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Economics Higher Level – Section 1: Microeconomics
Unit 1.0: Introduction to Economics
Scarcity – a situation in which the resources available for producing output are
insufficient to satisfy wants.
Factors of production – resources, typed into four categories.

• Land: the gifts of nature such as lakes, forests, minerals, wildlife
• Labor: the physical and mental work of people
• Capital: assets created for use in production of other goods
o Fixed capital: durable and used time and time again, e.g. machinery
o Circulating capital: used once, e.g. raw materials
• Enterprise: organizers and innovators
Opportunity cost – the cost of using resources for a certain purpose, in terms of the
next best alternative foregone.
A Production Possibilities Curve (reflected below) shows all the maximum

combinations of 2 goods that an economy can produce within a certain period,
within a certain level of technology and when all available resources are fully and
efficiently employed.
Capital goods – goods such as machinery and equipment

Consumer goods – consumed by people and yields satisfaction
Shifts in the PPC – an outward shift of the PPC indicates higher productive capacity
(higher potential economic growth), which an inward shift denotes the opposite.
Causes of economic growth include:
• Increases in the quantity of available resources
• Improvement in the quality of the resources
• Technological improvement
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Productive Efficiency – a situation where the economy is producing maximum
output with the given technology and resources, or producing output with the
lowest possible unit costs.
Allocative Efficiency – a situation where resources are allocated in a way that no

one can be made better off without another being worse off, achieving maximum
community surplus. It can also be defined as when the marginal cost of each good
equals the price that consumers pay (P = MC).
The Free Market Economy – one that relies totally on the market forces of demand
and supply for the allocation of resources. It answers the three economic questions.
• What and how much to produce is decided by the signaling and incentive
function of prices. The movement of prices signal to firms whether they
should produce more or less of a good. High and low prices incentivize firms
to either produce more or less.
• How to produce is decided by the profit motive of producers, choosing the
least cost method.
• For whom to produce is answered by the price which performs the rationing
function in the free market.
The Command Economy – one that relies totally on government direction and
coordination.
The Mixed Economy – resources are allocated partly via the price mechanism and
partly by the government. The economy is divided into the private and public
sectors.

Unit 1.1: Competitive Markets—Demand and Supply
Markets – where buyers and sellers interact to carry out economic transactions.
Demand – the quantities of a product that consumers are willing and able to buy at
various prices, ceteris paribus. There is an inverse relation between price and
quantity demanded. It is determined by the following factors:
• Price
• Non-price factors such as:
o Changes in income
o Changes in price of related goods: substitutes and complements
o Changes in tastes
o Legislation
o Population size/demographics
Supply – the quantities of a product that suppliers are willing and able to sell at
various prices, ceteris paribus. There is a positive relation between price and quantity
supplied. It is determined by the following factors:
• Price
• Non-price factors such as:
o Changes in cost of production
o Changes in state of technology
o Changes in number of sellers
o Changes in price of related goods: goods in competitive and joint
supply
o Legislation
Indirect taxation – taxes imposed on expenditure.
Specific tax – a tax that is levied as a fixed amount per unit sold irrespective of price.
It causes a leftward and parallel shift of the supply curve.
Ad-valorem tax – a tax that is levied as a percentage of the selling price of the
goods. It causes a leftward and pivotal shift of the supply curve.
Subsidy – a payment made by the government to producers to encourage the

production of certain goods, but not in exchange for any goods or services. It is
intended to decrease the marginal cost of production. It will shift the supply curve
rightwards.
Market Equilibrium Price refers to the price where the quantity demanded (Qd) is
equal to the quantity supplied (Qs). It is also known as a market-clearing price.
• Changes in demand: ceteris paribus, an increase in demand will increase the
equilibrium price and a decrease in demand will decrease the equilibrium
price.

• Changes in supply: ceteris paribus, an increase in supply will lower the
equilibrium price and increase Qd. A decrease in supply will raise the
equilibrium price and decrease Qd.
• Changes in both demand and supply will depend on the outcome of the
graph.
Complementary goods refer to goods that are used jointly together to satisfy a
want. Examples include washing machines and washing powder. The demand for a
product will tend to vary inversely with the price of its complementary good.
Substitute goods refer to alternative products that satisfy the same wants or
needs. Examples include beef and pork, or Coca-Cola and Pepsi. The demand for a
product will tend to vary directly with the price of its substitutes.
Derived demand refers to the demand for a good that is derived from the need to
produce other goods. Examples include the demand for steel due to the demand for
cars and ships. An increase in the demand for cars and ships will lead to an increase
in the demand for steel.
Joint supply refers to goods that are produced jointly with the same resources.
Examples include beef and leather from cows. An increase in the demand for one of
the product will result in a fall in the price of the other.
Competitive supply refers to goods that are produced with the same resources
such that resources used for one good cannot be used to produce the other.
Examples include wheat and maize. An increase in the demand for one of them will
cause a rise in the price of the other.
Consumer surplus is the difference between what consumers are willing and able to
pay for a unit of a good vs. what they actually pay.
Producer surplus is the difference between the revenue the producers receive from
the sale of a unit of good vs. what they are willing to receive.
See the diagram below for an illustration of consumer and producer surplus.

Unit 1.2: Elasticity
Price Elasticity of Demand (PED) refers to the responsiveness of a quantity

demanded of a commodity to changes in its price, ceteris paribus. It involves a
movement along the demand curve in response to price changes. The formula for
this is:
Percentage change in the Qd of Good A

PED of Good A =
Percentage change in the price of Good A
The PED is usually negative, as there is an inverse relationship between the price
and Qd of the good.
Magnitude of PED:
PED > 1 suggests that demand is price elastic, meaning that a given percentage
change in price results in a larger percentage change in Qd, ceteris paribus.
PED < 1 suggests that demand is price inelastic, meaning that a given percentage
change in price results in a smaller percentage change in Qd, ceteris paribus.
PED = 1 suggests that demand is unitary price elastic meaning that there is a
proportionate change in Qd when given a percentage change in price, ceteris
paribus.
PED = 0 suggests perfectly price inelastic demand. PED = ∞ suggests perfectly price
elastic demand. Both are reflected in the two diagrams below.

Relationship between PED and TR – when demand is price elastic, lowering the
price results in a rise in TR, while raising the price results in a fall in TR. This is
reflected below.
On the other hand, when demand is price inelastic, lowering the price results in a
fall in TR, while raising the price results in a rise in TR. This is reflected below.
When demand is unitary price elastic, there is no effect on TR.
Determinants of PED
• Availability of substitutes – greater availability and closeness of substitutes
results in a higher PED.
• Nature of the good or service – demand for food is relatively price inelastic
because it is a necessity.
• Degree of necessity – the greater the necessity, the lower the PED.
• Proportion of income spent on good – the lower the proportion, the lower
the PED.

Cross Elasticity of Demand (XED) refers to the responsiveness of a quantity
demanded of a commodity to changes in the price of another, ceteris paribus. It
involves a shift in the demand curve of Good A in response to price changes of Good
B. The formula for this is:

XED of Good A and B =
Percentage change in the price of Good B
Magnitude of XED:
If XED > 0 (positive), the goods are substitutes. An example is coffee and tea.
If XED < 0 (negative), the goods are complements. An example is computer and
computer software.
If XED is a large positive value, the two goods are very close substitutes. If XED is
a large negative value, the two goods are very close complements. If XED is 0,
the two goods are unrelated.
Diagrams reflecting complement and substitute goods are below.
Determinants of XED

• Degree of substitutability of complementarity

Income Elasticity of Demand (YED) refers to the responsiveness of a quantity
demanded of a commodity to changes in income, ceteris paribus. It involves a shift in
the demand curve in response to income changes. The formula for this is:

YED =
Percentage change in income
Magnitude of YED:
If YED > 0 (positive), this suggests that the good is a normal good and income
inelastic.
If YED > 1 (greater than one), this suggests that the good is income elastic and are
generally luxuries.
If YED < 0 (negative), this suggests that the good is an inferior good.
Determinants of YED
• Nature of goods
• Level of household income
Price Elasticity of Supply (PES) refers to the responsiveness of a quantity supplied

of a commodity to changes in its own price, ceteris paribus. It involves a shift along
the supply curve in response to price changes. The formula for this is:
Percentage change in the Qs of Good A

PES =
Percentage change in price of Good A
Magnitude of PES:
If PES = 0, the Qs remains constant despite any changes.
If PES is between 0 and 1, a change in price leads to a less than proportionate

change in quantity supplied.
If PES = 1, a change in price leads to a proportionate change in quantity supplied.
If PES is between 1 and infinity, a change in price leads to a more than

proportionate change in quantity supplied.
If PES = ∞, any amount will be supplied at a certain price but none lower. See
diagram below for representation.

Determinants of PES
• Existence of spare productive capacity
• Availability of stocks
• Factor mobility
• Barriers to entry
Applications of Elasticity Concepts
PED in maximizing total revenue

• Where demand for the product is price elastic, the price can be lowered to
increase TR.
• Where demand is price inelastic, the price can be raised to increase TR.
Diagrams are reflected earlier in the notes.
XED in maximizing total revenue

• Where XED is positive and high, one has to monitor the situation of their
competitors and react to their circumstances.
• Where it is negative and high, one is able to plan by monitoring the situation
of the complement goods.
YED in maximizing total revenue

• Primary Producers: raw materials such as rice has low YED, thus there is no
need to produce more in reaction to higher incomes.
• Secondary Producers: more income elastic, higher incomes will mean higher
demand.
• Tertiary Producers: very income elastic.

Unit 1.3: Government Intervention
Taxation – defined earlier
Taxation to raise revenue: the government will wish to maximize the tax yield.
Governments will have to consider demand and supply. The tax yield is greater,
ceteris paribus, when demand is relatively price inelastic. This is reflected in the
diagrams below.
Taxation to discourage consumption of a good is more effective when demand is

price elastic as in response to the higher price, the quantity demanded drops by
a larger proportion. This is reflected in the diagrams below.

Subsidies to encourage consumption of a good are more effective when demand
is relatively price elastic. This is reflected in the diagrams below.
Incidence of Taxation refers to the distribution of the burden of taxation; falling on

the producer or consumer. This depends on the relative price elasticity of demand
and supply of the good.
Case A: Demand is price elastic relative to supply – burden falls on the producer
Case B: Demand is price inelastic relative to supply – burden falls on the consumer

Case C: Supply is price elastic relative to demand – burden falls on the consumer
Case D: Supply is price inelastic relative to demand – burden falls on the producer
Distribution of subsidies between producers and consumers is similarly affected by

differing price elasticity in demand and supply.
Case A: Demand is price inelastic relative to supply – consumers benefit more

Case B: Demand is price elastic relative to supply – producers benefit more
Price controls refer to the setting of minimum of maximum prices by the

government (or private organizations) such that prices are unable to adjust to their
equilibrium level. This results in market disequilibrium and shortages and surpluses.
Price ceiling – legal maximum price that is set below the market equilibrium price. It
is usually to allow low-income households to afford essential goods and services,
achieving fairer distribution. An example is illustrated in the diagram below. Other
examples include rent and food price controls.
Consequences for the Economy and Stakeholders

• Shortages
• Non-price rationing
• Parallel/underground markets
• Under-allocation of resources and allocative inefficiency
• Negative welfare impacts

• Consequences for related markets
Price floor – legal minimum price that is set above the market equilibrium price. It is
usually to transfer income from consumers to producers, increasing producer
income. An example is agricultural price support. Another example is the minimum
wage to ensure the welfare of low-wage workers. An example is illustrated in the
diagram below.

• Surpluses leading to waste and price depression through dumping
• Firm inefficiency
• Overallocation of resources to production and allocative inefficiency
• Negative welfare impact
Minimum wage serves to guarantee an adequate income to low-wage workers. This

is reflected in the diagram below.

