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Diploma

in
Business Administration
Study Manual

ECONOMICS

The Association of Business Executives

William House 14 Worple Road Wimbledon London SW19 4DD United Kingdom
Tel: + 44(0)20 8879 1973 Fax: + 44(0)20 8946 7153
E-mail: [email protected] www.abeuk.com

Copyright RRC Business Training

abc

All rights reserved

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in
any form, or by any means, electronic, electrostatic, mechanical, photocopied or otherwise,
without the express permission in writing from The Association of Business Executives.

ABE Diploma in Business Administration

Study Manual

ECONOMICS
Contents
Study
Unit

Title

Syllabus

Page

The Economic Problem and Production

Basic Economic Problems and Systems
Nature of Production
Total, Average and Marginal Product
Production Possibilities
Some Assumptions Relating to the Market Economy

1
2
3
6
11
13

Consumption and Demand

Utility
Indifference Curves
The Demand Curve
Utility, Price and Consumer Surplus

17
18
21
32
36

Demand and Revenue

Influences on Demand
Revenue and Revenue Changes
Price Elasticity of Demand
Further Demand Elasticities

39
40
44
51
54

Costs of Production
Factor and Input Costs
Economic Costs
External Costs and Benefits
Costs and the Growth of Organisations
Small Firms in the Modern Economy

57
58
67
68
70
73

Profit, Supply and Expenditure Taxes

The Nature of Profit
Maximisation of Profit
Influences on Supply
Price Elasticity of Supply
Supply, Indirect Taxes and Subsidies

77
78
80
86
92
97

Contents (Continued)
Study
Unit

Title

Page

Markets and Prices

Nature of Markets
Functions of Markets
Prices in Unregulated Markets
Price Regulation
Market Defects The Case for A Public Sector
Price Changes and Indirect Taxes and Subsidies

101
102
103
104
108
110
113

Market Structures and Competition

Meaning and Importance of Competition
Perfect Competition
Monopoly
Monopolistic Competition
Oligopoly
Profit Maximisation and Alternative Objectives for the Firm

117
118
119
125
128
131
135

Money and the Financial System

Money in the Modern Economy
The Commercial Monetary and Financial System
The Central Bank of the United Kingdom
Interest Rates

139
140
142
147
148

Liquidity Preference
Options for Holding Wealth
The Keynesian View of Liquidity Preference
The Supply of Money
Implications of Liquidity Preference
Changes in Liquidity Preference

153
154
155
158
160
164

The National Economy

National Product and its Measurement
National Product
National Expenditure
National Income
Equality of Measures
Use of National Product Calculations
Limitations of National Accounts
National Product and Living Standards

165
166
170
173
175
175
176
177
178

Determination of National Product and Implications of Investment

Changes in Consumption, Saving and Investment
Government Spending and Taxation
Changes in Equilibrium, the Multiplier and Investment Accelerator
Business Investment and Interest Rates in the Economy as a Whole

181
182
186
186
193

Contents (Continued)
Study
Unit

Title

Page

The Deflationary and Inflationary Gaps

National Income Equilibrium and Full Employment
The Basic Keynesian View
The Deflationary Gap
The Inflationary Gap
Measurement of Unemployment and Inflation

203
204
204
205
208
212

Classical and Monetarist Economics

Basic Assumptions of Classical and Monetarist Economics
Distortions of Market Imperfections
Implications of the Monetarist-Classical Views for Economic Policy
The Importance of Money Supply
Controls over Money
The Problems of Monetarism

219
220
221
223
224
226
229

Government and the National Product

The Public Sector
Taxation and the Economy
Public Sector Borrowing Requirement (PSBR)

231
232
236
242

Economic Problems and Policies

The Major Economic Problems
Policy Instruments Available to Governments
Policy Conflicts and Priorities
Supply-side Policies

247
248
250
256
257

National Product and International Trade

The Balance of Payments
Payments, Surpluses and Deficits
Remedies for a Current Balance of Payments Deficit

265
266
277
281

The Economics of International Trade

Gains from Trade and Comparative Cost Advantage
Trade and Multinational Enterprise
Free Trade and Protection
Methods of Protection
International Agreements

287
288
290
293
297
301

Foreign Exchange
International Money
Exchange Rates and Exchange Rate Systems

311
312
314

Diploma in Business Administration Part 1

Economics
Syllabus
Aims
1.

Acquire an understanding of fundamental economic theories, concepts and policies.

Apply microeconomic principles and concepts to decision-making in a business environment.

Understand the general macroeconomic environment and its effect upon business organisations
and their markets.

Acquire an understanding of international trade and the economic mechanisms employed to

control and facilitate it.

Programme Content and Learning Objectives

After completing the programme, the student should be able to:
1.

Define the problem of scarcity, opportunity cost, the functioning of free market, command and
mixed economies and the difference between macroeconomics and microeconomics.

Describe and interpret the basic theory of consumer behaviour and demand including the
concept of utility, the law of diminishing marginal utility, the distinction between Giffen,
inferior and normal goods, the distinction between substitute and complementary goods, the
difference between individual and market demand, and the notion and measurement of
elasticity (own-price, cross and income elasticity).

Employ the theory of supply from a fundamental understanding of costs; define the difference
between the short-run and the long-run; differentiate between fixed, sunk and variable costs;
derive marginal, average and total costs; understand the nature and relevance of economies and
diseconomies of scale and the concept of elasticity of supply.

Describe the application of supply and demand analysis to the working of markets both in
equilibrium and disequilibrium, including examination of the effects of price restrictions,
quotas, subsidies and taxation.

Examine the effect of different markets structures (perfect competition, monopoly, monopolistic
competition and oligopoly) upon the conduct (particularly pricing policy) and performance of
profit maximising and non-profit maximising (sales revenue, market share and managerial
utility maximising) business organisations, and give examples of the forms and effects of
government intervention in this area.

Understand how exchange rates are determined, the main alternative exchange rate regimes and
their advantages and disadvantages. Explain the rationale for international trade agreements
and organisations (e.g. the World Trade Organisation), tariffs, quotas and other measures of
trade protectionism.

Evaluate national income as a measure of societal well being and derive it through its various
methods of measurement. Explain the main components of National Income Accounts
(Consumption, Investment, Government Expenditure and Foreign Trade).

Explain the determination of the equilibrium levels of national income in terms of the simple
Keynesian macroeconomic model.

Describe the functions of money and the role of the banking system in the creation of money.
Explain the relationship between the money supply, growth and inflation.

10.

Understand and interpret the main objectives of government macroeconomic policy and the
rationale for the various policies used to achieve these objectives. Employ the aggregate supply
and demand model to analyse the likely effects of fiscal and monetary policy upon output,
employment, the price level, and the balance of payments.

11.

Explain the fundamental principles of comparative advantages and specialisation and their
relevance to international trade. Explain the terms of trade, balance of trade and balance of
payments accounts.

Method of Assessment
By written examination. The pass mark is 40%. Time allowed 3 hours.
The question paper will contain:
Section A is composed of eight short-answer compulsory questions and Section B contains five
questions from which three must be attempted. Section A is worth 40% of the total marks available
and Section B 60% of the total marks.

Reading List:
Essential Reading
Introduction to Positive
Economics

Lipsey, R.G. and

Chrystal, A.K.

(Oxford University Press)

iii

Additional Reading
Economics
Economics
Dictionary of Economics
The Economic Review

Begg, D. Fischer, S. and

Dornbusch, R.
Sloman, J.

(McGraw-Hill)

Bannock, G. Baxter, R.E.

and Rees, R.

(Penguin)

(Harvester-Wheatsheaf)

Study Unit 1
The Economic Problem and Production
Contents
A.

Page

Basic Economic Problems And Systems

Some Fundamental Questions

Choice and Opportunity Cost

Nature of production

Economic Goods and Free Goods

Production Factors

Enterprise as a Production Factor

Fixed and Variable Factors of Production

Production Function

Total, average and marginal product

Total Product

Marginal Product of Labour

Average Product of Labour

Production possibilities

Some assumptions relating to the market economy

Consistency and Rationality

The Forces of Supply and Demand

Basic Objectives of Producers and Consumers

Consumer Sovereignty

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A. BASIC ECONOMIC PROBLEMS AND SYSTEMS

Some Fundamental Questions
Economics is concerned with peoples efforts to make use of their available resources to maintain and
develop their patterns of living according to their perceived needs and aspirations. Throughout the
ages people have aspired to different lifestyles with varying degrees of success in achievement but
always they have had to reconcile what they have hoped to do with the constraints imposed by the
resources available within their environment. Frequently they have sought to escape from these
constraints by modifying that environment or moving to a different one. The restlessness and
mobility implied by this conflict between aspiration and constraint has, of course, profound social
and political consequences but, as far as possible, in economics courses we limit ourselves to
considering the strictly economic aspects of human society.
It is usual to identify three basic problems which all human groups have to resolve. These are:
!

What, in terms of goods and/or services, should be produced

How resources should be used in order to produce the desired goods and services

For whom the goods and services should be produced.

These questions of production and distribution are problems because for most human societies
peoples aspirations or wants are unlimited we often seem to want more of everything whereas the
resources available are scarce. This term has a rather special meaning in economics. When we say
that resources are scarce we do not mean necessarily that they are in short supply though often, of
course, they are but that we cannot make unlimited use of them. In particular when we use, for
example, land for one purpose, say as a road, then that land cannot, at the same time, be used for
anything else. In this sense, virtually all resources are scarce: your time and energy, for example,
since you cannot at the same time read this study unit and watch a football match or play football.

Choice and Opportunity Cost

Since human wants are unlimited but resources scarce, choices have to be made. If it is not possible
to have a school, hospital or housing estate all on the same piece of land, the choice of any one of
these involves sacrificing the others. Suppose the communitys priorities for these three options are
hospital, housing estate and then school. If it chooses to build the hospital it sacrifices the
opportunity for having its next most favoured option the housing estate. It is logical, therefore, to
say that the housing estate is the opportunity cost of using the land for a hospital.
Opportunity cost is one of the most important concepts in economics and also one of the most
valuable contributions that economists have made to the related disciplines of business management
and politics. It is relevant to almost every decision that the human being has to make. Awareness of
opportunity cost forces us to take account of what we are sacrificing when we use our available
resources for any one particular purpose and this awareness helps us to make the best use of these
resources by guiding us to choose those activities, goods and services which we perceive as providing
the greatest benefits compared with the opportunities we are sacrificing. This cost will be a recurring
theme throughout the course.
You may have been wondering how the community might decide to choose between the hospital,
housing estate and school. Which option is chosen depends very much on how the choice is made
and whose voices have the most power in the decision-making process. You will probably have been
aware that changing the structure of many of the bodies responsible for allocating resources in the

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health and hospital services in Britain led to many strains and disputes. One reason for this was the
transfer of decision-making power from senior medical staff to non-medical managers, whose
perception of the opportunity costs of the various options available was likely to be very different
from that of the medical specialists.
Throughout history societies have experimented with many different forms and structures for
decision-making in relation to the allocation of the total resources available to the community.
Through much of the twentieth century there has been conflict between the planned economy, with
decisions taken mostly by political institutions, and the market economy, where decisions are taken
mainly by individuals and groups operating in markets where they can choose to buy or not to buy the
goods and services offered by suppliers according to their own assessment of the benefits and
opportunity costs of the many choices with which they are faced. As the century draws to a close it is
the market operation that is in the ascendancy, and this course is concerned mainly with the operation
of markets and the market economy. At the same time we need to recognise that market choices have
certain limitations and social consequences which cannot be ignored. All the major market
economies have important public sectors within which choices are made through various kinds of
non-market institutions and structures, and economics is able to make a significant contribution to
understanding these.

B. NATURE OF PRODUCTION
Economic Goods and Free Goods
The term goods is frequently used in a general sense to include services, as long as it does not
cause confusion or ambiguity. It is used in this wide sense in this section.
Goods are economic if scarce resources have to be used to obtain or modify them so that they are of
use, i.e. have utility, for people. They are free if they can be enjoyed or used without any sacrifice of
resources. A few minutes reflection will probably convince you that most goods are economic in the
sense just outlined. The air we breathe under normal conditions is free, but not when it has to be
purified or kept at a constant and bearable pressure in an airliner. Rainwater, when it falls in the open
on growing crops, is free but not when it has to be carried to the crops along irrigation channels or
purified to make it safe for humans to drink. Free goods are indeed very precious and people are
becoming increasingly aware of the costs of destroying them by their activities, e.g. by polluting the
air in the areas where we live.

Production Factors
Since there are very few free goods most have to be modified in some way before they become
capable of satisfying a human want. The process of want satisfaction can also be termed the creation
of utility or usefulness and is also what we understand by production. In its widest economic sense
production includes any human effort directed towards the satisfaction of peoples wants. It can be as
simple as picking berries, busking to entertain a theatre queue or washing clothes in a stream, or as
involved as manufacturing a jet airliner or performing open heart surgery.
Production is simple when it involves the use of very few scarce resources but much more involved
and complex when it involves a long chain of interrelated activities and a wide range of resources.
We now need to examine this general term resources, or economic resources, more closely. The
resources employed in the processes of production are usually called the factors of production and,
for simplicity, these can be grouped into a few simple classifications. Economists usually identify the
following production factors.

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Land
This is used in two senses:

(a)

The space occupied to carry out any production process, e.g. space for a factory or office

(b)

The basic resources within land, sea or air which can be extracted for productive use,
e.g. metal ores, coal and oil.

Labour
Any mental or physical effort used in a production process. Some economists see labour as the
ultimate production factor since nothing happens without the intervention of labour. Even the
most advanced computer owes its powers ultimately to some human programmer or group of
programmers.

Capital
This is also used in several senses, and again we can identify two main categories:
(a)

Real capital consists of the tools, equipment and human skills employed in production.
It can be either physical capital, e.g. factory buildings, machines or equipment, or human
capital the accumulated skill, knowledge and experience without which physical
capital cannot achieve its full productive potential.

(b)

Financial capital is the fund of money which, in a modern society, is usually needed to
acquire and develop real capital, both physical and human.

Notice how closely related all the production factors are. Most production requires some
combination of all the factors. Only labour can function purely on its own, if we ignore the need for
space. A singer or story teller can entertain with voice alone, but will usually give more pleasure with
the aid of a musical instrument and is likely to benefit from earlier investment in some kind of
training. The hairdresser requires a least a pair of scissors!
Much of economic history is the story of peoples success in increasing the quantity and quality of
production through the accumulation of human capital and the development of technically advanced
physical capital. I can dig a small hole in the ground with my bare hands, but creating the Channel
Tunnel between Britain and France has required a vast amount of very advanced physical capital
together with a great deal of human skill and knowledge.
Modern firms depend for their survival and success on both their physical and their human resources.
While some of us may feel that the current trend to replace the business term personnel
management by human resource management is in some degree dehumanising, others welcome it
as a sign that firms are recognising the importance of its employee skills as human capital.

Enterprise as a Production Factor

All economic texts will include land, labour and capital as factors of production. There is not quite
such universal agreement over what is often described as the fourth production factor, which is most
commonly termed enterprise.
The concept of enterprise as a fourth factor was developed by economists who wished to explain the
creation and allocation of profit. These economists saw profit as the reward which was earned by the
initiator and organiser of an economic activity the person who had the enterprise and special quality
needed to identify an unsatisfied economic want and to combine successfully the other production
factors in order to supply the production to satisfy it.

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In an age of small business organisations, owned and managed by one person or family, this seemed
quite a reasonable explanation. The skilled worker who gives up secure and often well-paid
employment to take the risks of starting and running a business is most likely to be showing
enterprise and is prepared to take risks in the hope of achieving profits above the level of his or her
previous wage. Many modern firms have been formed in the recent past by initiators, innovators and
risk takers of the kind that certainly fit the usual definition of the business entrepreneur. Their names
appear constantly in the business press. Few would wish to deny that profit has been and often
remains the spur that drives them.
Nevertheless this identification of enterprise in terms of individual risk-taking raises a great many
problems when we attempt to apply it generally to the modern business environment. Much
contemporary business activity is controlled by large companies such as BT, Shell, BP and Unilever.
Who are the entrepreneurs in such organisations? Are they rewarded by profits? How do these
companies recruit and foster enterprise? You, yourself, may work in a large organisation. Can you
reconcile the traditional economic concept of enterprise as a factor of production with your
observations of the structure of your company?
No one doubts the importance of enterprise and profit in modern business but their traditional
explanation in terms of the fourth production factor is at best incomplete and at worst actually
dangerous, in that it may be used to justify the very large salaries which company chief executives
seem able to award themselves in Britain and the USA.
We shall return to the question of profit in Study Unit 5.

Fixed and Variable Factors of Production

Both economists and accountants make an important distinction between production factors, based on
the way they can be varied as the level of production changes. To take a simple example, suppose
you own a successful shop. Initially you do not employ anyone but soon find you do not have time to
do everything and are losing sales because you cannot serve more than one customer at a time. So,
you employ an assistant. This gives you more time and flexibility and allows you to buy better stock;
your monthly sales more than double. You employ another assistant and again your sales increase.
You realise, however, that you cannot go on increasing the number of assistants since space in your
shop is limited and you can only meet demand in a small local market. You begin to think about
opening another shop in another area.
This example helps to illustrate the difference between a production factor which you can vary as the
level of production varies, i.e. a variable factor, in this case the assistants (labour), and a factor
which you can only move in steps at intervals when production levels change. This latter, which in
our example is the shop, i.e. land (space) and capital (the shop building and equipment), is the fixed
factor.
In most examples at this level of study it is usual to regard capital as a fixed factor and labour as a
variable factor. Although it is not possible to have a fraction of a worker we can think in terms of
worker-hours and recognise that many workers are prepared to vary the number of hours worked per
week. It is more difficult to have half a shop and even if a shop is rented rather than bought,
tenancies are usually for fixed periods. It is more difficult to reduce the amount of fixed factors
employed than the variable factors. When a machine or piece of equipment is bought it can only be
sold at a considerable financial loss.
This distinction between fixed and variable production factors is very important, particularly when
we come to examine production costs in Study Unit 4. It also gives us an important distinction in
time. When analysing production economists distinguish between the short run and the long run. By

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short run they mean that period during which at least one production factor, usually capital, is fixed,
e.g. one shop, one factory, one passenger coach. By long run they mean that period when it is
possible to vary all the factors of production, e.g. increase the number of shops, factories or passenger
coaches. Sometimes you may find the short and long run referred to as short and long term. This is
not strictly correct, but the difference in meaning is slight and not important at this stage of study.

Production Function
We can now summarise the main implications of our recognition of factors of production. We can
say that to produce most goods and services we need some combination of land, capital and labour.
At present we can leave out enterprise as this is difficult to quantify. In slightly more formal
language we say that production is a function of land, capital and labour. Using the symbols Q for
production, S for land, K for capital and L for labour, (with for function) this allows us, if we wish,
to use the mathematical expression:
Q = (S, K, L)
For further simplicity, we can leave out land so we can concentrate on just two factors, capital and
labour and, as previously noted, regard capital as a fixed and labour as a variable factor.

C. TOTAL, AVERAGE AND MARGINAL PRODUCT

Total Product
In this study unit we examine what happens when production increases in the short run, when the
production factor capital is fixed and when the factor labour is variable. Once again we can take a
simple example of a small business which is able to increase its use of labour. For simplicity we can
use the term worker as a unit of labour, but you may wish to regard a worker as a block of workerhours which can be varied to meet the needs of the business.
Suppose the effect of adding workers to the business is reflected by the following table, where the
quantity of production is measured in units and relates to a specific period of time, say, a month. The
amount of capital employed by the business is fixed.
Number of workers

Quantity of production
(units per month)

120

170

220

260

290

310

320

310

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The quantity of production measured here in units produced per month and shown as a graph in
Figure 1.1, is, of course, the total product. In this example total product continues to rise until the
tenth worker is added to the business; this worker is unable to increase total product. This is no
reflection on that particular worker who may, in fact, be working very hard. It is simply that, given
the fixed amount of capital, no further increase in productive output is possible. The addition of an
eleventh worker would actually cause a fall in production. It is not difficult to see why this could
happen.

Marginal Product of Labour

Examine now the amount of change to total product as each additional worker is added to the
business. The following table shows this change in the third column which is headed marginal
product. Strictly speaking, this is the marginal product of labour because it results from changes in
the amount of labour (workers) added to the business.
Number of workers

Quantity of production
(units per month)

Marginal Product of
labour
(units per month)
30

30
40

70
50

120

170

220

260

290

310

320

310

50
50
40
30
20
10
0
10

The marginal product of labour is the change in total product resulting from a change in the
amount of labour employed. It is called marginal because it is the change at the edge, and the term
marginal is used in economics to denote a change in the total of one variable which results from a
single unit change in another variable. Here the total is quantity of production resulting from changes
in the number of workers employed.
The marginal product column shows the difference in the total product column at each level of
employment. Notice that the marginal value is shown midway between the values for total product

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and number of workers. This is because it shows the change that takes place as we move from one
level of employment to the next. In Figure 1.1 the marginal product is represented by the vertical
distance between each step in production as each worker is added.
The sum of the marginal product values up to each level of worker is equal to the total product at that
level.

Figure 1.1
Notice how these marginal product values change as total product rises: one worker alone can
produce 30 units but another enables the business to increase production by 40 units and one more by
50 units. There are many ways in which this increase might be achieved, e.g. by specialisation and by
freeing the manager to improve administration, purchasing and selling. However, these increases
cannot continue and the additional third, fourth and fifth workers all add a constant amount to
production. Thereafter, further workers, while still increasing production, do so by diminishing
amounts until the tenth worker adds nothing to the total. At this level of labour employment
production has reached its maximum, and the eleventh worker actually provides a negative return
total production falls. Perhaps people get in each others way or cause distraction and confusion. If
the business owner wishes to continue to expand production, thought must be given to increasing
capital through more buildings and/or equipment. Short-run expansion at this level of capital has to
cease. Only by increasing the fixed factors can further growth be achieved.
This example is purely fictional it is not based on an actual firm; but neither is the pattern of change
in marginal product accidental. The figures are chosen deliberately to illustrate some of the most
important principles of economics, the so-called laws of varying proportions and diminishing
returns. It has been constantly observed in all kinds of business activities that when further
increments of one, variable production factor are added to a fixed quantity of another factor, the
additional production achieved is likely, first, to increase, then to remain roughly constant and
eventually to diminish. It is this third stage that is usually of the greatest importance, this is the stage

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of diminishing marginal product, more commonly known as diminishing returns. Most firms are
likely to operate under these conditions and it is during this stage that the most difficult managerial
decisions, relating to additional production and the expansion of fixed production factors, have to be
taken.
It must not, of course, be assumed that firms will seek to employ people up to the stage of maximum
product when the marginal product of labour = 0, or on the other hand that they will not take on any
extra employees if diminishing returns are being experienced. The production level at which further
employment ceases to be profitable depends on several other considerations, including the value of
the marginal product, which depends on the revenue gained from product sales, and the cost of
employing labour, made up of wages, labour taxes and compulsory welfare benefits. The higher the
cost of employing labour, the less labour will be employed in the short run and the sooner will
employers seek to replace labour by capital in the form of labour-saving equipment.

Average Product of Labour

The average product of labour employed is found simply by dividing the total product at any given
level of employment by the number of workers (or some unit of worker-hours). For reasons which,
by now, should be starting to become apparent to you the average product of labour, though a
measure easily understood and used by many business managers and their accountants, is less
important than the marginal product. However, the following table adds average product to our
earlier statistics, and Figure 1.2 shows both marginal and average product in graph form.
Number of workers

Quantity of production
(units per month)

120

170

220

260

290

310

320

310

Marginal product of
labour
(units per month)

Average product of
labour
(units per month)

30
30.00
40
35.00
50
40.00
50
42.50
50
44.00
40
43.33
30
41.43
20
38.75
10
35.56
0
32.00
10

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28.18

It might be that if the firm devoted all its resources to the production of one good instead of to more
than one then it would be able to use them more efficiently. They would then gain from what will
later be described as increasing returns to scale. In this case the curve would be shaped as in Figure
1.4.
Yet another possibility is that the firm could switch resources without any gain or loss in efficiency,
i.e. it would experience constant returns from scale in using its resources. In this case the curve
would be linear (a straight line) as in Figure 1.5.

E. SOME ASSUMPTIONS RELATING TO THE MARKET

ECONOMY
Consistency and Rationality
Although we recognise that all people are individuals, and it is usually impossible to predict with
complete certainty what actions any individual will take at any given time, nevertheless it is possible
to predict with rather more confidence what groups of people are likely to do over a period of time.
On this basis it becomes possible to estimate, for example, how much bread will be consumed in a
certain town each week or month. A supermarket manager does not know what any shopper will buy
when that shopper enters the store, but can estimate how much, on average, the total number of
shoppers will spend on any given day in the month and will know how much is likely to be spent on
each of the many classes of goods stocked. Patterns of spending will, of course, change but the
changes are not likely to be random when applied to large groups. There will be trends that will
enable projections to be made into the future with some degree of confidence. As groups, therefore,
people tend to be consistent and to behave according to consistent and predictable patterns and
trends.

Quantity of Y

Quantity of X

Figure 1.4
The production possibilities curve for a firm gaining increased efficiency by concentrating on one
product

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Quantity of Y

Quantity of X
Figure 1.5

The production possibilities curve for a firm which is neither more nor less efficient when it switches
resources from one product to another.
People are also assumed to be rational in their behaviour. Again, we are all capable of the most
irrational actions from time to time but if we behave in a normal manner we are likely to display
rational economic behaviour. For example if, given the choice between, say, cornflakes and muesli
for breakfast we choose cornflakes and if given the choice between, say, muesli and porridge we
choose muesli, then, if we are rational and offered the choice between cornflakes and porridge we
would be expected to choose cornflakes, because we prefer cornflakes to muesli and muesli to
porridge. It would be irrational to choose porridge in preference to cornflakes if we have already
indicated a preference for muesli over porridge and for cornflakes over muesli.
If we accept consistency and rationality in human behaviour then analysis of that behaviour becomes
possible, and we can start to identify patterns and trends and measure the extent to which people are
likely to react to specific changes in the economic environment such as price in ways that we can
identify, predict and measure. If we could not do this the entire study of economics would become
virtually impossible.

Utility

Meaning of Utility

Total and Marginal Utility

Maximising Utility from Available Resources

Indifference Curves

What is an Indifference Curve?

Indifference Curve Analysis and Income Changes

Indifference Curve Analysis and Price Changes Giffen Goods

The Demand Curve

What is a Demand Curve?

Indifference Curves and the Demand Curve

Use and Importance of Demand Curves

General Form of Demand Curves

Utility, Price And Consumer Surplus

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A. UTILITY
Meaning of Utility
Economists have always faced problems in explaining clearly why people are prepared to make
sacrifices to obtain many of the goods and services which they evidently wish to have. In a market
economy this difficulty can be stated as Why do we buy the things we do buy? Very often we do
not need them in the strict sense that they are necessary to our survival. In fact our basic needs are
really very small compared with all the things on which we spend our money in advanced market
economies. We can talk in terms of wants and recognise that there seems to be no limit to these
wants. We also have to recognise that at any given time we are likely to want some things more than
others.
What, then, is the quality that goods must possess that make us want to acquire them? Clearly this
will differ with different goods. Some may be pleasant to eat, some attractive to look at, some warm
to wear and so on. The one general term we can apply to all goods and services is that they provide
us with utility. This does not necessarily mean that they are useful in the sense that they help us to
do something we could not do before we had them but simply that we perceive in them some quality
that makes us willing to make some degree of sacrifice (usually of money) in order to acquire them.
Can we, then, measure this utility? In an absolute sense, the answer is almost certainly No. Some
economists have proposed adopting a measure called a util but no-one, not even the European
Commission, has yet proposed that we mark all goods to show how many utils they contain. It is
more practical to think in terms of money value since most of us measure the strength of our desire to
buy something in terms of the price we are prepared to pay for it. When, therefore, an estate agent
asks a potential house buyer, How much are you prepared to offer for this house? the agent is, in
effect, asking the buyer to indicate the value of the utility which the house has for him or her.
More often we find ourselves making comparisons of utility. This arises partly because of the basic
economic problem of unlimited wants and scarce resources, so that ranking our wants so we can
decide what we can afford to buy is for most people an almost daily occurrence; but it also arises
because, in modern advanced economies there is likely to be a range of different goods to satisfy any
particular want. If I want to travel by public transport from Birmingham to Glasgow I could do so by
motor coach, by train, or by air. My want is to get from Birmingham to Glasgow, and three options
offer the utility to satisfy this want. Each involves different sacrifices of money and time and offers
different associated utilities of convenience and comfort. My choice will depend on the resources
available to me (how much money I can afford to pay and how much time I have) and on my
valuation of the utility afforded by each option. Notice, further, that this utility is not an absolute
quality but depends on why I want to make the journey. If it is part of a holiday then I might prefer
the coach or train, but if I am attending a business meeting from which I hope to achieve a financial
benefit and need to be fresh and alert then the air option is likely to offer the greatest utility greater,
probably, than the price of the fare.
All this may seem very involved, but an appreciation of utility and how it can influence our actions
can be a very great help in understanding the true nature of economic demand.

Total and Marginal Utility

Our valuation of the utility provided by any good depends on how strongly we want to acquire it.
While there may be several elements involved in this, e.g. we find it attractive or useful, or think it
will impress our friends or neighbours, one factor that is always relevant is the amount of that or a

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similar good we already possess. Suppose I have enough spare cash at the end of the week to buy
either a pair of trousers or a pair of shoes but not both, though I would like both. If I already have an
adequate supply of trousers for the next few months but do not have any spare shoes then, assuming
that their prices are roughly similar, I am likely to buy the shoes. This does not mean that I always
value shoes more highly than trousers but that, considering what I already have at the present time, I
perceive greater utility in some additional shoes than in additional trousers.
By now, especially if you have remembered the explanation of marginal product in Study Unit 1, you
will recognise that I have just given an example of marginal utility, i.e. the change in total utility for
a good or group of goods when there is a change in the quantity of those goods already possessed.
Most of the important decisions relating to the demand for goods and services are influenced by
valuations of marginal utility compared with the prices of these goods. The more pairs of trousers I
possess the less value am I likely to place an obtaining more and the more likely am I to spend my
available money on other things of comparable price whose marginal utilities are higher.
Willingness to buy thus depends on the comparison of marginal utility with price so to some extent it
is reasonable to value utility in terms of price. To return to the original house buyer example, if the
buyer says to the agent, My highest offer is 100,000, then for this buyer the value of the marginal
utility of the house is 100,000. If this is the buyers only house then, of course, it is also the total
utility.
We must also bear in mind that money itself has utility. If I am saving money for a major holiday or
for an expensive durable (long lasting) good such as a house or furniture, then I may place a high
value on money savings and be less inclined to buy trousers and shoes as long as I have enough of
these for my immediate needs. If my income is secure and rising, my valuation of the marginal utility
of money could be low and I am more likely to spend it on goods. If, however, my job is not secure
and redundancy or retirement is a serious possibility, my valuation of the marginal utility of money is
likely to rise and I will spend less on goods and services. You can easily see the implications of this
for the general demand for consumer goods during periods of economic uncertainty when people
think they are likely to have less money in the future. Just as the marginal utility of a good
diminishes as the quantity already possessed rises, so marginal utility rises as the quantity of a good
already possessed falls or is expected to fall in the near future.

Maximising Utility from Available Resources

This relationship between total and marginal utility can be illustrated in a simple graph as in
Figure 2.1.

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Figure 2.1: Marginal and Total Utility

Suppose I have no use for more than 8 pairs of trousers. This number would provide maximum utility
to which we can give a hypothetical numerical value of, say, 100 (representing 100% of the total) but
clearly the largest marginal utility would be provided by the first pair. After this purchase the
marginal utility of each additional pair diminishes, as indicated by the figures under MU to the right
of the vertical axis. The total of 100 is reached with the eighth pair. If I have a ninth, no further
utility is added the total remains at 100. Should I receive a tenth pair my total utility actually falls:
perhaps they take up space in my wardrobe I would rather have for something else.
Does this, then, mean that I should aim at keeping eight pairs of trousers all the time? Not
necessarily, since Figure 2.1 takes no account of other important considerations, which include:
!

the price of trousers, i.e. the sacrifice I must make to buy them

my desire for other goods and services, i.e. other marginal utilities ( I would not, for example,
be too pleased to have eight pairs of trousers if I possessed only one shirt, nor would trousers
satisfy my hunger if I did not have enough food to eat)

how much money I have, i.e. my marginal utility for money

Only when all these are taken into account would it be possible to estimate how many pairs of
trousers would represent, for me, the best total to try and achieve.

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Assuming rationality, in the sense explained in Study Unit 1, the most satisfactory quantity of
trousers for me would be where my marginal utility gained from the last 1 spent on trousers just
equalled the marginal utility per 1 spent on all other available goods and services, and where this
also equalled the marginal utility of money. On the assumption that we are valuing utility in
monetary terms the marginal utility of the last 1 of money = 1.
Putting this statement a little more formally as an equation and using the symbols, MUA to denote the
marginal utility for the good A, MUB for the marginal utility for the good B, PA for the price of A, PB
for the price of B and so on, we can say that consumers achieve a position of equilibrium in their
expenditure when for them:
MU N
MU A
MU B
=
=
= 1 (which = the marginal utility of money)
PA
PB
PN

In this state of equilibrium consumers cannot increase their total utility from all goods and services
by any kind of redistribution of spending. Spending more on A and less on B, for example, would
mean that the marginal utility of A would fall and so be less than that of the marginal utility of B,
which would rise and be less than the marginal utility of other goods, including money. Also the
utility gain from A would be less than the utility lost from B so total utility would have fallen. No
one rationally spends 1 to receive less than 1s worth of utility.
You may object that this kind of reasoning takes no account of actions such as making contributions
to charity, but our use of the term utility does embrace such gifts. Presumably we give to a charity
because the act of giving to a use we perceive as worthy, affords us satisfaction. It has, therefore,
utility and can be regarded in the same way as other forms of spending. This means, of course, as
charities and the organisers of national charitable events have discovered, that giving to charity is
also subject to diminishing marginal utility. Aid fatigue is the term sometimes used for this.

B. INDIFFERENCE CURVES
What is an Indifference Curve?
An indifference curve is a graph linking all the combinations of two goods or two groups of goods
which provide the same level of total utility for an individual, group of people or community. It is
called an indifference curve because there is no preference for one combination over any of the
others. All offer the same amount of utility or satisfaction, so that people are indifferent as to which
combination they have.
One curve can, of course, indicate only one level of utility. If the resources available to acquire the
goods were increased people could move to a higher level, and if resources fell they would have to be
satisfied with a lower level. We can, therefore, imagine that any one curve is really part of a map of
very many curves all representing different levels of total utility.
A simple example of an indifference curve is shown in Figure 2.2.

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Figure 2.2
The figures given here for units of X and Y are purely hypothetical. They are not an actual case and
are intended simply to illustrate a general situation. From the table and the curve we see that the
person whose curve this is would have the same utility from 4 units of X and 1.5 of Y as from 3 units
of X and 2 of Y or from 2 units of X and 3 of Y.
Although these figures are, to some extent, just plucked out of the air, they are also chosen to
illustrate the general shape which we can expect all indifference curves to take, i.e. the curve is
convex to the origin of the graph since it is based on the principle already explained, of diminishing
marginal utility.
According to this curve, when the person has just 1 unit of X but 6 of Y, he or she is prepared to give
up 3 units of Y to gain 1 more unit of X, i.e. 1X has the same value as 6Y. However, when that
person has 3 units of C he or she will only be prepared to give up 0.5Y in return for one more X, i.e.
with 3 units of X possessed, a further unit of X is valued at only 0.5Y. Thus the marginal utility of X
has diminished from 3Y to 0.5Y as more X is accumulated.
You may think this is a rather involved way to illustrate the fairly commonsense principle that most
people readily accept that the more we have of something the less value we put on gaining yet more
of the same and the more we would prefer to have something else. This is all that we mean by
diminishing marginal utility. However, the indifference curve has given rise to a technique of
analysis that is used quite frequently in economics and which often helps to clarify thinking on some
fairly controversial topics.

Indifference Curve Analysis and Income Changes

Remember that the indifference curve is not a demand curve. By itself it tells us nothing about how
much of a good we are likely to buy; it only indicates relative preferences between different goods or

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groups of goods. As we noted earlier in this study unit, to be able to estimate how much of a good
people may be prepared to buy, in a market economy, we also need to know:
!

the price of the good

the amount of money they have available.

To carry out any kind of indifference curve analysis, therefore, we must take these two factors into
consideration.
Suppose that the price of X is 3 per unit while that of Y is 2 per unit. Suppose also that the amount
of money available for spending on X and Y is limited to 12.
Assuming that the full 12 is spent there is a range of spending possibilities. These are:
!

The whole 12 is used to buy X with nothing spent on Y. At a unit price of X of 3 this would
buy 4 units of X.

The whole 12 is used to buy Y with nothing spent on X. At a unit price of Y of 2 this would
buy 6 units of Y.

A combination of X and Y which involves a total price of 12, e.g. 2 units of X (2 3 = 6)

and 3 units of Y (3 2 = 6).

These possibilities are illustrated in the linear (straight line) spending possibilities curve of
Figure 2.3. (If you have studied some mathematics you will not be worried by the thought that there
are linear, or straight-line curves. If you have not studied mathematics, you will soon get used to the
expression.) The spending possibilities curve is sometimes called the spending possibilities line, to
help to distinguish it from the indifference curve, and it is also sometimes called the budget line.

Figure 2.3

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We now have two curves: one, the indifference curve, shows us combinations of X and Y that
provide us with the same level of total utility or satisfaction; the other, the spending possibilities line,
tells us what it is possible to buy at given prices and a given amount of money for spending.
When the two curves are combined, as in Figure 2.4, we see that the only combination on the
indifference curve that we can buy is 2X and 3Y. Had there been less than 12 to spend the spending
possibilities line would not have reached this indifference curve and only a lower level of utility (a
lower curve in the map mentioned earlier) would have been available.

Figure 2.4
Consider now what would happen if the person had 16, not 12 to spend. The spending possibilities
line changes as shown in Figure 2.5. The 16 can be used to obtain more of X or more of Y, or some
new and larger combinations of the two.

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Figure 2.5
Figure 2.5 also shows how movement to a higher spending possibility line allows movement to a
higher indifference curve, where there is a greater level of total utility or satisfaction. The point
where the new curve just touches the higher spending possibility line is at a level where more of both
X and Y is obtained.
This movement to a higher indifference curve results in more of both X and Y being bought. This is a
reasonable expectation: if our income rises we can spend more on most goods. However, there may
be some exceptions. As incomes rise, peoples pattern of spending may change; the extra income
may permit people to switch spending from some goods to preferred substitutes. The diet of people
on low incomes may include a substantial amount of bread or potatoes, but as their incomes rise they
may choose a more varied diet, spending less on bread or potatoes. If this happens we can say that
bread and potatoes are perceived by such people as inferior goods; they may, perhaps, buy more
fruit, biscuits and other foods.
When this happens there has been a change in the relative preferences between goods and this will be
reflected in a change in the shape of a higher indifference curve, as illustrated in Figure 2.6. Here a
rise in income allows the spending possibilities line to move outwards from AB to A1B1 and the
higher spending permits movement to a preferred combination of goods on the higher indifference
curve I1. This indifference curve is flatter than the lower curve I, which means that X is valued less
highly compared with Y. The amount of X that has to be given up to gain a given amount of Y is less
as you move along I1 than if you move along I. You can see this in Figure 2.7.

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Figure 2.6

Figure 2.7

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In curve I the group puts the same ability value on 5 units of X and 5 units of Y as it does on 4 units
of X and 6 units of Y. Thus at this level on indifference curve I, 1 unit of X = 1 unit of Y.
In curve I1 the different group puts the same utility value on 5X and 5Y as it does on 3 units of X and
6 units of Y or 4 units of X and 5.5 units of Y. The flatter curve, therefore, values X at half as much
Y as the steeper curve at the levels examined.
Notice that showing two curves intersecting in this way indicates that they must either reflect the
preferences of different groups or the same group at different times. They cannot possibly relate to
the same group at the same time, since 5X and 5Y cannot at the same time have the same utility as
both 4X and 6Y and 3X and 6Y.
Because of the danger of misleading examiners by appearing to show such an absurdity you should be
careful never to show indifference curves intersecting on the same graph. I have broken this rule in
Figure 2.7 only to give you a simple illustration of the difference between a flat and a steep
indifference curve.
Remember the flatter the indifference curve the greater the preference for the good measured along
the vertical or Y axis; the steeper the indifference curve the greater the preference for the good
measured along the horizontal or X axis. Thus, if the indifference curves get flatter as income and
total utility levels increase, this suggests that people are switching their spending preferences towards
the good or goods measured along the Y axis. If they do this to the extent that the quantity purchased
actually falls following an income rise then the goods on the horizontal axis can be described as
inferior in economic terms.

Indifference Curve Analysis and Price Changes Giffen Goods

The change illustrated in Figure 2.5 assumed that the prices of X and Y remained the same.
Suppose that, instead of a spending change, there was a price change. Let us say that the price of X is
increased to 4 per unit but that of Y stays the same at 2. The two extreme possibilities for a total
amount of spending of 12 are now 6 units of Y (no X) and 3 units of X (no Y). The line between
these two points on the graph shows all possible combinations of X + Y that can be bought for the
12. This line no longer meets our original indifference curve. The old combinations of 2X + 3Y
would now cost 14 above the limit of 12. A new mixture of X and Y has to be obtained, and this
we see in Figure 2.8.

Figure 2.10
The increased consumption of X between points B and C on the same indifference curve, i.e. from 7
to 813Y units, the result of a movement along the indifference curve, is the substitution effect. It is
the result purely of the change in price of X from 3 to 2, because the total utility gained from
consuming both X and Y has not changed.
Thus, if we consider the actual consumption movement from B to A, we see that it is made up of two
parts. These are the 113Y units rise which we have explained as the substitution effect, plus the 123
units rise which is the result of the increased income available for spending and which has enabled
movement to the higher indifference curve I1.
This increase resulting from movement to a higher level of satisfaction is the income effect, because
the reduction in price of X has provided more spendable income and some of this has been used to
purchase more X.
In this example X and Y are clearly normal goods since the full movement from B to A is the sum of
B to C plus C to A. But suppose X had been an inferior good: in this case the indifference curve I1
would have been flatter and the point of tangency (A) with the consumption possibility line 2 would
have been to the left of C, indicating a reduction in purchases as a result of the income effect. The
total change B to A would then have been the distance B to C minus C to A, i.e. a total somewhere
between B and C to a quantity level of X below 8.33.
Taking this one stage further, consider the possibility of a Giffen good. In this case the inferior nature
of the income effect would have been even greater and the indifference curve I1 even flatter until the
point of tangency A would actually move to the left of the starting point of B and the new level of
purchases of X would be under 7X.

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Notice that the income effect of a price change can move the level of consumption for the affected
good in either direction.
!

For normal goods (the majority) a rise in income available for spending on the good produces
an increase in purchases. Similarly a fall in income results in a reduction in purchases.

For inferior goods a rise in income available for spending on the goods produces a reduction in
purchases, while a fall in income results in an increase in purchases.

However the substitution effect is always in the same direction, i.e. in the reverse direction to that of
the price change and in favour of the good whose price has become lower relative to the price of the
substitute. In effect the substitution effect is a movement along the indifference curve caused by the
change in gradient of the consumption possibilities line, which is itself caused by the changes in the
relative prices. Thus we can say that:
!

For all goods the substitution effect causes a rise in the consumption of the good whose price
has become relatively lower and a reduction in consumption of the good whose price has
become relatively more expensive.

The Giffen effect, where a price rise produces an increase in consumption and a price fall leads to a
decline in consumption, occurs when the inferior income effect is actually greater than the
substitution effect.

C. THE DEMAND CURVE

What is a Demand Curve?
So far in this study unit we have considered some of the consequences of price and income changes
for the amounts of goods purchased. The general, and in most cases normal relationship between
price and quantity changes is frequently illustrated by graphing the anticipated amounts of a good that
people can be expected to buy, in a given time period, at a series of different prices within a given
price range. This produces a demand curve.
Bear in mind that the demand curve is a simple two-dimensional graph. It shows the relationship
between just two variables the price of a good and the quantity of that good that we believe is likely
to be purchased over a given time period.
In concentrating on just price and quantity we make the assumption that all other possible influences
on demand (quantities of possible purchases) are held constant. These other influences, including
income and prices of other goods, already noted, will be considered again in the next study unit but
for now we can conveniently ignore them. Our concern, for the moment, is with price.

Indifference Curves and the Demand Curve

We can make use of simple indifference curve analysis for a normal good to show how it is possible
to derive a demand curve. Suppose a group of consumers have, between them, an amount to spend
each week of 840, and they spend this on a combination of products or product baskets, X and Y.
Assume that the price of Y stays constant at 8.40 per unit but that X varies between 12 and 5 per
unit.
Given these figures, the maximum possible consumption of Y (no X consumed) is 100 units, whereas
that of X (no Y consumed) moves from 70 units per week at a price of 12 to 168 units at the lower
price of 5. These total possible consumption (spending) figures assume that the whole income is
spent on Y or X only. This enables us to draw the series of possible consumption or spending

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possibility lines in Figure 2.11, which also shows the actual consumption of X at the prices of 12,
8.75, 7 and 5, given the indifference curves of the diagram.

Figure 2.11
We see that actual consumption of X, given the relative preferences of X and Y represented by the
indifference curves, rises from 44 units per week at the price of 12 per unit to 96 units per week at
the price of 5 per unit. The actual consumption figures, related to these prices, are shown in Figure
2.12. This graph shows the demand for X at the range of prices 12 to 5. It is the demand curve for
the good X.

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Figure 2.12
This example illustrates the general shape of the demand curve and the normal relationship between
price and quantity demanded of a product. If all other influences remain constant, we would expect
the quantity demanded to rise as price falls and to fall as price rises. Notice that, in our example, we
have made the following assumptions:
(a)

Other prices, represented by Y, stay constant at 8.40 per unit.

(b)

Income also stays constant, at 840. Another point to remember is that we are here considering
a flow of demand related to a set period of time. It is always necessary to do this. We cannot
compare a weekly amount at one price directly with a monthly amount at another. When we
change one variable here price to analyse its effect on quantity, we have to keep all other
elements constant, including the time period to which the stated quantity relates. In our
example, this period was a week.

Use and Importance of Demand Curves

As you will see as you progress through this course, the demand curve is used extensively in
economic analysis. The price-quantity relationship is one of the most important things we need to
know when considering sales of products. A firm must know the likely result of a change in price,
because any alteration in quantity demanded will affect the total sales revenue.
Governments also need to know the probable effects of any change in a tax imposed on products.
Because such a tax will influence price, the price-quantity relationship is, again, an important issue.
If a government is considering an increase in a tax such as value added tax, which influences a very
wide range of goods, it needs to know what extra total revenue it can expect to gain from the tax
increase. It cannot assume that quantities consumed of all goods affected will remain the same; it
must take into account the probable changes in quantity demanded that will result from the changes in
price.

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General Form of Demand Curves

At this stage of study, you will meet demand curves chiefly in relation to general analytical problems.
Actual figures are then less important than the general shape and slope of the curves. It is normal,
therefore, to draw general curves, in which price and quantity are denoted simply by letters. For
reasons that will become clearer in later study units, it is simpler to draw what are called linear
curves, i.e. straight-line graphs, for part only of the full price and quantity range. This is because,
for most purposes, we are concerned only with a limited range of possible prices and quantities.
When there are special reasons for departing from these normal practices, we shall explain these.
Examples of typical general demand curves are given in Figures 2.13 and 2.14.
Notice that in Figure 2.13 a given change in price appears to produce a greater change in quantity
demanded than in Figure 2.14. This is assuming that they are drawn to the same scale. You must
remember that the steepness of a demand curve will be affected by the scale of the (horizontal) Xaxis, and graphs must be drawn to the same scale, so that comparisons can be made.
It is a convention (general rule) in economics that price per unit is measured on the vertical (often
called the Y) axis, while quantity in units per period of time is measured along the horizontal X-axis.
It is often custom to label the axes simply Price and Quantity.

Figure 2.13

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Figure 2.14

D. UTILITY, PRICE AND CONSUMER SURPLUS

The idea of utility is not too hard to grasp. We can all recognise that we will only buy something if,
for us, it satisfies a want, i.e. that it is of some use to use for us it possesses utility. We can also
appreciate that the utility we perceive for one more unit of a good depends on how much of that good
we already have. Suppose I have some apple trees in my garden. In a year when, for some reason,
the trees bear very little fruit, I value highly the few apples that do grow and will go to some trouble
to pick them carefully when they are ripe. However, in another year the same trees may fruit
abundantly and produce more apples than I really want. I that year I may not bother to pick them all
and may allow some to stay on the trees or lie on the ground. Thus, to me, the value of the apples
depends on the quantity available and is equal to their marginal utility the usefulness to me of
some additional apples to those I already have.
The same principle applies if I have no trees at all and I have to buy apples or any other goods. I will
only pay the price to obtain them if this price is not more than the value of their marginal utility. This
idea gives us a means of putting a monetary value on marginal utility. Let us say that I like to eat
apples but do not have to do so. There is other fruit readily available. I will only buy them at a price
I consider reasonable. Suppose that, one week, I see that apples are priced at 80p per pound. This, to
me, is dear and above my valuation of the utility of a pound of apples. I do not buy any. Next week
the price has fallen to 60p per pound, but I still think this is too dear and again do not buy. The third
week the price has fallen to 50p per pound. I give this more thought but, in the end, still do not buy.
By the fourth week, however, the price has fallen to 40p per pound, and this time I am prepared to
buy a pound. My marginal utility for apples is such that 40p is the highest price I am prepared to pay
for a pound of apples. I can thus put a value on my marginal utility for a pound of apples: it is 40p.
Suppose now that the next time I visit the store the price of apples has fallen yet again and it is now
30p. Again I buy a pound. The value of my marginal utility for a pound of apples has remained at
40p and I would have been prepared to pay 40p, but the price asked by the store was only 30p, so this

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is what I paid. Consequently I gained a surplus of 10p. The value of my sacrifice was less than the
value of the additional utility I gained: the difference was a surplus to me.

Figure 2.15
Since the price of 30p per pound was below my valuation of the marginal utility of a pound of apples
I might decide to buy two or perhaps three pounds. In this case I was valuing the marginal utility of
the additional amount bought above my usual quantity at less than the 40p but still now below 30p.
If, as seems likely, most consumers react in this way then we have no difficulty in accepting the
general shape of the demand curve outlined in the previous section, i.e. that people are prepared to
buy more of a good at a lower than at a higher price.
These ideas are illustrated in Figure 2.15, which shows a normal demand curve for a product the price
of which is 0p. The fact that the demand curve extends to prices higher than 0p indicates that there
are consumers who are willing to pay a higher price. However, if the price charged is 0p, then these
consumers achieve a surplus which is represented by the shaded area.
The demand curve is downward sloping to indicate that more of the product will be bought as the
price falls. This follows the assumption that most people will buy more of a product if they think the
price is favourable. Marginal utility diminishes as the quantity already possessed rises so, to sell
more, the supplier is likely to have to reduce price. Remember, as always, when considering the
effect of one change we make the assumption that other things remain unchanged. In practice they
will not, and in the next study unit we recognise this. My valuation of the marginal utility of apples
will change if I discover that the store has received a large consignment of nectarines and peaches and
is selling these at prices around my marginal utility for these fruits.

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Consumption and Demand

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Study Unit 3
Demand and Revenue
Contents
A.

Page

Influences On Demand

Flow of Demand

Products Own Price

Prices of Other Products

Income Available for Spending

Price and Availability of Money and Credit

Market Size

Advertising or Marketing Effort

Taste

Expectations

Other Influences

Summary of Influences

The Relative Importance of Influences

Shifts in the Demand Curve

Some Further Considerations

Revenue And Revenue Changes

Total Revenue

Average Revenue

Marginal Revenue

Price Elasticity of Demand

Calculation

Influences on Price Elasticity of Demand

Further Demand Elasticities

Income Elasticity of Demand

Influences on Income Elasticity of Demand

Cross Elasticity of Demand

Influences on Cross Elasticity of Demand

The Importance of Elasticity Calculations

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A. INFLUENCES ON DEMAND
Flow of Demand
The demand curve which we identified in the previous study unit illustrates the quantities of a
product that a group of consumers are prepared to buy at a range of possible prices. We must
remember that these quantities are always related to a time period. Demand is seen in terms of a flow
of purchases over a stated time. A greengrocer, for example, may want to know the weekly quantity
of apples he can sell at a price of 80p per kilo, and compare this with the weekly quantity he could
sell at 90p per kilo. The time is not always shown in simple demand graphs, but we must not forget
its importance. It is not much use being able to sell 100 kilos instead of 50 kilos if it takes three times
as long to do so.
If we clearly understand this idea of demand flow, remembering the points we made in Study Unit 2,
we can go on to identify the various influences which affect that flow.

Products Own Price

This is regarded as the most important influence on demand: normally, we expect a rise in price to
lead to a fall in quantity demanded, and a price fall to produce a rise in quantity.
It is claimed that some goods operate in the reverse way, as explained in Study Unit 2. These are
known as Giffen goods. Although, strictly, the term Giffen applies only when the inferior
income effect is more powerful than the normal price substitution effect, it is often used more widely
whenever demand appears to rise as price rises for whatever reason. There are a number of other
possible explanations. For example, people may, rightly or wrongly, associate price with quality
e.g. for tomatoes and prefer to pay a little more in anticipation of obtaining a more satisfactory fruit.
If there were some other trusted mark of quality, the normal price-quantity relationship would hold.
Demand may also rise for a work of art which people think is gaining acceptance in the art world. If
people think that the price is going to rise even more in the future, they may buy the work of art as an
investment and not simply because they get pleasure from looking at it. In this case, we are really
dealing with a different product. In yet more cases, the rise in demand is just the result of other
influences as described in this study unit and these are proving more powerful than the influence of
price on its own.
In general, therefore, we can accept that, if all other considerations are equal (which they seldom are),
people will prefer to pay a lower rather than a higher price for a product the quality of which they
know and accept.
We should also recognise that expectations of future price movements can influence current demand.
If people expect prices to rise next week, they will, if possible, prefer to buy now at the lower price.
On the other hand, this may be regarded as a temporary distortion of demand which will have little
effect over a longer period of time. If the longer-term effect is not taken into account, it might look as
though demand was rising as prices rose when, in fact, people had taken the view that a price rise
today was likely to be followed by further rises tomorrow, and were acting accordingly.
If a new product is introduced to the market, there is likely to be an effect on other goods. The
introduction of cheap electronic calculators destroyed the demand for slide rules. On the other hand
the development of portable radios and personal stereos also created a demand for the associated
(complementary) product the batteries needed for their operation. If a major product is introduced
and becomes popular enough to absorb a significant part of personal income then people will reduce
purchases of other products which they may consider less desirable. There may be no obvious
association between the desired product and the one neglected. For example, a person who decides to

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pay for a part-time degree course to enhance career prospects may think it worthwhile, perhaps, to
spend less on entertainment or to put off replacing a car or furniture.

