in between these two extremes.
As this and the following block utilise material from Blocks 5 and 6, it
is vital that you are familiar with the material contained therein. If you
are not, you should revise them now. In particular, you need to fully
understand why choice of the profit maximising output requires firms to
equate marginal cost and marginal revenue. You should also recall that the
return needed to keep a firm from leaving the industry is already included
in its cost curves, which include all opportunity costs – including the next
best alternative return to operating in the current market. In the long
run if a firm is earning a price above average cost it is earning abnormal,
supernormal, or economic profits (these three terms tend to be used
synonymously in economic texts).
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• define perfect competition
• describe why a perfectly competitive firm equates marginal cost and
price
• demonstrate how profits and losses lead to entry and exit
• draw the industry supply curve
• carry out comparative static analysis of a competitive industry.
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EC1002 Introduction to economics
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 8, sections 1 to 4
(which builds on Chapter 7 which you should revise if necessary).
Further reading
Lipsey and Chrystal (L&C) international edition, Chapter 5; UK edition,
Chapter 6.
Witztum (AW), Chapter 4.
Activity SG7.1
For the forex market (e.g. selling US dollars), note down how and to what extent each of
the four assumptions above are met.
In reality, there are not many markets which are truly perfectly
competitive. Nonetheless, for the reasons described in concept 8.1, it is
still a very useful model to study.
88
Block 7: Perfect competition
TR
TR
Slope=P
Q
Figure 7.1: Total revenue for a competitive firm.
This enables us to provide a diagrammatic treatment of profit
maximisation for a competitive firm.
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EC1002 Introduction to economics
TC
TR
TR, TC
Panel (a)
Q1 Q2 Q3 Q4 Q (output)
Profit, π
Profit, π, (TR–TC)
Panel (b)
Q1 Q2 Q3 Q4 Q (output)
£ MC
AC
D=AR=MR
Profit, π
Panel (c)
Q1 Q2 Q3 Q4 Q (output)
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Block 7: Perfect competition
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EC1002 Introduction to economics
Activity SG7.3
Reproduce Figure 8.4 from the textbook, except to show exit, not entry.
that, in practice, firms have different cost curves, it is much more likely that
the long-run industry supply curve will be upward sloping.
Comparative statics
► BVFD: read section 8.4.
Activity SG7.4
Suppose all firms in a perfectly competitive market are initially in both short-run and
long-run equilibrium. Then a lump-sum tax (i.e. a tax that is unrelated to a firm’s output)
is introduced.
a. What impact will this have on each firm in the short-run? (Explain your answer).
b. What impact will this have on market price in the long-run? (Explain your answer).
c. What impact will this have on each firm’s output in the long-run? (Explain your answer).
d. What impact will this have on the number of firms in the industry in the long-run?
(Explain your answer).
Draw a diagram to illustrate the effects of the lump-sum tax on an individual firm and the
whole industry.
The section on shifts in the market demand curve demonstrates that the
short-run industry supply curve is much less elastic than the long-run industry
supply curve. In the short run, firms cannot respond as much to a change in
price and the number of firms is fixed. As such, an increase in demand has a
much greater impact on price in the short run compared to the long run.
Activity SG7.5
Reproduce both graphs in Figure 8.8 but for an increase in demand, rather than an increase
in costs (the textbook also suggests this activity and already provides the industry side).
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EC1002 Introduction to economics
94
Block 7: Perfect competition
Solution
a. The first thing we have to realise is that the question is concentrating
on the long-run, so it is the properties of long-run equilibrium that are
going to be relevant in solving this problem. In the competitive model
free entry and exit ensure that firms are earning zero profit (they just
cover all opportunity costs). This is a vital step in solving the problem.
Zero profit means that TR = TC for each firm, i.e.
PQ = 144 + 20Q + Q2
But this is not yet helpful to us because it is one equation with two
unknowns. What can we do? Well our model of the competitive firm
also tells us that it will produce where P = MC. We are given MC so
we can substitute in to the left hand side of the equation above:
(20 + 2Q)Q = 144 + 20Q + Q2
This gives us Q2 = 144, i.e. Q = 12
Now from P = MC we know P = 20 + 2Q, i.e. P = 44.
b. Now turn to the market demand curve and substitute in this price to
estimate market demand:
∼
Q =2488 – 2 * 44 = 2,400
So now we know that market demand is 2,400 and that each profit
maximising competitive firm produces 12 units.
Therefore the number of firms in the market must be
2,400/12 = 200
c. The diagrams are shown below. Make sure that you label the axes and
any curves or lines in the diagram as well the solution values of prices
and quantities. This should all be obvious but it is surprising how
many examination answers fail to provide these important pieces of
information.
P, AC, MC LRMC P Market demand
LRAC
Market supply
44 44
12 Q 2400 Q
Overview
A market structure is the economic environment in which buyers and
sellers in an industry operate.
This block covered perfect competition and its underlying assumptions,
including that:
• there is a large number of buyers, all small relative to the whole
market and all producing a homogeneous product
• buyers and sellers have perfect information regarding prices and
available alternatives
• there is free entry and exit.
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EC1002 Introduction to economics
96
Block 7: Perfect competition
iii. Use graphs to illustrate how a decrease in costs changes the long-
run equilibrium of a competitive market. Carefully describe the
various components of your graphical representation.
b. In a perfectly competitive industry all firms have the Total Cost
function TC = 4 + q2, where q is output of the individual firm. The
market (industry) demand is given by Q = 120 – P where P is price
and Q is industry output. The figure shows the individual firm’s AC
and MC.
P, AC, MC
MC
AC
q
2 4
i. Suppose that initially the price is 8. How much output does each
firm produce? In the short run, with the number of firms fixed,
how many firms are there in the industry?
ii. Could this be a long-run equilibrium? Explain why or why not.
iii. What is the long-run equilibrium number of firms in this
industry?
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EC1002 Introduction to economics
Notes
98
Block 8: Pure monopoly
Introduction
Having examined perfect competition in the previous block, this block
now covers pure monopoly, which is a market structure where only one
firm supplies the whole market, and thus there is no competition between
firms. Utilities (such as gas or water) supplying a particular region
are often monopolies (this will be explored in the section on natural
monopolies). Furthermore, patents allow companies to hold a monopoly
over an invention (for example a pharmaceutical drug) for a limited
period of time. Although finding other real-world examples of companies
that are ‘pure’ monopolists can be as difficult as identifying examples of
markets that are ‘perfectly’ competitive, some companies that come close
include Microsoft, in the market for operating systems, and, a historical
example, de Beers diamonds, which controlled an estimated 80 per cent of
rough diamond supply in the 1980s.1 This block examines the theoretical 1
www.economist.com/
aspects of monopoly as a market structure, including how the monopolist node/2921462
determines its price and output, the social cost of monopoly due to
inefficiency, and price-discrimination by monopolists.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• define pure monopoly
• find the optimal price and output levels for a monopolist using
MC = MR
• relate PED to monopoly power
• recognise how output compares under monopoly and perfect
competition
• describe how price discrimination affects a monopolist’s output and
profits.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 8 sections 5 to 10.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapter 6; UK Edition,
Chapter 7.
Witztum (AW), Chapter 4.
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EC1002 Introduction to economics
Monopoly analysis
This section shows that profit maximisation for a monopolist, as for
a competitive firm, requires producing where MR = MC. But, unlike
the competitive case, MR is not equal to P – it is less than P (see next
paragraph). This means that in profit maximising equilibrium, where
MR = MC, P > MC and this turns out to be the source of monopoly’s
inefficiency. You need to be sure that you really understand the monopoly
diagram, BVFD Figure 8.11. What follows spells out in a bit more detail
some aspects of the monopoly analysis.
To begin with it is crucial for you to understand why, in the case of
monopoly, MR < P (remember from the previous block that MR = P for
a competitive firm). This is explained in section 8.6, but here it is spelled
out in more detail. The downward sloping demand curve faced by the
monopolist means that if a monopolist wants to sell more output it will
have to lower the price. But the lower price applies to all of its output,
not just the marginal unit. Marginal revenue is the price the monopolist
receives for the marginal unit less the price reduction it must accept on
all the units previously sold at a higher price. This is demonstrated in the
following simple diagrammatic illustration.
100
Block 8: Pure monopoly
10
9.5
Q
10 11
Figure 8.1: Marginal revenue when the firm faces a downward sloping
demand curve.
When the price is 10, 10 units are sold and total revenue received by the
firm is 100. To sell an extra unit (the 11th unit) the price must fall to
9.5. This, however is not the firm’s net gain in revenue because it now
sells each of the previously sold 10 units for 9.5 rather than 10. The net
revenue, the marginal revenue, from selling the 11th unit is its price,
9.5, minus the reduced revenue on the first 10 units, i.e. 0.5 * 10 = 5.
Therefore MR = 9.5 – 5 = 4.5. So MR is less than price.
Activity SG8.1
As part of your studies of microeconomics, it is important for you to be able to draw the
cost and revenue curves for a typical monopolist.
a. Reproduce Figure 8.11, making note of the key points (the point where the MC and
MR curves cross, the price level the monopolist chooses, and the average cost at this
quantity) and highlighting the monopolist’s profit.
b. Illustrate a rise in costs (as described in the section ‘comparative statics for a
monopolist’).
c. Illustrate an increase in demand (as described in the section ‘comparative statics for a
monopolist’).
As noted above, cutting the price increases demand but reduces the
revenue on existing units. The effect on a firm’s total revenue depends on
the price elasticity of demand, as you will remember from Blocks 3 and 5.
This is described in more detail in this section, especially the maths box.
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EC1002 Introduction to economics
The formula in equation 7 (or 8) of the maths box is very useful. Although
the derivation in the box uses calculus, the intuition can be seen by using
the delta notation as follows2 2
In fact, the expression
in the text is an
TR = P * Q approximation. The full
∴∆TR = P∆Q + Q∆P expression for ∆TR is
∆TR = P∆Q + Q∆P
Therefore we can write: + ∆P∆Q. For small
∆TR ∆P changes in P and Q
MR = =P+Q the final term can be
∆Q ∆Q
ignored, giving the
∆Q P
But PED (price elasticity of demand), ε, can be written as ε = . equation in the text.
∆P Q
( 1
( 1
MR = P 1 +
( =P 1–
(
ε |ε|
which is equivalent to equations 7 and 8 in the maths box. Here you can
see straight away that if demand is inelastic, |ε|<1, MR is negative. This
shows concisely what is explained in the text, namely that a monopolist
will never operate on the inelastic portion of the demand curve. Also,
because MR = MC for profit maximisation, some further straightforward
manipulation yields:
P – MC 1
=
P |ε|
1
|ε| , which is the proportionate mark-up of price over marginal cost, is
sometimes used as an index of monopoly power (the Lerner Index). In the
case of perfect competition this index is zero (P = MC, |ε| = ∞ ). What is
the maximum value this could take in the case of monopoly?
The equation:
∆P
MR = P + Q
∆Q
can also be used to show a useful result for MR where the demand curve is
linear. Suppose the (inverse) demand curve is given by P = a – bQ where
∆P
–b is ∆Q , then substituting into the above equation gives MR = a – 2bQ.
(Maths 8.1 shows the same result using calculus). Remember that this
is the case for linear (straight line) demand curves only. The marginal
revenue line has the same intercept on the P axis as the demand curve,
but is twice as steep. Thus, in Figure 8.10, the MR curve crosses the x-axis
at exactly half the quantity at which the demand curve crosses the x-axis
– this is due to the fact that when P = a – bQ, the DD curve crosses the
x-axis at a/b. The MR curve corresponding to this demand curve is MR =
a – 2bQ. This curve crosses the x-axis at a/2b: exactly half the quantity at
which the demand curve crosses.
The following question requires you to use the result we have just
explained about the slope of the MR curve relative to the slope of the
demand curve in order to solve for the monopoly equilibrium:
102
Block 8: Pure monopoly
Activity SG8.2
A monopolist faces an (inverse) demand curve given by P = 100 – 2Q. Marginal cost is
constant and equal to 16. Profit maximisation is achieved when price is equal to:
a. 45
b. 21
c. 58
d. 82
e. 16.
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EC1002 Introduction to economics
Solution
a. The MR curve has the same vertical intercept but twice the slope of the
demand curve. i.e.:
MR = 210 – 8Q
P, MR
210
D (AR)
Q
26.25 52.5
Figure 8.2
The monopolist maximises profit when MR = MC, 210 – 8Q = 10. So
Q = 25. Put this into the demand curve to calculate P = 110.
TR = P*Q = 2,750.
b. Following a similar procedure, when MC = 20, Q = 23.75, P = 115,
and TR = 2,731.25.
c. When the industry is perfectly competitive, the industry supply curve
is horizontal at P = MC = 10. At this price the demand curve tells us
that Q=50 and therefore TR is 500 (P*Q).
d. By the same method, when MC = 20, industry output is 47.5, P = 20
(from demand curve) and TR = 950.
e. When MC increases from 10 to 20 the monopolist’s TR falls and the
industry TR increases. Why the difference? The monopolist always
operates on the elastic portion of its demand curve, otherwise
MR would be negative and this is never optimal. So an increase
in price reduces TR – a consequence of an elastic demand curve.
At the competitive output, on the other hand, for the industry
as a whole the demand curve is inelastic (you can check this by
calculating the elasticity or by substituting the competitive output into
the MR equation and noting that MR is negative, implying inelastic
demand). Of course, with inelastic demand an increase in MC and
price will increase TR. For each firm in the competitive industry MR is
positive and equal to price.
Activity SG8.3
Consider two monopolists in two industries. One is the sole postal service operating in
a country. The other is the sole producer of a certain type of cheese (no-one else has the
technology to produce this cheese). Which of these do you think faces a more elastic
demand schedule? Draw a rough sketch of the demand, marginal revenue and cost
curves for each industry and examine the gap between the point where MC = MR and
the price chosen by each monopolist. Which firm has greater market power?
104
Block 8: Pure monopoly
D D
PM
S MC
PC PC
MR
QC Q QM QC Q
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EC1002 Introduction to economics
Price discrimination
► BVFD: read section 8.8.
Activity SG8.4
Define first-, second- and third-degree price discrimination. For first-degree price
discrimination, draw graphs illustrating producer and consumer surplus compared to a
competitive industry and to a non-discriminating monopolist.
106
Block 8: Pure monopoly
set to equal marginal cost and the fixed fee is set to equal the consumer
surplus for an individual consumer.
D
CS
P1 MC
Q
Q1
Activity SG8.5
Suppose that all consumers in the market have an inverse demand curve given by
P = 50 – 0.25Q. Suppose also the firm charges its customers £25 per unit. If it decides
to use a two-part tariff pricing strategy what is the maximum that it could charge each
customer as a fixed entry fee?
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EC1002 Introduction to economics
total cost curve of the form TC = a + bQ where a is the fixed cost and b
the constant marginal cost. Here the falling AC comes about as the fixed
cost a is spread over larger outputs. Take the case of railways where there
are large fixed costs in setting up the track network but the marginal cost
per journey mile (Q) may be quite low in comparison. In this case it would
be very inefficient to have several providers each installing their own
parallel rail networks.
► BVFD: read the summary and work through the review questions.
Overview
This block discussed the case of pure monopoly, where there is only
one firm and large barriers to entry, such that the monopolist faces no
competition from incumbent firms or even from potential entrants.
The profit-maximising output for the monopolist is discussed, with
the monopolist choosing the quantity where MC = MR. Price is higher
than MR for the monopolist. Just how much higher it is depends on the
elasticity of demand and indicates the degree of monopoly power for
that industry. Where a monopolist and a perfectly competitive market
can meaningfully be compared, a monopolist charges a higher price
and supplies a lower quantity of output. The allocative inefficiency of
monopoly is demonstrated by the loss of social surplus (called ‘deadweight
loss’) compared to the case of perfect competition.
A discriminating monopolist charges different prices to different
consumers. First-, second- and third-degree price discrimination are
explained, including the impact on output, price and profits. Monopolists
can also increase their profits by using a two-part pricing strategy. These
strategies transfer surplus from consumers to producers but reduce the
deadweight loss of the monopolist. Despite the allocative inefficiency of
monopoly, one possible advantage could be that monopoly profits provide
an incentive for firms to innovate. Furthermore, there are some industries
which work best as monopolies, these are called natural monopolies
and have a falling long-run average cost curve over the whole range of
production. These are generally industries with very large fixed costs such
as water, electricity and telecommunications, and are generally either
owned or heavily regulated by government.
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Block 8: Pure monopoly
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EC1002 Introduction to economics
Notes
110
Block 9: Market structure and imperfect competition
Introduction
Most firms in the real world do not operate within markets described
by the textbook definitions of perfect competition or pure monopoly.
This block introduces a theory of market structure and some models
of imperfect competition. These models help to explain some of the
phenomena we see in real world markets such as advertising, price
wars and product differentiation. Game theory is introduced as a useful
tool for analysing strategic interactions. The maths boxes show how to
find reaction functions of firms competing with each other in a market
structure called duopoly (where there are two firms). You will need to
practise using these to calculate price, output, profits and consumer and
producer welfare and compare these to the outcomes of other market
structures such as monopoly and perfect competition. Although these look
complicated, in fact, they are all based on the simple equations that:
Profit = Total Revenue – Total Cost and
Total Revenue = Price * Quantity.
The formulas for marginal revenue and marginal cost can be derived from
these using calculus. MR, in the case of linear demand, can also be derived
using the result from Block 7 (MR has the same intercept on the P axis and
is twice as steep as the demand schedule).
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• recognise imperfect competition, oligopoly and monopolistic
competition
• discuss how cost and demand affect market structure
• interpret an N-firm concentration ratio
• describe how globalisation changes domestic market structure
• identify equilibrium in monopolistic competition
• recognise the tension between collusion and competition in a cartel
• describe game theory and strategic behaviour
• define the concepts of commitment and credibility
• analyse reaction functions and Nash equilibrium
• describe Cournot and Bertrand competition
• describe Stackelberg leadership
• recognise why there is no market power in a contestable market
• define innocent and strategic entry barriers.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 9.
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EC1002 Introduction to economics
Further reading
Lipsey and Chrystal (L&C) international edition, Chapter 7; UK edition,
Chapter 8.
Witztum (AW), Chapter 4.
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Block 9: Market structure and imperfect competition
Activity SG9.1
1. Calculate the four-firm concentration ratio of an industry with the following
distribution of sales: 40%, 10%, 10%, 10%, 8%, 8%, 6% 4% 2% 1% 1%.
a. 100%
b. 80%
c. 70%
d. 40%.
Monopolistic competition
► BVFD: read section 9.2.
Activity SG9.2
Figure 9.2 shows the short-run and long-run equilibria for a firm in a monopolistically
competitive market. Remember that the demand curves DD and DD’ (and the associated
MR curves) refer to a single firm in the market. The market demand curve, of course,
lies further to the right. Make sure you understand this figure by reproducing it below,
highlighting:
i. the short-run monopoly profits
ii. the tangency of the DD’ curve and the AC curve in long-run equilibrium.
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EC1002 Introduction to economics
In the long run, the price charged by firms is equal to the average cost and
they are just breaking even. In industries where there are many producers
but of differentiated products, free entry will tend to eliminate profits in
the long run.
Oligopoly
► BVFD: read section 9.3.
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Block 9: Market structure and imperfect competition
Game theory
► BVFD: read section 9.4.
Activity SG9.3
The high-output/low-output game is based on a famous game called the ‘Prisoner’s
dilemma’. McGraw Hill has a nice interactive version of this which you can access at
http://highered.mheducation.com/sites/007243404x/student_view0/chapter9/interactive_
activities.html# (though the question appears to be slightly misworded). The prisoner’s
dilemma is described below. Read through the scenario and decide what you would do if
you were one of the prisoners
You and your partner were just arrested for the burglary you pulled off last
night, and are being interrogated separately in different rooms. The officer
says to you ‘Well, looks like you’ve got some decisions to make here. You can
confess to the burglary or you can continue to deny any role in it. Your problem
is that the consequence for you depends on what your partner does. If he
confesses and you don’t, we’ll throw the book at you and give him immunity.
You get 10 years in jail and he goes free. Of course, the reverse would be true
if you confess and he doesn’t. If you both confess, you’d both get a lighter
sentence, 5 years. If you both insist on denying the charges, we should have
enough evidence to get you both for 1 year for sure.’
Now answer the following questions:
a. What does the payoff matrix for this game look like? (base this on Figure 9.5) (it is
conventional to make the payoff for the player, on the left hand side of the payoff
matrix, the ‘row player’, the first entry in each cell and the payoffs for the player at
the top of the matrix, the ‘column player’ second).
b. Does either player have a dominant strategy?
c. Does this strategy result in the best joint outcome for the prisoners?
d. Does this strategy result in the best outcome for the police?
The game in Figure 9.5, and the traditional prisoner’s dilemma you have
just worked through are one-off games (sometimes called ‘one shot’
games). Many real world economic decisions, such as firms setting prices
or quantities, relate to repeated actions rather than one off moves. This
can quite dramatically change the expected outcomes. The intuition is
that repeated games provide incentives for cooperation that are absent in
one-off games; in a repeated game, honest behaviour can be rewarded and
cheating can be punished (it is necessary that the threat of punishment is
a credible threat). See the McGraw-Hill interactive version for a second
game on repeated interactions.
Models of oligopoly
► BVFD: read section 9.5, Maths 9.1 and 9.2 and concept 9.2.
Cournot model
The graphical analysis of the Cournot model is useful if you find the
mathematics in Maths box 9.1 difficult. If you don’t, the mathematical
treatment is more concise. Note that Maths box 9.1 uses calculus in
deriving the reaction functions. But in the last chapter, we showed that for
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Block 9: Market structure and imperfect competition
a linear demand curve the MR curve has the same intercept on the P axis,
but is twice as steep. Let us see how this works out in the example BVFD
use in the maths box.
We are given the market demand curve P = a – bQ, which we can write as
P = a – bQA – bQB. Now we want to write firm As MR curve as a function of
its own output, holding its rival’s output constant, so using the result from
the last chapter, MRA= a – 2bQA – bQB .
Although calculus is the most straightforward means, there is an
alternative method of finding MC. Using delta notation as before,
∆TCA = c∆QA. Therefore:
∆TC MC = c
= A
∆QA
a–C a–QB
Now setting MRA = MCA gives us A’s reaction function (QA = ) –
2b 2
and similarly for firm B. Solve the two reaction functions simultaneously
to get the Nash equilibrium in quantities. The same method can be used,
with suitable variations (for example in deriving the MR function for firm
A we first substitute B’s reaction function into the demand curve), in the
case of a Stackelberg leader to replace the calculus in Maths box 9.2.
Activity SG9.4
Consider a market for a homogeneous product with demand given by Q = 37.5 – P/4.
There are two firms, each with a constant marginal cost equal to 40.
a. Determine output and price under a Cournot equilibrium.
b. Compute the deadweight loss as a percentage of the deadweight loss under a non-
discriminating monopolist.
Activity SG9.5
Which model of strategic duopoly interaction (Cournot or Bertrand) would you think
provides a better approximation to each of the following industries, and why?
i. oil refining
ii. insurance.
