MACMILLAN WORK OUT SERIES

SUE GRANT & RICHARD YOUNG

MACMILLAN
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sue Gi UMM zichard Young

MACMILLAN
 To our families

The authors and publishers wish to thank the

following who have kindly given permission for
the use of copyright material: The Economist for
extracts from various issues of The Economist.
Copyright © The Economist 1995; The Guardian
for Sally Weale, ‘Dying girl in court fight for
treatment’, The Guardian, 10 March 1995, and
‘The poor get poorer’, The Guardian, 21 February
1995; Financial Times for an extract from ‘Fall in
MO eases rate rise pressure’, Financial Times, 31
January 1995; The Controller of Her Majesty's
Stationary Office for a table from Britain 1995:
An Official Handbook, table 16.1, and the Central
Statistical Office for material from Social Trends
25, 1992; Newspapers Publishing plc for an
extract from Marie Woolf, ‘Supermarket “real
bread” ruins the small bakers’, Independent on
Sunday, 19 March 1995; Times Newspapers Ltd
NEW COLLEGE DURH for David Smith, ‘Britain’s black economy soars
to £50bn’, The Sunday Times, 13 February 1995,
LIBRARY Garth Alexander, ‘Yen's unstoppable rise
threatens to end in disaster’, The Sunday Times,
MOOR 12 March 1995, and Colin Narbrough, ‘Leap in
FRAMWE!! “ATE
imports widens UK’s world trade gap’, The Times,
10 February 1995, Copyright Times Newspapers
CLASS No. | ACC ANG: Ltd, 1995.

eats HOULMSM The author and publishers wish to thank the

following examination boards for permission to
use past questions: The Associated Examining

| ORDER
Board; Joint Matriculation Board; Northern
No. — palo Ireland Council for the Curriculum, Examinations
and Assessment; Scottish Examinations Board;
Southern Universities’ Joint Board; University of
Cambridge Local Examinations Syndicate;
University of London Examinations and
© Sue Grant and Richard Young 1989, 1991, 1996 Assessment Council; University of Oxford
Delegacy of Local Examinations; Welsh Joint
Education Committee. All examining groups
All rights reserved. No reproduction, copy or
wish to point out that worked examples
transmission of this publication may be made without included in the text are entirely the
written permission. responsibility of the authors and have neither
been provided nor approved by the board. They
No paragraph of this publication may be reproduced, may not constitute the only possible solutions.
The University of London Examinations and
copied or transmitted save with written permission or in
Assessment Council accepts no responsibility
accordance with the provisions of the Copyright, whatsoever for the accuracy or method of
Designs and Patents Act 1988, or under the terms of any working in the answers given.
licence permitting limited copying issued by the
The authors are most grateful to the following
Copyright Licensing Agency, 90 Tottenham Court Road,
Heads of Economics for their careful reading and
London W1P 9HE. correction of some or all of the original
typescript: Clarrie Haynes, Marlborough School,
Any person who does any unauthorised act in relation to Woodstock, Oxfordshire; Danny Myers, New
this publication may be liable to criminal prosecution College, Swindon, Wiltshire; Brian Sangster,
Burford School, Oxfordshire; Jonathan Townsend,
and civil claims for damages.
Abingdon School, Oxfordshire; Laurence
Whitehouse, Farnborough Sixth Form College,
First edition 1989 Hampshire. A particular thanks should be given
Revised 1991 to Robert Ackrill for the long hours of invaluable
Reprinted 3 times assistance given freely in shaping the initial
stages of the book. Past students of West
Second edition 1996
Oxfordshire Technical College, Corrina Boreham,
Angela Frost, Clare Guy and Robert Prior-
Published by Wandesforde, and Sally Trego, formerly of
MACMILLAN PRESS LTD Matthew Arnold School, corrected many early
Houndmills, Basingstoke, Hampshire RG21 6XS errors. We also owe a huge debt to the many
other students who have painstakingly worked
and London
through the examples. Robert Sulley of
Companies and representatives Macmillan has given the most helpful support.
throughout the world
Since this is a joint venture, both authors
ISBN 0-333-62573-0 thank their families for their sacrifices, patience
and understanding throughout.

A catalogue record for this book is available Any failings which remain are entirely our own.
from the British Library.
Every effort has been made to trace all the
copyright-holders, but if any have been
LO): ah eee, SOD eC Sa 4 eee. l inadvertently overlooked the publishers will be
05 04 03 02 O1 00 99 98 97 96 pleased to make the necessary arrangement at
Millet me)Sslaculiaa
Printed in Hong Kong
Syllabus analysis Start and completion
atte la-t mele melal mele column Keeps tabs on
dale cole)(a- Mele mal--10 your progress — see ata
—no more, no less glance which areas still
need to be worked
idalcelerelal

Date Date Self-

completed | asse essment
begun /|

Investigative study

Data response

— scaly Self-assessement
v Essays
ie) mecelOm com arele-maleluy
Chapter breakdown
well you've done or
Shows you in detal
areas which to to be
what is covered in the
revised again
chapters
 Introduction IV THE NATIONAL ECONOMY
17 Measures of Living Standards
| THE ECONOMIC PROBLEM AND 18 Aggregate Demand
DEMAND AND SUPPLY 19 Aggregate Supply and Income
1 The Economic Problem Determination
2 Demand 20 Changes in Economic Activity
3 Supply 21 Money, Banking and Monetary
4 Price Determination Policy
5 Elasticity 22 Unemployment
6 Costs of Production 23 Inflation

Il MARKET STRUCTURE V_ INTERNATIONAL TRADE AND

7 Size of Firms GOVERNMENT POLICY
8 Market Structure 24 International Trade
9 Comparison of Market Structures 25 Balance of Payments
26 Exchange Rates
lll MARKET FAILURE AND 27 Development Economics
GOVERNMENT INTERVENTION 28 Managing the Economy
10 Competition Policy
11 Regional Economics Index
12 Income and Wealth
13 Market Failure
14 Labour Markets
15 Labour Market Failure
TD GEG
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ela tataim cele ital miclam iC
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 How to use this book such as inflation and unemployment. Use the solution
given as an indication of the sort of analytical skills of
This'book has been designed to help you prepare for
evaluation and judgement that you should be using
your A Leyel examination in economics. Simply
yourself.
buying a revision text does not guarantee examination
The section on objective questions gives you a
success. However, by working from this book over the
chance to test your knowledge and understanding of a
months leading up to the final examination you will
topic. Do these questions without looking at the
improve your ability to understand and apply key
answers provided. If you give an incorrect solution to
economic concepts.
one of the questions refer back to the relevant section
Work Out Economics A Level is not intended as a
in the fact sheet.
textbook but as a comprehensive revision manual. If
there are topics you have not covered in class, refer to
a good textbook and make notes from the relevant
chapter. Key economic terms are in italic type for Most courses in A Level economics are over two
emphasis and are clearly defined in the text. years. Ideally, preparation begins six months before
The book is divided into self-contained chapters, the final examination. You cannot hope or expect to
each covering a major topic. At the beginning of each sustain intensive concentration for twenty-six weeks.
chapter you will find a summary of the essential Start by obtaining a copy of the syllabus from the
economics you need to know. Make sure you become appropriate examining group. Use the syllabus to
thoroughly familiar with the material in these write out a study plan, listing the topics you are going
summaries. to revise each week. Spend most time studying the
Each chapter contains a number of worked concepts and issues that are central to the subject. For
examples of the type of question you can expect in the instance you may find that some topics, such as
final examination. For data response and essay-type welfare economics, are covered in more depth in Work
questions, suggested solutions are given. It is Out Economics A Level than is required by your
absolutely essential that you do not treat the solutions syllabus.
provided as ‘model’ answers to be memorised and Build up to a period of intensive revision during the
ther copied out in the examination. In economics last four weeks before the exam. Many people find it
there is almost always more than one ‘correct’ helpful to write as they revise. Make notes on one side
solution to a given problem. This is particularly true of loose-leaf paper, leaving generous margins in case
in macroeconomics, where professional economists you want to add new ideas. In particular, make sure
are divided as to the causes and cures for problems that when you have finished a topic you can:
 Az aay

work out economics ¢ Mtrodéction dit

(1) Define economic terms (a) Essay questions

(2) List key points
(3) Apply important concepts For this paper you are going to need two pens, a ruler,
(4) Draw relevant graphs a pencil, a rubber and a watch. Correcting fluids such
as Tipp-Ex are not allowed! Essay questions test your
It is important to be able to draw graphs quickly and ability to evaluate arguments and express viewpoints.
accurately, and a little practice will be needed. Most students find this type of question the hardest to
The number of hours you put in is far less tackle, and on average the marks earned in the essay
important than what you put into those hours. Most paper are lower than those for data response and
students find that they can concentrate better and learn objective test papers.
faster if they work in bursts of thirty minutes with Start by reading through the paper and identifying
regular breaks. Avoid uninterrupted three-hour slogs. the topic covered by each question. Check the
Promise yourself a special ‘treat’ at the end of a phraseology, taking particular note of key words as
successful revision session. these will indicate what the examiner is looking for.
Try to review the material covered shortly after you For instance, ‘compare and contrast’ means discuss
have studied it, and again a few days later. At the similarities and differences, while ‘elucidate’ means
beginning of the revision programme have a look at explain. Only answer questions on topics you have
past questions and write down the main points you revised. Only attempt questions where you can answer
would make in an answer. Draw and label relevant each part. Once you have decided to attempt a
graphs. Make sure you can explain in your own words question, briefly plan your answer. Many candidates
important concepts such as crowding out and inferior like to gain confidence by tackling their best question
goods. It may help to draw up your own glossary of first. Remember, there are two main reasons why
key economic words. Find time to familiarise yourself capable students underachieve when writing essays:
with current economic trends in the UK by reading
(1) Candidates decide a question is about one topic
economic articles in the quality newspapers and
(e.g. inflation) and then write all they know about
journals. For instance, do you know the present rate of
that topic. |
inflation or the balance of payments trend? Similarly,
(2) Candidates copy out a memorised answer to a
you should be aware of the current government’s
similar past question.
policy. Are you aware of the Chancellor’s strategy for
demand management of the economy? As the final You will do much better if your answer is a well-
exam approaches, practise answering questions in full reasoned explanation that is relevant to the set
and under examination conditions. You will soon find question. Develop a line of argument that has a
that your ability to apply economics has improved beginning, a middle and an end. Try starting your
beyond all measure. essay by defining the important economic terms given
Make sure your study programme is balanced and in the question. Then make clear any assumptions you
allows time for enjoyment and relaxation. Work hard, are going to make. For example, suppose the question
do your best and look forward to the long summer is ‘ “In the long run, all firms earn normal profits,
holiday, when you can take a well-earned break. only.” Discuss’. You might begin by defining firms
and normal profits and then continue by initially
assuming a perfectly competitive market structure.
The
After establishing that the ability of firms to leave or
¥¢ Slightly nervous on the day of the enter the industry ensures that only normal profits are
ie else. Remember, with careful earned in perfectly competitive markets, in the long
revision and good examination techniques picked up run, end the essay by evaluating an industry assuming
by reading this book, you should do well. Arrive in imperfect competition.
good time. Do not forget to take the appropriate Some questions, such as the one just discussed,
equipment for each paper. There are three main types lend themselves to a graphical analysis. Clear, neat
of question in the final examination, although boards and labelled graphs that are relevant to the set
also make use of case studies and investigative studies question can save a hundred words of explanation. It
— see the grid at the end of the Introduction. is always better to draw a series of graphs to advance
an argument than to use one diagram for all stages of
vith, work out economics * introduction

an argument. Avoid simply drawing diagrams and on the verge of running out. Data response questions
then ignoring them in your answer. Any graph should are especially good at testing your ability to apply
be an integral part of the essay. Draw the examiners’ economics and to quantify. There are two types of
attention to a diagram by stating, say, ‘in Figure | the data response questions: statistical data, displayed as
firm sets output at Q’. Write in clear, simple short graphs, tables, charts or diagrams, and literary prose
sentences. Often arguments are best developed by extracts from newspapers, journals, etc. Each
stating a point, explaining that point and then giving a examining board tends to have its own ‘house’ style
real-world example. For instance, suppose part of a of data response question. Make sure you have
question asked, “Explain the meaning of ad valorem familiarised yourself with examples drawn from
taxes’. You might write: previous papers. In the actual exam, allocate sufficient
time for a careful study of the entire question. Here is
An ad valorem tax means value added tax
a check-list of points to consider when tackling
[statement]. A given percentage is added to the
statistical data response questions:
selling price of a good and the resulting tax is passed
on to the government by the seller [explanation]. For (1) Ask yourself what key economic concepts are
example, 17.5% VAT on the sale of a £200 camera being tested by the question.
would increase its market price to £235 and raise (2) Look at how the data have been obtained:
£35 of tax for the government [example]. (a) Are there any hidden assumptions or
unsupported statements?
Once a point has been fully developed, start a new
(b) Is the evidence used selective or biased?
paragraph. Try to relate your theory to the real world.
(c) Is the survey complete (i.e. all the appropriate
Examiners are always impressed if a candidate can
display an understanding of how economics population have been included) or a sample
influences the world around us. Remember, too, that (i.e. only some of the population have been
included)?
good candidates avoid narrow interpretations and
(3 —— Identify major variables in the data:
recognise that there is more than one valid approach.
(a) Are the figures shown as absolute values,
Do not use unacceptable abbreviations, for example,
percentages, index numbers, billions of £s,
‘gov’ instead of government. When using acceptable
abbreviations, first write out the word or phrase in full thousands of people etc.?
(b) Which is the largest item?
with the abbreviation following in brackets. For
(c) How do other items compare?
instance, ‘International Monetary Fund (IMF)’.
(d) Which variables are stock values (i.e. an
Thereafter you may use the abbreviation.
It is absolutely essential that you complete the amount at a given moment in time) or flow
values (i.e. an amount per time period)?
required number of questions. If you are running out
(4 Observe any trends (patterns) in the data:
of time and cannot complete an answer, do a full —

(a) Which variables are rising, falling or stable?

essay plan, including graphs where appropriate.
(b) What is the percentage change in a variable?
Be careful to avoid irrelevant answers — these not
Use the equation:
only earn no marks, but also waste valuable time that
could have been used to earn marks from another percentage _ (present value — previous value) x 100
question. No marks are earned by waffle or by change previous value
repeating points made earlier in the essay. Do not
spend too much time on one particular question. Set (c) Are any variables cyclical?
out your work clearly and neatly. Use your (5) Is there a direct relationship between any
economics. Above all, make sure that what you are variables in the data? Look out for:
writing is relevant and answers the set question. (a) Causal relationships, where the value of one
variable determines the value of a second
variable. However, remember that unrelated
variables sometimes move closely together.
(b) Data response questions
(b) Lagged relationships, where the current value
For this paper you are going to need two pens, a ruler, of one variable is related to the previous value
a pencil, a rubber and a watch. Bring a calculator of a second variable.
along. Remember to check that the batteries are not (6) Relate your knowledge of theory to the data. Can
 work out economics ¢ introductig riix \
|

you give reasons for relationships, trends or on topics where economists are agreed that there is a
cycles observed? single correct answer.
(7) Always look for relevant data to explain your These multiple-choice questions contain a stem and
assertions. a number of possible answers, of which only one is
correct.
Gain confidence in handling and interpreting
statistical data by familiarising yourself with typical Example 1
examples. Much of the data used by economists is
presented as time series, which show the value of a STEM Industrial inertia occurs when:
particular variable such as national income at different A the share of
points in time. Great use is made of official statistics manufacturing in
issued by the Central Statistical Office (CSO). Try to national output
find time to look at CSO publications such as the declines
‘Blue Book’ (UK National Accounts) or the ‘Pink DISTRACTORS 4 B firms fail to exploit eOPTIONS
Book’ (Balance of Payments Statistics), which are economies of scale
kept in the reference section of most public libraries. C industry gains no
Literary data response questions present an extract cost advantage
and sometimes supporting tables for analysis. Spend from any one site
time reading the section of prose carefully. Many of KEY D the initial reasons
the check-list of points given above for use with for location have
statistical data can equally be applied to prose. You disappeared
are almost certainly going to be asked to identify and
express in your own words the main features of the The stem sets the question and candidates have to
data. Try to avoid making sweeping or vague choose between a number of incorrect distractors and
statements that are unsupported by evidence. Instead, the correct option, called the key. Some questions can
explain the essential features of the extract, quoting be answered quickly. Look at the options and see
relevant phrases from the text only to support a point where there are any that can be immediately
made in your own words. Always indicate such eliminated or accepted. If not, it is important not to be
phrases by ‘quotation marks’. delayed by those questions requiring deep thought or
Many literary data response questions ask lengthy calculations. Remember: each question,
candidates to apply economic concepts. You are whether easy or difficult, carries the same number of
expected to relate relevant theories such as supply- marks. Make a note of such questions for later
and-demand or theory of the firm to the extract consideration and carry on working through the paper.
presented. Remember that a variety of approaches A range of strategies can be used when tackling the
may be required. Diagrams should be used if objective question paper. Only one rule must be
appropriate. followed: answer all the questions. Some candidates
You may be asked to evaluate the data and then prefer to work through the paper, answering each
predict future trends or outcomes. Look back at the question in turn, irrespective of the amount of time or
extract and identify key variables, relationships and degree of difficulty involved. However we have
economic concepts. Use these as the basis of your already suggested that it may be better to delay
predictions. Avoid making a series of random answering time-consuming questions until you have
predictions unsupported by information contained in worked through all other questions. Be sure to treat
the data provided. each question carefully and not to give a wrong
answer through carelessly misreading the stem or
options. Questions with ‘not’ in the stem are
(c) Objective questions particularly dangerous! For this type of question, the
For this paper you are going to need a pencil, rubber, option to which you can answer ‘no’ is the correct
ruler, watch and calculator. Objective questions are solution.
well suited to testing your knowledge and If you begin to run out of time, work through the
understanding of theories, and deal with ‘certainty’ remaining questions allowing yourself a maximum of,
areas of economics. Hence, objective questions are set say, 20 seconds per question. If time is about to run
Erk out economics ¢ introduction

out completely, make sure you scribble down some ¢ Greater emphasis on examining the strengths and
answer and hope that at least one or two will be right. weaknesses of the market economy.
In any case, DON’T PANIC. Both authors wish you ¢* Reduced assessment weightings for knowledge
all the best and good luck in the final exams! and understanding, with most marks now being
awarded for achievement of ‘higher order’ skills.
¢ Greater focus on the application of economics to
The new A Level syllabuses
contemporary issues.
AlL thenew approved syllabuses have the following
There are also significant differences between the new
characteristics incommon:
syllabuses and these are illustrated in the following
¢ Less emphasis on some traditional areas of
table.
content, e.g. Keynesian 45° approaches.

Changed
assessment Multiple
weightings' choice

ULEAC
(Nuffield) yes partial’
ULEAC
(Traditional)

UCLES
Linear

UCLES
Modular

WJEC

Notes:
" Choice between business studies and economics routes.
* Extended study of a particular economic issue/context.
Source: The Economics & Business Education Association.
 The Economic

Date Date Self-

AEB NEAB | OCSEB UCLES | ULE | UODLE begun |completed | assessment

Fact sheets a ae

beet Investigative study ‘ialat

a Data response te

Objective questions Jb in

J Essays
 Tei yiilte
em

1.1 Fact sheet (4) If the hypothesis cannot be disproved, it becomes

an accepted theory.
(a) “The economic problem ¢ Economists isolate the relationship between two
(1) Wants and needs are satisfied through the variables by assuming ceteris paribus — i.e. that all
consumption (use) of goods and services. other influencing factors are held constant.
(2) Outputs (goods and services) are produced from ¢ Positive economics deals with statements of fact
inputs (resources) sometimes called factors of that can be proved or disproved, and shows how
production. The four factors are land, labour, the economy actually works.
capital and entrepreneurs. ¢ Normative economics deals with statements of
(3) The economic problem arises because, while our opinion that cannot be proved or disproved, and
resources are finite, our wants and needs are suggests what should be done to solve economic
infinite. problems.
(4) All societies have to decide which goods and ¢ Microeconomics considers the behaviour of an
services to produce, how to produce them, and individual consumer, firm and industry, and is
who is to receive them. mainly interested in resource allocation and
relative prices.
¢ Resource allocation refers to a particular use of ¢ Macroeconomics considers the behaviour of the
land, labour, capital and entrepreneurs. economy as a whole, and is mainly interested in
national output, employment, the balance of
payments and the general price level.
(b) Economic methodology
Economics is a social science that uses scientific
(c) Opportunity cost
methods:
The decision to produce or consume one product
(1) A hypothesis (prediction) is constructed about
involves the sacrifice of another product. The real or
economic behaviour that may be right or may be
opportunity cost of an action is the next best forgone
~ wrong.
alternative.
(2) A model is built describing the behaviour of
economic variables (influencing factors) involved e« Aneconomic good is in limited supply and
in the initial hypothesis. possesses an opportunity cost — e.g. a car.
(3) The hypothesis is tested against empirical (real ¢ However a free good is not scarce and has no
world) evidence by use of the model. opportunity cost — e.g. sunshine.
 work out economics ¢ the economic probleri Bp

(d) Production possibility curves resources will increase an economy’s productive

potential. This is shown by a shift to the right of
A production possibility curve (PPC) is sometimes the production possibility curve.
called an opportunity cost or transformation curve,
and shows the combination of two goods a country >

can make in a given time period with resources fully

employed (Figure 1.1). A PPC is drawn assuming a Good Y
country has a fixed amount of resources and a
constant state of technology.

Good X

Figure 1.2 A shift of the production possibility curve

(e) Types of economic system

An economic system is the network of organisations
Good X used by a society to resolve the economic problem.
Figure 1.1 A production possibility curve There are three categories of economic system.

(1) LM is a PPC
(i) Free market economy
(2) Points under the PPC (e.g. A) imply resource
underutilisation. Resources are owned by households.
(3) Points along the PPC (e.g. B) indicate a full Markets allocate resources through the price
employment of resources. mechanism. An increase in demand raises price.
(4) Points outside the PPC (e.g. C) are beyond the The higher price encourages firms to switch
current productive capacity of the economy. additional resources into the production of that
(5) The opportunity cost of producing OE amount of good.
good X is LF of good Y. Income depends on the market value of a resource.
(6) The opportunity cost of reallocating resources Factors in scarce supply and high demand are best
from B to D is FH of good Y. rewarded.

* A concave (bowed outwards) production

possibility curve indicates increasing opportunity (ii) Planned or command economy
cost. As more of good X is produced, increasing
Resources are owned by the state.
amounts of good Y have to be forgone to produce
The state allocates resources, and sets production
an extra unit of good Y.
targets and growth rates according to its own view
¢ A straight line production possibility curve
of people’s wants.
indicates a constant opportunity cost. As
Income distribution is decided by the state, and
production of good X changes, the amount of
ignores the scarcity value of a particular factor.
good Y that has to be forgone to gain an extra unit
of good X does not change.
¢ A convex (bowed inwards) production possibility (iii) Mixed economy
curve shows a decreasing opportunity cost. As In practice all economies are mixed where:
more of good X is produced, the cost of an extra
unit good X in terms of forgone good Y declines. Some resources are owned by the public sector
e An increase in the quantity and/or quality of (i.e. the government).
 out economics ¢ the economic problem and demand and supply

Table 1.1 Problems of different economic systems

Market economy can result in Planned economy can result in

The non-production of public goods Production not satisfying consumers’

Monopolies reducing competition real wants
Production ignoring externalities Reduced consumer sovereignty
An unequal distribution of income Shortages and surpluses of products
and wealth. The forgone output of administrators
High unemployment Reduced incentives lowering individual
effort

* Some resources are owned by the private sector (c) On what grounds might expenditure on treatment
(i.e. households). that has little chance of success be justified?
(4 marks)
(g) Move from a command (d) In what sense are all economic decisions ‘the
economy judgment of Solomon’? (5 marks)
Distinen; 3
In the transition from a command towards a market be) pg Leusaniah between how the, danas os
resources to be allocated to health care is
economy a number of problems may be encountered: ; ;
determined in a command and in a market
(1) Structural change as resources are reallocated to economy. (6 marks)
reflect the choices of households rather than the
government. Example 1.2
(2) Inflation resulting from the removal of
government price controls. Dying girl in court fight
(3) Redistribution of income leaving some people
for treatment
unable to afford basic necessities.
(4) Lack of regulation of firms as it will take time to
Sally Weale Other figures quoted by Mr Mcln-
tyre suggested the chances were slight-
establish new regulatory bodies. ly higher. “Even if it’s only in the
High Court judge will today order of 5 or 6 per cent, she has a sig-
(5) Industrial unrest as workers and employers rule on an application by the
father of a 10-year old girl
nificant chance of being cured.”
According to Mr Pitt the treatment
establish new wage rates, new working conditions with leukaemia who is seeking could not be justified on therapeutic
to overturn a decision by his local grounds. The only basis on which it
and new terms of tenure. health authority to refuse funding for could be justified was for experimental
further treatment which could save her or research reasons.
life. Mr Justice Laws asked: “‘How can it
The court heard yesterday that the not be justified on therapeutic grounds
See also chapter 13. girl, who in January was given six to when the alternative is certain death?
eight weeks to live, would die without It's what a betting man calls a risk
the £75,000 treatment. It would involve against certainty. Every man who want-
intensive chemotherapy followed by a ed to live would take that risk.”
second bone marrow transplant. Mr Pitt described the balancing act
Cambridge Health Authority argues performed by health authorities in
that her chances of survival are so deciding how to allocate limited
slight and the treatment so distressing resources. It was not the first desperate-
that its limited resources might be bet- ly needed operation not to have
ter spent. received NHS funding, he said “It’s the
The judge, Mr Justice Laws, sitting judgment of Solomon.”
e macroeconomic performance of in London’s Law Courts on the open- “If the health authority were to
ing day of the hearing yesterday, said spend all its money on treatments
two formerly planned economies, e.g. the Czech the case centred on the most precious which doctors had advised were
right of all, “namely the right to life” extremely unlikely to succeed and then
Republic and Russia. Nigel Pitt, counsel for the health had no money left to treat hundreds of
authority, said it was not a straightfor- other patients who might have been
ward question of life and death. The effectively treated, what would the
girl’s case was particularly difficult and public have to say about that?”
the treatment proposed was debilitating He asked whether any particular
with severe side effects, which “‘in all patient had any more fundamental right
probability” she would not survive. to life from NHS money than any
The alternative was to adopt a pallia- other.
tive approach, enabling B to enjoy a The judge responded: ‘Well possi-
few weeks or months of normal life.
(hat would be the opportunity cost of treating Mr Pitt claimed the chances of suc-
bly a child close to death may be said
to have a more pressing claim.”
cess, using statistics provided by Peter Mr Justice Laws will give his judg-
the 10-year-old girl? (6 marks) Gravett, the consultant haematologist ment today.
at the London Clinic, who would carry
(b) What would be the opportunity cost of not out the treatment, were in the region of Source: Extract from the Guardian,
2.25 per cent. 10 March 1995
treating the 10-year-old girl? (4 marks)
 work out economics ¢ the economic problem 5

Solution 1.2 week to 38 hours. What is the opportunity cost if the

worker opts for a 38 hour week?
(a) Opportunity cost is the best alternative forgone.
A 2hours B 38hours C £38 D £48
Treating the girl would take up limited resources,
including doctors’, nurses’ and theatre time. This
means that other patients would forgo the opportunity Example 1.4
of treatment. These patients might have a greater
A woman bought a car for £7000 but would like a
chance of recovery. The NHS has limited resources
new model costing £8200. She could obtain £5900 if
and choices have to be made as to who to treat.
she sold her car. What is the opportunity cost of her
Demand for treatment exceeds supply. Treating the
owning her current car?
girl might also reduce the quality of the girl’s life
A £1100 B £1200 C £5900 D £8200
during the period of treatment.

(b) By not treating the girl there is a risk that the

Example 1.5
girl’s life would be lost. The opportunity cost might
also involve missing out on the opportunity to try out Which of the following is a normative economic
new forms of treatment and improving the quality of statement?
the lives of the girl’s relatives. A The state decides what is produced in a command
economy
(c) Expenditure on treatment that has little chance of
B A higher proportion of consumer goods is
success can be justified on the ground that it may
produced in a market economy than in a command
improve medical knowledge and thereby increase the
economy
quality and length of people’s lives in the future.
C Command economies have a higher rate of
When heart transplant operations were first carried
economic growth than market economies
out, for example, the success rate was low.
D A market economy is a more desirable form of
(d) All economic decisions, whether in terms of what economic system than a command economy
to produce, what to buy or how to spend one’s time,
involve having to make choices. Just as it is not
Example 1.6
possible to treat everyone, given limited NHS
resources, it is not possible to produce everything that Which of the following is an example of a free
people would like to consume, for example. These good?
decisions can be very difficult and the opportunity A Sea water
cost high. B_ State education
C Anexpenses-paid business trip
(e) Ina command economy the quantity of resources
D_ A toy included in a cereal packet to encourage
to be devoted to health care is determined by the state.
people to buy the cereal
The state assesses the needs of the population and the
resources available and then issues directives to state
hospitals. In a market economy resources are Example 1.7
allocated via the price mechanism. If people want Which of the following would shift the production
more health care, the price of health care will rise and possibility frontier of an economy to the right?
more resources will be allocated to health care. The A Amore even distribution of wealth
price mechanism also rations goods. Those who can B_ An increase in the stock of capital
afford to pay will receive health care. C An increase in the number of people dependent on
the working population
D An improvement in the efficiency with which
1.4 Objective questions factors of production are combined

Example 1.3
ge NE
Example 1.8
A worker is currently earning £400 for a 40 hour
week. The management offer a 12% wage increase or The figure overleaf illustrates the production
a basic wage of £410 and a reduction in the working possibility curve of a country.
6 work out economics ¢ the economic problem and demand and supply

How could the economy eventually reach point N?

A Move to point H
B Move to point J
Good Y
C Move to point L
D Employ idle resources

Example 1.11
|
What is the essential characteristic of a market
| economy?
A Full employment
0 : V is
Good X B_ Producer surplus
C Public corporations
What is the opportunity cost of producing OT amount D Consumer sovereignty
of good X?
A OR amount of good Y
B_ RS amount of good Y Example 1.12
C TV amount of good X Only in a pure command economy does production
D OV amount of good X A respond to prices
B_ respond to directives
Example 1.9 C reflect the preferences of firms
D reflect the preferences of households
What does a straight-line production possibility curve
illustrate?
A A constant rate of opportunity cost in the
production of both goods 1.5 Solutions to objective
B A decreasing rate of opportunity cost in the questions
production of both goods
C An increasing rate of opportunity cost in the Solution 1.3. Answer: C
production of both goods A 12% wage increase on a 40 hour week would give a
D A decreasing rate of opportunity cost in the pay increase of £400 X 12/100 = £48. So a worker
production of one of the goods and an increasing
opting for a 40 hour week would earn
rate of opportunity cost in the production of the £400 + £48 = £448. Therefore if the worker elects to
other good. work 38 hours and earn £410 he/she will be forgoing
£38.
Example 1.10
The figure below shows the production possibility Solution 1.4 Answer: C
frontier for a country currently producing at point K.
Opportunity cost is cost in terms of the best
Consumer alternative forgone. By keeping her own car the
goods
woman is forgoing the opportunity to obtain £5900.
H

Solution 1.5 Answer: D

A normative statement is one based on opinion and

cannot be proved or disproved against real world
(empirical) evidence. Option D is a matter of opinion
since people will disagree about what is a desirable
form of economic system. Options A, B and C are all
positive statements as they can all be assessed
0 M_ Capital goods objectively. For instance, analysis of economic data
 work out economics * the economic problem 7

may prove that some market economies actually have is also producing OR amount of good Y. If it did not
a higher rate of economic growth than some command produce OT amount of good X and devoted all its
economies. resources to good Y, it would be able to produce OS
amount of good Y. So by producing OT amount of
Solution 1.6 Answer: A good X it is forgoing RS amount of good Y.

A free good is one that does not require resources to

Solution 1.9 Answer: A
produce it and is not scarce. Sea water is replenished
naturally and has no opportunity cost. Whilst the good A straight-line production possibility curve illustrates a
and services described in options B, C and D are free situation where resources are equally good at producing
to the consumer, they all require resources to produce both types of good. In this situation the opportunity
them that could have been put to alternative uses. cost of producing an extra unit of either of the goods
will remain constant. This is shown in the figure below.
Solution 1.7. Answer: B When the society increases its output of good X from |
to 2 units, the opportunity cost is half a unit of good
A production possibility curve (PPC) is sometimes
Y. Similarly to increase the output of good X from 14
called a production possibility frontier. A PCC 1s drawn to 15, half a unit of good Y has to be given up. The
on the assumption that a nation’s stock of resources, opportunity cost of producing good Y remains
including capital, is fixed. An increase in the stock of constant. To increase the output of good Y from 2.5 to
capital will increase the productive potential of a 3 or from 8 to 8.5 will include forgoing | unit of X.
country and hence shift the PPC to the right. Option B would be illustrated by a bowed outwards
B = A more even distribution of wealth may affect (concave) PCC and option C by a bowed inwards
the patterns of consumption and production but its (convex) PPC. The situation described in option D is
effect on the position of the PPC is uncertain. not possible.
C = An increase in the number of dependents will
increase the burden on the working population but not
the potential output of the country. Solution 1.10 Answer: C
D = An improvement in the efficiency with which The movement from point K to point N can only
resources are combined would cause a movement come about if the production possibility curve (PPC)
from inside to near or on the production possibility shifts to the right, to UW.
curve. This requires an increase in the productive capacity
of the economy. Moving along the PPC from K to L
Solution 1.8 Answer: B shifts resources out of the production of consumer
If the economy is producing OT amount of goal X, it goods and into the production of capital goods.

Good Y 10

ol

ee ee ae ee ee 7742 fat a 16 16 17 "18-19 *20

ae Good X
8 work out economics ¢ the economic problem and demand and supply

Consumer 1.6 Essays

goods 4
U
Example 1.13
H
(a) Distinguish between ‘market’ and ‘command’
economies. (10 marks)
(b) A number of countries have recently decided to
move from a command towards a market
economy. On what grounds can it be judged
which type of economic system is superior. (15
0 M W Capital goods marks)

¢ In (a), establish criteria such as resource

Additional capital goods can be used to make more
ownership for comparing market and command
consumer and capital goods and the economy can be
economies.
at point N. Other options are wrong because:
¢ In(b), (1) explain how welfare criteria can be
A and B = reduce the productive capacity of the
used to judge the success of an individual
economy.
economic system; (2) one economic system is
D => Point K lies on the PPC, so no idle resources
superior to another only if it is better able to
are available.
satisfy welfare criteria — discuss the evidence.
¢ Throughout, avoid making subjective, political
Solution 1.11 Answer: D statements of opinion.

In a market economy, households have consumer

sovereignty and determine what is produced by Solution 1.13
‘voting’ with their purchases. For instance, if (a) A market economy is an economic system where
consumers demand more of a product the price rises resources are owned by individuals and allocated by
and more is supplied. Other options are wrong the price mechanism without government
because: intervention. In a command economy, the government
A => Full employment is unlikely to occur in a owns resources and decides on the type and quantity
market economy. to be made. A study of comparative economic systems
B = Firms do not necessarily enjoy producer will try to identify and contrast characteristics
surplus. common to both types of economy. For instance
C = Public corporations are nationalised industries property rights are the rules that define the use to
and a feature of mixed economies. which resources may be put. In market economies,
individuals are free to buy and sell land, labour and
Solution 1.12 Answer: B capital, provided that they do not infringe the legal
property rights of others. In a command economy,
A command economy is run by the state and individuals can own consumer goods but they are not
directives (instructions) are used to organise
allowed to own industrial plant or machinery. All non-
production. Other options are wrong because: labour resource are owned by the state.
A => Prices are not used as a method of regulating Different economic systems have different methods
production in a pure command economy. of resolving the problem of scarcity. Market
C and D = Ina pure command economy economies use the price mechanism to allocate
production reflects the decisions of the state and not
resources. All goods, services and resources have a
the preferences of firms, nor directly the preferences market price. An increase in consumer demand raises
of households.
the price and encourages a firm to increase production
of a good by transferring resources out of the
manufacture of less profitable products. In command
economies, the state allocates resources according to_
its own view of what people want. A body of central
planners decides what proportion of resources to
 work out economics ¢ the economic problem 9

devote to consumer and producer’ goods. It then sets achieved by massive overmanning. Productivity and
production targets and arranges for the supply of standards of living could be raised following a
necessary inputs. Firms aim not to make a profit but to reallocation of resources. Modern economies are
meet production targets. highly specialised, interdependent and complex. In the
It can be seen that the decision-making process in absence of market prices, planners have insufficient
command economies is collectivist and centralised. information upon which to base welfare-maximising
The government is the single most important decisions. Distorted information prevents planners
economic institution. On the other hand, decision from taking full account of production and
making in market economies is highly individualistic consumption externalities.
and decentralised. The role of the state is limited to It used to be thought that there would be little
collecting taxes to pay for public goods such as pollution in command economies as state planners
defence, and enforcing property rights. would take into account social costs and benefits.
The method of motivating economic agents varies However recent evidence has shown that pollution
between the two systems. In market economies, jobs levels were very high in a number of former planned
in high demand but short supply command high economies, including East Germany, Romania and
wages. Successful entrepreneurs receive profits for Poland. In these cases the state was more concerned to
taking on the risk and responsibility of organising increase output than to improve the quality of the
production. Hence income and wealth distributions environment.
are unequal. In command economies, limited wage In conclusion, it can be seen that comparing market
differentials do exist to reward extra effort. However, and command economies is difficult and complex.
it is the sense of ‘shared purpose’ springing from the The final judgement depends on the importance
common ownership of resources that is meant to act placed on a particular measure. For example, in terms
as the prime ‘moral’ incentive to work. of productivity, evidence suggests that market
economies are superior to command economies; in
(b) The success of an economic system lies in its terms of unemployment levels, evidence suggests that
ability to use resources to satisfy as many wants as command economies are superior to market
possible. Welfare economics supplies a number of economies.
tests that can be used to judge the absolute efficiency
of an economic system. There are two main tests:
(1) Is it possible to reallocate resources and increase Example 1.14
output? (a) What fundamental economic principles are
(2) Is it possible to reallocate resources and make a illustrated by a production possibility frontier?
consumer better off without making anyone else Explain the usual shape of a production
worse off? possibility frontier. (10 marks)
The system that best meets these conditions will be (b) How does a production possiblity frontier
superior. Before considering empirical evidence, it is illustrate ‘economic inefficiency’? (5 marks)
important to note that real-world examples such as the (c) What can cause a movement of a production
USA and Cuba only approximate to theoretical possibility frontier? (5 marks)
market and command models. (d) What may enable an economy to consume a
Economic theory suggest that a competitive market combination of goods outside its production
economy automatically brings about an optimal possibility frontier? (5 marks)
resource allocation. However market failure occurs
when some private-sector firms in the USA do not ¢ Devote most attention to part (a) as it carries the
take full account of the spill-over effects of production highest number of marks.
such as pollution. Frictions in factor markets have e In part (a):
resulted in mass unemployment and a general (1) discuss scarcity, choice, opportunity cost and
depression. Moreover efficiency criteria make no efficiency, but efficiency only briefly as it
statement about the ‘fairness’ of an uneven comes into part (b);

distribution of income and wealth in the USA. (2) explain, using an example, the usual shape of
Data suggest that there is hardly any unemployment the production possibility frontier.
in Cuba. However critics argue that this has only been ¢ In part (b) explain, by using a point inside a
10 work out economics ¢ the economic problem and demand and supply

production possibility frontier, the meaning of resources from producing consumer goods to
economic inefficiency. producing capital goods. A decision to increase the
¢ In part (c) consider factors that can cause a output of capital goods from 23 to 30 will involve
rightward shift in the production possibility forgoing 25 consumer goods.
frontier and illustrate these.
Consumer
¢ In part (d) consider the significance of goods
international trade.
200

Solution 1.14

(a) A production possibility frontier shows the

maximum output that can be produced with the
efficient use of existing resources. Figure | shows that
if all resources are devoted to producing consumer
goods, 200 consumer goods can be made, whereas if
all resources are devoted to making capital goods, 50
can be made. It is also possible to produce any
combination of capital and consumer goods along and
inside the production possiblity frontier.

Consumer
goods 0 10 20 23: «30 40 47 50
Capital
goods
200
Figure 2
e Unattainable
position Production possibility frontiers are usually drawn
150 as curves concave to the origin as it is thought that, in
most cases, the opportunity cost of producing one
category of good will increase as its output rises. In
100
Figure 2 when the output of capital goods rises from
40 to 47 the opportunity cost rises from 25 to 48
consumer goods. Increasing opportunity cost occurs
50
because resources are not equally good at producing
both products. When the output of capital goods
initially starts to rise, resources that are good at
0 10 20 30 40 50 Capita producing capital goods will be used. Then, as the
goods output of capital goods increases, further resources
Figure 1
that are better at producing consumer goods will have
to be used. So more resources will have to switch
A production possibility frontier illustrates the
from making consumer goods to achieve any given
principles of scarcity. Society may like to produce,
rise in output of capital goods, and hence the output of
say, 180 consumer goods and 40 capital goods, but
consumer goods will fall further.
Figure | shows that this is not possible (it is an
Whilst any point outside the curve illustrates an
unattainable position). Society’s wants exceed
unattainable position, any point on the curve
resources. At any one time output potential is limited
represents full and efficient use of resources.
by the resources available.
A production possibility frontier also illustrates (b) Economic inefficiency can be illustrated by a
choice and opportunity cost. Figure 2 shows that point inside a production possibility frontier. Figure 3
society could choose to produce 150 consumer goods shows a society producing at point A, making 100
and 23 capital goods. If it decides to produce more consumer goods and 20 capital goods. This isan
capital goods it will have to produce fewer consumer inefficient position that can result from unemployment
goods. Society will be choosing to switch some or inefficient use of resources.
 work out economics ¢ the economic problem 11

Consumer Consumer
goods a

200
230

200
150

150 |
100

+n

50

ze

0 10 20 30 40 50
Capital goods ns — >
0 10 20 30 40 50 60
Figure3 Capital goods

Society is not achieving its productive potential. Figure4

Greater and more efficient use of resources will result
in arise in output without any opportunity cost. For frontier, international trade may enable an economy to
instance the output of consumer goods could be attain such a combination. By engaging in
increased to 165 without having to forgo any capital international trade countries can specialise in the
goods. goods they have comparative advantage in and then
exchange some of these for other goods. If the
(c) A rightward shift of a production possibility curve exchange rate lies within the countries’ respective
indicates a rise in productive potential. opportunity cost ratios, the amount that the countries
An increase in productive potential can be achieved can consume will rise. In our example, the country
by arise in the quantity or quality of factors of can increase the output of capital goods from 23 to 30
production. For instance an increase in technology, a by reducing the output of consumer goods from 150
rise in the amount and quality of education and to 125 (see Figure 2). However if it engages in
training and an increase in the labour force will all international trade it may be able to exchange
raise the output a society can produce. Barring natural consumer goods on the basis of one consumer good
disasters, wars and famine, most countries’ production for one capital good. This would enable the economy
possibility frontiers move to the right over time. to consume 143 consumer goods and 30 capital
(d) Although it is not possible to produce a goods, a combination that lies outside the production
possibility frontier.
combination of goods outside a production possibility
 A change in the price of a good never shifts the
demand curve for that good.
(a) Definitior of demand In Figure 2.1 an increase in price causes a
contraction in demand, and a decrease in price
¢ Demand is the amount of a good consumers are results in an expansion (or extension) in demand.
both willing and able to buy at a given price.
* Ademand curve shows the amount of a good (c) Individual and market demand
consumers are willing and able to buy at different
prices. Individual demand is one buyer’s demand for a
¢ The amount of a good demanded depends on: good.
(a) price; Market demand is the total demand for a good.
(b) the conditions of demand. A market demand curve is the horizontal
summation of all the individual demand curves.
(b) Movements along a demand
curve (d) Increases and decreases in
demand
* A change in price results in a movement along a
demand curve, resulting in a change in the A demand curve is drawn assuming ceteris
quantity demanded. paribus —1.e. that all factors influencing demand
are being held constant except price. The
Price
per conditions of demand refer to those factors held
unit
constant, and include:
(P)
(a) the real income of consumers;
(b) the price of other goods in (a) competitive
demand (substitution), (b) joint demand
(complements);
(c) consumer taste;
(d) advertising;
(e) expectations about the economy;
(f) the population size and structure.
0 Q, Q Q, Quantity demanded
A change in one of these conditions affects the _
per time period (Q) level of demand at all prices and results in a shift
Figure 2.1 Movements along a demand curve in the demand curve.
 work out economi demand 4

Figure 2.2 illustrates the effect of a decrease in substitution effect. In the case of a Veblen good
demand. the income and substitution effects also work in
opposite directions, but this time it is the
‘perverse’ substitution effect that outweighs the
income effect.

(f) Utility
Utils are used to measure satisfaction.
Total utility is the amount of satisfaction obtained
by consuming units of a good.
Marginal utility (MU) is the extra satisfaction
obtained from consuming one more unit of a good.
The law of diminishing marginal utility states that
the more a consumer has of a given commodity,
0 Quantity demanded the smaller the satisfaction gained from
Figure 2.2 A decrease in demand consuming each extra unit.
Rational consumers spend their income in order to
maximise satisfaction. Consumers compare:
Causes (a) the utils per extra pound spent on X, using the
A decrease in real income. equation MV,P,, with
An increase in the price of a complement. (b) the utils per extra pound spent on Y, using the
A decrease in the price of a substitute. equation MV,P,.
An adverse movement in consumer taste. If the number of utils per pound spent on X is
A reduction in advertising for this good. greater than the number of utils per pound spent
Reduced expectations about the economy. on Y, consumers can increase their satisfaction by
A decrease in the population. increasing their consumption of X.
Satisfaction is maximised by arranging
expenditure among commodities so as to achieve
Effect equi-marginal returns. This occurs when:
The demand curve shifts to the right. marginal utility of X marginal utility of Y
price of X price of Y
(e) Income and substitution effects Utility theory requires consumers to be able to
The income effect occurs when the price of a good measure satisfaction.
falls and the consumer can maintain current
consumption for less expenditure. Provided that (g) Indifference curves
the good is normal, some of the resulting increase
in real income is used to buy more of this product. An indifference curve shows the combinations of
If the good is inferior, an increase in income is two goods whose consumption yields equal total
used to buy more of a superior substitute and less satisfaction to the consumer.
A budget line or income line shows all the
of this product.
The substitution effect occurs when the price of a combinations of two goods the consumer can buy,
given a fixed income and constant prices.
good falls and the consumer substitutes more of
this product for others. A rational consumer maximises satisfaction by
The demand curve of a Giffen good (a low-quality adjusting his or her expenditure between two
product) and of a Veblen good (a good purchased goods so as to be at the point on the budget line
to show one’s wealth) slope up from left to right. tangential to (just touching) an indifference curve
In the case of a Giffen good this is because the furthest from the origin — i.e. point A in Figure
income and substitution effects work in opposite 2.3. In Figure 2.3, JK is the budget line of the
directions and the income effect outweighs the consumer, and /, and /, are indifference curves. /,
14 Awork owteconomics e the economic problem and demand and supply

is further from the origin and yields a higher level 2.2 Investigative study
of satisfaction that does /;. To maximise
satisfaction, the consumer will select point A and Example 2.1
buy A amount of good X, and C amount of good
An assessment of the effectiveness, over a period of
¥
time, of the measures producers can take to raise
e An increase in income would result in a parallel
demand for their products, e.g. ice cream.
shift to the right in the budget line JK.
e An increase in price of good X would pivot the
budget line around point J towards the origin. 2.3 Data response
Good Y
Example 2.2
Consumer expenditure at 1990 market prices (£
million). Examples of commodities:

Furniture and
Year floor coverings Food Tobacco Total

1988 6864 41541 8689 334 591

1989 6748 42281 8677 345 406
1990 6422 41816 8578 347 527
1991 \_.6115 41870 8336 339 993
Figure 2.3 Consumer equilibrium 1992, ..6303 42 380 7958 339 941

Source: CSO, Annual Abstract of Statistics, 1994.

(h) Consumer surplus
(a) Explain what is meant by ‘consumer expenditure
¢ Consumer surplus is the difference between the
at 1990 market prices’. (3 marks)
maximum a consumer would pay for a good and
(b) What is the main influence on total consumer
the price actually paid.
expenditure? (2 marks)
¢ The area of consumer surplus is that above the
(c) Comment on changes in:
price line and below the demand curve, as shown
(1) total consumer expenditure;
in Figure 2.4.
(2) expenditure on furniture and floor coverings;
(3) expenditure on food;
(4) expenditure on tobacco (13 marks)
Price
(d) Discuss the influence on demand for a product
that you have not covered in (b) and (c).
Consumer marks)
surplus

Solution 2.2

(a) Consumer expenditure at 1990 market prices

means that consumer spending has been adjusted for
inflation using 1990 as a base year and has been
0 Q Quantity measured in terms of the prices charged in the shops,
Figure 2.4 Consumer surplus so indirect taxes and subsidies have been taken into
account.

(b) The main influence on total consumer expenditure

is personal disposable income. As income rises total -
spending is likely to rise but the proportion spent may
decline.
 aa

work out economigs * dema

ale #
1
a

(c) 2.4 Objective questions

% change
Example 2.3
in furniture 9% change % change Which of the following is not held constant when a
Year and fittings in food in tobacco Total demand curve is drawn?
1.8 =(51 3.20 A Households’ real income
OS See |
oa ON! 0.60 B_ The price of the good itself
1990 —4.8 es |
C The price of competing goods
1991 —4.8 0.1 2 oe
D The price of complementary goods
1992 3.1 2 —4.5 —0.02

(1) Consumer expenditure rose relatively rapidly in Example 2.4

1989, its growth then slowed down in 1990 and fell in The demand curve for a normal good shifts to the left
1991 and 1992 during the recession. when:
(2) Expenditure on furniture and fittings showed
A the price of the good itself rises
the greatest fluctuations. Spending on furniture and B_ the price of complements rises
fittings is influenced by the state of the housing C the price of substitutes rises
market. When the housing market is doing well and D an indirect tax is imposed on the good
more houses are being bought and sold, more
furniture and fittings tend to be purchased.
Expenditure on furniture and fittings, a category that Example 2.5
includes some expensive items, is also significantly
A basic assumption of demand theory is that
affected by changes in interest rates. This is because
consumers allocate their incomes so as to maximise
many people will buy, for example, a new sofa on
their:
borrowed funds. In 1989 the rate of interest rose quite
A present consumption
significantly and in 1992 it fell by a significant
Bs savings
amount.
C total utility
(3) Expenditure on food was the most stable of the
D marginal utility
three commodities. Food is seen as an essential item
and people do not significantly change the quantity
they buy when income changes. Example 2.6
(4) Tobacco expenditure showed a downward trend
throughout the period. Spending on tobacco has The following table shows the total utility gained
from consuming each of three goods:
largely fallen because of increased awareness of the
dangers to health it imposes and the connected cause i
of it becoming a less socially accepted habit. Units of good x i zZ

(d) Demand for a product is influenced by a number | 40 16 10

of other factors. A rise in population size will increase Z 48 30 20
the demand for most products. A change in the age 3 he 42 30
structure will affect products differently. For instance 4 54 me AO
arise in the average age of the population will 5 my 60 50
increase the demand for bungalows. Advertising can
have a powerful impact on most products. A less even
distribution of income will increase the demand for The consumer experiences diminishing marginal
luxury goods. Changes in the price of substitute also utility in the consumption of:
influence demand, and for some products a change in A X alone B Y alone
weather conditions can affect demand, e.g. umbrellas. C Xand Y alone D X, Y and Z
 as

eet
16 Awork out €condihics ¢ the economic problem and demand and supply

Example 2.7

Good Price Quantity Marginal utility

A 20p 6 10
B 30p 2 ?

If a consumer buys the quantities of A and B shown

above and is maximising his utility, what is the
marginal utility derived from good B? Good X

A 3 B 5 Cano D 15

Example 2.11
Example 2.8
The law of diminishing marginal utility states that the
A consumer has the following demand schedule for more a consumer has of a given commodity the:
chocolate: lower the total level of satisfaction enjoyed
lower the price of each extra unit consumed
Number of bars 2 3 4 5
lower the usefulness of each extra unit consumed
Price 60p SOp 40p 30p 20p
lower the satisfaction from each extra unit
—~om--ia
If the price of chocolate is 40p and the consumer buys consumed
three bars, what is his or her consumer surplus?
A 30p B 40p C 50p D 60p
Example 2.12
What is a Giffen good?
Example 2.9
A A good whose demand rises with income
The diagram shows a demand curve for journeys over B_ A good whose demand rises with a rise in its price
a toll bridge. C A good whose demand rises with a rise in the price
of a complement
Toll (£) D A good whose income and substitution effects
work in the same direction

2.5 Solutions to objective

questions
0 1000 2000 Journeys
Solution 2.3. Answer: B

If the toll is reduced from £6 to £5, by how much When drawing a demand curve, all the factors
will consumer surplus increase? influencing demand are held constant except one.
A £1100 B £1500 C £6000 D £7500 Options A, C and D are incorrect because they are all
examples of conditions of demand held fixed when a
demand curve is drawn.
Example 2.10
The diagram shows a consumer’s indifference map. RS
Solution 2.4 Answer: B
is the consumer’s budget line, and points J, K, L, M
and N show different combinations of goods Y and X. If the prices of complementary goods increase, the
It can be seen that the consumer would prefer demand for this good decreases, resulting in the
A combination M to combination N demand curve shifting to the left. Other options are
B_ combination N to combination J incorrect because: :
C combination L to all others A => causes a movement (contraction) along the
D combination K to all others demand curve.
 : -

work out ccongiiiaantaa A

C => increases demand for the product. Solution 2.8 Answer: A

D = shifts the supply curve to the left.
Consumer surplus occurs when people are able to buy
a good for less than they were willing to pay. The
Solution 2.5 Answer: C price of a chocolate bar is 40p, so:

In allocating their incomes it is assumed that rational Consumer surplus on first bar = 60p — 40p = 20p
consumers seek to maximise their total utility or Consumer surplus on second
satisfaction. D is incorrect because consumers bar = 50p — 40p = 10p
maximise their total utility by ensuring that the Consumer surplus on third
marginal utility per penny or pound spend for each bar = 40p — 40p = Op
good is equal. Total consumer surplus = 20p + 10p = 30p

Solution 2.8 Answer: B

Solution 2.6 Answer: C

To answer this question it is necessary to calculate the

marginal utility (MU) for each product. Marginal
utility is the change (A) in total utility (TU) resulting
from consuming one extra unit (Q) and is found, using
the equation MU = ATU/AQ.

x Me vs

Units
of good TU MU TU MU TU MU
2000 Journeys
40 ZN(sed fv teaa!Ds agedLV bai a 1000

48 & 30) w14* 20% “S10

eee 442 12 30 10 In the diagram, consumer surplus is shown by areas
54 2 52 10 40 10 A +B. Those consumers who previously paid £6 now
BWN
Oa
= ae oe ee Ot) LY only have to pay £5. 1000 journeys are made at £1
less than people would have paid, so the increase in
surplus is area A —i.e. £1000.
The calculations show that while the marginal utility
In addition, a further 1000 journeys are undertaken.
of Z is constant, the marginal utilities of X and Y
The resulting increase in consumer surplus equals
decline as consumption increases, Indeed, in the case
area B. Area B is given by the equation
of X disutility occurs — i.e. the consumption of the
fifth unit causes total utility to decline. 0.5(P,; — P,) X (Q, — Q))
=05(£6 — £5( * (2000 — 1000)
= 0.5(£1) X (£1000)
Solution 2.7. Answer: D = £0.5 x 1000
Consumers will not change their pattern of = £500
expenditure if at present they are enjoying maximum Therefore the total increase in consumer surplus is
total satisfaction. This occurs when the marginal area A + area B = £1000 + £500 = £1500.
utility (MU) of each good divided by its price (P) is
equal, so that in each case:
Solution 2.10 Answer: D
MU OLB |
MUofB
MUofA e
ee tee 10? Consumers will always prefer the point furthest away
Pop 20. 30 from the origin, i.e. K. Other options are incorrect
Therefore because:
A => The consumer is indifferent between point M
10 15 and point N, because the two are on the same
Semen, that
0.5 =0.5
eal, indifference curve.
18 Awork out’economics ¢ the economic problem and demand and supply

B = Point J is further from the origin than is point ¢ Distinguish between movements and shifts in
N. demand curves.
C = While combination L is the consumer’s point ¢ Make a careful distinction between the cause and
of equilibrium, the question asks which combination effect of an increase in (1) demand and (2) price.
the consumer prefers. ¢ Include demand and supply graphs.

Solution 2.11 Answer: D Solution 2.13

Diminishing marginal utility means that the (a) Demand refers to the amount of a good
satisfaction gained from consuming extra units consumers are willing and able to buy at a given price.
declines as consumption increases. Other options are For most products, price and demand are inversely
incorrect because: related. A rise in price will cause a fall in the quantity
A = Total satisfaction (utility) usually rises as demanded. This is shown in Figure 1, where a rise in
consumption increases. price from P to P, causes a contraction in demand
B => The individual consumer is unable to from Q to Q).
influence the price at which the product is bought.
C = In economics, utility is concerned with Price
satisfaction rather than usefulness.
D

Solution 2.12 Answer: B le —,

A Giffen good is one with a direct relationship

P
between price and demand. The other options are
incorrect because: D
A => describes a normal good.
C = Demand for the complement and the Giffen
good would fall.
0 Q, Q Quantity demanded
D = In the case of a Giffen good the income effect
Figure 1
and the substitution effect work in opposite directions,
with the income effect outweighing the substitution
This relationship between price and demand can be
effect.
explained by income and substitution effects. A rise in
price will reduce people’s real income (purchasing
power) and so they will be less able to buy the good.
2.6 Essays
It will also cause some people to Switch to substitutes,
so that the willingness to buy the product will decline.
Example 2.13
In a few exceptional cases, price and demand vary
(a) Define ‘demand’ and explain the expected directly. Veblen goods are goods that people buy, in
relationship between price and demand. part, to show how wealthy they are, and Giffen goods
(8 marks) are poor-quality products the poor have to buy
(b) Discuss the following two statements: because they have insufficient purchasing power to
(1) An increase in demand raises the price of a switch to alternatives.
particular good.
(b) The amount of a good consumers are initially
(2) An increase in price cuts demand for that
willing and able to buy at different market prices is
good. (17 marks)
shown by the demand curve D in Figure 2.
\@ Briefly define demand. Assume that the good in question is apples. The
* Use either income and substitution effects of demand curve, D, is drawn by assuming that all
marginal utility theory to explain the relationship factors influencing the demand for apples are held
between price and demand. constant, except price. A change in a condition of |
* Mention, briefly, that there are exceptions to the demand invalidates this ceteris paribus assumption.
expected relationship. For example a rise in the price of a substitute good,
 a

work out economigs *dem and=19 WEED.

raise the price of a good. However the price increase

is the effect and not the cause of the increase in
demand. By itself, an increase in price does cut
demand. However the price increase is now the cause
and not the effect of the fall in demand.
In conclusion, it can be seen that the two statements
in the question are correct if considered separately,
but are incorrect if linked together.

Example 2.14
Quantity of apples
(a) Explain the difference between marginal and
Figure 2 total utility. (5 marks)
(b) How does marginal utility explain the shape of
such as oranges, encourages consumers to switch to the demand curve? (12 marks)
alternative commodities, such as apples. Hence the (c) Why is the price of diamonds higher than the
demand for apples increases at all prices. The increase price of water? (8 marks)
in demand has the effect of shifting the demand curve
to the right, to D,. The price of apples rises from P to ¢ First define utility.
P,, causing an expansion along the supply (S) curve ¢ Use a numerical example to explain the difference
from A to B. Initial analysis suggests that an increase between marginal and total utility.
in demand raises the price of a particular good. ¢ Use a diagram and a numerical example to explain
An increase in the price of a good also affects the the shape of the demand curve.
amount demanded by consumers. However, unlike an ¢ In examining the relative price of diamonds and
water, distinguish between total and marginal utility.
increase in demand, an increase in price does not shift
the demand curve for the good. Again using apples as
an example, an increase in price results in a fall in the Solution 2.14
quantity demanded, causing a contraction along the
demand curve from A to B in Figure 3. (a) Utility is the satisfaction a person gains from
consuming a good. Total utility is the total satisfaction
gained from consuming a given quantity of a good.
Marginal utility is the satisfaction gained from
consuming an extra unit of a good. The table below
shows that as more biscuits are consumed in a given
period, total utility rises but at a diminishing rate. This
is because the marginal utility declines.

No. of biscuits Total utility Marginal utility

| 20 20
As 38 18
Q Quantity of apples 3 53 15
4 63 10
Figure 3 5 68 5
6 70 a
In fact the fall in the quantity demanded in Figure 3
can only have been caused by a decrease in supply
causing the supply curve to shift to the left and the (b) Most demand curves slope downwards from left
price to rise. In these circumstances, an increase in to right. This can be explained by considering the
price reduces the demand for that good. marginal utility a person gains the more of a good she
Analysis has so far supported both statements given or he consumes and by examining what happens to
in the question. By itself, an increase in demand does demand when the price changes.
 eee.
cite ‘a

2o-werk out,econginics ¢ the economic problem and demand and supply

SiA ce LS sangeet

One way of assessing marginal utility is to ask Initially this may be:
people how much they would be prepared to pay for a
good. This information can then be plotted on a graph.
As marginal utility declines the more a person
consumes, the amount she or he is prepared to pay for If the price of biscuits rises to 10p the consumer will
extra units will decline. The diagram below shows the maximise total utility by buying fewer biscuits and
marginal utility gained from biscuits. more apples, or more of another good. As fewer
biscuits are bought, marginal utility will rise, and as
Price/MU
more apples are bought, marginal utility will fall.
20. 30
10p —-15p

Thus a rise in price results in a fall in demand, and

this inverse relationship is shown by a demand curve
that slopes downwards from left to right.