• Labor surpluses and unemployment
• Illegal workers at wages below minimum
• Misallocation of labor resources
• Misallocation in product markets
• Negative welfare impacts

Unit 1.4: Market Failure
Market Failure is defined as the failure of the market to achieve efficiency in the
allocation of society’s resources, resulting in an over-allocation of resources or an
under-allocation of resources in the absence of government intervention.
Social efficiency is achieved where the marginal benefit to society (MSB) is equal to
the marginal cost to society (MSC). There must be perfect competition and no
externalities. Reductive examples of welfare loss due to over or underproduction are
reflected in the diagram below.
Externalities are additional costs or benefits to society, over and above those
experienced by the individual producer or consumer.
Cost and Benefit Concepts
Marginal Private Cost and Marginal Private Benefit refers to the cost and benefit
to consumers and producers respectively of the consumption or production of an
extra unit of good.
Marginal External Cost and Marginal External Benefit refers to the third party
spillover effects of production or consumption that are experience by those other
than producer or consumer. They create a divergence between private and social
costs or benefits.
External Benefit or Positive Externalities refer to benefits from production or

consumption experienced by people other than the producer or consumer.
External Costs or Negative Externalities refer to costs borne by third parties who
are not involved in the consumption or production activity and are not compensated
for.

Marginal Social Cost and Marginal Social Benefit refers to the full/true benefit or
cost to society of an extra unit of good consumed or produced. It is the sum of
private and external cost and benefits.
Source of Market Failure

• Externalities
• Missing market for public goods
• Common access resources
• Asymmetric information
• Monopoly power (market structure)
Case 1: Negative externalities arising from production and government

measures (taxes/tradable permits vs. legislation) – example of a power plant using
coal to generate electricity
Solution Evaluation
Taxation – to internalize the external It forces the firm to take into account the
cost of production. When the tax is equal full social costs and incentivizes
to MEC, the MPC curve will be shifted to production of cleaner technology. The
MSC and attain a new socially efficient tax is variable and allows the tax on
equilibrium. other areas to be eased.
However, there is difficulty measuring

the true amount required to tax and may
harm international competitiveness.
Tradable Pollution Permits – setting a Incentivizes cutting back on emissions
limit on the amount of pollution those and is a relatively low-cost procedure.
firms can discharge. Cleaner firms can Setting a limit or cap on the actual
sell off their remaining pollution credits amount may yield better results. It also
and those who pollute more have to buy. encourages firms to reduce emissions
Incentivizes reduction of emissions. further to sell off any remaining
pollution permits.

However, it can be administratively
costly and will not lead to efficiency
unless the efficient level of total
emissions is known. Firms with greater
financial muscle may see no point in
cutting back and the market could
under-estimate the cost of pollution,
underpricing the permits. Technical
information is also limited and political
favoritism is a threat.
Legislation – controlling business Simpler and easier to operate than
activities through licenses, setting taxes. Penalties and regular inspections
standards, laws and rules. Requires firms will ensure better results in cracking
to install equipment and comply with down on producers.
tests.
However, it creates no market-based
incentives and makes no distinction
between firms that are cleaner and
those that are not. There may be
problems of enforcement. Lack of
technical information may be a
hindrance.
Case 2: Positive externalities arising from production (subsidies vs. provision) –

example of training for workers
Solution Evaluation
Subsidies – can be granted to firms that Subsidizing good practices incentivizes
offer training, internalizing such external firms to adopt more good practices. It
benefits. also incentivizes firms to send workers
for training, raising overall labor
productivity and increases income levels
for workers.
However, it is difficult for the

government to estimate the level of
subsidy deserved. The cost of the
subsidies may also imply an opportunity
cost, causing the government to cut
back spending on other areas.
Direct Provision – to provide vocational Helps to create jobs and generates
training courtesy of the state by setting temporary income.
up training centers.
However, the costs incurred are a
limitation, as is the quality of the
expertise sources and the difficulties in
diagnosing the needs of the labor
market. There is also time lag in the
implementation of the process.
Case 3: Negative externalities arising from consumption (taxes vs. legislation

and information provision) – example of alcohol abuse
Solution Evaluation
Taxation – shifting the MPC curve to the Allows the government to raise revenue
left, reducing market output to the and use it to compensate affected
socially optimal output and correcting parties, although there is difficulty
the over-allocation of resources. measuring the external cost and may
even encourage smuggling.
Taxation might not work as demand for

such goods may be price inelastic and
any tax would hurt the lower-income
groups more.
Legislation – enacting laws prohibiting Simple and straightforward policy,
the production or sale of alcohol, although enforcement and penalties
reducing demand and shifting MPB to must be up to the task.
MSB.
Information Provision – education by This is a long run policy that will change

the government to discourage the consumption habits, though the cost of
consumption of alcohol, shifting MPB to such policies will be high. It is also a long
MSB. and costly process to take with no
guaranteed outcome.
Case 4: Positive externalities arising from consumption (subsidies vs. legislation

and direct provision) – example of vaccinations
Solution Evaluation
Subsidies – granted to the forms It still permits markets to operate and
providing the vaccines, shifting MPC to ensures firms pass on the benefits to
MPC-subsidy, attaining a socially consumers and can be adjusted in
efficient equilibrium. response to the magnitude of the
problem.
However, success depends on the

accuracy of measuring the exact value of
external benefits. It is also costly and
may result in the imposition of more
taxes on the people.
Legislation – promoting greater Straightforward and simple policy but
consumption of vaccines, such as requires proper enforcement and
mandating vaccination at birth. resources to regulate.
Direct Provision – the government The quality and quantity is decided by
identifies the shortfall and provides for the government; most likely to be
it. The government could also take over socially optimal.
the provision of such goods.
However, it is difficult to gather enough
information to estimate the right
amount. May also require high taxes and
denies choice of services from the
private sector.

Merit goods – goods or services that have been deemed socially desirable by the
government to society.
Demerit goods – goods or services that have been deemed socially undesirable by
the government to society.
Public goods – goods that would not be provided at all in the free market. Is
characterized by its non-excludability and non-rivalry. Governments usually directly
provide such goods.
Common access resources – typically natural resources such as fishing grounds,

forests etc. They are resources for anyone who has free access and has rivalry in
consumption. They are in danger of over-consumption and threaten sustainability.
It may also result in environmental problems and reduction of resources,
suggesting a fall in the PPC. Government responses include pollution taxes, cap
and trade systems, legislation and use of renewable energy.
Asymmetric information – one party in an economic transaction has access to

more information or better information than the other party.
Adverse selection – products of different qualities are sold at a single price because
buyers and sellers are not sufficiently informed.

Economics Higher Level – Section 1: Microeconomics
Unit 1.5: Theory of the Firm
Unit 1.5.1: Production and Cost
Fixed factor of production – an input that cannot be increased within a given time
period
Variable factor of production – an input that can be increased within a given time
period
Law of Diminishing Marginal Returns – as more and more units of variable inputs
are added to a given amount of a fixed input, there will come a point in time where
each additional unit of the variable input will add less to total output than the
previous unit of input.
Total product (TP) – sum of all products

Average product (AP) – TP over quantity of labor
Marginal product (MP) – change in TP
Production is in three stages:

• Stage of increasing MP
• Stage of diminishing but positive MP
• Stage of negative MP
Relationship between TP and MP – MP is derived from the gradient of the TP

curve.
Relationship between TP and AP – AP is given by the slope of the ray from the
origin to the relevant points on the TP curve.
Relationship between AP and MP – if AP = MP, the average will not change. If AP <
MP, the average will rise. If AP > MP, the average will fall.
Explicit costs – payments made by a firm to outsiders to acquire resources for use in
production
Implicit costs – the sacrificed income arising from the use of self-owned resources
by a firm
Economic costs – explicit and implicit costs
Accounting profit – total revenue minus explicit cost

Economic profit – total revenue minus economic cost, can be negative, positive or
zero
Normal profit – total revenue is equal to total economic costs, and can also be
defined as the minimum amount of revenue that a firm must receive so that it will
keep the business running as opposed to shutting it down for other ventures.

Supernormal/abnormal profit – total revenue is more than total economic costs
Subnormal profit – total revenue is less than total economic costs
Fixed costs – total costs of fixed factors, which do not vary with output
Variable costs – total costs of variable factors, which vary with output
Total costs – TFC + TVC
Average costs = total cost/total output

Average fixed cost = total fixed cost/total output
Average variable cost = total variable cost/total output
Marginal cost = change in total cost/change in total output or change in total
variable cost/change in total output
MC, AFC, AVC and AC are reflected below.
Relationship between MP & MC and AP & AVC curves

Representation of the Long-run Average Cost Curve
Increasing returns to scale means a proportionate increase in inputs will lead to a

more than proportionate increase in output.
Constant returns to scale means a proportionate increase in inputs will lead to a
proportionate increase in output.
Decreasing returns to scale means a proportionate increase in inputs will lead to a
less than proportionate increase in output.
Economies of scale refer to the reduction in average cost enjoyed from the growth
in production scale of the form or the growth of the whole industry.
Internal economies of scale include:

• Specialization and division of labor
• Indivisibilities e.g. machinery
• Container principle i.e. surface area to volume ratio
• Organizational and managerial economies
• Research and development
• Bulk buying
• Marketing
• Financial advantages
Internal diseconomies of scale include:

• Bureaucracy
• Communication problems
• Absence of personal element

Unit 1.5.2: Perfect Competition
Characteristics of PC:
• Infinite numbers of buyers and sellers
• Homogenous product
• Free entry and exit of firms
• Perfect knowledge
• Perfect mobility in factors of production
• Negligible transport cost
Examples of PC include small rice producers in Indonesia and Japan.
Demand curves of the PC industry and PC firm are reflected below.
The revenue curves of the PC firm are reflected below (TR and P=AR=MR=Demand)
Profits of the PC firm are maximized at the output level where MR = MC and MC
curve cuts the MR curve from below. This is reflected in the diagram on the next
page.

Shutdown conditions of the PC firm in the short run
Case 1: short-run equilibrium when the firm is earning supernormal profit, i.e. TR >
TC. The firm earns profits in excess of what is necessary to compel remaining in the
industry. This will attract new firms to join in the long run.
Case 2: short-run equilibrium when the firm is earning normal profit, i.e. TR = TC.
The firm earns just enough to cover all of its economic costs.

Case 3: short-run equilibrium when the firm is earning subnormal profit, i.e. TR < TC.
The firm will attempt to minimize losses by either continuing production or shutting
down. The firm has to decide whether to shut down by checking if revenue covers
its variable costs.
Case 3a: subnormal profit where TR > TVC or AR > AVC. The firm should continue
production.
Case 3b: subnormal profit where TR = TVC or AR = AVC. The firm is indifferent,
but it will continue if there is optimism and already has a decent labor force and
customer loyalty in addition to maintaining the machines.
Case 3c: subnormal profit where TR < TVC or AR < AVC. The firm should shut
down.

Shutdown price – the price that enables a firm to cover its variable costs in the
short run. If the shutdown price is not reached, the firm will shut down in the short
run.
Breakeven price – the price that enables a firm to make normal profit in the long
run and cover its total costs. If the breakeven price is not reached, the firm will shut
down for good.
Due to the absence of barriers to entry, the free exit and entry of firms is what
results in PC firms making only normal profit in the long run.
Case 1: if existing firms are making supernormal profits, this will attract potential
firms to enter the industry and increase supply, causing the market price to fall. The
supernormal profits are competed away.
Case 2: if existing firms are making subnormal profits, this will cause some firms to
leave the industry. Supply will decrease and the market price will rise, causing the
smaller number of firms to earn normal profits.

