Equilibrium in a Perfectly Competitive Market

While each labor market is different, the equilibrium market wage rate and the equilibrium
number of workers employed in every perfectly competitive labor market is determined in the
same manner: by equating the market demand for labor with the market supply of labor. The
determination of equilibrium market wage and employment is illustrated in Figure .

The equilibrium market wage is W, and the equilibrium number of workers employed
is Q. At wage rates greater than W, the demand for labor would be less than the supply of
labor, implying that there would be a labor surplus. At wage rates belowW, the demand for
labor would be greater than the supply of labor, implying that there would be a labor
shortage. A labor surplus is eliminated when some workers agree to sell their labor for lower
wages, thereby driving down the market wage rate to W. A labor shortage is eliminated when
some firms agree to employ workers at higher wages, thereby driving the market wage rate
up to W. At the equilibrium wage rate, there is no surplus or shortage of labor.

Labor Demand and Supply in a Monopsony

A labor market in which there is only one firm demanding labor is called a monopsony. The
single firm in the market is referred to as the monopsonist. An example of a monopsony
would be the only firm in a “company town,” where the workers all work for that single firm.

Wage‐searching behavior. Because the monopsonist is the sole de‐mander of labor in the

market, the monopsonist's demand for labor is the market demand for labor. The supply of

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labor that the monopsonist faces is the market supply of labor. Unlike a firm operating in a
perfectly competitive labor market, the monopsonist does not simply hire all the workers that
it wants at the equilibrium market wage. The monopsonist faces the upward‐sloping market
supply curve; it is a wage‐searcher rather than a wage‐taker. If the monopsonist wants to
increase the number of workers that it hires, it must increase the wage that it pays to all of its
workers, including those whom it currently employs. The monopsonist's marginal cost of
hiring an additional worker, therefore, will not be equal to the wage paid to that worker
because the monopsonist will have to increase the wage that it pays to all of its workers.

A numerical example of a monopsony market is provided in Table . The first two columns
provide data on the market supply of labor that the monopsonist faces. The third column
reports the total cost to the monopsonist of hiring each worker, which is just the wage times
the number of workers. The fourth column reports the marginal cost of labor, which is the
change in monopsonist's total cost of labor as it hires additional workers.

Suppose the monopsonist wants to increase the number of workers that it hires from 2 to 3. In
order to attract the third worker, the monopsonist must offer an hourly wage of $20 instead of
$15. However, because the monopsonist cannot discriminate among its workers (and risk
alienating them), it must offer the higher $20 wage to its two current employees. Hence, the
monopsonist's costs from hiring the third worker are $60 (3 × $20), and the marginal cost
from hiring the third worker is $30 ($60 − $30). The marginal cost of $30 exceeds the new
market wage of $20 because the monopsonist must also pay its two current employees an
hourly wage that is $5 higher than before.

Equilibrium in a Monopsony Market

In a monopsony market, the monopsonist firm—like any profit‐maximizing firm—

determines the equilibrium number of workers to hire by equating its marginal revenue

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product of labor with its marginal cost of labor. Figure illustrates the monopsony labor
market equilibrium, using the supply and cost data from Table .

Labor Demand and Supply in a Perfectly Competitive Market

In addition to making output and pricing decisions, firms must also determine how much of
each input to demand. Firms may choose to demand many different kinds of inputs. The two
most common are labor and capital.

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The demand and supply of labor are determined in the labor market. The participants in the
labor market are workers and firms. Workers supply labor to firms in exchange
for wages. Firms demand labor from workers in exchange for wages.

The firm's demand for labor. The firm's demand for labor is a derived demand; it is
derived from the demand for the firm's output. If demand for the firm's output increases, the
firm will demand more labor and will hire more workers. If demand for the firm's output
falls, the firm will demand less labor and will reduce its work force.

Marginal revenue product of labor. When the firm knows the level of demand for its
output, it determines how much labor to demand by looking at the marginal revenue
product of labor. The marginal revenue product of labor (or any input) is the additional
revenue the firm earns by employing one more unit of labor. The marginal revenue product of
labor is related to the marginal product of labor. In a perfectly competitive market, the
firm's marginal revenue product of labor is the value of the marginal product of labor.

For example, consider a perfectly competitive firm that uses labor as an input. The firm faces
a market price of $10 for each unit of its output. The total product, marginal product, and
marginal revenue product that the firm receives from hiring 1 to 5 workers are reported in
Table .

The marginal revenue product of each additional worker is found by multiplying the marginal
product of each additional worker by the market price of $10. The marginal revenue product
of labor is the additional revenue that the firm earns from hiring an additional worker; it
represents the wage that the firm is willing to pay for each additional worker. The wage that
the firm actually pays is the market wage rate, which is determined by the market

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demand and market supply of labor. In a perfectly competitive labor market, the individual
firm is a wage‐taker; it takes the market wage rate as given, just as the firm in a perfectly
competitive product market takes the price for its output as given. The market wage rate in a
perfectly competitive labor market represents the firm's marginal cost of labor, the amount
the firm must pay for each additional worker that it hires.

The perfectly competitive firm's profit‐maximizing labor‐demand decision is to hire workers

up to the point where the marginal revenue product of the last worker hired is just equal to
the market wage rate, which is the marginal cost of this last worker. For example, if the
market wage rate is $50 per worker per day, the firm—whose marginal revenue product of
labor is given in Table —would choose to hire 3 workers each day.

The firm's labor demand curve. The firm's profit‐maximizing labor‐demand decision is

depicted graphically in Figure .