(c) It may appear strange that diamonds, which are an

unnecessary luxury, are more expensive than water,
MU/demand
which is a necessity. Water does indeed have a higher
total utility than diamonds. However the amount
consumers are willing to pay is based on marginal
0 1 2 3 4 5 6 utility and not total utility.
No. of biscuits Consumers buy a combination of goods when the
Figure 1 marginal utilities per pound spent are equal. Water
will be consumed in large quantities up to the point
As marginal utility can be assessed by using price, when the last gallon of water used gives a low
the marginal utility curve is in effect the demand marginal utility and the price paid is relatively low.
curve. People consume when P = MU. Most people do not buy diamonds, and the marginal
The relationships between the demand curve and utility gained from the last diamond bought and the
marginal utility can also be analysed by considering price paid is relatively high. For example:
the effect of a price change. A consumer achieves
marginal utility of water
maximum total utility when he or she equates
marginal utility with the amount spent on the goods price of water
he or she buys, i.e. marginal utility of diamonds
marginal utility of biscuits price of diamonds
10 250
price of biscuits
20p £50
marginal utility of apples, v=:fof
price of apples
 of supply
¢ Supply is the amount of a good that producers are
both willing and able to sell at a given price.
¢ A supply curve shows the amount of a good that
producers are willing and able to sell at different
prices. ,
¢ The amount of a good supplied depends on:
(a) price;
(b) the conditions of supply.
Quantity supplied
per time period (QS)
(b) Movements along a supply
curve Figure 3.1 Movements along a supply curve

¢ Achange in price results in a movement along a

supply curve, resulting in a change in the quantity (d) Increases and decreases in
supplied.
¢ Achange in the price of a good never shifts the
supply
supply curve for that good. ¢ A supply curve is drawn assuming ceteris paribus
¢ In Figure 3.1 an increase in price causes an —i.e. that all factors influencing supply are being
expansion (or extension) of supply, and a decrease held constant, except price. The conditions of
in price results in a contraction of supply. supply refer to those factors held constant and
include:
(1) Average (or unit) costs of production.
(c) Individual and market supply (2) The current state of technology.
¢ Individual supply is one producer’s supply of a (3) The price of other goods:
good. (a) in competitive supply (i.e. alternative
¢ Market supply is the total supply of a good. products the firm could make);
¢ A market supply curve is the horizontal (b) in joint supply (i.e. by products from
summation of all the individual supply curves. manufacture).
22work out,eeonomics ¢ the economic problem and demand and supply

(4) Unforeseen circumstances (e.g. a drought

Price
ruining a wine crop).
(5) Taxes and subsidies. S
(6) The number of firms in the industry.
(7) The goals of producers. P
Producer
* Achange in one of these conditions affects the surplus
level of supply at all prices and results in a shift in
the supply curve.
¢ Figure 3.2 illustrates the effect of an increase in
supply.

Price
Quantity

Figure 3.3 Producer surplus

3.2 Investigative study

Example 3.1
A study of the impact of changes in technology in an
0 Quantity industry, e.g. banking, on the quality of service, costs
and price.
Figure 3.2 An increase in supply

3.3 Data response

Causes
Example 3.2
e A decrease in unit costs of production.
* Improved technology. Output at current factor cost (£ million)
¢ A fall in the price of a good in competitive supply. Coal mines
* Arise in the price of a good in joint supply. Year and nuclear fuel Total production industries
¢ Beneficial unforeseen circumstances. PF eteek Ges aoe et
¢ A subsidy given to producers. 1988 2913 121 361
¢ New firms entering the industry. 1989 2452 130 031
* A firm changing its objective from profit to sales 1990 2134 134 365
RE RD 1991 2528 132 672
1992 2373 135 637
1993 1655 144 435
Effect Se, ee Bile, Bin FOAL. Th
Source: CSO, Blue Book, 1994; United Kingdom
¢ The supply curve shifts to the right. National Accounts.

(a) Calculate and comment on the change in the

output of coal mines and the nuclear fuel
(e) Producer surplus industry for the period shown. (8 marks)
(b) Do you think coal has an elastic or inelastic
* Producer surplus is the difference between the supply? Explain your answer. (8 marks)
minimum price a producer would accept to supply (c¢) What factors do you think could reverse the
a given quantity of a good and the price actually trend you have observed and shift the supply
received. curve in the opposite direction? (8 marks)
* The area of producer surplus is that above the (d) In which sector — primary, secondary or tertiary
supply curve and below the price line in Figure — are coal mining and nuclear fuel placed?
a:o: (1 mark)
 Eg 5.
oe
sf =F

_ » ce
pai
work out economi€s ©
supply
oe
Sms
ot

Solution 3.2 : (d) Coal mining and nuclear fuel are extractive
industries and are therefore placed in the primary
(a) sector.
—

% share of
coal mines
3.4 Objective questions
% change in output of and nuclear
coal mines fuel in total
Example 3.3
and nuclear output of production
Year fuel industries Why does a normal supply curve for corn slope
upwards from left to right?
1988 2.4 A Farmers’ profits increase as price increases
1989 —-15.8 1.9 B Farmers increase supply following increases in
1990 —-—13.8 1.6 demand
1991 17.4 1.9 C Farmers charge more to cover a rise in the price of
1992 -6.1 eg seed
[9925 =30.3 igh D Farmers are willing to produce more corn as price
increases
Over the whole period there was a sharp decline in the
actual output of coal and nuclear fuel, and this Example 3.4
industry’s share of the total output of all production The supply of a good is represented by the equation
industries. There was one exception to this: 1991 P =10+0.8 Q,, where P refers to the price in pounds
witnessed an increase in both output and the share of (£) and Q, is the quantity of the good sold. At what
the total of all production industries. The most marked price will the producer sell 20 units?
decline came in 1993, when output fell by more than a A £10 B £16 Cerz0. D £26
third. This reflected the large-scale closure of pits by
the government. Example 3.5
(b) The formula for measuring elasticity of supply 1s: Which of the following would cause a shift of the
supply curve to the right?
PES % change in quantity supplied A A decrease in VAT
* % change in price B A decrease in specific subsidies
C An increase in production costs
Whether at any particular time the supply of coal is
D An increase in the price of the product
elastic or inelastic is determined by two key factors:
the level of stocks held and the extent of spare
Example 3.6
capacity. If stocks are high and mines are not being
fully worked, a rise in price could bring about a Goods X and Y are in competitive supply. Other
significant rise in supply. However if stocks are low things being equal, what will be the effect of a
and mines are being worked to full capacity, it will be decrease in demand for good Y?
difficult to adjust supply to a rise in price and supply A An increase in the supply and price of good X
will be inelastic. B A decrease in the supply and price of good X
C An increase in the supply and a decrease in the
(c) A number of factors could cause supply of coal to price of good X
increase and thereby shift the supply curve to the D A decrease in the supply and in increase in the
right. New deposits of coal could be discovered away price of good X
from existing coal mines or new seams could be found
at mines currently being operated. The government Example 3.7
could subsidise coal production. Improvements in
technology may enable new seams to be tapped. Which of the following will cause the supply curve
for peaches to shift to the left?
These factors are also likely to reduce production
A Arise in the price of apples
costs, as will a fall in unit labour costs, perhaps
because of an improvement in productivity. B A successful advertising campaign for cream
 ics ¢ the economic problem and demand and supply

C A reduction in EU subsidies to fruit growers 3.5 Solutions to objective

D An increase in the total number of consumers of
questions
peaches

Solution 3.3. Answer: D

Example 3.8 A supply curve slopes upwards from left to right,

since higher prices induce producers to extend their
At a price of £10 the quantity supplied is 800. If supply. Other options are incorrect because:
elasticity of supply is 1.5, what will be the quantity A => Profitability cannot be assessed without
supplied if the price rises to £11? further information about revenue and costs.
A 680 B 720 C 840 D 920 B = An increase in demand for corn causes a rise
in price and an extension in supply, not an increase in
supply.
Example 3.9
C => When drawing.a supply curve all variables are
Goods that are in joint supply are: held constant except price. A rise in the price of seed
A. sold together shifts the supply curve to the left.
B_ consumed together
C produced together Solution 3.4 Answer: D
D_ produced by the same firm The equation P = 10 + 0.8Q, simply means price
equals 10 plus whatever quantity is being supplied
multiplied by 0.8. Therefore
Example 3.10 P=10+(0.8 X 20) = 10 + 16 = 26.
Which of the following would cause an expansion in
Solution 3.5 Answer: A
the supply of chicken?
A A fall in the price of beef A decrease in VAT increases supply and shifts the
B Arise in the price of chicken supply curve to the right. The other options are
C A rise in vegetarianism incorrect because:
D A rise in the price of chicken feed A and C = would result in a decrease in supply,
which would shift the supply curve to the left.
D = would cause a movement along the supply
Example 3.11 curve (expansion) and not an increase.

Why is the supply of fresh salmon more inelastic than

Solution 3.6 Answer: C
the supply of tinned salmon?
A Fresh salmon cannot be stored
B_ Fresh salmon is in more demand than tinned
salmon
C Producers of tinned salmon are more efficient than
producers of fresh salmon
D There are more substitutes for tinned salmon than
for fresh salmon

Example 3.12

Which of the following would increase the elasticity

of supply of a product?
A A rise in its price
B Arise in the capacity utilisation of the industry
C A fall in the time it takes to produce the product
D A fall in the mobility of the factors of production
that produce the good
The top diagram shows that a decrease in the demand chicken, lower its price and cause supply to contract.
for good Y reduces its price. Since good Y and good C => Arise in vegetarianism will again cause a
X are in competitive supply, a fall in the price of Y decrease in the demand for chicken, a fall in its price
encourages producers to increase their supply of and a contraction in supply.
X. The bottom diagram shows that an increases in the D = A rise in the price of chicken feed will
supply of X reduces its price. increase the cost of chicken feed and result in a
decrease in supply.

Solution 3.7. Answer: C

Solution 3.11 Answer: A
A reduction in EU subsidies to fruit growers would
decrease the supply of all fruit, including peaches. As fresh salmon is perishable its supply cannot be
Options A, B and D all describe events that would easily adjusted in response to price changes. For
increase the demand for peaches, thereby causing instance if the price of fresh salmon falls it cannot be
their price to rise and supply to expand. withdrawn from the market — it will still have to be
sold.

Solution 3.8 Answer: D

Solution 3.12 Answer: C
i %AOQS
~ AAP If the product can be produced more quickly,
producers will be able to alter supply more easily in
In this case: response to changes in price.
Sr %AOQS A = Elasticity of supply measures how supply
— responds to a change in price, it is not determined by
it.
1.5 X 10=%AQS B and D = would make it more difficult to alter
15% = %AOS supply and hence make supply more inelastic.

A rise in price will cause an expansion in supply, so

supply will now be:

800 + 15% = 800 + 120 = 920

Solution 3.9 Answer: C (a) What is the relationship between supply and
price? (10 marks)
Goods in joint supply are produced together. An (b) What factors could cause an increase in supply?
example is beef and leather. (15 marks)
A => Any types of good may be sold together.
¢ Use a diagram to illustrate the usual relationship
B = Goods consumed together are complements.
between supply and price.
C = Goods produced by the same firm are not
¢ Refer to extensions and contractions in supply.
necessarily in joint supply. Indeed they may be in
competitive supply. ¢ Briefly acknowledge that there are exceptions to
the expected relationship.
¢ Illustrate an increase in supply.
Solution 3.10 Answer: B ¢ Distinguish between a movement along and a shift
in the supply curve.
An expansion in supply is a movement along an
* Discuss the main causes of an increase in supply
existing supply curve and can only be caused by a
and give examples.
change in the price of the good concerned, in this case
chicken. A higher price will encourage chicken
farmers to sell more chicken. Solution 3.13
A = A fall in the price of beef may encourage
(a) Supply is the quantity of a good that producers are
some people to switch from consuming chicken to
willing and able to offer for sale at a given price. In
consuming beef. This will decrease the demand for
 AES sggeteenseee

Pe. a cond
Omics ¢ the economic problem and demand and supply
eas hii

most cases supply and price vary directly, so that a

rise in price causes an extension in supply and a fall in Price

price causes a contraction in supply. Figure 1 shows

that a rise in price from P to P, causes an extension in
supply from Q to Q,.

Price

0 Quantity

Figure 2

competitive supply falls and/or the profitability of

goods in joint supply rises, the supply of this good
0 Q Q, Quantity will increase. For example if the profitability of pork
Figure 1 production falls and the profitability of leather hides
rises, the supply of beef is likely to increase.
A rise in price usually causes an extension in A government subsidy or the reduction or abolition
supply because it enables the higher costs that are of an indirect tax will increase the supply of a
likely to result from a rise in output to be covered and product. The EU subsidy on linseed oil in the early
may increase the profitability of producing the good. 1990s resulted in an increase in the amount of linseed
In a few cases the supply curve may not be upward grown.
sloping. It is possible for a supply curve to be Producers will also supply more now if they believe
horizontal (perfectly elastic), vertical (perfectly that prices will fall in the future, or if they change
inelastic) or downward sloping. The last example can their objectives, for instance from profit to sales
occur in the case of some labour markets where a rise maximisation.
in the wage rate causes some already well-paid An increase in the number of firms in the industry
workers to reduce the number of hours they work. will increase supply. In some cities deregulation has
resulted in a rise in the number of bus companies
(b) An extension in supply results in more of a good
covering popular routes.
being supplied because of a rise in its price, other
A change in unforeseen circumstances can also
influences being held constant. An increase in supply
cause a change in conditions of supply. The ending of
also results in more of a good being supplied, but in
a war is likely to result in a rise in the range of civilian
this case because of a change in an influence on the
goods produced. A favourable spell of weather is
supply of a good other than its price.
likely to increase the supply of a number of
An increase in supply is illustrated by a shift in the
agricultural crops, including apples, wheat and wine.
supply curve to the right, with more being supplied at
each and every price. This is shown in Figure 2.
There are a number of causes of an increase in Example 3.14
supply. One of the main causes is a fall in the cost of
(a) Explain how the supply curve of a firm in perfect
production, for example an improvement in
competition is determined. (15 marks)
technology will enable producers to increase the
(b) How can the market supply curve be derived?
quantity and probably the quality of output at a lower
(10 marks)
unit cost. In the last twenty years technological
advances have significantly lowered the production ¢ This question can be answered relatively briefly.
costs and prices of a number of products, including ¢ Consider both the short-run and long-run supply
calculators and personal computers. curves. ——
A change in the profitability of other goods is ¢ Draw diagrams to illustrate how the supply curves
another influence. If the profitability of goods in are determined.
 work out econo)

¢ Distinguish between individual and market supply In the short run firms will stay in the industry
curves. provided that at least their variable costs can be
covered. So in the short run the supply curve is based
on the MC curve from X to Y (i.e. at and above
Example 3.14 average variable cost).
The supply curve of a firm shows the amount the firm In the long run all costs have to be covered and the
is willing and able to sell at different prices. When supply curve is based on the marginal cost curve at
plotting a supply curve the only influence that is being and above the average cost curve (i.e. from Y to Z).
changed is price. (b) An individual supply curve shows the quantity
The supply curve of a firm operating under that one firm will supply at different prices. A market
conditions of perfect competition is based on its
marginal cost curve. It is assumed that firms in this A
market structure are profit maximisers and will Cost/
MC
therefore produce an output where MC = MR. As revenue
Fd,
perfectly competitive firms are price takers, marginal
Average cost
revenue will equal average revenue (and hence price),
so these firms will produce where MC = P. Figure | Average
variable
shows the marginal cost curve for a perfectly Y cost
competitive firm. At a price of P, Q will be supplied,
at a price of P,, Q, will be supplied, at a price of P,, x

Q, will be supplied and so on.

Costs/
revenue
ee
0 Output

MR, = AR, = P; Figure 2

MR, = AR, = P,
supply curve is the total amount that will be supplied
MR, = AR, =P, by all the firms in the industry at different prices. It is
MR=AR=P
found by the horizontal summation of all the
individual supply curves (and hence MC curves). This
means the amount that each individual firm would
supply at each price is added together and then plotted
on a supply graph. For example Figure 3 shows the
supply curve of three firms (this is obviously a
a ae
Output
simplification because a perfectly competitive
industry would contain far more firms).
Figure 1
Ata price of £1 the market supply is 20(7+7+6),
Therefore the amount that will be supplied can be at £2 it is 30 (11 + 10 + 9) and at £3 it is £42
(15+ 144 13).
found from the marginal cost curve.
 Price Price
(£) (£)

S S

3 3

2 a

1 1

0 7 11 15 Quantity 0 ia 0 14 Quantity 9 13 Quantity

FirmA Firm B Firm C

Price
(£)

0 5 10 15 20 30 40 42 Quantity

Market supply

Figure 3
 only one market price where the amount that
producers want to sell equals the amount that
consumers want to buy. The forces of demand and
supply ensure that P is the equilibrium market
¢ In Figure 4.1, excess supply occurs at prices above price.
P, because producers are prepared to sell more
than consumers are willing to buy. Attempts to
maintain a minimum price above the market price
(b) Changes in equilibrium price
(e.g. the Common Agricultural Policy) results in
structural surpluses. ¢ An increase in demand will cause price to rise and
¢ Excess demand occurs at prices below P, because supply to expand.
consumers want to buy more than producers are ¢ A decrease in demand will cause price to fall and
prepared to sell. Attempts to maintain a maximum supply to contract.
price below the market price (e.g. by rationing) ¢ An increase in supply will cause price to fall and
results in artificial shortages. demand to expand.
¢ Equilibrium is a state of balance — i.e. a situation ¢ A decrease in supply will cause price to rise and
where there is no tendency for change. There is demand to contract.

Price

0 Q, Q Quantity
1 Quantity

Figure 4.1 Equilibrium and non-equilibrium prices Figure 4.2 The effect of a decrease in supply
 cer zy

30 work out economics ¢ the economic problem and demand and supply

(c) Indirect taxation (e) Price instability

An indirect tax (T,) is a surcharge on price imposed on ¢ Products with stable conditions of supply and
the sale of goods and services by the government and demand will have stable prices from year to year.
can be: ¢ Products with unstable conditions of supply and
demand will experience price fluctuations from
(1) specific —i.e. a fixed amount per unit;
year to year.
(2) ad valorem —i.e. a percentage of the selling price.
¢ Products with seasonal variations in demand, such
¢ The effect of an indirect tax is shown by adding as hotel accommodation, tend to be price-unstable.
the amount of the tax to the supply curve. ¢ Agricultural prices tend to be unstable because:
¢ Tax incidence refers to the burden of a tax. The (a) supply changes from one time period to the
more price-inelastic the demand for a good, the next because of variable weather conditions;
greater the tax incidence borne by the consumer. (b) the effects of changes in supply is amplified by
price-inelastic demand (see Chapter 5);
Tax incidence (c) the effect of changes in demand is amplified
S+T, borne by consumer
by price-inelastic supply;
Price [exe]
(d) supply lags (delays) exist between the
decisions to produce and the produce coming
Tax incidence onto the market. The resulting cobweb model
borne by producer
is explained in Example 4.14.

0 (o} (0) Quantity

(f) Interrelationships between
Figure 4.3 An ad valorem indirect tax. Area P2P1AB equals the
total amount of tax revenue raised
markets
A decrease in the supply of product A will cause:

(1) arise in the price and a contraction in demand for

product A;
(d) Subsidies
(2) an increase in demand for product B (a substitute)
¢ A subsidy (SU) is a discount on price given by the a rise in its price, and an expansion in its supply.
government. (3) a decrease in demand for product C (a
¢ A subsidy can be specific or ad valorem. complement), a fall in its price and a contraction
¢ The effect on a supply curve is shown by in its supply;
deducting the amount of a subsidy from the supply (4) a decrease in supply of product D (a good in joint
curve. supply), a rise in its price, and a contraction in its
¢ The more price-inelastic the demand for a good, demand;
the greater the share of the subsidy going to the (5 an increase in supply of product E (a good in
—

consumer. competitive supply), a fall in its price and an

Subsidy
expansion in its demand;
A received by
the consumer
(6 — a decrease in demand for the factors of production
Price S
that produce product A, a fall in their price a
contraction in their supply.

Subsidy
received by
the producer

Quantity

Figure 4.4 A specific subsidy. Area P1PJK equals the total amount
of subsidy paid
 PFA, egg
a trey

work out economics « price determination 31

P > determi on

ProductA » Product B

Price Price

P,

D,

—_——_
0 Q, Q Quantity 0 Q Q, Quantity

Figure 4.5 The effect of a decrease in the supply of product A on the market for product A and on the market for product B, a substitute.

4.2 Investigative study (c) What pricing policies for corn might a
government adopt for the period shown?
2)
oa
(10 marks)

commodity, e.g. coffee, their causes and effects. Solution 4.2

(a) Figure | indicates that the price of corn fluctuated

above and below £150 per tonne between 1990 and
4.3 Data response 1996. The highest price, £200 per tonne, was achieved

FS ve

The following table refers to an imaginary market for 200 |- x

corn. Farmers are assumed to plan next year’s Price of

corn
production on the basis of last year’s price. oa 175
tonne (£)

150 x Pos gt
Price per Amount bought
Year tonne (£) and sold (tonnes)
125 |
1990 150.0 3000
1991 200.0 1000
100
1992 125.0 4000
1993 162.5 2500
75
1994 145.0 3250
1995 150.0 3000
50
1996 150.0 3000

25
(a) Describe the annual variations in the price of
corn. (5 marks)
1990 1991 1992 1993 1994 1995
(b) Given that demand conditions are unchanged,
Year
how would you explain the annual variations in
the price of corn shown in the table? (10 marks) Figure 1
in 1991 and the lowest, £125 per tonne, in the intervene to stabilise price. Price intervention in the
following year. Note that the magnitude of the corn market requires the government to keep a buffer
oscillation diminishes. stock. For instance Figure 3 shows that the effect of
the poor harvest of 1991 on price could have been
(b) Market prices are determined by the interaction of
overcome by the government selling 2000 tonnes
supply and demand. Market equilibrium occurs when
from stock at the prevailing price of £150. Such price
there is a stable, long-run market price from which
intervention would have allowed avoidance of the
there is no tendency to move. A change in any of the
subsequent ‘cobweb’ shown in Figure 2.
conditions of supply or demand would affect
equilibrium by causing a shift in a supply or demand
curve, hence a change in price.
Agricultural goods such as corn are particularly
prone to unforeseen weather conditions, which affect
supply from one year to another. The fact that the
200
price of corn stood at £150 in three separate years
would tend to suggest that this is the long-run
equilibrium price for corn. The initial change in price
150 + -—-t—-—---— Excess demand
in 1991 is likely to have been the result of an
unexpectedly poor harvest brought about by, say, frost
damage. The resultant fall in supply shown in Figure
3 raised the price to £200, with only 1000 tonnes
bought and sold.
Quantity
Figure 2 shows the path the market might have
followed in moving back to equilibrium. Long-run Figure 3
disequilibrium occurred between 1991 and 1995,
because farmers were unable accurately to predict
next year’s price. In 1992 they produced too much,
and the price fell to remove the excess supply. In 1993
farmers produced too little and the price rose to 4.4 Objective questions
remove excess demand. By 1995 the amount
Examples 4.3 to 4.6 refer to the following diagram,
producers wanted to sell at £150 equalled the amount
which shows the supply of and demand for British-
consumers wanted to buy, and the price remained
made lawnmowers. The market is initially in
stable into 1996.
equilibrium at point X. Starting from point X each
(c) Pricing policy refers to the government’s ability to time, indicate the new equilibrium position — A, B, C
leave markets free to set their own price or to or D — after each of the events described.

Price
per
tonne (£)

Quantity

Figure 2
 work out economics ¢ pricedet natiot

Quantity 0 Q, Q Q, Quantity

Example 4.3 Example 4.8

The market demand for a good Y is given by the
What will be the new market price following the equation Y = 80 — 10P and the market supply for
introduction of labour-saving technology? good Y is given by the equation Y = —40 + 20P,
where P denotes the price of good Y. The equilibrium
Example 4.4 price for the good is
‘ Poe: : A 2P B 4P CIP D 20P
What will be the new market price if the price of
imported lawnmowers falls considerably? Example 4.9

Which of the following diagrams illustrates the effect

Example 4.5 that a rise in the price of beef has on the market for

What will be the new market price if there is a ot (a)

successful advertising campaign for lawnmowers,
while at the same time the government introduces an
indirect tax on, the sale of lawnmowers? Price Ss
bse
S,
Example 4.6
A subsidy is given to a product whose demand is price
elastic but whose supply is price inelastic. Who will is
benefit from the subsidy?
A Producers will keep the entire subsidy p
B Most of the subsidy will be kept by producers
C Consumers will receive the full benefit of the A
subsidy Lie(b) $2iseq ooHATED
D Most of the subsidy will be passed on to the
consumers S;

Price Ss
Example 4.7 At

The diagram below indicates the conditions of 2

demand and supply of wheat. What would be the P
effect of the government setting a minimum price of
Pa
A No effect J
B Cause an excess supply of wheat
C Make the market demand curve P,LM
D Require the intervention buying of Q — Q; amount 0 O, O Guahtity
of mustard
of wheat
34 work out-economics ¢ the economic problem and demand and supply

(c)
Demand Price Supply
Price
of A Increase Increase Expand
mustard S
B Expand Decrease Increase
C Contract Increase Decrease
D Decrease Decrease Contract

D,
Example 4.12
D
The original demand curve for wheat is FGH. The
government then introduces a guaranteed minimum
price of OP,, maintaining this price for intervention
0 Q, Q Quantity
of mustard buying for stockpile. What is the new effective
demand curve?
A FGM B P.GM C PGH D JKL
Price
of
mustard

Quantity of wheat
0 Q; Q Quantity
of mustard

4.5 Solutions to objective

Example 4.10 questions
The supply of a particular good is directly related to
Solution 4.3. Answer: C
price and its demand is inversely related to price.
During a certain period 5000 units are sold at £9 and The introduction of labour-saving technology reduces
during a later period 4000 units are sold at £8. Which unit costs, increases supply and shifts the supply
of the following, other things being equal, could curve to the right to S,. The new equilibrium position
account for this change? is given by the intersection of S, and D —1.e. point C.
A An increase in consumers’ incomes
B_ An increase in the cost of raw materials
Solution 4.4 Answer: B
C A decrease in the price of a substitute product
D A decrease in the productivity of factors of A fall in the price of a substitute good for home-
production produced lawnmowers reduces demand and shifts the
demand curve to D,. The new equilibrium position is
given by the intersection of D, and S —i.e. point B.
£xample 4.11

As a result of improved training there is a rise in the

Solution 4.5 Answer: A
productivity of car workers. If the rise in productivity
outweighs the rise in training costs, what effect will A successful advertising campaign shifts the demand
this have on the demand, price and supply of cars? curve for lawnmowers to the right to D,. A tax on the
 =e, AGRE ee

work out economics ® price determinatio 35

= Aare md jin
:
n
iS

sale of lawnmowers shifts the supply curve to the left manipulating equations that whatever is done to one
to S,. The equilibrium position is A. side of the equation must also be done to the other
side. The market price is found as follows:

Solution 4.6 Answer: B quantity demanded = quantity supplied

substitute 80 — 10P = —40+20P
It almost always helps to draw a diagram to illustrate add 10P 80 = —40 + 30P
details given in a question. D represents a price elastic add 40 120 =30P
demand curve and S represents a price inelastic supply divide by 30 4=P
curve. To show the effect of a subsidy, deduct an
amount (say P, — P,) from the supply curve at all Solution 4.9 Answer: D
output levels and label the new supply curve S,. The
initial market price is P, with Q amount bought and Beef and mustard are complements. A rise in the price
sold. The subsidy has increased supply and reduced of beef will cause a contraction in demand for beef
the equilibrium price to P,. While consumers pay only and a decrease in demand for mustard. The fall in
P,, producers receive P, per unit sold. Because demand for mustard will cause the price of mustard to
demand is price elastic and supply is price inelastic, decrease and its supply to contract, as shown in
the bulk of the subsidy goes to the producer (area A). diagram (d).
A smaller proportion (area B) goes to the consumer.
Solution 4.10 Answer: C
Price
The price of the product has fallen and a lower
Pek quantity is being bought and sold. This could have
so." been caused by a decrease in demand for the product,
a as shown in the diagram below.
P fh
i ; | Price ' Ss
| D

ad
Q Q, Quantity sae
ie
Solution 4.7. Answer: B
D
At the minimum price producers want to sell more D,
(Q,) than consumers want to buy (Q,). So there is an 0 >

0, Quantity
excess supply of wheat of Q, — Q,. The other options
are incorrect because:
A = A minimum price would have no effect if it A decrease in the price of a substitute product
was set below the equilibrium price. would cause an expansion in demand for that product
C = Above point L the market demand curve is and a decrease in demand for this product.
unaffected by government action; beyond point L the A = An increase in consumers’ incomes would
government is prepared to intervene and buy up any increase demand for the product, which would increase
amount of wheat necessary to maintain the price at P, both the price of the product and the quantity traded.
— the demand curve becomes perfectly elastic at L and B and D = would cause the cost of production to
extends to M — it becomes KLM. rise, which in turn would result in a decrease in
D = To maintain the minimum price would require supply, a fall in price and an increase in the quantity
intervention buying of Q, — Q, amount of wheat. traded.

Answer: B Solution 4.11 Answer: B

Solution 4.8

In equilibrium, the two equations given in the An increase in the productivity of car workers would
question must equal each other. Remember when lower the cost of production. This would increase
 supply, which in turn would lower price and result in * Consider in each case which curve — demand or
an expansion in demand, as shown below. supply — is likely to shift.
* Apply your understanding of general demand and
Price
of S
supply analysis.
cars ¢ Make assumptions about the price elasticity of
supply and demand for coffee and then draw flat
or steep curves to match.

Solution 4.13

In a market economy the price of coffee is determined

by the interaction of supply (the amount of a good
D
that producers are willing and able to sell) and
0 demand (the amount of a good that consumers are
Q Q, Quantity of cars
willing and able to buy).

(1) In Figure 1, S shows supply and D demand at

Solution 4.12 Answer: A different prices. P is the initial equilibrium market
price and Q the initial amount of coffee bought and
Above the guaranteed minimum price the government
sold. The relatively long time taken to grow coffee
will allow market forces to operate and therefore the
plants means that supply is price inelastic. Demand is
original demand curve will operate from F to
relatively price inelastic, because analysis suggests
G. However when the minimum price is reached the
that there are few close substitutes for coffee. S and D
government will buy up any extra quantity supplied to
are drawn assuming ceteris paribus (all other things
prevent the price from falling below OP... So at G
being equal). A severe frost will invalidate this
demand becomes perfectly elastic. The effect of the
assumption and cause a decrease in the quantity of
government’s action is illustrated in the diagram
coffee supplied at all market prices, causing the
below.
supply curve in Figure 2 to shift to the left, to S,;. The
decrease in supply causes a rise in price to P, anda
Price
of contraction in demand.
cars
Price
per jar

|
|

0 Q No. of
Quantity of jars each
wheat month

Figure 1

Price
per jar

Example 4.130 P,

Analyse the effect, in the short run only, on the price P

of coffee of (1) a severe frost, (2) a fall in the rate of

VAT and (3) the introduction of rationing.
(25 marks) 0
jars each
* You are not expected to have a detailed knowledge month
of the coffee industry. Figure 2
 work out economics pricedételipnatigA§

The more severe the frost the greater the decrease The final effect on the legal price is indeterminate.
in supply, and the greater the resulting increase in The government may decide to offer the good above,
price. The more price inelastic the demand the greater at or below the price prevailing before the
the increase in price for a given fall in supply. introduction of rationing. However the existence of
excess demand at prices below P, encourages the
(2) VAT is an ad valorem (according to value)
development of an illegal black market, where the
indirect tax on the sale of goods and services. In
price is likely to be higher than that set by the
Figure 3, the effect of VAT on coffee is found by
government.
adding the amount of the tax to the original supply
curve at each level of output. A fall in VAT rates
reduces the amount of tax received at each level of Example 4.14
output and the supply curve moves to the right, to
S+T,. The assumption of inelastic demand means a Explain why the prices of some goods change more
than those of other goods. (25 marks)
significant fall in price, to P).
¢ Explain why unstable conditions of supply and
demand result in price changes.
¢ Explain why price inelasticity amplifies the effect
on price of changes in supply and demand.
¢ Introduce time lags and apply the cobweb theory.
¢ Make use of graphs and relevant examples.

Solution 4.14

No. of jars Equilibrium is a situation of balance from which there

each month
is no tendency to change. Equilibrium prices change
Figure 3 only if there has been a change in a condition of
demand or supply. It follows that products whose
(3) Rationing, which usually occurs in response to a conditions of demand and supply are inherently
crisis such as war, is when the government intervenes unstable are subject to greater price fluctuations than
in a market to fix the price and output of a good. In those with more stable demand and supply conditions.
Figure 4, the government fixes the output of coffee at For instance, goods for which demand varies
Q,. Given that supply is now totally unresponsive to according to the time of year will display price
changes in price, S, is perfectly price inelastic and instability. For example the price of coal falls during
price rises to P,. Often rationing authorities consider the summer but rises in the winter. Similarly a rise in
high free-market prices to be unfair to those on low incomes increases the demand for all normal goods.
incomes and unable to buy coffee, so Q; coupons are Ceteris paribus, the greater the increase in demand
issued to consumers, allowing them to buy a fixed the greater the rise in price. Therefore goods with a
amount of the good each month at, say, price P. low income elasticity of demand usually possess
greater price stability. Goods with a low cross
elasticity of demand with respect to all other goods
Price have few substitutes or complements and are likely to
per show price stability. Similarly, products with few
jar
goods in joint or competitive supply are less likely to
P, be subject to price changes.
Empirical (real-world) evidence suggests that
agricultural goods have fluctuating prices. Farm
P Excess demand products are particularly prone to unforeseen events
such as bad weather and disease. Figure | shows that
as the weather changes, so does supply. The effect on
0 Q, Q No. of jars
each month price of each change in supply is exaggerated by
Figure 4 inelastic demand. Agricultural products have a low
38 work out Economics ¢ the economic problem and demand and supply

price elasticity of demand (PED) because they are only prepared to pay P, to buy up Q,. Farmers then
inexpensive and consumers tend to buy much the expect the next market price to be P, and so produce
same amount regardless of price. Q,. Because supply is more inelastic than demand, the
cobweb converges and the long-run equilibrium price
Supply given of P is eventually restored. Had demand been more
poor
inelastic the resulting divergent cobweb would have
caused even greater price variations over time.

Range of
price Supply given
ee
fluctuations good Price
weather
P,

Quantity

Figure 1

The cobweb theory explains why the price of some

goods fluctuates more than others. Assume that
farmers expect to sell their next crops at the same
Quantity
market price as in the previous season. This means
that this year’s price has no effect on current Figure 2
production but instead determines next year’s supply.
In Figure 2 the initial price is P. A ‘shock’ to the In conclusion, it can be seen that the prices of some
system (e.g. an unexpectedly poor harvest) causes commodities fluctuate more than those of others
price to rise to P,. Farmers expect price P, in the next because of differences in the stability of the
time period and produce Q,. However consumers are underlying conditions of demand and supply.
 of elasticity
Elasticity measures how one variable responds to a
change in another variable.

(b) Price elasticity of demand

Price elasticity of demand (PED) measures the
Quantity
responsiveness of demand to a given change in price.
The PED coefficient (value) is calculated by use of
either of the following equations: ¢ The PED coefficient can be between zero and
infinity (c9).
percentage change in quantity demanded
PED —— ¢ If PED is less than 1, demand is inelastic.
percentage change in price If PED is greater than 1, demand is elastic.
¢
_ %AOp ¢ PED is usually treated as a positive number and
~ AP any minus signs are often ignored.

PA Figure 5.2 shows that the gradient (slope) of a demand

on xX AQ
curve generally reflects its PED. However great care
QO, AP
should be taken when interpreting the gradient of a
where P is the initial price, Q, is the initial quantity demand curve.
demanded and A means ‘the change in’. From Figure
5.1, PED is calculated as follows: (1) The slope of a demand curve is not necessarily a
guide to price elasticity. The scale of each axis
PED between points A and B
affects PED.
%AQ, 400% (2) Ona steep demand curve, PED at points near the
y-axis can be elastic.
(3) Ona flat demand curve, PED at points near the x-
axis can be inelastic.
(4) PED falls as you move down a linear demand
curve.
 Pa arse i Se,
een - “Seth
Se ae ay |
er fA iN a
AGW Oko ut econgmics ¢ the economic problem and demand and supply

P P P

D.
D; D, 4
Q Q Q
(a) (b) (c)

P P

Sige D,
D;

Q Q
(d) (e)

Figure 5.2 Demand curves with different price elasticities. In (a) the demand curve is a vertical line; demand is perfectly inelastic; the
PED coefficient is equal to 0; and a price rise means no decrease in Q,. In (b) the demand curve is a steep line; demand is relatively
inelastic; the PED coefficient is greater than O but less than 1; and a price rise means a smaller percentage decrease in Q,. In (c) the
demand curve is a rectangular hyperbola; demand is unitary elastic; the PED coefficient is equal to 1; and a price rise means an equal
percentage decrease in Qp. In (d) the demand curve is a shallow line; demand is relatively elastic; the PED coefficient is greater than 1
but less than ~; and a price rise means a greater percentage decrease in Q,. In (e) the demand curve is a horizontal line; demand is
perfectly elastic; the PED coefficient is equal to ~; and a price rise means consumers buying perfect substitutes.

Table 5.1 Determinants of price elasticity of demand

Determinant The demand for a good is relatively price-inelastic because:

Number of substitutes If there are few substitutes for a good, consumers are
unlikely to switch products
Consumer loyalty If consumers are in the habit of buying a good, they
are unwilling to use substitutes
Absolute price of the If a good is inexpensive, a large percentage change in
good price represents only a few pence
Proportion of income If the good takes up only a small proportion of income,
consumers will not react significantly
Number of complements If the good has many complements, the product is
needed if the other items are used.
Consumer adjustment If consumers are slow to react to a change in price,
the amount bought is largely unaffected
Width of definition If the good is broadly defined, there will be few
substitutes for it.

(5) A demand curve shifting to the left becomes more ¢ If PED is elastic, a fall in price increases revenue.
elastic. ¢ If PED is inelastic, a rise in price increases
revenue.
If PED is unitary, a price change leaves revenue
(c) Price elasticity of demand and
unchanged.
revenue
The relationship between PED and marginal revenue
The e effect
effect of of aaprice
price chchange on revenue depends on ge toe a
the elasticity of demand. Figure 5.3 shows how a
change in price can increase or decrease revenue.
 work Out CCONGMUGS€l

Revenue gained [__]

Revenue lost [__]

Fig 5.3 (a) Elastic demand and revenue. Since the price decrease results in a proportionately larger increase in quantity demanded,
quantity
revenue rises. (b) Inelastic demand and revenue. Since the price increase results in a proportionately smaller decrease in
demanded, revenue rises.

(d) Income elasticity of demand (e) Cross-elasticity of demand

Income elasticity of demand (YED) measures the ¢ Cross-elasticity of demand (XED) measures the
responsiveness of demand to a given change in responsiveness of demand for good A to a given
income. change in the price of good B:

percentage change in quantity demanded XED

YED — percentage change in the quantity of A demanded
percentage change in income
percentage change in the price of B
_ %AQ
OY _ TAQD of A
Y A %AP of B
oer Qo
QO, AY Pay. AQm
or
¢ Since YED can be negative, it is important to Qn, AP;

include minus signs when applicable. ¢ Since XED can be negative, it is important to
* If YED is negative, the product is an inferior good. include minus signs when applicable.
¢ If YED is positive, the product is a normal good. ¢ If XED is positive, the two goods are in
¢ If YED is positive and greater than 1, the product competitive demand — i.e. are substitutes.
is a superior good. ¢ If XED is negative, the two goods are in joint
An Engel curve shows the amount of a good demand — i.e. are complements.
demanded at different levels of income. Figure 5.4 ¢ If XED is zero, the two products are unrelated —
shows that the slope of an Engel curve reflects its YED. i.e. are independent goods.

Quantity
demanded (Q,)

Income (Y)
Normal good Inferior good

Figure 5.4 An Engel curve with different income elasticities

AQ Ork. out.ecoffomics ¢ the economic problem and demand and supply

N Substitutes Complements

Price of Price of
eoed B D goodB | D

P, Fe

D D

0 OQ Q, 0 Q, Q
Quantity of good A demanded Quantity of good A demanded

Independent goods

Price of D
good B

Quantity of good A demanded

Figure 5.5 Cross elasticity of demand

Figure 5.5 illustrates the three possible types of cross- Figure 5.6 shows that the gradient of a supply curve
elasticity of demand. generally reflects its PES.

(f) Price elasti city of supply | eaeaseen to remember that for linear supply

Price elasticity of supply (PES) measures the

: ee ¢ PES is inelastic at all points when the supply
responsiveness of supply to a given change in price:
curve intersects the x-axis first.
PES = percentage change in quantity supplied ¢ PES is elastic at all points when the supply curve
percentage change in price intersects the y-axis first.
%AQ, ¢ PES is unitary at all points when the supply curve
= AP intersects the origin.

oe See
Qs; AP
* The PES coefficient can be between zero and
infinity (co)
* If PES is less than 1, supply is inelastic.
* If PES is greater than 1, supply is elastic.
 si

work out economics.e.@lasticity 43

yp Sec at

S;
Both S, and S, are
unitary elastic at
all points

S,
Q Q Q
(a) (b) (c)

P P

S,

S;

Q tO)
(d) (e)

Figure 5.6 Supply curves with different price elasticities. In (a) supply is perfectly inelastic, the PED coefficient is equal to 0; and a
price fall means no decrease in Qs. In (b) supply is relatively inelastic; the PED coefficient is greater than 0 but less than 1; and a price
fall means a smaller percentage decrease in Qs. In (c) supply is unitary elastic; the PED coefficient is equal to 1; and a price fall means
an equal percentage decrease in Qs. In (d) supply is relatively elastic; the PED coefficient is greater than I but less than %; and a price
fall means a greater percentage decrease in Qs. In (e) supply is perfectly elastic; the PED coefficient is equal to ~; and a price fall
means that suppliers halt production.

Table 5.2 Determinants of price elasticity of supply

Determinant The supply for a good is relatively price-elastic because:

Time In the long run, firms can adjust all factor inputs to
change supply easily
Production time If a good is manufactured quickly, supplies can be changed
easily
Stocks If a firm has a large amount of stocks, supplies can be
changed easily
Capacity lf labour and capital are underused, supplies can be
changed easily
Factor mobility If resources can move in and out of the industry, supplies
can be changed easily
nnn LEE

5.2 Investigative study 5.3 Data response

3
ERE
2 ase
hoe
Example 5.2

A study of the effect of a change in the rate of tax — Products X, Y and Z are produced in goods and
direct or indirect — on the market for a particular labour markets that operate under conditions of
product. perfect competition. Product X has an income
elasticity of demand of —0.2, product Y an income
elasticity of demand of 0.6 and product Z an income
elasticity of demand of 1.5.
 omics * the economic problem and demand and supply

Firms produce X, Y or Z, and at the start of the 1 shows the effect on the good market (a) and the
period all the firms in each industry are in long-run product market (b).
equilibrium. In the next year there is a rise of 5% in
average real consumer disposable income. 4
Price

(a) What term would you use to describe:

(1) good X
(2) good Y
(3) good Z (5 marks)
(b) Calculate how the change in income will affect
the demand for each good. (5 marks)
(c) Using diagrams, explain the changes that will
occur over time in the product and factor
markets. (12 marks)
(d) In assessing future changes in product markets,
which other elasticities should be taken into
account? (3 marks)
> Q,0 Quantity

(a) Product market

Solution 5.2

(a)(1) A good with negative income elasticity of

demand is known as an inferior good. An increase in Wage
income results in a fall in demand for this type of rate

good.
(2) A good with positive income elasticity of
demand is known as a normal good. An increase in
income results in an increase in demand for this type
of good.
(3) A good with positive income elasticity of
demand greater than one is known as a superior good.
In this case an increase in income results not only in
an increase in demand but a greater percentage
increase than the rise in income. It has income elastic
demand.
0 Q,OQ No. of
(b) Income elasticity of demand (YED) is calculated workers
from the equation: (b) Factor market

YED _ percentage change in quantity demanded

Figure |
i percentage change in income
Figure 2 shows the increase in demand for good Y
For good X: 0.2 = 7/5% = —1%- (demand for X
that follows an increase in income. The demand curve
falls by 1%)
for good Y shifts to the right. The resultant rise in
For good Y: 0.6 = ?/5% =3% (demand for Y
supply is achieved by attracting additional resources
rises by 3%)
such as labour into the industry. The increase in the
For good Z: 1.5=2/5%=7.5% (demand for Z
demand for the final product will increase the demand
rises by 7.5%)
for inputs used in the manufacture of Y, and cause the
(c) Answer (b) indicates that the demand for good X demand for the inputs to shift to the right.
falls by 1% over one year. This will cause demand for The effect on the product and good market in the
the good to fall, price to fall and supply to expand. As case of good Z is similar, except that the increase in _
less of the good will be produced, demand for the demand, the price rises and the payments for factors
factors of production to produce it will decline. Figure of production will be greater.
 work out econ ticity

Price

0 Q Q, Quantity 0 Q Q, No. of
workers

(a) Product market (b) Factor market

Figure 2

Price Wage
rate

P,
P ==

0 Q Q, Quantity 0 Q Q, No. of

(a) Product market (b) Factor market workers

Figure 3

The increase in payments for factors of production elasticity of demand) and a decrease in demand for
in the case of Y and Z will attract redundant factors of complements (negative cross-elasticity of demand). If
production from X. The reallocation of resources is supply is inelastic a rise in price will result in a
achieved through a change in the relative price of smaller percentage extension in supply.
products and factors of production between the
product and factor markets.

(d) It would also be useful to consider price and s questions

cross-elasticity of demand and price elasticity of
supply. For example a rise in the price of a good will
result in a greater percentage fall in demand and a fall
in revenue if demand is elastic. It will also cause an The following table shows a demand schedule for a
increase in demand for substitutes (positive cross- particular good:
 1 OF ics © the economic problem and demand and supply
ene

Example 5.7
Price (£) l PR ane oesRae a
Quantity demanded (kilos) 40 35 30 25 20 Which one of the following graphs refers to a good
that exhibits a negative income elasticity of demand at
all levels of income?
In which range does the price elasticity of demand
(expressed as a positive number) lie for a rise in price A B
from £3 to £4?
Income D Income
A 0.0-0.3 B 0.4-0.7 C 0.8-1.1 D 1.2-1.5

Example 5.4
If the demand curve for a normal good is linear, the
price elasticity of demand for the good: Bee

0 0
D

Quantity Quantity
decreases as the amount bought increases
increases as the amount bought increases SC D
is always less than |
Saneis unity Income D Income

Example 5.5
Which of the following diagrams illustrates the
relationship between two normal goods that are in
joint demand? Quantity Quantity

A B
Example 5.8
Price Price
of of B The following table gives an individual’s demand for
x x three goods at two different income levels:

Income (£000)
D 20 24
= rT lee

Quantity of Y Quantity of Y Units of A 10 15

demanded demanded
Units of B 8 10
Units of C 10 11

It follows that the proportionate rise in income leads

to:
A aproportionately greater increase in the amount of
A demanded
B a proportionately greater increase in the amount of
Quantity of Y Quantity of Y C demanded
demanded demanded
C aproportionately greater increase in the demand
for good B than for good A
Example 5.6
D a proportionately greater increase in the demand
If market price falls by 5% following a rise in supply, for good C than for good B
and there is no change in the quantity bought, the
demand curve is:
Example 5.9
relatively elastic
relatively inelastic A cinema ceases to offer half-price mid-week tickets
completely elastic and instead charges full price. As a result the cinema
TORScompletely inelastic experiences a fall in its total revenue from mid-week
 work out economics: élasticity"47
*

sales. What can be concluded from this information? C inelastic

A At these prices the demand for mid-week tickets is D_ perfectly inelastic
elastic
B At these prices the demand for mid-week tickets is 5.5 Solutions to objective
inelastic
questions
C The demand for mid-week tickets is more elastic
than the demand for weekend tickets
Solution oe Answer: B
D The demand for mid-week tickets is more inelastic
than the demand for weekend tickets Price elasticity of demand (PED) can be calculated by
using either of the following equations:
Example 5.10 A
Pepe ae
Price elasticity of supply will be smaller: 0, AP
the longer the time period under consideration %A
The larger the amount of stocks held by firms or PED = 2a¥2
%AP
the more immobile the factors of production used
om the shorter the time period required to train the where P is the initial price, Q, is the original quantity
labour used demanded, AQ, is the change in quantity demanded
and AP is the change in price.
Example 5.11
Using the first equation:
The diagram below shows three supply curves. Which 3 02357" ae o> ae
of the following statements relating to these supply PED =
30 rAveayeiO “61s 730
curves is correct?
and using the second equation
Price 16.67%
PED = =
Bepapet

Note that the question states PED ‘expressed as a

positive number’. By convention, all negative signs
are usually ignored when calculating PED.

Solution 5.4 Answer: A

A ‘linear’ demand curve is a straight line. The phrase

‘a normal good’ simply tells you that the demand
0 Quantity supplied curve in question slopes downwards from left to right.
Consider the following diagram:
A Supply curve S, is more elastic than supply curve
S
Price (£)
B Supply curve S, is more elastic than supply curve
S»
C All three supply curves illustrate elastic supply
D All three supply curves illustrate unit elasticity of
supply

Example 5.12
If the price of a product rises by 10% and total
revenue remains constant, price elasticity of demand
is:
A unity
10 Quantity
B elastic
 ics ¢ the economic problem and demand and supply

As you move down a demand curve, you are Solution 5.7. Answer: B
dividing a smaller percentage change in quantity
A good with a negative income elasticity of demand
demanded (%)AQ,) by a larger percentage change in
(YED) is an inferior good — i.e. as income rises, the
price (% AP). For example:
quantity demanded falls. As you move up the y-axis,
AtoB income rises but the quantity demanded continues to
hange in 2 decline. Other options are incorrect because:
%AOp =ene Bo y 199 =22 x 100 =100%
original Q, A => shows zero YED as the same amount is
change in P l demanded no matter what the level of income.
WAP =e eo os LE aa 5G C = shows positive YED throughout.
original P 3
D = shows a positive YED up to a certain level of
PED A toB income, then YED becomes zero and finally negative.
%AQ, _ 100
= Se ee ( Pls Glastic)
%AP $3.3 Solution 5.8 Answer: A
js
J to K 2AQ, = ra X 100 = 33.3% The question requires the calculation of (a) the
percentage change in income, and (b) the resulting
| percentage change in the amount of each good
%AP’ (== *'100='50%
2 demanded.
33.3 “if The percentage change (%A) of income (Y) is
Be ed1 Co 50 = ().67 (i.e. PED is inelastic)
calculated by using the equation:

Solution 5.5 Answer: A AY £24 000 — £20 000

BAYSB= 1O9% x 100
Two goods in joint demand are complements. Y £20 000
Complements have a negative cross-elasticity of
demand (XED). If the price of one good (e.g. ee ai oad
~ £20 000 rapt:
electricity) rises, the demand for a complement (e.g.
electric fires) falls. This type of relationship between The percentage change in demand for each good
price and demand is only shown in portion A. Other equals the change in demand, divided by the original
options are incorrect because: demand, times 100:
B = shows positive XED, which is possessed by 5
substitutes. %RAA = To x 100
= 50%
C = shows zero XED, which occurs when goods 2
are independent. AB = 8 X 100
= 25%
D = does not show a relationship. The quantity of
l
Y demanded is changing for a reason unconnected PAC
(9) yar)
10 X 100
= 10% 0
with the price of X, which is remaining constant.
The 20% increase in income results in a
Solution 5.6 Answer: D
proportionately greater increase (50%) in the quantity
A completely inelastic demand curve is a vertical demanded of A. Good C has an income inelastic
straight line. The 5% decrease in price results in no demand and good A has a more income elastic
change in the quantity bought. demand than good B, which in turn has a more
income elastic demand than good C.
Price

5% fall P,
Solution 5.9 Answer: A

The effect of discontinuing half-price mid-week

tickets is to increase price. If elasticity of demand for
mid-week tickets is greater than | but less than
infinity (i.e. elastic), then the increase in price brings —
about a greater percentage fall in sales. Hence total
Quantity revenue falls.
 work out econaatfLaffies

Option B is incorrect since, if the demand for mid- ¢ Apply your general understanding of demand
week tickets is inelastic, price and total revenue will elasticity.
move in the same direction. More information would ¢ Analyse each type of demand elasticity in separate
be needed to conclude whether the demand for mid- paragraphs.
week tickets is more elastic or more inelastic than the ¢ Use diagrams and relevant formulae.
demand for weekend tickets. * Be careful to ensure that arguments are supported
with worked examples relevant to a travel firm.
* <A detailed knowledge of the travel and tourism
Solution 5.10 Answer: C industry is not expected.
‘Price elasticity will be smaller’ means ‘supply
becomes more inelastic’. Firms will not be able to Solution 5.13
adjust supply quickly if they are unable to increase or (a) Elasticity of demand measures the responsiveness
reduce the quantity of factors of production they of demand to changes in other variables. There are
employ easily. Options A, B and D would all make it three types of elasticity of demand.
easier to adjust supply and hence would make supply (1) Price elasticity of demand (PED) measures the
elastic. responsiveness of quantity demanded to a given
change in price:
Solution 5.11 Answer: D = % change in quantity demanded
eeea
% change in price
Any straight-line supply curve that passes through the
origin has unit elasticity of supply. Most goods have either elastic or inelastic demand.
Elastic demand means that a change in price causes a
Solution 5.12 Answer: A greater percentage change in demand, whereas
inelastic demand means that a change in price causes
For total revenue to remain constant as price changes, a smaller percentage change in demand.
the quantity demanded must change by the same In most cases price elasticity of demand is negative,
percentage but in the opposite direction. This occurs so that price and demand will move in opposite
when elasticity of demand is unity. If demand is directions. Indeed so common is negative price
elastic (option B) a rise in price will cause a fall in elasticity of demand that usually the sign is omitted.
total revenue, whereas if demand is inelastic (option (2) Cross-elasticity of demand (XED) measures the
C) arise in price will cause a rise in total revenue. responsiveness of demand for one good to a given
When demand is perfectly inelastic a rise in price will change in the price of a second good:
cause a proportionate rise in total revenue — demand
change in quantity demanded of good B
will remain constant but consumers will pay more for XED = %
% change in price of good A
the same number of goods. For instance if demand
was originally 90 and price £10, total revenue would
be £900. A 10% rise in price to £11 would have no Price
effect on demand, which would stay at 90, but would of
cause total revenue to rise to 90 X £11 = £990, which good A

is a 10% rise in revenue.

P,

(a) Explain what is meant by:

(1) price elasticity of demand; D

(2) cross elasticity of demand; ———_—_—_—_—_—_—. ee te

(3) income elasticity of demand. (10 marks) 0 Q, Q Quantity of good

B demanded
(b) What relevance do these terms have for the sales
director of a firm of travel agents? (15 marks) Figure 1
 ARSED
Ps

50. work oult economics e the economic problem and demand and supply

The XED value indicates which pair of products are offer’ campaign where price is reduced by 20%
substitutes (+XED coefficient), complements (—XED affects revenue according to the PED for trips. Given
coefficient) or independent goods (XED = 0). Figure | d,, total revenue becomes £8 X 110 = £880. Given D,,
illustrates negative cross-elasticity of demand. A rise total revenue is £8 X 150 = £1200. Therefore the
in the price of good A causes a decrease in the special offer only increases the revenue of the firm if
demand for its complement, good B. PED is elastic.
(3) Income elasticity of demand (YED) measures
the responsiveness of demand to a given change in
Price of
income: day coach
trips
% change in quantity demanded
a Sg ee 10
% change in income

Most goods have positive income elasticity of

8
demand, which means that demand for them will vary | |
directly with income. These goods are referred to as | |
normal goods, although those with a positive income | |
| |
elasticity of demand that is greater than one (income |
elastic demand) are called superior goods. Figure 2 | |
shows positive income elasticity of demand with a rise |
|
in income causing a rise in demand. 0 100 110 150 Demand for
day coach trips

Income D Figure 3

Demand for holiday excursions, which are

Y,
expensive and have a number of close substitutes, is
likely to be elastic.
A knowledge of XED enables a director to estimate
Y
the wider effects of discounting one holiday. Assume
that the XED coefficient between holidays A and B is
2. A 10% reduction in the price of holiday A would
cause a 20% fall in the quantity of B (a substitute
holiday). This is likely to discourage the director from
discounting the price of A.
0 Q Q, Quantity XED also permits the firm to assess the effect of a
demanded
loss-leader strategy, where the price of one good is
heavily reduced in the hope that additional purchases
Figure 2
of other products will compensate. Loss-leader
campaigns are most effective when the XED of the
Inferior goods have negative income elasticity of
other product with respect to a large number of other
demand, which means that income and demand vary
goods sold by the firm is negative and greater than 1,
inversely so that a rise in income will cause a fall in
demand. e.g. —4. The loss made on one item is made up by the
profit from the sale of complements.
(b) The PED of a product will be of relevance to a A knowledge of YED allows the sales director to
sales director contemplating a price change and predict the likely pattern of future demand for travel
needing to know the probable effect on revenue. as consumers’ real incomes rise. For example, assume
_ Figure 3 shows two possible demand curves for that the firm has to decide between increasing the
coach day trips. D, is relatively price inelastic and D, number of coach day trips or introducing a new
is relatively price elastic. At the initial price of £10, luxury tour service. If market research shows that the
100 trips are sold and the firm’s total revenue YED for day trips is negative, then demand will fall
(price X quantity) is £10 x 100 = £1000. A ‘special over time and the firm will operate in a declining
 work out economicse.
©
SS

market. If the survey finds that the YED for luxury in response to price changes. If output is adjusted
tours is positive and greater than 1, then demand will easily in response to price changes, then PES is elastic
rise proportionately faster over time than income and and hence greater than one. Figure | illustrates elastic
the market will expand. The sales director may also supply.
try to change the image of trips and holidays that have Products whose output cannot be varied easily
negative income elasticity of demand from inferior to possess low PES. Figure 2 shows inelastic supply.
normal goods, e.g. by advertising, improving the
A
service etc. Price S

Example 5.14
(a) Explain what is meant by price elasticity of
supply. (7 marks)
(b) Why is the price elasticity of margarine likely to
vary over time? (18 marks)

¢ Give the formula for price elasticity of supply. P

¢ Explain what is meant by elastic and inelastic

supply.
¢ Include diagrams.
¢ Distinguish between the short run and long run.
¢ Cover the main influence on price elasticity of
i pameipe 25
supply. Q Q, Quantity supplied

Figure 2
Solution 5.14

(a) Price elasticity of supply (PES) measures the Analysis of the factors determining elasticity of
responsiveness'of quantity supplied to a given change supply requires a careful analysis of the factors
in price. PES is calculated by comparing the determining the ability of a firm to vary output.
proportionate change in price and quantity supplied (b) The short run is defined as the period of time in
by use of the equation: which a firm is unable to alter the amount of at least
percentage change in quantity supplied one factor of production, such as capital used in
PES = ameiel production.
percentage change in price
There are a number of reasons for believing that, in
Within a given time period, the elasticity of supply the short run, margarine output can be readily
depends largely on the ability of a firm to vary output adjusted and the PES of margarine is elastic. For
instance margarine is a relatively simple manufactured
good that requires little time for mass production.
Price
Output can be expanded rapidly by operating overtime
S
or by working night shifts. Margarine can be
refrigerated and stored for long periods. Stocks can
P, then be used to effect changes in the quantity
P
supplied.
On the other hand there are several factors that
would make the short-run PES of margarine inelastic.
The impact of diminishing returns and the difficulty of
substituting one factor of production for another raises
short-run unit costs and makes supply inelastic. If
0 Q Q, Quantity margarine factories are operating at or near full
supplied
capacity, output cannot be expanded rapidly in
Figure 1
response to a price rise. Again, if the labour used to
) on Cian, wie ”

52 work out,ecoric
SESE remem
mics ¢ the economic problem and demand and supply

operate machinery requires specialist training, it is used to produce similar products such as cheese
also difficult to expand production rapidly. spreads can be switched into our out of the production
The long run is defined as the period of time when of margarine. The industry can adjust production
the firm is able to vary the amount of any factor of capacity by installing or removing machines. If the
production. In the long run PES is more elastic than in firm decides on a very large adjustment in capacity, a
the short run, for a variety of reasons. In the long run new factory can be built or an existing plant can be
firms have an opportunity to overcome diminishing closed down. Moreover, provided that there are no
returns (which can occur in the short run) by adjusting barriers to entry, new firms can enter the industry.
the mix of labour and capital. The difficulties of factor Alternatively, existing firms can switch into the
immobility can be overcome through training. production of another good. It is also likely that
Supply is elastic in the long run because firms have supply will be affected by the development of new
longer to plan their production decisions and more technologies that improve production techniques and
time to manufacture the good. For example machinery increase PES.
 ¢ The addition to output made by each extra worker
is called marginal product of labour (MPL).
f production ¢ Output per worker is called average product of
labour (APL).
Output is produced with factors of production The concept of returns compares the percentage
(inputs). These are: change in favour of production, e.g. labour (%AL)
(1) Land — all natural resources, e.g. fishing grounds, with the resulting percentage change in output (%AQ
farm land, — Table 6.1).
(2) Capital — man-made goods used in the production ¢ The law of diminishing returns states that, as extra
of goods and services, e.g. factories and units of a variable factor are combined with a given
machines. amount of a fixed factor, the marginal products of
(3) Labour — mental and physical effort expended in the variable factor will eventually fall (Figure 6.1).
the production of goods and services. ¢ If only diminishing returns are referred to, this is
(4) Entrepreneurship — entrepreneurs bear the taken to mean diminishing marginal returns.
uncertain and uninsurable risks of production.
Output (Q) A
¢ A production function shows the relationship
between the amount of factors of production used
and the amount of output produced.

