AddisonEdwards. Economics Notes 2013.2015

ADDISON K.
EDWARDS
FORM 4 & 5 Business 1

Mrs. Roxanne Williams
Economics CSEC Notes

2013 - 2015
Addison K. Edwards Economics Notes 2013. 2015 1

INTRODUCTION:
What is economics? Economics is essentially a study of the ways in which humankind provides
for its material well-being.
A more formal definition of Economics: Economics is a social science concerned chiefly with
the way society employs its limited resources, which have alternative uses, to provide goods and
services for present and future consumption.
Why is Economics a social science? Economics is a social science because it deals with the
interactions of people, and in particular, the interaction of people as they buy, sell, produce and
consume.
Economics can be divided into microeconomics and macroeconomics. Microeconomics is

the study of individual markets while macroeconomics is the study of the whole economy.
Microeconomics is concerned with the specific parts or economic units that make up an
economic system and with the relationship between those parts. In microeconomics, emphasis
is placed on understanding the behavior of individual households, firms and industries and the
ways in which such entities interact.
Macroeconomics is concerned with the economy as a whole, or with large segments of it.
Macroeconomics focuses on such problems as the rate of unemployment, the changing level of
prices, the nation’s total output of goods and services and the ways in which government raises
and spends money.
Essentially therefore, Economics, both macro and micro, is about the satisfaction of material
wants.
Who is an Economist? An Economistis one who studies a phenomenon by observing the world
and collecting appropriate data. The purpose of this is to discover relationships between events
or between quantities called variable eg Price and Demand.
What is meant by an economy? An Economy is a range of economic activities where

production, distribution and consumption of goods and services for the people within the society
take place. In an economy issues related to money, prices, wages, employment, taxes, exports
and imports and spending and saving are dealt with.

1. ECONOMICS AS A SOCIAL SCIENCE
A. The creation of wealth out of scarce resources
Wealth is anything that has value because it is capable of producing income. It includes such
assets as land, houses, factories, shops, machines and personal possessions. There are three main
categories of wealth. These include:
1. Private wealth – This is individual possessions and include cars, jewellery, houses, banks
deposit, share in company and so on.
2. Social wealth – This is assets owned by the community. It includes roads, hospital, parks,
schools, libraries and so on.
3. National wealth – This is the sum of all wealth possessed by the citizens of a country,
whether it is privately owned or publicly owned.
B. The production and distribution of goods and service

Production is the process of making a good or providing a service. Production takes place so that
people’s wants can be satisfied. Distribution on the other hand has more to do with the goods
and services which are produced get to the final consumer.
C. The behavior, interactions and welfare of those involved in the process
The “invisible hand” is a key principle of the production process. It states that each person,
pursuing his or her self-interest will be led, as if by an invisible hand, to achieve the best for the
society. Therefore in every society some kind of interaction and exchange must take place
between the producers and consumers. Producers are out to make a profit whereas consumers
are interested in obtaining goods and services to satisfy their wants and needs.
D. Economics as a trade off

Economics is seen as tradeoff between needs and wants. It investigates how economic resources
that are scarce can be utilised in order to maximize the production of goods and services so that
the needs and wants of individuals are maintained and fulfilled. Since there would never be
enough resources to satisfy all needs and wants, choices would have to be made and certain
needs and wants would have to be forgone.
2. AN ECONOMY AS A MECHANISM
A. Organization of resources for production of goods and services

An economy can be described a system/mechanism in which a range of economic activities,
including production, distribution and consumption of goods and services, are undertaken by
individuals within society.
B. Satisfaction of society’s needs and wants
There seems to be no limit to people’s wants and no limit to new ideas for satisfying them.
However, at any moment in time, there is a limit to the amount of goods and services which can
be produced in any economy, since the resources which are needed are limited in supply.
Therefore, in both poor and rich societies in the world needs and wants for more goods and
services will never be satisfied.

Section 1 – The Nature of Economics
SPECIFIC OBJECTIVES
Students should be able to:
Objective 1: Define the term ‘Economics’;

Economics is the study of how individuals, businesses, governments and societies as a whole,
employ resources to satisfy competing wants and needs, in light of scarcity.
OR
Economics is the study of how scarce resources/ limited resources are used (Allocated) to satisfy
unlimited human wants and needs
Economics is also concerned with the production and distribution of goods and services, and as
such, delves into matters like:
- What goods/services should be produced;
- And in what quantity they should be produced;
- What means of production should be used;
- What are the materials or inputs used for production;
- And, how is the total output or income distributed.
Objective 2: Explain what is meant by an economy;

An Economy is the system in which available resources are distributed to meet society’s wants
and needs.
OR
An Economy is the way society is structured to help allocate its resources.
In deciding how to allocate these scarce resources, three questions must be answered:
1. What to produce?
2. How to Produce
3. For Whom to produce
Countries or societies must answer these questions regardless of the type of economy they
operate.
Types of economy vary depending on the level of government intervention. The four basic types
of economies are:
1. Traditional Economies – subsistence farming, bartering system; no government
intervention
2. Planned/Command Economies – those in which all economic decisions are made by
the government
3. Free Market Economies – those with no government intervention
4. Mixed Economies – those with a mixture of Planned and Free Market. In practice, all
economies are mixed economies.

Objective 3: List the Main Sectors in an Economy
There are three (3) main sectors in any economy. These include:
- Firms
Is also a decision-making unit. This is the unit that produces goods and services. To
produce these goods and services, firms buy factor services from households.
- Households
Is one decision-making unit. In economics, two assumptions are made about households.
First, households consume goods and services. Secondly, households are the owners of
the factors of production. A factor of production (factor input) is any resource used to
produce goods and services.
The four factors of production are land, labour, capital and entrepreneurship.
- Government
Provides the framework of rules and laws for households and firms to operate within; in
some economies, the government is also involved in production.
Objective 4: Explain the concepts of scarcity and choice within an economy;

Scarcity is the inability to satisfy human wants with the limited supply/resources we have. When
there is scarcity, we have to make a decision therefore we undergo Opportunity Cost - Because
of scarcity economies are forced to make choices about how to allocate their scarce resources/
limited resources.
Choice means selecting from among alternatives. The decision to choose one thing over another
involves a cost known as an Opportunity Cost.
OR
Choice is the range of options available to the individual household, firm or government when
making a decision.
Money Cost involves what was actually paid for the inputs used to produce a given good or
service.
Example
For instance, a garment factory produces a shirt. The money cost of the shirt is the actual cost of
the fabric and the labour, among other inputs, used to produce the shirt.
NB: Shortage of a good is different from a scarcity. A shortage occurs when demand for a
good exceeds supply: this can be solved. Scarcity, however will always exist because wants
will always exceed the availability of resources to satisfy them.
What are Needs and Wants?

Man has needs needs and wants.
Needs are any goods and services that are essential for life. Wants are goods and services that
are desired to improve the quality of life but are not essential.
Example

Basic clothing is necessary for life and, as such, is a need. However, a Shirt decorated with floral
designs is not vital to life and therefore is classified as a want.
Objective 5: Define “opportunity cost” and “money cost”;

Opportunity Cost is the loss of potential gain from other alternatives when one alternative was
chosen. Opportunity Cost is the next best alternative foregone; i.e. to give up something in order
to get something else.
Types of Opportunity Cost

- Constant Opportunity Cost
A steady potential price to a business that occurs when a company does not take
advantage of a feasible choice to earn profit
- Increasing Opportunity Cost
Large sacrifice of an alternative good caused by an increasingly greater production of
another good in a firm/ economy, where resources are already being fully efficiently used.
- Decreasing Opportunity Cost
The amount of one good that has to be sacrificed to produce one more unit of another
good.
Money Cost involves what was actually paid for the inputs used to produce a given good or
service.
NB: Price refers to the amount of money that consumer have to give up to acquire a
good or service while cost refers to the amount paid to produce a good or service.
Examples of Opportunity cost

Example 1: If the government elects to build more roads and finds the required money by
cutting down on its school construction programme, then the cost of the new roads can be
expressed as so many schools per mile of road.
Example 2: If one buys a watch, it may cost $50, but what is more significant is what has to be
given up to make the purchase. This may be the opportunity to purchase a pair of shoes or the
opportunity to have extra leisure instead of working to earn the $50.
On the other hand, money cost is the actual amount paid for goods and services purchased.
Objective 6: Illustrate opportunity cost and efficiency, using the production possibility
frontier;
What is efficiency?
Efficiency means using all of the available resources to produce one (1) or both goods.
Production Possibility Frontier/ Production Possibility Curve/ Production Possibility

Frontier/ Product Transformation Curve

It shows the contribution of two (2) types of goods that can be produced with the available
resources. The PPC is negatively sloped (sloped downwards from left to right). It divides the
combination of two (2) goods, whose production can be attained from those production that
cannot be attained.
Any point inside the curve shows an attainable combination but at the same time indicates an
efficient use of resources. Any point outside the curve indicates scarcity. This means that scarcity
does not have the resources to attain the combination at present.
The principle of opportunity cost can be made more vivid by using a production possibility
frontier. This is a graph which shows the possible combinations of goods that a producer can
manufacture given the available resources and the current level of technology.
Any point on the curve includes an efficient use of society’s resources. Note however, that any
combination previously unattainable may become attainable for any of the following reasons:
- Discovery of resources (E.g. Natural Resources such as Oil)
- Improvement in Technology
- Increase in Foreign Investment in the economy
- Increase in Migration (Skill workers, etc.) to the country
- More efficient methods of production being used
- Training the Labour force/ Increased Knowledge
- Economic Growth
Assumptions of the Production Possibility Curve (PPC)

Let’s begin by constructing a model for a hypothetical economy. The model is based on four
simplifying assumptions:
1. Two Goods - The economy produces only consumer goods and capital goods. The
assumption of two goods allows us to analyse the problem using the language of graphs.
2. Common Resources – The same resources can be used to produce either of both of the
two classes of goods and can be shifted freely between them. This means that labour
and other factors of production can be used to produce either consumer goods or capital
goods, or different combinations of both.
3. Fixed Conditions – The supply of resources and the state of technological knowledge
are fixed.
4. Full Employment – Society’s available resources are working in the most efficient
ways. It follows from this assumption that in the short run the economy may be able
to increase the production of one class of goods by taking resources away from the
production of another class of goods. However, the economy cannot increase the
production of both classes of goods because there are no excess resources available.
Causes of an inner shift of the Production Possibility Curve (PPC)

- Outward Migration of Skilled Labour (Brain Drain)
- Natural Disasters

- Loss of Natural Resources
- Obsolete Technology
- Firms Under Utilizing the Resources Available
‘Ceteris Paribus’ is a latin term meaning all other thing being equal
The opportunity cost of a decision is the value of the next best alternative this decision forces a
person to do without, while the monetary cost is the market price of goods. Therefore, the
opportunity cost of buying a blackberry is not its market price, but the value of the other things
that could be purchased instead. Taking into consideration the opportunity cost of pending
decisions, one has to make a rational choice.
A rational choice is one that gives the greatest benefit, having weighed the benefits of the
decision, against its opportunity cost.
Economic Efficiency is when an economy is producing on its production possibility frontier,

that economy is said to be efficient. All resources available in the economy are being used to
produce one of the maximum possible combinations of goods.

The following production possibility frontier shows the possible combinations of oranges and
sugarcane an agriculturer can yield on a plot of land.
Figure 1.1
Figure 1.1 above shows a production possibility frontier.
The table below lists the combination of oranges and sugarcanes depicted in the production
possibility frontier.
Tonnes ofTonnes of
Oranges Sugarcane Points
40000 0 A
30000 25000 B
20000 42000 C
10000 54000 D
0 65000 E
The production possibility frontier shows that the greater the quantity of one good that is
produced, the smaller the quantity that can be produced of the other good. If the agriculturer
decides to grow only oranges, the yield will be 40,000 tonnes, but if he/she decides to grow
30,000 tonnes, then 25,000 tonnes of sugarcane can also be yielded. Therefore, the opportunity
cost of obtaining 25,000 tonnes of sugarcane is the 10,000 tonnes of oranges the agriculturer
must forgo.
Production possibility frontiers also illustrate the concept of efficiency. The combinations of
goods depicted on the curve are attainable only if all the resources are fully employed, with the
most efficient means of production possible. In reality, there is no guarantee that resources will
be fully employed or that the latest technology is used in production. Where resources are not

fully employed or the latest technology is not used, the production point will lie below the
curve. This is point F in the production possibility frontier below.
Figure 1.2
Figure 1.2 above shows a production possibility frontier with production point F.
Important concept for the Production Possibilities Curve
Law of Increasing (Opportunity) Costs – As a society increase production of one good, it must
sacrifice increasing amounts of an alternative good to produce each additional unit. The real
cost of acquiring either good, therefore, is not the money that must be spent for it. The real cost
is the amount of the alternative good that must be sacrificed. Increasing costs are reflected in
the shape of the production possibilities curve, which is bowed outward.
Key points on Production -possibilities to remember
 Areas inside the production frontier represent points where some resources are
unemployed or not employed effectively.
 Areas outside the production frontier represent points that the economy is not able to
achieve. There are beyond the economy’s production possibilities.
 A situation in which the production possibilities available to an economy have
expanded is known as economic growth. This expansion shifts the production
possibility curve outwards. It may be due to an increase in the quantity and/or the

quality of resources available to the economy or improvement in the state of
technology.
 Production possibilities decline when resources available to the economy decline.
This decline shifts the production possibility curve inwards. Perhaps some of the
economy’s natural resources have become exhausted or the working population is
falling or technology available has changed.
 Some resources need to be devoted to the production of capital goods if the production
possibilities are to be maintained (investment).
 The more consumer goods and services produced, the higher the standard of living in
the current time period, but the standard of living might fall in the future if there is
failure to produce enough capital goods to replace those worn out in the process of
production (depreciation).

Objective 7: List the main influences on individuals in making economic decisions;
Economic Decisions
The economy is dynamic. Individuals or households are constantly choosing on what goods and
services to spend their income. They are choosing whether to save or spend. They are even
considering where to work. Firms are constantly choosing what goods to produce and what
quantities, and what prices to sell those goods. These activities all involve economic decisions
where an individual is faced with options and chooses one course of action.
Factors influencing the Economic Decisions of Individuals

The economic decisions of an individual can make are to spend or to save
Those economic decisions will depend on a number of factors, they are:
1. Individual Income
The more money some people earn, the more they spend and vice versa. Consumption is
therefore limited by their income
2. Personal Choice
Persons are free to choose and as such they purchase those goods and services that offer
them the most satisfaction or their personal preference
3. Level of Education
Income is often dependent on skills and qualifications, therefore a person with little or
no education may earn a very small income and hence may be unable to afford all the
goods and services needed.
4. Peer Pressure/ Bandwagon Effect
Persons often feel the need to spend or save as much money as their friends/ associates
in order to “fit in.”
5. Job Type
Based on your job we might be influenced whether to spend or save x amount of dollars
6. Natural Disasters
Often impact negatively on individuals and societies as a whole thus many individuals
living within certain societies especially those that have been affected by a natural
disaster before tend to reduce their consumption and save more for future use.
7. The Rate of Interest (Bank)
For some persons it is likely that higher interest rates on their savings will encourage
them to save more.
8. Political Climate
Individuals may opt (Choose) to save or spend based on the stability of the economy. In
industries where the economy is politically unstable, then persons may be forced to spend
less.

Objective 8: List the main influences on firms in making economic decisions.
Producers need to decide whether to produce goods and services and the quantities in which to
produce.
Factors that influence the economic decision of a firm are:
1. Availability of Resources/ Resource Base
A business needs suitable resources in order to produce goods and services demanded by
consumers.
2. Cost of Production
Increasing costs can reduce a firm’s output, unless the prospects for profits are high. In
such a case, the firm will produce even if costs are increasing.
3. Potential Profit
Supernormal profit is the excess of total revenue over total costs. Once there is the
potential for profits firms will invest. In economics, we assume that producers are rational
and that they are attracted by profits.
4. Industrial Relations
The relationship between the management of a firm and the workers (usually represented
by a trade union) is called “Industrial Relations”. Cordial (friendly but a quite formal and
polite) industrial Relations will make the firm willing to employ more labour. Poor
industrial relations will make the firm more inclined to use capital instead of labour.
5. Technical Know-how
Having the technical ‘know-how’ is needed before setting up any production process.
Technical expertise in any production will enable a firm to earn more profits than its
competitors who may not have the technical know-how or may have very little.
6. Changing Demand
If a firm is faced with falling demand for the good it produces, the firm will make a
decision to cut back on production. If there is increasing demand, then the firm will
produce more, provided that it is able to obtain all the factors of production to produce
the given goods.
NB:
Government influences on economic decisions
The government influences economic decisions in a number of ways. These include:
1. Laws and Grants
To induce firms to locate in a particular region of the country
2. Taxes
On the production and consumption of goods that impose a cost on society; for example,
cigarettes and gasoline. Taxes increase the price the consumer has to pay for the good,
and so they tend to curb consumption and production of such goods. In Trinidad and
Tobago, there are excise duties on cigarettes, alcohol and gasoline.
3. Setting up Industrial Zones
To encourage and facilitate the activities of firms
4. Provision of infrastructure
Provision such as roads, bridges and ports. In Trinidad and Tobago, the opening up of
the port at Point Lias encouraged many firms to locate there. These firms located there

to take advantage of the port facilities fo importing raw materials, and for easy
transportation of finished bulky goods.
5. General Laws
Are made to direct the firms’ activities
6. Laws concerning the employment of disabled persons

Section 2 - Production, Economic Resources & Resource Allocation
SPECIFIC OBJECTIVES
Objective 1: Define “production”;

Production is the use or conversion of the factors of production to make goods and services for
consumption.
Objective 2: Distinguish between production and productivity;

Production is defined as the means by which resources (whether tangible, such as, raw materials
or intangible, such as, ideas/information) are transformed into goods (tangible) and services
(intangible).
Productivity however, is the measure of the efficiency of the production process, and is
calculated as the ratio of what is produced to what is required to produce it. Recall, the tangible
resources needed for production are land, labour and capital; therefore the output/goods and
services produced via these resources would be measured as output per acre of land, per hour of
labour or as a yearly percentage for capital respectively.
Objective 3: Define the term “factors of production”;

Factors of Production are those resources used to produce goods and services.
OR
Factors of production are the inputs/resources required for the production of goods and
services, namely, land, labour, capital and entrepreneurial talent. What are the rewards of each?
The land yields rent, the labour force is paid wages or salaries for their services, capital invested
earns interest and the entrepreneurial talent warrants profit.

Objective 4: Identify the economic resources referred to as “factors of production”;
They are categorized as:
- Land
- Labour
- Capital
- Enterprise or entrepreneurial skills or entrepreneurship
Objective 5: State the rewards of the factors of production;

Factors of Production and Their Rewards
The factors of production are seen as inputs which are converted by the entrepreneur to generate
an output. Consequently, when the factors of production are put to use they are usually
compensated. These compensations are seen as a rewards.
a. Land – the reward for utilizing land is known as rent. Land is not a free good as there
are many different uses for it, and therefore the rent derived from its usage varies on the
activity to which it is put.
b. Labour – Labour is the human input into the production process, individuals who use
their labour, whether skilled or unskilled, physical or mental, to perform tasks are usually
compensated by way of wages or salary. Some individuals are more productive because
of their level of education, training and experience, so they would more than likely
receive a greater salary than persons without.
c. Capital – When man-made goods and services such as machinery are engaged in order
to produce more goods and service for the satisfaction of the consumer, this reward is
known as interest. Hence, the reward to capital is the rate of interest.
d. Entrepreneur – The entrepreneur is responsible for organizing and managing the other
three factors of production in order to produce goods and services for consumption. The
reward for taking on these risks and efficiently operating the business is profit.
Factors Rewards
Land Rent
Labour Wages (Salaries)
Capital Interest
Enterprise Profits

Objective 6: Describe the factors of production;
Land
This includes those resources provided by nature, which are available to us for production and
ultimately the satisfaction of our wants. e.g. minerals, soil, etc.
Characteristics of Land
- Limited in supply (i.e. land is fixed);
The amount of the factor land on the planet Earth is fixed. We can never acquire more in
that sense.
- Land has no cost of Production
Extracting minerals from the Earth requires large amounts of other factors of production;
for example, extracting oil from the earth requires large amounts of capital. Preparing a
Plot of land for agricultural use requires cleaning and ploughing. However, it never costs
society, as a whole, anything to produce the land itself.
- Land is Geographically Immobile
Mobility is the ease with which a factor of production can move from one place to another
(geographically mobile) or one use/occupation to another (occupational mobility).
- Made up of both renewable and non-renewable resources;
Example: renewable – forest and non-renewable – oil
- Approximately 28% to 30% of the earth’s surface is dry land and 70% to 72% is
water.
NB:*There is arable or agricultural land.

*Increased rewards, (i.e. rent), implies greater/improved productivity.
*Without land, production is impossible, since land includes air, water, minerals, soil, etc.
Labour
This refers to all human resources which include both mental and physical capabilities used in
production.
Refers to those people who are available for work in the economy.
Characteristics of Labour
Labour may be:
- Labour is the Human Factor
Labour services are provided by man
- mental;
- physical (manual);
- machine-based;
- Inherited; e.g. Plantation owners inherited the labour of slaves born on their
plantations.
- Acquired; e.g. Plantation owners acquired labour by buying slaves.
- Skilled, semi-skilled or unskilled.
- Not homogenous
- Geographically and Occupationally more mobile than Land
Functions of Labour
(i) to contribute to the production process;
(ii) to assist in maximizing productivity.
Productivity of Labour: This refers to the output per worker-hour, which may be calculated as:
Total Output
_________________________________
# of persons used to produce that output
If all individuals in the labour force contribute (the way they should) to the production of gods
and services, then productivity can be maximized; i.e. production may efficient.
Labour Force – all individuals of working age within a society.
Factors That Determine Productivity

(i) amount of capital available for production;
(ii) education and training – The standard of general education and the variety and quality
of the training facilities available to the population influence the efficiency or
productivity of labour.
(iii) work ethic – a conscientious worker would be more productive that an idle worker.
(iv) health of the worker – The more sickly a person, the more he/she may be absent or
late.
(v) motivation – Managers ought to motivate workers to encourage them to produce
more.
(vi) working conditions – Poor working conditions lead to inefficiency or poor
productivity.
(vii) management and equipment.
The Supply of Labour
This refers to the number of persons who are willing and able to work as well as the average
number of hours each worker is prepared to work.
Factors That Determine The Supply of Labour

1. size of the total population which available for and willing to, work;
2. the age of retirement;
3. the school leaving age;
4. religious and traditional attitudes; e.g. women are not allowed to work in some societies;
or some religions are against working on Saturdays.
5. the average numbers of hours workers are required to work (say per week, per month,
etc.)
6. labour laws and regulation;
7. the health/status of the economy and the industries operating in it;
8. price and supply of other factors of production;
9. the adequacy and efficiency of the social and health services available; e.g.
transportation, health benefits such insurances etc.
10. the level of wages (salaries) offered to workers.

Capital
**Productivity of Capital = Output/Capital Invested**
Investment is the purchase of capital goods.
This is anything that is produced, to be used subsequently for the production of goods and
services. e.g. factories, machinery, roads, raw materials, etc.
Types of Capital
1. Physical
2. Social
Is normally provided by the government and is made up of roads, schools, hospitals and
housing. In some newer housing developments, these might be provided by the developer
as a condition of getting planning permission. Generally, government provides this
capital to increase the productivity of the workforce.
3. Working Capital
The raw materials and the intermediate goods used in the production process. A higher
level of output requires more working capital and lower level less.
4. Human Capital
Human capital consists of people’s abilities, knowledge and skills. This capital is also
more important to production. For human capital to grow, there must be education, skills
training and health care for all citzens
Physical capital consists of:

(i) Fixed Capital – things which do not change their form in the production process; e.g.
factories and machines.
(ii) Working Capital – those things which are changed (used up) in the production
process; e.g. raw materials such as cement, fertilizers, etc.
(iii) Financial Capital – the money which a company or business uses to run it day-to-day
operations. Financial capital consists of loan capital and share capital.
NB: Both financial capital and raw material may be considered as working capital.
Financial, fixed and working capitals are used to produce consumer goods and capital
goods.
Capital Accumulation is the increase in the capital stock of a country. For there to be capital
accumulation, society must forego present consumption. The public must consume less and save
more income. Firms will borrow the funds saved to purchase more capital. The increased capital
increases the production capacity of the country.
Consumer Goods – goods which are wanted for their own sake because they provide immediate
satisfaction. e.g. bread, juice, etc.
Capital Goods – goods which are used to help firms increase their output of consumer goods,
e.g. buildings, machines, etc

Social Capital – mainly takes the form of public investment in such things as:
roads, airports, educational facilities, bridges, ports, etc.
The Supply of Capital

This is the extent to which people are prepared to forgo consumer goods now. In other words,
when capital goods are produced, it means that some consumer goods are forgone (not
produced). But persons are generally willing to give up some consumer goods (by allowing the
production of capital goods), since it will be possible to achieve a much greater output of
consumer goods, in the future.
(Investment, in Economics, refers to the production of real capital goods; i.e. investment takes
place when capital goods are produced.
Enterprise
This includes all the risk-bearing attitude, visionary skills and organizing ability (of the
entrepreneur), to produce goods and services.
In other words, enterprise involves the organizing of land, labour and capital in order to produce
goods and services.

Objective 7: Identify the costs associated with production;
The sum of the payments for all the factors used to produce the good is the cost of production.
All firms, whether they produce goods or services, are subjected to operational costs.
Variable costs, are those which increase and decrease with the productivity of a firm.
Fixed costs are costs which exist regardless of the level of production of the firm. Fixed costs
do not fluctuate with productivity.
Total revenue – A firm’s total receipts; equal to price per unit times the number of units sold.
Average revenue – The firm’s total revenue divided by the number of units sold (This is another
name for price).
Total cost is the sum of total fixed costs and total variable costs incurred in production at a given
level of output.
Total Fixed Cost is the sum of all the payments for fixed factor inputs.
Total Variable Cost is the sum of all the payments for the variable factor inputs.
TC= TFC + TVC
TVC=TC-TFC
TFC=TC-TVC
Average cost is defined as total cost divided by output or quantity produced (AC= TC/Q). The
cost of producing any given output divided by the number of units produced, that is, the cost per
unit.
Average Total Cost is the cost per unit of output. It is found by dividing total costs by output.
ATC= TC/Output
Marginal cost is defined as the increase in total cost that arises from the production of an
additional unit of output
The additional cost from an increase in activity. Thus marginal cost is the additional cost of
producing one more unit of output.
MC=∆TC/∆Q
Examples
#1
Output Total Fixed Costs Total Variable Costs Total Costs
0 10 0 10
1 10 5 15
2 10 12 22
3 10 17 27
4 10 34 44

5 10 55 65
Formulas Used: TFC = TC – TVC
TC = TVC + TFC
TVC = TC - TFC
#2
Output Total Cost Marginal Cost Average Total Cost
1 15 15
2 22 7 11
3 27 5 9
4 44 17 11
5 65 21 13
Formulas Used: ATC = TC/Output
Marginal Cost = Change in Total Cost/ Change in Units
#3
Output TFC TVC AFC AVC ATC
1 100 50 100 50 150
2 100 80 50 40 90
3 100 100 33.33 33.33 66.66
4 100 110 27.5 27.5 52.50
5 100 150 30 30 50
6 100 220 36.67 36.67 53.33
7 100 350 50 50 64.29
8 100 640 80 80 92.50
Curves:
The average total Cost curve is U-Shaped. At First. Average costs fall. Then they reach a
minimum, and then they increase. The marginal cost curve is shaped like a tick, falling at first
and then rising continuously
There are some important points to note about the relationship between average and marginal
costs:
- When marginal cost is below average cost, average cost is falling
- When marginal cost is above average cost, average cost is rising
- The marginal cost cuts the average cost curve at the latter minimum point
-
Objective 8: Differentiate between short run and long run;
The phrases, short run and long run are used frequently in economics. The major difference
between the economic short run and long run is, the flexibility afforded to decision makers.
The short run refers to the time period for which the commitments that a firm has made are
binding.
Short run is that period of time when it is not possible to vary the quantities of all the factors of
production used in the production process.
The long run, on the other hand, refers to the time period in which most (if not all) of the firm’s
commitments can be changed.

Long Run is that period of time when all the factors of production in the production process are
variable.
A variable factor is one the amount of which can be varied in the short run. Labour and Raw
materials are variable factors
A fixed Factor is a factor the amount of which it is not possible to vary in the short run. Land
and Capital are usually fixed factors
Therefore, a firm which has conducted its ‘efficiency of production’ tests and wishes to alter its
means of production would have limited opportunity to change these processes in the short run
due to binding commitments. Instead, these changes can be made in the long run.
Objective 9: Distinguish between goods and services;

Goods are tangible products whereas services are intangible.
Objective 10: Explain the concept of resource allocation;

Recall:Human beings are forced to make choices because of scarcity.
In order to deal with the problem of scarcity, societies must answer three (3) important economic
questions:
1. What to produce?
Firms and governments must decide what goods and services are to be produced or
provided. Should the economy produce only the basic items that people need (Such as
medicine, food, roads and schools) or should the economy produce other items which are
wants (Such as cars, designer clothing and Candy)? The economy has to decide whether
only needs will be satisfied. If wants are to be satisfied, the economy must find a way to
determine what people really want.
2. How to produce?
Firms and governments must also decide on how output is to be produced. The method
of production can be Capital Intensive (Meaning that a great deal of capital is used in
relation to each unit of labour in the production process) or Labour Intensive Method
(Meaning where a great deal of labour is used in relation to each unit of capital) can be
used.
Production can take place on a large-scaled where output is mass produced, or on a small
scale, where output is custom made to suit the individual needs of the buyer.
3. For whom to produce?
Economies must also decide how the goods produced with the limited resources are
available are to be sahred out amongst members of society. Some goods are distributed
based on the ability to pay the price.
These questions help to determine how resources (i.e. the factors of production), are allocated to
satisfy the needs and wants of citizens in any given economy. Therefore, resource allocation
is the manner in which a society uses its resources to produce and distribute goods and services

to satisfy the needs and wants of its people. As such, economic systems are developed to aid the
resource allocation process.
Objective 11: List the types of economic systems;

Objective 12: Describe the characteristics of each economic system;
Objective 13: Assess the merits and demerits of each economic system;
An economic system may thus be described as the way a society is structured to facilitate
resource allocation. There are four (4) basic types of economic systems:
1. The Traditional or Subsistence Economy
2. The Free Enterprise, Capitalist, Market Economy or Laissez Faire Economy
3. The Central Command, Planned, Socialist, or Controlled Economy; or (The Communist
System)
4. The Mixed Economy
The type of economic that exists within a society is dependent on which sector of the economy
answers the 3 basic economic questions.
The Traditional Economy

This is one in which a community operates on tradition, where customs and habits are followed
without change or adjustment. Most often, these communities are self-sufficient, hence the
reason for being called subsistence economies, (i.e. their production levels result only in their
survival and very little else).
The basic economic questions are answered based on tradition (what has been happening
before).
Features:
- It is an agriculture-based economy.
- Barter usually occurs.
- Jobs and skills are handed down from one family member to another; thus positions in
society are already established.
- Individuals/Families who own most of the capital will continue to do so.
- Economy is closed to trade and external influences
- There is no formal government, though many of these societies have a leader and systems
to ensure justice and order
Advantages:
(i) The basic economic questions are already answered based on tradition.
(ii) Positions within society are already established.
Disadvantages:
(i) There is inefficient provision of goods and services.
(ii) There is inadequate use of skill in relation to the factors of production.
(iii) No upward movement of labour takes place.
Economic Questions

What to produce, How to produce and for whom to produce remain the same generally over the
same time.
Market Economy/ The Free Market Economy