This figure graphs the marginal revenue product of labor data from Table along with the
market wage rate of $50. When the marginal revenue product of labor is graphed, it
represents the firm's labor demand curve. The demand curve is downward sloping due to
the law of diminishing returns; as more workers are hired, the marginal product of labor
begins declining, causing the marginal revenue product of labor to fall as well. The
intersection of the marginal revenue product curve with the market wage determines the
number of workers that the firm hires, in this case 3 workers.

An individual's supply of labor. An individual's supply of labor depends on his or

her preferences for two types of “goods”: consumption goods and leisure. Consumption
goods include all the goods that can be purchased with the income that an individual earns
from working. Leisure is the good that individuals consume when they are not working. By
working more (supplying more labor), an individual reduces his or her consumption of leisure
but is able to increase his or her purchases of consumption goods.

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In choosing between leisure and consumption, the individual faces two constraints. First, the
individual is limited to twenty‐four hours per day for work or leisure. Second, the individual's
income from work is limited by the market wage rate that the individual receives for his or
her labor skills. In a perfectly competitive labor market, workers—like firms—are wage‐
takers; they take the market wage rate that they receive as given.

An individual's labor supply curve. An example of an individual's labor supply curve is
given in Figure .

As wages increase, so does the opportunity cost of leisure. As leisure becomes more costly,
workers tend to substitute more work hours for fewer leisure hours in order to consume the
relatively cheaper consumption goods, which is the substitution effect of a higher wage.

An income effect is also associated with a higher wage. A higher wage leads to higher real
incomes, provided that prices of consumption goods remain constant. As real incomes rise,
individuals will demand more leisure, which is considered a normal good—the higher an
individual's income, the easier it is for that individual to take more time off from work and
still maintain a high standard of living in terms of consumption goods.

The substitution effect of higher wages tends to dominate the income effect at low wage
levels, while the income effect of higher wages tends to dominate the substitution effect at
high wage levels. The dominance of the income effect over the substitution effect at high
wage levels is what accounts for the backward‐bending shape of the individual's labor
supply curve.

Market demand and supply of labor. Many different markets for labor exist, one for
every type and skill level of labor. For example, the labor market for entry level accountants

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is different from the labor market for tennis pros. The demand for labor in a particular market
—called the market demand for labor—is the amount of labor that all the firms participating
in that market will demand at different market wage levels. The market demand curve for a
particular type of labor is the horizontal summation of the marginal revenue product of labor
curves of every firm in the market for that type of labor. The market supply of labor is the
number of workers of a particular type and skill level who are willing to supply their labor to
firms at different wage levels. The market supply curve for a particular type of labor is the
horizontal summation of the individuals' labor supply curves. Unlike an individual's supply
curve, the market supply curve is not backward bending because there will always be some
workers in the market who will be willing to supply more labor and take less leisure time,
even at relatively high wage levels.

The marginal revenue product of labor equals the marginal cost of labor when the firm
employs 3 workers. The equilibrium market wage rate is determined by the market labor
supply curve. In order to employ 3 workers, the firm will have to pay a wage of $20. Hence,
the equilibrium wage is $20, and the equilibrium number of workers employed is 3.

Because the monopsonist is the only demander of labor in the market, it has the power to pay
wages below the marginal revenue product of labor and to hire fewer workers than a
perfectly competitive firm. In Figure , the perfectly competitive firm would face a market
wage of $25 because that is the wage rate corresponding to the intersection of the market
demand and supply curves. If the perfectly competitive firm had the same marginal revenue
product as the monopsonist, the perfectly competitive firm would equate marginal revenue
product with the market wage and choose to hire 4 workers at $25. The monopsonist's
decision to hire only 3 workers at a wage of $20 makes it clear that monopsony, like
monopoly in a product market, reduces society's welfare.

Capital, Loanable Funds, Interest Rate

The demand and supply for different types of capital take place in capital markets. In these
capital markets, firms are typically demanders of capital, while households are
typically suppliers of capital. Households supply capital goods indirectly, by choosing
to save a portion of their incomes and lending these savings to banks. Banks, in turn, lend
household savings to firms that use these funds to purchase capital goods.

Loanable funds. The term loanable funds is used to describe funds that are available for
borrowing. Loanable funds consist of household savings and/or bank loans. Because
investment in new capital goods is frequently made with loanable funds, the demand and
supply of capital is often discussed in terms of the demand and supply of loanable funds.

Interest rate. The interest rate is the cost of demanding or borrowing loanable funds.

Alternatively, the interest rate is the rate of return from supplying or lending loanable funds.
The interest rate is typically measured as an annual percentage rate. For example, a firm
that borrows $20,000 in funds for one year, at an annual interest rate of 5%, will have to
repay the lender $21,000 at the end of the year; this amount includes the $20,000 borrowed
plus $1,000 in interest ($20,000 × .05).

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If the firm borrows $20,000 for two years at an annual interest rate of 5%, it will have to
repay the lender $22,050 at the end of two years. After one year, the firm will owe the lender
$21,000 as explained above; however, because the loan is for two years, the firm does not
have to repay the lender until the end of the second year. During the second year, the firm is
charged compound interest, which means it is charged interest on both the principal of
$20,000 and the accumulated unpaid interest of $1,000. It is as though the firm receives a
new loan at the beginning of the second year for $21,000. Thus, at the end of the second year,
the firm repays the lender $21,000 + (21,000 × .05) = $22,050.