(b) Short-run product curves

The short run is the period of time when the quantity 0 Labour (L)
of at least one factor of production is unchanged. Figure 6.1 Product curves: AP = Q/L ; MP = AQ/AL. A is the
Firms may be able to increase output by adding extra point of diminishing returns; B is the point of diminishing average
units of labour to a fixed amount of capital. returns

Table 6.1 Types of return

Type of return Description Marginal product

Increasing returns %AL is smaller than the resulting %AQ Rising

Constant returns %AL is equal to the resulting %AQ Constant
Decreasing returns %AL is greater than the resulting %AQ Falling
____ ae
ee
 ics © the economic problem and demand and supply

(c) Costs of production

Table 6.2 Types of cost

Term Symbol Definition Equation

Total cost TC The amount spent on producing TC=FC+VC

a given output
Variable costs VC Production expenses dependent VG= TC—ke
on the level of output
Fixed costs FC Production expenses independent f= 16 —¥G
of the level of output
Average cost AC The amount spent on producing AC=TC+Q
each unit
Average variable cost AVC Unit variable cost dependent on AVC =VC+Q
the level of output
Average fixed cost AFC Unit fixed costs independent of AFC =FC+Q0
the level of output
Marginal cost MC The amount spent on producing MC =ATC+AQ
one extra unit

Accountancy and economic definitions of costs * VC curve rises if output increases.

are different. * FC stay constant as output increases.
Economists use the concept of opportunity cost
when calculating productions costs.
If resources are owned by the firm, the inputed
(estimated) transfer earnings of the factor is vc
included as a cost.
BC

(d) Short-run cost curves

There are two main methods of illustrating short-run
cost curves. In Figure 6.2:
MC curve rises given diminishing returns. Figure 6.3 Total cost curves
AC curve rises if MC is greater than AC.
MC is made up entirely of changes in VC.
Optimum output is where AC is lowest (point A).
(e) Economies of scale
In Figure 6.3
In the long run the firm can increase output by varying
TC curve rises if output increases.
all factors of production. Economies of scale (EOS)
are reductions in long-run average (unit) costs that
occur from an increase in production.
MC
AFC ¢ Internal EOS occur within the firm as output rises.
AC
These can be divided into:
AVC
(1) plant economies: the benefits gained from
factories, offices and machines growing in
size;
(2) firm economies — the benefits gained from the
company growing in size. :
¢ External EOS occur outside the firm and are
Figure 6,2 Unit cost curves independent of the size of the individual firm.
 _ =

work out economics ¢ costsFay.

of p
p hry
orem

Table 6.3 Types of internal economy of scale

Types of internal EOS Description

Specialisation Large firms have more scope for the division of labour
than have small firms
Indivisibilities Some machines are of a minimum size that can only
be kept fully occupied by large firms
Increased dimension The cost of capital does not increase in proportion with
the output of each machine
Principle of multiples Large firms use a machine combination that eliminates
bottlenecks caused by different machines working at
different speeds
Linked processes Bringing together different stages of production in one
factory reduces costs
Managerial Big firms can spread the cost of employing the best
managers over a large level of output. Managerial costs
do not increase in proportion with output
Financial Large firms offer more security and pay a lower rate of
interest on loans than do small firms. Large firms can
raise capital cheaply through a rights issue
Commercial Large firms buy raw materials and components in bulk
and are therefore given a discount
Marketing Transportation and advertising costs do not increase in
proportion with output
Research and development Large firms can spread the cost of improving products
over a large level of output
EE
0

Table 6.4 Types of external economy of scale

Types of external EOS Description

Infrastructure Proximity to a good transport and communications

network
Ancillary firms Local back-up forms supply specialist support services or
components
Skilled local labour An area may have trained workers looking for jobs
Education An area may have colleges providing specialist training

(f) Diseconomies of scale (c) workers feel isolated and out of touch with
managers, and industrial relations decline.
Diseconomies of scale (DOS) are increases in long- (2) External DOS occur outside the firm when the
run costs that occur from an increase in production. long-run costs of all local firms rise when:

(1) Internal DOS occur within the firm when (a) local road congestion causes transportation

increases in output raise long-run costs. They delays;

occur mainly because of managerial difficulties in (b) local land and factories become scarce and
rents rise;
oversized firms:
(c) labour shortages develop within the area and
(a) managers are unable to exercise effective
wages rise.
control or coordination;
(b) internal communications within the company
are difficult;
 nomics ¢ the economic problem and demand and supply

(g) Long-run cost curves 6.3 Data response

e A short-run average cost curve (SAC) shows the
unit cost associated with a given size of plant. Example 6.2
¢ A long-run average cost curve (LAC) shows the A profitable UK airline is considering whether to
minimum unit cost of producing each level of expand by introducing a new flight to New York. It is
output, allowing the size of plant to vary. faced with the following costs per flight:
¢ AnLAC curve is found by drawing a line
tangential to each SAC curve.
pe
¢ Each SAC curve shows the unit cost from plants
of different size. Depreciation 1 500
¢ The size of plant associated with SAC, is the Fuel charges 29 400
smallest needed to minimise unit cost — i.e. Insurance 600
minimum efficient plant size (MEPS). Interest 800
¢ The slope of the LAC curve is determined by Labour 10 000
internal EOS. Landing charges 1 000
¢ The position of the LAC curve is determined, in Other fixed costs 6 700
part, by external EOS.

The concept of returns to scale compares the (a) State which of the above costs are fixed costs
percentage change in inputs (%A inputs) with the and which are variable. Explain your choice.
resulting percentage in output (%AQ). Table 6.5 (5 marks)
explains the relationship between returns to scale and (b) (1) If the maximum number of passengers per
economies of scale that usually exists. flight is 500, what is the minimum price per
seat that the airline must charge on this flight
to operate it in the short run? (6 marks)
Costs
(2) What is the minimum price that would have
to be charged to make the flight viable in the
long run? (6 marks)
(c) Explain the factors that are likely to determine
|
|
the actual price charged. (8 marks)
|
Economies of ! Constant-scale | Diseconomies
ee

scale | economies | of scale

0 Q Q, Output
Solution 6.2
Figure 6.4 Long-run average cost curve
(a) Fixed costs are costs of production that are
independent of the number of flights undertaken. An
6.2 Investigative study allowance for depreciation has to be made irrespective
of whether or not an aeroplane flies. In a given time
Example 6.1 period the amount of insurance paid, or interest owed
A comparative study of the performance of two firms on loans, does not change with the number of flights
in the same industry — one large and one small. made. Variable costs are costs that are dependent on

Table 6.5 Returns to scale and scale economies

Returns to scale Description Scale economies Scope of LAC curve

Increasing returns %A inputs is smaller than Economies of Falling

to scale the resulting %AQ scale
Constant returns %A inputs is equal to the Constant Horizontal
to scale resulting %AQ
Decreasing returns %A inputs is greater than Diseconomies of Rising
to scale the resulting %AQ scale
a
 work out economics ¢ costs SeaructighAh

the number of flights undertaken. Fuel charges, 6.4 Objective questions

landing charges and labour costs are incurred after
each flight. This assumes that labour is paid per flight Example 6.3 — _
and can be laid off at zero cost if no flights are made.
The addition to total output from the use of an extra
(b)(1) In the short run, a firm will continue to operate unit of one factor is:
at a loss, provided that variable costs are covered. A marginal cost
From the table, the total variable cost of each flight is B_ marginal product
£29 400 for fuel, £1000 for landing charges and C average cost
£10 000 for labour, making a total of £40 400. D average product
Assuming that all 500 seats are sold,
£40 400/500 = £80.80. So in the short run the Example 6.4
minimum price that would have to be charged would
A firm has fixed costs of £2000. Its average total cost
be £80.80. In this case the operating loss is less than
is £10 and its average variable cost is £6. What is the
the total fixed costs that would have to be met if the
firm’s output?
flight were cancelled.
A 125 units B 200 units
(2) In the long run all costs have to be met. From
C 333.3 units D 500 units
the table the total cost of each flight is £60 000. When
divided by seating capacity this gives a price of £120.
Example 6.5
However the table does not include a specific figure
for normal profit. This is considered to be a cost of In the diagram below, MP shows the marginal product
production and may have been included in the ‘other of labour and AP shows the average product of labour,
fixed costs’ category. If not, the airline may operate a at each level of output. Does the law of diminishing
‘cost-plus’ pricing policy and add, say, 20% onto returns begin to operate at level A, B, C or D?
costs (£24), giving a flight price of £140.
Output
It is also highly unlikely that the airline will be able
to sell all 500 seats for each flight. Therefore the
minimum price that must be charged is total cost
divided by average seating. For example, assume that
|
400 seats are sold for each flight. The minimum price |
becomes £60 000/400 = £150. |
|
|
(c) Airline flights are subject to international |
agreements between countries. These agreements are
Cc D Labour
highly restrictive and can specify the number of
flights each week, the timing of flights and the prices
that can be charged. Hence the market for Example 6.6
international flights is highly imperfect and essentially The table below shows the weekly output of a firm
oligopolistic in nature. Evidence suggests that even and its total costs.
when more than one transatlantic airline flies between
two cities, companies operate as a cartel and the price
i

Output (tonnes) 0 10 20 30
is fixed above the likely market price. With each
Total costs (£) 120 180 200 210
airline charging the same price, non-price competition i

and branding is used to differentiate products.

The actual price charged, then, is likely to be At which level of output is average variable cost
affected by the cost structure of each flight, the lowest?
number of seats sold on average, and the degree of A 10 B 20 C 30 D 40
competition between airlines on the transatlantic
route. Example 6.7
The diagram below shows short-run per unit cost
curves for a firm.
 &aise eekalde,

6g work outEconomics ¢ the economic problem and demand and supply

increases by 15%, the firm is subject to:

Costs A diseconomies of scale
B_ decreasing returns to capital
C decreasing returns to labour
D the law of diminishing returns

Example 6.11

The short-run total costs (TC) of a firm are given by

the equation TC = £30 000 + 5Q”, where Q is the level
of output. What is the firm’s fixed costs?
0 Q Output A £0 B £30000
C5 D £30 000/507
Which of the following areas represents total fixed
cost?
Example 6.12
A 0HMQ B HILM
C UKL D OILO If average cost is falling:
marginal cost must equal average cost
Example 6.8 marginal cost must also be decreasing
marginal cost must be lower than average cost
If a firm’s average variable cost curve is U-shaped, —oi marginal cost must be greater than average cost
then, as output increases from zero, marginal cost
must:
A always increase
B_ always decrease 6.5 Solutions to objective
C initially decrease and then increase questions
D initially increase and then decrease
Solution 6.3. Answer: B
Example 6.9 Marginal product refers to the addition to total
The diagram below shows the total cost curve of a product following the employment of an extra unit of
firm. a variable factor.

Costs (£) ie Solution 6.4 Answer: D

Average total cost = average variable cost + average

fixed cost, so:

£10 = £6 + average fixed cost

£10 — 6 = average fixed cost = £4

Output Average cost = total fixed cost/output

It follows from the diagram that, as the level of £4 = 2000/output
output increases, marginal cost must: £4 X output = 2000
always increase output = 2000/4 = £500
remain constant
initially decrease and then increase Solution 6.5 Answer: B
Cax>r
initially increase and then decrease
Unless otherwise stated, the law of diminishing
returns refers to diminishing marginal returns. In the
Example 6.10
diagram, the apex (top) of the marginal product curve
A firm increases the amount of labour, raw materials shows the point of diminishing returns and this
and capital used in production by 25%. If output corresponds to output level B.
 vw

work out economics * costs 4 produc

Solution 6.6 Answer: D : because, if the cost of production remains constant,

output rising by a smaller percentage than inputs will
Fixed costs have to be paid out by the firm even if it increase average (unit) cost.
produces zero output. There are no variable costs
Options B, C and D are incorrect as the question
when output is zero. The table indicates that the total states that all three factors of production are changing.
cost of zero production is £120. Therefore the firm’s B, C and D are short-run concepts.
fixed costs must be £120.
Total cost minus fixed cost gives variable cost and Solution 6.11 Answer: C
variable cost divided by the level of output gives
average variable cost. The table below shows that The equation TC = £3000 x SQ’ means ‘total cost is
minimum average variable cost is reached where found by multiplying a fixed sum £3000 by 5 times
output is 40 units. the particular level of output, squared.’ Fixed costs are
£3000. Variable costs are 5 times the particular level
of output, squared.
Output (tonnes) O10, 207, 30°40
Total cost (£) 120 180. 200: (2104225 Solution 6.12 Answer: C
Fixed cost 120° 120° 1205 1205120
Variable cost QO: <60_. 3807 9028105 To answer this question it is useful to draw the
Average variable cost — 6 - 3 2.03 marginal and average cost curves.
LE EEE
4 MC
Costs AC
Solution 6.7 Answer: B

Total fixed cost is average fixed cost multiplied by

output. Average fixed cost is average total cost minus
average variable cost. From the diagram, average fixed
cost is LM. So total fixed cost is the area HILM. The
area given in option A (OHM@Q) is total variable cost
and the area given in option D (OILQ) is total cost.
—$—$ =

Solution 6.8 Answer: C 0 Output

From the diagram it can be seen that when average

Fixed costs are not affected by changes in output.
cost is falling, marginal cost is below average cost.
Therefore marginal cost (MC) determines changes in
variable costs. Figure 6.2 shows a U-shaped average
variable cost (AVC) curve. Note that the AVC curve 6.6 Essays
slopes downwards, provided that MC is less than
AVC. The MC curve intersects AVC at its lowest point. Example 6.13
Once MC is above AVC, the AVC curve begins to rise.
(a) Explain the difference between fixed and
variable costs. (8 marks)
Solution 6.9 Answer: B What effect will an increase in output have on
(b)
A linear total cost curve means the cost of making average fixed, average variable and average total
(17 marks)
each extra unit — marginal cost — remains the same. costs?

¢ Indefining fixed and variable costs, give

Solution 6.10 Answer: A examples.
¢ In part (b):
Returns to scale compares the percentage change in
(1) concentrate on the short run;
all factors of production with the resulting change in
output. Since a 25% increase in factors of production (2) explain the relationship between marginal cost
and average variable cost;
results in a smaller percentage increase in output
(15%), the firm is experiencing decreasing returns to (3) explain the relationship between AFC, AVC
and ATC.
scale. Decreasing returns to scale are usually
associated with diseconomies of scale. This is ¢ Use diagrams and numerical examples.
 (onics ¢ the economic problem and demand and supply

Solution 6.13 Average variable cost is total variable cost divided

by output. AVC is likely to fall initially as output rises
(a) Fixed costs are costs that do not change with output.
and then increase. The shape of the AVC curve is
They are incurred even if output is zero and can also be
influenced by the shape of the marginal cost curve.
referred to as indirect or overhead costs. Examples of
Marginal cost is the change in total cost resulting
fixed costs include rent and business rates. The amount
from a change in output of one. Both the MC and
of rent paid for a factory or office of a given size will
AVC curves are U-shaped. When output first begins to
not alter if the firm increases its output by, say, 6%, or if
rise, increasing returns are experienced and marginal
it closes down for two weeks over the Christmas period.
cost falls. Then diminishing returns are experienced
Variable costs are costs that do change with output.
and marginal cost rises. The marginal cost curve cuts
They can also be called direct or prime costs. For
AVC at its lowest point (Figure 2).
example if an insurance company attracts more
customers its telephone bill is likely to increase.
Some costs will be fixed and some will be variable in Costs MC
the short run. This is because in the short run at least AVC
one factor of production will be fixed. In our example
above it was the size of the factory or office, making
rent the fixed cost. However in the long run all factors of
production can be altered, including the size and number
of factories and offices, and so all costs are variable.
(b) Average fixed cost is total fixed cost divided by
output. As fixed cost is constant, AFC falls with output.
This is shown in Table 1 and illustrated in Figure 1.
0 Output
Output Total cost Fixed cost Average fixed cost
Figure 2
100 100 —
180 100 100.0
250 100 50.0 Average total cost is total cost divided by output. It
300 100 ed is sometimes referred to as just average cost and
320 100 25.0 consists of AFC + AVC. The short run average cost
NAb
CO
FR
WN 360 100 20.0 curve is also U-shaped. It falls at first because fixed
costs are spread over more units and because of

AFC

Figure 1 0 1 2 Output
 work out economics ¢ costs of pra C

increasing returns. It then rises due,to diminishing ¢ The question tests your understanding of returns
returns. As with AVC, it is cut at its lowest point by and returns to scale.
MC. Figure 3 illustrates ATC, AVC and MC. The ¢ Make good use of accurate graphs.
vertical distance between ATC and AVC is AFC, and ¢ Use examples to develop important points.
so this distance declines as output rises since AFC
falls with output.
Solution 6.14
MC (a) A firm is a unit that organises the production of
Costs ATC
goods and services. Traditional new classical theory
assumes that firms use only two factors to produce
output: labour and capital. Furthermore it assumes
that firms can only increase output in the short run by
adding extra units of labour to a fixed number of
AVC
machines.
Marginal cost (MC) refers to the cost of producing
an extra unit. Extra units are manufactured by
employing additional workers. Assume that each
0 Output worker receives the same wage. Initially each extra
worker is able to produce more than the previous
Figure 3 worker because, at first, marginal workers have easy
access to a fixed number of machines and the division
Table 2 shows how ATC and AVC fall and then rise of labour principle can be applied. Since the firm is
with output. It also illustrates, as does Figure 3, that
initially obtaining an increasing return for a constant
average cost is above marginal cost when average cost outlay on wages, marginal costs are falling and the
is falling and average cost is below marginal cost
MC curve in Figure | slopes downwards. Beyond Q,,
when average cost is rising.
the law of diminishing returns operates and the firm
receives a decreasing return for a constant outlay on
Table 2
SLUUSES EE wages. Workers experience delayed access to
Average Average machines and the opportunities for the division of
Total Variable total variable Marginal labour have been fully exploited.
Output cost cost cost cost cost

0 100 — — — _
Costs MC
1 180 80 0.0 80.0 80
SAC
2 250 150 23.0" 7.0 70
3 300 200 100.0 66.7 50
4 320 220 20.0 4 55.0 20
5 360 260 eos S210 40
6 420 320 70.0 ef pe 60
7 500 400 Tis Sel 80
Quantity
8 600 500 (Li PRS 100
9 720 620 80.0 68.9 120
Figure |

So AFC will fall with output and AVC and ATC Average cost is the unit cost of producing a given
will fall and then rise. level of output. The shape of the short-run average
cost curve (SAC) in Figure 1 depends critically on the
behaviour of marginal costs. SAC slopes downwards
Example 6.14
until Q, because marginal cost is less than unit cost.
How is a firm’s average cost curve determined in: Beyond Q, marginal cost exceeds average cost and the
(13 marks) SAC curve begins to rise.
(a) the short run?
(b) the long run? (12 marks) It has been established that the shape of the short-
 “WORrk out, economics * the economic problem and demand and supply
Se epee a EDO SEARO

run average cost curve is determined by the shape of

Cost
the marginal cost curve, which in turn is determined
by the law of diminishing returns. The type of return SAC, SAC,
experienced depends on the degree of access workers
have to machines and on the scope for the division of
labour.
In the short run the firm is constrained to its current
SAC curve. In the long run the firm can increase plant
(production unit) size and move to a new SAC curve. Figure 4
Increasing the amount of capital employed shifts the
SAC curve to the right. The type of scale economy
then experienced determines whether or not the new (b) A long-run average cost curve (LAC) is the
SAC curve also shifts upwards or downwards. SAC envelope of the firm’s SAC curves. The shape of the
shifts downwards if the firm experiences economies of LAC curve is determined by the type of internal scale
scale (Figure 2), upwards if diseconomies of scale economies experienced by the firm. For example, the
begin to come into effect (Figure 3) and horizontally manufacture of cars offers significant potential
given constant scale economies (Figure 4). technical economies of scale. Highly automated
production lines populated with robot arms reduce
LAC. As more cars are produced, the firm’s greater
Cost requirement for raw materials such as steel allows it to
oe
negotiate substantial discounts with suppliers. Initially
the LAC curve of a car manufacturer slopes
downwards, as in Figure 2. However, beyond a certain
level of output LAC begins to rise, as in Figure 3.
LAC, Management becomes more difficult when the
activities of the firm become more complex.
Figure 2 Additional strata of middle managers (e.g. foremen)
increase wages with no corresponding increase in
output. Productivity may fall if workers feel alienated
SAC,
Cost by impersonal mass production techniques.
In conclusion, it has been demonstrated that the
SAC,
firm’s average cost curve is determined by the type of
return experienced in the short run and the type of
scale economy enjoyed in the long run.
LAC,

Figure 3
 Date Date Self-
AEB NEAB | OCSEB | UCLES ULE UODLE begun completed assessment

Fact sheets

Investigative study

Data response a

Essays
 ze of Firms

7.1 Fact sheet (3) Conglomerate, between two companies in

different industries.
(a)’ How firms grow
(c) Demergers
Firms may grow in one of two ways;
¢ A demerger is when a firm either:
(1) Internal growth — this is when a firm gets larger
(a) divides into two or more firms, or
by increasing its own output.
(b) sells off some of its subsidiaries.
(2) External growth — this is when a firm increases its
¢ The motives for demerging include:
size by taking over or merging with another firm (a) improving managerial control;
(integration).
(b) reducing or avoiding internal diseconomies of
scale;
(b) Integration (c) increasing profitability.
Integration occurs when two firms combine. The new
firm will probably enjoy significant economies of (d) Small firms
scale, and require fewer managers and workers.
¢ The size of firms can be measured in terms of:
* A merger is when the two firms agree to form a (a) number of people employed;
new company. (b) turnover;
* A takeover is when one company buys a (c) profit;
controlling interest in a second against the wishes (d) capital employed.
of that company’s directors. ¢ Small firms exist because:
There are three types of integration: (a) they are easy to set up;
(b) they can provide a personal service;
(1) Horizontal, between two companies in the same (c) the minimum efficient scale may be small;
industry and at the same stage of production. (d) they are able to react quickly to changing
(2) Vertical, between two companies in the same market conditions;
industry but at different stages of production, (e) they may be able to take work that is
either: subcontracted from larger firms;
(a) forwards, with a firm further up the chain of (f) entrepreneurs may be unwilling to expand;
production, or (g) demand for some products is low because —
(b) backwards, with a firm lower down the chain (1) they have a high price, (2) they are
of production. specialised, (3) they are sold locally.
 work out economic {Ea ses as

7.2 1 ve study

An analysis of a recent merger — the form taken, the

motives behind the merger, its advantages and
disadvantages.

Annual Number of Employment Number Employment

turnover (£000) businesses* 1993 size businesses* 1993 199]

1-34 26 838 1-9 90 672 280 805

35-49 12 894 10-19 13 934 194 481
50-99 25 598 20-49 14314 437 656
100-249 3301/6 50-99 5 628 390 344
250-499 19 633 100-199 3 234 448 027
500-999 13 974 200-499 2138 656 131
1000-1999 9 208 500-999 686 469 360
2000-4999 Leo 1000+ 516 1 381 514
10 000+ 4 024

Total 155 675 Total latsi22 4 258 318

————————————————————

* Defined as legal units, which includes companies, partnerships, sole proprietors, general government and
non-profit-making bodies.
Source: Britain 1995: An Official Handbook (London: HMSO).

(a) How many people do most UK manufacturing (b) The typically sized business, i.e. the small
businesses employ? (3 marks) business, employed only 6.59% of the total number of
(b) What percentage of manufacturing workers did manufacturing workers employed
the typically sized business employ in 1991? (5 (280805/4258318 x 100).
marks)
(c) Annual turnover is the total sales of a business
(c) What is meant by annual turnover? (2 marks)
during the period of a calendar year.
(d) What is meant by a sole proprietor? (4 marks)
(e) Which form of business entity — public limited (d) A small proprietorship is a business owned by a
companies, private limited companies, single person. This type of business is typically small.
partnerships or sole proprietorships — do you It has a number of advantages, including flexibility,
think has the highest annual turnover? (3 marks) speed of decision making and the provision of a
(f) How can a small business increase its annual personal service. However it also has disadvantages,
turnover? (6 marks) including lack of capital and limited liability.
(g) Identify one other measure of business size.
(2 marks) (e) Public limited companies, which are typically
large companies, have the highest annual turnover. For
instance the annual turnover of British
Solution 7.2
Telecommunications was £13.2 billion in 1992.
(a) Most UK manufacturing businesses are small.
The table shows that most businesses — 90 672 out of (f) A small business can increase its annual turnover
a total of 131 122 — employ between one and nine by internal or external growth. Internal growth
workers. involves a firm increasing its production by, for
 Omics © market structure

instance, taking on more workers or opening a new A Increase market share

factory. External growth can be achieved by merging B_ Improved staff facilities
with another business — this may be in the form of a C Improved management control
horizontal, vertical or conglomerate merger. D Increased ability to borrow at low rates of interest

(g) Another measure of business size is the market

share that businesses enjoy. Example 7.8

Which of the following is an example of internal

growth?
7.4 Objective questions A The merger of two supermarkets
B_ Achemical company opening a new plant
Example 7.3 : C A tobacco company buying a television
Horizontal integration occurs when a car manufacturer
manufacturer: D Acar manufacturer merging with a steel company
buys a chain of garages
merges with a steel firm Example 7.9
merges with a second car manufacturer
a combines with a company producing an unrelated
—omit A three-firm industrial concentration ratio of 80%
product
indicates that:
A there are only a few firms in the industry
Example 7.4 B the industry is dominated by a monopolist
C the majority of the industry’s output is produced
What is the main source of investment finance? by only a few firms
A Retained profits D most of the firms in the industry are based in one
B_ The issue of shares geographical area
C Borrowing from the banking sector
D Government financial assistance
Example 7.10

Example 7.5 Which of the following potential outcomes of a

merger is most likely to benefit consumers?
An oil company acquires a chain of petrol stations.
A Economies of scale
This is an example of:
B_ Increased bureaucracy
a conglomerate merger
C Increased market share
a horizontal merger
D Reduction in competition
a forward vertical merger
ia a backward vertical merger
on
Example 7.11
Example 7.6 The optimum size of a firm may be small because:
Which are the two main motives behind horizontal A raw material costs are high
mergers? B_ the market for the goods is small
A To diversify and gain control of supplies C the process offers scope for mass production
B_ To increase market share and to take advantage of techniques
economies of scale D there are significant potential economies of scale
C To lower prices to consumers and improve the
quality of the product Example 7.12
D To ensure an adequate number of outlets and to
Which of the following sources of investment finance
keep up with competitors.
is not available to a sole trader?
A Retained profits
Example 7.7
B_ The issue of shares
Which of the following is the most likely potential C Loans from banks
advantage of a demerger? D Overdrafts from banks
 work out economics® 5!

j ‘ions to objective company has become too large and is experiencing

diseconomies of scale, one of which may be the
problem of keeping control of all the company’s
activities.
‘Solution 7.3 Answer: C A, B and D = are all potential benefits of a
Horizontal integration occurs when two firms are at company growing in size rather than separating into
the same stage of production and in the same industry. smaller companies.
Other options are incorrect because:
A and B = are examples of vertical integration.
Solution 7.8 Answer: B
D = would be a conglomerate merger.
Internal growth occurs when a firm gets larger by
increased investment and/or increase in its labour
Solution 7.4 Answer: A
force. A chemical company that opens a new plant
Retained profits, the issuing of shares, borrowing and will grow in size.
government aid may all be used by a firm to finance A, C and D = are all examples of external growth.
expenditure on, for example, machinery and plant. Option A is an example of a horizontal merger, option
However the most important source of investment C of a conglomerate merger and option D of a
finance is retained profits, which in any year will backwards vertical merger.
account for more than 60% of all investment finance.
Solution 7.9 Answer: C
Solution 7.5 Answer: C
Industrial concentration ratios are concerned with the
A forward vertical merger occurs when a company extent to which the largest firms in an industry
merges with another company that is at a different dominate the market. A three-firm industrial
stage of production and is nearer to marketing the concentration ratio of 80% means that the largest
product. three firms account for 80% of total sales or output.
A => There may be a large number of firms in the
industry — the key point is that the largest three
Solution 7.6 Answer: B
control 80% of the market.
A horizontal merger is a direct way of reducing the B = If three firms have a market share of 80% the
number of competitors, and as the firms are in the industry cannot be dominated by a pure monopoly.
same industry and at the same stage of production Taking the government definition of a monopoly, the
there may be the potential to take greater advantage of industry could in theory contain three monopolies.
internal economies of scale, for instance commercial D = This refers to geographical concentration,
economies. which can give rise to external economies of scale.
A = Diversification is more likely to be achieved
by a conglomerate merger, whereas to gain control of Solution 7.10 Answer: A
supplies a firm may decide to engage in backward
vertical integration. Economies of scale may lead to lower costs of
C = Would be noble motives and may be stated by production and lower prices.
companies to be the reasons behind a merger. B, C and D => may result in disadvantages for
However in practice they are not the key motives. consumers including higher prices and reduced
D = To ensure an adequate number of outlets a quality, although with the exception of option B,
firm may engage in forward vertical integration, and which will raise costs, the effects are uncertain.
the desire to keep up with competitors could result in
forward participation in any type of merger. Solution 7.11 Answer: B

If demand for the product is small, a few small firms

Solution 7.7. Answer: C will be able to satisfy demand.
A demerger is when a company divides into two or A, C and D > would mean that the optimum size
more separate companies. This will occur if the of a firm would be large.
 = ornics © market st
ructure

Solution 7.12 Answer: B more than double increase in output. The principle of
multiples suggests that large firms can avoid the
A sole trader can make use of retained profits and can
bottlenecks that occur when machines operate at
borrow from banks in the form of loans or overdrafts.
different speeds, by installing a ratio of machines that
However sole traders do not issue shares.
keeps each fully utilised.
Financial economies allow large enterprises to raise
capital on advantageous terms. Large firms are
considered to be reliable and are therefore charged a
Example 7.13 low rate of interest. In particular, large firms have
access to capital markets such as the stock exchange.
Why, despite the technical and financial advantages of
Selling shares is a relatively inexpensive method of
large firms, are there so many small firms?
raising large amounts of capital.
(25 marks)
Despite the cost advantage to large firms of
e The questions tests your understanding of the producing in bulk, small businesses continue to
technical and financial economies of scale that are survive for a variety of reasons. Limited opportunities
open to large firms. for economies of scale allow them to find a niche by
¢ Describe the circumstances in which small firms providing specialised products for small markets. For
thrive. instance specialised design is non-uniform and cannot
¢ Where possible, use real-world examples. be manufactured in bulk. Service sectors such as
hairdressing cannot easily achieve a large scale of
operation, and therefore tend to be dominated by
Solution 7.13
small firms. An irregular or limited demand for a
It is important to distinguish between large and small product prevents mass production.
firms. The Bolton Committee Report (1971) suggests Small firms have the flexibility and low overheads
that small businesses are firms that are managed by needed to undertake ‘one-off’ projects, e.g. building
their owner(s) and have a relatively small share of the construction. Often small firms survive by accepting
market. Small manufacturing firms employ fewer than subcontracting work from large companies. In
200 people. Large firms are typically incorporated industries such as printing, where fixed costs form
(limited companies), where ownership and only a small percentage of total costs, low set-up costs
management are separated. Large companies that encourage the development of small firms. Where the
exploit economies of scale enjoy a cost advantage market for a good is restricted and highly localised,
over small firms in the same industry. In particular, small firms survive, e.g. village shops.
large firms have access to the following technical and In an attempt to stimulate the supply side of the
financial economies. economy the government has introduced a number of
Technical economies occur in the production of a schemes to help small firms to survive. For instance
good. As the firm expands, there is greater scope for the Enterprise Allowance is a weekly sum paid to the
specialisation and the division of labour. For example unemployed while they are setting up their own
large factories can employ specialist skilled workers businesses. The Business Expansion Scheme provides
to do the same job all day with no time lost in relief against income tax to investors in unquoted
changing tools or doing unfamiliar tasks. The companies.
indivisibility of certain types of capital means that
many production processes, including that of Example 7.14
chemicals, are impossible on a small scale. Mass
Glaxo bought out Wellcome, another drug company,
production allows large firms to keep specialist capital
in 1995.
fully utilised. Large firms can benefit by linking
production processes that would otherwise be carried (a) What type of merger was this? (5 marks)
out in separate factories. For example a large (b) What are the main motives behind this type of
manufacturer of shirts can reduce transport costs by merger? (10 marks)
combining the weaving and cutting of cotton under (c) What are the potential advantages and
the same roof. Economies of increased dimensions disadvantages of this type of merger for society?
mean that doubling the size of a machine results in a (10 marks)
 work out economics *size OF fi

¢ Distinguish briefly between horizontal, vertical advertise at competitive rates. In the drugs industry,
and conglomerate mergers. research and development economies of scale are
* Consider the main motives behind a horizontal particularly significant. Drug firms spend a
merger. considerable amount of time and money developing
¢ Relate at least some of the advantages and new medicines and bringing them to the market. A
disadvantages of a horizontal merger to the drug merger between two drug companies researching into
industry — although detailed knowledge of the different areas of illnesses or using different
drug industry is not required. ingredients will enable risks to be spread.
There may be a number of other possible motives
Solution 7.14 behind a horizontal merger at a secondary stage,
including increased ability to counterbalance the
(a) There are three main types of merger: horizontal,
power of purchasing companies.
vertical and conglomerate. A horizontal merger occurs
when two firms in the same industry and at the same
(c) A merger between any two drug companies will
stage of production merge. A vertical merger is when
benefit consumers if it results in lower costs, higher
two firms in the same industry but at a different stage
product quality and better service. If the merged
of production combine. Finally, a conglomerate
company passes on the benefit of lower costs achieved
merger is when two firms in different industries
through economies of scale, and possibly
merge. rationalisation, in the form of lower prices consumers
The merger between Glaxo and Wellcome was a
will gain. The increased research and development
horizontal merger as both firms were in the same
capacity may result in the development of new drugs
industry and at the same stage of production. The
that improve welfare by curing or alleviating illness.
industry is the drug (or pharmaceutical) industry and
For instance development of a cure for AIDS would
the stage of production is the secondary stage as both
be a significant benefit. If a new merged company is a
firms are manufacturing companies.
more efficient company it will be able to compete
(b) There are a number of possible motives behind a more effectively in the world drug market. This
horizontal merger, although the two main motives are should improve the country’s balance of payments
increased market share and increased opportunity to position.
take advantage of economies of scale. Merging with However there is no guarantee that a merger will
another company in the same industry is a direct way increase efficiency or benefit consumers. The new
of removing a rival and a quick way of increasing its company may be too large and may experience
size relative to other firms. This in turn will reduce the internal diseconomies of scale, thereby raising
chance of the new company being taken over as its average costs and prices. The reduced competition
larger size will mean that there will be fewer firms may also result in a reduction in the range of drugs
with access to sufficient financial resources to acquire and a fall in quality, perhaps including a failure to test
it. drugs adequately before they are put on the market.
A larger firm will also be able to take greater The move towards greater market power will reduce
advantage of internal economies of scale, thereby consumer surplus and increase producer surplus. A
lowering average (unit) costs and increasing merger is often accompanied, at least initially, by a
profitability. A larger company will, for example, fall in employment as the new company seeks to
probably be able to gain easier and cheaper access to rationalise production. This will have an adverse
finance, employ specialist staff, make use of larger effect on redundant workers if they are unable to
and more cost-effective machinery, buy in bulk and move to other, equally well-paid employment.
 (b) Revenue
The money received from the sale of output is
called revenue.
¢ A market exists where buyers and sellers negotiate
the exchange of a product. (c) Profit
e An industry is made up of firms producing similar Accountancy and economic definitions of profit
products. are different.
¢ Market structure refers to the number and type of —_* Economists regard normal profits as a cost of
firms in a particular industry. production.
¢ Concentration ratios measure the proportion of an ° Revenue minus production costs equals abnormal
industry’s output or employment accounted for by, profit T:
say, the five largest firms. ~=IR — TC=(AR — AC).X Q

Table 8.1 Types of revenue

Term Symbol Definition Equation
Total revenue TR The income received from the sale TR=ARXQ
of a given output
Average revenue AR The amount received from the sale AR=TR+Q
of each unit
Marginal revenue MR The amount received from selling MR = ATR + AQ
one extra unit

Table 8.2 Types of profit

Term Symbol Definition TR = TGis
Normal profit 20 The minimum amount of profit the firm Zero
must receive to carry on producing (i.e.
transfer income)
~Abnormal profit Tt Profits exceed the amount the firm must Positive
receive to carry on producing (i.e. economic
rent, super normal profit)
Abnormal loss Th Profits are below the amount the firm Negative
must receive to carry on producing (i.e.
subnormal profit)
 FA MS
Rad
A
eel

work out economics ¢ market’structuré 71

wae

¢ New classical theory assumes that firms aim to In Figure 8.1 the representative firm has to decide
maximise profits. However, where ownership and whether or not to produce extra units. The firm
control of a company are in separate hands, compares the cost of the marginal unit (i.e. MC) with
managers may have a different aim, such as sales the revenue received from its sale (i.e. MR). An extra
maximisation. unit is only worth producing if MR exceeds
MC. Since MC includes an amount of normal profit,
the firm maximises its profits by increasing
(d) Perfect competition production up to and including Q.

¢ A perfectly competitive industry is made up of a

large number of small firms, each selling (e) Supply curves in perfect
homogeneous (identical) products to a large competition
number of buyers. In Figure 8.2 an increase in demand raises the market
¢ No individual customer receives preferential price to P,. In the short run the firm earns an abnormal
treatment. profit of (P, — C,) X Q,. In the long run the entry of
¢ There are no barriers to entry or exit. new firms increases supply and the supply curve shifts
¢ Consumers and producers have perfect market to the right. Assuming constant scale economies, the
knowledge. price falls back to P and normal profits are restored.
¢ There is perfect mobility of factors of production.
¢ Each firm is a price taker, therefore MR = P(AR) ¢ The MC curve shows combinations of price and
and both are constant. quantity supplied by a firm. Therefore the MC
¢ The profit-maximising level of output occurs curve is the supply curve of the firm.
where marginal cost (MC) rises to equal marginal ¢ The addition of each firm’s MC curve gives the
revenue (MR) — i.e. when MR = MC. industry’s short-run supply curve.

Industry t Firm
Price Price
MC

4s D=AR=MR
=P

[ete eet
0 Q Q (thousands) 0 Q Q (tens)

Figure 8.1 Profit maximisation in perfect competition

( Industry Firm
Price
D,

P,

0 Q Q, Q, Q (thousands) 0 Q Q, Q (tens)

Figure 8.2 Long-run adjustment in a perfectly competitive market to an increase in demand

 Pras é ETS
ONES te

72,qWork out eeoffomics ¢ market structure

oremeaty

¢ The long-run supply curve (LS) shows the amount ¢ There is spare capacity in the industry.
of a good supplied by the industry at different ¢ Each firm is a price maker, so AR > MR and both
prices, allowing the number of firms and size of fall the more the firms sells.
plant to vary. ¢ There are no barriers to entry and exit.
e The firms are assumed to be profit maximisers and
will produce where MC = MR.
(f) Abnormal losses in perfect
¢ There will be non-price competition and possibly
competition some price competition.
e The absence of barriers to entry and exit is likely
to mean that normal profits will be earned in the
long run, as shown in Figure 8.5.

Cost/
revenue
MC

AC

P/C
Q
Figure 8.3 Revenue covers variable costs: losses are minimised by
carrying on production because total revenue covers all variable
costs and some (BC) of the fixed costs AR

2 Q MR Output

Figure 8.5 Long-run equilibrium output of a firm producing under

conditions of monopolistic competition

(h) Oligopoly
¢ An oligopolistic market is one dominated by a few
Q
firms so there is a high concentration of sales.
Figure 8.4 Variable costs exceed revenue: losses are minimised by ¢ The firms may produce identical products (perfect
ceasing production because total revenue fails to cover any
variable costs and none of the fixed costs
oligopoly) or differentiated products (imperfect
oligopoly).
¢ A loss-making firm carries on production in the ¢ Each firm is a price maker, so AR > MR and both
short run, provided that: fall with output.
(a) it believes the situation will improve in the ¢ There are barriers to entry and exit.
future; e Firms are interdependent. The behaviour of one
(b) it can cover its variable costs. firm will be influenced by the behaviour of its
¢ In the long run, some firms making abnormal losses rivals.
leave the industry, supply decreases and price rises. e Firms may seek to maximise profits or adopt other
The total revenue curves in Figures 8.3 and 8.4 will pricing strategies — see Chapter 9.
shift upwards until normal profits are restored. ¢ Supernormal profits are likely to be earned in the
long run.
¢ Prices are likely to be stable because:
-(g) Monopolistic competition
(a) firms may believe that changing price will gain
¢ Monopolistic competition is a market structure them no advantage — this is explained by the
with a large number of firms producing kinked demand curve, as shown in Figure 8.6;
differentiated products. (b) firms may engage in collusion.
 work out economics * marketa 's!

e There are significant barriers to entry and exit.

Price
¢ Monopolists are price makers and can set price or
output for their own product.
¢ Monopolists are usually assumed to be profit
makers and can set price or output for their own
product.
¢ Monopolists are likely to earn supernormal profits
in the long run. In Figure 8.7 supernormal profit
equals the area (P — C) X Q.

D 8.2 Investigative study

0 Q Quantity
Example 8.1
Figure 8.6 The kinked demand curve: above the price OP demand A study of public houses in the area to determine
is elastic as rival firms will not follow a price rise; below OP
demand is less elastic as rivals will match price reductions which market structure they operate in and the extent
to which their behaviour conforms with the pattern
¢ Firms wishing to increase sales are likely to use predicted by theory.
non-price competition such as:
(a) Advertising, where firms promote information
about the company or a product. Advertising
8.3 Data response
aims to: (1) increase demand for a products;
(2) improve brand image and encourage
Example 8.2
consumer loyalty, thereby making demand A feminist publishing company has decided to publish
more price-inelastic; and (3) create separate a novel by a new author, who agrees to be paid a
markets for the same product so that price percentage of the gross profits from the sale of the
discrimination can take place — e.g. soap book. The diagram below illustrates the publisher’s
powders. average revenue curve.
(b) Organising promotion campaigns (e.g. free (a) Draw in the publisher’s marginal revenue curve
offers). and explain why you have drawn it where you
(c) Providing improved after-sales service. have. (3 marks)
(b) Explain the slope of both the marginal and
average revenue curves (6 marks)
(i) Monopoly (c) Where will the publisher set price? Illustrate
* A pure monopoly is a sole supplier. In this case the your answer (6 marks)
firm is the industry.
¢ The definition used in government policy is a firm
that has at least a 25% share of the market. Revenue

Costs/
revenue MC

AC
7
P

c Lo

AR
0
Output in terms of
0 Q MR Output number of copies (000s)

Figure 8.7 Amonopolist earning supernormal profit Figure 1

74,.qwork out &conomics e market structure

(d) Would spending on advertising increase the

Costs/
publisher’s profits? (4 marks) revenue
(e) Ifthe writer renegotiated her contract to receive
payments on the basis of, say 10% of the cover
price of each book sold, explain and illustrate
£15
what output and price she would like to see.
(6 marks)

Solution 8.2

0 4
Output in terms of
MR number of copies (000s)
Revenue
Figure 3

(d) Advertising would increase the cost of production

and thus diminish profits. However, successful
advertising would increase demand and shift the
demand curve to the right, thereby increasing sales.
Hence profits only increase if the net revenue from
extra sales more than pays for the cost of the initial
advertising.
AR
(e) To receive the highest payment the writer would
0 2 4 want to see sales revenue maximised. This is achieved
Output in terms of
number of copies (000s) at the point where MR intersects the x-axis, Up to this
point marginal revenue is positive and revenue
Figure 2 increases with sales. The author would want sales to
be increased to 2000 by lowering the price to £10.

(a) Marginal revenue starts at the same point as Costs/

average revenue and cuts the horizontal axis half way revenue
along from where average revenue would cut it.

(b) The average revenue curve is the consumers’

demand curve for the book. The downward-sloping
curve indicates that consumers are prepared to buy £10

more copies of the book as price falls because of the

substitution effect (the book is now relatively cheaper
than substitutes) and the income effect (consumers
can now afford to buy more copies of the text).
0 4
The marginal revenue curve slopes downwards
because the publisher is a price maker. In order to sell Output in terms of
MR number of copies (000s)
more copies, price must fall not only for extra copies
Figure 4
sold, but also on all preceding books. Hence marginal
revenue is always less than price.

(c) The publisher will continue to print books up to

8.4 Objective questions
the point where the cost of the extra unit (MC) equals
Example 8.3
revenue from the sale of the extra text (MR). This
suggests a price of £15. (Note that the actual price Which of the following is a characteristic of a
charged depends on where the candidate draws the perfectly competitive industry?
actual MC curve.) A Firms are price takers
B Some differentiation of products
Revenue
C The presence of barriers to entry
D Some firms offer discounts to important customers

Example 8.4
One difference between a firm operating in a perfectly MR
competitive market and one operating in a
0 Q Output
monopolistically competitive market is that, for the
latter only:
A some producers advertise
Example 8.8
B average revenue equals price
C._ the number of producers is small The diagram below shows the total revenue (TR) and
D all firms produce an identical product total cost (TC curves of a firm. Under which of the
following market conditions is the firm operating?
Te
Example 8.5 Costs/ TR
revenue

A tailor charges £100 per suit up to and including the

fifth suit made. If more than five suits are ordered, the
price charged for all suits falls to £80 per suit. What
will be the marginal revenue to the tailor for the sixth
suit?
A £100 B £80 C £0 D = 40)

Example 8.6
0 Output
The following table shows the cost and revenue
conditions facing a firm. At what level of output A Perfect competition in the short run
would the firm be making maximum profit? B Monopolistic competition in the short run
i
C Perfect competition in the long run
Weekly Total Total D Monopolistic competition in the long run
output cost revenue

A 1 30 24 Example 8.9
B 2 4] 48 A firm will continue production in the short run,
Cc 3 65 72 provided that revenue covers:
D 4 90 96 A total cost
B average cost
C fixed cost
D variable cost
Example 8.7
The diagram shows a marginal revenue curve (MR). Example 8.10
From the diagram it can be seen that as output
increases from 0 to Q, total revenue is: Oligopolistic industries are usually characterised by:
A increasing A price stability
B_ decreasing B firms being price takers
C ata maximum C firms’ long-run average cost curves sloping
D ata minimum upwards
MUST EDGE S53
oe gS ETF

76,gNork outEcondimics « market structure

D firms’ average revenue equalling their marginal C = A condition of perfect competition is that
revenue firms are free to enter or leave the industry at will.
D = In perfect competition, no one buyer is
sufficiently large enough to be able to negotiate a
Example 8.11
discount on purchases.
A monopolist seeks to earn maximum profits. Will he
or she produce output A, B, C or D?
Solution 8.4 Answer: A

Costs/ AC Unlike a firm in perfect competition, monopolistically

revenue
competitive firms produce a slightly different product
from others in the industry. Therefore firms benefit
from advertising because: (1) it increases demand for
the product and (2) it improves the brand image of
the good so that demand becomes more price-
inelastic.
B = Average revenue equals price in all market
structures.
Output C = There are a large number of producers in both
perfect and monopolistic competition.
D => Whilst firms producing under conditions of
perfect competition make an identical product, firms
Example 8.12
producing under conditions of monopolistic
Which of the following is a necessary condition for a competition, as mentioned above, make differentiated
firm to practice price discrimination? products.
Seepage between the markets
The firm is a price taker
Different cost structures in each market Solution 8.5 Answer: D
a
~-
a Different price elasticities of demand in each The marginal revenue of the sixth suit is the change in
market total revenue resulting from the sale of an extra suit.
The total revenue from five suits is £100 X 5 = £500.
The total revenue from six suits is £80 X 6 = £480. So
8.5 Solutions to objective selling the sixth suit has caused total revenue to fall
questions by £20.

Solution 8.3 i Answer: A

Solution 8.6 Answer: C
A price taker is a firm that is unable to change market
The firm will maximise profits when marginal revenue
price by varying its own output. Firms producing
equals marginal cost. At three units MC = MR and at
under conditions of perfect competition are too small
this point profits (including supernormal and normal)
to affect price by changing their individual outputs.
are maximised.
They are also unable to raise their price above the
market price as their customers would switch to
perfect substitutes from competitive firms. Since the Weekly Total Marginal Total Marginal
firm is able to sell all its output at the going market output cost cost revenue revenue
price, there is no reason why it should sell any of its
a al 30 — 24 24
output for less.
B 1 41 by 48 24
B = Differentiated products means that consumers
Ca 65 24 TZ 24
are able to tell the difference between the output of
D =! 90 25 96 24
one firm and another. A condition of perfect
competition is that the produce of each firm is
identical. It is not possible to calculate the marginal cost of
 work out economics ¢ mar Fructygly

the first unit as it is not known what the cost of usually significant in what are often capital-intensive
producing zero output was (i.e. the fixed cost). Note industries, may be L shaped or downward sloping.
that the firm must be producing under conditions of
perfect competition since AR = MR and both are
Solution 8.11 Answer: A
constant.
A monopolist seeking to maximise profits will produce
where MC = MR. Option B shows the productively
Solution 8.7. Answer: A
efficient output, option C the allocatively efficient
Total revenue increases when marginal revenue is output and option D the sales maximisation output.
positive and is maximised when marginal is zero. It
falls when marginal revenue is negative. Since Q is to
Solution 8.12 Answer: D
the left of the point where the marginal revenue curve
intersects the x-axis (and TR is maximised), total If the price elasticity of demand in each market is
revenue is rising. identical, then the gradient of each demand curve is
the same and the firm is unable to charge different
prices for the same product.
Solution 8.8 Answer: A
A = Seepage between the markets would mean
It can be ascertained that the firm is producing under that consumers will buy in the cheaper markets and
conditions of perfect competition as the total revenue sell in the more expensive markets, which will equal
curve increases at a constant rate. Under conditions of out the prices in the two markets.
monopolistic competition and other forms of B => To set price in different markets, the firm
imperfect competition, total revenue rises and then would have to be a price maker.
falls. C = Price discrimination occurs when different
The firm is producing in the short run because it prices are charged for goods or services that cost the
has fixed costs, as shown by the fact that at zero same to produce.
output there are costs. In the long run all costs will be
variable.
8.6 Essays
Solution 8.9 Answer: D Example 8.13
If variable costs are covered then the direct costs of (a) What are the characteristics of a perfectly
production can be met and the loss from continuing to competitive industry? (7 marks)
manufacture is less than the total fixed costs that (b) What type of profits do perfectly competitive
would have to be paid out if the firm halted firms seek to earn? (5 marks)
production. (c) What type of profits do perfectly competitive
firms earn? (13 marks)

Solution 8.10 Answer: A e Cover the main characteristics of perfect

An oligopolistic industry is dominated by a few large competition and briefly explain them.
firms and they are interdependent. For example if one ¢ Discuss profit maximisation.
firm reduces price to increase market share, other Distinguish between the short and the long run.
¢ Include diagrams for the firm and industry.
firms follow, thereby undermining the effectiveness of
price competition. Oligopolists may also form cartels.
So oligopolistic industries tend to show stable prices. Solution 8.13
Non-price competition such as special offers are used
to increase sales. (a) A perfectly competitive industry is one that
B and D = Oligopolists are price makers and includes a large number of buyers and sellers. Indeed
hence their average revenue exceeds their marginal there are so many buyers and sellers that the actions
revenue. of any one buyer or seller will not affect price. The
C = Oligopolists long-run average cost curves may firms are price takers so that average revenue (price)
be U-shaped or, because economies of scale are equals marginal revenue. There is no product
 & aS i

78,<work out €conomics e market structure

differentiation, the products are homogeneous and shows a firm producing where marginal cost (MC)
there is no attachment between consumers and equals marginal revenue (MR), but also where
producers. There are no barriers to entry and exit so average revenue (AR) exceeds average cost (AC) and
that firms can enter the industry from outside and hence supernormal profits are earned.
firms in the industry can switch production to other
goods. There is perfect knowledge with consumers Costs/
revenue MC AC
and producers being fully informed about, for
example, price and profit levels. In addition there is
perfect mobility of factors of production, so if a firm
P,
wishes to expand its output it will have no difficulty
C, ho

attracting new workers and buying more machinery.

(b) It is assumed that firms that operate under

conditions of perfect competition are profit
maximisers. This means that they will produce where
0 Q, Output
marginal cost equals marginal revenue. The firms
would like to earn the highest profits possible and Figure 2
would much prefer supernormal to normal profits.
Given favourable market conditions firms may earn The absence of barriers to entry and the existence
supernormal profits in the short run. However the of perfect knowledge in this market structure means
forces of competition will drive down profits to the that firms outside the industry will be aware of the
normal profit level in the long run. This is the supernormal profits being made and will be able to
minimum return entrepreneurs need to receive in the enter the industry. This will cause an increase in
long run to keep them in the industry. supply in the industry, as shown in Figure 3.

(c) In the short run, when at least one factor of

production is fixed, any type of profit can be earned Costs/
by a perfectly competitive firm. However in the long revenue

run, when all factors of production can be varied, only

normal profits will be earned.
A rise in demand for the product will raise the price
in the short run and cause existing firms to extend
their supply. Figure 1 shows the effect on the industry
of an increase in demand.

Price
Output

Figure 3

Firms will continue to enter the industry until price

is driven down to the point where only normal profits
are earned, i.e. where AR = AC. Figure 4 shows a firm
earning normal profits.
Subnormal profits (losses) may be experienced by
firms in the short run. Figure 5 shows the effect on a
Quantity firm of a decrease in demand for the industry’s
product. It is producing where AC exceeds AR.
Figure 1 However, again this will be only a short-run
situation. This is because the absence of barriers to
As a result of the rise in price the firms will exit will mean that some firms will leave the industry.
experience supernormal (abnormal) profits. Figure 2 These will be the firms that cannot cover their variable
 ae
= r od , —-—

work out economics * mark “Structure”79 y

’ MC monopoly is a firm that has a 25% share of the market

Costs/ AC or more. A pure monopoly has a 100% share and in
revenue
this case the firm is the industry.
A private sector monopoly is likely to seek to
maximise profits. To do this it will produce when
marginal cost (MC) equals marginal revenue (MR).
P MR=AR=P
This output is shown as 0Q in Figure 1, with a price
being charged of OP.

0 Q Output Costs/
revenue
Figure 4

Costs/
revenue
MC AC Px

C,

P,
Le YL
— MR, =AR, = P;
MR
Output

Figure 1

0 O, > Output At this output, price exceeds MC and allocative

efficiency is not achieved. The allocatively efficient
Figure 5
x output is OQ, and the allocatively efficient price is
costs. The departure of firms from the industry will OP,. The private sector monopolist restricts output to
cause the industry’s supply curve to shift to the left. below 0Q, in order to raise price and increase profits.
Price will rise and firms that remain in the industry So it underproduces and overcharges.
will now experience normal profits. (b) Figure 1 also shows that the monopolist fails to
achieve productive efficiency as it produces where
Example 8.14 average cost exceeds MC. It could produce more and
lower its costs and prices. Consumers will suffer from
(a) Isa private sector monopoly likely to achieve its failure to do this.
allocative efficiency? (7 marks) Consumer surplus is likely to be low under
(b) What advantages and disadvantages may conditions of monopoly. Figure 2, a simplified
consumers derive from private sector diagram, shows lower output and consumer surplus
monopolies? (18 marks)
and higher price under a monopoly than under prefect
* Define allocative efficiency and monopoly. competition.
¢ Concentrate on pure monopoly. In addition to lack of competition possibly enabling
¢ Include a diagram showing monopoly output. a monopolist to drive up price, it may also mean that
¢ Consider the effect of monopoly power on prices, the quality of the product may be low — dissatisfied
output, quality and innovation. consumers are unable to switch to rivals in the case of
a pure monopoly.
The lack of competition may also mean that a
Solution 8.14 monopolist is not pressed into improving its product
(a) Allocative efficiency is achieved where price through research and development and innovation.
equals marginal cost. A private sector monopoly is a The monopolist’s costs may also be high if the firm
non-government firm. The legal definition of a becomes too large and thereby experiences
 Poaa
|cs © market structure

costs would be higher if the industry were to contain

Costs/ more than one firm.
revenue
A monopolist may also undertake more research and
development and innovate to a greater extent than a
Pu
firm in a competitive market. This is because it is likely
to be earning supernormal profits and so will have more
money to spend on research and development, and
because it will believe that it will be able to protect any
extra profits it earns through innovation due to the
existence of barriers to entry into the industry.
These very barriers to entry lead some economists
Output to argue that a monopoly market structure may
MR
encourage innovation. Schumpeter’s theory of creative
Perfect competition: price = OP; quantity = 00;
consumer surplus = PAB destruction argues that the only way to overcome a
Monopoly: price = 0Py; quantity = 0Q,; barrier to entry such as a patent will be to develop a
consumer surplus = PyAC;
producer surplus = PPyCD;
new and superior version of the product. This theory
sees one monopoly being replaced by a monopoly
Figure 2 producing a better product and that monopoly in turn
being replaced.
diseconomies of scale. It may also suffer from X- Where a monopoly exists in a contestable market,
inefficiency. i.e. when there are no barriers to entry and exit,
However it is possible that consumers may actually consumers may benefit. The firm will be able to enjoy
benefit from monopoly. A monopolist may be able to economies of scale, but knowing that rival firms can
take significant advantage of economies of scale. This enter the market it will have to keep price and profit
may mean that even if it is earning a supernormal levels low.
profit, the price it charges may be lower than that As there is uncertainty as to how a private sector
which would prevail in a competitive industry because monopoly will behave, in practice its relative
of its substantially lower average costs. Indeed in the advantages and disadvantages will have to be
case of a natural monopoly situation, long-run average considered on a case-by-case basis.
 (c) Elasticity of demand
¢ The greater a firm’s market share the more price
inelastic demand will be for its product.
¢ Figure 9.1 shows the MR, AR and TR curves of an
In assessing how firms will behave in different market imperfectly competitive firm.
structures it is important to note the following:

(1) Structure, including:

(a) the number of firms in the industry;
(b) the size of the firms;
(c) how easy or difficult it is for firms to enter or
leave the market.
(2) Conduct, including:
(a) the influence individual firms have over the
price of their products;
(b) the type of products produced;
(c) how the firms compete.
(3) Performance, including:
(a) the type of profits firms earn in the long run;
(b) how efficient the firms are.

Q,
Figure 9.1 Revenue curves and price elasticity of demand (PED)
(b) Degrees of competition
¢ The most competitive market structure is perfect * The MR curve bisects the origin and the AR
competition. curve.
¢ Imperfect competition covers market structures ¢ To sell more output, the firm has to reduce price
between perfect competition and monopoly, i.e. on the extra unit and all preceding units.
monopolistic competition and oligopoly. Therefore, MR is always less than price.
-e The least competitive market structure is pure * Upto Q, MR iis positive, TR is rising and PED is
monopoly. elastic.
e2 work out.ecohomics ¢ market structure

¢ Beyond Q, MR is negative, TR is falling and PED ¢ Given favourable market conditions, monopolists
is inelastic. and oligopolists can earn supernormal profits in
¢ At A, PED is unitary. the long run due to barriers to entry.
¢ Total revenue is maximised at Q. ¢ The absence of barriers to entry and exit means
¢ Oligopolies have relatively inelastic demand and that firms producing under conditions of
monopolies even more inelastic demand. monopolistic competition and perfect competition
¢ Firms producing under conditions of monopolistic earn normal profits in the long run.
competition have relatively elastic demand. ¢ A state-run monopoly may seek to achieve
¢ A perfectly competitive firm has perfectly elastic allocative efficiency rather than profit
demand and hence a total revenue curve that maximisation.
increases at a constant rate. This is shown in
Figure 9.2.
(e) Efficiency
Revenue
Total ¢ Allocative efficiency is achieved when a firm
revenue produces where MC = AR (marginal cost pricing).
¢ Productive efficiency exists when a firm produces
at the lowest unit cost, i.e. where MC = AC.
¢ Technical efficiency is achieved when a firm
produces a given quantity of output with the
minimum number of inputs.
¢ X-inefficiency arises when a firm fails to produce
on the lowest possible average and marginal cost
curves.
0 Output e Perfectly competitive firms are always allocatively
Figure 9.2 The total revenue curve of a perfectly competitive firm efficient and achieve productive and technical
efficiency in the long run.
(d) Profit levels ¢ Imperfectly competitive firms and monopolies are
usually allocatively, productively and technically
The level of profits a firm earns depends on:
inefficient.
(a) market conditions
¢ Monopolies often experience organisation slack
(b) market structure
and so are X-inefficient.
(c) the firm’s objectives

¢ Monopolists and oligopolists do not automatically

earn supernormal profits. Figure 9.3 shows a (f) Pricing strategies
monopolist experiencing a loss. (1) Profit maximisation pricing, i.e. producing where
MC = MR and charging the corresponding price.
Costs/
revenue (2) Price discrimination occurs when the same
product is sold in different markets for different
prices (Figure 9.4). A discriminating monopoly is
only able to practise price discrimination if it:
(a) has some monopoly power and so can set
price and exclude competitors;
(b) is able to prevent the resale of the product;
(c) has markets with different price elasticity of
demand for the product.
The monopolist adds together MR, from market
A and MR, from market B to find the MR curve
0 Output for both markets (MR, + MR,). Output is fixed at
the point where the MR, and MR, combined
Figure 9.3 A monopolist experiencing a loss curve intersects the MC curve at Q. Q is then
 ode a -
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4

work out economics * comparison of market Structures 83 “Sas

ee
ens
aa ise Duss cot wee

Table 9.1 Market structure ;

Above
Market No. of Nature of Price Barriers to normal
structure firms products Substitutes taker/maker entry profits

Perfect Many small Homogeneous Many perfect Taker None Only in

competition the short run
Monopolistic Manysmall Differentiated Many close Maker None Only in the
competition short run
Oligopoly Dominated Differentiated Few Maker Some Possible in the
by few large long run
Pure One large Unique None Maker Complete Possible in the
monopoly long run

divided between the two markets by setting (g) Contestable markets

output at MC = MR in each market. Note that
QA + OB = Q. Price is P, in market A and P, in ° The theory of contestable markets argues that
c what is important is not actual but potential
market B. Price is higher in the market where
competition.
demand is less elastic.
¢ A market is perfectly contestable when the costs
(3) Cost-plus pricing occurs when a firm adds a given
of entry and exit are zero.
percentage mark-up to average cost. A loss can be
¢ A contestable market is one where any entry costs
made if sales fall short of estimates.
can be recovered on exit, i.e. there are no sunk
(4) Market penetration pricing occurs when a firm
costs.
reduces price to increase market share (the
¢ Ina perfectly contestable market the threat of
percentage of an industry’s sales accounted for by
entry by potential rivals will ensure that the firm or
one firm).,
firms in the industry will:
(5) Limit pricing occurs when a firm sets price just
(a) earn normal profits;
low enough to discourage possible new entrants.
(6) Predatory pricing occurs when a firm reduces (b) achieve allocative, productive and technical
efficiency.
price in the short run so as to force competitors
out of the industry.
(7) Skimming pricing occurs when a firm charges a 9.2 Investigative study
high initial price if some consumers are prepared
to pay more for a new product. Eventually price is Example 9.1
lowered to extend demand.
A study of a particular market analysing how its
market structure appears to influence profit levels,
prices and efficiency.

