ECON1000

Introduction to Economics
Notes
Mohitha Chindepalli
Compilation of All Notes for Semester 1 ECON1000

Topics (Click on Each Topic to Get to That Section)

1. The Foundation (Page 2)
 Incentives, Scarcity, Values, Prices, Returns
 The Market Economy
2. Specialization and Trade (Page 8)
 Gains from Trade
 Production Possibilities Frontier
 Consumption Possibilities Frontier
 Production Possibilities Frontier with Diminishing Marginal Returns
3. The Market Model (Page 32)
 Demand Curve, Supply Curve
 Market Model, Special Cases of Market Model
 Welfare in a Market
4. Interfering in the Market (Page 60)
 The Effect of a Tax on a Market
 Price Ceilings and Price Floors
 Quantitative Restrictions
5. Market Failure (Page 73)
 Externalities, Non-Excludable Goods, Asymmetric Information
6. Output and Growth (Page 89)
 Total Output: Productivity
 Growth by Capital Investment, Innovation, Institutional Reform
 Solow Growth Model
7. Prices and Inflation (Page 103)
 Definition, Causes, Effects of Inflation
8. Interest Rates and Investment (Page 111)
 Savings-Investment Identity
 Financial Institution and Markets
 Real and Nominal Interest Rates
 Market For Funds
9. Exchange Rate and External Linkages (Page 124)
 Nominal and Real Exchange Rate
 Calculation of Real Exchange Rate
 Exchange Rates and Trade
 Market for Foreign Exchange
 Purchasing Power Parity
10. Economic Statistics (Page 137)
 Circular Flow of Income
 Defining GDP
 Measuring GDP
 Measuring Inflation

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Mohitha Chindepalli
Compilation of All Notes for Semester 1 ECON1000

The Foundation
Incentives
 It is observed the people often make decisions regarding their work, production, and
purchases by types of incentives
 An improvement in the benefit or reduction of the cost or effort to engage in an activity
will lead more people to engage in the activity more frequently
 Although incentives motivate people to make decisions, often they result in consequences
that were unintended by the maker of the said incentive
 This theory of incentives is used to interpret people’s economic decisions and also allows
for understanding of “rationality”
 Types
o Material- earnings and costs
o Social- praise and criticism
o Moral- right and wrong
o Emotional/Physiological- joy and pain
Scarcity
Economic Problem

 Occurs when society’s unlimited wants and needs cannot be satisfied by world’s limited
resources
 Result from a problem of scarcity
 Limited sources in economics are characterized under four broad areas known as the
FOP (factors of production) Land, labour, capital, entrepreneurship

Three Main Concepts

1. Scarcity
o Inability to satisfy human wants
o Scarcity represents the central problem of economics
o When resources are limited in supply and wants and needs are unlimited, it is
necessary to use limited resources prudently
o A society cannot have everything all at once o Therefore, choices therefore have
to be made
2. Choice
o Rises from the problem of scarcity
o Firms must make choices
o Not enough resources to produce all the goods and services that are wanted by
the society
o The choices that must be made are what to produce, how to produce and for
whom to produce
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Mohitha Chindepalli
Compilation of All Notes for Semester 1 ECON1000

o In a market economy, consumers determine what to produce on the basis of the

strength of ‘their’ demand
o How to produce refers to the method of production in term of how resources are
combined to achieve the lowest cost level of output (least cost combination of
resources)
o In a market economy, whatever is produced is distributed to those who have the
effective demand for the product, particularly those who have the income
o The amount of income one earns will depend of the quantity and quality of
resources that one possesses.
o What to Produce
 The question relates to what goods and services are to be produced and
in what combination
 Should a society produce more consumer goods such as, for example,
cell phones, cars, food, clothes, or capital goods such as factories and
machines
 What is clear is that producing more of one type of good means less of
the other due to limited resources
 What to produce then may simply be referred to as the product
combination that a society chooses
o How to Produce
 The choice to be made in this case is the combination of factors of
production that should be used
 Should sugar cane production in Barbados use more labour than capital
or vice versa
 Less labour would mean releasing human labour and replacing it with
machines, for example reaping sugar cane with a mechanical harvester
 A mechanical harvester would do a more efficient job because producers
would aim to get the greatest output (sugar) from the smallest input
(harvester)
 This becomes a choice of the factor combination that achieves the lowest
cost of production
o For Whom to Produce
 This question concerns the manner in which the goods and services
produced are distributed
 This is so since a limited quantity becomes available to individuals who
may desire more than the quantity offered to them
 Think of tickets for a limited overs cricket match or tickets for the World
Cup
 Lines are formed to distribute the available quantity because the capacity
at the stadium is fixed

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Mohitha Chindepalli
Compilation of All Notes for Semester 1 ECON1000

3. Opportunity Cost
o The best alternative foregone
when one alternative is chosen
o Making a choice implies a sacrifice
o For example, if you go to a cafeteria with limited pocket money you may choose
one item and give up purchasing the others
o You cannot choose everything you see because your money is limited. o The
choice of a soft drink may mean giving up a chocolate bar
o The sacrifice of giving up the chocolate bar is referred to as the opportunity cost
of purchasing a soft drink
o The real or opportunity cost of purchasing the soft drink is different from the
money cost of the soft drink
o Opportunity cost may therefore be defined as the sacrifice of the next best
choice whenever economic decisions are made

Values

 Types of Values
o Nominal- value in terms of money
o Real- value of the intrinsic commodity
 Real Values matter for decision making, and it gives a proper insight as to how people
respond to changing prices
 Since nominal values are expressed in monetary terms, it does not reflect changes in the
economy such as inflation etc., so often it is misleading
 The example below shows how to calculate real values from nominal values
o Column One shows the nominal value of one’s salary
o Column Two shows the average price of a commodity basket by the consumer
o Column Three shows the real value of the consumer’s salary
o It is seen that their purchasing power (real value) fell in 2016 and rose in 2017

Year Nominal Value Average Price Real Value

2015 $4,000 100 40
2016 $4,180 110 38
2017 $4,800 120 40

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Mohitha Chindepalli
Compilation of All Notes for Semester 1 ECON1000

Prices

 Market- a meeting of buyers and sellers. It can be physical, virtual, concentrated or

dispersed
 Prices fall and rise in order to reflect changes in the relative scarcity of goods and
services
 When a commodity becomes more scarce due to supply or demand side changes, its price
rises
 When a commodity becomes less scarce due to supply or demand side changes, its price
falls
 Exceptions to the Above Cases
o Price changes in some cases occur before the event, after the event, or even be
obscured
o Before
 Buyers who can anticipate an event that may reduce supply and thus
trigger a price increase may decide to stock up on the commodity before
the actual event occurs in an attempt to beat the price increase.
 The attempt to stock up, however, given unchanged supplies in the
present, makes the commodity relatively more scarce straightaway, even
before the supply-reducing event occurs.
 This scarcity stimulates the price to rise, also before the supply reducing
event occurs.
 In this way, the price increases in anticipation of the actual event that
would ultimately cause it to increase.
o After
 In other cases, the change in price will come after, maybe even long after,
the event precipitating the price change.
 For example, employees are the suppliers of labour and businesses are the
demanders.
 A sudden fall off in economic activity will reduce the need for labour by
businesses.
 But since workers don’t renegotiate their pay anew each week – indeed,
most firms don’t adjust salaries more often than once a year – then the
opportunity to reduce real salaries will come much later. It is well known
that changes in wages can lag behind changes in labour market conditions
by some time.
o Obscurity (No Change at All)
 Some sellers, reluctant to or prevented from making a change in the stated
price, will alter the price that is effectively paid in other ways.
 Changing the quantity or quality in the package is one way.

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Mohitha Chindepalli
Compilation of All Notes for Semester 1 ECON1000

 For example, improving the quality while sticking to the same posted
price is equivalent to a price reduction.
 For example, reducing the amount of a product in a package while
sticking to the same posted price is equivalent to a price increase.
 The Market is irrepressible which means that even if there are price controls placed by
the government, the effects are seen through other means
 This principle of prices aid to explain the price movements and the outcomes when prices
cannot change or do not change quickly
Returns

 Law of Diminishing Returns

o After some optimal level of capacity is reached, adding an additional factor of
production will actually result in smaller increases in output
o For example, a factory employs workers to manufacture its products, and, at some point,
the company operates at an optimal level
o With all other production factors constant, adding additional workers beyond this
optimal level will result in less efficient operations
 Marginal Product- the addition to output that results from employing one additional unit
of an input
 Marginal Utility- the additional satisfaction that results from consuming one more unit of
a commodity
 Marginal Benefit- the additional gain from incrementing any type of input that yields a
desired outcome
The Market Economy
Example of Coffee in Brazil

 Brazil is the largest producer of coffee in the world, supplying around a quarter of the
planet’s needs. Imagine that there is an outbreak of the berry borer beetle, a coffee
parasite, that one year destroys a significant portion of Brazil’s annual crop. How the
world adjust is explained below.
o Prices of Raw Beans: RISE
 Occurs as that buyers will compete for a reduced supply of beans
 Since producers also see a rise in costs, the prices of retail coffee in stores
will also rise
o Substitution of Tea for Coffee
 Consumers will see that coffee is relatively more expensive so they will
switch to cheaper alternatives such as tea or cocoa
o Price of Tea/Cocoa: RISE
 Since these are now more in demand, they become more scarce

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Mohitha Chindepalli
Compilation of All Notes for Semester 1 ECON1000

 So their prices will rise, which signals consumers to spread consumption

to cheaper alternatives and producers to produce more tea
o Commercial Farms Switch Production to Coffee
 Due to the rise in price of coffee beans, this pushes producers to producing
more coffee
 They will repurpose land that might have been growing tomatoes
o Price of Tomatoes: RISE
 The above creates an incipient shortage of tomatoes and pushing up that
price.
 Consumers, being on a budget, will likely buy fewer tomatoes even as
farmers, wanting to take advantage of the higher prices that tomatoes now
fetch, will switch land away from still other crops, perhaps cassava
Explanation of Example and the Interconnection of the Economy

 Even though an event in one part of Brazil creates a reduced supply of coffee beans,
consumers and producers throughout the world change their behaviour in the appropriate
ways to accommodate the reduced supply – consumers cut back on drinking coffee and
producers switch from other products to boost the supply of coffee.
 This accommodating happens automatically, because the change in the price of coffee
signals the appropriate response.
 Further, the accommodation extends to many other markets e.g. more tea and cocoa and
other types of drinks are produced and consumed, and fewer tomatoes, cassava, and
other crops are produced and bought
 This is done to accommodate the shift of resources and consumption required in the wake
of the coffee disease- happening through price signals.
 The natural behaviour of prices in response to changing market conditions ensures that
other markets, consumers, and producers adjust automatically and appropriately to those
changed conditions.

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Mohitha Chindepalli
Compilation of All Notes for Semester 1 ECON1000

Specialization and Trade

Gains From Trade
Theory of Absolute and Comparative Advantage
• These theories are based on the premise that nations benefit most when they
trade goods in which they produce more efficiently than anyone else, for goods
which some other country produces most efficiently
• Absolute Advantage
o A Country has Absolute Advantage when it can produce a good or
service at a lower cost or more efficiently than another country with the
same amount of input
• Comparative Advantage
o A Country has Comparative Advantage when it can produce a good o
service at a lower opportunity cost than another country with the same
input

Example: Comparative and Absolute Advantage with Inputs

Sausage Computer

Canada 2 Hours 6 Hours

UK 10 Hours 10 Hours

Opportunity Cost Calculations:

Note: For Inputs, it is Inversely Proportional to find How Many Hours to Give Up for
One Unit of the Good
Canada
Sausage: Computers
2 Hours : 6 Hours
1 Hour: 3 Hours (Reducing to One from Sausage Side)
1/3 Hour: 1 Hour (Reducing to One from Computer Side)
Opportunity Cost- Computer: 1/3 Hour of Sausage for 1 Computer
Opportunity Cost- Sausage: 3 Hours of Computer for 1 Sausage

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Mohitha Chindepalli
Compilation of All Notes for Semester 1 ECON1000

UK
Sausage: Computers
10 Hours: 10 Hours
1 Hour: 1 Hour
Opportunity Cost- Computer: 1 Hour of Sausage for 1 Computer
Opportunity Cost- Sausage: 1 Hours of Computer for 1 Sausage

a) Canada has absolute advantage in the production of both goods as they take less time to
produce one unit of the good.

b) UK gives up 1 Hour to produce a sausage. Therefore, Canada has the comparative

advantage as they only have to give up 1/3 hour to produce a sausage.

c) Canada gives up 3 Hours to produce a sausage. Therefore, UK has the comparative

advantage as they only have to give up 1 hour to produce a computer.

d) Terms of Trade for One Computer

• 6 Hours was used to produce 1 Computer; therefore 3 sausages can be produced in
that time for Canada (given that 2 Hours is needed to produce a sausage)
• 1 Hour was used to produce 1 Computer; therefore 1 sausage can be produced in
that time for UK (given that 1 Hour is needed to produce a sausage)
• One Computer= 1<sausage<3

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Mohitha Chindepalli
Compilation of All Notes for Semester 1 ECON1000

Example: Comparative and Absolute Advantage with Outputs

In Australia one unit of labour can produce 25 computers or 25 bushels of wheat. In
Taiwan one unit of labour can make 30 computers or 50 bushels of wheat. Assume
computers and wheat are the only two goods in the world.

Australia Taiwan

Computers 25 30

Bushels of Wheat 25 50

Opportunity Cost Calculations 1 to 1 1 Comp : 5/3 Bushels

3/5 Comp : 1 Bushel

e) Australia’s opportunity cost of making a computer is 1 Bushel of Wheat.

Taiwan’s opportunity cost of making a computer is 5/3 Bushels of Wheat
f) Australia’s opportunity cost of making a bushel of wheat is 1 Computer Taiwan’s
opportunity cost of making a bushel of wheat is ⅗ Computer
g) Australia does not have absolute advantage in both goods as they are using the same
amount of input (one unit of labour) to produce less computers and less bushels of
wheat than Taiwan respectively.
h) Australia has a comparative advantage in making 1 computer. This is so as they are
only giving up 1 Bushel of Wheat to produce one computer, while Taiwan has to give
up 5/3 bushels of wheat which is more.

i) Taiwan has a comparative advantage in producing 1 bushel of wheat. This is so as they

are only giving up ⅗ of a computer to produce 1 bushel of wheat while Australia has to
give up 1 computer to produce the same amount of wheat, which is more.

j) It is possible for Australia to gain by trading with Taiwan. They will be able to trade
their computers for Taiwan’s bushels of wheat. It costs more for them to produce the
bushel of wheat in their country, rather than importing it.

k) It is possible for Taiwan to gain by trading with Australia. They will be able to trade
their bushels of wheat for Australia’s computers. It costs more for them to produce one
computer rather than importing it.

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Mohitha Chindepalli
Compilation of All Notes for Semester 1 ECON1000

l) Terms of Trade Per Bushel of Wheat

1 Bushel of Wheat for ⅗ < Computer<1
Therefore, these concepts show that both countries can benefit from trade if they specialize
in the production of the good that they have a comparative advantage in and then import
the other goods.
Therefore, if the terms of trade are favorable and transportation costs are not high, there is
gains from trade for both countries in the agreement

Note: Specialization and Trade based on Comparative Advantage is beneficial to both trading
partners
Example 2

Jamaica and Germany are two trading partners on the world market, with a strong past and
successful relationship in exchange. Assume that both Jamaica and Germany produce apples and
oranges, which they trade with each other.

Apples
- For every singular unit of labor, Jamaica can produce one apple.
- For every singular unit of labor, Germany can produce four apples.

Oranges
- For every singular unit of labor, Jamaica can produce two oranges.
- For every singular unit of labor, Germany can produce three oranges.

Absolute Advantage and Comparative Advantage

- Germany is more productive in both activities, so they have an absolute advantage in

producing apples and oranges.
- Germany is 4 times better at producing apples
- Germany is 1.5 times better at producing oranges
3 Oranges by Germany / 2 Oranges by Jamaica = 1.5)
- Jamaica is ¼ times as good at apples
(1 apple by Jamaica/4 apples by Germany = ¼)
- Jamaica is ⅔ as good at oranges
(2 oranges by Jamaica/3 oranges by Germany = ⅔)

Jamaica has a comparative advantage in oranges. Germany has a comparative advantage in

apples.

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Mohitha Chindepalli
Compilation of All Notes for Semester 1 ECON1000

Relative Productivity

 By comparing Germany’s production of both apples and oranges, it is seen that it

produces apples better than it does oranges, each for one unit of labor (4 apples: 3
oranges), which means that they should capitalize on or maximize the production of
apples
 Jamaica’s production of apples and oranges concludes that Jamaica is better at producing
oranges for one unit of labor employed than it is at producing apples for one unit of labor
employed (2 oranges: 1 apple).
Trade Based on the Above Example

 Before Trade, Jamaica’s GDP is 2 apples (2 units of labor) + 2 oranges (1 unit of labor) =
3 products from the efforts of 3 units of labor
 Germany’s GDP is 8 apples (2 units of labor) + 3 oranges (1 unit of labor) = 11 products
from the efforts of 3 units of labor.
 If all three units of labor are shifted to or devoted to producing oranges, Jamaica would
have to give up three oranges, to get three apples, bringing their “GDP” to 6 (before it
was 4)
 Germany now has three oranges, and 9 apples, bringing their “GDP” to 12 (before it was
11).
Note: Destruction of local industry is also essential to the realization of the gains from trade
Advantages and Disadvantages of International Trade
Advantages Disadvantages
• There is creation of employment. As the • Infant industries will face a hard time
demand for the exported goods competing with foreign firms. As a
increases, there is an increase in result, they may be forced to shut down
demand for labour in order to produce  Underdeveloped countries see that they
these goods have to depend upon the developed
• This also leads to more specialization ones for economic development. They
and it stimulates the production of may become too dependent for the
various goods in different countries. critical goods and more. This may also
Additionally, this may be done at a lead to exploitation and manipulation.
lower cost In the long run, the depending country
• Countries also do not have to depend on may lose their sovereignty
scarce resources to produce something  As the race for growth picks up pace,
that they need. They can trade with there be an exponential depletion of
another country that has these resources natural resources. This is negative
to produce that good and acquire it sustainable development and poses a
need for trade diversification
 Loss of jobs and inequality in income
caused by competition. As states
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Mohitha Chindepalli
Compilation of All Notes for Semester 1 ECON1000

• Technology can be bought by the concentrate on free trade, the domestic

developing countries and economies industries adjust to this change. As a
which simulates growth result, they exist as the main exporters.
• Due to competition, producers and However, their products face
firms aim to produce higher quality and competition from imports.
better goods at a lower cost which • Less efficient firms exit the market.
eventually increase overall efficiency This happens due to the reallocation of
everywhere. This benefits consumers all resources according to whether a firm is
around the world expanding or contracting. As firms
• International Trade creates relationships close, some countries bear heavier
between countries and there is exchange losses than others.
of ideologies and such. These countries
may also become allies which will
prove advantageous in times of distress
• Trade liberalization increases real GDP.
Efficient allocation of resources has a
positive influence on GDP.
International trade offers a platform for
the exchange of ideas and flow of
technical expertise.