In general, the amount that has to be repaid on a loan of X dollars for t years at an annual
interest rate of r is given by the formula 

For example, if X = $20,000, r = .05, and t = 2, the amount repaid is found to be $20,000 ×
(1.05) 2 = $22,050.

Determination of the equilibrium interest rate. The equilibrium interest rate is

determined in the loanable funds market. All lenders and borrowers of loanable funds are
participants in the loanable funds market. The total amount of funds supplied by lenders
makes up the supply of loanable funds, while the total amount of funds demanded by
borrowers makes up the demand for loanable funds. The loanable funds market is illustrated
in Figure . The demand curve for loanable funds is downward sloping, indicating that at
lower interest rates borrowers will demand more funds for investment. The supply curve for
loanable funds is upward sloping, indicating that at higher interest rates lenders are willing to
lend more funds to investors. The equilibrium interest rate is determined by the intersection
of the demand and supply curves for loanable funds, as indicated in Figure .

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Rate of return on capital and the demand for loanable funds. The demand for loanable
funds takes account of the rate of return on capital. The rate of return on capital is the
additional revenue that a firm can earn from its employment of new capital. This additional
revenue is usually measured as a percentage rate per unit of time, which is why it is called the
rate of return on capital. Firms will demand loanable funds as long as the rate of return on
capital is greater than or equal to the interest rate paid on funds borrowed. If capital becomes
more productive—that is, if the rate of return on capital increases—the demand curve for
loanable funds depicted in Figure will shift out and to the right, causing the equilibrium
interest rate to rise, ceteris paribus.

Thriftiness and the supply of loanable funds. The supply of loanable funds reflects

the thriftiness of households and other lenders. If households become more thrifty—that is,
if households decide to save more—the supply of loanable funds increases. The increase in
the supply of loanable funds shifts the supply curve for loanable funds depicted in Figure
down and to the right, causing the equilibrium interest rate to fall, ceteris paribus.

Present Value and Investment Decisions

Firms purchase capital goods to increase their future output and income. Income earned in the
future is often evaluated in terms of its present value. The present value of future income is
the value of having this future income today.

Present value formula. The present value of receiving $20,000 one year from now can be
calculated using the present value formula. The formula for finding the present value
of X dollars received t years from now at the current market interest rate r is

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For example, if X = $20,000, t = 1, and r = .05, the present value of $20,000
received one year from now is 20,000/(1.05)1 = $19,047.62.

The present value of $20,000 received two years from now at an interest rate of 5% is found
by setting X = $20,000, t = 2, and r = .05. The present value in this case is $20,000/(1.05)2 =
$18,140.59. As you can see from these examples, the present value of the future income is the
amount of income that you would need to invest today, at current market interest rates, in
order to obtain the same amount of future income at the same future date.

Firm's investment decision. The firm's investment decision is to determine whether to

purchase new capital. In determining whether to purchase new capital—for example, new
equipment—the firm will take into account the price of the new equipment, the revenue that
the new equipment will generate for the firm over time, and the scrap value of the new
equipment. The firm will also take into account the interest rate, which represents the firm's
opportunity cost of investing in the new equipment. It will use the interest rate to calculate
the present value of the future net income that it expects to earn from its purchase of the new
capital equipment. If the present value is positive, the firm will choose to purchase the new
equipment. If the present value is negative, it is better off forgoing the investment in new
equipment.

As an example, consider a restaurant that is trying to decide whether to invest in a new piece
of capital equipment—a jukebox. The jukebox costs $7,000 and lasts 4 years. The restaurant
estimates that the jukebox will provide it with income of $2,000 per year, net of maintenance
costs. After 4 years, the scrap value of the jukebox is estimated at $500. In determining
whether to purchase the jukebox, the firm will calculate the net present value of the present
and future income that it receives from purchasing the jukebox. The firm's present value
calculations are shown in Table for an interest rate of 10%.

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The calculation of net present value includes the initial outlay of $7,000 for the jukebox. The
present value formula is used to calculate the present value of the $2,000 annual income
received in each of the 4 years. In the fourth year, the $500 scrap value is added to the $2,000
in income received from the jukebox. The total net present value of the jukebox turns out to
be −$318. Because this amount is negative, the firm will choose to forgo purchasing the
jukebox.

As Table reveals, the firm's net present value calculations depend on the interest rate. The
higher the interest rate is, the higher the firm's opportunity cost of investing in the jukebox. A
higher interest rate lowers the present value of the future income earned from capital, making
it less profitable for the firm to invest in new capital; however, if interest rates fall, the
opportunity cost of investing in new capital also falls. The lower the interest rate is, the
higher the present value of the future income earned from new capital investment, and the
more likely it is that firms will invest in new capital.

For example, consider what happens to the firm's net present value calculations for the
jukebox when the interest rate falls from 10% to 6%. Table repeats the present value
calculations of Table at the lower interest rate of 6%.

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At the lower interest rate, the net present value of the jukebox is positive ($326). If the firm
can obtain $7,000 in loanable funds at 6% interest, it will choose to purchase the jukebox.

The decision to invest in other types of capital goods can also be made on the basis of present
value calculations. For example, the decision to invest in human capital by attending college
is based on the present value of the future income that an individual can earn with a college
degree. If the present value is positive, the individual will choose to attend college. If the
present value is negative, the individual will not attend college and will perhaps take a job
instead.

Measures of Capital

While labor is measured in terms of the number of workers hired or the number of hours
worked, it is difficult to measure capital in terms of physical units because there are so many
different types of capital goods. Capital goods, therefore, are simply measured in terms of
their market or dollar value.