Stackelberg model
Activity SG9.6
Suppose there are two firms with the same constant average and marginal cost,
AC = MC = 5, facing the market demand curve Q1 + Q2 = 53 – P. Firm 1 is a Stackelberg
leader and makes its output decision before Firm 2 (a Cournot follower).
a. Find the reaction curves that tell each firm how much to produce in terms of the
output of its competitor and use these to calculate how much each firm will produce
and the profits it will make, as well as the market price and the total market profit.
b. If each firm believes that it is the Stackelberg leader, while the other firm is the
Cournot follower, how much will each firm produce, and what will its profit be?
c. In the Stackelberg model, the firm that sets output first has an advantage. Explain
why.
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EC1002 Introduction to economics
Contestable market
► BVFD: read section 9.6.
Sequential games
► BVFD: read section 9.7.
Entrant Entrant
In In
Out Out
Incumbent Incumbent
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Block 9: Market structure and imperfect competition
one leg of the decision tree involves a decision by the incumbent (i.e.
the left leg). The incumbent can either choose between a payoff of 1 (if
it accepts the entry without fighting) or –1 (if it fights). It will choose 1.
The threat to fight entry is not a credible one in this case. Now going back
to the first step of the game, where the entrant has a decision to make.
The entrant can either choose a payoff of 1 (if it enters, since it knows the
best move for the incumbent will be to accept its entry) or 0 (if it does
not enter). It chooses 1. The outcome of the game is thus that the entrant
enters and the incumbent accepts. Both make a profit of 1. Now for the
case where the incumbent has taken steps to deter entry – the game on
the right (the second row in Figure 9.9). As described in the textbook, this
could be by investing in spare capacity which is only useful if it chooses to
fight a market entrant. Starting again with the second part of the game,
the incumbent chooses between a payoff of –2 (if it accepts) and –1 (if
it fights). It will choose –1. The entrant thus faces the following choice:
a payoff of –1 (if it enters and the incumbent fights), or a payoff of 0 (if
it doesn’t enter). It will choose 0. Thus the outcome of the game is that
the entrant does not enter and the incumbent makes a profit of 2. As
compared to the first case (no spare capacity) the incumbent’s threat to
fight is credible, it does better by fighting than by accepting. Sequential
games and backward induction are useful tools for analysing this type of
market interaction. However, certain key assumptions are required, for
example that both players have accurate knowledge of the whole decision
tree, including the payoffs of their opponent.
► BVFD: read section 9.8 and the summary, and work through the review
questions.
Overview
Market structure is partly determined by firms’ minimum efficient scale
(the lowest point at which a firm’s LAC curve stops falling) relative to
the size of the total market as shown by the demand curve. Imperfect
competition exists when firms face a downward sloping demand curve.
The most important forms of imperfect competition are monopolistic
competition, oligopoly and pure monopoly. The key characteristic of a
monopolistically competitive market is product differentiation, which gives
each firm some limited monopoly power in its special brand. There is free
entry and exit. In long-run equilibrium, the demand curve is tangent to
the firm’s LAC curve, and price is equal to average cost but is greater than
marginal cost and marginal revenue.
The key characteristic of oligopoly is strategic interaction. Oligopoly is
often portrayed using a kinked demand curve. Firms can either compete or
collude, though many forms of collusion are illegal in domestic markets.
Strategic interaction can be analysed using game theory. The outcome
will depend on whether the game is played once or repeatedly, and if it
is possible for firms to make binding commitments. A specific example of
oligopoly is duopoly, where there are only two firms. In a Cournot duopoly,
each firm treats the other firm’s output as given. In a Bertrand duopoly,
each firm treats the other firm’s price as given. If one firm moves first, that
firm is a Stackelberg leader and will gain higher payoffs than the firm which
follows.
The outcomes of these forms of interaction can be compared with the
outcomes that arise under monopoly and under perfect competition.
In some oligopolistic industries, firms manage to approach joint profit
maximisation (in this case, the outcome in terms of market price and
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EC1002 Introduction to economics
Box 1
Note: Lower left payoffs are Bus Company B
A’s. Upper right are B’s Leave Early Leave Late
Bus Company £900 £850
Leave Early
A £1,000 £950
£650 £800
Leave Late
£750 £700
2. Which market structure is characterised by a long-run equilibrium
where price is equal to average cost but is greater than marginal cost
and marginal revenue?
a. perfect competition
b. monopolistic competition
c. oligopoly
d. monopoly.
3. The demand curve faced by a monopolistically competitive firm is
a. elastic
b. unit elastic
c. inelastic
d. perfectly inelastic.
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Block 9: Market structure and imperfect competition
Potential entrant
In Out
Incumbent
Accept 15, 10 50, 0
Fight –10, –20 50, 0
2. a. Monopolistic competition:
i. What are the particular characteristics of monopolistic
competition as a market structure?
ii. Draw a short-run equilibrium for monopolistic competition
where the firms are making losses, and show how exit results
in a new, long-run equilibrium.
iii. Is this outcome efficient?
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EC1002 Introduction to economics
b. Concentration ratios:
In the USA, the four-firm concentration ratio for beer increased
from 22 to 95 between 1950 and 2000. Explain what this means
and describe possible reasons for why this occurred.
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Block 10: The labour market
Introduction
The previous blocks discussed the theory of the firm and various market
structures. Part of the theory of the firm is the way in which firms aim to
combine inputs in the most cost efficient way possible. This gave us the
first taste of the roles of capital and labour in the production process.
In addition to labour and capital, the factors of production also include
land and raw materials, as well as entrepreneurship. These factors will
be briefly explained below. This block then focuses on the labour market.
Some of what you will learn about the labour market is also relevant for
the analysis of the other factors of production; however, there are also
key differences. We will not explore these further in this block. Interested
students can read BVFD Chapter 11 – otherwise, you will most likely cover
the analysis of markets for the other factors of production in later years as
you continue your studies in economics.
The study of the labour market is important – not least from an individual
point of view, as most of us will allocate a substantial fraction of our
time to the labour market in the future (if you are not already doing
so). Furthermore, many social policy issues concern the labour market
experiences of particular groups of workers. Finally, as we have already
mentioned, labour is a key input in the production process. The overall
productivity of an economy depends to a large extent on the productivity
of its labour force. The approach to this subject matter is similar to the
analysis of markets for consumer goods, and the structure of the textbook
chapter will also be familiar to you (covering demand, supply, equilibrium,
and adjustments). However, in some ways the details are quite different.
For example, labour is human effort, thus the supply of labour depends on
individual preferences.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• describe the factors of production
• analyse a firm’s demand for inputs in the long run and short run
• recognise marginal value product, marginal revenue product and
marginal cost of a factor
• define the industry demand for labour
• analyse labour supply decisions
• define economic rent
• define labour market equilibrium and disequilibrium
• demonstrate how minimum wages affect unemployment.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 10.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapters 8 and 9; UK edition,
Chapters 9 and 10.
Witztum (AW), Chapter 5.
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EC1002 Introduction to economics
Activity SG10.1
Use budget constraints and indifference curves to demonstrate the effect on the demand
for labour of a fall in the wage rate – clearly indicate both substitution and output effects
and accompany your graphs with a written explanation.
Activity SG10.2
A fall in the wage rate will:
a. increase the demand for capital but the effect on the demand for labour is uncertain
b. increase the demand for labour but the effect on the demand for capital is uncertain
c. decrease the demand for capital but the effect on the demand for labour is uncertain
d. decrease the demand for labour but the effect on the demand for capital is uncertain.
This section (BVFD Section 10.1) goes beyond the analysis in Chapter 7
to demonstrate how the elasticity of demand impacts on the output effect
of a change in one of the factor prices. The (perfectly elastic) horizontal
demand curve DD is much more elastic than the downward sloping
demand curve D’D’. If the firm faces the less elastic curve, the output effect
of an increase in costs is smaller – as can be seen in Figure 10.1. This
shows the importance of recognising that the demand for factors is derived
demand such that the characteristics of the demand for the output have an
impact on the demand for the factors of production.
The firm can calculate the optimal amount of capital and labour to use as
inputs in the production process using marginal analysis: the extra value
gained from one more unit of the input must be equal to the unit price of
that input. The extra value gained from one more unit of the input is, in
turn, the marginal physical product of the input multiplied by how much
the firm gets, per unit, from selling that extra output. In the case of a
price taking firm, and section 10.2 only considers competitive firms, the
marginal physical product is just multiplied by the price of output, which
is of course constant for the firm. In the case of a firm facing a downward
sloping demand curve for its product, a monopolist for example, we
cannot just multiply MPL by the original product price to get the monetary
value to the firm of the extra output. Why not? Because to sell more
output the price will have to fall, not just for the marginal unit but for all
units. If you don’t remember why this is, revise the monopoly block and
chapter. When the demand curve is downward sloping the optimal rule
for hiring an input is, in the case of labour, to hire labour until the wage is 1
Some textbooks using
equal to the marginal revenue product of labour (MRPL)1, i.e. until the term marginal
revenue product for
W = MRPL = MRQ * MPL both competitive and
non-competitive firms,
where MRQ is the marginal revenue that the firm gets from selling an extra
others, such as BVFD,
unit of output. Recalling from block 7 that: reserve the term MVPL
( 1
MRQ = P 1 +
( for the competitive case
ε where MR=P.
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Block 10: The labour market
where ε is price elasticity of demand for output, the hiring rule becomes to
hire labour up to the point where
( 1
W=P 1+
(
.MPL
ε
in the case of perfect competition where ε =-∞ this just reduces to
W = P * MPL, or W = MVPL in the textbook. Note that because ε is negative,
the labour demand curve for a non-competitive firm lies below the labour
demand curve for a competitive firm with the same MPL curve and is steeper.
As in Figure 10.1, output, and hence the derived demand for labour, is less 2
This is the basis for one
responsive to wage changes the less elastic is the demand for output.2
of the Hicks-Marshall
laws of derived demand:
Activity SG10.3 other things equal the
elasticity of labour
Imagine you are the manager of a small firm which makes and sells doughnuts and you
demand with respect to
need to decide how many workers to employ. Use the information below to make your the wage is high when
decision. A doughnut sells for £1.50. All workers work an eight-hour shift and the wage the price elasticity of
rate given is the hourly rate. The market for doughnuts is perfectly competitive. Explain the demand for output is
reasoning behind your decision. high.
Labour supply
► BVFD: read section 10.4 and Maths 10.2, as well as case 10.1.
diagram which does show the separate income and substitution effects.
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EC1002 Introduction to economics
Activity SG10.4
On a blank piece of paper, draw a large diagram showing a budget constraint and
indifference curve for three different wage levels, such that it can be used to derive a
backwards-bending labour supply curve. For each of the two increases in the wage level,
clearly indicate the income and substitution effects, noting which is larger in each case
(you may need to refer back to Figure 5.14 in Chapter 5 to remember how income and
substitution effects can be distinguished graphically).
This section of the text assumes that leisure is a normal good4, more of it 4
In fact they make
will be consumed as real income increases. This is likely to be a realistic the even stronger
claim that leisure is
assumption, in practice, for most people. However, suppose that leisure is, in
probably a luxury good.
fact, an inferior good. How would this change the analysis of income versus Remind yourself of the
substitution effects? Could there be a backward bending labour supply curve distinction between a
in such circumstances? normal and a luxury
good (Block 3 – BVFD
Participation rates section 4.6).
One important concept from this section is the reservation wage – the
lowest wage a worker is willing to accept to work in a given occupation.
For this section, pay attention to the way that the four main factors which
increase participation are represented graphically, as per Figure 10.5.
Activity SG10.5
Match the factor which increases participation to the description of the graphical
representation of this factor in Figure 10.5.
Labour mobility
The extent of labour mobility into and out of an industry affects the slope of
the industry’s labour supply curve and the extent to which this curve shifts
when there is a change in wages in other industries. When there is a high
degree of labour mobility, wage increases in one industry easily flow over
into other industries. Labour mobility is a crucially important determinant
of a country’s economic efficiency, both in static terms, ensuring labour is
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Block 10: The labour market
Wage
Domestic supply
W1
Total supply
W2
Demand
N3 N1 N2 Employment
Figure 10.1: International migration and labour supply.
If only domestic builders supply the market, N1 will be employed and
the wage will be W1. Suppose now that there is immigration of builders
shifting the total supply outwards (and possibly, as in the diagram, making
it more elastic). Employment increases to N2 and the wage falls to W2.
We see that immigrant builders do not displace domestic builders on a
1 for 1 basis (as some crude views of immigrant labour would have us
believe). N2–N1 immigrant builders are employed, while the employment
of domestic builders falls by the smaller amount N1–N3. It is equally wrong
of course to say that building wouldn’t get done at all without immigrant
builders. Without the immigrant builders, the higher wages of builders
leads to a fall in the amount of building that gets done, but there is, again,
equilibrium in the market for building and builders.
Monopsony
A single purchaser in any market is called a monopsonist. When an
employer is a monopsonist, workers must either accept the wage offered,
or move to a different market. The analysis of monopsony in the labour
market is, in effect, the mirror image of the monopoly analysis of a firm
in the product market. The labour supply curve is upward sloping, since
more workers will be willing to work when the wage is higher. The
upward sloping labour supply curve represents the average cost curve
of labour for the monopsonist. The marginal cost of labour lies above
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EC1002 Introduction to economics
Many of the concepts in this chapter are analogous to concepts from the
general demand and supply analysis of Chapter 3. For example, economic
rent – payment to a worker in excess of their reservation wage – is
analogous to producer surplus, and is represented graphically by the
area above the labour supply curve and below the equilibrium wage. The
diagram (Figure 10.8) presented in the section refers to the market but,
of course, some individuals with reservation wages well below the market
wage of W0 can earn very substantial economic rents.
This section introduces five reasons why labour markets may not clear –
minimum wage laws, trade unions, scale economies, the insider–outsider
dichotomy, and efficiency wages. If wages are fully flexible, they will be
able to rise and fall to the equilibrium level where demand and supply
are equated and the labour market clears. These five factors provide an
explanation why wage levels may stay above the equilibrium rate, leading
to some of the labour force being unemployed. There is something of a
semantic issue involved in the use of the market clearing concept here.
What is really meant by a non-clearing market in this section is that the
equilibrium wage is above the competitive wage. Nevertheless, it could be
argued that in each of these cases the market does in fact clear, subject to
the institutions in place at the time. Take the case of the minimum wage
in Figure 10.9. The minimum wage essentially rules out that part of the
labour supply curve below W2. Although some workers would be prepared
to work at W < W2, the law of the land does not permit firms to employ
them at these wages, so the supply curve is essentially horizontal at W2
until it hits the supply curve at L = L2. Firms wanting to hire labour in
excess of L2 will have to pay above the minimum wage. So one could say
that the market clears where this modified supply curve intersects the
demand curve (at L = L1). In concept 10.2 this is the argument used in the
sentence just below the diagram.
The case of efficiency wages is another example where it is not really clear
that this is a disequilibrium situation. Firms pay above a market clearing
wage but get higher productivity as a result. Workers may collectively
accept a slightly lower probability of employment as a price worth paying
for the higher wages under such arrangements.
Incidentally, one of the most famous historical cases of efficiency wages
is the case of the Ford Motor Company just over 100 years ago. In 1913
the daily wage at the company was $2.50. Turnover and absenteeism
were high but there was a plentiful supply of workers willing to work at
that wage. Then, at the beginning of 1914 Henry Ford doubled the daily
rate to $5 (for workers who had been with the company for at least six
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Block 10: The labour market
► BVFD: read the summary and work through the review questions.
Overview
The three main factors of production are labour, capital and land. Labour
includes all forms of effort supplied by people to those who employ them
for monetary remuneration. Physical capital is the stock of produced
goods that are used in the production of other goods and services. Land
comprises all free gifts of nature such as land, forests, minerals etc.
Firms choose a production technique to minimise the cost of producing
a particular output level. By considering each level of output, they can
construct a total cost curve. Factor demand curves are derived demands.
A shift in the output demand curve for the industry will shift the derived
factor demand curve in the same direction. A firm will hire a variable
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EC1002 Introduction to economics
factor until its marginal cost equals its marginal value product (or
marginal revenue product in the case of a firm which is not a price taker).
A rise in the price of a factor reduces the quantity demanded of that factor
due to both substitution and output effects. A rise in the price of another
factor leads to an increase in demand due to the substitution effect and a
decrease in demand for that factor due to the output effect. It is unclear
which of these effects will dominate.
The supply of labour depends in part on the decisions of individuals to
participate in the labour force and also on the number of hours they
choose to supply. Four things raise the participation rate in the labour
force: higher real wage rates, lower fixed costs of working, lower non-
labour income and changes in tastes in favour of working. Higher wages
impact on the hours of work decision through both a substitution effect,
tending to increase the supply of hours worked, and an income effect,
which at high wage levels tends to reduce the supply of hours worked.
This leads to the labour-supply curve being backward bending. The
industry supply curve of labour depends on the wage paid relative to
wages in other industries using similar skills. Workers in unpleasant jobs
are often paid compensating wage differentials. Workers earning above
their reservation wage are said to be earning economic rent.
The wage is the rental price of labour but certain factors may lead to
wage levels being above the equilibrium level, leading to unemployment
in the labour market. These factors include minimum wage agreements,
trade unions, scale economies, insider–outsider distinctions and efficiency
wages. Discrimination may lead to workers from different groups being
paid different wages.
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EC1002 Introduction to economics
Notes
134
Block 11: Welfare economics
Introduction
This is a good time to think back to the questions from Chapter 1 of
BVFD which asked: what, how and for whom to produce. We have seen
how this question is answered by free markets, concentrating mostly on
markets for a single product or factor. Many economists would agree
that the free market can do quite a good job in allocating resources. But
how can we define what it means to do ‘a good job’? Welfare economics
uses the concepts of efficiency and equity to make normative judgements
about the workings of the market. There are reasons why markets fail in
certain circumstances and this can provide a justification for government
intervention in the economy. This block defines and discusses the concept
of externalities, where there is a clear role for government intervention
in the market. The following block will discuss the tools governments
use including taxation, redistributive spending and regulation. This block
on welfare economics is our first step towards looking at the economy
as a whole system. In contrast to the second part of the course on
macroeconomics, this block still uses microeconomic techniques; however,
it examines welfare at the economy-wide level rather than focusing on a
particular market. As such, the concept of general equilibrium is also an
important part of this block.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• define welfare economics
• describe horizontal and vertical equity
• discuss the concept of Pareto efficiency
• recognise how the ‘invisible hand’ may achieve efficiency
• define the concept of market failure
• recognise why partial removal of distortions may be harmful
• identify the problem of externalities and possible solutions
• discuss how monopoly power causes market failure
• analyse distortions from pollution and congestion
• discuss why missing markets create distortions
• analyse the economics of climate change.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 13.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapter 11; UK edition,
Chapter 13.
Witztum (AW), Chapters 6 and 7.
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Block 11: Welfare economics
Output of
good A
B F
C
D
A
E
Output of good B
137
EC1002 Introduction to economics
ƽC
ƽB
P David’s
Utility
BVFD and the utility possibility curve Figure 11.2 above have goods/utility
for Susie and David on the horizontal and vertical axes – thus they both
focus explicitly on allocation. These curves are constructed in such a way
that all points on the curve are Paretoefficient (implying productive and
allocative efficiency) and the optimal choice requires judgements about
equity, as indicated by the social welfare function.
General equilibrium
► BVFD: read concept 13.1 – general equilibrium.
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EC1002 Introduction to economics
Activity SG11.1
Coffee and tea are substitutes. The demand for each depends on its own price as well as
the price of its substitute. Supply and demand curves are given as follows:
Coffee demand: Q DC = 60 – 6PC + 4PT
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Block 11: Welfare economics
Activity SG11.2
Household A and B of an exchange economy with two goods x and y have the utility
functions UA(xA, yA) = (xA)(yA), and UB(xB, yB) = (xB)(yB). Household A has the initial
endowment (xA0, yA0) = (10,16) and Household B has (xB0, yB0) = (25,12).
a. Illustrate the initial endowment in an Edgeworth box
b. Assuming that this point is not on the contract curve, draw possible indifference
curves for the two households and indicate the area where trade could result in an
improvement for both households (you can draw standard indifference curves without
reference to the utility functions given above).
y
c. Given the utility functions above, the MRS of Household A is MRSA = xAA and the
y
MRS of household B is MRSB = xBB . Use this information to find the Pareto optimal
point when the price of x is £0.80 and the price of y is £1.00 (i.e. the relative price
is £0.80). Clearly state which household sells which quantity of which good and the
final Pareto-optimal allocation.
d. Calculate the utility of the two households at the initial endowment and at the new
optimal point.
e. Draw your solution onto your graph along with the budget constraint and the new
utility curves at this point. Also draw the contract curve on your diagram.
This section reviews the effect of a specific tax on a good and emphasises
that, at least in the absence of other distortions, this will lead to a
distortion in the market for the taxed good – the marginal benefit to
consumers is no longer equal to the marginal cost to producers. The fact
that taxes are often distortionary is not an argument against all taxation,
but highlights one important aspect of taxation that must be considered
in designing a tax system. ‘Second best’ has to do with introducing new
distortions to offset existing distortions and improve efficiency. Taxation is
one specific distortion, and the concept of second-best implies widespread
taxation may be more efficient than taxes in a single market, because
this helps to keeps relative prices intact. Chapter 14 (covered in the next
block) goes into more detail on taxation. Another way of stating the theory
of second best is that when there are several distortions in place (taxes
and subsidies on various goods for example) it is not always desirable to
eliminate some of these distortions; if markets were otherwise competitive,
eliminating all distortions would be efficient, but eliminating some but not
others could actually make the situation worse (increase inefficiency). The
intuition is that some of the distortions may have been offsetting others
and piecemeal removal of distortions may destroy this balance.
This section introduces the potential sources of market failure that can
prevent a free market allocation of resources from being efficient, but
doesn’t analyse them in depth; subsequent sections do that. The following
is a list of sources of distortions that lead to market failure. Read through
and make sure you understand what each of these means:
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EC1002 Introduction to economics
Common property
All of these are described in BVFD except common property, which refers
to a resource such as fishing grounds or common grazing land, which is
open to everyone, but where one person’s activities detract from the total
available to everyone (in this sense common property can be thought of
as a kind of externality). For example, fish in the ocean can be caught
by anyone, but once one is caught, no-one else can catch it. Common
property tends to be over used, leading to a degradation or depletion
of the resource. This is because individuals only take into account their
private costs and benefits and neglect the social cost of their actions.
For this reason, various kinds of sea life are nearing extinction due to
overfishing. This problem applies to any common resource which is
unregulated.
Activity SG11.3
Here is a game-theoretic treatment of the common property problem. Suppose both
England and Norway fish in the North Sea. Both countries know that their fish supplies
are being depleted and that this depletion could be slowed down if they both cut their
fishing fleets in half. The matrix below shows the payoff for both countries (England’s
payoff is first entry in each cell) with unchanged and halved fleets. Will they agree
between them to reduce their fleets? (Hint: what is the Nash equilibrium?). Should they?
Norway
10 boats 5 boats
10 boats 300, 300 550, 250
England
5 boats 250, 550 500, 500
Externalities
► BVFD: read section 13.5 and case 13.1.
Activity SG11.4
Using the equations below, find the level of production which will occur without
regulation and the socially optimal level of production, and calculate the social cost of
the externality. Graph your answers and shade in the area representing the social loss of
inefficient production.