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Mohitha Chindepalli
Compilation of All Notes for Semester 1 ECON1000

Methods of Protectionism

 Tariffs
o This may be ad valorem or specific
o An ad valorem tariff is a portion of the market price of the imported good paid to
the government
o A specific tariff is a tax on the weight or physical quantity imported of a
commodity

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 Quotas
o Limits on the amount of goods that can enter a country
o These are implemented for Reasons such as
 Protection of infant industries from large scale competition
 Reduction of competition against local products
 Retaliation against trading policies set by other countries

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Mohitha Chindepalli
Compilation of All Notes for Semester 1 ECON1000

Productions Possibilities Frontier (PPF) (Economic Model)

• Principles of constrained choice, opportunity cost and scarcity can be shown using
this simple graph
• PPF shows a combination of products which can be produces within an economy, if all
its resources are being fully utilizes
• Usually shown in the form of a curve, showing combinations of 2 goods, one good on x
axis and one of the y
• FRONTIER- boundary beyond which the economy cannot go, because it does not have
the resources to do so.
• We have to assume certain things in order to show the principles These are:
o Two Goods
 A simplifying assumption of production possibilities analysis is that the
economy produces only two goods
 In that the economy actually produces tens of thousands of different
goods, this is one of these seemingly unrealistic assumptions
 It is, however, a useful simplifying assumption. Limiting the analysis to
two goods means that only two dimensions are needed to display graphs
and curves
 Two dimensions can be shown easily on paper or a computer screen. But,
best of all, most conclusions reached for two goods and two dimensions
apply, in principle, to tens of thousands of goods
 And if necessary, more than two goods can be handled using advanced
mathematics
o Fixed Resources
 A second assumption is that the economy has limited and fixed quantities
of resources
 This is both a reasonable assumption, given the limited resources aspect
of the scarcity problem, and also one that makes for useful and
interesting analyses
 There is no question that the economy has limited amounts of labour,
capital, land, and entrepreneurship at any given time
 This is the reasonable aspect of this assumption
 However, these quantities of scarce resources are also bound to change,
especially increase, over time
 The initial assumption of fixed resources makes it possible to analyse the
consequences of any changes, especially as it affects economic growth
o Fixed Technology
 A third assumption is that the economy has a fixed level of technology
 Technology is the information and knowledge that society has about the
production of goods and services

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 This assumption works much the same as the fixed resources

assumption. At any given time, the economy has a certain level of
technology
 As such, it seems entirely reasonable to make this assumption. However,
technology does increase over time
 The analysis can then be used to see what happens when technology
changes
o Technical Efficiency
 The last assumption is that resources are used in a technically efficient
manner
 Technical efficiency means there is no waste in production, that the most
physical output is obtained from the resource inputs
 This can also be thought of as engineering efficiency
 If, for example, 1 1/4 cups of flour, 3/4 cup of sugar, and 2 eggs are used
to make two dozen cookies, and a baker uses 1 1/4 cups of flour, 3/4 cup
of sugar, and 2 eggs, then two dozen cookies are produced
 No waste and mistakes
 Note that technical efficiency does not mean consumers actually want the
goods, only that the maximum quantity is produced
Limitations That Result from the Assumptions

• Preferences
 Production possibilities analysis is designed to analyze production capabilities
 It can answer questions about the quantity of one good produced, given the
production of another good
 This analysis does not say if anyone actually wants the goods produced
 Production possibilities says nothing about which goods people want and which
provide the most satisfaction
 It only indicates the available options
• Economic Efficiency
 Because production possibilities are unrelated to preferences, it provides no
indication of economic efficiency
 While production possibilities might indicate what quantities can be produced, it
does NOT indicate if this is an efficient use of resources
 It does not indicate if this combination of goods provides the most satisfaction
possible.
 Production possibilities assumes technical efficiency, but it does not ensure the
economy has economic efficiency--the combination of goods that generates the
most satisfaction from the resources
PPF Example and Explanation

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From this, the PPF curve would look like:

• If only bananas are produced and no resources allocated to oil production, then 8,000 kg
of bananas will be produced and zero barrels of oil
• Similarly, if only oil is produced then 9,000 barrels per day (bpd) would be produced
and 0 kg of bananas
• Society, however, needs both goods; therefore, moving from combination A to B
requires a shift of factor inputs from banana production to oil
• When this happens, 1,000 kg of bananas are given up producing 3,000 barrels of oil at a
ratio of 1 kg of bananas to three barrels of oil

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Compilation of All Notes for Semester 1 ECON1000

• The gradient or slope of the curve at that point therefore is a loss of one to gain three
• We conclude that the opportunity cost of choosing combination B over A is 1,000 kg of
bananas
• Note: because the curve is not a straight line it has a 20 different slope at different
points.
NB
• Choosing a different combination of two goods incurs an opportunity cost, which
expresses what is sacrificed in order to produce another good
• Any point outside of the PPF curve is unattainable
• Any point along the curve is an attainable combination (A, B, C, D, E, F, G, H, I) and
are a result of full utilization
• These combinations are considered to be full utilization of resources
• Points within the PPF curve (under it) are attainable but not efficient
• In any economy, investments into capital goods will do more to increase economic
growth than investments into consumer goods will
• For both all types of curves, every point along the curve is efficient, meaning this
combination of producing two goods is at our capacity

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Compilation of Module 1, 2 and 3 Notes

The country is producing the most that it can with the least amount of costs
• Movement along this curve reveals the trade-offs that are required to produce more or
less of a good
• We said that any point inside the curve is not efficient but is attainable, and any point
outside the curve is unattainable
Shape of the PPF curve
Law of Diminishing Returns

• After some optimal level of capacity is reached, adding an additional factor of

production will actually result in smaller increases in output
• For example, a factory employs workers to manufacture its products, and, at some
point, the company operates at an optimal level
• With all other production factors constant, adding additional workers beyond this
optimal level will result in less efficient operations

Concavity

• The PPF owes its ‘bowed out’ or concave shape to the law of increasing costs
• Careful reading would reveal that moving from combination A to B sacrifices the
resources producing 1,000 kg of bananas to achieve 3,000 barrels of oil
• Moving down the PPF to combination C, D, E and F, the same 1,000 kg of bananas
given up yield 2,000 barrels of oil for combination C but not for combination D, E and
F
• From combination B to C yields 2,000 bpd, C to D yields 1,300 and only 500 barrels of
oil for combinations E to F
• This may be explained by the fact that the resources are more suited to banana
production than oil production and adding these extra resources to oil production
eventually leads to overcrowding of fixed oil resources, causing the rate of production
to decrease
• This is due to an important law in economics called the law of diminishing returns or
the law of increasing costs

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Convexity

Increasing returns in production

• Moving from combination A to B on figure 2, 20 kg of bananas are given up allowing

resources to transfer to oil where the gain in oil is 10 barrels
• Moving from point B to point C, 20 kg of bananas given up yield 15 barrels of oil
• Note again that from combination C to D the gain in oil is 25 barrels and D to E, 50
barrels
• In this case, the resources taken from bananas and redirected to oil is better suited to oil
production than bananas
• This is the law of decreasing opportunity cost in action. It is also called the law of
increasing returns in production
• When the PPF is convex to the origin, moving down the curve from left to right results
in increasing returns or decreasing opportunity costs

21 | E C O N 1 0 0 0 N o t e s 2 0 2 2
The linear PPF
A close examination of the linear PPF shows that moving from combinations A through
to F indicates a one-to-one ratio, that is, 1,000 kg of corn given up would yield 1,000 kg
of peas
• The conclusion to be drawn in this instance is that resources are equally productive
when they are allocated to either good
• This curve is typical of production of similar goods, for example, corn and peas
production
• A linear production possibility frontier illustrates an equal ratio of exchange when
resources are shifted from the production of one good to the other
• We refer to this phenomenon as the law of constant opportunity costs

22 | E C O N 1 0 0 0 N o t e s 2 0 2 2
Points within and outside the PPF

• A combination of bananas and oil represented in figure 4 by point X, that is, 40,000
bananas and 40,000 bpd of oil means that resources are inefficiently employed or that
there are unemployed resources yielding less output of both goods
• Moving to point X1 (75,000 bananas and 80 bpd of oil) and using idle resources yields
more of both goods
• This point illustrates efficiency in production
• Over a 10–20-year period, new technology, inventions resulting from research and
development, innovation and investment that increase capacity, may shift the curve
outward resulting in production of more of both goods as illustrated in point X2
• This is also referred to as long-term economic growth
• Points within the PPF denote underemployed resources or inefficiency in production,
while points on the curve denote efficiency
• Points beyond the PPF are unattainable in the present but may be attainable in the
future, if productivity increases and other newly discovered resources shift the curve
outward, as X2

Comparative advantage
• Comparative advantage is an economic term that refers to an economy's ability to
produce goods and services at a lower opportunity cost than that of trade partners
• A comparative advantage gives a company the ability to sell goods and services at a
lower price than its competitors and realize stronger sales margins
• Comparative advantage is one of the most important concepts in economic theory and a
fundamental tenet of the argument that all actors, at all times, can mutually benefit from
cooperation and voluntary trade
• It is also a foundational principle in the theory of international trade

23 | E C O N 1 0 0 0 N o t e s 2 0 2 2
 • The key to understanding comparative advantage is a solid grasp of opportunity cost
Put simply, an opportunity cost is a potential benefit that someone loses out on when
selecting a particular option over another
• In the case of comparative advantage, the opportunity cost (that is to say, the potential
benefit which has been forfeited) for one company is lower than that of another
• The company with the lower opportunity cost, and thus the smallest potential benefit,
which was lost, holds this type of advantage Shift of the PPF Curve (Outward and
Inward)

• Shifts in the production possibility frontier can be to the right if the economy grows or
to the left if the economy worsens
• Economic growth shifts the economy's production possibility frontier to the right from
its initial location
• Given the increased amount of available resources, or new and better technology, the
economy can produce more of both goods
• This shifts the PPF to the right of its original position
• Additionally, a biased technological change can increase the production of just one
good, which can cause a pivot of the PPF
• This occurred historically in some areas of the North of the United States when milling
became manufactured and mill towns focused on producing cloth rather than grain

Shifts in Jerry's Production Possibility Frontier

24 | E C O N 1 0 0 0 N o t e s 2 0 2 2
Shift of Only One Good in Jerry's Production Possibility Frontier

Summary of PPF and Concepts Using Jerry’s Example

• For example, if Jerry develops an improved method of catching fish, his PPF pivots to
reflect this change
• The maximum number of bananas Jerry can gather has not changed, but his opportunity
cost changes, because now each additional fish he catches means giving up fewer
bananas (he is more efficient at catching fish)
• The opposite is also true
• If the number of workers or the amount of available raw material decreases, the
production possibility frontier shifts to the left, indicating a worsening in the economy
for both goods
• This may be caused by a major natural disaster or as an effect of war
• On an isolated island, Jerry is a one-person economy
• Through experience, Jerry becomes more efficient at gathering fish and bananas and
now produces more fish and bananas per hour
• This results in economic growth
• The effect of his increased efficiency can be shown by shifting his production
possibility curve to the right
• Jerry now has new maximum amounts of each good (the end points of his new frontier)
• It is also important to note that what used to be efficient at Jerry's original skill level
(any point on his original frontier) is now inefficient because it is now inside his new

25 | E C O N 1 0 0 0 N o t e s 2 0 2 2
 frontier With Jerry's new skill set, it is logical that for any given quantity of bananas
gathered, Jerry will choose to catch more fish
• He wants to produce on his new frontier because he now has the ability to do so
• In both frontiers, the maximum number of fish Jerry can catch (with zero bananas) is
greater than the maximum number of bananas he can gather (with zero fish)
• While Jerry can produce both goods, he is better at catching fish
• Jerry could have a comparative advantage in catching fish, that is, the benefit
gained by producing a good with lower opportunity cost than others have to
produce the same good
• If Jerry's production possibility frontier is compared to someone else's, this can illustrate
the benefits of comparative advantage and trade, although in the current example, Jerry
has no one to trade with
• In a different scenario, Jerry might instead increase his ability only to catch fish
• His ability to harvest bananas does not change
• This could be due to him making improved technology, such as weaving a fishing net.
• This causes his PPF to pivot, because the maximum number of bananas he can gather
has not changed, but the maximum number of fish he can catch has changed
• His opportunity cost for each good change as well, because the entire frontier has
shifted

26 | E C O N 1 0 0 0 N o t e s 2 0 2 2
Consumption Possibilities Frontier
Using Another Jamaica and Germany Example

 Imagine one unit of labor in Jamaica can produce either two oranges or one apple. The
same unit of labor can produce three oranges or four apples in Germany
 If it takes one unit of labor a day to produce two oranges, then in half a day the unit could
produce one orange and half an apple.
 In Germany, one labor unit can produce three oranges, then in one third of a day the unit
can produce one orange, and 1 ⅓ of apples.
 Comparatively, we see that the opportunity cost of producing one orange, is lower in
Jamaica.
 It means the oranges for apples forgone, are cheaper in Jamaica
 Assume that Jamaica is self-sufficient, it can produce its own apples and oranges.
 If it specializes, it switches to what its best at producing, then Jamaica can produce 6
oranges and 0 apples.
 With international trade, Jamaica can give up one orange for one apple, which is a point
outside the Production Possibilities Frontier. (Trade)
 If it is to acquire one more apple, it will give up another orange. (6 -2=4 oranges
remaining with Jamaica). And so on to achieve point C.
 Connecting the dots, with specialization and trade gives Consumption Possibilities
Frontier.
 Therefore, the difference between PPF and CPF is PPF is shifting units of labor to
achieve what you are best at and CPF expands feasible set with trading.
 People use Trade to get what you want, without production efforts, through a technology
called Trade

27 | E C O N 1 0 0 0 N o t e s 2 0 2 2
Jamaica’s CPF

 Imagine that all resources are devoted to producing oranges as seen in the first point
 In order to get Apples as well, it can be done in two ways
1. Production
 If resources are allocated to producing apples as well, the opportunity
cost is 2 oranges for 1 apple as seen from the production graph (green)
2. Trade
 By allocating all resources to oranges, the opportunity cost is 1 orange for
1 apple as seen from the trade graph (orange)

28 | E C O N 1 0 0 0 N o t e s 2 0 2 2
Germany’s CPF

 The green graph shows Germany’s PPF

 The orange graph shows Germany’s CPF
a. Production
 If resources are allocated to producing orange as well, the opportunity
cost is 2/3 apples for 1 orange as seen from the production graph (green)
b. Trade
 By allocating all resources to apples, the opportunity cost is 1 orange for
1 apple as seen from the trade graph (orange)

29 | E C O N 1 0 0 0 N o t e s 2 0 2 2
Standard of Living

1. Can be increased by increasing the resources in the economy

2. Can be increased by increasing the productivity in the economy through new technology,
rules and regulations etc.
3. Can be increased by bettering the terms of trade between the economies
Example
 The graph below shows an economy that has three units of labour that produces 2
oranges each

 If the resources are increased from three units of labour to three units of labour, there is
an increase in standard of living

30 | E C O N 1 0 0 0 N o t e s 2 0 2 2
  If the productivity is increased from two units of oranges per labour unit to three there is
an increase in standard of living

 If there is a betterment in the terms of trade, there will also be a rise in the standard of
living

31 | E C O N 1 0 0 0 N o t e s 2 0 2 2
The Market Model
Demand

Definition of Demand

• Economists use the term demand to refer to the amount of some good or service
consumers are willing and able to purchase at each price
• Demand is based on needs and wants—a consumer may be able to differentiate between
a need and a want, but from an economist’s perspective, they are the same thing
• Demand is also based on ability to pay
• If you can’t pay for it, you have no effective demand
• What a buyer pays for a unit of the specific good or service is called the price
• The total number of units purchased at that price is called the quantity demanded
• A rise in the price of a good or service almost always decreases the quantity of that good
or service demanded
• Conversely, a fall in price will increase the quantity demanded
• When the price of a gallon of gasoline goes up, for example, people look for ways to
reduce their consumption by combining several errands, commuting by carpool or mass
transit, or taking weekend or vacation trips closer to home
• Economists call this inverse relationship between price and quantity demanded the law
of demand
• The law of demand assumes that all other variables that affect demand are held constant
Example
Table 1. Price and Quantity Demanded of Gasoline
Price (per gallon) Quantity Demanded (millions of gallons)
$1.00 800
$1.20 700
$1.40 600
$1.60 550
$1.80 500
$2.00 460
$2.20 420

• A table that shows the quantity demanded at each price, such as Table 1, is called a
demand schedule
• Price in this case is measured in dollars per gallon of gasoline
• The quantity demanded is measured in millions of gallons over some time period (for
example, per day or per year) and over some geographic area (like a state or a country)

32 | E C O N 1 0 0 0 N o t e s 2 0 2 2
 • A demand curve shows the relationship between price and quantity demanded on a
graph with price per gallon on the vertical axis and quantity on the horizontal axis
• Note that this is an exception to the normal rule in mathematics that the independent
variable (x) goes on the horizontal axis and the dependent variable (y) goes on the
vertical
• Note also that each point on the demand curve comes from one row in Table 1
• For example, the upper most point on the demand curve corresponds to the last row in
Table 1, while the lower most point corresponds to the first row

• The demand schedule (Table 1) shows that as price rises, quantity demanded decreases,
and vice versa
• These points can then be graphed, and the line connecting them is the demand curve
(shown by line D in the graph, above)
• The downward slope of the demand curve again illustrates the law of demand—the
inverse relationship between prices and quantity demanded
• The demand schedule shown by Table 1 and the demand curve shown by the graph in
Figure 2 are two ways of describing the same relationship between price and quantity
demanded

33 | E C O N 1 0 0 0 N o t e s 2 0 2 2
Reason for the Downward Slope of the Demand Curve

• The demand curve is downward sloping, indicating the negative relationship between
the price of a product and the quantity demanded
• For normal goods, a change in price will be reflected as a move along the demand curve
while a non-price change will result in a shift of the demand curve
• Two exceptions to the law of demand are Giffen goods and Veblen goods

Factors Affecting Demand

Determinants of Demand

• Price Factors
Changes in the price of the good itself
 Change in the quantity demanded
 The price of the good increased or decreased, and according to the laws of
supply and demand, the quantity demanded will change
• Non-Price Factors
 Changes in Income
 When one has an increase in income, the he or she would want to
demand more and buy more
 When it decreases their demand would decrease as well
 Changes in the Price of other Goods
 Substitutes: alternative good that can be used in place of another
 Complement: goods that are bought and used together
 When the price increases for the original good, then consumers would
shift to buying the substitute, however the suppliers supply more of the
original good due to the profit motive
 The opposite is for when the price decreases
 Changes in taste and fashion
 For example, if the population of the Jamaica, now shift from liking
Versace to Louis Vuitton, the demand for LV will increase
 Vice versa for the other good
 Advertising
 If one good is advertised more than the other, it is highly likely that
majority of the population will go for buying the advertised good.
 This is so at it would be more appealing
 Government Policies: Taxes and Subsidies
 Taxes would decrease demand, as taxes result in a higher price. So
according to the law of demand, the demand would be low

34 | E C O N 1 0 0 0 N o t e s 2 0 2 2
 Subsidies are an incentive given by the govt. to a firm which will help to
lower their cost of production
 With a decrease in the cost of products, firms can reduce their unit price,
therefore increasing demand
 Changes in the size and composition of the population
 If the population grows, then the demand will increase and vice versa
 If a certain age group of the population increases, then only certain goods
will have an increase in demand
 Expectation of future price changes
 If the price of a certain good is to increase later on in the future, the
demand for the good will increase by a significant amount, and then
decrease when the price changes Effective Demand

• Effective demand refers to the willingness and ability of consumers to purchase goods at
different prices
• It shows the amount of goods that consumers are actually buying – supported by their
ability to pay
• Effective demand excludes latent demand – where the willingness to purchase goods
may be limited by the inability to afford it – or lack of knowledge.

35 | E C O N 1 0 0 0 N o t e s 2 0 2 2
Movements and Shifts of Demand Curves

• Changes in the price of the good cause a MOVEMENT along the curve
• Changes in the non-price determinants result in SHIFTS of the curves Demand Curve

• An increase in price results in a decrease in the QUANTITY DEMANDED and a

movement UP the demand curve
• A decrease in price results in an increase in the quantity demanded and a movement
down the demand curve
According to the diagram, an increase in
price from P to P2 will result in a decrease in
quantity demanded from Q to Q2. There is a
movement up the demand curve
Vice Versa for A decrease in price there will
be the opposite effect

36 | E C O N 1 0 0 0 N o t e s 2 0 2 2
Shifts of the Demand Curve

An increase in demand, will shift the demand

curve to the right from D to D1, as the quantity
demanded for the good increases from Q to Q1

A decrease in demand results in a shift to the left

from D to D2 as the demand decreases from Q to
Q2.