Case 3: Ultimate long-run equilibrium of the PC industry is reflected below.
Productive efficiency occurs at the level of output where the LRAC is minimum and
allocative efficiency occurs where P = MC. At E, both are achieved.
Evaluation of PC
Good Bad
Productive efficiency (minimum AC) – Unable to reap economies of scale – a
the firm is using the minimum amount of PC firm is unable to enjoy the cost
resources from society’s viewpoint to savings that come with large output.
produce. It is operating at full capacity Therefore, PC is untenable for industries
and cost inefficient firms cannot stay in such as cars, aircraft, and aluminum.
business in the long run. There is also no
need for advertisement due to
homogenous product.
Allocative efficiency (P = MC) – when P Lacks incentive and funds for R&D –
= MC, the consumer values the good as due to perfect knowledge and free entry
much as it costs to produce that unit. of firms, any advantage will be
There is no under or over production of competed away very quickly.
the good to meet consumers’ needs.
Resources are efficiently allocated.
Consumer sovereignty and profit Homogenous products – unable to
motive – firms have no market power cater to the varying preferences of
and no ability to manipulate prices. consumers in terms of size, quality,
Resources are also produced according design, color and style.
to consumer needs and wants.

Unit 1.5.3: Monopoly
Defined as a firm that is the sole supplier of an industry.
Characteristics of a Monopoly:
• One seller with many buyers
• Unique product
• Formidable barriers to entry
o Lack of availability of inputs
o Administrative and legal barriers e.g. regulations and patents
o Branding and image
o High start-up cost
o Natural monopoly – a firm that has economics of scale so extensive
that the single firm can produce for the entire market at a lower AC
than two or more. Examples include water, gas, railroads, electricity
etc. Competition is wasteful as it leads to duplication of extensive
networks.
o Technical superiority
o Predatory pricing
Demand = AR and MR curves are reflected in the graph below. The demand curve is
also the AR curve, as price = AR. The MR curve is downward sloping and lies below
the AR curve.
Price and Output decisions of a Monopolist: he can choose to either lower price or
lower output but not both. The monopolist will never produce a quantity that is on
the price inelastic portion of the demand curve. Revenue maximization will see him
produce at output where MR = 0 to maximize TR. Profit maximization will see
him produce at output where MC = MR (and MC cuts MR from below).
The monopolist in the short run can earn supernormal, normal or subnormal profit.
In the long run, the monopolist would rather shut down than suffer subnormal
profit, though in rare cases may not at the request of governments.

Case 1: Monopolist earning supernormal profits in the short-run (diagram below)

Case 2: Monopolist earning normal profits in the short-run
Case 3: Monopolist incurring subnormal profit in the short-run

Equilibrium positions of profit maximization vs. revenue maximization reflected in
the diagram below:
Price discrimination – when a producer sells the same commodity at different

prices, for reasons not associated with differences in the costs of production. It will
benefit a firm if it increases total profits.
• Motives of price discrimination:
o Increase profits
o Gain access to foreign markets
• Three conditions necessary
o Market power required
o Prevention of resale and ability to separate markets
o PED must be different in the two markets
Evaluation of Monopoly
Good Bad
Internal economies of scale – Persistence of profit – Barriers to entry
monopolies can exploit internal makes it possible for the monopolist to
economies of scale and in the case of earn supernormal profit even in the long
natural monopolies, are in society’s best term. Accumulation would be
interests. objectionable if it was not redirected to
R&D.
It may aid innovation – Only monopoly Allocative inefficiency – the monopolist
profits can finance enormous projects produces below the optimal level of
for R&D programs. Furthermore, profit output due to its tremendous market
motive and immunity from competition power. The monopolist is able to restrict
means that the firm can capitalize on output and set prices higher than
any benefits from cost savings as a result competitive levels.
of R&D.
Greater stability – the firm is better Productive inefficiency – the
placed to bear a period of business monopolist is producing under
uncertainty due to its ability to fall back conditions of excess capacity.
on its accumulated profits. It does not

need to reduce employment, benefiting
society.
Less advertising expenditure – the Complacency – lack of competition
monopolist does not have to worry leads to inefficiency and lessens the
about competition. need to meet the needs of consumers.
Political domination – powerful
monopolies can exert power on a
political party.
Legislation and regulation to reduce monopoly power

• Protecting competition (anti-trust)
• Legislation to regulate mergers
• Marginal cost pricing – forcing the firm to price their products at MC for
allocative efficiency
• Average cost pricing – forcing the firm to price their products at AC,
allowing the firm to make normal profit while being more efficient than
market solutions, though it may discourage R&D investment
• Nationalization – defined as the transfer in ownership of a firm from private
sector to government ownership.
• Trade liberalization – reducing barriers to trade e.g. tariffs and quotas

Unit 1.5.4: Monopolistic Competition
Defined as a situation where there are numerous firms competing but each firm
does have their own degree of market power.
Characteristics of Monopolistic Competition:

• Large number of firms
• Slightly differentiated products – may result in non-price competition e.g.
promotions
o Physical differences
o Location
o Differences in service
o Consumer loyalty
• Free entry and exit
Output and price determination in monopolistic competition
Case 1: Supernormal profit in the short-run
Case 2: Normal profit in the short-run (breakeven; AR = AC or TR = TC)

Case 3: Subnormal profit in the short-run – if this is the case; AR must at least cover
AVC to continue production.
Long-run equilibrium under monopolistic competition – when existing firms earn

supernormal profits in the short run, new firms will be attracted. This will result in:
• Each firm having a smaller market share and lower demand for its
product
• Demand curve of the firm will shift leftward and slope is gentler due to
the existence of substitutes
• AR will shift to where it is tangent to the AC curve: AR = AC
• No more firms will enter.
When existing firms are making losses, firms will leave. This will result in:
• Each firm having a larger market share and higher demand for its product
• Demand curve of the firm will shift rightward and the slope will be
steeper due to decreased substitutes
• AR will shift rightward until AR curve is tangent to the AC curve, making
normal profit
• No more firms will exit.
Evaluation of Monopolistic Competition
Good Bad
Product variety – there is a large Allocative inefficiency – the consumer
number of firms that differentiates itself values an additional unit of the good
from its competitors. more than it costs society to produce it,
this not enough is produced.
Income distribution – the firms will earn Incentive and funds for development
normal profit in the long run and thus are limited – supernormal can only be
will not lead to greater income earned in the short-run and firms are
inequality. usually small and lack R&D funds due to
the free entry and exit of firms.
Higher price and lower output than in

PC under same cost conditions –
however, there is a larger variety.
Productive inefficiency – excess
capacity: empty tables, lack of queues,
etc. Some argue that this is
compensated by the proliferation of
product differentiation.

Unit 1.5.5: Oligopoly
It is a market dominated by a few sellers who between them share a large

proportion of the market.
Characteristics of an oligopoly include:

• A few dominant firms (concentration ratio: total value of output of the n
largest firms divided by total output value of the industry)
• Standardized or differentiated product
• Substantial barriers to entry
• Mutual interdependence of firms
• Price rigidity
Behavior of Oligopolistic Firms:
Case 1: A collusive oligopoly – in an attempt to maximize industry profits, they

agree to restrict competition among them and maximize their combined profits.
They form a cartel – a formal collusive agreement and behave like a monopoly. The
graph is illustrated below. Cartels usually fail due to the incentive to cheat, cost
differences, different demand curves, possibility of a price war, recessions and
lack of barriers to entry.
Case 2: A competitive oligopoly – firms compete to gain a larger share of industry

profit for themselves. The Kinked Demand Theory is illustrated below to explain
price rigidity. If price is increased above the kink, the sales revenue declines. If
price is decreased below the kink, the sales revenue declines as well. The
discontinuous MR also results in price rigidity, as despite changes in MC, there is
still no change in price and output.

Role of Non-Price Competition
Due to the risks associated with price competition, this is the alternative. This is
favorable as oligopolies have considerable financial resources to devote to such
endeavors and the development of new products gives them a competitive
edge. Product differentiation also increases a firm’s profit position without risk
of immediate retaliation.

Unit 1.5.6: Objectives of Firms
Profit Maximization – the difference between TR and TC. To reach this, a firm must
produce at MC = MR.
Cost plus Pricing – many firms add their profit margin to the AC. P = AC + markup.
Sales revenue maximization – high revenues can enable an easier time obtaining
loans from banks. To reach this, a firm must produce at where MR = 0 as TR will be
at its peak then.
Growth maximization – to maximize sales volume as opposed to other objectives

to increase the size of the firm
Profit satisficing – aiming for a moderate profit level to keep all stakeholders happy

Economics Higher Level – Section 2: Macroeconomics
Unit 2.1: Level of Overall Economic Activity
Macroeconomic objectives
• Economic growth – steady rate of growth
• Employment – low level of unemployment
• Price stability – low and stable rate of inflation
• Income distribution – an equitable distribution of income
• External stability – favorable balance of payments position
National income – a measure of the value of the output of the goods and services
produced by an economy in a given time period. Factors of production that create
the output will received rewards in the form of wages, rent, interest and profits.
Therefore, as the circular flow of income in a 2-sector (households and firms)
economy will show, income (Y) = output (O) = expenditure (E)
Withdrawals (leakages) – only part of the income received by households and

generated by firms will be passed on in the real world.
• Savings (S) – income that consumers choose not to spend but to put aside
for the future, normally deposited in financial institutions such as banks and
building societies.
• Taxes (T) – this is a withdrawal of money as it is income not spent on goods
and services.
• Import expenditure (M) – goods and services that have been produced in
other countries and purchased by domestic buyers.
• Total Withdrawals (W) = S + T + M
Injections – only part of the demand for firms’ output arises from consumers. The
remainder comes from other sources. These are additional components of AD.
• Investment (I) – the spending by firms on capital goods such as buildings,
machinery and equipment
• Government expenditure (G) – when the government spends money on
goods and services produced by the firm

• Export expenditure (X) – goods and services produced domestically and
purchased by foreigners
• Total Injections (I) = I + G + X
The circular flow of income in a 4-sector economy is shown in the diagram below. In
the real world, W and J are unlikely to be equal.
If W > J, more money is being withdrawn than injected. On the net, lesser income
is spent on domestically produced goods and services.
• Firms cut back on output and purchase fewer factors of production
• Households receive lesser income
• Consumer expenditure falls
• Circular flow decreases in size
If W < J, more money is being injected than withdrawn. On the net, more income
is spent on domestically produced goods and services.
• Firms increase output and hence purchase more factors of production
• Households receive higher income
• Consumer expenditure rises as a result
• Circular flow increases in size
Measure of Economic Activity

• Expenditure approach – adds up all spending by different sectors on final
goods and services produced within a country over a time period. Spending
is broken up into C, I, G and (X-M) and provides a measure known as GDP.
• Income approach – adds up all income earned by the factors of production
within a country over a time period. The result is national income, often used
as a measure.
• Output approach – calculates the value of output by economic sector such
as agriculture, manufacturing, financial etc. in a country over a time period
and sums them up to obtain the total value of all final goods and services
produced in the entire economy.

Gross Domestic Product (GDP) – the market value of all final goods and services
produced over some period of time by productive factors that are located within the
geographical boundaries of the country. It includes goods and services produced by
productive factors owned by foreigners mainly in the form of capital invested
locally.
Gross National Product (GNP) – the market value of all final goods and services
produced over some period of time by productive factors owned by residents of the
country, irrespective of the location of these factors whether within or beyond the
geographical boundaries of the country.
GNP = GDP + net property (or factor) income from abroad
Nominal national income – valued at current prices
Real national income – valued at constant prices after allowing for inflation
GDP deflator – an index of the average prices of all the components of GDP.
Measures the current year level of prices relative to the level of prices in the base
year.
Current year price

GDP Deflator = ×100
Base year price
Nominal GDP
Real GDP = ×100
GDP Deflator
Per capita – per person
GDP
Per Capita GDP =
Total Population
Uses of national income statistics

• Indicates a country’s economic performance – real GDP facilitates the
calculation of a country’s economic growth rate. The formula for economic
Real GDP Year 2 – Real GDP Year 1
growth is as follows: × 100%
Real GDP Year 1
o Expenditure statistics – breaking down the figure into various
components allows one to deduce the proportion of consumption vs.
investment expenditure or even trade relationships and openness by
examining (X – M).
o Income statistics – reflects income distribution as it shows the
contribution by each type of factor of production.
o Output statistics – indicates maturity and economic structure of the
country by looking at the contribution of each sector, indicating high
and low performers.