MC

MR, at MR,

Qs Q, Q

Market A Market B Market A + Market B

Figure 9.4 Price discrimination in two markets

 HGPRT, Mp » 4 hou) eu
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&fi “Work out{economics * market structure

oe ee

9.3 Data response shop. Once in, it is hoped that they will buy a range of
other products.
Example 9.2 (c) Supermarkets have attracted customers by
copying the personal approach of family bakeries.
Food/Cut Throat Bread and related items are frequently sold in a
separate section of the shop by people dressed as
Competition bakers. The supermarkets also offer a greater range of
Supermarket ‘real bread’ ruins loaves, including more exotic items. In addition they
advertise on a large and national scale.
the small bakers
THE SMELL of fresh bread, once The National Association of (d) Supermarkets have significant advantages over
on every British high street, is Master Bakers is alarmed by the small bakeries. They spread their overheads over a
now more common in the super- speed of closures. It fears that
market as scores of local bakeries supermarkets may be trying to large number of items and they can take advantage of
— unable to compete with mass- drive bakeries out of business and a number of forms of internal economies of scale,
produced loaves — close each has asked the Office of Fair Trad-
month. ing to intervene. including financial, risk bearing, technical and staff
There are now only 3,500 fami- “Bakers haven’t been able to
ly bakeries left in Britain. In the keep up with competition,’ said
facilities. As well as offering staff canteen facilities,
past five years, 1,500 have closed. Mary Rance, Director of the for example, they offer higher pay and greater
Fifty years ago, small bakeries NAMB. “They have tried vigor-
produced 83 per cent of British ously, but supermarkets have been promotion prospects. They can sell bread at a loss, if
bread. Today, with the advent of selling bread below its market they so choose, because they can cross-subsidise it
the sliced loaf and the supermar- price as a loss leader for some
ket bakery, they sell only 8 per years. The family bakeries are with other items on sale. They also have a national
really fighting against very
cent. reputation and so attract passing as well as local
adverse trading conditions. They
Over the past 10 years, super-
are closing every day.” trade.
markets such as Tesco, Sainsbury
But the OFT, although it said it
and Safeway have sought to repro-
sympathised with the small bak-
duce the ambience of the high-
eries’ plight, concluded _ that (e) The closure of more bakeries will reduce
street bakery to attract customers.
supermarkets were not trying to consumer choice and competition. Family bakeries
Most loaves are baked overnight drive them out of the market and
and the assistants wear bakers’ refused to act. may be conveniently situated and may provide a
hats and aprons. The choice of
bread is wider than in a local bak- Source: Extract from an article by personal service as the baker will have a small enough
ery, ranging from ordinary white Marie Woolf, Independent on
customer base to get to know them all. The baker may
sliced loaves to Italian ciabatta. Sunday, 19 March 1995.
also be willing to meet any specific requirements they
(a) Under what market structure do family bakeries have. Shopping in a family bakery is a more leisurely
produce? Explain your answer. (5 marks) and less pressurised experience than shopping in some
(b) Explain what is meant by a loss leader.(3 marks) supermarkets. With fewer family bakeries,
(c) Apart from loss leaders, how else have supermarkets will be faced with less competition and
supermarkets attracted customers away from may be tempted to reduce choice and raise price.
family bakeries? (5 marks)
(d) What advantages do supermarkets have over
family bakeries in the sale of bread? (6 marks)
9.4 Objective questions
(e) What disadvantages would consumers
experience as a result of more bakeries closing? Example 9.3
(6 marks) The following details are known about the long-run
cost and revenue position of a firm:
Solution 9.2
¢ Marginal cost = £5
(a) Family bakeries operate under conditions of e Average cost = £8
monopolistic competition. Although declining, ¢ Marginal revenue = £5
there is still a large number of them. They produce e Average revenue = £8
- a slightly differentiated product, do not make
Which of the following markets cannot be consistent
high profits and it is relatively easy to enter the
with this information?
market.
A monopoly B_ oligopoly
(b) A loss leader is a product sold at cost or below C perfect competition D monopolistic
cost with the aim of attracting consumers into the competition
 work out economics * comparison of m ctures

Example 9.4 ;
Two firms are making supernormal profits. One is TR
monopoly and the other is operating under conditions
of perfect competition. Only in the former case will:
average revenue be equal to average cost
marginal revenue be equal to marginal cost
average revenue be greater than marginal revenue
Samemarginal revenue be greater than marginal cost

Example 9.5
Which of the following diagrams illustrates the total Example 9.6
revenue curve of a firm operating under conditions of
The diagram below shows the short-run costs and
imperfect competition?
revenue of a profit-maximising monopolist. This
A monopolist is worried about potential competition and
believes that engaging in limit pricing and setting a
TR price of Py will prevent the entry of new competitors.

Price

0 OQ

TR
Which level of output will ensure that the
monopolist achieves maximum profit compatible with
preventing the entry of new competitors?
A 0Q, B 0Q, C 00; D 0Q,

Example 9.7

The diagram below illustrates the output of a profit-

0 a)
maximising firm.

Cc
Costs/
revenue
TR MC
AC

AR

Output
86 work out économics e market structure

Isthe firm producing under conditions of: Example 9.11

A perfect competition and earning normal profits
The diagram below shows the cost and revenue curves
B_ imperfect competition and earning normal profits
of a monopolist.
C_ perfect competition and earning supernormal
profits
D imperfect competition and earning supernormal
Costs/
profits revenue

Example 9.8
A firm operating under conditions of perfect
competition will achieve allocative efficiency when it
earns: AR

Subnormal Normal Supernormal

profit: profit: profit: Output
A yes yes yes MR
B no yes no
C yes no yes If the monopolist changes her or his objective from
D no yes yes making normal profits to achieving sales revenue
maximisation he will alter her or his output from:
A Q,toQ, B Q,toQ, C Q;toQ, D Q;toQ,
Example 9.9
In the diagram below, OP represents the price that Example 9.12
would be charged by a perfectly competitive industry
and OQ is its output. OP, and OQ, represent the price In which type of market structure are there no barriers
and output, respectively, of a monopolist. to entry and exit?
A Duopoly B Monopoly
J C Oligopoly D Contestable
Costs/
revenue
Px
9.5 Solutions.to objective
questions
Solution 9.3. Answer: C

The information shows that the firm is producing at

the point where MC = MR, and hence is maximising
_ Output
profits, and where AC = AR, and so is making normal
MR
profits. The firm cannot be producing under
Which area represents the dead weight loss that conditions of perfect competition since perfectly
would occur if a perfectly competitive industry was competitive firms are price takers and thus their
replaced by a monopoly? average revenue 1s equal to their marginal revenue.
A P,JK B PPyKM C PP,KL D KLM A, B and D = In all these cases AR > MR and it is
possible that firms producing either these market
Example 9.10 structures could earn normal profits.

In which market structures may supernormal profits

Solution 9.4 Answer: C
- be earned in the long run?
A Perfect competition and monopoly A monopolist is a price maker and his AR > MR. As
B_ Perfect competition and monopolistic competition stated in Solution 9.3 a firm producing under
C Monopolistic competition and oligopoly conditions of perfect competition is a price taker and
D Oligopoly and monopoly its average revenue equals its marginal revenue.
 work out economics * comparison of ae

A => If supernormal profits are earned, average Solution 9.11 Answer: D

revenue will exceed average cost.
Normal profits are earned at the point where AR = AC,
B and D = In both cases the firms are likely to be
i.e. at an output of QS. Sales revenue is maximised
profit maximisers and hence be producing where
where MR = 0, i.e. at an output of Q,. Q, is the
marginal cost equals marginal revenue.
maximum profit output, Q, the productively efficient
output and Q, the allocatively efficient output.
Solution 9.5 Answer: C
Under imperfect competition, total revenue rises when Solution 9.12 Answer: D
demand is elastic and marginal revenue is positive. It
A market is perfectly contestable when there are no
reaches its peak when elasticity of demand is unity
entry or exit costs.
and marginal revenue is zero, and falls when demand
A, B and C = In each case there are barriers to
is inelastic and marginal revenue is negative.
entry and exit.
B = shows the total revenue curve of a firm
producing under conditions of perfect competition.
9.6 Essays
Solution 9.6 Answer: A
Example 9.13
To ensure a price of Py the monopolist will have to
(a) Explain why a firm’s profits are maximised when
sell the output at the point where quantity intersects
marginal cost equals marginal revenue.
the average revenue (demand) line.
(10 marks)
(b) Do firms always use profit maximisation for
Solution 9.7. Answer: B determining prices? (15 marks)
The firm is producing under conditions of imperfect ¢ Demonstrate profit maximisation, assuming either
competition as AR >MR. It is making normal profits perfect or imperfect competition.
as it is producing at the point where AC = AR. ¢ The second part of the question asks you why
firms use non-profit-maximising pricing strategies.
Solution 9.8 Answer: A
Allocative efficiency is achieved at the point where Solution 9.13
P(AR) = MC. Firms producing under conditions of (a) There are three types of profit in economics.
perfect competition always produce where P = MC Normal profit is a return that is sufficient to keep the
since they produce where MC = MR and in this firm in the industry. Normal profit is seen as a cost
market structure P = MR. of production and is therefore included in the firm’s cost
curves. Any return above normal profit is called
Solution 9.9 Answer: D supernormal (or abnormal) profit. It is also possible that
a firm may make a subnormal profit (i.e. produce) when
Under perfect competition consumer surplus is PJM.
average cost exceeds average revenue.
Under monopoly it would be P,JK, which is a
reduction of PPyKM. Of this fall in consumer surplus, Price
PP,KL is converted into producer surplus and KLM is
lost to both parties, i.e. is a deadweight loss.

Solution 9.10 Answer: D

Supernormal profits can be earned in market

structures where there are barriers to entry and exit —
these exist under oligopoly and monopoly.
B = Firms producing under conditions of both
perfect competition and monopolistic competition
earn normal profits in the long run due to the absence
Output
ee ee 1
tage i
of barriers to entry and exit.
 The diagram shows the short-run unit cost and functions such as production, sales and finance. Each
revenue curves of an imperfectly competitive firm. department has a different objective, so that the
Assume that the firm can produce any level of output maximisation of one goal — profits — is inappropriate.
between 0 and Q,,,,. The marginal cost curve, MC, Instead, satisficing occurs when each department is
tells the firm the cost of making the extra unit. The set minimum acceptable levels of performance — for
marginal revenue curve, MR, tells the firm the example asking the sales department to obtain a given
revenue received from the sale of the extra unit. At Q,, market share.
the difference between MR and MC (J — K) is The firm may feel that the cost of collecting
greatest. However there is an incentive for the profit- information about marginal cost and revenue is too
maximising firm to increase output beyond this point. high and therefore managers use a cost-plus pricing
The revenue received from the sale of each additional strategy. The firm fixes output and then estimates unit
unit up to Q, is greater than the cost of making that cost. Adding a profit margin to average cost gives the
extra unit. Any firm that fixed output at Q, would be final selling price.
forgoing a profit on each of Q, and Q,. A normal Nationalised industries aim to operate in the public
profit is made on the sale of the Q, unit. Above output interest. Profit maximisation results in an inefficient
level Q,, a loss is made on the sale of each extra unit, allocation of resources. Instead, state-owned firms
because marginal cost exceeds marginal revenue. For adopt a marginal cost pricing strategy and increase
example, at Q; a loss of L — M is made on the sale of output to the point where, including externalities,
that unit alone. Profits are therefore maximised when marginal cost equals price.
marginal cost equals marginal revenue.

(b) Economic theory assumes that individuals and Example 9.14

firms are ‘rational’, acting in a manner that maximises Compare and contrast oligopoly and monopolistic
their own satisfaction. In the case of the firm, the competition. (25 marks)
maximisation of profits guarantees the largest possible
income for the owners of a company. A profit- e Discuss the similarities and differences between
maximising pricing policy is likely to be used by sole the two market structures.
traders and partnerships. ¢ Concentrate on how firms behave in the two
However the emergence of limited companies market structures.
means that ownership and control of the most
important firms are now separated. In general,
Solution 9.14
shareholders expect the firm to maximise profits and
therefore to set its output so that marginal cost equals Monopolistic competition and oligopoly are both
marginal revenue. Managers may have different forms of imperfect competition. In both cases firms
objectives. are price makers. A change in their output will affect
New ‘managerial’ theories of the firm suggest that price and their average revenue will exceed their
companies use pricing criteria that improve the marginal revenue. In monopolistic competition and
welfare of managers. For example salaries and ‘fringe oligopoly, productive and allocative efficiency are
benefits’ are more likely to be linked to sales than to unlikely to be achieved. The firms are likely to
profits. Bonuses may be paid for achieving sales produce at the point where average cost exceeds
targets. It follows that manager-controlled firms will marginal cost (and hence not at the bottom of the
try to maximise sales revenue rather than profit and to average cost curve) and where price exceeds marginal
fix output so that average cost equals average revenue. cost. In both market structures the firms will engage in
Managers may decide that setting a price that non-price competition and product differentiation may
maximises the firm’s rate of growth is in their own occur.
best interest. An expanding company increases a Monopolistically competitive firms produce a good
manager’s salary and status. Moreover the resulting that is only slightly different from that of all other
increase in the value of the company’s shares is in the sellers. Buyers can therefore tell the difference
interest of the owners. between the output of different firms. The output of
Large businesses are highly complex, with different oligopolies can be homogeneous (perfect oligopoly)
departments taking responsibility for specialised or differentiated (imperfect oligopoly).
 work out economics * comparison of negQrip hey

In monopolistic competition there are a large In monopolistic competition, new firms are free to
number of small producers selling to a large number enter and leave the industry. However there are
of buyers. In oligopolistic industries a small number barriers to entry into oligopolistic markets. This
of large producers dominate the market. difference affects the types of profit that firms in
The large number of firms in monopolistic the different market structures can earn in the long
competition means that the actions of one firm have run. Figure 2 shows a representative firm in
little effect on competitors. In an oligopoly the actions monopolistic competition. Supernormal profits
of one of the dominant firms can have a significant attract new firms into the industry, reducing market
effect on its competitors. share and thereby reducing demand for the
The independence of monopolistically competitive individual firm. In Figure 3 the demand curve shifts to
firms means that pricing policy is influenced only by the left until price equals average cost.
cost and revenue considerations. Interdependence Monopolistically competitive firms earn only normal
means that oligopolistic pricing decisions take into profits in the long run.
account the likely response of other firms. The theory
behind the kinked demand curve (Figure |) argues
Costs/
that if an oligopolistic firm increases its price, other revenue
firms will not raise theirs and customers are lost.
Reducing price has no effect on market share, because
other firms will follow suit. Oligopolies therefore tend P

to exhibit price rigidity.

Gc

Price

0 Q Quantity

MR

Figure 2

Costs/
0 Quantity
revenue
The kinked demand curve

Figure 1 MC

AC
Economies of scale are more significant in an
oligopoly than in monopolistic competition. When
FG
economies of scale are available, those firms able to
increase their plant size acquire a cost advantage over
smaller competitors. Small firms are uncompetitive,
and the industry becomes oligopolistic. In industries
offering little or no scope for scale economies, firms AR
are unable to reduce unit costs or are unable to reduce
them significantly by increasing their size. Such 0 Q Output
MR
industries tend to be perfectly or monopolistically
competitive. Figure 3

Non-price competition is used in both market

structures but the scale differs. Indeed UK advertising The ability of oligopolists to exclude competition
is dominated by oligopolies trying to increase allows them to continue earning supernormal profits
consumer loyalty to their product. in the long run.
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Market Failure

Date
‘a eae assessment

a Fact sheets fons

ee Investigative study its

10.1 Fact sheet (2)~— The Restrictive Trade Practices Act 1976, which
deals with uncompetitive practices.
(a) Measures of UK (3 — The Resale Prices Act 1976, which concerns
competitiveness attempts to set minimum prices at which goods
can be sold.
The competitiveness of UK industry can be measured (4) The Competition Act 1980, which covers anti-
in terms of: competitive practices.
(1) Profitability
(2) Return on capital employed (c) Monopoly and merger policy
(3) Productivity
This is implemented by:
(4) Export performance
(5) Import penetration (1) The Office of Fair Trading (OFT)
(6) Employment levels (2) The Monopolies and Mergers Commission (MMC)

¢« A merger can be investigated when:

(a) the total assets of the company to be taken
(b) Competition policy over exceed £70 million in value;
UK competition policy seeks to encourage and (b) the new merged company will have 25% or
enhance the competitive process. It is based on a case- more of the supply or purchase of goods.
by-case examination. It does not assume that * The MMC decides whether a merger will operate
possession of market power is in itself against the against the public interest and have anti-
public interest, but that certain uses of it may be. competitive effects.
Consumers would be disadvantaged by, for example: ¢ The OFT can refer a monopoly to the MMC if it
thinks it is acting against the public interest.
(1) Excessive prices
¢ In practice few monopolies and mergers are
(2) Restrictions on output
investigated.
(3) Decline in the levels of service
(4) Unfair restrictions on entry into the market
(d) Restrictive practices policy
Key Competition Acts are:
* This is designed to take action against practices-
(1) The Fair Trading Act 1973, which is concerned that reduce competition and harm the public —
with monopolies and mergers. interest, including:
 work out economics * comp olic

(a) cartels; (4) The contracting out of services by central and

(b) resale price maintenance. local government.
Collective agreements that include restrictive (5) Deregulation, i.e. the removal of government
practices must be registered with the OFT. regulations that restrict entry and exit of firms and
The Restrictive Practices Court was established in competition.
1956 to consider exemptions for individual cases.
¢« Arguments for privatisation:
To obtain exemption an agreement must pass
raises revenue;
through at least one of eight so-called gateways,
may promote efficiency;
e.g. that it helps to protect jobs and on balance
exposes firms to market forces;
operates in the public interest.
may open up firms to competition in the goods
market;
firms are obliged to compete for finance;
(e) Anti-competitive practices
increases share ownership.
policy
¢ Arguments against privatisation:
The Competition Act 1980 defines an anti- may reduce revenue in the long run;
competitive practice as one that restricts, distorts private sector firms may not be efficient;
or prevents competition. public sector assets may be sold off too
If, after a preliminary investigation, a practice is cheaply;
found to be anti-competitive the Director General competition may not be increased;
of Fair Trading can refer it to the MMC. private sector firms may not take externalities into
account;
reduction in government control over the
(f) The role of the European Union economy.
UK competition policy is influenced by EU
competition rules, as contained in Articles 85 and 86 10.2 Investigative study
of the Treaty of Rome.

Article 85 prohibits restrictive practices, including Example 10.1

price fixing and discriminatory terms of supply, A critical analysis of the role and success of one of
within the EU. the regulatory agencies, e.g. OFLOT, which regulates
Article 86 prohibits the abuse of monopoly and the National Lottery.
oligopoly power insofar as it may affect trade
between member states.
Since 1990 the European Commission has had the 10.3 Data response
power to control mergers that have a union-wide
dimension. Mergers where the parties have an Example 10.2
aggregate exceeding 5 billion ECUs, at least two PRIVATISATION and liberalisation are in fashion, even in the once-
of the companies have an EU turnover above 250 straitjacketed economies of Latin America and Eastern Europe. And
rightly so: as a rule, the best thing a government can do with an indus-
million ECUs and the companies do not conduct try is to let businessmen, not bureaucrats, run it. Ordinarily, competi-
more than two thirds of their ECU-wide business tion forces firms to keep prices and costs low. But many utility
industries (such as electricity, telecommunications and water) are
in one member country must be notified to the largely monopolies. When the discipline of competition is absent, gov-
European Commission. ernments cannot afford to abandon all controls when they give up own-
ership. Regulation is needed to stop the monopolists fleecing their
customers.
Source: Extract from ‘The regulatory experiment’, The Economist, 28
(g) Privatisation January 1995.

Privatisation covers: (a) Explain the thinking behind the statement ‘the
(1) Denationalisation. best thing is to let businessmen, not bureaucrats,
run it’. (5 marks)
(2) The sale of government shares in private sector
companies. (b) Why does competition keep prices and costs
low? (4 marks)
(3) The sale of council houses to sitting tenants.
 mics © market failure and government intervention

(c) What is the government definition of a monopoly

Price
and how does this definition differ from the
definition of a pure monopoly? (2 marks)
(d) In what sense may a monopoly ‘fleece’ its
customers? (7 marks)
(e) What forms does government regulation of
privatised monopolies take? (7 marks)

Px
Solution 10.2

(a) Supporters of free-market forces argue that

government intervention reduces efficiency. They
argue that entrepreneurs are better informed about
what consumers want and about changes in demand.
0 Output
Entrepreneurs, it is claimed, are responsive to changes
in consumer demand because they have a financial
incentive to be so. If consumers demand more of a Figure |
product they will bid up its price. The opportunity to
increase profits will encourage firms to make more of change in the retail price index plus or minus a
the product. certain, specified amount each year, known as *X’.
This encourages the utilities to cut their costs as they
(b) If an industry consists of a large number of
gain from any increase in cost efficiency.
similar sized firms making products with a high
degree of positive cross-elasticity of demand there
will be a high level of competition. In this situation, if 10.4 Objective questions
one firm fails to keep down its costs and prices it will
lose all, or a substantial number, of its customers to Example 10.3
more efficient companies.
What is the most likely reason for the Monopolies and
(c) Government competition policy defines a Mergers Commission to prevent a proposed merger
monopoly as a firm whose share of the market 1s 25% from going ahead?
or more. In contrast a pure monopoly is a firm that has A The aim of the merger is found to be to asset strip
a 100% share of the market. B_ The merger will result in significant economies of
scale
(d) A monopoly, because of its market power, can
C The proposed merger is of a vertical rather than a
reduce output and thereby raise price. This means that
horizontal nature
it may fleece its customers in the sense of charging a
D The new merged company will control more than
price above, and producing an output below the
40% of the market
socially optimum level. The diagram below contrasts
the socially optimum price and output (P; and Q,)
with the output of a private sector monopolist (P and Example 10.4
Q). A government policy of deregulation is intended to:
(e) Monopolies, whether privatised or not, can be A increase government control
referred by the Director General of the Office of Fair B_ improve the supply-side performance of the
Trading or the President of the Board of Trade for economy
investigation to the Monopolies and Mergers C reduce the size of the manufacturing sector
Commission if it engages in harmful anticompetitive D reduce the prices charged by nationalised
practices. Monopolies, other than pure monopolies, industries
may engage in restrictive practices with other firms in
the industry, and thus are subject to restrictive
practices legislation. Privatised utilities have
regulators who limit the annual price increases to the
 work out economics comers Poche 05

Example 10.5 C The Bank of England

D The Restrictive Practices Court
According to the government definition, a monopoly
is a firm that has:
A 25% or more of the market Example 10.10
B 333% or more of the market When may the imposition of a government tax on a
C 50% or more of the market
good enable a market to work more effectively?
D 100% of the market
When social costs exceed private costs
When there is too much competition in the market
Example 10.6 When production costs in the industry are falling
When short-run supernormal profits are being
Same
Which of the following is the best definition of earned
privatisation?
A Denationalisation
B The transfer of assets from the public to the private Example 10.11
sector In relation to which products is resale price
C The sale of government held shares in private maintenance legal?
sector companies A Cars B_ Houses
D The sale of government-owned assets, compulsory C Televisions D Pharmaceuticals
competitive tendering and deregulation

Example 10.12
Example 10.7
A merger will qualify for possible investigation by the
A firm controls the supply of a raw material used in Monopolies and Mergers Commission in terms of
the production of a good. It is also involved in all assets if it has total gross assets over:
stages of the productive process of the product. It sells A £30 million B_ £50 million
the raw materia] to competitors at such a high price C £70 million D £100 million
that its competitors are unable to compete with it in
selling the finished product. This action is known as:
10.5 Solutions to objective
A price discrimination
B predatory pricing questions
C selective distribution
Solution 10.3. Answer: A
D vertical price squeezing
Asset stripping is when a company buys another
company (usually one which it believes is
Example 10.8
undervalued), breaks it up, sells the parts to other
When may price discrimination be beneficial for companies and usually closes down the remainder.
consumers? If it: The aim is profit, and whilst the asset stripper will
A reduces consumer surplus benefit, consumers are likely to suffer from the fall in
B increases industrial concentration output and choice and the workers made redundant
C enables a foreign firm to eliminate domestic will obviously suffer.
producers B => Consumers are likely to benefit if the costs of
D turns a loss-making monopoly into a profitable one production fall since this may result in lower prices.
The economy will also benefit from the firm
becoming more internationally competitive.
Example 10.9 C and D => The Monopolies and Mergers
Which government body decides if a monopoly Commission judges each proposed merger on its own
should be referred to the Monopolies and Mergers merits or otherwise. A vertical nature and control of
Commission? more than 40% of the market do not in themselves
A OFT imply that the proposed merger will be against the
B OFTEL public interest.
 vy mics ¢ market failure and government intervention
—

Solution 10.4 Answer: B C = The elimination of domestic producers will

reduce competition and is likely to lead to higher
Deregulation is the removal of regulations on the prices and less choice.
activities of the business sector, e.g. ending the legal
monopoly that qualified opticians had over the sale of
spectacles. The prime aim behind deregulation is to Solution 10.9 Answer: A
enable market forces to operate more effectively, free A monopoly can be referred for investigation by the
of government intervention. Supporters of President of the Board of Trade and by the
deregulation argue that this will increase firms’ Director General for the Office of Fair Trading
efficiency and make them more responsive to changes
(OFT).
in consumer demand. The supply side of the economy B = OFTEL is the Office of Telecommunications,
will improve. which regulates the telecommunications industry.
C = The Bank of England regulates the banking
Solution 10.5 Answer: A sector.
D = The Restrictive Practices Court decides
The minimum-market-share criterion for a monopoly whether agreements between firms are against the
subject to investigation by the Monopolies and public interest.
Mergers Commission was given as 25% in the 1973
Fair Trading Act.
D = This is a pure monopoly where the firm is the Solution 10.10 Answer: A
industry, i.e. the sole supplier. If social costs exceed private costs there are external
costs (negative externalities) that do not go through
Solution 10.6 Answer: D the market. If the tax is placed on the good is equal to
the external costs, social costs will equal private costs
Privatisation has a broad meaning. Options A, B and and resource allocation will be improved.
C all describe forms of privatisation, but the most
complete definition is option D.
Solution 10.11 Answer: D

Currently, resale price maintenance is permitted in the

Solution 10.7. Answer: D
case of certain medicines. Resale price maintenance is
In this case the firm is making its finished product when a producer can legally insist that retailers charge
more price competitive by charging its rivals a high a set price for its products.
price for the raw materials. What enables the firm to
do this is its monopoly of the raw material source and
Solution 10.12 Answer: C
the fact that the firm is vertically integrated.
A => Price discrimination is charging different There are two tests to determine whether a particular
prices to different groups of consumers. merger is liable to investigation. One is the market-
B => Predatory pricing is charging low prices, share test, i.e. 25% plus, and the other is the assets
sometimes below cost, with the intention of drawing test. In the latter case mergers can be investigated if
out existing competitors or preventing the entry of the companies’ joint assets exceed £70 million.
new competitors into the industry.
C = Selective distribution is when a producer will
only sell to outlets that meet certain requirements.
10.6 Essays
Solution 10.8 Answer: D
Example 10.13.
Price discrimination may enable a firm to stay in
Examine the economic arguments for and against
business. If that firm confers positive externalities this
privatisation. (25 marks)
will benefit society.
A and B = are potential disadvantages of price ¢ Define privatisation
discrimination from a consumers’ point of view. ¢ Give some examples
 work out economics * comp ol

Solution 10.13 companies that were sold off in 1990 quickly rose,
indicating that the initial share prices could have been
Privatisation is a broad term. It includes the sale of
higher. The sale of profitable industries, for example
nationalised industries, the sale of part of nationalised
gas and electricity, also results in a long-term loss of
industries, the sale of government shares in public
government revenue and could cause a long-term rise
limited companies and the contracting out of work by
in the PSBR.
local authorities.
The sale may also divert funds from other
Since 1979 the UK government has privatised a
organisations, including banks and building societies.
significant proportion of the public sector. This policy
A private sector firm may be less concerned with
has been adopted by many other countries, including
externalities and base its pricing and output decisions
France, Italy, New Zealand and former command
on private costs and benefits. For this reason the
economies. government has established a number of regulatory
The sale of nationalised industries in whole or part bodies, including OFFER (electricity) and OFGAS
and the sale of government shares in public limited (gas), to monitor price and output decisions.
companies raises revenue and reduces the PSBR. This Privatisation can also make it more difficult to
was a significant consideration in the early 1980s, implement government policy. With fewer industries
when the government was keen to reduce the under direct government control a prices and incomes
PSBR. Revenue, in the form of corporation tax, will policy or a new training initiative may have less
also be increased if privatisation results in a rise in chance of success.
efficiency and profitability. This may occur because
private sector industries may be more subject to
market discipline in both the goods and the financial Example 10.14
market — if they are not efficient they will go out of
How may the government promote competition?
business due to their inability to sell their products
(25 marks)
and raise revenue. Depending on how the privatisation
is organised, the new private sector firms may become * Recognise that competition can take various
subject to greater.competition, e.g. British Telecom is forms.
now facing increasing competition from Mercury. * Comment on UK competition policy.
Those in favour of privatisation also argue that
private sector firms are more responsive to changes in
Solution 10.14
consumer demand, as reduced government
intervention results in greater flexibility and speed of Competition may be in the form of price or non-price
response. This may in turn bring about the more competition. Non-price competition includes
efficient allocation of resources. advertising, free gifts, brand names, competitions,
Privatisation can promote shareholding among the after sales service, guarantees,
population, and indeed shareholding is now higher Government competition policy mainly seeks to
than in 1979. However many of the new shareholders promote price competition. This can be achieved in a
have shares in only one privatised company and these number of ways. To discourage monopolists from
are often purchased with the intention of selling them charging high prices a tax can be placed on
quickly in the hope of making a capital gain. supernormal profits. This occurred in the mid 1980s in
Privatisation may provide increased opportunities the UK when the government placed a windfall tax on
for raising investment finance as nationalised the high profits earned by retail banks.
industries can have limits placed on their external A government could also nationalise the industry to
funds. ensure that the monopolist charges a price equal to
Whilst privatisation has been a major movement, marginal cost. However in the 1980s and 1990s the
there are nevertheless a number of arguments against UK government used privatisation rather than
it. One concerns the process of privatisation. It has nationalisation to promote competition. The thinking
been claimed that a number of industries have been behind this approach is that private sector firms are
sold off at artificially low prices, thereby involving a more subject to market forces. If they do not supply
loss of potential income for the government. For what consumers want they will go out of business —
example share prices in the regional electricity they will not be ‘bailed out’ by the government.
,
 DO Ios e

utveconomics ¢ market failure and government intervention

A government could also break up a monopoly into output and production process have to be registered
separate competing units. This approach has been with the Office of Fair Trading. To be allowed to
followed in the USA but the main thrust of UK policy continue they have to be able to prove that the benefits
is to regulate monopolies. This is achieved through outweigh the disadvantages of such agreements, and
the Monopolies and Mergers Commission, which they have to satisfy at least one of a number of
investigates existing and potential monopoly ‘gateways’, e.g. to protect the public against injury.
situations. The MMC and the Office of Fair Trading The primary aim of the 1980 Competition Act was
act on the assumption that possession of market power to promote greater competition. It identified a number
is not in itself harmful, but that how it is used may be of anticompetitive practices, including predatory
— so a case-by-case approach is followed. pricing and price discrimination. The OFT can
The privatisation of public utilities resulted in a investigate such anticompetitive practices if the firms
number of specialised regulators being set up to concerned are monopolies (as defined in terms of a
regulate industries. These include OFTEL (which market share of 25% or more).
regulates the telecommunications industry), OFGAS Competition may also be promoted by reducing
(the gas industry), OFFER (electricity), OFWAT barriers to entry into industries and occupations.
(water) and OFLOT (the lottery). The regulator Deregulation has been used in the 1980s and 1990s to
checks the output and price decisions of the industry increase the role of market forces. For example bus
and can, if it thinks it appropriate, refer to the services were deregulated in 1986 and a number of
MMC. routes were opened up to greater competition from
Competition can also be promoted via merger different bus companies.
policy. A government can investigate proposed The government has also sought to promote
mergers and prevent those which act against the competition in the National Health Service by
public interest from going ahead. The MMC can developing an internal market, and in a range of other
investigate mergers that will result in the new areas by contracting out services to the most
company controlling 25% or more of the market or competitive bidder. These areas include schools career
has assets of £30 million or above. services, schools canteen services and refuse
Restrictive practice agreements concerning prices, collection.
 ¢ Industrial inertia occurs when a firm remains in
its original location even after the initial
advantages have disappeared.

A profit-maximising firm expands in a location (b) Location of industry in the UK

that minimises unit costs. The firm takes account See Table 11.1 on page 100.
of:

(1) Natural advantages, including: (c) Deindustrialisation

(a) the area’s proximity to raw materials;
Deindustrialisation refers to a continuing reduction in
(b) the physical features of the area;
the share of manufacturing in national output.
(c) the climate of the area.
Deindustrialisation may cause:
(2) Nearness to markets.
(3) Acquired advantages from other firms having (1) Unemployment if there is no corresponding
located in the area. (The resulting external increase in service-industry employment.
economies of scale are described in Table 6.4.) (2) Economic decline in regions with a high
(4) Government regulations and financial incentives concentration of manufacturing industries.
(regional policy). (3) A reduction in the rate of economic growth.
(4) A deterioration in the balance of payments if the
Weight-losing industries use bulky raw materials import of manufacturers increases while the
to produce a compact finished product, and tend to export of goods falls.
locate near a major source of raw materials.
Weight-gaining industries use compact raw
materials to produce a bulky finished product, and (d) The regional problem
tend to locate near a major market for the good. The regional problem refers to an uneven spread of
A footloose industry gains no cost advantage from living standards and employment levels between
any one particular site and therefore can set up different areas of the UK. A region may be in relative
anywhere. decline because:
Improved transport and power networks (e.g.
motorways and the national grid) have made many (1) Factory and office closures result in a regional
industries footloose. multiplier effect.
 mics market failure and government intervention

Table 11.1 Structure of UK industry by region

Standard regions Major industries

North Traditional heavy industry concentrated around Tyneside

and Teeside; public administration; vehicles
North-west Heavy engineering; cotton; clothing; glass; chemicals;
vehicles
Yorkshire and Humberside Iron and steel; textiles and clothing; fishing; agriculture
East Midlands Diverse industry, including hosiery, footwear and clothing
West Midlands Mechanical and electrical engineering; vehicles; iron
and steel; potteries.
South-west Agriculture and food processing; tourism; aerospace;
tobacco.
East Anglia Agriculture and food processing; footwear; tourism;
micro-technology
South-east Financial and commercial centre; technological and
light engineering; public administration
Wales Iron and steel; agriculture; light engineering.
Scotland North Sea oil; agriculture; tourism; construction
Northern Ireland Textiles; agriculture; construction; public administration
Nn

(2) Net migration from the area reduces: * Government measures have been mainly geared
(a) the local demand for products; towards moving jobs to workers rather than
(b) the local supply of skilled labour. workers to jobs.
(3) Local authorities have insufficient income to ¢ The European Regional Development Fund is
provide an adequate infrastructure and services. used to provide financial assistance to declining
(4) A contracting industrial base reduces the external regions.
economies of scale of an area.

(g) The urban problem

(e) Regional policy approaches
Since 1945 there has been a significant movement in
¢ Interventionist economists believe that market employment and population from conurbations to
forces will not remove regional differences and rural areas because:
that government policies are required.
* Supply-side economists favour removing (1) there is little urban land for expansion;
restrictions on free-market forces so that the (2) urban rents, rates and wages are high;
unemployed can move to prosperous regions and (3) more industries have become footloose.
firms can move to areas where inputs are cheaper.
¢ The most serious decline has occurred in inner-
city areas. The population has a high proportion of
(f) Regional policy measures semi-skilled, low-income and ethnic minorities
who cannot afford to move elsewhere.
* Government regional policy aims to reduce high
levels of regional unemployment and to reduce
congestion in prosperous areas. (h) Urban policy
* Assisted areas qualify for special government aid
including: Government urban policy instruments include the
(a) regional selective assistance (RSA), which
following:
covers financial aid for projects that either (1) Restricting the growth of urban areas through
create new jobs or preserve existing ones; green-belt legislation.
(b) regional enterprise grants (REGs), which are (2) Encouraging firms to locate in derelict inner-city
grants to help small firms in assisted areas. enterprise zones and simplified planning zones by
 oy
4 .
4
og

work out economics 4 region

Table 11.2 Multinationals

Advantages of MNCs for the host Disadvantages of MNCs for the host
country country

MNCs provide domestic employment MNCs may force competing local firms
opportunities out of business
Investment improves the current account Returned profits worsens future balance
of the balance of payments of payments
Investment increases the domestic MNCs may exploit monopsony (sole
growth rate buyer) power in wage negotiations
Imports replaced by home-produced MNCs may deplete local natural
MNC-made goods resources too quickly
Technology and production techniques Transfer pricing may be used to
are transferred. minimise tax payments.

offering rate and tax rebates, and exemption from (c) The regions of the UK are sometimes classified
many planning restrictions. in terms of North and South. Four regions are
(3) Encouraging investment in declining areas by grouped as the South, i.e. the East Midlands,
allowing ‘free ports’, where goods can be East Anglia, the South East and the South West.
processed for re-exportation without incurring Do the data support the view that living
customs duties. standards are higher in the South? (9 marks)
(4) Establishing urban development corporations (d) Name three other indicators of living standards
(UDCs) to buy up and improve derelict land with that could be used to make a comparison
the involvement of local private sector firms. between regions. (6 marks)
(e) Give three reasons why unemployed workers do
not move from regions of low income and high
(i) Multinationals
unemployment to regions of high income and
A multinational corporation (MNC) is a company low unemployment? (6 marks)
that produces in more than one country.
Example 11.2
The largest MNCs have turnovers in excess of the
GNP of most countries, and account for the bulk
1993
of world trade in manufactures.
GDP
MNCs reduce unit costs by locating different
(index Unemployment
production processes in different countries.
per head) (per cent)
Region (UK = 100) (UK average = 10.4)
11.2 I
North 89 12.0
Yorkshire & 91 10.4
Humberside
A study of what influences local firms to base East Midlands 96 9.6
themselves in the area, or a study of the performance East Anglia 102 8.2
of a multinational company and the influences on and South East 116 10.2
results of its locational decision. South West 97 9.5
West Midlands 93 10.9
North West 9] 10.8
Wales 85 10.4
Scotland 98 9.9
ny regions had below-average GDP per Northern Ireland 82 14.1]
ead? Z (2 marks)
(b) How many regions had above-average Sources: CSO, Social Trends, 1995; Monthly Digest of
unemployment? (2 marks) Statistics, March 1995
 éfket failure and government intervention

Solution 11.2 C the initial reasons for location have disappeared

D the share of manufacturing in national output
(a) Nine of the eleven regions had below-average
declines
GDP per head. These were the North, Yorkshire and
Humberside, the East Midlands, the South West, the
West Midlands, the North West, Wales, Scotland and Example 11.4
Northern Ireland. In other words, all regions except Weight-gaining industries tend to locate:
East Anglia and the South East. A in assisted areas
(b) Four regions had above-average unemployment. B_ close to major markets
These were the North, the West Midlands, the North C close to the source of raw materials
West and Northern Ireland. Two regions — Yorkshire D close to important transport networks
and Humberside and Wales — had unemployment that
equalled the national average. Example 11.5
(c) The data does not provide conclusive evidence of Which one of the following industries is the least
higher living standards in the South. All four Southern dispersed throughout the UK?
regions did have unemployment levels that were A Retailing B Agriculture
below the national average. However the C Tourism D Car manufacturing
unemployment rate in Scotland, a Northern region
was below that in the South East. Two of the Southern
Example 11.6
regions (the East Midlands and the South West) also
had below-average income per head and Scotland had Multinational corporations are firms that:
a higher rate than these two regions. A invest overseas
The three areas with the lowest income per head B_ export and import goods
(Northern Ireland, Wales and the North) were all in C have shareholders in many countries
the North. Similarly the three regions with the highest D produce goods in more than one country
unemployment were in the North (Northern Ireland,
the North and the West Midlands). Example 11.7
(d) There are number of possible additional Which of the following is not used by the UK
indicators of living standards that could be studied. government to solve regional unemployment?
These include average life spans, net migration A Enterprise zones
inwards or outwards, number of cars per head or B_ Direction of labour
number of a particular type of consumer durable per C Regional enterprise grants
head, e.g. washing machines. D Regional selective assistance
(e) Unemployed workers may not move to regions of
greater prosperity and lower unemployment because Example 11.8
of family ties, the difficulty of obtaining
accommodation in another region or lack of Which of the following is an example of infrastructure
qualifications and training for the jobs on offer there. improvement in the assisted areas of the UK?
It is also possible that, whilst other regions have lower A Development grants
unemployment, they may not necessarily have many B_ Low-interest loans
unfilled vacancies, suitable or otherwise. C Expenditure on road improvements
D Grants towards the cost of training labour

11.4 Objective questions Example 11.9

An example of an acquired locational advantage is:
Example Lee
A. flat land
Industrial inertia occurs when: B_ coal deposits
A labour is geographically immobile C amild climate
B firms fail to exploit economies of scale D an international airport
Example 11.10 farms and tourist organisations and companies.
There are a number of car companies in the UK
Which of the following industries is market
but these are less widely spread than business
orientated?
units in the agricultural, retailing and tourist
A Banking B_ Fishing
industries.
C Sugar-beet D Iron and steel

Example 11.11 Solution 11.6 Answer: D

Which of the following is an external economy? A multinational corporation is a firm with production
A Increased bureaucracy capacity located in two or more countries.
B Employment of specialist staff
C Bulk buying of raw materials
Solution 11.7. Answer: B
D The development of ancillary industries
Direction of labour has been used in the UK only
under conditions of war and then its aim was not to
Example 11.12
solve the regional problem.
A host country that allows a multinational company to A, C and D = are currently being used to reduce
undertake direct foreign investment generally benefits regional unemployment.
from:
transfer pricing
technology transfer Solution 11.8 Answer: C
rapid depletion of natural resources Infrastructure includes roads, bridges, sewers etc. It
on the multinational company gaining a monopsony particularly covers transportation and communications
position — the services that support industry.

Solution 11.9 Answer: D

An acquired locational advantage is an advantage that

has developed over time as a result of the deliberate
action of firms and/or the government.
A, B and C = are natural advantages.
Once the natural advantages of a site have
disappeared, the firm may still find it cheaper to
expand at its current location. This is because it is Solution 11.10 Answer: A
expensive to move plant to a new site. Hence steel
A market orientated industry is one based near to its
plants are found in areas where the local supply of
customers.
coal has long been exhausted.
B, C and D = are raw material orientated
D = refers to deindustrialisation.
industries.

Solution 11.4 Answer: B

Solution 11.11 Answer: D
As the finished product of a weight-gaining industry
tends to be relatively bulky in comparison with its raw An external economy is an advantage of an industry
materials, it is likely to locate near to its main growing in size which is available to the firms in the
markets. industry. The development of ancillary industries, i.e.
industries that produce raw materials, components and
services for the industry concerned, is a major
Solution 11.5 Answer: D external economy.
A dispersed industry is one spread throughout the A = is an internal diseconomy of scale.
country. In all counties there are, for example, shops, B and C = are internal economies of scale.
 failure and government intervention

Solution 11.12 Answer: B younger members of the local workforce have moved
to areas of high employment. The negative regional
A host country may be able to pick up information
multiplier reduces the size of the market, thereby
about developments in technology from multinational
reducing the area’s external economies of scale. Firms
companies setting up plants in the country.
that suffer industrial inertia expand at their current site
A, C and D = are potential disadvantages.
and their location decision is unaffected by regional
policy.
11.6 Essays — Regional policy is likely to be more successful in a
period of economic expansion. During a recession
Example 11.13 firms will not open up new factories and offices
and may be more concerned about the risks of
To what extent is the location of industry determined
relocating.
by government regional policy? (25 marks)
Firms where government financial incentives make
e Avoid simply describing the theory of location and up a large proportion of locations costs are most likely
the regional problem. to take account of regional policy. For example
e Explain how government industrial policy affects capital-intensive firms such as ICI have been attracted
industrial location decisions. into assisted areas. Multinational enterprises
¢ Consider the likely impact of other factors on considering direct foreign investment in UK
location. greenfield sites have accepted grants and located in
development areas. The Nissan plant at Washington in
Tyne and Wear is an example. However other
Solution 11.13
multinationals have emphasised different location
The UK is divided into eleven standard economic factors, such as proximity to markets and transport
regions. Income per capita tends to be higher and networks, in their location decision. Honda have sited
unemployment lower in the south than in the north. In their engine plant in Swindon without any government
theory, market forces should eliminate regional assistance.
disparities over time. The low wages and rents of Microtechnology is a footloose industry where no
depressed areas influence location decisions and one site offers a cost advantage. Transport costs are
attract new firms. However, capital and labour can be only a small proportion of total costs. Despite the
geographically immobile. allowances on offer elsewhere, many ‘sunrise’
To offset these market imperfections, a number of information technology firms have decided to locate
controls and incentives have operated since 1945 to along the M4 corridor between London and Bristol.
influence the location decisions of firms. Currently However government assistance has helped to create a
firms that locate in assisted areas may be able to gain high concentration of silicon chip firms in Scotland’s
regional selective assistance and, in the case of small glens.
firms, regional enterprise grants. In conclusion, it has been demonstrated that the
Firms, then, have to compare the cost advantage of financial assistance given by postwar regional policy
sites in development and non-development areas. is an important but not overriding consideration in the
Companies take into account the natural advantages of location decision of the firm.
an area, including the physical features and climate of
a region. The acquired advantages of an area, such as
transport network, labour force and proximity to Example 11.14
markets, are also important factors.
(a) What has caused the economic decline of inner-
However it is difficult to isolate the impact of
city areas of the UK? (15 marks)
government regional policy on location decisions
(b) Discuss possible remedies for this decline.
since 1945. Detailed regional statistics have only
(10 marks)
recently become available, and the areas actually
qualifying for assistance have been changed ¢ Explain what is meant by inner-city decline.
frequently. Let us consider the evidence. * Include examples of recent government policies
New firms may ignore offers of assistance and be and their effects.
reluctant to locate in declining regions because the (1) Discuss the negative multiplier effect.
 work out economics egior

Solution 11.14 residents are low-skilled low-income ones. As a

result, average earnings in outer areas have risen
(a) The decline in inner-city areas can be measured in
while inner-city earnings have declined. The resultant
terms of falling output, increased unemployment and
negative local multiplier effect has further reduced
below-average income levels. Two major factors have
income output and employment in inner cities.
contributed to this trend: (1) the movement of labour-
intensive firms away from inner areas and (2) the (b) Many argue that inner-city decline can only be
flight of well-paid employees to outer-urban and rural arrested by government intervention. One possible
areas. remedy is to offer firms incentives to locate in inner
One reason for the migration of inner-urban firms is cities. Since 1981 a number of enterprise zones in the
the introduction of modern production techniques, most derelict inner-urban areas have been established,
which have increased the demand for floor space. which give firms tax allowances and exemption from
Greenbelt restrictions and the active use of Industrial rates and certain planning regulations. Special
Development Certificates in the 1960s and 1970s agencies for urban renewal (urban development
made it difficult for firms seeking expansion to locate corporations) have been given resources to acquire
in inner-city areas. Footloose firms faced with high land, improve social and industrial infrastructure, and
rents and the availability of selective financial involve private-sector firms. Urban development
assistance in assisted areas have left some inner-city grants are available to encourage investment in inner-
areas. In the service sector, many companies have city areas that would not otherwise take place.
relocated their offices, with a subsequent loss of inner- In 1990 simplified planning zones were introduced
city office jobs. The continuous flight of firms to encourage firms to set up in deprived inner-city
generates a negative inner-city multiplier effect, areas. They do not provide financial incentives but
causing even further decline. The negative multiplier they do simplify planning regulations. 1991 saw the
effect is shown in the diagram. introduction of the City Challenge scheme. This
involves local authorities drawing up plans to
a + Local demand ae improve particular inner-city areas. The
Department of the Environment then selects the best
proposals.
1 Local incomes + Local output
Incentive schemes that are successful in generating
new investment have a spin-off multiplier effect.
De { Local employment Soh Local businesses experience an increase in the
demand for their products. Yet there is no guarantee
The type of external economy of scale available in that the employment created by new investment will
inner-city areas has changed. Transport economies automatically reduce unemployment in inner-city
gained by locating weight-gaining industries close to areas. New jobs may be filled by workers from other
the market have been eroded by diseconomies caused areas. Moreover incentives can have the effect of
by traffic congestion. Inner-city decline has left local simply diverting investment from one region to
authorities with insufficient income to maintain an another. Increased employment in inner-urban areas
adequate social infrastructure. would have taken place elsewhere. Government
Demographic trends also account for the decline of intervention can lead to a misallocation of resources.
inner-city areas. Many workers have used increased Siting production in inappropriate inner-urban areas is
real incomes to move to suburban and rural areas justified on the basis of the resulting social benefits.
where improved communications allow them to However these must be weighed against the costs of
commute to work. Many of the jobs left to inner-city not producing at the least-cost site.
12.1 Fact sheet Payment

(a) Factor incomes production

The demand for all factors of production (inputs) is a

derived demand — i.e. the demand for factors of P,

production depends on the demand for the products

they produce. In return for providing their services,
land, labour, capital and entrepreneurs receive factor
incomes.

0 Che io; Units of factor of

(b) Marginal revenue productivity production

The demand for a factor of production is based on Figure 12.1 An increase in marginal revenue productivity

its marginal revenue productivity.

Marginal revenue product is marginal physical (b) encourages invention and innovation;
product multiplied by marginal revenue: (c) indicates efficiency;
MRP = MPP X MR (d) encourages firms to switch resources
MRP will increase if either MPP and/or MR from loss-making to profit-making
rise. operations;
An increase in MRP will increase the payment the (e) provides a source of finance for investment.
factor receives, as shown in Figure 12.1

(d) Economic rent

(c) Profit
Rent is a payment made for the use of an asset
Profit is the reward for bearing uninsurable risks owned by someone else.
associated with production. The types of profit are Economic rent is a surplus paid to any factor of
explained in Table 8.2. Note that profit is uncertain production over its supply price.
and may even be negative. Profit has the following Transfer earnings is the minimum payment
functions: needed to keep the factor in its present occupation.
(a) rewards those who bear uncertain risks; This can also be defined as the payment that can
 work out economics ncom

Factor Factor Economic Factor

income income rent income
S D

Ww Ww 5
w
Economic D
rent Transfer D Transfer D
earnings earnings

0 Q Quantity 0 Q Quantity 0 Q Quantity

(a) (b) (c)

Figure 12.2 Economic rent and elasticity of supply: (a) perfectly inelastic supply; (b) elastic supply; (c) perfectly elastic supply

be earned in the factor’s next-best-paid occupation °¢ The loanable funds (classical) theory states that
(opportunity cost): the rate of interest is determined by the demand
present earnings less transfer earnings = economic for loanable funds (largely for investment) and the
rent. supply of loanable funds (savings) (Figure 12.3).
(lawyers pay £40 000) less (teacher’s pay ° Keynesian theory states that the rate of interest is
£22 000) = £18 000. determined by the demand for and supply of
¢ Quasi-rent is short-term economic rent arising money. For simplification, the supply of money is
from a temporary inelasticity of supply. presumed to be largely government-determined
e Pure economic rent is the reward to any factor that and to be perfectly interest-inelastic. Keynes
is in completely inelastic supply. identified three motives for demanding money
¢ The proportion of a factor’s earnings made up of (liquidity preference) — that is, for holding wealth
economic rent increases as supply becomes more in the form of money:
inelastic. (a) the transactions motive is the desire to keep
money to make everyday purchases.
(b) The precautionary motive is the desire to hold
(e) Interest money to meet unexpected expenses and take
¢ Interest is the reward for forgoing liquidity, and is advantage of bargains.
an amount paid to a lender over and above the (c) The speculative motive is the desire to hold
original sum borrowed. idle balances to take advantage of changes in
the price of bonds.
In Figure 12.4 the liquidity trap occurs after point
fob Supply A, when the rate of interest is so low (and the
caeatee? ae bhie price of bonds is so high) that everyone anticipates
funds a future fall in the price of bonds. If the money

Rate
of
interest

R
Demand for
loanable funds

0 Q Quantity of
loanable funds 0 Q Quantity of money

Figure 12.3 The determination of the rate of interest according to Figure 12.4 Determination of the rate of interest according to the
the loanable funds theory liquidity preference theory and the liquidity trap
108 Perko nomics r cet failure and government intervention

Table 12.1 Functional distribution of income in the UK, 1993

Share of total earnings

Source (factor of production) (£m) (%)
Income from employment 352 896 64.6
Income from self-employment 61 360 11432
Profit 74 733 /
Rent 52 872 a7
Other 4259 0.8
Total domestic income 546 120 100.0

Source: Adapted from Blue Book, 1994 edition, UK National Accounts (CSO)

supply increases, people will hold all the extra

money for fear of making a capital loss from % of
income
holding bonds. Hence the demand for money
becomes perfectly interest-elastic.

(f) Wages
Wages are a payment to labour. A number of factors
help determine wage rates:

(1) Demand for, and supply of, labour. The marginal

productivity theory suggests that any factor of
% of population
production will receive a payment equal to the
value of its marginal product. So in the case of Figure 12.5 The Lorenz curve. OY = complete equality;
OXY = complete inequality, with the last person having all the
labour: wage rate = marginal revenue product. income; OZY = degree of inequality
(2) Government action in the form of incomes
policies, arbitration and conciliation, and as an
employer.
The Gini coefficient has a range from 0 (complete
(3) Trade unions and professional organisations.
equality) to 1 (complete inequality).
Income has become more unevenly distributed
(g) Income distribution since 1979. In 1979 the top fifth of individuals
received 35% of disposable income. By 1992 this
Income is a flow of earnings. The functional
had risen to 41%.
distribution of income is the distribution of income
between factors of production.
The size distribution of income is concerned with
the proportion of income received by different
proportions of the population. The degree of (h) Wealth distribution
income inequality can be represented by Lorenz
Wealth is a stock of all those assets capable of
curves and Gini coefficients.
earning an income.
The Gini coefficient is the ratio between the area
Wealth can be human (e.g. skills, qualifications) or
material (e.g. time deposits, shares, property).
between a Lorenz curve and the 45° line and the
Inheritances, capital gains, pensions and savings
area below the 45° line:
are the major sources of wealth.
area da 100 Note that wealth is more unequally distributed
areaat+b 1 than income in the UK.
 work out economics inco

Table 12.2 Distribution of wealth in the UK in 1992

Marketable Marketable wealth less value

% of wealth owned by wealth (%) of dwellings

Most wealthy 1% 18 29
Most wealthy 5% 37 53
Most wealthy 10% 49 65
Most wealthy 25% V2 82
Most wealthy 50% 92 94

Source: Social Trends 1995 (CSO)

ative study in absolute or relative poverty? Explain your

answer. (5 marks)
(d) Which groups of the poor would benefit from the
introduction of a minimum wage? (4 marks)
An assessment of the effect of profit sharing of (e) Identify two other measures to reduce poverty.
schemes on, for example, labour productivity, labour (4 marks)
turnover and profitability. (f) How would the reduction in poverty benefit
those not directly affected by poverty? (5 marks)

Solution 12.2

(a) The report by the Joseph Rowntree committee

The poor get poorer found that the distribution of income became more
uneven between the late 1970s and early 1990s. The
THE gap between the incomes of the national average. The number
the rich and poor in Britain grew fell from 10 per cent in the 1960s
gap between rich and poor widened. This is in
rapidly between the late 1970s to a low of 6 per cent in 1977 contrast to previous recent periods, when income
and the early 1990s, ending a but has since risen to over 20 per
process of increasing equality that cent. became more evenly distributed.
stretches back for several cen- Government ministers dispute
turies. that the growing divide between (b) Absolute poverty has to be related to a level of
A report earlier this month by high and low incomes has left
poorer people worse off than
living standards considered necessary for human
the Joseph Rowntree Foundation,
which funds research into eco- when the Conservative Party came health and existence. Those living below this level can
nomic and social issues, said that to power in 1979. Both the Prime
between 1979 and 1992 the poor- Minister and the Social Security
be said to be experiencing absolute poverty. Relative
est 20-30 per cent of the popula- secretary, Peter Lilley, said last poverty is experienced by those who are poorer than
tion failed to benefit from week that all groups in society
economic growth. It warned that had seen their standards of living other members of the community. The extract refers
the way in which the living stan- rise, even though the Department to 20% of the British population living on incomes
dards of a sizeable minority of of Social Security’s own figures
people had lagged behind over the show that the poorest 10 per cent less than half the level of the national average. This
past 15 years was not only a prob- of the population saw __ their 20% forms the lowest quintile group of income
lem for those affected directly, but incomes fall by more than 15 per
also damaged ‘“‘the social fabric cent between 1979 and 1992, once recipients.
and so affects us all”. the cost of housing was taken into
The Rowntree report found that account. (c) The Social Security Secretary, Peter Lilley, was
there had been a sharp increase in
the number of people living on
Source: Extract from the denying a rise in absolute poverty. He claimed that all
Guardian, 21 February 1995.
incomes less than half the level of groups had experienced a rise in living standards. His
view was that whilst the gap between rich and poor
had increased, the greater distance was between those
(a) What happened to income distribution who had become substantially richer and those who
between the late 1970s and the early
had become richer by small amounts.
1990s? (2 marks)
(b) Distinguish between absolute and relative (d) Single people of working age, one-parent
poverty. (5 marks) families, and working-age couples with and without
(c) Was the Social Security Secretary denying a rise children would benefit if they are in employment,
 <e

110 Awork out egonomics * mark t failure and government intervention

initially receiving less than the national minimum Example 12.4

wage, and if they remain in employment after its
The diagram at the foot of the previous column shows
introduction. Pensioners and the unemployed would
a firm producing under conditions of monopoly.
not benefit directly.
OYBZ contains:
(e) Among other suggested measures to reduce A supernormal profit B_ normal profit
poverty are: C economic rent D quasi-economic rent?

(1) increasing benefits and pensions;

(2) increasing tax thresholds and lowering the Example 12.5
standard rate of taxation;
An acre of land could receive a yearly rental of £5000
(3) retraining, training and education;
in its least remunerative occupation. It is currently
(4) increasing employment by increasing demand
earning £7600 in its present use. Which of the
and/or incentives.
following statements is correct?
(f) A reduction in poverty would benefit society in a A Transfer earnings are £2600
number of ways. Demand and output are likely to rise. B_ Economic rent is £2600
Tax revenue would rise and the need for government C Economic rent is £5000
expenditure on social security and health care D Economic rent cannot be determined from the
associated with illnesses related to poverty would fall. information given.
The education performance and future productivity of
the children of previously poor families is likely to
Example 12.6
increase. The stock of housing would be better
maintained and the circle of poverty could be broken. The following diagram shows the demand for and
supply of a group of workers.

12.4 Objective questions

Example 12.3
Normal profit is:
A the positive difference between total revenue and
total cost
B_ the level of profit earned where marginal cost
equals marginal revenue
C the average level of profit made by the firms in the
industry
0 Q Number of workers
D the level of profit necessary to keep the firms in the
industry in the long run.
If OQ workers are employed, what are the total
Costs/ transfer earnings received by the labour force?
revenue
A OWZQ B WXZ Caz D 0XZQ

Example 12.7
Which of the following is an example of quasi-
rent?
A Normal profits earned under conditions of perfect
competition
B_ Supernormal profits earned under conditions of
perfect competition
C Normal profits earned under conditions of
monopoly
Output
MR D Monopoly profits
 work out ey fee” /woah

Example 12.8
Number of workers Total output
If the market rate of interest is 12%, what will a bond
2 560
paying £18 interest sell for now?
3 640
A £88 B £112 C £150 D £168
4 740
a 810
6 850
Example 12.9

The liquidity trap is said to occur when: The price of the product is £4 and the wage rate is
A achange in the rate of interest has no effect on the £280. How many workers should the firm employ to
price of bonds maximise profits?
B_ achange in the price of bonds has no effect on the A 3 B 4 Gigs) D 6
rate of interest
C demand for money becomes perfectly elastic as
people expect the rate of interest to rise in the 12.5 Solutions to objective
future questions —
D demand for money becomes perfectly inelastic at
high rates of interest as people expect the rate of Solution 12.3. Answer: D
interest to fall in the future. Normal profit 1s the supply price of entrepreneurship
—i.e. the minimum that needs to be paid to
entrepreneurs for them to supply their services and
Example 12.10 keep their firms in the industry. This can also be
referred to as transfer earnings.
Year 1 Year 2
A => refers to supernormal profit.
Hourly wage rate £6 a1 B = A firm that produces where MC = MR is
Price index 120 150 producing at the equilibrium output, and this may be
where normal profits are earned. However it may also
be where supernormal profits or losses are earned.
The above table shows that between years | and 2 the C = In the short run, under any market structure
hourly wage rate in real terms changed by the average level of profit may be supernormal,
approximately: normal or subnormal. In the long run, under
A 126% B 83% C 47% D 333% conditions of perfect competition and monopolistic
competition the average level of profit will be normal
profit but under conditions of oliopoly and monopoly
Example 12.11 it may be supernormal profit.
Demand for a factor of production will be more
elastic: Solution 12.4 Answer: B
A the less elastic the demand for the final product
OYBZ represents the cost of producing OZ quantity.
B the greater the level of employment of factors in
Normal profits are included in costs of production, so
the economy
costs of production include the return to all the factors
C the greater the ease with which the factor input can
of production — i.e. wages, interest, rent and normal
be substituted by other inputs
profit. In this case the firm is producing at the point
D the lower the proportion of the cost of the factor in
where total revenue is greater than total cost, and
the total cost of production
hence it is earning more than normal profits. The area
of supernormal profits is shown by YXAB.

Example 12.12
Solution 12.5 Answer: D
A firm operating under conditions of perfect
competition in both the labour and product markets is If an acre of land can earn £5000 in its least
faced with the following output schedule: remunerative occupation, the word ‘least’ implies that
pa out ed6r arket failure and government intervention

the land has more than two uses. Economic rent is a of interest is very low (and hence the price of bonds is
surplus above what can be earned in its next best paid very high), everyone might expect that the price of
occupation — i.e. above transfer earnings. In this case bonds will fall and the rate of interest will rise in the
it is not known what can be earned in the next best future. They will hold any increase in the money
paid occupation — just what can be earned in the least supply, since they will not want to buy bonds now for
most profitable use. So it is not possible to calculate fear of making a capital loss if and when their price
economic rent or transfer earnings. falls.