Prices of Other Products

In our earlier illustrations, a little more was bought of Y when the price of X rose. This was because
Y and X were, to some extent, substitutes for each other. The indifference curve was based on the
assumption that more X could compensate for less Y. This will not always be the case. Sometimes,
two products are clearly associated petrol and motor oil or motor-car tyres, for instance. A rise in
petrol costs may lead to a fall in the use of cars and, hence, to reductions in demand for oil and tyres.
Even when products are not directly linked, a change in the price of one may still influence a wider
demand. If a man smokes heavily and is unable to check his habit, a rise in tobacco prices will lead
him to spend less on a wide range of other products. In the same way, a rise in mortgage interest will
force families to spend less on other goods.

Income Available for Spending

In Study Unit 2 substitution analysis showed how an increase in income could lead either to a rise or
a fall in the demand for goods. For the majority of goods and services, i.e. for normal goods, we
would expect the change in demand to be in the same direction as the change in income but for some,
inferior goods, the changes would be in the reverse direction so that a rise in income produces a fall
in demand and vice versa.
Notice that a good is inferior only if it is perceived as offering less satisfaction for a particular type of
want. Thus, as a normal means of transport a motor cycle may be perceived as inferior to a car even
though, as a piece of engineering, it may be superior. Suppliers may be able to revive demand for an
inferior good by changing its appeal; adapted and marketed as sporting and leisure good the motor
cycle has enjoyed such a demand revival and as such is often bought by people who also possess cars.

Price and Availability of Money and Credit

Many goods are bought with the help of borrowed money (credit). Money and credit have an
influence on demand separate from the effect of income. If the cost of credit, i.e. the rate of interest,
rises there is likely to be a reduction in demand for the more expensive goods.

Market Size
Many factors can change market size. A firm selling clothes to teenagers will benefit from any
increase in the numbers of teenagers in the population. Specialist shops selling babies and childrens
wear suffered from the declining birth rate of the early 1970s. Market size can be increased by
improvements in communications and technology. The development of commercial television greatly
increased the market area open to many consumer-goods firms. Increased foreign travel in the 1960s
helped to extend the demand and market area for foreign wines and foods. Improved techniques of
refrigeration extended the market for frozen vegetables.

Advertising or Marketing Effort

Very few products sell themselves. Most have to be marketed, and the more extensive the advertising
effort, the more is likely to be sold. Some marketing specialists suggest that there is a direct
relationship between the firms share of market advertising and its share of market sales. Certainly, it
is the volume of advertising in relation to competitors advertising that is likely to be important.

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Taste
This is a quality difficult to define. Peoples desire to buy products is the result of many influences,
not all of which are fully understood. Fashions change, and these changes cannot always be caused
by advertising. The successful firm is often the one that is able to make an accurate prediction of
changes in fashion and taste.

Expectations
Expectations of future changes in any of the above influences can affect present demand. For
example, people expecting rising prices will buy now rather than later. On the other hand, if they fear
unemployment and falling incomes, they will cut down their present spending. Notice that these
reactions may actually help to bring about the feared future changes.

Other Influences
Certain products may be subject to special influences other than the ones we have already mentioned.
The demand for soft drinks or for waterproof clothing, for instance, will be influenced by weather
conditions. The demand for private education in an area will be influenced by the reputation of Stateowned schools in that area.

Summary of Influences
All these influences on demand for a product can be expressed in a form of mathematical shorthand.
Thus, we can say that:
Q = (Po, Pa, Yd , N, A, T).
This simply means that the quantity demanded of any product (Q) is a function of, i.e. is dependent
upon (), its own price (Po), the prices of other goods (Pa), disposable income (Yd), market size (N),
marketing effort (A), and customer taste (T).

The Relative Importance of Influences

The relative importance of these influences varies, of course, for different products and it is necessary
for suppliers to estimate this if they are to avoid damaging errors. For example, if price is not of first
importance, a price reduction will simply reduce revenue and profit. The supplier would, perhaps,
have more to gain from increases in price and advertising expenditure.
Suppliers can attempt to estimate the relative importance of the demand influences by recording and
measuring the effect of those, such as price and advertising, under their control and also noting the
effects of other measurable changes such as movements in average incomes. Much information may
also be gained from market research, e.g. by asking people why they favour certain brands and what
their reactions would be to price movements. In some cases, shopping simulations can be staged with
people given a certain amount of money and then asked to spend it on a range of goods displayed in a
store. The scientific study and calculation of demand functions from information gained from all
available sources is known as econometrics. In some cases these studies have resulted in
calculations that have proved remarkably accurate but others have been less successful. There are
many things that can go wrong in the estimation of future demand! Business decisions still have to
be made against a background of market uncertainty.

Shifts in the Demand Curve

Because a normal two-dimensional graph can cope with only one influence in addition to quantity
changes, and because the normal demand curve relates quantity to the products own price, a change

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in quantity demanded brought about by a change in one or more of the other influences has to be
represented graphically by a shift in the whole demand curve.
Suppose there is an increase in disposable income which increases the quantity demanded at each
price within a given range. This effect can be shown as in Figure 3.1, where the price remains
constant at 0p but the increase in income has shifted the curve from DD to D1D1, so that the quantity
demanded at 0p rises from 0q to 0q1. A fall in income or a decline in taste, etc. would produce the
reverse result, i.e. a shift from D1D1 to DD.
Remember always to distinguish a movement along a demand curve produced by a change in price
(all other influences remaining unchanged) as shown in Figure 2.14 from a shift in the whole curve,
showing that demand has moved at all prices within the range under consideration.

Figure 3.1

Some Further Considerations

It has been argued that the normal influences identified above do not tell the full story, and that a
fuller understanding of social psychology can give further insights into consumer behaviour. For
example, supermarket chains well know the importance of impulse buying, when goods are skilfully
displayed. There is also a recognised snob effect, when goods may be bought because they are
expensive and they appear to be indicators of the owners wealth and status. While these
considerations are interesting and are clearly of importance to marketing specialists, we can include
them under the more general headings of advertising and taste, for the purposes of general analysis of
consumer demand.

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B. REVENUE AND REVENUE CHANGES

Total Revenue
Revenue, in general, refers to the money received from the sales of a product. For this reason, the
term sales revenue is often used. To have any practical meaning, revenue should also be related
either to a time period or to a definite quantity of goods sold. For example, a shopkeeper may refer to
his weekly sales revenue (the total amounts of sales achieved in a week) or to his revenue from the
sales of, say, n pairs of shoes or k kilos of potatoes. A statement that his revenue is y means nothing,
unless we can relate it to some quantity of time.
Revenue will not always increase as more goods are sold this will be the case only if the firm can
continue to charge the same price, regardless of quantity it sells. If, say, I make leather belts and can
sell all the belts I can make at a standard price of 5, then my total revenue is always 5 multiplied by
whatever quantity I sell.
This can be shown in the form of a total revenue curve, as in Figure 3.2.
However, if I continue to produce more and more belts, there will come a time when customer
resistance sets in. I shall have difficulty in finding more people who value belts at this price of 5,
i.e. the marginal utility of which is at least 5. When this time comes, I may still, however, find more
people who are willing to pay 4.

Figure 3.2
Now, in the Western world, shopping conditions are such that I cannot leave my belts unpriced and
hope to sort out from the people who visit my shop those willing to pay 5 and those willing to pay
4. If I want to sell more belts and am willing to charge 4, then I must charge this price to everyone.
If I continue to produce even more, I might then find that, to sell the increased quantity, I have to
charge 3. If I go on doing this, I am likely to find that my total revenue starts to fall.
Suppose I find that total revenue rises if I reduce the price from 5 to 4, but falls if I reduce the price
to 3. This will happen if the reduction from 4 to 3 does not produce enough additional sales to

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make good the loss suffered when I charge 3 to those people who would still have bought at prices
of 5 or 4. My sales schedule at the three prices might, perhaps, be as follows:
Price per belt

Number of belts I can sell

per month

Total revenue

200

1,000

280

1,120

340

1,020

This effect can be shown in the form of a simple graph but this time the turning point can be seen
(Figure 3.3). If I try to reduce the price still further, below 3, I shall lose even more revenue.

Figure 3.3

Average Revenue
The term average here is used in its commonest sense that familiar to you, perhaps, in the form of
cricket average or goal average. It is the total revenue divided by the quantity of goods sold. If a
shops weekly revenue from selling broccoli is 600 and it sells 300 kilos in the week, the average
revenue of the broccoli sold is 2 per kilo.
If all goods are sold at the same price in the given time period as, say, with our leather belts then
the average revenue is the same as the price. The average revenue curve for the belts is shown in
Figure 3.4.

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Figure 3.4
Notice, in this case, that the average revenue curve is really just the same as the demand curve. This
will always be the case where all items sold in the time period are sold at the same price, i.e. where
there is no price discrimination between different customers.
Now, to return to our shopkeeper selling broccoli at 2 per kilo; let us suppose that he is selling every
kilo for 2 and that he finds he can sell as much broccoli as he can handle at that price. He does not
need to reduce his price to increase quantity sold from, say, 200 kilos per week to 300, to 400, and
again to 500 kilos. The average revenue curve in this case is still the same as the demand curve but it
reflects this increasing quantity sold at a constant price. This produces the horizontal line graph
shown in Figure 3.5.

Figure 3.5

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Marginal Revenue
If the firm is able to maintain a constant price as it increases output, then the additional amount it
receives for each extra unit sold is, of course, that units price. In this case, the price, which is the
same as average revenue, is also the same as the change in total revenue resulting from the sale of the
extra unit. The change in total revenue brought about by a small or unit change in the quantity flow
of sales is known as the marginal revenue.
Marginal revenue is not always the same as the price or average revenue. Remember the example of
the leather belts.
There, an increase in sales from 280 to 340 belts per month produced a fall in total revenue. For the
change in this output range, the marginal revenue must be negative. The reason is the same as for the
fall in total revenue in order to increase sales, the price had to be brought down and, in this case,
the revenue gained on the additional quantity sold was not enough to make good the revenue lost for
customers who would have been prepared to buy at the higher price.
A simple example will show how marginal revenue can change when price has to be reduced in order
to increase the quantity sold. Look at Table 3.1. There are some important features to note about this
table. The marginal revenue column has its figures placed mid-way between the rows. This
emphasises that the marginal revenue relates to the change from one output level to the next. On a
graph, the marginal revenue is also plotted mid-way between the output levels. This is shown in
Figure 3.6.

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Number of TV sets
sold per week

Price per set

Total Revenue

600

Marginal Revenue

550
2

575

1,150
500

550

1,650
450

525

2,100
400

500

2,500
350

475

2,850
300

450

3,150
250

425

3,400
200

400

3,600
150

375

3,750
100

350

3,850
50

325

3,900
0

300

3,900
50

275

3,850

Table 3.1

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Figure 3.6
Look carefully at the price and marginal revenue columns. Notice that, as each additional TV set is
sold, the price (average revenue) falls 25. The fall in marginal revenue for each additional set is
exactly double this 50. In Figure 3.7, we see the marginal and the average revenue curves
together. Notice that, at each price level, the marginal revenue is exactly halfway between the price
axis and the average revenue. Although Figure 3.7 does not continue the average curve until it meets
the quantity axis, we can deduce where it would meet if continued in the same straight line. It would
meet the quantity axis at 25 TV sets twice the marginal revenue quantity when marginal revenue =
0, thus indicating that this supplier would be able to dispose of only 25 sets, even if he did not charge
any price at all.
The average revenue curve cannot, of course, pass below the quantity axis, as we do not expect
suppliers to pay customers to take their goods. The marginal revenue curve can, however, pass into
the negative area of the graph, and so indicate quantities where continued price reductions would
result in an actual fall in total revenue. We can see this clearly from Table 3.1. Marginal revenue
remains positive until 12 sets are sold. The increase from 12 to 13 sets does not change total revenue
at all, so marginal revenue here is zero. If we continue to reduce price and sell 14 sets, then total
revenue falls to 3,850 and marginal revenue indicates the loss as 50.

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Figure 3.7
The total revenue curve for this table is shown in Figure 3.8. Compare this with Figure 3.7 and see
how the marginal revenue relates to the total revenue at the various numbers of TV sets sold.
This example has illustrated an important rule. Whenever we have a linear average revenue curve,
i.e. where there is a constant relationship between price and quantity changes, resulting in a straightline graph, then the marginal revenue curve is also linear (a straight line) and always bisects (cuts
into two equal halves) the horizontal distance between the price/revenue axis and the average revenue
curve.

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Figure 3.8

C. PRICE ELASTICITY OF DEMAND

We have now seen that there is a definite relationship between price, revenue and quantity changes.
This is most important for practical studies of price and sales movements, and we need to have a
precise way of measuring and analysing the various possible relationships. Because demand is seen
as stretching and shrinking in response to price movements, the concept we use is called the price
elasticity of demand.

Calculation
This can be denoted by the symbol Ed. It is the relationship between a proportional change in
quantity demanded and a proportional change in price, so that Ed = proportional change in quantity
demanded proportional change in price, or
Q DP

Q
P
where: P = price of the product
Q = quantity demanded of the product

= a significant change in.

As explained earlier, for the great majority of goods a rise in price leads to a reduction in quantity
demanded and a fall in price leads to an increase in quantity demanded. Thus the change in quantity
is the reverse of the change in price. One of the changes will be negative, indicating a reduction; thus

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the value of Ed will also be negative. In some older text books this used to be ignored but the general
tendency today and the one you should follow is to keep strictly to using this negative sign. So:
!

When the calculation of price elasticity of demand produces a result which is more negative
than 1, i.e. when the proportional change in quantity is greater than the proportional change in
price, we say that demand is price elastic.

When the calculation of price elasticity of demand produces a result which is less negative than
1, i.e. when the proportional change in quantity is less than the proportional change in price,
we say that demand is price inelastic.

When the calculation of price elasticity of demand produces a figure of 1, i.e. when the
proportional change in quantity is equal to the proportional change in price, we say that
demand has unitary elasticity.

The demand for fish is likely to have a price elasticity of around 0.9, that for washing powder about
0.3, and that for eggs around 0.02. These demand elasticities are price inelastic but fish is clearly
much more price-sensitive than eggs. Notice that while the demand for washing powder is price
inelastic that for a particular brand of washing powder might well be price elastic say, around 1.3.
One important feature of price elasticity of demand is that it changes as price changes. Consider the
demand curve shown in Figure 3.9.
At point A, Ed = 1, so that here demand is neither elastic nor inelastic. Here, revenue remains the
same at both prices because the change in price produces exactly the same proportional change, i.e.
Q P
.

=
P
Q
At point B, however, Ed is more negative than 1, so that demand is price elastic, i.e.
Q P

.
>
P
Q
A reduction in price at B results in a more than proportional increase in quantity demanded, so that
there is an increase in total revenue. A firm in this position will increase revenue by reducing price
but lose revenue if it increases price.
At point C, the position is completely reversed and Ed is less negative than 1, so that demand is
price inelastic, i.e.
Q P

.
<
P
Q
A reduction in price here results in a less than proportional increase in quantity demanded, so that
there is a fall in total revenue. A firm in this position will lose revenue by reducing price but gain
revenue by increasing price.

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Figure 3.9
The point of greatest possible revenue on any linear demand curve is where price elasticity is at unity
(where Ed = 1).
Notice also that the calculations shown in this illustration are made around the mid-point of each
change. Calculations made in this way are called arc elasticity, and they are the correct way to
measure price elasticity, unless we are able to use the necessary mathematical techniques to calculate
point elasticity at a particular point on the demand curve. For all but very small changes, pointelasticity calculations will show different results depending on whether we assume a price rise or a
price fall, and this is confusing and inaccurate. You can test this for yourself if you compare the
calculation for a price rise from 9.50 to 10.50 with a price fall from 10.50 to 9.50.

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Influences on Price Elasticity of Demand

We have seen that the price elasticity of demand can be expected to change as price changes, so that
the products own price can normally be regarded as an influence on its elasticity. The important
point, really, is whether buyers are likely to pay much attention to the price when deciding whether to
buy, or if other influences are more important. These may include current fashion or social attitudes,
strong habits (even addiction, in some cases such as tobacco smoking) or the need to buy in order to
achieve some other desired objective, such as buying petrol in order to drive to work.
If the product price is only a relatively small amount compared with normal income then price is
likely to be less important than the other influences affecting demand, which is thus likely to be price
inelastic. Toothbrushes, matches, shoe polish, are all examples of products likely to be price
inelastic. Here, high relative price changes at normal price levels are unlikely to weigh heavily with
consumers, because annual spending on these items is only a very small part of total income. Other
influences, e.g. social attitudes (toothbrushes), smoking decline, the move away from coal fires
(matches), and development of non-leather shoes (polish), are likely to be much more important.
We must also be careful to distinguish between the demand elasticity for the class or product and that
for a particular brand of the product. My decision whether or not to buy household soap is not likely
to be greatly influenced by a 10% rise in its price, but when I am actually making my purchase I am
quite likely to compare the prices of two brands and choose the cheaper, assuming that I do not think
that one is superior in quality to the other. Thus, demand for a product can be price inelastic, whereas
demand for a specific brand of the product can be price elastic. This difference can often be seen in
foods. Families may keep to a tradition of the Sunday joint of meat and pay roughly the same price
for this each week thus showing a demand price elasticity of around unity. However, the choice of
which meat to buy can be very much influenced by its price, so that we can expect the demand price
elasticity for pork, beef and lamb, and certainly for some particular cuts of beef and lamb, to be
higher than unity, especially if the general level of all meat prices has been rising.

D. FURTHER DEMAND ELASTICITIES

The general concept of elasticity can be applied to any of the influences on demand. If you think
about the concept, you will realise that it is simply the ratio of a proportional change in quantity
demanded to the proportional change in the influence considered to be responsible for that quantity
movement. The only limiting element in using elasticity is that the influence must be capable of
some sort of precise measurement or evaluation. This makes it difficult to produce a definite
calculation for, say, changes in taste or fashion, as this is very difficult to measure. The most
commonly used elasticities, in addition to the products own price, are those for income and for other
prices.

Income Elasticity of Demand

This relates to proportional change in quantity demanded to the proportional change in disposable
income or customers for the product.
It can be denoted by Ey, so that
Ey = proportional change in quantity demanded proportional change in disposable income.
This may be positive or negative, because there may be an increase in demand following an income
increase or a fall in demand. If the income and quantity changes are in the same direction, then the
figure for Ey is positive. If the changes are in the opposite directions to each other, then the figure
). A rise in income usually leads to a rise in demand, but demand for some
carries the negative sign (

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goods may fall. In the 1950s, in Britain, demand for motor cycles fell as incomes rose and people
bought cars. As we saw earlier, such goods are known as inferior goods.
Notice that we are referring here to disposable income, i.e. the income left to the consumer after
compulsory deductions have been taken. The most important of these are income tax and National
Insurance contributions. We may also include contributions to pension schemes or to trade unions or
professional bodies, where membership is necessary for employment.
In recent years, some economists have argued that we should really be thinking in terms of
discretionary income. This is the income that is left after all the regular and largely essential
household payments have been made, over which the individual has very little control once a
particular pattern of life has been chosen. The further deductions which would, then, be made to
arrive at discretionary income would be such items as rent or mortgage interest, water rates, essential
fuel charges (gas and/or electricity) and possibly the cost of travelling to and from work. When these
items have all been allowed for, the amount of discretionary income, i.e. the income which people are
genuinely free to spend as they choose, is usually very small in relation to the original gross income.

Influences on Income Elasticity of Demand

The following influences are likely to increase a products income elasticity of demand:
!

A high price in relation to income. If a period of saving is required before purchase is possible,
or if consumers have to borrow money to obtain a product, then demand can increase only
when an income rise makes this possible.

If goods are preferred to inferior substitutes, then people may be ready to buy more of these
when income increases make this possible.

Association with a higher living standard than that currently enjoyed is likely to lead to rising
demand when incomes do rise.

In general, the more highly-priced durable goods (household machines, motor vehicles, etc.) and
services are more likely to be income elastic than the staple items of food and clothing. We do not
usually buy twice as much of these if we receive double our former income. On the other hand, our
spending on holidays may increase by far more than double. Increased spending on motor transport
is also associated with rising incomes. Although we have been considering income rises, very similar
comments apply to income reductions. Holidays and motor cars are often the first things to be
sacrificed in the face of a sudden drop in income.

Cross Elasticity of Demand

This relates the proportional change in demand of one product to the proportional change in price of
another:
Ex = proportional change in quantity demanded of X proportional change in price of Y.
Again, the demand movement may be in the same or the opposite direction to the price movement,
and the same rules for negative signs apply.
If two products are substitutes for each other, we can expect a rise in price of one to lead to a rise in
demand for the other. Beef and pork are in this position, or meat and fish.
If, however, the two products are linked together, e.g. petrol and motor-car tyres, then a rise in price
).
in one leads to a fall in demand for the other, and Ex carries the negative sign (

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Demand and Revenue

Influences on Cross Elasticity of Demand

The more close substitutes a product has, the more likely it is to react to changes in price of any of
those substitutes. The demand for coach travel reacts to changes in rail fares, and the link became
closer in the UK when motorways cut down the times of road journeys between the major cities and
long-distance coaches became more directly comparable with inter-city trains. Brands of goods are
normally much more cross elastic with each other than the good itself is with other goods. We are not
unduly influenced by other price movements when we decide how much soap to buy, but we are
much more ready to switch to a competing brand when there is a rise in the price of the brand we
normally buy.
In the same way, the intensity of negative cross elasticity depends on how closely products are
associated with each other. For people in England, the demand for sun-tan lotion is likely to fall if
the price of package holidays in the sun rises.

The Importance of Elasticity Calculations

The calculation of elasticities is not just of academic interest. Anyone, including the business
manager and the member of government who wishes to predict accurately the effect of changes in
price or income on revenue and on quantities bought, needs to have a clear idea of elasticity and their
calculation. If a business manager thinks that a price rise will always increase sales revenue, then he
or she needs to be reminded that this is far from being true. A price rise when demand is price elastic
will, as you have seen, reduce total sales revenue.
Governments making changes in income or expenditure taxes must be able to calculate their effects
on demand. If they do not, then their predictions about the results of the tax change are likely to
prove badly out of line with reality.
A government wishing to increase its tax revenue will tend to choose goods the demand for which is
price inelastic tobacco for example, or petrol. If, however, it goes on increasing the tax, the time
will eventually come when demand becomes price elastic and any further increase will result in a
reduction in sales revenue and a fall in tax receipts. This can be seen by referring to Figure 3.9 where
a price rise from, say 5 to 7 will move the good to that part of the demand curve where price rises
produce a reduction in total revenue. Price elasticity of demand can also change as a result of other
influences. If, for example, there is a long-term trend away from smoking, we can expect demand for
cigarettes to become price elastic at lower price levels in the future.
If governments wish to influence consumer demand by price changes, they are likely to try to make
demand more price elastic by ensuring that suitable substitutes are available for the target product.
For instance, if they wish to reduce consumption of leaded petrol, they must encourage the
availability and demand for unleaded petrol, and ensure that vehicle engines can be converted easily
and cheaply to unleaded petrol. They may wish to support any tax changes by changes in the law,
perhaps requiring all new vehicles to be adapted to use unleaded fuel.

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Study Unit 4
Costs of Production
Contents
A.

Factor And Input Costs

Production Factors and Costs

Fixed Costs

Variable Costs

Total and Average Costs

Marginal Costs

Long-run Costs

Economic Costs

External Costs and Benefits

External Costs

External Benefits

Economics of Externalities

Externalities and the Government

Quantity

Total Cost

(units per week)

10,000

Marginal Cost
Changes in Total Cost
from One Quantity
(column 3 divided by 10)
Level to the Next

100
10

11,000

1,000
60

11,600

600
40

12,000

400
100

13,000

1,000
100

14,000

1,000
100

15,000

1,000
100

16,000

1,000
100

17,000

1,000
115

18,150

1,150
135

100

19,500

1,350
165

110

21,150

1,650
210

120

23,250

2,100
275

130

26,000

2,750
355

140

29,550

3,550
445

150

34,000

4,450

Table 4.1: Cost Table

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Figure 4.6
In Figure 4.7, the marginal cost graph has been combined with the average cost graph. Notice where
these two curves intersect.
The rising marginal cost curve cuts the average cost curve roughly at 110 units per week. This is the
output level which we have already noted as the lowest level of the average total cost curve. This
illustrates a rule that you must remember. The rising marginal cost curve always cuts the average cost
curve at its lowest point. If you think a little, you will see that it must do that. If the cost of the last
unit to be produced is less than the average up to that point, then the new average will be a little
lower. If the cost of the last unit is higher than the average up to that point, then the new average will
be a little higher.
Experiment with any simple figures and you will see that this always must be true. This is a
relationship that you must remember, and you must always show the correct intersection when you
draw graphical illustrations.

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Costs of Production

Figure 4.7

Long-run Costs
In the long run all factors of production may be increased, i.e. no costs are completely fixed. In
practice, of course, the factors which are fixed in the short run will be increased in definite stages
e.g. when a new factory is built, new technology introduced, etc. The graph of fixed costs in the long
run, therefore, appears as in Figure 4.8.

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Costs of Production

Costs
LONG-RUN
FIXED COSTS

Output
Figure 4.8
The effect of this on the average total cost curve in the long run is shown in Figure 4.9.

Figure 4.9

The flat part of the average cost curve is prolonged. The question, then, is whether this merely
stretches the average cost curve delaying the point of eventual diminishing returns and the rise of
the U shape or whether it can be continued indefinitely in order to prevent the U shape completely
and make the long-run average cost curve L-shaped.
The relationship between short- and long-run average cost curves is sometimes shown as in
Figure 4.10. This emphasises the fact that one reason for the increase in fixed factors and costs is to
overcome the effect of short-run diminishing returns.

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Costs of Production

Figure 4.10

B. ECONOMIC COSTS
We are now beginning to see production costs from a variety of angles.
!

Opportunity Costs
These were identified in Study Unit 1 and may be defined as the cost of using resources in one
activity measured in terms of the lost opportunity of using them to produce the best alternative
that had to be sacrificed.

Absolute Costs
These are the full costs of the factors used in the activity under consideration. They may be
measured in monetary terms but the real absolute cost is best measured by the actual quantity
of factors used, e.g. the amount of land or the numbers of people employed.

Private Costs
These are the costs actually paid by the producer to the owners or providers of the production
factors employed. They are the costs usually taken into account by the accountant and are
measured in monetary terms, since the accountant has to account for the use of whatever
finance has been entrusted to the production organisation. We have been looking at these costs
in this study unit and have also examined the important distinction between fixed and variable
costs.

External Costs
We will go on to look at these now.

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Costs of Production

C. EXTERNAL COSTS AND BENEFITS

These are also sometimes referred to as externalities.

External Costs
Not all the costs of factors used in the production process are paid by the producer as private costs.
Suppose, for example, that, during a dry summer, a farmer watered his crops with water pumped from
a canal, and as a result, the canal level fell and it could no longer be used by waterway travellers.
Unless the farmer paid compensation to the travellers, it is clear that they would be contributing to
the costs of the farmers production. Because these costs are being paid by people external to the
production process, they are called external costs.
We can think of many examples of such costs. Travellers who incur additional fuel and machinewear costs resulting from motorway delays, when these delays are caused by repairs needed to make
good damage brought about by very heavy lorries travelling at high speeds, are contributing to the
costs of transporting goods by these heavy lorries. If a proportion of the cost of road repairs is paid
from general taxation, then all taxpayers are contributing to the costs of road travel even those tax
payers who rarely travel at all.
Other examples of external costs include the poisoning of rivers by industrial waste, the pollution of
sea coasts by waste oil discharged by oil tankers, the sickness and early deaths of workers from
industrial diseases. The list is almost endless, and you can probably add to it from your own
observation. Some costs may even be borne by later generations. In the 20th century, the UK has had
to pay to make good much of the damage caused by 19th-century industry. The schoolchildren of
Aberfan who were killed when an old coal waste tip moved and smothered their school in 1966 paid a
bitter price for the coal produced by their forefathers.

External Benefits
In contrast, it is possible for people to receive benefits from production towards the cost of which
they have not contributed. These are external benefits. If a large firm builds modern roads or
provides other transport facilities which are then available for use by the general community, then
that community gains external benefits. If a business firm provides a good canteen and housing for
its workers and, by improving standards of housing and welfare, improves the health of workers and
their families, then this, too, is an external benefit. We are well aware of cases where firms cause
damage to the environment but there are also cases were firms improve the environment by
renovating property, creating sports grounds, or even parks. The power of a large successful business
firm to bring benefits to a community was well known to such industrialists as the Cadbury family in
Birmingham and the Rowntree family in York.

Economics of Externalities
It might be thought that economists would favour external benefits and dislike external costs but, in
fact, economic theory suggests that all externalities distort the use of resources, and that even external
benefits are probably better provided in other ways. The danger of external costs can easily be
recognised. If, for example, road users, especially heavy goods vehicle users, do not pay the full
costs of their road use but pass some of these on to the rest of the community, then the relative costs
of, say, transporting goods by road as opposed to by rail or water are distorted in favour of road.
Consequently, goods are carried by road transport at a higher cost to the community than it would
have paid if they had been carried, say, by rail. The community is not making the most efficient
possible use of its available resources, and its living standards are lower than they would otherwise

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Costs of Production

be because some production is being lost. Moreover, the problem tends to increase. If road transport
is artificially cheap, then goods are diverted to road from rail. Road services are overcrowded, and
there is pressure to devote more land to roads. Rail services are under-used. Agricultural and
residential land is lost to roads to carry traffic which could otherwise have been carried by substitute
services.
This is what we mean when we say that externalities distort the use of scarce economic resources.

Externalities and the Government

What can be done about externalities? Does the community just have to accept their existence?
Clearly neither the producers who are able to pass costs to others nor the buyers of their goods or
services who obtain reduced prices because of the reduction in private costs are likely to volunteer to
pay more unless they are obliged to do so. They could not do so as individuals in competitive
markets. Only the government, acting on behalf of the community as a whole and reacting to
political pressures, can take effective measures and the options open to government are the following.
!

Legislate to make actions considered undesirable illegal, and enforce the law. In a democracy
such laws must be acceptable to the community as a whole; care must be taken to ensure that
desirable benefits are not lost and that the cost of law enforcement is not out of proportion to
the costs avoided.

Legislate to ensure that producers behave in a socially acceptable way and follow practices
designed to avoid the undesirable external costs. Water and sewerage companies may be
required to achieve certain minimum standards. The costs of complying with the law thus
become private costs and part of the production cost which must be met by users of the goods
and services. All producers then become subject to the same requirements so that none can
gain a competitive advantage by not complying with the standards. If producers have to
compete with foreign imports the government will have to ensure that these imports are subject
to the same minimum standards.

Impose special taxes designed to make some products very expensive and so discourage their
use. There are several objections to this course of action. The government might start to rely
on the revenue from the taxes and so take care to keep them at a level where the products are
still bought and used; the taxes may well then cease to deter or reduce the external costs.
Alternatively the government might impose very high taxes with the result that there is
widespread tax evasion; the cost of collecting the tax and punishing evaders then rises to
impose additional burdens on the community.

Clearly it is more desirable to try and ensure that external costs are removed altogether than that they
should simply become private costs. Even if employers are forced to pay adequate compensation to
workers whose lungs are damaged by dusty manufacturing processes, the workers still suffer.
However, if manufacturers are required to have efficient dust extraction equipment, private costs are
increased but the health of the workers is improved. At the same time care must be taken to ensure
that external costs are not simply exported. For example, one way of dealing with dangerous gases
might be to ensure that they are expelled through very high chimneys, but unfortunately these may
simply redirect the gases to another country for that country to bear the cost.
There is no universal and simple method of dealing with externalities, but on the whole it does appear
that the market economies have been more successful in controlling and reducing undesirable
external costs associated with environmental pollution than have the old command economies. This
is probably because in the more open and consumer-orientated societies producers and government

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Costs of Production

have had to be willing to respond to pressures from the public when that public has been determined
to eliminate socially unacceptable practices.

D. COSTS AND THE GROWTH OF ORGANISATIONS

Returns to Scale
We have already seen the results of increasing inputs of a variable factor when at least one other
production factor is held constant. We saw that this was likely to bring about increasing, then
constant, and then diminishing marginal returns. However, we have also pointed out that, in the long
run, all factors can be increased, and there is the possibility of economies of scale resulting for the
continued growth in size of the firm. We must now look at this possibility more closely, but first we
must be clear as to the meaning of returns to scale when all factors are being increased. If a given
proportional increase in factors results in a larger proportional increase in output, then the firm is
enjoying increasing returns, or economies of scale. This would be the case, for example, if a 10%
increase in factor inputs produced a 20% increase in production output.
If the proportional increase in output is the same as the proportional increase in factor inputs e.g.
when a 15% increase in factors produces a 15% increase in output then the firm is experiencing
constant returns. If, however, a 15% increase in factor inputs produces less than a 15% increase in
output only 10%, say then the firm is suffering decreasing returns, or diseconomies of scale.

Economies of Scale
Real scale economies, as defined above, should be distinguished from purely pecuniary or monetary
economies which do not represent a more efficient use of factors but which are the result of the
superior bargaining power of the large firm in the market. A large customer, for instance, can often
gain discounts greater than can be justified on the grounds of savings in delivery or distribution costs,
and workers in some large firms may be willing to accept a lower wage in return for what is believed
to be greater security of employment or the social prestige of working for a famous organisation.
Real economies the genuine efficiencies in the use of production factors resulting from growth in
the scale of activities can be identified in the following main areas.
(a)

Labour Economies
These result from greater opportunities for the division of labour which increase with the skills
of the work-force, save time and allow greater mechanisation. The automated assembly line in
modern motor-vehicle assembly is an extreme example of this.

(b)

Technical Economies
These result chiefly from the use of specialised capital equipment. Large firms are able to
make use of equipment that could not be fully employed by smaller operations, and large firms
are also able to support reserve machines to avoid disruption following breakdown. A small
firm, using three machines, adds one-third to its capital cost if it tries to add a further machine
to keep in reserve. A large firm employing 20 machines adds only one-twentieth if it decides to
do likewise.

(c)

Marketing Economies
Very great economies are available from large-scale advertising. A television-commercial film
using top stars is very expensive to make, but the cost per potential customer is very low if
essentially the same film can be shown in several different countries. Large firms can also
afford to keep very skilled marketing specialists fully employed.

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(d)

Financial Economies
Large firms are able to obtain finance from markets that are denied to small firms, and
multinationals can raise money in many different countries. Nevertheless, although financial
economies still exist, we do have to recognise that finance markets have, in recent years,
become more responsive to the needs of smaller enterprises.

(e)

Distribution and Transport Economies

Transport movements and the location of depots can be carefully planned by large
organisations, so that vehicles and storage space are used efficiently.

(f)

Managerial Economies
These arise from the employment of specialised managers and managerial techniques, although
many of these techniques have been developed in order to overcome the problems of managing
large organisations, so that many economists suggest that managerial economies of scale are
often exaggerated and difficult to achieve in practice.

Diseconomies of Scale
Diseconomies of scale are usually associated with the problems rising out of the management and
control of large organisations. Formal communication systems are necessary but are expensive to
maintain. Whereas the manager of a small organisation can see what is going on around him in the
course of his daily work, the manager of a large firm may have to establish an inspection system to
obtain equivalent information which is unlikely to be as reliable.
There can also be a loss of control over managers at the lower levels of the managerial pyramid.
These managers may then pursue their own private objectives e.g. building up the power of their
own department at the expense of efficiency and profitability.
Diseconomies of scale, then, are mostly managerial. If diseconomies just balance economies, i.e.
when a 10% increase in factor inputs produces the same (10%) increase in production output, the
long-run average cost curve will have the L shape of Figure 4.11. If economies of scale continue
roughly to balance diseconomies, this shape may be retained over a long period. If, however,
diseconomies start to rise substantially, then the long-run average cost will again start to rise.

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Costs of Production

Figure 4.11
Notice here the position of what is called the Minimum Efficient Size (or Scale) (MES), also
known as the Minimum Optimum Scale (MOS). Up to this output level there are significant gains
from internal economies of scale, and firms below the MES are at a cost disadvantage when
competing against those up to or beyond that size. However, beyond the MES, further cost savings
are not significant, and there is no cost advantage in further growth. On the other hand the shape of
the curve can change as firms learn how to overcome sources of inefficiency, in particular managerial
inefficiency, especially when new managerial skills and communication technology are introduced. It
is possible to control very large firms today in ways that would have been impossible half a century
ago. Jet travel and modern telecommunications, not to mention computers and microelectronics,
have transformed management techniques.

External Economies
The economies of scale listed earlier all apply to the individual firm and they are known as internal
economies of scale. There are other economies that are external to the firm and which arise when an
industry grows large or when business firms congregate in a particular area. External economies
usually arise from the development of specialised services available to many firms. For example, an
area containing numbers of small engineering companies may provide opportunities to support one or
more specialised toolmakers. Each engineering company can call on the specialist, without having to
carry the full cost of having its own specialised department. External economies help small firms to
survive in competition with larger organisations. However, if one or two companies become
dominant and they internalise these economies by setting up their own specialised departments which

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Costs of Production

they are large enough to keep fully employed, then the external economies may be lost to the smaller
firms, which can then no longer survive in the market.

E. SMALL FIRMS IN THE MODERN ECONOMY

It is sometimes assumed that, because of economies of scale, large firms are always likely to be more
efficient and to be able to produce at lower cost than small firms. If this were true, small firms would
be much less numerous than they are. Of course, one reason for their survival is that the definition of
a small firm tends to change in time. As the average size of the firm grows, so firms which would
have been considered large become classified as small. Moreover, if we take as the main
qualification to be considered a small firm, the fact that the whole enterprise is controlled by a small
group of employer-managers (usually all belonging to the one family), continued advances in
technology, including information technology, enable one or two people to control larger enterprises,
so that in fact, many more firms can now grow larger and still, in fundamental respects, remain small.

Economies of Scale
A closer look at economies of scale shows that large firms are not always inevitable. If we assume
that the typical successful large company has an L-shaped cost curve, this can still cover a number of
different possibilities.
Figure 4.12 shows two possible long-run average cost curves. It shows that each reaches a point
where further cost reductions as output increases are very small. As noted in the previous section,
this point is known as the minimum efficient size: it is reached at 0b for industry B and 0a for
industry A. We would, therefore, expect firms in industry A to be rather larger than in industry B.
There is no further significant advantage for firms when they grow beyond these points.
This minimum efficient size, of course, must be related to the size of the market. If, for example,
industry B served a much larger market than industry A then we would expect many more firms
competing in B than in A. Some world markets have room only for a very few firms. Here, fixed
costs are very high and only very large organisations can consider entry.

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Figure 4.12: Long-Run Average Costs

The oil industry is an example of this. In contrast, the manufacture of many kinds of plastic
household fittings does not require very expensive equipment, and many small firms are able to
compete successfully in the market. The general term economies of scale also covers both internal
and external economies, and it is only internal economies that favour large firms. External
economies, such as specialised services, are available to all firms in an area or industry, and these, in
fact, often help small firms to survive. It is when the number of small firms drops below the level
necessary for the survival of the specialist as an independent organisation that all the remaining small
firms are faced with severe problems, and may have to disappear.
Special services to industry such as industrial cleaners, photographers, designers and others often
serve a restricted market and are likely to remain small. This is especially likely to be true if the
service is localised. The service may only be needed occasionally by any one firm, but when it is
needed the need is urgent and some one has to be found very quickly. Small local firms are better
placed to provide a satisfactory service than a large national organisation.
The MES is not the only determinant of the size of firm likely to be found within an industry. The
attitudes, abilities and objectives of owners or senior executives play an important part. Liptons
became a national retail chain in a period when most retail shops were small family firms, as did
W H Smith, Woolworths and Boots among others. We can always expect to find some large firms in
sectors when small firms form the majority.
At the same time we are also likely to find small firms in industries where the MES is large, implying
that only very large firms could survive. This may be because they serve a specialist niche which
forms a small part of a larger market. Industry definitions can be misleading. The term motor
industry covers activities ranging from motor vehicle assembly to the manufacture of small,

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Costs of Production

specialised components. These activities are not really comparable and the MES for a component
manufacturer could be much smaller than for vehicle assembly. Nevertheless it is the giant
corporations which dominate the industry. If one of these fails, large numbers of the satellite firms
which supply goods and services to it are also likely to fail. If the dominant firms all prosper, the
satellites also flourish.

Services
Services generally tend to be smaller than manufacturing organisations, although there are, of course,
some very large service firms developing in activities such as the law, accounting and business
consultancy. On the other hand, these large firms tend to serve large-scale customers. A leading
international accountant is not really suited to do the books of the small corner shop. In any case,
the shop would not be able to pay the accountants fees. There will always, therefore, be small local
firms of accountants, solicitors and so on. If any of these meet problems they cannot handle
themselves, then they may be able to call on the specialist services of the giant.
As the service sector of the economy, including the rising leisure services, grows, so the scope for
small firms continues to increase and as already suggested, new technology based on the chip and the
microcomputer is enabling the small firm to achieve a level of administrative efficiency that would
have seemed impossible only a short while ago. A business-owner who can afford to spend around
two to three thousand pounds on a computer, software packages and a good printer can maintain
accounting and secretarial services with just one or two people, whereas the same standard of service
would have required an office of 15 or more people or a very expensive mainframe computer
complete with specialist programmer only a decade or so ago.
Traditionally, the small-firm sector has been seen as the seed-bed of enterprise and the nursery in
which tomorrows giants are reared. The microcomputer industry itself is an example. It was not the
giant computer monopolists that produced the microcomputer but brilliant electronics engineers
working on their own initiative. There will always be scope for the entrepreneurial genius.

Recent Trends
During the 1980s, small firms faced a more favourable financial climate. Small-scale enterprise
became fashionable and received government support through the Business Expansion and Small
Business Loans Guarantee Schemes. The Stock Exchange also sought to make it easier for smaller
companies to raise capital by developing the Unlisted Securities Market (USM) and, for a time, a
Third Market. The USM was closed in the mid-1990s and is to be replaced by an alternative
market which is intended to operate more effectively for smaller companies within the structure of
the Stock Exchange. You should look out for this development and watch its progress.
The environment for small businesses turned increasingly hostile as the boom years turned to
recession and, more recently, to the much deeper depression of the 1990s. Government antiinflationary policies based on high interest rates and attempts to link the value of sterling to the
German mark helped to destroy those firms, large and small, that had expanded over-ambitiously.
The government realised that providing guarantees for firms unable to obtain finance through normal
commercial channels was a sure way of squandering taxpayers money and abandoned earlier
experiments.
Any form of government intervention tends to distort markets. Even socially worthy schemes to
assist the unemployed can create as many problems as they solve. If, for example, an unemployed
person is given government financial help to start a new window-cleaning business in an area where
demand is roughly in equilibrium with supply from existing window cleaners, the entry of a new,
subsidised cleaner is likely to undermine and drive out of business one or more of the established

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small firms which do not enjoy government financial help. The result may be that one person leaves
the dole queue and is replaced in it by two others.
The banks also became disillusioned with the small-firm sector and reversed the policies that were
proving to lead to heavy losses. There is still official encouragement for the creation of new small
firms, and the number of people entering self-employment always increases when unemployment
rises, as many people decide that the risks of starting in business are preferable to unemployment; but
no one any longer believes that small firms offer a serious solution to current economic problems.
In an economic depression, large as well as small firms suffer and many companies which had
developed into conglomerates of different, often unrelated, activities as a result of the mergers of the
1960s and 1970s rediscovered the virtues of specialisation and sold, closed or allowed managers to
buy out those enterprises which did not fit into the mainstream of their core activities. Many of
the management buy-outs were heavily dependent on bank finance and a high proportion have
become victims of the depression. Others have survived and prospered once released from the weight
of large company bureaucracy. In spite of the difficulties, there are still large numbers of small firms
and as the 1990s have shown that growth and size are no guarantee of security, fewer of these will
wish to grow too rapidly and become too dependent on borrowed funds.
In recent years earlier tendencies which resulted in large firms internalising specialised activities have
been reversed. Specialist departments which had proved difficult to keep fully employed have been
closed and in many cases the specialists have been helped to form their own businesses, supported
with contracts from their former employers. These newly independent firms are once again able to
provide their specialist services to large and small organisations.
New communications technology is leading to a revival of a very old form of enterprise what may
be seen as a collection of independent firms, all working under the overall guidance of a central,
largely marketing, organisation. Computer software production is often produced on this basis, with
self-employed programmers producing software to detailed requirements set by the central marketing
body.
Many small retailers have found it possible to survive as members of a larger voluntary chain made
up of retailers and wholesalers, e.g. Mace, Spar.
Franchising is another way in which independent traders work under a degree of central control.
These organisational structures all combine some of the advantages of large-scale operation with the
benefits of the small entrepreneur working for him/herself.
Although the life expectancy of the majority of small firms continues to be short, there are nearly
always people willing to fill the gaps left by the casualties. The small firm sector as such continues
to exist and the record of innovation and enterprise from small firms compares favourably with the
large corporations. A healthy and dynamic economy requires a diversity of firms of all sizes and
activities. Most large organisations have occasion to rely on the services of small firms: often they
use them to fulfil contracts which are too small for them to carry out profitably but which are
necessary to retain the goodwill of valued customers. Moreover the continued existence of smaller
rivals can often be a healthy reminder to large corporations that they are neither immortal nor
indispensable. The growth of own-brand labels developed by the large supermarket chains has
provided openings for many smaller manufacturers who could not otherwise have hoped to compete
with the established food corporations.
The flexibility and versatility of the modern market economy, then, depends on the existence of many
different sorts and sizes of organisation, and this diversity is essential to the maintenance of high
living standards and wide employment opportunities.

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Study Unit 5
Profit, Supply and Expenditure Taxes
Contents
A.

Page

The Nature of Profit

Profit as a Factor Payment

Normal and Abnormal Profit

Profit as a Surplus

Summary of Explanations of Profit

Maximisation of Profit

Calculation

Profit Maximisation

Influences on Supply

Costs and Supply

Supply Curve

Other Influences on Supply

Effect of Other Influences on Supply Curve

Relative Importance of Supply Influences

Price Elasticity of Supply

Calculation of Elasticity

Elastic and Inelastic Supply Curves

Elasticity of Supply in the Long Run

Supply, Indirect Taxes and Subsidies

What are Indirect Taxes and Subsidies?

Effect on Supply

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A. THE NATURE OF PROFIT

The simplest definition of profit is that it is the excess of revenue over cost. This is a little deceptive
because it is not always easy, in practice, to decide what is revenue and what is cost, and there are
also problems arising from changes in the value of property. For example, the value of a building
may rise or fall for reasons that have nothing to do with the trade carried on in that building. At this
stage, however, it is convenient to overlook problems of this kind and keep simply to the idea of
profit as the excess of the revenue gained by selling products over the cost of producing those
products.
Nevertheless the above definition does not satisfy the economists desire to explain why profit exists
and what its economic function really is; and here we come up against two rather conflicting ideas.
On the one hand there is what might be called the traditional view of profit as a payment to a factor of
production, just as wage is the payment to labour or rent the payment to capital; while on the other
there is the view that profit is surplus which remains when the payments to production factors have
all been made. Both views present difficulties as we shall now see.

Profit as a Factor Payment

Although considered by many as being rather old-fashioned and difficult to reconcile with modern
realities, this is the view which still dominates most of the basic economics text books and, as far as it
is possible to tell, the thinking of most of todays examiners of economics in the professional
examinations. You must, therefore, take it into account. Attempts to reconcile the idea of profit as a
factor payment with the reality that it is very uncertain and subject to all kinds of pressures, as well as
being impossible to predict or guarantee, have resulted in the development of the concepts of
normal and abnormal profit.

Normal and Abnormal Profit

Here profit is seen as a payment to a fourth factor of production, the factor enterprise provided by
entrepreneurs, people who take economic risks by organising and combining the other factors to
produce goods and services for sale in the markets. Normal profit is, thus, frequently described as the
reward to the entrepreneur an attractive idea, but one which raises many difficulties.
!

How do we quantify normal? The usual answer to this question is to suggest that it is the
minimum necessary to keep the entrepreneur in the market. However, this surely depends as
much on conditions in other possible markets as on the amount of profit available in the one
under scrutiny. Firms that have been operating in a particular market for a lengthy period, or
which operate in that market only, face greater costs of transfer to another market than
newcomers, especially those which already operate in many markets. Thus, the minimum
required to keep firm A in the market is unlikely to be the same amount as that sought by firm
B. As economics has become more and more precise, scientific and mathematical, fewer
people have been prepared to accept a concept as vague and unquantifiable as normal profit,
in this sense.

Who is the entrepreneur entitled to normal profit? The early economists who developed the
concept were accustomed to markets containing small, individually owned and controlled
firms, so that the entrepreneur who was the driving force behind the firm was usually
identifiable without much trouble.
Modern markets, on the other hand, are dominated by large, corporate organisations with clear,
bureaucratic, managerial structures. The success of this type of enterprise may lie as much in

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the ability of managers to reduce risks as to take them and, while individual managers may be
expected to show enterprise in their work, this is rarely rewarded directly with a proportionate
share in profits even if the profit attributable to the enterprise shown could be calculated.
The statistical profit of the organisation belongs legally to the ordinary shareholders, who are
specifically denied any right to share in management and who rarely have much detailed
knowledge of the activities of the organisation. When we further recognise that the large
public company, today, is likely to operate in many markets, in many countries, we have to
agree that all this is impossible to reconcile with the definition of normal profit.
If, however, it is accepted that there is such a thing as normal profit then this implies that there can be
abnormal profit. Some text books do, in fact, describe all profits above the normal as abnormal.
Others, clearly unhappy at the emotive implications of this term, use the less derogatory
supernormal. In either case, the impression is usually given that firms should not be permitted to
earn profits above normal.
Instead of either abnormal or supernormal, some writers have referred to what they call pure profit,
by which they appear to mean any surplus over and above all payments to factors including the
normal profit due to the entrepreneur.

Profit as a Surplus
If we see profit not as a factor payment but as a surplus remaining after the production factors have
been paid for, the question then arises as to who owns, or should own, this surplus.
To Marxist economists the answer is clear. Economic value is created by human labour, without
which there can be no economic activity. The berries growing wild on the bush belong to the picker,
whose labour of picking has turned them into food. Thus any surplus created by work belongs to
those who carry out the work. Profit, therefore, to the Marxist who does not recognise a separate
entrepreneur, belongs to the workers. However, the Marxist recognises that, in the modern capitalist
society where production is organised by the owners of capital and, in the Marxist view, for the
benefit of the owners of capital, profit is, in practice, allocated to the owners of capital.
If this view is accepted, profit, not interest, becomes the payment to the owners of capital. To the
Marxist, the fact that it is paid to the owners of capital rather than to the rightful owners, the
contributors of labour, is the result of the domination of capital over labour in the modern capitalist
society.
In support of this view it is possible to point to company law, which provides that a companys profit
belongs to the companys shareholders or, more precisely, to the contributors of the risk capital or
equity, the ordinary shareholders in American terminology, the common stock holders. There is
no legal requirement that the company should share its profits with the suppliers of labour
(employees) or with the suppliers of loan capital, who receive their agreed rate of interest.
Still largely accepting this concept of profit as a surplus other economists, some of whom belong to
what has been called the Austrian school, take a very different view of its economic function. They
see it as the driving force of the modern economy and the incentive which has been largely
instrumental in bringing about the enormous improvement in general living standards in the market
economies over the past two centuries. They see the striving for profit as the force that produces new
products, new production technology, new forms of business organisation and new uses for basic
resources. The profit that produces this economic energy and invites people of all kinds to take risks
with their own resources of money, time and futures, is not normal profit but the largest possible
profit that can be made in the circumstances within which business operates. There is no need to
distinguish between normal and abnormal profit. All profit is necessary to stimulate future economic

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activity and to provide the investment finance necessary to make the activity possible and raise the
level of technology.
Unlike Marxists, the economists who take this view do not see profit as being stolen from workers,
nor do they see any need for labour to be given only the lowest possible wage. Indeed for business
enterprise to succeed, goods and services have to be sold to workers whose incomes are well above
subsistence levels, who have disposable incomes and the freedom to choose how to spend these
incomes and who expect to have rising incomes. Workers therefore, benefit from profitable economic
activity by earning rising wages.

Summary of Explanations of Profit

One economist who recognised the various ways in which profit has been explained was the great
American writer and teacher, Professor Samuelson. He identified six distinct views, which can be
summarised as follows:
(a)

Profit is seen as a balancing item and a result of accounting conventions but should properly
be seen as a return to one or more of the production factors. For example, most of what
accountants show as the profit of the majority of small family firms would better be
described as the proprietors wage for his physical and mental effort and interest on his
personal savings invested in the business.

(b)

The second view sees profit as a reward to enterprise and innovation and a return for the
temporary monopoly achieved by being first in the field with a successful new commercial
idea.

(c)

The third sees profit as a reward for successful risk-taking and, although willingness to take
risks does not always (or often) bring compensating profits, it is usually the hope of earning
such profits that provides the spur to help business people overcome their natural inclination to
avoid risk.

(d)

The fourth view simply takes the third view further; profit is a positive incentive to coax out
the supply of risk-bearing capital. It is the high return sought by providers of what is often
known as venture capital.

(e)

The fifth view regards profit as a return to monopoly, whether natural or achieved by
artificial means. It is this association of abnormal profit with monopoly that has coloured so
much teaching about business profits and objectives.

This is a most important rule which you should remember carefully, i.e. to maximise profits the firm
produces at the output level where marginal cost is equal to marginal revenue.

Figure 5.6

Supply Curve
If we accept this view that firms will seek to increase the quantity supplied if price increases, and
reduce it if price falls, then we can produce a supply curve showing the amounts involved. A supply
curve can be for an individual firm in which case, assuming profit-maximising objectives, it will be
the marginal cost curve or for all firms supplying a particular product, where it will be made up of
the sum of the marginal cost curves of all the firms supplying the product.
However the supply curve is formed, we can accept that its general shape will be as in Figure 5.9.
This shows the general assumption that more will be supplied as the price rises all other influences
remaining the same.