Example 1: Grating, unpleasant music
Demand: DD = £40 – 0.3*Q
Marginal private cost: MPC = £10
Marginal social cost: MSC = £10 + 0.1*Q.
Example 2: Beautiful, pleasant music
Marginal private benefit: MPB = £20 – 0.2*Q
Marginal social benefit: MSB = £24 – 0.2*Q
Marginal cost: MPC = MSC = £4 + 0.2*Q.
As the next section BVFD Chapter 13 will discuss, we live in an age where
the theory of externalities is ever more important; climate change, the
effects of pollution on human health and biological diversity, and many
other examples are increasingly at the centre of policy debates. This
section of BVFD covers the assignment of property rights as a method of
dealing with externalities, postponing the use of taxes and subsidies to
achieve similar ends until the next chapter, although if you want to look at
Figure 14.7 and the accompanying text that would fit in with the current
analysis. It is important to realise that, just as the optimal size of the
neighbour’s tree is not zero in the example illustrated in Figure 13.7, the
fact that industrial production generates pollution as a side effect does not
mean that the socially optimal level of pollution is zero; what is required
is that the marginal cost of pollution is equal to the marginal benefit (if it
seems strange to you that pollution can have benefits, consider the effect
on the costs of production of requiring firms to reduce pollution levels).
These two sections again introduce issues that are rigorously analysed in
more advanced courses (risk, uncertainty, missing markets and asymmetric
information tend to be topics dealt with in intermediate microeconomic
courses). However, you should follow the general principles outlined
here. Missing markets are a further reason for market failure. Externalities
occur in cases where there are missing markets, for example for noise or
pollution. Section 13.7 discusses other missing markets, namely time and
risk. That is not to say there are no markets at all which relate to time or
risk, but rather there are many aspects of time and risk that cannot be
traded in markets. The scope of futures contracts is very limited. Also,
although there are many things people can buy insurance for, there are
also many things which cannot be insured against. This is partly due to
moral hazard – for example, you cannot insure your house against poor
maintenance or general wear and tear, as insurance companies would not
be able to monitor which parties are taking a reasonable amount of care of
their homes and for this reason, once insurance is taken out, the incentive
to care for the home is reduced.
Section 13.8 discusses other aspects of market failure in relation to
information. Gathering information is costly and incomplete information
may lead to inefficient private choices. Certification provides information
more efficiently, as the benefit is reaped by the whole society but the cost
is borne by a single agency. Certification is generally provided by public or
non-profit organisations rather than businesses because the profit motive
may distort incentives to reveal the truth. This was one of the key causes
behind the recent global financial crisis, when ratings agencies, being paid
by banks and financial institutions, rated ‘junk’ products as if they were
extremely sound and reliable financial instruments.
The imposition of standards requires value judgements. Costs and benefits
must be calculated and weighed up against each other, but there is often
a subjective element to these calculations (e.g. the value of human life, or
the optimal level of risk-aversion). An economic approach is useful in this
case since it helps make decisions about subjective factors transparent and
as such, can make the calculations as objective as possible.
► BVFD: read the summary and work through the review questions.
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Block 11: Welfare economics
Overview
This block provides an introduction to welfare economics, which involves
normative judgements as to how well the economy is working. Two
key concepts are equity (horizontal and vertical equity) and efficiency
(productive and allocative efficiency, as well as Pareto efficiency). The
textbook shows that perfect competition, under strict assumptions, is
Pareto efficient, since under perfect competition MC = MB = P. Much of
economic policy making concerns a conflict between equity and efficiency.
For example, redistributive taxes improve vertical equity but are not
allocative efficient. Perfectly competitive markets are rare in practice
and, in reality, there are many distortions which lead to market failure.
Distortions occur whenever free market equilibrium does not equate
marginal social cost and marginal social benefit. Key sources of distortions
are taxes, imperfect competition, externalities, and missing markets. The
first best solution to a distortion is to remove it and restore efficiency,
however, if distortions cannot be removed or if policy makers would rather
leave them in place than lose the benefits to equity that arise through these
distortions, the second-best solution is to spread distortions widely over
many markets rather than concentrating the distortion in a single market,
looking for ways in which distortions can be offsetting rather reinforcing.
A major cause of market failure is externalities – there are both production
or consumption externalities and these can be either positive or negative.
An externality occurs when there is a divergence of private and social
costs and benefits due to the absence of a market for the externality itself.
Inefficiencies can also occur due to information problems, such as moral
hazard, adverse selection and incomplete information. Regulations provide
information and express society’s value judgements about intangibles.
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146
Block 12: The role of government
Introduction
As we saw in the previous block, there are reasons why markets fail in
certain circumstances and this can provide a justification for government
intervention in the economy. This block provides a more concrete
examination of the workings of government from an economic perspective.
Government has an important role to play, for example in maintaining
important institutions such as private property rights, providing public
and merit goods, redistributing income to promote greater equality and
regulating the behaviour of individuals and firms. The main tools the
government uses are taxation, regulation and government spending (on
purchases and transfer payments). The size of government is expressed by
the amount it spends, relative to GDP, and the optimal size is a question
of considerable debate. Key points relating to local government, national
economic sovereignty, and political economy are also briefly introduced
in this block. This block focuses on Chapter 14 of BVFD; however, since
one important function of the government is to redistribute incomes, the
block also provides a short section on the income distribution, drawing on
material from Chapter 11.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• define different kinds of government spending
• discuss why public goods cannot be provided by a market
• identify average and marginal tax rates
• discuss how taxes can compensate for externalities
• describe functional and personal distributions of income
• explain what a Gini coefficient measures and compare Ginis across
different countries or time periods
• define supply-side economics
• describe why tax revenue cannot be raised without limit
• recognise how cross-border flows limit national economic sovereignty
• describe the political economy within which governments set policy.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 14 and Chapter 11
section 11.9 and concept 11.2.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapter 12; UK edition,
Chapter 14.
Witztum (AW), Chapters 6 and 7.
will fail to provide the optimal quantities of pubic goods and merit and
demerit goods. Public goods are goods which are non-rival and non-
excludable. As such, the free-rider problem and transaction costs will
mean they are under-provided by free markets. The government also plays
an important role in redistributing incomes to promote greater equality.
This block provides an introduction to taxation, including types of taxes,
their deadweight burden, tax incidence, and the relationship between
tax rates and revenues (as demonstrated by the Laffer curve). Finally,
the block explores further topics related to government including local
government, national economic sovereignty in the face of increasing global
interdependence, and political economy including political equilibrium,
incentives to adopt particular policies and the importance of the median
voter.
Government functions
► BVFD: read the introduction to Chapter 14 and section 14.1.
There are certain basic functions which governments have carried out
throughout history (albeit more or less effectively); these include defence
against invasions from other nations, the protection of private property,
and the enforcement of law and order. As L&C (UK edition p,301;
international edition p.226) summarise: ‘within a secure framework of
law and order, and well-defined and enforced property rights and other
essential institutions, a modern economy can function at least moderately
well without further government assistance’. The previous chapter
discussed how in perfectly competitive markets, the price mechanism
and the ‘invisible hand’ lead to an efficient allocation of resources. It
also discussed reasons why markets fail and the role of government in
improving outcomes in these cases. Another key role of government is to
influence the distribution of incomes within a society so as to promote
greater equality. This is often achieved through transfer spending
providing benefit payments that are funded through taxation. Government
frequently also sponsors education and healthcare, for example with the
aim that at least a basic level is available to all citizens. Social protection,
health and education are the three largest segments of the government
spending pie chart in Figure 14.2.
The size of government is expressed by the amount it spends, relative to
GDP, and the optimal size is a matter of debate. The introduction to this
chapter provides a historical perspective on how the size of government
has changed in recent times.
Taxation
The key source of government revenue is taxation. The introduction
provides definitions of marginal and average tax rates as well as
progressive and regressive taxes. The marginal rate does not apply to the
whole amount of income, but is rather the tax paid on the last pound of
income. The average tax rate, on the other hand, is calculated by dividing
the total tax paid by the total income. The graphs below are based on
Table 14.3 from BVFD and depict marginal and average tax rates for
the two periods in the table. When the marginal tax rate lies above the
average tax rate, the average rate will always be rising.
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Block 12: The role of government
1978/79
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
£5,500 £7,520 £10,500 £15,500 £25,500 £36,900 £45,500 £75,500
2008/09
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
£5,500 £7,520 £10,500 £15,500 £25,500 £36,900 £45,500 £75,500
Figure 12.1: UK marginal and average tax rates’ based on Table 14.3 of BVFD.
A progressive tax takes a larger percentage of people’s income the larger
their incomes, while a regressive tax is the opposite – taking a smaller
percentage of people’s income the larger their incomes. In the UK, income
taxes are progressive, with the marginal rate rising with income. The tax
system as a whole is also progressive, but not to the same extent as the
income tax component, because a substantial amount of tax is collected
via VAT (the sales tax) which is regressive, since poor people tend to
consume a higher proportion of their incomes. Progressive, proportional
and regressive taxes are depicted below – how progressive a tax is depends
on the relationship between income and average tax rates.
Progressive
Average Tax Rates
Proportional
Regressive
Personal Income
Figure 12.2: Progressive, proportional and regressive taxes.
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EC1002 Introduction to economics
Public goods
Markets tend to deal best with private goods, but there are several other
types of goods which exist. These categories depend on the combinations
of two distinct characteristics: rivalry and excludability, as defined in
BVFD. The table below clarifies all four theoretical types of goods with
examples.
Excludable Non-excludable
Private goods Common property
Rival Examples: ice cream, mobile Examples: fisheries, common
phones grazing land
Non-rival Club goods Public goods
(up to capacity) Examples: cinemas, toll roads Examples: defence, police force
Activity SG12.1
Complete the following table:
between private and public good equilibria can be characterised, for the
case of N consumers, as follows:
Private good (perfect competition):
q1 + q2 + ... + qN = Q
MB1 = MB2 = ... = MBN = P =MC
Public good:
q1 = q2 = ... = qN = Q
MB1 + MB2 + ... + MBN = MSB =MC
where qi are individual quantities and Q is total quantity. The MBs are
private marginal benefits, MSB is social marginal benefit and MC is
marginal cost.
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Block 12: The role of government
45
40
35
30
25
20
15
10
5
0
Cuba India Hungary Sweden UK USA
Principles of taxation
► BVFD: read section 14.3 and case 14.2.
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EC1002 Introduction to economics
This maths box shows how a Pigouvian tax can be used so that a firm
with a negative production externality will take this into account when
determining their efficient level of production, such that their quantity of
production will be the socially optimal quantity.
It is also possible to introduce Pigouvian subsidies to increase activities
with positive externalities.
While this maths box uses calculus, the basic analysis is the same as that
illustrated in Figure 14.7. The tax has to be set at a level equal to the
marginal damage caused by the externality at the socially optimal level
of output – it has to raise private costs so that private decision making
generates the socially optimal quantity.
Activity SG12.2
Planting a tree improves the environment: trees improve soil quality and water retention
in the soil, and transform greenhouse gases into oxygen. Assume that the value of this
environmental improvement to society is £10 per tree for the expected lifetime of the
tree. The following equation provides a hypothetical private (excluding the value of the
externality) demand schedule for trees to be planted:
Q = 32 – 0.8*P where Q refers to the quantity of trees demanded in thousands.
a. Assume that the marginal cost of producing a tree for planting is constant at £20.
Draw a diagram that shows the market equilibrium quantity and price for trees to be
planted.
b. What type of externality is generated by planting a tree? On your diagram, indicate
the optimal number of trees planted. How does this differ from the market outcome?
c. On your diagram, indicate the optimal Pigouvian tax/subsidy (as the case may be).
Explain how this moves the market to the optimal outcome.
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Block 12: The role of government
Local government
► BVFD: read section 14.5.
Impact of globalisation
► BVFD: read section 14.6.
Political economy
► BVFD: read section 14.7 and complete activity 14.1.
► BVFD: read the summary and work through the review questions.
Overview
The government plays an important role in basically all economies.
Government revenues mainly come from direct and indirect taxes,
and government spending comprises government purchases of goods
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EC1002 Introduction to economics
and services and transfer payments. The government can also play an
important role in redistributing incomes, especially by using a progressive
tax system. Externalities provide a further justification for government
intervention. These can be dealt with through the allocation of property
rights, the levying of taxes and/or subsidies which cause the private sector
to internalise the externality, or the imposition of standards/regulation.
Public goods are non-rival and non-excludable, and as such will tend
to be underprovided in private markets due to the free-rider problem.
Governments can provide public goods though the socially optimal
level can be difficult to determine in practice. Except for taxes to offset
externalities, taxes are distortionary because they make the sale price
differ from the purchase price, preventing the price system from equating
marginal costs and marginal benefits. Rising taxes initially increase tax
revenues, but at very high tax rates, they eventually lead to such large
falls in the equilibrium quantity of the taxed commodity or activity that
revenue falls. The economic sovereignty of nation states is reduced by
cross-border mobility of goods, capital, workers and consumers. Political
economy examines political equilibrium and incentives to adopt particular
policies. When all those voting have single peaked preferences, majority
voting achieves what the median voter wants.
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EC1002 Introduction to economics
Notes
158
Block 13: Introduction to macroeconomics
Introduction
Macroeconomics is the study of the economy as a system. While
microeconomics is focused on the choices of an individual household or
firm and interactions in a particular market, macroeconomics examines
the whole economy and is therefore concerned with aggregates. The
demands of all the individual consumers and the supply provided by all
individual firms are aggregated together into a whole. The role of the
government and the financial markets in the economy also become much
clearer, as do the effects of international trade and financial transactions.
Macroeconomics makes it possible to examine certain questions which
relate to the whole economy, and which are difficult to answer if we just
focus on any individual market. Issues such as unemployment, inflation
and the business cycle can be studied much more effectively using the
tools of macroeconomic analysis and these and other issues will be covered
in the second part of the guide. This block provides an introduction to
macroeconomics.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• describe the nature of macroeconomics as the study of the whole
economy
• discuss internally consistent national accounts; why measuring GDP by
income, by expenditure or by output produces the same result
• explain the circular flow between households and firms
• recognise and understand the identity Y ≡ C + I + G + NX
• explain why leakages always equal injections
• identify nominal versus real measures of national income and output
• describe the shortcomings of GDP as a measure of economic activity
and wellbeing
• analyse more comprehensive measures of national income and output.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 15.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapter 13; UK edition,
Chapter 15.
Witztum (AV), Chapter 8.
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EC1002 Introduction to economics
of the system. These will be introduced in the textbook chapter and the
exercises and revision questions in this block are designed to help you work
through the key points and gain a better understanding. This will provide a
foundation for more in-depth analysis in the following blocks.
Macroeconomic analysis
► BVFD: read the introduction to Chapter 15 and sections 15.1.
Activity SG13.1
Do you know the long-term trend of growth, unemployment and inflation for your
own country? If you live outside the UK/USA/EU/China it would be useful to attempt
to replicate Table 15.1 for your own country. This will help to provide you with some
empirical context for your study of macroeconomics and also show you how your own
country relates to the places that the textbook has selected. You can use the following
websites to do some research:
•• stats.oecd.org
•• data.worldbank.org
•• www.imf.org/external/datamapper
•• www.worldeconomics.com
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Block 13: Introduction to macroeconomics
Measuring GDP
This section also describes the three equivalent ways of measuring the
total economic activity in the economy, namely the:
• value of all goods and services produced
• total value of earnings arising from the factor services supplied
• total value of spending on final goods and services.
Activity SG13.2
Which of these three do you think is easiest to measure? What kind of data would you
use if you were to try to measure economic activity in these three ways?
► BVFD: read section 15.4 and case 15.1 and complete the following
revision questions.
Activity SG13.3
Fill in the blanks in the table below (based on Table 15.4)
(1) Good (2) Seller (3) Buyer (4) Transaction (5) Value (6) Spending (7) Household
Value Added on Final Goods Earnings
Wood Timber Stamp £100
producer manufacturer
Wood Timber Paper £800
producer Manufacturer
Stamps Stamp Paper £300
manufacturer manufacturer
Special paper Paper Households £1,200
with stamped manufacturer
design
Total
Transactions
GDP
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EC1002 Introduction to economics
Activity SG13.4
Short answer questions
1. Which components of GDP would each of the following transactions affect:
a. Your family buys a new TV.
b. All motorways are repaved.
c. You buy a bottle of Italian wine.
d. Porsche opens a new factory in England.
2. Why, in the absence of government and foreign sectors, are saving and investment
always equal? How does this change when the government and foreign sectors are
introduced?
3. The level of wealth can be measured by looking either at the gross national product
or at the GDP. Suppose that the government wants to maximise total income of
British citizens: which of the two concepts should it look at? Would you change
your answer if the aim is that of maximising the total amount of economic activity
occurring in the UK?
4. Leakages and injections – complete the following table.
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Block 13: Introduction to macroeconomics
spending exceeds receipts there must be borrowing to pay for the excess
spending. Suppose S = I in the private sector then, if the government is
running a deficit (G > T), the government is borrowing from abroad and
there is a deficit with the rest of the world (imports greater than exports).
On the other hand if the government account is in balance (spending =
tax receipts) then a trade deficit (exports insufficient to pay for imports)
requires borrowing in the private sector (I > S).
Y ≡ C + I + G + NX represents GDP at market prices, which equals
consumption plus investment plus government spending plus net exports.
We can extend the formula so it represents GDP at basic prices by
subtracting indirect taxes. It would then be: Y ≡ C + I + G + NX – Te
Maths box 15.1 depicts an extended representation of the circular flow,
including the government sector as well as households and firms. The
overseas sector is implied by arrows pointing outwards for imports and
inwards for exports. Similarly, the banking sector is implied with arrows
pointing outwards for savings and inwards for investment. An alternative
representation that includes all five sectors explicitly is provided below. The
‘five-sector model’ is the most complete version of the circular flow of income
model and, as such, you should be familiar with it. It will also help you in
fitting together the material in the remaining macroeconomics blocks.
Activity SG13.5
Access the following website: www.dineshbakshi.com/ap-economics/ap-
macroeconomics/175-revision-notes/1965-circular-flow-of-income. Re-draw the five
sector model (the second image on the web page) yourself in the box provided, making
sure you understand the meaning behind each of the flows.
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EC1002 Introduction to economics
This section deals with real versus nominal GDP, the GDP deflator, per
capital GDP and the scope of GDP.
Activity SG13.6
Complete the exercises below to check your understanding.
1. Say the price level rises 10% from an index of 1 to an index of 1.1 and nominal GDP
rises from £4 trillion to £4.6 trillion. What is nominal GDP in the second period? What
is real GDP in the second period?
2. The table below shows nominal GDP for two countries A and B. Which economy
experienced higher growth in real GDP per capita between 1960 and 2010?
1960 2010
Country A Nominal GDP (current £bn) 20 2000
GDP deflator (2010=100) 8 100
Population (bn) 1 5
Country B Nominal GDP (current £bn) 60 5000
GDP deflator (2010=100) 1 100
Population (bn) 3 5
Activity SG13.7
From the chapter as a whole, what are the advantages and limitations of GDP as a
measure of wellbeing in an economy?
► BVFD: read the summary and work through the review questions.
Overview
This block started by describing the scope of macroeconomics and
macroeconomics as a study of the economy as a whole. The circular
flow was also introduced, and the block extended the discussion in the
textbook to introduce the five sector model, including households, firms,
the government, the financial sector and the overseas sector. Leakages
from the circular flow are always equal to injections, by definition. The
net output of all factors of production is called GDP and this can be
measured in three different but equivalent ways: income, production and
expenditure. For the production method, including only the value added
at each stage is important to avoid double counting. GDP can be measured
at market prices or at basic prices (exclusive of indirect taxation).
Furthermore, there is an important distinction between nominal GDP
(measured at current prices) and real GDP (measured at constant prices).
GDP, and in particular per capita GDP, is a useful indicator of a country’s
economic situation, however, it does have limitations in terms of accuracy
and comprehensiveness.
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EC1002 Introduction to economics
6%
4% Pakistan
2%
USA
0%
–2%
–4%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
a. What are the key features of the trend path for each country?
b. Why is it important to compare per capita growth rates when
countries have different rates of population growth? How might
this apply to the case of Pakistan and the USA?
c. Although Pakistan shows a faster growth rate for many of the
years in the graph above, the level of per capita GDP is much
lower, as can be seen below. Briefly discuss how the magnitude of
each component of GDP is likely to differ for countries at different
stages of development.
2. This graph shows per capital GDP in constant 2005 international $.
USA
50,000
40,000
30,000
20,000
10,000
Pakistan
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
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EC1002 Introduction to economics
Notes
168
Block 14: Output and aggregate demand
Introduction
The chapter starts by introducing the difference between actual output and
potential output. While potential output tends to increase steadily over
time, actual output tends to fluctuate strongly, sometimes growing faster
than potential output and sometimes growing slower or even decreasing.
Much of macroeconomics is concerned with modelling the gap between
actual and potential output. In Chapter 16, we start to develop a model of
the determination of output, which will be developed further until Chapter
28. Chapters 16 to 20 operate under a basic assumption that the price
level is constant (i.e. there is no inflation). This assumption will be lifted
in Chapter 21 when the supply side is introduced. To start with, the focus
is on demand and actual output is assumed to be demand-determined.
Aggregate demand is defined initially as planned or desired spending and
short-run equilibrium is defined as the point where aggregate demand is
equal to actual output. In the last block we saw that income and output
can be defined as Y = C + I + G + NX. In equilibrium, output and
aggregate demand are equal, hence Y = AD = C + I + G + NX. Chapter
16 goes into more detail on consumption (C) and investment (I), while
Chapter 17 looks at government spending (G) and net exports (NX).
One very important concept in this block is the multiplier, which shows how
much equilibrium output changes due to a change in aggregate demand.
You will need to understand this, be able to calculate it and show how it is
affected by changes in consumption behaviour, taxation and imports.
In macroeconomics, there are two major policy instruments available to
the government: fiscal policy and monetary policy. Fiscal policy has to do
with government spending, taxation and the budget. By the end of this
block, you should have a good understanding of fiscal policy, including its
limitations.
The analysis in these two chapters is best understood by use of graphs, in
particular, the consumption function, the aggregate demand schedule, and
graphs of leakages against injections. You will also need to understand
the meaning of the 45 degree line (along which the values on the x-axis
are equal to the values on the y-axis) and how this can be used to indicate
equilibrium, as well as inflationary and deflationary gaps. You will need
to learn these graphs and practise drawing them. They are the building
blocks you will need in later analysis.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• contrast actual output and potential output
• show how aggregate demand determines short-run equilibrium output
• explain inflationary and deflationary gaps
• define the marginal propensity to consume c and the marginal
propensity to import z
• analyse consumption demand, investment demand, foreign trade and
equilibrium output
• calculate the multiplier and the balanced budget multiplier
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EC1002 Introduction to economics
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapters 16 and 17.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapters 14 and 15;
UK edition, Chapters 16 and 17.
Witztum (AW), Chapter 10.
► BVFD: read the introduction to Chapter 16, case 16.1, sections 16.1 and
16.2 and concept 16.1.
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Block 14: Output and aggregate demand
Activity SG14.1
Draw the consumption function in the box below. What does the intercept mean? What
does the slope indicate?
Consumption function
Equilibrium output
► BVFD: read section 16.3 and complete activity 16.1.