Solution 12.6 Answer: A

Solution 12.10 Answer: C
Transfer earnings is the minimum that must be paid to
To calculate rises in real income it is first necessary
keep a factor in its present occupation. It is shown by
to remove the effects of price changes by use of
the area below the supply curve.
a price deflator. In this case money wages rose
B => WXZ represents economic rent.
to £11 when the price index increased from 120
C => XYZ is consumer surplus.
to 150. Thus in year 2 the real wage changed
D => OXZQ represents total earnings, consisting of
to:
both economic rent and transfer earnings.
price index in base year 120
£TTex oS
(haa
ak: iS = £11 xX —
Solution 12.7. Answer: B price index in current year 150
= £8.80
Quasi-rent is short-run economic rent. In the long run
it is usually competed away by an increase in the So in real terms the wage has risen by £2.80, which in
supply of the factor concerned. percentage terms is:
Supernormal profits are a surplus over what is
2.80
necessary to keep the firm in the industry. In perfect — x 100=4
6.00 ? ue
competition these will last only in the short run, since
in the long run new firms will be attracted into the
industry, which will lower price and return output to
the normal profit level. Solution 12.11. Answer: C
A and C => Normal profits represent transfer
Demand for a factor of production will be elastic
earnings.
when a rise in the price of the factor causes a greater
D = Monopolists may produce at the point where
percentage fall in demand for the factor. If a factor can
AR > AC in the long run, and so in these cases
be easily substituted by another factor, if it rises in
supernormal (monopoly) profits may be regarded as
cost the employer will switch to using more of the
economic rent.
other factors.
A, B and D = In each case demand will be
Solution 12.8 Answer: C inelastic and a rise in price of the factor would
If the market rate of interest is 12%, a bond paying cause a smaller percentage fall in demand for the
factor.
£18 interest will sell for a figure that means that £18 is
12% of it:

Solution 12.12 Answer: C

In theory, a firm will employ the number of

The bond will sell for £150, earning £18 interest, workers where the wage rate equals the marginal
i.e. 12% interest. revenue product of labour. To calculate MRP it is
necessary to work out marginal product (change in
Solution 12.9 Answer: C total output as a result of employing one more
workers) and multiply it by MR (which, under
Keynes believed that, at a low interest rate, demand conditions of perfect competition, equals price). So in
for money could become perfectly elastic. If the rate this case:
 work out ey A yf wealth:

elastic no economic rent will be received and all of

Marginal
the earnings will represent transfer earnings. In
Numberof Total product Marginal = MRP
practice, for most factors supply will be neither
workers output (£) revenue (¢£)
perfectly elastic nor perfectly inelastic. Figure 1
1 500 shows that in a case where supply is relatively elastic
2 560 60 4 240 some of the payment received will represent economic
3 640 80 4 320 rent, while the rest will represent transfer earnings.
4 740 100 4 400
5 810 70 4 280
6 850 40 4 160

Thus the wage rate of £280 equals MRP when five

workers are employed.
Economic
rent

Transfer
earnings

(a) What is meant by economic rent? (10 marks)

(b) Why do some economists argue that taxes should 0 Q Quantity
be imposed on economic rent? (15 marks)
Figure 1
¢ Define economic rent and give examples.
¢ Explain the main determinants of economic rent. (b) It is sometimes suggested that a tax should be
¢ Discuss the effect on resource allocation of a tax placed on economic rent, as it is a surplus. If some but
on economic rent. not all of this surplus is taken by the government in
tax, then the factors are unlikely to transfer to other
uses. For instance, if a model is being paid £4000 per
Solution 12.13
week when her next best paid occupation is as a shop
(a) Economic rent can be earned by any factor of assistant earning £170 per week, then taxing the
production. It is a surplus paid above the income economic rent of £3830 at 90% is unlikely to result in
needed to keep that factor in its present occupation. her giving up her modelling job.
For instance, a football player earning £6000 a Monopoly profits are a form of economic rent, and
week may have as his next best paid occupation a tax on monopoly profits (provided that it is less than
bricklaying, for a wage of £300 a week. So the 100%) will not result in a change in the output or
football player will be receiving an economic rent of
£5700 and the opportunity cost of his present job will
Costs/
be the £300 (transfer earnings) he is forgoing as a
revenue
result of being a professional sportsman. Similarly, an
area of land that is used for industrial purposes may
receive a rent of £1000 per week, whereas if it were to TC,
be used for residential purposes it might receive a rent
of £800. So the land will be receiving an economic TC,

rent of £200. If a piece of machinery has no

alternative use, then all of its earnings will be
economic rent. TR
Indeed one of the main determinants of the
economic rent a factor receives is that factor’s
elasticity of supply. If supply is perfectly inelastic,
0 Q Output
then all of the factor’s earnings will constitute
Figure 2
economic rent, whereas if the supply is perfectly
 work out ego failure and government intervention

pricing policy of the monopolist. Figure 2 shows the bonds, shares, antiques etc. It is referred to as
total revenue and total cost curves of a monopolist. liquidity preference.
Prior to the imposition of a tax, maximum profits are There are thought to be three main reasons why
earned at 0Q output. The imposition of a tax causes economic agents hold their wealth in a money form.
the total cost curve to shift from TC, to TC,, but the One is the transactions motive. People hold money in
maximum profit output remains at 0Q. Some order to buy goods and services. Influences on how
economists argue that at least part of monopoly profits much they hold include income levels, price levels
should be taxed away on grounds of equity. and how frequently they are paid. Another motive is
The economic rent on land can also be taxed the precautionary motive. This refers to money held to
without affecting the allocation of resources. If all meet unexpected expenses and take advantage of
land, irrespective of use, is taxed at the same rate, the unexpected bargains and opportunities.
relative profitability of different uses will be It is thought that both the transactions and
unaffected. As supply will be unaffected, prices will precautionary motives are interest inelastic as a
not change and the burden of the tax will fall entirely change in the interest rate will not have a significant
on landlords. In addition, some economists argue that effect on the amount of money held.
the economic rent earned on land should be taxed,
because a high return from land may result partially
Rate
from public spending on the infrastructure. of
However, 1n practice it is not always easy to interest
identify economic rent, particularly as it may be
difficult to ascertain what a factor’s transfer earnings
are. For instance, at any particular time few workers
will know with certainty what employment they
would be able to gain if they left their present jobs.
Liquidity preference
So economic rent is a payment in excess of transfer (transactions and
earnings that may be earned by any factor of precautionary motives)
production that is not in perfectly elastic supply. It has 0 Quantity of money
been suggested that economic rent could be taxed Figure 1
without affecting the allocation of resources, but in
practice it can be difficult to isolate that part of a The speculative demand for money is much more
factor’s payment which represents economic rent. sensitive to interest rate changes. This motive is
concerned with money held, mainly by those who
deal in financial markets, to take advantage of changes
Example 12.14 in the price of bonds. If the price of bonds is low and
(a) What determines the demand for money? hence the rate of interest is high (since the price of
(15 marks) bonds and the rate of interest move in opposite
(b) What effect will an increase in the supply of directions), people will wish to buy bonds. This is
money have on the rate of interest? (10 marks) because they will expect the price of bonds to rise in
the future, when they will make a capital gain, and
* Explain what is meant by the demand for money. because meanwhile they will be enjoying a high rate
* Cover the transactions, precautionary and of interest. Figure 2 shows the speculative demand for
speculative motives. money.
* Include diagrams. Some economists include a fourth motive. This is
* Bring out the difference between Keynesian and the assets motive, which sees money being held as
monetarist view points. one of a range of assets, including shares. The amount
of each type of asset held will depend on the
significance of their returns to the holder. Shares
Solution 12.14
provide dividends, bonds provide interest and money
(a) The demand for money means the demand to hold liquidity.
wealth in the form of notes, coins and sight deposits The overall shape of the liquidity preference curve
rather than in the form of, for example, government will depend on which motive is dominant. Keynesians
 work out scbacitiagtocorl yf wealt

(b) An increase in the money supply will cause the

Rate of
interest
money supply curve to shift to the right and the
interest rate to fall.

MS;
Interest
rate

Liquidity preference
(speculative motive)

0 Quantity of money R
Liquidity
Figure 2 preference
R;,

believe that the speculative motive is the most

important one and so think that demand for money is
interest elastic. In contrast monetarists believe that the
transactions motive is the most dominant one and so 0 Q Q,
demand for money is more interest inelastic. Figure 3 Quantity of money
contrasts the Keynesian view (a) and the monetarist Figure 4
view (b).
When the money supply increases, people will be
Interest rate holding more money than they desire. They will use
at least some of their increase in money balances to
buy bonds. This higher demand for bonds will
increase the price of bonds and lower the interest
rate. How much the interest rate falls will depend
on the size of the change in the money supply
and how elastic the demand for money is. As
Keynesians believe that demand for money is more
elastic than monetarists do, they think the fall will
L
be smaller. Indeed at very low interest rates
Keynesians believe that demand for money may

0 Quantity of money
(a)
Interest
Interest rate rate MS MSi

0 Q Q,
0 Quantity of money
Quantity of money
(b)
Figure 5
Figure 3
Boy & out foriceap failure and government intervention

become completely interest elastic. In this case When the interest rate is very low, and hence the
(often referred to as the liquidity trap) an increase in price of bonds is very high, people may believe that
the money supply will have no effect on the demand the price of bonds will fall in the future and therefore
for money. will hold on to any extra money balances.
 ¢ Pareto efficiency criteria cannot be used in
resource decisions where someone gains and
al resource allocation someone loses as this requires the use of equity
criteria.
Economic systems have to choose between alternative ¢ Equity judgements can be made by using the Kaldor—
allocations (uses) of land, labour and capital. Welfare Hicks test. A change in production or distribution
economics provides a framework for deciding on the is desirable only if those who gain can compensate
optimal (best) use of scarce resources. A particular those who lose, and still be better off. Note that
resource allocation is assessed by using: compensation does not necessarily take place.

(1) Efficiency criteria (rules) first developed by

Pareto, whereby the economy should have:
(b) Social costs and social benefits
(a) Technical or productive efficiency. This
occurs when resources are fully employed and Analysis of a resource allocation requires an accurate
all firms are producing at minimum average valuation of the true costs and benefits involved in
cost. It is then impossible to increase the economic activity, including externalities.
output of any one good without reducing the Externalities are the spillover effects of production or
output of some other good. consumption, for which no compensation is paid.
(b) Consumption or allocative efficiency. This Externalities can be positive (e.g. beekeepers
occurs when it is impossible to redistribute indirectly provide a source of pollination to market
products to increase the welfare of any one gardeners).
consumer without reducing the welfare of Social benefit = private benefit + positive
some other consumer. externalities
(2) Equity (fairness) criteria, which judge the (benefit to the individual) +
‘desirability’ of a particular resource allocation. (benefits to third parties)

¢ Using Pareto criteria, a reallocation of resources Externalities can also be negative (e.g. pollution from
is desirable only if someone gains and no one a power station may damage the health of local
loses. residents).
* A Pareto optimal allocation of resources exists
when no one can be made better off without Social cost = private cost + negative externalities
(cost to the individual) + (costs to
someone else being made worse off, following a
reorganisation of production or distribution. third parties)
ny out Horie: failure and government intervention

Figures 13.1 and 13.2 show the effect of externalities In Figure 13.4, Q is the socially efficient level of
on social cost and social benefit. output where SMC = SMB. Only Q, is supplied by
Where social marginal cost exceeds private the industry. The resulting underproduction results in
marginal cost there is an external marginal cost. a welfare loss triangle of JKL.
Where social marginal benefit exceeds private
marginal benefit there is an external marginal benefit.
Price

SMC
Price

PMC
EMC

0 Q Q; Output

0 Output Figure 13.3 Negative externalities

Figure 13.1 Social marginal cost

Price

Price

EMB

SMB

D=PMB 0 Q; Q Output

“ Output Figure 13.4 Positive externalities

Figure 13.2 Social marginal benefit

(d) Market failure through public

goods, merit goods and demerit
(c) Market failure goods
Market failure occurs when the price mechanism . A public good is a product such as defence that
results in an inefficient allocation of resources. is:
An efficient allocation of resources occurs in a (a) non-rival — i.e. an individual’s consumption of
market where the opportunity cost of the extra unit a public good does not reduce its benefit to
(SMC) equals the value placed by society on its others;
consumption (SMB) — i.e. where SMC = SMB. (b) non-excludable — i.e. once a public good is
provided, others cannot be stopped from
consuming it.
(d) Market failure through
The non-excludability of a public good
externalities
encourages some consumers to avoid payment and
Figures 13.3 and 13.4 show market failure caused by become free riders.
negative and positive externalities. A merit good is a product that consumers may
In Figure 13.3, Q is the socially efficient level of undervalue but the government believes is
output where SMC = SMB. Q, is supplied by the ‘good’ for consumers, e.g. education. Unlike
industry. The resulting overproduction results in a public goods, merit goods can be bought and
welfare loss triangle of ABC. sold.
 work out conf e ae taille D8

¢ A demerit good is a product that consumers may dd —

Regulating companies, e.g. requiring car
overvalue but the government believes may be companies to fit antipollution exhaust
harmful to consumers, e.g. alcohol. systems.
¢ Market failure occurs because profit-maximising (2 Extending property rights so that, for example,
—

firms underproduce public and merit goods and people affected by air pollution can sue.
overproduce demerit goods. (3) Subsidising goods that create positive
externalities.
(4) Taxing or banning demerit goods.
(e) Market failure through (5) Providing information about merit goods and
imperfect competition demerit goods.
Assuming no externalities, marginal cost (MC) equals (6 Producing the goods itself or contracting private
—

social marginal cost (SMC) and price (P) accurately sector companies to produce the goods.
measures social marginal benefit (SMB). Figure 13.5 (7) Redistributing income by means of direct taxes
and Table 13.1 indicate that, unless a firm sets output and benefits.
at the point where the cost of making the last unit
equals its price (marginal cost pricing), market failure (g) Cost-benefit analysis
results.
Cost—benefit analysis (CBA) is a method of assessing
the social costs and benefits of an investment project.
This involves comparing the private costs and
negative externalities of a scheme with its private
benefits and positive externalities, using money as a
measure of value. Problems involved in CBA occur
because:

(1) Externalities are difficult to measure:

(a) negative externalities are valued by
calculating how much those who suffer need
to be compensated;
(b) positive externalities are valued by estimating
Q3 Q, Q; Output the change in consumer surplus of those
affected by the project.
Figure 13.5 Alternative pricing policies in imperfect competition (2) Future costs and benefits are difficult to measure.
The present value (P) of future net social benefits
* Nationalised industries generally use a marginal (social benefits less social costs) is found by
cost pricing policy. Following privatisation the discounting. For example £500 lent for two years
same firm will underproduce if it uses a profit- earning 10% interest per annum is worth: £500
maximisation pricing policy. (loan) + £50 interest (in year 1) + £55 interest (in
year 2) = £605 (total). Therefore the PV of £605

(f) Measures to correct market in two year’s time, discounted at 10% per annum,
failure is £500.

There are a number of measures a government can ¢ A scheme is worth undertaking only if the present
take to correct market failure. These include: value of net social benefits is positive.

Table 13.1 Consequences of pricing policies

Price Output Result Welfare loss
Pricing policy Condition
P, Q, Overproduction Triangle AJK
Average cost P =AC
FP, Q; Overproduction Triangle ABC
Profit maximisation Mc =MR
=MC P, Q, Efficient production None
Marginal cost P
120 failure and government intervention

(h) Green economics (c) The extract mentions four government measures.
One is fining those who leave litter in a public place
Green economics, which can also be called
or who dump it away from designated areas, e.g.
environmental economics, is the study of
council rubbish tips. It will also take legal action,
environmental issues, including the depletion of non-
including fining local authorities that fail to keep
renewable resources, the recycling of paper and other
public places as litter-free as practically possible. It
materials, and pollution.
gives financial support to the Tidy Britain Group and
° Green taxes are taxes imposed with the objective
runs anti-litter advertising campaigns.
of improving the environment.
In addition to these measures outlined in the
extract, the government promotes the recycling of
gative study
RO” Eh Siseasiee
waste materials by requiring local authorities to make
plans for the recycling of waste.

Feeae SS am (d) Many people might think that the optimum level
A cost-benefit analysis carried out on a local issue, of pollution would be zero. However to achieve an
e.g. assessing the costs and benefits of widening a entirely and permanently litter free environment
local road. would require the use of a vast number of resources.
For instance, even in a small town 600 workers and 60
machines may be needed. Society would view the
13.3 Opportunity cost as too high as the quantity of other
goods and services produced would have to fall to
release the resources for eliminating pollution. Figure
1 illustrates the optimum level of pollution which is
‘It is a criminal offence to leave totalling £2.9 million in 1994-95
litter in any public place in the — is given to the Tidy Britain 0Q.
open air or to dump rubbish Group, which is recognised as the
except in designated places. The national agency for litter abate-
Cost per
maximum penalty was raised in ment. It provides a comprehensive Marginal social
pollution
1992 to £2,500. The Act also litter abatement programme in unit cost of pollution
introduced new duties on local collaboration with local authori-
authorities to keep their public ties and the private sector. The
land as free of litter and refuse Group secures sponsorship from
(including dog faeces) as practi- industry to undertake litter abate-
cable and new powers for the ment promotions and programmes
public to take action against those such as its Neighbourhood Care
who fail to comply with their Scheme.’
responsibilities.
(Britain 1995: An Official
To help counteract the problem Marginal
Handbook, London: HMSO)
of litter, financial support — social cost
cost of
pollution
(a) Explain why litter is a negative externality. abatement
(4 marks)
(b) Identify two other forms of pollution. (2 marks)
(c) Discuss the ways in which the government seeks Quantity of
pollution
to reduce the problem of litter. (6 marks)
(d) Explain why the optimum level of pollution is Figure 1
not zero. (13 marks)
Reducing pollution to 0Q, would involve a welfare
Solution 13.2 loss. This is because the marginal social cost of
reducing pollution would exceed the benefit people
(a) A negative externality is a cost on third parties would receive. The resources that would have to be
resulting from the activity of others. A person who employed to reduce the quantity of pollution from 0Q
drops litter reduces the quality of the environment for to 0Q,, could be used to greater benefit producing
others. Some forms of litter may, in addition, pose a other products.
health threat, e.g. broken bottles and dog faeces.

(b) There are a number of other forms of pollution,

including water and noise.
 work out conf peat taitagh21

ye questions Example 13.6

The private costs of a firm do not equal its social
eet! costs. All other things being equal, which one of the
Market failure occurs when there is an imperfectly following government actions improves welfare?
competitive market because: A Tax the firm if social costs are less than its private
A price exceeds marginal cost costs
B all firms are profit maximisers B._ Tax the firm if social costs are more than its
C marginal cost exceeds marginal revenue private costs
D firms overproduce merit goods and underproduce C Subsidise the firm if social costs are more than its
demerit goods private costs
D Close the firm down if social benefits minus social
costs are positive.

Example 13.4
The following data refer to a cost—benefit analysis of
The : Example 13.7
three possible investment projects
The data below refer to a chemical factory that creates
a spillover effect in the form of river pollution:
Project Project Project
J K L Output (units) Lui 2290354 Fon Ges G
: Average revenue (£) 14120 106s Sola Om 2
Marginal private cost(£) 2 4 6 8 10 14
Private benefits
125 140 50 Marginal external cost(£) 2 3 4 5 6 8
(£000s)
Private costs
(£000s) 115 150 90 Assuming no external benefits, the socially efficient
External benefits level of output is:
(£000s) 75 50 200 A 2 B 3 Gx4 D 5
External costs
(£000s) 100 10 150
Example 13.8

It can be deduced that economic welfare would be Goods that could be provided by the market
improved by undertaking: mechanism, that have positive externalities and are
A project J only often supplied by the government are known as:
B projects J and K A merit goods B_ public goods
C projects K and L C Veblen goods D inferior goods
D projects J, K and L

Example 13.9

pps. |3.5 A government taxes a firm by an amount equivalent to

The government decides to fit filters to reduce the the external costs it imposes on the rest of society by
amount of sulphur dioxide discharged into the its productive activity. What will be the results?
atmosphere by power stations. To maximise net social A The firm will increase its output in order to cover
benefit, the government should fit extra filters up to its higher costs
the point where: B Production and resource allocation will not change
A total social benefit is maximised C The tax will increase the gap between the firm’s
B marginal social benefit is maximised social and private costs
C total social benefit minus total social cost is zero D There will be an improvement in resource
D marginal social benefit minus marginal social cost allocation as prices will move accurately to reflect
is zero costs and benefits.
 1afket failure and government intervention

Example 13.10 Solution 13.4 Answer: C

Which of the following comes closest to being a pure Adding together private and external benefits gives
public good? social benefits. Adding together private and external
A Education B_ Flood control costs gives social costs. Subtracting social costs from
C Medical care D Postal services social benefits gives net social benefits. If net social
benefits are positive, general welfare can be increased
by undertaking the project.
Example 13.11
The most common use of cost-benefit analysis has
Project Project Project
been for planning:
ai K rh
A the budget position
B_ public sector investment schemes Social benefit
C the pricing policy of private sector firms (£) 200 190 250
D the level of government Social cost
(£) 215 160 240
Example 13.12 Net social benefit
(£) = by 30 10
Demerit goods are products that:
create positive externalities
can only be bought in a black market
are likely to be overconsumed in a market economy
Solution 13.5 Answer: D
— involve no external costs in production or
lo
--
consumption Welfare is improved by fitting an extra filter, provided
that the social benefit from the extra filter is greater
than or equal to the social cost of installation.
13.5 Solutions to objective
A and B = ignore the social costs of installation.
ques 7 C = The decision to install extra filters requires a
marginal and not total method of analysis.
Solution 13.3. Answer: A
Market failure occurs when a free market economy
fails to reach a Pareto optimal allocation of resources. Solution 13.6 Answer: B
If the price of a good exceeds its marginal cost,
underproduction occurs. In the Figure below, the If a firm has costs that do not pass through the market
area BAC illustrates market failure from setting (e.g. pollution), then the government should tax the
output below the point where marginal cost equals enterprise so that the firm internalises the externality
price. and incurs its true total costs.
A = If social costs are less than private costs the
Costs/ firm’s production must be providing external benefits
revenue to third parties. In this case the output of the firm
should be encouraged.
C = A subsidy would only encourage the firm to
produce more, and hence increase negative
externalities.
D = Net social benefits are positive and
therefore the firm should be allowed to carry on
producing.

Output

MR
 work out conf ee ae

Solution 13.7 Answer: B Solution 13.12 Answer: C

Adding together private marginal cost (PMC) and Demerit goods, such as cigarettes, harm consumers
external marginal cost (EMC) gives social marginal and impose costs on society in general, for example
cost (SMC). The price consumers are willing to pay the cost of treating lung cancer caused by smoking.
for an extra unit of a good is given by average revenue Demerit goods are consumed in quantities above that
(AR) — remember that average revenue always equals which is socially desirable.
price. The socially efficient level of output occurs A => Demerit goods create negative rather than
when SMC = AR. At output level 3, positive externalities.
SMC = PMC + EMC = 6+4=10=AR. B => Some demerit goods, such as alcohol, are not
illegal and are readily available in the market.
D => Demerit goods do create external costs in
Solution 13.8 Answer: A
their consumption.
Merit goods are goods that can be provided by the
market mechanism but would be underproduced when
left to market forces. This is because market forces
only take into account private costs and benefits. The
social benefit of merit goods exceeds the private Example 13.13,
benefit as merit goods have positive externalities. A large chemical company decides to reduce its costs
B => Public goods are non-rival and non- by discharging waste products into rivers and lakes.
excludable. They will not be provided by the market (a) Explain why such discharges may constitute a
mechanism negative externality. (5 marks)
C = Veblen goods are goods with ‘snob value’ and (b) On what grounds may the level of output of the
positive price elasticity of demand chemical company be regarded as excessive?
D = Inferior goods are goods with negative income (10 marks)
elasticity of demand (c) What government policy could be implemented
to achieve a socially more efficient level of
Solution 13.9 Answer: D chemical production. (10 marks)

The tax will internalise the external costs and will ¢ This question focuses on a particular example of
mean that the firm will produce at the point where market failure through negative externalities.
marginal revenue (reflecting marginal benefit) equals ¢ Use social cost and benefit curves to illustrate the
marginal social cost, since marginal social cost will welfare loss of overproducing chemicals that
now equal marginal private cost. cause negative externalities.
¢ Becareful to concentrate your analysis on the
specific example of a chemical firm.
Solution 13.10 Answer: B

It is difficult, if not impossible, to make consumption Solution 13.13

of flood control dependent on prior payment. One
person benefiting from flood control will also not (a) An externality occurs whenever the production or
reduce another person’s benefit. consumption decision of an individual or firm directly
A and C = are examples of merit goods, which are affects others, other than through market prices. That
rival and excludable products. is, an externality is a spillover effect from economic
activity that affects third parties but for which no
compensation is paid. The discharge of waste
Solution 13.11 Answer: B products into rivers and lakes is an example of a
Cost—benefit analysis (CBA) is a method of evaluating negative externality. The private cost to the firm of
investment projects to include all costs and benefits, waste disposal is the cost of transportation. Society at
i.e. social costs and benefits. It is usually used in the large has to bear, without compensation by the firm,
evaluation of public sector investment projects but the external costs that arise from the resulting
there is no reason why it could not be applied to destruction of the environment, reduced leisure
private sector schemes. facilities and other inconveniences.
 ER of > a
Pp 4

rk out,eeo' omicsi@
SE ce fay

(b) The diagram illustrates the amount of welfare loss legislation banning the discharge of waste products
from the overproduction of chemicals. into the environment. Firms would then have to
include waste treatment as a private cost. However the
PMC of chemicals, including treatment might then
Price exceed SMC, excluding treatment, so legislation
would only achieve a socially efficient level of
production if combined with a subsidy to chemical
firms.
Finally, the government may consider a policy of
banning chemical production altogether. This would
result in a loss of welfare. Even after taking into
account the pollution chemicals cause, consumers still
value extra units up to Q,, more than the social cost of
Quantity manufacture. Government policy would be more
successful if a quota restricting output to Q, were
Figure 1
introduced.

Assuming no positive externalities, the demand

curve, D, shows the money value placed by society on Example 13.14
the consumption of each extra unit of chemicals — i.e.,
social marginal benefit (SMB). How do public sector investment decisions differ from
Assuming perfect competition, the industry’s private sector investment decisions? (25 marks)
supply curve, S, is the addition of each firm’s ¢ Use either the discounted cash flow or internal rate
marginal cost curve. The private costs of producing of return method to explain investment decisions.
each extra unit of chemicals is given by the private ¢ Private firms only calculate private costs and
marginal cost curve (PMC). In a market economy, benefits. Public bodies include private and social
profit-maximising chemical firms ignore the wider costs and benefits in a cost-benefit analysis of
social costs of their activity. If any one company were investment decisions.
to incur the cost of treating its waste product it would e The bulk of the essay should consider the
become uncompetitive and unable to match the price difficulties involved in such a cost-benefit
of rivals. The interaction of supply and demand results analysis.
in quantity Q1 being produced.
In the diagram, external marginal cost, EMC, is the
amount consumers would be prepared to pay to avoid Solution 13.14
the pollution associated with the manufacture of extra
Profit-maximising private firms only take into account
units of chemicals. Adding EMC to PMC gives the
the effect on their own costs and revenues of buying
social marginal cost, SMC, of producing extra units of
capital. The spillover effects of investment are of no
chemicals. The socially efficient level of output occurs
concern. Social-welfare-maximising public agencies,
at Q,. Profit-maximising firms produce Q,. Chemical
on the other hand, take full account of the social
production at levels above Q, is excessive because
implications of buying capital. Public bodies have to
social cost exceeds social benefit. Total loss from
include in their investment calculations any indirect
overproduction is given by the triangle ABC.
effects on third parties.
(c) The government can achieve a socially more The calculation of private costs is a relatively
efficient level of chemical production by imposing a simple matter for the private firm. The cost of the
specific tax equal to EMC at each level of output. machine can be found in a catalogue. There may be an
Firms include the amount of the tax as a private cost element of uncertainty in estimating the probable net
and reduce their level of activity to the desired level of yield from the project in times of inflation or changing
Q,. However a socially efficient level of output is market conditions, but usually the firm can predict
achieved only if the government is accurate in future private benefits. The business then buys new
calculating the monetary cost to society of pollution. plant or machinery, provided that the return on the
Alternatively the government could introduce investment exceeds its cost.
 work out conf ° failure

Public bodies have to undertake a more detailed bypass affects local residents, a sum is deducted in the
and involved cost-benefit analysis. For instance a cost-benefit analysis that represents that damage. The
local authority considering building a bypass around a authority must be particularly careful not to include
town has first to identify and then value the likely irrelevant changes. For example reduced travel time
social costs and benefits that arise in each year of the may increase the value of local houses but this is not a
project. Private costs and benefits from building the true benefit of the scheme.
bypass are included at their market price. However, if All investment decisions have to calculate the
market prices are distorted and do not accurately present value of future net benefits. Benefits received
reflect true opportunity cost, alternative ‘shadow’ in the future are worth less than the same benefit
prices will have to be calculated. received now. Firms resolve this problem by
Money is also used as a unit of account for valuing discounting future benefits at a given rate of interest.
external costs and benefits. For instance the bypass is For example, at an interest rate of 10% per annum,
likely to benefit motorists by reducing travel time. £550 in one year’s time is worth only £500 now.
Multiplying the number of minutes saved by the Private firms use the current market rate of interest in
average wage rate gives an estimated value of the their calculations. Public bodies have to calculate a
resulting social benefit. If the scheme reduces the social rate of discount that states the true opportunity
number of road accidents, reduced expenditure on cost of future benefits.
medical treatment is included in the calculations. The Finally, private investment decisions typically
benefit the bypass brings to new travellers is another involve schemes with only a short life. Machines are
positive externality, which is included by estimating expected to last only a few years before being
the increase in consumer surplus. replaced by an improved model. Public projects
The wages of anyone unemployed before working have a lifespan measured in decades. Estimates
on the bridge should not be included as a social cost, of future supply and demand patterns, and
because they would not otherwise have produced demographic trends over a period of 20 years, make
anything. On the other hand a monetary value is public sector investment decision peculiarly difficult
placed on the loss of landscape. If noise from the and complex.
14.1 Fact sheet The activity (or participation) rate is the
percentage of the population of working age in the
(a) Population structure labour force.
An ageing population occurs when the average
Demography is the study of population. Population age of the population is rising.
size is a stock value (an amount at a given moment in Malthus argued that, since population has a
time). Population size is affected by inflows (births tendency to grow geometrically (i.e. as the series
and immigration) and outflows (deaths and 1, 2, 4, 8, 16) while agricultural output rises
emigration) over time. arithmetically (i.e. as the series 1, 2, 3, 4, 5),
¢ The birth rate is the number of live births per economies may eventually operate at a subsistence
thousand of the population in a year. level. Unless people raise small families, famine,
¢ The death rate is the number of deaths per war and disease would be the only checks on
thousand of the population in a year. population growth.
¢ The natural change in population is the difference Agricultural innovations, international trade and a
between the number of births and deaths in a low birth rate have enabled the UK to avoid
year. Malthus’s prediction.
¢ Net migration is the difference between Optimum population occurs when productivity
immigration and emigration in a year. (output per person) is highest.

Economically active Economically inactive

Labour force Dependent population

People able and willing to work People unable and unwilling to work

wis aS People on Children

/ Handicapped Voluntary
Employees training House unemployed
Employers schemes managers
(i.e. housewives
Self- Registered Students anq
employed unemployed househusbands)
Figure 14.1 Economic activity and inactivity
 work out me” ee Ae 27

¢ Population pyramids show the age and gender (e) Wage differentials
distribution of a country at a particular moment in
Wage differentials are the difference in wages between
time.
workers in different occupations, age groups,
industrials, areas etc. Wage differentials arise through:
(b) Supply of labour
(1) occupational immobility due to non-monetary
The total supply of labour depends on: advantages and disadvantages of jobs;

(1) the size and age structure of the population; (2) occupational immobility because of age, physical
skills and qualifications;
(2) the activity rate;
(3) geographical immobility due to family ties,
(3) social acceptance of women working;
housing shortages etc.;
(4) wage levels;
(5) the level of income tax and of the job seekers’ (4) economic rent arising from high demand for
special talents;
allowance;
(6) the length of the working week and of holidays; (5) differences in the strengths of trade unions and
professional organisations;
(7) industrial relations record.
(6) social convention and public opinion influencing
wage claims and settlements.
(c) Demand for labour
The total demand for labour depends on:

(1) the level of economic activity;

(2) the productivity of labour;
(3) wage levels; A study of the extent and causes of differences in the
(4) productivity and price of substitute and amount paid to students undertaking part-time jobs.
complementary factors of production.

¢ Elasticity of demand for labour measures the

responsiveness of demand for labour to changes in
the wage rate. Demand for labour is elastic when:
(a) demand for the finished product is elastic; Real gross weekly earnings by selected occupation
(b) labour costs form a high proportion of total Great Britain £ per week at April 1994 prices
costs; 1981 1994
(c) labour can be easily substituted by other Cleaner 169 180
factors of production; Bricklayer aD) 252
(d) the time period is long. Medical Practitioner 550 746
Nurse 188 316
(d) Occupational distribution of Secondary Teacher 314 427
labour Solicitor 367 569

Table 14.1 shows that there has been a relative decline Source: Adapted from CSO Social Trends 1995
in the share of agricultural and manufacturing (a) Explain what is meant by real gross weekly
employment in total employment. The service sector earnings (2 marks)
of the economy has expanded. (b) Calculate and comment on the percentage
increase in earnings experienced by the three
Table 14.1 Distribution of employment in the UK occupations shown. (7 marks)
(%) (c) Give three reasons why cleaners receive
1964 1984 1994 relatively low pay. (6 marks)
ji |) = practitioner s
(d) Give three reasons why medical
Primary sector 5 5) 1 (6 marks)
receive relatively high pay.
Secondary sector 47 32 28 wage differential why do
(e) Given the size of the
Tertiary sector 48 65 71 (4 marks)
Cee
bricklayers not become solicitors?
 market failure and government intervention

Solution 14.2 lack of qualifications acts as a barrier to the market for

solicitors. Some bricklayers may have the ability to
(a) Real gross weekly earnings is the pay a worker
become solicitors but may not seek to enter the labour
receives inclusive of overtime and bonus payments
market for solicitors because they are unaware of the
and adjusted for inflation. In this case earnings have
pay and conditions of solicitors or because they
been adjusted to April 1994 prices.
believe that the non-monetary advantages of being a
(b) bricklayer, e.g. working outside, exceed those of
being a solicitor.
%A real gross
weekly earnings
Occupation 1981-94
14.4 Objective questions
Cleaner 6.5

Example14.
Bricklayer 12.0
Medical practitioner 35.6
Nurse 68.1 Optimum population occurs when, with current
Secondary teacher 36.0 resources:
Solicitor 55.0 A. productivity is rising
B_ productivity is constant
C productivity is highest
All the occupational groups received an increase in
D the largest population possible is supported
real gross weekly earnings but at markedly different
rates. The earnings of cleaners and bricklayers rose
relatively slowly. It was nurses and solicitors who Example 14.4
experienced the most rapid rise in earnings. Nurses
An ageing population will be most likely to result in:
have been required to carry out more highly skilled
A an increase in labour mobility
tasks and the qualifications necessary to become a
B_ areduction in transfer payments
nurse have risen. There are now a number of graduate
C aconstant pattern of consumption
entrants to the nursing profession. There is also a high
D increase in the dependent population
proportion of male nurses now than in the 1980s and
this has tended to raise the status of nursing as a
profession. Increased recourse to law, both criminal Example 14.5
and civil, and the increase in fees that can be charged
Which of the following factors will increase the
for the services of solicitors, has increased the
average age of the population?
marginal revenue product of solicitors.
A Arise in the birth rate
(c) Cleaners receive low pay because their supply is B Arise in net immigration
relatively high. It takes no or few qualifications to C A decline in the death rate
become a cleaner. Demand is relatively low and | D A decline in the infant mortality rate
elastic, as with improved cleaning machines fewer
cleaners are needed. They can also be replaced easily
Example 14.6
by currently unemployed workers. Cleaners are not
highly unionised and many are part-timers. Which of the following may cause an increase in the
(d) Medical practitioners are highly paid because they labour force in the short run and a decline in the long
run?
are in short supply and high demand. It takes a high
A Net emigration
level of education and training to become a doctor. It
B_ A fall in the birth rate
is also difficult to replace a doctor by machinery.
C A fall in the retirement age
Doctors belong to a powerful professional body, the
D A fall in the school leaving age
British Medical Association (BMA), and are held in
high social esteem.
Example 14.7
(e) Bricklayers do not become solicitors, primarily
because they lack the necessary qualifications. This The next diagram shows the offer curve (S) for labour:
 work out o oge shee Prarh

Wage rate Example 14.11

As an economy develops, the proportion of the labour
force in which sector (S) usually declines?
A Primary
B_ Primary and secondary
C Primary and tertiary
D Secondary and tertiary

0 Hours worked Example 14.12

Which of the following will increase occupational
Beyond point OX: wage differentials?
A the wage rate rises more rapidly A A reduction in labour mobility
B_ workers substitute work for leisure B_ A decline in labour market discrimination
C workers are unresponsive to changes in the wage C An increase in information about job opportunities
rate D A decline in the differences in non-monetary
D the income effect of a rise in wages is greater than advantages between jobs.
the substitution effect

For Examples 14.8—14.10 use the diagram below, 14.5 Solutions to objective
where DD is the original demand curve for
bricklayers and SS the original supply curve. S is the
initial equilibrium position. “Solution 14.3. Answer: C
Optimum population occurs when productivity
Wage rate (output per person) from a given amount of resources
is highest.

Solution 14.4 Answer: D

An ageing population is likely to cause an increase in

the number of retired people. People who have retired
are economically inactive and are classified as
dependents.
A = As people get older they tend to become less
0 Hours worked occupationally and geographically mobile.
B => More pensions will increase transfer payments
as more pensions will be paid.
Example 14.8 C => There will be an increase in demand for
products required by the elderly, e.g. bungalows.
An increase in the productivity of bricklayers.

Solution 14.5 Answer: C

Example 14.9
A decline in the death rate will mean that people are
A reduction in the apprenticeship period for living longer, which will increase the average age of
bricklayers. the population.
A and D = will increase the number of very young
Example 14.10 children and will lower the average age of the
population.
A significant increase in interest rates. B => This will tend to lower the average age as
most immigrants are relatively young, aged between
20 and 40.
130ferout eco ‘or et failure and government intervention

Solution 14.6 Answer: B Solution 14.12 Answer: A

A fall in the birth rate will reduce the number who A decline in labour mobility will mean that
leave the labour force to raise children. However in differences in wages for different jobs are likely to
the long run a fall in the birth rate will result in fewer increase as workers become less able to move from
people entering the labour force. low-paying jobs to high-paying jobs.
A and C => would decrease the labour force — net B, C and D = will reduce occupational
emigration for as long as it continues as most differentials.
emigrants are aged between 20 and 40 — and a fall in
the retirement age for as long as the legislation
remains in place.
D = would increase the labour force as people will
become potential workers earlier.
Why are pilots paid more than shop assistants?

Solution 14.7. Answer: D e¢ Make use of marginal revenue productivity theory

and demand and supply analysis.
Up to point OX a rise in wages would cause an
e Avoid value judgements.
expansion in the supply of labour. Workers respond to
higher wages by substituting work for leisure.
However after point OX workers would work fewer Solution 14.13
hours, as with higher incomes they would choose to The wage rate operating in any particular labour
‘buy’ more leisure. market is influenced by the demand for labour, the
supply of labour, the activities of trade unions and
Solution 14.8 Answer: C professional bodies, government policy and social
convention.
An increase in productivity raises the marginal Wages will be higher in occupations where demand
revenue product of bricklayers, which, in turn, for labour is high and supply is low, and where
increases the demand for their labour. The demand demand and supply are inelastic.
curve for bricklayers shifts to the right. Demand for labour is a derived demand. Marginal
revenue productivity (MRP) is concerned with the
Solution 14.9 Answer: D demand for labour. The higher the price (and hence
MR) that can be obtained for the output of labour and
A reduction in the apprenticeship period means that the greater the output (marginal physical product) that
more people are likely to be willing to become labour can produce, the higher the wage rate that will
bricklayers and these people will become bricklayers be earned. Pilots have a high MRP. The price that can
more quickly. The supply of bricklayers will increase. be charged for air travel is relatively high and pilots
can fly planes that carry a large number of passengers.
Solution 14.10 Answer: A Demand for pilots is also inelastic as it is not possible
to provide air travel without pilots.
An increase in interest rates reduces aggregate In contrast, demand for shop assistants is relatively
demand and increases the cost of mortgages. A elastic. Reorganisation of shops and the introduction
consequent decrease in the demand for houses reduces of new technology means that shop owners may have
the derived demand for workers involved in the opportunity to reduce quite significantly the
construction, such as bricklayers. number of shop assistants if their wage rises. Shop
assistants may work hard but the products they sell do
not always command a high price and their MRP
Solution 14.11 Answer: B
tends to be low.
As an economy develops, the proportion of the labour The supply of shop assistants is also high and
force employed in the primary and secondary sectors elastic because it is a job that requires few
tends to decline whilst the proportion employed in the qualifications and little training, whereas the supply of
tertiary sector increases. pilots is lower and more inelastic. To become a pilot a
 work out ae ee Ae

person needs to have both relatively high academic increased the number of airlines that can operate on
qualifications and good health. This limits the number routes. This has increased the demand for pilots,
of people who can become pilots. whereas the requirement for health checks has
Figure 1 shows the demand and supply of pilots (a) reduced the supply of pilots. Social convention also
and the demand and supply of shop assistants (b). favours pilots. Most are white, middle-class men, and
society tends to value work undertaken by this group
more highly than that done by working-class women.
Wage Ss
rate Most shop assistants are in fact women. Views on the
value of different jobs will influence the wage claims
WwW workers advance and the offers employers make.

Example 14.14
(a) Explain what is meant by the elasticity of
demand for labour. (4 marks)
(b) What may cause the demand for bank clerks to
D become more elastic? (14 marks)
(c) What effect would an increase in the elasticity of
0 Q Number of workers demand for bank clerks have on the power of any
(a) trade union representing them to raise their wage
rate? (17 marks)
Wage
rate ¢ Give the formula for elasticity of demand for
labour.
¢ Explain elastic demand for labour.
Ss ¢ Bring out the main determinants of elasticity of
demand for labour.
WwW ¢ Although given below, it is not necessary to know
the name of the union representing bank clerks.
D
¢ Consider more than one way of raising the wage
rate.

0 Q Number of workers
Solution 14.14
(b)
(a) Elasticity of demand for labour measures the
Figure 1 responsiveness of demand for labour to a change in
the wage rate. The formula is:
The British Air Line Pilots Association is a
powerful trade union. It supports limited entry into the % change in quantity of labour demanded
profession by requiring artificially high qualifications. % change in wage rate
This has the effect of reducing supply and thereby
Demand for labour is elastic when a given change in
raising wages.
the wage rate, e.g. a 10% rise, causes a greater
In contrast shop assistants have weak bargaining
percentage change in demand for labour, e.g. a fall of
power. The union that represents shop assistants is 12% (giving an elasticity of 1.2).
USDAW (The Union of Shop, Distributive and Allied
Workers). However not all shop assistants are in the (b) A number of factors could cause demand for bank
union and those who are, are widely dispersed clerks to become more elastic. If the required period
throughout the country and employed by different of training is shortened, demand will become more
employers. They are therefore difficult to get together elastic. This is because if the existing trained workers
and organise. press for a wage rise, their employers will be more
A variety of government policies have contributed willing to make them redundant as it will take less
to high wages for pilots. For instance deregulation has time to train new workers. Employers will also find it
 et failure and government intervention

easier to attract new staff in periods of high and will become more reluctant to see their total wage
unemployment and will find it cheaper when the costs bill rise.
of recruiting new staff (e.g. advertising, interviewing The longer the time period under consideration the
time) fall. more elastic demand will be, as it will be possible to
A rise in the wage rate will have a more significant reorganise production to make less use of labour and
impact if it becomes easier to substitute capital for more of other factors of production if wages rise.
labour or if the relative prices of capital and labour There will also be time to give workers legally
change to favour capital. This has been a significant adequate periods of notice.
factor in the case of bank clerks. The introduction of
modern technology, including the electronic transfer (c) The main union representing bank clerks is the
of funds, has considerably reduced the demand for Banking Insurance and Finance Union (BIFU). An
bank clerks. increase in the elasticity of demand for bank clerks
A related influence is the proportion of labour costs would make it more difficult for BIFU to push the wage
in total costs. The greater the proportion the more rate above the equilibrium level. Figure 1 shows that
significant any wage rise would be on firms’ total when demand is elastic this action will cause a greater
costs, and so the more elastic demand will be. fall in employment than when demand is inelastic.
Whether the cost of labour in banks’ total costs A union is unlikely to be prepared to accept a large
increases or falls will depend not just on the number fall in the employment of its members. However the
of workers and machines employed but also on their increase in elasticity of demand does not prevent the
relative costs. union employing other approaches to raise wages. It
Over time, with increasing competition in the may support measures to raise the marginal revenue
financial sector, the demand for bank services may productivity of bank clerks. Indeed bank clerks do, on
become more price elastic. Consumers may be more occasion, appear in television advertisements to
willing and able to switch away from those banks that promote banking services. The BIFU can also support
charge relatively high interest rates on loans and pay measures to restrict the supply of bank clerks, e.g. by
relatively low interest rates on saving deposits. This pressing for an increase in the qualifications or
will mean that banks will have to keep their costs low training needed.

Wage iS Wage S
rate rate

W, Ww

W WwW

0 Q, Q Number of workers 0 Q; Q Number of workers

employed employed

(a) Elastic demand (b) Inelastic demand

Figure 1
 yilmivela. (i:
iitlas
ee

(a) regional variations in house prices;

(b) lack of rented accommodation;
(c) existing family and social ties.

Labour market failure occurs when labour markets

fail to clear at the going wage rates, when wage rates (c) Discrimination
are distorted and when the most efficient use of labour Discrimination arises when one group of workers is
resources is not achieved. treated differently from others in terms of wages paid,
The main causes of labour market failure are and employment and promotion opportunities.
immobility of labour, discrimination, concentrated Discrimination may be on the basis of:
market power in the buying and selling of labour and
lack of information. (1) gender
(2) ethnicity
(3) sexual orientation
(b) Immobility of labour (4) social background
There are a number of barriers to the movement of (5) age
workers and these may cause shortages of workers in (6) height
certain jobs, industries and areas, but surpluses in others. (7) appearance

¢ Workers may be prevented from changing jobs Negative discrimination will result in a group
(occupational immobility of labour), e.g. due to: having lower pay and lower employment and
(a) unwillingness, lack of opportunity or inability promotion opportunities than other groups. Figure
to retrain; 15.1 shows the effects of demand for black
(b) employment barriers placed by unions and workers being below the MRP. The wage rate
professional bodies. (OW) and the number employed (OL) are below the
¢ Workers may experience difficulty in moving efficient levels of OW, and OLy.
between jobs requiring the same skills (industrial
immobility). Workers in declining industries tend
(d) Concentrated market power
to be industrially immobile.
¢ Workers may be prevented from moving to A monopoly trade union may cause
different regions (geographical immobility), €.g. unemployment by using its bargaining power to
due to: push the wage rate above the market equilibrium
 rk out eco i failure and government intervention

Wage
rate Supply of
paid labour
to
black
workers

Wx
W

MRP Demand
for
Demand with labour
discrimination
0 Lee Number of workers
0 IL Lx Number of black
workers Figure 15.3 The effect of union action in restricting the supply of
labour
Figure 15.1 The effects of discrimination

Marginal
level. This is shown in Figure 15.2, where union Wage cost of
rate labour
action raises the wage rate to OW but lowers the
number of workers employed to OL;. A monopoly
trade union may also seek to raise the wage rate Average cost
by restricting the supply of labour, e.g. by insisting of labour
(supply of labour)
on artificially high qualifications (Figure 15.3).

Supply of
labour

Demand
for
labour

0 iL Lx Number of workers
Demand
for labour
Figure 15.4 A monopsonist employer. With a monopsonist
employer, wage rate = OW, number of workers employed = OL. In
a competitive labour market wage rate = OWy, number of workers
employed = OLy.

0 Ly L Number of workers
have incorrect information about pay, promotion
Figure 15.2 The effect of union action in raising the wage rate structure and working conditions in alternative
jobs, industries and areas.
¢ A monopsonist employer is a sole buyer of labour ¢ Employers may not employ the most skilled
and one that is likely to pay a wage below the workers at the most cost-effective wage rates
MRP and below that which would operate in a because they lack information or have incorrect
competitive labour market (Figure 15.4). information about the number of people
willing and able to work for them, the skills of
potential workers, the cost and quality of training
(e) Lack of information
courses and the wage rates rival companies are
Participants in labour markets do not have perfect paying.
knowledge. This often results in suboptimal decisions
being made.

¢ Workers may not be in the best paid and most

appropriate jobs because they lack information or
 work out economics Pow rio faite =

_(e) What is the TUC and what are its functions?

(f) Government measures to
(3 marks)
correct labour market failure
These include:
Solution 15.2
(1) providing education and training to increase
(a) Unemployment fell from 1988 to 1990 and then
labour mobility;
rose from 1990 to 1993. The number of days lost
(2) trade union reform;
through strikes fell from 1988 to 1989, then rose in
(3) antidiscrimination legislation;
1990, fell from 1990 to 1992 and then rose very
(4) provision of labour market information, e.g.
through government training centres; slightly in 1993. This does not produce a consistent
pattern and indeed the number of days lost due to
(5) labour market reforms, e.g. ending the legal
industrial disputes fluctuates widely from year to year.
monopoly of solicitors in the conveyancing of
Nevertheless this period does show that the number of
house property.
days lost are highest in the period 1988 to 1990, when
unemployment was falling, and lowest in the period
ative study 1990 to 1993, when unemployment was rising. Higher
unemployment means that the number of workers
declines, so there are fewer people to go on strike. It is
also likely to make workers more wary of going on
An analysis of the extent of one form of
strike for fear of losing their jobs.
discrimination in a local labour market.
(b) The other two main measures of strike-proneness
are the number of stoppages and the number of
workers involved.

(c) As mentioned above, unemployment fell between

1988 to 1990 and then rose from 1990 to 1993. Trade
Working days Trade union membership fell throughout the period. Indeed
lost ih industrial union now only approximately 35% of the civilian labour
disputes Unemployment membership force in employment belong to a trade union. One
Year (million) (%) (million) cause of the decline in union membership has been
the relatively high levels of unemployment. However
1988 1.64 8.4 10.4
this is not the sole cause. As the data here shows,
1989 0.75 6.3 10.2
membership fell even when unemployment declined.
1990 1.10 5.8 9.9
Other causes include a decline in the strength of trade
1991 0.22 8.0 9.7
unions as a result of legislation passed by the
1992 0.09 9.8 9.2
government, a decline in the manufacturing and
1993 0.11 10.4 8.7
———E—_————_———————
I public service sectors (both of which have a higher
Sources: Annual Abstract of Statistics, 1994, Social than average membership) and a rise in part-time
Trends, 1995; Monthly Digest of Statistics, March employment as fewer part-time workers join unions.
1995; Employment Gazette, March 1995. (d) The number of trade unions declined for two main
reasons. One was the fall in membership of trade
(a) Comment on the relationship between unions and the other was the mergers that occurred
unemployment and the number of working days between trade unions. For instance the UK’s largest
lost in industrial disputes. (8 marks)
union, UNISON, was formed in 1993 from a merger
(b) What are the other two main measures of strike- between the Confederation of Health Service
(2 marks)
proneness? Employees (COHSE), the National Union of Public
(c) Comment on the relationship between Employees (NUPE) and the National and Local
unemployment and trade union membership. Government Officers’ Association (NALGO).
(8 marks)
Why do you think the number of trade unions (e) The Trade Union Congress is the national body of
(d)
declined in the 1980s and early 1990s?(4 marks) UK trade unions. It seeks to promote the interests of
1 Py & out econemi {emarl et failure and government intervention

the trade unions that belong to it, to improve the C An increase in the cost of an alternative,
economic and social conditions of working people automated manufacturing process
and to campaign for higher employment and job D An increase in the proportion of labour costs in
security. total costs of production.

15.4 Objective questions Example 15.7

Examples 15.3to > are based on the following If a government introduces equal pay legislation that
diagram, which shows a monopsony employer in a raises the wages of women workers, what is the most
labour market. likely outcome?
A A fall in the wages of male workers
Wage B_ A decline in female participation in the labour
rate
MC force
C Anexpansion in the supply of women workers
D The replacement of male workers by women
workers
Wa
S Example 15.8
W,
W,
Under which of the following conditions would a
labour market be described as oligopsonistic?
WwW A There are many employers
D
B_ There is a single employer
C There are a few dominant employers
0 Q, Q, Qs Qs Quantity of labour D There are an equal number of employers and
employees
Example 15.3
What will be the number of workers hired by the Example 15.9
monopsonist?
The government raises the wages of teachers to
A Q, B Q, C QO, D Q, encourage more people to train as teachers. The effect
of this on the economic rent and transfer earnings of
Example 15.4 those already employed as teachers will be to:

What would be the level of employment if this labour Economic rent: Transfer earnings:
market had been perfectly competitive? A increase leave unchanged
A Q, B Q, C Q, D Q, B leave unchanged increase
C leave unchanged leave unchanged
D increase increase
Example 15.5
What will be the wage rate paid by the monopsonist?
A W, B W, Example 15.10
C W, D W,
It has been suggested that a cut in money wages
Example 15.6 would stimulate economic activity. However this may
not occur if:
Which of the following would increase the ability of a A the aggregate level of demand falls
trade union to increase the wages of its members B the fall in wages reduces firms’ costs of production
without significantly affecting employment? C the lower prices increase spending by higher
A A reduction in demand for the finished income groups
product D the lower prices reduce the transactions demand ~
B_ A reduction in the national level of employment for money and thereby reduce the rate of interest
 work out economics Pow iS tailyy 7

Example 15.11 from the average cost of labour (supply curve). The
marginal cost curve shows the change in the total cost
In a particular area workers can gain employment in of employing labour and not the wage rate paid. This
one of two firms, X and Y. If firm X starts to is illustrated in the example below.
discriminate, in terms of pay and employment
opportunities, against women workers, what effect
will this have on the wage rate paid to women workers Wage rate Total cost Marginal
by firm X and firm Y? No. of workers (ACL) of labour — cost

Firm X: Firm Y: 1 200 200 200

A reduce reduce i 240 480 280
B reduce leave unchanged 3 290 870 390
C leave unchanged increase 4 360 1440 570
D reduce increase

Solution 15.6 Answer: C

Example 15.12
A trade union will be in a stronger position to raise
If the entry qualifications to an occupation are
wages without significantly affecting the employment
reduced, what effect is this likely to have on the wage of its members if demand for the labour of its
rate paid and the economic rent enjoyed by employees?
members is inelastic. If an alternative automated
Wage rate: Economic rent: manufacturing process becomes more expensive,
A increase increase employers are unlikely to make many workers
B increase reduce redundant following a wage rise, provided machinery
Le reduce reduce remains relatively more expensive.
D reduce increase A, B and D = would all reduce the ability of the
trade union to raise wages without causing a
significant rise in unemployment among its members.
If demand for the finished product is falling, fewer
workers will be needed anyway. A reduction in the
national level of employment would make it easier
for employers to replace existing workers with
previously unemployed workers, and if labour
A monopsonist is a sole purchaser of labour and will
costs form a higher proportion of total production
hire the number of workers where the demand for
costs the demand for labour will become more elastic
labour (based on marginal revenue product) equals the
as any wage rise will have a significant effect on the
marginal cost of labour, i.e. at Q;.
costs and price of and demand for the finished
product.
Solution 15.4 Answer: D

If the labour market had been perfectly competitive Solution 15.7 Answer: C
the employer would not have altered the wage rate
Higher pay for women will encourage more women to
when employing more workers. So the average cost of
participate in the labour force, resulting in an
labour (the supply of labour) would have equalled the
expansion in the supply of women workers.
marginal cost of labour. The firm would have
employed the number of workers where the average
cost of labour (the supply of labour) equalled demand, Solution 15.8 Answer: C
Le Ox
An oligopsonistic market is one in which there are a
few dominant buyers. In the case of a labour market
Solution 15.5 Answer: B there will be a few dominant buyers of labour, i.e. a
As determined in Solution 15.3, the monopsonist will few dominant employers.
employ Q; number of workers. The wage rate is found B = is a monopsonist.
138 rkout economi t failure and government intervention

Solution 15.9 Answer: A labour. The low wage will encourage women to
seek employment with firm Y. The increase in the
People already employed as teachers will receive a
supply of women workers to firm Y will lower the
wage rate that is above, or even well above, what is
wage rate. These effects are shown in the diagram at
required to keep them working as teachers. Hence
the bottom of the previous column.
their economic rent will rise.
Transfer earnings are what workers can earn in
their next paid jobs, and therefore the minimum Solution 15.12 Answer: C
necessary to keep them in their present job. Transfer
If the entry qualifications to an occupation are
earnings will be influenced by the rate of pay in
reduced, the supply of potential workers will increase,
alternative occupations.
which will lower the wage rate. Supply will also
become more elastic, which will reduce economic
Solution 15.10 Answer: A rent.

If lower money wages reduce aggregate demand, then

output and employment are likely to fall.
B, C and D => could all stimulate economic
activity, ceteris paribus.
15.6 Essays —
Firm X
Wage Exam ple 15.13 |
rate
Assess the arguments for and against the introduction
Supply (ACL) of a national minimum wage. (25 marks)

¢ Explain how minimum wage legislation

W works.
W, * Concentrate on a minimum wage set above the
existing level.
MRP
¢ Discuss the impact on wages and poverty.
MRP
(with discrimination) ¢ Discuss the impact on employment.

Number of workers
Example 15.13
Firm Y
The effects of introducing a national minimum wage
Wage
rate S (ACL) will depend mainly on the level at which it is set and
how workers and employers respond. The main
S,(ACL1)
motive is likely to be to reduce poverty, while the
main argument against the introduction of a minimum
WwW wage is that it may result in a rise in unemployment.
Ww, If a minimum wage is set below the existing level,
then there will be little or no effect. For instance, if an
employer is paying a wage rate of £150 and
MRP legislation is introduced stating that workers have to
be paid at least £180, it is unlikely that there will be a
Number of workers change in the wage paid to existing workers. However
there is a possibility, particularly during times of high
unemployment, that new workers may be recruited at
Solution 15.11 Answer: A lower wages, although existing workers are likely to
resist any cut in money wages.
If firm X discriminates against women it will pay However it is more likely that the minimum wage
them a wage rate below the point where their true will be set above the existing wage level in some
marginal revenue product equals the supply of industries. The introduction of a national minimum
 work out economics Pow mar fai

wage is sometimes urged as a measure to reduce

income inequality and, in particular, poverty. A
national minimum wage can be imposed to raise the
wage level of the lowest-paid and possibly reduce the
number of people who decide not to work, even
though there are vacancies, because the wages they
would receive are below the benefits they are
currently receiving.
Another argument for setting a minimum wage is to
protect workers in industries dominated by
monopsonists. In the case of a monopsonist, the
marginal cost of hiring additional labour (MCL) will 0 Lo L, Labour services

be greater than the average cost of labour (wage per Figure 2

employee). Figure 1 shows that the employer initially
equates the marginal cost of labour with his/her The extent to which unemployment will occur in
demand for labour (DL) and employs OL, amount of different industries will depend on a number of
labour at wage of W,. The establishment of a factors. These include the profitability of the industry,
government minimum wage of W, (where DL equals the proportion of total costs accounted for by wages,
the average cost of labour) raises both the wage rate the type of market structure and the elasticity of
and employment. demand for the product.
Another influence will be the extent to which
labour can be substituted. As labour becomes more
Wage
rate MCL expensive, there may be some substitution of capital
for labour. The extent to which this occurs will
SL =AC depend on the nature of the product being produced,
and the relative productivities and prices of the
factors.
New classical economists believe that a
government-imposed national minimum wage will
interfere with free market forces and thereby reduce
DL
the efficiency of the labour market. This could result
in a decrease in aggregate supply and a fall in output
0 Ly Lo Labour services and employment.
Figure 1
However some Keynesians argue that if a national
minimum wage is imposed, then demand for most
However in most industries a minimum wage set industries’ products will rise. So although costs will
above the equilibrium level, while raising wages, is rise, the level of employment may remain constant or
likely to result, at least in the short term, in the supply possibly rise.
of workers exceeding the demand for workers and a Nevertheless the response of workers to the policy
fall in employment. Figure 2 shows the minimum may result in a further rise in production costs,
wage (W,) being set above the equilibrium wage (W)). inflation and unemployment. Workers may press for
This causes a fall in employment from OL, to OL). wage rises to restore their wage differentials. If
The groups of workers who are most likely to be successful and if productivity does not rise, this will
made redundant or who are less likely to be taken on increase the costs of production and possible cost-
include the elderly, the disabled and the less skilled push inflation. Rising prices may reduce domestic
workers. These may be the very groups that a national competitiveness, and hence domestic employment. If
minimum wage may be designed to help. Raising the unsuccessful, the narrowing of wage differentials may
wage rate will also increase the cost of training reduce labour mobility and result in a shortage of
workers, which may result in higher unemployment skilled workers. The effectiveness of a national
among school leavers and in the longer term may lead minimum wage in reducing poverty will be affected
to a shortage of skilled workers. by the fact that a large number of poor people will not
 et failure and government intervention

be helped by the legislation, including those past or professional organisation. In the UK people who
retirement age, the unemployed and some single parents. wish to become actors first have to gain an equity card.
A person may have the qualifications and other
requirements for a better paid job, indeed it may be
Example 15.14
the same occupation as she is currently working in,
(a) Why may a worker stay in a less well paid job but she may be unable to take it because it is ina
when there is a vacancy in a better paid job? different part of the country. Geographical immobility
(15 marks) arises mainly because of family ties and differences in
(b) How may a government promote labour the availability and cost of housing in different parts
mobility? (10 marks) of the country.
For workers to be able to move easily from one job
¢ Discuss both monetary and non-monetary
to another there would have to be perfect competition
advantages and disadvantages of jobs.
in the labour market. This obviously is not the case.
¢ Mention some relevant labour market
Labour is not homogeneous. In practice there are a
imperfections.
number of separate labour markets that have barriers
* Cover both occupational and geographical mobility.
to entry, including qualifications. Some of these
labour markets are closer than others. For example it
is easier for a teacher to become a civil servant than it
Solution 15.14
is for a bricklayer to become a brain surgeon.
(a) A worker may stay in a less well paid job because One example of labour market imperfection is
she believes its overall benefits outweigh those in imperfect knowledge — people may be unaware of job
other, albeit better paid, jobs, because she is unaware vacancies for which they are suitable.
of suitable better paid vacancies or because she is
unable to change jobs. (b) A government can seek to promote labour
A less well paid job may be more attractive because mobility in a number of ways. If successful this will
it may offer better promotion chances, greater job mean that workers will find it easier to switch jobs
security, better working hours and conditions, so a and the labour market will become more flexible,
person may not be tempted by higher wages if the job allowing successful firms to expand and declining
on offer is, for example, dangerous, involves working firms to contract.
unsocial hours or working in a noisy, unpleasant One measure is to increase information about job
environment. vacancies. At present the government does this
People do take into account both monetary and primarily through job centres.
non-monetary advantages. However, in practice many The government can promote geographical mobility
jobs with pleasant working conditions and good by giving grants to workers transferring from one part
promotion chances are well paid and those with of the country, making it easier for people to change
unpleasant working conditions and poor promotion council and housing association accommodation and
chances are badly paid. This is because the supply of encouraging the development of the private rented
workers for the less pleasant jobs is higher than those sector. Improvements in infrastructure and social
for pleasant jobs because fewer qualifications are capital in depressed areas of the country may also
needed. make workers more prepared to move.
Lack of qualifications, training or skills are Occupational mobility can be improved by more
significant reasons why a worker may be unable to and higher quality education and training and by
transfer into better paid jobs. Many people might be removing unnecessary entry barriers to particular
attracted by the wages paid to barristers, but few have occupations. The government may itself provide this
the necessary training and qualifications. A number of education and training, or it may encourage private
people would also like the pay and life style achieved sector provision of education and training, e.g. by
by top film stars, but again few have the talent giving tax incentives to firms that spend a given
required. A person may also be too old, too young or amount on training. The government may also remove
lack a physical requirement to gain entry into the job. artificial restrictions on entry to occupations, e.g. by
For example pilots need to have good eyesight! breaking down the distinction between barristers and-
Another requirement may be the need to join a union solicitors.
 arkets

The demand for health care exceeds supply. NHS

treatment is rationed by means of waiting lists.
Demand for health care treatment is increasingly
due to:
Education is a merit good, some people (a) an increase in the average age of the
underestimate its private benefits and it confers population;
benefits on third parties, e.g. higher output (b) advances in medical technology that enable
resulting from a better educated workforce. more illnesses to be treated;
Education is both a consumption and an (c) a decline in willingness to put up with minor
investment good. It both provides enjoyment and medical complaints.
increases earning potential. The 1990 National Health Service and
The opportunity cost to society of providing Community Care Act introduced an internal
higher education is the alternative uses to which market with fundholding GPs purchasing services
the resources could have been put, e.g. health care. from hospitals.
The opportunity cost to a student of attending In the UK the average life span is increasing by
higher education may include lost leisure time, two years every decade.
lost earnings and lost opportunity to attend an Half the men and two fifths of the women in the
alternative course. UK are overweight.
In 1991 the UK government introduced a student The greatest cause of preventable death in the UK
loans scheme. is smoking.