Figure 5.9

Other Influences on Supply

The concept of the supply curve reflects the view that price is one of the most important influences
on the quantity supplied. There are other influences, however, and these are mostly concerned with
the cost of production and with profits. Remember that, in a market economy, the great driving force
for supply is profit, so anything that affects profit will affect supply. In very broad terms, since profit
is the difference between revenue and costs, supply will be directly affected by anything affecting
revenue, price and costs.
We can summarise some of the most important influences as follows:
(a)

Costs of Factors and Other Inputs

Any change in costs, with price staying constant, will change the profit expectations and will
thus influence decisions regarding supply. For the profit-maximising firm, a change in variable
costs will change the marginal cost curve, and so change the supply schedule. Examples of
factor costs include wages, land and property rents, interest rates on capital, basic material
prices and the prices of fuel and power. Any of these may also affect the prices of intermediate
products and services required by the firm, and so further influence supply.

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(b)

Changes in Taxes
If a tax, payable to the government, is charged at any stage of production or on the profits of
the business, then any change in the tax rate will affect the profits anticipated from supply, and
thus affect supply intentions. An increase in a production tax, such as value added tax, will
have the same effect as an increase in factor costs; it will tend to reduce the quantity that firms
are willing to supply at all prices in a given range.

(c)

Changes in Technology
By technology is meant the methods of combining factors and inputs in order to achieve
production. An improvement in technology, which allows a given level of production to be
achieved with fewer factor inputs or with a different combination of factors, so that the total
cost is lower, will tend to increase the quantity likely to be supplied at all prices within the
range. Some types of technology may be possible only if production is required on a large
scale. This can have a marked effect on supply. Thus, small-scale supply may be possible only
at much higher prices than large-scale supply, when the different technology becomes
worthwhile. The result may be to shift the whole supply curve when production reaches the
critical level required for the large-scale technology.

(d)

Efficiency of the Firm

Multinational production of similar products has shown that firms in country A can sometimes
produce more from a given combination of labour and capital than similar firms in country B,
even though production methods and levels of technology are all much the same. Differences
in the productivity of labour and capital (the amount produced per unit of labour and capital)
must, in these cases, be caused by differences in managerial efficiency or in the conditions
under which people work. In some cases, the movement of managers from one country to the
other makes little difference to the gap in factor productivity. The causes of these differing
levels of efficiency are not fully understood, but they do help to explain why large
multinational firms tend to prefer some countries to others. A change in the level of business
efficiency will, of course, influence supply.

(e)

Changes in Relative Profitability of Products

If a firm can produce either product X or product Y from similar factors, machines and skills,
and if it becomes more profitable to produce Y, then the firm is likely to switch its production
activities from X to Y. This may happen if the firm normally makes X, but the price of Y rises
while the price of X stays the same.
There can be other causes of production switches. If there are numbers of firms able to choose
between producing X or Y, and the market for Y suddenly disappears, perhaps because of a
political decision, then firms previously making Y will have to switch to X if they wish to
remain in business. The result will be to increase the supply of X at all prices.

Effect of Other Influences on Supply Curve

All the above changes can be illustrated by a movement of the whole supply curve, indicating a
change in supply intentions throughout the given price range. Such a shift in the supply curve is
illustrated in the general graphical model of Figure 5.10.

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Figure 5.10
A shift of this type may follow a change in one or more of the influences as described above.
Moreover, several influences may be operating, in different directions. For example, a tax increase
may be depressing supply intentions while an improvement in technology is raising them. The final
result depends on the relative strength of the influences. It is not easy to analyse these effects through
simple graphical models. This is why more advanced studies make rather more use of algebraic
models which can be easily handled by computers, and why you should begin to become familiar
with functional expressions such as the following.
Qs = (P, C, T, v, y, o )
where: Qs = quantity of a product supplied
P

= products price

= factory and input costs

= business taxes

= level of technology

= level of business efficiency

o = relative profitability of products

This simply states that quantity supplied is a function of, or is dependent on, the various influences
symbolised.

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Relative Importance of Supply Influences

As with demand, different products will be affected to different degrees by the various influences on
supply. In the case of supply, much will depend on the methods of production and the ease with
which producers can respond to changes in factor costs and availability as well as in technology.
Consequently, it is easier to assess the relative importance of the supply influences than those on
demand. A careful study of production technology and relative factor costs will indicate which are
likely to have the most impact on producer intentions. A production process heavily dependent on
labour (labour-intensive) will be more responsive to changes in wage levels than one that is highly
mechanised or automated and thus capital-intensive. On the other hand, production which is highly
capital-intensive will be more vulnerable to changes in interest rates, since much capital is likely to
be borrowed in one form or another. The potential costs of changing production levels tend to be
greater with capital-intensive production methods.

D. PRICE ELASTICITY OF SUPPLY

Calculation of Elasticity
The concept of elasticity, which we applied to demand, can also be applied to supply. However, here
it is usually only price elasticity with which we are concerned. The method of calculating supply
elasticity is exactly the same as for price elasticity of demand, i.e.
Supply elasticity of a product (Es) =
or

Es =

Proportional change in quantity supplied

Proportional change in the product's price

Q s P PQ s

=
Qs
P
Q s P

Notice that the value of Es is always positive (+). This is because the change of quantity is in the
same direction as the change in price.
Figure 5.11 shows an example of a simple supply-elasticity calculation.
Notice here that figures for both P and Q are obtained from the mid-point of the change in price and
quantity, so that the calculation is the same for both a rise and a fall in price. Notice also that the
result of this particular calculation is that Es = unity (1).
If you calculate values for Es at any other price level on this curve, you should obtain the same
results. The reason for this is explained in the next subsection.

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Figure 5.11

Elastic and Inelastic Supply Curves

Price elasticity of demand was shown to change as price changed. A rather different position obtains
in the case of supply elasticity. We said that the value of Es for the supply curve of Figure 5.11 would
always be 1. This is because the curve starts at the point of origin.
A simple proof follows, relating to Figure 5.12, and assuming a knowledge of simple geometry.

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Figure 5.12
From the diagram:
= 1 ,
so,

P
P
= tan and
= tan1
Q
Q

P
P
=
.
Q
Q

But, Es =
=

Q P Q P

Q
P
Q P
P Q

.
Q P

So,

P P

== 1
Q Q

and

Es = 1.

A supply curve which passes through the vertical (price) axis is elastic, and one which passes (or, if
extended, would pass) through the horizontal (quantity) axis is inelastic. This holds regardless of the
slope of the curve, and it applies to the whole curve when this is linear (forming a straight line).
These statements can be proved by the same method as in Figure 5.12. Dont worry if you cant
prove them yourself just remember the position. Examples are given in Figures 5.13 and 5.14.

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Figure 5.13

Figure 5.14

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Figure 5.15
When the curve is non-linear, the important point is the direction of the tangent to the curve at the
price level under consideration. This is shown in Figure 5.15.

Elasticity of Supply in the Long Run

The main influence on the elasticity of supply is the speed with which producers can respond to
changes in cost, price and profitability. Few firms can alter their production plans immediately when
basic materials, capital and labour have already been committed to them. As time goes on, however,
plans can be changed, workers can be hired or fired, and new machines bought or old ones scrapped.
The speed and ease with which production plans can be changed depends on the nature of the
production process. As a general rule processes, such as services, which are labour-intensive can be
changed more quickly than those that are capital-intensive. Workers, especially if they are part-time
can have their working hours increased or reduced and the number of workers employed can be
changed, whereas capital-intensive processes, such as motor-vehicle assembly lines, still have to pay
costs of capital even when equipment is no longer used. It may, therefore, be better to maintain
production as long as variable costs are covered by sales revenue and there is some contribution to
unavoidable fixed costs rather than suffer the heavy losses of a major production change. When,
however, the decision has to be made to reduce production the consequences can be swift and farreaching, with large numbers of workers suffering redundancy.
We can say, then, that supply will be inelastic in the short run and elastic in the long run. What
constitutes short run and long run depends on production methods. Nevertheless, supply is
unlikely to be completely inelastic even in the very short term, as some adjustment is usually

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possible. Even the motor-assembly track can be speeded up or slowed down, in response to a
managerial decision, in a matter of hours.
The change in elasticity over time is illustrated in Figure 5.16.

Figure 5.16

E. SUPPLY, INDIRECT TAXES AND SUBSIDIES

What are Indirect Taxes and Subsidies?
Governments often influence markets through taxes and subsidies.
!

An indirect tax is one that is not levied directly on individuals or organisations but is applied
at some stage in the production or distribution of goods or services. It therefore affects prices
and so is paid indirectly, through price, by consumers and income-earners. For this reason
indirect taxes are often referred to as expenditure taxes and are listed as such in the British
national accounts which appear in the annual publication known as The Blue Book of National
Income and Expenditure.

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Study Unit 6
Markets and Prices
Contents
A.

109

Market Defects The Case for a Public Sector

110

Defects in Market Allocation

110

The Case for a Public Sector and its Boundaries

111

Price Changes and Indirect Taxes and Subsidies

113

Effect of Tax on Price

113

Subsidies

114

Government Use of Indirect Taxes

115

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A. NATURE OF MARKETS
In economics, a market is an area within which the forces of demand and supply for a particular
economic good can communicate and interact, so that the good can be transferred from suppliers to
buyers.
This definition contains a number of important elements which have to be considered whenever we
analyse a particular market or compare one market with another. Let us look at these elements.

The Economic Good

A good is any benefit which accords utility to people, and to obtain which they are prepared to
sacrifice scarce resources. The term utility is chosen because it avoids the idea that there has to be
any particular virtue in the good. If people want something and are prepared to make some
sacrifice of their resources (usually represented by money) to obtain it, then we assume they gain
utility from it, even if it does them actual harm. Thus, economists may analyse the markets for
tobacco or heroin.
The good can be a physical object, such as a motor car, or a service. It can be a consumer, or
intermediate, or capital good, or a factor of production. In this course, we are concerned chiefly with
consumer and production factor markets.
We must be careful to give a precise definition of any market we are considering. The total market
for motor cars contains a number of subsidiary markets e.g. for sports cars or saloon cars. We must
always distinguish the market for the whole class of product from that for a particular brand or other
sub-division. Thus, the market for the Mini Metro is distinct from the market for small cars which,
in turn, is distinct from that for private cars and from the market for personal transport as a whole.
Confusion sometimes arises when we are concerned with the price elasticity of demand for a product.
The class or product may be price inelastic, whereas a particular brand may be price elastic. For
example, petrol in general may be price inelastic, but the price of Ks petrol can be price elastic. The
motorist has to have petrol, but he may have the choice of a number of filling stations offering a
variety of petrol brands at different prices, and he may also be prepared to go a few miles out of his
way to obtain the cheapest brand of petrol.

Market Area
We need to examine the market area when considering the conditions of a particular market. The
area is that within which communication takes place, and not simply where final negotiation is
arranged. A sale of antiques or fine paintings may take place in a small room in London but,
beforehand, catalogues may have been sent to dealers throughout the world, and many foreign buyers
may be represented by their agents when the sale or auction actually takes place. In contrast, a small
retail shop may be concerned with a market area restricted to a few streets or a single housing estate.
The goods it sells may be available in other shops serving different market areas nearby.

Communications and Transport

The extent of the market is really determined by the efficiency of communications and the ability to
transport the goods from seller to buyer. X does not really have a choice between goods A and B if he
does not know that B exists, or if he has no means of comparing price or quality. Thus, if I am buying
tomatoes on one side of the town, I cannot really compare them with those on sale on the other side
of the town, even if someone tells me that they are several pence cheaper. I need to be sure that they
are products of similar quality.

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103

Some markets have developed very precise descriptive terms. The use of these terms, for example, in
some of the basic commodity exchanges, enables buyers and sellers to know exactly what quality
goods are being traded.
There can be an effective market only if it is possible to transfer the product from seller to buyer.
Any barrier to transfer will limit the market area.

Conditions of Supply and Demand

There can be a market only if there are suppliers able to deliver the goods at the time agreed, and
buyers with the necessary resources to acquire them.
The good does not necessarily have to be in existence at the time it is traded, as long as there is a
guarantee that it will be available when and where agreed. The ability of certain commodity markets
to trade in crops not yet grown, or metals not yet mined, is well known; but a manufacturer can also
agree to sell goods not yet made, and a few authors can even sell books not yet written! However,
both buyer and seller must have a clear idea of the product that is to be delivered. The more precise
the definition of a product, the easier it is to sell in this way.
The desire to buy must also be realistic. Many of us would like to possess an ocean-going cruiser or
a private aeroplane; but few of us, unfortunately, have the resources to acquire and operate them.

B. FUNCTIONS OF MARKETS
A market has other purposes, apart from providing the means whereby a good is transferred from
supplier to buyer.

Information
The market serves to convey information about the conditions of supply and demand. I may go to a
furniture store, not just to buy a piece of furniture but to see what furniture is available and at what
price. The better the communication system within the market, the more information I can gain about
what can be bought and the more chance I have of achieving full utility from my purchase.
This communication function works both ways. The market also informs actual and potential
suppliers about the strength and pattern of demand about what people want to acquire and what
level of price they are prepared to pay. Suppliers need this information in order to plan production.
The problem from the suppliers point of view is often that the information comes too late. He has to
make supply decisions before accurate information is available. The supplier wants to know today
what market conditions are going to be like tomorrow. The impossibility of achieving accurate
forecasts all the time is one of the main sources of business risk.

Establishing Price
Arising out of the two-way communication function is a further most important function that of
establishing the price at which the buyer is willing to buy and the supplier willing to supply. How
this may be achieved is the subject of much of the rest of this study unit.
It is such an important function of the market that some large firms ensure that certain markets
continue to operate only because they need a reliable mechanism for price-setting. The large
manufacturing companies do not really need to buy metal on the London Metal Exchange they can
obtain all they need direct from suppliers. But they do need to know the conditions of demand and
supply in the main areas where metal is bought and sold. By keeping the metal exchange in

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Markets and Prices

operation, they obtain this information, which provides a price-setting mechanism and so helps to
reduce some of the uncertainties which they have to face in obtaining essential materials.

C. PRICES IN UNREGULATED MARKETS

Definition of Unregulated Market
The term unregulated here means not subject to any price-setting regulation. An unregulated
market can be subject to detailed regulations regarding the conditions of payment and transfer and the
procedures for settling disputes. These, however, assist rather than impede the free communication of
buying and supplying intentions, and allow them to interact in order to establish a market price. An
unregulated market is, thus, one in which the forces of supply and demand are free to interact,
without any form of outside price control.
We tend to think of regulation in terms of control by the State or its agencies, but a market can, of
course, be controlled in other ways. Certain local antiques auctions are reputed to have been
controlled by rings of dealers who agree not to bid against each other and to share purchases among
themselves after the auction. This is not an unregulated market! The prices paid for goods at such an
auction are not market prices because they do not reflect the true conditions of demand.

Equilibrium Price
The equilibrium price is the one at which the intentions of suppliers are just matched by the
intentions of buyers, i.e. where the amount of the good demanded is just equal to the amount
provided. In this state there is no pressure from either supply or demand to move away from this
price, so the market forces are in a state of rest in equilibrium.
We have examined the concepts of supply and demand schedules and curves. If we put supply and
demand schedules and curves together, we can arrive at the equilibrium price, i.e. the market price.
Suppose we have the supply and demand schedules for the product Whizzo as set out in Table 6.1
and illustrated in Figure 6.1.
Price per kilo

Quantity (kilos per week)

Producers willing to supply

Consumers willing to buy

1.50
2.00
2.50
3.00
3.50
4.00
4.50
5.00

200
300
400
500
600
700
800
900

700
675
650
625
600
575
550
525

Table 6.1: Supply and Demand Schedules for Whizzo

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105

Figure 6.1
We can see from the schedules and the graph that it is only at price 3.50 (600 kilos per week) that
the intentions of producers and buyers are the same. At any higher price, producers will be supplying
more than buyers are willing to buy. At any lower price, producers will not be supplying enough
Whizzo to meet demand. 3.50 is the equilibrium price, and 600 kilos per week the equilibrium
quantity. As long as neither set of intentions changes, there is no incentive for any movement away
from this price and quantity, once it is achieved.

Changes in Intentions Shifts in the Curves

We can show the concept of equilibrium price and quantity in a general graphical model, as in
Figure 6.2. Here, equilibrium price is Op and equilibrium quantity Oq the price and quantity level
where the supply and demand curves intersect. We can develop this approach to analyse the result of
movements in the supply and demand curves.

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So far, we have considered only a possible shift in demand or supply. In practice, of course, a
movement in one is likely to influence the other through the effect on price and quantity.
Suppose there is a major increase in demand, represented by a movement of the demand curve
in Figure 6.5, from DD to D1D1. This shift, if supply remains unchanged at SS, results in an
increase in equilibrium price from Op to Op1, and in quantity from Oq to Oq1.
Now suppose that this increase in quantity makes it worthwhile for one or more producers to
develop new production methods, so that the good can be mass-produced at a lower unit cost.
The result, after a time interval, is to shift the supply curve from SS to St+ 1 St + 1. Here the
t + 1 indicates a change in time-period.
The new supply schedule, combined with the increased demand, produces a fresh equilibrium
price and quantity at Opt + 1, Oqt + 1. We have the apparently unusual result of an increase in
demand resulting in a reduction in market price. Note, however, that this can happen only
when given some rather special assumptions about the stage of a products development and
the possibility for change in supply conditions.

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Price
D1
S

D
P1

St+1

P
Pt+1
D1

S
St+1
D

qt+1

Quantity

Figure 6.5
Normally, we expect an increase in demand to raise equilibrium price and quantity. This is the direct
effect. The later reduction in price can result only from a shift in the supply curve, indicating a
completely new set of supply conditions.
A somewhat similar process can be initiated by a change in technology allowing mass production at a
reduced price. Here, there is first a shift outwards in the supply curve. Demand then rises, but not
enough to stop the price from falling. Consider the market for pocket calculators in this light.

D. PRICE REGULATION
Reasons
If price and quantity will always move to an equilibrium provided economic markets are left alone,
we must ask why governments and other agencies should ever wish to intervene. In practice, there
are several reasons, of which the following are among the most common:
(a)

Social Unacceptability
If the price resulting from an unregulated market were considered to be socially unacceptable,
as causing hardship or conflict in the community, attempts might be made to control it. This
could happen in a period of food shortage caused by war and/or climatic disaster, and also if
there were a shortage of housing in urban areas sufficient to cause hardship and increase risks
of disease, crime and other social evils.

(b)

Incomes of Producers
Attempts might be made to maintain high prices if it were desired to raise the income of
producers and their employees. This is one of the motives of the European Unions Common
Agricultural Policy (CAP).

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Stability of Supply
Some markets are notoriously unstable because of unplanned variations in supply, caused by
weather and other circumstances beyond the control of producers. In these cases, attempts may
be made to control prices to ensure greater stability in the market.

Effects of Price Controls

If prices are controlled without any attempt also to control demand and/or supply, the result can be
the opposite of that intended. This is illustrated in Figure 6.6.

Figure 6.7

PRICE CHANGES AND INDIRECT TAXES AND

SUBSIDIES

Effect of Tax on Price

In Study Unit 5 we saw how the supply curve was likely to shift as a result of a change in an indirect
tax or subsidy. For the likely effect on market price, however, it is also necessary to take account of
the conditions of demand since it is likely that the producers efforts to recoup the tax by adding this
to the price will leave the quantity demanded in the market unchanged.

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Look now at Figure 6.7. Here we show the movement of the supply curve from SS to S1S1 (resulting
from the increase in tax) and the demand curve DeDe. The equilibrium price moves up (from Op to
Op1) but by an amount less than the increase in tax. The amount supplied to the market falls from Oq
to Oq1 and the output/quantity fall is greater than the price rise.

Figure 6.8
Now look at Figure 6.8. Here we have the shift in supply curve SS to S1S1 and a demand curve D1D1.
Again we have an increase in equilibrium price (Op to Op1) and a reduction in quantity supplied (Oq
to Oq1). This time, however, the reduction in quantity is less than the increase in price.
Why the difference in the two situations? You will have noticed that the curve D1D1 is much steeper
than DeDe. This reflects the fact that demand in Figure 6.7 is more price elastic than demand in
Figure 6.8. The two illustrations show that the more price elastic the demand for a product is, the
smaller will be the market-price increase following an increase in indirect tax, and the greater will be
the cutback in supply to the market.
This, after all, is really common sense. Price elasticity indicates the degree of responsiveness of
quantity demanded to any change in price.

Subsidies
The effect of a subsidy will be the exact reverse of that of the tax. Instead of the movement of the
supply curve from SS to S1S1 there is an increase in supply at all prices, i.e. as from S1S1 to SS, and
there will be a reduction in market price, as from Op1 to Op. Such a reduction is likely to have been
the main government objective in arranging the subsidy, particularly if the good is a socially
worthy one such as a basic food in a time of shortage, housing, or a service such as education or
health care.

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Remember also that the new supply curve need not be exactly parallel to the original before the tax or
subsidy change. If the tax, or subsidy increases with value, i.e. is an ad valorem tax or subsidy, the
gap between the curves will increase as price rises, as illustrated in Figure 5.17.

Government Use of Indirect Taxes

If the government increases indirect tax on goods which are price elastic, it will not receive much
extra tax but it will depress demand. If it imposes the tax on goods which are price inelastic, it will
not have much effect on output but the government will collect more tax revenue.
If you think back to when we discussed the income effect you will realise that the effect of the tax
may go further. Suppose there is a general increase in indirect tax on all goods. Some will be
demand price inelastic, and their pricing will increase without much reduction in the amount supplied
and bought. The buyers are paying more for nearly the same quantity of goods. This means they
have less income to spend on other goods they will have to cut purchases of goods which are price
elastic.
The unfortunate producers of price-elastic goods will suffer a double blow. They will suffer a drop in
demand from the tax increase and not be able to increase price by anything like the full amount of the
tax, and they will suffer a further drop in demand because consumers discretionary incomes have
fallen. It is no surprise, then, that business bankruptcies began to increase rapidly in the UK after a
general increase in VAT.
We have so far assumed that these taxes would be used either to increase government revenues or to
reduce consumer demand if the government believed that excess demand was causing inflation.
There is, however, another aspect of government policy that is not beginning to appear: this is the
control of pollution, which is now recognised as a significant problem.
As indirect tax on expenditure could be used as in instrument to reduce demand, and hence the
production or use of something that was believed to be a source of pollution. An example would be
an additional tax on petrol to discourage the use of motor vehicles. However, as the demand for
petrol is price inelastic then the tax will not have much effect on vehicle use but will reduce
consumer incomes available for spending on other goods. One of the main reasons why demand for
petrol for car use is price inelastic is because of the lack of satisfactory substitutes. As motor vehicle
ownership has increased the demand for, and supply of, public transport has fallen; and as public
transport provision falls and its price rises so even more people are induced to use their own private
cars.
We conclude, therefore, that a pollution tax on petrol would fail in its objective unless the
government also made provision for, and probably subsidised, alternative public transport, at least in
urban areas where cars are used for travel to work and for relatively short journeys. If the
government also wished to discourage car use for longer journeys it would need to provide
alternatives, probably in the form of subsidised rail travel combined with coal transport to convey
people from the main rail-heads. A tax is a very blunt instrument and a government wishing to
influence consumer behaviour needs to take many aspects into account. It is not sufficient simply to
increase the price of the good whose use it wishes to discourage.
Reverting to our general discussion of the effects of taxes on prices, notice that we have not taken
into account differing elasticities of supply. This is because supply reactions will take place over a
period of time. If suppliers can react by cutting back supply fairly quickly, then there will be further
effects on market price. You can examine these for yourself by changing the supply curve to make it
more elastic in Figures 6.7 and 6.8.

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Monopoly

125

Definition

125

Sources of Monopoly

125

The Monopoly Model

126

Comment

127

Monopolistic Competition

128

Main Features

128

General Model

129

Comment

130

Oligopoly

131

Price Competition

131

Price Stickiness

131

Kinked Demand Curve

131

Limitations of the Kinked Demand Curve Model

133

Price Leadership

134

Profit Maximisation and Alternative Objectives for the Firm

135

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Market Structures and Competition

A. MEANING AND IMPORTANCE OF COMPETITION

Competition is one of those simple words which are common in everyday speech and which we all
assume we understand but which, when we really try and explain, start to present difficult problems.
Ask yourself what benefits you think you get from competition as a consumer. Suppose you think in
terms of being able to buy from different suppliers, of being able to choose from a variety of different
but broadly similar goods for example choosing shoes of different styles, sizes, quality and price
ranges and perhaps of having some power as a consumer to bargain over price, or knowing that
some suppliers will charge lower prices than others. Notice that the word that recurs constantly when
most of us think about competition is choice. You and I, as consumers, value the ability to choose
between a range of goods, different prices and different standards of quality and service.
Because of the buyers ability to choose and apply pressure on prices, we expect competition to
oblige producers and distributors to use their resources efficiently and keep production and
distribution costs low. Competition is usually thought to be a very powerful force to ensure
production efficiency.
Competition is thus widely believed to be a desirable feature of markets. Most of the major modern
market economies have legislation and institutions concerned with preserving or increasing
competition and the Treaty of Rome, the founding Treaty of the European Economic Community
now the European Union contains a strong commitment to competition and the prevention of
attempts to limit it.
Economists have generally been in favour of competition as a force likely to increase the efficient use
of scarce resources, and they have developed a concept of perfect competition which we shall
examine in this study unit. More recently, however, they have recognised that traditional views of
competition have limitations and that the pressures on business firms are more complex than have
sometimes been believed in the past. There is also a recognition that increased competition can
sometimes have consequences that are not beneficial to consumers or which are not socially very
desirable.
For example, competing firms are likely to seek to attract the largest number of buyers and may do
this by providing those goods and services for which there is the greatest demand. Consequently,
consider the following possibilities:
!

Five or six television channels or stations all offering similar styles of soap serials at the
same peak viewing times, with the result that viewers can choose between stations but not
between types of entertainment.

Four or five multiple stores all offering similar styles and sizes of childrens clothes, with little
to offer buyers wanting different styles or the less common sizes.

Rival buses, some nearly empty, jockeying for custom in the streets of populous cities but little
or no transport to outlying rural areas.

Twelve or more insurance offices all offering cut-price insurance but with policies containing
conditions that are likely to allow the companies to avoid meeting claims for losses that policy
holders thought had been fully covered.

These examples and you can probably think of others suggest that competition can lead to less
genuine choice for consumers or can lead to a reduction in the quality of services provided. This
quality reduction can be very damaging in the financial services sector: competitive banking does not
appear to have improved relationships between the major banks and their customers.

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We must, therefore, be careful in our assessment of the benefits of competition and be prepared to be
critical when examining some of the traditional economic models of competitive markets. These
models have been developed in the belief that the degree of competition in a market is likely to
influence the behaviour and performance of firms operating in it. In this study unit we look at some
of the best known models, and these provide an essential starting point for understanding the often
complex markets existing in modern economies.

B. PERFECT COMPETITION
Definition
Our first theoretical model covers the situation where the economic market operates in its purest or
most perfect form. Perfect competition is the state of affairs existing in a market totally free from
imperfections in the communication and interaction of the economic forces of supply and demand.
Some writers like to make a distinction between perfect or ideal markets and perfect competition, in
addition to the distinction between the market as an area and competition as a condition found in that
area. They suggest that the conditions for perfect competition are satisfied when the individual firm
is a price-taker, i.e. when it can sell all that it can produce at the market price, which by itself it
cannot alter, and when buyers are indifferent as to which sellers product they buy at that price. Such
a very limited set of requirements would be satisfied when firms in an industry were subject to a
regulated price set by a government or some other regulatory body which had powers to buy goods
unsaleable in the market. This would certainly not be a perfect market.
For true perfect competition to exist, it seems more realistic to stipulate that sellers must be free to
enter and leave the market, so that total supply can change and bring about the equilibrium position.
Just to establish a market price through some form of price regulation would not produce the same
result, unless the regulating body is very sensitive to demand shifts, and production plans can be
adapted quickly.
It seems, then, that full operation of perfect competition can be achieved only in a perfect economic
market, and to put too much emphasis on differences between the two does not really help very much
in our analysis of the main market forces.

Conditions for Perfect Competition

These can be summarised as follows:
(a)

Goods Must Be Homogeneous

This means that, in the perception of the buyer, all units of the goods offered by all suppliers
are equally acceptable. The buyer is indifferent as to which unit he receives, as long as it
conforms to any description adopted by, and understood in, the market.
Notice that it is the perception of the buyer that is important. Suppose two large retail stores
make an arrangement with a manufacturer to be supplied with canned baked beans in plain tins.
The manufacturer supplies beans of the same type and quality to each retailer in the plain cans
quite impartially. However, each store adds its own label to the cans and sells the beans under
completely different brand names and at slightly different prices. The products are physically
the same, but they are not homogeneous, because the public perceives them as different and
competing products.

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(b)

Perfect Transport and Communications

All consumers in the market must have the same information. Suppliers must have access to
the same information about production factors and the technical conditions of production. No
producer is in a more favoured situation than any other.

(c)

Price Established Only by Market Forces

No producer and no buyer is able to influence the price by his own actions, nor by actions
agreed with other producers or buyers. There is no degree of monopoly power in the market.

(d)

Economic Motives Only

The actions of suppliers and buyers are influenced only by economic motives. If buyers or
sellers are influenced by a desire to support a charity or a political party the market will not be
purely economic, however worthy the social motives.
Economic rationality in a market economy assumes an underlying self-interest and a desire to
maximise benefits that can be gained from available scarce resources. For the consumer this
means maximising utility, as defined in Study Unit 2, while for producers it is usually
interpreted as wishing to maximise profit an objective examined later.

(e)

No Barriers Limiting Market Entry and Exit

Suppliers and buyers must be free to enter and leave the market as they choose and as they are
guided by considerations of profit and utility. This is a very important element in any
competitive market and in some modern models of market behaviour, notably that of
contestable markets, it is the most important consideration.
Barriers to market entry and exit may be natural, i.e. arising out of the nature of the goods or
the production process, or artificial, i.e. arising out of market regulations.
Natural barriers are highest when production requires large amounts of highly specialised
capital, e.g. oil exploration and extraction or motor vehicle assembly. Only firms with access
to very large amounts of finance can enter these markets and, once this capital has been
acquired, the firms are committed to staying in the market, since exit would usually involve
very large financial losses. Natural barriers are low when little specialised capital or skill are
needed to commence production.
When natural barriers are low established producers may seek to protect themselves from new
entry by building artificial barriers, such as membership of a trade or professional
association, entry to which may require a long period of apprenticeship or education or high
membership fees. It is not unknown for established traders to prevent new entry illegally by
the use of force, as in the case of ice cream selling in some areas and, of course, street trading
in illegal drugs.
The lower the barriers, both natural and artificial, the more contestable the market, and the
theory of contestable markets suggests that contestability is a powerful force determining the
behaviour of suppliers in a market. If producers know that they can easily be challenged by
new competitors they will behave as if they were subject to competition because they will not
wish to provide incentives for new firms to come into the market. Such incentives would
include supernormal profit or the existence of buyers who were dissatisfied with existing
goods, standards of service or prices.
Consequently we would expect a perfectly contestable market to exhibit most if not all the
characteristics of perfect competition.

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Movement towards Equilibrium in Perfectly Competitive Markets

We can now examine the behaviour of firms operating under conditions of perfect competition.
If we assume that the firm is experiencing diminishing marginal returns and can sell all it can produce
at the market price, over which it has no control, then it will have average and marginal cost curves
and an average revenue curve as shown in Figure 7.1. Since all units of the good are sold at the same
price whatever the firms sales level, price will equal average revenue and will also be the same as
marginal revenue.
Suppose the price resulting from the interaction of supply and demand in the market as a whole is Op;
then there is no level of output at which the firm can produce at a profit.
At all levels of output price, average revenue is below the average cost curve. However, the profitmaximising condition of marginal cost = marginal revenue is also the loss-minimising condition, so
the best output for the firm to choose is at Oq where marginal cost equals marginal revenue. At this
output level, average cost at Oc is higher than average revenue at Op, so the firm suffers a loss equal
to the shaded area cdbp.
Given the conditions for perfect competition, if this is the situation faced by one firm, it is the
situation of all firms subject to the same market information and technology. Firms cannot continue
indefinitely suffering losses. Some will withdraw from the market (remember that unrestricted entry
and exit is another condition of this market) because they are less able to withstand losses or they
have other markets they can enter. As supply declines, the total market supply curve moves to the
left, as shown in Figure 7.2.

Figure 7.1

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Price

S
P1

If firms suffer losses at price Op1

some withdraw from the market.
Market supply falls from Oqm to
Oqm1 and equilibrium price rises
from Op to Op1 as supply shifts
from SS to S1S1.

P
D

S1
S
O

qm1

Output

qm
Figure 7.2

The market equilibrium price then rises assuming that demand remains unchanged. Supposing the
equilibrium price moves up from Op to Op1, this produces the situation for the individual firm
illustrated by Figure 7.3.

Individuals have monopoly control over the supply of their own skills, and this may be a source
of considerable profit. The top footballers, tennis players and entertainers are monopolists of
this type. When the skill lies in producing something written or recorded, then the monopoly
position is protected by copyright laws which, however, modern technology has made more
difficult to enforce.

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(c)

Market Control
It is difficult to achieve total monopoly over supply without the protection of the law, although
it is not unknown especially in the production of some intermediate products. For a number
of years, all the valves for pneumatic tyres on British motor vehicles were produced by one
manufacturer. Such a monopoly rarely lasts very long. When a large rival decides to challenge
the monopolist, there is little that can be done to prevent this.

The Monopoly Model

The model has been developed to explain the outcome of a monopoly not subject to any special legal
protection or control. It assumes that the firm is pursuing a profit-maximising objective, and that it is
able to make abnormal profits.

Figure 7.5
A monopolists output is the total market supply, and the demand for its product is the total market
demand. The firm will thus face a downward-sloping demand curve. If we assume that it is not
practising price discrimination, then this curve will be the price/average revenue curve. The
graphical model is shown in Figure 7.5.
The profit-maximising monopolist will produce at output Oq , where marginal cost equals marginal
revenue, and will charge price Op. Abnormal profit is represented by the shaded area. Oc is the
average cost, so Op Oc is the average profit earned on each unit of product sold.

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If the firm were to set price to equal marginal cost, which is the position desirable from the consumer
viewpoint, it would produce output Oqw and charge the lower price Opw. This is why the profitmaximising monopolist is said to restrict output and increase price in comparison with a firm
operating in a competitive market.

Comment
There is much evidence that large firms with considerable market power may not maximise profits
but may pursue quite different objectives, such as growth or sales revenue maximisation. The
average cost curve was drawn on the basis that abnormal profit was being made. There is nothing in
the model itself that says that the average cost curve must be this shape and in this position. We can
move it up or down without affecting the other curves, and so alter the profit quite legitimately.
In short, the model proves nothing. It simply illustrates the assumptions made. Notice that, if we
drop the profit-maximising requirement, we can allow the firm to increase output and reduce price,
and so come closer to the consumer-benefiting output level of Oqw. This would also reduce average
cost and allow the firm to make more efficient use of its resources.
In answer to the charge that monopoly is against the public interest because it restricts output and
raises price, the following arguments can be put forward:
(a)

The monopolists size and ability to produce for the whole market enables it to achieve
economies of scale, so that costs are actually lower than they would be under perfect
competition.

(b)

The monopolist employs professional managers who make more efficient use of available
resources than small owner/managers, who often lack managerial skill.

(c)

The monopolist does not maximise profits but is content with just a satisfactory level of profit.

(d)

Some element of abnormal or monopoly profit (normal profit is considered to be included in

the firms costs as for perfect competition) is desirable, so that the firm can:
(i)

spend money on research and gather funds for further capital investment;

(ii)

have the incentive to take risks and innovate, and sometimes suffer losses that would
cripple smaller firms.

The position where a monopolist is actually able to charge lower prices than would be possible under
perfect competition is illustrated in Figure 7.6. Here, for simplicity, constant average total costs have
been assumed and the monopolists cost curve is below that of small firms by reason of economies of
scale and improved technology. Assuming that the monopolist seeks to maximise profits, the
appropriate price will be Pm, still higher than the perfectly competitive price of Pc. However, this
could be reduced if the monopolist had some other objective such as maximising growth or revenue.
The revenue-maximising price (Pr), i.e. the price applicable to producing at the quantity level where
marginal revenue is 0, and therefore total revenue is at its maximum, is lower than the perfectly
competitive price of Pc. Notice that, unlike the firm under perfect competition, the monopolist can
charge a range of prices, depending upon the firms objectives, and still make a profit.

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Figure 7.6: Price and Output Under Perfect Competition and Monopoly
The argument really boils down to a question of performance. Does the monopolist behave against
the community interest or does it achieve levels of efficiency beyond the capacity of small firms
operating in highly competitive markets? There is no clear answer. As the extreme cases of
monopoly are fairly rare in practice, examination is usually made of markets which approach
monopoly conditions.
If the demand curve faced by the monopolist shifts, this will alter the marginal revenue curve and
consequently the profit-maximising output and price. However, we cannot assume that the demand
curve will simply move outwards parallel to the old one. It is possible that its slope may change
(become steeper or less steep). Consequently, while normally we would expect an increase in
demand at all prices to lead to an increase in monopoly price (assuming costs remained unchanged),
we cannot be absolutely sure of this. Try experimenting with differently sloped average revenue
curves. Remember that the marginal revenue must bisect (cut into two equal halves) the horizontal
distance between the average revenue curve and the revenue (vertical) axis. You will find that there
are changes that could produce a reduction in the profit-maximising price!

D. MONOPOLISTIC COMPETITION
Main Features
Monopolistic competition still retains many of the features of perfect competition unrestricted entry
to and exit from the market, good (but not perfect) communication and transport conditions,
motivation by economic considerations only, and the perception by buyers that the products of the
various firms are good substitutes for each other.

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It is in this last point that monopolistic competition differs from perfect competition. Although the
products are considered to be good substitutes, they are not homogeneous. Buyers do express
preference for one sellers product as opposed to anothers.
Sellers seek to increase this preference by differentiating their product through branding (giving it
distinguishing features) and especially by advertising. The greater the degree of preference they can
establish, the stronger the brand loyalty and the greater the freedom gained by the supplier from
needing to follow the market price for that class of product. Success brings an increased degree of
market power and a reduction in price elasticity of demand.

General Model
In the general model of monopolistic competition, however, we assume that the individual firm is not
able to achieve a high degree of price inelasticity, so that the demand curve for the individual product
has only a fairly gentle slope, i.e. there is still a high degree of substitutability between competing
brands. This prevents the individual firm from making monopoly profits. It is still closely governed
by the market price for the class of product. The result is shown in Figure 7.7.
Features of this model are outlined below.
!

There is no abnormal or monopoly profit, i.e. average cost equals price/average revenue at Op
and, as for perfect competition and monopoly, it includes an element of normal profit.

At the profit-maximising output of Oq, average cost is still falling to its minimum at Oc, where
average cost is equal to marginal cost the output level where the rising marginal cost curve
cuts the bottom of the average cost curve.

Price (at Op) is above marginal cost (Om) at the profit-maximising output Oq.

Price is thus higher and output lower than would be the case if price were to be equal to marginal
cost, as in perfect competition. The lack of monopoly profit is the result of competition and the
ability of firms to enter and leave the market.

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Figure 7.7: Monopolistic Competition

Comment
It can be argued that this market structure is not really in the best interests of either consumers or
business firms, for the following reasons:
!

Price is higher and output lower than would be the case with perfect competition.

The firm is not making the best use of its resources, since average cost is still falling at output
Oq, as we saw a moment ago.

Profits are confined to the normal minimum required to keep firms in the market the amount
included in our definition of costs for the purposes of these market models. They cannot
achieve the profits needed for investment and research or the high output levels necessary for
economies of scale.

It is also argued, however, that consumers are prepared to accept these additional prices and costs in
return for the benefits they receive through greater choice of product the ability to choose between
competing brands and competing suppliers. This competition may also lead to improvements in
product quality and design as well as services to the consumer.
We can expect firms operating in such market conditions to seek to increase their monopoly power
and make their product-demand curves less elastic. They will do this by brand advertising, by
securing favourable treatment from distribution organisations or through technical improvements in
their products. They may be able to keep an advantage by securing patent protection or keeping
processes secret from their competitors.

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E. OLIGOPOLY
Oligopoly is the market structure where supply is controlled by a few firms which are large in relation
to the market size. Very often the firms are also large by any standards, and are likely to be
oligopolists in several markets. (For example, Unilever is a very large company which supplies major
brands of many grocery products, including Birds Eye frozen foods, and washing products
including, among many others, Surf and Stergene.)
Oligopoly is now commonly found in the advanced industrial countries and a great deal of attention is
paid to it. There is, however, no single model which can be held to apply under all circumstances.

Price Competition
One influence that is thought to be important is the extent to which the products are in price
competition with each other. If there is little price competition and if consumers are not thought to
choose brands on the basis of comparative price (i.e. if cross elasticity of demand is low) then each
oligopolist has a high degree of monopoly control over the demand for his own product.
This will, of course, depend chiefly upon whether the products are regarded by consumers as
homogeneous or whether they consider each brand to be distinct and different. It is unlikely that
consumers will find much to choose between, say, various brands of plain, salted crisps. Cross
elasticity of demand between the brands is thus likely to be high when the crisps are on sale in similar
distribution outlets. If there are price differences, customers will choose according to price.
In these circumstances, suppliers may seek to operate in different sections of the market, e.g. through
different supermarket chains or in hotels and pubs rather than retailers. They may also seek to
differentiate their products through such devices as flavour or by developing novelty shapes or other
related products. You may be familiar with various products which have been developed by the four
major firms in this market.
A full study of oligopoly is likely to embrace problems of prices and non-price competition, and even
the question of how far firms may collude together to limit the extent of competition between
established firms and to protect themselves against possible newcomers to the market.

Price Stickiness
Efforts have been made to produce models based on traditional assumptions of profit maximisation.
One such model seeks to explain the observed tendency that the prices of some goods in oligopolistic
markets remain steady in spite of fluctuations in the prices of basic commodities. This stickiness is
apparent in more normal, less inflationary times. For some years the price of a standard 4-ounce bar
of chocolate remained at 6d (old pence) in spite of frequent movements in the prices of the basic
materials required for chocolate manufacture.
This particular feature of an oligopolistic market for a product still regarded as fairly homogeneous
(in spite of brand advertising) has given rise to the model known as the kinked demand curve.

Kinked Demand Curve

Suppose the current and sticky price of a product is 1 per unit. This is the price that customers
have come to expect. If one oligopolist supplier tries to increase the price, rival producers will be
reluctant to follow. They keep their prices the same and gain market share at the expense of the
price-raiser. If, however, the oligopolist reduces the price, the other suppliers are obliged to reduce
their prices also to prevent his encroaching on their market share.

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Market Structures and Competition

Thus there is a kink around the price of 1 in the demand (unit price or average revenue) curve faced
by the individual oligopolist. At higher prices the curve is more elastic, due to the loss of market
share, than at lower prices where all market shares stay the same. You can see the general shape of
such a kinked curve in Figure 7.8.
Price
per
unit

At price 1 the oligopolist has

difficulty changing price. At higher
prices he loses market share. At
lower prices all oligopolists in the
market keep the same share but lose
revenue.

Quantity

Figure 7.8
Now consider a possible table of revenues resulting from this condition.
Price per Unit

Quantity

Total Revenue

units per time period

1.40

1.30

13.00

1.20

24.00

1.10

33.00

1.00

40.00

Marginal Revenue
(Change in TR)
pence

130
110
90
70
60 or 20
0
0.80

40.00

0.60

36.00

0.40

28.00

0.20

In Figure 7.10 the demand curve DD is the demand curve for the market and SsSs is the supply curve
for the smaller firms. At price Po these firms are unwilling to supply to the market; it is their
minimum price. At price Ps the smaller firms are able and willing to supply the full market demand at
that price.
This knowledge allows the dominant firm to estimate its own demand curve, which is made up of
market demand at each price less the amount which the smaller firms are able to supply. Thus the
demand for the dominant firms product is nil at price Ps but it is the same as market demand at prices
Po and below. Between these two prices the dominant firm is able to supply the balance between
market demand and supply from the smaller firms.
On the assumption of profit maximisation the dominant firm will wish to supply quantity qd which is
the quantity at which its marginal cost is equal to its marginal revenue. At this quantity level the
dominant firms market clearing and profit maximising price is Pd. If it charges this price the other
firms will have to follow, and market demand at this price is shared on the basis of qd to the dominant
firm and qs to the smaller firms.
Notice that if you raise the dominant firms marginal cost curve you will reduce qd and increase qs.
However, if you lower this curve you will increase the market share going to the dominant firm,
which is thus able to maintain its dominance as long as it is able to keep its costs lower than those of
the smaller firm. We may assume it is able to achieve this through economies of scale, a higher level
of technical knowledge and managerial skill, and by its superior power to secure low prices in the
factor markets.

PROFIT MAXIMISATION AND ALTERNATIVE

OBJECTIVES FOR THE FIRM

In the discussions of perfect competition and monopoly, we noted that whereas under perfect
competition long-term survival depended on the firm maximising its profits, whether or not this was
its conscious objective, under monopoly the firm could survive without actually maximising profits.
As long as it made a satisfactory profit it was able to pursue other objectives. We now develop this
point more fully.
Any firm which possesses a substantial degree of market power as a producer and which is large in
relation to the total size of the market in which it operates, will have a product demand curve which is
downward sloping and, if it is successful, is also likely to be able to make profits above the minimum
needed to keep it in the market. Its position may, therefore, be represented by a model similar to that
usually used for monopoly as in Figure 7.11.
This models assumes that the firm does not practise price discrimination, so that its product demand
curve is also its average revenue curve. Assuming that its market power allows it to make profits
above the minimum, there will be a substantial range of output levels and prices between which it can
make profits. This, in Figure 7.11, is the range between output level A (price PA) which is the lower
break-even point where the falling average cost just equals average revenue, and output level C (price
PC) which is the higher break-even point where the rising average cost just equals average revenue.

often at the expense of profits, take-over battles are commonplace and the salaries and prestige of top
business managers appear to bear little relationship to the profitability of the companies they manage.
On the other hand, an economic theory of the firm should be concerned not only with how firms
actually do behave but also how they should behave, if the economic goals of technical and
allocative efficiency are to be achieved. Unfortunately, the alternative theories appear to suggest that
if firms operate as they predict, they are likely to be less efficient in the full economic sense than if
they pursue profit maximisation the desire to make the largest achievable profit consistent with
market conditions. One thing that has to be remembered always is that profit maximisation does not
mean making very large and anti-social profits, but simply the largest profit possible under prevailing
market conditions. Profit maximisation under perfect competition suggests lower profits than
satisficing behaviour in an oligopolist market. A market economy appears to operate more efficiently
when firms seek to maximise profit. Consequently, most economists continue to work with profitmaximising models, whilst fully recognising that firms do frequently depart from profit-maximising
behaviour in practice.

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Interest Rates

148

Importance of Interest Rates

148

The Determination of Interest Rates

150

The Pattern of Interest Rates

152

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A. MONEY IN THE MODERN ECONOMY

Features and Types of Money
Throughout history money has taken many forms. Almost anything can serve as money as long as
people are prepared to accept it in exchange. Acceptability is the one quality that money must have.
If this is lost, i.e. if people are no longer willing to trust it and thus refuse to take it in exchange for
real goods and services, then it is useless.
Other qualities can add to its usefulness. Ideally money should be:
!

portable it will not be much use as an aid to transfer if it cannot easily be moved

divisible it must be capable of reflecting a range of values; animals were once a symbol of
wealth but as money they had limitations a valuation of one and a quarter cows could prove
difficult to pay!

durable saving presents problems if the money saved is likely to die, rot or rust away

controllable preferably in short supply, not too easily obtained and capable of being
controlled by an accepted authority

recognisable if people cannot recognise money as money they are unlikely to accept it very
readily.

One of the oldest forms of money, and one that is still in limited use, is gold. When, from time to
time, the world economy becomes unstable and other forms of money become less acceptable the
price of gold always rises as people turn or return to it as a haven for their threatened savings.
Other precious metals have often been used, especially silver, but this lacks some of the qualities of
gold. Many metals suffer deterioration over time.
To aid recognition, add acceptability and assist in measuring value, many communities over the ages
have fashioned coins from previous, semi-precious and base metals. With the exception of a limited
supply of gold, these are now used mainly for units of low value.
Metal is bulky and expensive to transport in large quantities so, from very early times, traders have
used paper as a more convenient substitute. Paper has always been used in two ways as money:
(a)

As a receipt or representation of precious metal or some more solid form of money and
exchangeable for the preferred form of money under certain conditions. The Bank of England
note still contains the .... promise to pay the bearer on demand the sum of ... .. At one time
the holder could exchange such notes for gold. Today handing over a note at the Bank of
England will only be met with another note, but the promise serves as a reminder that the paper
really just represents money and has no intrinsic value in itself.

(b)

As an instruction to a clearly identified person or organisation, or a promise from a person or

organisation, to make a payment under certain conditions. A letter of credit is an instruction to
make money available to the holder while a bill of exchange, still widely used in international
trade, is an unconditional promise to make a payment. Such instruments of payment are almost
as old as trade itself.

In recent years plastic cards have replaced or supplemented paper as conveyors of instructions to
make payments, and the development of modern telecommunications has made such cards with their
magnetic strips among the most important means of carrying out everyday trading transactions. As

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information technology continues to advance we can expect these cards to gain further uses but also
to be replaced by direct instructions through computers or over the telephone.
All these convenient forms of payment by simple instruction depend on peoples willingness to hold
their store of money in banks. Early banks actually did store the wealth of their customers in the
form of precious metals but wealth is now stored purely in the form of credit balances recorded in
computer memories. Money is now held in the form of a device that can store and transmit electrical
impulses. Even at this stage it has not yet reached its ultimate form, though in simple terms we can
ignore all present and future methods of transferring and storing money and simply refer to it as
bank credit. In this form we can choose to store it as a bank deposit or use it to make payments by
any of the techniques made available to us by current technology.

Functions of Money
The functions of money are generally summarised as follows:
(a)

Facilitating Exchange
The basic purpose of money, as we have already noted, is to make easier the exchange of goods
or services. Without money, people have to resort to direct exchange or barter, and this is often
wasteful, time-consuming and inefficient. Money allows trade to develop much more freely.

(b)

Measure of Value
Even if people do exchange goods directly, they can be more certain of fair dealing if they can
measure the value of their goods in terms of recognised money. If farmers wish to exchange
pigs and cows, they are helped if they know the values of both in money terms.

(c)

Measure of Deferred Payments

Exchange and trade can flow more freely if it is possible to carry forward debts of a known
amount. Money can help by standing as a measure for any payments that are deferred for
future settlement. For example, the farmers exchanging pigs and cattle may agree that A took
cattle from B to a higher value than the pigs he passed to B. If the difference in value is
expressed in money, then both know the size of the debt and the future payment required.
Money measurement may help them later to settle the debt say, with some other animal,
perhaps sheep.

(d)

Store of Value
Finally, money can be kept as a store of value that can be held in reserve for purchases not yet
planned. This value can be held over time as long as money value does not fall.

The importance of acceptability has already been stressed. Without it, money cannot be used in
exchange. This is why a great deal of international trade is carried out in a relatively few generallyacceptable currencies e.g. American dollars, Swiss francs, Japanese yen, German marks, and British
pounds. These currencies are all readily acceptable and transferable in world trade and finance
markets.
We can see that acceptability and transferability depend on the confidence of traders. If this
confidence is lost, then money ceases to have any value, because it cannot fulfil its essential
functions.
The functions that causes the most problems is that of storing value. No form of money in the
modern world has escaped the problem of inflation the tendency for money prices to rise as time
goes by. If all prices rise, then the value of money itself is falling. The difficulty of storing value

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undermines confidence, acceptability and transferability, and so makes trade generally more difficult
and uncertain.

Measuring Money the Monetary Aggregates

The measurement of money supply depends on how we define it. The wider our definition, the more
we have to measure. Difficulties in deciding precisely what should be counted as money help to
account for the fact that there are several possible definitions. These are currently divided into two
groups.
(a)

(b)

Narrow money comprising three measures:

M0, the narrowest, made up of notes and coin in circulation with the public + banks till
money + the banks operational balances with the Bank of England

NIBM1, made up of notes and coin + the non-interest-bearing private sector sterling
sight deposits of banks (bank customers non-interest bearing current accounts)

M2, made up of notes and coin + the sterling, retail deposits of banks + the retail
building society shares and deposits + national savings bank ordinary accounts.

Broad money comprising two measures:

M4, made up of notes and coin + all private sector sterling bank and building society
deposits

M5, made up of M4 + private holdings of money market and national savings

instruments.

In 1995 the measures in most use were M0 for narrow money and M4 for broad money. All measures
can be manipulated to some extent by banks, particularly if they are used as the basis for government
money controls. There is also a tendency for governments to stress whichever measure appears to
support whatever policies they are currently pursuing.

B. THE COMMERCIAL MONETARY AND FINANCIAL

SYSTEM
Structure of the Monetary System
The British monetary system is made up of a range of banking and related financial institutions, and
these have been undergoing far-reaching changes in recent years. You are likely to find a number of
terms used to describe banks when you read text books and journal articles. Many relate to older
conditions, and are no longer in active use. Others are still used, but in such a wide, general sense
that they are difficult to define with any degree of precision. Most modern writers now classify banks
and financial institutions according to the terminology employed in this section, i.e. Retail Banks;
Accepting Houses and other British Banks; Foreign and Consortium Banks; Discount Houses;
Building Societies; Life Assurance Companies and Superannuation Funds; and Other Financial
Intermediaries.
You will probably come across the term merchant bank and this is used to refer chiefly to those
banks which are here classified as Accepting Houses and other banks which carry out functions very
similar to these. The following subsections provide brief outlines of the various categories. You
should also be alert for references and descriptive accounts which appear from time to time in the
leading financial journals.

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The Retail Banks

These are the banks which handle the individual accounts, both small and large, of private and
business customers. They consist of the English and Scottish banks (including the familiar Big
Four High Street banks) the Irish banks, the Co-operative Bank, Trustee Savings Bank and the
Girobank. They are distinguished from the wholesale banks which handle only large sums of money
(upwards from $1m) and which concentrate their activities in a limited number of major world
financial centres. The large retail banks (also known sometimes as branch banks) do engage in
wholesale banking in addition to their retailing functions, and the terms retail and wholesale
really apply more to functions than to separate, specialised institutions.
The major functions of a retail bank are:
(a)

Safe-keeping of Money
This is the basic function of banking. Many customers still keep jewels and important
documents in bank safes. However, as modern money is now mostly in the form of
transferable credit, this function is chiefly performed through the various types of bank account
held by customers. The current account is used for day-to-day transactions. Other accounts are
usually in the form of time deposits, i.e. deposits where an agreed period of notice is
required for withdrawals without penalty. The longer the period of notice and the higher the
amount deposited the higher the rate of interest paid by the bank. If immediate withdrawal is
required then a certain amount of interest is usually forfeited, though in some accounts
immediate withdrawal is permitted without an interest penalty provided a stated minimum sum
remains in the account. You should obtain details of the range of accounts offered by your own
bank.