Invisible Hand- Adam Smith

• The unobservable market force that helps the demand and supply of goods in a free
market to reach equilibrium automatically is the invisible hand
• The phrase invisible hand was introduced by Adam Smith in his book 'The Wealth of
Nations'
• He assumed that an economy can work well in a free market scenario where everyone
will work for his/her own interest
• He explained that an economy will comparatively work and function well if the
government will leave people alone to buy and sell freely among themselves
• He suggested that if people were allowed to trade freely, self-interested traders present
in the market would compete with each other, leading markets towards the positive
output with the help of an invisible hand
• In a free market scenario where there are no regulations or restrictions imposed by the
government, if someone charges less, the customer will buy from him
• Therefore, you have to lower your price or offer something better than your competitor
• Whenever enough people demand something, it will be supplied by the market and
everyone will be happy
• The seller ends up getting the price and the buyer will get better goods at the desired
price

37 | E C O N 1 0 0 0 N o t e s 2 0 2 2
Theory of Consumer Demand

• Study of consumer behaviour as it relates to decisions related to purchasing goods and

services through markets
• Utility generated from the satisfaction of wants and needs is analyze
• Law of diminishing marginal utility, which is the key principle and explains the
negative slope of the demand curve
A fall in price has the following effects:
• Income Effect
 The real income of a consumer increases when the prices are decreased. Now
the consumer can afford more purchases within the unchanged income.
• Substitution Effect
 When the price of a product decreases, it tends to be substituted for other
commodities.
• Cumulative Effect
 A commodity with decreased price is put to more uses before; and therefore, it
has a cumulative effect when the commodity is more purchased and used by the
consumer
• Price Effect
 Price effect refers to the change in consumer’s equilibrium as a result of a
change in the price of a commodity, while his income and price of other
commodities remaining the same
 The price effect is depicted with the help of price consumption line. Price Effect
= Income Effect + Substitution Effect
• The Law of Diminishing Marginal Utility (LDMU) is the basis of the
Law of Demand (LD). The consumer will buy more only if the price
falls because more he buys the lower is the marginal utility.
• Demand is the function of price:
• D = f (P)
• In constructing the demand curve, we only consider the factor of price,
and we ignore other factors, i.e., changes in fashion, wealth distribution,
changes in real income, etc.

38 | E C O N 1 0 0 0 N o t e s 2 0 2 2
Theory of Supply

Factors of Production (FOP)

• FOP are the economic resources that are used to produce goods and services
• The sum of all the payments to the FOPs used to produce a given amount of a good is
the same as the firm’s costs of production for that good
Factor of Production Reward
Land Rent
Labour Wages
Entrepreneurship Profit
Capital Interest

Explanation of Each Factor of Production

Land
• Land is defined as all the factor services available naturally, whether on, above or
beneath the surface
• Types of This Factor
 Land itself on the earth’s surface for agriculture and buildings
 Land above the ground which include atmospheric gases and climate conditions
 Seas and rivers which include fish in the seas and rivers, coral reefs for tourism
 Resources beneath the earth for example mineral deposits: bauxite and
petroleum
• Land is in fixed supply
 Land on Planet earth is fixed
 In that sense we cannot acquire more
 Man’s ability to tap the resource land could increase as he earns more capital
and other resources
 For example, if a company was to buy more ships and boats, for fishing, they
may be able to acquire more fish, but that does not increase the number of fish in
the sea
• Land has no cost of Productivity
 People might have to pay for a plot of land on which to build a house
 Taking out minerals from the earth can take large amounts of other FOPs
 Preparing a plot of land requires a lot of clearing and ploughing
 However, it never costs society as a whole, anything to produce the land itself
• Land is Geographically Immobile

39 | E C O N 1 0 0 0 N o t e s 2 0 2 2
  Some climatic conditions and landscapes are immobile as they cannot be moved
from one place to another
 However, modern technology can change this. For example the manmade
islands of Dubai
Labour
• Labour supply refers to those people who are available for work in the economy
Characteristics of Labour:
 Labour is the only human factor (only factor provided by man)
 Only the worker himself can sell his labour services o In the case of skilled
labour, no one else can perform his services
 Labour services cannot be stored in the same way as units of land and capital
 Labour is not uniformed o Each unit of labour has different skills and abilities
• Division of Labour
 Many factories have this
 Production process is divided into a series of separate tasks
 Workers work in the field they are skilled at
• Labour Force
 Number of people willing to work
 Supply of Labour o Number of persons available for work in the economy o
Factors affecting it:
 Size of the population
 Age distribution of the population
 Social habits (norms and cultural standards of society)
Efficiency of Labour o Factors affecting
Efficiency of Labour
Education and training available to the production
 Level of training that the labour force receives will
determine their level of productivity
 HEART, MIND, NCT are organisations that help in this
Working conditions
Work environment

40 | E C O N 1 0 0 0 N o t e s 2 0 2 2
 Capital
• Refers to any man made goods used to produce more goods
• Purchase of capital goods is investment as they are not being used in current
consumption
• For example, the sewing machine used by the seamstress is her capital
• Features of Capital:
 Capital is manmade. While land is naturally occurring
 Units of the same type of capital are uniformed (homogenous)
 Mobility of capital varies with size and the job that the unit of capitals is meant
to perform
• Types of Capital
 Working Capital
o Raw materials and the intermediate goods used in production process
o A higher level of output needs more working capital and a lower level
needs less o Examples
 Fixed Capital o Comprises the factories and machinery used in production o
Remains fixed for a certain range of output o “Physical Capital”
 Social Capital (infrastructure) o Normally provided by the government
o They provide it to increase the productivity of the workforce
 Human Capital
o Consists of people’s abilities, knowledge and skills
o For human capital to grow, there must be education, skill training and
human capital
• Increased Capital increases the capacity of the country
• Due to more technology, capital is replacing labour in the workplace
• Capital is important as it can be imported
• By importing capital, a country can increase its productive potential Entrepreneurship
• It involves the combination of the other three FOPs in a profitable manner
• The entrepreneur is the factor that involves the risk of production
• The risk involves paying for the factors required for production of goods before any
revenue is received from selling the goods produced
• The entrepreneur might receive a negative return for his services and paying for any of
the other factors
• The entrepreneur is important to the economy as all of the firms start out with an
entrepreneur Supply
• Production is the process of turning inputs of scarce resources into an output of goods or
services

41 | E C O N 1 0 0 0 N o t e s 2 0 2 2
 • The role of a firm is to organize scarce resources to satisfy consumer demand in a
profitable way
• Supply is defined as the willingness and ability of firms to produce a given quantity of
output in a given period of time, or at a given point in time, and take it to market
• Not all output is taken to market, and some output may be stored and released onto the
market in the future
• Supply can be measured for a single factor of production, for a single firm, for an
industry and for the whole economy

Determinants of Supply
• Price Factor
 Change in the price itself
 Change in the quantity supplied
 Referring to the law of supply (higher the price the higher the supply and
vice versa)
• Non-Price Factors
 The availability of factors of production
 The availability of factors of production, such as labour or raw materials,
can affect the amount that can be produced and supplied
 For example, if a firm producing motor vehicles experiences a shortage
of steel for its body panels, then its ability to produce vehicles will be
reduced Cost of factors
 Changes in costs will alter a firm’s calculation of how much to supply at
a given price
 For example, if the same motor manufacturer experiences an increase in
labour costs due to an increase in the wage rate, the cost of producing
each vehicle will rise
 This means that the price the manufacturer expects to receive will
increase
 If the price does not increase, less will be produced, ceteris paribus
 New firms entering the market
 In terms of total supply to a market, the number of firms in the market
will affect the total supply
 New firms in a market will increase market supply and firms leaving will
reduce supply
 New firms may be attracted into a market because of the expectation of
profits and existing firms may leave because they cannot cover their
costs and make losses
 They may also leave because they cannot cover their opportunity cost,
meaning that leaving becomes the best alternative
 Weather and other natural factors

42 | E C O N 1 0 0 0 N o t e s 2 0 2 2
 Changes in the weather can have a considerable impact on the ability to
produce certain products, like farm produce and commodities
 This tends to affect the primary sector more than manufacturing
 Taxes on products
 Taxes on products, such as Value Added Tax (VAT), have a direct effect
on supply
 An indirect tax imposed on a product has an effect similar to that of a
cos.
which means that increased taxes affect a producer’s decision to supply,
and how much to supply
 Subsidies
 Subsidies are funds given to firms to enable them to increase their supply
or to reduce the price of their product to the consumer
 Subsidies can alter the firm’s willingness and ability to produce and
supply
The Upward Sloping Nature of the Supply Curve

43 | E C O N 1 0 0 0 N o t e s 2 0 2 2
Movements and Shifts of Supply Curves

• Changes in the price of the good cause a MOVEMENT along the curve
• Changes in the non-price determinants result in SHIFTS of the Curve

• An increase in price results in a increase in the QUANTITY SUPPLIED and a

movement UP the curve
• A decrease in price results in an increase in the quantity demanded and a movement
down the demand curve
According to the diagram, an increase
in price from 10 to 10 will result in a
increase in quantity supplied from 110
to 180. There is a movement up the
demand curve
Vice Versa for A decrease in price will
cause the opposite effect

44 | E C O N 1 0 0 0 N o t e s 2 0 2 2
Shifts of the Demand Curve

An increase in supply, will shift the

supply curve to the right from S0 to S1, as
the quantity supplied for the good
increases.

A decrease in supply results in a shift to

the left from S0 to S2 as the quantity
supplied decreases.

Market Model

45 | E C O N 1 0 0 0 N o t e s 2 0 2 2
Equilibrium Point
 Point at which the quantity demanded by consumers is EXACLTY equal to the quantity
supplied by suppliers at a particular price
 This point or market price is arrived at by a gradual process of trading
 If trading takes place at other prices, there will either be a shortage or surplus, this causes
the price to move until it settles at the equilibrium
Excess Supply
 If the price increases, sellers would want to sell more than consumers would want to buy
 There would be excess supply
 Due to the law of demand, the consumers do not demand more if the price is high
 Suppliers need to lower the price in order to sell the excess
 This is a surplus
Excess Demand
 IF the price decreases, buyers would want to buy more than sellers would want to sell.
There would be excess demand.
 Buyers would compete for the scarce goods and this would result in an increase in price
46 | E C O N 1 0 0 0 N o t e s 2 0 2 2
  This is according to the law of demand

Example

47 | E C O N 1 0 0 0 N o t e s 2 0 2 2
Special Cases
When Supply and Demand Are Elastic or Inelastic
Degrees of Elasticity
 Elastic
 Inelastic
 Unitary
 Perfectly Elastic
 Perfectly Inelastic

Elastic Demand Curve

A small change in price will
cause a relatively large
change in the quantity
demanded, that is Quantity
Demanded is HIGHLY
RESPONSIVE to a price
change.

48 | E C O N 1 0 0 0 N o t e s 2 0 2 2
Inelastic Demand Curve

A change in price even if it is large will

result in a relatively small change in the
quantity demanded. That is Quantity
Demanded is not highly responsive to a price
change.

Unitary Demand Curve

If PED is exactly 1, it is of unitary

elasticity.

49 | E C O N 1 0 0 0 N o t e s 2 0 2 2
Perfectly Elastic Demand Curve
At a certain price, demanded is unending.
The firm can sell all it can put on the market
but above that price it will sell nothing.

Perfectly Inelastic Demand Curve

Whatever the price, the quantity demanded
remains the same, for example, salt-a consumer
will demand the same amount whatever the price.

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Firms and Elasticity
1. When demand is elastic, the seller should lower the price to increase revenue. This is
because the percentage increase in quantity sold will be greater than the percentage
decrease in price. That is the Quantity Demanded goes up more than the price goes down.
2. When the demand is of unitary elasticity, the seller is maximizing the revenue
3. When the demand in inelastic, the seller should raise the price to increase the revenue.
This is because the percentage decrease in quantity sold is less than the percentage
decrease in price. That is the quantity demanded, goes down less than the price goes up.
Elasticity of Supply
 The responsiveness of the quantity supplied to a change in price
When Supply is Price Elastic
 Percentage change in Quantity supplied is greater than the percentage change in price.
 When firms can easily and quickly change the amounts supplied in response to a change
in price

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When Supply is Price Inelastic
 Percentage change in quantity supplied is less than the percentage change in the price.
 When quantity cannot be easily and quickly changed when price changes

Cases of Exception
 The amount offered for sale is the same at all prices: Supply is Perfectly Inelastic
Elasticity of Supply=0

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  2. The firms are prepared to supply whatever quantities are demanded: infinite amount
when needed
Elasticity of Supply=infinity

Firms and Elasticity

 They wish to measure the elasticity since it provides an insight into the way in which
prices are affected by the supply available
 When the supply is low, prices will increase and vice versa

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Determinants of Elasticity of Demand
1. Availability of Substitutes
o When a good has many close substitutes, at similar prices, the demand for it
will be ELASTIC
o A small price increase will cause several consumers to switch to the substitutes.
They are “RELATIVELY” cheaper
o A small reduction in price will attract many consumers who were buying the
substitute good before
o E.g. soap powder brands and coffee
o When a good has no close substitute, demand will be INELASTIC
o When the price of it changes, consumers cannot switch to or away from other
similar competing goods
o This price change will have a “RELATIVELY” small effect on the quantity
demanded
o E.g., the total demands for petrol and paint will be inelastic
o Different brands of petrol are close substitutes for one another, and the demand
for any one brand is elastic
2. Habit-forming Goods
o Addiction to certain products such as alcohol and tobacco is common
o In this case, demand for them will be inelastic
o For the addict, such goods have no substitutes
o There may be different brands of tobacco and alcohol, but there is no substitute
for the tobacco and alcohol themselves
3. Luxuries and Necessities
o Demand for necessities are inelastic as we cannot do without them
o Demand for luxuries are elastic as the amounts that people buy will be influenced
by their prices
o Demands for necessities such as water, food, clothing and shelter are inelastic
o If prices of these things increase, people will continue to buy them, even
sacrificing other desirable goods
o Households’ Demands for goods such as petrol, tobacco and alcoholic drinks
o It is difficult to regard those goods as necessities in the same way as food and
clothing
o What people consider as necessities depends upon their present standard of living.
E.g. washing machines are considered necessities in most developed countries
4. The Proportion of Income Which is Spent on the Commodity
o Where the total spending on a good or service mounts to small fractions of a
household’s income, the demand for it will be inelastic
o For example, an increase of $1 in the price of a matchbox would be described as a
small increase in price
o In fact, it represents a large percentage increase in price
o There would, however, be a very little effect on the quantity demanded

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 o The demand for matches, therefore is inelastic, and the same is true of such items
such as table salt, shoelaces and hair clips
o If a large percentage of income is spent on a goods, demand for it would be elastic
when price changes
5. Long Run and Short Run
o In the long run, elasticity is usually higher, since if the price of a product
increases unexpectedly, it is highly unlikely that demand for the product will
change automatically
o Time will elapse whilst consumers look for alternative products and existing
consumption habits will also gradually change
o In the long run: demand in elastic
o In the short run: Demand in inelastic

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Determinants of Elasticity of Supply
1. Excess Capacity
 When an industry is working below capacity, machines will be lying idle and
labour will be unemployed or working short-time
 Here, supply will the price elastic
 Taking on more labour and putting the idle machines to work can meet an
increase in demand fairly quickly
 If the industry is fully employed, however, supply will be price inelastic, at least
in the short run
 It may take a long time to build new factories or extend the existing ones
 Even if there is unemployed labour, supply may still be price inelastic if there is a
shortage of labour with particular skills
2. Level of Stocks
 If an industry is holding large stocks of its products, an increase in demand can be
met by running down the stocks
 While the stocks last, supply will be elastic
3. Manufactured Goods and Agricultural Products
 PES is affected by the length of the growing season in farm products
 Vegetables and cereals have no great change in supply that can be brought about
for at least a year
 Some plantation products such as natural rubber, tea, coffee and cocoa will be
price inelastic in supply over even longer periods of time, because it takes several
years for new trees and bushes to reach maturity
 Manufactured products are more price elastic in supply than agricultural products
 In manufacturing, it is often possible to deal with a fall in demand by dismissing
labour or working short-time and switching off machinery
 An increase in demand can be met by bringing idle machinery into production,
hiring more labour or working overtime
4. Length of Production Periods
 Supply is usually more price elastic when a firm is able to use raw materials,
converting them into a finished product within the space of a few days or even a
few hours
 E.g. pepper sauce, bottled seasonings, local crafts etc.
5. Factor Substitutions
 Firms are able to use a variety of different combinations of factors of production
in order to manufacture goods and provide services
 When a firm can easily find other substitutes to use within its production, the
supply will be price elastic
 Likewise, when raw materials, labour and capital, for example cannot be
switched, the supply will become more inelastic
6. Number of Firms in The Market

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  When there are a large number of firms operating within the industry, the supply
will become more elastic
 When there are only a few firms, supply will become more inelastic
7. Time
 The long run and short run also affect the supply since during the long run supply
becomes more elastic
 This is so as in the long run, a firm is better able to alter its units of factors of
production
 Another factor is the ability of firms to enter and leave the market
 This is much harder to do in the short run because of the costs which must be met

Welfare in a Market
Consumer Surplus

• The consumer surplus, as marked in red, is bound by the y-axis on the left, the demand
curve on the right, and a horizontal line where y equals the equilibrium price
• The difference between the degree of satisfaction from consuming a product and the
amount paid

• Consumer surplus decreases when price is set above the equilibrium price, but increases
to a certain point when price is below the equilibrium price
• Consumer surplus is defined, in part, by the price of the product. Recall that the
consumer surplus is calculating the area between the demand curve and the price line
for the quantity of goods sold

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 • Assuming that there is no shift in demand, an increase in price will therefore lead to a
reduction in consumer surplus, while a decrease in price will lead to an increase in
consumer surplus.

Consumer Surplus: An increase in the price will reduce consumer surplus, while a decrease in
the price will increase consumer surplus.

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Producer Surplus

• Producer surplus is the difference between how much a person would be willing to
accept for a given quantity of a good versus how much they can receive by selling the
good at the market price
• The difference or surplus amount is the benefit the producer receives for selling the
goods in the market
• A producer surplus is generated by market prices in excess of the lowest price producers
would otherwise be willing to accept for their goods
• A producer surplus is shown graphically below as the area above the producer's supply
curve that it receives at the price point (P(i)), forming a triangular area on the graph
• Total revenue - total cost = producer surplus.
• The size of the producer surplus and its triangular depiction on the graph increases as
the market price for the good increases, and decreases as the market price for the good
decreases

Total Welfare Gain= Consumer Surplus + Producer Surplus

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Interfering in The Market
Effect of a Tax on a Market
Deadweight Loss of Taxation

• The deadweight loss of taxation is a measurement of the economic loss that is caused by
the imposition of a new tax
• Deadweight loss of taxation measures the overall economic loss caused by a new tax on
a product or service
• It analyses the decrease in production and the decline in demand caused by the
imposition of a tax
• It is a lost opportunity cost
• The theory posits that imposing a new tax or raising an old one can backfire, resulting in
insufficient or no gains in government revenues due to the decline in demand for the
goods or services being taxed
• The equilibrium between supply and demand has been disrupted

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Understanding Deadweight Loss of Taxation
• Deadweight loss of taxation may be viewed as the overall reduction in demand and the
subsequent decline in production levels that follow the imposition of a tax
• This is usually represented graphically
• The graph illustrates the supply curve for the product or service that is being taxed
alongside the demand curve for it
• The difference represents the deadweight loss of taxation.
Example of Deadweight Loss of Taxation
• Imagine a city-state of imposed a flat 40% income tax on all of its citizens
• Through this tax, the government will collect an additional $1.2 trillion a year in taxes
• That big chunk of money which is now going to the government is no longer available
for spending on consumer goods and services, or for consumer savings and investment
• Suppose consumer spending and investments decline at least $1.2 trillion, and total
economic output declines by $2 trillion
• In this case, the deadweight loss is $800 billion. ($2 trillion total output less $1.2 trillion
consumer spending or investing equals $800 billion deadweight loss).
Effects of Deadweight Loss
• Not everyone agrees that deadweight loss can be accurately measured
• However, many economists agree that taxation can be counterproductive
• Deficit spending means borrowing, which only delays deadweight loss of taxation to
some future date when the debt must be repaid
• Taxes result in a higher cost of production or a higher purchase price for the consumer.
• This, in turn, causes a lower production volume and product demand than would
otherwise exist
• The gap between the taxed and tax-free production volumes is the deadweight loss
• Neoclassical analysis says the amount of loss depends on the shapes and elasticities of
the supply and demand curves

Arguments Against Taxation

• Taxation reduces the returns from investments, wages, rents, and entrepreneurship
• This, in turn, reduces the incentive to invest, work, deploy property, and take risks
• It also encourages taxpayers to spend time and money trying to avoid their tax burden,
diverting valuable resources from other productive uses
• Most governments levy taxes disproportionately on different people, goods, services,
and activities
• This distorts the natural market distribution of resources
• The limited resources will move from their otherwise optimal use, away from heavily
taxed activities and into lightly taxed activities, which may not be advantageous to all.