Capital stock. The market value of capital goods at a given point in time, for example, at the
end of a year, is referred to as the capital stock. A firm's capital stock is the market value of
its factory, equipment, and other capital goods at a given point in time. A household's capital
stock is the market value of its residential structures, human capital, and other capital goods
at a given point in time. Firms' and households' capital stocks will vary over time due
to investment and depreciation.

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 Investment. Investment is the addition of new capital goods to a firm's or household's
capital stock. Investment is a flow measurement; it represents the market value of new
capital purchased or produced per unit of time. For example, if a firm with $90,000 in capital
at the end of last year purchases $10,000 in capital during the current year, its investment for
this year is $10,000, while its capital stock at the end of the current year is $100,000.

Depreciation. Depreciation is also a flow measurement; it measures the reduction in market

value of a firm's or household's capital stock per unit of time. Depreciation of the capital
stock is caused by normal wear and tear and by the obsolescence of capital goods over time.

When depreciation over a period of time exceeds investment over the same period of time,
the capital stock decreases; otherwise, the capital stock increases or remains the same. For
example, if the firm with $90,000 in capital at the end of last year purchases $10,000 in new
capital during the current year, but experiences $20,000 in depreciation during the current
year, its capital stock at the end of the current year will have decreased to $80,000 ($90,000 +
$10,000 − $20,000). If depreciation during the current year is only $5,000, instead of
$20,000, then the firm's capital stock at the end of the current year will have increased to
$95,000.

Living Standards
Living standards or standards of living refer to all the factors that contribute to a
person’s well-being and happiness
Measuring Living Standards
 GDP per head/capita: this measures the average income per person in an economy.
Real GDP per capita = Real GDP / Population
Merits of using GDP per capita to measure living standards:

 GDP is a useful measure of the total production taking place in the country, and so indicates
the material well-being of the economy
 it also takes population into consideration, adding emphasis on the goods and services
available to individuals
 since it is calculated on output, is a good indicator of the jobs being created
 GDP data is readily available so is population data

Limitations of using GDP per capita to measure living standards:

 it takes no account of what people can buy using their incomes. A country with a high
GDP per head may be no better off than a country with a low GDP per head, if there are far
fewer products to choose from
 similarly, GDP doesn’t consider changes in technology that can have a large impact on
living standards. People might have had more income in the last decade but they couldn’t
benefit from all the technology available today
 distribution of income is very unequal in reality, so the GDP per head isn’t accurate. Some
people might be very rich while others very poor, but the GDP per head will only give the
average incomes
 real GDP excludes the unpaid work people do for charities and voluntary organizations etc.
Thus, it understates the total output

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 GDP also doesn’t differentiate between the positive and negative values economies place
on different output/expenditure. For example, if the output rises because the sales of
tobacco, alcohol or pornographic materials, it might show in the records as a rise in GDP per
head but might not actually make people better off. Similarly, GDP might rise if the
government has to rebuild after a natural disaster, which doesn’t mean living standards have
risen
 the official GDP figures can be overstated due to technical errors or by political manipulation
to look good, and give a wrong picture of living standards
 this measure doesn’t consider leisure activities, health and education levels, environmental
quality- all that determines people’s happiness and well-being
 in order to effectively compare GDP per head across countries, they need to be converted to a
common currency and adjusted for differing purchasing power in different countries
 comparing GDP per head can also be unreliable as GDP accounting methods can be different
for different countries.
 

 Human Development Index (HDI): used by the United Nations to compare living standards
across the globe, the HDI combines different measures into one to give a HDI value from 0
(lowest) to 1(highest). These are:
 Income index, measured using the average national income – GNI per head adjusted for
differences in exchange rate and prices in different countries (purchasing power parity)
 Education index, measured by how many years on average, a person aged 25 will have
spent on education (mean years of schooling) and how many years a young child entering
school can now be expected to spend in education in his entire life (expected years of
schooling)
 Healthcare index: measured by average life expectancy at birth
The benefits of using HDI to measure living standards:

 it takes into account some major indicators of living standards

 recognises that it is not just output or income that determines living standards, but also social
factors
 it is a useful method to compare global living standards– it shows clear patterns of living
standards
 it is very useful and reliable measure since its produced by the UN and is thus also widely
used and recognised
The limitations of HDI to compare living standards:


 it combines a set of separate indicators into one, so a country with good literacy rates
and living standards but poor life expectancy can have a low HDI value
 there are wide divergences in HDI within countries
 GNI per head doesn’t say anything about inequalities in income and wealth within
countries
 it doesn’t consider other factors such as environmental quality, access to safe drinking
water, political freedom, crime rates etc. which are also important indicators of living
standards
 the HDI information for all countries may not be available such as war-struck
countries where civilisation has been disrupted

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 In the 2019 HDI index published by the UN, Norway comes first with an HDI index of 0.954
while Niger comes last with an index of just 0.377 owing to very low levels of education and
GNI per head.
 

Reasons for differences in living standards and income distribution within and between
countries

These have been discussed above in the merits and limitations of using GDP per capita and
HDI. More will be discussed in the coming chapters. Some other reasons are discussed below

Difference in living Standards within a country: there can be variations in living standards

within a country. An excellent example of this is the high living standards of the Indian state
of Kerala (where IGCSE AID is based!) which has a HDI index of 0.779 while the poorest
state of Bihar stands at 0.567 (2018).
 