If private individuals and firms (i.e. the private sector) play a dominant role in making economic
decisions, the economy is said to be a market economy.
Features:
- Private individuals own all the factors of production and business units
- The government assumes full responsibility in the economy for making laws and
providing infrastructure
- The private sector owns and allocates resources
- Resources are allocated through price mechanism
- Producers are guided by profit motive. This means that the responsibility of earning
profits motivates production.
- There is freedom of choice for the consumer. Choices are determined by the range of
goods produced by firms – consumers can choose to buy or not to buy.
- Workers can also choose whatever occupation they wish, as well as for whom they work.
-
Advantages:
(i) Manufacturers are free to produce what the consumers demand and the consumers in
turn are free to spend their money as they see it fit.
(ii) The decision of what to produce is not controlled by government or any single
individual/firm. Hence, there is greater participation in the decision-making process.
(iii) A large variety of goods and services are produced to satisfy the needs of consumers.
(iv) Prices are determined by the forces of demand and supply (the price mechanism).
(v) There is freedom from government interference.
(vi) Efficient production is promoted since resources are allocated to their most profitable
use.
(vii) Competition among firms improves quality, keeps prices low and spurs new
technology and innovation.
(viii) Private property – individuals have the right to own, control and sell land,
buildings, machinery etc.
(ix) Freedom of choice and enterprise – individuals are free to buy, organize and sell
the factors of production and their final products.
(x) Self-interest – individuals or firms will act in ways which, they believe, will lead to
their own self-interest, eg, maximizing profits.
(xi) Competition – Large numbers of buyers and sellers in the market.
(xii) Reliance on the price system – demand and supply
(xiii) Limited role for government – Laissez-faire-hands off policy of government
Disadvantages:
(i) Since the making of profits is the dominant motive of the private sector, only goods
and services that yield the highest profit will be produced.
(ii) Since there is no government intervention in this type of system, consumer could be
exploited through the charging of high prices for essential goods and services.
(iii) This system leads to great inequalities as the few rich get richer and the many poor
get poorer.
(iv) There is much pollution associated with this system especially when industrialization
begins to develop.
(v) There tends to be an over-consumption of demerit goods such as alcohol, cigarettes
and drugs.
(vi) Reliance on the price system - allows only consumers with the most money to
exercise greater spending power. Hence, the means of production may be devoted to
producing luxuries for the rich rather than necessities for the poor.
(vii) Some vital services are not marketable – e.g defense, justice, etc. would not be
produced adequately by private enterprise.
(viii) Competition itself may lead to inefficiency – competitive advertising may waste
resources.
(ix) Creates monopolies – limits consumer’s position, he is not able to take his business
elsewhere
(x) Social Cost – The producer is only concerned with profit and not much else – e.g
environmental concerns may not be addressed.
Economic Questions
What to produce - Firms Decide what to produce based on what is being demanded by buyers.
Each time a product is sold, it is a signal to producers to produce more of the item. Producers
will mover more resources into the production of goods that are in high demand
How to produce –Firms decide on how to produce based on factor availability, the level of
technology, and the relative costs of factors of production.
For Whom to Produce –Firms decide for whom to produce based on the price mechanism. If the
price mechanism signals that sugar-free snacks are in high demand, firms will produce them.
The Planned Economic System/The Command Economy (Socialist)
In this type of economy, all 3 economic questions are answered by the state. The state controls
all economic activities, and decides how much of each good or service the people should get.
Features:
- The state owns all the factors of production and business units
- The government assumes full responsibility for the economy – the government makes
laws, provides infrastructure and is involved in production
- There is no private sector
- The state, through central planning authority, allocates resources
- The workers are employed by the state
- There is restricted choice for the consumer, since producers are told what to produce by
the central planning authority and there are not many firms producing the same product
- There are no shareholders in companies, and production is not profit-driven
- Prices are fixed – shortages do not lead to price rises but to some form of rationing.
Advantages:
(i) The welfare of citizens is the primary goal of the economic system.
(ii) Income is more evenly distributed.
(iii) Since wages are controlled by the state, there is no industrial dispute (e.g. strike
action).
(iv) There is greater emphasis on the quality of life (e.g. health care, education, etc.) than
on the quantity of production in the country.
(v) It allows for the production of very important goods and services which do
Not yield high profits.
(vi) It allows central government to act as a protector and regulator from upward
pressure on prices to consumers.
Disadvantages:
(i) There is no freedom of choice for consumers or producers.
(ii) Conflicts of interests can arise because what the country needs may not be what the
people want.
(iii) There are too many officials and too much unnecessary procedure (bureaucracy or
red tape).
(iv) There is wastage of manpower because large numbers of people are required for
central planning.
(v) The lack of incentives for workers results in low morale and inefficiency.
(vi) The system is too rigid to adjust when changes occur; this can lead to shortages.
(vii) Government cannot always accurately determine the level of demand and this may
result in an inefficient allocation of resources.
(viii) Difficult to ascertain the satisfaction which consumers derive from consuming
different goods, difficult to match output to wants. Hard to test consumer demand.
(ix) Bureaucracy – excessive form filling, an addiction to red-tape, impersonal approach
to consumers, slowness in arriving at decisions, corruption. All this comes about as
officials estimate wants and the direction of the factors of production.
(x) Co-ordination (difficulties arising). Politicians have little experience with
administration, difficulties in managing a large organization.
(xi) State ownership of factors of production lessens incentives, diminishes efforts and
initiatives.
Economic Questions:
How to produce – Based on what resources it has, the level of technology present, and other
government goals. In such an economy, the state might, in fact, choose to use a labor-intensive
even though it has the technology to produce a good more efficiently. This could be because it
wishes to create jobs for the population.
For Whom to Produce – Based on the needs of the population and might direct labour into
whatever work is though necessary. Resources might not be used to produce luxury items.
The Mixed Economy
Most real-world economies are mixed economies. A mixed economy is one where there is a
combination of free market and planned economy. In this type of economic system, both the
government (public sector) and the private sector work together to manage the economic affairs
of the economy.
Decision-Makers:
1. Consumers – They decide which goods and services to buy.
2. Firms – They produce the goods and services according to consumer demand.
They aim to maximize profit.
3. Factor Owners – They own the factors of production; e.g. workers own labour.
4. Government – Gov’t guides the economic activities of a country through policies and
by providing certain goods and services for citizens.
Advantages:
(i) The state can intervene in areas of the economy through the passing of laws to protect
citizens from unfair trading practices.
(ii) Both the government and the private sector can cooperate in offering certain services;
e.g. transportation, health care.
Disadvantages:
(i) Too much government regulation may dampen the free enterprise spirit.
(ii) Some state-owned industries are allowed to operate inefficiently, thus wasting
resources.
(iii) Where government intervenes in the market by setting maximum and minimum
prices, this may cause excess demand or supply, which may be difficult to regulate in
the long-run.
(iv) Since the private sector helps to answer the economic questions, there can be the
creation of monopolies.
(v) Inequitable distribution of wealth can also arise.
The Private and Public Sectors

The Private Sector – refers to that part of the economy that is owned and controlled by private
individuals and firms;
Main Aim – to maximize profit;
Main Source of Funds – through loans from banks, etc.
The Public Sector – that part of the economy that is controlled by the government;
- does not use the profit motive as its driving force but concentrates
more on the provision of services for the benefit of the country;
Main Source of Funds – through taxation.

Economy Ownership of the Role of Government Role of Private Sector How resources are allocated
Factors of Production
Traditional The entire society owns No formal government No formal Private Sector, Decisions based on customs and
resources; they are however, Private individuals habit
passed on to future allocate resources based on what
generations by ancestors was done by ancestors
Command State Allocates resources and is None Central Planning authority
producer of goods and services allocates resources based on the
state’s decisions as to what is
best for individuals and the
economy
Free market Private Individuals  Provides the Framework  Owner of factors of  Price Mechanism
of laws production
 Provides the aids to trade  Allocates Scarce
– roads, electricity, water Resources
 No role in the allocation
of resources
Mixed Government and Private  Provides the framework  Owner of factors of  Government
Individuals of laws production  Price mechanism
 Provides the aids to trade  Allocates scarce resources
 Producer of some goods
and services

Objective 14: Identify the main types of business organizations in a free market;
Objective 15: Describe the features of each type of business organization;
What is a firm? A firm is a business organization that brings together and co-ordinates
the factors of production for the purpose of supplying goods and services.
Why is the firm necessary? Production is organized in firms because efficiency

generally requires large-scale production, the raising of significant financial resources
and careful management and monitoring of ongoing activities.
Types of Business Organisations

There are several types of business organisations that co-exist in an economy. These
include:
(i) Sole Traders or Sole Proprietorships (v) Franchises
(ii) Co-operatives (vi) Partnerships
(iii) State Corporations & Nationalised Industries (vii) Joint Stock
Companies
(iv) Conglomerates & Multinationals
Sole Proprietorship
This is a business owned by one person who provides capital for the business and
usually directs and supervises its activities. The owner takes responsibility for the total
debt of the business with unlimited liability; i.e. he is solely responsible for all debts,
moneys owed, losses, etc. of the business. The opposite is also true; i.e. all the profits
go to the owner.
Features
- Sole propietorships are usually small businesses
- They are easy to establish, as very little capital is needed to start one up.
- They are easy to operate, as the business might be involved in just one or two
activities; for example, production and selling, or providing a service.
- They are generally, though not always, small retail shops
Advantages
 It can be easily and quickly formed.
 The sole trader accounts only to himself or herself.
 The sole trader makes decisions quickly because he/she has no one to
consult.
 All profits belong to the sole trader.
 The sole trader can enjoy a personal relationship with his/her customers.
 He/She has access to a government small-business loan.
 A sole trader is usually flexible and can enter or exit the firm easily
according to changes in the market.
 A sole trader can progress or grow into a large company.
Disadvantages
 A sole trader assumes all the risks and losses himself or herself.
 It is not easy to obtain loans from a bank.
 In assuming all responsibilities the sole trader has long working hours.
 A sole trader has unlimited liability.
 If the sole trader’s business is disrupted, his/her customers may turn to
another competitor.
 Usually, a sole trader’s business dies with the owner.
Partnerships
A partnership occurs when 2 or more (up to 20) persons carry on business in common
with a view to making profits. The partners usually provide the capital and direct and
supervise the activities of the business.
All partners have the right to take part in the general management of the business.
 Sleeping or silent partners do not play an active role in the day-to-day

operations of the business.
Partners may have either limited or unlimited liability.
 A limited partner is only responsible for debts of the firm to the extent of the
capital he invested.
 Unlimited partners are responsible for the total debt of the business;
(collectively and individually).
Features
- Partnerships provide the financial capital needed
- Partners share profits as well as losses
- Partners bear the liabilities for debts incurred by the business
- Partners need to register the business with the Registrar of Companies
Advantages
 As with a sole trader, a partnership is easy to form with little legal
formalities.
 More capital can be raised by the combined resources of a number of
partners.
 Specialisation in management is possible as each partner may participate
in the field in which he has experience and training.
 In a partnership, the work load can be shared among the partners. This
makes it possible for a partner to take a vacation, and, on the death of a
partner, the remaining partners can continued to run the business on their
own or they may find a new partner.
 There is still the incentive to succeed and there is also close contact with
employees and customers.
 A partnership is usually flexible and partners can join or leave the firm
easily according to changes in their market.
 A partnership can progress or grow into a large company.
Disadvantages
 All the partners stand to lose if on partner makes a mistake.
 Capital is still limited.
 Except in the case of a limited partnership, there is still unlimited liability
if the business fails.
 There is the risk of disagreement and quarrelling among partners.
 At least 1 partner must have unlimited liability.
Co-operatives
A co-operative is an association of persons who have voluntarily joined together to
achieve a common goal through the formation of democratically controlled
organisation, making equitable contributions to the capital required and accepting a fair
share of the risks and benefits of the business.
Co-operatives have a great deal of freedom to draw up their own by laws, but there are
certain principles and practices that distinguish them from private business, to which
they must adhere.
(i) Open (voluntary) membership, without discrimination, once persons are
willing to accept the responsibility of membership.
(ii) Democratic control – Co-operative affairs should be administered by
persons elected or appointed in a manner agreed by the members and
accountable to them.
(iii) Limited interest on capital invested – Share capital should receive only a
strict limited rate of interest, if any.
(iv) Profit sharing – The economic benefits resulting from the operations of the
co-op belong to the members and should be distributed fairly.
In addition to these principles, co-ops should:

- make provision for the education of their members, officers, employees and the
general public;
- actively co-operate in every way possible, with other co-ops at local, regional
and international levels so as to serve the best interest of their members and their
communities.
Advantages
 There is a guaranteed market for members.
 Little or no advertising costs are incurred.
 There is no profiteering.
 There is a democratic form of management.
 Employment is created within the organisation.
Disadvantages
 Management may be poor and inexperienced.
 Conflict may arise when members are both employers and employees.
 Lack of capital may cause problems.
 Co-operatives may be unable to attract skilled professionals.
 Capital base is limited.
State (Public) Corporations/Nationalised Industries
These are corporations or industries that are owned, controlled and managed by the
government or state. The main aim of the public corporation is to provide specific
goods and/ or services that meet the need of the country, at a reasonable price.
Main Features
1. There are no private shareholders; government owns 100%.
2. The government appoints the controlling board
3. A government minister is usually responsible for seeing that the corporation is
acting within the policy requirements laid down by Parliament.
NB: Any profits made by a public corporation must be used for capital investment,
the lowering of prices, the raising of wages, etc.
Advantages
 State corporations provide vital services at reasonable prices, e.g. water,
electricity and postal services.
 They enjoy economies of scale resulting in low cost of production.
 Their profits are distributed to the population.
 They safeguard jobs rather than engage in retrenchment.
 They have regards for the environment and working conditions of
workers.
Disadvantages
 Losses by the companies are usually born by the taxpayer.
 State corporations and nationalized industries are not usually run
efficiently, often due to political interference.
 The lack of a profit motive causes losses due to tax management.
 There is often a lack of proper accountability.
 Too much red tape in management decisions causes unnecessary delays.
 National issues are given preference over local ones.
Conglomerates
A conglomerate is simply a group of companies each operating in different industries
and sectors of an economy.
Advantages
 There is strength and security in numbers; hence risk of failure is spread.
 Companies can draw on each other’s resources leading to economies of
scale.
 There is much interaction between members in terms of staffing,
promotions, etc.
 Successful companies help to make up for companies that perform below
expectations.
Disadvantages
 Because of the diversity of interests, analysis of the group’s companies
is difficult.
 Some managers may resent control outside of their own company.
 There may be friction between lines of authority.
Multinationals/ Multinational Corporations

A multinational firm is one which owns controls and operates enterprises in several
countries at the same time in order to increase market share and improve overall profits.
The parent company makes all the decisions which are carried out by the management
of the subsidiary companies.
Examples: Shell, Digicel
Features
- MNCs invest heavily in the primary and secondary sector in the host countries
- They have branches or subsidiaries in many foreign countries. Globalization has
allowed these companies to extend their geographical reach.
- The subsidiary might not be totally owned by the parent company. However,
the parent company has the controlling share in subsidiaries.
Advantages
 Multinationals provide much-needed investment in Caribbean
economies.
 They provide foreign expertise and train local workers.
 They allow access to already-existing markets.
 They are a valuable source of taxation, revenue and foreign exchange.
 They create employment.
 They encourage positive work ethics.
Disadvantages
 Multinationals extract raw materials but do not add value locally.
 The welfare of the economy is not a concern of a multinational.
 They transfer profits to home countries.
 They may change the culture of a country.
 They bargain for tax holidays and ‘sweetheart deals’ in exchange for
investment.
Joint Stock Companies or Limited Liability Companies

These are companies that issue shares. There are 2 types of joint stock companies:
private and public joint stock companies.
Private Joint Stock Companies

These often consist of not less than 2 persons and more than 50. A private company
must have the word limited (Ltd) included in its name. The shares in this type of
company cannot be offered to the public for sale. (The company is usually owned and
operated by family members.)
Examples: Caribbean Glass Company Ltd., Flame Industries Ltd.
Features
- The business is a distinct entity in the eyes of the law, separate from its owners.
This means that is an individual with its own identity. A customer or a creditor
can file a suit against the company but not the owners.
- The owners (Who finance the business) are called Shareholders. The
shareholders are private individuals in the economy and could be family
members. Shareholders have limited liability (means that in the event that the
business is liquidated, the shareholders are only liable to pay to a maximum of
the amount that was invested into the business)
- The company must be registered with the Registrar of Companies in the Country
in which it is operated
- The name of the business must include the word “Limited” (Ltd.)
- By law, this business must have a minimum of two members and a maximum
of 50
- The company’s accounts must be audited by an established auditor. The
accounting records must be properly kept. These records can be inspected by
shareholders and the authorities
Advantages
 Privacy is retained.
 There is limited liability.
 Continuity is ensured – the death of a shareholder does not affect the
company.
 It enjoys benefits such as specialized or expertise help, flexibility, etc.
Disadvantages
 Shares are not freely transferable without the director’s consent.
 The amount of capital is limited and growth is slow.
 It is vulnerable to changes in demand., the minimum
 The entrepreneurial pool is restricted to family members and close
friends.
 Such companies are not known as innovators or for research and
development.

Public Joint Stock Companies
Like the private joint stock company, the minimum number of persons is 2. However,
there is no limit as to the number of persons that can be a in a public company. It must
have the words public limited company (PLC) at the end of its name. This company
can offer shares and debentures for sale to the general public.
Features
- Funding for this business comes through borrowing from banks and other
financial institutions or through the sale of stocks and shares on the stock
exchange to members of the public
- Members of the public purchase stocks and shares from their savings
- Shareholders have limited liability
- A minimum of seven persons can begin the business operations. There is no
limit to the maximum number of investors
Advantages
 There is easy access to capital for expansion.
 They enjoy economies of scale.
 Specialists or experts are hired to run the company.
 The PLC is independent of its owners.
 Risk is spread over many shareholders.
Disadvantages
 The objectives of the managers may be different from shareholders
(owners).
 Small powerful groups, e.g. insurance companies, may dominate the
company.
 Over-expansion can lead to diseconomies of scale.
 Workers feel left out in decision-making.
 Accounts must be submitted annually to the Department of Trade for
inspection.
 (Please identify examples of each of these businesses.)
Objective 16: Explain the concept of economies of scale;

Economiesof scale refer to the benefits of large-scale production which leads to lower
average costs for a firm.There are internal and external economies of scale as well as
internal and external diseconomies of scale.
Economies of scale are the cost advantages that accrue to a firm as the firm increases
in size
Economies of scale are measured by the decrease in the long-run average costs of a
firm. Output (quantity Produced) is plotted on the X-Axis, and Long-run average cost
is plotted on the Y-Axis. The long-run average cost curve is U-Shaped. When Long-
run average costs are falling, the firm is experiencing economies of scale.

Objective 17: Give examples of economies of scale;
Internal Economies of Scale
Internal Economies of scale are those benefits derived from the increase in size of the
firm.
Internal Economies of Scale are the benefits to the firm that originate from the
organization itself.
They refer to factors over which the firm has control; i.e. benefits derived from the
firm’s own action. These may include:
(i) Technical Economies of Scale
(ii) Marketing Economies of Scale
(iii) Financial Economies of Scale
(iv) Risk-Bearing Economies of Scale
Technical Economies of Scale

(i) Increased Specialisation: This is where workers are employed to perform
specialized tasks and operate specialized equipment. The larger the firm the
greater the opportunities for the specialization of men and machines.
(ii) Indivisibility: Some types of capital equipment can only be used or

employed efficiently in units of minimum size, and this minimum may well
be too large for the smaller firm. Smaller versions of these equipment could
be made but their usefulness would not justify their cost. This therefore
means that firms with small output will be unable to use highly specialized
equipment to their advantage.
(iii) Underutilization: Highly qualified specialists may also be underutilized in

a small firm if they are put to perform tasks other than those for which they
have been specially trained.
(iv) Increased Dimensions: This is where the dimensions of an equipment,

container, building, etc. are increased. However, this may require little or
no extra labour, costs, etc. For example, a small photocopier may be able to
make 20 copies per minute. If the firm purchases a larger copier that can
make 40 copies per minute, it will still need no more than one (1) person to
operate the copier. In other words, the size of the machine increased and the
number of copies (i.e. output) per minute increased but the labour remained
the same.
Marketing Economies of Scale

In marketing economies, the large firms are at an advantage over the small
firms. For instance:

1. They realize high profits, incur lower costs, and so on. A large firm often buys
its materials in bulk thus it obtains preferential terms and treatments from
suppliers. The goods would be at a lower price and the large firm would be able
to dictate quality, delivery, etc. more effectively than a small firm. It is much
easier a supplier to deal with a large order from a bulk buyer rather than a
number of small orders from small firm that may require say different colours
and sizes. For example, it may take a supplier one (1) hour to deliver goods to
a number of small firms whereas, travelling the same route at the same speed, it
may take him half an hour to deliver the same number of items to one (1) bulk
buyer. (In this case, time is seen as money.)
2. A large firm will be able to employ specialist buyers whose expertise will be
used in deciding: the right materials, the right time, the right price, etc.
3. The selling cost per unit of the larger firm will be much lower than that of the
smaller firm.
4. The packaging cost per unit of the larger firm will also be lower.
5. The clerical and administrative costs involved in ordering say 1000 articles for
a large firm may be just the same as the costs of ordering 100 articles in a small
firm.
Financial Economies of Scale

The large firms are able to borrow more at lower interest rates simply because of their
size and popularity. They also have access to more sources of finance.
Risk-Bearing Economies of Scale

The large firms are usually better prepared than the small firms to cope with the risks
of trading. Many large firms practice diversification as a means of reducing the risks
of trading. Many of them manufacture a variety of products so in the event that demand
for one product falls it is possible that the demand for another or several of their other
products will increase. A small firm will mainly specialize in one product thus a fall in
demand may result in decreased profits or a total loss.
a. Increased risk – The willingness to bear greater risks may lead to growth of the
firms; hence, the firm may experience economy of scale as it increases its scale
of production increases.
b. Growth of auxiliary facilities – may benefit or encourage other firms to develop

ancillary facilities, e.g, warehouse, transportation system
External Economies of Scale

External economies of scale may arise from growth in the size of the industry within
which the firm operates.
External Economies of Scale are the benefits given to the firm that originate from
outside the firm, especially from the neighboring firms.
They are sometimes referred to economies of concentration. This is because similar
firms tend to group together so as to enhance:
(1) labour
(2) ancillary services
(3) commercial facilities
(4) co-operation among themselves
Labour: The grouping of similar firms in one area leads to the creation of a skilled
labour force. The skills learned are those used in the industry.
Ancillary Services:As the industry expands, specialists may be established or hired to
provide the necessary services for the major industry.
Commercial Facilities: These may be set up because of the existence of the industry,
e.g. banks, insurances, etc. Transport firms may develop
special equipment to deal with the industry requirements.
Cooperation: There will likely be more joint venture, e.g. research centres and trade
societies are often formed as a result of cooperation among
firms.
Objective 18: Explain the concept of diseconomies of scale;

Diseconomies of scale are the cost disadvantages experienced by a firm due to
expansion.
OR
Are the Cost disadvantages incurred by a firm due to over-expansion by a firm.
Internal Diseconomies of Scale

These occur as a result of the firm’s own action.
1. As the firm expands, it becomes more difficult for the general manager to
control the different activities.
2. Large investments in machinery, tools, etc. can make the firm inflexible. As a
result, it will be unable to respond quickly to changes in consumers’ demand.
3. As a firm grows, management will lose touch with the customers.
4. As a firm expands, more people will know about it. It becomes more visible
and as a result can be subjected to government regulations such as price controls
and closer scrutiny to prevent say monopolies.
External Diseconomies of Scale

These occur as an indirect result of a firm’s actions. For instance, we may look at:
Labour – As a firm’s demand for labourers with particular skills increases, the wage
rate can increase; (through trade union pressures).
Inputs – As the demand for raw material increases, the cost for these raw materials will
increase.

Objective 19: Outline the advantages and disadvantages of division of labour.
Specialization & Division of Labour
Specialization of labour refers to the division to economic activity into a number of

specialized portions. (e.g. in schools there are several subject areas.)
Division of labour is where each portion is assigned to a specific person or worker.
(e.g. each teacher is given a specific subject area to teach.)
NB: With specialization and division of labour, each person works at what he/she does
best, so as to maximize output.
Advantages and Disadvantages of Division of Labour

(See previous definition)
Advantages
1. Quality is improved – Workers become extremely proficient.
2. Time is saved – Production is increased.
3. Easier training of workers
4. Output increases
5. Lower cost of production – You can sell at a lower price.
6. Less Manual Labour – Since more machines are affordable workers will be less
fatigued (physically).
7. More use can be made of machinery – When a complex process has been broken
down into a series of separate, simple processes, it is possible to devise
machinery to carry out each individual operation.
Disadvantages
1. Work can become boring and monotonous.
2. There is loss in pride of a job – One individual will not be able to say that he/she
made an item by him/herself.
3. Loss in craftsmanship – Work can be done by machines instead of craftsmen.
4. Increased risk of unemployment since workers’ skills might be limited.
5. Interdependence between separate firms (or departments within a given firm)
may cause problems since draw backs in one firm (or department) may affect
production in another.
NB:
How Firms Grow
Firms grow in two ways: by market penetration or expansion in product range offered.
However, many firms grow by way of mergers and amalgamations. The joining
together of two or more firms is known as integration.
Vertical Integration
Rationalism
This describes the process of eliminating less efficient plants or factories, and
concentrating production in the more efficient units of production.
Section 3: Markets and Prices
SPECIFIC OBJECTIVES
Objective 1: Explain the term “market”;

A market refers to any medium or situation in which goods and services can be
produced and exchanged.
A market is any mechanism that facilitates the interaction of buyers and sellers with a
view to the purchase and sale of a good or a service.
Price refers to the amount of money consumers are required to pay for a good or
service.
The Price Mechanism - This is a basic regulation of economic activity. There are
three (3) components of the price mechanism: demand, supply and price.
Market systems are those in which decisions relating to resource allocation,

production, consumption and price levels are left up to individuals and organizations,
who act in their own best interest.
There are however two variables which influence the rational choice(s) for both
consumers and firms. They are supply and demand.
Objective 2: Identify the market forces;

Objective 3: Describe the relationship between price and demand, and price and
supply;
Market Forces are the conditions of demand and supply that affect demand and supply
in the market.
Generally:
Demand refers to how much quantity of a good or service is desired by consumers.
Supply is the amount of a good or service producers are willing to offer at a particular
price.
There are several determinants which influence the quantity demanded and supplied
of goods and services. However, our focus is first placed on price because of its pivotal
role in markets. Assuming all these other determinants are held constant, ceteris
paribus, the quantity demanded, is the amount of a good or service consumers are
willing/can afford to purchase at a given price. And the quantity supplied, is the
amount of a good or service producers will provide at a given price.
Demand
In Economics, demand refers to the willingness and ability of consumers to purchase a
good or service at a particular price, at a given time. The law of demand states that as
price rises demand falls (and vice versa). Therefore, demand is negatively related to

price; i.e. it varies inversely with price. As such, a normal demand curve slopes
downward from left to right, indicating that consumers buy more of a product when the
price is low.
Supply
This refers to the willingness and ability of producers to produce a commodity at a
particular price at a given time. The law of supply states that as price increase, the
quantity supplied also increases (and vice versa). Therefore, supply and price move
together; (in the same direction). In other words, there exists a positive relationship
between price and supply. A normal supply curve slopes upward from left to right.
This is because producers are willing to produce more goods when price is high.
Summary:
The law of Demand states thatthe quantity demanded of a good varies inversely with
its price, assuming that other things that may affect demand remain the same. The most
important of these are the buyer’s income and price of related goods.
The Law of Supply states that the quantity of a commodity supplied usually varies
directly with its price, assuming that all other factors that may determine supply remain
the same.
Objective 4: Explain the concept of ceteris paribus;

The Principle of Ceteris Paribus
Ceteris paribus is a Latin phrase that means, ‘all other things being equal’; i.e.:
- It is understood, or should be taken for granted that everything else remains
unchanged or constant.
- There are no other factors or assumptions to take into account because they
will not change.
- Everything else is normal.

Objective 5: Illustrate the concepts of demand and supply by using demand and
supply curves;
DEMAND CURVE
The law of demand states that, the higher the price of a good or service, the less of
these products consumers are willing to purchase, ceteris paribus. As the price of these
goods and services fall, the more of these products consumers are willing to
purchase,ceteris paribus.
Figure 3.1
Above is a demand curve; it shows the relationship between price and quantity
demanded, ceteris paribus.
The demand curve depicts the law of demand, and shows that, when the price of a
good or service is at a high price, P1, the quantity demanded will be low, Q1. When the
price is lower at P3, the quantity demanded will increase to Q3.
Note:
1. Because the quantity demanded increases as the price decreases, the demand curve
has a negative slope
2. The change in price resulted in a movement along the demand curve.

Price Effect on DEMAND
Price Change Effect
Increase Movement (upwards) along the demand Curve; contraction of demand, or fall in
quantity demanded
Decrease Movement (downwards) along the demand curve; extension of demand, or rise
in quantity demanded
Shifts in the Demand Curve

Effect Shift
A rise in Demand Shift of the demand curve to the right
A Fall in Demand Shift of the demand curve to the Left
SUPPLY CURVE
The law of supply states that, as the price of a commodity rises, so does the quantity
supplied, ceteris paribus. As the price falls, the quantity supplied also falls, ceteris
paribus.
Figure 3.2
Above is a supply curve; it shows the relationship between price and quantity supplied,
ceteris paribus.
The supply curve is a graphical representation of the law of supply, and shows that,
when the price of a commodity is low at P1, the quantity supplied will also be low at
Q1. As the price of the commodity increases to P3, the quantity supplied also increases
to Q3.

Note:
1. Because the quantity supplied increases as price increases, the supply curve has a
positive slope.
2. The change in price results in a movement along the supply curve.
Price Change Effect

Increase Movement (upwards) along the demand Curve; contraction of demand, or fall in
quantity demanded
Decrease Movement (downwards) along the demand curve; extension of demand, or rise
in quantity demanded
Objective 6: Explain the determinants of demand and supply;

Determinants of Demand
There are several factors that influence the quantity of any good demanded by
consumers in a given market or industry. These include:
1. The price of the commodity itself – Once the price of the commodity changes,
then qty demanded of that commodity also changes.
2. Level of household income – An individual’s income determines his demand

for a product. If there’s an increase in income then the qty of goods demanded
(ceteris paribus) will increase.
3. Tastes and Fashion – Everyone has preferences for particular products over
others. Therefore, changes in fashion or consumer taste lead to changes in qty
demanded of a commodity. Some of these changes may be caused by sales
promotion, rumours, etc.
4. Prices of other goods – In some cases, the demand for on commodity will
depend partly upon the prices of other commodities, which are seen as
complements and substitutes.
Substitutes are goods that are seen as being in close competition with on another,
since they may be used to satisfy the same purposes, e.g. pepsi and coca cola;
margarine and butter. When an increase in the price of one good causes an
increase in the demand for another good, those goods are said to be substitutes
for each other.
Complementary goods refer to goods that are consumed or used together, e.g.
car and gasoline; printer and ink. For complements, an increase in the price of
one good leads to a decrease in the demand for another. If the price of petrol
continues to increase, fewer people are likely to buy cars in the future.

5. Population or Number of buyers – An increase in the population and hence
the number of buyers or consumers, increases market demand for products. The
age composition of the consuming public also affects the demand for many
goods and services. For example, persons over the age of 90 are likely to
demand more wheel chairs than bicycles.
6. Government policy – The demand for some goods is affected by government

policy toward them. Government taxation on imported motor cars will tend to
increase the price of cars and hence reduce the demand for cars.
7. Seasonal Factors – The demand for some goods varies according to the time of
year. Thus the demand for umbrellas in the Caribbean increases during the rainy
season, while the demand for air conditioning units increases in the USA during
the summer.
8. Consumer Expectation – If people expect the price of foodstuff to increase

tomorrow, they will stock up today to try and beat the price increase.
Determinants of Supply
Several factors also influence the supply of a given commodity in any industry or
market.
1. The price of the commodity itself

2. The prices of the factors of production (input costs)
3. The goals of producers
4. The state of technology
5. The scale of operation (the size of the industry)
6. Taxation
7. Sellers’ price expectation

Objective 7: Illustrate how changes to the determinants affect demand and supply
curves;
DEMAND CURVE
There are factors which can cause a shift in the demand curve. These factors are non-
price determinants and include:
– Disposable income
– Consumer preferences
– Changes in population size
– Changes in the price of substitutes or complements.
Changes in these factors will result in a shift of the demand curve to the left. A
rightward shift will occur as a result of an increase in the price of substitutes, decrease
in the price of complements and an increase (or decrease) in income where the good is
a normal good (or inferior good).
Figure 3.3
Figure 3.3 above shows that at any given price level, consumers are now willing to
purchase more of a commodity.

A leftward shift of the demand curve will occur if there is a decrease in the price of a
substitute or increase in the price of a complement, or a decrease in income (where the
good is normal) or increase in income (where the good is an inferior good).
Figure 3.4
Figure 3.4 above shows that at any given price level consumers are now willing to
purchase less of a commodity.
SUPPLY CURVE
The factors which impact quantity supplied are the price of inputs, improvements in
technology, the number of suppliers and prices of related goods.
A fall in the price of inputs, increase in the level of technology, increase in the number
of suppliers, rise in the price of a complementary good or fall in the price of a substitute
will result in a rightward shift of the supply curve as shown in the graph below.

Figure 3.5
Figure 3.5 above shows that at any given price level, suppliers are willing to supply
more commodities.
On the other hand, a rise in the price of inputs, rise in the price of a substitute, fall in
the price of a complement or decrease in the number of suppliers cause a leftward shift
in the supply curve. This is also shown in the diagram below.
Figure 3.6

Figure 3.6 above shows that at any given price level, suppliers are now willing to supply
less of a commodity.
Summary:
Price
Shift to Right
(increase)
Demand
Curve
Shift to Left
(decrease)
Quantity Demanded
^^DEMAND CURVE^^
Price
Shift to Left
(decrease)
Supply Curve
Shift to Right
(increase)
Quantity Demanded
^^SUPPLY CURVE^^

Objective 8: Explain the concept of market equilibrium;
Market Equilibrium
Equilibrium is a point of stability between opposing forces. The point at which both
the demand and supply curves meet or intersect is known as the point of
equilibrium. The corresponding price and quantity are known as equilibrium price (or
market-clearing price) and equilibrium quantity respectively. At equilibrium price,
both quantity demanded and quantity supplied are equal.
 Equilibrium Price – the price at which Qd = Qs
 Equilibrium Qty – the amount bought and sold at equilibrium price

OR
A market is said to be in equilibrium where the supply and demand curves intersect. At
this point, for a given price, the quantity supplied is equal to the quantity demanded and
the market is most efficient.
Shortage and Surplus

Since there is only one point at which demand and supply are equal, (i.e. at equilibrium)
then:
 At prices above the equilibrium price, there would be a surplus of commodities
(excess supply);
Quantity Supplied > Quantity Demanded
 At prices below the equilibrium price, there will be a shortage (excess demand).
Quantity Demanded > Quantity Supplied

Objective 9: Illustrate market equilibrium diagrammatically;
Figure 3.7
Figure 3.7 above shows a market in Equilibrium.