• Indicates standard of living – material and non-material well being; income
statistics facilitates examination of material well-being and comparison
between countries.
• Helps private firms plan production and investment – useful for private
firms that are planning their overseas production and investment.
• Helps formulating of government policy – e.g. to determine overall labor
productivity, governments calculate GDP per employed person or hours
worked.
Evaluating National Income Statistics
Problems in measuring welfare between Problems in measuring living standards

countries
Measurement problems such as: Measurement problems such as:
• Inaccuracy of figures • Data collection problems
• Differences in statistical • The unrecorded economy (illegal
processes as well as undeclared legal
activities)
• Non-market economy (non-
monetary sector)
Interpretation problems such as: Interpretation problems such as:
• Differing domestic price levels • True distribution of GDP is not
(Market exchange rates very reflected
from day to day and do not • Composition of output
reflect the relative price (consumption and investment
differences across countries. Use goods while living standards
the purchasing power parity depend only on consumption
rates instead – the rates of goods)
currency conversion that • External costs are not taken into
equalize the purchasing power account
of different currencies by • Sacrifice of leisure time is not
eliminating the differences in considered
domestic price levels. It is found
by taking the ratio of prices in
national currencies of the same
basket of goods and services in
different countries.)
• Differences in the distribution of
income
• Differences in proportion of
national income spent on
different types of goods
• External costs are not taken into
account
• Loss of leisure time

Alternative measures of living standards
• Health indicators such as – life expectancy, infant mortality and maternal
mortality
• Education indicators such as – adult literacy rate, primary and secondary
school enrolment
• Composite indicators such as – Human Development Index and Green GDP
The Business Cycle – periodic but irregular up and down movements in economic
activity, measured by fluctuations in real GDP and other macroeconomic variables.
It is shown below. It has four phases:
• Peak – sharp expansion of real GDP and overheating economy, very high AD
and high inflation rates
• Recession – 2 consecutive quarters of negative growth in real GDP, the
falling of AD and easing of inflationary pressures
• Trough – characterized by high levels of unemployment and low AD. Little
to no inflationary pressures
• Recovery – increased AD and expansion. Inflationary pressures begin to
mount.

Unit 2.2: Aggregate Demand and Aggregate Supply PPC
Aggregate demand – total expenditure on domestically produced final goods and

services in an economy. AD = C + I + G + (X – M). The AD curve is downward sloping,
indicating a negative relationship between GPL and real GDP. This is due to:
• Real income effect – lower GPL leads to more spending by people as real
income rises
• Interest rate effect – lower GPL leads to a decrease in the demand for money
and interest rates, resulting in an increase in purchases and investment
spending
• International trade effect – lower domestic inflation relative to foreign
inflation makes domestic goods relatively cheaper, thus net exports rise and
AD
Determinants of AD
• Consumption
o Consumer confidence
o Interest rates and availability of credit
o Level of disposable income
o Level of wealth of households
o Level of household debt
o Expectations of future prices
• Investment
o Interest rates
o Business confidence
o Corporate tax levels
o Corporate debt
o Improvements in technology
• Government spending
o Economic factors
o Political factors
• Net exports
o Relative changes in income level
o Domestic vs. foreign prices
o Exchange rate
o Changes in level of trade protection
Aggregate supply – the value of goods and services produced in an economy (real
GDP) at different price levels over a particular time period. The supply curve shows
the relationship between real output and GPL. Higher prices entice industries to
produce more. However, an economy cannot sustain a production level that is
beyond its full-employment output.
Short-run aggregate supply (SRAS) is defined as the time period where factors of
production do not change in response to price changes. This applies to wages. It is
upward sloping as the LDMR compels firms to increase output only when there is an
increase in GPL.

Factors influencing the SRAS curve – leftward shift indicates fall in SRAS while
rightward indicates a rise
• Changes in prices of inputs
• Changes in business taxes and subsidies
• Supply shocks – events that have a sudden and strong impact on SRAS e.g.
bad weather causing a fall in harvest
Long-run aggregate supply (LRAS) is where the prices of all resources including
labor are flexible so as to reflect fully any change in price levels.
Classical theory states that a market economy would automatically tend toward full
employment output level with no unemployment in the long run, advocating
laissez-faire approaches. It assumes:
• A competitive market
• Flexibility of prices
• Full employment of resources
• Profit motive
• Price mechanism crucial in allocation of resources
Characteristics of Classical LRAS:

• Supply creates its own demand – the production of goods and services will
generate income and expenditures sufficient to ensure that they are sold.
• The equilibrium level of real national income at any time was a point of full
employment. Price flexibility provides a self-correcting mechanism to
restore full employment.
• Changes in AD only affect GPL and not real output in the long run
• Saving leads to investment and thus growth
The model is illustrated below.

Keynesian theory advocates government intervention.
Characteristics of Keynesian LRAS:

• Prices and nominal wages are inflexible
• The economy is able to be in equilibrium below full employment output level
• AS up to full employment output level is determined entirely by AD
• A rise in saving does not translate to investment
The model is illustrated below.
Factors influencing LRAS over the long-term (illustrated below)

• Changes in technology
• Changes in quantity of resources
• Changes in quality of resources

Equilibrium national income exists when there is no tendency towards a
contraction or expansion of national income and this level will be maintained unless
the economy is disturbed. It occurs when demand intersects SRAS. It is shown in
both the Classical and Keynesian examples below.
Impacts of changes in short-run equilibrium – increase in AD and increase in SRAS is

reflected below.
Long run equilibrium and full employment level of national income – AD cuts AS at
the full employment level of real GDP.

Inflationary gap refers to when the actual output exceeds the full employment
national income. Actual output > potential output. It implies that there is excessive
AD relative to the level that would give rise to full employment. In the classical
model shown below, it implies that unemployment is less than the natural rate of
unemployment and that the equilibrium level of real national income is above the
full employment level.
Deflationary gap refers to when the actual equilibrium national income is below the
full employment national income. Actual output < potential output. It implies that
there is deficiency in AD relative to the level that would give rise to full employment.
It shows that unemployment is higher than the natural rate and that the equilibrium
level is below full employment.

The Keynesian Multiplier is an impact on real GDP due to a change in any of the
components of AD.
Marginal Propensity to Consume (MPC) refers to the fraction of additional income

that households spend on domestically produced goods and services.
Marginal Propensity to Save (MPS) refers to the fraction of additional income

saved.
Marginal Propensity to Tax (MPT) refers to the fraction of additional income

taxed.
Marginal Propensity to Import (MPM) refers to the fraction of additional income

spent on imports.
Marginal Propensity to Withdraw (MPW) refers to the fraction of additional

income flowed out of the money flow as savings, taxes and expenditures.
Change in real GDP

Multiplier k =
Initial change in injections
1
Multiplier k =
1 − MPC
1
Multiplier k =
MPS
1
Multiplier k =
MPS + MPT + MPM
1
Multiplier k =
MPW (withdrawals = S + T + M)
The Production Possibilities Curve (PPC) illustrates output changes in an economy.

It shows all the combinations of the maximum amount of two goods that an
economy can produce within a certain period, with a certain level of technology and
when all available resources are fully and efficiently employed. The PPC illustrates
concepts such as:
• Scarcity – points beyond the PPC are unattainable combinations due to
limited resources
• Choice
• Opportunity cost – to produce more consumer goods; some capital goods
have to be sacrificed.
• Potential output
• Actual output

Shift of the PPC and reasons
• An outward shifts indicates potential growth (an increase in potential
output). It can be caused by an increase in the quality, quantity of resources
as well as technological improvements.
• A movement of a point from within a point on the PPC boundary indicates
actual growth. It can be caused by expansionary policies and efficient usage
of resources.

Unit 2.3: Macroeconomic Objectives
Unit 2.3.1: Low unemployment
Unemployed – people of working age who are without work and actively seeking
employment or waiting to take up an appointment
Labor force – the number of people who are unemployed plus the number of people
who are employed. They are also known as the economically active group.
Economically inactive – the group comprising of those who are able but unwilling
to work as well as those who are unable to work.
Unemployment rate = number of unemployed/labor force x 100%
Labor force participation rate = labor force/working age population x 100%
Official measures of unemployment

• Claimant rate of unemployment – measure of all those in receipt of
unemployment benefits
• Standardized unemployment rate – the result of national labor force
surveys
Difficulties of measurement
• Hidden unemployment (underestimates)
• Under-employment (underestimates)
o Underground economy and false representation (overestimates)
• Differences in demographics and regions
Consequences of unemployment
• Economic costs
o Loss in real GDP
o Loss of income
o Reduction of tax revenue
o Costs to the government
o Deskilling and hysteresis
• Social costs
o Stress
o Social problems
Types of Unemployment
Full Employment refers to when there is equilibrium in the aggregate labor market.
The unemployment that exists at this point is known as the natural rate fo
unemployment.

Frictional unemployment – unemployment that occurs when workers are in
between jobs, in search of better jobs or waiting to begin a new job. Can also be due
to imperfect information.
Seasonal unemployment – unemployment that occurs because the demand for

certain types of labor fluctuates on a seasonal basis due to variations in needs.
Structural unemployment – caused by structural changes in the economy that

results in some workers being unemployed for very long. There is a mismatch
between the labor skills demanded and the skills supplied. An example due to the
shift to eBook readers from hard-book printing is shown below. Reasons include:
• Changes in demand for particular skills
o Technological changes and automation
o Change in the pattern of demand
o Loss of comparative advantage
o Changes in geographical location of industries
o Labor market rigidities
Cyclical or demand-deficient unemployment is caused by an excess supply of

labor especially when AD rises. It is unemployment that occurs during the
downturns of the business cycle. It is illustrated below.

Policies to deal with unemployment
Demand-deficient unemployment requires expansionary demand-side policies.

• Expansionary monetary policy (fall in interest rates to encourage C and I)
• Expansionary fiscal policy (increasing G)
Evaluation:
• Limited by consumer and business confidence
• Limited by multiplier size
• Time lag of legislation
• Deficit spending
• Government overspending – crowding out effect
• Price instability and unfavorable trade balance
Structural unemployment requires supply-side policies.

• Market oriented policies
o Lowering unemployment benefits and personal income taxes to
encourage people to work
o Deregulating labor markets
• Interventionist policies
o Encouraging retraining of workers
o Geographical mobility and relocation of factories
Evaluation:
• Could increase income inequality
• Spending may not be sustainable
• Receptiveness of the workers
• Market structural rigidities
Frictional unemployment requires supply-side policies.