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EC1002 Introduction to economics
GDP and bath water: an analogy (based on L&C UK edition, Box 16.3,
p.407) – A country’s GDP can be thought of as the amount of water in a bath
when the tap is on and the plughole is unblocked. There are flows into and
out of the bathtub. Whether the level of water is rising or falling depends
on which flow (either in or out) is greater. If both are the same, the level of
water will be constant – GDP is in equilibrium. If the bathtub fills up until it
starts to overflow, it is clear that is has reached its capacity (let’s call this full
employment equilibrium). Macroeconomics was originally invented to deal
with the problem of the water getting too low, and to find solutions to this
problem.
► BVFD: read case 16.2 and case 16.3 – how did the financial crash affect
the economy in the country where you live? Also read section 16.4.
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Block 14: Output and aggregate demand
Activity SG14.2
Using the following savings and investment functions, calculate the equilibrium level of
output Y and the level of planned saving and planned investment. Graph these in the
second box below.
S = –5 + 0.3Y
I = 55
This maths box shows why planned investment equals planned savings.
Read it through and then, without looking at the textbook, use the
following equations to show that planned investment equals planned
savings:
Y = AD = C + I (in equilibrium)
C = A + cY
S=Y–C
The multiplier
► BVFD: read sections 16.5 and 16.6 and concept 16.2.
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EC1002 Introduction to economics
Activity SG14.3
Given, C = 10 + 0.5Y, calculate the equilibrium output when I = 20.
Now check that Y = AD = C + I in equilibrium.
For a more detailed exposition of this topic, interested students should see
AW chapter 10, self-assessment Q3, which is followed up on with Chapter
12 section 12.4.2 – you can return to the discussion in Chapter 12 later
once you have learned the IS-LM framework, to be introduced in later
blocks.
► BVFD: read the Summary and attempt the revision questions and read
Chapter 17.
Activity SG 14.4
Draw the aggregate demand schedule with and without the government sector given the
following parameters:
C = 200 + 0.6YD I = 300
G = 200 t = 0.3
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Block 14: Output and aggregate demand
The budget
► BVFD: read section 17.3 and 17.4 as well as case 1.2.
Activity SG14.6
Multiple choice questions
1. The structural budget shows what the budget would be if is at .
a. actual spending; planned spending
b. actual tax revenue; forecast tax revenue
c. forecast consumers’ expenditure; actual consumers’ expenditure
d. output; potential output.
2. The inflation-adjusted budget:
a. uses real interest rates to calculate government spending
b. uses real GDP to calculate the deficit-to-GDP ratio
c. uses the tax rate minus the inflation rate to calculate tax revenues
d. shows what the budget will be if output is at potential output.
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EC1002 Introduction to economics
Activity SG14.7
Which of these are automatic stabilisers and which are discretionary fiscal policies?
a. unemployment benefits
b. a high savings rate
c. increasing the income tax rate
d. decreasing the vat rate
e. decreasing government spending
f. education opportunity grants for low-income families.
Activity SG14.8
Complete the following table
This introduces the fourth sector in our circular flow model: the rest of the
world. We now have the complete equation: In equilibrium, Y = AD = C
+I+G+X–Z
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Block 14: Output and aggregate demand
Activity SG14.9:
Using the following parameters:
C = 100 + 0.4Y I = 300
G = 200 t = 0.2
X = 300 z = 0.4
Draw the aggregate demand schedule for the following economies:
a. a closed economy with no government
b. a closed economy with government
c. an open economy with government.
In each case, what is the size of the multiplier? What is the equilibrium level of income?
What is the budget deficit or surplus and the trade balance?
The full multiplier, taking into account all leakages savings, taxation
and imports, is lower than in the simple, two-sector model, at
1/[1 – c(1 – t) + z].
Activity SG14.10
Show that this is equivalent to the version on p.406, given as: 1/[t + s(1 – t) + z].
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EC1002 Introduction to economics
Overview
This block examines the components of aggregate demand, as well as how
aggregate demand determines output, based on the multiplier effect.
Aggregate demand is defined in this block as planned or desired spending
and short-run equilibrium is defined as the point where aggregate
demand is equal to actual output. In equilibrium, output and aggregate
demand are equal, hence Y = AD = C + I + G + NX. Chapter 16 of the
textbook examines consumption and investment. Consumption consists of
autonomous consumption (at zero income) plus the proportion of income
that is spent rather than saved. This proportion is represented by the
marginal propensity to consume (MPC). Investment is treated as constant.
When prices and wages are fixed, the goods market is in equilibrium when
planned spending equals actual spending and actual output (not potential
output). In equilibrium, planned saving equals planned investment. When
the goods market is not in equilibrium, companies’ inventory levels will
change to restore equilibrium – either through unplanned disinvestment
(reductions in inventories) or unplanned investments (increases in
inventories). Changes in inventory send a signal to firms to increase or
decrease future output levels. Such changes in planned investment lead to
greater changes in equilibrium output, due to the multiplier effect. In its
simplest form, the multiplier is equal to 1/(1 – MPC).
Chapter 17 of the textbook examines the government spending and net
exports components of aggregate demand/output. The government levies
taxes and buys goods and services. Taxes reduce private disposable income
and hence consumption. Government spending raises aggregate demand
and equilibrium output. An equal increase in government spending and
taxation leads to an increase in aggregate demand and output, which is
known as the balanced budget multiplier. Government decisions regarding
spending and taxation are known as fiscal policy. Fiscal policy can either
be expansionary or contractionary, in practice however, fiscal policy
cannot completely stabilise output. The budget deficit is a poor indicator
of the government’s fiscal stance, because it is not only influenced by
discretionary policy decisions, but also by economic conditions. Automatic
stabilisers such as unemployment benefits act to reduce fluctuations in
GDP. Budget deficits add to the national debt.
The final element of the equation Y = C + I + G + NX is net exports.
Exports raise aggregate demand and can be viewed as autonomous.
Imports are a leakage and are assumed to rise with domestic income. Both
taxes and imports reduce the effect of the multiplier. In the full model, the
multiplier is equal to 1/[t + s(1 – t) + z]. In equilibrium, desired leakages
(S + NT + Z) must equal desired injections (G + I + X).
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Block 14: Output and aggregate demand
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EC1002 Introduction to economics
Notes
180
Block 15: Money and banking; interest rates and monetary transmission
Introduction
This block introduces an economic approach to the analysis of money.
Money plays a vital role in facilitating the exchange of goods and services.
It differs from standard commodities that are desirable in themselves –
the most important aspect of money is its various functions, which will
be discussed further in this block. However, we can still analyse money
in terms of demand and supply and a market equilibrium. The price of
money is the opportunity cost of holding money rather than investing
in other financial products which provide a return, notably bonds. The
interest rate on bonds is thus the price of money; this is an important
application of the concept of opportunity cost. Understanding how interest
rates bring about equilibrium in the market for bonds and the money
market, as well as their impact on the ‘real’ economy through consumption
and investment is an important aspect of this block. This block is also
heavily informed by what went on in global financial markets leading
up to and during the recent global economic crisis, which originated in
the banking sector. How governments responded to this, especially the
approach of quantitative easing, is also discussed.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• explain the medium of exchange and other functions of money
• explain how banks create money
• differentiate between liquidity crisis and solvency crisis
• define narrow and broad money
• explain the money multiplier and the bank deposit multiplier
• identify motives for holding money
• discuss how money demand depends on output, prices and interest
rates
• describe the central bank’s role in influencing the money supply and in
financial regulation
• describe money market equilibrium
• discuss intermediate targets and the transmission mechanism of
monetary policy
• describe how a central bank sets interest rates and how interest rates
affect consumption and investment demand.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapters 18 and 19.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapters 16 and 17;
UK edition, Chapters 18 and 19.
Witztum (AW), Chapter 11.
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EC1002 Introduction to economics
References cited
Tee, O.C. An exchange-rate-centred monetary policy system: Singapore’s
experience, In Mohanty, M. S., et al. Market volatility and foreign exchange
intervention in EMEs: what has changed?. (Bank for International
Settlements, Monetary and Economic Department, 2013). Available at:
www.bis.org/publ/bppdf/bispap73w.pdf.
reserves and reserve ratios. Using the notation used in BVFD, it works as
follows:
Let R be cash held in bank reserves, C be the cash held by the non-bank
public, H (for high-powered money) be the total cash in the economy, and
D be the size of bank deposits. Thus:
C+R=H
This shows that the all cash in the economy is held by either the banks or
the public. If the desired reserve ratio of the banks is cb , we can write:
R = cbD
If the public holds a fraction, cp, of its bank deposits in cash, then:
C = cpD
Substituting the second and third equations into the first gives:
cbD + cpD = H
And solving for D gives us:
H
D=
cb + cp
which shows that deposits depend on the total cash in the economy,
the banks’ reserve ratio and the public’s ratio of cash to deposits. The
calculation of the money multiplier follows on from this in the same way
as in BVFD, such that:
H = (cb + cp)D
M = C + D = (cp + 1)D
M (cp + 1)
=
H (cp + cb)
M (cp + 1)
The bank deposit multiplier is equal to =
R (cb)
Activity SG15.2
Based on the model above, use the following information to calculate the money
multiplier, the bank deposit multiplier, and the money supply (broad money).
Cash held by the public = £600
Banks reserves = £900
Banks hold cash reserves of 5% of deposits
The private sector holds cash in circulation of 3.333% of deposits.
Measures of money
A few points to note:
• The terms money-base, narrow money and high-powered money
are interchangeable and generally refer to the sum of currency in
circulation with the public plus cash reserves held by banks.
• ‘Money supply’ generally refers to broad money, which is a more
inclusive measure of money and includes deposits in banks and
building societies.
• The exact definitions (i.e. what is included) in various measures of
money differ for different countries, and have also changed over time.
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EC1002 Introduction to economics
This section discusses the demand for money and explains the three main
reasons people hold money rather than storing all their wealth in interest-
bearing assets such as bonds. These three reasons are the transactions
motive, the precautionary motive and the asset motive. Figure 18.2 shows
the marginal cost and marginal benefit functions for holding money –
people hold money up to the point at which the marginal benefit of holding
another pound just equals its marginal cost. Changes in real income shift
the MB schedule while changes in interest rates shift the MC schedule.
Activity SG15.3
Figure 18.2 and Table 18.3 in the textbook provide a good summary of the various factors
behind the demand for money. Draw the MB and MC curves for the demand for money in
an economy, and use these to answer the following question:
What will happen to the demand for money in the following cases, assuming all other
factors remain constant?
•• Real incomes fall (say, because of a recession).
•• There is a general rise in prices.
•• Interest rates fall.
Financial crises
► BVFD: read section 18.6 and case 18.1.
If you are interested in learning more about the causes of the financial
crisis, there is a great deal of information online, including several
documentaries which have been made about it, such as ‘Inside Job’
(2010). You may also want to research the changes to regulation that have
been implemented and are still being implemented in many economies
worldwide as a result of the crisis.
► BVFD: read the summary and work through the revision questions.
184
Block 15: Money and banking; interest rates and monetary transmission
r2
A
Md (Y2)
Md (Y1)
0
M
Figure 15.1: Money market equilibrium.
The money supply is shown by the vertical line MS, this is set at the level
that is chosen by the central bank. This shifts to the left or right if the
central bank lowers or raises the money supply. (A change in the price
level would also shift this curve, but for now we are assuming a fixed price
level. This assumption will be lifted in Block 17). Money demand is shown
by the downward sloping line Md. This depends on the level of real income
in the economy (GDP). A rise in real income shifts the Md curve upwards.
Money market equilibrium occurs at the intersection of the demand and
supply curves. This is shown by point A (where the interest rate is r1 and
income is Y1) and alternatively at point B (where the interest rate is r2 and
income is Y2).
Figures 19.1 and 19.2 in the textbook show the quantity of money
demanded as a function of the price of money (interest rates). As such,
unlike what is written in this maths box, changes in the cost of holding
money (r – rd) move us along a given money demand curve while changes
in autonomous money demand α or in income and output Y lead to a shift
in money demand. This matches up with what is written in the sub-section
‘A rise in real income’.
This section describes how central banks now tend to determine the
supply of money indirectly by setting the interest rate at a certain level.
Rather than trying to control cash in circulation or the money multiplier to
determine the money supply directly, central banks now tend to focus on
keeping interest rates at a certain level.
Although many central banks use interest rates as their way of influencing
the money supply, an alternative approach is to focus on the exchange
rate. This is the approach of the Singaporean central bank (the Monetary
Authority of Singapore – MAS), and is described more fully below:
Since 1981, monetary policy in Singapore has centred on the management of the exchange
rate. Unlike most other countries, which use interest rates as the instrument of monetary policy,
Singapore has chosen to use the exchange rate. This choice is predicated on the Singapore
economy’s small size and its high degree of openness to trade and capital flows. In Singapore,
which has no natural resources and is almost completely dependent on imports for necessities
such as food and energy, the import content of domestic consumption is high (with nearly 40
cents out of every $1 spent going to imports).
The economy is thus extremely open to trade, which totalled more than 300% of GDP in 2011.
This openness means that the exchange rate bears a stable and predictable relationship to price
stability as the final target of policy over the medium term. The exchange rate is also relatively
controllable through direct intervention in the foreign exchange markets, which means the
government can use an exchange-rate-based monetary policy to retain greater control over
macroeconomic outcomes such as GDP and consumer price inflation, and over the ultimate
target of price stability. By contrast, interest rates are less easily controlled in Singapore for
various reasons, including the dominance of multinational corporations in the corporate sector.
The effectiveness of the exchange-rate-centred monetary policy as an anti-inflation tool for the
Singapore economy is demonstrated by the relatively low domestic inflation rates over the past
30 years, averaging 2.1% per annum from 1981 to 2012. A further result of the long record of
low inflation is that expectations of price stability have also become more entrenched.
Based on Tee (2013). Available at: www.bis.org/publ/bppdf/bispap73w.pdf
186
Block 15: Money and banking; interest rates and monetary transmission
Interested students who would like to know more about how QE works
can refer to the following articles:
www.economist.com/node/21558596
www.economist.com/blogs/economist-explains/2015/03/economist-
explains-5
www.bbc.com/news/business-15198789
Y = C + I + G + NX
Consumption Investment Government Net Exports
Spending
Wealth Consumer Permanent Fixed Capital Inventories
Credit Income
Higher real The credit Consumption Lower Lower
(Fiscal policy (The effect of
money supply available to demand interest rates interest rates
is generally interest rates
increases consumers reflects long- mean more reduce the
determined on net exports
wealth directly increases run disposable investment opportunity
independently is covered in
Lower interest Low interest income. Lower opportunities cost of holding
of monetary later parts of
rates increase rates make interest rates exceed their inventories
policy) the textbook)
wealth borrowing for increase opportunity
indirectly consumption consumption cost (with a
more by increasing more powerful
affordable the present impact on
value of long-term
expected investments)
future labour
income
Complete Activity 19.1.
Overview
Chapter 18 of the textbook provides an introduction to the economic
analysis of the money market. The four main functions of money are as
a medium of exchange, a store of value, a unit of account and a standard
of deferred payment. Narrow money, also known as high-powered money
or the money base, consists of currency in circulation plus bank’s cash
reserves. Broad money (M4), the money supply, includes deposits at banks
187
EC1002 Introduction to economics
and building societies. This chapter examines how banks operate, as this
helps generate the money supply. Money supply is greater than the money
base by a factor known as the money multiplier, which depends on banks’
reserve ratios and the public’s holdings of cash relative to deposits.
Moving on to the demand for money, the textbook discusses how people
have various motives for holding money, including the transactions motive,
the precautionary motive and the asset motive. The cost of holding money
is the interest foregone through not holding assets as bonds. The quantity
of real money demanded rises as the interest rate falls, and is higher at
each interest rate when real income is higher.
Banks play an important role in the economy, but this is not without risk.
Regarding financial crises arising in the banking sector, it is important to
distinguish between liquidity crises and solvency crises. One approach to
dealing with the recent financial crisis (quantitative easing) is explored in
Chapter 19 of the textbook.
Chapter 19 also discusses the Bank of England and the two key
responsibilities of central banks, namely monetary control and financial
stability. It also brings together demand and supply to discuss equilibrium
in money markets. Equilibrium is achieved through changes in the
interest rate, which affects the demand and supply of bonds and thus
indirectly, demand for money. Money supply is controlled by the central
bank, although nowadays, central banks focus on the interest rate rather
than setting a specific money supply target. The central bank’s decisions
regarding interest rates (or historically, money supply) is known as
monetary policy. Interest rates are a common instrument of monetary
policy, and a common target is price stability (low inflation rates).
Changes in interest rates affect the real economy through their impact
on consumption and investment. Consumption, because higher interest
rates reduce household wealth, make borrowing dearer and reduce the
present value of future labour income, leading to a fall in consumption.
Investment, because higher interest rates mean fewer investment projects
exceed their opportunity cost and the opportunity cost of holding
inventories increases, leading to a fall in investment.
188
Block 15: Money and banking; interest rates and monetary transmission
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EC1002 Introduction to economics
Notes
190
Block 16: Monetary and fiscal policy
Introduction
Block 14 discussed the goods market while Block 15 covered the money
market. This block introduces a framework called the IS-LM model which
brings these two markets together in a basic general equilibrium analysis,
that is, it analyses the requirements for the goods and money markets to
be simultaneously in equilibrium and how this simultaneous equilibrium
is affected when certain factors, initially held constant, are allowed to
change. The IS-LM model is a simple and effective model for examining
the two key tools of demand management – fiscal and monetary policy.
After completing this block, you should understand how the combination
of these two policies (i.e. the ‘policy mix’) affects the level of demand in
the economy. This block completes the demand side of the macro section.
At this stage, we are still making the strong assumption that the price
level is fixed, an assumption that will be relaxed in the following textbook
chapters. Because the price level is fixed there is no distinction between
nominal and real values, so that all the variables in the analysis of this
chapter can be thought of as real.
IS-LM is sometimes not taught, one reason is the above assumption
regarding the price level. Other criticisms of the IS-LM model include the
fact that it is a static model, while interest rates are meaningless unless
time is a factor; and the fact that the central bank no longer uses money
supply targets (most central banks now set inflation targets). Nonetheless,
it is a useful model for clarifying several fundamental concepts and
although it is sometimes seen as being a little old-fashioned, in practice
it is often still used by policy-makers (see, for example, a defence for
teaching it by the Nobel Prize laureate Paul Krugman: http://web.mit.
edu/krugman/www/islm.html). If you work through this block thoroughly
and gain a good understanding of this model and the effects of fiscal and
monetary policy mixes, this will help a great deal in progressing through
the following blocks where the analysis becomes more complex (and more
realistic).
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• describe different forms of monetary policy
• derive the IS curve and the LM curve
• find equilibrium in both the output and money markets
• link shifts in the curves to fiscal and monetary policy respectively
• discuss the impact of fiscal policy, with different funding mechanisms
• discuss the impact of monetary policy
• describe the liquidity trap
• use graphs to describe the effect on output and interest rate of the mix
of monetary and fiscal policy
• realise how expected future taxes affect current demand.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 20.
191
EC1002 Introduction to economics
Further reading
Lipsey and Chrystal (L&C) international edition, Chapters 17 and 18; UK
edition, Chapters 19, 20 and 25.
Witztum (AW), Chapter 12.
Monetary policy
► BVFD: read section 20.1.
In the past, central banks used monetary targeting – now they tend to use
inflation targeting. This chapter is based on the assumption that central
banks use monetary targeting, since it makes the concepts in this chapter
easier to understand. However, it’s important to keep in the back of your
mind that inflation targeting is the most common current practice. The
following chapters will explore inflation targeting more deeply.
10%
8%
150 200 I
Δ = 50
192
Block 16: Monetary and fiscal policy
AD
AD (r = 8%)
B
AD (r = 10%)
350 A
Δ = 50
300
45°
1500 1750 Y
r
A
10%
B
8%
IS
1500 1750 Y
Figure
A: at 16.2: Deriving
an interest the
rate ofIS10%
curve.
the goods market is in equilibrium at 1500
B: atAanshows
Point interest
anrate of 8% theingoods
equilibrium market
the goods is in equilibrium
market where theatinterest
1750
The IS curve gives you all the combinations of interest rate and
rate is 10% and output is 1,500. Point B shows an equilibrium where the income
where rate
interest the goods
is 8% market
and outputis in equilibrium
is 1,750.
Mapping points A and B onto a graph of interest rates against output gives
us the IS curve. The IS curve shows all the combinations of interest rate
and income where the goods market is in equilibrium.
Activity SG16.1
Given the following information, provide a graphical derivation of the IS curve: The
multiplier is equal to three. When interest rates are equal to 5%, autonomous demand is
200. When the interest rate rises to 8%, investment falls from 100 to 80.
To derive the LM curve, we must start with the money market. This is
depicted below in the left-hand graph.
MS
r r
D
15% 15%
D
C
10% 10%
C Md (Y2)
LM
M (Y1)
d
0 Y1 Y2
M Y
193
EC1002 Introduction to economics
The money supply is fixed at a certain level by the central bank (remember
in this block we are still assuming the central bank is using a money
supply target). In this depiction of the money market, money demand
depends endogenously on the interest rate r and exogenously on the
level of income Y and is downward sloping. At point C, the market
is in equilibrium. The mechanism that provides the LM curve can be
summarised as follows: if there is an increase in income, this will lead
to an increase in the demand for money at any interest rate (due to the
increase in transactions). This means there will be excess demand for
money at the initial interest rate – some people want to sell their bonds
and convert them into cash. These people will need to find a lender, so the
price of bonds would have to fall and the interest rate – the return to the
lender – would have to increase. In this way, competitive market forces
will restore equilibrium in the money market.
In short: ↑Y → ↑Md → ↓Pb → ↑r, where Y is income, Md is money demand,
Pb is the price of bonds and r is the interest rate.
At point D, interest rates have risen to such a level that equilibrium in the
money market has been restored. Mapping points C and D onto a graph
of interest rate against output gives us the upward sloping LM curve. The
LM curve shows all the combinations of interest rate and output where the
money market is in equilibrium.
Activity SG16.2
Given the following information, provide a graphical derivation of the LM curve. There is
a fixed supply of money. When output is at 600, the money market is in equilibrium when
interest rates are equal to 5%, when output rises to 800, the interest rate rises to 8% to
restore equilibrium in the money market.
Putting the IS curve and the LM curve together gives us the complete
model. This is a general equilibrium model which shows the interactions
between two variables (interest rates and output) which are dependent on
each other but which are determined in different markets.
The IS curve shows combinations of interest rate and output where the
goods market is in equilibrium. These variables are connected in the goods
market because interest rates affect investment (and also consumption),
which are components of aggregate output.
r
LM
r* X
IS
Y* Y
194
Block 16: Monetary and fiscal policy
Activity SG16.3
Answer the five questions in the boxes below:
IS-curve: LM-curve:
combinations of interest rates and combinations of interest rates and
income that lead to equilibrium in income that lead to equilibrium in
the goods market the money market
Lower interest rates increase consumption The quantity of money demanded rises
demand (Why?) with the level of output (Why?)
Lower interest rates increase investment Higher interest rates lead to a fall in
demand (Why?) money demand (Why?)