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Taxing the Producer

- Buyer pays $135, sellers receive $85 per bottle

- Since the original price was $100, the buyer’s share of the tax is $35
- The Seller’s share is $15
- The buyers are bearing the larger burden of the tax
Taxing the Buyer

- Buyer pays $135, sellers receive $85 per bottle

- Since the original price was $100, the buyer’s share of the tax is $35
- The Seller’s share is $15
- The buyers are bearing the larger burden of the tax
The Incidence of a Tax is Independent of the Target of the Tax

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Determination of the Incidence of the Tax
 The slope of the curves determines the incidence of the tax
 As supply becomes more inelastic, or steeper, the burden of the tax falls more upon the
producer
 As demand becomes more inelastic, or steeper, the burden of the tax falls more upon the
buyer
 This is seen in the diagrams below

Taxes may not always be passed on if the demand curve is relatively flat, as buyers would not
buy the product

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Price Ceiling and Price Floor
Price Ceiling

 In times of severe shortages, for example in war time, the government will fix the prices
of the essentials such as foodstuffs at levels where the great majority of the population
can afford to pay
 It does this because, the shortage of goods causes the equilibrium price to be too high and
many people would not be able to afford them
 Price ceilings are set to protect consumers
 However, problems could occur:
 Excess demand
 Shortage of goods
 Long lines
 First come first serve basis
 Rationing
 The Black Market could develop (Underground Market)
Price Floor

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  Price floors are set to protect producers
 At times the market price will be too low
 For example, the government can guarantee a minimum price for the producer’s products
especially in the agricultural sector
 This price will be higher than that of the market price hence the price floor is set above
the equilibrium
 In the case of a price floor, there will be a surplus
 The government normally takes the surplus and store it, or export it to other countries in
need
 Minimum wage is considered a price floor
Inefficiency of Price Floors and Price Ceilings

• The imposition of a price floor or a price ceiling will prevent a market from adjusting to
its equilibrium price and quantity, and thus will create an inefficient outcome. But there
is an additional twist here
• Along with creating inefficiency, price floors and ceilings will also transfer some
consumer surplus to producers, or some producer surplus to consumers
• Imagine that several firms develop a promising but expensive new drug for treating
back pain
• If this therapy is left to the market, the equilibrium price will be $600 per month and
20,000 people will use the drug, as shown in Figure a
• The original level of consumer surplus is T + U and producer surplus is V + W + X
• However, the government decides to impose a price ceiling of $400 to make the drug
more affordable
• At this price ceiling, firms in the market now produce only 15,000.

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Explanation (A)

• The original equilibrium price is $600 with a quantity of 20,000

• Consumer surplus is T + U, and producer surplus is V + W + X
• A price ceiling is imposed at $400, so firms in the market now produce only a quantity
of 15,000
• As a result, the new consumer surplus is T + V, while the new producer surplus is X
Explanation (B)

• The original equilibrium is $8 at a quantity of 1,800

• Consumer surplus is G + H + J, and producer surplus is I + K
• A price floor is imposed at $12, which means that quantity demanded falls to 1,400
• As a result, the new consumer surplus is G, and the new producer surplus is H + I

Explanation Overall

• As a result, two changes occur. First, an inefficient outcome occurs, and the total
surplus of society is reduced
• The loss in social surplus that occurs when the economy produces at an inefficient
quantity is called deadweight loss
• In a very real sense, it is like money thrown away that benefits no one
• In Figure (a), the deadweight loss is the area U + W
• When deadweight loss exists, it is possible for both consumer and producer surplus to
be higher, in this case because the price control is blocking some suppliers and
demanders from transactions they would both be willing to make
• A second change from the price ceiling is that some of the producer surplus is
transferred to consumers
• After the price ceiling is imposed, the new consumer surplus is T + V, while the new
producer surplus is X
• In other words, the price ceiling transfers the area of surplus (V) from producers to
consumers
• Note that the gain to consumers is less than the loss to producers, which is just another
way of seeing the deadweight loss

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Efficiency and Price Floors and Ceilings

• Figure (b) shows a price floor example using a string of struggling movie theaters, all in
the same city
• The current equilibrium is $8 per movie ticket, with 1,800 people attending movies
• The original consumer surplus is G + H + J, and producer surplus is I + K
• The city government is worried that movie theaters will go out of business, reducing the
entertainment options available to citizens, so it decides to impose a price floor of $12
per ticket
• As a result, the quantity demanded of movie tickets falls to 1,400
• The new consumer surplus is G, and the new producer surplus is H + I
• In effect, the price floor causes the area H to be transferred from consumer to producer
surplus, but also causes a deadweight loss of J + K
• This analysis shows that a price ceiling, like a law establishing rent controls, will
transfer some producer surplus to consumers—which helps to explain why consumers
often favor them
• Conversely, a price floor like a guarantee that farmers will receive a certain price for
their crops will transfer some consumer surplus to producers, which explains why
producers often favor them
• However, both price floors and price ceilings block some transactions that buyers and
sellers would have been willing to make and creates deadweight loss
• Removing such barriers, so that prices and quantities can adjust to their equilibrium
level, will increase the economy’s social surplus

Rent Control Is an example of a Price Ceiling

• In the beginning, the equilibrium, E0 lay at the intersection of supply curve S0 and
demand curve D0 corresponding to an equilibrium price of $500 and an equilibrium
quantity of 15,000 units of rental housing
After more awareness was brought to these apartments it shifted the demand curve for
rental housing to the right, as shown by the data in the table below and the shift from
D0 to D1 on the graph
• In the new market, at the new equilibrium E1 the price of a rental unit rose to $600 and
the equilibrium quantity increased to 17,000 units.

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 • The graph shows a shift in demand with a price ceiling
• The original intersection of demand and supply occurs at E0
• If demand shifts from D0 to D1, the new equilibrium would be at E1— unless a price
ceiling prevents the price from rising
• If the price is not permitted to rise, the quantity supplied remains at 15,000
• However, after the change in demand, the quantity demanded rises to 19,000, resulting
in a shortage.

Price Floor
• A price floor is the lowest legal price that can be paid in a market for goods and
services, labour, or financial capital
• Perhaps the best-known example of a price floor is the minimum wage, which is based
on the normative view that someone working full time ought to be able to afford a basic
standard of living
• The federal minimum wage at the end of 2014 was $7.25 per hour, which yields an
income for a single person slightly higher than the poverty line
• As the cost of living rises over time, Congress periodically raises the federal minimum
wage
• Price floors are sometimes called price supports because they support a price by
preventing it from falling below a certain level

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 • Around the world, many countries have passed laws to create agricultural price
supports. Farm prices, and thus farm incomes, fluctuate—sometimes widely
• So even if, on average, farm incomes are adequate, some years they can be quite low
• The purpose of price supports is to prevent these swings
• The most common way price supports work is that the government enters the market
and buys up the product, adding to demand to keep prices higher than they otherwise
would be
• In the absence of government intervention, the price of wheat would adjust so that the
quantity supplied would equal the quantity demanded at the equilibrium point E0 with
price P0 quantity Q0
• However, policies to keep prices high for farmers keep the price above what would have
been the market equilibrium level—the price Pf shown by the horizontal line in the
diagram
• The result is a quantity supplied in excess of the quantity demanded—Qd. When
quantity supplied exceeds quantity demanded, a surplus exists

• The graph shows an example of a price floor which results in a surplus

• The intersection of demand, D, and supply, S, would be at the equilibrium point E0
• However, a price floor set at Pf holds the price above E0 and prevents it from falling

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 • The result of the price floor is that the quantity supplied, Qs, exceeds the quantity
demanded, Qd
• There is excess supply, also called a surplus
• If a government is willing to purchase excess agricultural supply—or to provide
payments for others to purchase it—then farmers will benefit from the price floor, but
taxpayers and consumers of food will pay the costs.

Price Ceilings and Price Floors Effect on Demand and Supply

• Neither price ceilings nor price floors cause demand or supply to change
• They simply set a price that limits what can be legally charged in the market
• Remember, changes in price do not cause demand or supply to change
• Price ceilings and price floors can cause a different choice of quantity demanded along a
demand curve, but they do not move the demand curve
• Price controls can cause a different choice of quantity supplied along a supply curve,
but they do not shift the supply curve.

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Quantitative Restrictions

 Form of government intervention in a market that limits the production and sale of goods
to some fixed amount
Supply Restrictions

 In the example above, the quota or supply restriction is placed at 14

 Initially the equilibrium price and quantity were PA and QA respectively
 After the supply restriction was placed, the new price is PB at 5.9 and the Deadweight
loss in green is 5.47
 The effective supply curve (the blue line until point C, and then upwards on the red) is
represented by quantities less than the QR and the QR itself
 The market clears where the demand and supply curve meet, therefore getting the higher
market price
 Therefore, producers who are able to procure the necessary things to proceed within the
restriction are better off, while the others are worse off, outside of the QR

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Demand Restrictions

 In the example above, the quota or supply restriction is placed at 14

 Initially the equilibrium price and quantity were PA and QA respectively
 After the demand restriction was placed, the new price is PC at 4.0 (just based on the
diagram and point C) and the Deadweight loss in green is 5.47
 The effective demand curve (the orange line until point B, and then downwards on the
red) is represented by quantities less than the QR and the QR itself
 The market clears where the demand and supply curve meet, therefore getting the lower
market price
 Therefore, consumers who are able to procure the necessary things to proceed within the
restriction are better off, while the others are worse off, outside of the QR
Problems with All Market Interferences

 Deadweight Losses
 Enforcement Costs
 Favoritisms and Corruption
 Misallocation of Resources

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Market Failure
• Occurs when free markets make an inefficient use of scarce resources by failing to
deliver allocative or productive efficiency
• Productive inefficiency means that firms are not maximising input
• Therefore, there is lost potential output
• Allocative inefficiency means scarce resources are not being used in a way that
maximises consumer satisfaction

Efficiency

• Economic efficiency is making the best use of scarce resources Types of Efficiency:
o Productive Efficiency
 Firms deliver the highest possible output using the least amount of
scarce resources
 This means that firms produce output at lowest possible unit cost
o Allocative Efficiency
 Scarce resources are used in a way that maximises consumer
satisfaction
 Resources are used to make items most valued by society, given their
costs

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Private, Public, Merit and Demerit Goods
Private Goods
• Consumption of this by one individual reduces its availability to others
• Most goods are private goods
• They are consumed by some individuals and therefore cannot be consumed by others
Examples: foods that only you eat
Public Goods
• Consumption of it by one individual does not reduce its availability to others
• Egs. Light houses, street lights
• Free market would not provide public goods as there are no charges for them
• If one person paid for street lighting, others would be using it for free
• These persons are called ‘free riders’
• Public goods are provided by the government and paid out of tax revenue
• Some people do not pay taxes but consume the free goods (free riders)
• Characteristics of Public Goods
 Has non-excludability
 Has no competition for it
 Non-diminishing and is collectively consumed Merit Goods
• Has both private and public (social) benefit
• Under consumed and undersupplied in the free market
• Many would not access these goods if it were not for the government
• It would be offered at a too high price in the free market as the govt’ does not think that
education should depend on a person’s ability to pay
• Egs. Health and education
• Education confers private benefits as it brings greater earning power to the individual
• Also brings public benefit as it increases productivity in the economy
• Private benefit is enjoyed by the person consuming the good and social is that which the
whole society enjoys Demerit Goods
• Have private benefits but public costs and would be overconsumed and over supplied in
a free market
• Egs. Cigarettes and alcohol
• Have costs to the society in terms of loss of productivity, possible violence, accidents,
and is also a drain on the health service
• Govt’ intervenes in the market by taxing demerit goods to reduce their consumption

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Rivalry and Excludability
• Rival: a good whose consumption by one consumer prevents simultaneous consumption
by other consumers
• Excludable: A good for which it is possible to prevent consumers who have not paid for
it from having access to it.

Social, Private, External Benefits and Costs

• Private Costs
o Costs to individuals or firms consuming or producing a good or service
o These are measured by supply curves which reveal the private cost of the
resources used up in production such as wages and rent
• Private Benefits
o The gain to individuals or firms of consumption or production
o Consumers gain satisfaction from using items while firms earn revenue
from sales
• External Costs
o Cost a consumer or producer’s economic decision imposes on others
o No compensation is made
• External Benefit
o Gain that a consumer or producer’s economic activity creates for others o
No payment is made
o E.g. a new leisure facility creates benefits to third parties for which no
payment is made by generating local employment and extra trade for local
shops
• Social Costs
o Total cost to society of a given economic activity
o Cost to both the consumers and firms involved (first parties) and any costs
imposed on others (third parties)
o These are found by adding together both private and external costs

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 • Social Benefits
o These are the total gains to society from a given economic activity
o The benefit to both first parties and any beneficial spillover effects on third
parties
o Social benefits are found by adding together both private and external benefits
• Socially optimum output level of output occurs when scarce resources are used in
a way that maximises consumer satisfaction
• Social costs and benefits are used to define this output
o Allocative efficiency in a given market involves comparing the full social
cost of producing an extra unit (Marginal Social Cost MSC) with the full
benefit gained from its consumption (Marginal Social Benefit MSB)
o Allocative efficiency also means providing consumers with the products they
most value, given their cost of production
o This is achieved when PRICE=MARGINAL COST
o However, these only refer to private benefits and costs o The Externalities
need to be taken into consideration
o Therefore, the socially optimum allocation of resources requires output to be
increased to the point where marginal social benefit=marginal social cost
(MSB=MSC)

Externalities

• Spillover effects of an economic activity on others not directly involved in the

production or consumption of the service or product
• Negative Externalities
o Occur when production or consumption imposes costs on third parties who
receive no compensation
o Examples include, when a car journey has spillover effects such as increased
noise and pollution
• Positive Externalities
o Exist when third parties receive benefits from the spillover effects of
production or consumption for which they do not pay
o Example, firms benefit when workers are educated or trained at the taxpayer’s
expense
• The impact of externalities is valued using money, however many of the
externalities such as loss of life and loss of limbs cannot be fully compensated with
money
• A missing market means that there is a non-existent market, therefore there is
missing market for externalities generated by economic activity
• Shadow prices are used by economists to estimate the value of externalities, since
money cannot evaluate everything

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Graphs and Explanation

• This is the graph showing negative externalities

• The Supply curve (S1) shows the Marginal Private Cost (MPC) of economic
activity to the decision maker
• The Marginal External Cost Curve (MEC) shows the estimated negative impact of
this economic activity imposed on third parties without compensation
• Adding MEC and MPC gives the marginal social cost to society, full cost to society
(MSC)

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 • This is the graph showing positive externalities
• The demand curve D1 reveals the marginal private benefit (MPB) of economic
activity to the consumer
• The MEB (Marginal External Benefit) curve shows the estimated positive impact of
an economic activity enjoyed by third parties without payment
• MEB+MPB gives marginal social benefit curve (MSB), showing full benefit to

society

Causes of Market Failure

• Monopoly
o Monopolies have little or no competition when producing a good/service and
so they have the power to set prices wherever they want and therefore the
demand is inelastic
o Monopolies’ main goal is to make profit and so they will set a specific price
that is available to all consumers
o However, there is a lesser quantity of the good sold and the price would be
higher, the pricing would create a deadweight loss, and there will be no
benefit to the producer or consumer
o In the long run, since monopolies have less competition they will start under
producing and become inefficient and other competitions may come in and
replace these monopolies.
• Public Goods and Merit Goods
o Public goods are goods where the total cost of production does not increase
with the number of consumers
o As an example of a public good, a lighthouse has a fixed cost of production that
is the same, whether one ship or one hundred ships use its light

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 o Public goods can be under produced; there is little incentive, from a private
standpoint, to provide a lighthouse because one can wait for someone else to
provide it, and then use its light without incurring a cost
o This problem – someone benefiting from resources or goods and services
without paying for the cost of the benefit – is known as the free rider problem.
o A merit good is a private good that society believes is under consumed, often
with positive externalities
o For example, education, healthcare, and sports centres are considered merit
goods and these are believed to be under produced as well so market failure
occurs
• Demerit Goods
o Opposite of merit goods
o They not only adversely affect the direct consumers but adversely affect third
parties in that the confer substantial external cost
o Example of demerit goods are tobacco products, alcoholic beverages,
gambling and prostitution
o In the case of demerit goods, consumer lack adequate information regarding
the dangers of demerit goods
o Left to the consumers, they consume more than the socially optimum amount
of demerit goods, to force consumer to reduce their consumption of demerit
goods, the government would impose a tax on these products
o Economic theory states that the tax will raise the price of the product and will
decrease demand, shifting the demand curve to the left
o The extent to which a tax will discourage the consumption of demerit good
will depend on the price elasticity of demand
o The more elastic is demand, the more the tax will discourage the consumption
of demerit goods
o The more inelastic is demand, the more the tax will increase governments
revenue o Note, demerit goods are addictive and demand would be inelastic,
the tax will increase governments revenue
o In the presence of demerit goods, there is an overproduction, over
consumption and over-allocation of resources
o Those resources that are used to increase the production of demerit goods
could have been redeployed o produce more merit goods
o This has led to a dead weight loss
• Imperfect Information and Asymmetric Information
o Asymmetric information in the financial markets can occur whenever either
the buyer or seller has more information on the past, present, or future
performance of an investment

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 o One party can make an informed decision but the other party cannot. o The
buyer may know that the asset is under-priced, or the seller may know that it
is under-priced
o In either case, one party has the opportunity to profit from the transaction at
the expense of the other
o In any transaction, a state of asymmetric information exists if one party has
information that the other lacks
o This is said to cause market failure o That is, the correct price cannot be set
according to the law of supply and demand. o For example, a company might
consider offering health insurance to individuals o An analysis might indicate
that such insurance is feasible based on average incidences of medical claims
and willingness of individuals to pay premiums
o However, due to the risk that the insurance policies will be most attractive to
those who expect to submit high claims, the insurance company may decide to
set its premiums a little higher than average to protect itself
o The higher premiums may scare away some potential clients who do not
expect to receive enough benefits to justify the premium
o As a result, the customer base for the policy will tend even more toward those
individuals who will make high claims, and the company is likely to respond
by charging even higher premiums
o Eventually, as the customer base grows smaller and riskier, the insurance
company may withdraw the health insurance product entirely
• Open access to resources (tragedy of commons)
o The tragedy of the commons is a type of market failure in which individuals
have equal and open access to resources that is shared or common resources
o They act on their self-interest and have an incentive to act against good but to
please themselves
o In the end, the group is made worse of as well as the individual o This results
in tragedy such as depletion of resources, deforestation, overfishing.
overgrazing etc. o The tragedy involves non-excludability but rivalry
o This is because the increase in the activity or consumption by one reduces the
amount available to others
o A group of fishermen descended into a lake to fish. each fisherman wanted to
catch as many fish as possible
o If an individual tried to conserve the fish for the future, he would only
increase another fisherman's catch today
o Another example is a group of farmers grazing the cattle on a common pasture
o Where each famer tries to graze as many livestock as possible and new
farmers join them
o In the end the plot of land will be totally over grazed and will be useless