(b) Health
(c) Housing
Health care is a merit good, some people
underestimate its private benefits and it confers Housing used to be seen as both a consumption
benefits on third parties, e.g. people will benefit and an investment good. It provides
from others being inoculated. ‘accommodation and it used to rise in value by
Health care is both a consumption and an more than the rate of inflation. However the recent
investment good. It improves the quality of falls in house prices have resulted in housing
people’s lives and increases earning potential by being perceived more as a consumption good.
reducing the number of days sickness and Negative equity occurs when a house is worth less
increasing average lifespan. than the loan (mortgage) on it.
 sae AAS

york outfecon Omics a

¢seit failure and government intervention

¢ The housing market is volatile due to: 16.2 Investigative study

(a) inelastic demand in the short run — no close
substitutes and consumers respond slowly to Example 16.1
house price changes as they take other costs
An investigation into how the introduction of student
into account, including estate agents’ fees,
loans for higher education has affected peoples’
solicitors’ fees, removal expenses and the
decisions to proceed on to higher education, their
stress involved in moving;
choice of course, their staying-on rates and the
(b) inelastic supply in the short run — it is difficult
implications any changes have for society.
to adjust supply quickly;
(c) people take changes in house prices as
indicators of future price changes. 16.3 Data response
¢ A fall in house prices:
(a) causes some building firms to go out of Example 16.2
business;
(b) makes it difficult for people to sell their homes
and so reduces labour mobility;
Roads policy
(c) reduces demand for consumer goods as the Much of Britain’s road system is the next 30 years have produced a
snarled with congestion; so is near-universal agreement that the
value of people’s main asset falls and because, government transport policy. supply of road space cannot be
for example, curtains, washing machines etc. Bolder men would risk the radi- increased to meet demand. Even if
cal solution: to price, and then annual spending on road building
are often purchased when people move into a privatise, almost every road in were raised by half, congestion
new home. the land would still get worse, according to
As road traffic grows, so do the a British Road Federation study
¢ The government promotes home ownership by: indirect costs it inflicts on every- published last year.
(a) tax relief on mortgage interest payments — one, motorist and non-motorist The most direct and efficient
alike. In London, for example, way to restrain traffic is by charg-
although this is being reduced; traffic congestion causes more air ing for the use of roads. It should
(b) exemption from capital gains tax; pollution today than existed be an attractive option for a goy-
before the Clean Air Act banned ernment which believes in market
(c) sales of council houses to sitting tenants. the burning of coal in 1956. Con- forces. Yet ministers are
sumers pay for gas, electricity and approaching the introduction of
¢ Houses are provided by the private sector, housing water. Rail fares include a return road pricing as though it were a
associations and local authorities. on the capital costs of the track. It short cut to political suicide.
is difficult to see, at least in terms A three-year study of the feasi-
¢ There is a continuing rise in the number of of economic rationality and equi- bility of restraining traffic in Lon-
dwellings occupied by one person. ty, why drivers should not pay for don by road pricing is due to be
road use if some way can be published by the Department of
found to charge them for it. Transport this spring. But even
Current transport policies, before the study’s publication,
(d) Transport based on free access to roads, are ministers are backing away,
unsustainable. At a time when the claiming that the technical diffi-
¢ Transport can be by air, rail, road or water. roads are becoming more and culties of introducing charging in
more congested and the railway’s such a large city with the technol-
¢ The main method of transport is by road. tiny share of the passenger and ogy currently available are insur-
freight market continues to dimin- mountable.
¢ Road transport imposes a number of negative
ish, total public spending on trans-
Source: Extract from The
externalities including: port is being cut. Official forecasts
Economist, 1 April 1995.
that road traffic will double over
(a) air, noise and visual pollution;
(b) congestion;
(c) damage to buildings; (a) On what grounds can it be argued that UK road
(d) accidents. space is increasingly fitting into the category of a
¢ Government action to reduce road transport may private rather than a public good? (5 marks)
include: (b) What is the current relationship between the
(a) taxing road transport, e.g. petrol tax; demand for and supply of UK road space?
(b) subsidising rail transport; (4 marks)
(c) road pricing, e.g. tolls on motorways; (c) Explain why increasing road space is unlikely to
(d) providing information to the public about the be a solution to road congestion. (4 marks)
relative costs and benefits of different forms of (d) What difficulties would be involved in direct
transport. road pricing? (6 marks)
* In 1995 more than 80% of UK households had a (e) Outline two other methods of reducing the
Car. demand for road space. (4 marks)
(f) Identify a negative externality caused by road being applied to the question of road pricing.
use not mentioned in the extract. (2 marks) Imposing tolls or using some other form of road
pricing on some roads only, e.g. motorways, may
cause diversion of traffic away from these roads to
Solution 16.2
other roads. If this is the case, overall congestion will
(a) A private good is one that is rival and that non- not be reduced. This may mean that some form of
payers can be excluded from enjoying. Increasing use charge may have to be made on most roads.
of UK roads meant that one more car on the road will, Differential pricing could be used, with a higher price
in most cases, reduce the enjoyment of other drivers, being charged for congested roads at peak times.
e.g. by adding to congestion. It has always been Road pricing may also be regressive, i.e. take up a
possible to put tolls on roads but these can add to higher proportion of the income of the poor. Many of
traffic delays. However advances in modern the poor do not have a car, but those that do may live
technology will make it increasingly easy to charge in areas that suffer from congestion and could be
for the use of roads. assisted to pay any extra costs by increased benefits.

(b) Currently, demand for road use exceeds supply. (e) Demand for road space could be reduced by
With no price for the use of most roads, demand is increasing fuel tax. This would increase the cost of
greater than supply. Figure | shows the resulting using a car but would not discriminate between use on
shortage of OQy. congested and uncongested roads. The government
could also use direct regulation, limiting the use of
vehicles at particular times or banning them from, for
Price
of S example, city centres.
road
space (f) Road use imposes a number of costs on third
parties, i.e. negative externalities. The extract mentions
air pollution, but cars, lorries and buses also cause
noise pollution, damage to buildings and accidents, and
prevent children from playing in the streets.

16.4 Objective questions

D
Example 16.3
0 OQ OQ, Quantity
Investment in education is investment in:
Figure 1 A fixed capital
B human capital
(c) Increasing road space involves an opportunity C_ financial capital
cost. With few open spaces this opportunity cost is D the primary sector
increasing. There is also increasing evidence that
building more roads, far from easing road congestion,
actually generates more road use. The higher the Example 16.4
quality and the more initial space on roads, the more A rise in house prices could be caused by an increase
people will be tempted to drive and the more each in the:
person is likely to drive. A rate of interest
(d) There are a number of potential problems with B level of disposable income
direct road pricing. The technology is still relatively C level of investment in new housing
expensive for most forms of direct road pricing. D supply of trained building workers
However it is developing quickly, including satellites
to deduct charges via smart cards installed in cars. For Example 16.5
some time relatively high-technology methods have
been used to control the speed at which people A government decides to replace a student grant
drive, e.g. speed cameras, and now these methods are system by a scheme of student loans that have to be
 ket failure and government intervention

repaid by the students from their future incomes. The A Reduced operating costs of public transport
most likely outcome is: B A saving in the time experienced by
A an increase in government expenditure on higher commuters
education C A reduction in the running costs incurred by
Ban increase in the number of students applying for private motorists
higher education D An increase in the quality of the environment near
C an increase in the private rate of return on the motorway
investment in higher education
D aswitch in demand by students towards job-
Example 16.10
related courses
A government introduces a grant of £5000 for people
wishing to buy a house costing less than £80 000. The
Example 16.6
effect of this will be to:
What is the most likely effect of a fall in mortgage A. benefit first-time borrowers only
interest rates on house prices and house building? B_ increase the demand for houses across the price
range
House prices: House building: C increase the demand for houses costing less than
A decrease decrease £80 000 only
B decrease increase D result in a reduction in the resources committed to
C increase increase house building
D increase decrease

Example 16.11
Example 16.7
If the government decides to provide free higher
A government decides to introduce an urban road tax. education to students, it follows that higher
If this is set at the socially efficient level this will: education:
A maximise road use is available to all
B_ eliminate road congestion has no opportunity cost
C maximise government revenue cannot be provided by the private sector
D reduce congestion to an optimal level i
—oe is likely to be allocated by some form of direct
rationing

Example 16.8
Example 16.12
Which of the following arguments provides support
for a government policy of subsidising higher Which of the following is an external benefit of rail
education? transport?
A Higher education is a public good A The revenue from rail fares
B_ The social benefit of higher education exceeds the B_ Reduced road congestion
private benefit C The comfort of rail travel
C The provision of higher education helps to D The sale of refreshments on trains
increase the size of the labour force
D Higher education helps to redistribute income as
the poor participate in higher education to a
16.5 Solutions to objective
greater extent than middle- and high-income
groups
oP yihe An SM tan ee $48) ey

Solution 16.3. Answer: B

Example 16.9
Human capital is the accumulated skill, knowledge
In a cost-benefit analysis of a proposed motorway, and expertise of workers. Education and training
which of the following is unlikely to be included increase the value of human capital, thereby raising ©
among the prospective benefits? workers’ productivity.
 work out a Ld AS =

Solution 16.4 Answer: B consumption choices people take into account private
benefit rather than social benefit. Left to market
The price of houses can rise as a result of an increase
forces, higher education is likely to be underprovided.
in demand or a decrease in supply. Higher disposable
A => Higher education is a merit rather than a
income will result in an increase in the demand for
public good.
houses, which have positive income elasticity of demand.
C => The provision of a higher education reduces
A => Arise in the rate of interest will increase the
the size of the labour force but raises its quality.
mortgage interest rate, which will in turn reduce the D = The middle- and high-income groups
demand for houses participate in higher education to a greater extent than
C and D = will increase the supply of houses and
the poor.
reduce price.

Solution 16.9 Answer: D

Solution 16.5 Answer: D
There is likely to be a deterioration in the quality of
Knowing that they will have to repay the loans, some the environment near a motorway.
students are likely to reject courses that are not A, B and C = are all likely to occur and would be
directly job related in favour of, for example, degree taken into account in a CBA.
courses in accountancy and medicine.
A => Replacing student grants with loans will
reduce government expenditure on higher education, Solution 16.10 Answer: B
ceteris paribus. A grant of £5000 to buy a house costing less than
B = The introduction of a student loan scheme is £80 000 will increase demand for houses in that price
likely to discourage some potential students from range. This will raise the price of those houses and
undertaking higher education courses. make them easier to sell. People selling these houses
C = The private rate of return on investment in will be able to ‘trade up’ and buy more expensive
higher education will fall as students will have to pay houses. This process will continue upwards through
back the loans out of their future income. the price range.

Solution 16.6 Answer: C Solution 16.11 Answer: D

A fall in mortgage interest rates will increase the Unless unlimited resources are devoted to higher
demand for houses, thereby raising their price and education (a very unlikely event!) demand for free
leading to an expansion in house building. higher education will exceed supply and will therefore
have to be rationed in some way. In practice this is
likely to be by requiring students to gain a certain
Solution 16.7 Answer: D
level of qualifications.
A socially efficient urban road tax would ensure that A => This does not necessarily follow and is an
the level of road congestion is reduced to the point unlikely proposition.
where the marginal benefit of congestion reduction B = Higher education has an opportunity cost as
equals the marginal cost of congestion reduction. The the resources used to provide it could be put to
benefit that people are likely to derive from using a alternative uses.
large number of resources to eliminate all road C = Higher education can, and is, provided by the
congestion is likely to be less than if some of these private sector. Students can be excluded from
resources are put to alternative uses. enjoying higher education unless they pay.

Solution 16.8 Answer: B Solution 16.12 Answer: B

Education has positive externalities. It is not only the An external benefit is a benefit from the production or
students themselves who benefit from education. consumption of a good or service experienced by
Society also benefits from having a better informed people who are not involved in the production of the
and skilled population. When making their good and are not consumers of it, i.e. third parties.
 gerry
ey

146 Avork outtfeco Yomics e market failure and government intervention

Road users can benefit from other people travelling by requiring car manufacturers to fit, and drivers and
rail. their passengers to use, seat belts. Other examples of
A, C and D = are private benefits. merit goods include training and inoculation.

(b) In the UK education and health are both private

and merit goods. To benefit from private medical care
16.6 Essays
people have to pay and those who are willing or able
to do so are excluded. Similarly if people do not pay
Example 16.13
school fees for their children, those children will not
(a) Define public, private and merit goods. be able to receive private education (unless they gain a
(15 marks) scholarship).
(b) What type of goods are education and health? However in the UK most people receive medical
(10 marks) care under the National Health Service and most
children receive state education. In these cases the
¢ Give clear definitions, bringing out the
services are financed by taxation and provided free to
characteristics of the examples.
consumers because the state views them as merit
¢ Give examples.
goods. The consumers may lack knowledge about the
true benefits of these services, may take short-term
Solution 16.13 views on them and may just make mistakes. So both
these services would be underconsumed if left entirely
(a) A public good is one that is non-rival and non-
to market forces.
excludable. This means that one person’s enjoyment
Education and health also provide both private and
of the good does not reduce another person’s, and that
external benefits. Education provides enjoyment and
those who are not willing to pay for the good cannot
increases the potential earning power of the
be excluded from consuming it — they can be free
consumers. It also creates a better educated
riders. These are the two defining characteristics of a
workforce, which benefits third parties by increasing
public good, which may also have other
the quantity and quality of output. Consumers of
characteristics. The marginal cost of providing the
health care receive the private benefit of improved
good to one more individual is often zero and it may
quality of life and others gain from increased output
be non-rejectable in the sense that individuals may not
and reduced risk of catching contagious illnesses.
be able to abstain from consuming it even if they want
to. Examples of public goods include defence, public
drainage, flood control dams and street lighting. The Example 16.14
market mechanism will not provide public goods.
They have to be financed by the state, through Discuss the effects on the housing market of:
taxation or borrowing, and are provided directly or by (a) the abolition of tax relief on mortgage interest
giving contracts to private sector firms. payments (9 marks)
A private good is one that is both rival and . (b) arise in real income (8 marks)
excludable. One person’s consumption will mean that (c) an increase in the wage rates of building workers
the good is not available for another person to (8 marks)
consume it. The enjoyment of the good can also be
made dependent on payment. Most goods are private ¢ Include diagrams.
goods. Examples include books, cars, televisions and ¢ Concentrate on the short run.
yachts. Private goods can be provided through the ¢ Consider the effects on demand, supply and price.
market mechanism.
A merit good is one that is underprovided by the
Solution 16.14
market mechanism as individuals do not appreciate its
true benefits. It is also likely to have positive (a) Most people buy houses with the use of a loan —a
externalities. A state can encourage the consumption mortgage. If tax relief on mortgage interest payments
of merit goods by providing them free to consumers, were to be abolished, this would increase the amount
by subsidising them, by providing information about of interest house buyers would have to pay on their
their benefits or by passing legislation, for example mortgage loans. This is likely to discourage some
 work out economicsi@=-key

first-time buyers and some people,who had been Houses are normal goods with positive income
seeking to sell their existing property and to purchase elasticity of demand. So income and demand move in
more expensive accommodation. The demand for the same direction. Demand for houses is relatively
mortgage loans would decrease. Mortgage loans and income elastic. A rise in real income means that
houses are in effect, complements. The decrease in people’s purchasing power also rises. They are able to
demand for mortgage loans would cause a decrease in borrow more and purchase more expensive houses.
the demand for houses, which in turn would cause Higher incomes also promote house purchase via
prices to fall and supply to contract. expectations and the ‘feel good factor’. When
incomes are rising and the economy is expanding
people feel optimistic and may be more confident that
Price &
of
they will be able to pay off a larger loan. Changes in
houses income and economic activity can have a significant
effect on the housing market.
P
(c) An increase in the wage rates of building workers
P, that is not offset by an equal rise in productivity will
cause building costs to rise. This in turn will cause
supply to decrease, prices to rise and demand to
contract.

D, D
Price S;
0 Q, Q Quantity of houses of iS
houses
Figure 1

P,
A change in demand could have a significant effect
on price as both demand for and supply of houses are P

relatively price inelastic. A gradual withdrawal of

mortgage interest tax relief is planned by both major
UK political parties.
(b) A rise in real income would increase the demand D
for houses, thereby raising their price and causing 0 Q, QO Quantity of houses
supply to expand. Figure 3

Price Ss
A rise in wage rates may cause a relatively large
of decrease in supply as house building is still a labour-
houses
intensive industry where wage costs make up a
significant proportion of total costs. The rise in wage
P, rates may stimulate the building industry to become
P
more capital-intensive.

D,
D

0 Q Q, Quantity of houses

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 Date Self-
completed | assessment

Za Fact sheets -

er Investigative study

Data response ‘oe

Objective questions ee

Essays
17.1 Fact sheet (i) The income method
First calculate total domestic income by adding up all
(a) Indicators of living standards the money earned by people and firms in producing
this year’s output. Include:
A number of indicators of living standards are used,
including: (1) income from employment;
(2) income from self-employment;
(1) national income figures; rent;
(3)
(2) measurable economic welfare (MEW); gross trading profits of companies;
(4)
(3) the human development index (HDI); gross trading surpluses of nationalised industries;
(5)
(4) consumer durables per head; an imputed charge for the consumption of non-
(6)
(5) mortality rates; traded capital.
(6) the amount of time taken to earn sufficient money
Then proceed as in Figure 17.1
to buy given products.
GDP refers to gross domestic product and is a
See also Section 27.1 (a).
measure of economic activity within a country.
GNP refers to gross national product and is a
(b) Uses of national income figures measure of the activity of the country’s citizens all
National income figures have a number of functions. over the world.
They provide data for: NNFP refers to net national product and is the
technical term for national income.
(1) showing the current allocation of resources; NDP refers to Net Domestic Product and is NNP
(2) government economic planning; minus property income from abroad.
(3) calculating trends within the economy; Stock appreciation is the increase in the value of
(4) measuring a country’s standard of living; inventories brought about by inflation.
(5) comparing standards of living between different
Statistical discrepancy occurs because income and
countries.
expenditure data are collected from different
sources. The two statistical discrepancies used in
(c) Calculating national income the income and expenditure methods are jointly
National income is the money value of the goods and known as the residual error. They are amounts
services produced by a country in one year. There are used to balance up the difference between the two
three methods of calculating national income. estimates.
 Net
— Stock
Total property GNP at
appreciation _ Capital
domestic income =| factor ;
consumption
= factor
+ statistical
income
discrepancy
from cost cost
abroad

Net
NNP at property
factor income =
cost from
abroad

Figure 17.1 The income method

(ii) The expenditure method ¢ Adding up each sector’s value added, and
including an imputed (estimated) value for the
First calculate total domestic expenditure by adding ownership of dwellings, gives GDP at factor cost.
up all the money spent buying up this year’s output.
The relationship between the different measures of
Include:
national income is shown in Table 17.1.
(1) consumer expenditure (C);
(2) general government final consumption (G); (d) Problems in calculating
(3) investment expenditure (/) on: national income figures
(a) gross domestic fixed capital formation (e.g.
Difficulties arise in the calculation of national income
machinery, vehicles);
figures because of:
(b) physical increase in stocks and work in
progress. (1) double counting if transfer payments (e.g.
pensions), intermediate expenditures or outputs
Then proceed as in Figure 17.2. (e.g. components) and stock appreciation are
included;
|

(2) unrecorded production in the black economy;

(iii) The output method (3) arbitrary definitions:
(a) the imputed value of services from owner-
The economy is divided into industrial sectors (e.g.
occupied houses is included in national
construction etc.). The value of inputs (purchases) is
figures, while the imputed value of services of
then deducted from the value of outputs (sales) to find consumer durables (e.g. cars) is not;
each industrial sector’s value added. For example: (b) paid production (e.g. a decorator) is included
Sales — purchases = value added in national income figures, while unpaid
£60b — £50b = £10b production (e.g. DIY) is not.

- Taxes on Then proceed

Total + Exports = as for the
ary likepee = expenditure
domestic income
a Statistical + Subsidies
income method
discrepancy

Figure 17.2 The expenditure method

Table 17.1 National income accounting equations

National income national expenditure = national output
GNP = GDP +net property income from abroad
NNP = GNP — capital consumption
NDP = NNP — net property income from abroad
Gross investment = net investment + capital consumption
Factor cost = market prices — expenditure taxes + subsidies
 hh@ national economy

(e) Real and money national (3) additional output is on non-consumer items such
—

income as defence and capital goods;

(4 increased output is the result of harder conditions
—

¢ Money (or nominal) national income (MNY) is of work or reduced leisure time;
the value of this year’s output at current prices. (5 quality of output declines
—

* A price deflator is an index used to eliminate the

effect of inflation. There are two main price
indices in the UK:
(g) Comparing living standards in
(a) the retail price index (RPI), covering only
different countries
consumer goods and services; Using per capita RNY to compare standards of living
(b) the GDP deflator, covering both consumer and between countries is difficult because:
capital goods.
(1) the distribution of income varies between
¢ Real national income (RNY) is the value of this
countries;
year’s output at constant prices and is calculated
(2) the extent of the black economy varies between
by using either of the following equations:
nations;
NNY (3) the proportion of capital and defence goods
RNY = —————_ X_ 100
GDP deflator differs between countries;
price index of base year (4) working hours and conditions vary between
RNY =MNY, eres ee countries;
price index of current year
(5) different statistical procedures are used to
calculate national income in different countries;
(6) the extent of externalities varies between
(f) Using national income figures countries;
as a measure of a country’s standard (7) the amount of home-produced goods and services
of living varies between countries.

¢ Changes in the exchange rate can affect the

In assessing standard of living it is appropriate to use
relative value of each country’s national income.
real national income per capita (per person). This is
For this reason national income figures are
calculated by using the equation:
increasingly being compared with the use of
RNY purchasing power parities — e.g. if a basket of
Standard of living = —————— goods costs £40 in the UK and $60 in the USA,
population
then national income should be converted at an
Table 17.2 gives examples of calculating changes in a exchange rate of £1 = $1.5.
country’s standard of living, over time.
An increase in the value of RNY per capita implies (h) Measurable economic welfare
an increase in economic welfare, unless: (MEW)
(1) only a small fraction of the population receive the MEW (devised by Nordhaus and Tobin) adjusts GDP
benefits because of an unequal distribution of by adding the value of, for example, leisure time, DIY
income; and unpaid housework and deducting expenditure on,
(2) additional output results in negative externalities for example, defence, police and road maintenance
such as pollution; and negative externalities.

Table 17.2 Calculating the standard of living

MNY RPI RNY Population SOL

Year (£m) (deflator) (£m) (m) (£)

1989 £20 000 100 £20 000 5.0 £4000

1990 £22 000 105 £20 952 5.0 £4190
1991 £24 000 110 £21818 5.5 £4970
 work out economics ¢ mer oliving ~~

(a) What is the black economy? (5 marks)

(i) Human development index
(b) How can the size of the black economy be
(HDI)
estimated? (3 marks)
The HDI was introduced by the UN in 1990. It is (c) What factors influence the size of the black
based on three sets of indicators: economy? (8 marks)
(d) What are the disadvantages of the black
(1) Real GDP
economy? (6 marks)
(2) Mean years of schooling and adult literacy
(e) Mention one of the benefits of the black
(3) Life expectancy
economy. (3 marks)
These take into account not only the goods and
services produced but also the ability of a population
to use them and the time they have to enjoy them. Solution 17.2

(a) The black economy covers undeclared and hence

itive study unrecorded economic activity. The output of goods
and services may not be declared in order to avoid
paying tax on the resulting income. For instance a
roof tiler may repair a roof damaged in a storm. He
A comparative study of living standards in two
may ask to be paid in cash and not include the figure
countries.
in his earnings when completing his tax return. The
other reason for not declaring economic activity is
17.3 because the activity is illegal, e.g. the sale of
unlicensed guns.

(b) The size of the black economy can be estimated,

as the extract mentions, by comparing the amount
people spend and the incomes they declare to the tax
BRITAIN’s black economy — The IFS researched household authorities. The gap between expenditure and income
income and spending that evades spending and compared it with can give an indication of undeclared economic
the taxman — may have topped the declared incomes of the self-
£50 billion, according to Inland employed. It concluded that their activity.
Revenue estimates. Data for cash true incomes were up to 12 times
in circulation and employment those declared for tax purposes. (c) The size of the black economy is influenced by a
Taken with a rise of more than 1m
suggest the black economy is
in self-employment since the late number of factors. One is the tax rate. The higher
growing faster than the officially
recorded economy, probably 1970s, this points to a substantial taxes are, the more people may be tempted to evade
increase in the black economy.
because, with taxes going up,
there is a greater incentive to
them. Their decision as to whether or not to take this
Source: Extract from ‘Missing
avoid them. Billions that Dwarf Government action will also be influenced by the detection rate of
The black economy ranges
from criminal activities such as
Spending’, by David Smith, The tax evasion and the penalties imposed.
Sunday Times, 13 February 1995
drug-dealing and theft to unde- Tax evasion is also affected by how many people
clared self-employment income
by plumbers, builders and decora- are self-employed. The larger the size of the self-
tors. It can include selling by pro- Britain's
black
employed sector, the greater the amount of tax evasion
fessional traders at car-boot sales
and the re-sale in Britain of alco- economy that tends to occur. This is because tax evasion is
hol and tobacco bought at low easier when people are responsible for paying their
duty in France.
The Inland Revenue, drawing own tax than when it is deducted at source.
on research last year by the Insti-
tute for Fiscal Studies (IFS), esti-
The size of the black economy is also influenced by
mates the black economy is worth the public attitude to law-breaking, both in terms of
tax evasion and in terms of, for example, selling drugs
6%-8% of gross domestic prod-
uct — or between £41 billion and
£54 billion for 1994-95. If taxed and crime detection rates and penalties.
at the same rate as the rest of the
economy, it would bring in £14.5 Missing tax? (d) The black economy results in a loss of
billion-£19 billion in extra rev- £17bn |
enue, enough to wipe out the tax government tax revenue. As the extract indicates, this
70 20 30 40 £50bn
could be above £50 billion. This amount exceeds
increases announced last year by
Kenneth Clarke, the chancellor,
and his predecessor, Norman expenditure on, for example, education. If the tax
Lamont.
were to be collected it would enable spending on
 tional economy

education or another area to rise or tax rates to be A Real national income

reduced. B_ Nominal national income
The existence of the black economy can also make C Per capita real national income
government planning difficult. Using official national D Per capita nominal national income
income figures the government may underestimate
economic activity and may inject extra spending into
the economy when activity is already high. Example 17.7
(e) The black economy may enable certain goods and The following table gives information about a country
services to be produced that would otherwise not be in 1995, 1996 and 1997. In 1994 real GDP per capita
provided. For example a plumber may not be prepared was £8200
to mend a leaking pipe for a pensioner if the return is
too low.
GDP GDP deflator Population
(£ millions) index (1990 = 100) (millions)
17.4 Objective questions 1995 440000 110 50

Example 17.3
1996 450000 120 50
1997 480000 120 Si
Which one of the following is not a reason for a
country collecting national income statistics? From the data, it can be deducted that real GDP per
A To calculate changes in the cost of living Capita:
B_ To estimate the rate of economic growth A has increased in all three years
C To calculate changes in the standard of living B_ has decreased in all three years
D To compare standards of living between countries C increased in 1995 and 1996 only
D decreased in 1995 and 1996 only
Example 17.4
On reaching 65, a builder earning £30 000 per year
sells his firm for £200 000 but stays on as a consultant Example 17.8
for a fee of £8000 per year. He receives an annual If, over the last twelve months, prices have gone up by
occupational pension of £9000. One of two assistants, 6%, the population has increased by 2% and nominal
each earning £12 000, loses his job and is not eligible national income has risen by 6%, then:
for state benefits. As a result national income: real national income has increased
A rises by £175 000 real national income has decreased
B rises by £166 000 real income per capita has increased
C falls by £25 000 —om real income per capita has decreased
D falls by £34 000

Example 17.5 Example 17.9

Gross national product exceeds gross domestic All other things being equal, which of the following
product by the amount of: would increase the average standard of living of a
transfer payments country?
capital consumption A A fall in population and no change in national
subsidies less expenditure taxes product
Pp
STAm
net property income from abroad B_ Nochange in population and a decrease in national
product
C Arise in population and a proportionately smaller
Example 17.6
increase in national product
Which of the following is the most accurate measure D A fall in population and a proportionately greater’
of a country’s standard of living? decrease in national product
 work out economics ¢ measure living praf is 5

Example 17.10 measure of incomes generated within the UK,

irrespective of the nationality of the people who have
The difference between gross national product at
earned them. So GNP is GDP plus net property
factor cost and net national product at factor cost is:
income from abroad.
A imports
B_ depreciation
C taxes on expenditure Solution 17.6 Answer: C
D net property income from abroad
Per capita real national income is national income
adjusted for changes in the price level and changes in
Example 17.11 population. A rise in per capita real national income
will indicate a rise in the material standard of living of
Which of the following is included in the measure of
the population, whereas a rise in national income may
measurable economic welfare but not GDP?
not mean a rise in the number of goods and services
A Exports
available per head of population. It is possible that the
B_ The value of leisure time
same number of goods and services have been
C The output of consumer goods industries
produced but at a higher price, or that changes in
D Government expenditure on goods and services
output have merely kept pace with changes in
population — there are more goods and services to
Example 17.12 share among a larger population.
Which of the following must increase the quality of a
person’s life? Solution 17.7. Answer: D
A Amore even distribution of income
B An increase in negative externalities There are two stages in calculating real GDP per
C An increase in expenditure on the police force capita:
D None of the above (1) divide GDP by the GDP deflator to find real
GDP;
(2) divide real GDP by population

In 1995 real GDP = (£440 000/110) = £400 000, so

real GDP per capita = £4000 000/50 = £8000.
In 1996 real GDP = (£450 000/120) x 100 =
£375 000, so real GDP per capita = £375 000/120 =
Change in the cost of living is calculated by use of the £7500.
retail price index. In 1997 real GDP = (480 000/120) < 100 =
B, C and D = are all reasons for a country £400 000, so real GDP capita = £400 000/51 = £7843.
collecting national income statistics.

Solution 17.8 Answer: D

Solution 17.4 Answer: D
A and B = Equal percentage increases in nominal
The pension of the builder (a transfer payment) and
(money) national income and prices mean that real
the money received from the sale of the firm (a
national income is unchanged.
transfer of ownership) are not included in national
C = A 2% population increase with constant real
income. The fall in national income is £22 000 (the
national income means that real income per capita has
builder’s reductions in earnings) + £12 000 (the loss
decreased.
of the assistant’s salary) = £34 000.

Answer: D Solution 17.9 Answer: A

Solution 17.5

Gross national product is a measure of incomes The question states all other things being equal, so it
earned by UK residents in whichever countries they can be assumed that there has been no change in the
earn them, whereas gross domestic product isa general price level. So when it states in option A that
national product has remained constant, it can be e« Material welfare is the satisfaction derived from
taken that real national product is unchanged. The the consumption of wealth.
same real national product to be shared among a ¢ National income is a narrow measure of a nation’s
smaller population will mean a rise in real national wealth creation in a given time period.
income per capita. ¢ Include a discussion of the circumstances in which
B, C and D = would all result in a fall in the an increase in national income does and does not
average standard of living of a country. improve welfare.
¢ A detailed discussion of how national income
accounts are calculated is not required.
Solution 17.10 Answer: B

Gross national product includes all investment, i.e.

Solution 17.13
both net investment and replacement investment
(which can also be called capital consumption or (a) Any asset that can be exchanged for money can be
depreciation), whereas net national product only regarded as an item of wealth. There are two main
includes net investment. So GNP minus depreciation types:
equals NNP.
(1) Material wealth consists of financial assets such
as shares, and real assets such as property and
Solution 17.11 Answer: B consumer durables.
MEW takes the value of leisure time into account (2) Human wealth consists of the skills, training and
education of individuals.
whereas GDP does not.
A and C = are included in both MEW and The consumption of material wealth satisfies the
GDP. wants and needs of individuals. The higher an
D => Government expenditure on goods and individual’s rate of consumption the higher his or her
services is included in GDP and most is included in material welfare. Hence wealth and material welfare
MEW, although spending on certain items, e.g. are interlinked.
defence, are omitted.
(b) A nation’s stock of wealth allows it to produce an
enormous variety of goods and services, which can
Solution 17.12 Answer: D
then be used to satisfy material wants and needs.
A => This will benefit some people, particularly the National income is simply the money value of all final
poor, but not necessarily everyone. products provided during a year that flow through the
B = although owners of some of the companies markets. Hence national income is an indicator of
creating externalities may benefit from a fall in their economic welfare.
costs of production, negative externalities will reduce However an increase in national income does not
the quality of most people’s lives. automatically raise living standards. For instance an
C => The quality of people’s lives will improve if increase in national income may be the result of an
the expenditure on the police force reduces crime and increase in the price level, with output held constant,
the fear of crime. However if the expenditure is or an increase in output, with prices held constant.
undertaken in order to keep pace with rising crime, Only the latter suggests an increase in material well-
people will suffer a deterioration in their living being. To measure changes in real as opposed to
standards. money national income, output is valued at constant
prices by dividing current money national income
by a general index of all prices, called the GDP
17.6 Essays
deflator.
Yet an increase in real national income is still no
Example 17.13 7
guarantee that average living standards have
(a) Distinguish between wealth and welfare improved. Any improvement in material standards
(5 marks) could be negated by a proportionately larger increase
(b) Does an increase in national income mean an in population. The actual standard of living of a nation -
improvement in welfare? (20 marks) is found by dividing real national income by the total
 work out economics aaeges living PriagH 57

population. Material well-being, then, increases only * Detailed knowledge of other countries’ economic
if per capita real national income increases. systems is not required.
It can be argued that per capita real national income * Place the emphasis of the essay on the problems of
is a restrictive, narrow welfare indicator. Official comparing the living standards of different
statistics only count final products sold in markets and countries.
ignore the value of non-market activities such as the
output of unpaid housekeepers. The value of leisure
Solution 17.14
time finds no place in national income accounts.
Official statistics fail to take into account the impact Standards of living can be compared in a number of
of intangibles such as the quality of the environment ways, however they are often defined in terms of real
on overall social welfare. The presence of negative per capita income. Hence international comparisons
externalities may cause the material and social are usually made by referring to national income
welfare of a nation to diverge. statistics. However great care should be taken when
William Nordhaus and James Tobin (1972) have using raw national income figures. Money national
devised an alternative measure of social welfare: income states the value of this year’s final marketed
measurable economic welfare. Here real national output at current prices. An increase in one country’s
income is adjusted to include an allowance for non- nominal national income may be the result of inflation
marketed output and leisure time, while expenditure rather than an increase in total output. Therefore
on ‘regrettable necessities’, including defence, and the national income divided by an index of all prices —
effects of negative externalities such as pollution are e.g. the GDP deflator — provides a better basis for
deducted. An improvement in measurable economic comparison. Even then, real GDP alone is not an
welfare indicates an improvement in social welfare. accurate guide to a country’s standard of living. The
Similarly an increase in human development index, real GDP of China is obviously higher than the real
which takes into account income levels, years of GDP of Luxembourg. So it is necessary to divide
schooling and average lifespan, would indicate an GDP by total population. This will show that the real
improvement in welfare over time. The United GDP per capita of Luxembourg is higher than that of
Nations publishes data on the infant mortality rates, China.
suicides and road accidents of various countries. A A further adjustment is also often made to convert
fall in these figures implies an improvement in a the figures of each country to the same currency. This
nation’s quality of life. Similarly an increase in the can cause problems if the market rate of exchange of
proportion of the population owning various types of one country does not reflect different costs of living.
consumer durable such as video recorders, or a For example the amount of roubles exchanged for £1
reduction in the time taken to earn sufficient money to at the official rate may buy fewer goods in Russia than
buy given products, implies improved social welfare. can be bought with £1 in the UK. Converting Russian
In conclusion, it has been shown that a country’s national income into sterling at the official exchange
stock of wealth helps to determine the quantity of rate would result in an overvaluation. Moreover a
goods available for the satisfaction of material wants number of countries have floating exchange rates, and
and needs. Increases in real per capita national income the resulting continual changes in the relative value of
are a suitable indication of improvements in material currencies make a direct comparison difficult. It is for
welfare. However a simultaneous and larger increase these reasons that increasing use is being made in
in negative externalities or reduced leisure would international comparisons of GDP and other national
lower overall social welfare. income figures of purchasing power parities. This
involves converting the GDP figures not in terms of
the official exchange rate, but in terms of how much
Example 17.14 of the domestic currency is needed in each country to
buy a given basket of goods. For instance if it takes
Discuss the difficulties involved in comparing the
270 roubles and £90 to buy the basket the GDP of
standards of living of different countries.
Russia would be converted on the basis of 3 roubles =
(25 marks)
£1, even if the official exchange rate was 2 roubles =
¢ Discuss various methods of measuring living £1.
standards. Countries vary in terms of what proportion of
 a 2 j
« he
a

are
fia tional economy
) eal

economic activities are recorded. Intensive of Brazil is not. Thus the national income of Finland
specialisation means that most UK citizens use includes expenditure on heating, which Brazil does
markets to buy the goods and services they do not not have to undertake to the same extent, and the
have time to make or carry out themselves. Hence UK value of the resources used to heat buildings is
national income figures include most of the economic included in Finland’s national income.
activity that took place in the previous year. Working conditions, working hours, the distribution
Unmarketed and undeclared activity (the black of income and the quality of goods produced will
economy) is only likely to account for a small differ between countries. The extent of negative
percentage of total output. For example the tax returns externalities, e.g. pollution, and the proportion of
of a UK farmer are usually an accurate indicator for national income spent on ‘regrettable necessities’ also
national income accountants of the value added by a vary between countries. For example defence
farmer in any one year. By way of contrast, markets spending in the UK accounts for a larger percentage
are less developed in, for example, Mali because of GDP than in Switzerland. Measurable economic
communities are more self-sufficient and practice less welfare, developed by Nordhaus and Tobin, adjusts
specialisation and exchange. The output of a Mali GDP figures by deducting expenditure on ‘regrettable
farmer will not be officially recorded if a crop is either necessities’, negative externalities and expenditure on
consumed by the farmer or exchanged for other consumer durables and adding services given by
goods, or if the income from it is not declared to the consumer durables, the value of non-marketed work,
authorities. including DIY, and the value of leisure time.
Problems arise when different countries use A number of other measures of welfare are used to
different statistical procedures when calculating make international comparisons of standards of living.
national income figures. For instance Cuba is a The country where least time is taken by a worker to
planned economy where resources are allocated by earn sufficient income to buy a given basket of goods
the state. Official prices are used to value output, but is likely to enjoy the highest standard of living. Low
these may not reflect the relative value of goods and suicide rates and low infant mortality rates also
services consumed in Cuba. indicate a good quality of life. The human
Physical conditions vary widely between countries. development index takes into account not only income
The climate of Finland is severe in winter; the climate levels but also access to education and average life span.
 Price
level

ggregate demand curve

Aggregate demand (AD) is the total of all planned
expenditure at each level of prices. It is composed
of consumption C), investment (/), government
spending
(G) and exports minus imports (X — M):

AD=C+1+G+(X
— M) Aggregate
demand
The aggregate demand curve slopes down from
left to right because:
(a) the lower the price level the lower the interest 0 National output

rate and hence the greater the demand for Figure 18.1 Aggregate demand
interest-sensitive investment and consumer
goods;
(b) as prices fall, people’s wealth buys more
products;
(c) as UK prices fall, UK and overseas consumers Price
level
substitute UK goods for goods produced
overseas.

(b) Movements along and shifts in

aggregate demand
A movement along the aggregate demand curve is
caused by a change in the price level. AD,
The AD curve shifts to the right if there is an
AD
increase in aggregate demand at each price level.
This may be the result of an increase in planned:
0 National output
(a) consumption due to, for example, a fall in tax
rates; Figure 18.2 An increase in aggregate demand
160

(b) investment due to, for example, a rise in

optimism;
(c) government spending due to, for example, a
rise in the government’s desire to promote
training;
(d) exports due to, for example, an improvement
in the quality of UK goods and services.

(c) Consumption
Consumption is expenditure by households on goods
and services that satisfy current wants.

¢ The consumption function in Figure 18.3 shows

how much will be spent at different levels of 0 G H Yo
disposable income and is given by the equation: Figure 18.4 The marginal propensity to consume: DE/GH = b

C=a+byYy
Influences on consumption include level of
where C = consumption, a = autonomous disposable income, credit facilities, distribution of
consumption (what is spent when income is zero income, the population’s age structure, quality and
and does not vary with income), b = the marginal availability of consumer goods, amount and
propensity to consume and Y = disposable income. distribution of wealth and expectations of inflation.
bY is income-induced consumption. It is important to remember that there is more than
¢ As disposable income rises the amount spent rises, one theory of consumption. Most economists agree
depending on the value of the marginal propensity that the main influence on consumption is income.
to consume. As disposable income rises, the However there are three main theories as to which
proportion spent usually declines. particular form of consumption is most important:
¢ The average propensity to consume (APC) is the
proportion of disposable income spent: (1) Absolute income hypothesis: this is the Keynesian
APC OY. view that consumption depends on current
¢ The marginal propensity to consume (MPC) is the disposable income.
proportion of each extra pound of disposable (2) Relative income hypothesis: this is the theory put
income spent by households and is the change in forward by Duesenberry that people’s
consumption resulting from a change in consumption is influenced by the spending
disposable income: MPC = AC/AY. pattern of others.
(3) Permanent income hypothesis: this is the view put
forward by Milton Friedman that spending is
based on average lifetime income.

(d) Saving
Saving is that part of disposable income (income less
direct taxes plus state benefits) not spent on goods and
services.

¢ The saving function shows how much will be

saved at different levels of disposable income and
is given by the equation:

=—at+SY
0 H ts
Figure 18.3 Autonomous and induced consumption: OA or where S = saving; —a = autonomous dissaving
HF = autonomous consumption = a; DH/BH = APC (the amount of S when Y = 0); s = the marginal
 work out cconomighheaa Geeppmanfhs:

propensity to save, Y = disposable income and (f) Government

sy = induced saving. As income rises, both the
amount saved and the proportion saved usually Government spending (G) adds to aggregate demand
increase. and taxation (7) reduces it.
¢ The average propensity to save (APS) is the ¢ The marginal rate of tax (MRT) which is also
proportion of disposable income saved: called the marginal propensity to tax (MPT) is the
APS = S/Y proportion of each extra pound of income taken by
¢ The marginal propensity to save (s or MPS) is the the government, and is the change in tax resulting
proportion of each extra pound of disposable from a change in income: A7/AY.
income not spent and is the change in saving ¢ The average rate of tax (ART) is the proportion of
resulting from a change in income: s = AS/AY total income taken in tax: 7/Y.

Savings (g) The international sector

Exports (X) add to income and demand in the home
economy whereas imports (M) result in income

Savings
leaving the domestic economy and aggregate demand
falling.
Dissavings ¢ The marginal propensity to import (MPM) is the
proportion of each extra pound of disposable
income spent on foreign-made goods and is the
Figure 18.5 The savings function change in expenditure on imports resulting from a
change in disposable income: AM/AY.
Influences on saving include level of income, rate of
interest, rate of inflation, quality of financial
institutions, general attitudes to the virtue of saving,
government policies (e.g. tax concessions), ey

expectations of inflation, and advertising. Example 18.1

An investigation into changes in the savings ratio,
their causes and effects.
(e) Investment

18.3 Data response

Investment is expenditure on capital goods and
changes in stock.

¢ The marginal efficiency of capital is the expected

rate of return on investment. Example 18.2
prices)
¢ The accelerator theory states that a given change (£ million, 1990
in the demand for consumer goods will cause a
greater percentage change in the demand for Gross domestic Treasury
capital goods. So the level of planned investment GDP atfactor _ fixed capital bill
is a function of changes in income: Year cost formation rate

I=(F)AY 1988 465 746 105 164 12.91

1989 476228 111 470 15.02
The level of investment is also influenced by: 1990 478 886 107 577 13.50
(a) the rate of interest; 1991 468 913 94 403 10.45
(b) the relative prices of capital and labour; 1992 466 564 96 280 6.44
(c) corporation tax; 1993 475 889 96 611 4.98
(d) technological change and innovation;
(e) business expectations; Sources: CSO, Economic Trends, Annual Supplement,
(f) profits. 1995; Monthly Digest of Statistics, February 1995.
 national economy

(a) Define: changes in investment. The accelerator theory is

(1) GDP at factor cost; actually concerned with net investment. Nevertheless
(2) gross domestic fixed capital formation; it can be expected that if income starts to rise more
(3) treasury bill rate. (3 marks) quickly firms will wish to expand their productive
(b) Do the data indicate a relationship between capacity and hence buy more capital goods. Similarly
changes in GDP at factor cost and changes in if income starts to grow more slowly firms may
gross domestic fixed capital formation? (5 become reluctant to expand.
marks) The data shows, with one exception, that
(c) Do your findings in (b) reflect the relationship investment fluctuated more than income. The fall in
that economic theory would lead you to expect? GDP in 1991 was probably a reaction to the
(6 marks) slowdown in economic activity and reflected
(d) Do the data indicate a relationship between entrepreneurs’ pessimism about the future. Positive
changes in the treasury bill rate and changes in growth in investment may have resulted in
gross domestic fixed capital formation? (5 entrepreneurs becoming more optimistic as the
marks) economy moved out of recession. The unusual
(e) Do your findings in (d) reflect the relationship relationship shown in 1993, with GDP growing more
economic theory would lead you to expect? (6 rapidly than investment, may be explained by other
marks) influences on investment.

(d)
Solution 18.2 %A gross
(a)(1) GDP at factor cost is gross domestic product at domestic fixed %A treasury
factor cost. It is a measure of output, income and Year capital formation bill rate
expenditure generated in a country in the period of 1989 6.0 16.3
one year. It is net of indirect taxes and subsidies. 1990 305 =10A
(2) Gross domestic fixed capital formation is total 199] 1212 seal
ky |
spending on fixed capital goods, e.g. plant and 1992 2.0 —38.4
machines, in the UK. 1993 0.3 ess |
(3) The treasury bill rate is the rate of interest paid
on treasury bills, which are short-term loans to the
government. It influences other interest rates in the The treasury bill rate fell from 1990 to 1993, whereas
economy. investment fell from 1990 to 1991 and then rose from
1991 to 1993. In 1989 both investment and the
(b) treasury bill rate rose. In three of the five years the
%A GDP %A gross variables moved in the same direction.
at factor domestic fixed
(e) It would be expected that investment and the
Year cost capital formation
interest rate would move in opposite directions. A fall
1989 Did 6.0 in the interest rate might increase investment as it will
1990 0.6 3D become cheaper to borrow to finance investment, and
1991 =2:1 2.2 if — as in most cases — retained profits are used,
1992 =5 2.0 marginal investment projects become viable. Figure 1
1993 2.0 0.3 shows a fall in the interest rate, causing planned
investment to rise.
The data do not bear out this expected relationship.
The data shows that in three of the five years GDP and
At the start of the period investment rose despite a
investment change in the same direction and that in
large increase in the interest rate. In 1990 and 1991
tour of the five years the change in investment
falls in the interest rate did not cause investment to
exceeded the change in GDP in percentage terms.
rise. In 1992 and 1993 large falls in the interest rate
(c) The accelerator theory states that variations in the only caused small rises in investment.
rate of change in income cause greater percentage It would be useful to know the real interest rate, i.e.
 work out economia GeePprnattS

Example 18.5
Rate
of
interest An economy has a saving function (S$), which is
given by the equation S = — £500 + 0.2Y (where Y
is national income). If the level of national income
is £5000m, what is the average propensity to
R
save?
A 0.1 B 0.2 C 0.8 D 0.9

R,

MEC Example 18.6

In the diagram below, as income increases from
0 Q Q, Planned investment £15 000m to £17 000m, what is the marginal
Figure 1 propensity to consume?
A 0.8 B 0.6 C 04 D 0.2
nominal interest minus inflation rate. With this
reservation, the data do suggest that in this period S+/

other influences on investment were more significant

than the interest rate.
£5800 m
£5000 m

questions
£15000 m £17000 m_ NY

A man has a rise in income from £25 000 to £27 000.

Example 18.7
As a result, his saving rises from £900 to £1300. His
MPC is | A firm makes 10 000 goods using 20 machines.
A 0.2 B 0.3 C 0.6 D 0.8 Each year two machines wear out. If demand for the
good rises to 12 000, gross investment will increase
by:
Example 18.4 A 50% B 100% C 200% D 300%
The following table shows a country’s consumption
schedule:
Example 18.8
In an economy, Y (national income) = C
Income (£m) Consumption (£m)
(consumption) + / (investment). If
0 60 consumption = £50m + 0.75Y, planned
100 130 investment = £80m and national income = £800m,
200 200 realised investment will be:
300 270 A £50m B £100m C £150m D £200m
400 340

Example 18.9
C is consumption and Y is national income. Which
of the following represents the consumption According to Keynesian analysis, consumption is a
function: function of:
A C=-—£60m + 0.3Y A permanent income
B C=£60m + 0.3Y B_ current income
C C=£60m + 0.7Y C estimated lifetime income
D C=£130m + 0.7Y D previous income
 fational economy

Example 18.10 Solution 18.6 Answer: B

Which of the following is concerned with how capital When income rises by £2000m, savings rise by
expenditure responds to a change in consumer £800m, so MPS = £800m/£2000m = 0.4. So MPC is
expenditure? l— 0.4=.0.6,
A The multiplier
B_ The accelerator Solution 18.7. Answer: C
C The consumption function
D The savings function Each machine makes 10 000/2 = 500 goods, and the
firm originally buys two machines. To produce an
extra output of 2000 it will need additional machines
Example 18.11 of 2000/500 = 4. So the firm will purchase a total of
The largest component of UK aggregate demand is: six machines — two replacement and four to expand
net exports output (net investment). Thus gross investment
investment (depreciation + net investment) rises from 2 to 6 —i.e.
consumption an increase of 4/2 X 100 = 200%.
Se
SQWgovernment expenditure
Solution 18.8 Answer: C
Example 18.12 Realised investment is actual investment and includes
Which of the following would cause a movement both planned investment and changes in stock.
along an aggregate demand curve? A change in: C=£50m + 0.75 X £800m = £650m. So
A_ business expectations savings = Y — £650m = £150m. Since actual
B_ the money supply investment = actual savings, actual investment will be
C the exchange rate £150m. This consists of £80m (planned
investment) + £70m unsold stock (£720m consumer
D the general price level
goods made but only £650m sold).

18.5 Solutions to objective Solution 18.9 Answer: B

questions —
According to Keynesian analysis, the main
determinant of consumption is current income.
Solution 18.3. Answer: D
A => Milton Friedman and other supporters of the
The man’s savings rise by £400 when his income rises permanent income hypothesis suggest that
by £2000. So his MPS is consumption depends on permanent income.
400/2000 = 0.2. 1 — MPS = MPC, so Therefore, if people experience what they expect to be
MPC = 1 — 0.2=0.8. a short-term change in income, they may not alter
their consumption.
Solution 18.4 Answer: C C = Franco Modigliani and Albert Ando
developed the life cycle hypothesis, which states that
The consumption function shows the relationship people estimate the income they are likely to earn
between income and consumption, i.e. C= a + bY. In over their lifetime and upon this base a lifetime
this case, autonomous consumption (a) is £60m and consumption plan.
MPC is 70/100 = 0.7. So the consumption function is
C = £60m + 0.7Y.
Solution 18.10 Answer: B

The accelerator theory states that a given change in

Solution 18.5 Answer: A
demand for consumer goods will cause demand for
If the savings function is § = —£500m + 0.2Y, then, capital goods to change by a greater percentage.
when NY is £5000m, total savings will be A => The multiplier is concerned with how NY
—£500m + 0.2 X £5000m = £500m. So changes as a result of a change in an injection, e.g. -
APS = £500m/£5000m = 0.1. investment.
 work out economic aggregate | man

Solution 18.11 Answer: C

Consumption is the largest single component of

aggregate demand and accounts for approximately
half of total final expenditure.

Solution 18.12 Answer: D

A rise in the general price level would cause a

contraction in aggregate demand, and a fall in the
general price level would cause an expansion in
Figure 1
aggregate demand. The one thing that can cause a
movement along the aggregate demand curve is a
incorporated by Keynes into his analysis, states that a
change in the general price level.
given percentage rise in the demand for consumer
A, B and C => would all cause a shift in the
goods will induce a greater percentage rise in the
aggregate demand curve.
demand for investment goods. For instance, if 100
goods are usually produced by 10 machines and one
18.6 machine wears out each year, then the demand for
capital goods will be one per annum. Should
consumption rise by 50% to 150 goods, the demand
for capital goods will rise by 500% to six machines,
Describe the interrelationships between consumption,
one of which will be to replace a worn-out machine
investment and income, and discuss how a change in
and five will represent net investment. However if
each one will affect the other two. (25 marks)
income is increasing, government investment may be
¢ Stress the interrelationships between the three reduced. Part of government investment may be
variables in Keynesian analysis. undertaken to influence the level of aggregate demand
¢ Make use of the multiplier and accelerator in the economy. When private-sector demand is low,
concepts. ' the government may inject investment into the
¢ Discuss how an increase in one variable will cause economy to raise aggregate demand. Conversely if
the other two to increase. private-sector demand is high, the government may
reduce investment in order to offset inflationary
pressures.
Solution 18.13
A rise in income will induce a rise in consumption.
Income, consumption and investment are all Income is the main influence on consumption. While
interrelated and are important variables in Keynesian investment is likely to increase by a greater
analysis. percentage than the rise in income that has brought it
Income equals consumption plus investment. If about, consumption is likely to rise by a smaller
investment and/or consumption rise, income will percentage than income. Keynes pointed out that,
increase. Keynes used Kahn’s concept of the when income rises, a person’s or a society’s spending
multiplier to show that not only will income increase, is also likely to rise. However the proportion of total
but also it will rise by a multiple amount. income spent (the average propensity to consume) and
A rise in investment and a rise in autonomous the proportion spent out of extra income (the marginal
consumption are injections into the circular flow of propensity to consume) are likely to decline. When
income, which will result in a multiple rise in NY. For people or a society are poor, the whole of their or its
instance, if investment increases by £50m and MPC is income is likely to be spent. Indeed there may be
0.8, the final rise in NY will be £50m X 5 = £250m. dissaving — i.e. spending more than income by
The diagram shows that a rise in investment from J to borrowing or drawing in past savings. However as
I, causes NY to increase from Y to Yj. income rises there will be increased opportunities for
Just as a rise in investment will result in a rise in saving and therefore, while both saving and spending
income, so an increase in income will cause a rise in will rise, the proportion devoted to consumption is
private-sector investment. The accelerator theory, likely to decline.
 Consumption and investment are not only
Price
components of national income, they are also level
influences on the level of that income and are in turn
influenced by income.
—

Example 18.14
——$—$

(a) What might cause an increase in aggregate

demand? (10 marks)
AD,
(b) What effect will an increase in aggregate
AD
demand have on long-run output and the price
level? (15 marks)
0 Output
¢ Define aggregate demand.
Figure 1
¢ Bring out the components of aggregate
demand.
in equilibrium so they believe the long-run aggregate
¢ Consider the effect of an increase in aggregate
supply curve (LRAS) is vertical and the economy will
demand from a Keynesian and a new classical
operate at the full employment level (the non-
viewpoint.
accelerating inflation rate of unemployment). Hence
¢ Include diagrams.
they think that changes in aggregate demand will
affect only the price level.
Solution 18.14

(a) Aggregate demand is the total of all planned Price LRAS

level
expenditure in an economy and consists of
consumption, investment, government spending and
net exports. An aggregate demand curve plots P,
equilibrium national income (output) against the price
level. A movement along an aggregate demand (AD) P

curve is caused by a change in the price level.

However an increase in AD will occur if any of the AD,
components of desired expenditure rise for a reason AD

other than a change in the price level. Now more will

be demanded at any combination of price level and
real income. For example consumers may decide to 0 Q Output
spend more and firms to increase their investment if
Figure 2
they feel more optimistic. A government may raise its
expenditure in a bid to improve educational standards
In contrast Keynesians believe that the economy
and net exports may rise due to a rise in incomes
may operate at any level of employment as the
abroad.
labour market will not automatically clear and AD
An increase in AD is represented by a shift in the
may be below that required to achieve full
AD curve, as illustrated in Figure 1.
employment.
(b) All economists agree that if an increase in Figure 3 shows that at low levels of output when
aggregate demand occurs when the economy is unemployment is high and there is spare capacity in
operating at full employment its only effect will be to the economy, an increase in AD will increase output
increase the price level. It will not be possible to raise and have no effect on the price level. When the
output and the higher demand will bid up prices. So at economy approaches full employment and some
this level of real national income an increase in AD supply constraints are experienced, e.g. shortages of
will result in demand-pull inflation. skilled workers, the aggregate supply becomes
New classical economists believe that in the long upward sloping. If AD increases at this point, both -
run the economy will operate with the labour market prices and output will rise.
 work out Ae gate | mayer

LRAS So Keynesians believe that the effect of an increase

Price in AD will depend on the level of economic activity in
level
the economy, and that when unemployment is high
the main impact will be on output. New classical
economists believe that the impact will be entirely on
the price level, as in the long run the economy will be
operating at the full employment level.
lA Ta

AD,

AD,
AD

0 Q Q, Q, Output
Figure 3
 Determination
19. 1Fact prert (b) Short-run aggregate supply
curve
(a) ‘Aggregate supply ¢ The short-run aggregate supply curve (SRAS)
ee supply is the total of all planned production slopes up from left to right because, whilst it is
in a period at each price level. A change in the price assumed that the prices of all factors of production
level will cause a movement along the existing are fixed, an increase in output will raise unit
aggregate supply curve, whereas any other influence costs. This is because to raise output in the short
on aggregate supply will cause a shift. run a less efficient combination of resources may
have to be used and overtime paid.
¢ The SRAS is relatively elastic because, whilst
unit costs rise with output, they rise by small
amounts.

Price Short run Price

level aggregate | be SRAS,
supply (SRAS) ye
curve SRAS

0 ;
National output 0
National output

Figure 19.1 Short run aggregate supply curve Figure 19.2 A decrease in short-run aggregate supply
 work out economics * aggregate supply and ightme

(c) Shifts in the short-run unemployment), rises as supply constraints are

aggregate supply curve experienced and becomes vertical when full
employment is experienced. This is shown in
The possible causes of a decrease in the SRAS, as Figure 19.4.
shown in Figure 19.2, include:
(1) arise in corporation tax;
Price LRAS
(2) arise in wage rates; level
(3) arise in raw material costs.

(d) The long-run aggregate supply

curve
There are two main views on the /ong-run aggregate
supply curve (LRAS):

(1) The new classical view is that the LRAS

is vertical as the economy will operate at the 0 National output

full employment level. This is shown in

Figure 19.4 Keynesian view of the LRAS
Figure 19.3.
The LRAS will shift to the right if the quantity
and/or quality of factors of production increase.
Price
level LRAS

(e) Determination of output and

prices
Equilibrium output and the price level occur when
aggregate demand equals aggregate supply.
Figure 19.6 shows short-run equilibrium output.
New classical economists believe that in the long
run aggregate demand will equal aggregate supply
0 National output
at the full employment level (Figure 19.7a)
Figure 19.3 New classical view of the LRAS
Keynesians believe that the long-run equilibrium
(2) The Keynesian view is that the LRAS is output can occur at any level of employment
horizontal at low levels of output (and high (Figure 19.7b).

(b)
(a)
Price LRAS_ LRAS,
Price
level LRAS LRAS, level

0 Q Q; National output 0 National output

Figure 19.5 New classical view (a) and Keynesian view (b) of an increase in aggregate supply
170 rk out Fieve Prone economy

Price
level

National output

Figure 19.6 Short-run equilibrium output

(b)
LRAS
Price Price
level level

0 National output 0 Qz Qy National output

Figure 19.7 New classical view (a) that long-run equilibrium output will be at the full employment level of OQy. Keynesian view (b) that
long-run equilibrium output may be at less than the full employment level of OQ, — in this case at 0Q;.