(This approach assumes that whatever is Higher output induces a higher interest
demanded will be supplied. Supply side rate to keep money demand in line with
economics will be covered in Chapter 28) money supply. (Who determines this?)
the monetary authorities change the interest rate, equilibrium output will
change, other things equal.
Activity SG16.4
Using the IS-LM framework, draw a fiscal expansion and a monetary expansion in the
boxes below. What are the effects on output and interest rates?
Crowding out
An increase in government spending, G, leads to an increase in output and
an increase in interest rates. However, this increase in interest rates will
lead to a fall in private spending – a fall in investment and consumption.
This means that the overall increase in output is less than it otherwise
would have been. To a certain extent, the increase in government
spending has merely replaced private spending that would otherwise have
taken place. Another way of thinking about this is that an increase in G,
unmatched by an increase in taxation reduces desired national savings.
At unchanged interest rates there will be an excess of desired investment
over desired savings so the interest rate increases to eliminate this excess.
As the text explains, investment does not fall by the same amount that G
has increased unless the LM curve is vertical. Look at the text to determine
under what conditions there would be no crowding out at all.
Not all economists are convinced by the notion that increases in
government spending crowd out private investment. One counter
argument is that when confidence is very low, say in a deep recession,
government spending may actually crowd in private spending by boosting
confidence in the future performance of the economy.
196
Block 16: Monetary and fiscal policy
Activity SG16.5
The figure below summarises this section, showing how changes in money demand (other
than those caused by changes in interest rates and output) cause the LM curve to shift.
Complete the empty boxes in the second row.
Banks want LM
to increase curve
their profit shifts
margins right
Figure 16.5
This maths box provides a neat way of summarising the various factors
at work in these models. Work through the algebra yourself to make sure
you understand it. You would then find it useful to work through the
additional material below.
Derivation of IS-LM
We now provide a mathematical treatment of the derivation of IS-LM. It is
basically an elaboration of Maths 20.1 with the inclusion of government. This
latter extension enables the equations to incorporate the effects of monetary
and fiscal policy.
Y=C+I+G
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EC1002 Introduction to economics
Y = AC+c(Y – T)+AI – dr + G
Collecting terms, this gives us the IS curve which we can write in terms of
equation (1a) in Maths 20.1:
Y = A – br
AC + AI − cT + G d
Where A = and b = .
1− c 1− c
Turning to the LM curve, we simplify again by assuming that the money
supply is exogenous, M is simply set by the government (we short-circuit the
deposit multiplier analysis) so the equilibrium in the money market is, again
using the notation of Maths 20.1, given by:
M = fY – hr
Y = D + er
Where, D = Mf and e = h
f
Solving for simultaneous equilibrium in the goods and money markets (IS=LM)
yields expressions for Y and r in terms of the exogenous variables and the
parameters (constants) c, d, f, and h from the consumption, investment
and money demand functions. The equations (which are the equivalent of
equations (2) in Maths 20.1) are quite complicated but they show how and
why equilibrium income and the interest rate are affected by a change in any
of the exogenous variables in the model. We show the equation for equilibrium
Y only (you are not expected to learn this equation – you will not be asked to
reproduce it).
AC + AI – cT + G M
Y= +
df h
(1 – c) + (1 – c) +f
h d
From these equations we can derive the fiscal and monetary policy multipliers;
the change in Y for a given (relatively small) change in G, T or M.
∆Y 1
=
∆G (1 – c) + df
h
∆Y –c
=
∆T (1 – c) + df
h
∆Y 1
=
∆M (1 – c) h + f
d
Thus, the increase in equilibrium income is large when (1 – c) is small (i.e.
when the MPC is large) and the standard multiplier, covered in Chapters 16
and 17, is large and there is less leakage in the re-spending rounds. Other
things equal, the increase in G on Y is larger when d is small. Why? There
is a smaller crowding out effect on investment when the interest rate rises,
as it must given that money supply stays constant while the demand for
money increases due to the increase in income. How much the interest rate
will increase will itself depend on f and h. When f is high the increase in the
demand for money is high when an increase in G raises Y so the interest rate
will have to increase by more to maintain equilibrium in the money market.
This reduces investment by more so the overall increase in equilibrium Y is
smaller. Other things equal, when h is higher in absolute terms (the demand
for money is more sensitive to the interest rate) then a smaller adjustment in
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Block 16: Monetary and fiscal policy
It would be useful for you to trace out the economic impacts of c, d, f, and h in
the other two equations.
Activity SG16.6
1. a. Find the interest rate and level of output at which both goods and money markets
are in equilibrium, given the following equations:
Y = 80 – 4r (IS curve)
M = 360 (money supply)
M = 10Y – 4r (money demand)
b. How would this change if there is expansionary fiscal policy and autonomous
demand in the IS schedule increases to 102?
2. Find the interest rate and level of output at which both goods and money markets are
in equilibrium, given the following information:
C = 100 + 0.7(Y – T)
I = 100 – 0.2r
G = 150
T = 50
M=310
M = 0.3Y – 0.2r.
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EC1002 Introduction to economics
M1s M2s
M
0
A
r M D (Y3) r
M 52
LM(M 52)
M (Y2)
D
M D(Y1)
0 M Y
A Y1 Y2 Y3
B
Y
Y *
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Activity SG16.7
Describe the policy mix you would adopt in the following situations, assuming you are in
a position of power over both fiscal and monetary policy, and provide an explanation of
the reasoning behind your decision:
a. A very deep recession.
b. There is a need to build a solid foundation for long-term growth, but there is currently
a temporary bubble in the economy.
c. The country is heavily engaged in a war which is being fought outside of the country.
This section also briefly makes the point that expansionary fiscal policy
can be financed in different ways. The effects of the policy on interest rates
and output may differ depending on how it is financed. The three main
alternatives for financing an expansionary fiscal policy are below.
a. An expansionary fiscal policy financed via an increase in taxes. This
will not cause an increase in the money supply so fiscal policy and
monetary policy will be independent. It does cause a decrease in
consumption but not by as much as the tax increase since people are
likely to reduce savings as well as consumption. Interest rates will
increase and output will increase, though probably less than it will
in (b).
b. An expansionary fiscal policy financed via borrowing (selling bonds to
the public). This doesn’t affect money supply as the money the public
uses to buy bonds is re-injected into the economy. Fiscal and monetary
policy will be independent in this case. Crowding out will occur due
to the increase in interest rates. Output will most likely increase more
than in (a), depending on how much crowding out of investment and
consumption occurs.
c. An expansionary fiscal policy financed via printing money (selling
bonds to the central bank). This will lead to an increase in the money
supply and can be highly inflationary if the government has large debts
– more on this later. Output will rise and there will be no crowding
out. The effect on the interest rate is unclear.
Activity SG16.8
Use IS-LM curves to represent these three options graphically (note that at this stage we
still make the assumption that prices are constant).
What are the reasons why Ricardian equivalence is too strong in practice? What evidence
exists to support this?
► BVFD: read section 20.7, the summary and work through the review
questions.
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Block 16: Monetary and fiscal policy
Overview
This block introduces the IS-LM model and provides a derivation of each
curve. Fiscal policy shifts the IS curve while monetary policy shifts the LM
curve. An expansionary fiscal policy leads to a higher interest rate and
higher output, with government spending a large part of total spending.
An expansionary monetary policy leads to lower interest rates and higher
output, with private consumption spending and investment making up
a large part of total spending. These two policies can be used to support
each other or balance each other out. Often, fiscal policy will be heavily
influenced by political concerns, while in many countries the central bank
makes decisions on monetary policy independent from political influences.
This model provides a simple way of depicting the effects of each policy, as
well as policy mixes.
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Block 17: Aggregate demand and aggregate supply
Introduction
Up to this point, the blocks on macroeconomics have assumed that the
price level was fixed. In this block, we introduce a supply side and lift
the assumption of fixed prices. This raises the question of how flexible
prices (and wages) really are. There are different schools of thought on
this issue – the classical school assumed that prices and wages were fully
flexible. Later, the Keynesian school argued that they are sticky (especially
downwards) and will not change in the short-run. These two perspectives
give rise to the short-run aggregate supply curve (following the Keynesian
perspective) and the long-run, vertical aggregate supply curve (following
the classical school of thought). This block examines changes in output
and the price level – how the economy can deviate from its long-run
equilibrium level of output, and how it can get back there again, either
through market mechanisms or through government intervention.
The AD-AS model can either be represented graphing output against the
price level, or against inflation (i.e. the rate of change in the price level).
BVFD uses the model with inflation. This is the model we will concentrate
on this block and which is examinable for you. However, you may find
it easier to start with the model using the price level. A brief description
of this (based on L&C) has been included in a box (‘The price level or
its rate of change?’) and is laid out in further detail in an appendix to
this block. This is optional material included only to aid your
understanding and is not examinable.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• describe inflation targets for monetary policy
• explain and graph the ii schedule
• describe how inflation affects aggregate demand
• define aggregate demand and graph the AD schedule
• define aggregate supply in the classical model
• analyse the equilibrium inflation rate
• describe complete crowding out in the classical model
• recognise why wage adjustment may be slow
• analyse short-run aggregate supply
• discuss the effects of short-run and permanent demand and supply
shocks
• describe how monetary policy reacts to demand and supply shocks
• recognise flexible inflation targets
• explain the Taylor rule.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 21.
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EC1002 Introduction to economics
Further reading
Lipsey and Chrystal (L&C) international edition, Chapters 19 and 20; UK
edition, Chapters 21 and 22.
Witztum (AW), Chapter 13.
Aggregate demand
► BVFD: read section 21.1.
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Block 17: Aggregate demand and aggregate supply
On the supply side, one can think of the AS curve being upward sloping due to increasing
marginal costs of production; for perfectly competitive firms an exogenous increase in
prices raises output and for price-setting firms if higher output increases costs, firms
who price with a mark-up over costs will increase prices. The AD-AS model then jointly
determines output and the price level and enables analysis of the effects of monetary and
fiscal policies as well as supply shocks which exogenously increase or decrease costs to
producers.
Aggregate supply
► BVFD: read section 21.2 and case study 21.1.
We now move away from the Keynesian model, with rigid wages and
prices in which output is entirely demand determined, and include a
supply-side in the model of output determination. Aggregate supply
describes the relationship between the output that businesses willingly
produce and the rate of inflation, with other factors held constant. Initially,
the textbook introduces the vertical aggregate supply curve. This is
often known as the long-run aggregate supply curve as it is based on the
assumption that prices and wages are completely flexible. While almost all
economists would agree that prices and wages are flexible in the long-run,
the classical school assumed they were always flexible.
For example, suppose inflation increased; if nominal wage growth did not
change then real wages would fall. But in the classical model, nominal
wage growth would match the new, higher, rate of inflation so that real
wages would be unaffected and there would be no forces acting to change
aggregate output. The vertical aggregate supply curve shows that in the
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EC1002 Introduction to economics
Equilibrium inflation
► BVFD: read section 21.3.
Now we can finally put together the pieces of the full model – aggregate
demand and aggregate supply – to show both the level of output and the
inflation rate. Where the two curves intersect, there is equilibrium in the
goods market, the money market and also the labour market. The position
of the vertical AS curve reflects potential output. The position of the AD
curve reflects the government’s monetary policy and the impact of interest
rates on the goods market.
In the long run, aggregate supply is vertical at the level of potential
output determined by the economy’s available inputs and its technology
(broadly defined). All prices, inputs and outputs increase at the same rate
so nothing real changes. For example both money wages (nominal wages)
and prices change at the same rate so the real wage, which affects both the
supply of and demand for labour, is unchanged.
The SAS curves described in this section display how much firms are
willing to supply at each level of inflation given a certain nominal wage
growth. In Appendix B, there is a description of SAS curves for a model
with the price level on the vertical axis. Once again, this has been included
to aid your understanding and is optional and not examinable.
Figure 21.5 shows why it can be useful to understand the AD curve from
the perspective of interest rates. Then, we can see how the government
can respond actively to a shift in aggregate supply. In this case, the
government responds to an increase in aggregate supply by reducing
interest rates, as this leads to an increase in aggregate demand such that
inflation is maintained at the target rate.
Activity SG17.2
Beginning at point C in Figure 21.5, where would the economy end up if there was an
adverse supply shock shifting the AS curve from AS1 to AS0 and the central bank did not
react?
Activity SG17.3
Select the appropriate response below in regards to the following two statements:
i. Central banks can offset temporary demand shocks but in doing so they will face a
trade-off between stabilising output or inflation.
ii. Central banks can offset temporary supply shocks without facing any trade-off
between stabilising output or inflation.
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Block 17: Aggregate demand and aggregate supply
Wage rigidity
► BVFD: read section 21.4.
This section discusses wage rigidity. It summarises why prices are sticky
(especially downwards), since wages, the largest component of firms’
costs, adjust slowly to changes in demand. Prices may also be sticky for
other reasons, such as the fact that it is costly for firms to set, implement
and advertise new prices – this may lead to a reluctance to increase prices,
even in situations where a price increase would be expected, for example
due to a major increase in costs or demand.
Why do SAS curves slope upwards? An explanation for a model with price
level on the y-axis is included in Appendix B. For the model with inflation
on the y-axis, the discussion below should help you understand the
explanation in the textbook.
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EC1002 Introduction to economics
In the short run, some prices cannot adjust or can only do so partially. To
derive an upward sloping short-run supply curve, this chapter assumes
a very specific type of labour market rigidity, namely that, in the short-
run, firms are stuck with a given rate of growth (note: not level) of
nominal wages inherited from previous wage negotiations. Prices change
more easily than wages. Both suppliers and demanders of labour will
have negotiated the rate of growth of money wages on the basis of their
inflation expectations (i.e. they will have implicitly been negotiating
over real wages). If the rate of change of nominal wages is fixed by wage
agreements but inflation deviates from the rate assumed by the parties
to such agreements then the real wages will differ from those implicitly
agreed by the negotiating parties.
Now suppose that for given expectations about the growth of money
wages and prices, the rate of inflation is higher than expected. Firms get
higher prices for their product and real wages are lower than expected
because prices are rising faster than was expected when nominal wage
growth was negotiated. So production becomes more profitable and firms
increase output. Similarly, if inflation is lower than expected the prices at
which firms sell their output is lower than they were counting on and real
wages are greater than expected. Output falls, unemployment increases.
After a period of time, if inflation deviates from its expectations and thus
the workers and firms are not receiving and paying the real wages they
negotiated, they will go back and renegotiate how fast nominal wages
grow and this in turn will shift the whole short run AS schedule, that
schedule having been drawn for a given rate of change of money wages.
The short-run aggregate supply curves in Figure 21.7 can be written:
Y = Y* + α(π – πe) where α is a positive constant and πe is expected
inflation. As explained, each supply given is based on inherited agreements
on the growth of money wages.
Shifts in the SAS curve: Each SAS curve reflects a given rate of inherited
nominal wage growth (and more generally, given input prices). When
inherited nominal wage growth is lower, firms will not increase prices
as quickly, and the SAS curve will be lower. Changes in input prices and
changes in productivity also both lead to shifts in the SAS curve.
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Block 17: Aggregate demand and aggregate supply
The adjustment process for a negative demand shock (described more fully
in section 21.6) is similar 0 – just in the opposite direction, with the AD
curve shifting left from AD0 to AD2, moving the economy into recession at
a lower rate of inflation. At point D, there is involuntary unemployment.
This will put downward pressure on future wage negotiations, resulting in
lower wage growth and a shift in the SAS curve, eventually to point E.
AS
SAS1
π1 C SAS0
②
SAS2
Inflation
①
π0 D A B
①
②
π2
E
AD1
AD0
AD2
Y*
Output, income (GDP)
Figure 17.1 Demand shocks.
Activity SG17.4
Identify the following shocks (demand or supply, permanent or temporary, positive or
negative) and use AD-AS curves to demonstrate their short-run and long-run effects on
output and inflation. Clarify the appropriate monetary policy response and its effects on
output and inflation.
i. A technological breakthrough significantly enhances productivity
ii. A major trading partner suffers a deep recession
iii. A country realises that its stock of minerals is significantly lower than what it had
previously estimated
iv. The price of a key input into production rises for some time.
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EC1002 Introduction to economics
Activity SG17.5
Search online to find some predictions or analysis relating to the expected (or announced)
actions of a major central bank (e.g. the Bank of England, US Federal Reserve, European
Central Bank). How well do they fit with the theory described in these sections (flexible
inflation targeting and the Taylor rule)?
► BVFD: read the summary and work through the review questions.
Overview
This chapter introduces a model of aggregate demand and aggregate
supply, showing the relationships between output and inflation. The ii
schedule is introduced first to help explain the AD curve. The ii schedule
shows, under a policy of inflation targeting, how the central bank sets high
interest rates when inflation is high and low interest rates when inflation
is low. The ii schedule shifts left (right) when monetary policy is loosened
(tightened) – this means at each inflation rate, real interest rates are higher
(lower). On the assumption that the central bank is taking this approach,
the AD curve shows how higher inflation reduces aggregate demand by
inducing monetary policy to raise real interest rates.
The classical model of macroeconomics assumes full flexibility of wages
and prices and no money illusion. In the classical model, the economy is
always at full employment equilibrium. This is represented by a vertical
aggregate supply schedule at the level of potential output. Equilibrium
inflation occurs at the intersection of the aggregate demand and aggregate
supply schedules. Monetary policy is set to make the equilibrium inflation
rate coincide with the inflation target. In the classical model, fiscal
expansion cannot raise output, but will simply lead to a crowding out of an
equal amount of private spending.
In the real world, prices and wages do not adjust instantaneously. In
particular, wages are thought to be sticky downwards. This is a feature
of the Keynesian model of macroeconomics. The Keynesian model is a
good guide to short-run behaviour whilst the classical model describes
the long run. The vertical aggregate supply curve is thus called the long-
run aggregate supply curve. Short-run aggregate supply curves slope
upwards. They show firms’ desired output given the inherited growth of
nominal wages. Output is responsive to inflation in the short-run because
nominal wages are already determined and people’s expectations regarding
inflation do not always prove correct. A re-negotiation of the rate of wage
growth causes a shift in the short-run aggregate supply curve.
Permanent supply shocks alter potential output. Regardless of the policy
adopted, their output effects cannot be escaped indefinitely. Temporary
supply shocks merely shift the short-run supply curve for a period.
These force central banks to make a decision on the trade-off between
output stability and inflation stability. Demand shocks however, could be
completely offset by monetary policy, if the effects were instant.
Flexible inflation targeting implies the central bank need not immediately
hit its inflation target, allowing some scope for temporary action to
cushion output fluctuations. A Taylor rule views interest rate decisions
as responding to both deviations of output from target and deviations of
inflation from target. Many central banks appear to follow a Taylor rule-
type policy.
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Block 17: Aggregate demand and aggregate supply
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EC1002 Introduction to economics
10
-2
Shortfall
-4 Taylor Rule Estimate
Fed Funds
-6
-8
6/1/1995
12/1/1995
6/1/1996
12/1/1996
6/1/1997
12/1/1997
6/1/1998
12/1/1998
6/1/1999
12/1/1999
6/1/2000
12/1/2000
6/1/2001
12/1/2001
6/1/2002
12/1/2002
6/1/2003
12/1/2003
6/1/2004
12/1/2004
6/1/2005
12/1/2005
6/1/2006
12/1/2006
6/1/2007
12/1/2007
6/1/2008
12/1/2008
6/1/2009
12/1/2009
6/1/2010
12/1/2010
6/1/2011
12/1/2011
6/1/2012
12/1/2012
6/1/2013
12/1/2013
Source: http://blog.commonwealth.com/independent-market-
observer/2014/01/28/12814-where-are-interest-rates-headed-lets-consult-
the-taylor-rule Reproduced with kind permission of P. Essele and B. McMillan.
a. What is the Taylor rule?
b. For the first half of the time period shown, the Taylor rule provides
a good estimate of the actual Fed Funds rate – explain why this
might be the case
c. Explain the section of the graph where the green colour (see VLE
version) indicates a substantial shortfall
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Block 17: Aggregate demand and aggregate supply
LM2(P2)
LM1(P1)
LM0(P0)
Interest rate
E2
E1 E0
IS0(P0)
IS1(P1)
IS2(P2)
0 Y2 Y1 Y0
Real GDP
e2
Price level
e1
e0
AD
0 Y2 Y1 Y0
Real GDP
Figure 17.2
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EC1002 Introduction to economics
The AD curve above shows the relationship between the equilibrium level
of output and the price level. For a given nominal money supply, changing
the price level (from P0 to P1 to P2) causes both the IS and the LM curves
to shift leftward in the upper graph. When the price level is P0, the curves
IS0(P0) and LM0(P0) intersect at E0 with the equilibrium level of output
being Y0. Plotting Y0 against P0 in the lower graph gives the first point on
the AD curve: e0. An increase in the price level to P1 shifts the LM curve to
LM1(P1) and the IS curve to IS1(P1). The intersection of these curves gives
a new equilibrium at E1 where the output level is Y1. Plotting P1 against Y1
gives the point e1 in the lower graph – the second point on the AD curve. A
further increase in the price level to P2 shifts the LM curve to LM2(P2) and
the IS curve to IS2(P2). This takes equilibrium to E2 at an output level of Y2.
Plotting P2 against Y2 gives the final point on the AD curve – e2. Connecting
points e0, e1 and e2 yields the AD curve, showing the relationship between
output and the price level.
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Block 18: Inflation
Introduction
In Block 17, we analysed how changes in aggregate demand and aggregate
supply affect output and inflation. Inflation, economic growth (i.e. growth
in output) and unemployment are the three key macroeconomic indicators
you will most likely have heard discussed in the media. In this block, we
focus on inflation, which is defined as a rise in the general level of prices.
This block examines the causes of inflation, its implications, as well as
policies to address it.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• explain and criticise the quantity theory of money
• discuss nominal and real interest rates and inflation
• analyse seigniorage, the inflation tax, and why hyperinflations occur
• assess when budget deficits cause money growth
• explain the Philips curve
• analyse inflation expectations
• evaluate the costs of inflation
• discuss central bank independence and inflation control
• analyse how central banks set interest rates.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 22.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapters 19–21; UK edition,
Chapters 21–23.
Witztum (AW), Chapter 13.
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Block 18: Inflation
2.3
2.2
2.1
2.0
(Ratio)
1.9
1.8
1.7
1.6
1.5
1.4
1960 1970 1980 1990 2000 2010
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EC1002 Introduction to economics
If nominal money growth leads to a fall in demand for real money, P must
rise faster than M so that real money supply (M/P) falls in line with the
fall in demand for real money.
Activity SG18.1
What does this section tell you about the velocity of money during a hyperinflation?
Assume that output is constant and the money supply is rising rapidly (for example
because a government is printing large amounts of money to cover its debts), and use the
equation of exchange to describe the change in the price level.
[ ∆M
[
∆M .
[ M
Seigniorage = real revenue from money creation =
[=
[ [
P M P
However, the two terms on the right-hand side of this equation are not
independent, because an increase in the growth of the money supply will
increase inflation which, in turn, will decrease the demand for real money
balances. This is the reason for the ‘hump shaped’ curve in Figure 22.3.