Objective 10: Explain changes in the market equilibrium;
Objective 11: Illustrate changes in the market equilibrium;
A shift in demand or supply curves will cause changes in the equilibrium price,
equilibrium quantity, or both.
Shifts in the demand and supply curves alter market equilibrium. On the demand side,
any factor which makes the demand curve shift to the right (without affecting the supply
curve) will increase the equilibrium price and quantity.
Figure 3.8
Figure 3.8 above shows the effects of a rigthward shift of the demand curve on the
market equilibrium.
Factors which shift the demand curve to the left (without affecting the supply curve)
will decrease the equilibrium price and quantity.

Figure 3.9
Figure 3.9 above shows the effects of a leftward shift of the demand curve on market
equilibrium.
As it relates to quantity supplied, any factor that shifts the supply curve to the right
(without affecting the demand curve) will lower the equilibrium price and increase the
equilibrium quantity.
Figure 3.10
Figure 3.10 above shows the effects of a rightward shift of the supply curve on market
equilibrium.

Factors which shift the supply curve to the left (without affecting the demand curve)
will increase the equilibrium price and decrease the equilibrium quantity.
Figure 3.11
Figure 3.11 above shows the effects of a leftward shift of the supply curve on market
equilibrium.

THE EFFECT ON EQUILIBRIUM PRICE AND EQUILIBRIUM QUANTITY OF A SHIFT IN DEMAND OR SUPPLY
From the table above, we can draw two (2) conclusions:
Shift of Curve Effect on Equilibrium Price Effect on Equilibrium Quantity Law of Demand and Supply
Increase in Demand (Shift to the right in Increase in Equilibrium Price Increase in Equilibrium Quantity Third Law of Demand and Supply
the Demand Curve)
Decrease in Demand (Shift to the left in Decrease in Equilibrium Price Decrease in Equilibrium Quantity Third Law of Demand and Supply
the demand Curve)
Increase in Supply (Downward shift of Decrease in Equilibrium Price Increase in Equilibrium Quantity
the supply Curve)
Decrease in Supply (Upward Shift of the Increase in Equilibrium Price Decrease in Equilibrium Quantity
Supply Curve)
1. A change in demand causes equilibrium price and equilibrium quantity to move in the same direction as that change in
demand
2. A change in supply, ceteris paribus, causes equilibrium quantity to move in the same direction as the change in supply, and
equilibrium price to move in the opposite direction.

The Third law of Demand and Supply states that:
1. An increase in demand, ceteris paribus, will tend to increase both equilibrium
price and equilibrium quantity traded; and
2. An decrease in demand, ceteris paribus, will tend to decrease both equilibrium
price and the equilibrium quantity traded.
The Fourth law of Demand and Supply states that:

1. An increase in supply, ceteris paribus, will tend to lower quilibrium price and
increase the equilibrium traded; and
2. A decrease in supply, ceteris paribus, will tend to increase equilibrium price and
lower the equilibrium quantity traded.
Summary:
The impact of changes in market conditions on market equilibrium
From the demand side
1. Increase in buyer’s income > increase in demand and increase in price

2. Price of related goods > increase of price, increase in demand for substitutes,
decrease in demand for complement
3. Non-monetary factors eg change in population, advertisement and change in
taste and fashion > increase in population, increase in demand, increase in price
4. Buyer’s expect increase in price > increase in demand and increase in price
5. Changes in the distribution of income > increase in income distribution, increase
in demand for normal goods, decrease in demand for inferior goods, decrease in
demand for luxury goods.
From the supply side
1. Increase in the cost of the factors of production > shift of the supply curve to the
left > resulting in a decrease in supply and an increase in price.
2. Prices of other goods > increase in the price of other goods, decline in supply of
good A and increase in supply of other goods.
If because of an increase in demand, the prices of other goods increase, the

production of these goods will become more profitable, and resources would tend
to move towards the industries making these higher-priced commodities. The
production of goods, with prices unchanged, would now be less attractive to
suppliers.
3. Suppliers’ expectation > Suppliers expect increase in demand > increase in

supply
4. Non-monetary factors eg technology, weather, changes in the number of
producers, unexpected events. Increase in technology result in increase in
supply
5. The Gulf War decreased the supply of oil. Natural disasters, decrease in yield
of crops and animal and terrorist bombs can all affect supply.
6. Changes in the number of producers - Supply will increase if new firms enter
the market.
7. Taxation and subsidies – The imposition of indirect taxes will bring about
changes in supply. A tax on a commodity may be regarded as an increase in the
costs of supplying that commodity, and the supply curve will move to the left
Objective 12: Explain the concept of price elasticity of demand;

Elasticity of Demand
Recall that changes in the determinants of demand and supply lead to changes in both
the quantity demanded and the quantity supplied.
Elasticity of Demand refers to the responsiveness of quantity demanded to a change in
any one of the determinants of demand; i.e. how quantity demanded behaves when one
of the determinants of demand changes.
Formula: % ∆ in quantity demanded (QD)

% ∆ in the determinant
Where ∆ means change
There are different types of elasticities of demand including:

- Price elasticity of demand
- Income elasticity of demand
- Cross elasticity of demand
Price Elasticity of Demand (PED)

This refers to the degree of responsiveness of quantity demanded to a change in price.
For some products, price changes give rise to very significant changes in the quantity
purchased, for others, price changes give rise to very little changes in the quantity
purchased. For example, if the price of airfare falls during the summer, demand would
rise significantly, especially since many persons travel around that time. However, a
fall in the price of salt would not result in a ‘mad rush’ of consumers to the
supermarkets.

When consumers are quite responsive to small changes in the price of a commodity,
the demand for that commodity is said to be elastic. However, when small price
changes result in modest or insignificant changes in the amount purchased, demand is
said to be inelastic.
Objective 13: Outline factors affecting price elasticity of demand;

Determinants of Price Elasticity of Demand
1. Availability of Substitutes or Complements

If a commodity has a number of close substitutes, all at similar prices, the demand for
the commodity itself will be elastic. This means that a small price increase in the
commodity will cause many consumers to switch to substitutes.
E.g if the price of Colgate increases, people will switch to Pepsodent, Aquafresh, or
other brands and as such, the Ed for Colgate will be elastic.
When there are no close substitutes for a commodity, consumers will buy the same
quantity regardless of the price changes. Thus demand will be inelastic.
E.g No matter how much the price of petrol rises, persons with vehicles will still
purchase it in order to drive.
Similarly, if good X is a complement to good Y, the demand for good X tends to be

inelastic. This is because both goods (X and Y) depend on each other. Again, using
the example of petrol, persons who must drive will purchase petrol, no matter how
much its price increases. Also organizations that have to use printers on a daily basis
will purchase ink even if the price increases.
2.The Price of the Commodity Itself

If a commodity is relatively inexpensive its demand will be price inelastic but if it is
relatively expensive demand will be price elastic. For example, if within 6 months the
price of matches rose from $1 to $1.50, persons may hardly complain, although there
is a 50% increase in price. However, a 50% increase in the price of a car will strongly
affect buyers – they may decide not to buy. A 50% decrease may however influence
persons to buy cars.
3. Income Level
The rich, especially the super-rich, are usually not bothered by the change in prices.
Therefore, their demand for most goods tends to be inelastic. On the other hand, the
low-income group is very sensitive to prices. Hence, their demand for most goods tends
to be price elastic. As such, any price change is more than likely to affect their
expenditure patterns.

4. Portion of Total Expenditure
Goods that form a very small portion of our total expenditure have inelastic demand.
For example, if a consumer spends $1000 every month and only $2 is spent on light
bulbs, then an increase in the price of bulbs will not affect him greatly since the $2
represents only a minor portion of his total monthly expenditure. The opposite also
holds true. For expensive items such as jewelry or houses, demand is elastic; even a
small increase in price will significantly affect Qd.
5.Time Period
In the short-term, the demand for most products tend to be inelastic; (exceptions may
include stocks, bonds and other securities). In the long-term however, demand tends
to be more elastic. This is because it takes time to adjust to a change in price. As time
goes by, people become more aware of the price changes and move toward substitutes.
6.Advertising
Advertisements of sales, discounts or new products can influence consumers to increase
their demand for a product thus making demand elastic. However, without
advertisements many consumers might not know of the existence of new products,
discounts or sales. Hence even with a significant decrease in price, there may be a very
small increase in Qd; demand is therefore be inelastic.
7. Whether the Product is a Necessity or Luxury

If the product is a necessity, demand will tend to be price inelastic. Buyers will be
relatively indifferent to price changes. For e.g diabetics will purchase insulin whether
the price increases or not because it is a necessity.
8. Brand Loyalty
When persons are loyal to a particular brand, an increase in price leads to a small
decrease in Qd; i.e demand is inelastic.
So far we have been looking at elastic and inelastic demand. But what happens when
demand is neither elastic nor inelastic?

Objective 14: Illustrate price elasticity of demand, using simple calculations;
Price Elasticity Formula: % ∆ QD
% ∆ Price
NB: (i) % ∆ QD = Q2 – Q1 (ii) % ∆ Price = P2 – P1

Q1 P1
Where: Q1 = the quantity demanded before the price change

Q2 = the quantity demanded after the price change
P1 = the original price
P2 = the new price
The formula compares the % change in quantity demanded with the % change in
price. The number produced by the formula is called the coefficient of elasticity,
usually written as Ed.
 Price elastic demand means that the % ∆ in quantity demanded or quantity
purchased is large relative to the % ∆ in price.
 Inelastic demand means that the % ∆ in quantity purchased is small relative to
the % ∆ in price.
 Where demand is elastic, Ed> 1
 Where demand is inelastic, Ed< 1
Price elasticity of demand is always negative. However, to determine elastic or

inelastic demand, only the absolute value of the coefficient is considered; (the negative
sign is more or less ignored).
Examples: Ed = -0.5 means that demand is inelastic because 0.5 is less than 1.
Ed = -2.5 means that demand is elastic because 2.5 is greater than 1.

DEGREES OF ELASTICITY
Degrees of Elasticity Of Meaning Elasticity of demand

Demand Coefficient
Perfectly inelastic The percentage change in quantity PED = 0
demanded is zero. Quantity demanded
does not respond to a change in price
Fairly inelastic The percentage change in quantity 0 < PED < 1
demanded is less than the percentage
change in price
Unitary Elasticity The percentage change in quantity is equal PED = 1
to the percentage change in price
Fairly Elastic The percentage change in quantity 1 < PED < Infinity
demanded is greater than the percentage
change in price
Perfectly Elastic Quantity demanded changes when there PED = Infinity
is no change in price of the good
The coefficient of elasticity may range from zero to infinity.
 No change in price ► change in quantity = perfectly elastic

Perfectly Elastic ( E = ∞ )
 Slight change in price ► large change in quantity = Relatively elastic

Relatively Elastic ( E> 1 )
 Change in price ► equal change in quantity = unit elastic

Unit Elastic ( E = 1 )
 Large change in price ► Slight change in quantity = Relatively inelastic

Relatively Inelastic ( E< 1)
 Change in price ► No change in quantity = Perfectly inelastic

Perfectly Inelastic ( E = 0 )
There are 3 additional categories into which price elasticity of demand can divided.
Category 1 – Perfectly Inelastic
When price elasticity of demand is equal to zero, demand is said to be perfectly
inelastic. This is an extreme situation in which a change in price results in no change
whatsoever in the quantity demanded.
Category 2 – Unit or Unitary Elasticity

When price elasticity of demand equals 1, this is termed unit elasticity. In this case, %
∆ in price is exactly equal to % ∆ in Qd. For e.g a 1% fall in price causes an exact 1%
increase in Qd or a 20% increase in price leads to a 20% decrease in Qd. (See diagram
4)
Category 3 – Perfectly Elastic
When price elasticity of demand equals infinity, demand is said to be perfectly elastic.

Illustration, by graphs, of elastic and inelastic demand
Examples of calculations
Mathematically, it is the ratio of the percentage change in quantity (demanded or

supplied) to the percentage change in price.
E = Percentage change in quantity = (Q2 – Q1) / (Q1)

Percentage change in price (P2 – P1) / (P1)
EXAMPLE 1:
If Price increases from $20 to $24 and demand falls from 400 to 300 then the coefficient
will be
Q2 – Q1) / (Q1) = (300 – 400) x 20 = - 5 = - 1.25 elastic

(P2 – P1) / (P1) (400) (24 - 20) 4
EXAMPLE 2:
If Price decreases from $4 to $3 and demand rises from 30 to 60 then the coefficient
will be
Q2 – Q1) / (Q1) = (60 – 30) x 4 = - 4 elastic

(P2 – P1) / (P1) (30) (3 - 4)
EXAMPLE 3:
If Price decreases from $4 to $3 and demand rises from 20 to 24 then the coefficient
will be
Q2 – Q1) / (Q1) = (24 – 20) x 4 = - 4 = - .8 inelastic

(P2 – P1) / (P1) (20) (3 - 4) 5
Perfectly Inelastic Demand Curve (E = 0)

P
Perfectly elastic Demand Curve (E = ∞)
Relatively Inelastic Demand Curve (E < 1)
D
Q

Relatively elastic Demand Curve ( E> 1)
P
D

FOR FURTHER KNOWLEDGE
Price Elasticity and Total Revenue (TR)

Total Revenue = Price x Quantity
Producers tend to raise their prices in order to increase their revenue. However, this is
not always a wise economic decision as the increase in price negatively affects demand
at times. Thus the elasticity of demand for a particular product must be known in order
for a producer to determine if or when to lower or raise his price.
(i) Elastic Demand & TR

When demand is elastic, the producer should decrease his price in order to increase
total revenue. Why? Because even though a lower price is being received for each
unit, economists assume that enough additional units are being sold to more than make
up for the lower price. Hence, TR will increase.
Example using New Era hats

Price Qd TR
$110 50 $550
$70 120 $840
(ii) Inelastic Demand & TR

When demand is inelastic, the producer should raise his price to increase total revenue.
This increase in price will be followed by a les than proportionate fall in Qd. This means
that the revenue that will be lost due to the fall in Qd will be much less than the revenue
that will be gained due to the increase in price. As a result TR will increase.
Let’s look at an example with eggs

Price ($) Qd (dozen) TR
7 6 $42
11 5 $55
Price increased by: $4

Qd fell by : 1 doz.
TR increased by : $13
(iii) Unitary Elastic Demand & TR

When demand has unitary elasticity, prices should be kept constant as total revenue
will not change despite changes in price. An increase (or decrease) in price will be
followed by a proportionate fall (or rise) in Qd. Therefore, the producer will neither
gain nor lose.

Example using pencils
Price ($) Qd TR ($)
1.20 100 120
1.00 120 120
(iv) Perfectly Inelastic Demand & TR

When demand is perfectly inelastic Qd neither rises nor falls. However, a fall in price
leads to a fall in TR and a rise in price leads to a rise in TR.
For instance, if an individual must take insulin then whether the price increases or
decreases that individual will purchase the insulin. Additionally, if the person uses 3ml
of insulin daily, then he/she will not buy and use more insulin simply because it is
cheaper. Why?
(1) Possibility of over dose; (2) product may expiry before being used.
As a result, lowering the price on insulin will lead to a loss in TR since no extra units
will be demanded.
(v) Perfect Elasticity & TR

How will perfectly elastic demand affect TR?
Note the following relationships between TR and PED

 When TR is increasing, PED is said to be ˃ 1 (elastic)
 When TR reaches maximum, PED
 = 1 (unitary)
 When TR is falling, PED is ˂ 1 (inelastic)
Objective 15: Illustrate other types of elasticities of demand, using simple

calculations;
Income Elasticity of Demand (YED)
The income elasticity of demand for a good is defined as the responsiveness of demand
to changes in income.
Formula: YED = % ∆ in Qd
% ∆ in Y where Y represents income
Unlike price elasticity of demand which is always negative, income elasticity may be
either positive, negative or zero.
 Positive income elasticity means that when a consumer’s income increases, the Qd
of the good will also increase, implying a positive relationship between income and
Qd. Such goods are referred to as normal goods.
 Negative income elasticity means that when a consumer’s income increases, the Qd
of the good will decrease; (this implies an inverse or negative relationship between
income and Qd). As people’s income increases, they will buy less imitation, poor
quality or outdated products. Such goods are known as inferior goods.

What determines YED?
The types of good – Different types of goods have different elasticities.
1. Normal goods – those goods for which consumers demand more when their income
increases; they may be either:
(a) Luxury or superior goods, e.g diamonds and high-priced cars.
For superior/luxury goods YED ˃ 1, meaning that income elasticity of demand is
elastic.
(b) Essential or basic goods, e.g soap and water. For these types of goods, YED ˂1
but not negative, meaning income elasticity of demand is inelastic.
2. Inferior goods – those goods for which consumers demand less as their income
increases. The YED for these goods is negative.
3. Useless Goods – These are goods that consumers themselves determine are of little
or no use (or perhaps harmful) to them when too much or even the smallest quantity
is consumed.
E.g Consuming too much sugar or salt per day is bad.
Consuming even a small amount of cocaine per day is bad.
YED for these types of goods = 0
4. Giffen Goods – products that people consume more of as their prices increase;
PED is positive. Demand for these goods is driven by poverty that makes buyers unable
to afford anything else.
Cross Elasticity of Demand (XED)

This can be defined as the responsiveness of Qd for good X to a change in the price of
good Y, ceteris paribus. Like income elasticity, cross elasticity can be negative,
positive or zero.
Formula: XED = % ∆ in Qd of good X

% ∆ in price of good Y
Complementarycommodities such as cars and petrol have negative cross elasticities.

This means that when the price of one commodity increases, the Qd of another
commodity (the complement) decreases. Eg as the price of fuel increases, persons will
demand less vehicles.
On the other hand, substitute commodities such as plastic bottles and glass bottles;
Pepsi and Coca-cola, have positive elasticities. This means that an increase in the price
of one good leads to an increase in the Qd of another good (the substitute). Eg, if the
price of Pepsi increases the Qd of Coca-cola will increase as persons will switch from
Pepsi to Coca-cola.
Meanwhile, independent goods such as umbrellas and light bulbs have zero cross
elasticities. This means that when there is an increase or decrease in the price of one
good, the Qd for another good will not be affected because the two goods are
independent of each other.

Objective 16: Explain price elasticity of supply;
Price Elasticity of Supply
The concept of price elasticity of supply closely resembles that of price elasticity of
demand, in that it measures the responsiveness of supply to a change in price. The
easier it is for firms to change the amounts supplied in response to a change in price the
more price-elastic is supply and vice versa.
Objective 17: Illustrate price elasticity of supply, using simple calculations;

Formula: Percentage change in quantity supplied % ∆ in Qs___
Percentage change in price % ∆ in Price
There are five (5) broad categories into which elasticity of supply can be divided, based
on the numerical value of the coefficient derived.
1. Perfectly Inelastic Supply – When elasticity of supply equals zero, supply is

said to be perfectly inelastic. As such, changes in price have no effect on the
quantity supplied.
2. Inelastic Supply – When elasticity of supply is greater than zero but less than
1, supply is inelastic. Inelastic supply indicates that the % ∆ in the Qs is less
than % ∆ in price.
3. Perfectly Elastic Supply – When Qs is highly responsive to a change in price,
supply is said to perfectly elastic. Hence, if there’s a rise in price, the Qs will be
infinite. In diagram 8 below, at a price of $10, Qs is infinite but will be zero if
the price falls below $10.
4. Elastic Supply – When elasticity of supply is greater than 1 but less than
infinity, supply is said to be elastic. Elastic supply indicates that any price
change would result in a more than proportionate change in Qs. For e.g, if the
price of computers rises by 20%, Qs will rise by more than 20%. Similarly, if
price falls by 50%, Qs will fall by more than 50%.
5. Unitary Elastic Supply
Unitary elastic supply means that a change in price will bring about a
proportionate change in Qs; the coefficient of elasticity is therefore =1. For e.g,
if the price of televisions increases by 50%, Qs will also increase by 50%. Any
straight line drawn from the origin will display unitary elasticity of supply at all
points
(SEE DIAGRAMS BELOW)

Illustration, by graphs, of elastic and inelastic supply
Perfectly Inelastic Supply Curve (E = 0)
Q S
Perfectly elastic Supply Curve (E = ∞)
Unit Elastic Supply Curve (E = 1)
S
P
\
Q
Relatively elastic Supply Curve (E > 1)
P
S

Relatively Inelastic Demand Curve (E < 1)
S
Q

Determinants of Elasticity of Supply
1. Time Period – The long run and the short run affect supply. The longer the
amount of time a producer has to adjust to a given price change, the greater will
be his output and therefore the greater the elasticity of supply. It means then
that supply is elastic in the long-run and inelastic in the short-run. Similarly, it
is much harder for a firm to enter or exit a market in the short-run because of
the costs which must be met.
2. The Availability of factors of Production – If factors of production are not

easily available, the supply tends to be inelastic. For e.g, if it takes time to
recruit, hire and train labour, then the producer cannot respond quickly to an
increase in price and increase supply at once. However, if factors of production
are easily available, for instance a ready pool of trained workers who are about
to enter the market, then supply will be price elastic.
3. Ease of Factor Substitution – Many firms produce a range of different

products or services and are able to switch machines and labour from one type
of production to another. If factors of production can be switched in this way,
the supply of one particular product or service will tend to be elastic.
4. Excess Capacity – If suppliers have spare machines and their employees are
working short-time or even part-time, then supply will be price elastic since it
will be easy to increase output by fully utilizing the spare machines and having
employees work full time or for longer periods. However if a firm or the
industry is already faced with full capacity, then supply is price inelastic since
output cannot be readily increased in the short term.
5. Length of Production Period – Some products go through several long and

complex processes before completion, while others may be completed after a
few basic processes. For e.g, it may take years to construct an aircraft but only
a few hours to make bottled seasoning. Therefore, the supply of bottled
seasoning is more price elastic than the supply of aircrafts, given the length of
time it takes to convert the raw materials into finished products.
6. Number of Firms in the Industry – Generally, the greater the number of firms
in a market, the more the more elastic will be the market supplies because it
means that more firms will readily respond to changes in demand.
7. Gestation Period – In the case of agricultural products, price elasticity is

affected by the length of the growing season. For instance, there is a special
gestation period before rubber trees and cotton trees can be harvested. Hence,
most agricultural products are price inelastic, (some more than others); e.g
rubber will be more inelastic than vegetables. On the hand, manufactured
products are more elastic since production can be more readily altered based on

the market demand; e.g an increase in demand can be met by utilizing idle
machinery, hiring more workers or having employees work overtime.
8. The Level of Stock – The more stock an industry has, the more elastic will be
its supply since it will be able to meet increases in demand (while stocks last).
(Explain how the following can determine elasticity of supply.)
9. Perishability
10. Problem of Storage

DEGREES OF ELASTICITY OF SUPPLY
Degrees of Elasticity Of Meaning Elasticity of Supply

Supply Coefficient
Perfectly inelastic The percentage change in quantity PES = 0
supplied is zero. Quantity supplied does
not respond to a change in price
Fairly inelastic The percentage change in quantity 0 < PES < 1
supplied is less than the percentage
change in price
Unitary Elasticity The percentage change in quantity PES = 1
supplied is equal to the percentage change
in price
Fairly Elastic The percentage change in quantity 1 < PES < Infinity
supplied is greater than the percentage
change in price
Perfectly Elastic Quantity supplied changes when there is PES = Infinity
no change in price of the good

Objective 18: Define the term ‘market structure’;
Market Structures
Market structures refer to the ways in which markets are designed or organized, in order
for firms to sell their products. Market structures are characterized by 4 basic
characteristics:
1 number of buyers and sellers;
2 nature of the product;
3 conditions of entry and exit; and
4 the price of the product
These characteristics affect the behaviours of firms within the industry in which they
operate. Market structures range along a continuum with two extremes, perfect
competition at one end and monopoly at the other, with monopolistic competition,
oligopoly and duopoly (representing imperfect competition) in the middle.
Very No
Competitive Competition
Perfect Monopolistic Oligopoly Monopoly

Competition Competition
Duopoly
Imperfect Competition
The aim of the firms in each of these market structures is maximize profit.

Objective 19: Outline the characteristics of market structures;
Objective 20: Identify the main types of market structures;
Perfect Competition
The perfectly competitive market structure does not exist in the real world. However,
for convenience, economists have used the theory of ‘perfect competition’ so that
industries can be compared. There are a few markets in the real world that closely
resembles this market:
(i) The Foreign Exchange (Forex) Market
(ii) The Stock Exchange Market
(iii) The traditional food markets in the Caribbean
Features/Characteristics of Perfect Competition

Key Features
1. Large numbers of buyers and sellers– no one buyer or seller can affect the
market price by deciding to buy or not to buy, to sell or not to sell (since each
is too small to do so).
2. Homogeneous commodity – all units of the commodity that sellers make

available are identical in the minds of buyers. Hence, there is no motive for
preferring the product of one over that of another. Therefore, given a raise of
price, sales will fall. Buyers must be willing to purchase from the seller who
offers the good at the lowest price.
3. Perfect knowledge of the market prices and quantities – means that all
buyers and sellers are completely aware of the prices and quantities at which
transactions are taking place in the market. This permits buyers to compete with
buyers, and sellers with sellers.
4. No Discrimination – This condition of no discrimination requires that buyers

and sellers be willing to deal openly with one another. This means that they
must be willing to buy and sell at the market price with anyone and all that may
wish to do so. This condition also means that buyers and sellers must not offer
or accept any special deals, discounts, or favours that are not available to
everyone on equal terms.
5. Perfect Mobility of resources – The condition of perfect resource mobility

requires that there be no obstacles – economic, legal, technological or other – to
prevent firms or resources from entering or leaving the particular market or
industry. In general, owners of resources and commodities are free and able to
take advantage of the best market opportunities as they arise.
In essence, perfect competition is a technical term that refers to a market in which no

firm or consumer is large enough to affect the market price. Also the most efficient
bundle of output is produced with the most efficient techniques. Under perfect
competition the existence of flexible prices enables an economy to allocate its resources
efficiently.
Simplified:
1. All buyers and sellers know everything about the market in which they operate,
e.g. price, alternatives, etc.
2. Buyers and sellers can trade as much as they can at the ruling market price.
3. Each firm is a price taker – No single firm (or individual) can influence the
market price by increasing or decreasing supply. They can only adjust quantity,
not price.
4. It is assumed that there’s no government intervention in this market structure.

Since firms in the perfectly competitive market can only vary their output (not price),
the demand curve facing this market structure is usually flat, indicating that it is
perfectly elastic. It is the same as the price line, which is also equal to both marginal
and average revenue. (See diagram below)

Merits of Perfect Competition
 The market mechanism brings about an efficient allocation of resources.
 The price charged is low and consumer welfare is maximized.
 It eliminates sales promotion effort and expenditure because all firms produce
identical products.
Demerits of Perfect Competition

 There is hardly any research and development (R&D).
 Perfect Competition works best in equilibrium conditions but these conditions
do not exist for any extended period.
When should a firm in the perfectly competitive market produce?

NB: Average revenue refers to the revenue per unit of output sold; i.e. Total Revenue
No. of units sold
Marginal revenue refers to the additional revenue received by a firm for every
extra unit of a commodity it sells; i.e. Δ in Total Revenue.
It will be worthwhile for a firm in perfect competition to produce as long as:

1. Total revenue obtained from the sale of output is greater than the total variable
cost incurred in producing such output;
2. The price at which the product is sold is greater than the average variable cost
of producing it.
Note the following:

 If any additional unit of output adds more to revenue than it does to cost, then
producing and selling that unit will increase the firm’s profit. However, the
opposite also holds true.
 The production of an extra unit of output will increase profit, if the marginal revenue
(MR) obtained from selling it, is greater than the marginal cost (MC) incurred in
producing it.
The ideal situation for the firm is to produce at the level of output where MR = MC.
If the firm continues to produce beyond this point of equilibrium, it will encounter
a situation where MC > MR; this serves to reduce profits.
 In the short-run, firms in the perfectly competitive market can earn either normal
orabnormal (excess) profitsor they can incur losses. However, in the long-run,
they can earn only normal profits or incur losses.
 The term ‘normal profits’ the economic jargon for breakeven. It means that the
firm is neither making a profit nor a loss. When a firm’s revenue exceeds its costs,
it is said to be making ‘abnormal’ or ‘excess’ profits.
Monopoly
A monopoly is a market structure in which a single producer controls the entire output
of a certain commodity – there is only one supplier of the commodity for which there
are no close substitutes. There are different types of monopolies:
1. Natural Monopolies – These monopolies are largely found in utility industries

such as electricity (e.g. Vinlec) and water (e.g. CWSA). Competition is not
encouraged because it is argued that a single firm can achieve technological and
cost advantages. Pure monopolies are frequently created and regulated by
law; government bodies determine the prices they charge and the conditions of
service.
3. Statutory Monopolies – These are established by the government. Such

monopolies may include natural or utility monopolies. However, not all
statutory monopolies are utility monopolies, e.g. SVG Post; or a government
may deliberately obtain exclusive control of a television station and permit one
company to operate it without competition.
4. Technological Monopolies – With these monopolies, a firm attains monopoly

power because of the vast amounts of capital it employs. It is almost impossible
for a new firm to enter and compete in an industry which is dominated by one
supplier who has control over large amounts of sophisticated capital.
A special type of monopoly is sole distributorship or franchise. This allows a firm

exclusive right to import and sell a product from an overseas company; e.g KFC.
Characteristics of Monopolies
1. There is no close substitute to the product being offered.

2. The firm and the industry are one and the same.
An industry is a group of firms that produce the same product.
3. There are barriers to entry and exit.
4. The firm restricts output and input, thereby controlling either price or quantity
(not both); the firm is a price setter or a quantity setter.
5. The firm is the only seller of the product; (however there are many buyers).
6. The firm charges the price which maximizes its profits (not necessarily the
highest price). The monopolist also practises what economists call ‘price
discrimination’.
7. There is imperfect knowledge in the market.
Price Discrimination – Some firms do not sell all their products to all customers at the
same price. When this happens such sellers are practicing price discrimination. Price
discrimination therefore occurs when a firm is able to charge different customers
different prices for the same product.

The demand or average revenue curve of the monopolist is negatively sloped (i.e.
downwards from left to right). This can be understood from the concept of the
monopolist being either a price setter or a quantity setter, (but not both).
 When the firm sets the quantity it must accept the corresponding price;
 If it chooses to set the price, the quantity will be determined based on the
theory of demand; i.e. as price increases quantity will fall and vice versa.
Barriers to Entry
These refer to the restrictions imposed by the existing firms in the industry to block the
entry of new firms. The restrictions place the entrants at a cost disadvantage relative
to the established firms. Some of the restrictions include:
 Predatory Pricing – The monopolist will lower his prices, forcing competitors
to do likewise. As competitors lower their prices, they incur losses and are
unable to recover from them. As a result, they are forced to close down and
leave the market.
 Patents and Copyright – The rights of the producers are protected through
legislation. These are useful especially to book publishers, compact disc
producers and so on.
 Economies of Scale – Large scale production may enable a firm to produce at

very low average cost. As such, any new firm thinking of entering the same
industry would find it difficult to achieve such low average cost straight away.
 Legal Prohibition – In some countries the government does not allow

competition in some industries.
 Ownership of Certain Raw Materials – The monopolist may own all of the
raw materials, e.g. mineral resources. Without access to these raw materials,
rival firms would not be able compete with the monopolist.
 Climatic Conditions – Certain agricultural products do not grow well in certain

climates.
 Sabotage – The monopolist can sabotage a rival firm’s operation by attracting

the staff of the rival firm with higher salaries.
 Government Intervention – Marketing boards, with the help of the

government, could be the sole seller of a particular product.
 Restrictive Trade Practices – Firms within an industry may act together so as

to make it difficult for new firms to enter.
 Advertising – (Explain)
How are monopolies formed?
1. By Legal Restrictions – The law of patents can allow a firm to secure the sole
right to manufacture a new product or use a new process.
Also legal restrictions may be found in tariffs or taxes on imports which prevent
foreign producers from competing with a local firm.
Additionally, government can grant monopoly powers to a firm by making it
illegal for other firms to enter the industry.
2. By Control of Raw Materials and Market Outlets – A firm may attempt to

establish monopoly power over the source of raw materials or the market outlets
for their products in order to deny access to their competitors.
3. By Competition – Fierce competition can drive weak and less efficient firms
out of an industry.
4. By Mergers and Amalgamations – When an industry is made up of a few

relatively large firms, a series of mergers or take-overs could lead to a monopoly
situation.
5. By Forming a Cartel – A cartel is created when the individual firms in an

industry make an agreement to restrict their output to some agreed amounts and
to charge a common price.
The Merits of Monopoly
1. It prevents duplication and hence wastage of resources.

2. Being the sole producer, the firm is usually a large one and the firm can therefore
enjoy economies of scale with lower cost.
3. Stability is ensured; there are rare cases of bankruptcy. The stability of the firm
may in turn contribute to stability of the economy especially in cases of large
utility companies.
4. The monopolist can afford to recruit more professionals.
5. The monopolist can also afford to purchase the latest sophisticated machinery
and thus produce a higher level of output.
6. The firm can undertake research and development so as to develop better
products and gain bigger market share.
The Demerits of Monopoly

1. The monopolist usually charges a higher price since he is the only producer; he
also practises price discrimination.
2. There is absence of consumer sovereignty, meaning that consumers have no
choice but to buy whatever goods and services are produced by the monopolist
at the stated price.
3. There is greater inequality of income; the monopolist can earn excessive profits
by charging high prices even if persons’ incomes remain the same.
4. There is absence of competition, which can lead to poor quality products being
offered by the monopolist.
Identify some of the ways in which government can control monopoly

power.
Monopolistic Competition
This market structure is a cross between monopoly and perfect competition as it
demonstrates features of both structures. It is one in which there are many sellers, each
selling a product which is somewhat different from those of other firms. For instance,
there are many producers of vehicles but the styles and models are all different – the
Toyota Rav4 is different from a Nissan X-trail in terms of shape and so on. The
products offered in the monopolistic market structure are relatively close substitutes of
one another.
Main Characteristics of Monopolistic Competition
1. There are many firms and many sellers in the industry.