(b)

Transfer of Money
Much of the daily work of the retail banks is concerned with making payments through
cheques and other written instructions, including bank giro. Some of the work of money
transfer has now been passed to the credit card companies (themselves mostly owned by the
large banks) but credit card payments still require final settlement by a bank transfer. The large
international banks are deeply involved in foreign payments for the import/export trade. Bills
of exchange are still used extensively in handling trade payments, especially as these are very
closely linked with the extension of credit.

(c)

Lending Money
Banks make most of their profits from lending money. Traditionally they have been chiefly
concerned with short-term loans very short-call (overnight or 24-hour) loans to other
banking institutions, overdrafts, trade loans made by discounting bills of exchange (usually for
up to 60 to 90 days) and commercial loans for up to around two years for business or approved
private projects.
In recent years, banks have been encouraged (by government pressure or by competition) to
lengthen their lending terms. Clearing banks have entered the private house mortgage market
where loans can be made for twenty or more years. Of greater importance to business has been
the increased willingness of banks to lend for periods of between five and ten years for
business capital development.

(d)

Money Management, Advisory and Agency Services

The banks have become increasingly involved in selling their financial skills to help people
manage their money. They also recognise that they have a responsibility to provide financial
help to business ventures which operate with bank money. Apart from becoming financial

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consultants, banks are also becoming more actively involved in the fringe financial services
such as insurance broking, investment advice and the handling of trusts and estates.
More recently, a number of banks have entered the field of stockbroking. This has been made
possible by the Stock Exchange reforms of October 1986. The retail banks also control a
number of specialised subsidiaries, offering hire purchase, leasing and factoring services to
customers.
!

Leasing is an alternative to hire purchase, and is used frequently by business firms to

obtain vehicles and equipment under a form of instalment credit.

Factoring is used chiefly in foreign trade. A factor takes over responsibility for a
companys approved trade debts and arranges collection and administration, thus
releasing cash to the company. It is an expensive way of speeding up a firms cash flow
(the speed at which money spent on production is recovered from sales) but worthwhile
if the cash can be used at greater profit than the cost of the factoring service.

Accepting Houses and Other British Banks

The distinction here is more one of status than of function. The term accepting house is usually
reserved for a member of the Accepting Houses Committee. This consists currently of 16 highly
reputable institutions, most of which have been long established in the City of London. The term
accepting house is derived from the traditional business of accepting commercial bills of exchange
on behalf of customers. A bill of exchange is an unconditional promise to pay a certain sum of
money at a definite time and place. It is still a common method of payment in foreign trade. The bill
(and therefore the terms of payment) is drawn up by the exporter, and these terms are accepted by the
importer or by an accepting house on the importers behalf. When the accepting house accepts a bill,
it effectively guarantees payment; and the bill becomes a most useful instrument of payment,
recognised throughout the world.
Although the houses do carry out a small amount of retail business for selected customers, their main
activities are in the wholesale finance markets where they handle very large sums of money in a
number of world centres. They also act as issuing houses, arranging share and loan issues for
commercial companies, and they thus form a bridge between the monetary and capital markets. They
act as financial advisers to companies, and have specialised subsidiaries or departments dealing in
finance for foreign trade, for business equipment leasing and other financial services to business.
They sell high quality financial advice, mostly to large companies and to very wealthy individuals
and to other financial institutions such as pension funds. You will find these banks closely involved
in company mergers, take-over battles and management buy-outs, in fact in any business activity
which involves some kind of financial arrangement.

Foreign and Consortium Banks

A feature of recent years has been the extension of foreign banking in London. The main challenge
has come from the American banks following their own multinational companies. A more recent
development has been the entry of the major Japanese banks to form an effective link between the
large financial centres of Europe and Asia.
On the whole, there has not been any major or sustained competition for the business of British
industrial companies. Most foreign banks are concerned chiefly with their own national
organisations and with operations in wholesale banking i.e. lending large sums to other banks and
financial institutions, usually on a short-term basis. The increase in oil wealth has, of course,
encouraged the entry to London of a number of Middle Eastern banks.

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Consortium banks are those jointly owned by British and foreign banks. The existence of foreign
banks in London has helped to make the large British banks more alive to the threat of potential
competition and the need to keep developing their own services.
The foreign banks are also active in what is termed the eurocurrency market which handles
transactions in the bank deposits of banks held outside the banks countries of origin. Thus the dollar
deposits of an American bank in London form part of the eurodollar market in Britain. Eurocurrency
markets have become a major part of the wholesale banking structure.

The Discount Houses and the Money Market

Although they no longer enjoy a monopoly in handling the regular issues of Treasury Bills from the
British Government, the discount houses still play a very important part in bringing these bills to the
banking system, where they form a significant element in the banks short term assets. At the same
time they have widened their activities to include a greater range of commercial and banking
securities and banking activities generally. Nevertheless they continue to specialise in the short and
very short term markets in money and still enjoy a close association with the Bank of England.
In 1989 the Bank of England invited applications from other banks to join the discount houses in
entering the Bill market with similar conditions and responsibilities to those accepted by the
discount houses. Most of the large high street and wholesale banks have entered the Bill market.
The Money Market is the term given to the market in short-term money in which all the main banks
take part and where a major role is played by the discount houses. The market brings together
business organisations, all banks as well as central and local government, all of which have funds that
they have to keep almost liquid but which they cannot afford to have lying idle. The most important
intermediaries in this market are the discount houses, which are able to play an essential role in
effectively lengthening the terms over which such money can be used. By keeping very short-term
finance constantly flowing and turning over, the intermediaries can enable borrowers to use a high
proportion of that money for longer periods. For example, if bank A recalls money which a discount
house has lent to X, the discount house can repay this money and replace it with funds borrowed from
bank B. Consequently X is able to use the money it has borrowed without the fear of having to repay
it at very short notice. This, effectively, is what all banks do. If I withdraw money from my account
with a High Street bank this does not cause the bank to recall a loan to one of its borrowing
customers. Normally my withdrawal will be balanced by additional deposits from other account
holders. Of course, this only works as long as everyone has confidence in the system and believes
that funds can be withdrawn quickly when required. If all lenders in the system decide to withdraw
their money at the same time the whole structure starts to collapse. Banking can only function on a
firm foundation of confidence.
Although much of the money flowing through the Money Market comes from bank deposits and bank
money lent on call or short notice, as already described, a great deal is also available from trading in
Treasury and Commercial Bills of Exchange where a debt is put in writing and liability for making
the payment is accepted by a bank (or the government) on behalf of the debtor).
In the Money Market funds are not allowed to lie idle. When London sleeps its money may be
working hard in Sydney, Hong Kong, Singapore, Tokyo and many other places. If you have 10 spare
you will not earn much interest by lending it overnight but if you have 10 million it could easily be
earning over 1,000 while you sleep and still be back in your account next morning ready to meet
any payment due to be made.

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Building Societies
The main function of these institutions is the provision of funds for house purchase by individual
owner-occupiers. They are also a major channel for the savings of individuals. The societies have
expanded with the huge growth of private home ownership in the United Kingdom. At the same time,
there have been many mergers so that the number of societies has been falling, but their average size
has increased. The larger societies have been seeking to widen the range of their activities, and have
been offering sight deposit, cheque books, cash card, personal lending and other banking-type
services in competition with the banks.
The Building Societies Act 1986 opened the way for the larger building societies to convert to public
companies as full banks, but by 1995 only the Abbey National had taken this route. In that year,
however, Lloyds Bank sought to take over the Cheltenham and Gloucester Building Society. The
Halifax and the Leeds merged, other societies were planning to do so, and it seemed clear that in
various ways the number of independent societies was likely to decline.

Life Assurance Companies and Pension Funds

These are now important financial institutions. The life and pension companies differ from general
insurance companies in that they provide long-term investment services and are not normally selling
protection on an annual basis. The payment made, say, for motor insurance, covers the cost of
protection for the year of insurance. The premium thus buys a specific and limited service. The
typical life assurance or pension contract provides for a return payment to be made at some time in
the future, prior to which there is a continuing obligation to pay premiums and a continuing
obligation on the part of the company to invest those premiums to the mutual benefit of the company
and its policy holders. This gives the life and pension companies substantial funds which they invest
in a range of ways including property, shares, government bonds or in direct lending to business.
The growth of company pension schemes since the early 1980s has meant that individuals have had
little control over the funds invested in their names. Currently the Government is seeking to
introduce schemes for more personal control over pensions. If this movement develops, it could
change the structure of the pension market and introduce more direct competition for this class of
business.

Other Financial Institutions

(a)

Unit Trusts and Investment Trusts

These represent slightly different forms of pooling revenues to spread the risks of investment.
Unit trusts are the more popular. A trust sets up a fund which is invested in a published range
of securities and divided into units of fairly small denominations which are then sold to savers
in a variety of ways. The unit trust holder thus has his or her savings effectively spread over all
the funds investments. Units are bought and sold by the Managers of the fund so that they do
not pass through the Stock Exchange. The managers, of course, deal through the Stock
Exchange in the course of managing the Funds investments.
Investment Trusts are limited companies which use their share capital to invest in other
companies. Their own shares are bought and sold through the Stock Exchange, and
shareholders are effectively investors in a range of other shares.

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Finance Houses
These are mostly dealers in consumer credit or providers of specialised financial services.
They generally obtain their funds through the banking system. Many are now officially
regarded as banks and are classified among Other British banks.

C. THE CENTRAL BANK OF THE UNITED KINGDOM

Of rather greater economic importance is the central bank the Bank of England. This does not
compete for ordinary commercial banking business but is, essentially, the banker to the government,
the regulating body for private-sector commercial banking and the office link with other central banks
and with international banks, especially the International Monetary Fund (IMF).

Banker to the Government

The Bank carries out the three basic banking functions for the government. It keeps the spending and
money-receiving accounts for government departments and some public-sector organisations, such as
the Post Office. It carries out money transfer services for the government, including the payment of
interest and dividends on government loans, and it arranges loans required by the government.
The main forms of government borrowing are Treasury bills, and dated and undated bonds known
usually as gilts or gilt-edged stock carrying either a fixed or variable rate of interest and marketable
through the ordinary stock exchanges. Some gilts (on the National Savings Register) can also be
bought directly by the public through the National Savings (Government Stock) Office at Blackpool.
Unmarketable stocks (loans not transferable through stock exchanges) can be bought through post
offices or the National Savings (Government Stock) Office, and sold back to the government in the
same way under agreed terms and conditions. These include National Savings Certificates and
Bonds, and Premium Bonds.
The Bank of England also has a duty to give financial advice to the British Government concerning
the value and stability of sterling. In effect this means regarding the exchange rate against other
currencies and on monetary policies designed to limit inflation. The Bank considers that its main
duty is to fight inflation and to encourage the Government to pursue what it considers to be the
correct anti-inflationary monetary policies. The main policy instrument at its disposal, subject to the
overall control of the Government is the rate of interest.
Some have argued that the Bank of England should be like the Federal Reserve Bank and the
Bundesbank, the central banks of the USA and Germany respectively, that is, independent of direct
government control and free to set interest rates and direct monetary policy according to its own view
of what is in the best long-term interests of the British economy. This, it is argued, would stop
governments manipulating the economy for political ends. The usual accusation is that British
Governments engineer inflation in the period before a General Election and then have to impose
recessionary measures to curb inflation in the period after the Election.
The counter argument to this is that the government is ultimately responsible for the economy of the
country and control of inflation is not the only economic objective it is obliged to pursue. No British
Government would escape blame if it allowed the Bank of England to pursue policies that eliminated
inflation at the cost of massive unemployment and social unrest. It must, therefore, retain continuing
responsibility for all aspects of economic policy, including monetary policy and interest rates. The
Bank of England, therefore, gives advice but cannot decide these issues.
However, under the current (1995) Chancellor of the Exchequer, the Bank of Englands authority has
been strengthened by making public the minutes of the monthly meeting which the Chancellor has

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with the Governor of the Bank of England. The Chancellor it is suggested, would be taking a great
political risk if he were seen to ignore clear advice given by the Governor, particularly if it was clear
that the advice was ignored in an attempt to gain short-term political advantage.
Another issue over which the Bank of England is likely to exert considerable influence is the question
of monetary union with other countries in the European Union and, associated with this, the matter of
a single European currency. Over this issue the Bank has been seeking to contribute to a serious
debate on the economic issues involved and to separate these from the heated emotional and political
passions that have become aroused.

Banker to the Banks and Regulator of the Banking System

The Bank provides the paper currency and coin issued to the public through the banking system,
within limits set by Parliament. It also mints gold sovereigns. As banker to the banks, it keeps the
accounts of the clearing banks themselves, and the inter-bank debts revealed at the daily clearings are
settled by book transfers between the various accounts held at the Bank of England.
The regulation duties of the Bank are of two kinds:
!

It is responsible for the stability and integrity of the institutions which make up the banking
system and, in this capacity, it has very clear duties under the Banking Act 1987. In 1991 the
Bank closed down the Bank of Credit and Commerce International (BCCI) in the face of clear
evidence of massive fraud.

It also has a wider duty to control the actual supply of money within the banking system. The
extent to which it seeks to impose monetary controls and the methods chosen for control are
determined in consultation with the government. This is very much a political matter on which
the Bank can only advise. The reasons for monetary controls and the ways in which they may
be exercised are examined later in our studies.

International Links
As the national bank, the Bank of England keeps the nations gold reserves and the international
accounts for money entering and leaving the country, as well as the nations reserves in other
currencies. The Bank of England works closely with the central banks of other nations.
The Bank maintains continuous contacts with the major international banks, especially the
International Monetary Fund (the IMF is probably closest to being a genuine world bank).
The Bank has a duty to maintain the stability of the national currency in its exchange value with other
national currencies, and to co-operate with other countries and international institutions to uphold the
stability of the world financial system. It has a special account which it can use to deal in sterling
and other currencies in order to stabilise demand and supply and control exchange rates, or at least
control the speed at which exchange rates change. This account is called the Exchange Equalisation
Account.

D. INTEREST RATES
Importance of Interest Rates
We have seen how important borrowing and lending are to the workings of a modern economy, and
this dealing in money always takes place at a price. The price of money is interest, and the level of
interest has become an important issue in modern economics. The reasons why interest rates have
gained this importance include the following:

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(a)

149

They influence the level of business investment and business costs.

If interest rates are high, new investment is discouraged and, as most loans provide for interest
rates to be linked with bank base rates, the costs of existing borrowing rise. The result of a
prolonged period of high rates is that business efficiency declines. This reduces the supply of
business goods and services, and makes it more difficult for business to compete with countries
with lower interest rates.

(b)

They influence the cost of public borrowing.

The government, in one form or another, is by far the largest borrower of money. Some
government debt is subject to changing rates a number of loans are linked to rates of price
increase, and the governments short debts (Treasury bills) have to be constantly renewed at
current market rates. Governments have to pay interest out of revenue, and taxation is the
largest source of revenue. A large proportion of tax revenue thus has to pay for the costs of
past spending, and this proportion is not available for new spending. Any rise in interest rates
reduces the amount of public services that can be provided from taxation and makes the
government dependent on further borrowing thus increasing future costs still further.
There is also a social effect. Remember that taxes are paid, directly or indirectly, from income
earned by labour. Interest goes to holders of capital, so that the higher the rate of interest, the
greater the effective income transfer from labour to capital.

(c)

They influence consumer spending.

Much consumer spending on major capital goods and the more expensive household durables
is with the help of credit. If interest rates are high, consumers may go on spending for a time
but
(i)

they purchase less expensive goods, because a higher proportion of the amount spent
goes on borrowing costs, and

(ii)

the burden of repayments takes up an increased proportion of income leaving less for
other spending. As everyone with a mortgage loan knows only too well, any increase in
the interest charged on the loan reduces the amount of household income left for
spending on other goods and services. If, for any reason, the household cannot meet the
mortgage payments the home may be re-possessed. Changes in the rate of interest have
become of very great importance to large numbers of people.

High interest rates also appear to increase savings partly, no doubt, because of the
discouragement to spending. We shall see later in the course how an increase in saving and a
reduction in consumer spending can have a depressing effect on total business activity. A
prolonged period of very high rates can be an important influence leading to general depression
and increased unemployment.
(d)

They affect the rate of inflation.

Because interest rates affect the cost of consumer spending, and because building society and
bank mortgage interest rates now affect around 60% of all households in Britain, any change in
rates influences movements in the Retail Price Index which is the official measure of average
price increases (inflation). If interest rates go up, then inflation rises and people tend to spend
less on new purchases. If spending also falls, the unemployment may rise, even though prices
are also rising.

Because of the direct impact of interest changes in all these ways, the ability to make changes has
become a major instrument of economic policy in all the main market economies. Since most

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contemporary governments in the advanced market economies appear to be pursuing mainly

monetarist, anti-inflationary polices, they all rely on interest rates to pursue their objectives.

The Determination of Interest Rates

Since interest rates have so many important influences on our lives we should have some knowledge
of the processes which determine them. Interest is of course the price of money, so that ultimately we
would expect the forces of supply and demand in the finance markets to determine the levels of
interest ruling at any given time. This in fact is the basis for one of the most widely accepted theories
of interest rate determination, which suggests that the market equilibrium rate of interest is that rate at
which the stock of available capital is equal to the demand for capital arising from its marginal
efficiency.
The marginal efficiency of capital within the community is the average return available to business
organisations from capital investment. Our earlier discussion of business investment showed that
business firms can be expected to invest capital and to acquire capital for investment as long as the
return from investment is more than the cost of capital which, in this analysis, we can equate with the
market rate of interest. Firms will not knowingly invest where the return is less than the cost of
capital (market rate of interest). The interaction of supply of capital and its marginal efficiency is
illustrated in Figure 8.1.
As there is only a limited number of high yielding investment projects we can expect the marginal
efficiency of capital (MEC) to fall as more capital is invested. The MEC curve is thus downward
sloping. The stock of capital is fixed at any given time and is shown by the vertical line which
intersects with the MEC curve at interest rate i and quantity of capital q. At this rate and quantity the
demand for capital resulting from its MEC is just equal to its supply the capital stock so that
demand and supply are in equilibrium at interest rate i. At any higher rate there is an excess of
demand as at rate i1 where demand rises to q1 with supply remaining at q. At rates above i there
would be an excess of supply over demand.

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Figure 8.1
In the absence of any other influence, interest rates would be determined by considerations of this
nature. However, other influences are almost always present in the shape of government or central
bank intervention. Because some governments or central banks intervene to move interest rates to
levels thought necessary to achieve their desired economic objectives, other governments also have to
intervene to ensure that their economies are not put at a disadvantage.
Governments or other regulatory bodies are likely to want to push rates higher than the market
equilibrium levels if they wish to restrict demand and production in order to control inflationary
pressures. They may seek to bring rates below the equilibrium if they are faced with high and rising
unemployment and fear a deep recession-depression. By reducing the cost of capital they hope to
encourage business investment and consumer demand for goods and services. No major trading
country can afford to be too far out of line with interest rates in other countries otherwise there would
be a huge movement of capital towards high-rate countries and away from low-rate countries. This
movement would put immense strains on the low-rate countries balance of payments and on its
currency exchange rate. Consequently the freedom of any individual government or central bank is
restricted by the actions of governments and banks in other countries. Finance now circulates in a
genuinely international market.

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Governments can influence rates either by controlling the stock of capital, usually by measures over
bank lending, or by direct controls over the major banks. Notice that in Figure 10.1 the equilibrium
rate will rise if the cost of capital line moves to the left and fall if it moves to the right. This results
from the general shape of the MEC curve.

The Pattern of Interest Rates

It must not, of course, be assumed that the market rate of interest applies to all borrowers and lenders.
In the first place financial institutions always charge their borrowers a higher rate than they pay to
depositors. In 1995 there appeared to be a difference of anything from 4% to 6% between the rate the
major banks were paying to customers who had, say 10,000 in a deposit account and the rate they
were charging individuals and small firms who borrowed a similar sum.
In general those who lend money to others require a rate of interest which reflects:
!

The time period over which the loan is made the longer the period the higher the interest rate
required, unless market rates are expected to fall over the period, when long-term rates can
sometimes fall below those for short-term lending.

The ease with which money loaned can be recovered; the greater the degree of liquidity, i.e. the
more speedily and simply the money can be recovered, the lower the rate of interest. Banks
pay a higher rate on deposits where several months notice is required before repayment is
made than on deposits which offer instant access (immediate cash withdrawal).

The credit standing of the borrower large companies with a long record of financial stability
can obtain loans at lower rates than new, small companies.

The degree of risk which, in fact, is the underlying factor in all the above considerations.
Share dividends are not the same as interest payments but very similar principles apply. If you
look at the dividend yield as shown in a share price list in any of the leading daily papers you
will see that the yield (dividend return as a percentage of the price of the share) is much lower
on shares in the most profitable and secure companies than on shares of small companies in the
riskier sectors of activity, e.g. house builders.

You should examine the deposit accounts offered by several of the main banks and see how far the
differences in interest rates offered can be explained by the above factors.

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Study Unit 9
Liquidity Preference
Contents
A.

Options for Holding Wealth

154

Physical Assets

154

Financial Securities

154

Liquid Money Cash

155

The Keynesian View of Liquidity Preference

155

The Supply of Money

158

Money and Bank Credit

158

Credit Creation

158

Illustration

158

The Multiplier

159

Implications of Liquidity Preference

160

Interest Rates and Demand for Goods and Services

160

Classical and Monetarist View

161

The Keynesian View of Interest Rates and Expenditure

161

Implications of the Differences

162

Changes in Liquidity Preference

164

Page

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A. OPTIONS FOR HOLDING WEALTH

There are three main ways in which wealth may be held. These are generally described as:
!

physical assets

financial securities

cash (liquid money).

Physical Assets
Examples would include houses, land, furniture and private cars. Everyone who has wealth of any
kind will have some assets, as these are necessary to everyday life in a modern society, but it is also
possible to hold the wealth you wish to store for the future in the form of assets. In this case your
choice of which assets to hold will be guided less by what you need or find useful in normal life but
by what you think is most likely to hold or increase its value in the future. Since the future is
uncertain you may or may not choose correctly!
Holding wealth in the form of physical assets offers the following advantages:
!

They are likely to be useful or enjoyable as well as valuable and may remain so even if they
lose their value; for example, vintage wine may not increase in value as hoped at the time of
purchase but it is very pleasant to drink.

In periods of inflation or financial-political uncertainty they are likely to hold or increase their
value when money is losing its purchasing power.

They are visible symbols of wealth and status and this can be important for some people.

On the other hand there are some serious disadvantages:

They can excite envy and attract thieves and if, as a result, they have to be stored in a bank
vault they cannot be enjoyed.

They can be destroyed by fire or accident, or damage may reduce their value.

Keeping physical assets involves costs such as insurance premiums, maintenance, cleaning and
guarding, and these costs can be heavy.

Fashions change, and what is in demand and valuable one year may be considered unattractive
and without value a few years later. This applies particularly to the so called collectibles
such as works of art, coins and postage stamps. Those who bought houses in the late 1980s
know only too well that asset values can fall as well as rise.

Under normal circumstances, therefore, few people with wealth to store are likely to hold all their
wealth in the form of physical assets. This would be an option only when the normal financial system
was in danger of collapsing.

Financial Securities
These are mostly either titles to the ownership of property or to a right to share in the benefits of
property ownership, or they are promises to make a future payment. It is often an advantage to hold a
written title to property because ownership can be transferred by handing over the written title or it
can be used as a security for a loan. Similarly a written promise to make a future payment will also
have a value and the right to receive the payment can be sold to someone else.

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To be useful as a financial instrument, of course, the promise to pay must carry respect. An
undertaking by a major High Street bank will be more transferable, and therefore useful, than one
signed by an unknown individual. Such promises to pay or to repay a loan or debt on a stated date or
by a stated date, with interest payable to the holder in the meantime, are often known as bonds. With
the apparent decline of inflation in the 1990s, bonds issued by public companies and termed
corporate bonds have returned to investor favour. Bonds issued by the British Government, termed
government bonds or stocks, or gilt-edged securities (gilts) are an important element in the capital
market. Details of these can be obtained from most post offices and their market prices are quoted
daily in the financial press.
Wealth held in the form of bonds and securities, including the ordinary shares of companies, can also
be referred to as loanable funds. Besides ease of transfer, holding wealth in this form has the
advantage that it provides the holder with an income from interest or dividends paid by the issuer of
the securities. This is in contrast with owning physical assets, which incurs costs of maintenance and
insurance. As with any form of wealth there are risks of suffering a loss. For example if a company
which has issued bonds fails and goes into liquidation with insufficient assets to meet its obligations
to bondholders then the bonds are worthless. The bonds of very risky companies are frequently
called junk bonds.

Liquid Money Cash

Liquid money is most likely to be in the form of bank credit held in current accounts which,
technically, are sight deposits, i.e. depositors can withdraw or transfer money without having to
give notice to the bank. Most people will hold some liquid money in order to make payments by
cheque, plastic card or cash in the form of notes and coin. However, since sight deposits generally
earn only insignificant rates of interest, if cash were wanted purely for payment purposes the majority
of people would keep only the minimum needed for their regular payment needs. In practice many
people with sufficient wealth to be able to choose between the three options, may keep liquid money
in preference to assets or securities.
Classical economists offered little explanation for this tendency since they believed that the desire to
hold money in its liquid form depended mainly on the desire to use it for making purchases. They did
not attempt to relate the demand for liquidity to any other single variable such as interest rates. That
such a relationship could exist was argued by the great Cambridge economist of the 1930s, Keynes,
whose view of the elements in the demand for liquidity, i.e. liquidity preference, we will now look
at.

B. THE KEYNESIAN VIEW OF LIQUIDITY PREFERENCE

We have seen that economists had long believed there to be no direct relationship between demand
for money and interest rates. Keynes believed that there was such a connection, and in his analysis
he concentrated his attention on the choice between holding money (liquidity) and bonds. He
identified three elements in the attraction of money.
In doing so, he effectively elevated money to the status of a commodity for which there is a demand
in its own right not simply as something to hold when other forms of wealth are temporarily out of
favour. The three elements in the preference for liquidity in Keynes theory are the transactions, the
precautionary and the speculative motives.

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(a)

Transactions Motive
This is the desire to hold money because it is needed for the purchase of goods and services
i.e. to carry out trading transactions.

(b)

The Precautionary Motive

This is the need to have some liquid money available as a precaution against unexpected
developments, including favourable opportunities to purchase goods.

(c)

The Speculative Motive

It is here that Keynes parted company from earlier teaching. Something of a financial
speculator himself, Keynes regarded the speculative element, as in the choice between bonds
and money, as particularly significant.
The opportunity for speculation (gambling) arises out of changes in interest rates, and the fact
that the interest on bonds is normally paid at a fixed rate. Suppose a bonds fixed interest rate
was 5% because it had been first issued at a time of fairly low interest rates, when people
were content to receive 5% on their money. Suppose some years later interest rates in general
had risen to 10%, so that anyone lending money at that time would want at least 10% from the
borrower. Clearly, anyone holding a 5% bond would not be able to sell it to another at its
original price. A purchaser would expect to receive two 100 bonds for every 100 paid,
because only then would he be able to secure a total interest payment of 10, which is the
amount he could obtain by lending his 100 elsewhere in the financial marketplace.
Thus, with market rates of interest at around 10%, we could expect the market price of a 100
bond paying fixed interest of 5% to be 50.
Now, suppose the market rate of interest started to fall, so that the best rate a lender could
obtain was 7.5%. Anyone willing to buy bonds would now be prepared to pay somewhere
around 67. (If you cannot see why, then work out how many 100 bonds, paying interest at
5% per year, you would need to give yourself an annual payment of 15 in return for a total
payment for the bonds of 200. When you have decided that, work out the price per bond.)
This means that a fall in interest rates from 10% to 7.5% would enable anyone who had
purchased a 5% bond for 50 to sell it for 67 a handsome profit, especially if the change had
taken place over a fairly short time-period.
We can deduce from this then that, if interest rates are high and expected to fall, the people
would wish to buy bonds. As bonds and money are seen as alternative forms of holding
financial wealth, the demand for money would, consequently, be low. By the same reasoning,
if interest rates are perceived to be low and expected to rise, people would not want to be left
holding bonds the value of which, as financial assets, is falling. Instead they would sell bonds
and hold money the demand for which would, thus, be high. Roughly equivalent to bonds are
ordinary shares of first-class industrial and commercial companies, the profits of which might
not be expected to fluctuate greatly and the dividends of which are fairly constant.

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Figure 9.1
What is high and what is low in relation to interest rates depends on a great many other
considerations, including peoples experiences of rates in recent years. The ten per cent used
in the above example would have been regarded as very high in the early 1960s but very low in
the early 1980s. You should take an interest in the movement of interest rates and in changes
in the prices of bonds (government stocks) while you are studying economics.
This stress on the speculative motive for holding money led Keynes to the belief that the
demand for money does have a direct relationship to interest rates. It was thus possible to draw
a liquidity preference curve of the type shown in Figure 9.1.
Notice that, at the lower rates of interest, the curve flattens out, because no one believes that
the rate is likely to fall further, so there are no takers for bonds and people will wish to see a
rise to a higher rate before there can be any expectation of a fall and a chance for a speculative
gain. This is the liquidity trap which also features in the Keynesian v. monetarist debate, and
which we shall come to shortly.

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C. THE SUPPLY OF MONEY

Money and Bank Credit
Disagreements between groups of economists about the motives for holding liquid money in
preference to other forms of wealth may not seem too important but, in practice, they affect
government economic policies and the way they seek to control the economy through interest rates.
Anyone with a house mortgage or a bank loan knows only too well the effect of changes in interest
rates.
In order to take our understanding of the issues a little further, we must examine the relationship
between the demand for money and its supply.
This mention of a relationship between demand and supply may surprise you. In our examination of
demand and supply for goods and services at an early stage in the course, these two market forces
were kept separate. Money, however, is rather different. It is not produced like other commodities,
except in the very limited sense that gold and silver are produced. Most of the supply of modern
money is not found in physical form at all it is credit held in bank accounts on behalf of the banks
customers. The total amount of credit held by the banks on behalf of customers is not a fixed amount
but can, itself, be varied by the banks own actions.

Credit Creation
Banks, in fact, can create credit through lending to their customers, and lending is a most important
and profitable part of a banks activities. When people or firms borrow from the banks, they use the
amount borrowed to make payments to other people or firms, who deposit the payments with their
banks. Suppose I borrow 2,000 from my bank to help buy a new car. When I buy the car, I pay the
Swifta Motor Company. Suppose this company also has its accounts at the same bank. When I pay
my cheque, drawn on the bank, to Swifta, it then pays in my cheque to its own account. In effect, the
bank has created 2,000 in one account (my loan account) and thereby increased the volume of its
customer deposits (through the extra 2,000 paid in by Swifta).
Thus, for the factor capital, we have the peculiar position that demand appears to create its own
supply.
You may think we have cheated by using one bank only in our example but, as long as there is a fairly
closed banking system in a country, the effect will be the same if different banks are involved. In the
UK, the great mass (over 80%) of daily payments pass between the four large clearing banks
(Barclays, Lloyds, National Westminster and Midland), so that this close relationship between
demand, borrowing, depositing and supply does exist.

Illustration
In practice, the banks keep a proportion of all their funds in the form of coin, notes or deposits with
their own bank (the Bank of England), or in loans to other banking institutions, which can very
quickly be recalled. If we call these liquid assets of the banks cash, and assume, for simplicity, that
a country has a system of two banks only, each keeping 10% of its assets in cash, then we can give a
very simple illustration of how the total supply of bank money can grow following the injection of
new money from some outside source.
Suppose that our two banks are A and B, and the initial injection is 100 units, which goes to B. As
customers borrow money to pay to customers of B, and vice versa. The banks are of equal size.

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Bank A
Customer deposits

Held as:

1,000

Cash

100

Loans

900
1,000

Bank B is in the same position. Then there is an injection of 100 to the deposits of A. Bank A
initially adds this to its cash but idle cash earns no money. As soon as possible, therefore, it lends it
to suitable customers, and its accounts then appear as follows.
Bank A
Customer deposits

Held as:

1,000

Cash

110

Loans

990
1,100

This additional lending soon gets paid into customer deposits of bank B, which also lends 90% of this
increase, so that its accounts appear as:
Bank B
Customer deposits

Held as:

1,090

Cash

109

Loans

981
1,090

Additional loans of 81 units have now been made to customers of bank B, who have made payments
to customers of bank A.
The process continues, and bank As accounts become:
Bank A
Customer deposits

1,181

Held as:

Cash
Loans

118
1,063
1,181

Notice how the total of deposits (and, hence, the total money supply) is increasing, but (because 10%
is being held back all the time) by a decreasing amount at each lending/deposit round.

The Multiplier
This progression is called the bank credit (or money) multiplier. The total increase in our example
will be ten times the amount of the original injection. This is because:
Kb =

1
c

where: Kb = value of the bank credit multiplier

c = proportion of customers deposits held by the bank as cash
In our example, the proportion held as cash is 1/10 and 1/10 = 10.

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As the original injection was 100, the final increase would be 1,000. Thus, the greater the proportion
of customer deposits that the banks are able to lend to other customers, the greater will be the size of
the bank multiplier and the effect of lending on total money supply.
This power of the banks to create money, and the close link between lending money and the
increase in total money supply, are both extremely important issues. You must make sure you fully
understand them.
Because of this close relationship between the demand for and the supply of money, we can suggest
that the supply of money is likely to have very similar features to the demand. Thus, if we believe
that there is a particular relationship between interest rates and the demand for money, then a very
similar relationship can be expected for interest rates and the supply of money.

D. IMPLICATIONS OF LIQUIDITY PREFERENCE

Interest Rates and Demand for Goods and Services
We now return to an earlier statement concerning the preference for money. Remember that the
classical and monetarist view regards money as one of a number of possible ways to hold wealth.
Another way is to buy goods, so that we should now consider what is likely to influence the desire to
spend money in buying goods in preference not only to holding money but also to holding bonds or
company shares. If, then, we see interest- or dividend-bearing securities as being in competition with
goods for a share of spending, we can also see that bonds, etc., are likely to be desirable, because they
yield an income. Goods do not yield an income but they offer other satisfactions. We thus have to
balance the desire to obtain an income with the desire to enjoy goods and services. If interest rates
are high, then bonds and other income-yielding securities can seem attractive because of the income
that they produce. If interest rates are low, the income attraction is also low and goods and services
offer greater satisfactions.
Taking this approach, we can see a relationship between movements in interest rates and movements
in the demand for goods. When interest rates are high, the demand for goods is low, because people
prefer bonds. At low interest rates, demand for goods is high because they seem more attractive than
the low income obtainable from bonds.
This relationship is shown in Figure 9.2.

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Monetarist view of demand for goods and services and changes in interest rate
Interest
rate
%

i1
i
total expenditure
(demand for goods
and services)

Quantity of goods
and services

Figure 9.2
If interest rate rises from 0i to 0i1, the demand for goods and services falls from 0q, to 0q1, because
people are attracted towards buying bonds and other income-yielding securities.

Classical and Monetarist View

We can now summarise the classical and monetarist position with regard to interest rates and money,
and also with regard to interest rates and the demand for goods and services.
It is that the demand (and therefore the supply) of money is not very responsive to changes in interest
rates. Putting this in more formal economic language: money demand and supply are interest-rate
inelastic.
On the other hand, the willingness to spend money on goods and services is responsive to changes in
interest rates i.e. the expenditure demand for goods and services is interest-rate elastic.

The Keynesian View of Interest Rates and Expenditure

As we saw earlier in our studies, in the Keynesian view of the national economy, consumption i.e.
total expenditure on goods and services is mainly dependent on income levels. In other words, the
main influence on the level of consumer demand is seen as the level of income and not the supply or
the price of money (interest rates).
The Keynesian, therefore, does not believe that changes in interest rates are likely to have much
effect on the level of expenditure (consumer demand). Again, the more formal economic statement is
that total expenditure or demand for goods and services is believed to be interest-rate inelastic. In
contrast, we have seen in this study unit that the Keynesian, stressing the speculative motive in
liquidity preference, believes the demand (and hence the supply) of money is interest-rate elastic.

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Implications of the Differences

These two differing views of the relationship between interest rates, demand for money and demand
for goods and services have major implications for government policy, especially for policy on money
supply and the control of money supply.
Suppose it is possible for the government to engineer a reduction in the money supply e.g. by
forcing the banks to reduce lending to customers and so reduce their credit-creation. Then this
change in supply, like any other market shift, will result in a price change. Interest is the price of
money, so a reduction in money supply can be expected to force up interest rates; but the amount of
change will depend on the supply and demand elasticities on the responsiveness of supply and
demand to interest rate. Given that there will be some effect on interest rate, this, in turn, will affect
total demand for goods and services again, the extent of effect will depend on the relationship
between expenditure demand and interest rates.
Now we can begin to see the importance of the differences in views between Keynesians and
monetarists. These are illustrated in Figure 9.3.
Keynesians believe that there is a close relationship between money demand and interest rates but
this interest-rate elasticity ensures that any shift in rates brought about by a forced shift in supply also
reduces demand so, in effect, the interest rate change is small. Expenditure is not much influenced
by interest rate anyway (it being influenced more by income), and the small rise in interest produces
little movement in expenditure.

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Figure 9.3
The position according to the monetarist view is very different, although the mechanism is the same.
Demand remains largely unaffected by the shift in supply and the change in interest rate which is,
thus, pushed up higher than in the Keynesian view. This steep rise in rate produces a major reduction
in the interest-responsive demand for goods and services.
These are very marked contrasts, in effect, and you would expect the debate to be settled fairly easily
by research into actual interest-rate and money-supply changes. In practice, economists research
faces a great many practical difficulties not least, as we shall see, the problem of actually defining
and measuring money supply!
There are also other influences operating both on interest rates and on the demand for money, and
there are further problems in distinguishing between short and long-term effects. Even after many
years of economic management by a monetarist government, following the changes of 1979, there
is still much uncertainty, and the debate is far from resolved.

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You may now also see that our analysis has to take into account some important modifications
resulting from the way money is handled in the actual finance markets, so that, before we go further
into this general debate over monetarism and the effect of government attempts to control the
economy according to monetarist principles, we should pause and examine the structure of the
finance market within which money and the supply and demand for money actually interact.

E. CHANGES IN LIQUIDITY PREFERENCE

So far we have looked at the consequences of changes in the quantity of liquid money demanded in
response to changes in interest rates. We also need to consider the effect of a shift in the whole
liquidity preference curve, i.e. see the effects when people wish to hold more, or less, liquid money at
all relevant rates of interest.
If people desire to hold a higher proportion of their wealth in the form of liquid money, then they will
have less available for use as loanable funds or to purchase physical assets. The logical consequences
of reductions in each of these would be to reduce levels of business investment.
!

If the supply of loanable funds falls we would expect interest rates to rise and this would
increase the investment costs faced by business firms and tend to reduce their investment
intentions.

If expenditure on goods and services falls, this would reduce the aggregate level of consumer
expenditure and lead to a reduction in business investment. Firms invest in order to increase
future production. There is no point increasing future production if current expenditure on
goods and services is falling. The reduction in investment would have a depressing effect on
the equilibrium level of national income through the investment accelerator and multiplier.

This process and the terms investment multiplier and investment accelerator are explained in
Study Unit 11. At this stage it is simply necessary to recognise that any reduction in investment is
likely to depress the general level of economic activity in a country.

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173

Calculation of GDP

173

Gross and Net National Product

174

National Income

175

Equality of Measures

175

Use of National Product Calculations

176

Reasons for Introduction of National Accounts

176

Helping to Solve Economic Problems

177

Making Comparisons

177

Limitations of National Accounts

177

Limited Accuracy

177

Value to the Community

178

Changing Money Values

178

National Product and Living Standards

178

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A. NATIONAL PRODUCT AND ITS MEASUREMENT

Flows of Production and Money
In this study unit we start to examine the national economy as a whole. We see this in terms of one
large market in which total or aggregate demand from the whole of the community is satisfied by total
production. We are, thus, concerned with totals or aggregates in this part of the course. When we
have gained an understanding of the national system, we can begin to see its inter-relationship with
the wider international economy.
We are concerned chiefly with modern industrial economies or with agricultural economies
organised on an industrial basis (e.g. states such as Denmark or the Republic of Ireland). Some of the
important assumptions which we shall be making will be valid for these economies but would have
less relevance for subsistence agrarian economies, organised around self-sufficient local
communities, or for completely state-regulated socialist economies.

Flow of Production and Consumption

The national economic concepts we use assume the following:
!

That production and consumption are separate production being organised by business or
government organisations, and consumption being decided by individuals, families and
households. The family is, thus, seen as purely a consumption and social unit, and not as a
production/consumption/social unit, as it would be in an agrarian (farming) economy.

That most of the goods and services produced are exchanged through a market system, with
households paying money to buy products, and firms paying money for the use of production
factors.

That a proportion of production is organised by the state and its agencies, and paid for by
revenue raised by the state from the community.

This system can be illustrated in the form of two circular flow diagrams. One shows the flow of
goods and services the productive activities of production factors (Figure 10.1(a)), while the other
(Figure 10.1(b)) shows the counterflow of money which oils the really important flow of production
and consumption. Notice that, for simplicity, we use the terms firms for production organisations,
and households for the individuals and families who consume what is produced. These diagrams
assume that the total volume of production is immediately and totally consumed, i.e. there is nothing
to enlarge or diminish this continuous circular flow.
Notice that firms are seen as hiring the production factors, which are owned by households, which
then supply the labour, capital and land employed in production, and purchase the goods and services
produced.

The Consumption Function

If, for simplicity, we imagine an economy where there is no foreign trade, no taxation and no
government spending, then we can say that total income is either spent (consumed) or not spent (not
consumed). If we then define savings as income that is not spent or consumed, then we can make the
proposition that income (Y) is either consumed (C) or saved (S), i.e. that Y = C + S.

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Figure 10.1

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Given this proposition and retaining our simplified model of the economy, we can then see that any
increase in income is apportioned between consumption and saving. The amount of any increase in
income which is consumed is often referred to as the marginal propensity to consume. It may also
form the basis for an equation which helps us to determine the level of consumption for any given
level of national income. For example, we may say that:
C = 300 + 0.75Y
This is then termed the consumption function. If you have studied mathematics, the term function
will be familiar to you.
Given this function, i.e. the direct relationship between total consumption and total income we can
calculate values for C for any level of Y. If Y = 1,000, then C = 300 + (1,000) = 1,050. At this
level, people are trying to consume more than their total income and will have to use up past savings
or borrow from another country. At the income level of 4,000, C = 300 + (4,000) = 3,300. This
means that savings will equal 700, i.e. 4,000 3,300.
In this example, the 300 is a constant; it is the minimum amount of consumption required by the
community, whatever the level of income. Total consumption is made up of this minimum plus a
proportion of total income. The greater the marginal propensity to consume, the higher will be the
proportion of total income that is consumed at any given income level. If the marginal propensity to
consume remains the same at all income levels, then this will also be the proportion of Y that is
consumed in the equation.

Modifications to the Basic Flow

We must now modify some of the assumptions made in the basic circular flow concept. The main
modifications we need to make are to take into account the following factors:
(a)

Not all the income received by households is immediately spent on goods and services; some
income is saved.

(b)

Another part of total income of households is not actually spent on goods and services but
handed over to government authorities as taxation, either taken directly from income or
indirectly when certain goods and services are purchased. At this stage, all forms of taxation
are considered together. We shall examine forms of taxation later.

(c)

Yet another portion of income is spent on goods and services produced by other national
economies, i.e. it is spent on imports from other countries.

(d)

Firms enter the general flow as buyers of goods and services, such as factories, machines and
research, in their efforts to increase their capacity to produce. We call this investment or
capital accumulation.

(e)

The government must be seen as a separate force which produces goods and services on behalf
of the community as a whole e.g. it builds roads, schools and hospitals, and it provides forces
to maintain law and order and defence against external aggression. We can combine all these
activities under the heading government expenditure.

(f)

Firms supply other countries with exports of their products. Trade is a two-way process.

We can regard modifications (a) to (c) as leakages from the main flow of economic activity, because
they reduce the purchasing power of total incomes, and (d) to (f) as injections into the flow, because
they increase total purchasing power and demand. This concept of leaks from and injections into the
main flow is illustrated in Figure 10.2.

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Figure 10.2

National Product, Income and Expenditure

This total flow of economic activity, modified by injections and leaks, can be given the general term
national product. This is the term used chiefly today, and it serves to emphasise that it is the total
production of goods and services that is the really important matter. This is the total flow as seen in
our first illustration (Figure 10.1(a)). The counter flow of money in the second diagram
(Figure 10.1(b)) can be seen as both the total income of households and as the total expenditure of
households.
Notice that these three total product, total income and total expenditure are all really describing
the same essential flow. They can be regarded as equal provided that the total amount of leakages
from income (savings, taxes and imports) is equal to the total amount of injections of expenditure
(from investment, government spending and exports).
At the moment, we shall assume that this equality does exist and that total production = total income
= total expenditure. Thus, if we use P to denote total product, Y to denote total income, and E to
denote total expenditure, we can say that:
P = Y = E.
We therefore need to examine each of these aspects of the flow more carefully.

National Income Treatment of Taxes and Subsidies

It is useful here to examine more closely the treatment of taxes and subsidies in the national income
summary accounts calculated from incomes and from expenditure.
The national account summaries actually show two versions of Gross Domestic Product based on
expenditure. One, at market prices, takes no account of expenditure taxes or subsidies paid to
producers. They show the totals of spending at the prices actually paid in the market. GDP at
factor cost, however, is calculated by deducting the total value of expenditure and other indirect taxes
and adding back the total of subsidies paid to producers.

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The total based on factor cost is the one normally used. It is considered to be the fairer reflection of
true expenditure on goods and services. After all, total expenditure includes government spending on
final consumption, and much of this is paid for from expenditure taxes. If we value GDP at market
prices, then we are, in effect, counting in expenditure taxes twice once when they are paid by the
consumer, and once when they are used to pay for goods and services by the various government
bodies. Similar adjustments need to be made to take account of subsidies. These are payments made
by Government to producers and have the effect of reducing market prices. To obtain the true cost of
goods and services any subsidies need to be added back. Thus, to convert GDP from market prices to
factor costs indirect taxes are deducted and subsidies are added. In the summary accounts this
process is usually referred to as the factor cost adjustment.
The treatment of direct (mostly income and profits) taxes appears, on the surface, to be rather
different, but the effect is the same i.e. to ensure that total incomes are a fair reflection of the
incomes actually earned in the course of producing the national product.
Income and profits taxes are not deducted from employment incomes, nor from the trading profits of
companies and the trading surpluses of government-owned bodies.
The gross incomes, profits and surpluses are the true incomes actually paid by the production
organisations.
On the other hand, no account is taken in the summary totals of incomes from pensions,
unemployment benefits or other state welfare payments. These incomes are not received in return for
a contribution to production. They are transfer payments being transfers from the income of a
contributor to the production process to someone who is a non-producer. (No moral judgment is
intended here. The non-producer may have been a valuable past producer, or he may become a
valuable future producer. Our concern is to arrive at a true valuation of production in the year of
account.)
The accounts do, of course, include the incomes of those in the employment of state organisations,
even though their incomes may have been paid for out of income taxes. This does not matter the
incomes of state employees are earned in return for their work which is included as part of total
production, and the process is no different, in principle, from any other use of income to provide an
income to another in return for goods or services. If I use part of my income to pay for my
daughters dancing lessons, then those payments are included again in the accounts as part of the
dancing teachers income. If part of my income is taken from me to pay the salary of a teacher in my
daughters comprehensive school, then, again, these payments are included in the national accounts.
The only difference is that the state directs what I shall pay towards teaching in the school, whereas I
choose whether or not to pay for dancing lessons. In each case, the payments are made in return for
services which contribute towards the production of the national product. What is not included as a
further income is the payment made out of my taxes towards the unemployment benefit paid to my
unemployed nephew. His income is not earned in the course of producing anything, and it is ignored,
as though it were a voluntary contribution from me to him.

B. NATIONAL PRODUCT
Avoiding Double Counting Value Added
The National Product is the sum of the values of all the goods and services produced by a community
within a recognised time period normally a calendar year. However, we cannot simply add up the
values of all goods and services produced by all business organisations in the country. If we did this,
we would be counting some things more than once. For example, a set of screws may be made by

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firm A, sold to firm B which makes timing equipment, which, in turn, is sold to firm C a motorvehicle assembler. The completed vehicle is then sold to firm D, a motor distributor.
The final price of the vehicle includes the cost of the screws but, if we added up the total value of the
products sold by firms A, B, C and D, we would find that we had counted the screws four times.
One possibility might be to add up only the value of the product sold by the final distribution firm,
but this might not give us a very accurate result, because our motor distributor does not always know
whether he is selling to a householder or to a small business firm which will use the vehicle for
business purposes and includes its cost in the value of the goods or services it produces. There would
also be considerable problems of allowing for goods imported and exported.
The solution actually adopted is to count the value added to inputs by all firms producing outputs.
This is now much easier than in the past, because of the introduction of Value Added Tax. All firms
paying the tax, in effect, are also reporting their value added to the taxation authorities. In very
simple terms, the value added by each firm is the difference between the revenue it obtains from
selling its product and the cost of all goods and services purchased from other firms. In this way, the
screws of our original example are counted only in the value added of firm A. They are excluded
from the totals obtained from firms B, C and D. Notice that value added includes the cost of labour
employed by each firm in adding value to the inputs it purchases.
We shall go on to show how public sector spending contributes to the Gross National Product.
However, there is a reservation that should be made when we consider the public sector. This
concerns what are often called transfer payments. Consider, for example, what happens when a
person receives unemployment or some similar social security benefit. This is not a payment made in
return for work performed or services provided. It is a transfer to the unemployed person through
taxation from the income earned by people in employment. If we counted the unemployment benefit
into the National Product in addition to the full income of those who, in effect, are making the
transfer, then we would be double-counting the amount. Incomes are counted as part of National
Product only if they are earned by some contribution to economic activity, e.g. by employment or by
making capital available to government or business. Payments received by way of transfer through
taxation are not included in the total though, of course, they have to be taken into account when we
examine how the total National Product or Income is distributed.
A similar transfer payment within the private sector takes place when parents give pocket-money to
their children. The income has been earned by the parent and is simply transferred to the child. Total
national accounts, therefore, do not include childrens pocket money! Of course, the transfer
payments taking place through the public sector are much larger, and it is important that we
understand why they should be excluded from the final totals.

Gross Domestic Product

The figures published in the annual accounts of the United Kingdom in a publication known usually
as the Blue Book (National Income and Expenditure) show total product figures classified by
categories of industry and service. The following table is adapted from the Blue Book of 1994 and
shows the figures for 1983 and 1993.

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Gross domestic product by industry

1983
%

1993
%

Agricultural, hunting, forestry and fishing

1.99

1.82

10,373

Mining and quarrying including oil and gas extraction

7.41

2.13

12,147

23.68

20.77

118,294

Electricity, gas and water supply

3.18

2.46

13,994

Construction

5.83

5.13

29,221

12.26

13.76

78,348

7.22

8.12

46,263

18.17

23.52

133,956

Public administration, national defence and compulsory

social security

6.81

6.71

38,199

Education, health & social work

8.42

10.09

57,457

Other services including sewage and refuse disposal

5.03

5.49

31,292

100.00

56,544

Industry sector

Manufacturing

Wholesale and retail trade; repairs; hotels and restaurants

Transport, storage and communication
Financial intermediation, real estate, renting and
business activities

Total

1993
million

less Adjustment for financial services

-23,741

Adjustment for statistical discrepancy

317

Gross domestic product at current factor cost

546,120

The item adjustment for financial services requires explanation. The gross figure of (23,741m)
for banking and finance services includes interest payments received from financial companies and
other institutions. These payments should really be deducted from the totals of other industries to
which they relate but, as this is impossible, the only way to adjust the total is by including this special
item.
One further adjustment is made to these figures. As we see in this study unit, the total of Gross
Domestic Product is calculated in three ways, corresponding to three different points in the same
circular flow of activity. Because they are measuring the same thing, each total should be the same.
In practice, errors and omissions are inevitable so they are never quite the same. No one measure is
considered to be more accurate than the other so each is adjusted by a statistical discrepancy to
bring them all to the same figure. In this case the corrected figure for total Gross Domestic Product is
546,120m.
This total represents the value of the economic activity of the community, measured from the output
of business and government organisations. This figure is termed Gross Domestic Product (GDP).
The basis on which this figure is valued does not include indirect taxes and government subsidies, so

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that it is assumed to be valued at factor cost, i.e. at the cost of the factor inputs, not at the prices
paid by final consumers.
Notice also that, in this calculation, there is no separate identification of imports and exports. This
would be too difficult when counting business output of firms operating within the country. In
practice, we would expect the figures to include the value of goods and services which have been
produced for export, but not to include those produced in other countries. Domestic product
represents the value added from the home or domestic activities of production organisations in both
the private and public sectors.

Trends in Domestic Product

The largest item in the domestic product in 1993 was that relating to financial and business services,
a sector which accounted for over 23.5% of product, outstripping manufacturing, under 21%, which
for years had been the largest sector. The decline in manufacturings share of total product has been
continuing for many years as services of all kinds have assumed an increasing importance. This is a
trend that is common to all the old industrial countries of North America and Western Europe and
reflects both rising living standards in these countries, where people spend an increasing proportion
of incomes on services instead of goods, and changes in the pattern of world production. If you look
at the goods for sale in the shops or in your own home you will see how many of these have been
manufactured in the Pacific Rim countries of Japan and South East Asia. Notice also the rise in the
proportion of product accounted for by education, health and social work. This reflects changes in
technology affecting the work performed and equipment used by these services, the age structure of
the population as the rising numbers of older people put more pressure on the health services, and
changes in economic and social conditions with the expansion of education to cope with the demands
of the modern technology-based society and of social work to cope with the casualties of that society.
The relative growth of services at the apparent expense of manufacturing does not mean that
manufacturing is no longer important to economies such as that of Britain. It is still extremely
important, not only because the financial and business services need a strong manufacturing base for
their own development but also because it still provides a very large share of the wealth of the
community. Manufacturing has, of course, changed. It is no longer made up of simple metal
bashing but based on complex, computer aided processes often involving very high levels of
technology. The borderline between the new manufacturing processes and services is often rather
vague. Assembling a computer is clearly manufacturing but designing the software and systems
that control the computer and all the other equipment in the factory depends on the services of teams
of designers and programmers who would not think of themselves as working in manufacturing.
Further developments may also be slightly exaggerating the trend away from manufacturing towards
services. The old style manufacturing firm employed in house many groups such as caterers,
designers and other commercial service activities which today are more likely to be carried out under
contract by specialised services firms but which are still actually performed for the manufacturing
firm and its workers. These statistics, like all others, need to be interpreted with some caution and
against a background awareness of what is actually happening on the ground.