The relation is not a mechanical one. It depends on how quickly increases
in the money supply feed through into increases in inflation and by how
much and how quickly people adjust their real money balances when
inflation changes. This section of the chapter also explains the inflation
tax. Inflation acts as a tax, eroding the real value of money balances. The
inflation rate is analogous to a tax rate and the holding of real money
balances is analogous to the tax rate. So we can write the inflation tax as:
M
Inflation tax = π
P
Note that this is not the tax revenue the government gets from increasing
the money supply. That is given in the expression for seigniorage. But 2
Named after New
looking at the two equations it is clear that seigniorage and the inflation Zealand-born economist
∆M
tax are equivalent when M = i.e. when inflation is equal to nominal A.W. Phillips, who spent
much of his academic
money growth (when nominal money growth and real income are
career at the London
constant this will be assured). School of Economics.
Apart from using
Activity SG18.2 statistical methods
to investigate the
Use your own words to explain seigniorage and the inflation tax.
relationship between
unemployment and
inflation, the subject
The Phillips curve and inflation expectations of this section, Phillips
(who initially trained as
► BVFD: read section 22.4. an engineer) was also
famous for building
Up to this point in the chapter, the emphasis has been on monetary and an analogue hydraulic
computer which could
fiscal relationships. Section 22.4 relates these more explicitly to the
be used for modelling
real economy (via output and unemployment) and begins to analyse the macro economy.
the crucial role of expectations in macroeconomics. The Phillips curve,2 Several copies of this
which depicts the relationship between unemployment and inflation, is machine still exist
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Block 18: Inflation
introduced. Just as there was for aggregate supply, there is both a long-run
Phillips curve and a short-run Phillips curve. The short-run curve slopes
downwards, depicting a trade-off between unemployment and inflation.
This can be explained in a simple and intuitive way as follows. In the short
run, when inflation increases unemployment decreases. For example,
inflation is usually demand-pull inflation, this occurs when aggregate
demand increases. The quantity supplied by firms needs to increase to
meet the increase in aggregate demand, and to increase quantity supplied,
firms must hire more workers, hence unemployment falls. Higher prices
make firms supply more output and demand more workers. Alternatively,
when unemployment rises, inflation falls. This could be because as
unemployment rises, people can no longer afford to buy as many goods
and services. Thus firms must lower their prices to attract customers and
inflation falls.
In its original form (naïve form, some would say) such a relationship could
be written as:
= α0 − α1u α0 > 0, α1 > 0
This trade-off at first seemed to offer a powerful lever to policy makers
seeking to an acceptable compromise in attaining two of the most
important but seemingly conflicting macroeconomic objectives (low
unemployment and low inflation). However, this trade-off was soon
revealed to be illusory over the longer term; the long-run Phillips curve is
vertical – equilibrium unemployment is independent of inflation.
Demand shocks will move the economy along the short-run Phillips curve
– permitting the economy to temporarily diverge from equilibrium levels.
Thus an inflation rate that is different from people’s expectations leads to
a movement along the short-run Phillips curve. The height of the short-run
Phillips curve is affected by people’s expectations about future inflation.
A change in expectations leads to a shift in the short-run Phillips curve.
Temporary supply shocks also affect the height of the short-run Phillips
curve (causing it to shift upwards or downwards), while permanent supply
shocks affect the position of the long-run curve.
Inflation depends on inflation expectations and the gap between the actual
and equilibrium unemployment rates. Inflation expectations also depend
on this gap. Therefore, inflation is affected by deviations of unemployment
from the equilibrium rate through two channels – directly, and also
through the impact on expectations.
Second, Equation (1) (representing the short-run Phillips curve) shows
that the gap between inflation and inflation expectations is proportionate
to the difference between actual and equilibrium unemployment.
Equation (4) shows that the gap between actual and potential output
is also proportional to the difference between actual and equilibrium
unemployment. Putting these together lets us find the short-run aggregate
supply curve (equation 5) which shows the relationship between the gap
between actual and potential output and the gap between inflation and
inflation expectations.
One of the central points in this section is the correspondence between
the Phillips curve and the aggregate supply curve (see Figure 22.6 and
associated discussion). We can see this mathematically by recalling from
the previous block that aggregate supply can be written:
Y = Y* + α(π – πe)
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When reading news reports on the state of the economy, you may have
come across the term ‘NAIRU’, this is an acronym which means the ‘non-
accelerating-inflation rate of unemployment’. This is the unemployment
rate consistent with maintaining stable inflation. It is similar to the natural
rate of unemployment discussed in this current chapter.4 Understanding 4
The natural rate of
the accelerationist hypothesis from this concept lets us understand unemployment can
be seen as a more
where the terminology of the NAIRU comes from. When output is at its
long-term concept,
potential level, the unemployment rate is not zero, even though this state whilst the NAIRU can
is sometimes referred to as the ‘full employment level of output’. There will be interpreted as the
be a certain level of unemployment that is not caused by a lack of demand, unemployment rate
but rather is caused by the movement of people between jobs (frictional consistent with steady
unemployment) or a mismatch in the skills that workers have and inflation in the near
term. In full equilibrium,
the skills demanded by employers (structural unemployment). If
they are the same.
unemployment is pushed below its natural rate, or below the NAIRU,
inflation will tend to accelerate. To decrease unemployment permanently
without generating inflation, governments try to decrease the NAIRU by
increasing the efficiency of labour markets and focusing on skills, such as
through retraining programmes.
From our analysis above, and that in concept 22.2 which you have just
read, it is clear that people’s expectations about inflation are crucial. If
we rewrite the above equation with time subscripts, t, t = te – b(ut – u*)
and assume that people expect this period’s inflation to be the same as last
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Block 18: Inflation
periods we can write: t = t–1 – b(ut – u*) then we can see that if policy
makers keep current inflation above last period’s inflation they can hold
unemployment below the natural rate. If instead of assuming that t = t–1
e
Activity SG18.3
Based on Figure 22.6, use the LRAS and the long-run Phillips curve, together with the
short-run curves, to depict what will happen to output, unemployment and the price level
when there is:
a. a negative shock to aggregate demand in the context of a credible, constant inflation
target
b. an expectation that the inflation rate will rise and that the central bank will not be
able to contain this
c. the productivity of the labour force increases permanently (for example due to
changes in the county’s education and training systems)
d. a temporary adverse supply shock that is not fully accommodated.
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EC1002 Introduction to economics
This section discusses the costs of inflation, which are very different to what
many people think. In thinking about the costs of inflation it is important to
ask the following. Is the inflation expected (anticipated) or unexpected? If
expected, has the economy adjusted and adapted to the expected inflation?
Where inflation is fully anticipated and all tax rates, nominal interest rates,
wage rates etc. have all fully adjusted then the remaining costs of inflation
are shoe leather costs and menu costs (make sure you understand
these concepts). Where nominal magnitudes have not adjusted there can be
further costs; if tax brackets have not adjusted to inflation (‘bracket creep’
or ‘fiscal drag’) taxpayers will find themselves with a higher real tax burden
(governments gain). Similarly, if capital gains tax (CGT) is levied on the
nominal value of assets people can find themselves paying CGT on assets that
have not increased in real value; again taxpayers lose and governments gain.
When inflation is unexpected or unanticipated there are different types of
costs.
Say inflation is greater than expected. If nominal interests are indexed
to expected inflation then lenders will lose because the real interest rate
they receive (the nominal rate minus the rate of inflation) is less than they
expected. On the other hand borrowers benefit. Similarly if nominal wages
are indexed to expected inflation and actual inflation exceeds expectations
workers receive lower real wages than expected. Firms benefit, on the other
hand, because their real wage costs are lower than expected. Further costs
are incurred if inflation is very volatile or uncertain. Not only does this make
planning and writing contracts more difficult but imposes direct utility costs on
risk averse individuals or firms. To the extent that higher average inflation is
associated with more volatile inflation (there is some evidence for this) this is
another argument in favour of maintaining inflation at reasonably low levels.
This is not to say that zero inflation would be a sensible target either. Low
and stable inflation has benefits as well as costs. One of these, seigniorage,
we have already discussed above. Another benefit of low inflation arises from
noting that zero inflation would provide no margin of error in protecting
against deflation (and the warning of the perils of deflation in Case 22.1
– ‘Public enemy number two’ – is timely. At the time of writing this subject
guide in 2015, several Eurozone countries have negative or extremely low
inflation). An inflation rate of 2 or 3 per cent can allow for unexpected price
falls without tipping the economy into deflation. Inflation rates of this order
of magnitude are also helpful if governments want to engineer negative real
interest rates to stimulate investment and consumption. Suppose equilibrium
interest rate in the long-run is 2 per cent (supply equals demand at the
equilibrium or natural level of output in goods markets). If the economy has 3
per cent inflation then nominal rates are 5 per cent. Suppose the government
wants to stimulate the economy in the short-run. It can engineer a reduction
of nominal rates to 0 per cent (but not lower, we assume). This reduces real
interest rates to –3 per cent (nominal interest rate minus rate of inflation)
as long as inflation stays at 3 per cent. On the other hand, if this economy
started with 0% inflation then both real and nominal rates are 2 per cent. In
these circumstances the best the government can do is reduce to the nominal
and real interest rate to zero – which obviously provides less of a stimulus
than a rate of –3 per cent.
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Block 18: Inflation
Activity SG18.4
You can use the following website to find inflation figures for your country and see how
these changed during the financial crisis. Was there deflation in your country between
2007 and 2009? http://databank.worldbank.org/data
Controlling inflation
► BVFD: read sections 22.6 and 22.7 and complete activity 22.1.
While Sections 22.6 and 22.7 are about controlling inflation we have
already dealt with the analytics of this in the previous block and in
Chapter 21 of BVFD (Sections 21.6 through 21.8, including discussion of
the Taylor rule). The final two sections of the current chapter add some
real world institutional context. They describe how credible low inflation
targets are used to get inflation under control, and how this has been
relatively successful in the past 20 years. Central bank independence
has been an important part of this. Nonetheless, deciding where to set
interest rates to achieve an inflation target is no easy task. There are
continual shocks to the economy of various sizes, and it is not always
easy to distinguish permanent and temporary demand and supply shocks,
or to know how best to respond to these. Many central banks publish
reports after their committee meetings, detailing why they have decided
to maintain or to change interest rates.6 Transparency regarding their 6
You can find the Bank
decision making process also helps to keep inflationary expectations in of England’s quarterly
inflation reports here:
line.
www.bankofengland.
co.uk/publications/
► BVFD: read the summary and work through the review questions.
Pages/inflationreport/
default.aspx
Overview
The chapter started by looking at the quantity theory of money, which is
based on the equation of exchange (MV = PY) and argues that increases
in the price level are a direct result of increases in the money supply.
Reasons why this may not hold in the short run include the fact that
income and the velocity of money and may not be constant. Next, the
Fisher hypothesis was introduced, which states that higher inflation leads
to higher nominal interest rates such that real interest rates do not change
greatly. This can be expressed by the Fisher equation: real interest rate =
nominal interest rate – inflation. Furthermore, the relationship between
inflation and government indebtedness was discussed. Governments
with excessive debts may be tempted to print money – though there is
some scope for revenue generation through seigniorage and the inflation
tax, this approach is very risky and can result in hyperinflations. In most
advanced economies, we do not expect a close relationship between
deficits and money creation. A very important topic covered in this block
is the Phillips curve. The short-run Phillips curve demonstrates a trade-
off between inflation and unemployment in response to demand shocks.
The long-run Phillips curve is vertical at equilibrium unemployment.
Permanent supply shocks shift the long-run Phillips curve left or right,
while temporary supply shocks shift the short-run Phillips curve higher or
lower. Inflationary expectations also shift the short-run Phillip’s curve, in
part because people’s expectations regarding inflation affect negotiated
wages and nominal wage growth. Stagflation is the situation where
unemployment and inflation are both high. The costs of inflation are
different to what many people think – not simply higher prices, but other
costs such as shoe-leather costs and menu costs, as well as undesirable
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EC1002 Introduction to economics
226
Block 18: Inflation
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EC1002 Introduction to economics
Notes
228
Block 19: Unemployment
Introduction
A microeconomic approach to studying unemployment was introduced in
Block 10. This described disequilibrium in the market for labour, which
occurred due to wages being above the market clearing level for reasons
such as minimum wage laws, trade union power and efficiency wages.
Until the Great Depression of the 1930s, it was generally accepted in
economic theory that unemployment was solely the consequence of wages
being higher than the equilibrium wage rate and that in time, wages
would adjust naturally so that the labour market would clear. The events
of the 1930s, including very high levels of persistent unemployment,
shifted attention to the potential ‘stickiness’ of wages (i.e. the fact that
wages may not fall despite high levels of unemployment) and the level of
aggregate demand in the economy. This change was primarily thanks to
the revolutionary ideas of British economist John Maynard Keynes, who
published his best-known work The general theory of employment, interest
and money in 1936. A major policy recommendation from this work
was that governments should help reduce unemployment by increasing
government spending to substitute for a lack of demand from private
consumption and investment.
A macroeconomic approach to studying unemployment thus emphasises
the role of aggregate demand, especially any gaps between actual and
potential output. At the same time, market imperfections which cause
wages to be ‘sticky’ above the market-clearing equilibrium level are also
important factors in determining the rate of unemployment in an economy.
Key themes of this block thus include the different types of unemployment,
as well as their causes and various policies for reducing unemployment.
Although there is a positive role for short-term frictional unemployment in
terms of workers moving between jobs and achieving a better skills-match,
in general, unemployment is associated with large costs on both a personal
and societal level. As such, low unemployment is one of the three major
macroeconomic goals of economic policy, along with steady growth and
low inflation.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• discuss measured unemployment, both claimant count and
standardised rate
• define classical, frictional, structural and demand-deficient
unemployment
• distinguish between voluntary and involuntary unemployment
• analyse determinants of unemployment
• explain how supply-side policies reduce equilibrium unemployment
• evaluate private and social costs of unemployment
• explain hysteresis.
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EC1002 Introduction to economics
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 23.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapter 21; UK edition,
Chapter 23.
Witztum (AW), Chapter 9, section 9.3.
Rates of unemployment
► BVFD: read the introduction to Chapter 23.
230
Block 19: Unemployment
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
82
10
90
92
08
00
12
94
98
88
02
84
04
86
96
06
19
20
19
19
20
20
20
19
19
19
20
19
20
19
19
20
Figure 19.1 Malaysia: Unemployment rate.
Source of data: Department of Statistics, Malaysia www.statistics.gov.my/index.
php?r=column/ctimeseries&menu_id=NHJlaGc2Rlg4ZXlGTjh1SU1kaWY5UT09
Reproduced with kind permission.
High unemployment rates in the 1980s were due to a combination of
various factors, including an international recession, the collapse of
commodity prices, weak competitiveness in technology, large outflows
of foreign capital and capital-intensification in the manufacturing sector
(Yi, 2003).2 2
Yi, Ilcheong The
national patterns of
Activity SG 19.1 unemployment policies
in two Asian countries:
Find out what the trend has been in the country where you live.
Malaysia and South
Korea. (Working Paper
► BVFD: read section 23.1 and case 23.1. 15: Stein Rokkan Center
for Social Studies,
This section contains several important definitions – the labour force; the Bergen University
participation rate and the unemployment rate. The relationships between Research Foundation,
2003) Available at:
these variables can be expressed by the following equations:
www.ub.uib.no/elpub/
• Let the number of employed people be E (these are people who work rokkan/N/N15-03.pdf.
for at least one hour per week).
• Let the number of unemployed people be U (these are people who are
actively seeking work).
• Let the labour force be LF (those who are either employed or looking
for work).
• Let people who are not in the labour force be NFL (these are ‘inactive’
and include homemakers, students who are not working, people who
are too sick to work, etc.).
• Let the working age population be P:
Working-age population: P = LF + NLF
Unemployment rate: u = U/LF
Employment rate: e = E/P
Labour force participation rate: lfp = LF/P.
Activity SG19.2
What is the unemployment rate in a country with a working-age population of 1,000, a
labour force participation rate of 80% and 100 unemployed people?
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EC1002 Introduction to economics
Activity SG19.3
Why do you suppose the incidence of long-term unemployment is so low in Korea?
This section also highlights that youth unemployment is often higher than
unemployment for the labour force as a whole. Young people tend to have
unemployment rates that are higher than the national average, partly
because they generally have less work-experience. In recent years, many
countries have seen extremely high levels of youth unemployment. For a
data visualisation of this problem on a global scale, interested students
should see: www.weforum.org/community/global-agenda-councils/youth-
unemployment-visualization-2013
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Block 19: Unemployment
Analysis of unemployment
► BVFD: read section 23.2 and concept 23.1.
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EC1002 Introduction to economics
Activity SG19.4
Match the concept of unemployment with its definition in the schematic below.
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Block 19: Unemployment
Changes in unemployment
► BVFD: read section 23.3 and complete activity 23.1.
This section is also UK oriented but in reading the material, do your best
to extract the general principles. For example, the four key reasons cited
for changes in equilibrium unemployment are likely to apply not just to
the UK and you should make sure you understand them clearly and can
explain them using the diagrammatic framework (LD, AJ, LF) used in
BVFD. The specific conclusions drawn depend, of course, on being able
to separate actual from equilibrium unemployment when looking at the
unemployment data for a given economy. The reason that BVFD don’t
explain how this is done is because the separation requires understanding
of technical statistical techniques that go beyond what can be covered
in an elementary course. It is perhaps worth saying that estimates of
equilibrium unemployment are likely to be subject to a considerable
margin of error. That does not mean that it is not worth making such
estimates. As explained in the chapter, if observed unemployment coincides
with equilibrium unemployment then governments should not attempt to
reduce it by expanding aggregate demand, but instead need to address the
underlying structural factors, largely on the supply side, that determine
equilibrium unemployment. This is valuable information for policy makers.
An income tax can be seen as a tax on sellers, since workers are supplying
their labour to the firm and income tax reduces the incentives for workers
to supply their labour. This would be represented in Figure 23.9 by an
upward sloping line parallel to and to the left of AJ, passing through point
A. Alternatively, it can be described, as it is in this maths box, as a factor
that shifts demand for labour, since firms care about the gross cost of
hiring workers. This would be represented in Figure 23.9 by a downward
sloping line parallel to and below LD, passing through point B.
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EC1002 Introduction to economics
Activity SG19.6
Use the (LD, AJ, LF) framework to illustrate the effects of the following supply-side factors
on unemployment:
a. a rise in the use of online employment websites for job search decreases skill
mismatch
b. a fall in unemployment benefit, decreasing the replacement rate
c. a fall in trade union power
d. an increase in marginal tax rates.
Activity SG19.7
Based on the equations in Maths 23.1, let a = 10, b = 0.2, c = 0.3, e = 30, f = 1, t = 10
a. Draw a graph of this initial setup with two labour demand curves – with and without
the tax.
b. Calculate equilibrium unemployment.
c. How does equilibrium unemployment change when the tax is reduced to 5? Draw this
line onto your diagram as well.
d. Imagine c was in fact equal to 0.8 – now calculate equilibrium unemployment when t
is equal to 10 and when t is equal to 5.
Cyclical unemployment
► BVFD: read section 23.4 and case 23.2.
The way that cyclical unemployment is defined in L&C (UK edition p.573;
international edition p.473) helps to connect the analysis here with
what was learned in the previous chapters – ‘Cyclical unemployment, or
demand-deficient unemployment, occurs whenever there is a negative
GDP gap’ (i.e. total demand is insufficient to purchase all of the economy’s
potential output, causing a recessionary gap in which actual output is
less than potential output). Cyclical unemployment can be measured as
‘the number of people who would be employed if the economy were at
potential GDP minus the number of persons currently employed’.
While section 23.3 focused on supply-side policies to address
unemployment, this section discusses the use of counter-cyclical demand
management policies. Keynes’ original policy recommendations to
address the extremely high unemployment levels of the 1930s focused on
increasing government spending to offset the lack of private consumption
and investment. He argued it didn’t necessarily matter what the money
was spent on (though of course he favoured productive projects) – what
was important was to increase aggregate demand. This would lead to
economic growth and a fall in unemployment. Keynesian ideas strongly
influenced the US Presidents Herbert Hoover and Franklin D. Roosevelt,
who embarked on extensive public works programmes including the
building of roads and bridges as well as relief programmes providing
housing support, food, medicines, and other basic necessities to the
unemployed. The massive spending undertaken as countries invested
in armaments for the Second World War has been credited with finally
ending the mass unemployment of the depression years.
Various countries also used expansionary fiscal policy in an attempt to
re-stimulate their economies after the recent credit crunch. For example,
the US Economic Stimulus Act of 2008 (a $152 billion stimulus consisting
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Block 19: Unemployment
Flexible labour markets: Recall from the section above on the natural rate
of unemployment the definitions of j (the rate of job loss) and h (the rate
of hiring). The figure in this Case displays (approximately) the equivalent
of j plus h over the period of a year, for each of the countries shown.
Cost of unemployment
► BVFD: read section 23.5 and concept 23.2.
Hysteresis
Concept 23.2 outlines four reasons why hysteresis (a temporary fall in
demand inducing permanently lower output and employment) may occur
and its policy implications. The existence of hysteresis is one reason why
governments are so eager to prevent unemployment rising in the first
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EC1002 Introduction to economics
place. Hysteresis also undermines the strict classical view of the natural
rate of unemployment whereby fluctuations in demand affect only short-
run output, employment and unemployment, all of which return to their
underlying classically-determined levels in the long run. If hysteresis could
be established empirically as a significant phenomenon, and there is still
controversy on this point, then recessions could raise the natural rate of
unemployment, leaving the economy permanently scarred.
Overview
The total working-age population consists of the labour force and those
who are ‘inactive’. The labour force consists of the employed plus the
unemployed. The participation rate is the labour force divided by the
total population. The unemployment rate is the unemployed divided by
the labour force. Unemployment can be classified as frictional, structural,
classical or demand-deficient unemployment. BVFD define ‘voluntary’
unemployment, or equilibrium unemployment, to include frictional,
structural and classical unemployment. Involuntary unemployment is
equivalent to demand-deficient unemployment, also known as cyclical or
Keynesian unemployment. The natural rate of unemployment is defined
as the equilibrium rate of voluntary unemployment. Temporary recessions
lead to increased cyclical unemployment. This can be addressed using
the demand-management tools of fiscal and monetary policy. A one
per cent increase in output is likely to lead to a much smaller reduction
in cyclical unemployment due to increases in hours worked by those
currently employed and increased numbers joining the labour force. In
the long run, the only way to reduce unemployment permanently is to
reduce the natural rate of unemployment through supply-side policies
such as reducing mismatch through better information and retraining,
reducing trade union power, cutting the marginal rate of income tax
and reducing unemployment benefits (of course, society may choose
a higher equilibrium rate of unemployment rather than adopt some of
these policies). There is also a link between cyclical unemployment and
the natural rate of unemployment, since short-run changes can move the
economy to a different long-run equilibrium. This is known as hysteresis.
Most forms of unemployment, apart from frictional unemployment, are
associated with large personal costs including lost income, an erosion of
human capital and psychic costs, as well as social costs including a loss of
output and aggregate income, increased inequality, a loss of human capital
for the society as a whole resulting in lower productivity, and the effects
on the public finances of unemployment benefits and lost tax revenue.
Low unemployment is one of the three major macroeconomic goals of
many governments, along with steady growth and low inflation.