2. Firms tend to produce a differentiated product so that although their market
power is weak, each firm is its own price setter.
3. There is freedom of entry and exit.
4. There is excess capacity.
5. Firms engage in non-price competition.
6. It is assumed that there is no government intervention unless firms violate the
laws of the land.

The demand curve of the monopolistically competitive firm is negatively sloped (like
that of the monopolist). However, it is not as steep as that of the monopolist; (i.e. it is
more elastic than the demand curve facing the monopolist). It must be noted though,
that the demand curve of the monopolistic firm is less elastic than that of the
perfectlycompetitive firm. In fact you will recall that the demand curve in perfect
competition is perfectly elastic. (The following diagram makes the comparison among
the 3 demand curves.)
Where: DM means demand curve for monopoly

DPC means demand curve for perfect competition
DMCmeans demand curve for monopolistic competition
Oligopoly
An oligopoly is a market structure where only a few large firms operate, resulting in a
high concentration sales (as there are many buyers); e.g. newspapers.
Firms may produce identical or homogeneous products such as cement, in which case
they are referred to as pure or perfect oligopolies. However, firms that produce
differentiated products such as cars are referred to as imperfect or differentiated
oligopolies.
Firms in an oligopolistic market structure always have to be concerned about their

competitors. This is because any action on their part can lead to a number of reactions
on the part of their competitors which, if they are not careful, can turn out to be quite
expensive for them, maybe even forcing them out of business.

There are three types of oligopolies:
1. Class One Oligopolies – These are mainly characterized by stable or fixed
prices and a non-price competition. Each acts independently, but is affected by
the action and response of its competitors.
2. Class Two Oligopolies – These are commonly known as cartels. They join
together or collude in order to increase profits and to reduce uncertainty. These
firms agree to collude on several aspects such as quantity, price, quality, brand
or package differentiation and advertising.
3. Class Three Oligopolies – These are mainly characterized by price leadership,

where the dominant, i.e. largest or low-cost firm sets the price, which all other
firms (fringe) follow; e.g. petroleum and cigarette industries.
Other features of an oligopoly may include:

 Barriers to entry and exit;
 No government intervention except where firms violate the laws of the
country;
 Factors of production are assumed to be readily available;
 Perfect knowledge may or may not exist.
Duopoly
This is where there are only two firms operating in the industry. It bears features similar
to an oligopoly.
Objective 21: Define the term “market failure”;

Market Failure
Market failure is where consumers or producers do not have to bear the full cost of
transactions they undertake.
This is a situation where there is a break down in the price mechanism leading to
inefficiency. Therefore, a market fails when private decisions do not result in an
efficient allocation of resources – there is either allocative inefficiency or productive
inefficiency.
For there to be allocative efficiency, MC must equal price (P) in all industries in the
economy. Whenever P is greater or less than MC, allocative inefficiency will occur.
Productive efficiency occurs when a firm employs resources and uses techniques
which are available at the lowest possible cost. Productive efficiency is measured by
the lowest point on a firms average cost curve.
What can the government do?

- impose tax on offending firms and individuals
- set and enforce policies and standards on all industrial activities
- establish industrial zones
Social costs are a combination of both private and external costs; costs borne by
society. Goods for which social costs are greater than their private costs are labeled
demerit goods.
 Positive externalities arise when social benefits are greater than private benefits.
Private benefits are those benefits enjoyed by an individual, whether as a consumer or

a as producer. It is known as total utility to the consumer and total revenue to the
producer.
NB: Utility refers to the satisfaction a consumer obtains from consuming a good
or a service.

- reward firms or individuals
- offer incentives to firms or individuals
The Inadequate provision of Merit Goods – Many firms will only produce merit
goods it is profitable to do so.
What can the government?

- encourage the consumption of merit goods, e.g. through free health care
The Over Production of Demerit Goods – Since there is always a high demand for
demerit goods, firms in the private sector tend to produce substantially high quantities
of these goods, from which they make huge profits.

- discourage the consumption of demerit goods, e.g. through price controls,
bans, etc
Imperfect Competition – Where there are oligopolies, collusion quite often occurs,
which works in favour of producers rather than consumers.
Similarly, with the presence of monopolies, suppliers are able to:
- control prices
- charge very high prices
- practise price discrimination regularly
What can the government?
- monitor business activities
- taxation on some businesses such as monopolies or foreign companies
- offer subsidies and other financial assistance to some businesses

Imperfect Information – This is where consumers, workers and entrepreneurs possess
inadequate knowledge about prices, quality and the nature of goods and services as well
as about future prospects. As such, they are unable to make the best economic
decisions.

- provide information through radio and television programmes, e.g. API
- offer free or cheap magazines, journals, etc. with information about prices,
quality, availability and so on
Objective 22: Outline the main causes of market failure;

Causes of Market Failure
In Economics, the situation of perfect competition is idea. However, no market can be

totally efficient and will therefore be unable to maintain perfectly competitive market
conditions. As such, market failure is inevitable. Apart from inefficiency, market
failure is also caused by:
1. The non-provision of public goods;
2. The presence of externalities

3. The inadequate provision of merit goods and the provision of substantially
higher quantities of demerit goods;
4. Imperfect competition;
5. Imperfect information.
The Non-provision of Public Goods – Since the aim of the private sector is to
maximize profit, then firms in this sector will not produce public goods as no profits
can be earned from them. As a result, government must intervene and provide these
goods; examples of such goods include national defense and street lights.
The Presence of Externalities – Externalities arise when the actions of producers and
consumers affect not only themselves but also others. Externalities can be in the form
of costs (negative externalities) or benefits (positive externalities).
 Negative externalities arise when social costs are greater than private costs.
Private Costs are costs incurred by a consumer (e.g. cost of buying a book) or a
producer (e.g. cost of producing a car). In producing its output, one firm may cause
another to incur costs referred to external costs. This is also known as the ‘spill over
effect’ or the ‘neighbourhood effect’; e.g. a call centre located close to an airport may
have to incur costs to become sound proof in order to keep out the noise.

Objective 23: State the main consequences of market failure.
Consequences of Market Failure
Market failure has several effects on an economy, including:
1. Unemploymentof the factors of production – Since there is imperfect

information in every economy, persons seeking employment may be unaware
of job vacancies or the skill required for certain jobs and so may remain
unemployed or under-employed.
2. Retrenchment – Given that there is inefficiency within markets, it leads to a

fall in industry profits and an increase in costs. As a result, firms are forced to
retrench workers.
3. Economic Depression – Because market failure can result in low or negative

profits for some industries, there are repeated periods during which the real GDP
of an economy falls. When such periods are severe, they are called depressions
and when they are mild they are referred to as recessions.
4. Rise in Levels of Poverty – All of the above factors lead to poverty since many
people are unable to support themselves and their families. Additionally, market
failure leads to inequity in wealth distribution, so that the rich get richer while
the poor get poorer.
5. Decline in Welfare of Society – Market failure causes a decline in welfare since

rising poverty levels, economic depression and unemployment always impact
negatively on society.
6. Over consumption of demerit goods.
7. High prices under imperfect competition, especially monopoly.
Terms and Concepts
Barrier to entry – Is anything that prevents new firms from entering and competing in
an industry
Price rigidity – Means that prices remain at a certain level over a long period
Price War – Occurs when rival Firms continuously reduce prices to undercut each
other.
Collusion – Occurs when there are price and quantity agreements with other firms.

SUMMARY OF MARKET STRUCTURES
Monopoly Oligopoly Monopolistic Perfect
Competition Competition
Number of Sellers One Few Many Many
Numbers Of Buyers Many Many Many Many
Product Unique Homogenous Differentiated Homogenous
/Differentiated
Knowledge of market Imperfect Imperfect Imperfect Imperfect
Price Price-maker Price-maker Price- maker Price – taker
with price
rigidity
Entry Conditions No Free Entry High barriers to Low Barriers to Freedom to entry
Entry entry

Section 4: The Financial Sector
SPECIFIC OBJECTIVES
Objective 1: Explain the concept of the Financial Sector;

The Financial Sector
The financial sector is that sector of an economy that facilitates lending, saving and
investing. In this sector, ordinary citizens (households) who aim to save a portion of
their income, investors (individuals or business housed) and governments all interact
with each other to provide financial services.
The major types of financial intermediaries/institutions include banks, both Central

Bank and Commercial banks, the credit unions, development banks and insurance
companies.
Objective 2: State the role of the Financial Sector;

The Role of the Financial Sector
The financial sector is responsible for bringing together those persons who have money
to save (savers/lenders) and those who need money to borrow (borrowers), in order to
conduct business transactions. This is mainly done through financial institutions
(intermediaries) operating in the money market and the capital market.
Money Market – where short term loans are obtained or short term investments are
made
Capital Market – where long term loans are obtained or long term investments are
made

Objective 3: Identify the functions of the Financial Sector;
The Functions of the Financial Sector
In any economy, the financial sector has several important functions including:
1. Being a safe haven for savings – The public must feel confident enough to
deposit their money in banks and other financial institutions and know that it is
safe. These institutions must present evidence that people’s money is in safe
hands and that the chance of them losing their money is minimal.
2. Facilitating the storing of wealth and purchasing power – Financial
institutions assist individuals and businesses in storing their wealth by:
- accepting deposits from them and encouraging them to save through current and
deposit accounts, pension funds and so on
- offering savers high interest rates on their savings
3. Providing Liquidity in the Economy – This refers to the degree of ease with
which financial assets can be converted into cash while causing very little
change in the price or value of the assets, e.g. selling off share for money.
However, financial institutions must aim to ensure that there is not too much or
too little liquidity in the economy.
4. Maintaining profitability and liquidity – Financial institutions aim to maximize

profits and at the same time, maintain liquidity. In so doing, they offer both
short term and long term loans but must ensure that some reserves of cash are
held in order to meet customers demand for cash. Interest is charged on both
long and short term loans. However, the interest charged on the short term loans
is lower than on long term loans because long term loans are more risky. But
although the rates on long term loans are higher, they are less profitable because
they are illiquid assets as opposed to short term loans which are liquid assets.
5.Making credit available for consumption and investment purposes – Firms

operating within the financial sector can lend money to consumers for several
purposes including:
- to purchase vehicles, land, houses and other assets
- for weddings and vacations and so on
Similarly, businesses and entrepreneurs require loans and credit for investment
purposes such as:
- to establish new businesses or expand existing ones
- to purchase heavy duty equipment and so on
Additionally, financial institutions (particularly commercial banks) usually provide

government and local authorities with loans to finance their negatively skewed
budget that result from having expenditure greater than their revenue earned from
taxes.

Banks and other financial institutions lend customers money in several ways:
 Loans
 Overdrafts
 Documentary credit
 Other services
Research each of the above methods of credit.
Instruments or Mechanisms of Payment

Financial institutions enable firms and individuals to pay for good and services in
several ways using various instruments including:
(i) Cheques
(ii) Standing orders
(iii) Direct debits
(iv) Bank giro credits
(v) Credit and debit cards
(vi) Traveller’s cheques and foreign currency
Research each of the above instruments of payment
6. Providing insurance protection – Firms such as insurance companies provide

other firms and individuals with insurance protection against death, accidents
and losses resulting from arson, burglary, natural disasters and so on. This
allows them to reduce the level of risk that they face.
7. Assisting the government in stabilizing the economy – Financial institutions

including the Central Bank often provide the government with the necessary
funds in situations when government expenditures are greater than its revenues.
These funds are mainly obtained through open market operations where
financial securities such as bonds and treasury bills are sold to the public.
Objective 4: Explain the concept of the Informal Sector;

The Informal Sector
Economic activities that are not officially regulated and which take place outside the
norms of formal business transactions occur within the informal sector of an economy,
e.g. sousou.
The informal sector provides jobs and reduces unemployment, but in many cases the
jobs are low-paid and there is no job-security. This sector facilitates the growth of
entrepreneurs activity among the lower income groups, but the entrepreneurs might not
abide by tax and labour regulations.

Objective 5: Explain the concept of money;
Money
Money may be defined as anything that is generally accepted in exchange for goods
and services or for the payment of a debt. But money did not always exist.
Commodity Money – Consists of items used as money that are in themselves, valuable.
Fiat Money – Items that serve as money but which have no value in themselves
Types of Money
1. M0 – Thisis the narrowest definition of money which includes notes and coins
in circulation.
2. M1 – This is a less narrow definition of money which includes currency (M0),

travellers’ cheques and checkable deposits.
3. M2 – This includes M1 and money deposit accounts, money market mutual fund
shares, small denomination time deposits, saving deposits, overnight repurchase
agreements and overnight Eurodollars.
4. M3 – This includes M2 and large denomination time deposits, long-term

repurchasing agreements, term Eurodollars and institution money market
mutual fund shares.
5. M4 – Liquid and near liquid assets – the broadest classification of money. It

consists of the most liquid assets, so M3, treasury bills, saving bonds and certain
short-term business obligations.
Objective 6: Describe the development of money;

The Development of Money
Early economies were mainly subsistent with some aspects of specialization developing
later. With specialization, people started to produce surplus. Consequently, trading
began to take place where goods were used in exchange for other goods. This is
referred to as barter.
Econ text Page 108 -109
Objective 7: Explain the functions of money;

The Functions of Money
Money functions as:
(i) Medium of Exchange – It can be used to purchase goods and services

easily. This function of money removed the difficulties of barter, e.g. the

double coincidence of wants. Since money can be easily converted into a
medium of exchange, it is regarded as the only perfectly liquid asset.
(ii) Standard of Deferred Payments – Money can be earned at one time and
spent at another. Customers can purchase goods on credit and pay at a later
date. Similarly, borrowing and lending are easy to organize.
(iii) Measure of Value (Unit of Account) – Money makes it possible for prices
to be given to goods and services and therefore, their values can be
calculated.
(iv) Store of Value – Money can be put away or saved.
Objective 8: Describe the qualities of money;

Qualities/Characteristics of Money
For a commodity to be considered as money, it must possess the following qualities:
1. Acceptability – It must be readily accepted by most persons.
2. Limited in supply – The supply of money should be relatively stable. It should
not be unlimited in supply as this will cause its economic value to fall.
3. Homogeneity – The features must be identical. All notes and coins that are
similar must have the same value.
4. Portability – It should be easy to carry around or to move from one place to
another.
5. Divisibility – It should be easily divided into smaller units without any loss in
value; e.g. you can change up a $100 bill into five $20 bills.
6. Durability – It should last for a relatively long time and not be easily destroyed.
7. Difficult to forge – Money should be difficult to counterfeit.
Objective 9: Explain the phrase “money supply”;

The Value of Money
The value of money is based on the number of products it can buy – i.e. its purchasing
power. Therefore, when there is a general or all round rise in the price of goods and
services, the value of money falls. The value of money also falls when a too much of
it is in circulation chasing too few goods.
Money Supply – This refers to the total stock of money in the economy at any given
moment. The money supply is controlled by the Central Bank of the country.
Narrow Money consists of all notes and coins in circulation, all deposits on which
cheques can be drawn, and travelers’ cheques.
- Coins
Issued for the convenience of small everyday transactions; for example purchase
of newspapers

- Notes
Issued to purchase general goods and services. Some items – for example, lunch,
foodstuffs and taxi fares – can only be paid for with notes and coins. However,
notes are being used less for the purchase of dearer items.
- Deposits on which cheques are drawn – can be used to buy foodstuffs, furniture
or even a car. This is considered money because a chequebook is equivalent to
dollar bills in your pocket/
- Travelers’ Cheques
In foreign currency – Can be used to purchase goods and services directly, or
can be changed into cash to do so.
Broad Money consists of narrow money plus savings accounts in financial institutions
and money market accounts. Savings accounts and money market accounts are
considered part of broad of money, as such savings can easily be converted into cash
or transferred to a cheque account to be used as money.
Objective 10: Describe the role of the Central Bank and other financial
institutions;
The Central Bank is a monetary authority owned and controlled by the government.
It is given legal powers by the government to control the financial system.
Central bank is the head of the financial sector in any economy. Its two-fold purpose
is:
- To oversee the operations of all financial institutions in the economy; and
- To implement monetary policy on behalf of the government
The Main Functions of the Central Bank

1. Making payments on behalf of the government and manages the national debt;
2. Sometimes makes temporary loans to the government;
3. Keeps a record of the government financial activities and maintains the
government’s accounts;
4. Acts as a financial agent, making deals with the International Monetary Fund
(IMF), World Bank and the central banks of other countries, when arranging
external loans for the government;
5. Acts as an economic agent for the government. The government uses the
Central Bank to carry out its monetary policies which include controlling the
money supply and interest rates.
6. Responsible for storing and monitoring the country’s supply of foreign
exchange reserves;
7. It is the only institution authorized to print and recall notes and coins from
circulation.
Other functions of the Central Bank include:

 Banker to commercial banks – The Central Bank provides financial services to
commercial banks just as commercial banks provide financial services to the
public.
 Responsible for keeping a percentage of commercial banks’ deposits; by law the
commercial banks must keep a portion of all their deposits in an account at the
Central Bank.
 Clearing cheques for the various banks
 Managing the public debt of the economy
 Inspiring local and foreign confidence in the currency
 Lender of last resort – The Central Bank supplies cash to the banking system in
order to maintain liquidity. This prevents bank failures that will result from a
shortage of cash.
 Supervising the activities of commercial banks
There are few Central Banks which operate in the Caribbean, namely:
 The Eastern Caribbean Central Bank (the ECCB)
 The Central Bank of Trinidad and Tobago
 The Central Bank of Guyana
 The Central Bank of Barbados
 The Central Bank of Jamaica
Commercial Bank
A commercial bank provides individuals and firms with banking services.
Examples: RBTT, Scotiabank
Functions of a Commercial Bank

 Collects deposits from customers/savers
The depositors are paid interest by the bank. The rate of interest is the price
charged for borrowing money.
 Provides a save place of customers deposit;
Customers use the bank safety deposit boxes to store important document and
valuables, such as property deeds and jewelry.
 Collects payments on the customers’ behalf from those instructed to lodge
money to those accounts
 Makes payments on its customers’ behalf when instructed by them to do so.
 Makes loans to customers either by means of a short-term overdraft facility or
longer term loans/ Makes Loans to Individuals, Firms and the Government
Individuals might need a loan for purchasing a house, for educational purposes
or to start a small business. Firms use loans to invest, and they might create more
jobs. The government might need a loan to meet expensive or to bridge its
current expenditure if revenues do not come in on time
 Allows people to make payments using cheques, which is much safer than cash
 Distributes notes and coins in the country
 Buys and sell shares on behalf of customers
 A channel of funds from lenders-savers to borrowers-spenders (loans).
 A store of funds (accepting deposits)
 Acts as agents for payment

 Provides other services to customers, including travelers cheques, bank drafts,
exchanging of foreign currency, ATM services, etc.
Other Functions of a Commercial Bank

- Night safe facilities
- Safety deposit facilities
- Automatic teller machines
- Credit cards
- Debit cards
Etc.
Share Market
A share market or stock market, is a market for the trading of company stock or shares.
A company’s assets can be divided into equal parts called shares. A collection of shares
is called stock. The stocks might be listed on the stock exchange or traded privately.
The term “The stock market” is simply the mechanism that enables the trading of
company stocks. The sellers in the share market are the company itself and other
holders of shares. The buyers might be other companies, bank and non-bank financial
institutions, or private individuals. The items are the shares of different companies.
Stock Markets
- The stock market is one of the most important sources through which companies
can raise money.
- At the stock market, investors can quickly and easily sell shares, and so obtain
cash. This is an advantage of investing in stocks, compared with, say real estate
- The price of shares can be an indicator of business conditions in an economy.
Rising share prices, for instance, tend to be associated with an increase in
business investment, and falling share prices with a decrease.
- Share ownership allows private individuals to earn additional income
- A stock exchange is often the most important component of a stock market.
Stock Exchange/ Stock Market

The stock market (stock exchange) is the market (whether physical or electronic) in
which shares are issued by public companies for sale; i.e. a market that facilitates the
buying and selling of shares either through exchanges or over the counter.
The primary market: where new securities or financial instruments such as stocks,
bonds, etc. are first offered for sale
Investors purchase securities directly from issuers in the primary market
The secondary market: also called the aftermarket; it is where second hand
shares/stocks are sold
After the initial issuance in the primary market, investors purchase securities from other
investors in the secondary

Role of the Stock Market
1. Raising capital for businesses
2. Transferring savings to investments
3. Facilitating company growth
4. Creating investments opportunities for investors
5. Raising capital for government’s development projects
6. Facilitates the raising of capital by private industry and governments.
7. It provides a daily ‘barometer’ of industrial and commercial success.
8. Stock Exchange prices provide a means of valuing wealth held in the form of
shares.
9. Provides a form of investment

10. Transfer of funds from lenders to borrowers
11. Provides funds for the production of goods and services
Risks and Benefits of the Stock Market

Risk – In the stock market a risk is seen as investing without knowing what to expect;
i.e. there is a possibility of losing.
Benefit – This is a gain or profit made from investing in shares.
Some Benefits
1. Long-term investments result in relatively high returns.
2. Stocks can be used as a sort of retirement plan.
3. Stocks/shares allow you to own part of a company.
4. In addition to owning part of a company, you have the potential to receive
monetary benefits (e.g. dividends, interests, etc.).
Some Risks
1. The most risky aspect of investing in the stock market is the uncertainty of
returns; returns are not guaranteed.
2. Even when there are returns, they may be lower than expected.
3. In times of financial crises, one may lose his/her entire investment.
4. Stock prices continually adjust to new information entering the market; (this is
referred to idiosyncratic risk).
5. The behavior of some stock prices affects other stocks.
6. The risk tolerance of some individuals or firms may be too low to withstand
losses in the stock market and may lead to detrimental outcomes for either party.
- Firm may lose profit, close down, etc.
- Person can suffer heart attack due to heavy losses, etc.

Terms and Concepts of the Stock Market
The Bear Market – one in which prices are expected to fall continuously.
The Bull Market – one in which prices are expected to rise continuously.
Bear – an investor who believes that a particular security or market is heading
downward. Bears are generally pessimistic about the state of a given market.
Bull – an investor who believes that prices in a particular market are headed upward.
Bulls are optimists.
Stag – Someone who traders stocks frequently and tries to make quick profits in a short
amount of time.
Cross Listing – where a firm lists its equity shares on one or more foreign stock
exchange in addition to its domestic exchange.
Arbitrage – the simultaneous purchase and sale of similar instruments in different
markets to take advantage of price discrepancies.
Ask price –The price at which a seller is offering to sell.
Offer – Indicates a willingness to sell at a given price; opposite to the bid. This may
also be referred to the ask price
Bid – An expression indicating a desire to buy an instrument at a given price; opposite
of the offer.
Cash Price – Current market price of the stock or other instruments; also called “spot
price”
Instruments – Products traded on an exchange or in an over the counter market, such
as stocks, bonds, or futures contracts.
Over-The-Counter (OTC) Market – A market where instruments such as stocks and
foreign currencies are bought and sold by telephone and other means of
communications
Par/Par Value – The face value of a security. For example, a bond selling at par is
worth the same dollar amount it was issued for or at which it will be redeemed at
maturity.
Credit Union
A Credit Union is a corporative financial institution that is owned and controlled by its
members. Credit unions differ from traditional financial institutions in that the members
who have accounts in credit union are the Credit Union’s Owners.
Only a member of a credit union can deposit money with that credit union or borrow
money from it. Credit Unions are committed to helping members improve their
financial situations. Credit Unions typically pay a higher dividends on shares (or
interest on deposits) and charge lower interest rates on loans than banks.
Credit Union revenues (from Loans and Investments) must exceed operating expenses
and dividends (or interest paid on deposits) in order for the credit union to stay in
business. Credit Unions are not as profitable as banks, as they focus on serving
members.

Development Bank
A development bank is an institution set up to facilitate growth and production in a
particular sector in the economy. It grants loans at competitive rates to potential
investors. Developments banks do not accept deposits from the general public. Funds
are obtained from international and regional institutions and grants from the
government. The development bank might invest its idle funds in securities in order to
increase its earnings.
Example: Agricultural Development Bank (ADB) In Trinidad and Tobago
Insurance Company
Insurance is an agreement whereby a company guarantees to give compensation for
loss of life or property, for damage to property, for injury or for illness in return for
payment of a regular sum of money. This sum of money is called a premium. Insurance
companies provide insurance.
Examples: CLICO, Sagicor
They operate on the principle that not everyone will suffer the same loss to the same
extent at the same time. Insurance companies receive funds from the payment of
premiums by those who buy insurance. When a buyer suffers a loss, the insurance
company must compensate the buyer of insurance of his beneficiary
The services offered by insurance companies are a security to firms and individuals.
Private property is protected against risk of loss. Businesses are protected against loss
of or damage to property by fire, and stock and goods in transit are protected against
loss. Insurance offers security for traders.
Insurance companies use their funds to purchase government and private sector
securities. Therefore, insurance companies also provide a source of funds to
government and businesses.
Mutual Fund
A mutual fund is a collective investment company. An investor buys a share in the
mutual fund and is paid a dividend based on the number of shares he holds. The
dividend might be at a fixed rate, or it might vary depending on the performance of the
fund. The fund pools money from many investors and invests their money in a range of
securities. The advantage of the mutual fund is that the investor has the services of an
expert fund manager to make investment decisions. The investors’ collective funds are
used to invest in securities to which the individual investor might not normally have
access.
Building Society
A building society is a financial institution owned by its members that offers banking
and other financial services, especially mortgage lending. The term ‘Building Society’
first arose in the nineteenth century in UK. Groups of people pooled savings so that
members could buy or build their own homes. Today, building societies offer services
similar to those offered by commercial banks.
Such services include a range of savings accounts, money transfers and foreign
currency transactions. They still offer loans and mortgages for home and land
ownership. Also, in some building societies, loans are available to non-members. Two
examples of building societies in the region are the Jamaica National Building Society
and the New Building Society Ltd. Of Guyana.
Investment Trust Company

A trust company accepts deposits from the public. These deposits fund commercial
mortgages for the corporate sector. Trust companies, therefore, make funds available
to very large firms so that they are able to make capital investments. Trust companies
have assisted in the development of the capital market in the economy through the
management of share issues of public companies. They also assist through the purchase
of government and private securities. As buyers of securities, investment trusts are a
source of funds to private and public sector.
Informal Credit Institutions

For many years, the financial sector in the Caribbean economies remained relatively
underdeveloped. However, the people of the Caribbean had financial needs that need
to be satisfied. Informal financial institutions developed, arising from the needs of the
people. In later years, formal financial institutions extended to reach a larger part of the
population. However, the people of the Caribbean still held onto these simpler
institutions. As a result many of these informal institutions exist to this day. Some of
them include:
a.) Sou-Sou – This is an informal arrangement where a small group of people
contribute an equal fixed sum each week or month on a payday to a common
fund called a Pot. The total amount in by all participants goes to one member of
the group each week or month. This sum is called a hand. In some sou-sou, this
is called a box. People will ‘throw’ a sou-sou with others whom they know, such
as neighbors or work colleagues. Clearly, if you took one the earlier hands, it is
as if you are borrowing the sum of money at zero percent interest and repaying
by installments in later months or weeks.
b.) Money Lenders – In Caribbean societies, money lenders or usurers also used
to conduct a fair amount of business. The usurers usually lent money at very
high rates of interest to borrowers. However, the borrower might not have to put
up any security (collateral) to obtain the loan. Money lenders and their activities
still survive in Caribbean societies, especially the rural areas.

Objective 11: Distinguish between the types of financial instruments.
Companies and governments (through the Central Bank) issue financial instruments.
These instruments provide a means for other companies and individuals to participate
in business activity by lending or investing (and earning an income), and even decision
making. These instruments are called securities.
Securities are certificates proving entitlement to debt repayment or part-ownership
of a company.
Securities are traditionally divided into debt securities and equity. Debt securities are a
loan to the business or the government. Equity security constitutes part-ownership of
company.
Types of securities
Treasury Notes (bills) and Bonds

These are debt securities issued by the government, hence the use of the term ‘treasury’.
Bills and bonds represent loans to the government. The buyer of a bill or bond is giving
the government a loan. Treasury bills are short-term loans, (usually for 91 or 182
days) while bonds are long-term loans (of a 5,10,20 or 30 Year period).
Corporate Bonds
Corporate Bonds are long-term debt security issued by companies or corporations. A
Bond holder is a creditor who has a claim against the company equal to the value of the
bond. Once the claim of the bondholder is paid off, the bondholder has no claim on the
company. Corporate bonds are a source of finance for companies
Municipal Bonds
Municipal Bonds represent the debt of a municipality or other government unit other
than the central government. It is a source of finance and is a loan made by the buyer
to the government unit. The funds received from the sale of these bonds are used to
finance community projects such as road building, drainage and park maintenance.
Some municipal bonds might entitle the holder to tax credits.
Equity Securities
These are certificates of stock that represent ownership in the company. A stockholder
is a part-owner of the company.
For example if a company has 100,000 Shares of stock and you own 1000, you own
one per cent of the company.
As a part-owner you are entitled to part of the profits, which are paid in the form of
dividends. As a holder of ordinary shares, you also have a right to vote in the selection
of management.
READ Economics Text page 117 – Information on Central Bank Deflationary

Monetary Policy

Section 5: Economic Management: Policies And Goals
SPECIFIC OBJECTIVES
Objective 1: Explain the role of government in stabilizing the economy;

The Economic Role of Government
The government of a country is that group of officials who manage the affairs of the
state, on behalf of its citizens. Therefore, in an effort to achieve a high degree of
economic efficiency, government must set goals and formulate and implement policies
- fiscal, monetary and direct - to correct the problems associated with market failure.
The goals and policies are geared mainly toward stabilizing the economy. Many
economists believe that government’s role in any economy is three-fold, as identified
below:
The allocation role

The distribution role
The stabilization role
The allocation role of government is concerned with correcting those problems caused
by market failure in order to bring about economic efficiency. For instance:
1. Government implements policies/measures to correct externalities; e.g. they tax
offenders, offer incentives to those who comply with certain environmental
laws, etc.
2. Public goods and services are also provided by the government as part of its
allocation role.
The distribution role of government is concerned with equity and fairness with regards
to income distribution. In many developing countries, the rich get richer while the poor
gets poorer. Governments attempt to redistribute income using a wide range of fiscal
measures such as:
1. Expenditure policy, e.g.
- providing scholarships to students
- selling low income homes to citizens
2. Offering social security and national insurance services such as:

- Pensions
- Maternity benefits
- Sickness benefits
- Unemployment benefits
These can also be referred to as transfer policies.
In its stabilization role, government tries to achieve and/or maintain:

(i) full employment
(ii) price stability

(iii) a favourable balance of payments (BOP)
(iv) economic growth and development
NB: These may also be achieved when the government attempts to implements policies
related to distribution, allocation, etc.
Full employment
Although difficult, most governments try to achieve a level of full employment (or
close to zero unemployment). This is where an attempt is made to have all able-bodied
persons within the labour force, gainfully employed. In addition, attempts are made to
fully utilize all other available resources (factors of production).
Price Stability
In an effort to control inflation and to avoid such things as recessions, governments also
tries to maintain stable prices for instance:
(i) Prices of the factors of production are sometimes set by government, e.g. a
minimum wage is established; (recall that the price or reward for labour is
wages).
(ii) Government offers subsidies to producers in order to protect them from
outside or foreign competition.
(iii) Price controls such as price ceilings and price floors are often used.
A Favorable BOP (Balance of Payment)

The BOP is a country’s record of all financial transactions with the rest of the world
(ROW); it shows the country’s payments to and receipts from foreign countries.
Government often tries to ensure that the economy has a positive or favourable BOP.
For there to be a favourable BOP, a country’s receipts from the rest of the world must
be greater than its payments to the ROW.
Economic Growth
When the output of goods and services has increased from one period to another we
say that ‘economic growth’ has taken place.
Economic Development
This can be defined as the process by which the standard of living and the well-being
of the entire nation have improved.
In addition to its economic role, government also performs the following

functions:
1. Protection of the state through:
- the provision of law, order and defense;
- the upkeep of the legislature and the courts of justice;
- diplomatic representation to safeguard its interest from external dangers
and to discharge its international responsibility
2. The encouragement and control of certain sectors of the economy for social,
strategic and economic reasons
3. Responsibility for the job security of and severance benefits to workers.