• Market oriented policies
o Increasing incentives to accept jobs
o Lowering personal income taxes
• Interventionist policies
o Improving information flows between employers and job seekers and
reducing asymmetric information
Evaluation:
• Opportunity cost of government spending
• Mentality of people
Seasonal unemployment
• Education
• Encouraging alternative employment

Unit 2.3.2: Low and stable inflation
Inflation – a period of sustained increase in the GPL in an economy over a period of

time
Deflation – a sustained decrease in GPL in an economy over a period of time
Disinflation – a fall in the rate of inflation
Mild inflation – no more than 5% per annum
Galloping inflation – double or triple digits
Hyperinflation – 1000% onwards, usually leading to breakdown of the country’s

monetary system
Measuring inflation or deflation
1. Consumer price index (CPI) – measuring the changes in the prices of a basket of
goods and services consumed by the average household
CPI Year 2 − CPI Year 1

Inflation or deflation rate = × 100%
CPI Year 1
Price of basket of goods and services in current year
Construction of the CPI – × 100%
Price of basket in base year
Given year price index

Formula to weight the CPI – Weights
Evaluating the CPI

• Allows governments to briefly identify the causes of inflation
• Is useful in formulating wage policies and welfare schemes
• Firms estimate revenue, costs and profit potential
• Is limited by the general basket
• The national average does not consider different geographical and
demographical trends
• Changes in consumption habits
• Does not reflect quality
• Errors in data collection
Core (underlying rate of inflation) – does not include food and energy products
that can have temporary price shocks
2. Producer price index (PPI) – several indices of prices received by producers of

goods at various stages in the production process. Measures price level changes
from the point of view of producers, not consumers.

1. Demand-pull inflation – occurring when AD exceeds aggregate supply when
the economy is near or at full employment, causing upward pressure on prices.
Shown as a rightward shift in the AD curve. This is shown in both the classical
and Keynesian graphs below.
2. Cost-push inflation – occurring when prices are forced upwards by sustained

increases in costs of production, which are not caused by excess demand. This
can also be due to wage push, imported inflation and exchange rates.
Additionally, tax-push inflation and profit-push inflation is also a factor.
Interaction of demand-pull and cost-push inflation – the inflationary spiral. Higher

AD leads to negotiation for higher wages, which pulls SRAS leftwards and maybe
higher spending, pushing AD rightwards more.

Consequences of Inflation
• Redistribution effects
o Household income and savings will fall in real value
o Firms will gain as prices rise faster tan production costs
• Uncertainty will hinder economic growth
• Export competitiveness of the country will also be damaged
Policies to deal with inflation
Demand-pull inflation requires demand-side policies, consisting of monetary and

fiscal policies.
• Monetary policy – the manipulation of monetary variables such as money
supply and interest rate to achieve macroeconomic objectives.
Deflationary monetary policy serves to curb demand-pull inflation by
reducing AD. However, this may not work if business and consumer
confidence is still high. Effect on investment is not guaranteed and this
reduction in inflation is achieved at the cost of lower employment and
economic growth.
• Fiscal policy – the use of government spending and taxation as
instruments to achieve macroeconomic objectives. To keep demand-pull
inflation in check, the government can raise taxation and/or cut government
spending. This directly influences AD and hence the rate of inflation.
However, this may not bring about the desired decrease in consumption and
investment if households and businessmen are optimistic. It is also difficult
to reduce government spending in practice. There will also be lower
employment and economic growth. The increase in taxes may also
disincentivize work. There are also time lags.
Cost-push inflation requires supply-side policies, consisting of monetary and fiscal

policies.
• For wage-push inflation, market-oriented policies include reducing labor
market rigidities and lowering personal income tax rates. However, it may
encourage people to work fewer hours and the former might worsen income
inequality. Interventionist policies include training and education but
takes time and costs a substantial amount before the effects are seen. The
policies are also contingent on the receptiveness of the population.
• For imported inflation, the government may appreciate or revalue the
domestic currency. However, it will make exports more expensive in foreign
currency and imports cheaper in domestic currency. The current account will
worsen. It may also lead to a fall in net exports and hence AD.
• For profit-push inflation, one can adopt more pro-competitive policies
such as antitrust laws, removal of barriers to entry and eliminating trade
barriers. However, it may make it difficult for companies to enjoy economies
of scale. A price ceiling could potentially be another solution.
The short-run Phillips Curve displays the inverse relationship between inflation rate
and the unemployment rate of an economy. As illustrated below, the lower the rate

of inflation, the higher the unemployment rate and vice versa. This can be explained
by the use of an AD-AS model. This is due to a trade-off between inflation and
unemployment.
Stagflation – a situation where there is a combination of low growth, high

unemployment and high inflation.
The long-run Phillips curve represents the long-run relationship between inflation
and unemployment. It is illustrated below. It is vertical at the level of full
employment (no demand deficient unemployment). The theory is that the adaptive
expectations of workers regarding inflation will result in the unemployment rate
moving back to the non-accelerating inflation rate of unemployment (NAIRU) even
with a long-run higher rate of inflation.
Deflation refers to a decrease in GPL. Negative consequences include:

• Decline in national output and rise in demand-deficient unemployment
• Decline in the ability of firms to invest
• Deflationary expectations
• Risk of bankruptcies and a financial crisis

Unit 2.3.3: Economic growth
Economic growth refers to an increase in real GDP over a period of time.
Actual growth refers to the percentage increase in actual output produced during
the given time period considered. It is represented in the PPC as a shift within the
boundaries of the curve. It is represented in the AD-AS model as either a shift in the
AD or SRAS curve.
Potential growth refers to the percentage increase in the economy’s capacity to

produce. It is represented in the PPC as a shift of the boundary outwards, while in
the AD-AS model it is represented as a rightward shift of the LRAS curve.
Causes of economic growth

• Actual growth
o Growth of AD due to a rise in C, I, G, or (X – M) or implementation of
expansionary demand-side policies
o Growth of SRAS possibly due to a fall in factor prices, business taxes
or rise in subsidies
• Potential growth

o Increasing quantity, quality of factors of production and
technological improvements.
Consequences of economic growth

• Increased levels of material living standards
• Enhanced non-material living standards
• Higher tax revenues
• Greater equity – redistribution of income
• Inflation e.g. demand-pull, affecting vulnerable groups
• Possibility of higher structural unemployment especially due to
technological changes
• Lack of sustainability
Consider effects on developing and developed countries.

Unit 2.3.4: Equity in the distribution of income, goods and services
Equity – distribution of income as fair and just.

Equality – equal income distribution across the population.
Causes of income inequality

• Ownership of factors of production is highly unequal
• Prices of factors of production determined in the market vary enormously
Indicators of income inequality

• Size distribution – examining how evenly income is distributed among the
population in intervals of 20% or so
• Lorenz curve – a graphical representation of the proportion of national
income earned by any given percentage of the population in an economy,
illustrated below
• Gini coefficient – a summary measure of the ratio of the area between the
Lorenz curve and the 45-degree line to the whole area below the 45-degree
line. Area A divided by Area (A+B). The closer the value is to 1, the higher the
income inequality.
Poverty – an inability to satisfy minimal consumption needs
Absolute poverty – living below a certain level of income that is necessary to meet
basic needs. The World Bank officially defines it as living on less than 2USD a day.
Relative poverty – living below the prevailing standards of living that are typical in a
society. (Below the poverty line)
Possible causes of poverty

• Low incomes
• Unemployment

• Low levels of human capital
• Low levels of land or capital ownership
• Poverty (vicious cycle)
Possible consequences of poverty

• Low living standards
• Lack of access to healthcare and education
• Social problems
• Inability to realize potential
Taxation – a compulsory contribution imposed by the government on individuals or

firms. They are levied generally for the purpose of obtaining revenue, reducing
production and consumption and to redistribute income and wealth.
Direct taxes refer to a tax that is imposed directly on the individual. The burden
cannot be shifted. Examples are as follows:
• Personal income tax
• Corporate tax
• Capital gains tax – levied on the gains from selling of real or financial assets.
• Property tax
Indirect taxes refer to a tax imposed on the production of goods and services, which
a firm may pass on to consumers via an increase in the prices of goods, and services.
Examples include:
• Sales tax
• Customs duties
Average tax rate – total taxes paid by a person divided by his total income
Marginal tax rate – additional tax paid per additional dollar of income
Progressive taxation – high-income taxpayers pay a larger fraction of their

income than low-income taxpayers: higher incomes have higher ATR levied (MTR
> ATR)
Regressive taxation – low-income taxpayers pay a larger fraction of their income
than high-income taxpayers: higher incomes have lower ATR levied (MTR < ATR)
Proportional taxation – both pay the same fraction: higher incomes have equal
ATR levied (MTR = ATR)
Taxation in redistribution of income

• Progressive personal income tax helps to promote income equality but does
not increase the income of the poor.
• Raising certain direct taxes will affect the rich more.
• However, this may lead to higher risks of tax evasion and reduced work
effort.
Other methods to promote equity include:

• Transfer payments – payments of income which are not a return for the
provision of current factor services
o Means-tested benefits are only available to those below a certain
income level
o Universal benefits are available to everyone
o Evaluation suggests that it is a burden on the government and
always entails an opportunity cost. Not everyone applies for benefits
even if they require it. The level of income above which ineligibility
sets in may be set too high. It also ignores the special needs of many
poor people.
• Subsidized provision – governments offering education and healthcare
services for free or almost free of charge.
o Evaluation suggests that it is a burden on the government and
always entails opportunity costs
• Price controls in markets – minimum wage, food price ceilings, price floors
for farmers etc.
o Evaluation suggests that it leads to market failure and loss of
welfare.
• Investment in human capital – increasing the quality of factors of
production
o Evaluation suggests that it tends to be long-term and has a lag
effect. It also requires subsidies, which is a burden. It is also
contingent on the receptiveness of workers.

Unit 2.4: Fiscal Policy
Refers to the government manipulating the level of government spending and/or

revenue so as to affect the level of AD.
Expansionary policy is when government expenditure is raised and/or direct taxes

are reduced.
Contractionary policy is when government expenditure is cut and/or direct taxes

are raised.
Government revenue is derived from

• Indirect and direct taxes
• The sale of goods and services by government-owned enterprises
• The sale of government-owned enterprises or property (i.e. privatization)
Government expenditure consists of

• Current expenditures
• Capital expenditures
• Transfer payments
A balanced budget refers to a budget where the estimated revenue just covers the
estimated expenditure.
A deficit budget refers to a budget where the estimated revenue falls short of the
A surplus budget refers to a budget where the estimated revenue exceeds the
The two kinds of fiscal policy are automatic stabilizers and discretionary fiscal
policy.
Automatic stabilizers refer to built-in stabilizers, which are left to respond

automatically without action. These include:
• Progressive taxation
• Transfer payments
Discretionary fiscal policies refer to that which entails the use of the government
budget and deliberate manipulation. These include:
• Expansionary fiscal policy – raising G and/or reducing taxes
• Contractionary fiscal policy – lowering G and/or raising taxes
Evaluation of fiscal policy

• Is a direct instrument of demand-management
• Able to target specific sectors of the economy

• Able to affect potential output
• Uncertain effects of tax changes on spending
• Inflexibility of government expenditure
• “Crowding out effect” – reduction in private consumption and investment
due to an increase in government spending
• Time lags (action and effect)
• Limited by the Keynesian multiplier
• Does not deal with supply-side causes
Unit 2.5: Monetary Policy
Refers to the government manipulating money supply or interest rate to influence

the level of economic activities in the country.
Expansionary policy is when money supply is raised or interest rates are reduced.
Contractionary policy is when money supply is cut or interest rates are raised.
The role of central banks

• Banker to the government
• Banker to commercial banks
• Regulator of commercial banks
• Conducts monetary policy
Determination of the rate of interest
Money is defined as anything that is acceptable as payment for goods and services.
The demand for money is a downward-sloping shape. The supply of money is an
upwards-sloping shape.
Monetary policy refers to conscious attempts by the central bank to influence the
level of economic activity by changing the money supply or interest rate.
Expansionary monetary policy increases AD, GPL and real GDP depending on the
model. Illustrated below is the classical model.
Evaluating monetary policy

• Quick implementation
• Incremental adjustments
• However, it suffers from time lags
• Possibly ineffective in a recession
• Conflicting government objectives
• Inability to deal with supply side causes of instability
Unit 2.6: Supply-side Policies