 Regional variances in income and consumption
 Major type of sectors/jobs: manufacturing and services heavy regions will have higher
incomes, education and health services compared to agricultural regions
 Local government provisions of education and health
Difference in living Standards between countries:
 Productivity of industries: more productive industries yield more output and incomes
 Major industries: what makes countries like Qatar and Norway achieve some of the world’s
highest per capita incomes is that their income comes mostly from petroleum industries that
are scare and highly demanded internationally
 Population: dense population lower per capita income and put pressure on scarce resource
 Ability of citizens pay taxes: higher tax-base and taxable incomes allow governments to
invest in infrastructure and welfare programmes
 Provision of health and educational facilities
 Variety of goods/services produced: if citizens can choose from a wide variety of products,
living standards rise. Western countries like US enjoy this
 War, crime and natural disasters: war-struck countries of Asia, the high crime rates of
Latin America and frequent natural disasters in island countries, drive down their living
standards as they damage infrastructure and put people into hardship

Poverty
Absolute poverty: the inability to afford basic necessities needed to live (food, water,
education, health care and shelter). This is measured by the number of people living below a
certain income threshold (called a poverty line).
Relative poverty: the condition of having fewer resources than others in the same society. It
is measured by the extent to which a person’s or household’s financial resources fall below
the average income level in the economy. Relative poverty is basically a measurement of
income inequality since a high relative poverty should indicate a higher income inequality.
Causes of poverty
 Unemployment: when people are unemployed and have to go without income for a long
time, they may end up having to sell their possessions, consume less and go and into poverty.
 Low education levels: this means that people are uneducated, unskilled and unable to find
better jobs, keeping them in poverty.

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 The size of family: more family members with only a few people earning, means more costs
of living, pulling the family into poverty if they’re not earning much.
 Age: older people are likely to have more health problems and be less suitable for further
employment, causing poverty. Young people are still employable and may find ways to earn
an income.
 Poor government support for basic services.
 Poor health: ill mental and physical health is both a cause and result of poverty.
 Overpopulation: high population density will put pressure on scarce resource and the
economy may not be able to produce and provide for everyone, causing poverty.
 Minority group/ethnicity/migrants: will face discrimination from bureaucrats, employers
and the society at large and so won’t be able to access and enjoy all services. E.g.: African-
Americans in the US tend to be poorer than their white counterparts.
 Gender: women usually face discrimination, especially in employment and end up being
poorer than men.
Policies to alleviate poverty
 Introduce measures to reduce unemployment: an expansionary fiscal/monetary policy will
increase aggregate demand and increase employment opportunities. Income and standards of
living will rise.
 Impose progressive taxes: income taxes are progressive, that is, they increase as
income increases. Imposing these will mean that people on higher incomes will pay a large
percentage of their incomes as tax and help reduce relative poverty.
 Introduce welfare services: money from taxes can be provided as income support to people
with very low incomes. It can also be used to provide free or low-cost homes, healthcare and
education.
 Introduce minimum wage legislation to raise the wage of low-paid employees.
 Increase the quantity and quality of education.
 Attract and invite inward investments from firms abroad to provide jobs and incomes for
people.
 Overseas aid could be gained from foreign governments and aid agencies. This will include
food aid, financial aid, technological aid, loans and debt relief.
Population is the total number of people inhabiting a specific area. Two-hundred years ago,
the world population was just over a billion, now it is about 7.7 billion, with China and India
having populations above 1 billion each! It is projected to hit 10 billion by 2056.

Factors that affect population

 Birth rates: the average number of children born in a country each year compared to the total
population of an economy is known as the birth rate. This is usually expressed as the number
of births for every 1000 people in the population.
Why do different countries have different birth rates?
 Living standards: improved quality and availability of food, housing, clean water and
medical care result in fewer babies dying. Countries where children often die due to poor
living standards have higher birth rates (people have more children fearing that some of
their children might die. These children can then work to produce food and earn incomes).
 Contraception: increased use of contraception and legalisation of abortion have reduced
birth rates in developed countries.
 Customs and religion: many religious beliefs don’t allow the use of contraceptive pills,
so birth rates in those communities rise. In developed economies it is now less fashionable
to have large families, so birth rates have fallen.

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  Changes in female employment: more females in developed countries entering the
labour force  has resulted in falling birth rates since they do not want motherhood to affect
their careers.
 Marriage: in developed countries, people are tending to marry later in life, so birth rates
have reduced.
 Death rates: the number of people who die each year compared to every 1000 people of the
population is the death rate of an economy.
Reasons for differing death rates in different economies:
 Living standards: just as birth rates, death rates also tend to be very high in less-
developed economies due to lack of good-quality food, shelter and medical care.
Malnutrition remains the major cause of high death rates in these countries. In developed
countries, the major causes of death include lifestyle diseases, mostly caused by unhealthy
diets.
 Medical advances and heath care: lack of medical care and infrastructure in less-
developed countries continue to be a cause for high death rates.
 Natural disasters and wars: hurricanes, floods, earthquakes and famine due to lack of
rain and poor harvests, and wars and civil conflicts increase death rates.
 Net Migration: migration refers to the number of people entering (immigration) and leaving
(emigration) the country. Net migration measures the difference between the immigration
and emigration to and from an economy. A net inward migration will increase the working
population of the economy, but can put pressure on governments finances as demand for
housing, education and welfare increase. A net outward migration may increase the income
per capita (if the emigrants send money to families back home) and thus the HDI, but can
result in loss of skilled workers.
Reasons for differing net migration in different economies:
 Living standards: people move to countries where living standards are high which they
can benefit from.
 Employment/wages: people migrate mainly to seek better job opportunities. Widespread
unemployment and low wages in the home country will cause people to move to countries
with better employment opportunities and higher wages.
 Climate: very cold or very warm countries/regions will face more emigration than other
countries.