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 • Lack of Property Rights
o Property rights state the legally enforceable rules for owning, using and
selling a resource such as land
o Owners protect their assets, so if assets such as sea and air have no owners
then anyone can use that resource regardless of any externalities imposed
o Coase’s theory states that creating property rights for ownerless assets reduces
externalities
o Owners can use the law to protect their land from polluters
• Non-Existence of Markets o Markets for certain things are incomplete or missing
under perfect competition o The absence of markets for such things as public goods
and common property resources is a cause of market failure
o There is no way to equate their social and private benefits and costs either in
the present or in the future because their markets are incomplete or missing

• Externalities
Graphs

• This graph shows the market failure from negative externalities through
overproduction
• The supply curve S shows the firm’s MPC
• Given negative externalities such as pollution, marginal external costs (MEC) are
added to the MPC curve to give the marginal social cost (MSC)
• The demand curve is a measure of the private marginal benefit
• If no positive externalities D shows social marginal benefit D=PMB=MSB
• The equilibrium level of output delivered by a free market, Q1 is allocatively
inefficient

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 • SMB=SMC at Q2
• The market has overproduced by (Q1 to Q2)
• The welfare loss (deadweight loss, where marginal cost does not equal market
price) triangle JKL gives the amount of welfare loss from over production

• This graph shows the market failure through positive externalities through under
production
• The demand curve D1 shows marginal private benefit but ignores potential positive
spill over effects on third parties
• Assume the monetary impact of positive externalities are estimated to=MEB
• The full gain of society is shown by the MSB=MPB+MEB
• Assume no negative externalities
• The supply curve S1 also shows MSC
• The equilibrium level of output delivered by a free market, Q1 is allocatively
inefficient
• SMB=SMC at Q2
• The market has under produced by (Q2 to Q1)
• The welfare loss triangle JKL gives the amount of welfare loss from under
production Measures to Correct Market Failure

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Government Intervention
• Legislation
o Enacting specific laws
o For example, banning smoking in restaurants, or making high school attendance
mandatory
• Direct provision of merit and public goods
o Governments control the supply of goods that have positive externalities
o For example, by supplying high amounts of education, parks, or libraries.
• Taxation
o Placing taxes on certain goods to discourage use and internalize external
costs
o For example, placing a ‘sin-tax’ on tobacco products, and subsequently
increasing the cost of tobacco consumption.
• Subsidies
o Reducing the price of a good based on the public benefit that is gained
o For example, lowering college tuition because society benefits from more
educated workers
o Subsidies are most appropriate to encourage behavior that has positive
externalities.
• Tradable Permits
o Permits that allow firms to produce a certain amount of something,
commonly pollution
o Firms can trade permits with other firms to increase or decrease what they can
produce
o This is the basis behind cap-and-trade, an attempt to reduce of pollution.
• Extension of Property Rights
o Creates privatization for certain non-private goods like lakes, rivers, and
beaches to create a market for pollution
o Then, individuals get fined for polluting certain areas.
• International Cooperation Among Governments
o Governments work together on issues that affect the future of the
environment
• State Ownership
o State ownership is already extensive in many OECD countries
o The OECD Product Market Regulation (PMR) shows that most
governments control firms that undertake commercial activities in a

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 significant number of sectors, notably energy, rail transport, finance, and
telecoms
o Good governance of state-owned enterprises (SOEs) is essential for these firms
to perform efficiently and compete fairly with private firms
o Micro-level evidence from the air transport and automotive sectors in OECD
countries shows that, on average, SOEs tend to have significantly lower returns
on equity than private firms
o However, in countries where SOEs are subject to the same market pressures as
their competitors and are insulated from political interference, SOEs perform
as well as private firms
o The OECD PMR indicators provide insights into areas of the corporate
governance of SOEs that would benefit from reforms
o For example, in roughly a quarter of OECD countries there are SOEs with a
legal status that may shield them from the (full) application of private
company law
o Similarly, in many OECD countries, accounting or legal separation between
commercial and non-commercial activities could be imposed more extensively
on
SOEs that also fulfil public service obligations
o This obligation would avoid the distortions caused by possible cross-
subsidization
o Other key OECD principles of SOE governance, not covered in the PMR
indicators, can also help governments in the context of the COVID-19
crisis
o In particular, governments should take equity stakes only in firms whose
financial distress is linked to the downturn, and which are likely to return to
profitability once economic conditions improve
o In addition, in order to contain costs to taxpayers and minimise moral hazard
risks related to the expectations of future bailouts, governments should impose
strict recovery plans on the firms benefiting from these interventions, set clear
conditions for exit from state ownership, and rely on independent advisory to
ensure sound valuations of investments and divestments
• Anti-Trust Policies
o The antitrust laws proscribe unlawful mergers and business practices in
general terms, leaving courts to decide which ones are illegal based on the
facts of each case
o Courts have applied the antitrust laws to changing markets, from a time of
horse and buggies to the present digital age
o This allows for less market failure as it removes dealing in bad faith

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Pros and Cons of Government Intervention
Pros
• Equality
o In a free market, there is likely to be significant inequality and poverty
o This is not due to a meritocracy, but it could be due to unfair advantages of
circumstances (inherited wealth, superior education)
o Governments can intervene to provide a basic security net – unemployment
benefit, minimum income for those who are sick and disabled
o This increases net economic welfare and enables individuals to escape the worst
poverty
o This government intervention can also prevent social unrest from extremes of
inequality.
• Public Goods
o Public goods tend not to be provided in a free market because there is no
financial incentive for firms to provide goods that people can enjoy for free
o Governments can provide national defense, law and order and pay for it out of
general taxation
o Looking after the environment is also a public good, there are an increasing
number of areas, where a government is needed to deal with issues such as
forest fires, rising sea levels and pressure on water supplies.
• Education
o Merit goods are under-consumed in free-market because people
underestimate the personal benefits and/or ignore the external benefits
o This leads to an under provision of health care and education o Government
intervention to provide free education can lead to a significant improvement in
the quality of life for people who are educated
o There are also many positive externalities to the rest of society o A well-
educated society can improve labor productivity and economic growth.
• Shift consumer behavior
o The consumption of demerit goods like alcohol, tobacco and opiates can
cause personal costs and significant social costs (e.g. crime)
o If the government identifies damaging goods, they can slowly change
consumer behaviour – such as using higher tax, advertising campaigns and
behavioural economics, e.g. making cigarettes difficult to buy with
unappealing packets.
o Long-term government campaigns to reduce smoking in the UK and US have
been effective in reducing smoking rates – something that has helped to
increase life-expectancy.
• Environment
o The environment is an area with a significant need of government
intervention.
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 The free market ignores external costs of business on the
environment
o It also fails to consider long-term considerations
o For example, market forces may lead to the burning of fossil fuels, which
cause increasing environmental problems around the world – which will get
worse in the future
o Given the potential costs to future generations, there needs to be government
action to shift behaviour to renewable energy which doesn’t cause these
environmental costs
o Also, the environment involves many issues where private ownership does not
apply
o If pollution causes a worsening air quality, then this affects everyone on the
planet, but market mechanisms do not provide an opportunity to deal with the
issue
o (If someone pollutes your back-garden, you can sue them. But, if air quality
deteriorates, who takes action?
• Monopoly power
o In a free market, firms can gain monopoly power to charge high prices to
consumers and monopsony power to pay lower wages to workers
o This increases inequality and deadweight welfare loss
o Government intervention to limit mergers and monopoly power can lead to
increased economic welfare.
• Strategic planning on infrastructure o Another limitation of the free market is to
underinvest in quasi-public goods like roads and railways
o This can lead to transport bottlenecks
o Governments can plan for future transport trends and invest in the roads and
railways which are needed for the future.
Cons
• Government failure
o Government failure is a term to describe how government intervention can
cause its own problems
o For example, the government may take decisions for short-term political
consideration which lead to an inefficient outcome
o For example, government tariffs to protect domestic industry spark off a trade
war, where the economy contracts.
• Lack of incentives
o In the free market, individuals have a profit incentive to innovate and cut
costs, but in the public sector, this incentive is not there
o Therefore, it can lead to inefficient production

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 o For example, state-owned industries have frequently been inefficient,
overstaffed and produce goods not demanded by consumers.
• Political pressure groups
o Milton Friedman once quipped ‘There is nothing as permanent as a
temporary government bailout.’
o He was referring to farming subsidies
o Introduced in the 1930s during the Great Depression to alleviate a farming
recession
o After the Second World War, no government dared to remove subsidies because
farmers were a powerful pressure group who wanted to keep the subsidies.
• Less choice
o Often government intervention in the economy (e.g. nationalization of
industries) has been associated with less choice
o Government produced services have a monopoly
o Command economies, often had very little choice as government decided what
to produce
o Choice is an important element of economic freedom and being able to
maximize individual welfare. (Not all government intervention leads to less
choice.)
• Impact of personal freedom
o An increasing aspect of government intervention is through efforts to shift
consumer behaviour – e.g. reduce congestion, improve health through
reducing smoking rates and a healthier lifestyle
o This includes taxes, behavioural influences and regulations
o Sometimes people can feel this is overbearing on their individual choice

Private Sector Intervention

• Moral codes
o Moral codes guide individuals’ behavior
o Individuals know that certain actions are simply not “the right thing to do”
or would elicit disapproving reactions from others
o This is illustrated in the case of littering
o The likelihood of being fined may be small, but moral codes provide an
incentive to refrain from littering.
• Charities
o Charities channel donations from private individuals towards fighting to
limit behaviors that result in negative externalities or promoting behaviors
that generate positive externalities
o The former can be seen in the case of organizations that protect the
environment, while the latter is exemplified through organizations that raise
money for education.

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 • Business mergers or contracts
o In the self-interest of relevant parties:
- Two businesses that offer positive externalities to each other can
merge or enter into a contract that makes both parties better off

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Output and Growth
Economic Growth

• Economic growth refers to the expansions of a country’s national income, output

and unemployment
• Increase in a country’s GDP or GNP- national income
• Can also be determined by the GDP per capita which is the GDP/population
- It gives a measure of the standard of living of a country’s residents
• This is more of a quantitative measure of a country’s economy and it occurs due to
an increase in the productive capacity or productivity of the factors of production
and their efficiency
Costs and Benefits of Economic Growth
Benefits
• Higher Average Income
o Enables consumers to consume more goods and services and enjoy
better standards of living.
o Contributes to overall economic development
• Lower Unemployment
o With higher output and positive economic growth, firms tend to employ
more workers creating more employment.
• Lower Government Borrowing
o Economic growth creates higher tax revenues, and there is less need to
spend money on benefits such as unemployment benefit.
o Therefore, economic growth helps to reduce government borrowing.
Economic growth also plays a role in reducing debt to GDP ratios.

• Improved Public Services

o Higher economic growth leads to higher tax revenues and this enables
the government can spend more on public services, such as health care
and education etc.
o This can enable higher living standards, such as increased life expectancy,
higher rates of literacy and a greater understanding of civic and political
issues.
• Environmental Improvement
o With higher economic growth a society can devote more resources to
promoting recycling and the use of renewable resources.

• Investment

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 o Economic growth encourages firms to invest, in order to meet future
demand. Higher investment increases the scope for future economic
growth – creating a virtuous cycle of economic growth/investment.
• Increase Research and Development
o High economic growth leads to increased profitability for firms,
enabling more spending on research and development. This can lead to
technological breakthroughs, such as improved medicine and greener
technology. Also, sustained economic growth increases confidence and
encourages firms to take risks and innovate.
• Decline in Absolute Poverty
o Income can be used by the government to provide more opportunities
for the people subject to poverty
Costs
• Inflation
o If Aggregate Demand (AD) increases faster than Aggregate Supply
(AS), then economic growth will lead to higher inflation as firms put up
prices.
o Economic growth tends to cause inflation when the growth rate is above
the long run trend rate of growth. It is when demand increases too
quickly that we get a positive output gap and firms push up prices.
• Current Account Deficit
o Increased economic growth tends to cause an increase in spending on
imports, therefore, causing a deterioration on the current account.
• Environmental Costs
o Increased economic growth will lead to increased output and
consumption. o This causes an increase in pollution.
o Increased pollution from economic growth will cause health problems such
as asthma and therefore will reduce the quality of life.
o Economic growth also means greater use of raw materials and can speed up
depletion of non-renewable resources.
o Economic growth can also lead to problems of congestion as more people
can afford to buy a car, but it is hard to increase the supply of roads to meet
demand.
• Income Inequality
o Higher rates of economic growth have often resulted in increased
inequality because growth can benefit a small section of society more
than others.
o For example, those with assets and wealth will see a proportionally
bigger rise in the market value of rents and their wealth.
o Those unskilled without wealth may benefit much less from growth.
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 o However, it depends upon things such as tax rates and the nature of
economic growth.
o Economic growth can also be a force for reducing absolute and relative
poverty.
• Diseases and Issues of Affluence
o With rising living standards, it can cause unintended consequences.
o For example, with rising incomes, there are more goods to steal. Also, high
growth can make people more materialistic – which encourages crime.
Productivity
 The output per working person
 Building Blocks of Productivity determine a country’s standard of living
o Capital
 Human- knowledge, skills
 Physical- tools, equipment
o Technology
 The production of any good or service can be accomplished in a
variety of ways, that is to say, with a variety of technologies.
 These different technologies, with a given amount of labour and
capital, will yield different amounts of output.
 In other words, the different technologies can raise or lower the
productivity of the labour and capital at hand
 An example of the role of technology can be seen in Adam Smith’s
Wealth of Nations in the scenario of pin making
 Smith compares two technologies for pin making, and comes to the
conclusion that the one in which each worker specializes in only a
small part of the pin making process results in a considerable
increase in productivity
 As seen from above, technology is not restricted to physical
sophistication, rather it can be a difference in the style of production
technology
o Institutions
 Laws, Regulations and Unwritten Codes that Govern Economic
Activity
 Any particular stock of capital, in the presence of whatever is the
prevailing technology of production, may produce either a smaller or
a larger quantity of output depending on the presence of restrictions
on commercial activity
 Based on the experiences in the world economy, the institutions that
are efficient for economic growth are:
 Secure Property Rights

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  Impartial enforcement of the rule of law
 Merit-based allocation of economic opportunities
 Independent, speedy justice system
 Constitutional limits to the arbitrary exercise of power
 An independent, competent central bank
 Social safety nets and channels for economic inclusion
 These institutions influence the ability and incentives of members of
society to work, invest and innovate, in turn accelerating economic
growth
 When there is a lack of utilization of a part of the population, there
is reduction in productivity and investment opportunities
 Insecurity of property rights reduces the incentive to invest in and
accumulate property.
 Many wealth-creating opportunities depend on the ability to enforce
contractual obligations over long periods of time.
 Poor monetary policy can result in high inflation which undermines
efficiency and increases uncertainty.
 If there is no set of stable rules, investment in physical and human
capital will be reduced, which in turn allows for under usage of
wealth creation opportunities
 The incentive to bring improved technology to commerce will be
diminished.
 Prosperity is best achieved when people are allowed to pursue their
material desires without fear that the fruits of their efforts will
confiscated, nationalized, stolen, frowned upon, or undermined by
arbitrary change of regulation, directive, or subsidy
Economic Growth Through Capital
 The theory states that the more the capital stock, the more productive each unit of
labour will be which in turn yields a larger amount of total output
 Therefore, the growth of capital stock through investment in human (skills,
knowledge) and physical (equipment, structures etc.) yields an increase in
economic growth
 Diminishing Returns of Capital
o Initially, the investment in capital will yield high returns, however, as the
opportunities are exploited, further investment will have lower returns
o Additional capital investment will exhaust the ability of the other factors of
production to utilize it, given that everything else is constant
o Effects
 In order to become wealthy, the most straight forward way is to
save, which increases investments

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  This eventually increases the human and physical capital in the
economy
 Although this way seems feasible, due to diminishing returns, it does
not yield continually high growth rates
 A country can save a set amount of its income each period, and
those savings can build and manufacture and educate so that the
capital stock grows, but the amount of additional goods and services
that will be produced by that capital will, after some point, start to
diminish.
 Capital investments can have a dramatic effect on the wealth of a
country, but such investments eventually begin to have only a small,
incremental effect on the economy’s total production.
 High levels of savings could eventually cease to have any effect on
growth at all.
 If the returns to investment become sufficiently low, even though
still positive, savings may be directed to higher-yielding investments
abroad or, investment may be sufficient only to replace worn-out
capital
 Capital Depreciation
o The reduction in the productive value of capital over time, usually due wear
and tear
o Physical capital tends to depreciate relatively quickly to human capital
o Human capital only depreciates when skills become less current or less
useful, without re training
o The tendency of most forms of capital to require repairs and maintenance
further reduces the likelihood that saving and capital investment can
produce endless economic growth.
o The larger is the stock of buildings and equipment, the greater is the need
for and the cost of maintenance.
o The cost of depreciation should rise proportionately with the stock of capital
o As the maintenance costs become higher, more savings are dedicated to
running or replacing the physical capital, which then means that there is less
savings left to expand capital stock
 Foreign Direct Investment
o Purchase of an interest in a company by a company or an investor located
outside its borders

Benefits of Foreign Direct Investments

• Build-Up of Physical Capital
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 o Small economies benefit from an increase in physical capital which is
caused by an increase in FDIs
o This fosters development
• Human Capital, Management and Organizational Skills
o FDIs provide the introduction of managerial strategies and new
organizational patterns
o With these, there is also investment in improving human capital in order to
build productivity and expand
o As a result, there is creation of jobs and opportunity for education
• Access to Technology
o With FDIs come the transfer or introduction of foreign technology to the
host economy
o This builds productivity and also stimulates economic growth
• Access to Markets
o The collaboration of the domestic markets and the firms with the FDI allow
for penetration into extra-regional markets
• FDI and Financial Crises
o This offers protection for the domestic economy in times of economic crises
o Therefore, the volatility experienced in the growth process is reduced
• FDI and Poverty Reduction
o FDIs help with generation of income for the government which may be used
to reduce poverty
o This allows for the people to be open to more opportunities and hence add
to national productivity

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Disadvantages of Foreign Direct Investments
• Repatriation of Profits
o There is a loss of foreign exchange when the profits from the FDIs are sent
back to the host country
o This is counted as an outflow or leakage

• Transfer Pricing
o This makes MNCs lower their tax burden to host economies by reporting
the profit levels away from high tax economies to low tax economies
o Therefore, the profit in high tax economies are understated
• Environmental Damage
o Some firms operate in such a way that destroys the host economy’s
environmental and natural resources
o This does not contribute to development
• FDI and Wage Inequality
o A higher wage rate is offered to workers who work in their firms over the
normal domestic wage rate in the host economy
o This disparity leads to economic and social barriers and detrimental
disparity
• FDI and Domestic Investment
o FDI can have the crowing out effect
o They can crowd out domestic firms in the same line of business because
they have a higher quality of managerial operation and technology
• FDI and Decision Making
o These foreign firms are also usually involved in the decision making by
governments
o This may lead to biasness and compromise of national sovereignty
o This may lead to discontent among the population
 The foreign source of the investment does not, however, exempt it from the
imperative of diminishing returns.
 Even foreign investment is constrained by the limited supply of local labour and
other factors.
 And, like domestic investment, FDI will try to enter the most lucrative industries
first.
 Both of those considerations will ensure that returns to investment will gradually
fall if there is no other economic stimulant.
 Saving and investing can, therefore, make some country rich, but it cannot sustain a
continuously high rate of economic growth.
 After a while, diminishing returns and rising depreciation combine to block the
boost that investing in capital alone can provide.