C. NATIONAL EXPENDITURE
Calculation of GDP
The main items of total expenditure were identified earlier as the main flow of household
consumption plus the injections of business investment, government spending and export demand.

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The concept is reflected in the Blue Book totals, which, in 1994, identified the National Product by
category of expenditure, as follows:
National Product by category of expenditure for 1993:
million
Consumers expenditure

346,162

General government final consumption

128,786

Gross domestic capital formation

Total domestic expenditure

87,025
561,973

Consumers expenditure is the same as the household expenditure already explained. Total
government spending is shown exclusive of capital investment. For example, it includes the running
costs of the Health Service but not the cost of building hospitals. This capital investment or
formation is combined with private sector investment to produce the third item in the table, gross
domestic capital formation.
This figure is not the same as domestic product calculated from industrial and government output,
because of the effect of imports and exports. Consumer and other spending will include spending on
goods and services produced in other countries (imports) but will not include the value of goods and
services sold to other countries. However, when we add on a figure of 150,504 million for exports,
deduct 166,266 million for imports and then also deduct a statistical discrepancy adjustment of
91 million, we obtain the total for gross domestic product calculated from expenditure of 546,120
million, the same figure calculated from product by industry.
The basis of valuation is factor cost, because the effect of taxes and subsidies on expenditure has
been removed. In fact, the National Income Blue Book also gives tables for Gross Domestic Product
calculated by category of expenditure at market prices. Further figures are then given for factor
cost adjustment. These are the total of taxes on expenditure to be deducted from Gross Domestic
Product, and of subsidies to be added. The result is Gross Domestic Product at factor cost.
For example, in 1993 the factor cost adjustment required:
Deducting
Taxes on expenditure

91,361 million

Adding back Subsidies 7,458 million

i.e. a total factor cost adjustment of 83,903 million. This is the amount by which gross domestic
product, measured at current market prices would be overvalued by the effects of taxation and
subsidy. Factor cost gives the true value of the production factors used to produce the total product.

Gross and Net National Product

The Blue Book makes two further adjustments to the GDP total. These are given below.
(a)

An allowance for net property income from abroad, i.e. earnings of British organisations
operating in other countries less the amount earned in the UK by foreign-owned organisations.
In 1993, there was a net inflow of this income of 3,062m and when this is added to gross
domestic product it produces a total of 549,182m. This is known as the Gross National
Product.

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An allowance for capital consumption, i.e. the using-up of capital investments made in past
years (e.g. the deterioration of roads, factories, etc.). In 1993, this was estimated to total about
65,023m. Thus, when this figure is deducted from the Gross National Product of 549,182m,
there remains a total for net National Product at factor cost (National Income) of
484,159m.

In practice, the figure most commonly used for international comparisons, etc. is that for Gross
National Product largely because the capital consumption figure has to be estimated, and different
countries use different methods of estimation.

D. NATIONAL INCOME
We noted earlier that total factor incomes suffered leaks from savings, taxes and import spending
before they were transformed into expenditure. The main Blue Book totals do not, in fact, show these
items directly, although they can be calculated from figures published in the book. Instead, they show
the Gross National Product by category of income. The totals are of gross incomes, so they include
taxation, savings and money which will be spent on imports. The categories of income are as below
again using figures for 1993 from the 1994 edition of the Blue Book:
million
Income from employment

352,896

Income from self-employment

61,346

Gross trading profits of companies

73,397

Gross trading surpluses of public corporations

Gross trading surpluses of general government enterprises
Rent
Imputed charge for consumption of non-trading capital
less Stock appreciation
Statistical discrepancy (income adjustment)
Gross domestic product by category of income

3,415
294
52,872
3,942
2,359
319
546,120

Notice that these correspond broadly to the rewards to factors of production. Income from
employment is the return to labour, as is most of the income from self-employment though this may
include some return to business owners capital. Company profits and government organisation
(including public corporation) surpluses may be seen as the reward to capital, while rent is the return
to land, including certain property on the land.
As we are concerned with incomes earned within the country, we do not have to make any
adjustments for imports and exports.

E. EQUALITY OF MEASURES
Notice that the Blue Book and countries other than the UK use similar calculations takes care to
emphasise the equality (or, more strictly, the identity) of the three measures by:

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(a)

ensuring that each is brought to the same total, where necessary by the device of a statistical
adjustment; and

(b)

labelling each set of summary accounts as National or Domestic Product thus stressing that
it is the same flow of activity that is being measured, whether by category of expenditure,
category of income or class of industry.

This also emphasises that it is the real product, i.e. the flow of actual goods and services, that is
important, rather than the flow of money through income and expenditure patterns.
Thus, the national account supports the concept of National Product and its circular flow. Remember
that total gross incomes were distributed by households as: consumer expenditure, savings, taxation
and spending on imports.
At the same time, total expenditure received additions (injections) from: investment, government
spending, and spending on exports by foreign countries. Bearing in mind that total income and total
expenditure are different ways of looking at what is, essentially, the same flow, we can use symbols to
state an equation. We have already used E for total expenditure and Y for total income. In addition
to these, it is usual to make use of the following:
S = savings;

I = investment;

T = taxation;

G = government spending; C = consumer expenditure;

X = exports;

M = imports.

Using these symbols, we can now say that:

Y = C+S+T+M

and

E = C+I+G+X

Remember that Y = E, so that:

C+S+T+M = C+I+G+X
C (consumer spending) is common to both sides of this equation, so that we can expect the remaining
elements of total income and total expenditure to preserve the equality, i.e.:
S+T+M = I+G+X
This is a proposition which is of very great importance in our analysis of national product, and we
shall be analysing its implications in some detail later.

USE OF NATIONAL PRODUCT CALCULATIONS

Reasons for Introduction of National Accounts

The detailed calculation and publication of National Product figures is a practice with only a short
history. United Kingdom figures have been compiled regularly only since the early 1950s. If the
nation managed to survive fairly successfully through the centuries before 1950 without national
accounts, why do we attach so much importance to them today?
The answer is two-fold. In the first place, the National Product concept based on the circular flow of
economic activity is relevant only to an industrial economy, and the UK could be called such only
from around 1850 onwards. The realisation that the periodic economic problems arising out of
industrial activity could not be measured and properly understood unless accurate figures were
available led eventually to acceptance by the government of its duty to prepare these figures.

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The second part of the answer lies in the changed economic role of the government. After the Great
Depression of the 1930s, there was a widespread belief that the government could, and should, seek
to become involved in some degree of economic planning. If a government is to try to manage the
national economy, it needs national accounts, just as much as business managers need business
accounts for the firms the activities of which they are seeking to control.

Helping to Solve Economic Problems

The existence of national accounting figures also helps us to understand how an economy actually
works. Without precise figures, we can only guess at such issues as the influence of interest rates on
savings or of income levels on consumption. When we have continuous records of interest rates,
savings, incomes and consumption over a reasonable number of years, then we can produce evidence
of cause and effect.
The more we know about the workings of a modern economy, the more hope there is that action can
be taken to produce results that are beneficial to the community and that solutions can be found for
the great problems which upset industrial societies, such as mass unemployment and price inflation.

Making Comparisons
Accounting records make comparisons possible. We can find out whether the economy is operating
more or less effectively than in the past, or more or less efficiently than the economies of other
countries. As we shall see in the next section, care has to be taken in making comparisons but,
without national accounting figures, no comparison is possible at all. For example, when we look at
the UK experience over the last decade in the light of, say, the West German experience over the
same period, we can see that there have been very different results arising from different policies and
objectives.
One very practical use for national income figures is as a basis for a number of United Nations
calculations. Member contributions to some UN institutions depend on national product. National
income and product figures are the starting point for many UN investigations designed to improve the
economic and social performance of poorer countries.

G. LIMITATIONS OF NATIONAL ACCOUNTS

We have to accept that too much reliance should not be placed on even the best national accounts,
and they should not be used, except with very great care, for purposes for which they were never
intended.

Limited Accuracy
It is, clearly, impossible to compile details of all the many economic activities in a modern
community. The desire to evade taxes is one of many reasons why some activities remain firmly
hidden from official eyes. The extent of the hidden, or black economy is sometimes put as high as
7% of the official economy. Business organisations come and go, and it is not easy to estimate the
size of activity in new industries or the extent to which older activities may be declining. We have
seen that the three measures of the British national product can be made to balance only with the help
of a statistical adjustment. Considering the huge amounts involved the proportional differences that
have to be reconciled are remarkably small. In countries able to devote fewer resources to statistical
services the margin of error is likely to be rather greater.
Remember that we are dealing with large aggregates or total figures, and these can conceal very wide
variations. For example, if, on the basis of our accounts, we say that the average income per head of

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the population is x, we should not imagine that the majority of people will be earning that figure.
Some will be earning much more and some much less. Some of the richest people in the world come
from the poorest countries. For a developing country, any average is likely to be very misleading in
view of the very great social, regional and other differences that exist.
Some countries may have an interest in ensuring that figures are not too accurate. A country hoping
to obtain maximum help from, and make the smallest possible contribution to, United Nations
institutions will wish to keep its national income figures as low as possible.
There is also the problem of comparing accounts when these are prepared in different national
currencies. International figures are usually converted to United States dollars at official rates of
exchange. Such official rates are often very different from the rates ruling in unofficial currency
markets.

Value to the Community

The IS Schedule (Curve)

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200

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A. CHANGES IN CONSUMPTION, SAVING AND

INVESTMENT
Equilibrium Conditions
We should now remind ourselves of the conditions necessary for National Product, income and
expenditure to be in equilibrium. The term equilibrium, remember, refers to a state of rest where
there are no pressures acting to disturb and change the balance of forces. Earlier, we suggested that
there would be equilibrium when total income was equal to total expenditure in the economy, and that
this implied:
C+S+T+M = C+I+G+X
where: C = personal or household consumption, S = savings,
T = taxation, M = imports, I = business investment,
G = government spending and X = exports.
If we remove C from each side of the equation, we are left with:
S+T+M = I+G+X
Putting this another way, we could say that total leaks or withdrawals from income = total injections
or additions to aggregate expenditure.
Equilibrium suggests that the state of rest remains for a period of time, so that we should take
successive time-periods into account. If, for simplicity, we use the symbols W = total withdrawals
(S,T,M), and J = total injections (I,G,X), then, using the usual symbols t, t + 1, t + 2, etc. for
successive time-periods, we can say that a total National Product in equilibrium implies that:
Wt = Jt+1 = Wt+1 = Jt+2, and so on.

Pressures Leading to Equilibrium

It seems reasonable to question why a national economy should achieve and maintain this form of
equilibrium. If we examine the processes operating within the economy, we can see that there are
strong pressures likely to produce such a state. For simplicity, we shall, at this stage, omit imports
and exports from our analysis.
To begin with, we shall also omit taxation and government spending. We are now considering, then,
only savings and investment. We shall, however, reintroduce consumption.
Consider the graph shown in Figure 11.1. Expenditure intentions at the various national income
levels are recorded in the curve C + I. Remember that we have reduced total spending to
consumption and investment, for our present purposes.
Assuming that the scales of both axes are the same, then the 45 dotted line represents all points
where total income just equals total expenditure. Remember, too, that when expenditure = income,
both are also equal to total output.
The graph illustrates that there is only one level of income where total income, output and
expenditure are, in fact, equal i.e. where National Product is in equilibrium.

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Figure 11.1
This is at the income level Oye, where the intentions curve intersects the dotted 45 line. What
happens, however, if this equilibrium is disturbed?
(a)

Lower National Income

Suppose national income is at the lower level Oy1, where intentions are trying to achieve a
higher level of spending than that possible from current total output.
At level Oy1, the combined demand from households (C) and business firms (I) is higher than
total output.
It cannot be satisfied at the current level of output. Some firms will have stocks of goods
produced earlier, and they will be able to sell from these stocks. Others, finding that they have
more customers than goods to sell, will ration sales by putting up the price or promising
delivery at a future date. Actual consumption and investment will thus be lower than intended,
as some would-be buyers are disappointed, but also money-spending will be raised by the
increased prices of goods.
Increased money-spending will feed into increased money incomes, and so the money value of
national income will move up towards Oye. We can also expect that firms, facing high demand
and good profits from rising sales, will seek to increase production. They will hire more labour
and pay more wages in order to do this. This will tend to push up production towards Oye.
There will be an upward pressure to achieve at least the money level of Oye, even if this still
leaves many spending intentions unsatisfied.

(b)

Higher National Income

We can apply this reasoning in reverse if national income happened to move out of equilibrium
to the higher level Oy2. Here, more is being produced than people want to buy. Warehouse

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stocks rise, and customers are not around to buy the goods and services on offer. Traders
needing money to meet current expenses will cut prices to achieve sales. Firms, seeing stocks
of unsold goods rise, will reduce production, lay off workers and cut overtime working.
Incomes will fall through declining wages and falling business profits. There will be a
movement downwards towards the equilibrium level Oye. Only at this level will there be no
pressures for moving either up or down, because only here does total income = total output =
total expenditure.

Pressures to Change Equilibrium

If we look again at Figure 11.1, we can see that this is only a stable equilibrium, lasting over
successive time-periods, if the curve of C + I remains unchanged. The higher we raise the C + I
curve, the greater will be the level of Oye.
Although, then, there are strong pressures to bring national income to equilibrium, there may also be
forces operating to change the position of the C + I curve, and so change the equilibrium. In order to
understand these forces, we need to examine more closely the decisions that lead to any given level of
desired or intended household consumption and desired or intended business investment.
(a)

Influences on Aggregate Consumption and Saving

Remember that we have dropped imports and exports from our simplified model, and at the
moment we are ignoring taxes and government spending. All income, therefore, can be
considered to be made up of consumption and saving. To emphasise this, we adopt a wide
definition of saving, seeing it as any income (net of tax) not consumed. Thus for each unit of
income:
C + S = I, or, S = I C.
Why, then, do people spend on consumption and why do they save? We can identify the
following motives:
(i)

They spend because they have income available for spending and because, perhaps, they
expect future incomes to rise.

(ii)

They spend because there is credit available.

(iii)

They may also spend because they expect prices to rise and the cost of credit may be less
than the amount of the expected price rise.

(iv)

Pressure to spend may also come from advertising and the marketing efforts of firms
wishing to maintain high levels of production and sales. Social attitudes may also
encourage a high level of spending, especially in a period when the level of social
security payments is high and money is losing its value and discouraging saving.

(v)

On the other hand, saving may be encouraged and spending discouraged by falling
incomes and rising unemployment, by controls on credit and the expansion of money,
and by expectations that prices may fall.

(vi)

People may also be forced to spend less and save more in order to pay off or reduce the
burden of past debts after a period of high spending. This tendency was clearly evident
during the early years of the 1990s after the spending and house purchase boom of the
1980s.

(vii) The depressed, low consumption years of the early 1990s also showed the importance of
house purchase as a foundation for general household consumption. When house
purchase and building activity is high and people are moving homes they also spend on

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house furnishings, household equipment and so on. When there is little activity in the
housing market all these associated household consumer durable markets are depressed.
Employment and incomes fall in the affected industries and the economic depression
deepens.
(viii) Savings may also be contractual, i.e. people undertake to save regular amounts out of
income through schemes arranged with insurance offices, building societies, etc. The
motives for contractual saving are to provide for retirement, for substantial future
purchases, for precautionary motives, or simply because of social habit the belief that
saving is a moral duty.
Some of these motives correspond with the influences on the demand for products, which we
identified in earlier study units. The general influences on total or aggregate spending and
saving can change over time, so that the amount saved from any given volume of income can
also change. Relationships between the amount consumed and saved and total incomes are
examined later in this study unit.
(b)

Business Production and Investment

Just as, leaving aside government spending, taxes, and foreign trade, we find that total income
is either spent on consumption or saved, so we see total production as being sold either for
consumption or for investment or capital accumulation. Here we have a slight problem, in the
sense that we cannot, in practice, distinguish between the purchase of equipment to replace old
and worn-out equipment and that purchased to increase productive capacity. Moreover, some
equipment may also be acquired simply to replace labour, with no significant increase in
production planned or desired. Also, when we define investment in terms of production not
sold for consumption, then this includes stocks of goods.
Not all total investment, then, could really be called productive investment, able to increase
the ability of business organisations to produce more. Yet, it is productive investment that
really interests us. For simplicity, at this stage we shall assume that all or most investment
does have a productive element (after all, most firms replace machines with better machines).
This enables us to link the desire of firms to invest with their desire to produce more output.
Thus, we can suggest that the main motive for investment is the belief of business firms that it
will be in their interests to increase productive capacity. They are more likely to believe this if:
(i)

current consumer demand is rising and expected to continue to rise;

(ii)

current profits are rising and expected to continue to rise;

(iii)

the cost of investment is falling and expected to continue to fall the main element in
this being the level of interest rates charged on borrowed finance.

Notice here that the influences on the level of investment are mostly not directly related to the
level of current income. For our purposes at this stage, therefore, we do not regard the level of
investment as being dependent on income levels. This is in contrast to the level of saving
which, provided other influences are constant, is directly related to the level of income.
Note that business firms, in making investment decisions, stress the importance of estimates of future
revenues related to present costs and how these are affected by expectations of future demand levels
and the costs of capital (linked to market rates of interest). You should remember that investment
decisions involve making judgments about the future, about future markets and about future
economic conditions and government policies. The future can never be forecast with accuracy but
the greater the degree of uncertainty about the future the higher are the risks of business investment
and the less the amount of investment undertaken. Political uncertainties and lack of confidence in

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the government can be as damaging to investment as market uncertainties, the two, in practice, being
closely related.

B. GOVERNMENT SPENDING AND TAXATION

We now return to government spending and taxation, and seek to examine which relationship exists
between these. Taxation, of course, is the main source of government revenue, and if a government
pursues a policy of a balanced budget, i.e. if it seeks to spend only what it earns through revenue,
then the amount of spending must be governed by the amount of taxation received.
However, if a government does not believe that it must maintain this balanced budget, then the level
of spending is released from the constraint of taxation and depends solely on policy decisions made
by government ministers. We cannot, therefore, know what the influences on this spending are,
unless we know the policy objectives of the government. Possible objectives and the economic ideas
underlying different policies will be examined later.
You may wonder how a government can escape from the constraint of its taxation revenues in
deciding how much to spend. The answer lies in its power to borrow, and this power is itself a major
influence on the economy. If the government borrows from the public directly, e.g. through national
savings certificates and bonds, it will simply transfer income from the private to the public sector. If,
however, it borrows from the banks, then it will be creating money. This is a difference that will have
some significance for economic policies.
Taxation must come, either directly or indirectly, from income. It may come directly from taxes on
private incomes and company profits, or indirectly through taxes on expenditure, such as value added
tax. Since consumption expenditure levels depend on income levels, we can say that the total level of
taxation is dependent on income.

C. CHANGES IN EQUILIBRIUM, THE MULTIPLIER AND

INVESTMENT ACCELERATOR
Equilibrium, Savings and Investment
If we assume once more that we have an economy where the government has a balanced budget, so
that taxation = government spending, and imports just balance exports, then we can concentrate again
on savings and investment. Under these conditions, national income will be in equilibrium when
savings equal investment. This is illustrated in Figure 11.2. Another way to illustrate this same
concept is shown in Figure 11.3. This enables us to concentrate solely on savings and investment and
to see the effect of changes more clearly.
Remember that investment is not regarded as directly dependent on the level of income, and so is
represented by a line parallel to the national income axis. Savings, however, are dependent directly
on income levels and can be expected to rise as incomes rise the savings curve is thus shown as
positive-sloping. This slope must, of course, be less than 45, because such an angle would indicate
that each additional 1 of income was entirely saved an unlikely situation.
Once again, we see that there is one income level where savings will just equal investment, and this is
the level that national income will tend to move towards. This is shown as Oe in Figure 11.2. Actual
savings will tend to equal actual investment, even though the savings intentions of households and
the investment intentions of business firms are not the same. Remember that it is consumption that
tends to bring them together. Firms will seek to produce for consumption that level of output

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which they believe households will buy for consumption. Remember, too, that prices, and stock
levels, may change as national income moves into equilibrium.
Investment
and savings
Savings

Investment

i
+
o

National
income (Y)

Figure 11.2
Now let us see what happens when there is a change in the level of investment. Look at Figure 11.3.
Here, investment rises, at all income levels, from Oi to Oi1. As a result, we see that the equilibrium
level of income, where actual investment equals actual savings, moves up from Oe to Oe1.
Investment
and savings
Savings

Investment 1

Investment

+
o

National
income (Y)

Figure 11.3

Change in Investment and Change in National Income

We shall now examine the relationship between a change in investment, as above, and the change in
total national income which results from the new equilibrium level. Look now at Figure 11.4.

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Investment
and savings

b
d
Investment 1

i1
i
+
o

Investment
c
e

National
income

Figure 11.4
This shows an increase in the level of investment at all income levels, from Oi to Oi1, but now we
have two savings curves ab and cd. Given the savings curve ab, the increase in investment lifts the
equilibrium level of national income from Oe to Oe1, but, if the savings curve is cd, then the same
increase in investment produces the larger income increase from Oe to Oe2.
We can now state the following.
!

An increase/decrease in investment will increase/decrease the equilibrium level of national

income.

The amount of increase/decrease in national income brought about by the change in investment
will depend on the slope of the savings curve i.e. on the amount of any increase in income
which is saved.

The more acute the angle of the savings curve, the less is the increase in savings from each additional
1 of income. What is really being represented in this diagram is the multiplying effect of an initial
increase in business investment. Suppose that firm A decides to buy an additional machine. This
stimulates activity from the machine manufacturer, who increases production and pays additional
incomes to his workers who, in turn, decide to increase their spending, which stimulates more activity
from other firms, and so on. We can visualise successive rounds of increased activity, but as some
part of each round of extra income is saved, the next round is slightly smaller than the last, until the
increases become too small to be significant, and the progression comes to an end.
The less the amount saved, the greater will be the total increase. For example, suppose there is an
initial increase of 100. The following table shows how this may be multiplied.

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In column A, 3/4 of each extra round of income is consumed and 1/4 saved, and in column B, 4/5 is
spent on consumption and only 1/5 saved.
A
B
(savings 1/4) (savings 1/5)
Initial
2nd round
3rd round
4th round
5th round

100
75
56
42
32

100
80
64
51
41

Total so far

305

336

These figures are rounded. If we were to produce completely accurate figures and carry on the tables,
we would find that A would arrive at a total of 400 and B at a total of 500. If you have an electronic
calculator, you can test this for yourself. These figures should suggest something to you.
!

An initial increase of 100, increased by successive additions of 3/4, arrives at a final total of
400.

An initial increase of 100, increased by successive additions of 4/5, arrives at a final total of
500.

Putting this another way, if the amount saved or held back from each successive increase is 1/4, then
the initial increase is multiplied by 4; if the successive increases are reduced by 1/5, the initial
increase is multiplied by 5. It looks as though the multiplying effect is the reciprocal of the amount
held back from each successive increase. This, indeed, is the case.

The Investment Multiplier

This is the term given to the ratio of the change in income to any given change in the level of
investment when national income equilibrium has been restored. In symbols, this can be expressed
very simply as:
Ki =

Y
I

where: Ki is the investment multiplier

Y is the change in national income
I is the change in investment.
The value of the investment multiplier is the inverse of the amount of each successive increase in
income which is saved:
Ki =

1
1
=
s 1 c

where: s = proportion of extra income that is saved

c = proportion of extra income that is spent on consumption.
A more correct definition of s and c would really be the marginal propensity to save and the
marginal propensity to consume.

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More Realistic Multiplier

So far, we have considered the multiplying effect only in terms of investment and savings, having
assumed that the government spends only its taxation revenue and that total exports = total imports.
These assumptions are rather unlikely in modern industrial economies, so a more realistic (and much
smaller) multiplier has to take these injections and withdrawals into account.
We can show this in Figure 11.5. This shows an increase in total injections (investment, government
spending and exports) and a withdrawals curve where total withdrawals from income are made up of
savings, taxation and imports, so that the propensity to withdraw (w) is now the total of the
propensities to save, to tax and to import, i.e. w = s + t + m.
This more realistic multiplier is the ratio of the change in national income to the change in injections
which brought it about, and it is the inverse of the propensity to withdraw:
K =

Y 1
1
= =
J w s + t + m

Suppose that, out of each additional 1 of national income, 1/10 is saved, 3/10 is taxed and 2/10 spent
on imports. Then:
s = 1/10; t = 3/10; m = 2/10
w(s + t + m) = 6/10
K, then, is 1/w which here is 10/6 = 123
a very much smaller value than the investment multiplier, which would have been 10, in this example.

Figure 11.5

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Change in the Marginal Propensity to Save and the Paradox of Thrift

The slope of the Savings function (curve) depends on the marginal propensity to save. If people start
to save a smaller proportion of their incomes, i.e. spend a higher proportion, then the curve becomes
less steep as each additional 1 of income gives rise to a little less saving. If they start to save a
larger proportion, i.e. spend a smaller proportion of income, then the curve becomes steeper, subject
to a maximum of 45 if the scales on both axes are the same, because each 1 of income additional
produces a larger amount of saving though not, we assume, more than the extra income.
This observation has given rise to what has become known as the Paradox of Thrift which is that the
more a community tries to save the less it may actually save. This paradox is illustrated in Figure
11.6.
The original equilibrium condition of the national income is represented by Oe0 where the level of
investment and savings are represented by I0 and Os0 respectively i.e. the level where the Saving
function S0 intersects the investment level of I0. Then, for some reason such as a growing fear of
unemployment and economic recession or misguided government policy trying to encourage greater
thrift and good housekeeping in the community, people generally start to save more and spend
less from their incomes. The Saving function becomes steeper and moves, say, to S1. The
equilibrium level of national income falls to Oe1. Business firms face declining sales and rising stock
levels so they cut back their production and invest less in productive equipment. The level of
investment falls to It+1. At this lower level the national income falls further to the equilibrium level
where Ost+1 = It+1 at Oet+1. At this new equilibrium the level of saving has also fallen to Ost+1.

Figure 11.6

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Thus, the attempt by the community to save more has resulted in the community actually saving less
because the total level of aggregate income has fallen. Remember this is the result for the community
as a whole. Some individual households will have increased their savings but others will be saving
less because they have suffered loss of income and may will be unemployed as a result of the fall in
national income and aggregate investment. This is the paradox of thrift in action. This is one case
where the macroeconomy, i.e. the economy as a whole behaves differently from the microeconomy,
i.e. individual firms and households. A virtue for the individual is not necessarily a virtue for the
whole community, a concept that some influential politicians have found difficult to grasp.
This example also illustrates the possibility that the fear of recession can become self-fulfilling. If
people anticipate that their incomes are likely to fall in the future and start to save more and consume
less, their actions can lead to reduced production, investment and employment.

The Investment Accelerator

We have seen that an increase in national income can be induced by a net injection, made up of an
increase in the combined forces of investment, government spending and exports. However, if we
return to the case of a country the government of which believes in a balanced budget (will not
spend more than its taxation revenue) and where international trade is depressed and there is unlikely
to be any net increase from international trade, then we are again left with investment as the main
motivating force, other than consumer demand itself.
Now, suppose people do start to consume a higher proportion of their incomes for some reason (the
savings curve swings to the right, as in a move from ab to cd in Figure 11.4). Consumer demand
therefore starts to rise. Suppose also that, at the old level of consumer spending, all business
equipment was fully used. If business firms believe that consumer demand is on an upward trend,
they will wish to increase their productive capacity and, to do this, they need to purchase more
equipment. There is, thus, an increase in productive investment.
The principle underlying the theory of the investment accelerator is that there is a constant ratio of
investment capital to the total output that is produced and that this ratio is greater than 1:1. If total
demand and, therefore, output is constant firms will only invest to replace worn-out equipment.
However, when demand rises they will replace old equipment and purchase new so that the increase
in investment is greater than the rise in output desired to meet the rise in demand. However
investment will only continue to increase if demand and the output it encourages goes on increasing
at a faster rate. If the rise in demand levels off or if demand falls investment will stop increasing or
fall. The precise changes to investment will depend on the ratio of investment capital to output and
on any time lags between observed changes in demand and business investment decisions.
We have seen that this increase in investment will, itself, have a multiplying effect on national
income, and hence on consumer demand. Initially, the expectations of business firms become selffulfilling, as their own investment induces the expected rise in consumer spending. Moreover, a quite
modest increase in initial consumer spending can have a very great effect on investment spending, as
the following rather simplified example will illustrate.
Example
Let us assume that one machine in the shoemaking industry is capable of producing 10,000 pairs of
shoes in a year, that the life of a machine is ten years, and that the industry uses 100 machines,
producing a total of 1,000,000 pairs of shoes per annum. Each year, one-tenth of the machines will
have to be replaced, so there is a demand for ten new machines a year.
What will happen if the demand for shoes increases by 10%? 1,100,000 pairs of shoes will be
required, and this means that 100 machines must be used. The industry will, therefore, order this

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year 20 new machines ten in order to replace those worn out, and ten additional ones to cope with
the new demand. The demand for machinery will thus increase by 100% because of a mere 10%
increase in demand for consumer goods.
It is the surge in increased investment spending that gives the accelerator its name.
However, there is a danger here. If consumption continues to rise at a constant rate, then investment,
after the initial burst, will stay the same. In order that net productive investment should increase,
consumption has to continue to increase at a faster rate. If it starts to level off, then investment will
fall away. Firms do not need to buy more machines if their production capacity is sufficient to cope
with expected demand. A fall in net investment now starts the accelerator in reverse it becomes a
decelerator, forcing a decline in national income. This decline has been caused by nothing more than
a levelling of demand and a consequent halt in new business investment.

The Business Cycle

We now have an explanation for the periodic tendency for an economy to expand and decline to
boom and become depressed which has been a feature of all industrial economies. This cyclical
tendency for boom and depression has been described as the business cycle. Notice that it is
explained in terms of consumer demand and business investment, and it assumes that the government
is neutral pursuing a policy of keeping a balanced budget.
The accelerator assumption of a fixed investment capital to output ratio has been criticised on the
ground that it very much oversimplifies the business demand for investment and ignores such
important and relevant influences as the pace and nature of technological change, competition from
foreign producers and changes in the management and use of labour. All these can change the capital
to output ratio and the desire to invest at any given time. The basic theory also assumes that firms
typically operate at full machine capacity whereas most of the evidence suggests that it is more
normal for firms to operate with some spare capacity which is used to even out fluctuations in
investment. The theory also ignores the influence of the capital market which can have a major effect
on the volume and timing of investment. For these and many other reasons earlier hopes that the
theory would provide the key to smoothing out the business cycle have proved much too optimistic.

D. BUSINESS INVESTMENT AND INTEREST RATES IN

THE ECONOMY AS A WHOLE
Business Investment and the Marginal Efficiency of Capital
In view of the importance of total business investment to the level and quality of total national
product, there is a great deal of interest in the level of business investment in the economy as a whole,
in addition to the cyclical movements examined earlier in this study unit.
We examined the influences on the individual firms demand for investment finance earlier, and it is
not difficult to recognise that total investment is the sum of the individual firms investment. We also
saw that interest (discount) rates play a crucial role in investment decisions. In general, the higher
the rate of interest the lower is likely to be the level of investment.
This will apply to business investment in the economy as a whole and, at this stage, we can apply and
extend our analysis of investment decisions to show how the market for capital might be expected to
operate, in the absence of any strong cyclical pressure.
Firms are likely to want additional investment capital, as long as the additional return it brings to
their profits is greater than its cost. If we express this return as a percentage rate applied to the

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amount of additional capital invested, then, we can make a direct comparison between this and the
rate of interest which firms have to pay to obtain capital, which, for the sake of simplicity, we can
equate with the cost of capital.
We can also describe this return on business capital as a measure of the efficiency of that capital.
Thus, the additional return achieved by an additional unit of capital will be the marginal efficiency
of capital (MEC). In the short term, and taking the economy as a whole, we can assume that
additional amounts of capital take place with the total supply of labour and land remaining constant.
Now, if we add additional inputs of one production factor, with the other factors remaining fixed,
then the law of diminishing marginal returns will eventually come into effect. Thus, the greater the
amount of capital already employed, the less will be the marginal efficiency, as more and more capital
is added. We can, therefore, expect the marginal efficiency of capital to fall as the quantity of capital
employed by the community rises. This is illustrated in the graph of Figure 11.7.

Figure 11.7

Marginal Efficiency of Capital and the Pure Rate of Interest

This view of the diminishing return which we can expect to receive from additional increments of the
total capital employed in the community gives rise to a theory of how the pure rate of interest may be
determined. The pure rate of interest is the rate which would apply in the absence of differing
conditions in the actual finance markets which have to take into account such elements as the risk that
money will not be returned, the length of time that money is wanted, changes in the purchasing power
of money and expectations of future changes in its purchasing power.
Suppose the capital stock, the total supply of capital available for business investment, is fixed in the
short run. If we relate this fixed supply to the demand for business capital, then we have a market
situation in which supply and demand can result in the determination of the price of capital i.e. the
interest rate for investment finance.

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Now, we can also expect profit-maximising firms to seek to employ additional capital, up to the point
where its marginal efficiency, as explained above, is equal to its cost. Thus, the marginal efficiency
of capital curve of Figure 11.8 is also the demand for investment finance curve, assuming that
business as a whole is seeking to maximise profits.
To derive the pure rate of interest, then, we need to relate the supply of capital to the marginal
efficiency curve, and the point where these are at the same quantity level will establish the pure rate
of interest. We can, of course, present the argument in a slightly different way. If we take the view
that the rate of interest is determined by a different set of market forces, or by the government, then
the same reasoning will suggest to us the quantity of capital that will be employed, if investment
finance supply and demand are allowed to reach equilibrium freely.
This idea is illustrated in the model of Figure 11.8, where the equilibrium rate of pure interest is Oi,
and the equilibrium quantity of capital invested where supply = demand is OK.

Figure 11.8

Marginal Efficiency of Capital and Interest Rates in the Long Run

In the long run, we can expect the stock of capital in the community to increase as people accumulate
more savings and the banking system becomes increasingly efficient. From the model of Figure 11.8,
we would, therefore, expect the marginal efficiency of capital to fall and, with it, the pure rate of
interest. Test this for yourself by moving the stock of capital line outwards to the right, to represent

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Determination of National Product and Implications of Investment

204

Earlier Views Equilibrium Produces Full Employment

204

The Basic Keynesian View

204

The Deflationary Gap

205

Possible Causes

205

Consequences

206

Policy Options for Closing the Deflationary Gap

207

The Inflationary Gap

208

Some Possible Causes

209

Consequences

210

Implications of Policies to Close the Inflationary Gap

211

Measurement of Unemployment and Inflation

212

Measurement of Unemployment

212

Measurement of Inflation

213

Retail Price Index

214

Tax and Price Index and Possible Further Changes

217

Special Indices

217

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A. NATIONAL INCOME EQUILIBRIUM AND FULL

EMPLOYMENT
Earlier Views Equilibrium Produces Full Employment
Earlier classical economists appreciated the concept of national income equilibrium but believed that,
if the economic forces were left to work freely, this equilibrium level would also produce a situation
of full employment. They argued that, as incomes fell, labour costs would also fall, until it became
worthwhile for business entrepreneurs to increase their demand for workers.
If instead of this happening, there were large-scale unemployment, then the fault lay, it was argued,
with trade unions and other institutional forces in the economy: they were keeping up wages and
prices and making labour overpriced in relation to the current level of demand. The remedy for
unemployment lay in forcing down wages despite any opposition that might be encountered.

B. THE BASIC KEYNESIAN VIEW

Keynes accepted that, in the long run, it might be possible to bring down wages until labour became
so cheap that all workers wanting jobs could be found employment. However, he regarded the price
of such action, in terms of social distress and political conflict, as being unacceptable in a modern
society. He doubted whether society could withstand the conflicts and pressures that would be set up
by the attempt to bring down wages far enough to achieve full employment.
For practical purposes, therefore, and in the interests of social and political peace, he considered that
it was better to regard the equilibrium level of national income and the level at which all workers
were fully employed as two separate levels, with no natural way of coming together through the
operation of the normal economic forces.
This concept of the separation of equilibrium and full employment levels of national income is
illustrated in Figure 12.1.
Here, we return to the model based on the 45 line which, you will remember, represents the curve
where all income is expended. The intended levels of expenditure at each level of income are shown
by the curve C + J (consumer spending + total injections from investment, government and exports).
The equilibrium level, where intentions are fulfilled without changes in prices and stocks, is Oe
where the C + J curve intersects the 45 line.

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Figure 12.1
Suppose that possible output of goods and services available for purchase by the community, given
full employment of all those seeking work, would push up income to level Of. However, at this level
of income there is a gap between the 45 line and the C + J curve. This gap indicates that possible
expenditure at this income level is greater than intended spending from the total forces of
consumption, investment, government and exports.

C. THE DEFLATIONARY GAP

The basic model of the deflationary gap was shown in Figure 12.1. The gap arises when total
aggregate demand from household consumption, business investment, government spending and net
exports (C + I + G + (X M)), is insufficient to absorb all the output that could be produced if all
available production factors, including those workers seeking employment, were fully employed.

Possible Causes
Strict classical and monetarist economists believe that a deflationary gap would not exist if both
product and factor markets were free to perform their basic functions of bringing supply into
equilibrium with demand through changes in price. Closing a gap by the operation of market forces
alone would imply significant reductions in wages. However, wage incomes are a major influence on
the level of consumer demand so that any large scale reduction in wage levels would further depress
the Consumption element in aggregate demand. Fear of future unemployment and falling incomes
would also depress demand and, of course, business investment so that there is no guarantee that
greater wage flexibility in a modern economy would close the gap. It could make it larger. Actions
of business firms in making workers redundant and deliberately creating an atmosphere of insecurity

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What causes the excess demand?

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(b)

Why, if it is the function of a market economy for supply to respond to demand, is the
production system unable to meet total demand?

In their extreme forms, Keynesians and Monetarists have given conflicting answers to these
questions. Today, they are closer together but still place different emphasis on different aspects. At
this stage these differences are just outlined.
Keynesians have blamed excess demand on excess income which is running ahead of potential
production. More recently they have been prepared to accept that money supply and government
borrowing have also played a significant part in stimulating demand.
Monetarists have tended to blame excessive demand on excess money supply for reasons that are
explained later but they have also linked this with rising wage levels made possible by business
borrowing. They have also linked excess money supply to government spending and borrowing.
The original Keynesian model of the inflationary gap assumed that the production system could
respond to rising demand up to the point where all production factors were fully employed. A
significant inflationary gap would only appear when the equilibrium level of national product rose
above the full employment level. This basic model offered little scope for a convincing explanation
for the stagflation of the 1970s and early 1980s when both inflation and unemployment were rising.
Consequently Keynesians have had to accept deficiencies in the production system at levels below
full employment. As already explained they have tended to emphasise problems arising from a period
of rapid structural change caused by the contemporary technological revolution.
Monetarists have traditionally been more prepared to see inflation and unemployment as associated
rather than opposing problems of a troubled economy. Not only do they regard inflation as a cause of
unemployment because of its effect on business productivity and ability to compete in world markets
but they also see inflation as being partly caused by defects in the supply side of the economy that
encourages people to remain unemployed even though there is excess demand in the economy.
Inefficient factor markets permit unused production capacity to remain unused in spite of high levels
of demand. However, they have had to recognise the deflationary and unemployment consequences
of their monetary and market reform/supply side policies aimed at reducing inflation. Inflation
control has proved a far more difficult economic and social problem than the monetarists anticipated.

Consequences
In the 1950s and early 1960s when inflation rates were low by later standards and when the economy
was growing at unexpectedly encouraging levels, it was not uncommon for observers to comment that
a low rate of inflation might be healthy and stimulating for an economy. However, as earlier
explained, inflation tends to feed on itself and can suddenly rise out of control unless measures are
taken to impose checks. The common socio-economic problems arising from inflation have tended to
be identified as:
!

Countries with inflation rates higher than their trading partners and/or rivals soon price
themselves out of increasingly competitive world markets. Exports fall and imports rise so that
an international payments problem undermines the currency in ways that are discussed more
fully in a later unit. To this extent inflation leads to rising unemployment.

Confidence is lost in the stability of the domestic currency and financial structure. Savings fall
and there is a flight of capital in spite of any financial exchange controls that might be
imposed. In extreme cases a flight from money to physical goods fuels further inflation.

As long as most incomes rise faster than prices people can be misled by an impression of rising
wealth, particularly when high value fixed assets such as houses and land gain high monetary
values. However, as more and more sections of the population fail to maintain the real

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211

(inflation adjusted) value of their incomes and living standards fall for a growing number of
people there is a big increase in social discontent. In extreme cases there is civil conflict,
destruction of property and loss of lives. At this stage there is a danger of complete social and
political breakdown with unpredictable consequences.
During the period of high and rising inflation of the 1970s there were still those who defended
inflation as being preferable to high unemployment and who argued that there would be no
undesirable consequences if all financial payments and obligations were to be index linked, i.e. if
all monetary values were periodically adjusted by an agreed inflation measure. Some even argued
that this would itself gradually bring down the rate of inflation since there would be nothing to gain
from raising prices when costs also rose at the same rate.
In practice, experience soon showed that although some degree of indexation was able to preserve the
value of some obligations such as real yields on savings and the purchasing power of pensions,
inflation itself is too complex and uneven in its effects for it to be simply indexed away into
insignificance. It also became clear that the low inflation countries such as Germany and Japan were
able to enjoy more successful economic growth and higher living standards than the high inflation
countries such as Britain and Italy. Indexation was, of course, no cure for the international trade
problems of the high inflation countries.
By the 1980s there was widespread agreement throughout Western Europe that inflation was a major
economic problem that governments had to solve and there was sufficient popular support for this
that governments could risk taking measures that they knew would increase unemployment. Few
people recognised the full implications of the anti-inflation policies they were embarking on. People
were prepared to tolerate high unemployment largely because the social consequences of being
without a job had been much reduced by the social welfare provisions that had been made possible by
a prolonged period of relatively high economic growth and a demographic and economic structure
that kept a rising proportion of older people small in relation to the large numbers of economically
active people born in the baby boom post second world war years and the growth in numbers of
working women.
By the 1990s, however, social, economic and demographic conditions were changing. Economic
growth, in the face of increased competition from the newer industrial nations, especially those in
Asia, was likely to slow and the cost of the social welfare structure was becoming a heavy burden.
Cuts would have to be made if heavy taxes and government borrowing were to be avoided. People
started to re-learn the social hardships of unemployment and these hardships were no longer confined
to the low paid manual workers. In the early years of the next century governments would face the
added burden of a rapidly rising proportion of economically inactive older people with costly health
care needs, as the post-war babies started to approach retirement age or were being forced into early
retirement by governments anxious to increase business efficiency without too high a rise in
published measures of unemployment. By the mid-1990s most Western European countries were
starting to cut social welfare obligations reversing the trend of the previous half century.

Implications of Policies to Close the Inflationary Gap

By now many of these will already have become evident. It has always been recognised that the
spending reduction anti-inflationary policies are likely to be more unpopular than policies to increase
spending to close a deflationary gap. It was largely an attempt to find a politically and socially
acceptable way to close the gap that led to the Keynesian inspired policies of voluntary prices and
incomes restraints. If the inflationary gap was caused by excess income then closing it meant
reducing or holding back the expansion of monetary incomes. As governments of the 1960s and
1970s shrank from the anticipated hostility of significant reductions in government spending they

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The Deflationary and Inflationary Gaps

seized on prices and incomes policies as offering a politically acceptable escape from the dilemma.
The policies depended on restraint from employers, labour unions and the governments in an attempt
to keep income increases close to the rate of economic growth, i.e. they sought to keep the rise in
demand as close as possible to the rate of production (supply) increase.
The failure of these policies left Keynesians with little credible and politically acceptable answer to
inflation and prepared the way for a fresh approach from a government influenced by monetaristclassical economic beliefs. The new policies were based on measures to remove impediments to the
interaction of supply and demand in both product and factor markets, weakening the influence and
reducing the relative spending and borrowing of the government and tolerating a degree of
unemployment in the effort to make the supply side of the economy more efficient and competitive in
world markets. Supporters of these policies can claim some success in closing the inflationary gap
but this success has not been rewarded by political popularity. This lack of success is due to several
factors including:
!

the widening gap between the very rich and very poor and increased employment insecurity
among all sections of the working population;

the reduction in asset, especially private home, values and the very great hardship this has
brought to large numbers of people who became first time home owners in the 1980s;

an increasing realisation that the social welfare structure constructed over the past half century
is under threat of being dismantled.

These three developments together have created a climate of uncertainty and real fear of the future.
For the past five decades people have believed that general living standards were rising and would
continue to rise in spite of temporary difficulties. People expected their personal incomes and wealth
to rise while sharing in general improvements to the State provision of social welfare. These
expectations are now being reversed. The burden of taxation has not been significantly reduced. In
total it was increased but more and more people are being expected to contribute to the cost of their
childrens education, to their own health care and to their own future pensions. In this general
environment of increasing insecurity people are understandably thinking that far too high a price has
been paid for what may yet prove to be a brief and temporary relief from inflation.

E. MEASUREMENT OF UNEMPLOYMENT AND

INFLATION
One of the problems facing economists, particularly when trying to make comparisons over time and
between countries is that there are no generally agreed ways of measuring the extent of two of the
most serious modern economic problems, unemployment and inflation. Moreover, since governments
have a vested interest in minimising each of these problems there is always the suspicion that official
measures are manipulated to reduce their reported size.

Measurement of Unemployment
There can be no accurate measurement unless we are clear about what precisely is being measured.
People are unemployed if they think of themselves as unemployed, i.e. if they seriously want to work,
are prepared to work but cannot find a job. Even this very simple attempt at a definition presents
problems. If a person is trained as an architect and is fully qualified to work as an architect but can
only obtain a job as a building labourer, waitress or shop assistant, that person, quite understandably
is likely to consider himself or herself as unemployed but will not be registered as such in official
records. Another person may have left the workforce to have a family and bring up young children

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213

and then, after some years seek to return to employment but find it impossible to obtain suitable
employment. Yet another may have been put under considerable pressure by an employer to accept
voluntary early retirement and may be receiving an employment pension but, should the
opportunity arise would prefer to be employed. None of these is likely to appear in the official
figures of the unemployed in Britain and other countries using roughly similar measures to those in
Britain.
British unemployment figures are based on those registered, and entitled to receive unemployment or
social welfare benefits as unemployed. Consequently it is frequently argued that these official figures
significantly underestimate the true unemployment total because they do not include those who are
not entitled or likely to become entitled to benefits and who are not, therefore registered. These
include those:
(a)

who have been out of the workforce for some years (mainly women), or who have never been
regularly employed, but who seriously wish to enter employment but cannot find work;

(b)

who have retired before the normal retirement age and who, if aged 60 or over are not
registered as unemployed. Many people under the age of 60, in receipt of pensions or other
incomes over a certain figure will also be ineligible for unemployment benefits and are
unlikely to appear in unemployment figures;

(c)

who would wish to be fully or regularly employed if they had the opportunity but are in
currently part time or temporary employment. This group includes many women and older
men and also young people in work experience or training schemes;

(d)

who would wish to be in employment if work were available but are remaining in full-time
education.

At the same time it is also argued that the official British figures may overstate the true amount of
unemployment by including some who receive benefit but who are not seeking work. These would
include people who:
(e)

intend to withdraw from the workforce for some time, for personal or family reasons but who
are entitled to unemployment benefits for a limited period;

(f)

are actually in employment or self-employment but who register illegally as unemployed in

order to receive benefits, sometimes with the connivance of employers who are thereby able to
pay low wages.

No one knows the actual size of any of these groups and estimates vary considerably. The true size of
the unemployed population is thus not known though changes in the figure for the recorded
unemployed are likely to be a reasonably accurate indication of changes in the true total.
Some countries, including the USA, base their unemployment figures on estimates obtained from
regular surveys. These figures will include people who are not entitled to social welfare payments
but they arouse even more suspicions of official manipulation than totals based on the officially
registered.

Measurement of Inflation
In most countries official figures intended to measure inflation are obtained from some kind of index
of price movements. It is, therefore, price, rather than wage inflation that is normally measured. As
with unemployment statistics, the methods of compiling the price indices, their content and the
recording of price changes differ considerably between countries. Comparisons which do not take
into account these differences can be misleading.

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The measure most commonly quoted in Britain is the All Items Index of Retail Prices. This is a
weighted average of separate price indices for different classes of goods and services. The weights
are revised annually in the light of information provided by a continuous survey of household
expenditure which records the spending habits of a sample selection of households in the country.

Retail Price Index

The basis for this is the continuous survey of household expenditure, which provides information on
spending habits of a sample selection of households in the country. Information supplied by the
sample households can also be checked to a great extent against information supplied by shops and
from tax returns.
(a)

Grouping and Weighting of Expenditure

Until 1986 consumer spending was divided into 11 main groups (which were further divided
into subgroups) and the weighting given to each group in compiling the index was changed at
the beginning of each year, on the basis of changes which had been observed in the pattern of
spending in the latest available year. The weights used for the years 1968, 1984 and 1986 are
shown in the Table below:
Table 12.1
Retail Price Index: Weighting of Each Main Class of Spending
Class

1968

1984

1986

All items

1,000

263

201

185

Alcoholic drink

Tobacco

Housing

121

149

153

Fuel and light

Durable household goods

Clothing and footwear

Transport and vehicles

120

158

157

Miscellaneous goods

Services

Meals bought and consumed outside the home

Food

Notice the increased importance of spending on services, housing, durable household goods
and transport; the reduced importance of spending on the basic necessities of food, clothing
and footwear; and the very steep relative fall of spending on tobacco. The group weights were
used to calculate the all items price change and it was this figure which was quoted so
extensively.
The basis of weighting and some of the elements of the Index were changed in 1987 and a new
Index commenced on 13 January 1987. Consequently, figures post 1986 are not comparable
with those up to that year. Table 12.2 shows the new main classes for which monthly figures
are produced. It is clear from these that pre-1987 trends have largely continued.

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Table 12.2
Revised Weightings for the Retail Price Index
1987

1990

1992

1995

1,000

Food and catering

213

205

199

184

Alcohol and tobacco

114

111

116

111

Housing and household expenditure

335

346

344

356

Personal expenditure

112

108

Travel and leisure

226

230

242

256

All items except seasonal food

974

976

978

All items except food

833

842

848

861

Non-seasonal food

141

134

130

117

All items except housing

843

815

828

139

132

127

123

Total weights

Broad classes of expenditure:

Seasonal food

Nationalised industries
Consumer durables

In the revised Index, prices on 13 January 1987 = 100.

(b)

Recording Price Changes

The actual price changes are recorded by officials of the Department of Employment, who
make regular checks on the prices of selected items sold in a variety of shops throughout the
country. Prices are checked on the same day of the week and at the same stage of each month.
The articles chosen for checking are those which experience has shown are reliable indicators
for a range of other prices.

(c)

Only an Average Indication

Notice that the Index is very much a type of average. The spending habits of the highest and
lowest income earners are not included in the calculations but the Index can never be more
than an average indication of what is happening to prices. If your spending does not fit the
average pattern, then you may be better or worse off than might be inferred from the price
changes recorded in the Index. If, for example, you spend more than average on transport, then
you will probably be worse off because it is in this group that some of the steepest price rises
have taken place.

The movement of the all items Index to 1987 is shown in Figure 12.4. This shows the very steep
rise in inflation in the period 1974-1987 in Great Britain.

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Figure 12.4: Price Index Monthly Averages

In January 1987 the Index reverted to 100 and the base for the Index changed so it is not satisfactory
to continue the graph beyond 1987. Since then the annual averages have been:
1987
101.9

1988
106.9

1989
115.2

1990
126.1

1991
133.5

1992
138.5

1993
140.7

1994
144.1

Notice that people have continued to spend an increased proportion of their income on housing and
household expenditure and on travel and leisure, while the proportion of income spent on food,
alcohol and tobacco has continued to fall.

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Distortions of Market Imperfections

221

Implications of the Monetarist-Classical Views for Economic Policy

223

The Importance of Money Supply

224

The Money Equation

224

Diagrammatic Expression of the Basic Monetarist View

225

Controls over Money

226

Control through Price

226

Control over Banking Ratios

227

Direct Controls over Banks

228

Control of Government Borrowing

228

The Problems of Monetarism

229

Theoretical Problems

229

Practical Problems

229

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Classical and Monetarist Economics

A. BASIC ASSUMPTIONS OF CLASSICAL AND

MONETARIST ECONOMICS
For purposes of simplicity we are not separating classical and monetarist economics; we are taking
quite a broad view of the various concepts and beliefs which all fit under these very wide terms. In
the interests of brevity we shall use the more widely known term monetarist unless there is a reason
to do otherwise. In practice there are differences, just as there are differences between groups of
Keynesians and groups of Marxists but it would be confusing and beyond the scope of this course to
attempt to describe them in detail. From time to time, however, we shall continue to give an outline
of what we take to be extreme positions for both classical monetarists and Keynesians, noting how
these are often modified, particularly when they form the basis for actual government policy
measures.
The extreme classical-monetarist belief is that, left to themselves, markets are highly competitive and
reach equilibrium very quickly. Demand, however, moves more rapidly than supply, particularly in
response to changes in the supply of money and credit. Consequently equilibrium is achieved
through price changes, i.e. a rise in demand, following an increase in money supply, produces a swift
rise in price levels with only a small increase in output and fall in unemployment. Similarly a
contraction or curb on increases in money supply will tend to produce a fairly swift reduction in price
inflation with little rise in unemployment. If unemployment does rise this is due to other factors such
as structural changes.
It is also argued that the actual rate of unemployment is the natural rate of unemployment and this
natural rate (the rate existing when supply and demand in the economy are in equilibrium) is
governed by microeconomic forces within firms and industry which are not affected by Keynesiantype adjustments of demand.
Modern monetarists take into account the rational expectations of decision makers in business firms
and labour unions. The idea of rational expectations is that people, especially the decision-makers in
firms and trade unions, learn from their experiences. They make adjustments in their bargaining to
take into account shifts in government policy. If, for example, the government expands demand and
money in the hope of increasing employment, the decision-makers in unions and firms know from
experience that this expansion will result in price rises, so they anticipate this result in the wages they
agree and the prices they charge hence, the expansion results in price and wage increases at the
same level of employment. Perfect equilibrium is, of course, not always achieved, because people
make mistakes, and because decisions have to be taken under conditions of uncertainty in advance;
but the longer certain macroeconomic policies are pursued, the better able the decision-makers are to
predict and nullify them, and the less effective those policies become. This offers an explanation for
the apparent collapse of Keynesian policies in the 1970s.
More moderate monetarists recognise that markets do not adjust swiftly so that the movement
towards equilibrium following a demand change is likely to involve some change in the level of
unemployment as well as in prices. Wage bargaining, for example, is not a continuous process but
takes place at regular intervals and, as in product prices, the actions of acknowledged trend-setting
groups are likely to be followed by others following their lead. Difficulties in securing wage
reductions are also acknowledged and employers frequently find it easier to make some workers
redundant than to secure a wage reduction that would enable the firms employment level to be
maintained. Many monetarists believe that the swift market adjustments predicted by their theory of
market behaviour are impeded by practical imperfections such as worker resistance to change and
reluctance to embrace new technology or adopt more flexible attitudes and practices. Consequently

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they regard supply side reforms in the structure of factor, especially labour, markets to be crucial to
success in improving economic efficiency and curing inflation. Because of the social and political
consequences of high unemployment, there can be only a gradual return to a full employment
equilibrium, so that, from a position of rapid monetary expansion and inflation, a government must
gain gradual control over money supply, and bring it down gradually by allowing smaller and smaller
successive increases over a period of time. Trade-union and big-business power may be among the
causes of slow reaction time in a modern economy but they cannot be wished away, and it is better to
adopt gradualist policies than to risk a severe recession.