Population structure
The structure of a population can be analyzed using:

 Age distribution: the number of people in each age-group.

Falling birth and death rates mean that the average age in developed countries are rising
whereas in developing and less-developed economies, high death and birth rates result in low
average ages. The median age in developed Monaco is highest at 53.1 while in under-
developed Niger it is just 15.3. Dependency ratio is the ratio of the dependent population
(those outside the labour force – children and senior citizens – who depend on the labour
force to supply them with goods and services by paying taxes) to the total population in an
economy. A high dependency population, such as in Japan, put pressure on the government to
increase taxes rates in order to raise more revenue to support the dependents, putting pressure
on the labour force.
Consequences of an ageing population:
 The workforce will decline and there will be much dependence on the tax-paying
population to fund the welfare of old people.
 Increase in demand for products for old people including healthcare.

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  The government will have to spend more on housing, old age welfare schemes etc.
 Old people are less mobile and so the economy will be slow to adapt to new technologies.
 Gender distribution: the balance of males and females. The sex ratio measures the no. of
males to the no. of females (the global sex ratio is 101:100; while Arab countries have sex
ratios as high as 2.87, island countries register low sex ratios). Since the average female lives
longer than the average male, there are more females in the older age-groups than
males. Gender imbalance is an excess of males or females and is caused by
 Wars killing many young males
 Violence towards females (honour killings, rapes)
 Sex-specific immigration – more males immigrate to a country looking for work
Consequences of changes in the gender distribution:
 having more females will encourage birth rates to rise and increase population growth
 more females in employment will increase productivity
 more females in education and employment will increase living standards
 a more balanced gender distribution can aid better social equality as social attitudes
towards women in education and employment become progressive
Population pyramids display the age and gender distribution of an economy. The vertical
axes show the age groups and the horizontal axes show the gender groups- males on the
left and females on the right.

 Geographic distribution: where people live. 90% of the world population live in developing
countries. This puts a lot of pressure on scarce resources in these countries. About half of the
world population live in urban areas, and this continues to rise, which has helped increase
production and living standards but resulted in rapid consumption of natural resources and
high levels of pollution and congestion.

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 Occupational distribution: what jobs people work in. In developed economies, more people
work in the service sector while in less-developed economies, most people work in
agriculture. In developing economies, there is a huge migration of workers from primary
production to manufacturing and service sectors. Female employment and self-employment
are also rising, which will add to production and higher living standards.
An optimal population is one where the output of goods and services per head of the
population is maximised. An economy is underpopulated when it does not have enough
labour to make the best use of its resources; and it is overpopulated when the population is
too large given the resources it has.
Effects of increasing population size
 Increases size of the home market and thus potential for increase in aggregate demand in
the long-run.
 Higher demand and incomes will lead to more economic growth and expansion.
 Increased supply of labour.
 Puts more pressure on already scarce resources, especially land.
 More capital goods will have to be produced to sustain and satisfy the needs and wants of
the enlarged population.
 Fall in rate of productivity in line with the law of diminishing returns – too many people
working on limited resources means low productivity.
 Shift of employment and output from the primary sector towards the services
sector because land for primary activities is fixed, but want for services is practically infinite
as population grows, and the emergence of mechanisation and technologies will force people
out of the primary sector.
 Congestion of urban centres: as population and incomes rise, people will move to cities and
towns which will become crowded. There will be need for heavy transport, communications,
housing, waste management infrastructure spending.
Developed and Less-developed Economies
Economic development refers to the increase in the economic welfare of people through
growth in productive scale and wealth of an economy. Governments aim for their countries to
expand from developing economies to developed economies.
Developed countries are characterised by high GDP per capita, high life expectancy, high
literacy rate, a stable or dwindling population growth, excellent infrastructure, high levels of
foreign investments, excellent healthcare, high productivity, and a relatively large tertiary
sector. Example: Japan
Under-developed economies or less-developed economies are characterised by very low
GDP per capita, high population growth, poor infrastructure, healthcare and education, low
literacy rates, low levels of foreign investments, poor productivity, and a relatively large
primary sector.
Example: Somalia
Developing economies are countries that are becoming more developed through expansion
of the industrial sector and fewer people suffering the extremes of poverty. They may attract
high levels of foreign investments and will be undergoing major economic shifts towards the
tertiary sector. However they may still have a low standard of living, owing to high
population growth. Example: India
The reasons for low economic development
 Over-dependence on agriculture: farming is the most common work in less-developed
economies. Most people work to feed themselves and their families and sell off any surplus.
This means that there is little or no trade happening , which results in poor incomes, no
economic growth or development.

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 Domination of international trade by developed economies: the more wealthier developed
economies have exploited poorer countries by buying up their natural resources at low prices
and selling products made from them in international markets at higher prices. Rich countries
also protect their industries by paying subsidies to domestic producers, increasing global
supply, and in turn, lowering prices. Poor economies cannot compete with these very low
prices, and they lose their jobs and incomes.
 Low levels of savings because of low incomes and widespread poverty.
 Lack of capital: low incomes in under-developed economies lead to a lack of savings that
could be invested in industries.
 Poor investment in infrastructure: good infrastructure in transport, health and education is
essential for growth and development.
 High population growth: rapidly expanding populations (due to high birth rates) in less-
developed countries will reduce the real GDP/income per head.
 Wars and conflicts deplete resources: there is little scope for development when the
country is a war zone.
 Corrupt and/or unstable governments: causes neglect of economy and citizens’ welfare
The opposites are true for developed economies.