Interventionist policies rely on government intervention and deemphasize the role
of market forces.
Market-based policies “free up” the market and minimize government intervention.
Interventionist policies include:

• Investment in human capital
• R&D
• Provision and maintenance of infrastructure
• Direct support for business/industrial policies
Market oriented policies include:

• Lowering personal income tax
• Lowering corporate tax
• Lowering taxes on capital gains and interest income
• Reduction in unemployment benefits
• Elimination of minimum wage and reduction in trade union power
• Privatization
• Deregulation
• Restricting monopoly power
• Trade liberalization
Evaluating supply-side policy

• Reduces inflationary pressures
• Time lags
• Impact on government budget
• Mixed effects on equity
• Effects on the environment

Economics Higher Level – Section 3: International Economics
Unit 3.1: International Trade
Free Trade – international trade that takes place without any trade barriers e.g.
tariffs, quotas, etc.
Benefits of Trade
• More efficient allocation of resources – specialization
• Acquiring needed resources
• Source of foreign exchange
• Internal economies of scale – a larger market base
• Increased competition
• Lower prices for consumers
• Greater choice for consumers
• Flow of ideas and technology
• Interdependency of countries – reduced hostility
• Trade as an engine of growth
Autarky – self-sufficiency
Absolute Advantage – when a country can produce more of a good with the same
amount of resources / when a country can produce one unit of a good with less
resources than another country
Comparative Advantage – when a country can produce a good at a lower

opportunity cost than another country. Sources include:
• Difference in factor endowments
• Difference in technology
• Changes in exchange rate
• Changes in relative inflation
• Protectionism
• Differences in quality
The World Trade Organization – promoting free trade by abolishing tariffs and other
trade barriers and resolving trade disputes
Restrictions on Free Trade
1. Tariffs – a tax imposed on imports and can be either ad-valorem or per-unit (but
the world supply curve will be shifted upwards either way)
Purposes of Tariffs
• Raising revenue
• Restricting imports and combating dumping (when a firm sells abroad at
a price below average cost or below its domestic price)

• Aims are conflicting as a tariff will not yield much revenue if it is effective in
reducing imports
Effect of a tariff on car imports in a small economy
Before:
Price: P1
Quantity of cars demanded: Q4
Quantity supplied by domestic producers: Q1
Quantity of cars imported: Q1Q4
After:
Price: P2
Gains Losses
Domestic producers Domestic consumers
• Increased revenue – (P1xQ1) to • Higher price – P2
(P2xQ2) • Decreased consumption – Q4 to
• Increased production – Q1 to Q2 Q3
• Increased consumer surplus – • Decreased consumer surplus –
area A loss of area A+B+C+D
Government Foreign producers
• Tariff revenue – area C • Decreased export revenue –
(Q1Q4)xP1 to (Q2Q3)xP1
Society
• Welfare loss – area B+D
(production inefficiency – extra
cost B, consumption inefficiency
– loss of consumer surplus D)
2. Quotas – restrictions on the maximum quantity of imports

Purposes of Quotas
• Reducing the supply of imports causing a higher equilibrium price – if a
good is highly price inelastic, tariffs may not work. As a result of this, foreign
exporters earn higher revenue.
Effect of a quota on car imports in a small economy
Before:
Price: P1
After:
Price: P2
Quantity of cars imported: Q2Q3 (quota amount)
Gains Losses
Domestic producers Domestic consumers
• Increased revenue – (P1xQ1) to • Higher price – P2
(P2xQ2) • Decreased consumption – Q4 to
• Increased production – Q1 to Q2 Q3
• Increased consumer surplus – • Decreased consumer surplus –
area A loss of area A+B+C+D
Foreign producers Foreign producers
• Quota rent – area C: is the gain • Decreased export revenue –
in C higher than the loss in export (Q1Q4)xP1 to (Q2Q3)xP1: is the
revenue? loss in export revenue higher
than the gain in C?
Government Government

• Unaffected • Unaffected
Society
• Welfare loss – area B+D
cost B, consumption inefficiency
– loss of consumer surplus D)
3. Subsidies – a grant provided by the government to firms to lower production

costs and increase output (not to be confused with export subsidies which is
paid for each unit of the good exported)
Effect of a subsidy granted to local car producers in a small economy
Before:
Price: P1
After:
Price: P1
Gains Losses
Domestic producers Foreign producers
• Increased revenue – (P1xQ1) to • Decreased export revenue –
(P2xQ2) (Q1Q3)xP1 to (Q2Q3)xP1
• Increased production – Q1 to Q2
• Increased consumer surplus –
area A
Domestic consumers Domestic consumers

• Unaffected • Unaffected
Government
• Subsidy expense – P1P2xCB
Society
• Welfare loss – triangle ABC
cost P1P2CB which is higher than
producer surplus P1P2CA)
4. Administrative or regulatory barriers – product standards, sanitary standards,

pollution standards, often set to protect domestic producers rather than
consumers by making it difficult and costly for foreign firms to comply
Health and safety regulations

• Protecting public safety and health
• Often an excuse to refuse import of certain commodities or causing hassle
Red tape
• Time consuming and difficult obstacles to imports and reducing quantity
Embargo
• Partial or complete prohibition of the importation and exportation of
particular goods for political and economic reasons
Import license
• An authorization of the importation of certain goods into the country
Evaluating Trade Protectionism
For Against
Infant industry argument – temporary Society and global resource allocation
protection until firms can take loses out – with reference to
advantage of economies of scale comparative advantage, free trade
achieves allocative efficiency on a global
scale. Deadweight loss is often
observed.
National security – certain industries Retaliation – chain reactions and a spiral
cannot be dominated by foreign of increasing protectiveness between
companies e.g. aircraft, weapons, steel countries
Health, safety and environmental Potential for corruption – restrictions
standards – protecting the local may pave the way for bribes and
population smuggling. Revenue can end up in the
wrong pockets.
Anti-dumping and unfair competition – Higher production costs and reduced
protectionism as an appropriate efficiency – incentive for local firms to
response to dumping operate efficiently is also reduced due to

protectionism
Protection of domestic employment – Consumers mostly lose – due to higher
maintaining domestic production prices of protected goods and lower
quantities of goods available in the
market
Overcoming a BOP deficit – correcting Increased costs of production and
the outflow of money from a country reduced export competitiveness –
(when there is an excess of imports over some goods are used as inputs in the
exports) production of some exports, thus
protecting the input good could increase
the cost of producing the export good
Tariffs as a source of government
revenue – more frequent in LEDCs
Strategic trade policy – protection of
high-tech industries (vital to a country’s
development) to aid in achieving
economies of scale
Efforts of LEDCs to diversify –
diversification into a different field
means it will impose barriers on the
imports of products in that field
Wage protection argument – imports
are restricted from low-wage countries

Unit 3.2: Exchange Rates
Exchange rate – the price of a currency in terms of another currency, showing the
rate at which two currencies are exchanged for one another, measuring the external
value of a currency e.g. S$1 = US$0.71 or S$1.40 = US$1
Freely floating exchange rates – freely determined rate by market demand and
supply of a currency e.g. Australia, USA, Japan
Sources of Demand for Currency (E.g. US$)

• Export of US goods and services to foreign countries – demand is derived
from the need for US dollars to pay for US exports
• Short- and long-term capital inflow into the US – making US$-
denominated deposits or purchases of shares and bonds issued by US
companies or FDI into the US requires US$.
• The demand curve is downward sloping. As the price of US$ rises, US
exports and assets will be more expensive and less US$ will be demanded to
purchase US goods and assets
Sources of Supply for Currency (E.g. US$)

• Imports of foreign goods and services into the US – US importers sell US$
to buy foreign currencies to pay for foreign imports (the sale creates this
supply)
• Short- and long-term capital outflow from the US – making foreign
currency deposits of purchases of shares and bonds issued by foreign
companies or FDI into foreign countries requires foreign currency to be
purchased with US$
• The supply curve is upward sloping. As the price of US$ rises, foreign goods
and assets become cheaper and more US$ will be sold to buy foreign
currencies to pay for imports and overseas investment
Changes in exchange rate – caused by shifts of demand and/or supply for the
currency. A rise in exchange rate is termed appreciation; a fall is termed
depreciation.

Causes of changes of demand and supply of a currency
• Changes in long-term capital movements (FDI) – greater profit
opportunities could lead to increased FDI and higher demand for the
currency, causing appreciation. Restriction of foreign investment in the
country could lead to decreased FDI and lower demand for the currency,
causing depreciation.
• Changes in money income – an economic boom leads to higher import
demand and an increase in supply of the currency, causing depreciation.
An increase in foreign income leads to higher export demand and an
increase in demand of the currency, causing appreciation.
• Changes in taste for exports and imports – foreigners favoring a country’s
exports will increase the demand for its currency, causing appreciation.
However, locals favoring imports will decrease the demand for its currency,
causing depreciation.
• Changes in relative interest rates – an increase in the domestic interest rate
attracts short-term capital inflow, increasing the demand for its currency
as higher rates increase the returns on short-term capital. A fall in relative
interest rates caused short-term capital outflow, increasing the supply for
its currency as lower rates decreases the returns on short-term capital.
• Speculation – a self-fulfilling phenomenon, based on expectations
• Changes in relative inflation – if a domestic country suffers from a higher
inflation rate, the price of domestic goods and services rises faster, and
imports become cheaper while exports become dearer. This can lead to an
increase in the supply of the currency and a fall in demand.
Effects of changes in exchange rates
Appreciation (exports are more expensive in foreign currency and imports are
cheaper in domestic currency)
• Inflation rate – cheaper imports reduce inflationary pressures as costs fall,
leading to lower GPL.
• Employment – exports are more expensive to foreign consumers, and
domestic producers sell fewer exports, causing a fall in revenue. (X-M) falls
and AD falls, leading to lower output. Retrenchment and rising
unemployment will follow.
• Economic growth – fall in the value of net exports will lead to lower AD and
real GDP, therefore a fall in economic growth, but cheaper imports may
drive higher growth if they are mainly factors of production as it increases
productive capacity.
• Current account balance – fall in (X-M) could worsen the current account.
Depreciation (exports are cheaper in foreign currency and imports are more
expensive in domestic currency)
• Inflation rate – dearer imports increase inflationary pressures as costs rise,
leading to higher GPL.

• Employment – exports are cheaper to foreign consumers, and domestic
producers sell more exports. Export industries grow and leads to higher
employment as demand-deficient unemployment falls. A rise in (X-M) due to
higher export expenditure and lower import expenditure leads to higher AD
and demand for labor.
• Economic growth – an increase in the value of net exports could lead to an
increase in AD and real GDP. However, an increase in the price of imported
capital goods could lead to an increase in the price of exports, eroding
competitiveness and growth.
• Current account balance – an increase in (X-M) could lead to an
improvement in the current account balance.
Fixed exchange rates – the government fixes the exchange rate by decree, and
commits to a particular exchange rate. It can be revised in the longer term if
necessary. E.g. Hong Kong and Saudi Arabia. To fix the rate, the government has to
buy or sell domestic currency.
To counter upward pressure on its currency (e.g. increase in demand), a

government will step in and sell more of its domestic currency in exchange of
foreign currencies (supply curve shifts right from SSHK to SSHK2). To counter
downward pressure on its currency (e.g. increase in supply), a government will
purchase more of its domestic currency in exchange of foreign currencies (demand
curve shifts right from DDHK to DDHK2). Both are illustrated in the diagram above.
Devaluation refers to the fixing of an exchange rate at a lower level, while a

revaluation refers to the fixing of an exchange rate at a higher level. Both are
officially announced when raising or lowering.
Managed float (“dirty float”) exchange rates – the rate is determined by demand
and supply, but the Central Bank intervenes periodically to prevent excessive
fluctuation.
A currency is overvalued when the exchange rate is higher than the free-market
rate. It is undervalued when the exchange rate is lower than the free-market rate.