For example, government must pass labour laws which ensure that workers are
paid adequate wages; laws which protect workers from unfair dismissal and so
on. Additionally, government must offer severance benefits to workers, e.g.
gratuity and pension.
4. Protection of the environment – Governments have a responsibility to ensure
that businesses and individuals adhere to the business laws such as those
governing the business environment, e.g. laws related to pollution, taxation and
labour.
5. Redistribution of Income – It concerns the division of a society’s output, (that
is, the income or value of what society earns from production) among its
members.
Because income distribution deals with the matter of who gets how much, it
raises the fundamental issue of equity or justice.
6. Balance of Payment Stability – To keep needed foreign reserves at home to
further the development process by importing less and exporting more.
Objective 2: Explain the meaning of terms and concepts associated with economic
policies and goals;
Terms and Concepts Associated With Economic Policies
 Public Finance – This deals with the management and organization of public
sector funds. (See your Econ text, pg132.)
 National Income (Net National Income) – defined as the total monetary value
of all the goods and services produced by a country in a given year.
National Income is the measure of economic activity in an economy over a
given period, usually one year.
National Income can be calculated using one of three methods:
1. Expenditure Method
2. Income Method
3. Output Method
Total Expenditure in the economy is equal to the total of all factor incomes
earned in which, in turn, is equal to the value of the total output in the economy.
 National Budget – described as the government’s income and expenditure

plans for the financial year; it is presented the Minister of Finance, outlining :
- how much government will be spending and what it will be spent on
(expenditure);
- how much money will be raised and from where it will be raised
 Personal Income (PI) – The portion of national income that is received by the
household sector; i.e. personal income shows the amount of national income
(NI) that is received by individuals.
PI = NI – Retained business earnings – Income received by government

Disposable Income (DI) – refers to the income of individuals that is available for
spending or saving.
DI = PI – Personal Income Taxes + Transfer payments
Transfer payments are payments for services which do not stimulate economic
activity, e.g. old age pensions, unemployment benefits, etc.
Transfer payments are monies given to one group by another for which no productive
activity took place; for example, government payments of social security benefits.
Since current expenditure takes place repeatedly each week or month (that is, recurs),
it is called recurrent expenditure.
Objective 3: Explain the concept of the circular flow of income;

Objective 4: Illustrate the circular flow of income;
The Sectors of the Economy
A sector of an economy can be defined as that part of the economy united by common
needs and functions. An economy is assumed to have four (4) sectors, namely:
1. Firms
Is also a decision-making unit. This is the unit that produces goods and services.
To produce these goods and services, firms buy factor services from households.
2. Households
Is one decision-making unit. In economics, two assumptions are made about
households. First, households consume goods and services. Secondly,
households are the owners of the factors of production. A factor of production
(factor input) is any resource used to produce goods and services.
The four factors of production are land, labour, capital and entrepreneurship.
3. Government
Provides the framework of rules and laws for households and firms to operate
within; in some economies, the government is also involved in production.
4. Foreign Sector
 Households supply firms with the factors of production in exchange for

incomes.
 Firms use the factors of production supplied by the households, to:
a. produce goods and services
b. pay households for the use of the factors
c. pay taxes to government
 Households then use the money received to:
d. purchase goods and services produced by the firms
e. purchase goods and services from foreign countries (imports)
f. pay taxes to the government
g. save in financial institutions or invest in other businesses
 The taxes received by government are used to:
h. provide public goods and services
i. provide subsidies to businesses
j. make welfare payments such as pensions, severances, etc
 The foreign sector uses the money received from households, to pay for goods
and services purchased from the firms.

Expenditure
There are two types of government expenditure: capital expenditure and current
expenditure.
Capital Expenditure involves investment in capital goods such as roads, schools and
even government enterprise to produce goods. This expenditure is also called
Development expenditure.
Current Expenditure is spending on goods for present consumption and expenditure
on wages and salaries of government workers.
Final goods for present consumption include paper for Government departments, boots
for soldiers and drugs for hospitals.
Governments also make transfer payments to the elderly and the needy in the economy.
Circular Flow of Income

Elementary National Income theory is based on a closed economy with no government.
This is a hypothetical economy, as there are no real economies such as this. In this
imaginary economy there are two sectors: households and firms
Firms buy the factor services of households and pay to the households a factor income.
Households, in turn, use this factor income to purchase goods and serices produced by
firms. This flow of funds in the economy is called the Circular Flow of Income
The Circular Flow of Income is that flow of factor incomes from firms to households
in return for factor services. This factor income then flows back to firms as payment
for goods and services that the households purchase.

This cycle continues and is illustrated on what is known as the Circular Flow of
Income diagram. This diagram shows the interrelations of the four identified sectors
of the economy by illustrating the movement of funds among the sectors. (See Below)
The Circular Flow of Income
(Inner Circle)
Factor Services
(Land, Labour,
Capital,
Entrepreneurship)
Firms
Households
Goods and
Services

Outer Circle
Payments for factor

services (rent,
wages, interest and
profit)
Households
Firms
Payment for goods

and Services

In the diagram on the previous page, it shows the flow of factor services from
households to firms
Firms use these factor services to produce goods and services. There is a flow of goods
and services from firms to households. The flow of goods and services and factor
services are called Real Flows. Firms pay incomes for the factor services. The factor
services flow from firms to households. Households then take this factor income to pay
for the goods and services purchased from firms. The flow of factor incomes form firms
to households and the flow of expenditure from households to firms are balance and
are so called Money flows.
Altogether money flows and real flows make up the circular flow of income. Whatever
the value of the income, it remains the same as the income flows from households to
firms and back to households, because there are no additions or withdrawals from the
circular flow of income.
Concepts
Leakages – are income of households and firms that is not passed on in the circular
flow of income
Savings – Consists of all income that is not consumed.
Disposable income - Is total Personal income minus taxes.
Investment – Is the purchase of capital goods (goods used to produce other goods)
Injections – Are additions to the circular flow of income.
Commodity Market
The commodity market is the market in which goods and services are exchanged for
money. Foreign commodities enter the commodity market (imports) and domestic
commodities (exports) leave the commodity market. Firms receive their revenue from
commodity markets on the sale of their goods and services. That which leaves the firm
is known as gross domestic income, this is income before taxation. Taxes are taken
from gross national income and paid to the government, who in turn issues transfer
payments.
Disposable Income
Disposable income is left after taxes are subtracted and are paid to households along
with transfer payments. Note that both firms and governments also deposit savings with
financial intermediaries. Financial intermediaries then invest this accumulation of
money in the commodities market and/or in firms. Note, that the government also
purchases goods and services from the commodity market.
Objective 5: Distinguish between Gross Domestic Product (GDP) and Gross

National Product (GNP);
National Income and Its Variants
National Income (NI) or Net National Product (NNP) can be described as the total
monetary value of all the goods and services (output) which are produced by a nation
during a year and are available for consumption. There are several concepts that must
be considered when looking at NI.
(i) Gross Domestic Product (GDP) – the total monetary value of all the goods
and services produced within the national boundaries of a country, (i.e.
within a country itself), over a calendar year.
(ii) Gross National Product (GNP) – the total monetary value of all the goods
and services produced by the nationally owned factors of production. GNP
takes into account not only what is produced locally but also what is
produced by firms abroad that are owned by local individuals and the
government. [The income received from abroad is called factor income
from abroad or income payments from overseas.]
(iii) Depreciation – the reduction in the value of assets such as machines and
buildings, over time, because of wear and tear.
Calculations:
1. GDP = Monetary value of goods and services produced locally over a year
2. GNP = GDP – Income payment to foreigners + Income payments from overseas
[Net Factor Income is the difference between income received from abroad and
income paid to foreigners.]
3. NI = GNP - Depreciation
4. Per Capita Income = NI / Population
Other Related Concepts
(i) GDP at Market Prices – This means that the values are measured at the final
price of goods or services; i.e. they represent the prices consumers pay.
GDP at Market Prices is national output for the year computed by adding
together all the spending of all sectors and subtracting imports.
(ii) GDP at Factor Costs – This is GDP measured at the cost of production; i.e.
the cost of the product. Indirect taxes are deducted and subsidies are added.
GDP at Factor Costs is national output for the year measured at the prices to
the factors of production to produce the output, and it excludes the effects of
indirect taxes and subsidies.
(iii) GDP at Current Prices – This means that no allowance has been made for
the effects of inflation on prices in the year of measurement.
(iv) GDP at Constant Prices – This means that the final figure has been adjusted
for the effects of inflation.

Approaches Used to Calculate NI
There are three (3) approaches used to calculate a nation’s output.
1. The Output Approach

2. The Income Approach
3. The Expenditure Approach
NB: Any of the methods used to calculate NI should yield the same answer.
 The Output Approach

This measures the value of domestic output and is calculated using the following
formula:
GDPFC FC means at Factor Cost

+NFI NFI means Net Factor Income
=GNPFC GNP means Gross National Product
– Dep’n Dep’n means Depreciation
= NIM NI means National Income
M means at market prices
 The Income Approach

This approach consists of the addition of all incomes earned in the production of goods
and services. Therefore, it measures NI directly, by adding the rewards/compensations
paid to the factors or production.
NB: Transfer payments such as pensions, etc. are not counted. (Why is this so?)
The following formula is used:
Income from employment (wages & salaries)

+ Profits
+ Rents
+ NFI .
= GNPFC
– Dep’n .
= NIM

 The Expenditure Approach
This method measures the amount of money spent on investment and consumer goods
and services produced during the course of the year. It is measured using the following
formula:
Consumption Expenditure (C)

+ Investment Expenditure (I)
+ Government Spending (G)
= Total Domestic Expenditure (TDE)
+ Exports (E)
– Imports (M)
= GDPM
+ Subsidies
– Indirect Taxes
= GDPFC
+ NFI .
= GNPFC
– Dep’n .
= NIFC
Note that GDPM = C + I + G + X – M
Uses of National Income Statistics

National income statistics must be known because:
1. The government must have some idea or estimate of the state of the economy.
2. It gives some indication of the standard of living of people in a country from
year to year.
Higher incomes indicate that the quality of life has improved.
Lower incomes indicate that there may might have been a worsening of the
quality of life of some residents.
3. NI figures can be used to compare the economic position of different countries.
4. NI figures indicate the rate at which NI is growing and so assist:
- government in developing economic policies ;
- businessmen in planning future investment; and
- trade unions in determining whether to ask for wage increases for their
members.

Questions: (a) What are the advantages and disadvantages of the different
approaches used to measure national income?
(b) How do the following factors affect national output?

(i)natural resources (v) factors of production
(ii)nature of the labour force (vi) technical resources
(iii)political stability (vii) capital equipment available
(iv)foreign aid (viii) financial stability
(c) Identify some of the social and economic benefits of government’s

participation and regulation in the economy.

Objective 6: Distinguish among nominal output, real output and potential output;
Real Output, Nominal Output and Potential Output
Real Output (Real GDP)

This is also referred to as constant priceoutputor inflation corrected output. The
value of a country’s goods and services produced in a year, measured at constant or
base year prices. In other words, the value of the nation’s output is adjusted for price
changes and inflation (using the base year).
 What is a base year? This is the reference year that other years are compared
to. It is a normal year; i.e. a year without any major occurrences that
significantly affected the economy (whether positively or negatively).
Nominal Output (Nominal GDP)

This is the value of country’s goods and services produced in a year, measured at
current prices; i.e. the nation’s output measured in actual dollars in a given year, with
no adjustment for price changes or inflation.
Real GDP account for GDP while Nominal jus use the prices as they ARE.
REAL GDP = Nominal GDP/ Price Index * 100

Example of Real GDP/Output – Suppose:
Year 1 SVG produced 5 tons bananas @ $100 a ton
Total $500
Year 2 SVG produced 8 tons bananas @ $120 a ton
Total $960
Assume Year 1 is the base year used to calculate Real GDP.

In Year 1 Nominal GDP = $500 & Real GDP = $960
In Year 2 Nominal GDP = $960 but Real GDP = $800
By eliminating the effects of price changes, real output allows economists to make
useful comparisons of a nations output of goods and services.
Potential Output (Potential GDP)

This is also referred to as “Natural GDP”. It is the highest level of real GDP that can
be sustained over the long term.
The GDP Gap

The GDP gap or the output gap is the difference between Potential GDP and actual
GDP.
GDP Gap = Y – Y* where: Y= potential output
Y* = actual output

Objective 7: Distinguish between economic growth and economic development;
Economic Growth and Development

Economic Growth
When the output of goods and services has increased from one period to another, we
say that ‘economic growth’ has taken place. This implies that per capita income has
increased in real terms, given that production increases more than population.
Economic growth can therefore be defined as an overall expansion of the economy and
refers as well to a real increase in GNP after the effects of inflation have been taken
into consideration. It is quantitative and is therefore concerned with the numerical
increases in NI. If there is no expansion in a country’s production, then it is considered
to have experienced negative growth.
Negative Effects (Disadvantages) of Economic Growth

Economic growth is usually accompanied by:
(i) increase in population
(ii) increase in demand for goods and services
(iii) increase in demand for skilled and professional labour
(iv) rise in prices of consumer goods and services
(v) pollution: water, air and land by heat, noise, chemicals and other wastes
(vi) emphasis on the progress of urban areas as against rural areas
(vii) overcrowding of urban areas
(viii) opportunity costs
(ix) accidents and suicides
Positive Effects (Advantages) of Economic Growth
Economic growth may also lead to:
(i) a rise in the acquisition of personal property

(ii) improved social benefits – (pensions, gratuities, public assistance or poor
relief funds, unemployment benefits, etc.)
(iii) increase in housing accommodation
(iv) improved educational facilities
(v) increased wage rates and possible tax reliefs
(vi) more and better recreational facilities
(vii) more leisure
(viii) social and political stability
(ix) possible decrease in the rate of unemployment
(x) creation of the conditions necessary for economic development

Economic Growth is measured by:
 the increase in the level of industrialization or modernization
 increase in real per capita income
 a rise in the SOL
 GNP or the total output of goods and services
 the level of savings and investments
 increases in sectors of the economy, e.g. tourism, agriculture, etc.
Economic Development
Whereas economic growth is quantitative, economic development is qualitative and is
more concerned with the pattern of economic change. It relates to changes in the quality
of actual goods and services available to the nation. Economic development can be
defined as the process by which the SOL and the well-being of the entire nation are
improved. The concept of Economic development is concerned with the quality of
housing, clothing, education, food, health, independence and freedom, self-esteem,
and self-respect, peace-of-mind and security, the eradication of poverty and
inequalities ofincome and wealth. It also looks at the ability of a country to exploit
itsnatural resources to their fullest advantage. Therefore, it would cover areas such
as: government institutions, educational facilities, financial institutions,
telecommunication facilities, transport and storage.
For a nation to fully benefit from both growth and development, there must be a positive
relationship between the two; e.g. (i) pollution must not increase; (ii) population size
must be controlled – i.e. NI must grow faster than, or proportionately with, the
population. This can only lead to increased or at least constant per capita income.
NB: Economic growth may not necessarily be accompanied by economic

development. For example, increased industrialization and modernization relate to
economic growth. However, these tend to increase the level of pollution – more
chemical waste, smoke, radiation, etc. These in turn lead to a reduction in SOL the
well-being of citizens in the form of environmental degradation, illnesses, death and
so on.
In general, economic development is accompanied by:
(i) new attitudes
(ii) the discovery of new techniques
(iii) the organization or formation of new institutions
To improve economic development, there must be:

 a favourable social environment;
 equality in the distribution of income and wealth;
 reduction in unemployment, cost-of-living and inflation;
 reduction in government intervention and control;
 increase in:
- savings and private sector investment
- infrastructural facilities
- real per capita income
- quantity and quality of resources
- modernization and free trade
Objective 8: Distinguish between inflation and recession;

Inflation
There are several definitions of inflation:
 A situation whereby there is too much money and too few goods.
 A situation whereby the general price level is rising.
 A situation whereby the value of money is falling.
The best definition of inflation is a situation of persistent or sustained increases in the

general level of the prices of goods and services in the economy, over a period of time.
Recession
On the other hand, there are repeated periods during which GDP falls; i.e. there is
negative economic growth. Such periods are called recessions if they are mild and
depressions if they are more severe.
A Recession is a period during which the total output in the economy declines. During
a recession, firms are producing less, so national output decreases. As firms are
producing less. It means that firms will use less factor inputs, including labour.
Unemployment grows during a recession. A recession is a short term, lasting some
months or up to a year. A recession can develop into a depression lasting several years.
A depression is falling national output over several years with high levels of
unemployment.
During economic recessions and depressions are associated production declines,

unemployment rises and consumer spending falls.
NB:Periods of falling prices are known as deflation while periods of rising prices are
known as inflation. Disinflation is where the inflation rate slows down
Inflation affects
** Interest rate is the price of a loan
- Investment
Interest rate affects investment as if the Loan Interest is High the investors
will tend not to invest.
- Savings
Since during this period interest rates are high savers will tend to try to
save more money as they will get high returns since the interest rates are
attractive.
Investment – the accumulation of newly produced physical goods or entities such as

factories, machineries, roads etc.

Savings – is considered to be deferred consumption or income not spent
Fiscal draft – This is where tax payers are dragged into higher tax brackets as a result
of increased incomes.
Important points to note about inflation:

 Inflation is never used with respect to increases in the price of a single item. There
must be persistent increases in a wide array of goods and services; e.g.
entertainment, utilities, food, clothing, education, housing, etc.
 Increases in prices must not be seasonal. Thus price increases at Christmas, Easter,
etc. are not inflationary.
 Small overall price increases of less than 2 or 3% yearly are not regarded as
inflationary; this is considered or accepted as a normal part of economic life.
 An outrageous or gigantic increase in the overall price level is known as hyper-
inflation and not inflation.

Objective 9: State the main causes and consequences of inflation and recession on
an economy;
INFLATION
Major Causes of Inflation
Three theories have been put forward by economists to explain the causes of inflation.
They are:
(i) The demand-pull theory
(ii) The cost-push theory
(iii) The structural theory
However, for our purposes, we will only look at the first two.
The Demand-Pull Theory

The traditional cause of inflation is known as demand pull inflation. It takes place
when total expenditures for goods are rising while the available quantity of goods is
not growing fast enough to meet the demand.
If aggregate demand (total demand in the economy) increases, there will be economic
growth because suppliers will respond to the increased demand by supplying more
goods and services. To supply more goods and services, more factors of production
will have to be employed. So far, so good for the economy
The problem arises when supply cannot respond to an increase in aggregate demand
because all resources are fully employed. Then an increase in aggregate demand will
drive up prices. This is what is known as demand-pull inflation.
Aggregate demand is the total expenditure on goods and services in the economy.
AD = C + I + G + X – M
Where AD is aggregate demand, C is consumption expenditure, Iis investment, G is
government expenditure/spending, X is exports and M is imports. X – M is net exports.
Some factors which influence aggregate demand and lead to inflation are:
 Large increases in government spending;
 Successive reduction in taxes;
 Successive falls in the interest rate;
 Depreciation of the exchange rate;
 Economic growth in other countries.~ ~~AND OTHERS~~~
Apart from an increase in aggregate demand, some economists believe that demand-
pull inflation is caused by an increase in the money supply. They believe that an over-
creation of money, or an over-extension of credit by financial institutions, causes
inflation. Each of these situations results in too much money chasing too few goods as
a result, prices are forced upwards.
Cost-Push Inflation
This occurs when the costs of the factors of production (such as wages) rise more
rapidly than output and this leads to an increase in the price of products and hence the
cost of living. In order to maintain their profit margins, firms pass on these costs to
consumers in the form of higher prices but they may also be forced to cut back on
production if costs are too high. The increased prices faced by consumers/households
lead to further factor claims that result in further price increases by firms; the cycle
continues……. This behavior results in what is known as a wage/price spiral. This is
where wages chase prices in an upward direction.
Cost-push inflation is often called ‘imported inflation’, especially in the Caribbean

where countries depend heavily on imports.
Wage Push Inflation – a special case of cost push inflation caused by the presence of
strong trade unions in the labour market. This is the case that is most relevant to the
Caribbean.
Profit Push Inflation – a special case of cost-push inflation due to the owners of large
businesses raising mark-ups without any increase in costs or demand.
Money Supply - An Increase in money supply causes an increase in aggregate demand.
Just as in demand-pull inflation, this increase in aggregate demand, output remaining
constant, causes an increase in prices.
Other factors that cause cost-push inflation are:

 Rising costs of imported raw materials; this is why cost-push inflation is often
called ‘imported inflation’.
 Higher indirect taxes imposed by government.
What do you consider an acceptable/unacceptable rate of inflation for an economy?

Commodity Inflation – This occurs when prices of material inputs rise sufficiently to
cause rapid increases in costs of production. Firms are prompted to respond by raising
the prices of finished goods.
Expectations Inflation – Inflation can result from simultaneous demand-pull and cost-
push forces. Suppose the public believes that the inflation rate is about to accelerate…
then the expectation that prices are going up will lead many people to increase their
spending, many workers to press for higher wages, and many firms to raise their prices.
The expectation of an increase in inflation can, therefore, be self-fulfilling.
Does inflation impose a burden on all of us? Not necessarily. The effects of inflation
are not distributed equally. Most people suffer from it, but others sometimes benefit.
To see why this is so, we must understand the difference between two kinds of incomes.
1. Nominal Money Income – This is the amount of money received for work done.

2. Real Income - This is the purchasing power of nominal income as measured by
the quantity of goods and services that it can buy.
Real income is determined not only by your nominal income, but also by the prices of
the things you purchase.
Consequences of Inflation
1. Inflation reduces the real value of money, that is, the actual quantity of goods
and services that money can buy. Therefore, money loses its purchasing power.
2. During inflation, persons with fixed incomes, such as pensioners, and those in
low income groups, stand to lose. In other words they lose purchasing power,
as that the given amount of money can buy fewer goods and services than
previously. This results in a reduction in standard of living.
Purchasing Power of Money is what goods and services can money buy at a
specific period of time.
3. There can be an increase in production and employment (due to demand-pull
inflation).
4. There is a redistribution of income from creditors to debtors, since repayments
made by borrowers to lenders are reduced in real terms as a result of inflation.
Similarly, businessmen will gain at the expense of consumers.
5. Inflation adversely affects investment decisions if investors consider the
economy to be unstable as well as if they think the country lacks the ability to
implement control policies.
6. There is a fall in cash savings since persons have to now spend more.
7. Balance of Trade (BOT) is likely to be in deficit, especially for countries that
depend heavily on imports; (e.g. Caribbean countries).
Balance of Trade – the difference between the value of exports and the value of
imports.
8. When prices are increasing in the domestic economy, it means that the prices of
gods that the country is exporting will rise.
As prices rise, foreigners will demand fewer of the country’s goods and services.
This means that the given country will earn less foreign exchange. If the level
of exports falls and the level of imports remains constant, the country will suffer
a trade deficit. Also, if the price of imports is lower than the rising price of
domestic goods, the country will import more. This would lead to an even
greater trade deficit.
9. Borrowers Gain
The value of the debt to be repaid in real term falls during an inflationary period.
Inflation tends to encourage borrowing.
10. Creditors Lose out
The sum to be repaid will now be able to buy less. Inflation tends to discourage
lending
11. Looking For better Prices

In times of Continuous inflation means that people might have to walk from
place to place. These are costs in terms of time and effort and are so called
leather costs.
12. Shops, Stores and restaurants also have to change price tags and menus
These are called Menu costs
13. Rising Costs of Production cannot be passed on
Some firms find it difficult to survive when their costs of productiona re rising
and they cannot pass on this increase in costs in the form of higher prices to
consumers. This is the case for goods with substitutes and such producers might
be forced out of the market.
14. Employers might be forces to reduce the quantity of labour employed
This will be so because of rising labour costs. This will lead to unemployment
of some employees.
RECESSION
A recession can be defined as a period of general economic decline. This is usually
observable through a drop in GDP for two or more quarters. There are many factors
which contribute to an economy going into a recession. This includes, a low level of
consumer spending. The reasons for the low level of consumer spending might differ,
as it may be a result of inflation (a rise in the cost of goods and services), or individuals
choosing to save more than they consume. Individuals consume less goods and services
which ultimately lead to a decrease in the total output of the economy.
Major Causes of Recession

1. The Trade Cycle
Economists have observed economic activity over the last two centuries.
Economic activity increases and then declines over time. This is called the
Trade Cycle. Economic Activity will not simply increase all the time. The
peak of economic activity is called a Boom and the through/decline is called
a Depression.
A Recession signals the end of the boom stage of the trade cycle. At the
point at which economic activity declines, this is the onset of the recession.
2. During a Boom, Demand is increasing
This increasing demand will fuel inflation. As the government puts in place
deflationary fiscal and monetary policy, this will cause aggregate demand in
the economy to fall. Prices will stabalise but there might be a decline in
output and a rise in unemployment. This is a recession
3. Cautious entrepreneurs might feel pessimistic about the future
This might simply be an instinct that demand will fall in the future. As a
result, they might simply be an instinct that demand will fall in the future.
As a result, they might cancel investment plans. They might even avoid
undertaking replacement investment. This fall in investment will lead to a
fall in national output.

4. The demand of households, firms, government and the export sector
might fall
This will cause aggregate demand in the economy to fall. Thereby causing
output to fall.
5. If firms are not making sufficient profits, they will close down
This will cause a contraction of a national output.
Consequences of a recession include:

1. In a Recession, Output is Falling
This means that GDP and Standard of Living is falling
2. If Output is falling, firms will use fewer factors of production
Including labour. This will cause rising unemployment.
3. Rising unemployment and falling incomes
Will Result in less inflationary pressure in the economy and therefore prices
will stabilize.
4. The government will find that its tax revenue from taxes on goods and
services and taxes on incomes will decline
As there is falling income and rising unemployment in the economy. This
will affect the governments ability to spend on the provision of merit goods,
such as health and education, and other amenities, such as water and
electricity. Government will also have to spend more on unemployment-
related benefits
5. In a recession output is falling, incomes are falling and unemployment
is rising
This leads to falling demand. This might result in further pessimism amongst
entrepeneurs and investors as they predict falling demand.
6. Falling incomes means that consumption will fall
With the fall in consumption, there will be a fall in the level of imports.
7. Decline in economic growth.
8. An increase in the unemployment rate. Firms are forced to cut the
operational costs incurred by paying wages.
9. Collapse or poor performance of the stock exchange markets.
10. Failure of businesses.
11. Financial market failure.
12. Decline in house value or prices.
13. Increase in loan defaults.

Objective 10: State ways used by governments to reduce inflation;
Government’s Role in Reducing Inflation
Any of the three sets of policies (fiscal, monetary and direct) can be implemented to
curb inflation.
To reduce demand-pull inflation, government can:

 Decrease its own spending;
 Increase the amounts consumers are required to pay in income taxes, NIS
contributions, etc.
 Raise the interest rate to encourage consumers/households to save more.
Also:
Deflationary Fiscal Policy - In order to reduce demand-pull inflation the government
must put in place deflationary fiscal policy. Reducing government expenditure and
increasing taxes reduces total spending in the economy, which in turn reduces the
pressure on prices.
Deflationary Monetary Policy will also be effective, as higher interest rates and a
credit squeeze will limit borrowing and spending. This will reduce inflation, as there is
less spending and less pressure on prices to increase.

Government
Government Taxes
Expenditure
Expenditure Increase Larger Down
Falls
Falls
Higher payments and
Interest Rates Shorter
repayment
periods
Total
Spending
Decreases
Total
Spending
Decreases
Inflation Falls
Inflation Falls
Above is the Deflationary Fiscal Policy Above is the Deflationary Monetary Policy

To reduce cost-push inflation, government can:
 Set policies directed at controlling prices and wages;
 Reduce interest rate on business loans etc.
 Lower indirect taxes such as sales tax, consumption tax, etc.
 Offer tax breaks to businesses;
 Provide subsidies to producers.
Also:
Regulations to limit the power of trade unions to increase wages will be effective in
curbing cost-push inflation. Also, government subsidies and grants to firms to help
increase production will make more goods and services available. This will put less
pressure on prices by overall supply of goods in the economy, even though aggregate
demand in the economy remains the same.
Other ways of reducing inflation:

- Imported Inflation
Cutting back on imported goods will reduce this type of inflation. If both final
goods and imported capital and imported capital and raw materials are
substituted by local goods, the country will buy less imports. This in turn, will
reduce imported inflation.
- Inflation due to increases in the money supply
Deflationary monetary will be effective because higher interest rates and a credit
squeeze both reduce the money supply in the economy. Reduced money supply
and limits on borrowing will reduce spending in the economy and so take away
pressure from prices.
Can you think of others?

Government reduces inflation by:
– Implementing appropriate fiscal policies: Governments reduce their spending and
increase taxes. This policy works in combating demand- pull inflation.
– Implementing a monetary policy: Central banks would reduce the money supply
available for spending or increase interest rates. This policy works in combating
demand- pull inflation.
– By designing policies which will spur productivity/reduce operational costs, such as
giving grants to firms and giving tax breaks and other incentives.
– Direct Intervention: these are measures taken to restrict wage increases and price(s)
of commodities. The two types of direct intervention are legislative (government
freezes wages and prices) and voluntary.
Objective 11: State ways used by governments to relieve recession;

Ways of reducing the effects of recessions
- Reflationary Fiscal Policy
Reflationary fiscal policy will relieve a recession. Increasing government
expenditure will create jobs for the unemployed. When they receive their
incomes, this will lead to increased spending in the economy. Cutting
income taxes and taxes on goods and services will encourage consumers to
spend more. Reducing corporation taxes (taxes on the profits of firms) will
encourage firms to invest more. The increased spending in the economy will
encourage firms to produce more. They will employ more labour, and
national income and output will rise.
- Reflationary Monetary Policy
Reflationary monetary Policy will also relieve a recession. Reducing interest
rates will encourage firms to invest, and individuals will borrow more and
so consume more goods and services. Even governments will have access to
borrowing at lower rates of interest. Easier accessibility to loans will also
encourage more spending. More spending by households, firms and
government increases aggregate demand. As aggregate demand increases,
firms will increase output. They will have to employ more labour, thus
reducing unemployment. Output and incomes in the economy will increase.
- Restrict imports
- Taxation (can have a two-sided effect)
- Subsidies – government would have to borrow money which would put
them in a another state
- Fine tuning an economy
- Is where the government through diff means and measures will try to
iron out things like slumps and booms in an economy.
- An attempt by government to “iron out” booms and slumps in the business cycle.
Can you think of others?
Government reduces the effects of a recession by:

– Implementing appropriate fiscal policies: Government would increase government
spending and decrease taxes.
– Implementing monetary policies: Central banks would increase the money supply
available for spending or decrease interest rates.
– Creating jobs: Government would try to create as many jobs as possible to reduce the
unemployment rate, increasing productivity and ultimately increasing spending.

OTHER CONCEPTS EXPLAINED
DEMAND SIDE POLICIES

These influence the level of aggregate demand in an economy using a number of policy
instruments
Some of these instruments may include:
1. Taxation
2. Government Spending
3. Interest Rate
SUPPLY SIDE POLICIES

These aim at increasing economic growth by raising the productive potential of an
economy.
An increase in aggregates supply of goods and services will require more labour and
other resources to be employed, reducing pressure on prices and providing more goods
and services for export.

Terms and Concepts Associated With Economic Policies
 Public Finance – This deals with the management and organization of public
sector funds.
A national budget is presented to parliament at the start of the fiscal year.
The National Budget is a statement of the governments; estimated revenue and

expenditure for a country for the coming year
There is a balanced Budget where expenditure is equal to revenue. Sometimes

the government will spend more than it earns. There is a budget deficit when
expenditure exceeds revenue. This is also called a fiscal Deficit. When there is
a budget deficit, the government must borrow locally and abroad to meet the
revenue shortfall. The sum of government borrowing (Locally and abroad) over
the years to finance budget deficits is the national Debt.
There is a Budget Surplus when revenue exceeds expenditure. Governments
might use this surplus to pay off past borrowing. In such a way a budget surplus
leads to a reduction of the national Debt.
 National Income (Net National Income) – defined as the total monetary value
of all the goods and services produced by a country in a given year.
 National Budget – described as the government’s income and expenditure

plans for the financial year; it is presented the Minister of Finance, outlining :
k. how much government will be spending and what it will be spent on
(expenditure);
l. how much money will be raised and from where it will be raised
 Personal Income (PI) – The portion of national income that is received by the
household sector; i.e. personal income shows the amount of national income
(NI) that is received by individuals.
 Disposable Income – Income remaining after payment of personal taxes
 National Debt - Total outstandingborrowings of a central government

comprising of internal (owing to national creditors) and external (owing to
foreign creditors) debtincurred
infinancing its expenditure.
 Fiscal Policy - Fiscal policy attempts to stabilize the economy at a high level of
employment by manipulating government spending and taxing. Fiscal policy
involves changes in taxation and government spending. A government can
deliberately alter tax rates and levels of government spending to influence
economic activity.

 Fiscal Deficit - When a government's total expenditures exceed the revenue that
it generates (excluding money from borrowings). Deficit differs from debt,
which is an accumulation of
yearly deficits.
 Monetary Policy - Monetary Policy refers to the attempts to manipulate either

the rate of interest or the supply of money so as to bring about desired changes
in the economy. e.g. banks ability to lend or households ability to borrow.
 Developing Economy – is an economy with a low level of material well-being.

The lower-income countries of the world, most of which are in Asia, Africa and
South and Central America.
They are usually characterized by the following conditions:
1. Poverty levels of income and hence little or no saving.

2. High rates of population growth
3. Substantial percentage of the labour force employed in agriculture
4. Low rates of adult literacy
5. Extensive disguised unemployment (resources not being used efficiently –
labour)
6. Heavy reliance on one or a few items (mainly agriculture) for export.
7. Government control by a wealthy elite, which often opposes any changes that
would harm its economic interes
a. Developed Economy - is an economy with a high level of material well-being.

These are nations with developed market economies based on large stocks of capital
goods, advanced production technologies and well-educated labour forces.
They are usually characterized by the following conditions:
1. Advanced production technologies

2. Well-developed Infrastructure – Communication and Transport,
Water and Sanitation.
3. Well-educated labor force
4. Limited government intervention
5. Well defined private sector
6. Well-developed financial markets
 Employment – Asituation in which available labor resources are being used to

produce goods and services to satisfy human needs and wants.
 Unemployment - Asituation in which available labor resources are left idle, and
are not used to produce goods and services to satisfy human needs and wants.
 Inflation - Inflation is a rise in the general price level (or the average level of
prices) of all goods and services over a prolonged period. The purchasing power
of a unit of money (such as the dollar,) varies inversely with the general price
level. For example, if prices double, purchasing power decreases by one-half; if
prices halve, purchasing power doubles by a unit of money.
 Deflation - A decline in general price levels, often caused by a reduction in

the supply of money or credit.
 Savings - The portion of disposable income not spent (extra money) on the
consumption of goods and services, but accumulated or invested directly in
capital equipment or stored in a financial institution.
 Investment – When resources are used to acquire goods and services which are
not consumer for their own sake, but which are used to generate future streams
of income or to create wealth.
PI = NI – Retained business earnings – Income received by government
Disposable Income (DI) – refers to the income of individuals that is available for
spending or saving.
DI = PI – Personal Income Taxes + Transfer payments

Transfer payments are payments for services which do not stimulate economic
activity, e.g. old age pensions, unemployment benefits, etc.
Fiscal Policy
A government raises most of its revenue through taxation. Fiscal policy refers to the
government’s plans for taxation, expenditure and the national debt.
With fiscal policy, the government must decide on whether to have:

1. a budget deficit, where expenditure exceeds revenue;
2. a budget surplus, where revenue exceeds
expenditure;
3. a balance budget, where revenue equals expenditure
What happens when there’s a budget surplus?