Some development indicators that are used to measure how developed an economy are:

GDP per capita, population living on less than $1 a day, life expectancy at birth, adult literacy
rate, access to safe water supplies and sanitation, proportion of workers in different sectors of
production etc.
International Specialization
Specialisation is when a nation concentrates its productive efforts on producing a limited
variety of goods and services in which they’re really efficient and productive at and
have an advantage over other economies in.
For example, due to the existence of vast oil and gas reserves in the region, Middle-Eastern
countries concentrate their production on petroleum and have made a fortune off of it.

Specialisation is determined on the basis of either resource allocation or of cost of

production.

Absolute advantage: when one country can produce more efficiently than another either
by producing more of a good or service with same amount of resources or producing the
same amount of a good or service with fewer resources.
For example, India has an absolute advantage in operating call centres because of its
abundant and cheap labour force, compared to western countries.
Comparative advantage: when one country can produce a good at a lower opportunity
cost (in terms of other goods and services being forgone) than another country. It takes into
account the opportunity cost incurred in producing each good.
For example, India may have an absolute advantage in operating call centres (against
Philippines), but it has lower opportunity costs in other IT industries, than Philippines. Thus,
Philippines has, in recent years, seen a growing call centre industry while India has seen
theirs decline.
Note: you are not required by the syllabus to know the terms ‘absolute advantage’ and
‘comparative advantage’, but only the principles.
Advantages of international specialisation:

 Economies of scale and efficiency: just like specialisation by individuals, countries can
specialise in what they do best, and this leads to efficiency and economies of scale. It can

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 therefore increase output while reducing costs. When more countries specialise, world output
increases.
 Job creation: specialisation leads to increased output and therefore it could lead to more
investment and thus jobs are created. Moreover, it requires skilled labour and thus earnings
are higher.
 Allows more international trade to take place. Therefore goods and services produced
under the most efficient conditions can be traded and all countries can benefit from them.
 Revenue to the government: as income increases and more trade takes place, it can increase
government revenue from taxes.
 Wider markets: specialisation and trade allow firms to sell their products to international
markets, helping them build international brands and increase market shares and profits.
 Consumer sovereignty: consumer across the globe will now be able to buy cheap and high
quality products from around the world. Because of specialisation and trade, we now can get
the best chocolate from Switzerland, the best coffee from Ghana and Colombia, cheap IT
services from India, oil from the Middle East, and budget cars from Japan.

Disadvantages of international specialization:

 Structural unemployment: even though national level specialisation usually creates more
jobs, there is a risk that certain types of structural unemployment might occur. As the country
moves towards specialisation, the workers in the declining industries will be put out of work.
 Over-exploitation of resources: output maybe increased by over-exploiting Today,
international specialization and trade is causing rapid depletion of non-renewable resources
like oil and coal. Middle Eastern countries are depleting their oil resources so quickly, they
are now building new industries to sustain them in the future.
 Threat of foreign competition: non-specialised industries of a country will face fierce
competition from the foreign countries that specialise in them.
 Risk of over-specialisation: because of more international dependence on other countries for
trade (they will have to sell their specialised products to other countries and buy other
products they need from abroad), any global economic change will greatly affect highly
specialised countries. For example, petroleum-exporting countries have seen their revenues
dip when oil prices fall. They are now trying to diversify into other products like tourism to
sustain them.
 Strategic vulnerability: relying on other countries for vital goods and services makes a
country dependent on those countries. Political or economic changes abroad may impact the
supply of goods or services available to the country.
Globalisation, Free Trade and Protection

Globalisation is a process of interaction and integration among the people, companies, and
governments of different nations, a process driven by international trade and investment and
aided by information technology

Multinational Corporations (MNCs)

Businesses which have their operations, factories and assembly plants in more than one
country are known as multinational businesses. Examples include Starbucks, IKEA, Toyota,
Adidas etc. The country they are based in is called the home country, and the countries they
operate in are called host countries.
Advantages to home country:

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 MNCs create opportunities for marketing the products produced in the home country
throughout the world.
 They create employment opportunities to the people of home country, both at home and
abroad.
 It aids and encourages the economic growth and development of the home country.
 MNCs help to maintain favourable balance of payments of the home country in the long
run as they export their products abroad.
Advantages to host country:

 Provides significant employment and training to the labour force in the host country.
 Transfers of skills and expertise, helping to develop the quality of the host labour force.
 MNCs add to the host country’s GDP through their spending, for example with local
suppliers and through capital investment.
 Competition from MNCs acts as an incentive for domestic firms in the host country to
improve their competitiveness and efficiency.
 MNCs extend consumer and business choice in the host country.
 MNCs bring with them efficient business practices, technologies and standards from
across the world, which can influence the industries in the home country.
 Profitable MNCs are a source of significant tax revenues for the host economy (for example
on profits earned as well as payroll and sales-related taxes).
Disadvantages to home country:

 MNCs transfer capital from the home country to various host countries causing

unfavourable balance of payments.
 MNCs may not create employment opportunities to the people of home country if it
employs labour from other countries, perhaps due to lower costs or better skills.
 As investments in foreign countries is more profitable, MNCs may neglect the home
country’s industrial and economic development.
Disadvantages to host country

 Domestic businesses may not be able to compete with MNC’s efficiency, low costs, low
prices and brand image, and may be forced to close shop.
 MNCs may not act ethically or in a socially responsible way, especially by taking
advantage of weak countries who gain a lot from the MNCs presence in their country. For
example, exploiting workers with low wages and poor working conditions in a country where
labour laws are weak.
 MNCs may be accused of imposing their culture on the host country, perhaps at the
expense of the richness of local culture.
 Profits earned by MNCs may be remitted back to the MNC’s home country rather than
being reinvested in the host economy.
 MNCs may make use of transfer pricing and other tax avoidance measures to reduce the
profits on which they pay tax to the government in the host country.