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Economic Growth by Innovation
 By innovation of new technology etc. there is productivity increase in all facets of
the economy
 A new innovation in one sector will produce a burst of economic growth as it
spreads throughout the economy
 The greater output and incomes that are produced by the innovation will also allow
people to save more.
 The availability of more savings will stimulate additional investment, either
because banks will be eager to lend it out or because government may tax some of
it to provide better roads and utilities.
 Moreover, the innovation itself is often embedded in hardware and so requires
additional capital spending.
 In this way, the adoption of a new technology permits and stimulates new
investment which expands the country’s productive capacity.
 As productive capacity grows over time, the effect that a new technology has on
economic growth is extended beyond the immediate productivity boost that came
directly from the innovation.
 The effect is not indefinite, though, since the larger stock of capital both diminishes
the return to further investment and raises the provision for depreciation.
 Additionally, new ideas stimulate more ideas, and in order for a constant economic
growth, a constant stream of innovation is necessary
 Sources of Innovation
o Investment in Research
o Entrepreneurs in Seek of Profit
o Adapting Technology from Other Advanced Economies
- Technology borrowers often have a higher potential for faster
growth than the innovators, as it is easier to import the technology or
through foreign direct investment gain the technology
- This may be a factor in many developed countries that limits their
growth
Economic Growth by Institutional Reform
 Decisions made by investors are motivated by the incentive of the expected return
value relative to the risk of the investment
 Institutions play a major role in determining the return and the risk
 In the case that the institutions favour or incentivize the economic activity,
investors and innovators are more likely to partake in the activity therefore
increasing growth, and vice versa if institutions restrict the activity
 The institutions that are important for economic activity, whether strong or weak,
good or bad, tend to be persistent over long periods of time.

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  Institutional changes should happen over a period of time, which builds trust,
however, if they have not been persistent over the years, the sudden change will
cause unrest in the economy
 Effects of Institutional Change
- Revolutionary change can sweep old institutional structures and
permit radical change in the rules governing economic activity.
- a confluence of propitious political economy forces and effective
leadership can bring about institutional reform
- In the absence of political accident or social fortune, a few steps can
be taken.
- Any action that promotes the adoption of or fidelity to the
institutions that facilitate commerce, outlined above, will stimulate
innovation and investment.
- Any extent to which, therefore, respect for property rights, the rule
of law, impartial justice, and the rest of the list can be encouraged,
and even more, embedded in constitutional law, will promote higher
economic growth.
- Without reform, in the presence of institutional obstacles in the way
of investment and innovation, potential surplus savings may go
unsaved or be saved in unproductive ways.
- Innovators turn to less entrepreneurial pursuits or even migrate
- Facilitating institutions is at the root of why some countries have
high rates of investment and innovation, and can therefore achieve a
high standard of living, while many others do not.

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Solow Growth Model
The Production Function

 Represents the quantitative relationship between inputs and outputs

 The input which can be in the form of capital stock etc. is on the x axis while the output
produced by the given inputs is on the y axis
 It is seen from this graph that as capital increases, the output increases as well, increasing
productivity, until a certain point where it begins to plateau
 As the gradient of the graph becomes less steep, it shows diminishing returns, where
increments to the input will yield less output

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Pivots in the Production Function

 When there is innovation, an increase in human capital or the labour force, the same
amount of factors of production can now produce a higher amount of output
 Therefore, there is a pivot upwards

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Solow Growth Model (Savings, Investment, Growth)

 In this model, savings=investments, which means as one has determined the amount of
savings, the level of investment in capital is also determined
 Depreciation is shown by the constant line, and it is proportional to the amount of capital
in the economy, so as capital stock rises, the costs of maintenance and replacement rises
proportionately
 At low levels of capital, such as is represented by K0, the capital is stock is sufficiently
small that the amount of investment that has to be devoted to replacing the depreciated
portion is low, represented by D0.
 As a consequence, the amount of savings and investment, S0 is large enough to be able to
replace depreciated machinery and still have some investment left over that represents net
additions to the capital stock.
 The extra investment is the gap between S0 and D0, due to the net investment over and
above capital replacement, the total capital stock, the economy’s productive capacity, will
increase.
 The expanded capacity will produce a greater amount of goods and services.
 In other words, as K increases, the production function indicates, so will Y. The economy
has experienced economic growth.
 However, as the capital stock grows (that is, as the economy moves to the right on the
horizontal axis), the flattening savings curve shows that that growth adds less to savings
each time.
 Worse, the growing capital stock requires ever larger amounts those savings to be used
simply to repair or replace depreciated capital.
 This is what is illustrated by the rising height of the depreciation curve.

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  So, despite the fact that a larger economy with a higher income can save and invest more,
the additional investment is too small and the amount required just to replace
depreciation becomes too large, that the portion left over for further expansion keeps
shrinking.
 Thus, the vertical distance between the savings and depreciation curves diminishes
 Eventually, the increase in savings is so small and the capital stock so large that the entire
pool of savings is devoted to replacing and repairing depreciated capital.
 This is shown at K* and S*, since there is no extra savings left over to invest in new
capital, then the further expansion of the capital stock and therefore growth in this
economy comes to a halt.
 Mere investment in more productive capacity that is not a technological improvement
may make a poor country wealthier, but it will not keep it growing indefinitely, as the
economy will stagnate
Graphs Below Explain the Phenomenons Above

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Effects of Innovation in the Growth Model

 When there is an increase in innovation, it is seen that the total output sees an increase
and so does the savings
 The higher incomes caused by the advanced production techniques would permit people
to save more, causing the increase in savings
 Therefore, the higher amount of savings is greater than what is necessary just to replace
the depreciated capital, which can be invested in new equipment, growing the capital
stock
 Note, however, that, notwithstanding the return to stagnant level of output, the economy
has become wealthier due to both higher productivity and also a larger capital stock.
Effect of Institutional Reform in the Growth Model

 As long as laws, prejudices, and habits hinder investment and discourage innovation, an
economy may remain stuck with a low level of capital and inferior technology.
 Reforms that open up new avenues for economic activity will motivate investment in
those activities and therefore in the higher savings required to finance them.
 The reform there raises the savings rate, shifting the savings curve upwards
 At the same time, the same reform that increases the incentive to investment by local
entrepreneurs will also make opportunities attractive to foreign investors.
 As a result, foreign direct investment will also rise, further expanding productive capacity
without any need for local savings.
 The same institutional reforms that open up and incentivize new business opportunities,
and so motivate its citizens to invest, will equally well motivate them to seek out more
efficient production technologies.
 Consequently, the pace of technological innovation will also rise
 Institutional reform, therefore, by stimulating a flow of innovations, will allow for the
production function to shift upwards at greater pace, causing a steady increase in the
equilibrium output on the vertical axis

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Prices and Inflation
Inflation

 Consistent increase in the overall price levels in the economy, which in turn reflects a fall
in the value of money
 Each unit of money now is able to buy a smaller quantity of goods and services
 P= Price Level, V= Value of Money, V=1/P
Money Supply, Demand, Equilibrium
Money Market Graph

Money Supply

 Amount of money in circulation in the economy at a given time

 Central bank determines the money supply based certain economic conditions
 This is reflected in the shape of the supply curve in the graph above
Money Demand

 Amount of money that people want to hold in liquid form

 Determinants of Money Demand
o Interest Rate
o Reliance on Other Forms of Money e.g. credit card
o Average Price Levels in the Economy
- People hold money for the transactionary motive

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 - The higher the price level, the more money that is required for a
transaction which means that people choose to hold more money, and vice
versa
- The Higher the Price Level (Lower the Value of Money), Increases the
Quantity of Money Demanded
- This explains the shape of the money demand curve seen above
Money Equilibrium

 Money supply and money demand are brought into equilibrium by the overall level of
prices
 If it is that the price level is above the equilibrium, people would like to hold more money
than what the central bank has created, so the price level falls to balance supply and
demand
 If it is that the price level is below the equilibrium, people would like to hold less money
than what the central bank has created, so the price level rises to balance supply and
demand
 Equilibrium of money supply and money demand determines the value of money and the
price level
Shifts in Money Supply

 Money Supply can increase due to monetary policies that the Central Bank implements
 As a result, the value of money decreases and the price level increases
 In order for the equilibrium to be reached, people use the excess money to buy goods and
services, savings or buying bonds
 Thus, the greater demand for goods and services causes the prices of goods and services
to increase.

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  The increase in the price level, in turn, increases the quantity of money demanded
because people are using more dollars for every transaction.
 Eventually, the economy reaches a new equilibrium
 If the money supply shifts to the left, the value of money increases and the price level
decreases
 The opposite effect of explained above occurs when money supply decreases
Nominal Vs. Real Variables

Money Neutrality

 Changes in the money supply affect nominal variables rather than real variables
 When the central bank doubles the money supply, the price level doubles, the dollar wage
doubles, and all other dollar values double.
 Real variables, such as production, employment, real wages, and real interest rates, are
unchanged.
 The irrelevance of monetary changes for real variables is called monetary neutrality
Quantity Theory of Money

• This is the increase in money supply by a given percentage will ONLY increase the
price level in the long run
• MV = PQ
• Total Expenditure=Nominal GDP (Respectively)
• Money Supply x Velocity of Money = Price Level x Output
• The Velocity of Money refers to the number of times a unit of currency is used to
purchase final goods and services within the economy

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Explanation of Equilibrium Price Level and Inflation Rate

 The velocity of money is relatively stable over time

 Because velocity is stable, when the central bank changes the quantity of money (M), it
causes proportionate changes in the nominal value of output (P x Y)
 The economy’s output of goods and services (Y) is primarily determined by factor
supplies (labor, physical capital, human capital, and natural resources) and the available
production technology. In particular, because money is neutral, money does not affect
output.
 With output (Y) determined by factor supplies and technology, when the central bank
alters the money supply (M) and induces proportional changes in the nominal value of
output (P x Y). These changes are reflected in changes in the price level (P).
 Therefore, when the central bank increases the money supply rapidly, the result is a high
rate of inflation
Real and Money Wages
• Nominal/Money Wages
o This is the actual wage earned
• Real Wage

o This is the purchasing power of wages o

o Formula= Nominal Wage/Price Level Real and Nominal Interest Rates

• Nominal Interest Rate

o Actual interest rate in the economy
• Real Interest Rate
o This is the net increase in purchasing power gained o
o Formula= nominal interest rate-inflation rate (Fisher Equation)
o The fisher effect states that the nominal interest rate adjusts
proportionally to the inflation rate
o In the long run over which money is neutral, a change in money growth
should not affect the real interest rate.
o The real interest rate is, after all, a real variable.
o For the real interest rate not to be affected, the nominal interest rate must
adjust one-for-one to changes in the inflation rate.
o Thus, when the Central Bank increases the rate of money growth, the long-
run result is both a higher inflation rate and a higher nominal interest rate.

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Methods of Measuring Inflation
• Consumer Price Index (CPI)
o Formula= ((Present CPI-Previous CPI)/Previous CPI) x 100
• GDP Deflator
o Measure of the change in the price level of all domestically produced goods
and services
o Formula= (nominal/real GDP) x 100
• Producer Price Index
o This is used to measure the changes in the price received by producers for
their output
o This may be used, however, it does not cover all of the industries in the
economy
Costs of Inflation
• Households now have reduced purchasing power, since as domestic price level
rises, the amount of fixed level of income can command falls
• Reduces the real value of money, as inflation rate doubles, the amount of money
loses half its value
• Causes the local currency to depreciate against the major foreign currency which
could lead to further inflation
• Leads to Shoe Leather and Menu Costs
o Shoe Leather
 One minimizes the amount of cash they maintain
 This means they could make frequent trips to the bank
 This is added transaction cost
 Persons tend to travel up and down searching for bargains, walking
up and down actually wearing down the shoe

o Menu
 Firms incur the administrative costs of making many adjustments to
new prices
 Example, restaurants
• Encourages Persons to buy non-desired assets to hedge against inflation
• Inflation leads to a fiscal drag
o This occurs when the rate of inflation increases and wages increases due to
the effect of trade unions or indexation
o If the system of taxation is progressive, a person will find himself in a
higher tax bracket
o They end up paying a larger percentage in taxes even though his real
income has not increased

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 • Inflation would make domestic output uncompetitive thus worsening a country’s
Balance of Trade or current account deficit
• Inflation increases the real interest rate and discourages investment
• Inflation causes uncertainty within the economy thus encouraging speculative
activities
• It redistributes income from persons who LEND to those who BORROW
• Inflation Induced Tax Distortions
o Most taxes distort incentives, cause people to alter their behavior, and lead
to a less efficient allocation of the economy’s resources
o Many taxes, however, become even more problematic in the presence of
inflation.
o The reason is that lawmakers often fail to take inflation into account when
writing the tax laws.
o Inflation tends to raise the tax burden on income earned from savings.
o Inflation exaggerates the size of capital gains and inadvertently increases the
tax burden on this type of income
o The income tax treats the nominal interest earned on savings as income,
even though part of the nominal interest rate merely compensates for
inflation
o Because of these inflation-induced tax changes, higher inflation tends to
discourage people from saving
o Thus, when inflation raises the tax burden on saving, it tends to depress the
economy’s long-run growth rate.
o In order to combat this, tax laws can be re written in order to take into
consideration the inflation rate
o In the case of capital gains, for example, the tax code could adjust the
purchase price using a price index and assess the tax only on the real gain.
o In the case of interest income, the government could tax only real interest
income by excluding that portion of the interest income that merely
compensates for inflation.
• Relative-Price Variability and the Misallocation of Resources
o Given that price levels for a business are set at the beginning of the year, if
there is no inflation, the relative prices of the business compared to the
prices in the economy will be constant
o If there is inflation however, the relative prices will fall each month, they
will be high in the early months of the year and lower nearing the end of the
year
o The higher the inflation rate the higher the variance of the relative prices
o Since market economies rely on relative prices to allocate resources, the
variance of the relative prices matters
o Consumers decide what to buy by comparing the quality and prices of
various goods and services.
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 o Through these decisions, they determine how the scarce factors of
production are allocated among industries and firms.
o When inflation distorts relative prices, consumer decisions are distorted and
markets are less able to allocate resources to their best use.
• Money Illusion
o Money illusion is an economic theory positing that people have a tendency
to view their wealth and income in nominal dollar terms, rather than in real
terms.
o In other words, it is assumed that people do not take into account the level
of inflation in an economy, wrongly believing that a dollar is worth the
same as it was the prior year.
• Price Confusion
o This is due to the confusion if prices are rising because of the scarcity of the
good or service or if there is more demand for the good or service
o Price signals become more difficult to interpret
• Hyperinflation
o When prices constantly increase at a very rapid level
o This leads to dollar devaluation
Measures to Reduce Inflation
• Income Policy
o The deliberate manipulation of the wage determination process in order to
control unjustified wage increases
o Excess demand can fuel inflation by controlling the main
determinant of demand which is income
o This is also done in the form of a wage freeze
o This can be used to combat the inflation rate
• Monetary Policy
o Changes in the money supply directly affects the level of aggregate demand
o The interest rate can be altered, the reserve requirement or the discount rate
o This can curb the rate of increase in prices in an economy
o The contractionary monetary policy can be used to reduce demand pull
inflation

• Fiscal Policy
o Contractionary fiscal policy can be implemented
o However, to reduce cost push inflation, the rate of taxation on
BUSINESSES can be reduced
• Supply Side Measures
o These are geared towards expanding the productive capacity in an economy

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 o These are implemented to reduce the amount of production bottlenecks
which contribute to rising prices
o These include, research and development, investment in capital formation
and investment in tertiary education and infrastructure

The Inflation Tax

 When government raises revenue by printing money, it is said to levy an inflation
tax
 When government prints money, the price level rises and the money that one holds
become less valuable
 This may lead to hyperinflation, as the government has high spending, inadequate
tax revenue, and limited ability to borrow
 The massive increases in the quantity of money lead to massive inflation
 The inflation ends when the government institutes fiscal reforms—such as cuts in
government spending—that eliminate the need for the inflation tax.

Deflation Effects
 Deflation lowers the nominal interest rate which reduces the cost of holding money,
according to the Fisher effect
 Costs of Deflation
o Falling price level induces she leather and menu costs
o Falling price level induces relative price variability
o Results in the redistribution of wealth toward creditors and away from debtors.
Because debtors are often poorer, these redistributions in wealth are particularly
painful.

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Interest Rates and Investment
Financial Institutions and Markets
Financial Markets

 Institutions through which a person who wants to save can directly supply funds to a
person who wants to borrow
 Bond Market
o Bond- certificate of indebtedness that specifies the obligations of the borrower to
the holder of the bond. Usually, sold by the governments or firms when they want
to borrow from the public (LOAN)
o The bond identifies the time at which the loan will be repaid (maturity date) and
rate of interest is paid periodically until the loan matures
o The buyer of a bond gives their money to the seller in exchange for the promise of
interest and eventual repayment of the amount borrowed (principal)
o The buyer can hold the bond until maturity, or he can sell the bond at an earlier
date to someone else
o Debt Finance- sale of bonds
o Three Characteristics of Bonds
- Term
 Length of time until the bond matures
 A bond that never matures is a perpetuity, where interest is paid
over time, but the principal is never paid
 Long-term bonds are riskier than short-term bonds because holders
of long-term bonds have to wait longer for repayment of principal
 If a holder of a long-term bond needs his money earlier than the
distant date of maturity, he has no choice but to sell the bond to
someone else, perhaps at a reduced price
 To compensate for this risk, long-term bonds usually pay higher
interest rates than short-term bonds.
- Credit Risk
 Probability that the borrower will fail to pay some of the interest or
principal (failure to pay is called a default)
 Borrowers sometimes default on their loans by declaring
bankruptcy
 When bond buyers perceive that the probability of default is high,
they demand a higher interest rate as compensation for this risk
 Government bonds tend to pay low interest rates as they are less
risk
 Financially shaky corporations raise money by issuing junk bonds,
which pay very high interest rates.