A budget does not have to balance. It depends on the fiscal policy implemented by the
government, which should be geared to the needs of the economy.
When revenue (R) is greater than government spending (G), the government will adopt
a budget surplus policy in order to prevent or reduce inflation. For example:
(i) Government will increase taxes, especially direct taxes.
(ii) Government will reduce its spending.
(iii) It will use the surplus to reduce the national debt.
Don’t these measures sound like the opposite of what should occur? No!! They aren’t.
Think about them carefully.
What happens when there’s a budget deficit?

As mentioned above, a budget or fiscal deficit occurs when expenditure exceeds
revenue. It is the gap or difference between government expenditure (G) and its
revenue (R). This gap represents the amount of money that government must borrow.
A government may want to boost the economy (i.e. close the gap) by spending more
than it collects in taxes. It can do this by borrowing. In such a case, the Minister of
Finance has to state the government’s borrowing requirements, known as the ‘public
sector borrowing requirement’, (PSBR). There are few ways a government can borrow.
Among them are:
(i) Selling treasury bills or short term loans to the public, banks or foreign
countries
(ii) Selling bonds or gilt-edged securities to the public
 Gilt-edged securities are long term loans. They come in the form of securities
issued by government for a fixed period of time at a fixed interest rate. They
usually last for 10 years. However, some last as long as 25 years. Interest is
paid every year and upon maturity, the principal sum is paid.
(iii) Borrowing the savings of the people through the national savings bank, e.g.
NCB
Each year the government sells bonds and bills to finance the PSBR. However, the
government does not always pay all the borrowed money quickly. The money that is
not repaid is known as the national debt.
NB:A budget deficit is inflationary, other things being equal, because the government
is ‘pumping’ money into the economy by spending more that it is taking out.
On the other hand, a budget surplus is deflationary because the government is

taking out more money from the economy that it is putting in.
What does it mean it say a government’s budget is inflationary and deflationary?

Taxation
A tax is a compulsory payment made by a citizen or a corporation, to the government,
for which they receive no direct benefits.
Purposes of Taxation
1. To raise revenue in order to:
m. provide public goods and services;
n. pay public servants;
o. meet the expenses of government projects/undertakings;
p. provide transfer payments or negative income tax (NIT) to the poor;
q. provide grants and subsidies
2. To control consumer spending and inflation, by reducing the money supply in

the economy;
3. To reduce the consumption of demerit goods such as alcohol and tobacco;
4. To protect infant industries or industries such as agriculture, (from imported

substitutes) and also to correct deficits on the BOP by imposing high tax rates
on imported goods. This is in an effort to reduce imports.
5. To lower unemployment by encouraging individuals to buy locally produced

goods thus encouraging linkages among sectors;
6. To achieve greater equality of wealth and income through redistribution by

taxing higher income earners so as to provide social services for the majority of
citizens;
7. To transfer resources from the private to the public sector;
8. To promote economic growth and development.

Types of Taxes
There are two main types of taxes:
(ii) Direct taxes;
(iii) Indirect taxes
There are two categories of taxes:
1. Direct tax – A tax that is not shifted – that is, its burden is borne by the persons
or firms originally taxed – e.g.- personal income tax, social security tax and
death tax.
2. Indirect tax – A tax that can be shifted either partially or entirely to someone
other than the individual or firm originally taxed – e.g.- sale taxes, excise taxes,
taxes on business and rental properties.

A direct tax is one levied by government on the income or wealth of individuals and
on the profits of firms. The following are examples:
 Personal Income Tax – tax paid on income (PAYE system)
 Corporation Tax – tax paid on profits earned by companies
 National Insurance Contributions
 Health Surcharge
 Capital Transfer Tax and Estate Duties – taxes levied when property is
transferred from on person to another
 Capital Gains Tax – levied on the proceeds resulting from the sale of assets ,
e.g. commercial properties
Other Direct Taxes Include:

r. stamp duties (on financial contracts)
s. motor vehicle duties
t. land tax
Indirect taxation occurs when the burden and the payment of the tax fall on different
individuals or firms, (rather than a single or firm). This tax is levied on the expenditure
on goods and services and is usually paid by the manufacturer or importer, who passes
the cost on to the consumer in the form of high prices. The following are examples of
indirect taxes:
 Excise Duty – tax on goods manufactured in a country
 Customs Duties – tax changed on goods that are imported such as appliances,
motor vehicles, tobacco and alcohol
 Purchase Tax – tax charged on certain consumer items bought at the retail
outlet, (e.g. on tobacco, wines, furniture) and the tax rate varies depending on
the type of goods
 Property Tax – tax levied on land
 Stamp Duty – paid when cheques are drawn or receipts are issued
 Value Added Tax (VAT) – a variation of the purchase tax levied on many
goods and services; a specific percentage (e.g. 10%, 15%, etc) is charged

Advantages of Direct Tax Disadvantages of Direct Tax
A large amount of revenue is earned People may feel less inclined to
work hard
compared to the cost of collecting when they have to pay more taxes if they
the tax. earn more.
Progressive direct taxes can redistribute Corporate tax will erode the profit margin
of
income from the rich to the poor. the company. This will also hinder a com-
pany’s possible expansion programme.
Direct taxes are designed such that only
those who can afford will pay this type Some people will evade tax if they have to
of taxes. pay a high tax.
The rate charged can easily be changed After a pay increase some persons end up
or varied for different circumstances. paying far more in taxes leaving
them worse
off than before; this can lead to poverty.

Question: What are some of the advantages and disadvantages of indirect tax?
Advantages of Indirect Tax Disadvantages of Indirect

Tax
The cost of collecting indirect tax is very Indirect taxes are regressive in nature; the
low. poor will feel the burden more than the
rest of the society.
Have very wide tax base or tax net. They tend to push up the prices of goods
They can capture everyone including Uncertainty may arise due to the ease
students, tourists and even retirees. with which indirect taxes can be altered.
They can reduce consumption of some
types of products such as cigarettes, etc.
Indirect taxes can be manipulated easily
to suit the economic situation of the
country.
Differences between Indirect and Direct Taxes

Direct tax – the burden cannot be shifted to someone else
Indirect tax – The burden can be shifted to the third party
Consumers do not always bear the burden if the good is elastic.
Direct Tax – Are Based On income and wealth
Indirect Tax – These are based on expenditure and consumption
Direct Tax – In Most cases direct taxes are progressive in nature are progressive in
nature
Indirect Tax – In All cases indirect taxes are regressive in nature

Tax Structures/ Types of Tax Systems
A tax system may take any of three forms:
1.Proportional Tax – This is sometimes called a flat tax. In proportional taxation, a

flat rate is levied, for e.g. 7%. Therefore, each taxpayer pays the same proportion
of his/her income in taxes. Hence, a low income earner is taxed @ 7% and so is a
high income earner. However, since every individual does not earn the same
amount of income in a country, we will find that 7% of some tax payers’ income is
more than 7% of others. Therefore, the higher income earner will pay more overall
in taxes.
(See example & graph below)
Example: Income Tax RatesTaxes Paid

$1000 7% $ 70
$2000 7% $140
$3000 7% $210

2.Progressive Tax – In progressive taxation, the rate of tax increases as income rises.
Therefore, a higher income earner pays a larger percentage of his/her in taxes. This
means that the taxpayer does not only pay a higher proportion of his/her income in
taxes, he/she also pays a larger amount in taxes overall. Most countries using
progressive income systems have simplified them in recent years into 3 or 4 tax
brackets, where very low incomes are not taxed at all. However, when income reaches
a ‘threshold’ or a certain amount, it becomes taxable. As income rises thereafter, it
passes into higher tax rates. (See example & graph below)

$1000 5% $ 50
$2000 7% $140
$3000 10% $300

3.Regressive Tax – A regressive tax is one where the tax rate decreases as income rises
(or increases as income falls). Therefore, a regressive tax is one where higher
income earners pay a lower proportion of their income in tax than lower income
earners.
(See example & graph below)

$1000 12% $120
$2000 10% $200
$3000 6% $180
[Indirect taxes are regressive because they take more of a low income than a high
income.]

The Principles of Taxation
According to economist, Adam Smith, a successful tax system must be based on 4
principles. These include:
1. Equality – Taxes should be based on the ability to pay. Those with higher
incomes should pay a higher proportion of their income in tax.
2. Certainty – The easier it is to understand a tax system, the less persons would
want to evade paying the amount levied. The form and manner of payment and
the quantity to be paid should be clear to the taxpayer and everyone else.
3. Convenience – A tax should be convenient for the tax payer to pay and for the
tax collector to collect. For instance, the pay as you earn (PAYE) method is
convenient because it is taken out by employers before employees receive their
pay.
4. Economic – If the cost of collecting the tax is more than the money received
then it is uneconomical. Taxes should be collected as economically as possible.
Monetary Policy
Monetary policy is concerned with the controlling of the economy by the Central Bank
through the use of the money supply and/or the interest rate and to an extent, the
exchange rate. (See Econ text, page 183)
Controlling the economy using the money supply is a long-term policy while the
interest rate and the exchange rate are short-term policies.
There are a number of economic and legal measures of monetary control which are
used by Central Banks to control the economy. These include:
1. Open Market Operations - Where the central bank through the government will sell
treasury bills and bonds which will lead to the reduction in the money supply. They
will do this in order to reduce inflation.
2. Moral Suasion
3. Legal Reserve Requirement – This is where the central bank dictate that the
commercial banks must deposit a legally accepted percentage certain amount of money.
They normally use this as a reserve.
4. Selective Credit Control
5. Discount or Bank Rate –
Assignment: Explain each of the above methods and state how the Central Bank
implements them.
Direct Policy
This policy usually involves government intervention in the price mechanism of the
country. The government is directly interfering with the market forces so as to reduce
the rate of inflation. The government can:

 Set Price Ceilings – This prevents the prices from rising above certain levels.
 Diversify the Economy – The government can do so by retraining the workers
so that they would be able to find work in other industries.
 Increase National Insurance Contributions – This is also known as
compulsory savings. The government does this to curb spending.
 Use Rationing – The government restricts the amount of a good that people are
allowed to buy. This is usually done as a last resort.
Objective 12: Explain the different types of unemployment;
Unemployment
Definition and Measurement of Unemployment
There are varying definitions and measurements of unemployment. One of the main
definitions used is: Unemployment is the situation where persons are actively searching
for employment but are unable to find work.
The most frequently cited measure of unemployment is the unemployment rate. This is
the percentage of the total work force that is unemployed (and is looking for a paid job)
at any given date. This is the number of unemployed persons expressed as a percentage
of the labour force; i.e. registered unemployed divided by the number of people in the
labour force.
Unemployment Rate = # of persons unemployed x100
Labour force
The labour force may be described as the actual number of people available for work.
The labour force of a country includes both, the employed and the unemployed.
Unemployment figures within a country can often over-state or under-state the number
of persons who are actually willing to work at the existing wage rates.
Under-statement may occur because:

 There may be those who are not at working age but are looking for work. For
instance, retired persons and minors are not counted in the unemployment
figures but if they are actively seeking employment and cannot find jobs then
they are unemployed.
 There may be persons who would like to work but have voluntarily withdrawn
from the labour force after becoming discouraged. They would accept a job if
one were available at the going wage rate.

Over-statement may occur because:
 There may be those who claim to be unemployed but are working in the black
economy.
 There may also be persons who are not willing to work but claim to be seeking
employment simply to collect unemployment benefits.
 Persons may give up looking for jobs when they decide to join training
programmes or pursue further studies but may still be on the official
unemployment list.
Stocks and Flows

Unemployment is a stock. The stock of unemployment is influenced by the flow of
people into the stock and the flow of people leaving the stock. New people entering
the stock of unemployment include those losing jobs and the previous non-participants
in the labour force who are now seeking employment; e.g. students leaving universities.
People who leave the stock include those who have found employment, retired, given
up looking for work, etc.
Unemployment will rise if the number entering the stock exceeds the number of new
jobs.
Voluntary versus Involuntary Unemployment
At a very basic level, unemployment can be broken down into:
Voluntary unemployment – Unemployment due to people willingly leaving previous

jobs and now looking for new ones
Voluntary unemployment is attributed to the individual's decisions. Much or most of

frictional unemployment is voluntary, since it reflects individual search behavior.
Voluntary unemployment includes workers who reject low wage jobs whereas
involuntary unemployment includes workers fired due to an economic crisis, industrial
decline, company bankruptcy, or organizational restructuring.
Involuntary unemployment – Unemployment due to people getting laid off or fired

from their previous jobs and needing to find work elsewhere; not surprisingly,
economists generally view involuntary unemployment as a larger problem than
voluntary unemployment since voluntary unemployment likely reflects utility-
maximizing household choices. Involuntary unemployment exists because of the socio-
economic environment (including the market structure, government intervention, and
the level of aggregate demand) in which individuals operate.
Types and Causes of Unemployment

Economists further break down unemployment into three main categories or types –
Structural, Frictional and Seasonal unemployment.

1. Structural Unemployment – This is unemployment that arises from a
fundamental change in the structure of industry, leading to an absence of or
decline in demand for, the workers that are available. In other words, there is
a mismatch with workers' skills and employers' needs.
*** There are two major reasons that cause changes in a particular industry:
1. Changes in Technology
2. Changes in Tastes
2. Seasonal Unemployment –is unemployment that occurs due to changes in the

season. It occurs because the demand for some workers varies widely over the
course of the year.
3. Frictional Unemployment – This is unemployment that comes from people

moving between jobs, careers, and location; labour is not perfectly
geographically or occupationally mobile. It will take some time to move, or
take up new jobs or even find new jobs if one is looking for a better paying job
than that being offered or a job that matches his skills.
Sources of frictional unemployment include the following:
1. People entering the workforce from school.
2. People re-entering the workforce after raising children. (Note that

maternity leave does not count as unemployment.)
3. People changing employers due to quitting or being fired (for reasons

beyond structural ones).
4. People changing careers due to changing interests.
5. People moving to a new city (for non-structural reasons) and being

unemployed when they arrive.
4. Cyclical Unemployment – This is also referred to as Demand-Deficient

Unemployment. Unemployment is higher during recessions and depressions
and lower during periods of high economic growth. Because of this,
economists have coined the term cyclical unemployment to describe the
unemployment associated with business cycles occurring in the economy.
This type of unemployment occurs when AE or AD is insufficient to achieve
full employment.
5. Search Unemployment – This occurs when someone who is employed does
not take the first job that he or she is offered. The unemployed person opts to
search for a better paying or more suitable job.

6. Real-wage Unemployment – This occurs when trade unions succeed in
raising the wage rate above equilibrium level. At a wage above the equilibrium
level, supply of labour exceeds the demand for labour. The surplus labour is
unemployed
See Diagram Below:

Consequences of Unemployment
The harm caused by involuntary unemployment is measured in terms of the output lost
to the whole economy and the harm done to the individuals who are affected.
 Lost output – Involuntary unemployment leads to an output (GDP) that is less
than the true potential of the economy. If all persons seeking jobs are employed
then the economy will produce an output valued at say $1 million. However, if
many persons who are seeking jobs do not find employment then the economy
may only be able to produce an output valued at say $.5 million.
 Personal Costs –(i) general reduction in aggregate income; (ii) increases in
inequality; (iii) human capital is eroded – the longer a person is unemployed the
less employable they may become; (iv) psychic costs – people need to feel
needed – there’s pain in rejection.
Effects of Unemployment
Possible Benefits of Unemployment
1. The unemployed have an opportunity to do some training or to pursue
hobbies
This is the only true if they have the money to pursue these activities. The
unemployed also get a chance to look for a better job, especially persons who
might have been ‘stuck’ in one job for a long time
2. When workers become unemployed, they embark on retraining
programmes
Such training programmes develop the workforce
3. Unemployment reduces the Cost-push inflation
As there are fewer workers in jobs to demand higher wages and so put pressure
on prices.
4. When there are unemployed workers, it means that the labour market is a
buyer’s market.
The buyers of labour have the upper hand, as such they are demanding fewer
workers than there were available for work. Such a situation makes workers less
willing to take industrial action. Workers will be more productive and might
voluntarily take on training.
Possible Costs of Unemployment

- The unemployed do not have the economic means to enjoy a good
quality life
Unemployment therefore leads to a fall in standard of living
- The unemployed might be depressed and discontented
Adding to social problems such as crime, drug abuse and idleness
- When people are unemployed for a long time, it erodes the quality of
the human capital
In the economy as they lose skills due to lack of practice.
- Unemployment means that society is not using all its resources to
produce goods and services

Having unemployed persons signifies a loss of output to society does not
benefit from the output the unemployed could have produced.
Measures to Reduce Each type of Unemployment

- Retaining Programmes
Will aid those who are occupationally immobile and thus frictionally
unemployed. Retraining also makes those who are unemployed through
structural unemployment more enjoyable. Training will also assist those
who are seasonally unemployed to find jobs during the ‘low’ seasons of the
year.
- Government Projects
Such as the construction of housing developments, schools, shopping malls
and sport facilities in areas where there are jobs available will lure workers
into the area. This will also reduce frictional unemployment for workers who
are geographically immobile.
- Jobs Centres and more Advertising
Advertising of available jobs will also reduce frictional and search
unemployment. It increases the chances of those between jobs and those
searching for jobs to find jobs.
- Reflationary Fiscal Policy
This will reduce unemployment. Government spending on development
projects can directly provide jobs for the unemployed. This reduces
seasonal, structural and cyclical unemployment. The workers receive a
wage, part of which is spend and so aggregate demand in the economy
increases. Government grants to firms located in areas where there are
unemployed persons will reduce frictional unemployment. Government can
also spend directly on the creation of job centres and retraining programmes.
On the taxes side, a fall in taxes increase consumption and investment, and
so increase aggregate demand. This also reduces cyclical unemployment
- Reflationary Monetary Policy
Will also expand aggregate demand in the economy. Falling interest rates
boost the spending of firms and individuals. This increases aggregate
demand in the economy. Firms will expand output to meet the rising demand
and so employ more workers
- Regulations and Agreements with Trade Unions
To avoid making demands to increase the wage rate above the equilibrium
wage rate will help to reduce real-wage unemployment.

SUMMARY
Type Description Cause Remedy

Structural Worker have the wrong skills in Declining industries and the Training and the mobility of labour
the wrong place immobility of labour
Cyclical All firms need fewer workes Low total demand in the economy Increased government spending or
lower taxes
Fictional Workers temporarily between Delays in applying, interviewing and Improve job information, eg.
jobs accepting jobs Computerized job centres.
Seasonal Marked seasonal patterns of Stimulate demand in off season

demand.
Real wages being above their Relax minimum wage laws Flexible labour markets
Real-Wage market wages Stimulate economic activity

Objective 13: Outline the role of trade unions in an economy.
Trade Unions are organizations created to represent/protect the rights of their members
in negotiations with their respective employers/managers.
Four basic types of unions
1. Craft Unions – represent workers with particular skills – e.g Tailors and garment
workers
2. Industrial Unions – represent all the workers in a particular industry – e.g mine
workers
3. General Unions – represent anyone wishing to join – eg Transport and General
workers
4. White Collar Unions – represent administrative, clerical and other non-manual
workers – eg Science and Finance
Trade Unions and the Supply Of Labour

Trade Unions work by affecting the supply of labour. This can be achieved in the
following ways
- Some Unions practice a Closed Shop Policy
All employees in a given workplace or in a given occupation must belong to
a specific union. A Worker is either a union member before he is employed
or, immediately after being employed, the worker must join the union
- The Practice of Demarcation
This is where the tasks of a job can be done only by the members of a
particular union. This occurs where there are several trade unions
representing different occupational groups in the workplace.
The Collective bargaining Process

Collective bargaining is the process by which trade union officials, representing
workers, meet with employers to negotiate for higher wages and better terms and
conditions of work. The term ‘collective’ is used since workers do not go in individually
to make requests. The union bargains for all workers as a group. It is a bargaining
process, since one party does not demand or request a certain benefit and the other give
in to the request. Usually, there is discussion and compromise. There might be
disagreement.
Collective bargaining aims to secure for workers:

- Higher wages and incomes, including bonuses and overtime benefits
- Improved terms and conditions of employment
Collective bargaining encourages communication between workers and employers, and
workers might get a chance to contribute to the decision making process

Industrial unrest is the term used to describe activities undertaken by woekrers when
they protest against pay or term and conditions of work.
Industrial Action may take the forms, including:
1. Strikes
A strike is a work stoppage caused by the mass refusal by employees to work.
Workers on strike mght have demmosntrations – that is walk with placards to
highlight their situation or they may form a picket line preventing other workers
from entering the company premises.
2. Sit-ins
A sit-in involves one or more persons non-violently occupying an area for
protest. In a sit-in, protesters usually seat themselves and remain in which they
would be working, and refusing to leave so they cannot be replaced with other
labour.
3. Sit-downs
A sit-down strike involves workers on a strike occupying the area in which they
would be working, and refusing to leave so they cannot be replaced with other
labour.
4. Slow-Downs
A slow-down (Go-slow) occurs when employees perform their duties but try to
reduce productivity when performing these duties. Unlike a strike, in a slow
down the worker will still get paid. Also, in a strike the worker might be
replaced, but this is not the case in a slow-down.
5. Work to rule
In a work-to-rule, the workers ‘follow the rules’, obeying each and every rule to
the letter, thereby reducing productivity.
6. Sabotage
Workers cause sabotage- by say, wrecking company machinery or a work
process- in order to place a cost on the firm or to reduce productivity. Unlike
other courses of action, this is illegal.
7. Lockouts
A Lockout is when an employer takes action to lock entrances and so debar
workers from entering the workplace.

The role of trade unions in a Free market Economy
Trade uions play an important role in the free market economy. Here are their functions:
- Trade Unions secure higher Wages for their members
- Trade Unions secure improved terms and conditions of employment
Safer, Healthier working environments (airy, well lit, clean and cool rooms),
protection of workers, privacy, hours of work, time off periods, maternity
leave, holiday entitlement (with pay), promotion, pay when on sick leave,
pension plans, opportunities for training and job security.
- Trade Unions can hold training sessions for workers
These might be work related, or could be motivational lectures or education
on the rights of workers. This increase productivity and prevents the workers
from being exploited by the employer.
- Trade Unions ensure that there is equity of treatment of all workers
- Trade Unions contribute to the development of the country.
As Workers bargain in an organized fashion. There is communication
between workers and management. Workers negotiate in an orderly way.
There is little or no disorder. However, there might be industrial unrest or
the threat of industrial unrest. When there is industrial unrest, it leads to a
fall in productivity. Generally, through, trade Unions contribute to stability
and economic progress.
- Trade Unions can also meet with government
They meet with the Ministry of Labour to represent workers’ views with
respect to issues that affect workers
Other Major rules of Trade unions include:

1. Representing their members in wage negotiations
2. Questioning the grounds on which members are suspended, fired or made
redundant
3. Representing members who have been harassed or victimized.
Costs of Trade Union Activity
- By Demanding Higher wages that do not match Productivity increases
Trade Unions can contribute to cost-push inflation. Trade Unions cause
wages to increase. Employers increase prices for the products so that profits
remain the same.
- When a trade Union succeeds in increasing wages
This might contribute to unemployment. The demand curve for labour is
downward sloping from left to right, indicating that a higher wages few
workers are demanded, and at lower wages more workers are demanded.
When the wage rate increases, ceteris paribus, fewer workers will be
demanded.
- Trade Unions contribute to a fall in economic activity and efficiency and
to social disorder
When they engage workers in protest.

Section 6: International Trade
SPECIFIC OBJECTIVES
Objective 1: Explain the meaning of terms and concepts associated with

international trade;
Balance of trade- is the difference in value of a country’s exports and its imports.
Current account- is the sum of the balance of trade (value of exports minus imports),
cross border interest and dividends payments, and gifts from both individuals and
governments from other countries such as foreign aid. It measures trade in goods and
services as well as income and current transfers.
Capital account- reflects the change in ownership of fixed assets and the acquisitions
or disposal of non-financial assets.
Financial account – records inward and outward flows of investment. This account
includes direct investment, portfolio investment, changes in reserves and other
investments.
Balance of payments (BOP)- is an accounting record summarizing international

transactions between a country and foreign territories over a period of time.
The balance of payments has three major components, a current account, capital
account and the financial account.
The BOP can either have a surplus (which occurs when a country sells more to foreign
countries than it buys from them or a deficit (when a country buys more from a foreign
country than it sells to them.
Tariff- is a tax imposed by a country’s government on imported products.

Common External Tariff (CET) – is a uniform tariff implemented by member
countries of a customs union, on all imported products from territories outside the
union, to any member country.
Common External Tariff (CET) – A prime example of the adoption of a CET is the
case of the Caribbean Community (CARICOM) countries where tariffs are levied on
imports from non-member countries outside CARICOM and to encourage member
countries to import from each other instead. This increases the region’s trade, as well
as the amount of money that flows into the region, and reduces the amount that goes
out.
Quota (non-tariff barrier) – is the maximum amount of foreign products that are
permitted to enter a domestic economy over a specific period of time.
Exchange rate- is the price at which one currency can be exchanged for another.

Exchange rate regime- is the means by which exchange rates between different
currencies are determined. The exchange-rate regime is the way a country manages its
currency in relation to other currencies and the foreign exchange market. It is closely
related to monetary policy and the two are generally dependent on many of the same
factors.
World Trade Organization (WTO) – is the international trade body which regulates
and enforces set standards regulating the trading of goods between countries on an
international level. The WTO replaced the General Agreement on Trade and Traiffs
(GATT).
The WTO has three objectives
1. Help global trade flow as freely as possible
2. Reduce trade restrictions
3. To provide an impartial means of settling disputes
Protectionism is the policy of protecting home industries from foreign competition by

the imposition of trade barriers on imported goods and/or services.
Trade is the exchange of goods and services (usually for money) in order to change
ownership.
International trade involves trading among different countries. It is the buying and
selling (trading) of goods or services between countries or across international borders.
Imports – bought from other countries and result in an outflow of funds.
Exports – sold to other countries and result in an inflow of funds.
An Open Economy – one that has engages in foreign trade/international trade.
A Closed Economy – one that doesn’t engage in foreign trade/ international trade.
Visible Trade: This looks at the imports and exports of goods only.
Invisible Trade: This examines the imports and exports of services only.
Some examples:
- aviation, insurance and shipping
- banking
- factor payments including dividends
- tourism
- military expenditure

Objective 2: Explain the rationale for international trade;
Rationale for International Trade
Differences in the climate and resources of countries mean that they have to trade in
order to obtain goods which they cannot produce themselves, or do not find it
economical to produce. As a result, countries tend to specialize in the production of
those goods or services for which they have the comparative advantage, so that
greater output can be achieved more cheaply. This is an extension of the specialization
and division of labour concept and economists refer to it as the Principle of
Comparative Cost.
Before the theory of comparative advantage can be explained, the theory of

absoluteadvantage must be understood. One country has an absolute advantage over
another country when it can produce a good using fewer resources than the other
country.
Assumptions of the theory:

a) There are only two countries in the model.
b) There are only two goods being produced.
c) The level of technology and resources are fixed.
d) Resources can transfer from the manufacturer of one good to another.
Absolute Advantage
The principle states that a basis for trade exists between nations or regions when each
of them, as a result of natural or acquired superiorities, can provide a good or service
that the other wants at a lower cost than if each were to provide it for itself. This law
accounts for much of the world’s trade. For example, Brazil has an absolute advantage
over the US in the production of coffee. However, the US has an absolute advantage
over Brazil in the production of chemical products. Therefore, US finds it
advantageous to specialize in chemicals. By trading, Brazil gets chemical products
more cheaply and the US get coffee more cheaply than if each produces both types of
products itself.
Oil Wheat Country A produces both oil and wheat, but it is a

better producer of oil than Country B because it
can produce 8 units in a man hour, whereas
Country A 8 4 Country B can only produce 3 units. Country B
can also produce both oil and wheat, but is a better
producer of wheat than Country A because it can
Country B 3 6 produce 6 units of wheat per man hour whereas
Country A can only produce 4 units. Each country
will specialize in the good in which it has an
absolute advantage: Country A will produce oil
and Country B wheat.

For CountryA: 1 unit of wheat = 2 units of oil
For CountryB: 3 units of wheat = 1 unit of oil (ONLY)
The Theory of Comparative-Cost Advantage

A country has a comparative advantage in the production of a good if it can produce
that good at a lower opportunity cost.
The principle states that if one nation can produce each of two products more efficiently
than another nation, and can produce one of these commodities more efficiently than
the other, it should specialize in the product in whose production it is most efficient,
and leave the production of the alternative product to the other country. Then, by
engaging in trade, the two nations will have more of both goods.
Oil Wheat Country A has an absolute advantage in the

production of both oil and wheat, but its advantage
in wheat is greater than its advantage in oil. We
Country A 4 3 say that Country A has an absolute advantage in
both goods but a comparative advantage in wheat
because a ratio of 3:2 is superior to a ratio of 4:3.
Country B 3 2 Country B has an absolute disadvantage in oil
because the ratio of 3:4 is not as favourable as the
ratio of 2:3.
Merits/ Advantages of International Trade

Once countries capitalize on their comparative advantage, they stand to gain. Hence,
international trade is considered as a “win-win” situation, since:
1. Countries can import goods and services which they cannot produce for
themselves. As such, countries enjoy a much wider range of commodities than
they can actually produce.
2. International trade gives countries the opportunities to specialize in the things
they do best, which results in larger outputs and lower costs, e.g. Brazil and
Colombia produce most of the world’s coffee at very low costs.
3. International Trade promotes better international relations among the countries
of the world
4. Free trade opens up the world as a market for your product. Small Caribbean
countries with small populations find themselves within a much larger market
for their products.
5. As firms have a wider market and they sell goods and services, the firms earn
valuable foreign exchange
6. As a range of industries grows and develops, it leads to economic development
in the producing country
7. As industries grow, output increases. Factor inputs must be increased; that is,
land, labour, capital and enterprise. This creates increased employment
Demerits/ Disadvantages of International Trade
1. International Trade can make a country dependent upon other countries for vital
goods; for example, foodstuff. If prices increase or if quantity supplied
decreases, the importing country will suffer
2. International Trade exposes domestic industries to unfair foreign competition.
Foreign firms might be well-established and able to offer cheaper prices for a
better quality product. Quantity demanded of local goods by foreigners and
domestic residents will fall, and so will employment. Firms might even be
forced to shut down.
3. Many developing countries might trade primary products; that is minerals and
agricultural produce. When a country has continuous trade and keeps on
producing, this might lead to depletion of mineral resources. When this occurs,
the country might not have other export alternatives to produce for trade.
Examples of non-renewable resources are: petroleum, natural gas and bauxite.
4. Overseas markets in underdeveloped countries might find the workers paid very
poorly, even by the standards of that country. Cheap production in China, India
and Africa has led to exploitation of workers through low wages and poor
working conditions.
Objective 3: Describe the primary factors that influence the level of international
trade;
Factors That Influence International Trade
Import Factors:
i. Domestic Income Levels
Higher incomes enable consumers to purchase more imports, and lower
incomes allow for fewer imports.
ii. Domestic currency value
The higher the value of the currency, the greater the level of imports.The
lower the level of the currency, the lower the level of imports. Assume the
exchange rate is:
$1.00 US = $2.00 TT [Equation A]
Then it changes to:
$1.00 US = $4.00 TT [Equation B]
Equation A shows a higher value for the TT$. Trinidadians have to spend
only TT$2 to buy say, a pencil case for US$1. They can therefore demand
many pencil cases.
Equation B shows a lower value for the TT$. Trinidadians have to spend
TT$4 to buy that same pencil case for US$1. They will therefore demand
fewer pencil cases.
In Chapter 21, you will learn that a change from Situation A to Situation B
is a depreciation of the TT$. It makes imports more expensive in terms of the
domestic currency.

iii. Domestic product prices vs. foreign product prices; i.e. the general price
level.
If domestic product prices are high compared with foreign product prices,
the country will import more and buy fewer locally produced goods. If
domestic product prices are low compared with foreign product prices, the
country will import fewer and buy more locally produced goods.
iv. Quality of domestic goods
If domestic goods are of a low quality when compared with the imported
goods, the country will import more and buy fewer locally. If domestic
goods are of a high quality when compared to the imported goods, the
country will import fewer and buy more locally, ceteris Paribus. More
recently though, developed countries are making purchasing decisions that
are causing the same thing to happen. There is a flood of cheap goods,
especially appliances, coming in from abroad. Consumers are taking
advantage of the lower prices, even though the goods might be of a lower
quality than other more expensive imports.
v. Information, the mass media and changing tastes of consumers
The small Caribbean economies are very open to foreign television, where
viewers are exposed to the lifestyle and products of large developing
countries. This has the effect of changing the tastes of consumers in favor of
the products of these countries; for example, clothes, shoes, chocolates,
make-up, and electronic devices such as cell phones and iPods.
Export Factors:
i. Foreign income levels
Higher income levels in the rest of the world enable a given economy to
export more. Lower incomes reduce the level of exports of a given economy
to the rest of the world.
ii. Foreign currency levels
When the value of a country’s currency is low, its goods will be relatively
cheaper and so it will be able to export more goods. When the value of a
country’s currency is high, its goods will be relatively dearer and will be
able to export fewer goods. Assume the exchange rate is:
$1.00 US = $4.00 TT [Equation A]
Then it changes to:
$1.00 US = $2.00 TT [Equation B]
Equation A shows a lower value for the TT$. If a mango costs TT$1, a
foreigner can purchase four mangoes with US$1 (TT$1=US25 cents).
Equation B shows a higher value for the TT$. Foreigners can only get two
mangoes with the US$1 (TT$1=US50 cents). Foreigners will therefore
demand fewer mangoes.
iii. Foreign product prices vs. domestic product prices
If domestic product prices are high compared with foreign product prices,
the country will not be able to export a large quantity of goods. If domestic
product prices are low compared with foreign product prices, the country
will export a greater quantity
iv. Quality of foreign goods vs. domestic goods

If foreign goods are of a high quality when compared with locally produced
goods and are technologically superior, then fewer domestic goods will be
exported. If locally produced goods are of a high quality when compared
with the foreign goods, the country will be able to export more.
v. Information and changing tastes of consumers in the rest of the world
We live in the age of the information revolution, cable television and the
Internet. When foreigners become aware of the products of the region, we
will be able to export more. The tastes of the consumers might change in
favor of the products of a given country and this will boost exports.
Objective 4: Explain the concept of gains from trade;

The gains from trade are the advantages that a country obtains as a result of trade. If
there was no trade, each person would have to be self-sufficient. Imagine having to
produce your own food, clothes and toiletries such as soap and toothpaste.
Trade allows people and countries to specialize. People produce according to their
abilities, skills and talents. Regions and countries produce according to the factors of
production they have, and exchange goods produced for other goods that they cannot
produce efficiently. Recall that, with specialization, there is increased output.
There are two (2) main sources of gains from trade:
1. Countries differ in climate and factor endowment
Each country has advantages in producing some goods, but cannot produce
other goods efficiently, or at all. The flat undulating plains and the warm climate
of the Caribbean are suited to sugar cane production. South Africa produces
diamonds, as it has the mineral deposits. Trinidad produces oil, because of its
oil deposits. The smaller Caribbean islands have sandy beaches and so
specialize in tourism
2. As countries specialize and increase production, their industries earn

economies of scale
There is, therefore, a fall in unit costs of production. The countries ca make
greater profits and/or pass on some of these cost advantages to the consumer,
who will get the product at a lower price.
Objective 5: Explain the concept of terms of trade;

The Terms of Trade (TOT)
A country’s terms of trade represents the relationship between the price it pays for
imported goods and the price it receives for its exported goods.
If the prices received for exports exceeds what it pays for imports, a country’s terms of
trade is said to be favorable as it means fewer exports have to be sacrificed to obtain a
given amount of imports. If the prices received for exports are lower than that paid for
the imports, then the terms of trade is not favorable and more exports have to be sold
to purchase a given amount of imports.
This can be defined as the ratio of a country’s export prices to its import prices; i.e. how
many units of foreign goods are worth 1 unit of domestic goods.
T
O
When the TOT ˃ 100 → TOT has experienced an improvement
Reason:
T Because of increased export prices or decreased import prices
=
Exportthe
When Price
TOTIndexImport
˂ 100 →Price
TOTIndex 𝑋100
is deteriorating
Reason: Because of decreased export prices or increased import prices
An increase in the terms of trade index means that the terms are more favourable for
exports; i.e. export prices have increased relative to import prices.
Example:
Year Export Price Index Import Price Index Terms of Trade
2000 100 100 100.0
2001 120 115 104.3
2002 130 110 118.2
2003 125 130` 96.2
An improvement in the terms of trade may mean:

1. More imports can be obtained for a given qty of exports;
2. Improvements are made in the BOP;
3. There are better incomes for workers in industry;
4. There is an increase in employment.
Question: How do you think the TOT affects the BOT and the BOP?