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Block 19: Unemployment
-2
240
Block 20: Exchange rates and the balance of payments
Introduction
This block examines the international sector in some detail. Net exports
has been part of our model of the economy since Block 13 (the very
first macro block), but we have not explored it in any depth. However,
interactions with other countries play an important role in almost all
economies. Globalisation has meant that the world is now very integrated,
such that countries cannot operate independently from each other. As well
as trade flows, there are also massive capital flows in foreign exchange,
shares and bonds, and other financial instruments. This block provides the
tools to analyse the international sector and its impact on the domestic
economy.
Throughout the block, the UK is used as the ‘domestic’ economy and
pound sterling as the ‘domestic’ currency. A choice had to made, but US
textbooks would use the dollar as the domestic currency and Malaysian
textbooks the ringgit. In following the analysis, use whatever you are most
comfortable with as the domestic and foreign currencies, but always pay
attention to which way the exchange rate is defined (foreign in terms of
domestic or vice versa).
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• analyse the foreign exchange market
• discuss balance of payments accounts
• explain determinants of current account flows
• define perfect capital mobility
• assess speculative behaviour and capital flows
• define internal and external balance
• analyse the long-run equilibrium exchange rate.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 24.
Further reading
Lipsey and Chrystal (L&C) international edition Chapter 22; UK edition
Chapter 24.
Witztum (AW), Chapter 14.
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EC1002 Introduction to economics
in the block. Under floating exchange rates, the balance of payments will
balance automatically, though when exchange rates are fixed, there is a
need for government intervention so that the current account and capital
and financial accounts offset each other. This block also introduces real
and purchasing power parity exchange rates as well as the interest parity
condition. Finally, the block also discusses the importance of external
balance as well as long-run trade balance between countries.
The exchange rate is the number of units of one currency that exchange
for a unit of another currency. A fall (rise) in the exchange rate is called
depreciation (appreciation). The exchange rate is just a price – the price
of one currency in terms of another. This price can rise or fall, like any
other price. As stated above and in the text, it is important to keep track
of which way round the price is expressed – the foreign value of the
domestic currency or the domestic value of the foreign currency. Where
we think of the exchange rate as the international or foreign price of the
domestic currency a lower exchange rate makes the domestic economy
more competitive (see the BVFD example of whisky with a UK price of £8
per bottle). Activity SG20.1 gives you some practice at keeping track of the
sometimes confusing concept of the exchange rate.
Activity SG20.1
Complete the following table:
You are in Exchange Rate International value of the What does it mean? (i.e. how
domestic currency, or domestic much of one currency can you
price of foreign exchange? buy for the other?)
UK $US1.571/£
Germany 1.244€/£
Malaysia $US0.286/MR
UK £0.804/€
It is common to assume the demand for imports is elastic and draw the
supply curve of currency sloping upwards. When demand for imports is
elastic, a fall in the $/£ exchange rate (the pound getting weaker against
the dollar) will lead to a fall in the volume of imports (since US goods
are now more expensive for UK residents), and this fall in volume will
be proportionately larger than the increased price of imports. Therefore,
fewer pounds in total will be spent on imports. Thus there is a positive
relationship between the exchange rate and the supply of pounds, and the
supply curve slopes upwards (when demand for imports is elastic).
Trade is often analysed as taking place between two countries (this
enables use of simple diagrammatic techniques among other things) and
242
Block 20: Exchange rates and the balance of payments
This section discusses fixed and floating exchange rates. This analysis
is essentially the same as standard supply and demand analysis, except
that when the price (the exchange rate) is fixed, this fixed price has to be
maintained by the central bank of the domestic country buying or selling
the foreign currency (although in practice the central banks of both the
domestic and foreign countries may work together to maintain the fixed
exchange rate).
To test your understanding of the basic supply and demand framework
answer the following multiple choice question.
Activity SG20.2
Assume that the UK is the domestic country (and the central bank is the Bank of England)
and that the exchange rate ($/£) is fixed. Supply the correct combination to fill the gaps
in the following sentence.
If, at the fixed exchange rate the pound (£) is ……………… the Bank of England must
……….. pounds and its dollar ($) reserves will ……..
a. overvalued buy rise
b. overvalued sell rise
c. undervalued buy rise
d. overvalued buy fall
Between these two extremes there are other methods of how the
government allows exchange rates to be determined. These include (for
example) a crawling peg system, where a country’s currency is pegged to
the value of another currency, but the government explicitly recognises
that this will be allowed to change from time to time, when needed;
and a managed float, where the currency is allowed to move freely, but
the government participates in the market to damp large fluctuations.
Exchange rate regimes are represented below as a continuum, with the
most government involvement on the left and the most market flexibility
on the right.
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EC1002 Introduction to economics
The balance of payments consists of the current account and the capital
and financial accounts as well as any balancing item required because of
statistical discrepancies. The current account records transactions arising
from trade in goods and services; income (i.e. employee compensation and
investment income paid to and received from people, business or assets in
other countries; and transfers such as the government paying a pension to
someone living abroad or people sending money to relatives abroad). The
capital and financial accounts record transactions related to international
movements of ownership of financial assets, such as shares, bank loans
and government securities. Under floating exchange rates, the balance of
payments is always equal to zero. To see this it is helpful to return to our
national income identity:
Y=C+I+G+X–Z
∴Y–C–G–I=X–Z
But Y-C-G is national savings, so S – I = X – Z
S-I is a country’s net capital outflow (the excess of domestic savings over
investment is lent to foreigners), sometimes called net foreign investment.
Therefore if S-I and the trade balance, X-Z, are both positive the domestic
country is, in net terms, lending to foreigners to enable them to purchase
more of the domestic country’s exports (foreign Z) than they can finance
by exporting to the domestic country (domestic Z). The trade surplus is
matched by a deficit (net capital outflows) on the capital and financial
accounts. Conversely, if the domestic country runs a trade deficit, S-I is
negative and the domestic country is borrowing from abroad to enable
it to import more than it exports. Positive net capital inflows lead to a
surplus on the current and financial accounts to offset the trade deficit.
The argument here, of course, abstracts from balancing items (statistical
discrepancies). There is more detail on the components of the current and
financial accounts in sections 24.5 and 24.6.
Under fixed exchange rates the balance of payments is not necessarily
equal to zero and official financing may be required to ensure that overall
demand and supply of currency are equal and the fixed exchange rate is
maintained. Table 24.2 helps to clarify this section.
Activity SG20.3
Complete the following multiple choice questions, providing a reason for your answer.
1. The value of a country’s exports is listed in its balance of payments account as:
a. a credit
b. a debit
c. a payment
d. an investment.
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Block 20: Exchange rates and the balance of payments
real exchange rate = RER = price of Malaysian Big Mac in terms of US Big Mac
(USD/MYR nominal exchange rate)PM
or RER =
P US
(0.28 USD/MYR)(7.63MYR/Malaysian Big Mac)
=
(4.79USD/US Big Mac)
US Big Macs
= 0.45
Malaysian Big Macs
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EC1002 Introduction to economics
(i.e. at current prices and the current nominal exchange rate) one obtains
0.45 of a US Big Mac per Malaysian Big Mac. If the exchange rate reflected
PPP a Big Mac would cost the same in both countries. Clearly, at the
nominal exchange rate a Big Mac is much cheaper in Malaysia than in
the USA. In fact, one can get 2.27 (4.79/2.11) Big Macs in Malaysia for
each US Big Mac. What does this say about the value of the Malaysian
ringgit versus the US dollar? It tells us that the ringgit is undervalued. To
see this, imagine Malaysia could export its Big Macs to the USA and sell
them for $2.11 (transport costs and food decay are ignored here just to
illustrate the basic principle). There would be a big demand for ringgits by
US importers and this would bid up the dollar price of ringgits. Americans
would have to pay more dollars for their ringgits. How much more? This
question is answered by calculating x in 7.63x = 4.79. x is the dollar cost
of a MYR, and the equation calculates what this would have to be in order
for an imported Big Mac to cost the same as a domestically made one. The
answer is $0.63 (63 cents).
When the dollar value of the ringgit increases from 28 to 63 cents it is
no longer advantageous to import Big Macs from Malaysia. Equivalently,
while the nominal exchange rate is 1USD = 3.62MYR, the implied PPP
exchange rate is 1USD = 1.59MYR (1/0.63). At the current nominal
exchange rate the ringgit is undervalued by (3.62 – 1.59)/3.62 (i.e. 56
per cent). Obviously this is an oversimplified example and it would not
be sensible to defend the precise 56 per cent undervaluation too strongly;
among other shortcomings of our example, transport costs cannot be
ignored, nor can trade barriers and in calculating PPP one needs to use the
price of basket commodities not just the price of a Big Mac. However, the
basic lesson is that calculations of real exchange rates can tell us whether
nominal exchange rates fundamentally undervalue or overvalue a currency
and consequently whether there is pressure for the currency to appreciate
or depreciate.
For more information on this see: www.economist.com/content/big-mac-
index
Recall from Block 13 that one of the long response questions asked you
to compare the real GDP of two countries using PPP figures. Using the
PPP exchange rate, rather than $US for example, helps provide a better
understanding of the standard of living in each country. Non-traded
goods and services tend to be cheaper in low-income than in high-
income countries and any analysis that doesn’t take these differences into
account will tend to underestimate the purchasing power of consumers in
emerging market and developing countries and, consequently, their overall
welfare.
The balance of payments consists of the current account, the capital account
and the financial account (ignoring the statistical discrepancy). Under
floating exchange rates, the current account is exactly equal and opposite in
sign to the sum of the capital and financial accounts. Section 24.5 discusses
the current account. The capital account is generally very small and is not
discussed here. Section 24.6 discusses the financial account.
To understand section 24.5 on the determinants of the current account,
you should be clear on the relation between the real exchange rate
(RER) and exports (X) and imports (Z). The lower the RER, the cheaper
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Block 20: Exchange rates and the balance of payments
are domestic goods relative to foreign goods; this increases exports and
decreases imports. If you understand this you will see that the following
relationship exists between the RER and net exports (X – Z), again taking
the UK as the domestic and the USA as the foreign country (this diagram is
essentially the same as Figure 24.4 in BVFD):
RER
($/£)
X-Z
Figure 20.2: Relationship between RER and net exports.
The volume of forex traded internationally is many times as great as global
GDP. While some of this is required for international trade in goods and
services, it has been estimated that at least 80% of the global currency
market consists of exchange rate speculation. Speculation can lead to a
lot of volatility and it is argued that it has been one of the major causes
of several large financial crises such as those in Mexico (1994), South
East Asia (1997–98), Russia (1998), Brazil (1999), Turkey (2000) and
2
www.globalpolicy.org/
Argentina (2001).2
global-taxes/currency-
Regarding Table 24.5, if you check the calculations, you will notice transaction-taxes.html
that when the exchange rate is exactly 1.8 US$/£, $200 actually equals
£111.11 and not £110. This difference may be due to rounding, since the
figure of £110 is attained when the exchange rate is 1.81 US$/£. Be sure
to examine this table in conjunction with the text as the surrounding text
explains the meaning more clearly than just the table by itself.
This maths box shows that the interest parity condition3 – expected 3
In fact what is covered
exchange rate changes offset the differences in the returns between in this section is the
uncovered interest rate
domestic and foreign assets – applies for both nominal and real interest
parity condition. There is
rates and exchange rates. You will not be required to use the equations an analogous condition,
from this maths box in the examination, but you do need to understand the covered interest
the general principle of interest rate parity. The basic idea is that, with rate parity condition,
international mobility of capital, the return to investing in two different which makes investors
countries will be equalised – if not there will be the potential for profiting indifferent between the
interest rates in two
from any difference in returns by shifting capital between countries
countries when they can
(arbitrage). So if interest rates differ in two countries this must be offset by hedge against exchange
expected changes in the exchange rate in order to achieve the no-arbitrage rate risk in the forward
condition. The return to investing abroad is the interest rate earned abroad exchange rate market.
plus the capital gain if the domestic currency depreciates (the overseas
currency now buys more units of the domestic currency when the invested
funds are returned to the home economy). This is captured in the ‘verbal
equation’ (2) on p.554 (just above the maths box), i.e.
Return on domestic asset = return on foreign asset
= foreign interest rate + % depreciation of exchange rate while funds abroad
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EC1002 Introduction to economics
Long-run equilibrium
► BVFD: read sections 24.7 and 24.8.
BVFD argue that ‘in long-run equilibrium, both internal and external
balance must hold’ (p.556). The long-run equilibrium exchange rate must
thus be compatible with internal and external balance. The next chapter,
on open economy macroeconomics, takes this assumption as the basis for
much of the reasoning.
However, long-run equilibrium is an analytical construct not often
approached in reality. In practice it can be argued that a current account
deficit is neither intrinsically ‘good’ nor ‘bad’. There are countries such as
Australia (a small open economy) which have sustained current account
deficits for several decades. The IMF writes that ‘whether a country should
run a current account deficit (borrow more) depends on the extent of
its foreign liabilities (its external debt) and on whether the borrowing
will be financing investment that has a higher marginal product than
the interest rate (or rate of return) the country has to pay on its foreign
liabilities’.4 This means that running a current account deficit (investing 4
www.imf.org/external/
more than is saved domestically) can be a good idea, even in the long- pubs/ft/fandd/basics/
term, if it is manageable and the incoming capital flows are being invested current.htm
productively, generating more wealth for the next generation out of which
the country’s debts can be repaid.
Despite this, external balance is nonetheless important in the sense
that global imbalances can have severe consequences. For example, it is
thought that the current imbalance between the USA and China – where
the USA has massive trade deficits and China has massive trade surpluses
(partly a result of the undervalued Chinese yuan) – helped establish the
conditions which contributed to the recent financial crisis.
The following block (covering textbook Chapter 25) focuses on internal
and external balance as a way of examining the effects of various fiscal
and monetary policy stances under different types of exchange rate
mechanisms and different assumptions concerning capital mobility.
► BVFD: read the summary and work through the review questions.
Overview
This block firstly introduces exchange rates, which express the price of
one country’s currency in terms of another country’s currency. Exchange
rates are determined by the supply and demand for currency, arising
from exports/imports and trade in assets. Floating exchange rates equate
demand and supply, while fixed exchange rates require government
intervention in the forex market (buying or selling domestic or foreign
currency) so that supply and demand are equated. The real exchange rate
takes into consideration the domestic and international price levels.
The balance of payments consists of the current, financial and capital
accounts. Monetary inflows are recorded as credits and outflows as
debits. Under floating exchange rates, the balance of payments is always
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250
Block 21: Open economy macroeconomics
Introduction
Having been introduced to fixed and floating exchange rates in the
previous block, this block examines the workings of the economy under
different exchange rate regimes, as well as different assumptions regarding
capital mobility.
By this stage in your studies, the chain of reasoning for why a change in
one variable may impact on another variable has become quite long. As
you read through this chapter of the textbook, it is important to take your
time to think through each step – keep asking yourself ‘why is that the
case?’. Understanding each step of the argument will help to make the
whole picture clear.
Although there is some discussion of adjustment to other shocks, the focus
of this block is on macroeconomic policy – the effectiveness of fiscal and
monetary under different exchange rate regimes and assumptions about
capital mobility. You will see that the exchange rate regime a country
adopts has a profound impact on the way the economy operates and how
it can be managed.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• describe price and output adjustment under fixed exchange rates
• explain the effects of a devaluation
• describe what determines floating exchange rates
• use the IS–LM–BP framework to analyse changes in monetary and
fiscal policy under fixed and floating exchange rate regimes.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 25.
Further reading
Witztum (AW), Chapter 14.
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Block 21: Open economy macroeconomics
LM
r* BP
IS
Y*
BP
r* r*
IS IS
Y* Y*
Activity SG21.1
Assuming fixed exchange rates and perfect capital mobility, use the IS-LM-BP framework
to demonstrate the effects of an increase in demand for exports on output and interest
rates.
When there is free capital mobility, countries can fix only one of the
following three: the interest rate, the exchange rate and the money supply.
Countries which peg their exchange rates to another country’s currency
cannot operate an independent monetary policy to address internal
inflation and aggregate demand issues, since domestic interest rates can
only be used to defend the fixed exchange rate. BVFD discuss how the
economy gets back to internal and external balance after a shock despite
not being able to pursue independent monetary policy. Since the domestic
price level is assumed to be constant in the IS-LM model, and since
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EC1002 Introduction to economics
The Tobin tax – Although there is still opposition to this idea, support for
a ‘Tobin tax’ is now quite widespread. It is likely that some (though not
all) member countries of the European Union will introduce a financial
transaction tax (FTT) in the coming years. It has been estimated that in
the year 2000, 80 per cent of foreign-exchange trading took place in just
seven cities and 58 per cent of speculative trading took place in just three:
London, New York and Tokyo. This means that even limited adoption of
such a tax could already have a large impact – it is not necessary for there
to be full global agreement for the beneficial effects of this strategy to be
felt. As well as dampening speculation, the tax has enormous revenue
raising potential.
The following graphs show how IS-LM-BP can be used to show monetary
and fiscal policy under fixed exchange rates and perfect capital mobility.
Monetary policy, fixed ER, perfect CM Fiscal policy, fixed ER, perfect CM
LM LM
LM’ LM’
ձ ձ
ղ
ղ r1
r* BP r* BP
IS’
IS IS
Y* Y Y1 Y2
Figure 21.2: Monetary and fiscal policy under fixed exchange rates and perfect
capital mobility.
In the diagram on the left above, if the government attempts to use
expansionary monetary policy the LM curve would shift right (1),
lowering domestic interest rates and sparking massive capital outflows as
investors switch to higher yielding foreign assets. The central bank buys
the unwanted domestic currency (selling foreign exchange), reducing the
money supply and causing the LM curve to shift leftward again (2). Thus
in an open economy with fixed exchange rates and perfect capital mobility,
monetary policy is not available as an option to combat inflation or to
affect the level of output, as any deviation from world interest rates will
lead to massive capital flows and the effect on money supply will need to
be offset by the central bank to protect the exchange rate, thus restoring
interest rates to their original level.
In the diagram on the right, the government uses an increase in G to
expand the economy. The IS curve shifts outwards (1) (Y increases to
Y1), interest rates are above the foreign level, and capital inflows result.
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Block 21: Open economy macroeconomics
To purchase the foreign exchange, the central bank sells the domestic
currency, increasing the money supply and shifting the LM curve outwards
(2) causing a further increase in output Y1 → Y2. Fiscal policy is actually
more effective in this scenario than in a closed economy. This is because
interest rates are held constant to protect the exchange rate, so there is no
crowding out of private investment as there would be in a closed economy
when expansionary fiscal policy is implemented.
This maths box shows that under floating exchange rates, there is a
negative relationship between output and inflation when the government
pursues a monetary policy where they raise interest rates when inflation
is higher. Under a fixed exchange rate, however, there are two ways in
which the price level is related to output – through real interest rates,
and through real exchange rates. Since nominal interest rates are fixed,
higher inflation leads to lower real interest rates – which boost aggregate
demand. On the other hand, higher inflation leads to an increase in the
real exchange rate and a fall in competitiveness, reducing aggregate
demand. The AD curve will slope down as long as the second effect
dominates the first. Work through the equations in this maths box to make
sure you understand this result.
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EC1002 Introduction to economics
0
t0
Time
Activity SG21.2
What policy measures should accompany a devaluation of a pegged exchange rate to
ensure optimal results in the medium term? Under what circumstances is a devaluation
likely to have the most positive impact on the economy?
The following is a key sentence of section 25.4: ‘in the long run, floating
exchange rates adjust to achieve the unique real exchange rate compatible
with internal and external balance’. In the short run, exchange rates
can be very volatile. They respond to current interest rate differentials
and inflation differentials between countries, expectations regarding the
future long-run value of the exchange rate and new information which
changes people’s expectations regarding interest rates, inflation or the
long-run equilibrium exchange rate. In working through the explanation
of Figure 25.4 remember that the key assumptions are first that there
are no long-run differences in interest rates between countries and
second that adjustment of the exchange rate to eliminate interest rate
differentials follows interest rate parity, with positive (negative) interest
rate differentials offset by expected and then actual currency depreciation
(appreciation).
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Block 21: Open economy macroeconomics
Activity SG21.3
The following graph shows the exchange rate between GBP and EUR – what might
explain the sudden drop just after 09.00 on 28 April?
1,4020
1,4000
1,3980
1,3960
1,3940
18:00 28Apr 06:00 12:00
Source: www.foremostcurrencygroup.co.uk/a-volatile-period-for-sterling/
The following graphs show how IS-LM-BP can be used to show monetary
and fiscal policy under floating exchange rates and perfect capital mobility
(the effectiveness of monetary and fiscal policy under fixed exchange rates
was analysed above, see Figure 21.2). With floating exchange rates, we
need to modify our IS curve to allow for the effect of currency appreciation
or depreciation on international competitiveness; we saw above how net
exports, a component of aggregate demand, are affected by the exchange
rate. (Exports are also affected by income levels abroad, but this factor
is usually taken as fixed in elementary open economy macroeconomics.)
Take first the case of expansionary monetary policy (the left-hand panel
below). LM shifts to the right (1). As the interest rate falls below world
levels there is an outflow of capital (an excess supply of the domestic
currency); the domestic currency depreciates against foreign currency. This
in turn increases net exports and the IS curve shifts outwards (2). This
depreciation continues until interest rates are again at r*. Output is Y2.
Monetary policy is extremely effective.
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EC1002 Introduction to economics
Monetary policy, floating ER, perfect CM Fiscal policy, floating ER, perfect CM
LM LM
LM’ ձ
r1
BP r* BP
ձ ղ ղ
IS’ IS’
IS IS
Y Y1 Y2 Y* Y1
Figure 21.5: Monetary and fiscal policy under floating exchange rates and
perfect capital mobility.
On the other hand, fiscal policy is rendered less effective, because it
impacts on interest rates and thus the exchange rate. See the right hand
panel above. A fiscal expansion (1) will cause interest rates to rise,
crowding out private investment, but also leading to large capital inflows
and an appreciation of the exchange rate which dampens demand for net
exports and shifts IS leftwards again (2). The exchange rate will continue
to appreciate until the capital inflow is halted, i.e. until domestic interest
rates are again equal to r* and output is again equal to Y*. Thus the power
of fiscal policy is reduced in an open economy with floating exchange rates
compared to a closed economy.
The table below provides a summary of the effectiveness of fiscal and
monetary policy under different exchange rate regimes. This is based on
the assumption that there is free capital mobility. We have concentrated
on the case of perfectly mobile capital. As an exercise you might think
about what happens when capital is perfectly immobile. Hint: external
balance now requires that the trade balance is zero (exports equal
imports) because there are no additional non-trade capital flows to
offset a trade surplus or deficit. Thus the BP curve must be vertical at
the level of Y which produces internal balance. Under flexible exchange
rates, what happens to the BP curve when shifts in IS or LM change the
internal balance? Answer: the BP curve shifts right or left as the currency
depreciates or appreciates.
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Block 21: Open economy macroeconomics
► BVFD: complete activity 25.1, read the summary and work through the
review questions.
Overview
A country’s exchange rate regime has a profound effect on the way the
economy operates, though this depends on the size and openness of the
economy. Openness is often measured by the size of exports relative to
GDP. However, capital flows also have a big impact. Capital can either
be perfectly mobile, perfectly immobile (due to capital controls) or
partially mobile (such as when foreign and domestic assets are not perfect
substitutes). The impact of various shocks and the effectiveness of fiscal
and monetary policy under fixed or floating exchange rates and different
assumptions about capital mobility can be illustrated using IS-LM-BP
analysis.