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 - Tax Treatments
 This is the way the tax laws treat the interest earned on the bond
 Interest earned on most bonds is taxable income
 Bonds from governments are called municipal bonds which do not
require a tax on the interest income
 Because of this tax advantage, bonds issued by state and local
governments typically pay a lower interest rate than bonds issued
by corporations or the federal government
 Stock Market
o Stock- represents ownership in a firm, so is a claim to the profits that the firm
makes
o Equity Finance- sale of stock
o After a corporation issues stock by selling shares to the public, these shares trade
among stockholders on organized stock exchanges.
o In these transactions, the corporation itself receives no money when its stock
changes hands
o The prices at which shares trade on stock exchanges are determined by the supply
of and demand for the stock in these companies.
o Because stock represents ownership in a corporation, the demand for a stock (and
thus its price) reflects people’s perception of the corporation’s future profitability.
o When people become optimistic about a company’s future, they raise their
demand for its stock and thereby bid up the price of a share of stock.
o Conversely, when people’s expectations of a company’s prospects decline, the
price of a share falls
 Difference Between Stocks and Bonds
o If the firm is profitable, stockholders enjoy the profits while bondholders only
gain the interest on their bonds
o If the firm is financially unstable, bondholders are paid what they are due before
stockholders receive anything at all
o Stocks offer the holder both higher risk and potentially higher return than bonds

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Financial Institutions
The Central Bank
 Head of financial sector in any economy
 Not involved in any banking issues
 Lender of the ‘last resort’
 Main purpose is to:
 Oversee operations if all financial institutions in the economy
 Implement monetary policies on behalf of government
Functions
1. It has the sole rights to issue notes and coins for the country
 Sole issuer of new notes and coins
 Accepts and replaces unfit notes and coins
2. It is the bank for all commercial banks
 All commercial banks must keep a percentage of their deposits as cash reserves at
the central bank
 They lend to the commercial banks only when necessary
 Commercial banks also seek and accept advice from the central bank
 They have to report regularly to the central bank on various aspects of their
operations
 Holds cash deposits and other liquid assets for commercial banks
 These balances allow the banks to settle indebtedness between themselves by
shifting deposits ir balances from one bank to another
 Through these balances the central bank can keep a tight rein on the retail banks
3. Banker to the government
 Keeps the accounts of the government
 These accounts are used for receiving funds, making payments and clearing
cheques issued by government departments
 They lend to the government if the govt needs money
 Manages national debt of the government
 National debt: sum of all outstanding government borrowing, internally (within
the country) and externally (abroad)
4. Implements monetary policy on behalf of the government
 When there is inflation and economy is overheating, the central bank will
implement deflationary monetary policy e.g. increasing interest rates
 This will reduce borrowing by firms and individuals, and then investment and
consumption in the economy will fall
 This will reduce aggregate demand and national income
 Investment and consumption will fall too
 Repo Rate: rate at which central bank provides overnight liquidity to commercial
banks
 This is an opportunity to convert assets to cash
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  As the repo rates rises (or falls), the interest rate will rise (or fall)
 Combats inflation
 When there is unemployment and low national income in the economy, the
central bank will implement expansionary monetary policy, e.g. might decrease
interest rates
 This will increase borrowing by firms and individuals, and then investment and
consumption in the economy will rise
 This will increase aggregate demand and national income
 Unemployment will fall
5. It manages foreign exchange reserves
 Looks after foreign reserves account
 Ensures that the country always has sufficient reserves and, if it does not, advises
the government on appropriate policy
 Also protects the exchange rate from fluctuations
 Government’s representative in all international financial matters
6. Supervises non-bank financial institutions (NFIs)
 Supervises operations of insurance companies, pension funds and investment
trusts
 E.g. Trinidad and Tobago
Commercial Banks
 Provides individuals and firms with banking services
 Profit making enterprises
 Commercial banks are financial intermediaries bridging gap between borrowers and
lenders.
 By offering a rate of interest on deposits, banks entice individuals and firms to save
 Savings form the basis of growth and development in the economy
 Savers are paid interest to deposit their funds in banks, and borrowers borrow these funds
at a higher rate of interest
 The banks, therefore provide funds for activities such as investment, home ownership and
education
 They provide services that aid trade within a country and between countries
Functions
1. Accept deposits from individuals and firms
 The depositors are paid interest by the bank
 Rate of interest is the prices charged for borrowing money
2. Make loans to individuals, firms and the government
 Individuals might need a loan for purchasing a house, for educational purposes or
to start a small business
 Firms use loans to invest, and they might create more jobs

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  The government might need a loan to meet expenses or to bridge its current
expenditure if revenues do not come in on time
3. Pay creditors for you
 Set up a standing order (fixed amounts paid at a fixed date each month)
 Direct debits if the amounts vary each month
4. Collect payment your behalf
5. Provides you with easy cash from your account when you need it
Services
1. Offer safekeeping services
 Customers use the bank safety deposit boxes to store important documents and
valuables, such as property deeds and jewelry
2. Offer a wide range of services
 Letters of credit
 Bills of collection
 Customer payment
 Services
 Cheque services
 Credit and debit card services
 24- hour banking
 Night safe facility
 Debit (cash card) and Credit (represents a loan) cards
3. Offer foreign currency banking services
 Banks issue travelers’ cheques, and buy and sell foreign currency
 They issue bank drafts in foreign currencies
 Commercial banks in the region now accept deposits in foreign currency

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Credit Union
 Cooperative financial institution that is owned and controlled by its members’
 Differ from traditional financial institutions in that the members who have accounts in a
credit union are the credit unions’ owners.
 Only a member of a credit union can deposit money with that credit union, or borrow
money from it
 They are committed to helping members to improve their financial situations
 Credit unions usually pay higher dividends on shares (or interests on deposits) and charge
lower interest rates on loans than banks
 Credit union revenues (from loans and investments) must exceed operating expenses and
dividends (or interest paid on deposits) in order for the credit union to stay in business
 Credit unions are not as profitable as banks, as they focus on serving members
Development Banks
 Institution set up to facilitate growth and production in a particular sector in the economy
 It grants loans at competitive rates to potential investors
 Developments banks do not accept deposits from the general public
 Funds are obtained from international and regional institutions and grants from the
government
 It might invest its idle funds in securities in order to increase its earnings
Insurance Company
 Insurance is an agreement whereby a company guarantees to give compensation for loss
of life or property, for damage to property, for injury or for illness in return for payment
of a regular sum of money
 This is called a premium
 They operate on the principle that not everyone will suffer the same loss to the same
extent at the same time
 They receive funds from the payment of premiums by those who buy insurance
 When the buyer suffers a loss, the insurance company must compensate the buyer of
insurance or his beneficiary
 Services offered by these companies are a security to firms and individuals
 Private property is protected against risk of loss
 Businesses are protected against loss of or damage to property by fire, and stock and
goods in transit are protected against Loss-Insurance offers security for traders
 Insurance companies use their funds to purchase government and private sector securities
 Therefore, insurance companies also provide a source of funds to government and
businesses

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Mutual Fund
 Collective investment company
 An investor buys a share in the mutual fund and is paid a dividend based on the number
of shares he holds
 Dividend might be at a fixed rate, or it might vary depending on the performance of the
fund
 The fund pools money from many investors and invests their money in a range of
securities
 The advantage of the mutual fund is that the investor has the services of an expert fund
manager to make investment decisions
 The investors’ collective funds are used to invest in securities to which the individual
investor might not normally have access
Building Society
 Financial institution owned by its members that offers banking and other financial
services, especially mortgage lending
 Groups of people pooled savings so that members could buy or build their own homes
 Services include a range of savings accounts, money transfers and foreign currency
transactions
 Loans are also available to non-members
Investment Trust Company
 A trust company accepts deposits from the public
 These deposits fund commercial mortgages for the corporate sector
 These companies therefore make funds available to very large firms so that they are able
to make capital investments
 Trust companies have assisted in the development of the capital market in the economy
through the management of share issues of public companies
 They also assist through the purchase of government and private securities
 As buyers of securities, investment trusts are a source of funds to the private and public
sector

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Savings and Investment Identity
GDP Identity (Under an Open Economy)

 Y = C + I + G + NX
 Income= Consumption + Investment + Government Spending + Net Exports
 (Y-T-C) + (M-X) + (T-G) = I
 Domestic Savings + Foreign Savings + Fiscal Balance= Investment

GDP Identity (Under a Closed Economy)

 Net Exports= 0
 Y=C+I+G
 I= Y-C-G
 Y-C-G= total income in the economy after paying for consumption and government
purchases, which is called National Savings or Savings
Savings and Investment Identity
 S=I (Based on the above explanation)
 S= (Y-T-C) + (T-G), T represents the amount that the government collects from
households minus the amount it pays back to the households in the form of transfer
payments
 Private Saving – is the amount of income that households have left after paying their
taxes and paying for the consumption (Y-T-C)
 Public Saving- amount of tax revenue that the government has left after spending (T-C)
- If T>G, budget/fiscal surplus
- If T<G, budget/fiscal deficit
 In the national context, S should equal I, however, it does not have to be equal for each
and every household or firm
 When an entity makes an investment, the excess can be deposited in a bank, and when
savings are less than investment, they can borrow from the bank
 Banks and other financial institutions make these individual differences between saving
and investment possible by allowing one person’s saving to finance another person’s
investment

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Real and Nominal Interest Rate
 Real Rate of Interest
o Rate adjusted for the erosion of the purchasing power of the loan principal due to
inflation
o Nominal Interest Rate – Inflation Rate = Real Interest Rate
o Guides lending and borrowing decisions, and is the “price” in the credit market
Market for Loanable Funds
Supply of Funds Markets for Funds Demand for Funds
Institutions
Deposit Commercial Banks Borrow
Deposit Near Banks Borrow
Premium Insurance Companies Investment

Markets
Purchase Stock Market Issue
Purchase Bond Market Sell

Loanable Funds- refers to all income that people have chosen to save and lend out, rather than
use for their own consumption, and to the amount that investors have chosen to borrow to fund
new investment projects.
In this market there is one interest rate, which is both the return to saving and the cost of
borrowing
Supply and Demand for Loanable Funds
 Supply for Loanable Funds
o Comes from people who have some extra income they want to save and lend out
o Lending can occur directly, such as when a household buys a bond from a firm
o Lending can occur indirectly, such as when a household makes a deposit in a
bank, which in turn uses the funds to make loans
o Savings is the source of the supply of loanable funds
 Demand for Loanable Funds
o Households and firms who wish to make investments and they borrow
 Interest is the price of a loan, and represents the amount that borrowers pay for loans and
the amount that lenders receive on their saving
 The higher the interest rate, the lower the quantity demanded for loanable funds (since it
is more expensive to borrow), the higher the quantity supplied of loanable funds (since
saving is more attractive)
 This theory is shown in the graph for loanable funds below

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  The adjustment of the interest rate to the equilibrium level occurs for the usual reasons.
 If the interest rate were lower than the equilibrium level, the quantity of loanable funds
supplied would be less than the quantity of loanable funds demanded.
 The resulting shortage of loanable funds would encourage lenders to raise the interest rate
they charge.
 A higher interest rate would encourage saving (thereby increasing the quantity of
loanable funds supplied) and discourage borrowing for investment (thereby decreasing
the quantity of loanable funds demanded)
 Conversely, if the interest rate were higher than the equilibrium level, the quantity of
loanable funds supplied would exceed the quantity of loanable funds demanded
 As lenders competed for the scarce borrowers, interest rates would be driven down
 In this way, the interest rate approaches the equilibrium level at which the supply and
demand for loanable funds exactly balance
Reason for Real Interest Rate Being Used
 Inflation erodes the value of money over time, so the real interest rate more accurately
reflects the real return to saving and the real cost of borrowing

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Shifts in the Loanable Funds Curves Based on Policies
 Saving Incentives
o An example is the reformation of the tax code to encourage greater saving
o This can be done through the expansion of eligibility for special accounts e.g.
Individual Retirement Accounts, that allow people to shelter some of their saving
from taxation
o This affects the supply curve, as it increases the willingness of households to save
at any given interest rate
o The supply curve shifts towards the right
o Demand stays the same as the tax change does not directly affect the amount that
borrowers want to borrow at any given interest rate

 Investment Incentives
o An example is an investment tax credit, which gives firms a tax advantage when
they purchase new equipment etc.
o This is an incentive to increase demand for investments in new capital, so the
demand curve shifts to the right
o Supply is not affected as this incentive does not affect the amount that households
save at any given rate

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  Government Budget Deficit and Surpluses
o Financing of Budget Deficits are done by borrowing in the bond market
o A budget surplus, an excess of tax revenue over government spending, can be
used to repay some of the government debt (accumulated budget deficits).
o If government spending exactly equals tax revenue, the government is said to
have a balanced budget
o Imagine that the government starts with a balanced budget and then, because of an
increase in government spending, starts running a budget deficit
o The supply curve shifts to the left, as there is a fall in the supply of loanable funds
o The fall in the demand for loanable funds or investments is called crowding out
o When the government reduces national saving by running a budget deficit, the
interest rate rises, and investment falls.
o Because investment is important for long-run economic growth, government
budget deficits reduce the economy’s growth rate.

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Difference Between Government’s Borrowing and Private Sector’s Borrowing
 As seen from the graphs, when the private sector borrows there is a shift in the demand
curve, while when the government borrows there is a shift in the supply curve
 The government budget deficit reduces the flow of resources available to fund private
investment (this definition would increase the demand rather than the supply)
 Regardless, a budget deficit increases the interest rate, which crowds out private
borrowers who are relying on financial markets to fund investment projects
Budget Deficit from Tax Cuts
 A tax cut reduces public savings T-G
 However, private savings Y-T-C increases, but as long as households respond to lower
taxes, the consumption increases, so private savings rise by less than public savings
declines
 National Savings falls, and the budget deficit reduces the supply of loanable funds and
drives up the interest rates
 This is turn crowds out borrows trying to finance capital investments
Budget Surplus
 As governments collect more tax revenue than spending, it saves the difference by
retiring the outstanding government debt
 A budget surplus increases the national savings, which increases the supply of loanable
funds, reduces the interest rate and stimulates investments
 This means higher investments, grater capital accumulation and economic growth
 This is shown by a shift in the supply curve to the right

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Exchange Rates and External Linkages
Exchange Rates

• Exchange Rate is defined as the rate at which one currency is exchanged for
another country’s currency in the foreign exchange market e.g. $1 USD= $158
JMD
• In general exchange rate reflects the overall health, vitality and productivity of a
nation’s economy
• However, exchange rates also affect international trade (exports and imports)
among nations, so they are often subject to governmental policy control

Nominal and Real Exchange Rates

Nominal Rate
 Price of a currency in terms of another
 Provides a relative price at which to exchange money in one currency into its equivalent
amount in another
 If the domestic currency Depreciates, it loses relative value to other currencies, so it
requires more of the domestic currency to purchase the other currencies
 If the domestic currency Appreciates, it gains relative value to other currencies, so it
requires less of the domestic currency to purchase the other currencies
Real Rate
 Measures the price of one country’s products in relation to another
 Formula= (nominal exchange rate x foreign price level)/ domestic price level
Explanation of the Formula
 If the domestic price level increases, the real exchange rate has a lower value
 This shows that it requires fewer domestic goods to procure a given amount of foreign
goods- Appreciation of Domestic Currency in Real Terms
 If local inflation rate is higher than the foreign inflation rate, the denominator is
expanding faster than the numerator, so the real exchange rate falls- Appreciation of
Domestic Currency in Real Terms
 If it is the complete opposite, the domestic currency will Depreciate, while the foreign
currency Appreciates

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Real Exchange Rate and Trade
Example
 Consider Country 1 and Country 2 that sell two different brands of soda A and B
respectively and a consumer splits his purchases between brands A and B
 There is an increase in relative price of both products, where Country 1’s price increases
by 3% and Country 2’s price increases by 10%, and nominal exchange rate stays the
same. The combined effect shows that brand B is more expensive related to A, so there
has been a real appreciation in Country 2’s currency
 The consumer will respond to this buy reducing his consumption of the now expensive
soda B and substituting it for soda A
 This therefore causes the increase in imports of Soda A into Country 2
 Correspondingly, a real depreciation of the local currency, which raises the relative cost
of imports, will lead to a decrease in imports
 Consumers outside of Country 2 will notice the change in relative costs, e.g. from another
Country 3 that imports soda, will shift from importing Soda B (more expensive) to Soda
A (less expensive). This in turn reduces the export demand that Country 2 has, therefore a
real appreciation in this country’s currency results in a fall in exports
 These changes in imports and exports that result from consumption decisions are
reinforced by decisions on the production side of the economy as well
 In Country 2, producers see an increase in revenue for Sodas sold at home rather than
from exports, due to the appreciation
 Therefore, the productive capacity is shifted from producing for the export market to the
local market, which causes exports to fall
 In Country 1, producers will be more inclined to send their Soda A product to Country 2
where it is getting a higher price than at home, again causing imports in Country 2 to rise
General Explanation
 The real exchange rate reflects the cost of the broad collection of goods and services
produced in an economy relative those produced in other countries
 And as those relative costs change, consumers and producers at home and abroad will
shift their consumption and sales pattern between the two economies even if the goods
and services produced by the two economies are not similar.
 The real value of the currency, as distinct from the nominal value, includes consideration
of relative price levels in order to arrive at the relative cost of foreign goods vis-à-vis
domestic goods.
 Changes in that relative cost influences the amounts of imports and exports of a country.
 In particular, a real appreciation reduces net exports (that is, reduces exports while
stimulating imports) while a real depreciation will have the opposite effect, increasing
exports and reducing imports.
 The real exchange rate signals consumers and producers about how to allocate their
purchases and sales between the domestic economy and the rest of the world.

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The Market for Foreign Exchange
 Consists of buyers and sellers of currency all over the world trading currencies through a
wide variety of institutions and media

The horizontal axis measures the amount

of foreign exchange that is bought or sold
during some time period
b a
The vertical axis shows the various
possible values of the real exchange rate

c
d

The vertical line labelled nKi stands for net capital inflows
 Which shows the net inflows from the capital account in the balance of payments
 This is the difference between inflows of foreign exchange (foreign direct investment,
purchases of domestic securities) and outflows (outward direct investment, purchases of
foreign securities by locals)
 This is vertical to show that the sale of assets and cross border purchases is not affected
by the level of the exchange rate
 International investors would certainly take into account their expectation about the likely
movement of the exchange rate over time, since that will affect their return on the
investment when that return is expressed in their local currency.
 With respect to different levels, however, net capital inflows will be the same and is
therefore represented by a vertical line
The negatively sloped line labelled “M-X” shows the foreign exchange flows
 Which comes from the current account of the balance of payments
 This is the trade deficit or the difference between the outflows of foreign exchange for
the purchase of imports and the inflows from the proceeds of exports
 This is affected by the level of real exchange rate as a rise (currency depreciation) makes
imports more expensive in local currency, which reduces the demand for imports, and
reduces the outflows of foreign exchange

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  A rise (currency depreciation) makes exports (domestic products) cheaper in to
foreigners, which increase the demand for exports, and increases the inflows of foreign
exchange
 The currency depreciation therefore reduces the net demand for foreign exchange for
trade purposes, this explains the downward sloping nature
Further Explanation
 If the current level of the real exchange happens such that the net inflows of foreign
exchange from inward direct investment and portfolio investment exceed the outflows to
finance the trade deficit
- Foreign exchange traders will lower the nominal exchange rate to attract
purchasers of foreign exchange
- This is shown on the graph at point “a” which exceeds the quantity
demanded to finance the “b”
- The reduction in the nominal rate would have to be sufficient to
compensate for any changes in the two countries’ price levels to ensure
that the real exchange rate falls.
 If the current level of the real exchange happens such that the net inflows of foreign
exchange from inward direct investment and portfolio investment are less than the
outflows to finance the trade deficit
- Foreign exchange traders will raise the nominal exchange rate rather than
wait until their foreign exchange float runs out leaving them with no more
foreign exchange to sell.
- This is shown on the graph where the quantity supplied from the capital
account is only “d” while quantity needed for trade is the larger amount
“c”
- Raising the nominal rate, other things remaining unchanged, will raise the
real rate.
 Since excess supply of foreign exchange induces the real exchange rate to fall and excess
demand induces it to rise, the real exchange rate will generally drift towards the market-
clearing equilibrium – exchange rate, where inflows and outflows are equal

127 | E C O N 1 0 0 0 N o t e s 2 0 2 2
Shifts to the Right of the M-X Curve
 As incomes in a country rise or fall, for example, purchases of consumer items will
naturally rise or fall along with it.
 Since a typical household’s consumption will include some foreign goods, and even
domestically produced goods and services will use some inputs procured from abroad,
any change in the level of income will therefore induce a corresponding change in the
amount of imports.
 In this way, rising income levels in a country will stimulate, through increased
consumption of imports, increased demand for foreign exchange.
 This is represented on the market diagram as an outward (or rightward) shift of the M-X
curve, shown below

Shift to the Left of the M-X Curve

 Rising income abroad, in the economies of a country’s trading partners, will induce
higher consumption there
 Consumption will include some commodities and inputs that are produced in the local
economy, raising exports and thereby increasing inflows of foreign exchange.
 In this way, higher incomes abroad result in an inward (or leftward) shift of the M-X
curve

128 | E C O N 1 0 0 0 N o t e s 2 0 2 2
Shifts to the Left of the nKi Curve
 Interest rates also influence the demand for and supply of currencies. The rate of interest
in a country indicates the returns to be had from holding financial investments in that
country, such as lending money to the government.
 If domestic interest rates were to fall, the return on the loans may not compensate some
lenders for the perceived risk of lending to a perhaps unreliable government.
 These investors would therefore want to shift their financial investments to other
countries whose interest rates may not have fallen and who therefore now offer a
comparatively better prospect.
 As financial capital moves out of the country, net capital inflows would be lower.
 As a consequence, then, of lower domestic interest rates, net capital inflows will fall and
consequently the exchange rate will rise, reflecting a depreciation of the currency, as seen
in the graph below

Shifts to the Right of the nKi Curve

 The opposite of what was explained above happens if there is a rise in the domestic
interest rates which attracts more investors
 The financial capital moves into the country and net capital inflows would be higher
 The exchange rate will fall, reflecting an appreciation in the currency, seen as a shift to
the right of the nKi curve

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The real exchange rate moves up and down to equate inflows and outflows of foreign
exchange. Those flows include those for the purchases and sales of assets as well as the
imports and exports of goods and services.