Barriers to International Trade
1. Tariff – a tax imposed on imports to protect local producers

2. Common External Tariff (CET) – A tariff imposed by member countries of a
given organization (e.g. EU, CARICOM) on goods imported from non-member
countries.
3. Embargo – a total ban of a product either for import or export or both
4. Physical Quota – a non-tariff barrierimposed by government to restrict the
importation of certain goods to a definite quantity.
5. Exchange Control – this is referred to as a financial quota whereby only a
certain sum of money is allowed to be taken out of the
country.
6. Licence – where importers are required to obtain permission (licenses) from
government before importing certain commodities.
Suggest some of the reasons why trade barriers are imposed and explain their
economic effects.
Objective 6: State the factors that influence the level of an exchange rate;
The Exchange Rate
The exchange rate is the price of one currency in terms of another, for instance the
US$1= EC$ 2.7169
The exchange rate is the rate at which one currency an be exchanged for another
country’s currency in the foreign exchange market. It is really the price of a currency
in terms of another
Foreign Exchange Market – is a market that specializes in the sale of different

currencies.
Hard Currency – a currency with a high exchange rate.
Exchange rate is determined by demand and supply; i.e. the demand for and supply of,
a given currency in the Foreign Exchange (Forex) market. Therefore, the Forex market
exists so that currency exchanges can take place among countries.
Factors That Influence the Exchange Rate
1. Market Forces – changes in demand and supply

Examples: Changes in the prices of imports
Changes in domestic prices
Changes in capital flows
Structural changes in the economy
2. Government’s Fiscal and Monetary Policies
3. Arrangements with lending agencies
4. Inflation
5. National Income
6. Interest Rates
7. Speculation
Objective 7: Distinguish between the various types of exchange rate regimes;

Exchange Rate Regimes
There are three (3) types of exchange rate regimes:

i. Fixed Exchange Rate
ii. Floating or Flexible Exchange Rate
iii. Managed Exchange Rate
History
1972 – Barbados adopted a fixed exchange rate.
1976 – EC$ was fixed to the US$
1991 – The government of Jamaica allowed the JM$ to float.
1993 - CB of T&T abolished its fixed exchange rate system and floated the TT$.
Each of the above currencies is tied to the US$. Identify the present exchange rate
of each.
Fixed Exchange Rate
This is where the exchange rate is kept at a particular value, neither falling nor rising.
Thus demand and supply of the currency is equated by its Central Bank. If there is an
excess supply of a given currency on the market, the Central Bank will restore
equilibrium by devaluing that currency so that the fixed exchange rate is maintained.
The opposite is also true when there is an excess demand for the currency. (See
Diagram below)

Flexible/Floating Exchange Rate
This exchange rate is determined by the demand and supply of the currency. Therefore
the Central Bank is not required to influence the value of the currency. If there is an
excess demand for or supply of the currency, the exchange rate will keep on adjusting
(appreciating or depreciating) respectively, until equilibrium is once again restored.
(See diagram below)
Dirty Floating – a system of flexible exchange rates where the Central Bank intervenes
to prevent wide fluctuations in the exchange rate.

Managed Exchange Rate
When Central Banks ‘manage’ exchange rates, they intervene in the exchange rate
markets by buying and selling currencies to counter the depreciation and appreciation
of a currency.
When the currency is floating, it can fluctuate considerably from day to day. It can gain
vale or lose value rapidly over a short period. These fluctuations can cause residents to
loose confidence in the currency. They can also hinder international trade, as a currency
can change value between the time at which a trader buys imports and the time at which
he actually pays for his purchase.
In many countries, the currency is allowed to float. However, a government, through
its central bank, can intervene in the foreign exchange market to maintain the rate at a
certain value or within a range of values. This is a Managed Exchange Rate (Or
Managed Float).
When the currency is losing value (or depreciating), it means that there is too much of
this currency on the market. For example, no one wants to buy TT$ to purchase TT
goods and/or TT importers are supplying lot of TT$ to buy imports! There is falling
demand and/or increasing supply. The government enters the market and buys up the
extra TT$ with US$. This helps to maintain the rate at the equilibrium level.
When the currency is appreciating, there is too little of the currency on the market.
Foreigners all want TT$ to purchase TT goods and Trinidadian residents are not buying
much imports. There is rising demand or falling supply of the TT$. The government
will supply TT$ to the market by exchanging TT$ for US$s. This helps to maintain the
rate at the equilibrium level
The interest rate can also be used to manage the exchange rate. A high interest rate
attracts inflows of capital which increases the demand for the currency and makes it
appreciate. However, this results in the flow of ‘hot money’.
Hot money – foreign funds that chase quick or immediate profits
When a currency floats with no inference from the government, this is clean floating.
When a currency floats but there is interference from the government, this is dirty
floating.

Objective 8: Distinguish between exchange rate appreciation and exchange rate
depreciation;
Depreciation and Appreciation
Depreciation occurs when a currency falls in value against another currency; i.e.
against the currency of its chief trading partner. For instance in 1993 when the TT$
moved from $4.25 to $6.29 per US$1, it was said that the exchange rate depreciated.
OR
Depreciation is the fall in the external value of that currency due to changes in the
forces of demand and/or supply.
Appreciation occurs when a currency rises in value against another currency.

OR
Appreciation is the rise in the external value of that currency due to changes in the
forces of demand and/or supply.
Currencies depreciate and appreciate under the floating exchange rate regime.
Objective 9: Distinguish between exchange rate devaluation and exchange rate

revaluation;
Devaluation and Revaluation
Devaluation occurs when a currency falls in value against all other currencies.
Countries can devalue deliberately to make their exports cheaper and their imports
dearer, but devaluation is monitored by the IMF and countries must obtain approval
from the IMF for large devaluations, e.g. 10%.
OR
Devaluation is a downward movement in the domestic currency; making the currency
cheaper on the foreign exchange market.
Revaluation means that a currency increases in value against all other currencies.
OR
Revaluation is an upward adjustment of the domestic currency, making the currency
more expensive on the foreign exchange market.
It is very rare. A country might revalue:

a) because of positive economic conditions; i.e. it is doing well in its BOP;
b) in order to lower inflation;
c) to please investors or trading partners.
Currencies devalue and revalue under a fixed exchange rate regime.

SUMMARY:
Exchange Rate Movement Fixed Exchange Rate Regime Floating Exchange Rate Regime
A fall in external value of the currency Devaluation Depreciation
A rise in the external value of the currency Revaluation Appreciation
Effect on Exchange Rate Change in Demand for Domestic Currency Change in Supply for Domestic Currency
Depreciation Falling Demand Increasing Supply
Appreciation Rising Demand Falling Supply

1. A depreciation in the exchange rate (figure below) – Depreciation in an
exchange rate can occur when there has been a fall in the demand for the dollar.
This shifts the demand curve to the left and could be caused, for example, by:
 A reduction in the number of US goods and services sold abroad. Importers of

US goods are demanding fewer dollars to settle accounts with US firms. This
could be caused, for example, by an increase in the price of US goods and
services due to inflation or a longer-term decline in the quality of US goods and
services.
 A reduction in the number of international investors who wish to place their
funds in the US economy. This might be because interest rates in the US are
lower than in other economies and, as a result, give a poorer return to investors.
D2
S (supply of $s)
P1
P2
Q1 Q2(Quantity of $s) D1 (demand for $s)

2. An appreciation in the exchange rate (see figure below) - Appreciation in the
exchange rate can occur when there has been a decrease in the supply of the
dollar. This shifts the supply curve to the left and could be caused, for example,
by:
 A decrease in the number of foreign goods and services imported into the
US. US importers are using dollars to purchase foreign currency on the
foreign exchange market. They provide a supply of dollars on to the market.
The fall in the number of foreign goods purchased in the US could be caused
by a rise in the price of foreign goods and services relative to those produced
in the US, or perhaps there has been a decline in the quality of foreign goods
and services.
 A decrease in the number of US investors who want to place their funds in

foreign economies. Again, if interest rates fall abroad, then investors will
want to place their funds in US banks rather than abroad. They will now
choose not to exchange their dollars for foreign currencies and the supply of
dollars on the foreign market will decrease.
S2
S1 (supply of $s)
P2
P1
Q1 Q2(Quantity of $s)
D (demand for $s)
Objective 10: Distinguish between balance of payments and balance of trade;

Balance of Payments
This is a record of all financial transactions of a country with the rest of the world
(ROW); it show a country’s payments to and receipts from, foreign countries. The BOP
sets out a country’s indebtedness to its trading partners.
The balance of payments is a summary of the payments and receipts of transactions

between a country and the rest of the world for a given period, usually one year.
Where there are foreign exchange flows into the country, these are called inflows or
receipts.
Where there are foreign exchange outflows out of the country, these are called outflows
or payments
Balance of Trade
The balance of trade is the difference between the monetary value of exports and
imports of output in an economy over a certain period. It is the relationship between a
nation's imports and exports. A positive balance is known as a trade surplus if it
consists of exporting more than is imported; a negative balance is referred to as a trade
deficit or, informally, a trade gap. The balance of trade is sometimes divided into goods
(visible) and services (invisible) balances.
Objective 11: List the constituent components of the balance of payments;

Objective 12: Describe the entries that would appear in the balance of payments
account;
It is divided into three (3) main sections:
1 Current Account which includes:
a) Visible Trade: Goods
Visible Exports – Visible Imports = Visible Trade Balance
The Visible Trade Balance is also referred to as the Merchandise Trade
Balance (MTB).
b) Invisible Trade:Services
Invisible Exports – Invisible Imports = Invisible Trade Balance
Balance of Trade (BOT) = Visible Trade Balance + Invisible Trade Balance
c) Income:
This includes Employee compensation; e.g. residents being paid for
working abroad. It also includes investment income such as profits,
interests and dividends earned.
d) Transfers:
These includes (i) government transfers such as social security payments
abroad; (ii) private sector transfers such as remittances
NB: The Balances: (a) + (b) + (c) + (d) = the Current Account Balance (CAB)
2 Capital and Financial Account: Looks at short- and long-term capital flows;
(capital coming into and leaving the country).
a) Outflows are represented by a minus (-) sign; (they can be bracketed).
b) Inflows are represented by a plus (+) sign.
CAB + Capital and Financial Account Balance=BOP figures
8. Net Errors and Omissions (the Balancing Item) – This is used to bring the
BOP into balance; it will either be a debit or credit figure depending on which
side of the BOP is “off”.

Official Financing: This section shows how the BOP balance is treated. If the BOP
balance is a surplus, it shows how the gov’t will use the surplus – save or spend it. If
it is a deficit it will indicate how the gov’t was able to finance the deficit, e.g.:
i. Borrowing from other countries;
ii. Obtaining grants from other countries;
iii. Decreasing gov’t spending;
iv. Devaluing the currency; and so on
Objective 13: Distinguish between balance of payments surpluses and balance of

payments deficits;
Once the BOP does not balance there is BOP disequilibrium; (there is either a surplus
or a deficit on the BOP). However, if there is neither a surplus nor a deficit on the
BOP then it is obviously in equilibrium.
At the year end, there might be a balance of payments surplus or deficit, or the balance
of payments may be in equilibrium.
A balance of payments surplus occurs when inflows are greater than outflows
(Inflows > Outflows). A Balance of Payments Deficit occurs when outflows are
greater than inflows (Outflows > Inflows).
Objective 14: Describe the factors that give rise to balance of payments surpluses
and deficits;
Balance of Payments Deficits
A deficit might be due to:
- Increasing Demand for imported goods and services
- Falling demand for locally produced goods and services by foreigners
- An Increase in Holidays taken abroad
- A Decrease in Visitors to the country
- Individual and government transfers out of the country being greater than those
coming in
- Investment incomes being paid out to foreigners being greater than those
coming into the country
- A greater value of investments being made abroad by domestic residents than
foreign investors are making in the domestic country.
Behind all these possible causes of a balance of payments deficit lies the assumption
that all other factors remain constant; that is the Ceteris Paribus assumption.
Others:
Causes of BOP Deficit
1. All factors that cause current account deficit
2. An unusual situation in the country – natural disasters, political instability, etc.
3. Too much foreign investment– profits are repatriated by foreign investors.
4. Loss of Export markets
5. Increases in the prices of essential raw materials
Causes of Current Account and BOP Deficit
1. Industrialization – This causes the imports of machinery to increase, leading
to an outflow of the country’s currency.
2. Foreign talent – These may be imported into the country due to a lack of
expertise to carry out the process of industrialization, e.g. Engineers, builders,
planners etc.
3. High Economic Growth – When there is a period of high economic growth,
demand for imported goods tends to increase.
Balance of Payments Surpluses

A surplus might be due to:
- Falling demand for imported goods and services
- Increasing demand by foreigners for locally produced goods and services
- A decrease in holidays taken abroad
- An Increase in foreign visitors to the country
- Individual and governmental transfers into the economy being greater than
transfers out
- Investment incomes paid into the country to domestic investors who invested
abroad being greater than those being paid out to foreigners who invested locally
- Greater investments in the local economy by foreigners than foreign investment
made by the domestic residents abroad
Behind all these possible causes of a balance of payments deficit lies the assumption
that all other factors remain constant; that is the Ceteris Paribus assumption.

Objective 15: State the possible consequences of balance of payments surpluses
and deficits;
Consequences of Balance Of Payments Surpluses
- Falling Unemployment
A surplus might mean falling unemployment as foreigners demand more locally
produced goods and services. Firms will expand to meet the increasing demand
and so employ more labour
- Increase in Reserves
A balance of payments surplus adds to the country’s foreign exchange reserves.
- Exchange Rate Appreciation
Increasing demand for the domestic currency by foreign firms and individuals
will lead to an apprecaiation of the exchange rate
- Inflationary Pressures
If the source of the balance of payments surplus is increasing demand for the
goods and services (which led to a balance of trade surplus) this can be
inflationary. This is especially true if there are few resources idle which to
increase supply to meet the increasing demand.
Consequences of Balance Of Payments Deficits

- Unemployment might increase
If the deficit is due to a deficit on the balance of trade account, this means that
the domestic residents are demanding more imports. Foreign firms that are
supplying cheaper imports or better-quality goods. This is a leakage, and
domestic firms will suffer a fall in demand leading to increased unemployment.
- Falling Foreign Exchange Reserves
A deficit means that outflows are greater than inflows. To finance the deficit, it
is necessary to draw on reserves.
- Exchange Rate Depreciation
A deficit means that the domestic residents are demanding more foreign
currency. They will increase the supply of domestic currency to the foreign
exchange market. This will lead to a depreciation of the domestic currency.
Objective 16: Describe the possible remedies for balance of payments surpluses
and deficits.
Remedies of Balance Of Payments Surpluses
1. Increasing of aggregate demand through reflationary monetary and fiscal
policy
Reflationary monetary policy includes the reduction of interest rates.
Consumers will save less and spend more. As consumers spend more, they will
purchase more imports. Reflationary fiscal policy is an increase in government
spending and a reduction of taxes. More government spending will increase
incomes in the economy, and this will increase spending in general, and
spending on imports in particular. Lower taxes will lead to higher disposable
incomes. An increase in incomes means more spending on domestically

produced goods and imports. When imports rise, outflows will increase and the
size of the surplus is reduced.
2. Reduction of Import Controls
When import controls are removed, the price of imports will fall. There might
be removal of tariffs, or the relaxation of a ban or quota, either of which will
lead to more imported goods being available at lower prices. As prices are lower,
more imports will be demanded, and this will increase flows out of the country.
Other things remaining constant, the size of the surplus will fall.
3. Revaluation
Higher the level of the currency, the higher the level of imports. Foreign goods
are cheaper for Trinidadians after the revaluation. A revaluation makes imports
cheaper. More imports will be consumed. Outflows will increase, and the size
of the surplus will shrink. Also, the price of exports will increase and the demand
will fall, reducing inflows and reducing the size of the surplus.
Remedies of Balance Of Payments Deficits

Any Policy to reduce a balance of payments deficit will have to reduce the amount of
funds flowing out of the economy, or increase inflows. Three such policies to reduce a
balance of payments deficit are:
1. Reduction of aggregate demand through deflationary monetary and fiscal
policy
Deflationary monetary policy is the increasing of interest rates. Consumer will
save more and spend less. As consumers spend less, they will purchase fewer
imports. Deflationary Fiscal Policy is the reduction of government spending and
the increase of taxes. Less government spending will reduce incomes in the
economy and this will reduce spending in general, and spending on imports in
particular. Higher Taxes will lead to less disposable income. Lower Incomes
mean less spending on domestically produced goods and imports. When imports
fall, outflows are reduced and the size of deficit is reduced. These are all
expenditure-reducing policies.
2. Import Controls
An embargo is a direct ban on the importation of a particular good.
A quota is a limit on the amount of a good that can be imported.
A tariff is a tax placed on an imported good.
All of these are import controls. When an import control is placed on an
imported good, it reduces the quantity of the good that can be imported.
3. Devaluation
Prices of exports will fall and demand will rise, increasing inflows and reducing
the size of the deficit.

Correcting a BOP Deficit
A persistent or recurrent BOP deficit is a problem to any country. Therefore, the

following measures can be used to correct this problem in the short term:
1. Borrowing from financial institutions (local and abroad), e.g. local commercial
banks, Caribbean Dev’t Bank, IMF (last resort)
2. Obtaining loans from other countries
3. Using funds from foreign currency reserves
4. Selling off foreign assets
5. Raising interest rates – This will act to slowdown the growth of consumer
demand (since they would want to save more) and therefore lead to cutbacks in
the demand for imports.
6. Offering investment incentives – E.g. investment tax allowance, tax breaks
7. Increasing direct taxes – This might also be used to reduce aggregate demand.
The risk is that a sharp fall in consumer spending might lead to a steep economic
slowdown (slower growth of GDP) or a full-scale recession
8. Lowering the Exchange Rate - Depreciation in the domestic exchange rate
should help to boost the overseas demand for local exports because local firms
will be able to supply more cheaply on overseas markets.
The extent to which export sales rise following a fall in the exchange rate depends on:
(a) Whether local firms actually decide to cut prices and
(b) The price elasticity of demand for local products from foreign consumers.
A lower exchange rate should also cause imports into the local economy to become
relatively more expensive - leading to a slowdown in import volumes and "expenditure-
switching" towards local output.
Longer Term Improvements in Trade Performance - focus on the Supply-Side

The key to controlling or reducing a balance of payments deficit in the long term is for
the local economy to achieve relatively low inflation with sufficient productive capacity
to meet the domestic demand from consumers.
This requires a period of low inflation, low interest rates and a competitive exchange
rate matched with sufficient non-price competitiveness in overseas markets.
Often, price is not the deciding factor in winning the demand from buyers. Greater
investment in research and development, more effective marketing strategies can have
powerful long term effects in winning and maintaining market share in highly
competitive global markets.

At a Glance:
When a BOP disequilibrium results from a capital or current account imbalance, use of
the following table can help, not only to correct the CAB or the Capital Account
balance, but the BOP in general.

Summary Table ↓ = decrease ↑ = increase
Economic Situation Causes Consequences Remedies
Imports ˃Exports  ↑ unemployment;  Importing on credit;
Current Account Deficit  Retrenchment;  ↓ spending by private & public
↑ Spending by private  Inability to provide public sectors;
and public sectors; goods;  Impose restrictions on imports;
 Deterioration of  Privatize state-owned export-
↑ cost of capital goods; infrastructure; oriented firms;
 ↓in total/aggregate demand  Devalue/depreciate domestic
currency;
 Defer payment of national debt
 Offer investment incentives
 Implement policies to improve
efficiency & productivity
 Possible ↑ in imports once

Current Account Surplus Exports ˃ Imports again; Opposite of Deficit
 Opening up of new
↓ spending by private businesses;
and public sectors  Development of new
markets;
 ↑ employment;
 ↑ productivity
Capital Account... Deficit Net outflow of funds  Slow down of the economy; Same factors used to correct BOP Deficit
 Dependent on loans

Recall
Exchange depreciation means decline in the rate of exchange of domestic currency in
terms of foreign currency. This device implies that a country has adopted a flexible
exchange rate policy.
Devaluation refers to deliberate attempt made by monetary authorities to bring down

the value of home currency against foreign currency. While depreciation is a
spontaneous fall due to interactions of market forces, devaluation is official act
enforced by the monetary authority. Generally the International Monetary Fund
advocates the policy of devaluation as a corrective measure of disequilibrium for the
countries facing adverse balance of payment position.
When devaluation is effected, the value of the home currency goes down against
foreign currency.

Section 7: Caribbean Economies In A Global Environment
Specific Objectives
Students Should Be Able To:
Objective 1: List the main characteristics of Caribbean economies;

Characteristics of Caribbean Economies:
1. Mainly Mixed Economies with relatively small private sectors
2. Relatively small in size with limited access to major international markets
3. High involvement of multi-nation co-orporations
4. Significant exploitation of primary products for exports
5. Depend heavily on one (1) or two (2) main income earners (Tourism, agriculture
6. Low endowment of natural resources
Objective 2: State the major economic problems associated with Caribbean economies;
1. High levels of unemployment

2. High dependency on mainly tourism
3. Highly vulnerable to changes in the international commodity market
4. Brain Drain/ Migration ‘out’ of skilled professionals
Skilled labour and professionals leave the Caribbean region in search of better jobs and
opportunities in developed countries. When people such as nurses, doctors, teachers
and technicians migrate, the economy will have fewer of these workers available to
provide for the needs of the population. In addition, resources spent to train these
professionals are lost.
5. Limited Export Base
6. Low Per Capita GNP
Caribbean economies have a low per capita GNP. This means that the average income
enjoyed by an individual for a given year is low. As a result, the standard of living is
low relative to the developed countries of the world. The standard of living is the level
of economic well-being of an individual or a population. It takes into account income
levels and the quality and quantity of goods and services consumed. It also includes
non-monetary factors, such as the quality of a person’s living environment and work
environment, hours of work, life expectancy, literacy rated and levels of externalities
7. Large Pool of Unskilled Labour
A large percentage of the population is unskilled and not trained for the modern
industrial sector. This means that there is little human capital-that is, a highly skilled,
trained and flexible labour force.
8. Little Access to technology and use of capital in the production process
Although some firms use modern, highly efficient methods, many firms have labour-
intensive production processes. This means that the ratio of labour to other factors of
production is high. Less use of capital in the production process means lower
productivity.

9. Large Food Import Bill
Many of the Caribbean countries have current account defecits. They spend more on
the importation of goods and services than they earn in the export of goods and services.
Much of this, is expenditure on goods and services for current consumption; for
example, food. While many of the countries are involved in agriculture, crops such as
bananas, sugar cane and nutmeg are not food crops.
10. Large part of the Population living under the Poverty Line
The Poverty Line is the minimum amount of income necessary to enjoy an adequate
standard of living. The Poverty Line will vary from country to country. Some people
live on less than US$1 per day. The poor have to rely on government provision of health
care and other social services. Many of the poor go without electricity and potable
water. Fortunately, the region does not have people living in extreme poverty; that is,
lacking in the basic needs of food, clothing and shelter.
Extreme Poverty occurs when people lack the very basic needs of food, clothing and
shelter.
11. Underdeveloped infrastructure hindering economic activity and trade

Some Caribbean economies do not have such efficient and modern transport and
communication networks as developed countries, even though urban areas might have
been developed. In some countries, remote aeras are not accessible by paved roads and
might not have access to piped water, electricity, telephones and the Internet.
12. Large Debt Burden
In Caribbean economies, GNP is low but the countries need funds to finance
infrastructure and the provision of services such as health and education. Export
earnings are low, but the countries must import goods and services to satisfy basic
needs. These countries are very poor and so have to borrow to meet expenditure.
The result is that the countries have a large debt and, because of the low GDP, they also
have a large debt burden. The Debt Burden is the cost of the debt in terms of the strain
it places on the government and the people of a country. When funds are used to repay
a debt and its interest, this represents a transfer of funds from the given country to a
foreign government, bank or international institution. These funds could otherwise have
been used in the country to provide goods and services such as health, education,
infrastructure and social services. There is little capital investment and the country
might experience little or no growth in real per capita GNP. The debt Burden is
measured by the debt-to-GDP-ratio
Economic Integration occurs when two or more nations join to form to form a free
trade zone or when two or more nations agree to eliminate/ reduce trade restrictions
between them.

Objective 3: Explain the meaning of terms and concepts associated with Caribbean
economies;
Monocrop Economies – Economies that are dependent on one export, usually from the
Primary Sector; for example, agriculture and the extractive industries such as petroleum,
natural gas and bauxite. The smaller islands specialize in tourism, which is a tertiary sector
activity.
Objective 4: Explain the concept of preferential tariff arrangements;

A preferential tariff is a reduced tariff granted by one country on certain goods from one
country to another country. It is a lower tariff or tax placed on goods imported from a given
country by the importing country compared with the tariff placed on the same goods imported
from other countries).
The reasons why preferential tariffs are granted are:
- A developed country might grant a preferential tariff to developing countries in order
to boost the developing countries’ exports and their economic growth
- Countries in a trading group might also grant a preferential tariff to their partners to
promote trade within the group and develop trading ties
- Preferential tariffs might also be put in place for foreign policy reasons. A country
might wish to reward another country with a lower tariff on a given good. This might
be in return for support on some international issue. Or the country might wish to punish
another country with a higher tariff. It might be that the country placing the higher tariff
disagrees with the policies of the other country
Benefits of Preferential Tariffs

- The exporting country benefits from the lower tariff
As the price of its product in the foreign market is lower than the same good imported
from other countries. Producers in the country which benefits from the preferential
tariff can earn higher sales revenue, and unemployment in the industry in that country
is maintained.
- Preferential Tariffs foster stronger trading Ties between Countries
They help to develop good international relations between countries which grant and
receive lower tariffs
- Preferential Tariffs give developed countries an opportunity to assist poorer
countries
By making their exports prices competitive. Traditionally, preferential tariffs have been
granted to nations that were once colonies of the European countries. To some, it might
be seen as a chance for the developed world to compensate for exploitation of land and
people during the colonial rule of more than 300 years.
Costs of Preferential Tariffs

- The more efficient suppliers might have higher duties placed on their goods
As a result, consumers in the importing country will have to pay more for a good whose
quality might be better (and price lower, before the tariff was placed) than the good
with the lower tariff.
- Consumers in the importing country do not benefit from the availability of goods
From competing suppliers, or from the best prices
- Preferential Tariffs cause other countries not in receipt of the lower tariff rate to
become discontented
They might retaliate, with negative consequences for the country granting the
preferential tariff. They might even complain to the World Trade Organization(WTO)
about such practices.
Objective 5: Identify the benefits and costs derived from CARICOM’s participation in
preferential trade arrangements;
 A guaranteed export market for regionally produced goods.
 A guaranteed price for regionally produced goods.
 A guaranteed supply of foreign exchange.
 Avoidance of competition from other exporters of the same product.
Objective 6: Explain the concept of trade liberalization;

What is Trade Liberalization?
Trade liberalization is the reduction, or even total removal of, barriers to trade. It allows the
free flow of goods and services across international boundaries
Objective 7: Explain the concept of globalization;

What is Globalization?
Globalization is the emergence of a single world market facilitated by improved technology
and communications, and deregulation.
It has led to an increasingly borderless world and the greater movement of people, goods,
capital and ideas.
There is the greater and freer movement of goods, money, Information ideas and people across
national Boundaries
The Drivers of Globalization

The following factors have fuelled the speeding train of globalization
- Leaps in Communication Technology
The Internet, computers and satellites enable the movement of information, money
(electronic funds), ideas and goods from one country to another.
- Improved Transportation
This has resulted in lower transport and shipping costs. Larger ships transport goods
more cheaply to countries all over the world. Improved Refrigeration and storage
facilities enable the movement of all kinds of goods. People can travel all over the world
quickly and with ease
- Trade Liberalization
The reduction, and even total removal of, barriers to trade allows goods to move freely
across international boundaries. There are few limits on what can be exported/imported.
- Liberalization of the Capital Markets
The market for financial instruments is open worldwide. Due to improvements in
communication – by means of the Internet, computers and fax machines – traders in

stock exchanges can purchase shares all over the world. Investors can move their funds
instantly from one continent to another where there are better rates of interest.
Companies are growing and are now setting up bases in different regions of the world
Objective 8: State the major economic features of globalization;
Objective 9: List the benefits to be derived from large scale production of goods;
Economic and Social Benefits of large-scale production

- Producing a larger output will enable small island economies to reap economies of
scale
Economies of scale are the cost advantages that benefit an organization as it grows.
These include marketing economies, financial economies, managerial economies,
research and development economies, welfare economies and technical economies.
When an industry reaps cost advantages, it can mean larger profits for producers, if
prices and revenue remain constant. The firm can choose to pass on lower costs to
consumers in the form of lower prices. When lower costs lead to lower prices, this can
enable the firm to earn a larger market share.
- There will be a reduction in unemployment
As firms employ more labour to produce more goods. This is true unless the large scale
leads to a mechanization and the use of more capital relative to labour. With lower costs
and ready markets available, firms will always be able to sell for their products. They
will not have to lay off workers.
- There is open competition throughout the world
Competition will result in lower prices and better-quality goods for all consumers.
However, goods produced in some low-cost economies, though cheaper, might not
process the same quality.
- Caribbean People will feel a sense of worth as world citizens
As they are making products for the people of the world to consume. When we travel
all over the world, we will see our products on the shelves of stores and we will feel a
sense of pride.
Objective 10: List the benefits to be derived from the Caribbean Single Market and
Economy (CSME);

Objective 11: State the effects of globalization and trade liberalization on territories,
firms, consumers and governments in the Caribbean;
Trade Liberalization and globalization are having, and will continue to have profound effects
on firms and consumers in the Caribbean region. They will also affect the sovereignty of
Caribbean territories.
Effects of Trade Liberalization and Globalization on firms in the Caribbean

- Domestic firms not have to compete with the products of foreign firms
With trade liberalization and globalization, there is an influx of a variety of goods from
all over the world. These goods might be cheaper and/ or of a higher quality, and will
compete with locally produced goods. These goods might not be substitutes for locally
produced goods, but might be so advanced technologically that they capture the taste
and incomes of the locals.
- There is the rise of multinational Corporations
Which continue to locate in developing countries. MNCs are also a source of
competition to domestic firms. They locate to take advantage of natural resources and
cheap labour supplies in the host country, or even to capture the markets of the
developing countries. They provide employment. Government must monitor their
activities to ensure that the relationship with the multinational corporations yields
benefits to the host country and not only to the MNCs.
- Caribbean Firms will now have to advertise internationally
To sell the products of the Caribbean. They will have to develop websites to advertise
products of the Caribbean. They will have to develop websites to advertise their
products, advertise in foreign magazines and television, and participate in international
trade shows to showcase the Caribbean.
Effects of Trade Liberalization and Globalization on consumers in the Caribbean

- There will be an increase standard of living
As consumers not have access to a greater variety of goods all over the world.
- The developed Countries are exporting artificial wants
Because of the influence of television and the movies, the Caribbean consumer wants
to buy these goods. Fashionable clothes, cosmetics and household gadgets are a few of
the goods we all want to buy, though we might not need such goods
- There is the spread of food culture
For example pizza, gyros, roti, Thai cuisine. The international culture is replacing local
culture in food.
- There is the westernization of the world
This shows that the people of the Caribbean are open to other cultures, which is
admirable. However, the effects are that we are consuming fewer domestically
produced goods and more imports. Imports use up valuable foreign exchange.