(b)
Price LRAS Price LRAS —_LRAS,
level level

P,
P

iz P,

AD

0 National output 0 Q Q; National output

Figure 19.8 New classical view of an increase in aggregate demand (a) and an increase in aggregate supply (b)
 work out economics * aggregate supply and ightrnedag ination

(a) (b)
Price Price
LRAS LRAS,
level level LRAS

AD,

AD

0 Q Q, National output 0 Q National output

Figure 19.9 Keynesian view of an increase in aggregate demand (a) and an increase in aggregate supply (b)

¢ Equilibrium output also occurs when planned (g) The multiplier

national expenditure equals national income. At
The multiplier (k) shows by how much income
this equilibrium output, injections will equal
changes as a result of a change in an injection. The
withdrawals.
value of the multiplier is given by
¢ Injections (J) are additions to the income of firms
that do not normally arise from the expenditure of AY l
= ey or W
domestic households. There are three types:
investment, government spending and exports.
Where W is the marginal propensity to withdraw, i.e.
Injections cause a rise in spending in the
the proportion of each extra pound withdrawn from
economy.
the circular flow.
¢ Withdrawals (W) or leakages is any income not
To calculate the effect of changes in an injection on
passed on in the circular flow of income. There are
national income, use the equation:
three types: saving, taxation and imports.
Withdrawals reduce spending in the economy. AYekRxXcAs

For example, assume an economy where W = 0.2. An

(f) Changes in national output increase of £50m in government spending results in
an increase in national income of
¢ Output may rise in the short run if there is an 1/0.2 X £50m = 5 X £50m = £250m. Note that:
increase in either aggregate demand or aggregate
supply. (1) W=s ina two-sector closed economy (i.e. one
¢ Newclassical economists argue that output with households and firms).
can only be increased in the long run by an (2) W=s+tina three-sector economy (i.e. one with
increase in aggregate supply. Figure 19.8 households, firms and the government), where f is
shows the contrasting effects of an increase in the marginal rate of tax (also called the marginal
aggregate demand and an increase in aggregate propensity to tax)
supply. (3) W=s+t+mina four-sector economy (i.e. one
¢ Keynesians believe that if the economy is with households, firms, government and
operating at a high level of unemployment, an international trade sector), where m is the
increase in aggregate demand will raise output marginal propensity to import.
without increasing the price level, whereas an ¢ The multiplier effect is the series of consumer
increase in aggregate supply will have no impact incomes and expenditures generated by an initial
on output. change in an injection.
 ational economy

19.2 Investigative study

Example 19.1.
An investigation into the causes of changes in GDP.

19.3 Data response

Example 19.2

The capacity crunch

THAT interest rates will have to rise again lished on January 24th, showed that spare facturing capacity is one reason why interest
soon to dampen inflationary pressures became manufacturing capacity is shrinking fast. The rates are likely to be raised, which will in turn
even more certain this week. Despite last percentage of firms working below capacity curb demand.
year’s rate increases, the economy continues fell to 49% in the fourth quarter of 1994,
Source: The Economist, 28 January 1995.
to go full steam ahead. According to statistics down from 57% a year earlier. This is the
published on January 23rd, in the fourth quar- lowest figure since July 1990. The proportion
ter of last year, GDP grew more sharply than of firms believing that their plant capacity An inflationary mix
most economists had forecast. It was up by will limit growth in their output over the next Balance of those firms polled
0.8% on the third quarter, and by 4% com- four months rose to 24%, the highest since believing that:
pared with the fourth quarter of 1993. A word October 1988.
of caution is in order, however; these growth Intriguingly, bigger firms (those with more
figures are estimates and, on past form, are than 5,000 staff) have more spare capacity
likely to be revised sharply one way or the than smaller ones. Those manufacturers sell-
other. ing unfinished goods to others have least
One of the biggest questions facing the capacity, but they have found it hard to pass
chancellor of the exchequer and the governor on price rises.
of the Bank of England when they next meet The puzzle is that, despite the fact that
on February 2nd is how much longer the spare capacity is rapidly disappearing, firms
economy can go on growing at the current remain reluctant to invest in new capacity.
rate before firms start to run out of productive The CBI survey found that, compared with
capacity. When that happens, supply will not October’s survey, fewer firms plan to invest
be able to keep pace with demand and prices over the coming 12 months. Apparently, firms
will start to rise quickly. have become less confident that demand will
The Confederation of British Industry’s lat- remain strong. This may become a self-fulfill-
est quarterly survey of industrial trends, pub- ing prophecy: the shrinkage of spare manu-

(a) Explain what is meant by spare capacity. (b)

(3 marks) LRAS
(b) Draw and explain an aggregate demand and Price
supply diagram to illustrate the fact that the ve
economy is experiencing a capacity constraint.
(8 marks)
(c) What was causing spare capacity to disappear?
(4 marks) P,
(d) Why were a number of firms reluctant to expand Pp
their capacity? (4 marks)
AD,
(e) What effect would an increase in investment
have on the long-run aggregate supply curve? AD
Illustrate your answer. (6 marks)

0 Output
Solution 19.2 Pigureil
(a) Spare capacity occurs when a firm is not making
full use of its plant, equipment and workers. When Figure | shows that when demand increases from AD
there is spare capacity a firm is able to produce more to AD, both output and prices rise. The economy is —
with its existing resources. capable of producing more but it is beginning to
 work out economics * aggregate supply and ” SedaghinatiS } a7

experience shortage of some factors of production,

Price AS
e.g. skilled workers. This results in the price of factors level AS,
of production and the products they make being bid
up. P

(c) Spare capacity was disappearing because of P,

the increase in economic activity. The higher level

of demand was causing firms to increase their
AD
output by making use of previously underutilised
machines in particular, but also factory space and
0 Q Q, Real NY
workers.

(d) A number of firms were reluctant to expand their Example 19.4

capacity for fear that the rise in demand would not
last. If firms purchase more machines and factory If, in an economy, out of every additional £100 of
space and they then lie idle, this proves expensive and national income, £20 is taxed, £20 is saved and £10 is
threatens profit levels. spent on imports, the value of the multiplier is
A 2 B25 C 38 D5
(e) An increase in investment, if it is net investment
or replacement investment that embodies new
technology, would increase the productive capacity of Example 19.5
the economy. This would cause the long-run A closed economy has a national income of £65m, a
aggregate supply curve to shift to the right, as marginal propensity to save of 0.3 and a marginal
illustrated in Figure 2. propensity to tax of 0.1. If the government wishes
to achieve the full employment level of NY of
£75m, it will have to increase government expenditure
Price LRAS LRAS,
level by:
A £lm B £3.3m C £4m D £10m

Example 19.6

——— A shift to the left of the long-run aggregate supply

curve indicates:
A improvements in technology
B an increase in wage rates
C the discovery of new materials
D a decrease in the productive potential of the
0 Q Q, Output
economy
Figure2

Example 19.7
19.4 Objective questions Which of the following represents a leakage from the
circular flow?
A Exports
B Investment
According to supply-side economics, which of the
C Interest paid on bank loans
following could have caused the short-run aggregate
supply curve to shift to the right? D National insurance contributions
A An increase in demand for consumer goods
B A reduction in marginal tax rates Example 19.8
C An increase in government spending
D A reduction in the differential between earnings C=40 + bY, 1 = 30, X = 50, M = 60 and b = 0.8
from employment and job seekers’ allowance (where C = consumption, Y = income, / = investment,
174 ek out frictions economy

X = exports, M = imports and b = the marginal Unemployment: The price level:

propensity to consume). The equilibrium level of Y A increase leave unchanged
will be: B leave unchanged increase
A T2195 B 300 C 400 D 550 C increase reduce
D reduce leave unchanged

Example 19.9
The table below refers to a closed economy: to objective

Income Investment Savings Government Taxation ~* olution Answer: B

(£m) (£m) (£m) — spending (£m) (£m)
The aggregate supply curve will shift to the right if
100 60 20 40 50 the productivity of the factors of production increases.
200 70 20 30 60 Supporters of supply-side economics urge tax cuts to
300 80 20 20 70 increase the attractiveness of paid employment and
400 90 20 10 80 the productivity of workers.
A and C => would initially influence demand rather
The equilibrium level of national income is: than supply.
A £100m B £200m C £300m D £400m D => Supply-side supporters argue that, if the
differential between earnings from employment and
the job seekers’ allowance is narrowed, this will
reduce the incentive for workers to increase
Example 19.10
productivity.
If the marginal propensity to consume of all members
of a closed economy is equal, than a rise in taxation of
£5000m and of government expenditure of £5000m Solution 19.4 Answer: A
will cause national income to:
In this case, the multiplier is:
A remain constant
B rise by £5000m 1/(MPT + MPS + MPM) = 1/(0.2 + 0.2 + 0.1)
C rise by £5000m =1/0.5=2
D rise by less than £5000

Solution 19.5 Answer: C

Example 19.11 If MPS is 0.3 and MPT is 0.1 the multiplier is:
1/(MPS + MPT) = 1/0.4 = 2.5. The gap between
An increase in government spending is likely to have
present and desired NY is £10m. To achieve this the
a large impact on the level of employment when there
government will have to increase its spending by
£10m/2.5 = £4m.
a high marginal propensity to save
a high marginal propensity to import
a high marginal propensity to consume
Solution 19.6 Answer: D
SOm>s
a high marginal rate of taxation
The long-run aggregate supply curve shows the
full employment level of output and productive
Example 19.12 capacity. A fall in potential output is shown by
a leftward shift in the long-run aggregate supply
If the long-run aggregate supply curve is vertical, curve.
what will be the effect, in the long run, of an increase A and C = would increase aggregate supply.
in aggregate demand on unemployment and the price B => would cause a shift in the short-term
level? aggregate supply curve to the left.
 work out economics * aggregate supply and ightmeday inaller >:

Solution 19.7. Answer: D Solution 19.12 Answer: B

National insurance contributions are a tax and If the long-run aggregate supply curve is vertical an
therefore reduce the amount of income passed round increase in aggregate demand will cause inflation but
the economy. will not alter the level of output and employment.
A and B => Exports and investment are injections This is shown in the diagram below.
into the circular flow.
LRAS
C = Interest is an income earned within the Price
economy and forms part of the circular flow. level

Solution 19.8 Answer: B P,

The equilibrium level of Y will be where:

Fe AD,
Y=C+I+(X — M)
Y=40+ 0.8Y + 30 + (50 — 60) AD

0.2Y = 40 + 30 — 10 0 Real NY
Y = 300

Solution 19.9 Answer: D

The equilibrium level NY is where planned injections (a) What could cause:
equal planned withdrawals. In a closed economy this (1) the short-run aggregate supply curve to shift
will be where: investment + government to the right;
spending = savings + taxation, i.e. 90 + 10 = 20 + 80, (2) the long-run aggregate supply curve to shift
which occurs when NY is £400m. to the right? (10 marks)
(b) What effect will an increase in long-run
aggregate supply have on output and
Solution 19.10 Answer: C employment? (15 marks)
According to the balanced budget multiplier theorem, e Distinguish between short- and long-run aggregate
if the MPCs of taxpayers and recipients of supply.
government spending are equal then a rise in ¢ Compare Keynesian and new classical views on
government spending and taxation of equal amounts the effects of a shift in the LRAS.
will cause NY to rise by the amount of the change. ¢ Include diagrams.
For instance, if MPC is 0.8, a rise in taxation of
£5000m will cause private spending to fall by
Solution 19.13
£5000m X 0.8 = £4000m. Public spending increases
by £5000m, so the net injection of spending is (a)(1) The short-run aggregate supply curve shows
£5000m — £4000m = £1000m. MPS is 0.2, so the how much all firms in the economy wish, and are
multiplier is 1/0.2 = 5. Thus NY will rise by able, to supply at each price level. In the short run it is
£1000m X 5 = £5000m.
Price
level SRAS

SRAS,
Solution 19.11 Answer: C i

A high MPC will mean a high multiplier, i.e. if MPC rH

is 0.9 the multiplier will be 10. Thus a rise in

government spending of £50m will cause NY to rise
by £50m X 10 = £500m. The larger the rise in NY the
greater the likely increase in employment.
A, B and D = A high MPS, a high MPM and a 0 Output

high MRT will all reduce the size of the multiplier. Figure 1
 2 Hational economy

assumed that the prices of all factors of production are increasing the LRAS has a good effect on the
fixed, e.g. money wage rates, as output changes. economy, they think an increase in aggregate demand
A shift to the right of the short-run aggregate will raise the price level but fail to have any impact on
supply curve (SRAS) means that more is being output and employment in the long run. They
supplied at each price level. therefore favour supply-side policies to promote
The SRAS will move to the right and supply will increases in output.
increase if firms’ costs of production fall. This could Keynesians agree that, if the economy is operating
be caused by, for example, a fall in wage costs per at full employment, an increase in the LRAS will raise
unit, a decline in raw material costs or a fall in taxes output and lower prices. However they believe that the
on firms. economy can operate at any level of employment as
(2) The long-run aggregate supply curve is drawn labour markets may not clear. They think that there
on the assumption that costs of production have can be disequilibrium unemployment with supply of
adjusted to changing market conditions. A shift to the labour exceeding demand and with actual output
right of the long-run aggregate supply curve (LRAS) being below potential output. This leads them to
means that the potential output of the economy has conclude that the LRAS will have a different shape
increased. This can be caused by anything that from that envisaged by new classical economists.
increases the quantity and/or quality of factors of Keynesians believe that the LRAS is horizontal at low
production in the economy, e.g. an increase in the levels of output (and hence high unemployment),
labour force and/or an increase in training. More slopes up as supply constraints are experienced and
investment and improvements in technology would only becomes vertical at the full employment level of
increase productive capacity. It is also likely, but not output.
certain, that increased incentives for entrepreneurs and The shape of the LRAS implies that an increase in
workers would increase long-run aggregate supply. the LRAS will increase potential output, but not
actual output when output is low. Figure 3 shows an
(b) New classical economists believe that an increase
increase in the LRAS occurring when output and
in long-run aggregate supply will have a beneficial
employment are low, leaving output and the price
effect on the economy, raising output and employment
level unchanged.
and lowering, or at least putting downward pressure
on prices. They believe that the LRAS is vertical, as in
Price
the long run the economy will operate at full level LRAS LRAS,
employment defined in terms of NAIRU (the non-
accelerating inflation rate of unemployment).

LRAS_ LRAS,
level P

AD
P,

0 Q Output
AD

Figure 3

0 Q Q; Output This leads Keynesians to believe that supply-side

Figure 2 policies, implemented on their own, will not succeed
in raising output and reducing unemployment when
An increase in investment, in technological the economy is operating at a low capacity.
advances or in those actually willing and able to work
will increase the economy’s productive potential.
Whilst new classical economists believe that
 Vd

work out economics * aggregate supply and Pine daghinatigAt 77

Example 19.14 benefits will have a multiplier effect on output. For

example the unemployed will be able to buy fewer
Discuss the likely effect on national output of:
clothes for their children, so the shops selling clothes
(a) acutin the rate of job seekers’ allowance; will receive less revenue and their owners and staff
(12 marks) will be able to spend less. A fall in benefits of £10
(b) an increase in government spending. (13 marks) million may actually cause output to fall by, say, £20
million. Hence Keynesians believe a cut in the job
e Consider both Keynesian and new classical
seekers’ allowance will reduce national output.
viewpoints.
¢ Include diagrams. (b) Keynesians believe an increase in government
spending will increase national output unless the
economy is already at full employment. Government
Solution 19.14 spending is an injection into the circular flow and will
cause national output to rise by a multiple amount.
(a) Economists disagree about the likely effect of a
For example, if the multiplier is 3 a rise in
cut in the job seekers’ allowance. Some supply-side
government spending of £20 million will cause
economists think that it will increase national output.
national income to rise by £60m. Figure 2 shows
This is because they believe that, by reducing the gap
aggregate demand increasing as a result of a rise in
between paid and unpaid employment, it will make
government spending.
the unemployed seek work more actively. Reducing
frictional unemployment, in particular search
LRAS
unemployment, will lower the non-accelerating
Price
inflation rate of unemployment (also sometimes level
known as the natural rate), which in turn will shift the
long-run aggregate supply curve (LRAS) to the right,
thereby increasing output.

Price LRAS LRAS,

level

AD,

AD
P

P, 0 Q Q, Output

Figure 2
AD

A crucial determinant of the impact of government

spending on aggregate demand is what it is spent on.
If the extra spending goes on benefits to the poor it is
0 Q Q; Output likely to have a relatively large impact on aggregate
Figure 1 demand, as the poor have a high marginal propensity
to consume.
However Keynesians argue that the reason most Some new classical economists believe that an
people are out of work is not an unwillingness on their increase in government spending is unlikely to
part to look for work but a lack of vacancies. They increase output, although the outcome will be
think that reducing the job seekers’ allowance will influenced by what it is spent on and how it is
make the situation worse. Those receiving the job financed. Monetarists in particular argue that a rise in
seekers’ allowance are likely to be poor and have a government spending financed by borrowing will
high marginal propensity to consume. Providing them succeed in raising inflation but will leave
with less income will reduce their purchasing power, unemployment and output, in the long run,
which will in turn lower aggregate demand. unchanged. To illustrate this view they make use of
Keynesians believe that the fall in spending on the expectations-augmented Phillips curve.
178 rk out omi tional economy

A rise in government spending succeeds in

% A
money reducing unemployment in the short run to U,, but in
wages the longer run the economy will return to Uy
(inflation)
unemployment, with 5% inflation and the expectation
of inflation built into the economy.
5% Government expenditure on training might succeed
in raising output by shifting the LRAS to the right.
However some new classical economists argue that
0
SPC,% Unemployment
‘ resources work more effectively when in the control
of the private sector. Government spending on training
would have to be financed by either borrowing or
Figure 3 taxation, both of which would involve a transfer of
resources from the private to the public sector.
 | Bana
(c) Benefits and costs of economic
growth
Economic growth provides benefits but may also
Economic growth typically refers to an increase in a impose costs. Some of these are outlined in Table
country’s output of goods and services. It is usually 2041,
measured by changes in real GDP.

(b) Causes of economic growth (d) Business cycles

A rise in output can occur following: A business or trade cycle is a fluctuation in economic
(1) An increase in resources through: activity and occurs when real GDP moves away from
(a) net investment; its trend path.
(b) the discovery of natural resources;
(c) an increase in the labour force.
(2) Better use of existing resources through:
(a) using previously unemployed factors; (e) Causes of business cycles
(b) training the labour force;
A number of explanations are put forward to explain
(c) innovations that increase productivity;
business cycles. These include:
(d) a reallocation of factors from low-
productivity (e.g. agricultural) to high- (1) Bursts of technological innovation, e.g.
productivity (e.g. manufacturing) sectors. development of the microchip.

Table 20.1 The effects of economic growth

Potential benefits of economic growth Potential costs of economic growth

Improved standard of living The opportunity cost of additional investment

Poverty can be reduced Resulting externalities, including pollution
Opportunities for more leisure time The depletion of non-renewable resources
A rise in people's expected lifespan Alienation and stress among the labour force
 Modern man does not experience himself as part of
nature but as an outside force destined to dominate
and conquer it. He even talks of battle with nature,
forgetting that, if he won the battle, he would find
himself on the losing side.
Trend,
real GDP
The illusion of power is based on the failure to
distinguish between income and capital where this
distinction matters most. Every economist and
businessman is familiar with the distinction and
applies it conscientiously and with considerable
subtlety to all economic affairs — except where it
really matters; namely the irreplaceable capital which
0 Years
man has not made, but simply found, and without
Figure 20.1 Business cycle which he can do nothing.
A businessman would not consider a firm to have
(2) Changes in the money supply. solved its problems of production if he saw it was
(3) Stop—go cycles. A government may seek to rapidly consuming its capital. How, then, could we
increase economic activity prior to a general overlook this vital fact when it comes to that very big
election and take harsher, deflationary measures firm, the economy of Spaceship Earth and, in
after an election. particular, the economies of its rich passengers?’ (E.
(4) Multiplier—accelerator interaction. An injection F. Schumacher, Small is Beautiful — A Study of
of extra spending will cause national income to Economics As If People Mattered, London, Abacus,
rise by a multiple amount. This will cause 1974, pp. 10-11).
investment to rise, which will further increase
national income. Once shortages are experienced, (a) From the above passage, distinguish between
costs rise and other difficulties are encountered, income and capital. (6 marks)
national income and investment will fall. (b) Explain the major problems that the author
identifies as being faced by nations. (9 marks)
(c) What are the implications of the passage for
20.2 Investigative study government policies promoting economic
growth? (10 marks)
Example 20.1
A study on the extent, causes and effects of the black Solution 20.2
economy among students.
(a) Income is a flow value, and is the amount of
money, goods or services received by an individual,
20.3 Data response firm or economy in a given period, usually one year.
Capital is a stock value, is one of the four factors of
Example 20.2 production and refers to producer goods used to
manufacture other goods. However the author is using
‘One of the most fateful errors of our time is the belief
a broader definition of capital than is generally
that ‘the problem of production” has been solved.
employed by economists by his inclusion of the
Not only is this belief firmly held by people remote
Earth’s natural resources. Traditional economists
from production and therefore professionally
count natural resources as land.
unacquainted with the facts — it is held by virtually all
the experts, the captains of industry, the economic (b) The passage advances two points of view
managers in the governments of the world, the concerning the problems facing rich nations. Most
academic and not-so-academic economists, not to traditional economists argue that great advances in
mention the economic journalists. For the rich technology have allowed rich countries to produce such
countries, they say, the most important task now is a surplus of goods and services that the bulk of human
“education for leisure” and, for poor countries, the wants and needs can now be satisfied. The problem is ~
“transfer of technology”. not so much one of scarcity as of knowing what to do
 work out economics ¢ change ec ivi 181

with the large number of workers now no longer encourage conservation of scarce gifts of nature by
needed in the manufacturing process and who require offering subsidies to firms that recycle waste products.
training in the use of free time. Schumacher argues that For example some local authorities convert refuse
the major problem facing rich nations is the over-rapid collected from households into electricity by burning
consumption of irreplaceable natural resources such as waste at plants.
metals and minerals. Hence economic growth is only Finally, government energy policy can be adjusted.
achieved by running down our ‘capital’ — that is, our One man-made source of energy is nuclear power, the
stock of finite natural resource. use of which avoids the depletion of finite resources
Poor countries, it is argued, do not have sufficient such as oil, coal and gas. The government might want
infrastructure to allow for capital accumulation to achieve economic growth in the energy sector by
through net investment, either because there is no building more nuclear power stations. However this in
surplus after output has been used to satisfy basic itself creates more problems because of the high,
needs or because the nation lacks the technology to long-term economic and social costs of disposing of
generate such surpluses. A transfer of ‘production radioactive waste.
know-how’ from rich to poor nations would overcome
this last problem.
20.4 Objective questions
(c) Economic growth is typically taken to mean an
increase in a country’s output of goods and services,
Example 20.3.
and occurs through either an increase in the amount of The most common measure of economic growth is
resources available or the better use of existing changes in:
resources. Measures that encourage increases in real GDP
production have been advanced by successive the output of consumer goods
governments because output increases allow more the productivity of labour
wants and needs to be satisfied. Measures to Se the share of capital goods in total output
Same
encourage economic growth through net investment
include subsidies to firms building new factories,
Example 20.4
particularly in depressed areas, and tax incentives to
firms buying new machinery. Which of the following is an advantage of economic
The passage highlights the concern of some growth?
economists for what they see as an unpleasant side- A An increase in negative externalities
effect of economic growth: the unacceptably high B_ An increase in the standard of living
level of consumption of resources that are gifts of C A decline in non-renewable resources
nature and that, once used, cannot be replaced. D A reduction in the capital stock
Sustained economic growth implies an accelerating
rate of consumption for non-renewable natural
Example 20.5
resources. Governments may be concerned to ensure
that the system of resource allocation used takes full If GDP has risen by 4%, population by 2% and prices
account of such negative externalities, as well as any by 3%, then:
pollution generated by high growth. A real and nominal GDP per capita have risen
For instance the price mechanism does not B_ real and nominal GDP per capita have fallen
immediately take account of the depletion of finite C real GDP per capita has risen but nominal GDP
resources such as oil. As the world’s resources begin per capita has fallen
to reach exhaustion, restricted supply will result in D real GDP per capita has fallen but nominal GDP
higher prices. But in the immediate term governments per capita has risen
might want consumers and producers to pay some
penalty for using irreplaceable resources, e.g. by Example 20.6
imposing an indirect tax on their consumption. For
example substantially taxing petrol reduces How would an increase in the productive capacity of
consumption and encourages conservation. the economy be illustrated on a production possibility
Alternatively the government might want to diagram?
 @&.,
182 Avork owtEconGmics_s ational economy

A A movement along the production possibility Example 20.11

frontier Which of the following ischia lagging
J indicator of
; ;
B A shift of the production possibility frontier to the
left changes in economic activity?

tionppossibility y frontier to the pe ie Fa

A Profits
C i aa hift of th e produc
duction
ng C Unemployment
D A movement from with inside the production Tiana whey aie:
possibility frontier to on it.

Example 20.12
Example 20.7
i ldb Fes a A recession is:
Which government policy would be most likely to ‘medlauhiemeatoloimenaat
stimulate‘ economic growth? “nei : Pygeky
ay. B arise in unemployment accompanied by a rise in
A An increase in income tax
ee eine A Raa inflation
n increase in education and trainin Fae te ! “
; ; : s C adecline in real GDP for two or more successive
C An increase in the rate of interest
quarters
D* Am increase if the exchange. tate D aperiod of rapidly declining inventories and
increasing capital utilisation

Example 20.8
What is the main, short-run opportunity cost of
to objective
economic growth?
A A reduction in capital goods
B_ A reduction in consumer goods
lution 20.3. Answer: A
C A reduction in non-renewable economic
resources Economic growth is usually measured in terms of a
D A reduction in the government’s ability to alleviate change in real GNP or, more commonly, a change in
poverty real GDP.

Example 20.9 Solution 20.4 Answer: B

Which of the following is a potential cost of economic One of the main benefits of economic growth is a rise
growth? in the goods and services that the population can
A An increase in capital deepening consume.
B_ An increase in positive externalities A and C = are potential disadvantages of
C An increase in the capital/labour ratio economic growth.
D An increase in the number of workers whose skills D = The capital stock is likely to increase with
are made obsolete by changes in rapid economic economic growth.
change

Solution 20.5 Answer: D

E xamplele 20.1 0 If GDP has risen by 4% and prices by 3%, then
Which of the following is a characteristic of the real GDP has risen by approximately 1%. If the
downturn of a business cycle? population has increased by 2% the increase in
A Increasing inflationary pressure real GDP has not kept pace with the increase in
B_ Increasing stocks of unsold goods population and real GDP per capita has fallen.
C Falling government expenditure on benefits Nominal GDP has increased by more than population
D A reduction in the number of companies going (4% compared with 2%) so nominal GDP per capita -
into liquidation has risen.
 oy

work out economics ¢ batiseaiec

Solution 20.6 Answer: C economic activity declines. Demand falls, so not all
the goods produced are sold and stocks rise.
An increase in the productive capacity of the economy
A => Falling demand and declining wage claims
will mean that the country will be able to produce
reduce inflationary pressure.
more goods and services. This is illustrated by a shift
C = Rising unemployment will increase
to the right of the production possibility curve.
government expenditure on unemployment-related
A => This is a change in the combination of goods
benefits.
produced with productive capacity remaining
D => More companies will go into liquidation.
unchanged.
B => This would illustrate a decrease in the
productive capacity of the economy. Solution 20.11 Answer: C
D => This would result in an increase in production.
A lagging indicator is one that reacts after the change
However the maximum potential output of the in the business cycle. If there is a downturn in
economy has not changed. When the economy was
economic activity firms will not immediately lay off
producing inside the curve it was not making as much workers — they will wait to see whether the fall in
as it was capable of, now it is. demand will last, just as when the economy is coming
out of recession firms will not immediately take on
Solution 20.7 Answer: B more workers — they have to be certain that the rise in
demand will last. Thus many changes in
Increases in education and training will raise the unemployment occur after changes in output.
productivity levels of workers, thereby raising the A and D = are leading indicators, i.e. indicators
productive capacity of the economy. that point to changes in economic activity.
A => An increase in income tax is likely to reduce B = is a coincident indicator as it forms the basis
aggregate demand, may discourage entrepreneurial of the business cycle itself.
effort and dissuade some people from entering the
labour force.
C = This may lower investment. Solution 20.12 Answer: C
D = An increase in the exchange rate will raise the A recession is usually defined as a fall in real gross
price of exports and lower the price of imports. This domestic product (GDP) over two or more successive
may reduce domestic output. quarters.
A = A slowdown in economic growth still implies
positive growth, although it may indicate that the
Solution 20.8 Answer: B
economy is moving towards a recession.
If a country is producing at or near full capacity it B = This is a definition of stagflation.
may have to reduce the output of consumer goods in D = This indicates increasing economic activity.
the short run, so that the freed resources can be Declining inventories means that stocks of goods are
switched to producing capital goods. The extra capital falling and increasing capital utilisation means that firms
goods made will, in the longer run, produce more are making more use of their machines and factories.
capital and consumer goods.

20.6 Essays
Solution 20.9 Answer: D

Economic growth requires workers to be mobile and Example 20.13

flexible. Workers will have to cope with new
(a) What is meant by economic growth? (5 marks)
technology and change jobs. Not everyone will be (b) Discuss the benefits and costs of economic
able to manage rapid change. growth. (20 marks)
A, B and C = are advantages of growth.
¢ Distinguish between actual and potential growth.
* Consider the impact not just on material living
Solution 20.10 Answer: B standards but also on the quality of life.
During the downturn of a business cycle the pace of * Cover the opportunity cost of growth.
 eff sionaeconomy

Solution 20.13 international status and its ability to influence

international organisations, including the IMF, WTO
(a) Economic growth refers to changes in actual
and EU. Economic growth also increases an
and/or potential growth. Actual growth is a rise in the
economy’s ability to improve the environment. Some
amount of goods and services provided. Potential
of the extra goods and services produced can be
growth is a rise in the productive potential of the
devoted to improving the quality of the environment.
economy and is represented by a rightward shift of the
Indeed what economic growth does is to provide an
country’s production possibility curve.
economy with more choice. The extra goods and
In the short run actual growth can be achieved by a
services produced can be put to a variety of uses.
movement from within a production possibility curve
Some may be used to help the poor, some to reduce
towards the curve. This will involve making fuller and
pollution whilst others may be used, for example, to
more efficient use of existing resources.
improve a state-financed health service.
However in the long run actual growth can only be
In a poor country extra goods and services are
sustained by a shift of the production possibility curve
likely to be used primarily to reduce malnutrition,
to the right following an increase in the quantity
improve the quality of drinking water and provide
and/or quality of resources. Figure 1 shows an
basic housing. In such a country economic growth is
increase in actual output from point X to point Y
likely to be viewed as a necessity. However in more
(actual growth) and a shift in the production
affluent countries the desirability of economic growth
possibility curve from AB to CD (potential growth).
is a more debatable issue. As well as conferring
benefits, economic growth also imposes costs.
Cc In the short run economic growth is likely to
A
involve an opportunity cost of forgone consumer
Consumer goods. This is because some resources may have to be
goods
diverted from producing consumer goods to
producing capital goods. The extent of this
opportunity cost will depend on the current degree of
utilisation of resources and how mobile they are.
Economic growth may result in a longer-term
opportunity cost in terms of forgone non-renewable
resources and environmental quality. The production
0 BD Capital goods
of extra goods and services may involve the use of,
Figure1 for example, trees from the rainforests of Brazil and
may create air, noise and water pollution.
(b) Actual economic growth is usually measured by Producing more goods and services may put extra
changes in real GDP. A rise in real GDP will mean stress on people, leading to increases in the divorce
that more goods and services are being produced. The rate, mental illness and other problems that reduce the
main benefit of economic growth is a rise in the quality of people’s lives. It is also questionable to
material living standards of the population. If real what extent the consumption of goods and services
GDP rises by more than the population, real GDP per makes people happier. The increase in car ownership
capita will increase. Over time the number and range has resulted in more congestion, more accidents and
of goods and services available to people have reduced opportunities for children to play in the street
increased. Now more than 90% of UK households and cycle and walk to school. Some claim that what
have a television and a significant proportion have at economic growth does is to generate demand for even
least one car and go on a foreign holiday at least once more goods and services. The greater availability of,
a year. for example, TVs, compact disc players and
Economic growth can make it easier to alleviate dishwashers in the UK has not necessarily increased
poverty. This is because at least some of the rise in people’s happiness significantly. What it has done is
income can be distributed to the poor. In the absence to increase the dissatisfaction of those who do not
of growth the income of the poor could only be possess these goods or who do not possess the
increased by reducing the income of the rich. quantity of goods they aspire to. So perhaps, rather-
Economic growth may improve a country’s than reducing the gap between current and desired
 work out economics ¢ change ec tivity

consumption, economic growth may increase it or will spend more.

keep it constant. |
(b) A consumer boom is likely to stimulate economic
A connected aspect is that economic growth may
activity. The higher aggregate demand, at least in the
increase the uneven nature of income distribution. As
short run, will encourage firms to increase their
the economy grows the demand for some factors of
output. In turn this is likely to raise employment.
production will rise whilst the demand for others will
Figure | shows a rise in consumer spending
fall. Some people may be unable, or less able, to cope
increasing natural income. The rise in the quantity of
with the need to learn new skills and to move to new
consumer goods and services will increase the
industries.
material standard of living people enjoy.

Example 20.14
Planned EX= Y
expenditure
(a) What may cause a consumer boom? (12 marks)
(EX)
(b) What are the advantages and disadvantages of a
consumer boom? (13 marks) Ci
+ l+ G+ (X-M)

¢ Define a consumer boom. C+ le G+ (XM)

¢ Consider causes of changes in autonomous
consumption.
¢ Consider the effects on output, inflation and the
balance of payments position.

— =
Solution 20.14
0 \data National income (Y)
(a) A consumer boom is a rise in economic activity Figure |
generated by extra consumer spending. It is
consumption-led growth. However a consumer boom may not be self-
A rise in GDP stimulated by a rise in consumer sustaining and may involve a number of
spending implies that autonomous consumption (i.e. disadvantages. Higher consumer spending may cause
spending independent of changes in income) has demand-pull inflation if aggregate demand rises at a
increased. faster rate than aggregate supply. This will occur if
There are a number of reasons why people may supply constraints are experienced and when full
choose to spend a higher proportion of their income. employment is reached,
One is expectation. If people feel more optimistic Higher consumer spending may result in the use of
about economic prospects in terms not just of future previously idle resources, However at least part of the
income levels but also of job security, they may spend extra consumer goods are likely to be produced by
more now. resources that have been switched from producing
An increase in the availability of credit and a capital goods. If more consumer goods are produced
reduction in its cost, via a fall in the real interest rate, at the expense of capital goods this will reduce future
may increase spending, particularly on consumer growth potential,
durables and housing. More people will be able to A rise in consumer spending may lead to a
borrow and each person who does borrow is likely to deterioration in the country’s balance of payments.
borrow and spend more. The higher demand in the home market will result in
A rise in wealth is another reason for higher more goods and services being purchased, some of
consumer spending. The main asset of many people is which will be imports and some of which may have
their own home. If house prices rise more than the been originally intended for the export market. So a
retail price index, people will experience a rise in the consumer boom tends to increase imports and divert
real value of this asset and this may encourage them goods from the export to the home market,
to spend more. The effect of a change in real wealth If the rise in consumer spending is based on
on consumer spending is known as the wealth effect. borrowing, people will experience difficulties if real
A change in social attitudes may also result in a interest rates rise above what is anticipated or if incomes
and job prospects improve less than anticipated.
consumer boom. If people value thrift less highly they
21.1 Fact sheet (b) Measures of the money supply
Two of the most important measures of the money
(a) Functions and characteristics of supply in the UK are:
money
(1) MO, which consists of notes, coins and retail
* Money is any item that is widely accepted as banks’ balances at the Bank of England. It is a
payment for products. Money has the following narrow measure, which means it concentrates on
functions: money that is used mainly as a medium of
(a) Medium of exchange: money is used to buy exchange.
goods. (2) M4, which consists of notes, coins and all
(b) Measure of value (unit of account): money is deposits with banks and building societies
used to compare the value of goods, services and denominated in sterling. It is a broad
factor rewards. measure, which means it concentrates on
(c) Store of value: money is used to hold wealth money kept as a store of value and on which
(savings). interest is paid.
(d) Standard for deferred payments: money is used
to enable people to borrow and lend agreed
amounts. (c) Financial intermediaries
* The most important characteristic of money is
general acceptability. If a commodity ceases to be Financial intermediaries are institutions that channel
acceptable, it will cease to act as money. funds from people and institutions wishing to lend to
* Other characteristics include portability, those wishing to borrow.
_ divisibility, durability, homogeneity and limited
supply.
(d) The Bank of England
The Bank of England (BoE) is the central bank. Its -
functions include:
 AURA LS:FS
+

work out economics ¢ money, banking é ary poli 87

Table 21.1 Examples of financial intermediaries

Institution Functions

Retail banks Also called commercial banks, high street banks and
clearing banks. They provide customers with three
traditional services — accepting deposits, acting as agents
for payment, and lending — plus a wide range of other services.
Building societies Accept deposits, lend to house buyers and, since the
1986 Building Societies Act, offer a wide range
of banking services.
Discount houses Borrow from the retail banks and other institutions at
short notice and use this money to buy treasury bills,
commercial bills and other financial assets.
Merchant banks Accept bills of exchange, arrange and underwrite the
issuing of new shares, provide credit and advice to
companies.

(1) Issuing bank notes. The BoE has sole The liquid asset ratio is the proportion of overall
responsibility in England and Wales for the deposits held in liquid form.
printing, issuing and distribution of notes. ¢ The bank, money or credit multiplier shows by
(2) Issuing and managing the national debt. how much total liabilities (deposits or low-
(3) Acting as the government’s bank. Tax revenues powered money) can increase as a result of a rise
and current government expenditure are recorded in liquid assets (high-powered money) deposited
in the Exchequer’s account. in the bank system.
(4) Acting as banker to the monetary sector. ¢ Using the equation D = 100/liquidity ratio X R, it
(5) Acting as leader of last resort. The BoE will is possible to calculate the change in deposits (D)
always lend to the banking sector, thereby following a change in liquid assets (R). Assume
ensuring sufficient liquidity in the monetary that the liquidity ratio is 12.5% and a bank’s liquid
sector to maintain confidence. assets increase by £2m:
(6 Supervising the monetary sector, checking that
—
D = 100/liquidity ratio X R= 100/12.5 x £2m=8
banks follow prudent policies and maintain
(the bank multiplier) x £2m = £16m
adequate liquidity ratios.
(7) Carrying out monetary policy. ¢ The change in bank lending (i.e. the credit
(8) Managing the Exchange Equalisation Account, created) is D —- R=£l6m — £2m=£14m.
which is a Treasury account operated by the BoE
to buy and sell sterling to influence the exchange (f) Monetary policy
rate.
Monetary policy covers measures that seek to change
the supply of money or the price of money (the
(e) Credit creation interest rate). Among monetary policy targets are:

¢ Liabilities are the money owed by retail banks and (1) growth of the money supply;
consist mainly of deposits (accounts). Assets are (2) the level and structure of interest rates;
the various resources owned by the bank. The (3) the exchange rate;
profitability of assets tends to increase as their (4) the inflation rate.
liquidity is reduced. Banks seek to maximise the
amount of profitable but illiquid assets held, while (g) Control of credit creation
maintaining sufficient liquid assets to meet their
customers’ demand for cash. The Bank of England can use a number of measures
Items (4)-(8) of the balance sheet are the liquid or to restrict the ability of banks to create credit,
reserve assets of the bank. although some have not been used recently:
Table 21.2 Balance sheet of a retail bank

Liabilities (D) Assets (A)

(1) Sight deposits (4) Cash in till

(2) Time deposits (5) Balances at the BoE
(6) Money at call and short notice
(7) Treasury and other bills
(8) Short-term investments
(9) Investments
(10 Advances
(11) Property

(3) Total liabilities (12) Total assets

(1) Customers’ current accounts.

(2) Customers’ deposit accounts.
(3) Total amount of money owed by the bank to customers.
(4) Cash in till held on the premises.
(5) Operational accounts used to settle interbank debts at clearing and to draw out cash when
necessary.
(6) Money lent at call or short notice (seven days) to the discount houses.
(7) Short-term (91 days) loans to the government or companies.
(8) Government and local authority stocks (securities or bonds) with less than a year to run.
(9) Government securities, etc. with more than one year to run.
(10) Loans to customers.
(11) The value of bank premises etc.
(12) Total amount of bank claims on other people.

(1) Open market operations, where the BoE sells (7) Quantitative controls on lending involve the
short-term government securities and bills, BoE setting an upper limit on the volume of
thereby reducing retail banks’ liquid assets and bank lending.
raising interest rates. (8) Qualitative lending guidelines involve
(2) Funding, where the BoE issues more long-term requesting banks to direct lending to particular
securities and fewer short-term securities, groups and/or restrict lending to other
thereby reducing the banks’ liquid assets. groups.
(3) The minimum lending rate (MLR) is the rate, (9) Moral (suasion). The BoE can informally try to
announced in advance, at which the BoE lends persuade retail banks to change their lending
to the discount houses. The MLR influences policy.
other market interest rates. (10) Monetary base control involves the BoE
(4) Interest rate policy. The BoE may operate a regulating base money.
number of undisclosed interest rate bands at
which it will discount bills, raising or lowering
these bands to influence the structure of interest (h) Effects of interest rate
rates in the money market. changes
(5) Special deposits are the compulsory loans that
A rise in interest rates is likely to:
the BoE can demand from the retail banks,
thereby reducing their liquid assets. (1) reduce bank lending;
(6) An increase in the liquid asset ratio (2) increase the savings ratio;
requirement reduces the amount of liabilities a (3) reduce consumer spending;
retail bank can have from a given volume of (4) reduce investment; -
liquid assets. (5) increase the external value of the pound sterling.
 “>
work out economics * money, bankinggnd monetary po

(i) The public-sector borrowing (b) What does the MO measure of the money supply
requirement include? (3 marks)
(c) What are the advantages of a government
The public sector borrowing requirement (PSBR) is announcing a target for the change in MO?
the positive difference between the total income and (6 marks)
expenditure of the public sector. This borrowing can (d) Why is MO seen as ‘a good indication of the
be financed by: level of retail sales’? (4 marks)
(1) Borrowing from the BoE, which is likely to (e) How may arise in interest rate reduce
increase the money supply via a rise in the high- inflationary pressure? (6 marks)
powered monetary base.
(2) Borrowing from the banking sector by selling Solution 21.2
treasury bills, which is likely to increase the
money supply via a rise in banks’ liquid assets. (a) Narrow money measures include assets that
represent immediate purchasing power, 1.e. assets
(3) Borrowing from the non-bank private sector by
selling government securities, which some argue used mainly as a medium of exchange. Broad money
may crowd out private investment. measures include not only assets used as a medium of
exchange, but also those used as a temporary store of
(4) Borrowing from overseas residents, which results
in a rise in interest payments on national debt value, i.e. immediate and potential purchasing power.
going abroad. (b) The MO measure of the money supply includes
¢ A negative PSBR means that the income of the banks’ operational balances at the Bank of England,
public sector exceeds its expenditure and there is a notes and coins. It is a narrow measure of the money
public sector debt repayment (PSDR). supply and focuses on the monetary base.

(c) Two main advantages are claimed for announcing

a target for the growth of a monetary aggregate. One
jative study
is that it imposes discipline on the government’s
monetary policy. The other is that it reduces
expectations of inflation. Announcing a target range
An analysis of the effects of a change in interest rates for MO of 0 per cent makes it possible to assess
on local businesses. whether the government has achieved its objective. In
addition, if people believe that a government is
determined to control the money supply it may
convince them that inflation will fall. The expectation
of lower inflation may result in a fall in wage claims
and price increases.

Pressure for a rise in interest This is still outside the govern- (d) If MO rises the monetary base increases. This
rates eased slightly yesterday ment’s target range for MO of enables bank lending to rise. More money in
after the Bank of England said zero to 4 per cent. However, Janu-
MO, the narrowest measure of ary was the third month in which circulation and increased bank lending is likely to
money supply, fell back in Janu- the annual growth rate of MO fell
after growing 7.3 per cent in
result in an increase in spending, so shops are likely to
MO fell a seasonally adjusted October. experience increased sales. Similarly a fall in MO is
0.3 per cent in January compared MO has _ traditionally been
likely to reduce retail sales.
with the previous month, the regarded as a good indication of
Bank said. the level of retail sales, and some
Measured without the volatile economists yesterday suggested (e) Arise in the interest rate, specifically the real
bankers’ deposits, the level of that the drop may indicate that interest rate, may reduce demand-pull inflation. This is
notes and coins in circulation — high street sales had fallen
which account for 99 per cent of sharply in January. because it will reduce demand for consumer durables
MO — fell 0.1 per cent in the Source: Extract from an article by purchased with borrowed money since borrowing will
month. Gillian Tett, Financial Times, 31
In the year to January, MO grew January 1995. become more expensive. A rise in the mortgage
a seasonally adjusted 6.4 per cent.
interest rate will reduce people’s discretionary income,
thereby lowering their ability to buy goods and
(a) What is the difference between narrow and broad services. A rise in the interest rate may also reduce
measures of the money supply? (6 marks) spending by encouraging people to save more.
190 Work out atoriomicé ¢ the national economy

21.4 Objective questions holdings of liquid assets was previously just meeting
its liquidity ratio, the withdrawal of cash will cause a
Example 21.3 total decrease of liabilities of:
A £11.25m B £90m C £720m D £1125m
The essential condition for an item to act as money is
that:
A itis homogeneous Example 21.10
B it is legal tender The Bank of England sells government securities to
C it is backed by gold the non-bank general public. This will tend to:
D it is generally acceptable A reduce the money supply and raise interest rates
B_ reduce the money supply and lower interest rates
Example 21.4 C increase the money supply and raise interest rates
D increase the money supply and lower interest
Which financial institution underwrites the weekly rates
treasury bill tender?
A Discount houses
B_ Market banks Example 21.11
C Retail banks If government’s prime objective is to reduce
D_ The Bank of England unemployment by increasing demand, the monetary
Examples 21.5—21.7 refer to three assets and one policy it is most likely to adopt is to:
liability of a retail bank: A call in special deposits
A Operational balances at the Bank of England B_ lower the interest rate
B_ Treasury bills C sell government securities to the non-bank private
C Advances to customers sector
D Customers’ sight deposits D sell fewer treasury bills and more long-term
government securities

Example 21.5
Example 21.12
Which of the items A to D constitutes the largest figure
on the assets side of a retail bank’s balance sheet? Which of the following means of financing
government spending is likely to lead to the greatest
increase in the money supply?
Example 21.6 A An increase in direct taxation
Which of A to D is a liability of a retail bank? B_ An increase in indirect taxation
C The sale of treasury bills to the banking sector
D The sale of national savings certificates to the
Example 21.7
general public
Which of the assets in A to D is the most liquid?
21.5 Solutions to objective
Example 21.8 questions
A bank keeping a liquidity ratio of 10% receives a
Solution 21.3 Answer: D
cash deposit of £240m. On the basis of this additional
cash, the maximum additional deposits it could create An item may possess many of the desirable
would be: characteristics of money, but if it ceases to be
A £1200m B £2160m C £2400m D £2640m generally acceptable, it will cease to act as money and
people will use another item.
A => is regarded as an important quality for money
Example 21.9
to possess but is not as significant as acceptability.
A bank that keeps a 12.5% liquidity ratio experiences B = The main form of money in the UK is bank
a reduction in liquid assets of £90m. If the bank’s deposits, which are not legal tender.
 C => The vast majority of money — i.e. all bank and 100/12.5 = 8. Thus a reduction in liquid assets of
building society deposits and cash — is not backed by £90m will cause a fall in total liabilities of
gold and therefore is fiduciary issue £90m X 8 = £720m.

Solution 21.4 Answer: A Solution 21.10 Answer: A

A number of financial institutions and individuals buy The sale of government securities will reduce the
treasury bills. However it is only the discount houses money supply. The increase in the supply of
that are committed to purchasing any treasury bills not government securities will also reduce their price. The
taken up through the competitive bidding process. In price of government securities and interest rates vary
return for carrying out this function, the discount inversely. Thus a fall in the price of government
houses are able to use the Bank of England’s ‘lender securities will be accompanied by a rise in interest
of last resort’ facility. rates.

Solution 21.5 Answer: C Solution 21.11 Answer: B

Retail banks hold a range of current and fixed assets. Lowering the interest rate is likely to stimulate
However their most profitable activity is lending, and borrowing and spending.
advances account for the largest single item in their A, C and D = are all likely to reduce bank lending
assets, usually in excess of 60%. and demand.

Solution 21.6 Answer: D Solution 21.12 Answer: C

Customers’ sight deposits are liabilities, as a retail The sale of treasury bills to the banking sector
bank has an obligation to pay these out to its will increase banks’ supply of liquid assets,
customers on demand. which will enable an increase in bank lending to
A, B and C = are all assets, items that the bank occur.
possesses. A, B and D = are likely to have a neutral effect on
the money supply. This is because the increase in
bank deposits resulting from the injection to
Solution 21.7. Answer: A
government spending is likely to be offset by a fall in
A retail bank can draw out money from its operational bank deposits arising from increased taxation or the
balances at very short notice. Operational balances are purchase of government securities.
regarded as very liquid assets, usually the next most
liquid after cash in till.
21.6 Essays
Solution 21.8 Answer: B
Example 21.13
A bank with a liquidity ratio of 10% has a bank What effect will an increase in the real UK interest
multiplier of 100/10 = 10. A cash deposit of £240m rate have on the level of:
will enable total liabilities to increase by (a) consumer spending; (8 marks)
£240m X 10 = £2400m. This includes the deposit (b) capital investment; (8 marks)
given to the customer who deposited the £240m. As a (c) the sterling exchange rate? (9 marks)
result, additional loans of £2400m minus the initial
deposit could be created, i.e. ¢ Distinguish between nominal and real interest
£2400m — £240m = £2160m. rates.
¢ Consider the effects on both spending and saving.
¢ Cover MEC.
Solution 21.9 Answer: C * Consider the effects under both a fixed and a
The bank multiplier works in reverse. A liquidity floating exchange rate system.
ratio of 12.5% will mean a bank multiplier of ¢ Include a diagram in parts (b) and (c).
 rk out ics @ ational economy

Solution 21.13 Interest

rate
(a) The real interest rate is the rate of interest
adjusted for inflation, It is the nominal interest rate
minus the inflation rate. For example if the nominal
interest rate is 10% and the inflation rate is 4%, the Ry
real interest rate is 6%,
A rise in the real interest rate is likely to reduce IMEC
consumer spending, for a number of related reasons. (marginal
efficiency
The higher interest rate charges will discourage of capital)
borrowing, which in turn will reduce expenditure on,
0 Q, Q Planned investment
for example, cars, foreign holidays, washing machines
and other consumer durables, which are often Figure |
purchased with borrowed money.
The higher interest rate will also mean that people to result in a net capital inflow into the UK. This is
who have borrowed in the past at a variable interest because the return on deposits in UK financial
rate will have less discretionary income. A high institutions will increase, which in turn will encourage
proportion of the population have taken out a foreigners to place money with these financial
mortgage loan on their homes and a rise in the interest institutions,
rate will reduce their purchasing power. Those net The higher demand for sterling from foreign
savers who hold interest-bearing deposits will financial investors will put upward pressure on the
experience an increase in their unearned income and pound. If the UK is operating a floating exchange rate,
these people may spend more. However those who this will raise the exchange rate, as illustrated in
hold their wealth in the form of houses, government Figure 2.
bonds or shares are likely to see their value fall and so
may reduce their spending. Price of
£ if
Consumer spending may also fall because a rise in Deutschmarks
the real interest rate will make saving more attractive.
People will save a higher proportion of their income Ss
and hence spend a smaller proportion.
(b) A rise in the real interest rate is also likely to
reduce capital investment, i.e. expenditure on goods
P,
that are used to produce other goods, such as P

machinery. Firms invest when the expected yield from

the investment, which is referred to as the marginal
D,
efficiency of capital, exceeds the cost. The cost of D
investment is the interest rate. This is because when
firms borrow to buy capital goods they have to pay
interest, In practice most firms use retained profits to
0 OSC Quantity of £s
finance investment. In this case the interest rate is the
Opportunity cost of investment. When deciding Figure 2
whether to use at least some of its retained profits to
buy capital goods a firm has to consider the return If the UK is operating an adjustable peg system
from alternative uses, for example placing the it may raise the exchange rate towards the top of
money in an interest-bearing deposit account, the upper margin. If it threatened to go above this,
Figure | shows the relationship between the interest the government would have to stop this trend by
rate and planned investment. A rise in the interest rate selling the currency. Similarly if the government
from RK to R, reduces planned investment from Q to wishes to maintain a fixed exchange rate it would
O). have to take similar appropriate measures to offset
(c) A rise in the real UK interest rate, if not matched the upward pressure caused by the rise in the interest
by arise in other countries’ real interest rates, is likely rate.
 work out economics * money, banking mo

Example 21.14 (c) A government whose main objective is to reduce

inflation, and which believes that inflation is caused
(a) What is meant by the money supply? (5 marks)
by the money supply growing too rapidly at a rate
(b) Why does the government measure the money
exceeding the growth of output, will place
supply? (5 marks)
considerable emphasis on controlling the growth of
(c) Why may a government seek to control the
the money supply.
growth of the money supply? (15 marks)
Monetarists argue that a rise in the money supply
¢ Define money and discuss what is included in the will increase people’s money balances, some of which
main two measures of money. will be used to purchase goods and services. The rise
¢ Concentrate on the relationship between changes in demand will, after a period of time, cause
in the money supply and inflation, but also producers to raise their prices. To illustrate this
consider how changes in the money supply will analysis, monetarists make use of the quantity theory.
affect other objectives. They suggest that if V (velocity of circulation) and T
(transactions) are presumed to be constant, then a rise
in M (money supply) will cause a percentage rise in P
Solution 21.14 (prices).
Monetarists wishing to see a reduction in the
(a) The money supply is a measure of the items that
growth of the money supply may urge a decrease in
fulfil the functions of money, i.e. act as a medium of
the PSBR (public sector borrowing requirement) and
exchange, unit of account, store of value and standard
possibly control of bank lending.
for deferred payments. An item that fulfils these
Some monetarists favour announcing targets for the
functions will have a number of characteristics, the
growth of monetary aggregates. They argue that this
most important of which is to be generally acceptable.
may help to convince people that the government is
The main components of the UK money supply are
taking steps to control prices and thereby reduce
notes, coins and bank and building society deposits.
expectations of inflation, which can affect wage
There are a number of official measures of the money
claims and price rises. They also suggest that this will
supply, each of which includes different items. At any
also impose discipline on the government, which will
one time the government is likely to concentrate on
not want to be seen to be failing to meet its targets.
one or two measures. In recent years MO (essentially
If the banks increase their lending, this may not
notes, coins and banks’ operational balances at the
only contribute to inflation but also worsen a current
Bank of England) and M4 (notes, coins, banks’ sight
account deficit. People borrowing from the banks may
and time deposits and building society deposits) have purchase imports, and the rising home demand may
received the greatest attention. cause some producers to divert goods from the export
(b) One reason why the government measures the to the home market.
money supply is as an indicator of economic trends In contrast some economists argue that a failure of
and the state of financial markets. For instance a rapid bank lending to keep pace with the demand for loans
growth of base money (MO) will indicate a future rise can cause problems. During times of inflation
in bank deposits. entrepreneurs face rising costs and are likely to try to
Another reason is that the government may wish to borrow more from the financial sector. If they are
use changes in the money supply as a policy unable to raise sufficient funds they may go out of
instrument or objective, to influence one of its four business, thereby causing unemployment.
main macroeconomic objectives. These are low The money supply may be regarded as an indicator,
inflation, balance of payments equilibrium, full a target and a policy instrument, and it plays a
employment and growth. To achieve the last two particularly important role in monetarist analysis and
objectives the government may wish to increase the policy. However it is difficult to know which
money supply, perhaps by encouraging bank lending. measure(s) of the money supply to use, and
However to achieve the first two objectives it may economists have found thai, once one measure is
seek to reduce the growth of the money supply and under control, others start to move in undesired
the level of demand. directions.
22.1 Fact sheet unemployed are unemployed because they are
unable or unwilling to take up vacancies.
(a) - Definition of unemployment ¢ Full employment does not mean that everyone is
employed. In a dynamic economy there will
Unemployment is a stock, the size of which is always be some workers changing jobs and some
influenced by inflows and outflows and the duration of people choosing not to take up paid employment.
unemployment experienced. ¢ Over-full employment occurs when the number of
¢ Disequilibruium unemployment occurs when the vacancies exceed the number of unemployed.
aggregate demand for labour is less than the
aggregate supply of labour at the current real wage
(b) Measuring unemployment
rate.
¢ Equilibrium unemployment occurs when the In the UK, official unemployment figures include
aggregate demand for and the supply of labour at those claiming unemployment-related benefits,
the current wage rate are equal. Those who are principally the job seekers’ allowance.

(a) (b)
Wage ; Wage
AS of labour
rate AS of labour rate
Aggregate
labour
force

WwW

AD for labour
AD for labour

0 Qp Qs No. of workers 0 Q Q, No. of workers.

Figure 22.1(a) Disequilibrium unemployment of QD _ QS; (b) Equilibrium unemployment of Q — Q).

 work out econo ° KrsD 3s

¢ Seasonally adjusted unemployment figures take (c) Types and causes of

out the effects of seasonal factors such as weather, unemployment
which results in unemployment being unusually
high or low in certain months. Figure 22.2 illustrates Keynes’ explanation of
unemployment caused by insufficient aggregate
Table 22.1 gives examples of adjustments that some demand. At the full employment level of national
suggest should be made to the official figures. income (¥;,), output is J, while aggregate demand is
The unemployment rate is: registered only K. The deflationary gap of J — K causes cyclical
unemployment/labour force < 100. unemployment.

Table 22.1 Measuring unemployment

Some economists/politicians believe Some economists/politicians believe

the following should be included the following should be omitted

Unemployed over-60s Severely disabled people

Discouraged workers Claimants working in the ‘black’ economy
Those in government special Claimants who are not looking for work
employment measures Mentally and physically handicapped
Unemployed not entitled to benefits people
Those on short-time working Those in between jobs
Those who choose not to register
Students on vacation

Table 22.2 Types and causes of unemployment

Type of unemployment Description

Frictional, or transitional Occurs when workers are temporarily unemployed

while moving from one job to another
Search A form of frictional unemployment when workers do not
accept the first job offered but remain unemployed while
searching for a better job
Casual Another form of frictional unemployment when workers
are unemployed in between short periods of employment
Seasonal Those who are unemployed as a result of seasonal
fluctuations in demand and/or changes in weather
conditions
Structural Those out of work because of a permanent decline in the
demand for an industry’s products
Regional Those out of work are disproportionately concentrated in
particular regions, largely as a result of these areas being
dependent on declining industries
Technological A form of structural unemployment due to the
introduction of new automated methods of production
International Those out of work due to a fall in demand for domestically
produced goods
Cyclical, or mass or demand-deficient Those out of work because of a lack of aggregate demand
Involuntary Workers without a job who are willing and able to work at
current wage rates

Voluntary Workers without a job who prefer to live on benefits

nnn nn
Sonn EtEEyStstdSSsStSSsssta
 A
ork out hs —
Aaa —
j
SO ner
e hational economy

Ex
(e) The costs of unemployment
The costs are influenced by the numbers unemployed
and the length of time they are unemployed. They
include:
Deflationary gap
C+1+G+(X-M) (1) Cost to the economy from lost production that
can never be regained.
(2) Cost to the government in the form of:
(a) lost revenue from, for example, income tax,
National Insurance contributions, VAT;
(b) increased expenditure on the job seekers’
allowance and other benefits, special
0 Y Yio ¥ employment schemes, redundancy payments
in the public sector.
Figure 22.2 A deflationary gap (3) Cost to the individual, usually in the form of:
(a) decreased income;
(b) loss of status, alienation and frustration;
(c) reduced chance of regaining employment the
(d) The non-accelerating inflation longer unemployed.
rate of unemployment (NAIRU)
(f) Remedies for unemployment
NAIRU can also be called the natural rate of
unemployment. It is the level of unemployment that is
associated with a constant rate of inflation. At NAIRU
22.2 Investigative study
the demand for labour is equal to the number of
people prepared to supply their labour for the Example 22.1
prevailing wage rate. Any unemployment is A study of the impact of changes in the rate of, or
equilibrium unemployment and arises from labour conditions needed to be fulfilled to receive, job
market imperfections. seekers’ allowance.

Table 22.3 Remedies for unemployment

Type Remedy

Frictional and search May be reduced by improved vacancy information services

and retraining
Casual and seasonal Finding other activities during slack periods; employ students,
retired people or work overtime during peak employment
periods
Structural Improve occupational mobility through retraining; import
protection for declining industries
Regional and Regional policies; retraining and import protection for
technological particular industries
International Lowering the exchange rate; imposing import controls
Cyclical Increasing aggregate demand by expansionary fiscal and/or
monetary policy. In addition, the Cambridge Economic
Policy Group believe in imposing general import controls to
ensure that rising demand goes on domestic goods and
providing protection while UK industry is restructured
NAIRU Monetarists suggest supply-side policies to widen the gap
between unemployment and employment income by reducing
direct taxes and unemployment-related benefits; reducing trade union
power; improving the mobility of labour
 work out ale ® CoD nage:

% change i UK unemployment Unfilled vacancies

Year in RPI (thousands) (thousands) (thousands)

1988 4.9 8.4 2370.4 247.8

1989 7.8 6.3 1798.7 218.4

1990 9.4 5.8 1664.4 es
1991 9 8.0 2291.9 116.6
1992 ai5 9.8 2778.6 116.0
1993 1.6 10.4 2919.2 126.6

1994 aus 9.4 2636.5 175.8

Sources: Employment Gazette, March 1995; CSO Economic Trends, Annual Trends, annual supplement, 1995.