Evaluating flexible exchange rate systems versus fixed
For flexible rates For fixed rates

Automatic correction of BOP Uncertainty discourages trade and FDI
disequilibrium – there is no need for – international traders may have more
specific government policies, while fixed confidence in fixed rates, as they will be
rates requite carefully deliberated more sure of their profit levels in
valuation. international business dealings. Inherent
instability will deter long-term
international contracts.
Flexibility to policy makers – Speculation and increased volatility –
governments can use monetary and free-floating systems encourage
fiscal policy to pursue macroeconomic speculation, increasing exchange rate
objectives without external constraints. fluctuations and uncertainty.
A fixed exchange rate system conflicts
with such policies.
No necessity to hold foreign currency
reserves – as opposed to fixed rates, as
reserves must be large enough to ensure
fixing is tenable.
Insulation from external economic
events – prevents a country from
experiencing the full effects of economic
crises or foreign inflation.
Comparison of different exchange rate systems
BOC\System Fixed System Floating System

Government intervention Government over- or The rate is determined
under-values the currency freely by supply and
through buying or selling demand. There is no
in the foreign exchange government intervention.
market.
Degree of certainty Stakeholders have certain There is no certainty and
knowledge about the rate. it can change on a daily
It will not change unless basis, depending on
the government fixes it at changes in demand and
a new rate. supply.
Ease of adjustment There is no adjustment to The rate will respond to
changes in supply and the free forces and there
demand as it is fixed by will be automatic
government intervention. adjustment. Rates can
automatically fall or
increase.
Need for foreign reserves Foreign currencies are Foreign currencies are not
required. required.

Flexibility to policymakers Domestic policy may be The government is free to
constrained by a fixed pursue any desired policy
rate. without reference to a
fixed rate.

Unit 3.3: The Balance of Payments
The balance of payments of a country refers to a summary statement of the

monetary value of all the economic transactions that have taken place over a period
of time between the residents of a country and the residents of all other countries. It
shows all payments made by the country to other countries (debits) and all
payments received from other countries (credits).
Debits refer to when a transaction requires foreign exchange payments (outflows of

money) to abroad. Credits refer to when a transaction earns foreign currencies
(inflows of money) from abroad.
A BOP surplus refers to when the balance has a positive value – inflows are larger
than outflows. A BOP deficit refers to when the balance has a negative value –
outflows are larger than inflows. Both are representative of the BOP before
government intervention through the use of reserve assets.
Current Account (most important component) – the sum of the balance of trade in
goods and services, net income flows and net current transfers.
• BOT in goods – the visible balance (tangible goods), consisting of all exports
and imports of merchandise goods.
• BOT in services – the invisible balance (intangible goods), consisting of all
services rendered or received from foreigners, e.g. transport, tourism, etc.
• Income flows – all inflows into a country of wages, rents, interest and profits
from abroad minus all out flows of wages, rents, interests and profits, e.g.
rental income from abroad, dividend income of stocks in another country.
• Current transfers – unilateral transfers: inflows into a country due to
transfers from abroad minus outflows of transfers to other countries e.g.
monetary gifts, foreign aid, etc.
Capital Account (smallest component) – composed of inflows minus outflows of

funds for capital transfers and transactions in non-produced, non-financial assets.
• Capital transfers – inflows minus outflows for items such as debt
forgiveness, non-life insurance claims and investment grants.
• Transactions in non-produced, non-financial assets – inflows of funds
minus outflows arising mainly from the purchase or use of natural resources
that have not been produced e.g. land, mineral rights, water, patent rights,
franchises, and airspace.
Financial Account (second largest component) – composed of inflows minus

outflows of funds for capital transfers and transactions in financial assets.
• Direct investment (FDI) – measuring inflows minus outflows of investments
in physical capital.
• Portfolio investment – inflows of funds minus outflows arising from
financial investments on stocks, bonds and other instruments as well as
government lending (outflows) and borrowing (inflows).

• Short-term capital movements (“hot money”) – inflow minus outflow of
capital aimed at making returns from different interest rates in different
countries, or returns from expectations of different rate changes.
• Reserve assets (considered only after the capital account) – the “balancing
item”, referring to foreign currency reserves that the central bank of a
country can buy or sell to influence the exchange rate. Drawing on reserves is
an inflow (in event of a deficit) while building up the reserves is an outflow (in
event of a surplus)
Current Account + (Capital Account + Financial Account) = 0 – the deficit/surplus

in the current account is exactly matched by the surplus/deficit in the combined
capital and financial accounts, as reserve assets in the financial account is a
balancing item and can be drawn from or deposited into.
Causes of a BOP Deficit (outflow > inflow):

• Relatively high domestic inflation rate
• Relatively high domestic growth rate
• Loss of comparative advantage
• Overvaluation of domestic currency
• Changes in taste
• Net factor income outflows
• Net unilateral transfer out of the country
• Hot money outflows
• Long term capital gains
Implications of a persistent BOP Deficit (usually not addressed in the short-term

or when due to long-term capital outflows, which can be corrected by property
income inflows)
• If due to lower (X-M), there will be a deflationary effect (decrease in AD),
leading to lower employment and depreciation of the currency and loss of
confidence, leading to imported inflation or depletion of foreign reserves
• If due to high inflation, the foreign reserves will run down and borrowing will
be required. Debt servicing is a concern.
Correcting a BOP Deficit

• Sale of foreign reserves
• Borrowing
• Raising interest rates
• Expenditure reducing – policies that reduce AD and therefore income in
order to reduce demand for imports (contractionary fiscal and monetary
policy)
• Expenditure switching – policies that reduce the amount of import
expenditure and switching this to domestically produced goods, reducing
the current account deficit (protectionism and currency devaluation)
• Supply side policies – increasing the competitiveness of the economy,
decreasing GPL and increasing price competitiveness as well as improving

competitiveness of industries with a comparative advantage, increasing
quantity demanded of exports and solving the deficit
Causes of a BOP Surplus (inflow > outflow):

• Relatively low domestic inflation rate
• Relatively low domestic growth rate
• Competitive exports
• Good infrastructure
• Large FDI
• Presence of common access resources
• Free trade agreements
Implications of a persistent BOP Surplus

• If due to a rise in (X-M), there will be an inflationary effect (increase in AD),
leading to rise in bank reserves, but the country will be allowing other
countries to run a deficit, “borrowing” from it with no interest paid.
• If due to currency appreciation, exports will be more expensive in foreign
currency.
The Marshall-Lerner condition – devaluation/depreciation will improve the current

account balance only if the sum of price elasticities of demand for imports and
exports is greater than 1:
|PEDx + PEDm| > 1
Theoretically, as long as demand for imports and exports are price elastic, the
devaluation/depreciation of the currency should result in an improvement in the
current account as the condition is satisfied. It will worsen if the condition is not
satisfied.
The J-curve effect – a devaluation or sudden sharp depreciation often leads to an

immediate deterioration in the BOP position, followed by a subsequent recovery.
This is due to demand for exports and imports being price inelastic in the short-run
as a result of:
• Information lag
• Consumer habits
• Contractual obligations

Unit 3.4: Economic Integration
Preferential Trade Agreement (PTA) – an agreement that gives preferential access

to certain products from certain countries by reducing or eliminating tariffs, or by
other agreements relating to trade. A member of the agreement will have easier
access to markets of other members for the selected products than countries that
are not members.
Trading blocs – a group of countries that join together in some form of agreement
to increase trade between them and/or to gain economic benefits from cooperation.
The three most common consist of an FTA, customs and monetary unions.
Free Trade Area (FTA) – consisting of a group of countries that agree to gradually
eliminate trade barriers between themselves, while retaining the right to pursue its
own trade policy towards other non-member countries, e.g. NAFTA, EFTA, SAFTA.
Customs Union – consisting of a group of countries that remove trade barriers

between themselves and adopt common external tariffs and quotas with non-
member countries, as well as acting as a group in all trade negotiations and
agreements with non-members, e.g. Russia-Belarus-Kazakhstan, Mercosur, EU-
Turkey.

Common Market – consisting of countries that have formed a customs union and
then proceed further to eliminate any remaining barriers to trade, eliminating all
restrictions on movements on any factor of production, e.g. EU, CARICOM.
Effects of trading blocs
1. Trade creation – when a trading bloc fosters specialization according to

comparative advantage, causing a shift in production from higher cost producers to
lower cost producers in the trading bloc. The goods are obtained more cheaply.
E.g. UK having a comparative advantage over France in lawnmower production

while the EU (with France) had placed a tariff on UK lawnmowers before the UK
joined. When the UK joins the EU, the tariff is removed. This is displayed below.
Effects of trade creation

Gain in consumer surplus: A+B+C+D
Loss of producer surplus: A
Loss of tax revenue to the French government: C
Net gain: B+D

2. Increased competition – induces producers to undertake R&D activities in
process and product innovations, leading to productive efficiency and higher quality
goods.
3. Expansion into larger markets – for firms
4. Economies of scale – a larger market allows a firm to grow large enough for
LRAC to fall and results in lower prices and greater export competitiveness.
Increased trade also enables exploitation of external economies of scale:
improvements in infrastructure of the member nations, etc.
5. Increased investment – enlarged markets lead to firms wishing to take

advantage of the larger market size by investing. Investing within the bloc also
allows firms to escape the tariff or other protection.
6. Improvement in terms of trade – an increased bargaining power with the rest of

the world enables such an improvement.
7. Spread of technology – integration may encourage a more rapid spread of

technology through the sharing of processes and production methods.
However:
8. Trade diversion – when the entry of a country into a customs union leads to a
shift in production away from low cost producers outside the bloc to high cost
producers inside the bloc.
E.g. The UK imported textile from Malaysia, which had a comparative advantage,
but then was compelled to impose the collective EU tariff on the Malaysian product.
This is illustrated below.
Results of trade diversion

Loss of consumer surplus: A+B+C+D

Gain in domestic producer surplus: A
Welfare loss: B+C+D
9. Unequal distribution of gains and possible losses – countries are unlikely to gain
equally from the operation of the bloc, creating potential for conflicts.
Monetary Union – a common market with a common currency and common bank
e.g. EU, Euro, ECB.
Advantages
• Elimination of exchange risk and uncertainty
• Elimination of transaction costs
• Encouraging price transparency
• Promoting more inward investment
Disadvantages
• Reduction in economic sovereignty

Unit 3.5: Terms of Trade
TOT – an index, which shows the value of a country’s average export prices relative
to their average import prices. It is calculated using the following formula:
Weighted index of average export prices

TOT Index = × 100
Weighted index of average import prices
An increase in the price of exports with the price of imports constant means more
imports can be bought with the same quantity of exports.
An increase in the price of imports with the price of imports constant means fewer
imports can be bought with the same quantity of exports.
Prices are measured by a weighted price index using a base year.
If the TOT index has increased, the terms have improved and more imports can be
obtained per unit.
If the TOT index has decreased, the terms have worsened and lesser imports can be
obtained per unit.
Causes of changes in TOT
1. Short term factors

• Availability of substitute goods (import availability)
• Changes in world economic conditions
• Changes in demand for exports and imports
• Changes in global supply
• Changes in the domestic rate of inflation relative to other countries
• Changes in relative exchange rates
2. Long term factors

• Growth in income and/or population, but do consider YED
• Depletion of non-renewable resources
• Changes in productivity and technological developments
• Trade protection (if substantial)
Consequences of changes in TOT
1. Impact on current account (balance of trade)

The outcome depends on the reason for the change in TOT:
• Changes in demand – TOT and trade balance will follow the direction of
change in demand
• Changes in supply – in the case of price inelastic demand, TOT and trade
balance will follow the direction of change in supply, while in the case of

price elastic demand, only trade balance will follow the direction of change
in supply, while TOT will go the opposite direction.
• Changes in exchange rate – depreciation will result in an improving trade
balance only if the Marshall-Lerner condition is met.
2. Impact on global income redistribution

• Improving TOT allows for greater opportunities for growth, while
deteriorating TOT hinders acquisition of imports for production and growth
prospects, as well as standard of living.
3. Impact on LEDCs specializing in primary production

• Impact of short-run fluctuations due to
o Low PED
o Low PES
Poses problems such as fluctuations in prices of primary commodities,
negative impact on export revenue, spending of gains on imported
consumer goods, dependency on primary commodities and fluctuation of
the incomes of primary sector workers
• Impact of long term deteriorations

Poses problems such as a fall in export revenue adversely affecting profits of
firms, leading to a fall in corporate and income tax revenue, as well as
worsening of current account deficits due to falling export prices combined
with low PED, and a rising opportunity cost of imports.