B. DISTORTIONS OF MARKET IMPERFECTIONS

Although monetarists accept that modern product and factor markets have many imperfections which
they regard as damaging, they also seek to remove these where possible, though with variable energy
and success.
Product market efficiency is most commonly impeded by the tendency for the most powerful
suppliers to collude to drive out competition and form restrictive oligopolies. All the major market
economies have some form of public anti-monopoly (anti-trust) policy with a legislative framework.
Since monetarists gained political influence in Britain in the late 1970s there has been much talk of
encouraging competition and the privatisation programme was sold largely on this platform.
However, there have been no significant movements to strengthen anti-monopoly policy in this period
and the major weakening of a former nationalised monopoly, i.e. the competition now faced by
British Telecom, has been the result of technical developments in telecommunications rather than
from British Government pressure. Comments from within the Department of Trade suggest that
legislation that was drafted some years ago to strengthen competition law has been delayed because
of lack of Parliamentary time! Cynical observers might wonder, no doubt unworthily, whether
there might be any association between the lack of enthusiasm for such a change in the law and the
number of large public companies that have made substantial financial contributions to the governing
political party in the 1980s.
This apparent lack of enthusiasm for increased competition in product markets contrasts with
encouragement for strong competition in the capital markets and resistance to any suggestion that this
might be restricted as some other European capital markets are restricted.
The argument for a competitive, unrestricted capital market is based on the belief that managerial
efficiency is ensured by the threat of takeover. If a firm is not using its resources as profitably as the
market thinks it could then one or more market predators will seek to take it over. The immediate
casualties of a takeover are the existing senior management team. Consequently if they wish to retain
their positions the senior managers of a public company must operate efficiently assuming that
efficiently and profitably mean similar things.
Unfortunately the desire to make more profitable use of under-used resources is not the only motive
for takeover. Another, powerful motive is to reduce the pressure of competition in the product market
by reducing the number of competitors. It is one of the main functions of anti-trust legislation to curb
this motive. In Britain the main responsibility for ensuring that product competition is not reduced by
capital market activity rests with the Office of Fair Trading, supported by the Monopolies and
Mergers Commission. Nevertheless these bodies cannot act decisively without the support of the
responsible minister, who currently prefers to be known as the President of the Board of Trade, so
that the vigour with which anti-competitive practices are discouraged depends, in the last resort, on
political judgments.

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During the 1980s more attention in Britain was paid towards efforts to make labour markets more
flexible by reducing the power of trade unions and making them more accountable to the wishes of
their members. It was felt that unions were preventing wage levels from reflecting changing
conditions of demand and supply in labour markets and encouraging attitudes among workers that
encouraged them to resist change and made them less adaptable to changing technology and the
movement of labour market forces.
It was argued that unemployment was increased by unions and by outdated labour attitudes and
practices. This is illustrated in Figure 13.1.

Figure 13.1
This model shows the demand for labour curve and a supply curve (Supply of Workers) to the left of
the curve representing the total Work Force (defined as the total of workers in employment added to
those officially registered as unemployed and claiming unemployment benefits). The supply curve
indicates a supply below the work force because some people will be out of work for frictional
reasons, for structural reasons (demand shifts and changes in production technology) and because of
worker reluctance to accept the full implications of changes in the labour market. It is not difficult to
understand this reluctance. A worker who has enjoyed a skilled and respected job for many years
loses income, social standing and self-respect when that skill is destroyed by changes in production

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technology. To such a person, unemployment or early retirement can be preferable to taking an

unskilled job.
The labour market is in equilibrium when the demand for labour and the supply of workers are at the
same level, i.e. where the curves intersect, at A (employment level Le and wage We). The gap
between the supply of workers curve and the work force curve at this wage, i.e. between intersection
points A and B (difference between employment levels L and Le) is the natural rate of
unemployment. This is the rate of unemployment when the demand for and supply of labour in the
market as a whole are in equilibrium. Such unemployment is frequently regarded by monetarists as
voluntary unemployment because work is available for those out of work but for various reasons,
including those listed above, it is not being taken up by people who identify themselves as seeking
employment.
Figure 13.1 also indicates the possible effect of labour unions. If unions raise the wage level above
the equilibrium level that unregulated forces of demand and supply would achieve, say, to Wu then
the employment level falls to Lu, the level demanded (point E on the demand for labour curve) at this
wage rate. At the wage Wu the number of workers who would be willing to take work is represented
by point D on the supply of workers curve but many individuals will be unable to obtain work
because demand is at the lower level (point E on the demand curve). As individuals these workers
are unemployed involuntarily. They are likely to be attending job interviews but finding that the
number of those attending with them exceeds the number of jobs available. However, since the gap
between demand and supply is the result of union pressure to raise wages many monetarists would
argue that this unemployment is also voluntary since union policies on wages are supported by their
members.
If unions are powerful enough to press for wage levels that anticipate future price inflation this
element of union inspired unemployment will be increased. If employers agree to union wage
demands without reducing employment levels in the belief that they can pass on rising wage costs to
customers in price increases they may succeed for a time but as their prices rise ahead of world prices
they will lose customers to lower cost, foreign suppliers so that domestic firms will go out of business
or cut back production and the demand for labour will fall, i.e. the demand curve will move to the
left. If you place a ruler to the left of the demand curve and roughly parallel to it you will see that the
new intersection points with the supply of workers curve and the union wage of Wu are both shifted
to the left, thus reducing employment and increasing unemployment levels.

C. IMPLICATIONS OF THE MONETARIST-CLASSICAL

VIEWS FOR ECONOMIC POLICY
Whereas Keynesians would argue that the unemployment produced by these gaps between supply and
demand could be reduced by increasing aggregate demand through increased public sector
expenditure, this option, as suggested in the previous unit, is rejected by monetarists on the grounds
that it would increase inflation and produce further unemployment as a result of this inflation.
Monetarists prefer to draw the following lessons from the model:
!

Union power should be reduced so that they are unable to push the wage rate above the
equilibrium level and so unable to create the kind of involuntary unemployment represented by
the E-D gap of Figure 13.1. In Britain a series of statutes in the 1980s reduced union
immunities and made it more difficult for them to take industrial action without first ensuring
that they had the support of a majority of members obtained by fairly conducted ballot.

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Individual workers should be put under greater pressure to take jobs that are available even at
lower wage levels. In Britain the governments of the 1980s felt that workers were able to stay
unemployed longer than was desirable from an economic viewpoint, because of the financial
protection afforded by rights to a range of unemployment and social security payments. The
range and scale of these benefits have been reduced by a series of measures in the 1980s and
1990s. In 1995 the British Government announced the withdrawal of some important rights to
housing benefits for unemployed workers with mortgage liabilities. However this development
has put increased pressure on an already depressed housing market and seems likely to increase
unemployment by reducing product demand and hence the demand for labour in the many
product markets associated with housing. One of the arguments for earlier Keynesian inspired
measures for maintaining income levels for those out of work was that these helped to prevent
falls in household consumption and this held up aggregate demand and the demand for labour.
It appears that, by 1995, the monetarist measures to restore market forces and pressures to
labour markets were recreating the kind of problems which had led to the Keynesian demandmanagement policies of the 1950s and leading to renewed interest in Keynesian models.

Employers should be put under pressure to prevent them meeting union demands for wage
rises. It was argued that firms were able to finance wage claims by borrowing until they were
able to adjust prices. Consequently if credit were made more expensive firms would find it
more difficult to do this and would have more incentive to resist paying higher wages. The fact
that their capital costs were increased would also put them under pressure to reduce their
labour costs. This element in the monetarist anti-inflationary policy leads to the core of
monetarist thinking and this is examined in the next section.

D. THE IMPORTANCE OF MONEY SUPPLY

The Money Equation
Attempts to explain the basis of monetarist belief tend to start with what is known as the money
equation. This, in very simple form, can be stated as follows.
MV = PT
where: M = money supply or stock
V = velocity of circulation of money (i.e. speed at which it circulates between buyers and
sellers)
P = average price of goods and services
T = number of transactions i.e. volume of production
(T is sometimes written as Q, representing the quantity of production.)
Now, on its own, this equation tells us very little. However, the important issues lie in the
relationships between the elements of the equation. Monetarists regard V as fixed or fairly fixed, and
they also regard T (or Q) as fixed at a given level of technology. If these assumptions are correct,
then the two variables in the equation are M and P. A given change in M (the money supply) can be
expected to produce a definite and predictable change in P (average prices). The relationship will not
always be as simple as this, because allowance will have to be made for known variations in V and T,
owing to forces outside the monetary relationship (e.g. improvements in technology and changes in
the financial structure). It will also take time for any change in money supply to work through into
general price increases, so that time-lags of up to two years are suggested though monetarists are
not always in agreement over the precise time-lag.

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There is a further modification that many modern monetarists would make to this argument. This
recognises that prices tend to be flexible upwards but not downwards: thus, it is argued, if money
supply is increased, then average prices will rise as already indicated; however, if money supply is
reduced sharply, then prices do not fall. The variable that has to give in this situation is T (or Q), i.e.
total output in the economy, as firms cut back production and consequently employ fewer workers.
The implication of this is that an attempt to cure inflation by a sudden and sharp reduction in money
supply will tend instead to an increase in unemployment rather than a check or reversal in price rises.
The reasons for this ratchet effect for prices are that large firms are reluctant to reduce their product
prices, and trade unions and workers resist strongly any suggestion of a reduction in wages.

Diagrammatic Expression of the Basic Monetarist View

We can illustrate the monetarist analysis of the relationship between changes in demand and price
quite simply, and this will also help to emphasise some of the assumptions on which the view is
based.
We must first repeat the belief that changes in demand arise from changes in money supply and the
price of money. Here, you should remind yourself of the monetarist case which was outlined earlier,
in relation to liquidity preference and the demand for money. Remember that a shift in money supply
produced a shift in interest rates which, in turn, produced a significant movement in demand.
Look now at Figure 13.2 which illustrates the effect of an increase in demand (the desire to spend on
purchases of goods and services).
Notice that the total demand for goods and services rises from DD to D1D1. The whole of this rise is
translated into a price increase from Op to Op1. This is because there is no shift in supply at all. In
this extreme monetarist view, supply is regarded as totally inelastic in the face of a change in demand,
and the only changes are in price. This accords with our previous explanation of the money equation
where T (or Q) failed to move following a change in M, so that it was P that had to change to restore
the equality.
This analysis faces the difficulty that prices, in a modern economy, clearly do not fall following a fall
in total demand. The monetarist argues that they would if the market were allowed to behave without
restriction. It is the power of large firms to maintain high prices and of trade unions to refuse to
permit wage reductions that prevents prices from falling in response to a decline in demand. Because
prices are not permitted to fall, the supply curve has to shift to the left to restore equilibrium.
To check your understanding of this, imagine that demand has fallen from D1D1 to DD in Figure 13.2.
Lay your ruler along the vertical supply curve and move it parallel to this vertical curve until it
intersects the DD line where the dotted horizontal line at price level p1 also intersects the DD curve.
The distance you have moved your ruler represents the reduction in supply needed to maintain
equilibrium at the higher price level. This reduction in supply means that employers will be laying
off workers, and firms will be closing down and making their workers unemployed.

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Price

Supply
D1
D

P
D1
D

Quantity of goods and services

Figure 13.2

A similar implication follows from the money equation if we assume that, when money supply falls,
prices do not fall. Then, if V continues to be constant, it is T (or Q) that has to be reduced to restore
the equation. A reduction in total quantity of goods and services has the same effect of reducing
employment.
It is not, of course, necessary to take the extreme position of assuming that supply is vertical in the
face of shifts in demand, to accept that much of the result of an increase in demand will be felt in
price rises. If you simply make the supply curve steeply-sloping, then, although the consequences are
a little less extreme, there is still a major increase in price or a shift in supply, if you examine a
demand fall.

E. CONTROLS OVER MONEY

Whatever the argument of the precise timing and severity of policies needed to control inflation, all
monetarists believe that there has to be strong government control over the supply of money. In fact,
even Keynesians would accept that there has to be some degree of control over money supply, though
they would not elevate these controls to the important place claimed by monetarists. We must now,
therefore, look at some of the methods by which governments attempt to control the money supply.
Remember that all our definitions of money have been based on deposits held by banks or similar
financial institutions, so that you must expect control over money to appear as a form of control over
the power of the banking system to create credit.

Control through Price

Remember that money supply and demand are very closely related. If the price of money rises i.e.
if interest rates rise generally then the demand for money can be expected to fall though a timeinterval may be necessary for the full effects to be felt. If people wish to borrow less, then the banks

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may be expected to lend less. If the banks lend less, then the volume of deposits will rise more
slowly, and money expansion may be checked.
A government may, therefore, seek to influence general interest rates. Until August 1981, the Bank of
England set its own minimum lending rate (MLR). This was the rate at which it was prepared to lend
money to other approved banks and, because the Bank of England is at the centre of the banking and
financial system, all other rates had to follow any change in MLR. The Bank of England no longer
announces a set minimum lending rate but it still operates as the lender of last resort to the banking
system, and is able to influence the interest rates charged by the main banks.
From about 1985, it became clear that the British government was exerting stronger control on
interest rates through the Bank of England. By 1989, the Bank of England was making little attempt
to conceal occasions when it was putting pressure on the commercial banks to raise interest rates and
the Chancellor was no longer pretending that this was not an active instrument, perhaps the only
instrument, of Government monetary policy, particularly when severe inflation returned in 1988/9.
When, however, the problem had changed to one of rising unemployment and falling business output
in the early 1990s the Government again sought to use interest rates to revive the economy. Once
forced out of the European Monetary System in the Autumn of 1992, the government used its
influence to bring interest rates down in an attempt to revive both consumer and business confidence.
In the mid-1990s, the Chancellor of the Exchequer responded to calls that the Bank of England
should be given more independence over its handling of monetary policy by undertaking to publish
(after a delay of six weeks) the minutes of his regular monthly meeting with the Governor of the Bank
of England. This gave greater prominence to these meetings and ensured that any disagreement over
interest rate policy between the Government and the Bank would be open to public debate and the
Chancellor would have to have sound reasons for overriding the wishes of the Bank. That there are
likely to be disagreements from time to time is not surprising. The Banks duty is to pursue one
element of economic policy only to curb inflation. The Bank is not under any obligation to take
account of any wider economic or social consequences of policies designed to control inflation. The
Government must, of course take all considerations into account, especially the possible effects on
unemployment, foreign trade and conditions in the domestic housing market. In the view of the
British Government the full economic responsibilities of government cannot be passed over to an
institution such as the central bank which has only a limited economic function.

Control over Banking Ratios

You have seen how the proportion of customer deposits held as cash affects the lending power of
the banks. If the proportion is one tenth, then the multiplier is ten. If the proportion rises to one
eighth, then the multiplier falls to eight, and so on. A central bank may seek to influence the ratio of
banking assets, and thus the multiplier, in several ways. It may do any of the following.
(a)

It may withdraw certain assets from the banks, and so force them to call in loans to replace
necessary cash requirements. The Bank of England, for example, has the power to call for
special deposits to be made by the banks, and to disallow inclusion of these deposits in any
necessary banking ratios. Under the 1981 regulations, all institutions with normal customer
deposits of 10m or more are required to hold % of these deposits in the form of non-interestbearing balances at the Bank of England.

(b)

It may itself establish which ratios the banks should maintain, and define which assets
should be included in which ratios. Before 1981, a reserve/assets ratio was set for British
banks by the Bank of England. (This was abandoned in 1981 but fresh measures could be
introduced, if thought desirable.)

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(c)

It may influence ratios by its own actions the central bank may conduct open-market
operations. These involve buying and selling government securities on the open market. The
Bank of England always keeps a store of government bonds (known as tap stock because the
Bank can release or hold stock like turning a tap on and off). If it offers some of its tap stock to
the public at an attractive price, people will buy and pay for the bonds with cheques drawn on
commercial banks. In this way, money can be withdrawn from the commercial banking system
and kept in the central bank. If the Bank buys bonds, then the opposite happens, and the supply
of money in the commercial banking system is increased. (In Britain, open-market operations
are used more to influence the day-to-day supply of money required by commerce, rather than
to impose major credit or monetary controls.)

Direct Controls over Banks

The government, acting through the central bank, may require the commercial banks to keep their
customer lending within stated limits, or to discourage certain forms of lending, or forbid lending for
stated purposes. In a market economy or a mixed economy containing a substantial free-market
element, such controls are unpopular and difficult to keep in force for very long. They may be
regarded as the first step towards total control of the banking system or complete nationalisation of
all banks.
The above methods of control assume that the central bank does not itself operate directly in the
ordinary commercial finance markets. In some countries, the national central bank does lend directly
to industrial and commercial organisations. In such countries, a government wishing to control the
money supply would have to keep careful and strict control over these lending operations.

Control of Government Borrowing

There is uncertainty over the effects of government borrowing.
A straightforward analysis of money supply and its changes suggests that an increase in government
borrowing will increase money supply only if this is financed through the banking system. If it is
financed by direct borrowing from the public, through sales of bonds or national savings certificates,
then there is no increase in money supply, and there could be a reduction through the withdrawal of
money from private-sector deposits with the banks to pay for the government securities.
However, there may be indirect consequences. If the government enters the finance market to
compete for a larger share of private savings, then firms may be forced to borrow from the banks
instead of raising money through issues of shares or debentures. This suggests that the government is
crowding out private investment and forcing it into the banking system. Also, if the government
forces up interest rates because it is competing with building societies and banks and capital markets
for private savings, firms will be unwilling to incur long-term debt at high rates of interest, and they
will prefer to borrow on short-term and on more flexible terms from banks, in the hope that future
conditions will be more favourable for longer-term funding.
Thus, some economists argue that part of the mechanism for reducing money supply must be to
reduce government borrowing, while others say this will have little or no effect.
In practice, modern monetarists tend to want to reduce public-sector borrowing and expenditure
because they also believe in the virtues of unregulated markets and the value of the private sector, and
wish to reduce the size and power of the public sector, whereas Keynesians will be less concerned
about the effects of public-sector borrowing, and may wish to encourage government spending. Once
again, the division tends to resolve into monetarist versus Keynesian terms.

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THE PROBLEMS OF MONETARISM

Theoretical Problems
The first problem faced by monetarists is that their basic theory is not generally accepted by all
economists. No one doubts that a massive increase in the supply of money without any
corresponding increase in the output of goods and services will result in an increase in prices, but it is
the closeness and inevitability of the relationship between increases in money supply, increases in
total demand and increases in prices that Keynesians and others find hard to accept; and some of the
other implications of monetarism, particularly those relating to unemployment, arouse considerable
dislike.
You might think that this argument should be fairly easy to settle. After all, if the relationship
between money supply and prices is so close, then it should be easy to prove by reasonably simple
statistical analysis. Unfortunately, proof is not so simple. As already noted, there is disagreement,
even among monetarists, regarding the speed with which the economy adjusts to changes in money
supply, and the introduction of time-lags between these changes and changes in prices makes
certainty difficult to achieve. Professor Friedman, among others, has shown clearly that there is a
close correlation between increases in money supply and price increases but, because of the timeintervals between the two sets of changes, this does not prove that a change in money supply must
always increase prices to a particular extent. If a close correlation is found between two sets or series
of data (say, between A and B), then there are the following possibilities.
Changes in A cause changes in B; changes in B cause changes in A; changes in both A and B are
caused by some other influence, say C; the correlation is accidental, so that A and B are not closely
related at all.
It is possible, therefore, that the correlation between money-supply rises and price rises is the result
of the expansion of money, made necessary by the increased prices caused by some other force.

Practical Problems
There are further problems, in the sense that money, as we have seen, is difficult to measure, and even
more difficult to control.
Monetarists are sometimes accused of choosing whatever measure of money most closely appears to
suit their particular purpose, and changing the measure when it no longer serves that purpose. The
British government has, several times, changed the measure used as the basis for its various monetary
targets. In the early 1990s it was publishing two measures, M0 for narrow money and M4 for broad
money (including building society deposits), but by this time it was admitting that attempts to base
policy on the performance of just a very few economic indicators were likely to be self-defeating. It
claimed that the measures of money supply were just two of a range of indicators that needed to be
taken into account when taking economic policy decisions.
Controlling the money supply has proved extremely difficult for many governments. The problem
tends to revolve around what is known as disintermediation.
When banks carry out their normal functions of lending to one set of customers the money deposited
with them by others, they are acting as intermediaries. If, because of government attempts to control
the money supply, their normal lending operations are put under strict controls, with penalties for
lending above stated limits, then disintermediation tends to take place. This takes three main forms:

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(a)

Firms develop ways of lending between themselves without the intervention of banks, by
simply extending trade credit or arranging deals whereby the debt of A to B is transferred to
enable B to settle his liabilities to C.

(b)

The business of lending and arranging credit passes from the controlled banks to other
financial institutions which are outside the existing credit controls; the growth of secondary
banking in the 1960s and 1970s owes much to the limitations placed on the activities of the
primary banks by governments seeking to control bank lending, and hence the money supply.

(c)

The banks themselves develop new ways to create credit that are outside the existing control
regulations. Among the more notorious devices used by British banks was the expansion of
commercial bills of exchange to evade controls over the simpler lending by overdraft.

The modern financial system has become so sophisticated and complex that attempts to impose tight
controls of lending and credit creation are likely to lead to increasingly devious methods of
disintermediation, with the main consequence that the price of borrowing and handling money is
pushed up, and borrowing by new and adventurous firms tends to be stopped, while established firms
which have forged close links with their banks or which have their own connections with the finance
markets have no trouble in acquiring the finance they desire.
Attempts to control money supply have been compared with efforts to squeeze a balloon. Such
efforts serve only to distort its shape; the amount of air in the balloon remains unchanged.
Some attempts to achieve monetary controls have failed because these have tended to put pressure on
the private sector of the economy while, at the same time, the government itself has been increasing
its own borrowing and, in so far as this borrowing has involved the issue of Treasury bills and bonds
which have been taken up by the banks, this has increased bank credit and the money supply.
The only effective way of restricting money supply appears to be the use of interest rates but these
have such a wide and indiscriminate effect that, as had become clear by 1992, they can turn inflation
into severe recession with all the social misery that results from high unemployment and the
repossession of peoples homes. By the mid 1990s there were very few economists prepared to claim
that a government could manage a modern economy using only monetary instruments of control.

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Study Unit 14
Government and the National Product
Contents
A.

Page

The Public Sector

232

The Size of Public Sector Spending

232

The Nature of Public Sector Spending

233

Financing Public Sector Expenditure

234

Taxation and the Economy

236

Types of Tax

236

Economic Effects of Direct Taxes

237

Economic Effects of Indirect Taxes

238

Economic Effects of a Payroll Tax

239

Social Aspects of Taxation

240

Adam Smiths Four Canons of Taxation

240

Taxation as an Instrument of Social Policy

241

Public Sector Borrowing Requirement (PSBR)

242

Financing of the PSBR

243

The General Government Financial Deficit

243

Importance of Public Sector Borrowing

244

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A. THE PUBLIC SECTOR

The public sector is the term given to the range of economic activities where resources are controlled
and decisions over their use are taken by agencies responsible to the government through its political
institutions. It is the economic sector controlled by the State and not directly subject to the normal
market forces of private consumption and supply though these may influence decisions taken through
the political machinery of the State.
The public sector in Britain consists of two main divisions, the central government and the local
authorities. Since the extensive privatisation programme of the 1980s the nationalised industries are
no longer a major division of the public sector. At the same time, there has developed a substantial
sector controlled by a range of non-elected bodies appointed mostly by central government and
popularly known as Quangos (Quasi-National Governmental Organisations). By 1995 no attempt had
been made by the Government Statistical Service to measure the size of this group or even to consider
it as a separate division of the public sector though there is a strong social and political case for doing
so.

The Size of Public Sector Spending

Monetarists have argued fiercely that the public sector has grown too large in modern times and that
it should be reduced so that taxes can be reduced and more of the economy left to market forces. The
British Governments of the 1980s and early 1990s have sought to identify themselves as reducers of
public expenditure and taxation. The official statistics as contained in the Blue Book (United
Kingdom National Accounts) tell a rather different story. The following figures do not take account
of the privatisation programme which technically transferred around ten per cent of gross domestic
product from the public to the private sector. We could argue that the major public utilities, which
dominated the old nationalised industries, are different in nature from both completely commercial,
competitive enterprises and public sector services such as primary education and hospital care. They
have always sold services to the public, have always been required to relate expenditure to revenue
and are still subject to a significant degree of non-market regulation. They are not fully part either of
the free market economy nor of what has been termed the non-market, public sector.
In 1972 the proportion of general government (central plus local authorities) final consumption (the
money spent by government on our behalf according to decisions made through the political
structure) to total domestic expenditure was 18.71%. In 1973 this proportion fell to 18.07% but in
1975 it jumped to 21.71%. In 1978, the year before the election of a self-styled monetarist
government, it was 20.37% but by 1983 it had risen to 22.17%. In 1990 the proportion had fallen to
19.94% still well above the figure of 1972-3 but in 1993 it rose again to 21.65%. There is no
evidence here of any significant reduction in the public sector, rather the reverse. The figures do
fluctuate from year to year, particularly when the governments share of fixed capital formation
(investment) is taken into account. This suggests that the government is prone to delay major capital
projects when it is seeking to reduce (or give the impression of reducing) expenditure. This, of
course, creates a climate of uncertainty and makes it difficult for private firms seeking public sector
contracts to make long term plans. The overall impression is that whatever governments may like to
say or imply in public, they are able to do very little about actually reducing public sector expenditure
but they do create an uncertain environment for public sector investment that is potentially damaging
to the economy as a whole.

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The Nature of Public Sector Spending

In view of the apparent inability of governments (which we must assume really do wish to reduce
public sector spending) to make any significant long term reduction, we need to examine more
closely what form this expenditure takes.
Analysis of total general government expenditure for 1993
million

General public services

12,633

4.63

Defence

24,384

8.94

Public order and safety

14,979

5.49

Education

33,885

12.42

Health

36,863

13.51

Social security

93,180

34.15

Housing and community amenities

10,939

4.01

3,705

1.36

954

0.35

Agriculture, forestry and fishing

3,930

1.44

Mining and mineral resources manufacturing and

construction

1,529

0.56

Transport and communications

6,838

2.51

Other economic affairs and services

4,977

1.82

24,053

8.82

272,849

100.00

Recreation and cultural affairs

Fuel and energy

Other expenditure
(mostly debt interest and non-trading capital consumption)
Total expenditure

60.08%

(apparent error
due to rounding)
Total general government expenditure (at current prices) for 1993 is broken down into broad classes
in the above table. This shows very clearly that a little over 60% of the total is accounted for by just
three major areas of spending. These are:
!

social security (which by itself accounts for over a third of all spending);

health; and

education.

It is not difficult to understand why these three sectors all feature so often as topics of political
controversy. It is not just monetarist economic theorists that are concerned about the amount of
social security spending. Any responsible government has to examine this huge element in its budget
and we have to recognise that the same problem now faces all the Western market economies which
developed strong social welfare structures in the years of strong economic growth and relatively
young, vigorous populations in the period 1950-1975.
However, when we try to learn from the Blue Book of United Kingdom National Accounts more
precise details of this social security spending the picture becomes a little confused. In view of the
importance of this item the confusion is rather disappointing. The total 1993 amount of 93,180

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million for social security expenditure is dominated by 80,392 million described as current grants
to the personal sector, i.e. they are transfer payments of one kind or another. Clearly they include
unemployment benefit, childrens allowances, social welfare payments and state pensions.
Unfortunately it is not possible from the Blue Book tables to produce a breakdown of benefits that
fits the total figure of 80,392 million. By far the largest amount is termed social security funds
benefits and this is made up of such items as retirement pensions, widows benefits relating to
unemployment, sickness, invalidity, maternity and so on. Supplementary benefit and income support
payments are another large item in social security spending. The largest single item appears to be for
retirement pensions. Again we can understand the concern of Western governments at the
implications to their budgets of the bulge in the number of elderly people expected from around the
years 2010 onwards and their anxiety to change the pension rules while the proportion of older voters
remains small enough to override without too rough a political storm.

Financing Public Sector Expenditure

Discussion of public sector spending, if we do not take care, tends to ignore the inconvenient fact that
the government has very little money of its own. It rarely has any significant savings, though it may
have accumulated some physical assets. The main inheritance each government gains from its
predecessor is a debt, the national debt and it has to assume liability to service (i.e. pay interest on)
that debt before it can begin to spend anything on the services it wishes to provide or which it is
legally liable to provide by laws enacted by its predecessors. Some politicians found it fashionable to
compare government finances with those of a family but not many families would care to become
burdened with huge debts and the cost of servicing those debts as soon as their parents departed this
world. They would quickly seek to repudiate the actions of their parents but if governments try to
take that course they become discredited in the world of international finance and find it very difficult
to borrow the money they need.
To raise the money it spends the government can take the following courses:
!

selling its assets;

selling services to the public in the market;

raising revenue from taxes or the sale of licences (permissions to carry out restricted
activities);

borrowing

(a)

Selling Assets
The most notable modern example of this has been the British privatisation programme for the
nationalised industries, mostly public utilities and major companies which had been taken over
by the State for various reasons in the past. It proved such a fruitful source of finance in the
1980s that other governments have sought to copy this example. If there is one certainty in
political life it is that when one government discovers a rich source of funds others, whatever
their political complexion, will certainly copy it. The only problem with this course of action
is that assets, once sold are not available for sale again. By 1995, there were no significant
trouble-free assets left for the British Government to sell. The nations family silver had
gone. If some enterprising politician can discover a way to sell the equivalent of homing
pigeons no doubt the attempt will be made. A near equivalent might be for a future government
to change the ordinary shares in the privatised utilities into fixed term debentures which could
be reissued periodically in constantly devalued currency.

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(b)

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Selling Services in the Market

Efforts have been made in recent years to charge for some services provided by the public
sector, the best known probably being the attendance of police at football matches. Many
former free services such as museums are now expected to cover a significant part of their
costs from charges. However these charges still form only a very small proportion of the
governments total receipts.

(c)

Raising Licences, Taxes and Near Taxes

The Blue Book summary tables do not show licences as a separate item though most of us are
familiar with licences relating to motor vehicles, television and activities such as fishing and
shooting. Most are a form of taxation on expenditure and many people have argued that there
would be advantages in replacing most of them with straightforward expenditure taxes, e.g.
additional tax on motor fuel so that people were taxed on the use of vehicles rather than on
their ownership.
The main classes of tax and near tax identified in the main national accounts are:
!

taxes on income roughly equivalent to what economists like to call direct taxes;

taxes on expenditure roughly equivalent to what economists like to call indirect

taxes;

social security contributions because there is no direct relationship between total

contributions and total expenditure on benefits, these are really a contribution to the total
tax receipts of the government and are more like employment, payroll or wage taxes;

local taxes unlike some countries Britain has only one major local tax which is now
levied on the ownership and occupation of property and is known as the Council Tax.

These taxes and their economic implications are examined more fully in the next section of this
unit.
(d)

Public Sector Borrowing

Except for a few years in the 1980s when the British Government was receiving substantial
amounts from oil revenues and the privatisation sales, most modern British Governments have
spent more than they have received. Consequently they have had to borrow to bridge the gap
between receipts and expenditure and this is broadly the Public Sector Borrowing
Requirement (PSBR). Clearly the government has to plan its borrowing which is mostly
administered by the Bank of England so it has to estimate its borrowing requirement and then
plan sales of various forms of debt to raise the money it expects to need. These estimates are
rarely completely accurate because the government does not know accurately in advance how
much tax will actually be paid as this will depend on the volume of household spending and on
the amount of incomes paid to workers and profits earned by firms. Its spending will also
depend heavily on the amount of unemployment and other social security benefits it becomes
liable to pay. When most workers lose their jobs and are unemployed for more than a few
weeks they change from being taxpayers into receivers of social security benefits so a sudden,
unexpected rise in unemployment can severely upset the Governments estimate of its PSBR.
Government borrowing has many important economic implications and these are also
examined more fully in a later section of this study unit.

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B. TAXATION AND THE ECONOMY

Types of Tax
The broad classes of taxation have already been outlined. We shall now adopt the three broad classes
of tax, i.e. direct, indirect and payroll and endeavour to fit the best known taxes into these.
(a)

Direct Taxes
These are called direct because they are levied directly on to people in accordance with the
income they receive or the wealth they create, inherit or transfer. Income tax itself is the main
generator of revenue for the government in this class and the most direct since all employees
have the tax deducted from their pay by employers who act as tax collectors for the
government. The earnings of the self-employed and those with investment income are assessed
separately. The British government is currently moving towards a system of self-assessment
similar to that operated in the USA.
Limited companies are legal entities in their own right and corporation tax is levied on their
profits. This is another major direct tax.
Government statistics treat taxes on capital as a separate class but for our purposes we can
regard them as direct taxes. The main types are capital gains tax, levied when financial and
physical assets are transferred and inheritance tax, levied on the estates of people when they
die. Recognition that capital gains tax is a form of income tax is implicit in the move by the
British Government in the summer of 1995 to tax the capital gains of investors in the
Governments bonds (known as gilts, or gilt-edged securities) as income.
The locally levied and collected council tax can also be regarded as a direct tax. It is a tax on
the ownership or occupation of property and rights to property have traditionally been regarded
as a form of income or wealth. It is also similar to an income or wealth tax in that the more
valuable the property owned the higher the amount of tax likely to be paid.

(b)

Indirect Taxes
These are called indirect because they are not levied directly on the people who eventually
bear the burden, or incidence of the tax but are levied on goods or services when they are
traded. They thus become a production cost which, along with all other costs, has to be
included within the price charged to the ultimate consumer.
Most are taxes on expenditure levied at some stage when goods or services are traded. The
best known is Value Added Tax (VAT). As goods pass between firms as they go through the
production process each firm purchasing goods and services pays VAT but is able to offset the
tax paid against the tax it collects when the goods are sold on to the next firm or to the
consumer. In effect, therefore, firms pay just the amount of tax levied on the value they add to
the inputs they purchase. Only the final consumer has to pay tax levied on the full, final total
value.
Other common taxes include customs duty paid when foreign goods enter the country, or in the
case of members of the European Union (EU), when goods produced outside the EU enter the
EU for the first time. Some goods, such as beers and wines are taxed when they are first
produced and these taxes are known as excise duty. A number of goods are subject to special
taxes. These include motor vehicles and hydrocarbon oils.
Although there is supposed to be a single EU market in goods (but not services) member
countries levy taxes, including VAT, at different rates and this provides considerable

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opportunities for smuggling and corrupt practices. This is not a new problem. Throughout
recorded history governments have constantly devised new forms of taxation while the
governed have been equally diligent in devising new ways to avoid paying taxes. Everyone
recognises that taxation is an unfortunate necessity. Very few of us want to pay a penny more
than is absolutely necessary. Most of us harbour some degree of dislike for the fact that we
have to hand over a proportion of our earnings to governments to spend in ways which we
often feel powerless to control. We also have to recognise that tax evasion is a crime and
punishable as such but tax avoidance is a major industry employing some of the best brains in
the financial services. The line between the two is sometimes so thin and delicate that
references are common to tax avoision.
(c)

Payroll Taxes
Governments have always sought new ways to impose taxes. For a period the British
government had a selective employment tax (SET) largely as a device to tax services which
were then untaxed in contrast to indirect taxes on goods. At that time unemployment was not a
problem and the government could use the excuse that an employment tax would encourage
employers to make more productive and efficient use of labour.
Entry to the European Community and the adoption of value added tax which applied to all
forms of production allowed the unpopular SET to be abandoned but a more general
employment or payroll tax still exists in the form of national insurance contributions paid both
by employers and employees. For a long time this was less disliked than income tax because
people felt that they were paying for benefits in the form of health and injury insurances and
for retirement pensions.
Today, however, there is a widespread realisation that the level of national insurance premiums
is not guided by any principle of insurance, and that the contributions simply go into the
governments current revenue. Health service costs and State pensions are also paid as current
expenditure. There are no State insurance or pension funds.
Consequently no one now disputes that national insurance contributions are anything other
than a payroll tax. Proposals have been made to abolish them and raise the levels of income
tax and VAT but governments are notorious for not abolishing taxes if they can possibly avoid
doing so and they fear the public hostility to the high rates of VAT and income tax that would
be necessary. We are unlikely to see the end of national insurance contributions in the near
future.

Economic Effects of Direct Taxes

A direct tax reduces the taxpayers financial ability to purchase goods and services. It also reduces
the taxpayers ability to save. The extent to which the tax affects the individuals consumption
expenditure and saving depends on that individuals marginal propensity to consume and to save.
The higher the individual income the more likely is it that the marginal propensity to save will be
high and a direct tax increase may have relatively little impact on the high earners consumption.
For very high income earners a rise in direct tax may make the individual feel that it has become
worthwhile to bear the cost of highly skilled tax advice and to take measures to avoid the extra cost,
e.g. by transferring property to another country. It is now recognised in both the USA and Britain that
a reduction in the highest rates of income tax can actually increase the amount of revenue paid in
taxes as the high earners find it cheaper and more convenient to pay the tax than to employ the more
costly and risky tax avoidance measures.

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For the economy as a whole the effect of a rise in direct tax will depend on the aggregate marginal
propensities to consume and to save bearing in mind that people cannot always make significant
changes in their consumption patterns quickly. However desirable it may be to have a smaller house
and lower mortgage payments or reduced travelling costs, it is expensive to move home. This is
especially true in a period of stable or falling house prices. Consumption and savings patterns are
sometimes linked together, e.g. when insurance schemes are tied to house mortgage loans. If these
cannot be changed people may have to reduce consumption on other goods or services. Consequently
we can say that the main effect of a rise in a direct tax will be to reduce consumption of those goods
and services which have a high income elasticity of demand and of those forms of saving which can
be abandoned without suffering financial loss.
Propensities to consume and save are not, of course, fixed and are partly determined by peoples
expectations of the future. If people expect incomes and living standards to rise they may not be too
concerned with a relatively small increase in a tax indeed they may simply press for a speedier or
greater increase in income to make good the loss through tax. One reason given by the British
Government for moving from direct to indirect taxes in the early 1980s was that rises in income tax
tended to add fuel to wage inflation. If, however, they face an uncertain economic future with high
unemployment and widespread job insecurity, a tax rise can have a very damaging effect on
consumption as people try to maintain savings as a hedge against a further drop in income. You are
more likely to carry an umbrella when the sky is dark and overcast than when it is bright and sunny!
If, as part of its fiscal policy to reduce inflation, a government wishes to use direct taxes to reduce
consumer demand the most effective economic measure would be to raise those rates of tax which
most affect the lower income earners since they will have a high marginal propensity to consume and
they will be forced to reduce consumption. However, this may have unacceptable social and political
consequences. These are examined in the next section of this unit.

Economic Effects of Indirect Taxes

As earlier noted an indirect tax acts as a cost of production and firms must cover all production costs
in their prices if they are to survive in a competitive market economy. A change in an indirect or
expenditure tax thus shifts the supply curve. This was explained and illustrated in Study Unit 5 and
you should revise this unit very carefully if you are not sure how these tax changes affect the supply
curve and the market price of the product taxed. Study Unit 5 also drew attention to the importance
of the slope of the demand curve and the price elasticity of demand for the product at the relevant
range of prices. You should remember that the immediate direct effect of the tax change will be
greatest on those goods and services whose demand is price elastic. Suppliers will face price
resistance when they try to pass on a tax rise in the price and supply will fall as will employment of
factors in the production of the product. Consequently, if governments aim to maximise tax revenue
they will seek to impose the heaviest burden of tax on those goods and services the demand for which
is price inelastic. Unfortunately this will reduce the remaining incomes of consumers available for
consumption and consumers will tend to buy less of those goods and services which are income
elastic. Factor employment in these industry sectors will fall.
Notice, therefore, that the most serious employment consequences of a rise in either a direct or an
indirect tax are likely to be felt in those business sectors the demand for whose products is income
elastic. Demand for these products is also often price elastic so the worse effects of any tax rise tend
to fall on the same group of products, usually the relatively high value household durable goods and
the more expensive services such as the more exotic foreign holidays. In the longer term there is
likely to be a fall in demand for houses and this will have a further effect on the demand for
household durables. At the same time of course, the sectors which suffer from tax rises will also
benefit most from tax reductions although a reduction that comes after a number of tax increases may

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be treated with suspicion and suppliers will want to see firm evidence that a demand increase will be
sustained before they risk expanding employment and production to any significant degree. It takes
longer to build up confidence in the economy than to destroy it.

Economic Effects of a Payroll Tax

This is the term frequently applied to British social security contributions. These are in two parts, the
contribution paid by the employer and that paid by the employee by deduction from salary. Both
have the same effect of creating a gap between the amount paid by the employer and the amount
received as disposable income by the employee. This is shown in Figure 14.1.

Figure 14.1
This shows a labour market in which there are payroll taxes or compulsory payments, which have
the same effect. There is a demand curve for labour, indicating the employers wish to employ
workers at a range of wage levels, and there is also a supply curve for labour, indicating workers
willingness to work at the same range of wage levels. Wp Wr is the extent of payroll tax, so that
OWp is the wage cost to the employer and OWr is the net pay received by the worker.
Under these conditions, the employment level will be OLa, which is lower than the level that would
be reached if there were no payroll taxes and the wage paid was the same as the wage actually
received (level OLe). Thus, the difference (Le La) is the amount of unemployment that can be
attributed to payroll taxes. Clearly, the proportion that this bears to total employment depends on:

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(a)

the slopes of the labour demand and supply curves

(b)

the proportion of tax to total earnings i.e. (Wp Wr)/OWp

In the case of low-paid manual and unskilled workers easily substituted by machines, labour demand
could be fairly elastic and, in the past, the proportion of national insurance costs to total pay has been
high, so that the amount of unemployment caused by the taxes has been thought to be significant.
More recently, the pattern of payments has been changed to reduce their cost in relation to the lowpaid workers and to compensate government revenue by increases in relation to highly-paid, highlyskilled workers whose demand and supply curves are thought to be inelastic at current wage levels.
The total effect should have reduced unemployment, especially among those unskilled workers who
suffer the highest rate of unemployment.
In practice, the change may have had further effects, in particular the encouragement of part-time
working by highly-skilled women workers in computing and similar occupations as, in practice, parttime work is not taxed as heavily as full-time work.
The illustration helps to emphasise the fact that no tax is really neutral in its economic effects.
People will seek to reduce the cost of any tax, and they will change their behaviour in order to reduce
their own burden of tax.
Governments, therefore, need to be aware of the consequences of any tax change, and to try to make
changes that accord with their own economic objectives. In effect, then, all governments have to
have a fiscal policy.

Social Aspects of Taxation

In economic terms there is really no such thing as a completely neutral tax. Any direct tax affects
spendable income and this affects different people and different sectors of the economy in different
ways. Some goods and services are more sensitive to changes in income than others. Any indirect
tax affects prices and different goods and services respond differently to changes in price. Moreover
the people most affected by the tax are likely to change their income and/or their expenditure patterns
to try and minimise the tax they have to pay. Consequently no government can ever be completely
sure what the ultimate effect of a tax change is going to be. Nevertheless, because the time horizon of
most politicians tends to be very short governments usually look only at the immediate effects and
leave the longer-term consequences for some future government to face.
We also have to recognise that historically governments have had a strong tendency to use taxation to
favour those groups on whose support they rely for continued power and have less consideration for
those believed to oppose them and even less for groups considered to have no political influence at
all.
Until relatively modern times, therefore, governments paid little attention to the wider economic or
social consequences of taxation and simply imposed them where they could be collected with least
trouble and protest. Often it was the poorer groups which had to bear the heaviest burdens because
they had the least power to resist.

Adam Smiths Four Canons of Taxation

It was Adam Smith, often known as the father of economics who, in the 18th century, established
four basic canons for a taxation system which, if followed, would minimise the social and economic
effects of taxes. These are still relevant today and will remain relevant as far as anyone can see into
the future. These four canons can be summarised as:

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Certainty
People should know what their tax liabilities are and be able to calculate their obligations and
plan their finances and expenditure accordingly.

Convenience
The government has a duty to organise its taxation structure so that payment can be made
conveniently.

Economy
The tax should not cost more to collect than it produces in revenue. It may appear difficult to
believe that any government would maintain a tax that reduced its revenue but many have done
so in the past and only an incurable optimist would believe that it will not happen again in the
future.

Equity
Liability to tax should depend on ability to pay. Adam Smith was well aware that many taxes
of his day bore hardest on the less well-off and he was concerned to correct this injustice. In
fact a proportional tax would probably have satisfied his requirement, i.e. if there were a single
percentage rate of income tax for everyone then those with high incomes would pay more than
those with low incomes. However, those who believe that income inequalities should be
removed have extended this canon to suggest that it requires higher income groups to pay a
higher percentage of their income in tax than lower groups. This, it is argued would narrow
the inequalities in disposable (after tax) incomes.

The underlying belief represented by these canons is that taxes should not breed resentment, should
not encourage evasion and should interfere as little as possible in the existing economic and social
structure. Tax is seen as a regrettably necessary burden that should sit as lightly as possible on the
shoulders of the community.

Taxation as an Instrument of Social Policy

During the nineteenth century the ruling groups in the more economically advanced countries began
to develop a social conscience, to recognise that there were serious social ills in society and that
governments did have a duty to try and cure these ills. This recognition was reinforced by the
growing political power and organisation of ordinary working people and a realisation that if reform
were resisted and denied then violent revolution was almost inevitable. Pressure for reform became
stronger in the present century. In Britain an organised Labour Party emerged as a major agency for
social reform while the foundations of the old social structure were violently shaken by the ravages of
two world wars.
Reforming governments, encouraged during the 1930s by the economic theories developed by
Keynes, came to see taxation as an effective instrument for social reform and the achievement of a
greater degree of income equality also came to be seen as a major objective of social reform. The
aim was to employ taxes to take money from the higher income groups and use it to improve the
incomes, living conditions and opportunities of the lower income groups.
Taxes need not be proportional i.e. taking the same percentage or proportion of everyones income,
they could be regressive or progressive.
A regressive tax is one that takes a proportionally higher percentage of income from the poorer
groups than from the better-off.

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A progressive tax is one that takes a proportionally higher percentage of income from the higher
income groups than from the lower. Social reformers, in their pressure to reduce income inequalities
have, of course, favoured progressive taxes.
Any tax can be regressive, progressive or proportional. It depends on how the tax is framed and
collected. The old purchase tax of the 1940s and 50s was a progressive expenditure tax as it was
levied on so-called luxury goods. Inevitably it led to many anomalies and a number of MPs made
popular reputations by exposing these. National insurance contributions are to some extent a direct
tax that is still partly regressive though not as much as in the past when all income earners paid the
same percentage up to a cut off income level. Earnings above this level required no further
contribution from employees.
In practice, British income taxes tend to be progressive in that the rate rises (1995 figures) from 0%,
through 20% and 25% to 40% in successive income bands. Indirect, expenditure taxes such as Value
Added Tax tend to be regressive in that the lower income groups are likely to spend a higher
proportion of their income on goods and services and thus pay a higher proportion of their income in
tax than the higher income earners.
These general statements should be modified to take account of anomalies. Some of the highest
marginal rates of tax are paid by low or below average income groups. For example a very low
income family can pass from a situation of paying no income tax and receiving income support and
other social security benefits to one of paying tax at 20% and losing entitlement to benefits following
a fairly small income increase. People over the ages of 65 and 70 can also lose their age-related
additional personal allowances if their income rises above a certain level. At the critical income level
which by 1995 was well below the average earnings level, they can thus effectively be paying tax at a
very high marginal rate. These anomalies encourage tax evasion and raise collection costs as the
revenue authorities have to take expensive anti-evasion measures or risk widespread evasion which,
in turn, creates a sense of injustice among honest taxpayers.
Notice also that the idea that tax should be an instrument for social reform requires that the additional
taxes collected from the well-off should be used for the benefit of the lower income groups. In
practice there is considerable evidence that the more articulate and better organised and educated
groups tend to gain an increasing share of government social expenditure over time. Schools and
hospitals in the more affluent areas become more effective and offer better services than those in
poorer areas. A higher proportion of the children of the higher income groups make use of higher and
further education facilities than the children of poorer groups. Some observers have argued that
taxation seldom leads to any significant degree of income re-distribution in favour of the poorer
groups and can lead to the opposite effect.
What is very evident is that the heaviest tax burdens tend increasingly to fall on the middle income
groups who receive relatively few of the benefits of social security, suffer from both high expenditure
and high marginal direct tax rates and who do not earn enough to justify employing expensive tax
advisers to arrange the more complex avoision schemes that have enabled the wealthy to maintain
their wealth.

C. PUBLIC SECTOR BORROWING REQUIREMENT (PSBR)

By the 1970s the British Government was recognising that there was a growing resistance from all
sections of the population to high taxation. At the same time there was strong resistance to reductions
in what was regarded as socially desirable public sector expenditure. There was an evident
temptation for the government to evade its difficulties by the short term remedy of increasing its
borrowing. The monetarist inclined governments of the 1980s sought to achieve balanced budgets

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and limit expenditure to the constraints of its revenue receipts. Its apparent success in this objective
was, however, achieved by the device of privatisation which brought it large sums of capital which
were treated and spent as revenue. By the early 1990s there was little left to privatise and the
Public Sector Borrowing Requirement (PSBR) again became a major economic issue.

Financing of the PSBR

There are three main sources of finance for government borrowing. These are the Non-bank, Nonbuilding Society Private Sector, the Banks and Building Societies, and the Overseas Sector.
The financial instruments whereby the government borrows from these three sources are all roughly
the same though, of course, their relative importance is different in each sector. The main
instruments are:
!

Notes and coin the cash we carry in our pockets is technically considered to be finance lent
to the government. This dates from the origins of the bank note as a receipt of money
deposited with a bank. Although we no longer have to deposit gold or silver with the Bank of
England to obtain a Bank of England note, this still takes the form of a receipt and it continues
to carry the now, meaningless ....promise to pay the bearer on demand the sum of..... The
government could increase its borrowing by ordering the central bank to print more and more
notes. If it did so the notes would soon lose their value and acceptability.

Treasury bills these are a kind of very formal IOU, issued for large sums and sold to banks
and other institutions prepared to lend money to the government on a short-term basis.

Other Government paper bonds, certificates, and other financial instruments sold
directly to the public and not to banks and building societies. The best known of these paper
securities are the national savings certificates and bonds that are issued through post offices or
through the Bonds and Stock Office in Blackpool. The bonds known as gilts (gilt edged
securities) are marketable, i.e. they can be bought and sold through the Stock Exchange at their
current market price. Others can only be bought and sold directly through the Bonds and Stock
Office on terms specified at the time of issue.

During the 1980s the British Government sought to finance as much as possible of its PSBR through
the non-bank, non-building society private sector and the overseas sectors as these sources were
thought to have less effect on the money supply than borrowing from the banks. However, in a highly
complex financial structure such as that of the United Kingdom there is some doubt as to whether that
is really the case. It was also able to increase its revenue income by privatisation, i.e. by the sale of
shares in the former public corporations such as British Telecom, British Gas and British Airways,
when these were turned into public liability companies and transferred technically from the public to
the private sectors of the economy. In doing this the Government was accused of selling the family
silver and there is certainly some doubt as to the long term desirability of treating as revenue the
proceeds of the sale of capital assets.

The General Government Financial Deficit

The danger with all the major economic indicators is that governments and others find ways to distort
it so that it ceases to be a reliable guide to the true position it is supposed to indicate. Some
economists argue that the British PSBR can be subject to distortions of the kind produced by
privatisation receipts in the 1980s and early 1990s and is, therefore, not always a true indication of
the relationship between the governments main taxation revenues and expenditure. They argue that a
more realistic picture of the relationship between government revenue and expenditure is provided by
the General Government Financial Deficit (GGFD). This is a simple measure of the difference
between total tax collections and the net spending by the whole of central and local government. It is

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Inflation

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Unemployment

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Trade Difficulties

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Regional Problems

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Monetary Policies

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Direct Controls

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Government Spending

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Policy Conflicts and Priorities

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Difficulties in Pursuing all Objectives at Once

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Differences in Priorities

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Supply-side Policies

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The Natural Rate of Unemployment

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Supply-side Objectives

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Taxation and Fiscal Measures

260

Trade Unions and Supply

262

Encouragement of Competition

262

The Removal of Bureaucratic Controls over Business

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Economic Problems and Policies

A. THE MAJOR ECONOMIC PROBLEMS

What Is An Economic Problem?
In many respects, an economic problem, as perceived by a government, is an aspect of what is
generally known as the fundamental economic problem i.e. the attempt to satisfy unlimited wants
with scarce resources, so that full satisfaction is impossible and choices have to be made between
competing claims on those resources. At the same time, this general problem is aggravated by
inefficiencies in the production system, so that the achievement of available resources is not as great
as it might be.
In practice, we can identify a number of distinct problems which afflict modern industrial economies
and which are considered to be within the power of modern governments to reduce, if not totally
solve.

Inflation
We have already noted this. Inflation is the term used to describe a condition of constantly-rising
product and factor prices the main factor price being wages: the price of labour. Inflation is a
problem because it makes the production and distribution system less efficient. It creates
uncertainties about costs and it makes planning more difficult and uncertain. It makes long-term
agreements difficult to make, because past agreements become unjust as the value of any agreed
constant payment is steadily reduced. Money is unable to fulfil those functions which depend on
confidence that it will retain its purchasing power and acceptability in the future. Savings lose their
value, and people who have saved for future needs feel a sense of injustice. Countries suffering the
most severe rates of inflation find that their exports become more expensive and difficult to sell in
world markets, while imports become cheaper and grow in volume.
If inflation is not checked, it increases in intensity until prices rise daily and all confidence in money
is lost. Trade reverts to a basis of barter, and all confidence in the financial system collapses. This
condition of hyperinflation is, usually, associated with extreme political and social unrest and
uncertainty for the future.