Effects of Trade Liberalization and globalization on the sovereignty of territories in the
Caribbean
- Natural Resources may be exploited by the multinational Corporations
As mentioned earlier, MNCs provide jobs, but Caribbean governments must be alert
and ensure that these international giants do not exploit our people and resources
- Small and Infant industries may close
In the Caribbean because of competition with other foreign firms. This will lead to
unemployment. Governments will have to develop policies to reduce such
unemployment.
- Increasing Imports may result in a Trade Deficit

Governments will be faced with the responsibility of finding ways to boost foreign
exchange earnings.
- There is an increase in immigration from poor countries to countries with more
opportunities
Governments will also have to plan for migration. An inflow of skilled professionals
might take jobs from locals. An inflow of unskilled labour might depress living
standards. Migration into a country must be of workers in occupations where there are
not enough locals to fill jobs. By extension, countries must beware the ‘Brain drain’,
where skilled workers migrate to more developed countries in search of better
opportunities.
- Some territories will lose some of their sovereignty as countries integrate
A country will not necessarily be able to make economic decisions on its own, but must
in some cases consult with the other members of the union. Each country of the union
will implement policies in agreement with other members
- National Borders are Disappearing
Goods, People and companies are moving freely into countries in this age of
globalization and free trade. Countries will have to adapt to these changes. Tax laws
and laws relating to ownership of property will have to be adjusted to take into account
the activities of foreigners and foreign companies. Laws governing holders of bank
accounts have already been amended to allow for foreigners

Research INFO:
Effects of globalisation and trade liberalisation on firm, consumer and the sovereignty of
territories.
Firms
 Increased competition from abroad could result in collapse of some firms
 Availability of new and improved technology cold assist firms to improve productivity.
 Greater access to international markets could increase economy of scale and lead to
greater profit.
 Greater access to international money markets for capital funded
 Reduced costs of production through e-commerce and better international business
environment.
 Greater use of e-commerce could lead to improved access to raw materials and facilitate
market of good.
 Improved efficiency through increased competition and access to skilled labour
Consumer
 Greater access to a wide variety of goods at competitive prices.
 Increased use of the internet for conducting e-commerce.
 Lower prices of goods due to increased competition.
 Improved quality of goods and services due to increased competition.
Territories
 Increase in foreign direct investment.
 Improvements in the standard of living through increased access to affordable goods.
 Increase access to larger markets for export
 Possibility of cultural imperialism through over-exposure to foreign goods and lifestyles.
 Possibility of increased gap between rich and poor through unequal access to knowledge
and technology on the part of the population.
Government
 Retrenchment due to the collapse of some firms.
 Economies become more vulnerable to external events, such as terrorism, war and extreme
temperatures that may have an impact on overseas markets.
 The state may lose some of its sovereignty by participating in bilateral and multilateral
arrangements
 Increased social problems associated with the drugs trade and money laundering due to
increased use of the internet to facilitate trade.
 Depletion of natural resources through over-exploitation by foreign firm bent on mass
production in competitive environment
 Possible environmental destruction by foreign firms.
 Unequal distribution of wealth.
Objective 12: Identify development strategies that Caribbean governments may use in a
globalised economic environment;

Development Strategies for Caribbean Economies in a globalized environment
1. Investment in human Capital

Provision of education and training will reduce the extent of poverty in these countries.
It enables the poor to find jobs, earn an income and increase their quality of life. Some
examples of the government of Trinidad and Tobago’s investment in human capital are:
investment in the University of Trinidad and Tobago, provision of free tertiary
education, and investment in the Multi-Sector Skill Training Programme (MuSt)
2. Foreign Direct Investment
Foreign Direct Investment is the long term investment in a country by an investor from
abroad The foreign investor sets up the firm or takes over a local company. By
definition, the foreign investor must have control in the given firm. This is unlike the
Portforlio investment, where a small foreign investor simply purchases shares in a local
company and earns dividends on those shares. With FDI, the foreign firm locates in the
host country to gain access to resources – that is cheap labour and natural resources –
and to gain access to markets. The FDI process consists of a parent firm setting up a
subsidiary in a host country, thereby forming a Transnational Corporation (TNC), also
called a Multinational Corporation. When the foreign firm locates in the Caribbean
economy, it will cause an initial flow of foreign exchange and so help to improve a
balance of payments deficit. FDI will increase the number of firms operating in a
country. This will increase economic activity in the country. Increased economic
activity will increase the jobs available and so help to reduce unemployment. It will
increase access to technology, thus increasing labour productivity and introducing new
methods of production to the region. More people employed means higher national
income and, possibly economic growth. It is possible for the foreign firm to provide
jobs for the skilled. This might encourage would-be migrants not to migrate, and so
reduce the brain-drain.
3. Export – Led Growth
Exports are an injection into the circular flow of income. Sale of exports increases the
earnings of domestic firms, create employment and result in the growth of real GNP
per capita (economic growth). This reduces the percentage of poor in the country
4. Foreign Borrowing
Countries can borrow from foreign governments, banks and international financial
institutions in order to promote development. Countries can also borrow to develop
infrastructure . The
Objective 13: Explain the concept of e-commerce;

E-Commerce is the conducting of business (buying and selling of goods and services) online.
E-commerce relies on the internet to transfer data from one party to another. Companies that
conduct trade using e-commerce are called e-businesses.
There are two types of e-businesses:

1. The company might be a web-based company, its only contact with the buyer being
the web page on which the company’s goods and/or services are advertised for sale.
The company has no physical store where buyers can shop and interface with sellers.
These businesses are called dot.coms. Dot.coms are internet trading companies.
Trinibiz.com is one such business.
2. The company might be a business with a store in an area where buyers come to shop.
There is face-to-face consumer-seller contact. This is a ‘bricks and mortar’ company.
However, the business extends its operations to a website to give its listing and potential
customers the opinion to view the goods online, and if they wish, buy electronically. In
so doing, the company increases its market to include customers who shop online and
who might be in foreign countries. The company then becomes a ‘bricks and clicks’
company
Whatever the type of business, e-commerce is a form of direct selling. The supplier can sell
directly to the final consumer, thus eliminating some need for wholesalers and retailers. There
is also less need for shops and shop attendants.
Here is how you purchase items form an e-business:
1. Obtain the website address of the business
2. Log on to the internet and visit the site
3. Browse through the site. You should see an e-catalogue (this is simply a list of items
for sale with the prices), there might be photographs or descriptions of the items to give
the buyer a clearer idea of the purchase.
4. Select the item(s) you wish to purchase. There might be an e-shopping cart in which
you place your items
5. Proceed to checkout
6. Pay for the items using your credit cards. There is an electronic transfer of funds from
your bank account to the seller’s bank account
7. Allow days to weeks for delivery, depending on where you live and where the business
is located.
Objective 14: List the benefits of e-commerce;

Advantages to the consumer
- Consumers now have access to a range of firms from which to purchase.
Caribbean shoppers can access cheaper products, better quality products and different
brands in another country within or outside the Caribbean region. Caribbean shoppers
are no longer limited to what the shops of the region offer and the prices they sell at.
Shoppers do not have to travel to a country to obtain a product of that country that a
local firm does not import.
- Goods are Cheaper
Because e-shops do not have costs such as construction or rental of buildings, or
payments to middlemen and workers such as shop attendants. However, the buyer now
has to pay for the cost of transportation.
- Shopping can be done in the comfort of your own home
At any time of the night or day, you can shop 24/7
- It is also faster
You do not have to go through traffic, as you might need to in order to get to the mall.
Also, you do not have to wait for a shop attendant to check out your purchase manually
for you.
- E-commerce makes it easier for people with disabilities
To shop from the comfort of their homes without having to physically move from their
homes.
Advantages to the Business

- The world is the market for the business
Companies can reach consumers all over the world. No Longer are companies limited
to customers who live nearby or to tourists visiting a foreign country. The firms of the
Caribbean region can reach customers all over the world. They can reach anyone with
a computer and internet access.
- Businesses can grow overnight
As an e-shop can reach millions of customers every day. Profits can increase quickly
- As the entire process is electronic, the owner of the e-business does not have to be
present at the business all the time
The owner’s hours of work are flexible.
- The cost of setting up of the business is smaller.
Anyone can set up an e-business. People can set up small home-based companies.
Advantages to the Economy

- There will be jobs for parcel delivery service workers and companies
Persons to deliver packages to buyers
Objective 15: Outline the challenges of e-commerce.

 Retraining – E-commerce can cause traditional sales persons to lose their jobs since
they are no longer adequately equipped to perform the job. However, these sales
persons can be retrained so that they will have the necessary skills to handle business
via the internet.
 Security of funds – Many people are cautious about conducting business and
purchasing goods via the internet because they are sceptical about whether their
financial information will be secure and not used illegally. Another reason is that they
are unsure that the goods ordered will arrive as expected. However, many economic
agents have demonstrated that it is quite possible to trade online. Many firms use a
secure server as well as a coding system which does not save financial data but simply
uses the information to finalise payments for goods.
 Money laundering and illegal drugs – As stated earlier, money laundering and the
slae of illegal drug are made easier through the internet. This means that governments
must ensure that certain laws are enacted to protect firms and consumers and to also
prosecute those persons using e-commerce for illegal.
 Small firms – The possibility for e-commerce are endless; however, a firm must have
adequate capital in order to engage in e-commerce. This means that large and medium-
sized firm will engage in e-commerce faster than a small firm. Therefore, methods and
strategies must be found to encourage small firms to engage in e-commerce such as the
provision of loans, the provision of expertise and knowledge, as well as education as to
the importance of e-commerce.
 The buyer cannot obtain the product immediately.
E-Shoppers have to anticipate the need for the products and allow time for delivery.
 Poorly Designed sites may act as a turn off to customers
 Goods will be difficult to return
 Some traditional Shops lose business and so earn reduced profits
Terms and Concepts:

a. Debt burden – This is the amount of a country’s debt which must be paid off.
b. Structural adjustment – This entails altering certain aspects of an economy in order

to achieve objectives. Structural Adjustment Policies are economic policies which
countries must follow in order to qualify for new World Bank and International
Monetary Fund (IMF) loans and help them make debt repayments on the older debts
owed to commercial banks, governments and the World Bank. Although SAPs are
designed for individual countries but have common guiding principles and features
which include export-led growth; privatisation and liberalisation; and the efficiency of
the free market.
c. Economic integration – Economic integration can be defined as a situation where

several states or countries seek to increase or expand the extent of their economic
relationship to facilitate trade so that each will benefit from access to larger markets
etc. and a possible higher overall level of economic growth. The aim of economic
integration is to reduce costs for both consumers and producers, as well as to increase
trade between
the countries taking part in the agreement.
d. Protectionism – This entails the implementation of certain policies on the part of

countries which seek to provide some sort of safeguard mechanism for local firms
against foreign firms which may have the advantage in terms of production, quality and
prices. Some of these protectionist policies include tariffs imposed on imports from
foreign countries and subsidies granted to local firms which enable them to compete
with foreign firms.
e. Laissez-faire – This is an economic state/condition which requires that there should

not be any interference from or regulation of the economy by the government. This
implies that all economic decisions are made by private individuals which are done
indirectly by signals transmitted via market system.

f. Common Market – This is an economic unit which is created by several countries with
the aim of reducing and /or totally removing trade barriers among themselves. It
involves the removal of all trade barriers as well as the free movement of factors of
production among member states.
g. Economic Union – An economic union exists when there has been an agreement
between two or more countries regarding the free movement of all goods and services,
labour and capital including an adoption of both fiscal and monetary policies as well as
social policies. An example of this is the European Union (EU).
h. Customs Union – A customs union and an economic union are similar in that the
member countries agree to remove all trade barriers among themselves. However, a
customs union has the added feature of establishing a common tariff as well as non-
tariff barrier and policies with regards to goods being imported from non-member
countries.
i. Globalisation – Globalisation can be defined as the increasing economic integration

and interdependence of countries through expanded movement of goods, services,
labour, technology and capital across international borders with greater penetration than
has occurred in the past.
j. Trade Liberalisation – Trade liberalisation refers to a situation where tariff and trade
barriers are lowered so that foreign firms can enter the economy of a country in order
to increase competition and so that foreign investment can be encouraged.
k. Bi-lateral agreement – A bilateral trade agreement indicates that two countries have
agreed to trade with each other, deciding upon certain terms of agreement such as the
reduction of trade barriers and/or which type of goods can be imported and so on. The
CARIBCAN trade agreement between the Caribbean and Canada is seen as a bilateral
trade agreement.
l. Multi-lateral agreement – This involves more than two countries – a multilateral trade
agreement means that three or more countries have engaged in some sort of trade
arrangement. For example, CARICOM trading arrangements are multilateral since
more than two islands are involved.
m. International Monetary Fund (IMF) – Comprising 184 countries, this financial

organisation aims to ensure that countries are able to secure financial stability, lower
poverty, increase economic growth and employment as well as foster international
trade.
n. Caribbean Community (CARICOM) – this is attempt by countries of the Caribbean

region to integrate in to order to achieve political, economic and social objectives. This
process is ongoing.
o. Africa, Caribbean and Pacific (ACP) – The Georgetown Agreement in 1975 was
responsible for the birth of the African, Caribbean and Pacific Group of States, other
known as the ACP. There are 79 countries belonging to the ACP: 48 from Sub-Sahara
Africa, 16 from the Caribbean and 15 from the Pacific.
Some of the objectives of the ACP Group include ensuring that there is peace and
stability within the countries, that unity and solidarity exist within and among the ACP
countries and reducing poverty.
The initial aim of the Group was to ensure that co-ordination and co-operation occurred
within the Group and with the European Union (EU). However, they have now
diversified their interests into other areas such as trade, economics and politics.
p. Free Trade Area of America (FTAA) – The Free Trade Area of the Americas is a
trade agreement which includes 34 of the 35 nations situated within the western
hemisphere. These countries have agreed to remove trade barriers and investment
barrier on almost all their goods and services. Additionally, they have agreed to lower
the price charged to consumers and to attempt to create more markets for firms.
q. Association of Caribbean States (ACS) – The Association of Caribbean State was

instituted on 23 July 1994 with the hope of encouraging the 25 member states s well as
the 3 associate members to have proper and effective consultation and co-operation.
Some of the objectives of the ACS included safeguarding the environment, encouraging
sustainable development within the Caribbean region and building up the regional co-
operation and integration process among the Caribbean countries.
r. Caribbean and Canadian Association (CARIBCAN) – The CARIBCAN

programme was set up by the Canadian government to allow duty free access to the
Canadian market for specific exports from the Caribbean. These export usually omit
products such as clothing, footwear, luggage, methanol and so on.
s. Caribbean Single Market and Economy (CSME) - The CSME is a proposed

integration agreement involving no barriers between or among Caribbean countries so
that goods and services, people, capital and technology can move freely within the
Caribbean. All physical, technical and fiscal barriers are to be removed so that the
Caribbean region will operate as a virtual single economy.
t. World Bank – Otherwise known as the International Bank for Reconstruction and
Development (IBRD), the World Bank is made up of 184 countries and seeks to
improve the welfare of the developing countries of the world. The WB’s aim is to
increase economic growth, reduce poverty and provide health care, water, electricity
and education. The WB typically provides loans and financial assistance to poor
countries of the world. It allows countries a much longer time in which to repay loans
than other typical financial institutions such as commercial banks.
u. Organisation of Eastern Caribbean States (OECS) – The OECS was created in1981,
initially with seven member countries which agreed to encourage unity and co-
operation amongst the membership. There are now nine members: Anguilla, Antigua
and Barbuda, British Virgin Islands, Dominica, Grenada, Montserrat, St. Kitts and
Nevis, St. Lucia, St.Vincent and the Grenadines.
The aim of the OECS is to ensure that its member are able to properly integrate into the
world economy, that they are able to voice their opinions regarding regional and
international issues, and to make sure that there is co-operation and economic
integration.
v. European Union (EU) – Formerly known as the European Community (EC), this
organisation was established in 1958 with the objective of removing customs duties
and other trade barriers which existed among the countries of Europe, including the
common external tariff. These European countries have also committed themselves to
working towards peace as well as prosperity.
The EU was initially concerned with trade and the economy of its member states, but
it has since become involved in the individual rights of its people, job creation and other
issues which benefit the lives of European citizens.
The now trades using a single monetary unit, the euro, which is intended to make trade
between the member countries of the EU easier as it eliminates the need for currency
conversion.
w. Caribbean Basin Initiative (CBI) – Twenty-four member countries from within

Central American and the Caribbean region make up the CBI.
The CBI is an agreement which allows for tariff exemptions for the products produced
by these countries. There are also tariff reductions for some products. The aim of this
US government programme is to enable a range of goods to be exported from the
Caribbean to United Stated without import duties.
x. Caribbean Development Bank (CDB) – The CDB was established in1970 with the
aim of promoting economic co-operation and integration as well as growth and
development among Caribbean economies. The CDB customarily provides member
countries with financial assistance to develop programmes which will help them in the
areas of economic growth and overall development.
y. Foreign Direct Investment (FDI) – This usually refers to any investment by non-
residents in another country. It can take the form of monetary investment in physical
assets such as plant, or capital investment in a domestic subsidiary firm in which the
investor has voting control.

OTHER NOTES:
Terms and Concepts in International Trade

National Debt - the total amount of money which a country's government has borrowed
Government debt (also known as public debt, national debt and sovereign debt) is the debt
owed by a central government. For countries the debt burden is the cost of servicing the
public debt.
'Structural Adjustment' – A type of credit facility that helps developing countries become
more economically self-sufficient.
Structural adjustment programs (SAPs) consist of loans provided by the International
Monetary Fund (IMF) and the World Bank (WB) to countries that experienced economic
crises.
Causes of Movements in the Terms of Trade

Changes in demand and supply conditions and changes in the external value of the currency
can alter the terms of trade. For instance, a decrease in overseas demand for a country’s
product is likely to lower the price (value) of its exports and hence cause an unfavourable
movement in the TOT. Similarly, a fall in the value of the country’s currency will also lower
the price of exports relative to imports and hence lead to an unfavourable movement in the
TOT.
Effects of Changes in the TOT

The effects of changes in the TOT will be influenced by:
1. Their Cause – An increase in export prices arising from an increase in demand will
have a more beneficial effect on the balance of payment position than an increase
arising from inflation.
2. The Elasticity of Demand for Exports and Imports – if for example, prices of exports
from SVG rise by 5% due to an increase in the costs of production it will earn more
foreign currency only if the quantities sold remained unchanged or fall by less than 5%;
(i.e. if demand is inelastic). Similarly, if foreign prices of imports fall by 5% less
foreign currency will be spent only if demand is inelastic. If demand for imports and
exports were elastic, the BOP will be worsened because expenditures on foreign
commodities would rise while revenues from exports would fall.
Free Trade and Protectionism

Trade liberalisation involves removing barriers to trade between different countries and
encouraging free trade.
Protectionism on the other hand is the restriction of international trade. It is the economic
policy of restraining trade between countries through methods such as tariffs on imported
goods, restrictive quotas, exchange controls, embargoes, etc.

Trade liberalisation involves:
 Reducing tariffs
 Reducing / eliminating quotas

 Reducing non-tariff barriers.
Non-tariff barriers are factors that make trade difficult and expensive. For example, having
specific regulations on making goods can give an unfair advantage to domestic producers.
Harmonising environmental and safety legislation makes it easier for international trade
Advantages of Trade Liberalisation
 Reducing trade barriers leads to trade creation

Trade Creation – This occurs when consumption switches from high cost producers to low
cost producers.
 Lower prices – The removal of tariff barriers can lead to lower prices for consumers.
This would be particularly a benefit for countries who are importers of food.
 Increased competition – Trade liberalisation means firms will face greater
competition from abroad. This should act as a spur to increase efficiency and cut costs
or it may act as an incentive for an economy to shift resources into new industries where
they can maintain a competitive advantage. It may prevent domestic monopolies from
charging too high prices.
 Economies of scale – Trade liberalisation enables greater specialisation. If countries
can specialise in certain goods they can benefit from economies of scale and lower
average costs, this is especially true in industries with high fixed costs or that require
high levels of investment. The benefits of economies of scale will ultimately lead to
lower prices for consumers.
 Trade is an engine of growth – World trade has increased by an average of 7% since
the 1945, causing this to be one of the big contributors to economic growth.
Problems of Trade Liberalisation
 Trade liberalisation often leads to a shift in the balance of an economy. Some industries
grow, some decline. Therefore, there may often be structural unemployment from
certain industries closing. Trade liberalisation can often be painful in the short run, as
some industries and some workers suffer from the decline in uncompetitive firms.
 Trade liberalisation could lead to greater exploitation of the environment, e.g. greater
production of raw materials, trading toxic waste to countries with lower environmental
laws.
 Trade liberalisation may be damaging for developing economies that cannot compete
against free trade. The infant industry argument suggests that trade protection is

justified to help developing economies to diversify and develop new industries. Most
economies had a period of trade protectionism. It is unfair to insist that developing
economies cannot use some tariff protectionism.
 Because of this argument, some argue that trade liberalisation often benefits developed
countries more than developing countries.
Reasons for Protectionism

Infant Industry Argument – If developing countries have industries that are relatively new,
then at the moment these industries would struggle against international competition. However
if they invested in the industry then in the future they may be able to gain Comparative
Advantage.
o This shows that comparative advantage can change over time
o Therefore protection would allow them to progress and gain experience to enable them
to be able to compete in the future.
The Senile industry argument – If industries are declining and inefficient, they may require
large investment to make them efficient again. Protection for these industries would act as an
incentive to for firms to invest and reinvent themselves. However protectionism could also be
an excuse for protecting inefficient firms
To diversify the economy – Many developing countries rely on producing primary products
in which
they currently have a comparative advantage. However relying on agricultural products has
several disadvantages
 Prices can fluctuate due to environmental factors
 Goods have a low income elasticity of demand. Therefore with economic growth
demand will only increase a little
Raise revenue for the govt. – Import taxes can be used to raise money for the govt however
this will only be a small amount of money
Help the Balance of Payments – Reducing imports can help the current account. However in
the long term this is likely to lead to retaliation
Cultural Identity – This is not really an economic argument but more political and cultural.
Many countries wish to protect their countries from what they see as an Americanisation or
commercialisation of their countries
Protection against dumping – The EU sold a lot of its food surplus from the Common
Agricultural Programme (CAP) at very low prices on the world market. This caused problems
for world farmers because they saw a big fall in their market prices
Environmental – It is argued that free trade can harm the environment because LDC may use
up natural reserves of raw materials to export. Also countries with strict pollution controls may

find consumers import the goods from other countries where legislation is lax and pollution
allowed.
 However supporters of free trade would argue that it is up to individual countries to
create environmental legislation
Weaknesses of Protectionism
 There are also weaknesses in using the system of protectionism. For
example, protectionism can cause a retaliation reaction from other countries, ruining
the relationship of the two nations. This is a major issue right now between the United
States and China. U.S. put restrictions on the Chinese tires, so China retaliated by
putting up barriers against different U.S. goods, such us their chicken. This hostility
decreases the specialization level of the two nations, harming their economy.
 Also, protectionism prevents the efficient use of factors of production therefore, nations
are unable to maximise their specialization level.
 It prevents consumers and sellers reaching the equilibrium price and quantity that
would prevail in a free market.
 There is lack of access to a wider variety of goods and services
Tools of Protectionism are the same as the barriers to trade; e.g. tariffs, quotas, exchange
controls and so on.
What is Exchange Control – currency restrictions which prevent domestic residents from
acquiring sufficient foreign currency for imports.
What is a Common External Tariff (CET) – When a group of countries form a customs
union they must introduce a common external tariff. The same customs duties, import quotas,
preferences or other non-tariff barriers to trade apply to all goods entering the area, regardless
of which country within the area they are entering. It is designed to end re-exportation; but it
may also inhibit imports from countries outside the customs union and thereby diminish
consumer choice and support protectionism of industries based within the customs union.
The common external tariff is a mild form of economic union, but may lead to further types of
economic integration. In addition to having the same customs duties, the countries may have
other common trade policies, such as having the same quotas, preferences or other non-tariff
trade regulations apply to all goods entering the area, regardless of which country within the
area they are entering.
Important examples of common external tariff are that of the Mercosur countries (Brazil,
Argentina, Venezuela, Paraguay and Uruguay)
Economic Union – an agreement between two or more countries that allows the free
movement of capital, labour and all goods and services and involves the harmonisation and
unification of fiscal and monetary policies. This is the aim of CSME.

A customs union is a type of trade bloc which is composed of a free trade area with a common
external tariff. The participant countries set up common external trade policy, but in some
cases they use different import quotas. Common competition policy is also helpful to avoid
competition deficiency.
Purposes for establishing a customs union normally include increasing economic efficiency
and establishing closer political and cultural ties between the member countries.
It is the third stage of economic integration.
Economic integration is the unification of economic policies between different states through
the partial or full abolition of tariff and non-tariff restrictions on trade taking place among them
prior to their integration. This is meant in turn to lead to lower prices for distributors and
consumers with the goal of increasing the combined economic productivity of the states.
Economic integration is an economic arrangement between different regions marked by the
reduction or elimination of trade barriers and the coordination of monetary and fiscal policies.
The aim of economic integration is to reduce costs for both consumers and producers, as well
as to increase trade between the countries taking part in the agreement.
There are varying levels of economic integration, including preferential trade agreements
(PTA), free trade areas (FTA), customs unions, common markets and economic and monetary
unions. The more integrated the economies become, the fewer trade barriers exist and the more
economic and political coordination there is between the member countries.
By integrating the economies of more than one country, the short-term benefits from the use
of tariffs and other trade barriers is diminished. At the same time, the more integrated the
economies become, the less power the governments of the member nations have to make
adjustments that would benefit themselves. In periods of economic growth, being integrated
can lead to greater long-term economic benefits; however, in periods of poor growth being
integrated can actually make things worse.
A free-trade area is a trade bloc whose member countries have signed a free-trade
agreement (FTA), which eliminates tariffs, import quotas, and preferences on most (if not all)
goods and services traded between them. If people are also free to move between the countries,
in addition to FTA, it would also be considered an open border. It can be considered the second
stage of economic integration. Countries choose this kind of economic integration if their
economic structures are complementary; i.e. they work well together. If their economic
structures are competitive, it is likely there will be no incentive for a FTA, or only selected
goods and services will be covered to fulfill the economic interests between the two signatories
of FTA.
The New Trading Environment – Implications for the Caribbean

 International standards for product and service quality
 Customs modernization – legislation, compliance responsibility…
 Obligations under the WTO Technical Barriers to Trade Agreement

The island nature of the small Caribbean countries – We consider the effects of higher
transportation costs for basic inputs and exports, the increased difficulty in access to bigger
markets, the concentration of economic activity in a small number of sectors that increases the
vulnerability to external shocks, and the reduced market size of the economy, whose negative
effect is compounded by the physical disconnect from other markets
- We are not able to meet certain standards thus we are less competitive
- We are unable to produce enough finished (or semi-finished) products for exports
- The volume of exports required to maintain some markets is difficult to meet
- We almost always have trade deficits
- We have limited capacity to produce
- There are several differences in economic and social development among countries.
These create problems when negotiating on international markets. National interests
often supersede regional interests
- Smaller islands do not produce enough food from animals to meet local demand thus
they can’t think of exporting
- Money is leaked out of the region to pay for imports
Laissez-faire –This is a policy in which industry and economics are free from government
restrictions, tariffs and especially any government monopoly. It is a French term which roughly
translated is 'allowing the people do as they please.'
It is a vision of free market and free trade without government intervention, keeping the
government involvement to a minimum. Laissez faire in theory does not wish to protect multi-
national companies at the expense of the people but it would look to allow the market to take
its own course.
In other words, laissez-faire describes a system or point of view that opposes regulation or
interference by the government in economic affairs beyond the minimum necessary to allow
the free enterprise system to operate according to its own laws.
'Laissez Faire' is economic theory from the 18th century that is strongly opposed to any
government intervention in business affairs. It is sometimes referred to as "let-it-be
economics."
Look at the following:
http://www.answers.com/Q/What_are_the_advantages_and_disadvantages_of_laissez_faire_
theory
Bi-lateral Agreement – Bi-lateral trade agreements give preference to certain countries in

commercial relationships, facilitating trade and investment between the home country and the
foreign country by reducing or eliminating tariffs, import quotas, export restraints and other
trade barriers. Bi-lateral trade agreements can also help minimize trade deficits.

The goal is to give them expanded access to each other's markets, and increase each country's
economic growth.
How do they do this? There are five general areas where they standardize business
operations, in an attempt to level the playing field. That keeps one country from stealing the
other's innovative products, dumping products at a cheap cost, or using unfair subsidies. These
agreements also standardize regulations, labour standards and environmental protections. Last,
but certainly not least, they eliminate tariffs and other trade taxes. This gives companies within
both countries a price advantage.
What then is a multi-lateral agreement?

Three or more parties, agencies, or national governments agree with signatures. A bilateral
agreement is only between two such parties.
How does it differ from a bi-lateral agreement?

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ADDISON K.

FORM 4 & 5 Business 1

Economics CSEC Notes

Addison K. Edwards Economics Notes 2013. 2015 1

Economics can be divided into microeconomics and macroeconomics. Microeconomics is

What is meant by an economy? An Economy is a range of economic activities where

Addison K. Edwards Economics Notes 2013. 2015 2

A. The creation of wealth out of scarce resources

B. The production and distribution of goods and service

C. The behavior, interactions and welfare of those involved in the process

D. Economics as a trade off

A. Organization of resources for production of goods and services

Addison K. Edwards Economics Notes 2013. 2015 4

Objective 1: Define the term ‘Economics’;

Objective 2: Explain what is meant by an economy;

Addison K. Edwards Economics Notes 2013. 2015 5

Objective 4: Explain the concepts of scarcity and choice within an economy;

What are Needs and Wants?

Addison K. Edwards Economics Notes 2013. 2015 6

Objective 5: Define “opportunity cost” and “money cost”;

Types of Opportunity Cost

Examples of Opportunity cost

Production Possibility Frontier/ Production Possibility Curve/ Production Possibility

Addison K. Edwards Economics Notes 2013. 2015 7

Assumptions of the Production Possibility Curve (PPC)

Causes of an inner shift of the Production Possibility Curve (PPC)

Addison K. Edwards Economics Notes 2013. 2015 8

Economic Efficiency is when an economy is producing on its production possibility frontier,

Addison K. Edwards Economics Notes 2013. 2015 9

Addison K. Edwards Economics Notes 2013. 2015 10

Important concept for the Production Possibilities Curve

Key points on Production -possibilities to remember

Addison K. Edwards Economics Notes 2013. 2015 11

Addison K. Edwards Economics Notes 2013. 2015 12

Factors influencing the Economic Decisions of Individuals

Addison K. Edwards Economics Notes 2013. 2015 13

Addison K. Edwards Economics Notes 2013. 2015 14

Addison K. Edwards Economics Notes 2013. 2015 15

Objective 1: Define “production”;

Objective 2: Distinguish between production and productivity;

Objective 3: Define the term “factors of production”;

Addison K. Edwards Economics Notes 2013. 2015 16

Objective 5: State the rewards of the factors of production;

Addison K. Edwards Economics Notes 2013. 2015 17

NB:*There is arable or agricultural land.

Labour Force – all individuals of working age within a society.

Factors That Determine Productivity

The Supply of Labour

Factors That Determine The Supply of Labour

Addison K. Edwards Economics Notes 2013. 2015 21

Investment is the purchase of capital goods.

Physical capital consists of:

Addison K. Edwards Economics Notes 2013. 2015 22

The Supply of Capital

Addison K. Edwards Economics Notes 2013. 2015 23

Addison K. Edwards Economics Notes 2013. 2015 24

Addison K. Edwards Economics Notes 2013. 2015 25

Objective 9: Distinguish between goods and services;

Objective 10: Explain the concept of resource allocation;

Addison K. Edwards Economics Notes 2013. 2015 26

Objective 11: List the types of economic systems;

The Traditional Economy

Addison K. Edwards Economics Notes 2013. 2015 27