Under fixed exchange rates and perfect capital mobility, there is no scope
for monetary policy to influence the domestic economy, since the domestic
interest rate must match foreign rates to prevent massive capital inflows
and outflows. In the long run, internal and external balance may be
restored without policy intervention through changes in prices and output.
Fiscal policy is a powerful tool in the context of fixed exchange rates and
capital mobility, since interest rates must remain stable and there is no
crowding out of private consumption or investment.
The level of fixed exchange rates can sometimes be changed – this is
either a revaluation (rise in value) or a devaluation (fall in value) of the
exchange rate. A devaluation improves competitiveness in the short run
but is unlikely to have a large effect in the long run, though it can help
speed up adjustment to shocks.
A floating exchange rate must begin at a level from which the anticipated
convergent path to its long-run equilibrium continuously provides capital
gains or losses to offset expected interest rate differentials. The actual path
of nominal exchange rates reflects changing beliefs about the future course
of domestic and foreign exchange rates and the eventual level of the long-
run exchange rate.
Under floating exchange rates, the effectiveness of fiscal policy is limited, but
monetary policy is a powerful tool. Monetary policy impacts on aggregate
demand through consumption and investment (as in a closed economy) and
also through its impact on the exchange rate and competitiveness.
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EC1002 Introduction to economics
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Block 21: Open economy macroeconomics
r
LM
BP
IS
Y1 Y2 Y3 Y
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EC1002 Introduction to economics
government to let the exchange rate freely float, assuming that this
would return the economy to potential output. Based only on this
information, use a second standard IS-LM-BP model diagram to
accurately and clearly show:
i. China’s initial economic situation, and what happens to
equilibrium, interest rates, and the balance of payments if
the Chinese government allows that exchange rate to become
completely flexible.
c. For each of the following variables, identify whether it is higher,
lower, the same, or indeterminate in Scenario #1 (monetary
policy) when compared to Scenario #2 (flexible exchange rate):
i. equilibrium income
ii. interest rates
iii. investment
iv. net exports
v. the exchange rate
vi. the balance of payments.
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Block 22: Business cycles
Introduction
This block examines fluctuations in aggregate output which occur in a
cyclical manner. This phenomenon occurs in economies all around the
world and recorded data on business cycles goes back to the early 19th
century. Despite this, there is still a lot of uncertainty and controversy
regarding the causes of business cycles. This block describes some of the
leading theories. It discusses fluctuations in actual output, in potential
output (the real business cycle theory), and international business
cycles. It concludes with an overview of the main schools of modern
macroeconomic thought, which is structured according to certain key areas
where there is disagreement within the field. This block is a little shorter
– if you become confident working through this material more quickly, it
might be a good chance to go back to some other blocks and revise what
you have covered previously, especially any areas you were unsure about.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• distinguish between trend growth and economic cycles around this
path
• analyse why output gaps may fluctuate
• discuss whether potential output also fluctuates
• describe the role of dynamic general equilibrium models
• contrast real business cycle models and New Keynesian analysis
• assess whether national business cycles are now more correlated
• summarise key issues dividing the main schools of economic thought.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD) Chapter 27.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapter 21; UK edition,
Chapter 23.
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EC1002 Introduction to economics
This section introduces the concept of the business cycle – the fluctuation
of output around a notionally smooth upward trend in potential output.
The phases of the cycle are also spelled out. The output gap shows the
difference between actual output and potential output. Note that this gap
has already been an important part of the analysis of the macroeconomy
for several chapters. The section shows the cycle in real GDP for the UK
(although note that Figure 27.2 graphs the growth rate, not the level, of
real GDP). Semi-regular fluctuations are discernible although from the
mid to late-1990s until 2006–07 the extent of these fluctuations was much
smaller than in the past (and than what was to come!), which may have
encouraged the UK Chancellor of the Exchequer, and later Prime Minister,
Gordon Brown to boast that ‘we… have put an end to the damaging
cycle of boom and bust’. Very few political remarks can have earned
more subsequent embarrassment. Cycles, of course, are not unique to the
UK and if you live elsewhere it would be instructive to look at a longish
time series of GDP growth such as that used in Figure 27.2 for your own
country. This section also introduces the notion of the political business
cycle but dismisses political manoeuvring as the primary source of
economic fluctuations, especially in the age of central bank independence.
Activity SG22.1
Draw a quick sketch showing an upward sloping smooth line for trend output and a wavy
line showing actual output – mark the phases of the business cycle on the actual output
curve:
264
Block 22: Business cycles
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EC1002 Introduction to economics
Activity SG22.2
The table below is based on Maths box 27.1 and includes consumption as a further
element of the system. Use the formulas provided for each column, assuming a = 5/4 and
c = 2/3, to complete the table (do calculations to the nearest whole number). Assume
that Y = 0 prior to period 1 (hint: this makes investment = 38 in period 2). This example
shows how the multiplier-accelerator interaction can produce cycles. In other respects, the
actual numbers are somewhat unrealistic. Think about why this is.
1 30 0 0
2
3
4
5
6
7
8
9
10
11
12
Figure 22.1 describes how ceilings and floors in aggregate supply and
investment can generate cycles. The various components of the figure can
be explained as follows: The equilibrium path of outcome is EE, around
which actual output fluctuates. FF is the floor line whilst CC is the ceiling.
VW is an expansion phase. The slow-down in growth from VW to WX leads
to a fall in induced investment and results in the downturn at point X.
XY is the recession/contraction phase. Investment is declining.
Once the fall in output slows down, this will lead to another turning point
at Z, followed by another increase in output in the new recovery phase.
C
X
W
C E
F
Output
E Z
Y
F V
Time
Figure 22.1: Ceilings and floors.
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Block 22: Business cycles
Activity SG22.3
In your own words, briefly summarise the discussion of how fluctuations in stockbuilding
and competitiveness can lead to business cycles.
Activity SG22.4
Answer the following multiple choice questions on real business cycles:
1. Real business cycles are cycles in:
a. potential output
b. actual output
c. real output
d. international trade.
2. Real business cycle theorists argue that can explain short- and long-
term fluctuations in output:
a. imperfect labour markets
b. rational expectations
c. intertemporal decisions of households, firms and governments
d. variations in mood, caused for example by the weather.
3. Real business cycle theories suggest that there is to correct
departures from the optimal growth path:
a. a role for fiscal policy
b. a role for monetary policy
c. a role for supply-side policies
d. no case for stabilising output over the business cycle.
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EC1002 Introduction to economics
Since the 1990s, countries around the world have experienced an upward
trend in international synchronisation of business cycles, especially in the 1
Duval, M.R.A., M.K.C.
euro area, Asia and Latin America. Within Asia, business cycles appear to Cheng, K.H. Oh, R. Saraf
be particularly synchronised among the ASEAN-5 economies, including and M.D. Seneviratne
‘Trade integration
Indonesia, Malaysia, the Philippines, Singapore and Thailand (Duval et
and business cycle
al., 2014).1 Research suggests that deeper trade and financial integration synchronization: a
can have strong positive effects on the synchronisation of business cycles reappraisal with focus
between trading partners (e.g. Goggin and Siedschlag, 2009, on Ireland on Asia (No. 14-52)’,
and its major trading partners in the EU).2 Business cycle synchronisation (International Monetary
appears to be much higher in times of crisis, largely due to effects of trade Fund, 2014).
– this means that trade links can act to propagate crises internationally
(Duval et al., 2014). 2
Goggin, J. and I.
Siedschlag International
transmission of business
Schools of macroeconomic thought cycles between Ireland
and its trading partners.
► BVFD: read section 27.6. Please refrain from reading Table 27.2 as this (No. 279). ESRI (The
will be used as a model answer for Activity SG22.5 below. Economic and Social
Research Institute,
This section briefly but informatively summarises some areas of Dublin, 2009) working
paper.
disagreement between macroeconomists and the major schools of modern
macroeconomic thought. In some textbooks this section could appear as
a separate chapter, rather than as a sub-section of a chapter on business
cycles, because the differences between schools do not just relate to cycles
but more generally to how the economy operates, its long- and short-run
equilibria and the role for economic policy.
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Block 22: Business cycles
Activity SG22.5
To help you work through this material, summarise it by filling out the table below. Then check your responses by comparing it to the
summary table the authors have created (Table 27.2).
Unique
long-run
equilibrium?
Issues
Expectations
formation
Short run
and long run
Policy
Implications
► BVFD: read the summary and work through the review questions.
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EC1002 Introduction to economics
Overview
This block firstly defines business cycles as fluctuations in output around
the long-run trend path of output. Data on output clearly demonstrate the
existence of business cycles, which tend to last around five years. Secondly,
various possible causes of business cycles are discussed, including
political opportunism, the interaction between consumption, investment
and previous output, as described by the multiplier-accelerator model,
fluctuations in stockbuilding, and reactions to shocks under fixed exchange
rates. Some economists argue that potential output also fluctuates; this
is described by real business cycle theory, which argues that fluctuations
in potential output are the result of people’s rational, efficient reactions
to shocks in the real economy, especially productivity shocks. Although
most counter-cyclical policies are demand focused, aggregate demand
and aggregate supply both contribute to the business cycle. If a demand
shock has a long-term impact on output and aggregate supply, such that a
short-run shock impacts the long-run path of the economy, this is known as
hysteresis. The increasing integration of world markets, including financial
markets, has led to movements in output becoming increasingly linked to
output fluctuations worldwide. Synchronisation of business cycles between
countries has increased over the previous few decades, especially between
countries which are trading partners. This block concludes with an
overview of the main schools of modern macroeconomic thought. The key
points on which they differ are the speed with which markets (especially
the labour market) clear, how expectations are formed, the possibility of
hysteresis, and the relative importance of the short run and long run.
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Block 22: Business cycles
5%
4%
3%
World
2%
1%
0%
-1%
-2%
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
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EC1002 Introduction to economics
Notes
272
Block 23: Supply-side economics and economic growth
Introduction
Having built up a model of the macroeconomy over several blocks and
analysed short-term fluctuations in aggregate output, this block now takes
a long-term perspective. Starting with supply-side economics, which has
to do with the economy’s productive potential, the block moves on to
discuss historical trends of long-term growth in various countries as well
as models which have been proposed to explain these trends. The two key
models presented in this block are the Solow model – including population
growth, depreciation and technical progress; and the Romer model of
endogenous growth. The material in this block takes the analysis of these
two models somewhat beyond the coverage in our textbook. Work through
the material carefully – the equations, the graphical representations, and
the explanations – so you gain a robust understanding of these models.
You are also encouraged to do some research for your own country to find
out what the long-term rate of growth has been, specific factors driving
or hindering growth in different periods, and how this fits into the world
economy as well as the models seeking to explain long-run growth.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
• explain supply-side economics
• discuss growth in potential output
• describe Malthus’ forecast of eventual starvation and how technical
progress and capital accumulation made this forecast wrong
• describe the Solow model of economic growth
• explain the convergence hypothesis
• analyse the growth performance of rich and poor countries
• discuss endogenous growth and the potential impact of policy on
growth
• discuss the implications of growth for environmental sustainability.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 28.
Further reading
Lipsey and Chrystal (L&C), international edition, Chapter 23; UK edition,
Chapter 26.
Witztum (AW), Chapter 9.
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Supply-side economics
► BVFD: read the introduction to Chapter 28 and section 28.1.
While the main focus of this block is on economic growth (i.e. sustained
increases in economic well-being, the chapter begins with a discussion
of factors that can lead to one-off changes in output. Analytically, these
can be characterised as increases in any of the inputs in the economy’s
aggregate production function (see BVFD section 28.3) or anything that
makes a given level of these inputs more productive.
Economic growth can be represented very simply as an outward shift in a
country’s PPF. The frontier is determined by the quantity and productivity
of a country’s resources (land, labour, capital and raw materials), and an
increase in either will lead to an expansion in the country’s production
possibilities.
Output of
good A
Output of good B 1
The textbook
Figure 23.1: PPF before and after economic growth. discussion on increasing
labour input implicitly
Section 28.1 discusses supply-side policies in regards to labour input1 and holds population
labour productivity. More broadly, supply-side policy includes any policy constant, but of course
that improves an economy’s productive potential, with the aim of shifting increases in population
the LRAS curve to the right. Supply side policies include low marginal tax can increase labour
input and total output
rates, competition policy, privatisation of state industries, and reducing
as well. The effect of
unnecessary red tape and bureaucracy. Generally, supply-side policies aim population growth on
to increase flexibility in product or labour markets, remove distortions to per capita output is, of
incentives, improve the quantity and quality of labour, and increase an course, another matter,
economy’s competitiveness. as we discuss below.
Economic growth
► BVFD: read section 28.2.
The remainder of this chapter considers economic growth over the long-
term. Anything that affects the long-run rate of economic growth by even a
very small amount makes a vast difference to potential output after a few
decades. For example, a difference in annual growth rates of just half a per
cent leads to huge differences in living standards after 25 or 50 years.
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Inputs to production
► BVFD: read sections 28.3 and 28.4 as well as case 28.1.
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Two key assumptions of this model are that there are constant returns to
scale (CRS), and diminishing marginal productivity of capital (MPK).
CRS enable us to write the production function in the ‘per worker’ version:
Y K
= Af ( ,1)
L L
(we have multiplied K and L by 1/L. CRS then means Y is also multiplied
by 1/L). Ignoring the constant 1 and writing y and k for output and capital
in ‘per worker’ terms:
y = AF (k)
This is illustrated in Figure 28.3 of BVFD – the green line shows the path
of income against capital per worker, and is concave downward because of
the decreasing MPK. Adding more capital per worker, k, increases output
per worker, y, but with diminishing returns. A slightly fuller version of that
diagram is presented here as Figure 23.1. This enables us to analyse the
Solow model in a bit more detail. The per worker production function is
represented by the curve labelled y. This production function represents
the supply side of the model.
The demand side is represented very simply by the equation Y = C + I
which you should be very familiar from the closed economy macro models
in earlier blocks. Assume a constant marginal (and average) propensity to
save of s. Dividing through by L again we have:
y = (1-s)y + i
or: i = sy = sF(k)
(savings equals investment in a closed economy). This investment
schedule is also shown in Figure 23.2 and by the orange line in BVFD
Figure 28.3. The dotted line from k* up to the green line represents output
at that level of capital per worker. This can be divided into investment
(below point E) and consumption (above point E).
This is the basic model. It is very simple. The production function
determines the economy’s output and the consumption function
determines how this output is divided between consumption and
investment. There is one additional feature which is important; the Solow
model makes the growth of the economy’s capital stock endogenous to the
model. Investment increases the capital stock, while depreciation of capital
reduces it. Let δ per cent of the capital stock wear out each year (δ is the
depreciation rate). Thus:
∆K = I – δ K
Dividing through by L, this can be written in per-worker terms:
∆K = i – δ K = sy – δ K = sF(k) – δ K
(This is equivalent to equation (1) in Maths 28.1).5 5
Note: Δk (used above)
denotes the change
For the capital stock to be constant we require ∆k = 0, i.e. i = δ K . If L is in capital between
not constant, but is growing (due to population growth or immigration) at two periods, such as
a constant rate n, then in order to keep the capital per worker constant not two months or two
only does worn out capital have to be replaced but additional investment years, while k (used in
Maths 28.1) denotes
is required to provide capital for the new workers resulting from
the continuous rate of
population growth; so now for ∆k = 0 we require: change in capital.
i = (δ + n)k
In Figure 23.2 this is shown by the straight line with slope (δ + n). The
(δ + n)k line is not related to output, it simply depicts the amount of
investment that is required for capital per worker to remain constant when
there is population growth and depreciation; in this sense, one can think
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consumption
net investment
depreciation
k1 k* k
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Block 23: Supply-side economics and economic growth
even investment line upwards, leading to a lower steady state capital per
worker and lower output per worker. Thus the Solow model predicts that
countries with high savings rates and low rates of population growth will
tend to have higher per capita income. To some extent, this is empirically
corroborated.
Activity SG23.2
In a model without technical progress, use a graph to demonstrate how an increase in the
rate of population growth can lead to changes in the long-run level of per capita output.
Will this affect the long-run per capita growth rate?
Technical progress
► BVFD: read section 28.6.
Although it provides some useful insights, the basic model discussed in the
previous section predicts that the rate of per person output growth tends
to zero (i.e. at the steady state, growth in per capita output is zero). Since
that is not what is observed in practice, the Solow model is now extended
to include technical progress – specifically, labour augmenting technical
progress. This is key to explaining long-run growth and the improvement
in living standards over generations.
Let us explain more clearly what is meant by labour augmenting technical
progress. Consider the labour input to the production function. We have
written this as L where L is the number of workers. In practice, however,
we are concerned not just with the number of workers but with their
productivity. So we can think of the labour input as being the product
L × E (henceforth LE), where E is efficiency per unit of labour. So LE is
units of effective labour (worker-equivalents in BVFD), not just a head
count of workers. Now suppose that due to technical progress E is growing
at a rate t. Hold L constant to keep things simple. Effective labour is
growing at the rate of technical progress, t. If we were to redefine y, and
k as output and capital per unit of effective labour then the steady state
equilibrium would have constant y* (Y*/LE) and k* (K*/LE). For the
capital stock per effective worker to be constant, investment is needed
not just to cover depreciation and population growth but to supply the
extra units of effective labour with capital to work with – failure to do this
would result in reductions in capital per unit of effective labour. Note now
that if (Y*/LE) is constant, then with L constant and E growing at a rate
t, Y* and Y*/L must also be growing at a rate t. With technical progress,
the Solow model can produce long-run growth in per capita output. If
we drop the assumption that population and the workforce are constant,
output per worker still grows at t, but total output, Y, in the steady state
grows at t+n.
This extended model is depicted in BVFD Figure 28.5 (for the case where
δ = 0). The two differences to 28.3 are that the break-even investment
line has the slope (t+n)k, and that all variables are now measured per
unit of effective labour or per worker-equivalent, not per worker. Since
the technological progress was assumed to be labour augmenting, labour
productivity has increased. Investment at the rate (t + n)k now ensures
that steady state capital per worker-equivalent, and hence output per
worker-equivalent, are constant. Since worker-equivalents grow at rate
t+n and workers grow at rate n (which is slower – since t is a positive
number), output per worker and capital per worker are increasing at rate
t. With technical progress, there is a steady state level for output and
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EC1002 Introduction to economics
capital per worker-equivalent, but output and capital per worker continue
to grow at a positive rate over time.
Thus the Solow model provides good insights into factors leading to
high levels of output per capita (high saving rate (s), high total factor
productivity (A), low depreciation (δ)). Growth or decline will occur due
to transition dynamics when something shocks the economy away from
its steady state. The model is less successful at explaining long run growth
in per capita output (income), but exogenous technical progress can
generate such growth. However, as BVFD point out, the fact that there is no
examination of where technical progress comes from – it is simply assumed
– is unsatisfactory. This shortcoming is what modern endogenous growth
theory attempts to rectify, but before turning to that section 28.7 of the text
provides some more empirical background on economic growth.
Activity SG23.3
MCQ: Convergence implies that:
a. Rich nations will grow faster than poor nations.
b. The rich will get richer and the poor will get poorer.
c. The rich will get poorer and the poor will get richer.
d. Poor nations will grow faster than rich nations.
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Costs of growth
► BVFD: read section 28.9.
► BVFD: read the summary and work through the review questions.
Overview
This block starts by discussing supply-side economics. Supply-side policies
aim to improve an economy’s productive potential. Higher labour input
and increases in labour productivity are important elements of supply-side
economics as are increased flexibility in product or labour markets and
improved competitiveness. Although policies which boost aggregate supply
are desirable, in practice this may be difficult to achieve.
Secondly, this block examines long-term economic growth. Economic
growth is most commonly measured by real GDP or real GDP per capita,
though this measure has weaknesses and other alternative measures are
being referred to more frequently. Even small annual changes in economic
growth can lead to huge changes in living standards in the long term.
Potential output can be increased either by increasing the inputs of land,
labour, capital and raw materials, or by increasing the output obtained
from given input quantities. Technical advances are an important source
of productivity gains, and can be fostered for example through subsidised
research in universities and the provision of patents for companies that
make new discoveries.
The simplest theory of growth, as characterised in the Solow growth
model, has a steady state in which capital, output and labour all grow at
the same rate. Whatever its initial level of capital, the economy converges
on this steady state path. This theory can explain output growth but not
growth in output per worker (productivity growth). Labour augmenting
technical progress allows permanent growth of labour productivity.
Convergence theory argues that countries will converge, both because
capital deepening is easier when capital per worker is lower and because
of catch-up in technology. There have been several examples of this in
recent decades, where developing countries have grown much faster
than developed countries, though not all countries fit into this pattern.
Institutional frameworks impact on the adoption of new technology, which
strongly influences growth rates.
Theories of endogenous growth are built on the assumption of constant
returns to capital. If this assumption holds, the long-run growth rate of
productivity can be influenced by choices about saving and investment,
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Block 23: Supply-side economics and economic growth
F
Saving, output and break even investment per worker
Output y = f(k)
A G
Savings f(k)
E
k1 k2 k3
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284
Appendix 1: Syllabus
Appendix 1: Syllabus
Introduction
The Economic Problem: production possibility frontiers, opportunity
cost, the role of the market, positive and normative economics, theory and
models in economics.
Microeconomics
The Theory of Consumer Behaviour: rationality, utility, indifference
curves, utility maximisation, demand functions, substitution and income
effects, substitutes and complements, demand elasticity, consumer surplus
The Theory of the Firm: technology and production functions, returns
to scale, the law of diminishing marginal return, isoqants and isocost lines,
cost functions, profit maximisation, the distinction between the long and
the short run, fixed and variable costs, behaviour of the firm in the long
and in the short run, the firm’s supply function.
Markets: demand and supply, equilibrium, competitive industry (the
competitive firm, entry and exit, short-run and long-run equilibrium, some
comparative statistics), monopoly (the firm, monopoly and competitive
equilibrium compared), natural monopoly, monopolistic competition
(differentiated products, the firm’s behaviour, the role of entry), oligopoly
(interdependence, game theory, reaction functions)
Factors Market: demand and supply of labour (utility maximisation
and the supply of labour, profit maximisation and the demand for
labour), monopsony, factors affecting labour market equilibrium (unions,
immigration), returns to factors of production, economic rent, the income
distribution, the Gini coefficient and Lorenz curves..
Coordination and Welfare: General equilibrium, horizontal
and vertical equity, allocative and Pareto efficiency, market failures,
externalities, Coase theorem, government interventions, public goods,
incidence of a tax
Macroeconomics
Aggregation: the problem of aggregation, value added and the NNP=Y
identity, depreciation, the circular flow of income, real and nominal GDP
The Goods Market: actual and potential output, consumption,
investment, aggregate demand, income determination, equilibrium, the
multiplier, consumption and taxation, the government budget, automatic
stabilisers (the financing of government), aggregate demand and
equilibrium (IS), the multiplier and taxation, the role of fiscal policy, the
paradox of thrift, imports and exports, the multiplier in an open economy.
Money and Banking: the role of money, real balances, the liquidity
preference approach and the demand for money (liquid assets),
commercial banks and the supply of money (banks and the various
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286
Appendix 2: Outline of readings
287