Unemployment
Unemployment is said to exist when resources, especially people, available and seeking employment
cannot find employment. It is an economic problem, in the sense that the community loses the
production that could have been achieved, had all resources been employed. Unemployment is also a
major social problem because work is an important element in a persons standing in the community.
A person who feels that he ought to be working but who cannot find work often feels rejected by
society and, not uncommonly, resorts to anti-social behaviour.
We have already noted that Keynesians and monetarists have differing views concerning the nature
and causes of unemployment, and it is convenient here to summarise some of these important
differences.
(a)

Both groups agree that there are elements of frictional and structural unemployment but
monetarists believe that the structural element in modern Britain is higher than it need be,
because relatively high unemployment and welfare payments reduce the pressures to adjust to
changing economic conditions. They also believe that social attitudes by trade unions delay
adjustment to change.

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(b)

Keynesians believe that much unemployment is caused by a deficiency in total demand

consisting of household spending (C), business investment (I) and government spending (G).
This element is sometimes referred to as demand deficiency, or Keynesian unemployment.
Monetarists believe that, if it exists at all, its extent is exaggerated by Keynesians.

(c)

Monetarists believe that the natural rate of unemployment would be very small if markets were
free to operate according to the unrestricted interplay of the normal market forces of supply
and demand. The natural rate of unemployment is that rate which exists when the total demand
for labour is roughly equal to total supply. People are then unemployed for frictional reasons
the normal wear and tear of firms closing, people changing jobs for personal reasons and so on
and structural reasons changes in the labour market caused by shifts in product demand and
changes in production technology. A high rate of unemployment is, therefore, blamed on
imperfections in labour markets. These are seen mainly in terms of failure to understand and to
adjust to structural change, and undue trade union power. They argue that a large part of high
unemployment is voluntary, in the sense that people are waiting for jobs they think suitable,
instead of accepting what is available, and because they support trade union measures which
force wages above the market equilibrium and, so, reduce the demand for labour.

Trade Difficulties
These are closely associated with inflation which increases export and reduces import prices in world
markets. Both Keynesians and monetarists would agree that rising imports indicate a condition
where demand is greater than the supply from the home-production system. However, whereas
Keynesians would concentrate attention on what is perceived as excess demand, monetarists pay
more attention to failings in the supply or production system which they would tend to regard as
inefficient for a variety of reasons, including trade union power, lack of profit incentives, inefficient
management, often associated with monopoly power and bureaucratic barriers to business enterprise.
The UK has suffered from persistent trade problems since the early 1960s. Between 1980 and 1986
these were largely hidden by earnings from North Sea oil but as you will see later in the course there
have been further problems since those years and the UK now imports more manufactured goods than
it exports. The traditional earnings from financial services are no longer as reliable as they have been
in the past so that trade revenues remain very much a problem area for the British economy.

Regional Problems
If you live and work in the United Kingdom, you will, probably, be aware that the central problems of
inflation and unemployment do not affect all areas of the country with equal intensity. In the
southern areas, for example, inflationary pressures seem to be greater, whereas unemployment is,
generally, more severe in the northern areas. If you live in some other country, you are likely to be
aware of similar regional differences. These are regarded as economic problems, because the failure
of some areas to develop as successfully as others suggests that production is being lost through the
under-use or inefficient use of available scarce resources.
People tend to think that they are well or badly off, according to the comparisons they are able to
make with other people. If living standards and employment opportunities are very different in
different regions, there is likely to be social and political discontent. There is also the problem that
large-scale movement of people from one region to another to find employment is a further possible
cause of social trouble, as families are divided and pressures build up on housing and other services
in the more prosperous areas.

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The regional problem as it relates to the United Kingdom is examined later in this study unit. You
should try to apply similar general principles and arguments to the problems of your own country, if
this is not the UK.

Lack of Adequate Economic Growth

What is adequate depends on what is achieved elsewhere. If the economy of the UK grows at the rate
of 1% per year, this will be seen as inadequate if other countries of similar size and stages of
development are able to achieve growth rates of 4% or more.
It is also true that all the problems identified in this study unit so far seem fairly minor if the economy
is growing at what is seen as a fast rate, and if living standards for the great majority of the people are
rising fast and constantly. If, on the other hand, there is very little growth, then these problems
become magnified and harder to solve. Peoples aspirations may be raised by what they see being
achieved in more successful economies, and there is dissatisfaction and unrest at the failure to make
similar progress at home. When there is a high rate of growth, governments have resources to
introduce measures which are politically popular, and their chances of keeping power are greater.
Low growth and inability to carry out popular measures make it difficult for governments to stay in
power, at least by democratic means.
Economic growth, with particular reference to the UK experience, is examined more fully later in the
course.

B. POLICY INSTRUMENTS AVAILABLE TO

GOVERNMENTS
Fiscal Policies
These relate to the use of government spending and taxation as instruments to influence the economy.
They are chiefly associated with Keynesian ideas of using the power of the government to influence
aggregate demand on the assumption that the economy is demand led, i.e. that total supply responds
to changes in total demand.
The belief that a government can influence the behaviour of an economy by influencing total demand,
largely through fiscal policies, owes much to the arguments of Keynes and the set of economic
principles that are broadly known today as Keynesian. To understand these, it is helpful to remind
ourselves of the simple Keynesian model of the economy. This is shown below in
Figure 15.1.
Assuming that the scale of the national income axis is the same as for national expenditure, the 45
line represents the series of equilibrium positions where total income = total production = total
expenditure. Total demand is shown by the C + I + G curve. This, ignoring foreign trade or assuming
it to be in balance, shows total or aggregate demand as consisting of household consumption (C), +
business investment (I) + government spending (G). Given the position of this particular C + I + G
curve, the economy is in equilibrium with total income = total expenditure at level Oe but this lies
below the level of national income where there is full employment (i.e. where all resources available
for and desiring work, are employed). The consequent differences between what could be produced
at the level of Of and total demand at that level is the deflationary gap, represented by Oa Ob. As
long as this gap remains, there will be unemployment, caused by the deficiency of total demand. The
remedy this analysis suggests is, clearly, to raise the total demand curve.

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Figure 15.1
Roughly the same idea is illustrated through the familiar supply and demand analysis shown in
Figure 15.2.

Figure 15.2

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If an increase in demand is to reduce unemployment, then it must be assumed that total supply and,
therefore, the demand for labour and other production factors will rise in response to the change in
demand. The extreme Keynesian position assumes that supply will always respond fully to an
increase in demand, as long as there are unemployed resources in the economy. It will cease to do so
only at the full employment level, where all available resources are already employed.
This view produces the total supply curve shaped as in Figure 15.2. It is totally elastic as far as the
full employment level Of, and then it becomes totally inelastic.
Thus, an increase in total demand at any level below Of will result in a rapid increase in supply. In
the model, the increase, following a shift of total demand from DD to D1, is from Os to Os1. The
increase in supply will be achieved by employers increasing production and their employment of
labour, etc.

Demand Management and the Deflationary Gap

If our theory suggests that to reduce unemployment we must raise total demand, then the problem
becomes one of how to achieve this. Our earlier national income analysis suggests that this can be
achieved by injections of new demand which will then be multiplied within the economy to produce
the new and higher equilibrium level that is desired.
Keynesians argue that the desired effect can be achieved if the government is prepared to operate
with an unbalanced budget i.e. if it spends more than it receives in taxation. This means that, to
raise the total level of aggregate demand, the government can increase its own spending (G) without
increasing taxes, and/or reduce taxes in order to encourage household spending. Remember that
Keynesians believe that the most powerful influence on total spending is income. A reduction in
income tax will increase peoples net, disposable income, so that they will increase their spending in
accordance with the marginal propensity to consume.
Fiscal policies are, thus, very important to the Keynesian, because it is through the adjustment of
taxation, and income tax in particular, that the government is able to influence the level of disposable
income, changes in which will have an immediate effect on spending and, hence, on aggregate
demand which, in turn, produces a change in supply and the level of employment. The effect of the
income tax reduction does not end there. The initial injection of extra spending will produce a larger
change, in accordance with the national income multiplier. There will also be an additional impact
resulting from the perception by business firms that demand for their goods and services is
increasing. To meet the increased demand, they will increase investment and this produces a
further injection in the economy, with a further multiplying effect. The combination of investment
accelerator and national income multiplier will ensure that the total increase in demand will be larger
than the initial injection achieved by the tax reduction.
The Keynesian relies, then, on a fiscal policy of tax manipulation combined with a willingness to
tolerate an unbalanced budget to achieve and maintain full employment or something as close as
possible to full employment in the economy.
A reduction in indirect or expenditure taxes would also be expected to stimulate the economy,
because more of the consumers gross spending will actually go to the suppliers of goods and
services. Firms can be expected to increase the quantities they are willing to supply at each level of
market price the supply curve will shift to the right. The precise effect on output and price will
depend on the slopes of the demand and supply curves. This is analysed later in the study unit but we
can see that we would certainly expect some increase in supply and employment following a
reduction in indirect taxes a reduction which could also mean the governments having to be

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Governments generally think that they have more power than they actually possess. When controls
are imposed to prevent actions that people would otherwise take, there will be attempts to evade the
controls, and the government may be forced into increasingly difficult, complex and expensive
control measures. Many countries have sought to impose strict import controls, only to discover that
they have created a major smuggling industry, while many of those responsible for maintaining the
controls simply use their powers to increase their personal incomes with bribes from both legal and
illegal traders. We have only to note the problems of seeking to prevent the import of illegal drugs to
see what happens when a government tries to suppress trade for which there is an effective demand.
It is only too clear that a government cannot stop the abuse of drugs just by trying to prevent drugs
imports.

C. POLICY CONFLICTS AND PRIORITIES

Difficulties in Pursuing all Objectives at Once
Keynesians recognise the possible conflict of objectives more readily than monetarists. The success
of demand management depends on holding a very fine balance between total demand and total
supply, and any swing in one direction is going to lead to difficulties. In order to reduce
unemployment, the Keynesian will wish to expand demand, and he would be prepared to operate an
unbalanced budget. He accepts that this may bring about some price inflation, and that it could also
lead to rising imports and trade difficulties. To reduce unemployment, the Keynesian recognises that
he may increase problems of inflation and excess imports. Similarly, he will accept that action to
bring trade into balance, or to control price rises, will, probably, bring about a reduction in the growth
of the economy and in an increase in unemployment.
A monetarist will have a rather different analysis. He believes that, in the long term, successful
achievement of economic growth, successful trade and full employment all depend on an absence of
inflation and a stable financial system. He believes that business enterprise, freed to operate in
unregulated markets, will achieve growth, exports and employment, provided that the government
keeps its own spending under control, keeps a tight grip on the money supply, and avoids inflation.
There is, therefore, no fundamental conflict of aims in the monetarist analysis in the long term.
However, starting from a position of high inflation and unemployment inherited from a period of
Keynesian misguided demand-management, the monetarist believes that it is not possible to avoid
some increase in unemployment. The monetarist is also sceptical concerning Keynesian remedies for
regional problems, as explained in the next section of this study unit.
The monetarist does not believe that macroeconomic policies, as understood by the Keynesian, are
effective at all. The Keynesian is concerned with aggregates, in the belief that injections of demand
from government spending and tax reductions will operate on the economy as a whole, to increase
employment. The monetarist is not convinced that the government has the power to influence the
whole economy in this way, and he tends to prefer supply-side policies which operate on the economy
through improving the operation of individual product markets i.e. through microeconomic
measures. If all, or the majority of, individual markets operate more efficiently, then the economy as
a whole will prosper.

Differences in Priorities
If, to begin with, we adopt the Keynesian position, then it is clear that there has to be some sense of
priorities in choosing objectives. This is because not all can be pursued at once. The Keynesian
would argue that his most important objective is to achieve and maintain full employment but that
this may have to be modified from time to time if inflation or trade difficulties become too serious.

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However, the main objective is always to avoid large-scale unemployment; and, if this is threatened,
some inflation or trade imbalance may have to be accepted.
Critics of Keynesian economics would suggest that, in practice, governments do little more than react
to a series of crises, lurching between expansion and deflation as each problem becomes steadily
more serious and as the production system becomes increasingly dislocated by sudden shifts in
demand policy. They see the inevitable consequence as uncontrollable inflation which, eventually,
brings about mass unemployment as the production system fails to compete with more efficient
foreign systems.
The monetarist, thus, argues that there is no alternative to controlling inflation and freeing privatesector markets from controls and barriers, so that they can expand production and increase
employment. In the meantime, however, the effect of reducing public-sector activity and restoring a
more competitive and efficient private sector is likely to cause strains and to increase unemployment.
We have seen earlier that monetarists differ in their approach to the timing of policies. Some prefer a
gradual approach, accepting that inflation should not be brought down too swiftly, in order to avoid
the social and political upsets of too rapid a rise in unemployment, while others consider that the
adjustment can be carried out more quickly and that more vigorous methods can be applied to remove
restrictions to industrial markets.

D. SUPPLY-SIDE POLICIES
The disappointing experience of demand management policies when inflation became a major
economic issue and the monetarist argument that demand expansion almost invariably led to inflation
because of the failure of domestic production to respond quickly enough to demand stimulation led to
the development of what became known as supply-side economics. It is monetarists who are most
closely associated with modern approaches to the stimulation of supply. In this approach, supply-side
economics is seen as the use of microeconomic incentives to change the level of full employment, the
level of potential output and the natural rate of unemployment. The objectives are to increase total
production, to increase the productivity of labour, and to make producers more competitive in world
markets. A government pursuing supply-side policies wants business firms to produce more and to
employ more labour but to do so profitably, in competitive markets.

The Natural Rate of Unemployment

Central to understanding the theory on which supply-side economics is based is the concept of the
natural rate of unemployment. This is the rate at which the labour market is in equilibrium i.e. in
which labour demand is equal to labour supply, so that there are no pressures to increase or decrease
money wages. This concept and the related diagrammatic model were introduced in Study Unit 13
but it is summarised again in view of its importance to the contemporary debate over appropriate
policies for reducing unemployment without increasing inflation.
The natural rate of unemployment will never be zero, because at any given time there will be
unemployment arising from two important causes. These are known as frictional and structural
causes. Frictional unemployment arises from the normal wear and tear of business life. There will
always be people changing jobs, for a whole range of different reasons, from dissatisfaction with an
employer or with working conditions; because of moving home; the failure of individual firms; or just
simply boredom or the desire to do something different. It is not always possible to move
immediately from one job to another, although the average length of time that a frictionallyunemployed person can expect to be without work varies with the level of total unemployment. It is
not, usually, more than a few weeks.

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Structural unemployment has two related meanings. It arises, on the one hand, from shifting patterns
of demand. If, for example, many women decide to give up wearing jeans and trousers, and instead
choose to wear skirts and dresses, then jeans manufacturers will have to lay off workers, while skirt
manufacturers will be expanding their activities. Different firms in different localities may be
involved, and it is not always possible for workers in the declining activity to move quickly into one
that is expanding.
The other form of structural change is also known as technological change. It arises from changing
production methods, usually from the increased use of machines, including advanced electronic
devices and computer software which can do a great deal of work previously carried out manually.
When this kind of change takes place, there is no immediate compensating expansion in another
activity. New technology always creates new activities and occupations in time but these may be
very different from the old, requiring new and different skills, and they are often located in
completely new areas. Structural unemployment from technological causes can be greater and more
disruptive than that from shifts in demand.
The two types, however, are often related, in the sense that new technology creates new products
which replace old ones. The transistor destroyed the radio-valve industry; the small electronic
calculator destroyed the production of slide rules and mechanical calculating machines. Modern
electronics has, in fact, changed a great deal of product demand, and it has had a very great impact on
the labour market.
It is clear, then, that, if we regard the natural rate of unemployment as being made up of frictional and
structural unemployment, it is likely to be much higher today than it was in the 1950s and the early
1960s, before the current electronics revolution. Where monetarists differ from other, particularly
Keynesian, economists is in their belief that the whole or almost the whole of the actual amount
of unemployment is natural unemployment. If the actual rate of unemployment is seen as being at a
level which is socially and politically unacceptable and economically damaging, in the sense that
production that would be possible at a higher level of employment is being lost then the problem
lies in reducing this natural rate. Monetarists believe that this natural rate is too high, and that it can
be reduced by microeconomic (supply-side) policies.
The effect of the natural rate of unemployment is illustrated in Figure 15.3.
In this model, the curve WP represents the labour force that is available for work, and it is the
working population, recorded as wishing to work.
The curve SL lies to the left of WP, and it represents the actual supply of labour i.e. those workers
prepared to take a job at the wage offered. This supply is less than the working population at each
wage level, because there are always those between jobs (frictionally unemployed) and those who
have not adjusted to the changed structural position in which they are now unable to obtain work at
their previous earnings level, and they still hope to obtain better jobs than those on offer. Given the
demand schedule for labour, the equilibrium employment level is at E at wage rate OW, and the
quantity of workers represented by the distance EZ is the natural rate of unemployment. This
analysis, so far, assumes that the market is left to find its own equilibrium, without outside
intervention. If, in fact, there are trade unions powerful enough to force up the actual wage level
above OW to, say, OWu, then the actual rate of unemployment is increased to UB. On to the natural
rate, as previously defined, which is now AB, there is the additional collectively-agreed
unemployment resulting from trade union influence. This is, normally, regarded as part of the natural
rate of unemployment at the higher wage level.

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Figure 15.3
Almost the whole of this unemployment (UB) is also seen by supporters of this view as voluntary
unemployment, in the sense that it is the consequence of unwillingness to accept the realities of
market supply and demand, and of individual and collective decisions to achieve what people regard
as acceptable wages, rather than market-determined wages. Those who do obtain these wages may be
regarded as doing so at the expense of those unable to find work at all, because the number of jobs on
offer at wages above market equilibrium is lower than the number of workers seeking those jobs.
Figure 15.3 gives the general analytical model. The actual distances UA, AB and EZ are not based on
any statistical research. Indeed, these are the subject of some controversy, and you can imagine that it
is extremely difficult to produce the actual SL and the total demand for labour schedule.
Clearly then, monetarists and supporters of supply-side theories, take an almost opposite view to
Keynesians of the basic causes of unemployment. Whereas Keynesians see unemployment and
inflation as opposite forms of national income disequilibrium (the deflationary and inflationary gaps)
monetarist/supply-siders see unemployment and inflation as caused by similar forms of market failure
with inflation as the primary result of this failure and helping to produce unemployment by pricing
domestic production and production workers out of employment in world markets. Much supply-side
policy, therefore, depends on removing imperfections, including government intervention, from
product and factor markets.

The Removal of Bureaucratic Controls Over Business

It has been a frequent complaint of business managers that costs have been raised, efficiency reduced,
and expansion hindered by the great range of planning and other bureaucratic controls to which
business has become subjected in the second half of this century.
Controls on business activity have been imposed for, generally, sound social reasons usually, to
protect the environment and to prevent indiscriminate expansion of industrial activity, to protect
workers from exploitation, to protect consumers from unscrupulous or careless marketing and
production. A defence could be made for every measure but, taken as a whole, their cost has become
great, and if the general result is to reduce output and employment, then the balance of cost and social
benefit may have swung against the overall interests of the community.

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A. THE BALANCE OF PAYMENTS

Trade Revenues and the National Income
We now return to our basic model of national income. Remember our proposition that total
expenditure = total spending = total product. In a closed economy, where there are no foreign
payment transactions (or where these are ignored):
!

total income can be expressed as Y = C + S + T; and

total expenditure, which also represents total demand (the desire to spend) can be expressed as
E=C+I+G

where: Y = national income; C = consumer spending; S = household saving;

T = taxation; E = total spending; I = business investment and
G = government current capital spending.
From these propositions, we saw that, when national income and expenditure are in equilibrium i.e.
when total spending demand = total production and income then, because C features on both sides
of the national income/expenditure identity, S + T = I + G. If the government pursues a balancedbudget policy, then this will force savings towards equality with investment.
When we open up the economy to take into account foreign payment transactions, then this pattern
has to be modified. If, for simplicity, we ignore non-trading transactions in international payments,
then we can limit our consideration to the production of goods and services. Some of these will be
produced at home and give rise to domestic factor incomes (exports), and others will be produced in
other countries and bought at home (imports). Thus, some part of total income will be leaked away
through spending on imports, while total spending demand will be augmented by the expenditure of
foreign people on a countrys exports. Imports are, therefore, a leak from the circular flow of
economic activity, while exports can be regarded as an injection.
Using the symbol M for imports (because I has already been used for investment) and X for exports
(because E has already been used for expenditure), we can now incorporate trading transactions into
the model. We can do this either by adding to both sides of the equilibrium equation
i.e. S + T + M = I + G + X or we can emphasise the rather separate nature of these transactions by
keeping M and X together. We can then ignore them on the income side and include them on the
expenditure side, to produce: C + S + T = C + I + G(X M), where X M represents the net
expenditure flow resulting from the balance of trading transactions. If import payments exceed
export receipts, then the net result is, of course, negative.
Notice that C has been reintroduced here, because we can regard much spending on imports as being
a part of household consumption. Total import spending from total income will, of course, be made
up of spending on consumer goods, on investment goods, and on goods required by the government.
If total imports equal total exports in value, then there is no direct effect on the size of the national
income flow. Leaks are just balanced by injections. If import payments are greater than export
receipts, then there is a contraction in the circular flow. If export payments are greater than import
payments, then there is an increase. Remember always that it is payments that concern us, not
volume. These effects can be illustrated as in Figures 16.1(a) and (b).
Here we see how a net excess of import payments brings down the equilibrium level of national
income (Figure 16.1(a)), while a net excess of export earnings increases it (Figure 16.1(b)). This,
after all, is what normal common sense leads us to expect. People gain jobs and earn incomes by

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providing and selling goods and services for export. If, on the other hand, people spend their incomes
on foreign-made goods, then this leads to the creation of jobs and incomes in foreign countries.

Figure 16.1
Another method of illustrating this is as in the graphs of Figures 16.2(a) and (b). In Figure 16.2(a),
we see the effect of increasing injections by net export earnings the equilibrium level of national
income rises from Oe to Oe1.

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Figure 16.2
In Figure 16.2(b), imports raise the slope of the withdrawals (S + T + M) curve to bring down the
equilibrium income level from (Oe to Oe1). Notice that net exports are shown as a parallel line,
indicating that they do not rise directly as national income rises, whereas imports are shown as having
a greater effect at higher income levels. This is because the consumption element in imports
increases with higher incomes, showing a behaviour pattern similar to that of any other form of
consumption.

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These illustrations help us to appreciate how imports reduce the value of the national income
multiplier, in the sense that:
(a)

increased consumption on imports makes the withdrawal curve steeper; the value of the
multiplier is 1/w and any increase in the value of w, which represents the steepness of the
withdrawal curve the propensity to withdraw, reduces the value of the reciprocal of w;

(b)

any increase in the import element in business investment spending reduces the net rise in I
and, hence, the injection brought about by I; if a firm buys machines made in another country,
it is not creating jobs in home factories;

(c)

any government spending on imports reduces the value of G to the domestic income in exactly
the same way.

There is nothing strange in any of these propositions. They are exactly what we would expect.
However, we should remember that they all assume that the home and foreign economies are entirely
distinct i.e. that the home economy is not affected in any way by changes in foreign economies. A
little further thought causes us to doubt this. Modern economies are closely interrelated.
It is true that there is no direct relationship between the size of the national income of country A and
the level of exports to country B but, if the two are trading partners, the national income of country B
and its ability to buy goods from A will depend to some extent on its ability to sell its own products to
A. There is a connection, and we should beware of making over-simple deductions from the
apparently obvious propositions above.

The Balance of Payments Accounts

The balance of payments is defined as a systematic record of all economic transactions between the
residents of a country and the rest of the world during a period of time.
The national accounts which give details of payments and receipts and general financial transactions
with other countries are called the balance of payments accounts. They mostly follow a fairly
standard pattern, so that, although the following details relate chiefly to the United Kingdom, the
main principles involved are likely to apply to most countries.
There are two main accounts:
!

The Balance of Payments on Current Account

Transactions in external assets and liabilities (the Capital Account)

The Current Account is divided into:

The Visible Trade Account The Balance of Trade

The Invisible Trade Account services, transfers and interest, profits and dividends.

It is important to remember that the accounts represent flows of money. These flows are in the
opposite direction to those of goods and services. For example, exports flow out, payment for them
flows in; British ships carry goods for German firms and payment flows in. Capital investment by
UK companies in America is an outflow of money, whereas the purchase by Americans of shares in
British companies is an inflow.

Structure of the Accounts

The Balance of Payments accounts are shown in Table 16.1, where a minus sign represents money
flowing out of the country and a plus sign indicates money flowing in. We shall then go on to discuss
what the various items mean.

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billion
Current account
Goods
Exports
Imports
Balance of visible trade

+121.4
134.6
13.2

Services
Exports
Imports
Interest, profits and dividends
IPD receipts
IPD payments
Transfers
Transfer receipts
Transfer payments
Balance of invisible trade

+36.6
31.6
+74.0
71.0
+5.4
10.5
+2.9
10.3

Balance of payments on current account

Transactions in external assets and liabilities
(the Capital account)
Direct and portfolio investment
Investment overseas
Investment in the UK
Net investment

102.9
+49.5
53.4

UK bank transactions
Lending abroad
Borrowing abroad
Net lending and borrowing

+12.7
+23.7
+36.4

General Government Transactions

Overseas assets
Overseas liabilities
Net increase or decrease
UK non-banks transactions
Lending overseas
Borrowing overseas
Net lending and borrowing

0.6
0.1
0.7
10.1
+12.7
+2.6
+8.3

Net transactions in assets and liabilities

(balance of payments on capital account)
Balancing item

+2.7
(Note: The figures may not add because of rounding)
Table 16.1: The UK Balance of Payments in 1993

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Visible Trade
When we think of trade, we usually think first of trade in actual physical goods, such as motor
cars, oil, food. This is, normally, called the trade in visible goods, and the balance between
the value of imports and exports is called the visibles balance. Some writers and
examiners still refer to this as the trade balance or balance of trade so, you should be
prepared to meet this term.
Visible trade is usually classified into a number of broad groups, and it is useful to look at the
composition of UK trade on the basis of these groups. (You should try to obtain similar figures
for your own country, if this is not the United Kingdom.) The main classes are the following:
!

Food, Beverage and Tobacco

In 1993, over 7% of Britains exports and a little under 10% of her imports were in this
group. Imports account for a substantial share of food in the UK but they are no longer a
dominant part of trade.

Basic Materials
Sometimes referred to as raw materials, these are the basic metals and commodities
required for manufacturing. The UK has few of these to export and less than 2% of
exports fall into this class, but it accounts for a little under 4% of imports (1993).

Mineral Fuels and Lubricants

This class, of course, includes oil, and here, the British position has changed since the
discovery of oil in the North Sea. British oil is of high quality too high to use on its
own for most purposes and it has to be blended with the heavier oils of the Middle
East. The UK, thus, both imports and exports oil, and it accounted for over 6% of
exports and over 4% of imports in 1993. Exports of North Sea oil reached their peak in
1985.

Semi-manufactured Goods
In 1993, these accounted for over 29% of exports and over 25% of imports. The
massive trade in components and goods destined to become parts of other goods
illustrates the international nature of modern production. Descriptions such as made in
Britain usually mean assembled in Great Britain from goods made in several other
countries. Much of this trade in semi-manufactured goods represents trade between
different parts of the same large company group. This is called intra-company trade,
and it has become a most important part of total world trade. Its implications are
considered more fully in a later study unit.

Finished Manufactured Goods

There is still, of course, a substantial trade in finished products, and these form the
largest group for both imports and exports in 1993, they accounted for over 53% of
exports and nearly 54% of imports. There was, in that year, a substantial deficit in
finished manufactured goods.

If you add up the figures given so far, you will notice that there is a gap for both imports and
exports. This 2% gap, represents commodities and transactions not classified according to any
of the groups (a) to (e), above.

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(b)

Direction of Visible Trade Flows

We should also be aware of the main trading partners in this general process of international
exchange. Britains main trading partner has, for some years, been the rest of the European
Community as anyone living near one of the main roads to the Channel ports knows only too
well. Increased trade was one of the main benefits hoped for by the UK when she joined the
Community, and this has, indeed, taken place. Over 52% of exports and over 51% of imports
related in 1994 to the EU, but this trade resulted in a deficit of nearly 4,000 million.
Other western European countries accounted for over 8% of exports and over 11% of
imports, so that, in 1993, about 62% of British trade was with western European countries.
In the same year North America accounted for over 14% of exports and 13% of imports; other
developed countries for nearly 4% of exports and 7% of imports; and the oil-exporting nations
for nearly 5% of exports and over 2% of imports; leaving a little over 15% of exports and
imports for the rest of the world. As far as these geographical groups are concerned, by far the
largest deficit was experienced in trade with western Europe, including the European
Community. The largest favourable (from the British viewpoint) balance was with the oilexporting nations.

(c)

Invisible Trade
Invisible trade is so called to distinguish it from trade in goods, which are tangible items. It
consists of:
!

Services including sea and air transport, tourism, consultancy and financial services. In
1992 the City of Londons invisible earnings were 10,572 million.

Interest, Profits and Dividend (IPD) comprising interest on borrowing and lending
abroad by UK banks, remitted profits in overseas branches where a UK company has
made a direct investment or to foreign firms investing in British subsidiaries, and
payment of interest and dividend on portfolio investment in stocks and shares.

Transfers of funds to or receipts from other countries for non-trading and noncommercial transactions. The government is responsible for most transfers in the form
of grants to developing countries, subscriptions to international organisations like the
United Nations and net payments to the European Community. Private transfers include
payments to dependants abroad by UK residents, and gifts.

The amount of IPD earnings depends on the amount invested in the past. Direct investment
refers to the purchase of foreign assets. It includes buying control of firms in other countries,
establishing subsidiaries and acquiring land and property. Portfolio investment is in stocks and
shares. IPD receipts are influenced by the level of interest rates and the conditions in the
economy which affect interest and dividend payments.
Profits and dividends in the balance of payments can cause confusion about how they appear in
the accounts. If a British company has a wholly-owned subsidiary overseas which earns a
profit, the invisible earnings are the profit remitted to the UK, but the part of the profit which is
retained in the overseas subsidiary is treated as a capital outflow and appears under direct
investments in the capital account. If the British company does not control the overseas
subsidiary but receives a share of the profit, it only appears in the invisible account.
A more detailed breakdown of the balance of invisibles is shown in Table 16.2. This shows the
main group headings and the actual balances (difference between money going out and money
coming into the country). Study these group headings carefully. You will see that, for the

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United Kingdom, the largest money outflows are accounted for by general government
transfers, Travel, General Government services and General Government Investment income.
Clearly the public sector develops a substantial deficit with the rest of the world through its
grants to foreign countries and organisations and the cost of foreign aid and for armed forces
overseas. Travel includes both tourism and business travel. The deficit under this heading has
widened considerably in recent years, suggesting that foreign holidays have become more
popular with the British.
The largest inflow of funds comes from the financial services and other services, many of
which are related to industrial and commercial services and invisible exports, such as the
royalties received for pop music, television films, business management services, and so on.
Britain also receives money for licences and patent rights for goods manufactured overseas.
She has become an exporter of skills and know-how, as well as of finished goods.
When you study the table, remember that the service headings Sea transport and Civil
aviation refer to travel on ships and aircraft. Trade in ships and aircraft themselves is, of
course, part of the countrys visible trade.
Note also the heading Investment income. This relates to the earnings received from past
investment in foreign countries less payments to foreign investors in Britain. This net balance
has fluctuated during the past decade and although it continues to provide a substantial inflow
of revenue we must expect the capital investment in British industry by foreign companies to
lead to increased payments of profits to foreign investors.
Table 16.2 shows the visible balances for 1983 to 1993, the main classes of invisibles and the
resulting total balance, which is shown as the current balance of payments.
This figure represents a countrys income or loss following a years general trading with the
rest of the world. The importance of this balance is examined in the next section of this study
unit.

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Table 16.2: Balance of invisibles/visibles

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(d)

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The Capital Account

The correct name for this account, as we have seen, is Transactions in external assets and
liabilities. This account records only changes in assets and liabilities. When the pound rises
in value against other currencies it becomes relatively cheap for British companies to invest
abroad, whereas if the dollar is strong compared to sterling,
American investors will buy assets in the UK. Portfolio investment is undertaken by pension
funds, unit trusts and investment trusts to diversify their portfolios and to seek gains from
rising share prices in rapidly growing countries.
The cumulative effect of investments into and out of the UK is that, at the end of 1993, the
UKs balance sheet (its external assets and liabilities) showed a surplus of assets over liabilities
of 20.3 billion.

(e)

The Balancing Item

The balancing item is a statistical adjustment to account for the failure to record some of the
thousands of items in the current and capital accounts. It is the difference between the
recorded entries in the balance of payments accounts and the change in official foreign
exchange reserves.

Table 16.3 develops the information in Table 16.1 by providing a summary of the full balance of
payments for the years 1983 to 1993. You will see that, apart from the current balance, there are a
number of other monetary movements which, together, cancel out the current balance. At this stage
of study, you do not need a detailed knowledge of these but note that they include movements of
capital (the capital account), payments to and receipts from the International Monetary Fund (IMF),
and a range of transactions with foreign monetary authorities.
From this table, you can see what is meant when it is said that, in the end, the balance of payments of
a country will always balance, but, in effect, this balance may have to be achieved by borrowing,
from payments from past reserves and with the help of a balancing item which is often quite
substantial! The really important balance, though, is the current one. This shows whether the
country is trading profitably and successfully or not. It is the current balance which is the best
indication of a countrys economic health. No country can overspend its current income and draw on
past savings or borrow from other countries for ever.

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Table 16.3: Summary of balance of payments

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B. PAYMENTS, SURPLUSES AND DEFICITS

Current Balance Surplus
We have seen how a surplus of revenue from all forms of export over payments for imports results in
the equilibrium level of national income being raised.
The implications depend on whether or not the extra money available for spending pushes the
national income equilibrium above the full employment level. If it does i.e. if demand for goods
and services is greater than the amount of goods and services available for purchase then there will
be inflation i.e. prices will rise, or there will be shortages.
If it does not, then the extra inflow of money will generate extra economic activity, and
unemployment will fall. The general level of employment and standard of living of the country will
rise. This is often known as an export-led boom.
However, if there is pressure on the countrys capacity to produce sufficient to meet the higher level
of total demand, inflation may still be avoided if the country exports some of the surplus money by
investing abroad, or by making loans or grants to other countries. This may help these countries to
develop their economies, and it will also help the revenue-exporting countrys invisible balance in
future years.
The ability to allow or to encourage money to be used abroad will also help the countrys political
power and influence. It is little wonder that governments seek to achieve a balance of payments
surplus on current account.

Current Balance Deficit

The equilibrium level of national income is reduced by an import surplus. In this case, money flows
out of the country and the flow of goods and services in relation to the pressure is increased.
The immediate effect, again, depends on the existing level of economic activity. If the economy is
operating under inflationary conditions, with demand greater than can be satisfied at full
employment, the deficit will reduce the inflationary pressure. People who cannot buy home-produced
goods, because not enough are being made, will buy foreign goods instead.
However, if the economy is operating at lower than full employment, then the effect is to increase
that rate of unemployment more people will lose their jobs, and more machines will be idle.
In an advanced country, this can be only a fairly short-term effect, as a deficit causes other problems.
These problems lead to measures to correct the deficit, and there are then yet further effects on the
price level and on the extent of unemployment.
In a developing country, a deficit can be tolerated for a longer period, if it can be financed by foreign
countries or by loans from the International Monetary Fund as measures to raise general world living
standards and increase the speed of world economic development.
In the advanced country, the outflow of funds to pay for imports will be greater than the inflow paid
for exports. This means that the demand for foreign currencies to pay for foreign-produced goods
and services is greater than the demand for the home currency to pay for that countrys goods sold
abroad. In this situation, the exchange value of the home currency is likely to fall.

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Causes of a Persistent Current Balance Deficit

It is difficult to work out effective remedies for a balance of payments deficit, unless the causes of the
problem are known. We have to admit that there is some uncertainty on this question. It is possible,
however, to examine some of the influences operating on the pattern of a nations trade.
(a)

Changes in the Terms of Trade

The terms of trade measures the relative movement of import and export prices. It is
calculated from:
unit value index of exports
100
unit value index of imports
The unit value index represents the average movement in price of a unit of imports or
exports. The unit itself is a kind of average of all types of visible imports and exports. The
terms of trade thus gives a general indication of how average import and export prices are
moving. The actual calculations for the UK for 1983 to 1993 are shown in Table 16.4.
We can analyse the results of changes illustrated by the index. At one time, a rise in the index
was regarded as being favourable because a given quantity of higher-priced exports could earn
enough to buy more imports. In the modern world, the results of trading-price movements are
a little more complex.
!

Import Prices Rise Faster than Export Prices

The effect will depend upon the elasticity of demand for imports. We can assume that,
in an advanced country, the demand for imported raw materials and foods and oil is
fairly price inelastic, whereas the demand for most manufactured (especially consumer)
goods is likely to be price elastic provided that the home country is able to
manufacture acceptable substitutes for foreign-made products. In this case, the demand
for the price inelastic goods will fall in a smaller proportion than the rise in price, so that
the total cost of payments for these imports will rise. In the case of imports the demand
for which is price elastic, the fall in demand will be greater in proportion to the rise in
price, and the total cost of these imports will fall.
For a country such as Britain, where over half of the imports consist of manufactured
goods, the effect of a change in import prices will depend on which imports are most
affected. A price increase on foods, basic materials or imported oil would create a
balance of payments deficit or make an existing deficit worse. If it is the prices of the
manufactured goods that rise, we would expect there to be a fall in the total cost of
imports. That is, of course, if demand is price elastic. If, in fact, there are not sufficient
home-produced alternatives to make good the higher-priced imported products, then the
demand may turn out to be inelastic and upset the predictions relating to total revenue.
For a developing country, most imports are likely to be demand inelastic if they are
needed to promote development, so that a rise in import prices would make for a deficit
or aggravate an existing deficit.

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Rise in Export Prices

Again, the effect depends on the price elasticity of demand for exports. In this
connection, a developing country exporting basic materials with price inelastic demand
would gain, and would receive an increase in total export earnings. In a developing
country, it might be difficult to absorb a large balance of payments surplus, and much of
it might have to be invested abroad until the home economy could be developed. This
was the case of some oil-exporting countries when they gained from oil-price rises.
One problem for a developing country that relies on the export of a few basic
commodities is that its living standards are very much at the mercy of world prices of
these commodities. When prices are high, the country might develop a standard of
living highly dependent on imports, and this might be very difficult to maintain when
world prices of the exported goods fall. It would be no use trying to stimulate demand
by reducing prices, because this would only cut export earnings still further.
For a country such as Britain, exporting chiefly manufactured goods, export demand is
likely to be price elastic and a price rise caused, perhaps, by home inflation is likely
to lead to a fall in total export earnings and, hence, to a deficit or the worsening of an
existing deficit.

(b)

Economic Weakness
Many economists think that relative price movements are little more than a symptom of
economic conditions, rather than a basic cause of those conditions. For a developing country, a
balance of payments deficit may simply reflect the world-market situation that ensures that
total export earnings for the volume of goods exported are not sufficient to provide enough
money to pay for the goods and services needed for development. The position will be made
worse if:
!

World demand is declining for the countrys basic exports, or

there is a failure in production, resulting from natural disaster or other causes e.g. a
crop failure or internal conflict, or

there is a high demand for imported consumer goods from a section of the population
that has developed a fashion or taste for imported clothes, cars or food.

For an advanced country, the problem may be caused by a weak economic or business
structure, an economy that is less successful than that of competing nations. If production is
cut by poor working methods, under-investment in modern machinery or labour disputes, then
export earnings are likely to fall and imports and the cost of imports rise, almost regardless of
price advances, in favour of the home country. Germany and Japan, for example, have been
consistently more successful in exporting than Britain and the USA.
(c)

Activities of Multinational Companies

About a third of international trade is made up of payments between the different parts of
multinational empires. These companies, operating on a world scale, may prefer to move
production away from high-cost, highly-taxed and closely-regulated countries to other areas
where they have lower costs and more control over production methods. It is notable that
countries with a high proportion of multinationals the USA and Britain tend to have
persistent problems with their balance of payments, whereas Germany and Japan which, until
recently, have not produced world-scale enterprises, have had very successful export records
and few balance of payments difficulties. It will be interesting to see which effect the

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development of German and Japanese multinationals has on those countries payments

balances.

C. REMEDIES FOR A CURRENT BALANCE OF PAYMENTS

DEFICIT
There are three main remedies for a balance of payments deficit.

Devaluation
By devaluation we mean the reduction in the exchange value of a nations currency in terms of
foreign currencies. For example, before devaluation a British pound might be equal to 12 French
francs but, after devaluation, it may be equal to only ten francs.
Devaluation may be allowed to happen through the normal operation of the foreign exchange
markets. If, on these markets, the demand for pounds falls and that for francs rises, the price of the
pound is likely to fall relative to that of the franc.
Alternatively, if exchange rates are fixed by governments, then the governments can change the value
by declaration. In whichever way it is brought about, a devaluation raises the price of imports and
reduces the price of exports, at least in the short term.
Some writers (and examiners) distinguish between devaluation (action by governments when
exchange rates are fixed) and depreciation (fall in value of a currency as a result of market
movements). You should be aware of this but you must also recognise that governments do
intervene in currency markets to try to influence market movements, and a change in interest is
sometimes brought about by a government in a deliberate attempt to change the currency value.
(a)

The J Curve
It is sometimes pointed out that in the very short term firms cannot change their plans. It takes
a little time for traders to react to international price changes resulting from exchange rate
movements. Consequently a swift devaluation or depreciation will increase the prices of
imports and decrease those of exports without changing quantities traded very much. The
immediate effect of the price changes will be to deepen the balance of payments deficit. Fairly
soon, however, plans and trading patterns are modified and we would expect demand for
imports to fall and foreign demand for exports to rise. The result would be to reduce the deficit
and, if the reactions were strong enough, to turn it into a surplus. This is illustrated by what is
usually known as the J curve, as illustrated in Figure 16.3.

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Figure 16.3: The J Curve

(b)

Importance of Demand Elasticities

For the changed trading pattern to replace a balance of payments deficit by a surplus, the rise in
demand for exports at the reduced world price must increase export revenues by a greater
amount than any increase in import costs resulting from the import price rise. It will, of course,
help if the import costs actually fall. The desired gain in net revenues can only come about if
the combined price elasticities of demand for exports and imports add up to a value that is
more negative than 1.

(c)

Effect in Industrial and Developing Countries

In Britains case, where manufactured goods dominate exports and form a high proportion of
imports, we would expect a devaluation to have a favourable effect on the balance of payments
in the short term.
In the long term, this beneficial effect of increasing net earnings is likely to be weakened.
Britain has to import most of her basic commodities and, until recently, these included essential
oils. She also imports much of her food. Any rise in the prices of these imported commodities
fuels and foods must soon increase the costs of manufacturing. It will also lead to an
increase in the living costs of the workers. If the workers are able to secure wage increases in
an attempt to restore living standards, then manufacturing costs will, again, rise. Inflation of

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both prices and wages, thus, erodes the competitive price advantages gained for exports against
imports by the devaluation. If inflation continues at a high rate, the export price advantage
may be lost very quickly.
For a developing country, both exports and imports are likely to be price inelastic. Thus, the
result of a devaluation, in this case, is to worsen an existing balance of payments deficit. The
devaluation will reduce total export earnings and increase total import costs. Devaluation,
therefore, will not help a developing country with balance of payments problems. It may help
an advanced industrial country but, probably, only in the short term. In itself, it does nothing
to cure the basic economic weakness which gave rise to the trading imbalance in the first place.
(d)

UK Experience
The British experience has been mixed. In the early 1980s, when sterling was valued at a high
rate as the UK started to become an oil-exporting nation, there was a very satisfactory
favourable balance for manufactured goods. This owed much to the depression of those years,
as distribution firms ran down stocks and as consumer demand for exports was also falling.
Manufacturers, however, were as much concerned about the very great fluctuations in rates as
about their level, and there is no doubt that the very large swings in 1984-5 were damaging to
trade. At the same time, it seemed that British manufacturers were suffering from an overpriced sterling, brought about by the oil situation. In 1983, Britains manufacturing account
moved into deficit for the first time since the Industrial Revolution, and in 1984 there was a
manufacturing deficit of around 3,250m. This seemed to indicate that sterling was overvalued
in relation to Britains non-oil trade. This position was probably owing not only to North Sea
oil but also to high interest rates caused by the British governments monetarist economic
policies. By 1988-89 a series of record monthly trade deficits, accompanied by renewed
domestic inflation was calling into question the entire economic strategy being pursued by the
British Government. Nevertheless the Government persisted in a high exchange rate strategy
and reinforced this with entry to the European Exchange Rate Mechanism which required this
rate to be maintained. The Government apparently hoped that exchange rate pressures would
ensure that business firms would resist inflationary tendencies to squeeze inflation out of the
system and make British business more efficient and competitive. However, an overvalued
currency could not be sustained in the long run and sterling was forced out of the ERM in the
Autumn of 1992. Its value quickly fell by about 15% against most other major trading
currencies.
Helped largely by this devaluation, the manufacturing account and the current balance of
payments responded well and the UK was able to follow the USA out of recession before the
other members of the European Union. This experience raised serious doubts about the value
to Britain of full membership of the European Union and helped to set in motion a fierce
political debate that, by mid-1995, was threatening to split the Conservative Party and which
was also a highly controversial issue within the Labour Party.

Deflation
Spending on imports is a form of consumption that is usually regarded as being dependent on the
level of income of a community. The higher the income, the more is likely to be spent on imports.
One way, therefore, to correct a balance of payments deficit is to reduce import levels or, at least, to
stop them rising too fast. A government faced with a balance of payments problem may seek to
reduce disposable income in the hands of consumers, and so reduce all consumption expenditure.
This will cut the demand for imports and also reduce the strength of demand for home-produced

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Free Trade and Protection

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Advantages of Free Trade

293

Protection

294

Dangers of Trade Protection

297

Methods of Protection

298

Tariffs

298

Quotas

299

Embargoes

300

Voluntary Export Restraints

300

Export Subsidies and Bounties

300

Non-tariff Barriers

301

Exchange Control

301

International Agreements

301

Trading Blocs

301

The European Community

303

GATT/WTO and the Liberalisation of Trade

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A. GAINS FROM TRADE AND COMPARATIVE COST

ADVANTAGE
Common Advantages of Trade
Even without any assistance from economic theory, it is not difficult to list some important
advantages from international exchange. Among the more common benefits are the following:
(a)

Better Supply of Goods

Through international trade, a country may obtain goods which it could not obtain otherwise.
Britain, for instance, could not enjoy tropical fruit or manufactured goods made of copper,
nickel, and many other metals, if it were not for the existence of international trade.

(b)

Lower Costs
A country can obtain goods which it could not grow or produce itself, and it can also obtain
goods which it could grow or produce but only at higher cost than in other countries.
International trade, by opening up the whole world for trading purposes, increases the size of
the markets for various goods. Production on a larger scale is, then, possible allowing full
advantage to be taken of economies of scale. If Switzerland only made watches for her own,
comparatively small, domestic market, the cost of production per unit would be much higher
than it is in fact, since Switzerland supplies most parts of the world with her watches.

(c)

Famines Can Be Prevented

World trade reduces the likelihood of famine and of other results of shortages of supply, since
it is possible to offset temporary domestic shortages by getting additional supplies from abroad.

(d)

A Curb on Monopoly
The existence of international trade is an obstacle to the development of monopolies. Even if
there are monopolies in existence in a country, their control over prices will be limited by the
ever-present threat of foreign competition.
We must, of course, recognise that this threat is often weakened by the development of large
multinational companies, and the tendency for these to limit world competition by agreements
between themselves and by their own power to absorb competitors.

(e)

Encouragement of International Co-operation

The existence of international trade also leads to a greater degree of interdependence between
sovereign states, and this should be a factor making for international peace and friendly cooperation between nations.

Comparative Cost Advantage

In addition to the above benefits, economic theory suggests a further benefit which enables us to
explain why countries may buy goods which they could quite well produce for themselves. However,
before examining the concept of comparative costs, we can consider an example where there are
some fairly obvious gains from specialisation and trade.
Let us assume that there are only two countries, A and B, and that these countries produce only two
commodities (disregarding any commodities which could not enter into international trade), which
are wheat and copper.

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Assume that, for a given outlay (which might be measured in terms of labour and money),
!

A can produce 300 units of wheat and 150 units of copper;

B can produce 150 units of wheat and 100 units of copper.

Country A apparently has an advantage over country B in the production of both wheat and copper.
Both commodities can be produced more cheaply in country A, as, with a given outlay, more of each
will be produced in A than in B. Will there, then, be any scope at all for international trade? The
answer will be in the affirmative, provided that As advantage over B is not proportionately the same
for both commodities. A country will, thus, tend to specialise in the production of those commodities
in which it has the greatest comparative advantage, or the least comparative disadvantage.
Let us now illustrate this principle with the help of our example. In the absence of international
trade, A will produce 300 units of wheat and 150 units of copper, and for the same outlay, B will
produce 150 units of wheat and 100 units of copper. This makes a total of 450 units of wheat and 250
units of copper. In A, then, the cost of production of wheat is half that of copper, while in B it is 2/3
that of copper. As As comparative advantage in the production of wheat is greater than her advantage
over B in the production of copper, it will pay A to specialise in the growing of wheat and to leave
copper production to B.
Suppose B abandons production of wheat and concentrates on copper, then A can make good the lost
150 units of wheat by transferring half the original outlay from copper to wheat. This still leaves A
producing 75 units of copper, in addition to the increased 100 units of copper in B. Thus,
specialisation in each country has increased copper production without any loss of wheat. Provided
both countries trade with each other to share the increased production, both can gain from
specialisation and trade and A can gain by reducing its production of copper and importing from B,
even though it is more efficient as a copper-producer.
Table 17.1 illustrates the example just described. Here, the given outlay in resources is assumed to
be 20 workers available for producing either commodity.
Table 17.1
(a) Before specialisation
Country A
Product

Country B

Total

Units

Workers
employed

Units

Workers
employed

Units

Wheat

300

150

450

Copper

150

100

250

(b) After specialisation

Wheat

450

Copper

200

275

The same total resources (40 workers) now produce an additional 25 units of copper, without any loss
of wheat.

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Limitations to the Gains from Comparative Advantage

It is sometimes argued that, because of comparative advantage, there will always be gains from
international trade, and that such trade should be freed as much as possible from government rules or
restrictions. Before accepting this, we should remember that there can be general gains from
increased specialisation and international trade only if:
!

production factors, including workers, are able to move from one activity to another within
each country i.e. there is factor mobility within countries;

no factors are left unemployed and unproductive as a result of the movement resulting from
increased specialisation;

there is a demand for the increased product made possible by changes;

there is no movement of production factors between countries.

If, for example, the advantage of country A, in the example above, arises out of superior managerial
skill, then the greatest gains might be achieved by exporting managers from A to B and improving the
standard of production in B.
These are very important qualifications, and they do not always hold good under modern conditions.
Production, today, is often highly specialised, and it is difficult and sometimes impossible to
transfer resources (including workers) from one activity to another within a country. Machines are
often built for one purpose only, and people may take years to retrain, and unions are often hostile to
movement. Many people displaced from one activity are just not able to learn the skills required for
another, expanding, activity. In these circumstances, it is not unusual to find high unemployment in
some sectors of production and a shortage of workers in another.

B. TRADE AND MULTINATIONAL ENTERPRISE

The Multinational Company
The traditional theory of international trade based on the concept of comparative cost advantage now
requires some reconsideration. There is no general agreement on a precise definition of a
multinational company but, for our purposes, we can regard it as any company which produces goods
and/or services in several different countries. The company must own and directly control production
facilities in the various countries. This is often referred to as direct investment overseas, and it is
in contrast to portfolio investment, where the home company simply owns shares or loan stock in
foreign enterprises, and does not directly control their activities.
The term multinational usually conjures up an image of a very large company and, indeed, the
leading multinationals are giant enterprises. These include the oil-producers and the mass-production
motor manufacturers. On the other hand, there are many small companies which operate across
national boundaries and take advantage of modern communications.
There are multinational companies owned and directed in many different countries but the majority
are American, European or Japanese owned. Until recent years Japanese companies preferred to
concentrate production in Japan and export to the rest of the world but as a result of several trends
and pressures they have now started to take the multinational path to expansion.

Reasons for Growth of Multinational Enterprise

There have been some large, world-scale, producers for a long time. The British Hudson Bay
Company and the British and Dutch East India Companies were large organisations as early as the

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18th century. However, these grew out of trading enterprises. World-scale manufacturing is a
development that belongs more to this century, and especially to the period after the Second World
War.
There are many reasons for this development. Among those most commonly put forward are the
following:
(a)

Improvements in Transport and Communications

In a world of jet air travel, international telephones, fax, telex and radio links, it is possible to
retain control over the day-to-day activities of a worldwide enterprise in a way that would have
been impossible in earlier times.

(b)

Efficient International Capital Markets

An international banking system has developed with the growth of world trade and the spread
of European influence in other continents. Bankers are often anxious to finance local branches
of the large world-scale companies, sometimes in preference to more risky local business.
Restrictions on capital movement from countries such as the USA and the UK in the 1950s and
1960s also tended to ensure that money earned in foreign countries was kept abroad to finance
foreign direct investment, because, if it returned home, it was likely to be kept there by
government controls.

(c)

Encouragement by Developing Countries

The developing countries in Africa, Asia and South America offered growing markets for a
wide range of goods, and many encouraged the entry of foreign manufacturing companies as a
means of speeding up national industrial development and of earning much needed foreign
currency from industrial exports.

(d)

Rising Costs and Production Difficulties in the Industrial Nations

Growing state intervention, the rise of trade union power and rapidly-increasing wage, land and
other production costs in the USA and Europe encouraged many companies to look to
investment opportunities in developing countries where costs were lower and there was much
less resistance to the introduction of new machines and working methods.
Japanese companies have also been influenced by increasing production, especially wage, costs
within Japan to establish production divisions in other countries in both Asia and Europe.

(e)

Product Life-cycle
If a company builds up a large export trade for a product, and if that trade is directed towards
countries the development of which is a little behind that of the home country, the time is likely
to come when the export market in the developing countries is larger than the domestic market
in the country of manufacture. By this time in the life of the product, it is probable that
competition is developing from firms situated inside, or closer to, the export market, and the
home market may also be starting to decline. It may well be that the production facilities will
need replacing.
At this stage, the manufacturer is likely to consider setting up new production facilities
(factories and machines) in the developing countries, where markets are growing. The
remaining market at home can be fed from imports out of the new factories.

In practice, some or all of these influences may be operating at the same time. The more influences
that do bear on an industry, then, of course, the greater the likelihood that it will become
multinational in character.