Economics Higher Level – Section 4: Development Economics
Unit 4.1: Sources of Economic Growth and/or Development
Economic Development – a sustainable improvement in living standards that

implies
• Increased per capita income
• Reduced income inequalities
• Better education
• Better health and employment opportunities
• Environmental protection
Increased quantity of resources refers to the physical increase in the amount of

land, labor and capital
Increased quality of resources refers to enabling the same quantity of resources to

produce more output, achieved through increases in productivity due to
technological advances, development of human capital and entrepreneurship
Natural factors – quantity and/or quality of land or raw materials such as mineral
deposits, fuel, soil fertility and favorable climate, e.g. OPEC and oil in the 1970s,
though not a sufficient—or even necessary—condition for growth, e.g. Ghana,
Kenya and Singapore, ROK and Taiwan
Human factors – quantity and/or quality of human capital such as the workforce,
increases in productivity or population of workforce shifts the PPC outwards,
though many suffer lack of complementary factors of production thus leading to
lagging capital growth and causing LDMR to set in
Physical factors – quantity and/or quality of physical capital such as tools,

equipment and factories

Institutional factors – set of rules and laws, norms and conventions e.g. legal
framework, property rights and stable systems
Common characteristics of LEDCs

• Low per capita GDP
• Low standard of loving
• Poverty
• High rates of population growth
• Large urban informal sector
• Low productivity
• High un- and underemployment
• Dependence on agricultural sector
• Imperfect markets
• Poor systems and infrastructure
• Inappropriate taxation structure
• Dependence and vulnerability in diplomacy
The Poverty Cycle
International Development Goals

• Eradicate extreme poverty and hunger
• Achieve universal primary education
• Gender equality
• Reduce child mortality
• Improve material health
• Combat HIV/AIDS, malaria and other diseases
• Ensure environmental sustainability
• Develop global partnerships for development

Unit 4.2: Measuring Development
GDP – market value of all final goods and services produced over some period of
time, usually a year, by productive factors that are located within the geographical
boundaries of the country before provision for capital consumption
GNI – market value of all final goods and services produced over some period of
time, usually a year, by productive factors owned by residents of the country before
provision for capital consumption
Health indicators
• Infant mortality
• Life expectancy at birth
• Maternal mortality
Education indicators
• Adult literacy rate
• Primary school enrolment
• Secondary school enrolment
• Primary school pupil to teacher ratio
HDI Indicators
• Life expectancy at birth
• Mean and expected years of schooling
• Per capita GNI
Disadvantages – no information on income distribution, malnutrition, gender

inequalities and demographic trends

Unit 4.3: The Role of Domestic Factors
Education – increasing knowledge and skills is an investment in human capital and

enables the workforce in an economy to use skills to develop new ideas or import
them from abroad
Health – a developing requires a proper healthcare system, but such a huge merit
good would need to be subsidized therefore giving rise to the need for a large tax
base
Usage of appropriate technology – technology that is suitable for use with existing
factor endowments, both for consumption and in production
Access to credit and micro-credit – lack of inefficiency of banks prevent the ability
of people to get loans and hinders growth and development; microcredit is the use
of very small loans designed to spur entrepreneurship
Empowerment of women – financial and educational empowerment develops not

only themselves but also their society
Income distribution – improvement in income distribution leads to increase in

demand for locally produced goods and services, which encourages production and
promotes local employment and investment—increasing AD in the short-run and
output
Sustainable development – increase in production and consumption to meet the

needs of the present generation without compromising the needs of the future
generation
Infrastructure – essential facilities and services that are necessary for economic
activity to take place, e.g. roads, railways, public utilities, services and
telecommunication systems

Unit 4.4: The Role of International Trade
Trade problems in LEDCs

• Over-specialization in a narrow range of products, usually primary
products with low value-add (the value of a good that is added in each step
of a production process)
• Price volatility of primary products which work with the inelastic PED for
primary products to pose problems for LEDCs
• Inability to access international markets as developed countries impose
higher tariffs from developing countries than on imports from each other
due to protectionism while developing countries impose higher tariffs in
imports from each other
• Long term changes in TOT – e.g. countries specializing in the export of non-
oil commodities have been seeing a deterioration of their TOT, meaning that
they can buy fewer imports for the same amount of exports—reasons
include low YED and PED for primary products and protection of agriculture
and technological advances in agriculture in developed countries.
Result of deteriorating TOT on LEDCs – countries will have to keep increasing

exports to maintain a constant level of imports—constantly increasing opportunity
cost and therefore more resource will be transferred to the production of exports,
increasing the difficulty of achieving diversification of the economy; furthermore,
falling export income could lead to a BOT deficit and BOP problem, resulting in
borrowing and debt traps; lastly, falling export income could harm rural incomes
and increases poverty, affecting tax revenue and thus ability to spend
Trade strategies for growth and development

• Import substitution – deliberate effort to replace major imports by
encouraging domestic industries through use of protectionist measures
• Export led growth – relies on increasing exports through international trade,
accompanied by a reduction in protectionism and greater openness
• Trade liberalization – removal or reduction of trade barriers that block the
free trade of goods and services between countries
• Trading blocs – see unit 3.5
• Diversification – moving from the production and export of primary
products to manufactured and semi-manufactured products

Unit 4.5: The Role of FDI
Foreign Direct Investment – long term fixed capital investment by MNCs or local
companies in countries overseas, e.g. remitting funds or buying existing foreign
enterprises
MNCs or transnational companies – firms that undertake foreign direct investment

and operates in more than one country, running business operations in both home
and host countries—they take their operations overseas as:
• Costs of labor is lower
• The countries may be rich in natural resources
• Some developing countries represent huge growing markets
• Government regulations are still lacking in many developing countries
Benefits to MNCs Benefits to the host nation

• Lower cost of production • Greater employment and
especially for labor intensive economic activity
industries • Increase in corporate and income
• Direct access/proximity to a huge tax revenue
market • Improvement of critical
• Tax holiday schemes, lower infrastructure
regulations or weak labor laws • Fills saving gaps of LEDCs
• Bypassing protective measures • Contributes to foreign currency
earnings
• Brings in knowledge and
expertise which can be
transferred to local companies
• Creates demand for a variety of
services and semi-finished
products
• May provide greater choice and
lower prices to consumers
However, MNCs may stifle competition through exclusivity agreements with host
governments and fail to reinvest profits or even deprive domestic firm of talents
through hiring the best

Unit 4.6: The Role of Foreign Aid and Multilateral Development Assistance
Foreign aid – the help a country receives from the government of a donor country,
through development assistance (economic development through long-term
grants, loans, tied aid, project aid, technical assistance aid and commodity aid)
and humanitarian aid (alleviating poverty and other suffering, through emergency,
medical or food aid)
NGOs – organization that is not part of a government and was not founded by
states—therefore typically independent of governments
IMF – an organization of 184 countries working to foster global monetary

cooperation, secure financial stability, facilitate international trade, promote high
employment and sustainable economic growth and reduce poverty
World Bank – collection of 5 individual organizations to promote economic

development

Unit 4.7: The Role of International Debt
Foreign debt – a nation’s level of external debt—total amount of public and private
debt incurred by borrowing from foreign creditors
Debt crisis – occurs when the level of debt in developing countries exceeds their
ability to pay
Reasons for borrowing from abroad

• Underdeveloped domestic financial markets
• Abundance of loanable funds in international financial markets
• Foreign exchange needed to finance import purchases as well as a source of
investment funds
• To service existing debts, worsening BOP
Consequences
• BOP problems
• Debt trap
• Opportunity costs and lower public investment
• Lower private investment
• Lower economic growth and development
Debt rescheduling – new loans on better terms, longer repayment period and lower
rates
IMF lending and stabilization policies – conditional loans from the IMF for country
to pursue stabilization policies
World Bank lending and structural adjustment loans – conditional loans, forcing
the government to pursue economic and trade liberalization
Debt cancellation – funds can be transferred to development and overcomes heavy

debt, but risks moral hazard and rewards irresponsible governments

Unit 4.8: The Balance between Markets and Intervention
Market-oriented policies – designed to minimize the role of government

intervention and maximize the free operations of demand and supply in the market
Interventionist policies – involves an active role by the government and

manipulation of the workings of the markets in the economy
Benefits of market-oriented policies Detriments of market-oriented policies

• More efficient allocation of • Market failure
resources • Income inequalities
• Economic growth • Development of a dual economy
• Reduced budget deficits
Benefits of interventionist policies Detriments of interventionist policies

• Provision of infrastructure • Excessive bureaucracy
• Investment in human capital • Poor planning and corruption
• Provision of a stable
macroeconomic economy
• Provision of a social safety net

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Economics Higher Level – Section 1: Microeconomics

Unit 1.0: Introduction to Economics

Factors of production – resources, typed into four categories.

A Production Possibilities Curve (reflected below) shows all the maximum

Capital goods – goods such as machinery and equipment

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Allocative Efficiency – a situation where resources are allocated in a way that no

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Indirect taxation – taxes imposed on expenditure.

Subsidy – a payment made by the government to producers to encourage the

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Price Elasticity of Demand (PED) refers to the responsiveness of a quantity

Percentage change in the Qd of Good A

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When demand is unitary price elastic, there is no effect on TR.

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Percentage change in the Qd of Good A

Diagrams reflecting complement and substitute goods are below.

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Percentage change in the Qd of Good A

Price Elasticity of Supply (PES) refers to the responsiveness of a quantity supplied

Percentage change in the Qs of Good A

If PES = 0, the Qs remains constant despite any changes.

If PES is between 0 and 1, a change in price leads to a less than proportionate

If PES = 1, a change in price leads to a proportionate change in quantity supplied.

If PES is between 1 and infinity, a change in price leads to a more than

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Applications of Elasticity Concepts

PED in maximizing total revenue

XED in maximizing total revenue

YED in maximizing total revenue

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Taxation – defined earlier

Taxation to discourage consumption of a good is more effective when demand is

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Incidence of Taxation refers to the distribution of the burden of taxation; falling on

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Distribution of subsidies between producers and consumers is similarly affected by

Case A: Demand is price inelastic relative to supply – consumers benefit more

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Price controls refer to the setting of minimum of maximum prices by the

Consequences for the Economy and Stakeholders

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Consequences for the Economy and Stakeholders

Minimum wage serves to guarantee an adequate income to low-wage workers. This

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Cost and Benefit Concepts

External Benefit or Positive Externalities refer to benefits from production or

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Source of Market Failure

Case 1: Negative externalities arising from production and government

However, there is difficulty measuring

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Case 2: Positive externalities arising from production (subsidies vs. provision) –

However, it is difficult for the

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Case 3: Negative externalities arising from consumption (taxes vs. legislation

Taxation might not work as demand for

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Case 4: Positive externalities arising from consumption (subsidies vs. legislation