Purchasing Power Parity

Arbitrage and Law of One Price
 Arbitrage- exploitation of price differences between different markets that sell the same
commodity
- The arbitrageurs increase the demand for the commodity in the market
where the price is lower, pushing the price up, and increase the supply in
the market in which the price is higher, driving the price down.
- These forces should continue until the two prices are unified, or at least
until the difference between them is sufficiently small such that the cost of
transportation between the markets will absorb any profit remaining to be
had from arbitraging further
 Law of One Price- a commodity can have only one price, price variation in markets
between which there is trade will be arbitraged away
- Price differences for the same commodity may also persist if the
difference reflects conditions that differentiate the two markets, such the
convenience, security, or pleasure of shopping in one place versus another.
- But arbitrage will always eliminate any price differences that are greater
than those considerations can justify.
- The law of one price operates only weakly between different countries.
- Governments erect artificial barriers to trading commodities, barriers such
as import tariffs and quality restrictions.

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 - Additionally, it is inconvenient and costly to transport some types of
commodities, across great distances, and many products are not tradable at
all
- For these reasons, the forces of arbitrage exhibit only a weak influence
across international borders.
- For particular commodities, large price differences can and do persist
between countries
PPP Exchange Rate= Local Cost of Goods/Foreign Cost of Goods
 This explains the behaviour of the nominal exchange rate in the long run
 The PPP rate rises at a rate equal to the difference between the inflation rates locally and
in foreign
 A large difference in inflation will cause a rapid increase in the PPP exchange rate and an
equally rising nominal exchange rate
Real Exchange Rate in the Long Run
 If, at the current level of the nominal exchange rate, goods are generally cheaper abroad
than they are in the home country, an arbitrage opportunity will be present.
 Even if inflows and outflows of foreign exchange are in balance to begin with, before
long, consumers will seek to take advantage of cheaper imported goods.
 The growing demand for those imports will be an outflow of foreign exchange.
 At the same time, the relative costliness of domestic production will be recognized by
consumers abroad as well who will therefore reduce their purchases of our exports
 This reduces inflows of foreign exchange on the trade account locally
 Both of these developments are illustrated by the outward shift of the M-X curve
 In this way, whenever there is a substantial divergence between the cost of goods at home
and abroad, trade flows and the corresponding demand for and supply of foreign
exchange, it will drive the real exchange rate towards the one that equates the purchasing
power of a given amount of money in the two currency areas
 That is, towards the exchange rate that achieves purchasing power parity or PPP

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Exchange Rate Regimes
Free or Floating/Clean/Flexible Exchange Rate
• Exchange Rate is determined by the market forces of demand and supply
• Supply of Foreign Exchange is Influenced by the import of goods and services
(changes in international prices)
• Investment Abroad
• Foreign Governments and Central Bank (Changes in Overseas interest rate)
• Changes in local taste and preferences
• Changes in domestic income
• Demand for foreign exchange is influenced by export of goods (changes in
domestic prices while foreign prices remain fairly constant)
• Investment in the Country
• Government and Central Bank (change in local interest rate)
• Changes in relative income of foreigners
• Speculators Believe that the rate of exchange could change
Fixed Exchange Rate
 Maintained by the intervention (via purchases or sales of currency) of the Central
Bank
 If the demand for foreign currency increases relative to the supply, that there is a
shortage of foreign exchange, the central bank will sell foreign currency in order to
increase the supply to match the demand
 If it is the opposite, the central bank will buy the surplus of foreign currency thus
creating increase in demand to match the increase in supply.
Managed or Dirty Float
 Combination of the fixed and free floating
 The exchange rate is determined by the forces of demand and supply and the
government as well
 Governments can set a price ceiling and price floor within which the currency is
allowed to fluctuate
 Once the currency fluctuates beyond the band, the central bank will intervene in the
foreign exchange market buying or selling foreign currencies o Revaluation and
Devaluation is done by the Central Bank

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Category Advantages Disadvantages
Free Floating • Leads to • Encourages reckless
competitiveness and government spending
efficiency • Leads to uncertainty
• No outside because investors will
interference by the not be able to predict
Central Bank the exchange rate
• No need to hold foreign (uncertain for returns
exchange on investment)
reserves • Due to constant
• Allows for government movement of the ER, it
to make independent leads to a rise in
macroeconomic polices speculations which
• Allows for automatic can disrupt the natural
stabilization of the movement of economic
BOP, meaning that an variables
increase in imports will • Fall in the value of
depreciate the currency currency can lead to
and this depreciation imported inflation as
will cause exports to the price of imports
rise, which leads to increases
equilibrium
Fixed Reduces speculation No automatic
Discouraged reckless stabilization
gov’t spending Leads Government has to
to certainty and also store reserves so that
certain returns on they can intervene n
investment the market
Reduces risk in Reduces
international trade competitiveness of
firms
Government policies
are tied to polices of
other countries

133 | E C O N 1 0 0 0 N o t e s 2 0 2 2
 Managed Allow monetary Triggers speculation
policy independence. activities, especially
It also allows the when foreign
central bank to use exchange reserves
other policies, such as are insufficient.
interest rates, to
stabilize exchange
rate movements, not
just using foreign
exchange reserves.

Graphs and Explanations for the Different Exchange Rates

Free Floating Exchange Rate

• The Graph below shows how the shifts in demand and supply cause depreciation
and appreciation of the currency given the reasons stated above in the explanation
of the Floating Exchange Rate.

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Effect of Certain Examples on Demand for Jamaican Dollar and Supply of US Dollar
• Increase in the Interest Rate
• Demand for JA decreases and there is depreciation of the JA dollar
• Inflation in US
• Increase in demand for JA, so shift to the right and then appreciation of JMD
• There is a recession in the JA
• Demand for JMD increases, so demand curve shifts to right, so there is dollar
appreciation of JMD and vice versa
• Jamaicans Travel to the US
• Increase in Supply of the US Dollar, so shift of supply curve to the right so USD
appreciates and vice versa

Fixed Exchange Rate

D1

S1

Refer to the demand and supply explanation above. The shifts in demand and supply are due to
what the Central Bank does.

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Managed Exchange Rate

• The ER fluctuates between P and P1

• If the rate goes above P, then the government will supply its own currency on the
market to reduce the value
• If it goes below P1, the government will lower the market and demand its own
currency to make its value increase
Balance of Payments
 Accounting of all payments that cross a country’s borders
 Current Account
- Goods and Services
- X-M= Trade Balance
- Add exports and subtract imports and add remittances
 Capital Account
- FDI and Portfolio Investments
- Add inflows of FDI and Portfolio Investments
- Subtract outflows of FDI and Portfolio Investments
- Subtract change in Net Income Receipts
- nKi= Net Capital Inflows

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Economic Statistics
Circular Flow of Income
Economic Agents (Circular Flow Model)
 This model shows how money is circulated throughout society
 The THREE Main Economic Agents are the Households, Governments and Firms
 Among these three, money is circulated

Explanation of Diagram
 As Seen above there are two MAIN players, the households and businesses
 This model begins with the household sector participating in Consumer Expenditure and
then moves to the business sector which manufacture commodities
 The government and International trade sector contribute to the circular flow through
government expenditure, exports which bring in cash flow from international purchases
respectively
 Firms that invest money to buy capital stocks also allow money to flow into the economy
 When all elements are added together, the outcome is a country’s GDP or National
Income
 Households/Individuals
o The flow begins from here
o These households/individuals demand GOODS AND SERVICES from the
Product Market and in turn participate in Consumer Expenditure (C)

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 o These households/individuals supply Factors of Production/ Resources/Labour to
the Resource Market and in turn receive Income in Factor Payments
o The households/individuals pay Taxes to the government in exchange for Public
Goods
o They also receive Transfer Payments from the Government
 Businesses/Firms
o These firms supply GOODS AND SERVICES to the Product Market and in turn
receive Revenue
o These firms demand Factors of Production/ Resources/Labour from the Resource
Market and in turn pay Factor Costs
o The firms pay Taxes to the government in exchange for Public Goods
o They also receive Subsidies from the Government
Leakages and Injections
 Leakages
o Money leaving the circular flow of income
o Taxation (T)
 Money paid to the government by individuals as a percentage of their
income
o Imports (M)
 Money paid to the foreign sector in exchange for a good or service
o Savings (S)
 Money that is saved by firms or individuals for future investments etc.
 Injections
o Money entering the circular flow of income
o Government Expenditure (G)
 Money that government spends to develop the country or injects into the
economy
o Exports (X)
 Money received from the foreign sector in exchange for a good or service
o Investments (I)
 Payments made to acquire the securities of other entities, with the
objective of earning a return
Note: In Order for an Economy to be Balanced

 T+M+S=G+X+I
 Leakages=Injections

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Types of Circular Flow Models
Two Sector Model

Explanation of Two Sector Model

 Households
o All households own ALL of the factors of production
o They sell these to the firms and earn:
 Rent from land
 Wages for labour
 Profit and Interest for the use of capital
 Firms
o They use these factors states above and produce goods and services
o In turn they sell them back to the households
 Total Income in the Economy= Rent + Wages + Profit + Income
 Total Output in the Economy= Goods + Services
 Total Expenditure in the Economy= Spending on Goods and Services
 IF THERE WRE NO LEAKAGES AND INJECTION THEN
o Income=Output=Expenditure
 Including Leakages and Injections
o Leakages
 Savings (S): Income Earned but Not Spent: S=Y-C. These are deposited in
banks or capital markets and firms borrow to invest from the same
 Aggregate Expenditure (total Expenditure in the Economy)

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 - Types of Expenditure in the Economy Are Consumption
(Households) and Investment (Firms)
- AE=C+I
- But not all the income that households earn is spent (some is saved)
- Y= C + S
- Therefore, Equilibrium is Y=AE
- C+S=C+I
- Therefore, Savings = Investments for Equilibrium
 If savings is not equal to investments, the firm’s stock levels will adjust
until actual investment = actual saving
 Total Expenditure is equal to the value of the total output or GDP (AE=Y)
 If AE>Y, total spending EXCEEDS GDP
o Firms will start to produce more
o Response to disequilibrium
 If AE<Y, total spending is LESS than GDP
o Some output will not be old and will accumulate as inventory
 Total Injection MUST = Total Leakages

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The 3-Sector Model

Explanation
 This sector includes the Government Sector
 AE= C + I + G = Y
 Injection/ Leakages Method: I + G = S + T
 The economy is in equilibrium at these two conditions
 Investment can be higher than saving AS LONG AS taxation is higher than government
spending

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The 4 Sector Model

Explanations
 This model includes the foreign sector
 Injection: Exports (X)
 Leakage: Imports (M)
 Y= AE
 C + S + T + M=C + I + G + X
 S+T+M=G+I+X
 Leakages = Injections (Order of the Formulas)

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GDP (Gross Domestic Product)
 Total monetary value of all of the completed goods and services produced WITHIN a
country’s boundaries in a certain time period
 Final Goods are the ones that are SOLD to consumers for final use
 Intermediate Goods are those that are produced and sold to other firms for further
processing or resale
 GDP is calculated on an annual basis or quarterly basis
 If the entire value of exports GREATER than the value of imports, a country’ GDP rises
and there is a trade surplus
 If the entire value of exports LESSER than the value of imports, a country’ GDP falls and
there is a trade deficit
 GDP can be calculated nominally or on a real basis
Methods of Calculating GDP
1. Expenditure Method
 This method calculates the total amount of money that is spent by the different
sectors in the economy
 GDP= C + I + G + (X-M)
 GDP= Consumption + Investment + Government Spending + (Exports – Imports)
 Consumption
- Most Important Component
- Refers to private consumption spending
- Consumers purchase various products using their money
 Government Spending
- This the money that the government spends on equipment,
infrastructure, payroll etc. and government consumption and gross
interest
- This is very important when consumer spending and corporate
investment both fall substantially and in the aftermath of a recession
 Investment
- This is private domestic investment or capital expenditure by firms
 Net Exports
- This is the difference between imports and exports
- It includes spending by firms in a specific nation even if they are
foreign enterprises
 Detailed Approach:
- Total domestic expenditure/total domestic absorption = Total
consumption + Investment + Government spending
- Total final expenditure = Total domestic expenditure + exports

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 -GDP at market price = Total final expenditure – Imports +
statistical discrepancy
 Statistical Discrepancy Is a balancing item in order to ensure
that all the methods of GDP calculations are equal
 If there is a large statistical discrepancy, the information is
inaccurate
 If there is a small statistical discrepancy, the information is
accurate
- GDP at factor cost = GDP at market price + subsidy – indirect
taxes
 GNP (Gross National Product)
- Total market value of ALL final goods and services produced within
and outside of a country by factors of production owned by the
residents or nationals of that country
- The NPIA/ NFIA (Net Factor/Property Income from Abroad) is
the difference between the income of the residents of a country from
their FOPs and the payment made to foreigners for their factors of
producing invested in that country
- GNP at factor cost = GDP at factor cost + net factor income/ net
property income from abroad
- GNP at market price = GDP at market price + net factor
income/ net property income from abroad
2. Income Approach
 Calculates GDP by adding the total income received by households as payment
for services of their factors of production that are used to produce final goods and
services produced within the economy
 This is GDP at factor cost
 Detailed Approach:
- Gross Domestic Income at factor cost = Income from
employment + income from self-employment + gross trading
profit of private limited company+ gross trading profit of public
limited company+ gross trading surplus of public enterprises
(RGD or executive agencies) + rent + capital consumption or
depreciation
- Gross Domestic Product at factor cost = Gross Domestic income
at factor cost – stock appreciation
 Stock appreciation occurs when the value of a product
increases solely as a result of an increase in the price level
 Occurs when old stocks sell at new prices
- Gross Domestic Product at market price = Gross Domestic
Product at factor cost + indirect taxes – subsidies
- GNP at market price= GDP at market price + net property
income

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 - GNP at factor price= GDP at factor price + net property income
3. Output/Value Added Method
 Calculates GDP by adding the total market value of all final goods and services
produced by the different sectors in the economy
 This is used to prevent double counting (adding final good along with
intermediate goods)
 Detailed Approach
- GDP at market price = the sum of the price of all goods and
services produced in each sector of the country.
- GDP at factor cost = GDP at market price + subsidy – taxes
- GNP at factor cost = GDP at factor cost + net property income
- GNP at market price = GDP at market price + net property
income
Example:
Goods Final Value Value Added
Soft Wood 1000 +1000
Pulp 3000 +2000 (3000-1000)
Paper 5000 +2000 (5,000-3000)
Newspaper (wholesale price) 8000 +3000 (8,000-5,000)
Newspaper (retail price) 10,000 +2,000 (10,000-8000)
$10,000 (GDP)

Components Not Included in GDP

Component Reason
Purely Financial Transaction Transfer of money from one party to another
(no addition to GDP)

This is not a payment for goods or services

Examples are stocks, bonds, treasury bills

Sale of Second Hand Items Item would have been recorded in GDP of the
year in which it was first sold

This leads to double counting

Transfer Payments Any Income received by individuals that is
not payment for goods or services

Examples are remittances, pensions etc.

Intermediate Goods Have already formed part of the final goods

Counting would lead to double counting

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 Imports Goods produced outside of country while
GDP is goods produced within a country

Examples of Components That Should Be Included in GDP

 Underground Economy
o Include both legal and illegal transactions
o Some legal transactions are unrecorded in pursuit of tax evasion
 Informal Economy
o Refers to productive activities that are not recorded due to size and nature
o Transaction for which no money was exchanged
Other Measures of National Income Accounting
 Net National Product
o Sum of all the final goods and services produced by the resources of a country in
a given year less depreciation in the same year
o = GNP at market price – Capital consumption/depreciation
 National Income
o All income earned by citizens of a country, whether the income is earned locally
or abroad
o = Net National Income (NNP) – indirect taxes + subsidies
 Personal Income
o Refers to the level of income which is adjusted for net transfers
o Three main types of income/transfers include contributions to social security or
national insurance programmes, corporate profits
o Income Received but Not Earned include social security and other welfare
benefits
o = National Income + income received but not earned (IRBNE)
– income earned but not received (IEBNR)
o
 Disposable Income
o Residual personal income after taxes have been removed from gross income
o = Personal income – direct/income taxes
 GDP Per Capita
o Primary tools for determining the level of development in a country over time and
across countries
o Measures average distribution of income per unit of the country’s population
o =GDP/Population

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Use of National Income Accounts to Measure Economic Performance
 National Income can be used to evaluate a country’s economic performance
 From this a number of problems rise when comparing national incomes overtime
 Rising Prices
o As price level increases overtime, this decreases purchasing power of money
o In order to fix this, the REAL GDP per capita is calculated which deflates the
nominal GDP by the Retail Price Index in order to get Real GDP
 Quality of Goods and Services Overtime
o As an economy matures the quality of goods and services produced can change
o Although people are materially well off, there is a reduction in overall welfare due
to a drop in the quality
Calculations of Real and Nominal GDP
Nominal GDP
 Measure of economic output in a country that takes current prices into account
 Therefore, this does not account for the rate at which prices increase or inflation
 This will give a wrong growth number which is much exaggerated
 This is used in comparing various quarters of out in the same year
Real GDP
 Measure of economic output in a country that takes inflation into account and calculates
with the prices maintained constant from year to year
 Although prices rise, and GDP increases, it does not represent the changes in the output
and the quality of goods
GDP Deflator
 Difference in process between the current year and base year
GDP Growth Rate
 This analyses a change in the country’s economic production year over year
 This determines how fast the economy expands
 This allows the banks to make decisions on the level of interest rates
 If the growth rate is negative, then banks will decrease interest rates
 If the growth rate is positive and accelerating fast, banks will increase interest rates
Formulas
1. Real GDP = Nominal GDP x the base year price level

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 The current year price level

OR

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 100

2. Real GDP = 𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟 × 1

3. GDP deflator = nominal GDP x 100

Real GDP

[Measures the changes in prices for all of the goods and services produced in an economy.]

Consumer Price Index

 CPI measures the weighted average prices of a basket of consumer goods and services
 This identifies periods of inflation or deflation
 CPI= (Cost of Market Basket in Given Year/Cost of Market Basket in Base Year) x 100
Real GDP Growth Rate
 Formula= ((Real GDP in Year 2 – Real GDP in Year 1)/Real GDP in Year 1) x 100

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Calculating Inflation
CPI Use
 (Current CPI – Previous CPI)/Previous CPI x 100
GDP Deflator Use
 (Current Deflator – Previous Deflator)/Previous Deflator x 100
Uses of GDP and GNP
 Measure of Country’s rate of economic growth
 It is used by economists to test hypotheses
 It is used to determine the stage of the business cycle that the economy is in
 It is used to make comparisons within a country from one period to another as well as
international comparisons
 It is used to determine a country’s contribution to international organizations such as
World Bank, IMF, United Nations, etc.
 The country’s real GDP per capita provides a rough guide of the country’s standard of
living
 A growing economy attracts investments more internally and externally
 It can be used by government officials to predict the amount of tax revenue that will be
collected.
 It can assist the government to formulate its fiscal or monetary policy

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Limitations of GDP
Limitation Explanation
Exclusion of Informal
Economic Activity
Earnings Made by
Offshore Firms
Negative Externalities
Income Distribution
Business To Business
Activity
Inclusion of all Final
Private and Government
Spending
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 GDP is based off of recorded transaction data and official
statistic
 Ignores unrecorded economic activity
 There is black market activity, volunteer labour (unpaid)
 Does not account for the value of leisure time or household
production
 This money is sent back to foreign investors which makes
GDP geographically constrained in a globally open
economy
 Although GDP maybe high, it doesn’t take into
consideration the country’s quality of life
 This doesn’t take into account a population’s well being
 Externalities include pollution etc.
 Does not account for the disparity in income distribution
 GDP may increase only because of a small percentage of
the economic society
 GDP only examines final products output and new capital
investment, netting out intermediate expenditures and
business interactions.
 GDP overstates the significance of consumption in the
economy in comparison to output, making it less susceptible
to economic changes than measurements that incorporate
business-to-business interaction.
 It includes this as contributions to society's revenue and
production, regardless of whether they are truly productive
or profitable.
 This means that actions that are clearly useless or even
harmful are frequently counted as economic production and
contribute to GDP growth.
All The Best for Exams 😊