Free Trade and Protection

Free trade is when there are no restrictions for trade between economies.
The advantages of free trade:

 Allows countries to benefit from specialisation: if there was no international trade, then
countries wouldn’t be able to specialise – that is, they would have to become self-sufficient
by producing all the goods and services they require themselves. Total output would lower

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 and costs would rise. With specialization and free trade, output, incomes and living standards
will improve.
 Increases consumer choice: consumers can now enjoy a variety of products from around the
globe.
 Increases competition and efficiency: international trade means that there will be more
competition among firms in different countries. This would help increase efficiency.
 Creates new business opportunities: free trade will allow businesses to produce and sell
goods for overseas consumers and expand and grow their operations by doing so. Profits and
revenue would rise.
 Enables firms and economies to benefit from the best workforces, resources and
technologies from around the world.
 Increases economic inter-dependency and thus fosters cooperation and reduces potential for
international conflicts.
The disadvantages of free trade:

 Free trade may reduce opportunities for growth in less-developed economies and
threaten jobs in developed economies. Small businesses in developing countries may not be
able to compete with larger foreign firms. Established businesses in developed countries may
lose market share as new firms keep entering the market. The US has seen considerable
unemployment in manufacturing sectors since China joined the WTO and flooded
international markets with their cheap products.
 Causes rapid resource depletion and climate change as more resources are used up by
firms.
 Exploitation of workers and the environment: free trade has allowed firms to relocate to
countries with lower costs (usually lower wages), where workers and the environment can be
exploited (as health, safety and environmental laws in such countries are likely to be relaxed).
 Income inequality worsens: multinational firms and consumers have dominated the
international supply and demand. This means that the rich keep getting richer (by buying and
selling more products) while the poor lose out on products and resources.
Protection involves the use of trade barriers by governments to restrict international market
access and competition. Trade barriers include:
 Tariffs: these are indirect taxes on imported (or exported) goods that make them more
expensive, imposed in order to discourage domestic consumers from buying them.
 Subsidies: government allows subsidies to domestic producers so that they can increase their
output and reduce costs and in turn reduce prices, in the hope that consumers will be
encouraged to buy inexpensive domestic goods rather than imports.
 Quotas: this is a limit on the number of imports allowed into a country in a given period.
Restricting supply will push up their market prices and discourage consumption of those
imports.
 Embargo: this is a complete ban on imports of a good to a country.
 Excessive quality standards: imports may only enter a country after extensive quality
checks which will be costly and so foreign producers will be discouraged to sell their
products in the country, reducing imports.
Reasons for protection:

 To protect infant industries: trade barriers will help protect infant/sunrise industries
(industries that are new and are hoping to grow). Lesser competition from foreign firms will
increase their chances of survival and growth.

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 To protect sunset industries: sunset industries are those that are on their declining stage.
They would still employ many people and closure of firms in that industry will result in high
unemployment. Lesser competition from foreign firms will decrease their rate of decline.
 To protect strategic industries: strategic industries will include transport, energy, defence
etc. and governments will want to protect these so they are not dependent on supplies from
overseas. If foreign firms supplied these, they would restrict output and raise prices.
 To limit over-specialization: if a country specializes in the production of a narrow range of
products and there is a global fall in demand for one of them, then the economy is at risk.
Protectionism will ensure diversification into producing more products and reduce this risk.
 To protect domestic firms from dumping: dumping is a kind of predatory pricing, that
occurs when imports are sold at a price either below the price charged in the home market or
below its cost of production. As a result, domestic firms will be unable to compete and be
forced to go out of business. Once this happens, the foreign firms will raise their prices and
enjoy monopolistic power. Trade barriers will eliminate the risk of dumping.
 To correct a trade imbalance: protectionism can reduce the imports coming into a country
and thus reduce expenditure on imports by domestic consumers. If a country is experiencing
a deficit (imports exceeding exports), then protectionism will correct this imbalance.
 Because other countries use trade barriers.
Consequences of protection:

 They restrict consumer choice.

 They restrict new revenue and employment opportunities.
 High levels of import tariffs and quotas will increase the costs of production at home and
drive up prices, causing cost-push inflation.
 They protect inefficient domestic firms: when trade barriers are used to protect domestic
industries, it might include inefficient industries. Protectionism means that even very
inefficient industries are protected (when they are better off being exposed to foreign
competition and being forced to become more efficient).
 Other countries may retaliate: if a country introduces trade barriers to restrict imports from
other countries, the countries that are affected by this will also impose similar trade barriers.
A trade war may develop. Relations between countries will worsen.
 In today’s globalised society, being heavily protected and not engaging in free trade will
result in the country being out of pace with the rest of the world. They will be unable
to grow and develop, and will lose out on the benefits of free trade.
Tip: If you have trouble remembering all the pros and cons listed above, just remember this:
basically, the advantages of free trade are the disadvantages of protectionism and the
disadvantages of free trade are the advantages of protectionism.

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