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(f)

Trade Barriers
Some countries and groups of countries discourage imports by tariffs and other trade barriers.
The European Community may be moving towards free trade between members but it has
many barriers to trade with non-members. It has been particularly restrictive against imports
from Japan so that to trade within the EC Japan has had to set up production units within the
Community. To avoid hostility against these units Japanese companies have built up
partnerships with European companies and have consented to use agreed proportions of
Community produced materials and components in their goods.

Consequences of Multinational Enterprise

Multinational enterprise involves a transfer of production capacity from one country to another. It
has consequences for the home country of the multinational company, the host countries where new
enterprises are established, and for the whole pattern of international trade and production.
(a)

Consequences for the Home Country

If a British manufacturing company decides to locate a new factory in Brazil rather than in
England, then England loses the investment to Brazil. From the British point of view, this is
called divestment i.e. the loss of productive investment. The decision may mean a loss of
some capital though research indicates that much foreign investment takes place with the
help of locally-raised capital, and that the amount of finance exported, even to developing
countries, is relatively small.
In the home country, however, there is a loss of production work. Jobs are lost. Most of these
jobs are likely to be in the routine work of manufacturing the unskilled and semi-skilled jobs
and the work of supervision. The more highly-skilled work of research, planning, marketing,
etc. is still likely to be controlled by the home headquarters of the multinational company.
Home-country nationals are also likely to be asked to fill managerial and skilled technical jobs
in the overseas country. It is possible that there are now more British people working overseas
than there were in the days of the British Empire. The American and Japanese multinational
companies are even more likely than the British to ensure that managerial and technical posts
are filled by their own nationals.
Another consequence of divestment for the home country is that visible exports fall and visible
imports rise. Invisible earnings rise, as the overseas sections of multinationals pay fees and
royalties for patents and services, and remit profits to the home country. Profits, however, go
to the owners of capital insurance offices and funds and do little to make good the loss of
jobs suffered by industrial workers. There is also a good chance that the profits will be reinvested in further foreign production, and not used to develop business at home.

(b)

Consequences for the Host Country

The host country gains jobs and some capital investment. If local capital is raised, then this is
denied to the countrys own domestic industry and commerce. The country also gains export
earnings and saves some import payments by having producers of products for world markets
within its own economy. There is some doubt, however, whether it gains the full value of
production, because the home part of the multinational company will require heavy payments
for technical and managerial services, as well as a substantial share of profits. It is notable that
the group of what are now called the newly-industrialised countries Korea; Greece; Hong
Kong; Mexico; and others in spite of gaining a substantial share of world production of a
growing number of industries (textiles, shoe manufacture, electronic equipment), nevertheless
still have a balance of payments deficit with the advanced industrial countries.

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It is frequently claimed that host countries gain benefits from importing managerial skills and
technical know-how. There is certainly some transfer of managerial skill and technology but
this can be exaggerated, especially where the majority of skilled functions are kept for
nationals of the home country, and where the home country retains full control over all
research and development.
It will be in the interests of the multinationals to keep factor costs low, and for labour to be
non-unionised, so they will not encourage the development of domestic industries which may
prove to be competitors, both in selling products and as employers of production factors. If
factors, especially wage-costs, do start to rise, then the multinational may be able to transfer
production to another country, leaving the original host country worse off than before.
(c)

Consequences for International Trade

There is no doubt that the growth of multinational enterprise has changed the pattern of
international trade. Visible trade is no longer a matter of a flow of basic materials to the
western industrialised countries and a counter flow from them of manufactured goods.
Manufacturing is now carried out in a very wide range of countries, though much of it is still
controlled by, and relies on, technology supplied by the advanced industrial nations.
Even more important, perhaps, is that the multinational companies have shown the importance
of factor transfer between countries. If you refer to the example of specialisation based on
comparative advantage given earlier in this study unit, you will see that the whole process is
transformed if we allow for the possibility that As superiority in the production of both
products is the result of superior managerial skill, and that this skill could be transferred from
country A to country B. We cannot, then, predict the result of the transfer, because this will
depend on which industries are affected, and on which terms the transfer takes place.
What we can say, however, is that multinational enterprise on a large scale further undermines
the theory of comparative cost advantage as the basis for international trade and exchange.
Multinationals will locate in those areas where costs will be lowest for themselves in absolute
terms. They are not concerned with the domestic comparative or opportunity costs of local
factors they employ. They will seek that combination of local and transported factors
(managerial skill and technology) which will give the production levels required at minimum
cost. This is likely to mean that some parts of the production process will take place in one
country and some in others. We can now see the association between the growth of
multinational enterprise and the trade in semi-manufactures, much of which is intra-company
trade i.e. transfer between sections of the multinational companies.

C. FREE TRADE AND PROTECTION

Advantages of Free Trade
The principle of comparative advantage shows that free trade and specialisation brings gains to the
participating countries. So long as a country has a comparative advantage in producing something, it
can benefit from specialising in its production and trading the surplus over home consumption for
other materials and products from abroad.
The advantages of free trade can be summarised as being that:
!

countries can specialise and increase production safe in the knowledge that they can export
their surplus

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resources are allocated efficiently

countries can export surpluses and import what they need

countries gain economies of scale from access to the world market

competition from imports increases efficiency and limits the creation of monopolies

free movement of capital allows countries to develop their industries

trade develops Cupertino and political links between countries.

The factors of production are immobile. Land, most labour and invested capital cannot move
between countries. Only enterprise, uncommitted capital and some labour can move to where the
other factors are abundant and production can be organised. Free trade overcomes the immobility of
factors: it permits the free movement of the product of immobile factors so that countries worldwide
can benefit from an abundant factor endowment in any place.
Access to the global market is essential for the 138 developing countries if they are to achieve
economic growth. Trade with the other 23 developed economies would give the developing nations a
large market for their goods and the opportunity to import new technology. Firms could gain
economies of scale and new techniques; competition would increase efficiency; monopolies are
avoided. Production for export helps to diversify the economy: it reduces dependence on what is
often a single crop subject to disasters, like sudden frosts which halve the output of coffee.

Protection
All trading nations engage in some form of trade protection as governments have to face political
pressures from powerful domestic interest groups. At the same time they are often reluctant to admit
that they are imposing barriers so they may avoid the formal measures that would invite retaliation
and invite censure from the World Trade Organisation. Instead they make use of a variety of devices
to delay imports or make them more expensive. These include cumbersome import procedures with
complicated documentation or safety measures with a dubious safety value.
At the same time the more formal measures still survive and are employed by individual countries
and regional groups such as the European Union (EU). The main such measures are:
!

import tariffs, also known as customs duties, which are taxes imposed on goods when they
enter a country or one of a group of countries such as the EU; whereas

quotas, which are quantitative restrictions on the import of goods

We examine these and other forms of protection in the next section of this study unit.
The belief that free trade (trade free from imposed restrictions) should be encouraged as much as
possible is linked closely to the theory of comparative cost advantage. However, the benefits of
comparative advantage have been shown to depend on the existence of competitive markets, absence
of monopoly power, full employment, and ready factor transfer within countries and no factor
transfer between countries. We have, instead, a world economy dominated by the monopoly or
oligopolistic power of the large multinational enterprises, where few industries approach anywhere
near the conditions of perfect competition, where domestic economies are highly specialised, where
there is large-scale unemployment and little factor transfer within countries but important transfers
between countries. In these conditions, we have to ask whether the case for free trade should be
questioned and that for import controls looked at more seriously.
If a country does decide that, in its own case, the possible benefits of controls outweigh the dangers,
the following arguments can be advanced in favour of the use of protectionist measures.

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(a)

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Protection of Infant Industries

Infant industries need protection from foreign competition until they become strong enough
to stand on their own feet. They are those industries which are being introduced to a country
where the industry has not previously been present. The absence of external economies makes
the costs of production high for new industries. In other countries, which are in competition
with the country imposing the duties, the industries are already in existence and are, therefore,
enjoying external economies of scale. As the infant industry grows, skills and productivity, as
well as external economies, will grow so increasing the industrys relative competitive
advantage.
Domestic pressures for protecting home industries are always greatest in periods of economic
recession and high unemployment as in the early years of the 1990s. There are also many
people within the European Union who would like to try and avoid the challenge of the
emerging industrial nations of Asia by erecting high barriers against the entry of goods from
non-EU countries. On the whole, the opponents of increased trade protection have managed to
contain the protectionist pressures while the establishment of the World Trade Organisation
should ensure that these temptations will continue to be resisted and that further progress will
be made towards reducing the present barriers.

(b)

Protection Against Dumping

It is sometimes suggested that measures are needed to protect a country against the dumping of
foreign goods. Dumping means the application to international trade of the methods of a
discriminating monopoly. Goods are sold abroad at a lower price than at home, partly in order
to avoid swamping the home market with a surfeit of goods which would bring down home
prices, and partly in order to kill off foreign competition by undercutting it on its own markets.
The alternative is stockpiling, which means the goods may be released in times of need, or
sold over a number of years under a controlled agreement. Dumping is generally looked upon
as an unfair trading practice and, for that reason, industries fearing competition from dumped
goods ask for tariff protection.
Here again, however, some objections may be raised. The main objection is that many
industrialists begin to complain if they have to face competition from foreign goods which are
cheaper than their own but this does not represent dumping if the exported goods are sold at
the same prices at which they are available in their home markets. The home producers may
simply be inefficient. Also, when dumping takes place, the imposition of protective duties may
be too slow a weapon, since, by the time the new duties have been introduced, the dumped
goods may already be in the country. The European Economic Community member countries
and the USA came to a special agreement in 1970, for example, to prevent the dumping of
grain surpluses.

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(c)

Increase in Employment
Controls cut imports and, therefore, there may be an increased demand for home-produced
goods, and a resulting increase in employment. Income is directed away from foreign exports
and towards domestic producers. On the other hand, if there is already full employment at
home, such measures will tend to be inflationary in their effects.

(d)

Improvement of the Terms of Trade

The imposition of import duties may lead to an improvement in the terms of trade, particularly
where the goods taxed are in inelastic supply and elastic demand.

(e)

National Security
Key industries, such as agriculture and those producing goods which are important for the
defence of the country, must be maintained for security reasons. A wide diversity of industries
is important to a country, as it renders her independent of foreign supplies which may be
jeopardised in the event of war.

(f)

Improvement of the Balance of Payments

This point has also been discussed already but you should remember that the balance of
payments is not only concerned with imports but also with exports, and the government will
have to consider what effect the imposition of protectionist measures by a country will have on
that countrys exports.

(g)

Possibility of Shifting the Burden

This is a hope which concerns any tax i.e. that someone else will pay it. We have shown that
this is likely to happen only if the foreigners need to supply us is much greater than our own
need to acquire his goods. This will be the case where foreign supply is inelastic i.e. does not
respond readily to price changes while our demand for imported goods is elastic. If the
higher price resulting from the imposition of import duties were to be passed on to the home
consumer, his purchases would drop substantially and the tendency would be to make up for
the higher duty by reducing the import price of the commodity. If the price to the consumer in
the importing country rises by less than the full amount of duty, the balance of the duty has, in
effect, been borne by the exporter, in the form of a lower price which he has received for his
goods.

(h)

Equalising the Costs of Production

It is sometimes suggested that competition from foreign producers who enjoy lower production
costs is unfair, and that import duties should be levied at rates which would equalise costs, so
that foreign and home producers would then compete on equal terms. This argument is quite
nonsensical. International trade takes place just because there are comparative cost differences
between different countries. If every country were to impose duties equal to existing cost
differences, international trade would practically disappear.
There is also a practical argument against the theory outlined above. Cost differences may
mean one of two things, they may refer to basic costs i.e. differences in wage rates, or in
rents, or interest rates or they may refer to total costs.
The fact that, for instance, wages in a certain country are lower than in the United Kingdom
does not necessarily mean that either wage costs or total costs in that country are lower than in
the UK, since labour may be less efficient than UK labour, or it may be wastefully employed.
Moreover labour is only one factor of production and its productivity usually depends on both
managerial skill and the availability of modern capital equipment. Countries with low wage

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costs are often short of capital so that finance and equipment are frequently scarce and
expensive. Countries with high wage costs but with high levels of labour and managerial skills
and ready access to capital need to adopt different production methods from those applied in
low wage cost countries.

Dangers of Trade Protection

The case against import controls is based on the following factors.
(a)

Continued Faith in the Benefits of Free Trade Based on Comparative Cost Advantage
It can be argued that multinational enterprise, unemployment and specialised production
represent modifications and imperfections only, and do not change the fundamental truth and
importance of the benefits to be derived from international specialisation and trade. According
to this view, efforts should be made to reduce the harmful effects of these including efforts to
reduce the monopoly power of large multinationals and to increase trade, not to interfere with
it.

(b)

The Fear of International Retaliation

If all countries sought to reduce, and impose barriers against, imports total trade and
production would fall, and unemployment would increase in all countries. Far from being a
cure for unemployment, the spread of protectionism would increase it.

(c)

Reduction in Industrial Efficiency

Those who believe that competition is the main incentive to business efficiency fear that
protecting domestic industry against foreign competition would make firms less able to
compete in world markets. The longer controls lasted, the more they would be needed, and the
country would lose the variety of products provided by imported goods. Its standard of living
would fall with this loss of choice and as increasingly inefficient firms required more and more
resources to produce less and less.

Those who favour import controls argue that the case for free trade based on comparative advantage
has been weakened, as already explained. They also argue that controls are no more harmful to world
trade than the other measures which have been used in the past to correct balance of payments
deficits, and much less harmful to domestic production. They may even be less harmful than
deflation and devaluation, because they can be more discriminating. Deflation harms all forms of
production. Deflation also damages domestic industry by reducing total demand, and this tends to
harm some industries more than others. When demand rises again, these industries may not be able to
recover, with the result that imports rise to an even greater extent than before. Successive deflations
produce ever-increasing imports.
Import controls can be applied more heavily in those industries where the home firms are weakest
and, it is argued, help them to recover their lost markets. Where home industries have been
completely lost or very seriously weakened by past policies, it is suggested that state aid may be
necessary to bring about recovery and, in these cases, continued protection would be needed until
they were strong enough to compete again in world markets.
Supporters of import controls argue that, as the total effect is no worse than other measures to reduce
balance of payments deficits, there is no reason why the danger of retaliation would be any greater.
They also suggest that controls have the effect of reducing the propensity to import rather than the
absolute level of imports, and so allow the economy to expand more readily. Any reduction in the
marginal propensity to import will increase the value of the national income multiplier. An

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expanding economy could actually permit more total imports rather than less as a part of
increased total consumption.

D. METHODS OF PROTECTION
A country which has nevertheless decided to restrict the freedom of international trade can use many
methods. The main methods of protection are:
!

tariffs (customs duties)

import quotas

embargoes

voluntary export restraint (VER)

export subsidies and bounties

non-tariff barriers applied through safety rules and administrative controls

exchange control.

Tariffs
Tariffs or customs duties are taxes on imported goods and so, of course, they raise money for the
government. The object is to raise the cost of the imported goods so that importers have to raise
prices or accept reduced profits. The imports thus suffer a competitive disadvantage compared with
home produced substitutes. The tariff raises the price paid for the imported good by the domestic
consumer and reduces the quantity purchased thus, domestic producers supply more to the market,
and foreign suppliers provide less, than if there were no tariff.
Customs duties may be imposed by a specific duty of so much per item or per tonne or ad valorem,
which is by value. Specific duties work best for goods of low value and high weight like iron. Ad
valorem duties obviously have more impact as goods increase in value, so they are best applied to
items like jewellery and those whose prices change often.
The amount received by foreign exporters may be the same or less than before the tariff depending on
the elasticity of demand. The more price-elastic the demand for the product, the more the producers
have to absorb the effect of the tax to prevent a loss of sales which would cause them a loss. The
effects of a tariff are shown in Figure 17.1.

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Figure 17.1: The Effects of a Tariff

The gross cost to consumers of the rise in price caused by a tariff is the sum of the areas
a + b + c + d, where:
!

a represents a redistribution of income from consumers to producers

b is the production cost arising for the misallocation of domestic resources

c is the tariff revenue paid by consumers to the government, and

d is the loss of consumption in the country imposing the tariff.

Areas b and d added together give the net costs of tariff protection to the economy. Tax and the
additional domestic supply remain in the economy.
Not only do consumers pay a higher price and buy less but there is also some loss of economic
welfare because they are forced to buy the domestic product, which restricts their choice.

Quotas
Quotas are restrictions on the quantity of a product which can be imported.
While the purpose of protective customs duties is to restrict the import of goods by making them
more expensive to the home consumer in order to persuade him not to buy them, the purpose of
import quotas is to lay down the exact quantity of a commodity which may be imported in a given
period of time. Import quotas may, but need not, be accompanied by customs duties. If they are, it
means that the limited amount of goods which may be imported is subject to the duty as well. Quotas
first came into prominence during the 1920s and 1930s but they have also been widely used since the
Second World War.
The reasons why some countries prefer to substitute quotas for customs duties or to strengthen
protective duties by quotas are as follows:

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(a)

Protective duties were sometimes considered to be insufficiently protective. This was

particularly the case where the duty was a specific one rather than one related to the value of
the imported goods. A specific duty is one which is imposed at so many pence (or pounds) per
unit of commodity. At a time of quickly-rising prices, the specific duty becomes a declining
proportion of the price of the commodity and it, thus, loses much of its protective value.
Frequent changes in the rate of duty may be difficult to administer, and would also lead to
strong protests from the countries importing the goods. Thus, a quota appears to provide the
simplest solution to the problem.

(b)

Quotas may generally be altered by administrative means e.g. by an order by the Department
of Trade and Industry. Customs duties are taxes and, as such, they are subject to parliamentary
control. If it is desired to strengthen or to relax protection, a change in customs duties might be
hotly contested in Parliament, while a change in quotas could be brought into effect without
much ado.

(c)

Many pre-war international trade agreements expressly prohibited the participating countries
from changing their existing customs duties, and the imposition of quotas was one way of
getting round this restriction.

(d)

Quotas also lend themselves admirably to a policy of discrimination. With customs duties, the
same rate of duty will, normally, be payable on goods of a certain kind, irrespective of the
country from which they come. A country wishing to reduce the volume of her imports,
however, may wish to cut down imports from a particular source e.g. because the country
concerned has a so-called hard currency, i.e. a currency which is in short supply. This end
may be achieved by a quota scheme under which different countries are allocated different
quotas, the quotas for goods from countries with soft currencies being rather more generous
than those for countries with hard currencies.

(e)

A mistaken argument in favour of quotas, which is occasionally heard, is that quotas, unlike
customs duties, will not lead to higher prices. This argument is wrong because, if a quota is
effective in the sense that it lowers the supply of certain imported goods, these goods will be in
scarce supply in relation to the demand for them, and this situation will, inevitably, lead to
higher prices.

Embargoes
An embargo is a total ban on imports or exports, usually applied for political reasons. A recent
example is the United Nations embargo on exports of armaments to Iraq and on oil exports from Iraq.

Voluntary Export Restraints

VERs are quotas operated by exporting countries. They are usually applied to avoid the more severe
effects of government-imposed tariffs and quotas, thus Japanese car manufacturers operate a VER on
car exports to the UK and the EC. A VER tends to prevent new firms from entering the export
market. The permitted exports tend to be the more expensive versions as this earns the most profit
from a restricted quantity.

Export Subsidies and Bounties

These can be of the visible type, where a bounty is paid to exporters by the government according
to how much they send abroad; but GATT rules generally forbid bounties, so hidden subsidies tend
to be provided instead. For example, exporters get government insurance against political and
commercial risks at very low rates, tax concessions on equipment used for making exports and help
with borrowing to finance export production.

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Non-tariff Barriers
This is a term used to cover a multitude of measures applied to restrict imports, especially where
countries cannot use tariffs and quotas because they belong to GATT or a free trade area. They
include oppressive safety measures like the USA requirement for destructive car tests which would
require the whole annual output of a small specialist manufacturer to be crashed. France attempted to
keep out Far Eastern video recorders by insisting they went through one small, remote customs post
where there were bound to be very long delays in clearing them. In the 1970s Britain required
importers to pay an advance deposit on all goods: this imposed an extra borrowing cost and pushed
up the price of imports. Around the same time the UK had two rates of VAT, the higher rate applied
to goods like motor bikes which were mostly imported.
The term is also applied when discussing trade liberalisation, to all restrictive measures except tariffs.
This is because tariffs are the only measure to be visible and measurable with accuracy. Agreements
to reduce tariffs are pointless if duties are replaced by other measures which are difficult to police.

Exchange Control
Control is enforced in many countries by requiring all buying and selling of foreign exchange to be
done through the central bank; the currency is not convertible into other currencies of the holders
choice. The government can then allocate foreign exchange to whichever activities it considers
should have priority. This is effectively the same as a quota and is subject to the same dangers.
Governments can avoid some of the problems by auctioning off foreign exchange, as was done in
Nigeria. The amount released to auction is determined by the state of the balance of payments.
Governments have also set multiple exchange rates for example the South African rand had a
commercial and a financial rate until 1995 and they can alter the value of the currency to make
exports cheaper and imports dearer. The majority of countries have retained some form of exchange
control; very few have followed Britains 1979 example of abolishing all exchange controls and all
restrictions on the movement of capital.

E. INTERNATIONAL AGREEMENTS
Trading Blocs
Countries can join together in several different ways to obtain the benefits of free trade among
themselves while keeping others out. What is included in the agreement depends on the political will
of the members; they may be unwilling to expose agriculture to competition, or to accept the full
degree of international specialisation which goes with completely free trade. Giving up some control
of their national economies makes it difficult for countries to enter into these agreements.
There are effects on the direction of trade some countries benefit and others lose. These blocs all
have tariff walls which discriminate against imports from non-members. Trade may be diverted by
the tariff from a low-cost producer country which is a non-member to a high-cost member state. The
effects of trading blocs have to be carefully evaluated to see if they really do benefit the citizens of
the member countries and not just protect inefficient producers.
(a)

Types of Bloc
The types of international integration are as follows.
!

In preference areas countries agree to levy reduced, or preferential, tariffs on imports

from qualifying countries. The European Community operates a system of preferences
through its Association Convention, covering the former colonies of member countries.

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Free trade areas are where the members abolish tariffs on trade between themselves,
but each country keeps its own tariff on imports from outside the area. This makes it
necessary to have rules of origin to prevent imports being brought in through the lowest
external tariff country. The North American Free Trade Area and the Association of
South East Asian Nation are examples.

Customs unions have free trade within the area with a common external tariff.

Common markets are customs unions with additional measures to encourage the
mobility of the factors of production and capital. The EC opened its common internal
market on 1 January 1993. Citizens of the member countries can live and work
anywhere in the EC, capital can move freely and there is a continuing programme of
harmonisation of standards and regulations to permit the free flow of goods and services.
The 1991 Maastricht Treaty agreed to a programme to move to economic and monetary
union and to take the first steps towards political union by agreeing common foreign
policies.

Effects of a Bloc
Creating a trade bloc has two major effects:
!

Trade creation when a country which previously placed tariffs on imports from
another member and produced the goods itself, switches to buying such goods from
another member country, this creates trade (although it may cause structural
unemployment).

Trade diversion, when the removal of barriers inside the bloc results in trade being
switched from a more efficient producer outside the union to a less efficient one inside.

In addition to the benefits of trade creation, there are other benefits from setting up a free trade
area.
!

Economies of scale develop because the member countries now have a much larger
home market.

Specialisation in products having a comparative advantage creates greater opportunities

of economies of scale.

Greater efficiency is enforced because the members industries are exposed to more
competition.

Consumer welfare is increased as people have more, better-quality and cheaper goods,
with more variety, to choose from.

There is more political co-operation as the member countries develop common policies
and become more dependent on each other.

Against this must be set loss of political and economic independence, because the countries
must take into account the policies and rules of the union when deciding their own policies.
The larger the trading bloc, the greater the potential benefits because of the better chance of
including the lowest-cost producer and the bigger opportunities for economies of scale. There
will be more opportunities for trade creation whereas there will have been a lot of duplication,
and large cost differences between the production of the members, before the union. There will
be more to be gained from specialisation. This is especially the case when there were high
tariffs before the union; there would then have been a lot of domestic production for relatively

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small markets. The lower the external tariffs imposed by the union, the better, as this reduces
the possibilities of trade diversion.

The European Community

In 1952 Belgium, France, Germany (West), Holland, Italy and Luxembourg joined in the European
Coal and Steel Community (ECSC). A major aim was to integrate Germany both politically and
economically, so as to prevent further conflicts. All countries hoped to benefit from expanded trade
and faster industrialisation. In 1958 the six countries went on to establish the European Atomic
Community (Euratom). There are still certain initiatives which operate under these treaties, for cooperation in research, retraining, and other regional development measures to assist former coal and
steel areas.
It was recognised that there would be rationalisation of industry as free trade permitted comparative
advantage to work. The Belgian coal industry duly disappeared; steel rationalisation is still being
discussed in the European Community; Germany keeps its coal industry going only through massive
subsidies. Unless the political will is present to accept structural economic change, free trade
agreements will never secure the potential benefits.
The six countries realised that greater benefits could be obtained from closer economic integration,
and in 1958 they formed the European Economic Community. Shortly before that, Britain and the
other West European countries had tried to get the six to join in a large free trade area. In this each
member would be free to trade with non-members as it wished, while getting the benefits of free trade
within the area; there would be no loss of political sovereignty. This plan broke down because France
would not agree.
The result was that Austria, Denmark, Iceland, Norway, Portugal, Sweden, Switzerland, the UK and
Finland as an associate member, formed the European Free Trade Area (EFTA), with Liechtenstein
joining later. Their neutral status, and Russian opposition in the cases of Austria and Finland,
prevented most of these countries from wishing to join in a political association. The objectives of
EFTA were purely economic; the treaty excluded agriculture. Each country could pursue its own
economic policies and impose its own restrictions on trade with non-members. Rules of origin were
devised and enforced to cover the movement of goods from outside the free trade area. The countries
soon found that free trade benefited their industries, but some also wanted access to a bigger market
and free trade in agriculture with the EC countries.
There were attempts by Britain, Denmark, Norway and Ireland to join the EC but these were blocked
by France until 1973 when these countries, except Norway, where the move was rejected in a
referendum, joined the original six in an expanded common market. The remaining EFTA countries
continued their association and signed a free trade agreement with the EC.
The EC continued its development with Greece joining in 1981, and Portugal and Spain in 1986, after
they had returned to democracy. Greenland, which had joined the EC as part of Denmark, left on
becoming independent in 1985 and became an associated territory. (The Treaties do not contain any
provisions for withdrawal.)
In 1993 the EC and the EFTA joined in the European Economic Area (EEA), though Switzerland
voted in a referendum to stay out. This followed on the establishment of the Single European Market
(SEM) which created an area without internal frontiers in which there is free movement of goods,
people and capital. The EFTA countries could join in most of the aspects of the SEM, creating the
largest single market in the world with 19 countries and 380 million people.
During 1993 Denmark and Britain ratified the Maastricht Treaty of 1991, which had set out a
timetable for political and economic union, although both countries retained opt-out rights. This

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cleared the way for Austria, Finland, Norway and Sweden to apply to join the EC. A referendum in
Norway voted to stay out, but the others joined the community in 1995, making the membership 15
countries. Also in 1995, Liechtenstein voted to join the EEA.
Turkey, which signed an association agreement in 1964, is still awaiting a decision on membership,
and Cyprus and Malta also have long-standing applications. In addition, several East European
countries have applied for full membership, and the EC is gearing up for considerable expansion in
the future.
The EC has association agreements with countries having former colonial ties with member states:
these provide for exemption from the common external tariff, and for financial and technical
assistance from the European Development Fund. The Lom Conventions have expanded duty- and
quota-free access to 66 African, Caribbean and Pacific countries. Co-operation agreements are less
comprehensive than association agreements, as they provide merely for intensive economic cooperation; they have been signed with Mediterranean countries.
The original aims of the ECSC, Euratom and EEC treaties were:
!

to preserve and strengthen peace

to achieve economic integration through the creation of a large economic area

to work towards political union

to strengthen and promote social cohesion in the Community.

Since then, a numbers of measures have been taken to develop these aims and give form to the
concept of a common market.
(a)

The Single Market

The Single European Act of 1986 built on the dismantling of internal barriers, the common
external tariff, freedom of movement within the Community and a system to ensure that
competition was not distorted. The Act came into force on 1 January 1993, by which time
many of the proposals in the Act had been achieved. The Act covered the following.
!

Removal of physical barriers to trade internal customs controls, immigration and

passport controls and speedier transit of goods. Internal customs duties were abolished
in 1968.

Removal of technical barriers to trade agreement on basic quality and safety standards,
general acceptance of national testing procedures, opening up of public procurement to
EC-wide tendering, and dismantling of any remaining barriers to the free movement of
workers, services and capital, including mutual recognition of educational qualifications.

Removal of fiscal barriers to trade removal of fiscal checks at frontiers (there is one
VAT documentation system EC-wide), approximation of indirect taxation rates.

Consumer protection harmonisation of public health standards and of consumer

protection.

Lessening barriers to competitiveness the creation of an improved EC system for

vetting mergers and takeovers and government subsidies.

It was estimated that economies of scale, job creation and stabilised prices arising from the
creation of the Single European Market would add 5% to Europes industrial output; further
benefits would come from scrapping frontier formalities.

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There is still a lot to be done to free the market from restrictions. Air traffic is subject to rules
which prevent airlines from picking up passengers at intermediate stops. Freedom of entry to
the telecommunications market is impossible in most countries where it is a state monopoly.
However, the Act did remove 300 restraints and provided for further freeing of trade.
Countries can retain border checks for criminals and illegal immigrants.
(b)

The Treaty on European Union (Maastricht) 1991

The Maastricht Treaty, which adds to and amends the three original treaties ECSC, Euratom
and EEC Treaties (which remain in force), gives a collective political identity to the
Community. The main provisions are:
!

A common European currency by 1999 (which we have already touched on and will
come back to again shortly)

Special rules on social policy because the UK exercised its right to opt out of the
relevant chapter of the Treaty

Provisions for a common security and foreign policy

Rights to citizenship of the European Union (EU) (also, for example, EU citizens not
living in their home countries can vote in local elections in the country in which they
live)

Provisions on co-operation in the fields of justice and home affairs for example, there
is a move to set up a police force co-ordinating body which the French stopped at the last
minute in 1995.

The last three are additions to the existing treaties.

Germany and France particularly wanted the Social Chapter on workers rights to be passed,
but the UK originally opposed it on the grounds that it would reduce Britains competitiveness
(although the new Labour Government signed up to its provisions in 1998). The Chapter
covers minimum standards for health and safety, working conditions, sex equality, information
and consultation of workers; it does not cover pay, rights to form worker or employer
associations, or rights to strike or lock out labour.
One slightly confusing aspect of the Treaty is that there are, strictly speaking, two names for
the same group of countries European Community when talking of the common market, and
European Union when discussing the political union.
(c)

Common Policies
In a number of areas the member states have transferred sovereignty to the Community and
given it power to make and implement its own policies. These include the following.
!

Almost 10% of the total EC workforce is employed in agriculture, the proportion ranging
from 2% in the UK to 26% in Greece. It is a powerful political lobby. The common
agricultural policy (CAP) guarantees a minimum price to farmers through intervention
to buy surpluses when the market price drops below the target price. Threshold prices
are set for imports, which are generally higher than world market prices. A levy is
placed on imports to bring them up to the threshold. Agriculture takes 65% of the
Communitys budget.
The CAP has created the notorious wine lakes and butter and beef mountains, as overproduction was bought and placed into intervention stores, later to be sold off cheaply to
the Soviet Union. Reform of the CAP has led to strict quotas for production and

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payments to farmers to leave land fallow; pricing of the reduced output is now more
market-oriented. There is a continuing programme of reform, which was given an added
impetus by the GATT agreement on reducing subsidies.

(d)

Competition policy lays down rules for free competition. The European Commission
and the European Court of Justice punish with heavy fines abuse of a dominant market
position to fix prices, to limit output, or to restrict market access or technical
development. The policy also bans or supervises national subsidies to firms or
industries, to prevent them from gaining an unfair advantage. International mergers
which would give a firm a dominant position are scrutinised by the Commission.

Social policy carries out the aims of the Social Charter. It sets aims for use of the Social
Fund, which gets about 8% of the budget. The main priority is job creation. The Fund
provides basic vocational training and specialist training in other areas, for example in
information technology and for the disabled. There is a regional dimension to the Social
Fund spending.

Regional policy controls the use of the Regional fund to target assistance towards
national schemes, so as to stimulate investment and create jobs in less developed regions
and reduce the disparities between rich and poor regions. Regional policy gets about
11% of the budget and targets regions with lagging development, areas affected by
industrial decline, combating long-term and youth unemployment, and structural
adjustment of agricultural areas.

The common commercial policy is concerned with the Communitys relations with the
rest of the world and includes common customs tariffs, customs and trade agreements,
liberalisation of trade with non-member countries, and export policy. The EU negotiated
as a unit in the Uruguay Round of GATT talks on trade liberalisation.

The Single Currency

As early as 1970 the EEC had a plan and a programme aimed at achieving economic and
monetary union by 1980. By 1974, the attempt had failed, although the development of the
European Monetary System (EMS) in 1979 gave a new impetus to monetary union and, until
its breakdown after 1992, the monetary discipline it imposed appeared to bring the economies
of the member states closer to convergence.
The Maastricht Treaty laid down rules and a timetable for monetary union through a series of
stages, culminating in the establishment of a common currency and associated financial
institutions and policies. The key stage was reached in 1998 with confirmation of the countries
meeting the convergence criteria and EMU started on 1 January 1999. The convergence
criteria were that:
!

planned or actual government budget deficits should not exceed 3% of GDP at market
prices

the ratio of total government debt should not exceed 60% of GDP at market prices

one-year inflation rates must be within 1.5% of the three best performing economies

one-year long-term interest rates must be within 2% of the three best performing
economies

the currency must have remained within the narrow ERM band for the two previous
years without devaluation.

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Some softening of the requirements in the Treaty, allowing for the debt ratio to be reducing and
for the annual deficit to be ignored if it is temporary, enabled more countries to meet the
criteria. (Ironically, Britain which has reserved the right to opt out and will hold a
referendum on future membership is one of the few nations able to meet all the criteria.)
The European Central Bank, located in Germany, took over from the European Monetary
Institute and became responsible for monetary policy as part of the European System of Central
Banks (ESCB), the other members being the national central banks. The European Central
Bank has to ensure that the ESCB carries out the tasks imposed on it by Maastricht, namely:
!

to define and implement the monetary policy of the EC

to conduct foreign exchange operations

to hold and manage the foreign exchange reserves of the member countries of the EC

to promote the smooth operation of the payments system for cross-border monetary
transfers

to contribute to the smooth conduct of policies concerning prudential supervision of

credit institutions

to ensure the stability of the financial system.

There will be a four year interim period before the European Central Bank authorises the issue
of bank-notes and coins which would be the sole legal tender (the Euro) in the member states.
The jury is still out on the success of European Monetary Union. There should be benefits to
industry and commerce of all countries in the EC using the same currency, with the problems
and costs of doing business in two currencies disappearing. This should provide an incentive
to trade.
The main debate has been over the implication of a single currency that there would have to be
an integrated fiscal policy to develop and maintain the economic convergence necessary. This
implies that countries would have to give up control of their economic policies. The policy
stance will be likely to be anti-inflationary and may mean high levels of unemployment with
strong economies being obliged to pay for unemployment in the weak, so there would be a
transfer of resources from high-employment countries to the others.
The role and status of the Euro on the worlds money markets is also unclear. It has not fared
well over the first year of its existence, although its loss of value against other currencies has
made Euroland highly competitive against other countries.
Further, by the time that EMU is fully implemented in 2003, there may well have been an
enlargement of the community, and it is unclear how the concept will fare when there are over
20 member states.

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Study Unit 18
Foreign Exchange
Contents
A.

315

Exchange Rate Structures

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A. INTERNATIONAL MONEY
The Need for International Money
We have seen earlier in the course that anything can serve as money, as long as it is accepted as
money. It will be accepted only as long as it can be readily used to purchase real goods and services.
Money, therefore, ceases to have any value as money when it cannot be easily traded for real goods.
The area of acceptability, thus, becomes extremely important for the value of any form of money, and
this is a point of very great concern for matters of international finance and trade.
Therefore, when one country sells goods to another, it wishes to be paid in a form of money
(currency) which it can readily use to purchase its own goods elsewhere, or which it can change into
its own currency to pay its own workers and suppliers at home.
You might think that it would all be a lot simpler if every country in the world used exactly the same
currency, which would then be universal, and which would not be identified with any one nation.

Gold its Use and Limitations

In a sense, there is such a form of money which is universally acceptable and which is not associated
with any one nation. This is gold, which has been used as money in almost every part of the world
since the dawn of civilisation. It has all the qualities required of money, and it is noticeable that,
whenever a countrys financial or political system seems to be in a state of collapse, those able to do
so in that country abandon paper money in favour of gold which, if they can take it with them to
another country, is readily acceptable there. Some international trading contracts are also arranged in
terms of gold, and most countries keep at least part of their reserves in gold, the world price of which
is a fairly good indicator of the general state of political tension in the world.
However, there is just not enough gold to meet all the worlds trading needs, and the natural supply of
gold is very unevenly distributed between countries. If gold were the only international form of
money, those countries where gold is found would have a degree of political power that other
countries would find unacceptable. Moreover, because gold, as a physical good, is in fixed supply in
any given period, any of the metal that is held in reserve is withdrawn from circulation and, thus, it
cannot be used in exchange. Some countries, such as the USA, have such a large share of total world
supplies in their reserves that they can influence its price (value in exchange for goods) by their sales
in world markets.
Gold and, indeed, any other precious metal does not provide an easy solution to the problems of
international currency.

Uses of National Currencies

An attempt has been made to produce a form of paper gold, to serve as a genuinely international
currency. This resulted in the Special Drawing Rights (SDRs) produced by the International
Monetary Fund, but it has been found difficult to reach agreement on the issue and control of SDRs
and they have only a limited use in exchange and as a reserve.
The problem with any form of international currency is that there must also be some system of
international control which all countries will accept. This immediately introduces political
implications which, so far, have proved impossible to reconcile.
Consequently, the great mass of world trade has to be conducted in the normal national currencies of
the world. Some of these are more acceptable than others, chiefly because some countries have

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stronger economies than others, and some governments have firmer control over their national
economic and financial systems than others. For simplicity, we can identify four classes of currency
used in international trade.
(a)

The United States Dollar

The US dollar is the most-widely-acceptable currency, and it is used throughout the world.
Many of the worlds commodities and services are valued in dollars. They include oil and
hotel charges. Dollars are also widely used in the internal trade of many countries, whose own
currencies are very weak because of severe domestic inflation.

(b)

Other Major Trading Currencies

The currencies of many of the other leading trading nations of the world have a wide
acceptability, though not as universal and general as the US dollar. When the dollar itself is
under pressure and losing some of its exchange value, one or more of these currencies becomes
a refuge for international finance but no other country shows any inclination to encourage the
use of its national money as a genuine substitute for the dollar. Among the main trading and
reserve currencies in this group would be included the British pound sterling, the Japanese yen
and the Swiss franc. We could also include here the Euro the single currency of the
European Monetary Union which, although not yet available as notes and coins, is used for the
purposes of trade.

(c)

Currencies with Limited Acceptability

Some currencies may be acceptable within a particular region. Most of the western European
currencies are used in general European trade, for example, but there are also many that have
almost no circulation or acceptability outside the national boundaries and, often, are not too
popular within the country either! Sometimes, a national government discourages international
exchange involving the currency, as a means of keeping greater control and preventing the
export of wealth. In other cases, the currency is too weak to support any external trade, or the
official value in exchange for other currencies maintained by the national government is so
unrealistic that no one who can possibly avoid it is willing to exchange foreign money at that
rate.

(d)

The Basket Currencies

These are currencies which are not the currencies of any nation but whose exchange value is
based on a weighted basket of those currencies with which they are associated. The weights
relate to the relative use of the various currencies for purposes of trade and international
finance.
The main basket currency now is SDRs issued by the International Monetary Fund, although
previously, the ECU (European Currency Unit) was the basis for certain transactions within the
(old) European Monetary System
One of the advantages of using such a currency as a basis for valuing trading transactions even
if actual payments are made in a national currency, is that the basket currency fluctuates much
less than any one of the individual national currencies. This is because changes in its value are
simply the weighted average of all changes among the underlying currencies and some of these
are likely to cancel each other out a falling currency could be balanced by a rising one. At
present use of a basket currency for business trade and settlement purposes is restricted by lack
of general availability and also by lack of any widespread awareness of the position people
generally feel happier to stay with a currency they know and understand.

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Trade may often be conducted by barter arrangements with some countries with weak currencies. For
these agreements, some form of acceptable valuation is necessary and, again, the basis of this tends
to be the United States dollar, either directly or indirectly (e.g. through oil).

B. EXCHANGE RATES AND EXCHANGE RATE SYSTEMS

What Are Exchange Rates?
We have seen that various national currencies are used in international trade, and we must now
examine a little more closely what is involved when one currency is exchanged for another. The
exchange rate is the rate at which the national currency can be exchanged for the currencies of other
countries. There is not one rate, therefore, but many, relating to all the different countries in the
world. Some of the leading rates are shown in those banks which have a bureau de change i.e.
which can provide an over-the-counter service for changing currencies. However, the principal rate
which is of interest to most countries is the one relating to the main currency in use in international
trade the $US. For simplicity, then, it is convenient to concentrate on the US dollar/pound
relationship. If, for example, the rate is $1.20 = 1, then each can be exchanged for $1.20 (ignoring
dealing and other costs of exchange). Thus, 100 = $120. If, however, the rate changes to $1.10,
then 100 becomes worth only $110.

Effect of Exchange Rate Changes

Suppose there is a fall in the value of the pound in terms of US dollars, so that, say, in the space of a
few months, the rate falls from $1.30 to $1.10. There is, then, an immediate effect on the prices at
which traders are prepared to trade in international markets. Suppose, for example, that a
manufacturer has a motor vehicle which he is prepared to sell, provided he receives 5,000. At the
rate of $1.30 and, again, ignoring transactions costs he could sell the car in the USA for $6,500
(5,000 1.30).
However, when the pound falls in value and is worth only $1.10, he will now accept $5,500
(5,000 1.10), if he still wishes to receive 5,000. Thus, a fall in the currency value makes exports
cheaper in foreign prices. Cheaper goods are likely to be easier to sell and, provided the increase in
sales is proportionately more than the change in dollar price, exporters can hope to receive more
revenue for their exports hence, the use of devaluation to help in correcting a balance of payments
deficit.
On the other hand, imports become dearer, and this will affect the pound price of goods imported
from other countries. Suppose the vehicle manufacturer buys his steel from abroad and pays for it in
$US. Each $1,000 worth of steel, which used to cost 769.23 (1,000 1.3) now costs 909.09
(1,000 1.1). Most manufactured goods contain materials imported from other countries, so that
manufacturing costs inevitably rise following a fall in the exchange rate.
There will also be other effects. A high proportion of British food and many consumer goods come
from overseas and so they rise in price. Living costs are pushed up and workers seek wage
increases in order to try to maintain their living standards. If they succeed, then labour costs rise, and
also manufacturing costs and prices are also likely to rise. Under circumstances such as these, it is
highly unlikely that manufacturers will reduce their foreign prices by as much as the full fall in
currency value. In our example, the motor manufacturer will want more than 5,000. We can see
that the effects of currency changes are far-reaching, and not always too certain.

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The Formation of Exchange Rates

The exchange rate represents the price of the national currency and, like any other price, it is formed,
ultimately, by the forces of supply and demand. These, in turn, are the result of the trade flows of
imports and exports. In order to pay for imports priced, say, in US dollars, the United Kingdom has
to earn dollars by selling British goods and services to other countries. The more Britain can export,
the more dollars the country earns.
However, British firms want to receive their payments in pounds, and to obtain pounds to pay for
British goods and services, foreign firms have to sell their own currencies in the markets for foreign
exchange, and buy pounds. Thus, the greater the demand for British products in world markets, the
higher is the demand for pounds in the currency exchanges. Conversely, the higher the demand in
Britain for foreign products, the more pounds have to be sold to obtain the foreign currencies needed
to pay for them. It is evident that one immediate cause of a change in currency exchange rates is the
way the balance of payments is changing. If the balance is in surplus, then revenue from exports is
greater than that paid for imports, and the supply of foreign pounds is high. Thus, the pound is likely
to rise in exchange value. A persistent balance of payments deficit has exactly the reverse result. The
weaker the balance of payments the weaker the pound is likely to be.
The views of traders and bankers about future movements in trade flows and currency exchange rates
will also have an effect. For example, traders often have to hold large sums of money for a few days,
or weeks, in anticipation of having to make large payments. They cannot afford to have money lying
idle, so they lend it out in return for interest. They do not want to see the interest earned being lost
through a fall in the exchange value of their money, so that any suspicions that the pound is likely to
fall will persuade the traders that their money is more safely kept in some other currency. This
reduces the demand for pounds and increases the demand for foreign currencies and so, it adds to
the pressure resulting from a weak balance of payments unless, as did the UK in 1989-91, the
government tries to maintain an artificially high exchange rate through forcing up interest rates in
order to attract sufficient foreign capital into the country to counter-balance the outflow of funds paid
for imports.

The Purchasing-power Parity Theory

If the immediate cause of exchange rate changes is a change in the flow of trade, then we are forced
to ask whether it is possible to identify influences on these trade flows.
Various attempts have been made to explain these, and one such attempt is based on the view that
they are directly linked to changes in inflation rates i.e. in the relative purchasing power of the
various national currencies. This is often referred to as the purchasing-power parity theory. This
theory states that the percentage depreciation of the home currency against a particular foreign
currency can be expected to be equal to the excess of the home rate of price inflation over the other
countrys rate of price inflation. In other words, it is held that changes in currency values reflect
changes in the purchasing power of the various national currencies. If country A has a higher rate of
inflation than country B, then its currency buys fewer goods and will, consequently, fall in exchange
value in terms of the currency of country B, until Bs currency returns to the position where it will
purchase roughly the same quantity of goods, in A, when converted to As currency, as it did before
the price inflation. The theory is attractive but it is not entirely supported by the available evidence.
It fails to take into account elements other than price which affect the demand for exports and
imports. The theory also assumes perfect markets in currencies but, in practice, governments tend to
intervene to defend exchange rates. Governments can influence the rate of interest offered to
investors or depositors of money. Traders may be persuaded to leave funds in London in pounds, in
order to earn high interest rates likely to more than compensate for any change in exchange value.

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In the long term, currency movements are most probably influenced by relative rates of inflation; in
the short term this consideration can be outweighed by other influences such as interest rates, trade
flows and political stability. You should also remember that, as in other markets, buyers and sellers
are as much concerned with the future as with the present and the past. If the market thinks that a
currency is likely to fall in the future it will anticipate that belief by selling now so that expectations
can be self-fulfilling. This does not mean that the market is always right. Anticipations about future
movements are based on past experience so that the market may not recognise that a fundamental
shift has taken place until this becomes completely clear and then it may over-react. For example,
between 1962 and 1992 Britain had a generally poor record in controlling inflation so that by 1995
currency markets remained sceptical about future inflation rates in Britain in spite of the declared
intentions of the British Government and its relative successes between 1992 and 1995. Over a
similar period Japans economic record had been one of spectacular success so that the market
continued to believe that its economic problems of the first half of the 1990s were likely to be
temporary. It is quite feasible that the judgement of the currency markets was wrong in the mid1990s for both countries. The currency traders risked losing a great deal of money if their beliefs
were wrong and only future events will show whether or not they were correct.

Exchange Rate Structures

There are basically two types of exchange rate system fixed and floating exchange rates. There
may be variants on these, but the basic principles remain the same.
(a)

Fixed Exchange Rates

It is very rare to have an exchange rate structure that is rigidly fixed. Some movement within a
band either side of a central rate is normal. The more confident governments are that they can
maintain the agreed rates, the narrower the band within which floating is permitted. A
movement towards either the floor or the ceiling of the band requires action to correct the rate.
The usual short term action is to change interest rates to attract or discourage capital
movements but longer term action through taxation or a fundamental shift in government
spending or policy priorities is likely to be needed. If the government is unable or unwilling to
take action to restore the agreed exchange rate or if its action is unsuccessful then the rate will
have to be changed. If member countries cannot agree on a satisfactory change the whole
structure becomes unstable.
The problem with any fixed exchange rate structure is reconciling the desired level of
stability with sufficient flexibility to allow changes to take place as economic conditions
change. National economies are dynamic. They are subject to constant change. A system
designed to prevent short-term fluctuations can easily block desirable long-term developments
until the currency values get so out of touch with reality that a structural upheaval becomes
inevitable.
Nevertheless there have been a number of important attempts to create exchange rate structures
to provide the stability that business firms desire.
The longest, most comprehensive and for many years the most successful attempt was the
Bretton Woods system which linked the main currencies to the United States dollar throughout
the 1950s and 1960s a period of generally rising world living standards and of considerable
prosperity for the Western world. The European Communitys Exchange Rate Mechanism
sought to reproduce the Bretton Woods conditions with a roughly similar system of limited
currency movements within defined bands, during the 1980s and 1990s in the lead up to the
establishment of the single European currency. Supporters of such systems usually claim that:

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they provide the stability and reduction in currency risks that traders need if they are to
expand trade and production

they oblige governments to pursue financially responsible economic policies designed to

control inflation and curb the tendencies of communities to live beyond the means
provided by their production and trading systems.

Opponents of fixed rate structures point out that periods of apparent exchange rate stability
tend to be punctuated with intense speculative crises and periods of serious and damaging
instability when finance markets realise that a major currency (usually sterling!) has become
overvalued and they suspect that the government does not have the power to prevent a
devaluation. A series of crises led to the abandonment of the Bretton Woods system in the
early 1970s and a similar crisis led to the withdrawal of sterling from the ERM in 1992.
Opponents also point out that the only measures that governments can take to uphold the
exchange value of a currency in the short term are extremely damaging to their domestic
economies and further undermine long term confidence in the currency. A monetarist
government will rely on high interest rates to keep capital in the country but these high rates
can have a devastating effect on consumer demand and business investment as shown in Britain
in the period 1989-1992. A Keynesian government would raise taxation and curb wages and
other incomes and this would have a similar deflationary effect to high interest rates. Clearly a
government seeking to maintain an overvalued currency will damage its own domestic
economy, create high unemployment and destroy business firms. Living standards fall in the
interests of an artificial currency stability which cannot be sustained for more than a short
period.
Currency exchange rates represent the market price of a nations currency. They are the
international traders valuation of the nations production system. Stable exchange rates can
only be achieved when economies are themselves stable, prosperous and competitive in world
markets. A falling exchange rate is the symptom of an unhealthy economy. To prop it up
artificially is like propping up a weak patient and pretending that the patient is fit and well. It
is as dangerous to the economy as it is to a sick person and eventually all such pretences have
to be abandoned.
(b)

Floating Exchange Rates

When the price of the currency in terms of every other is set by demand and supply in the
market, the country is said to have a freely floating exchange rate. If the demand increases and
the supply remains the same, the exchange rate rises (appreciates); should the supply increase
faster than demand, the rate falls (depreciates). There are no exchange controls and the
government does not intervene in the market. Figure 18.1 shows how changes in demand and
supply affect the exchange rate of a currency.

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318

Foreign Exchange

Figure 18.1a: The Effect of Increased UK Exports or More Investment in Britain

Figure 18.1b: The Effect of Increased UK Imports or More UK Investment Abroad

If Britains exports increase there will be more demand from importers to exchange their
currencies into sterling. The pound will also be in demand if people want to invest more in the
UK, either in deposits and shares or in physical assets. More sterling will be supplied if
importers in Britain are buying more from overseas and require more foreign currency. UK
investment abroad increases the supply of pounds.
Just as in any other market, an increase in demand for pounds, with supply unchanged, will
cause the price of sterling to rise, or appreciate more francs have to be paid for each pound.

Licensed to ABE

Foreign Exchange

319

Conversely an increase in supply, with demand remaining the same, would cause the currency
to depreciate and each franc would buy more pounds i.e. the price of a pound has fallen.
Governments have often attempted to manage floating exchange rates: this is called dirty
floating. A government may intervene in the market to buy or sell its currency because it
wants to hold down a rise in the rate, which would affect international competitiveness, or
support a rate to keep foreign investments.
There have been attempts by the major industrial countries to influence the exchange rate of
the US dollar. Many commodities and raw materials, especially oil, are priced worldwide in
dollars; a rise in the value of the dollar for speculative reasons unconnected to trade could
cause inflation. When, in 1991, the dollar rose by a quarter against the deutschmark, the G7
(the seven most industrialised nations) took concerted action to stem the rise by central bank
intervention to sell dollars. In 1995 the dollar was falling against other currencies because of
fears about the effect of the very large US government deficit and the political situation; this
led to a flight into the deutschmark, a rise in its rate and a depreciation of other currencies.
The effect is to make the exports of appreciating countries less competitive and those of
depreciating ones more so this is destabilising and has nothing to do with the trading position
of the countries. Central banks intervened to buy dollars in an attempt to prevent further falls
in the rate.
Even when all the major central banks act together, they cannot have a significant effect on the
foreign exchange market. The sheer size of the markets daily dealings makes the reserves of
the industrialised countries look small. The banks can try to influence the feeling in the market
so that dealers change their attitude to the future of the currency.
The advantages of floating exchange rates are:
!

There is an inbuilt adjustment mechanism. If imports exceed exports, the currency will
depreciate and exports become relatively cheaper in foreign countries, thus helping to
increase exports. There is no need for government intervention.

There is continuous adjustment of the rate, in contrast to the infrequent, large and
disruptive revaluations in fixed systems.

Domestic economic policy can be managed independently of external constraints

imposed by the need to maintain the exchange rate.

There is no possibility of imported inflation, as the exchange rate adjusts relative prices.

There is no need for large official reserves (unless there is managed floating).

Adjustments to the exchange rate are made by the market: they are not delayed by
political considerations.

The disadvantages of floating exchange rates are:

They create uncertainty and raise the costs of international activities because of the need
to cover risk.

There are no restraints on inflationary domestic economic policies.

Changes in the rate may be due to speculation or flight from weakening currencies and
have nothing to do with the trading position of the country. This may make exports
relatively dearer and imports cheaper and cause a payments deficit.

The impact of a change in a floating exchange rate depends on the price elasticities of demand
for exports and imports. If both are elastic, a fall in the rate will reduce imports, which become

Licensed to ABE

320

Foreign Exchange

dearer in the home market, and increase exports, which become cheaper in foreign markets.
The opposite happens if the rate appreciates. If the demand for exports abroad is inelastic, the
effect of a depreciation will be that the volume of exports does not increase but the lower price
earns less foreign exchange. If imports are price-inelastic, the rise in their price does not
reduce demand significantly and more foreign exchange is bought to pay for them: this
worsens the balance of payments. Higher import prices for materials, components and finished
goods may cause inflation.

Licensed to ABE

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