It is estimated that only about one third of all The figures do support the relationship suggested
vacancies are notified to job centres and that by the Phillips curve. From 1988 to 1990 inflation
approximately one quarter of all appointments are rose and unemployment fell. From 1990 to 1993
made through job centres. inflation fell and unemployment rose. Then from 1993
In any period, some of the vacancies may be in inflation rose and unemployment fell. So throughout
different areas of the country from the areas in which the period inflation and unemployment moved in the
the unemployed live, may require different skills and directions predicted by the Phillips curve.
qualifications from those possessed by the
(b) A fall in the inflation rate could make UK goods
unemployed, or may be for jobs that the unemployed
are unwilling to do. more competitive at home and abroad. If the UK
inflation rate were to fall below that of the UK’s main
(a) Do the figures support the relationship between competitors, then the demand for exports would rise,
inflation and unemployment indicated by the while the demand for imports would fall. The extent
Phillips curve? (6 marks) to which unemployment will fall will depend on the
(b) Explain how a fall in the inflation rate can reduce original level of unemployment, how much output
unemployment. (6 marks) rises, the relative costs of labour and capital and
(c) Discuss the relationships between vacancies and changes in technology.
unemployment from 1988 to 1994. (5 marks)
(d) Why might the proportion of vacancies notified (c) Between 1988 and 1990 both unemployment and
to job centres (i) increase or (ii) decrease during vacancies fell, but at different rates. Unemployment
times of high unemployment? (5 marks)
(e) ‘... some of the vacancies ... may be for jobs that Year Number of unemployed
the unemployed are unwilling to do’: what types per unfilled vacancy
of unemployment may this describe? (3 marks)
1988 9.6
1989 8.2
Solution 22.2 1990 9.6
199] 19.7
(a) The Phillips curve suggests that high inflation will 1992 24.0
be associated with low unemployment, and vice versa. 1993 2h |
It implies a trade-off relationship between inflation 1994 15.0
and unemployment.
rose between 1990 and 1993 and then fell in 1994. Example 22.6
Vacancies fell from 1990 to 1992 and then rose. The
The government attempts to reduce cyclical
number of unemployed per unfilled vacancy
unemployment by means of an expansionary fiscal
fluctuated throughout the period.
policy. The impact of the policy in lowering
(d) During times of high unemployment, employers unemployment would be reduced by:
may be keener to notify vacancies to job centres as a low interest rate
they believe that people possessing higher skills and a high marginal propensity to import
qualifications will be registered there. However it is a low marginal propensity to save
possible that a smaller proportion of vacancies may be omita high marginal propensity to consume
notified, since employers may be able to fill vacancies
relatively easily and quickly through, for example,
word of mouth, ‘in-house’ publications and
Example 22.7
newspaper advertisements. Which of the following would increase a deflationary
gap?
(e) A situation where jobs are available but the
A An increase in savings
unemployed do not take them up may describe
B_ An increase in investment
voluntary or search unemployment. The former occurs
C An increase in export revenue
when people are unwilling to work, and the latter
D An increase in government spending
occurs when people do not accept the first job offered
but remain unemployed while seeking a better job.
Example 22.8
22.4 Objective questions Which of the following conditions will ensure full
employment in an economy?
Example 22.3 2 A A balanced budget
Which group of workers is most likely to experience B_ Planned savings equalling planned investment
casual unemployment? C Total leakages from the circular flow of income
A Accountants equalling total injections
B_ Actors D None of the above
C Chiropodists
D Undertakers
Example 22.9
Search unemployment is a form of:
Example 22.4
frictional unemployment
As aresult of a decrease in the demand for blankets, structural unemployment
several blanket mills are closed down and the workers regional unemployment
are made redundant. This is a result of: —ot cyclical unemployment
demand deficiency unemployment
seasonal unemployment
Example 22.10
residual unemployment
— structural unemployment
ot An increase in which of the following would reduce
the NAIRU?
A Income tax
Example 22.5
B_ Labour mobility
The natural rate of unemployment is the rate: C Government expenditure
at which unemployment is zero D Job seekers’ allowance
at which inflation is constant
at which all unemployment is involuntary
Example 22.11
SARS
below which it is impossible to lower
unemployment, in both the short and the long Which of the following groups is included in the
term, by increasing aggregate demand government’s official unemployment figures?
 work out Cie ° Gg Breas

A Unemployed men aged 60-plus prepared to work at that wage rate and people in
B People on government training schemes for the between jobs.
unemployed C => Monetarists argue that unemployment above
C Students looking for jobs in vacation periods the natural rate is voluntary and not involuntary.
D People who are claiming the job seekers’ D => Monetarists believe that, while it is not
allowance while working in the “black economy’ possible to reduce unemployment below the natural
rate in the long term by increasing demand, it is
possible to do so in the short term but only at the
Example 22.12
expense of accelerating inflation.
What will be the effect, certeris paribus, of an
increase in unemployment?
Solution 22.6 Answer: B
Government expenditure: Taxation revenue:
A increase increase Cyclical unemployment arises from a lack of
B increase decrease aggregate demand. Expansionary fiscal policy will
C_ decrease decrease increase demand. However a high MPM will mean
D_ decrease increase that a significant proportion of the extra demand will
create increased employment abroad rather than at
home.
ns to objective A, C and D = are all likely to mean that a high
proportion of the extra demand will be spent, much of
it on domestic output.
olution

Casual unemployment occurs when workers who are Solution 22.7 Answer: A
usually employed on a short-term basis are laid off.
Actors are frequently ‘resting’, i.e. are unemployed A deflationary gap exists when aggregate monetary
between roles. Accountants, chiropodists and demand is below the level required to ensure full
undertakers are usually employed on a more regular employment —people demand fewer goods and
and long-term basis than actors. services than the labour force can produce. An
increase in savings would reduce demand and hence
increase the gap.
Solution 22.4 Answer: D B, C and D = would all tend to increase the
This is an example of unemployment arising from an demand for domestic goods and services and hence
industry experiencing a decline in demand for its reduce the gap.
products.
A = Demand deficiency unemployment arises as a Solution 22.8 Answer: D
result of a lack of aggregate demand.
B = Seasonal unemployment results from changes None of the conditions will ensure full employment.
A and B = consider only some of the potential
in demand occurring in particular times of the year
injections and leakages and neither condition will
and when weather conditions prevent production.
C = Residual unemployment refers to those people guarantee full employment.
C => will mean that the economy is in equilibrium,
who would be likely to be unemployed even when
but Keynes argued that an economy can be in
demand is high.
equilibrium at any level of employment and not
necessarily at the full-employment level. Indeed,
Solution 22.5 Answer: B without planning it would be very unlikely to be at
According to monetarists the natural rate of this level.
unemployment (which can also be referred to as the
non-accelerating inflation rate of unemployment) is Solution 22.9 Answer: A
when inflation is stable but not necessarily zero.
A = At the natural rate there is likely to be some Search unemployment arises when unemployed
unemployment in the form of those who are not workers do not accept the first jobs on offer but seek
4 O cach Cre QRionaieconomy

better pay and/or conditions. The unemployed, in this

case, are in between jobs and hence search
unemployment is a form of frictional unemployment.
The length of time people are unemployed in this case =
will be influenced by, for example, the level of the job (a) Distinguish between disequilibrium
seekers’ allowance and the amount of information unemployment and equilibrium unemployment.
about job opportunities. (15 marks)
(b) What measures may be used to reduce
equilibrium unemployment. (10 marks)
Solution 22.10 Answer: B
¢ Define equilibrium and disequilibrium
The non-accelerating inflation rate of unemployment unemployment and discuss their causes.
(NAIRU) can be reduced, according to new classical ¢ Include diagrams.
economists, by supply-side measures, including ¢ In part (b) concentrate on supply side measures.
increasing labour mobility.
A => An increase in income tax will lower
disposable income and may discourage some people Solution 22.13
from seeking paid employment. (a) Disequilibrium unemployment occurs, as its name
C = will increase demand, but according to new suggests, when the labour market is not in
classical economists will not reduce NAIRU in the equilibrium. It arises when the aggregate supply of
long term. labour exceeds the aggregate demand for labour at the
D = New classical economists argue that an going wage rate. It represents involuntary
increase in the job seekers’ allowance is likely to unemployment — potential workers who are willing to
increase NAIRU by raising voluntary unemployment. work at the going wage rate but who are unable to find
jobs. It is assumed that money wages are sticky
Solution 22.11 Answer: D downwards, with workers resisting cuts in money
wages. So labour markets will not clear. If aggregate
While many would agree that those who are working supply exceeds the aggregate demand for labour, the
in the ‘black economy’ are not really unemployed, if wage rate will not fall to restore equilibrium. Figure 1
they are receiving the job seekers’ allowance they will shows disequilibrium unemployment of QQ,.
be counted. Indeed it is difficult to assess which
claimants are looking for work and which are illegally
Wage
claiming benefit.
A, B and C => These groups have been included in
official unemployment figures in the past and some
economists believe they still should be, but they are
not currently included. W

Solution 22.12 Answer: B

A rise in unemployment will mean that the

government will pay out more in unemployment-
ADL
related benefits, including the job seekers’ allowance,
whilst the more people are unemployed the lower
expenditure (and hence, for example, VAT revenue) 0 Q Q; No. of workers
will be and the lower income (and hence, for example,
Figure 1
income tax) will be.
There are three main causes of disequilibrium
unemployment. One is trade unions pushing up the
wage rate above the equilibrium level. Another is an
increase in the labour supply with no corresponding
fall in the wage rate. However the cause that receives
 meee.
ae le &
the most attention is a fall in demand with no (b) There are a number of measures that supply-side
corresponding fall in wages. The lack of aggregate economists advocate to reduce equilibrium
demand at the going wage rate results in unemployment.
disequilibrium unemployment. To reduce unemployment arising from a lack of
Equilibrium unemployment occurs when, in willingness to accept jobs at the going wage rate
contrast to disequilibrium unemployment, there is (voluntary unemployment) they suggest increasing the
equilibrium in the labour market. The labour market is gap between earnings from paid employments and the
in equilibrium when the aggregate demand for labour benefits that can be received by the unemployed. This
and the aggregate supply of labour are equal at the can be achieved in one of two main ways. Direct taxes
going wage rate. At this point there can still be in the form of income tax and national insurance
unemployed workers. Not all of those in the aggregate contributions can be cut to increase the return from
labour force will be in employment. Figure 2 shows employment and effort. The return from
equilibrium unemployment of QQ). unemployment can be reduced by cutting the job
seekers’ allowance and other benefits the unemployed
Wage ASL can receive, such as housing benefit.
rate ALF To increase the ability of the unemployed to obtain
employment, the government could promote training
and education. Mobility could also be encouraged by,
for example, removing rent controls and promoting
flexible pension schemes.
WwW
Supply-side economists also favour trade union
legislation to reduce the ability of trade unions to
place artificial restrictions on entry to, and flexibility
ADL of, labour markets. They also advocate cutting
corporation tax to encourage enterprise, output and
employment. Other measures that they suggest would
increase employment via improvements in the
0 Q OQ; No. of workers
efficiency of markets include deregulation and
privatisation, as they believe resources work more
Figure 2
efficiently in the private sector.
As the wage rate rises the gap between the
aggregate labour force and the aggregate supply of
labour (those willing to work at the going wage rate)
Example 22.14
becomes narrower. This is because people become (a) What are the costs of unemployment?
more willing to accept jobs the higher the wages on (15 marks)
offer. (b) Are there any benefits arising from
Equilibrium unemployment represents those in the unemployment? (10 marks)
labour force who are unwilling or unable to find
¢ Include costs and benefits to different groups.
employment at the going wage rate or who are
¢ Include a production possibility curve to illustrate
unaware of job opportunities. Some unemployed
the loss of potential output.
workers may be seeking higher wages, some may be
occupationally immobile because they lack suitable
skills, training and qualifications, some may be Solution 22.14
geographically immobile and some may lack
information about vacancies. So whilst there can be (a) Unemployment imposes costs on the unemployed,
macroeconomic equilibrium in the labour market, taxpayers and the wider society.
there can also be microeconomic disequilibrium with The main cost to society is forgone output. This
frictional, structural and seasonal unemployment. output is lost for all time. People will consume fewer
Equilibrium unemployment is also referred to as goods and services than the economy is capable of
the natural rate of unemployment or the non- producing. Hence actual living standards are below
accelerating inflation rate of unemployment. potential living standards. Figure 1 shows that the
 Pa

1@ national economy

economy is capable of producing, for example, OB standards. Being unemployed can lower a person’s
consumer goods and OD capital goods, or any other self-esteem and can lead to depression, suicide and
combination on the production possibility curve. divorce. In addition, when people are out of work they
However with unemployed workers it only produces lose out on promotion and training, and experiencing
OA of consumer goods and OC of capital goods, and the routine of work. The longer people are out of
produces at point X inside the production possibility work, the harder it is for them to find another job.
curve. Some employers are reluctant to interview, for
example, anyone who has been out of work for more
Consumer than a year. The costs of unemployment are not
goods
evenly spread as certain groups are more likely to
experience unemployment. These include the
disabled, the young and those from ethnic minorities.

(b) Whilst the costs of unemployment exceed the

benefits, there are some potential benefits. Having a
pool of unemployed workers provides some flexibility
in the economy. Those firms wishing to expand
should find it relatively easy to do so, provided the
unemployed possess the right skills and are in, or are
able to move to, the right areas of the country. During
times of high unemployment recruitment costs may be
lowered. It may not be necessary to advertise jobs
—word of mouth may be sufficient.
0 & D Capital goods
Firms may also benefit from the existence of
Figure1 unemployed workers if their presence keeps the
pressure for wage rises low and stimulates increased
There is increasing evidence of a link between productivity among workers in fear of losing their
unemployment and crime, particularly between jobs. The existence of unemployed workers also
unemployed young men and crime. The costs of crime allows firms to take on staff on a temporary basis to
are obviously high and include the costs of prevention cope with short-term rises in demand.
and detection, imprisonment of those found guilty of Unemployment by lowering aggregate demand and
committing crimes, national health care of victims, wage claims may reduce inflationary pressure in the
damage to property and fear of crime. National Health economy. It may also reduce a deficit on the current
Service costs can also rise as a result of increased account of the balance of payments. Spending on all
mental illness due to depression and increased goods, including imports, is likely to fall and some
physical illness due to the poor living conditions that goods may be diverted from the home to the export
occur because of higher unemployment. market. Firms, unable to sell at home, will have to
Unemployment imposes a financial cost on . work harder in terms of marketing, quality of goods
taxpayers for two main reasons. Because fewer are in and after sales service to find gaps in the export
work the government will receive less tax revenue, market.
both direct and indirect. It will also have to pay out The unemployed have more time, but less money,
more in unemployment-related benefits such as the to spend on leisure activities — unless they are on
job seekers’ allowance. Hence those paying tax will government training schemes. They also have more
have to pay more to make up both the shortfall and the time to spend in search of jobs. If they find jobs to
need for extra expenditure. which they are well suited, both they and society are
The unemployed themselves will experience likely to gain. Those gaining employment may enjoy
financial, psychological and reduced employment higher earnings and more satisfaction in their new
upportunity costs. Most of the unemployed experience jobs than if they had taken the first job on offer.
a loss of real disposable income as a result of Society will benefit if their productivity is higher in
unemployment. This reduces their material living the jobs they eventually accept.
23.1 Fai purchased by the retired.
(5) The GDP deflator measures changes in the price
tion of inflation of consumer goods, capital goods and exports. It
is used to convert national income figures at
Inflation is a persistent rise in the general price level, current prices to national income at constant
and hence a sustained fall in the value of money. prices (i.e. real NY).
¢ Creeping inflation is a low rate of inflation. ¢ These measures are weighted indices, which
¢ Hyperinflation is a very high rate of inflation that means that particular importance is attached to
can cause major economic problems and political items that form a large proportion of expenditure
instability. or output.
¢ Stagflation is a situation of high inflation and high
unemployment.
¢ Slumpflation occurs when there is high inflation,
high unemployment and negative growth. (c) Cost-push
Cost-push inflation occurs when a cost of production
(e.g. wages) increases and firms put up prices to
(b) Measuring inflation maintain profits. Causes of cost-push inflation
(1) The retail price index (RPI) is the most widely include:
used index of general consumer prices. RPIX is (1) Wage increases, which may result from:
the RPI minus mortgage interest payments and is (a) a wage-price spiral, when wage increases
the government’s target measure. RPIY is the raise prices, thereby encouraging further wage
RPIX minus indirect and local authority taxes and demand etc.;
is known as the underlying rate of inflation. (b) a wage—wage spiral, when a wage increase in
(2) The tax and price index (TPI) measures average one industry sets off a series of wage claims
household purchasing power, including the effects in other industries so as to maintain
of changes in direct taxes as well as prices. differentials.
(3) Producer price indices (PPI) measure changes in (2) Imported inflation from overseas increases in the
material and product prices, and give an price of goods imported into the UK.
indication of the future trend of retail prices. (3) An increase in the price of imports as a result of a
(4) The pensioners’ retail price index (PRPI) depreciation of sterling.
indicates price changes in goods and services (4) An increase in profit margins.
4 QoQ aofpicions economy

¢ Monetarists assert that V and 7 are constant in the

Price AS;
level
short term. Any increase in M must necessarily
increase P.
AS ¢ However Keynesians argue that at less than full
employment an increase in M causes an increase
P, in T, as more output is made, and may leave prices
unchanged. Vrises in times of boom and falls
P
during recessions.

(f) The benefits of inflation

AD
A low level of inflation may confer a number of
advantages, including:
0 Q, Q National output
(1) Stimulating output if prices are increased before
23.1 Cost-push inflation wages rise.
(2) Increased efficiency. Inflation may enable prices
(d) Demand-pull inflation and wages to respond more quickly to changes in
market forces. It is easier, for example, to reduce
Demand-pull inflation occurs when aggregate demand real wages than nominal wages.
exceeds aggregate supply. In Figure 23.2 an increase (3) Increased demand if negative real interest rates
in a component of aggregate demand means that reduce the debt burdens of households and firms.
aggregate demand exceeds the full employment value
of output. An inflationary gap of J—K results.
(g) The costs of inflation
The costs of inflation include:

(1) Shoe leather costs: the high opportunity cost of

holding money means people hold lower money
balances and make frequent journeys to banks,
building societies etc.
(2) Menu costs, as a result of changing price tags, slot
machines etc.
(3) Fiscal drag occurs when people’s money income
rises, dragging them into higher tax brackets. A
higher percentage of real income is paid in tax.
0 National output (4 ~— Uncertainty may reduce investment and increase
the resources devoted to planning.
Figure 23.2 Demand-pull inflation
(5) The balance of payments will be adversely
affected if the country’s inflation rate is higher
than that of competitors and there are no
(e) Monetary inflation
offsetting exchange rate changes.
Monetarists argue that, if the growth of the money (6) Labour unrest may occur as workers seek wage
supply exceeds the growth of output, prices will rises to maintain real income.
eventually rise. The quantity theory of money states: (7 Expectations of inflation may arise, further
—

fuelling inflation.
MV
= PT
(8) Money illusion may occur when people confuse
where M is the money supply; V is the velocity of changes in nominal balances with changes in real
circulation (i.e. the number of times one unity of balances.
currency changes hands): P is average prices; and T is (9) Arbitrary redistribution of income and wealth
the number of transactions (goods bought). may occur, as shown in Table 23.1.
 work ond (soi ation

Table 23.1 Redistribution of income through inflation

From To

Taxpayers The government

Holders of the national debt The government
Savers Borrowers
Creditors Debtors
Workers in weak trade unions, Those who can raise their incomes
non-unionised labour and those by more than the rate of
on fixed incomes inflation
Domestic producers Foreign producers with lower inflation rates

% rate of change
(h) Remedies for inflation of money wages

The measures taken to cure inflation depend on its

perceived cause.

W,
(i) Cost-push inflation remedies
(1) Imposing prices and incomes policies in order to
freeze price and income increases breaks the
wage-price and wage—wage spirals.
(2) Subsidising production in order to reduce costs. % unemployment
(3) Reducing indirect taxes in order to reduce the cost
of imported materials and components and to
force domestic producers and exporters to remain Figure 23.3 The Phillips curve
competitive with foreign producers.
¢ The expectations-augmented Phillips curve reflects
the monetarist view that there is no long-term
(ii) Demand-pull inflation remedies inflation—unemployment trade-off. Any attempt to
reduce unemployment below the natural rate will
(1) Deflationary fiscal policy, where increased taxes
only succeed in accelerating the rate of inflation.
and/or reduced government spending lowers
Money wage
aggregate demand. inflation

(2) Deflationary monetary policy, where reducing the

growth of the money supply and/or raising the
rate of interest lowers demand.
(3) Stimulating output by improved productivity,
labour relations, etc.

(iii) Monetary inflation remedies Ae ae

(1) Implementing measures to restrict bank lending.
(2) Reducing the PSBR.
% unemployment

(i) Inflation and unemployment Figure 23.4 An expectations-augmented Phillips curve. SPC, and
SPC, are short-term Phillips curves. LPC is the long-term Phillips
¢ The Phillips curve implies a trade-off relationship curve at the NRU. Economy initially on SPC, curve at Uy at point
A. Government reduces unemployment to U, by increasing
between inflation and unemployment. For instance demand. This causes prices and wages to rise. Move to point
in Figure 23.2 the percentage change in money B. Higher wages and costs result in a rise in unemployment to Uy
wages is high when unemployment is low. but at a higher expected rate of inflation on SPC,. Move to point C.
me a
¢
{* the Hational economy

The rational expectations hypothesis suggests that (Cc) What evidence is there in the passage of:
there is no long-term or short-term trade-off. Supporters (1) cost-push inflationary pressures? (2 marks)
argue that people base their actions on past experiences (2) demand pull inflationary pressures?
of inflation and their expectations of current and future (3 marks)
government policies. On average, they correctly forecast (d) Why would Mr Clarke have taken comfort in the
the results of current economic events and policies, and November 1994 average earnings figure?
do not suffer from money illusion. (3 marks)
(e) How could arise in interest rates curb inflation?
(4 marks)
23.2 Investigative study (f) Discuss other policies that might be adopted to
cure inflation. (7 marks)
Example 23.1
An investigation into what influences people’s
expectations of inflation and how those expectations Solution 23.2
affect their behaviour.
(a) Retail prices, as measured both in terms of
headline and underlying inflation, rose throughout the
23.3 Data response period but at varying rates.
The headline rate of inflation peaked at
‘Example 23.2 approximately 11% in spring 1990. Then prices rose
more slowly until autumn 1992, when inflation
A warning reached its lowest point of approximately 1%.
The underlying rate of inflation followed a similar
““DISAPPOINT- mortgage-interest payments) mea- pattern to the headline rate in the first part of the
ING” was Kenneth sures. The annual headline rate of
inflation was 2.9%, and the under-
Clarke’s verdict on period. It peaked at approximately 9% in late spring
lying rate 2.5%. Firms may finally
December’s _ infla- 1990 and then the inflation rate fell (as retail prices
tion be passing on to customers the
figures,
much-discussed increases in fac-
released on January rose more slowly). Unlike the headline rate, the
tory-gate prices.
18th. This was an
understatement. The chancellor’s That December’s inflationary
underlying rate continued a downward trend
hope that he might avoid, at least
rise is unlikely to prove a blip is throughout the period after early 1990. It started and
underlined by that month’s sur-
until the spring, the next inflation-
prisingly buoyant retail-sales fig-
curbing rise in interest rates have finished below the headline rate, but for most of the
been dashed. Mr Clarke next ures, released on January 19th. period was above it.
meets Eddie George, the governor These showed a monthly rise of
of the Bank of England, on Febru-0.5%, in volume terms, and a
ary 2nd to discuss interest-rate yearly one of 3.8%. (b) The headline rate of inflation is a measure of
policy. Another rise may not be Inflationary fears were further changes in the retail price index, RPI. It includes
far behind. fuelled by December’s unemploy-
The inflation numbers were ment statistics, also released this mortgage interest payments.
well above expectations. Retail week. These revealed an unex-
prices jumped by 0.5% in Decem- pectedly large fall of almost (c) (1) The extract mentions increases in factory-gate
ber, on both the headline and 55,000 in the jobless total, com-
underlying (excluding changes in pared with November, to just over prices, which implies that costs of production had
2.4m. In this economic recovery,
changes in unemployment have
risen.
coincided with changes in output; (2) The extract mentions buoyant retail sales,
on that basis, December’s jobless
numbers suggest that the economy which increased — in volume terms — by 3.8% ona
is still growing rapidly. yearly basis. This suggests that consumer demand was
Mr Clarke will take comfort
that, amidst so many worrying increasing. The extract also mentions falling
numbers, November’s growth in
average earnings was the same as
unemployment, which would have increased
October’s, at 3.75% year-on-year. consumer demand. People would have experienced
The consensus forecast was for it
to edge up to 4%. higher incomes and increased confidence, leading
Source: The Economist, them to spend more.
21 January 1995, p. 30.

(d) The growth of average earnings was less than had

(a) What happened to retail prices over the period been anticipated. This means that firms’ costs of
1990-94? (5 marks) production rose more slowly than expected. Indeed if
(b) What is meant by the headline rate of inflation? average earnings had risen in line with productivity -
(1 mark) increases, costs would not have risen. Rises in
 work
gunn
earnings above productivity increases would have had Example 23.4
a significant impact on firms’ costs.
The following information shows a country’s
(e) A rise in interest rates may reduce demand-pull consumer expenditure pattern on four goods and the
inflation. The higher cost of borrowing is likely to price indices of these commodities for two years.
reduce consumer demand for items purchased with
borrowed money. Demand for other products will fall Index of Index of Consumers’
as consumers’ income, after paying higher mortgage prices prices expenditure
Commodity in year in year (£ million)
interest charges, decline. The greater return from
| 2 in year 1
saving may also cause some people to spend less and
save more. W 100 80 300
Xx 100 110 200
(f) The policies that may be adopted to cure inflation ae 100 120 100
will depend on what is believed to be the cause of Z, 100 150 400
inflation and views on the effectiveness of the
policies. Economists who consider that inflation Between years | and 2 the general level of prices has:
results from increases in costs of production may urge remained the same
the implementation of a prices and incomes policy. risen by 4.5%
They argue that this will reduce price rises while risen by 12%
avoiding the adverse effects of deflationary policies — pe
STArisen by 18%
in particular, rises in unemployment. Economists who
consider that inflation has resulted from demand Example 23.5
exceeding supply (demand-pull inflation) may urge a
reduction in demand. This could be achieved by Which of the following groups is most likely to
deflationary fiscal policy, i.e. reducing government benefit from a period of higher than anticipated
spending and/or increasing taxation. An alternative to inflation?
reducing demand is increasing output by, for example, A Creditors
giving subsidies to producers. This will only be a B_ Non-unionised labour
viable policy if the economy is below the full C The government
employment level. D The unemployed
A rise in the exchange rate may also be employed
to reduce inflationary pressures. The resulting fall in Example 23.6
import prices will lower the cost of finished imported
goods, some UK producers’ costs of production and Demand-pull inflation may initially be caused by:
possible wage claims. The lower import prices may an increase in wages
also increase pressure on domestic producers to keep an increase in bank credit
their prices low in order to remain competitive at an increase in profit margins
home and abroad. ~ an increase in the price of imported raw materials
a
i
on

we questions Example 23.7

An inflationary gap is said to exist when:
A government spending exceeds government revenue
The weights in the retail price index indicate: B_ leakages exceed injections at the full employment
seasonal fluctuations in price level of national income
by how much the prices of goods have changed C aggregate demand is greater than the full-
the relative amount spent on each category of good employment level of national income
SORwhich goods have risen by more than the average D the full-employment level of national income
rise in prices exceeds the equilibrium level of national income
satoatieoO cat cag
the
Gtional economy

Example 23.8 Example 23.12

In conditions of full employment, which of the Which of the following must occur as a result of
following would be most likely to lead to inflation? inflation?
A An increase in income tax Fiscal drag will take place
B An increase in the demand for exports Debtors will gain and creditors will lose
C An increase in labour productivity The volume of exports will decline
D An increase in expenditure on imports oi The domestic purchasing power of the currency
will decline

Example 23.9
If a government believes that inflation is the result of ms to objective
cost-push factors and it wishes to reduce inflation,
which of the following measures is it likely to adopt?
A Arise in interest rates
“solution 23.3 Answer: C
B_ An increase in income tax
C The imposition of a prices and incomes policy The index of retail prices is a weighted price index.
D A reduction in the growth of the money supply This means that the price changes of different
categories of goods and services are multiplied by
weights. These weights indicate what proportion of
Example 23.10 consumer expenditure is devoted to the different
In year 1, an economy has a money supply of £400 categories. For instance if, out of a total expenditure
and a velocity of circulation of 6, and it produces 800 of £100m, £30m is spent on food, then food will
goods. In year 2 the velocity of circulation and the receive a weighting of 3/10.
level of output remain constant, but the money supply
increases to £600. According to the quantity theory,
Solution 23.4 Answer: D
this will cause the price level to rise by:
A £1.5 B £3 Ce 243 D £6 To determine the change in the general price level it is
necessary to multiply the price change of each
commodity by its weighting. The total of the weighted
Example 23.11
price changes gives the answer.
In the diagram below Uy, is the natural rate of
Commodity Weight Price change Weighted
unemployment, SPC,, SPC, SPC;, and SPC, are
price change
short-run Phillips curves associated with successively
higher levels of inflationary expectations, and LPC is W (3/10) X 20% = =e
the long-run, vertical Phillips curve. If inflationary xX (2/10) X 10% = 2%
expectations are at 6% and a government wishes to i (1/10) X 20% = 2%
eliminate wage inflation, it would have to permit Zz (4/10) X 50% = 20%
unemployment in the short run to change to: 18%
A U, B U, GiU, D U,

Solution 23.5 Answer: C

SPC, SPC,
SPC, SPC3 LEG
The government is a net debtor and therefore is likely
10%
to have to pay lower real interest. The government
Rate of
change of may also raise more revenue if fiscal drag occurs.
money
wages 6%
Other options are incorrect.
A => Creditors are likely to lose during a period of
3% higher than anticipated inflation, since the real rate of
interest is likely to fall.
% unemployment
B => Non-unionised labour is likely to suffer, since -
it will be in a weak position to maintain real wages.
 D => The unemployed may experience a fall in
iP EISP
Solution 23.10 Answer: A
living standards if benefits are not adjusted in line
The quantity theory is represented by the formula
with inflation or if there is a lagged response.
MV = PT, or P = MVIT. In year 1 the price level is:
P= MVIT = 400 X 6/800 = 2400/800 = £3

Solution 23.6 Answer: B In year 2 the price level is:

P = MV/T = 600 X 6/800 = 3600/800 = £4.5
An increase is bank credit will mean that firms and
consumers will have more to spend and the resulting Therefore the price level has risen from £3 to £4.5, i.e.
increase in demand may result in demand-pull by £1.5. The money supply has increased by 50%,
inflation. causing a 50% rise in the price level.
A, C and D = are likely to increase the costs of
production, which might result in cost-push inflation. Solution 23.11 Answer: C

If inflationary expectations are at 6%, the economy is

on the short-run Phillips curve SPC;. On this curve,
Solution 23.7 Answer: C
U, is the rate of unemployment that will reduce the
An inflationary gap occurs when aggregate demand is rate of change of money wages, since U;, is where
greater than the output that can be produced when SPC; cuts the zero percentage of change of money
there is full employment. wages line. In the long term, when the expected rate
A => Describes a budget deficit. of inflation equals the actual rate of inflation,
B and D = describe a deflationary gap. unemployment will return to the natural rate of Uy.

Solution 23.12 Answer: D

Solution 23.8 Answer: B
If prices rise, each unit of currency (e.g. each £1) will
An increase in the demand for exports will mean more be able to buy fewer goods and services.
money coming into the country while goods are going A B and C = May occur, but not necessarily.
out. Thus there will be more money but fewer goods Fiscal drag will only take place if tax rates are not
to spend it on. With full employment it will be adjusted in line with inflation. Debtors will gain and
difficult to produce more goods and an inflationary creditors will lose if the inflation rate rises more
gap is likely to develop, with demand exceeding rapidly than the interest rate. However the interest rate
supply. may rise in line with inflation, and possibly at a faster
A and D => would be likely to reduce demand, and rate. Whether or not the volume of exports decreases
hence inflationary pressure. will depend on a number of factors, including the
C: => would result in more goods being available inflation rate experienced in other countries. Indeed if
and, assuming no increase in wages, a fall in the the home country’s inflation rate is below that of rival
inflation rate. countries, its exports will become more and not less
competitive.

Solution 23.9 Answer: C

Cost-push inflation arises when prices are pushed up

by increases in the costs of production, such as wages.
One possible solution is a prices and incomes policy
that aims to limit rises in prices and incomes while Is inflation only harmful if it is at a rate above that
avoiding deflation. All the other measures mentioned prevailing in other countries? (25 marks)
are designed to reduce demand and/or the money
supply — A and D by monetary measures and B by a ¢ Consider the effects of inflation on a country’s
fiscal measure — and are likely to be implemented if it external position.
is believed that inflation is being caused by demand- ¢ Also consider the effects on a country’s internal
pull or monetary factors. position.
 oS ea ra
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ape out economics & ional economy

Solution 23.13 is because a situation where demand exceeds supply

may make entrepreneurs optimistic about the potential
Inflation, which is a persistent rise in the general price returns that can be earned by expanding output.
level, may have detrimental effects, not only However inflation, particularly if it is high, has
externally but also internally. The internal effects can effects within a country as well as on its competitive
occur even if the country has a lower inflation rate position abroad. While it is possible to alleviate some
than that of other countries. of the internal effects, some may cause inconvenience
If the UK’s inflation rate is higher than that of other or disruption, and possible hardship. For a number of
countries, then the UK’s products will become less countries, including the UK, a reduction in
competitive both at home and abroad. This is likely to international competitiveness would be significantly
result in a fall in export revenue and a rise in import detrimental, but it is not the only adverse effect the
expenditure. Investment in the UK may be country may suffer as a result of inflation.
discouraged. So there is likely to be an adverse effect
on the UK’s balance of payments position and
Example 23.14
employment. It may also result in a fall in the
exchange rate, which will accelerate inflation. (a) Explain what is meant by cost-push inflation.
Inflation, especially if it is above a creeping level, (10 marks)
will also probably be undesirable, because of the (b) Discuss the policies that may be used to reduce
internal effects. Inflation will affect the distribution of cost-push inflation. (15 marks)
income, and this can create social tension. For
¢ Discuss the main causes of cost-push inflation.
instance unions will have to press for wage rises
e Assess some of the policy measures that may be
merely to keep pace with inflation, i.e. to maintain
implemented.
real wages. Members of weak unions — e.g. UsDAW
—are more likely to suffer a decline in real wages than
are members of strong unions. Solution 23.14
The effects of inflation can be alleviated by index
(a) Cost-push inflation is a sustained rise in the
linking wages and/or benefits. However if, for
general price level caused by increases in the costs of
example, the job seekers’ allowance is not raised in
production. Higher costs of production cause the
line with inflation the unemployed will experience a
aggregate supply curve to shift to the left — ‘a supply
fall in their living standards. In contrast house owners
shock’. The decrease in aggregate supply causes the
may benefit as the value of their property is likely to
price level to rise, as illustrated in the diagram.
rise by more than the rate of inflation, while the real
cost of their mortgage payments is likely to fall.
Creditors may suffer and debtors may gain if the Price
level AS,
interest rate does not rise in line with inflation. Fiscal
drag may occur, although the government could Aggregate
eliminate this effect by adjusting tax bracketsin line supply

with inflation.
P,
There are costs involved in living with inflation.
P
Firms will incur menu costs and will have to adjust
prices regularly, and time and effort may have to be
taken to estimate future inflation. Firms and
Aggregate
individuals may also experience shoe leather costs. demand
Government measures to reduce inflation may have
an adverse effect on other economic objectives, 0 O@0 Output

particularly growth and full employment. Deflationary

monetary policy and fiscal policy reduce demand and Higher costs of production can arise as a result of
hence tend to result in lower output and employment, wage increases in excess of rises in productivity.
at least in the short term. Wage rises may be a significant factor as wages form -
One possible advantage of inflation may arise if it the highest proportion of factor incomes —
is at a low level and is of a demand-pull nature. This approximately 70% — so any change in wage rates is
likely to have a relatively large impact on costs and example if employers wish to raise the prices of their
prices. Wage rises may also result in a wage—wage products or raise the wages of their workers above a
spiral and a wage-price spiral. If one group of limit set by the government they can, for example,
workers receives a wage rise this may stimulate other change the weight of their goods and promote their
groups of workers to press for a wage rise to restore staff to newly created posts.
wage differentials. Higher wages may push up prices, To offset the effects of higher imported raw
which in turn may cause workers to press for wage material costs a government could raise the exchange
rises to restore real pay. rate. This would lower import prices and reduce cost-
An increase in the price of imported raw materials push inflation by reducing the costs of production and
will also increase the costs of production. For placing increased pressure on domestic producers to
example if the price of oil rises, firms, transport, keep their costs and prices low in order to remain
heating and manufacturing process costs will increase competitive in the home and overseas markets.
and they are likely to pass at least some of these However, a higher exchange rate may result in lower
higher costs on to the consumer in the form of higher domestic output and higher unemployment if
prices. domestic producers are unable to improve their
Cost-push inflation can also be caused by firms competitiveness.
increasing their profit margins and the government A government could also seek to reduce cost-push
increasing indirect taxes or decreasing subsidies to inflation by cutting indirect taxes and increasing
firms. subsidies. This approach should increase aggregate
supply. However the effectiveness of the measures
(b) A number of policy measures may be have to be assessed carefully. For instance a subsidy
implemented to reduce cost-push inflation. To counter to promote training will not only immediately lower
inflationary wage and profit margin rises a firms’ costs, assuming they are already undertaking
government may impose a prices and incomes policy. some training, but should also reduce costs in the long
This is a direct way of seeking to reduce inflation run by increasing productivity.
without creating unemployment. Limits or freezes can A government could also lower firms’ costs by
be placed on wage and price rises. However this reducing real interest rates. Firms may have borrowed
policy approach has a number of drawbacks. in the past, so a cut in interest rates will reduce their
Percentage pay limits will benefit the highly paid interest rate payments. However, lower real interest
whereas fixed-sum limits will benefit the lowly paid, rates may contribute to demand-pull inflation by
so whichever form is used it will tend to cause stimulating a rise in consumer expenditure.
dissatisfaction among one group of workers. Other There are a number of other measures that some
problems of this policy include the fact that workers economists would advocate to increase the cost
and employers will seek to get round any limits or efficiency of firms, including deregulation and
freezes and the inflexibility it creates in markets. For privatisation.
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 International

Date Date Self-

AEB | NEAB } OCSEB} UCLES | ULE begun |completed} assessment

J Fact sheets

/ Investigative study

J Data response

"A Objective questions

J Essays
24.1 Fact sheet (c) Absolute and comparative
advantage
(a) Problems of international trade The main advantage claimed from international trade
International trade is the exchange of goods and is higher world output. The theories of absolute
services between countries. Problems arise over: advantage and comparative advantage explain how
output may be increased by specialisation and trade.
(1) currencies;
(2) language; ¢ Absolute advantage exists when a country can
(3) distance; produce more of a product per resource unit than
(4) customs/tastes; another country.
(5) foreign competition; * Comparative advantage exists when a country can
(6) import restrictions; produce a product at a lower opportunity cost than
(7) legal and technical regulations; its trading partners.
(8) possible delays in payment.
Table 24.1 An example of comparative advantage

(b) Benefits of international trade Country Daily output per resource unit

(1) A greater variety of goods for consumers. Cars Boats

(2) A larger market allows domestic producers
A 2 4
greater scope for economies of scale.
B 4 10
(3) An opportunity to obtain goods that the country
cannot produce itself. This accounts for a very
While country B has an absolute advantage in the
small percentage of the goods the UK imports.
production of both goods, A has a comparative
(4) Consumers’ welfare may increase as a result of
advantage in the production of cars. A sacrifices only
lower prices resulting from international
two boats for one extra car (four boats/two cars),
competition.
while B has to forgo 2.5 cars (ten boats/four cars).
(5) Trade with other countries may lead to the spread
of technology, management techniques and ideas.
(6) International specialisation raises output. (d) Costs of international trade
(1) Infant industries (also called sunrise industries)
may not be able to become established if faced
 work out ccononisserernayffal ron

with competition from foreign companies with form of restriction. In addition to protecting
lower costs due to greater economies of scale. domestic industries, tariffs may be imposed to
(2) Declining industries (also called sunset raise revenue.
industries) may decline rapidly, causing a (2 —
Quotas are limits on the quantity of a commodity
significant rise in unemployment. that is allowed to enter the country.
(3) Foreign producers may engage in dumping (i.e. (3) Exchange control occurs when a government
selling surplus output at a low price, even controls the availability of foreign currency. This
sometimes below average cost) in the home often involves a limit on the foreign exchange
market. available to importers.
(4) A country may become dependent on other (4) Physical control (embargo) occurs when a ban is
nations for products — e.g. weapons, food — which placed on the export or import of a certain good
may be cut off during periods of dispute or war. or on trade with a particular country or countries.
(5) A country may experience the disadvantage of (5) Purchasing policy is when a government places
overspecialisation, including diseconomies of orders with domestic producers in preference to
scale, vulnerability to sudden changes in demand more competitive importers.
and unemployment. (6) Administrative restrictions may cover lengthy
paperwork to be completed by importers in
(e) Pattern of UK international connection with artificially high health and safety
trade regulations.
(7) Import deposit schemes require importers to
The UK is a major trading country, importing and
deposit a sum of money before they can bring in
exporting mainly manufactured goods from and to
goods from abroad.
mainly developing countries. Voluntary export restraint is an agreement
(8)
between two countries where the exporter agrees
(f) Protectionism to limit the volume of its exports.
Protectionism is the restriction of international trade Subsidies are an indirect measure designed to
by means of tariffs, quotas and non-tariff barriers. The reduce imports by making domestic products
main forms of restriction are: more price competitive.

(1) Tariffs (also called customs duties), which are a ¢ A government may seek to protect particular
tax on imported goods. This is the most common industries or industries in general.

Table 24.2 The UK’s main trading partners in 1993

(g) Trading blocs
Most important Most important
There are four main types of trading bloc:
sources recipients
of UK imports of UK exports (1) A free trade area is a group of countries that

1. Germany Germany Table 24.3 Arguments for protectionism

2. USA USA Arguments for Arguments for
3. France France general controls
selective controls
4. Netherlands Netherlands
5. Japan Belgium and Help infant Improve terms of
Luxembourg industries trade
6. Italy Irish Republic Help declining Raise revenue
7. Belgium and Italy industries
Luxembourg Protect strategic Correct current
8. Irish Republic Spain industries account deficit
9. Switzerland Sweden Prevent Avoid
10. Norway Japan dumping overspecialisation
a
Further political Promote growth
Source: Monthly Digest of Statistics, February 1995 objectives
(CSO). eeaU UEUEEENEESER
sewth our effonc tional trade and government policy

removes tariff barriers between member countries but

allows each member to decide its own tariff Leap in imports widens
policy towards non-members.
(2) A customs union, in addition to removing tariffs UK’s world trade gap
between members, also imposes common external
urging imports widened the both volume and value terms.
tariffs on non-members. UK’s trade gap with the rest However, imports rose faster
(3) A common market is a customs union that permits of the world in November,
according to the latest government
than exports, climbing 3.5 per
cent to £12.7 billion, reflecting
the free movement of capital and labour between continued
figures, and City economists believe economic recovery.
member states. that it has since widened further. Most forecasters expect import
The trade deficit for November growth to run ahead of export
(4) An economic union is a common market whose was £640 million, after a revised growth, as the competitive edge
£553 million shortfall in October, derived from lower sterling fades.
members follow common economic policies.
bringing the deficit for the first 11 The latest three-month figures,
which provide a guide to the trend
months of last year to £8.2 billion,
down from £12 billion at the same in visible trade, showed exports
(h) The European Union stage in 1993. up by 3.5 per cent in value terms
and imports up by 3 per cent.
The Budget forecast for the
whole of 1994 is an £11 billion In volume terms, excluding oil
The European Union (EV) currently has fifteen deficit. Previously published fig- and erratic items, such as aircraft
member countries. ures for trade with the European and gems, exports increased by 5
Union (EU) revealed a_ sharp per cent, while imports gained 3
widening of the deficit in Decem- per cent, suggesting a core
¢ The Common Agricultural Policy (CAP) seeks to improvement in the trade balance.
ber, to £1.05 billion, which points
increase agricultural productivity, ensure a fair to a full-year global deficit of In November, however, volume
below £10 billion, against 13.3 exports rose by only 2 per cent,
standard of living for the agricultural community, billion the year before. against a 3 per cent increase for
stabilise markets and ensure the availability of Export growth imports. Excluding oil and errat-
remained
impressive. A 3 per cent rise from ics, the November deficit widened
supplies. The high support prices have resulted in October took exports to £12.1 bil- to £940 million, for £899 million.
large surpluses and considerable expenditure. lion in November. Richard Need- Source: Article by Colin
ham, the Trade Minister, said that Narbrough, The Times, 10
¢ The UK is a net contributor to the EU budget. exports were at record levels in February 1995.
¢ The Maastricht Treaty, signed in 1992 and ratified
in 1993, sets out a common foreign and social
policy and a timetable for economic and monetary
Solution 24.2
union.
(a) The UK’s trade gap is the negative difference
between UK visible exports and UK visible imports.
It is a visible trade deficit. The article states that in
November 1994 the trade gap was £640 million, i.e.
the UK imported £640 million more in value of
imports than it exported.
A study of the impact the move towards economic and
monetary union is having on UK firms. (b) There are a number of causes of an increase in
exports. More exports are likely to be sold if they
become more price competitive. This may be because
of a fall in unit costs or because of a reduction in the
value of the currency. An improvement in the quality
of exports, their marketing and, in some cases, after
sales service will also tend to increase demand and
(a) What is meant by the UK’s trade gap? (2 marks) sales. Other possible causes are an increase in
(b) What can cause a growth in exports? (6 marks) incomes abroad, a fall in income at home and the
(c) What is the difference between the value and the removal of import restrictions abroad.
volume of exports? (2 marks)
(c) The value of exports is the quantity of exports
(d) Why may imports increase at a faster rate than
multiplied by price, i.e. the amount earned from the
exports during an economic recovery? (5 marks)
sale of exports. The volume of exports is the quantity
(e) Why does a fall in the value of sterling give UK
of exports.
goods a competitive advantage? (4 marks)
(f) What measures can be taken to reduce a trade (d) During an economic recovery incomes will rise
deficit? (6 marks) and so will spending. More imports will be purchased.
 work out cconongsorarnayfinal rag

Some countries, including the UK, have a high 24.4 Objective questions
marginal propensity to import. This means that a
significant proportion of extra income is spent on Example 24.3
imports. Most imports purchased are finished
manufactured goods, but imported raw materials are A country is said to have a comparative advantage in
also purchased and these are likely to be brought in the production of a good when:
larger quantities as domestic firms increase their A it can produce more of it than any other country
output. However exports may rise more slowly Bit can produce it at a lower opportunity cost than
because the buoyant home market may cause goods to its trading partners
be diverted from the export to the home market. C it has captured a larger percentage share of the
world market than any other country
(e) A fall in the value of sterling relative to other 0 it accounts for a greater percentage of total world
currencies lowers the price of exports in terms of sales in the product than in any other product it
foreign currencies. For example, if initially £1 = $2, a produces
UK good priced £10 would sell in America for $20. If
the value of the pound were to fall to £1 = $1.5 the
same good would sell for $15. The lower price abroad Example 24.4
should enable a large share of the overseas market to
With respect to the table below, which of the
be captured. If demand is elastic the rise in quantity
following statements is correct?
demanded will be of a higher percentage than the fall
in price, and total revenue will rise. Units of resources required to Country A Country B

(f) There are three main immediate measures that can Produce one TV 30 60
be taken to reduce a trade deficit. One is to devalue Produce one radio 10 40
the currency, which will not only lower the price of
A Country B has an absolute advantage in the
exports in terms of foreign currency but also raise the
production of both products
price of imports in terms of the home currency. For
B_ Country B has a comparative advantage in the
devaluation to be successful a number of conditions
production of radios
have to be met, including elastic demand for exports
Q Country A has a comparative advantage in the
and imports.
production of TVs
The government could also deflate the economy in
D None of the above statements is correct
the hope that the resulting lower demand will reduce
expenditure on imports and divert some goods from Examples 24.5 and 24.6 are based on the following
the home to the export market. However deflation information
may have an adverse effect on domestic output and
Cuba USA
employment.
Another possible measure is to impose or increase Output of cigar units per factor input 30 10
import restrictions. For example a quota could be Output of sugar units per factor input 90 50
placed on the number of cars allowed into the country
from overseas. However membership of international
organisations may restrict a country’s ability to Example 24.5
impose import restrictions.
In the longer run a government may seek to reduce Which of the following is true of the situation above?
a long-lasting trade deficit by introducing measures to A Cuba has a comparative advantage in the
increase the quality and price competitiveness of production of sugar
domestic goods, e.g. by increasing expenditure on B Cuba has an absolute advantage in the production
training. of both sugar and cigars
Q The USA has an absolute advantage in the
production of both sugar and cigars
— The USA has an absolute advantage in the
production of sugar and Cuba has an absolute
advantage in the production of cigars
ms out fori GOB rtionsatrade and government policy

Example 24.6 D No trade, since the opportunity cost ratios are

identical
Which of the following exchange rates will benefit
both Cuba and the USA?
A 1 cigar for 6 sugar Example 24.9
B 1 cigar for 4 sugar
Which of the following would reduce the level of
C 1 sugar for 8 cigars
protection faced by domestic producers in the home
D 1 sugar for 6 cigars
market?
A An increase in VAT
B._ The introduction of exchange control
Example 24.7
C A reduction in the level of import quotas
The following table shows the output per factor input D An agreement to implement reciprocal tariff
in two products concessions proposed by WTO

UK Nigeria
Example 24.10
Units of iron 240 48
Units of steel 80 16 Before the imposition of a tariff, the domestic price of
good T is Py and domestic producers supply
If there are no trade barriers and no transport costs,
DS. Domestic demand is represented by DD. When
which of the following is most likely to occur?
the country engages in free international trade, the
A Nigeria will import iron and steel from the UK
world supply is represented by WS and the price is Py.
B_ The UK will export iron to Nigeria and import
The imposition of a tariff on the product causes price
steel from Nigeria
to rise to Pz. The tariff will result in domestic
C Nigeria will export iron to the UK and import steel
producers increasing their output by:
from the UK
A 0C B CD CDF D FG
D There will be no trade between the two countries
in the products concerned

Price
°f
Example 24.8 good T

Figure 1 shows the production possibility curve of

country X and Figure 2 shows the production
Px
possibility curve of country Y. In this case, which of
Pz
the following is most likely to occur? Py

A Country X will tend to export wheat to country Y

B Country Y will tend to export wheat to country X
Output
C No trade, since country Y is better at making both
products

Wheat Wheat

216

18 Tractors 0 54 Tractors
 work out econo ternational tr

Example 24.11 more efficiently (i.e. with fewer resources) and so it

has an absolute advantage in the production of both
Which of the following is the main feature
goods. Option A is incorrect.
distinguishing customs unions from free-trade areas?
Country A is even better at producing radios, since
A Only free-trade areas have no tariff barriers
it requires only one quarter of the resources that
between members
country B does to produce radios, whereas it requires
B Only customs unions maintain tariffs between
one half of the resources that B does to make one
member countries
TV. So country A has the comparative advantage in
C Only customs unions require members to adopt a
producing radios, and hence option C is incorrect.
common external tariff with non-members
Country B has the comparative advantage in
D Only free-trade areas require members to adopt a
producing TVs, since it requires twice the resources to
common external tariff with non-members
make TVs but four times the resources to make
radios. Thus option B is also incorrect.
Example 24.12
What is the main argument for protecting sunset Solution 24.5 Answer: B
industries? Cuba can produce more of both products per factor
A To enable them to develop economies of scale
input and therefore has an absolute advantage in the
B_ To prevent a rapid increase in unemployment
production of both goods. Hence option B is correct
C To offset the effects of dumping by overseas
and options C and D can easily be rejected.
producers Cuba has the comparative advantage in producing
D To ensure that there is a basis of production if
cigars, since it has a lower opportunity cost in the
imports are cut off during a war
production of the good than the USA has. In Cuba the
opportunity cost of one cigar equals three units of
to objective sugar, whereas in the USA it is five units of sugar.
Thus, after due consideration, option A can be
rejected.

The law of comparative advantage states that Solution 24.6 Answer: B

international trade is beneficial to two or more
An exchange rate that will be beneficial to both
countries, provided that there are differences in their
trading countries must be between their internal
opportunity cost ratios. For instance, in the example
opportunity cost ratios. In Cuba one cigar equals three
below the two countries with one resource unit can
units of sugar and in the USA one cigar equals five
produce: units of sugar. In terms of sugar, in Cuba one unit of
UK France sugar equals one third of a cigar and in the USA one
unit of sugar equals one fifth of a cigar, so the only
Cars 20 Z
exchange rate that will benefit both countries must lie
Steel > 1
in the range: 1 cigar = 3—5 units of sugar.
France has the comparative advantage, or lesser
disadvantage, in producing steel. In France the
Solution 24.7 Answer: D
opportunity cost of producing one unit of steel is two
cars, whereas in the UK it is four cars. The UK has the absolute advantage in both products.
However, as the opportunity cost ratios are the same, a
situation of comparative advantage does not exist and
Solution 24.4 Answer: D
the countries will not benefit from specialisation and
In this question it is important to remember that the trade.
figures given relate not to the output per resource unit,
as is most commonly the case, but to the number of Solution 24.8 Answer: B
resource units required to produce one TV and to
produce one radio. Country A can produce both goods A production possibility curve shows the potential
 wieare

‘national trade and government policy

output of two commodities a country can produce trade areas allow member countries to decide their
with its resources. Country Y has absolute advantage own external tariff policies.
in producing both tractors and wheat and comparative
advantage in producing wheat. It can produce three
Solution 24.12 Answer: B
times more tractors than country X but four times
more wheat. So country Y will specialise in wheat Sunset industries are declining industries. If these are
and will export to country X in exchange for tractors. given protection, which is gradually removed, they
Country X will concentrate on producing tractors and can be allowed to go out of business gradually and
will export these to country Y. As there are employment can be reduced by means of ‘natural
differences in the relative efficiencies with which the wastage’.
countries can produce the goods, there is a potential A => is an argument for protecting sunrise industries.
for them to benefit from specialisation and trade. C = Dumping may affect any industry and not just
sunset industries.
D => is an argument for protecting strategic industries
Solution 24.9 Answer: D

A reduction in the level of protection faced by

domestic producers means that home producers will
face more competition from foreign producers.
24.6 Essays
At first glance the answer may appear to be option Example 24 13, .
C, but a reduction in import quota levels would mean
Discuss the arguments for and against the use of
that fewer imported goods would be allowed into the
import controls. (25 marks)
country, and hence protection for home producers
would be increased. ¢ Distinguish between arguments for selective and
The introduction of exchange control would enable general import controls.
a government to control the value of imports and VAT ¢ Concentrate on the arguments rather than detailed
is charged on both foreign and home-produced goods descriptions of the different types of import
in the domestic market. control.
In contrast the acceptance of reciprocal tariff
concessions proposed by WTO will mean a reduction
Solution 24.13
in taxes on imports, which will make foreign goods
more competitive than home products. Protection limits the entry of goods into a country. It
is usually imposed to protect domestic industries. The
main argument against protection is that it prevents
Solution 24.10 Answer: B
full advantage being taken of the principle of
The pre-trade domestic production of the good is OE. comparative advantage, which states that world output
With free trade the quantity bought is OG, where the will be higher when countries specialise and engage
domestic demand (DD) cuts the world supply (WS). in free trade. Moreover protection may reduce choice,
Of this quantity, OC is supplied by domestic producers reduce competition, create shortages, increase
and CG by foreign producers. When the tariff is inefficiency and provoke retaliation.
imposed and price rises to Pz, the new quantity bought However some economists argue that selective
is OF (where DD cuts what is, in effect, a new supply import controls should be placed on particular
curve running parallel with P,). Of this OD is supplied countries. These calls for selective controls are backed
by domestic producers and DF by foreign producers. by a number of arguments. One reason given is that
So domestic producers increase their output by CD. protection is necessary to enable infant industries to
grow and take advantage of economies of scale.
At the other end of the industry age span,
Solution 24.11 Answer: C
protection may be used to help industries decline
Both customs unions and free-trade areas remove gradually. The idea is that this will permit natural
tariff barriers between member countries. However, wastage to occur and avoid a sudden increase in
whereas customs unions also require member unemployment.
countries to impose a common external tariff, free- Selective import controls may also be used to
 work out econo ter al eran

prevent dumping, where foreign companies sell ¢ Explain comparative advantage and then consider
products at or below cost price. Predatory pricing the assumptions underlying the theory.
benefits domestic customers in the short term. In the ¢ Keep the numerical example simple. It should be
longer term, artificially low prices may eliminate designed to illustrate economic theory and not to
domestic firms. Foreign producers can then use their prove elaborate mathematical skill.
monopoly position to raise prices.
General import controls may improve the terms of
trade so that each export can be exchanged for more Solution 24.14
imports. This will occur if the imposition of tariffs or
(a) The theory of comparative advantage states that,
other forms of import control forces foreign producers
provided that their opportunity cost ratios differ, even
to reduce their prices in order to remain competitive.
a more efficient country and a less efficient country
Import restrictions may also enable a country to
will benefit from specialisation and trade with each
diversify and avoid overspecialisation. If a country is
other. However the simplicity and unreality of some
highly specialised there is a danger that it will suffer if
of the assumptions upon which the theory is based
there is a fall in world demand or if there are supply
have led to reservations about its applicability to the
problems, Protection of strategic industries guarantees
real world.
a domestic supply of essential goods, for example
It is relatively straightforward to ascertain that
weapons and food.
countries with absolute advantages in different
In some developing countries import controls are
products will benefit from specialisation and trade.
used to raise revenue, and both developing and
However David Ricardo, in developing the theory
developed countries may use import controls to gain a
of comparative advantage, went further. He stated that
strong bargaining position or to retaliate against other
both countries will benefit from specialisation and
countries’ trade restrictions. However the danger is
trade, even if one country is more efficient at making
that a trade war may develop.
both products concerned, provided that it is even
Countries may also use import controls to correct
better at making one of the two. It is relative and not
or prevent a balance of payments deficit. However
absolute efficiency that is crucial.
import controls are usually only used as a last resort,
and are likely to be combined with other measures to
UK USA
reduce the underlying tendency to purchase a high
level of imports. Units of output per factor: cars 10 50
Some economists, including the Cambridge Units of output per factor: wheat 20 200
Economic Policy Group, urge the adoption of a
system of general import controls in order to In the example given above, the USA has absolute
restructure the UK economy. They do not wish to advantage in producing both cars and wheat since it
reduce imports, merely to control their growth and to can produce more of both. However it has
prevent an injection of government spending — comparative advantage in producing wheat since it is
designed to stimulate the UK economy — being largely even better at growing this product, being able to
spent on imports. Their main ideas is that a protective produce ten times more wheat but only five times
wall will enable UK industry to regain its efficiency more cars than the UK. In contrast the UK has
and growth, creating a situation of full employment. comparative advantage or lesser disadvantage in
making cars since it is not so bad at making this
product, producing one fifth of the quantity of cars but
Example 24.14 only one tenth of the quantity of wheat produced in
the USA.
(a) Explain the theory of comparative advantage.
Another way of determining which product a
(10 marks)
country has a comparative advantage in is to examine
the internal opportunity cost ratios. A country has
(b) To what extent is it a satisfactory explanation of
comparative advantage in a product when producing it
the basis of international trade? (15 marks)
involves a lower opportunity cost than in another
¢ Distinguish between absolute and comparative country.
advantage. Output will be increased by specialisation, and both
 ate inational trade and government policy

countries should be able to enjoy more goods than specialisation. Also, there is not perfect knowledge, so
previously if the exchange rate lies between the it may be difficult to calculate comparative advantage.
internal opportunity cost ratios — in this case, | car: There may also be imperfect competition in the
2-4 wheat. domestic markets. This is likely to mean that at least
some prices do not accurately reflect domestic
(b) However the applicability of the theory to opportunity cost ratios. Countries also have different
international trade has been questioned on a number of degrees of economic power, and in practice exchange
grounds. It is often stated in terms of a few countries rates are more likely to favour developed than
and a few products, whereas the real world is more developing nations.
complex. It also ignores transport costs. These will The theory concentrates on the supply side. A
reduce the advantages of specialisation and trade — country may specialise in making a product and yet
particularly in the case of low-price bulky goods. still import it if home demand exceeds its output
The theory assumes constant opportunity costs as potential.
resources are moved from one industry to another, A country may also experience significant
whereas in practice economies or diseconomies of scale unemployment, and it maybe considered better to
may arise. The shifting of resources from one use to employ factors relatively inefficiently rather than not
another also presumes perfect factor mobility, whereas to employ them at all.
some factors — particularly labour — may be immobile. The theory of comparative advantage indicates that
Indeed the theory presumes that perfect output will be increased by specialisation and trade,
competition exists in the international and domestic but the simplicity and unreality of some of the
markets. In practice completely free trade does not assumptions means that it does not fully explain the
exist, and the presence of import restrictions reduces actual pattern of world trade.
 (c) Results of a favourable
movement
| of the terms of trade (1) In the short term, higher export prices and lower
The terms of trade (ToT) is the ratio comparing export import prices are likely to improve the current
and import prices: account balance before demand has had time to
adjust.
index of export prices Y (2) In the longer term:
ToT 100
~ Index of import prices (a) if demand for exports is elastic, export
revenue will fall;
A favourable movement means that the ToT get larger.
(b) if demand for imports is elastic, expenditure
Favourable movements are caused by:
on imports will rise;
(1) arise in export prices; (c) if demand for imports is inelastic, foreigners
(2) a fall in import prices; may experience a fall in income and reduce
(3) arise in export prices and a fall in import prices; demand for UK exports;
(4) export prices rising faster than import prices; (d) UK subsidiaries abroad may suffer a decline
(5) import prices falling faster than export prices. in revenue.

(d) Composition of the balance of

payments
(b) Causes of changes in the terms
of trade The balance of payments (BoP) is a record of all
economic transactions between residents in the UK
The ToT change in response to: and residents in the rest of the world, over a period of
changes in demand - e.g. increased demand for raw a year. The BoP has three components:
materials during a boom; (1) the current account;
(2) changes in supply — e.g. a crop failure; (2) UK external assets and liabilities;
(3) changes in value of the currency — e.g. a (3) the balancing item.
depreciation results in a fall in export prices and a
rise in import prices: (e) The current account
(4) changes in the inflation rate — e.g. an acceleration
in the inflation rate will result in higher export Particular attention is paid to the current account,
prices. which is made up of:
 fnational trade and government policy

(1) The visible balance (also called the balance of balances, in the sense that the current account balance
trade), which shows exports and imports of plus net transactions in external assets and liabilities
tangible goods — e.g. cars, radios. A trade gap plus the balancing item must equal zero.
occurs when the value of visible imports exceeds
Table 25.1 The 1993 UK balance of payments
the value of visible exports.
(2) The invisible balance, which shows the net total £ millions
of:
Current account
(a) services, including sea transport, civil
Visibles —13 209
aviation, travel, banking and insurance,
Invisibles 2 029
expenditure on embassies abroad and staff
—11 180
stationed abroad;
UK external assets and liabilities
(b interest, profits and dividends (investment
—
transactions in assets — 156 303
income is included, whether it is remitted or
transactions in liabilities 164 724
retained for investment);
Net transactions 8 421
(c) transfers, including government grants
Balancing item 2759
overseas, subscriptions to international
organisations (including the EU) and private Source: Monthly Digest of Statistics, February 1995
transfers in the form of payments to overseas (CSO).
dependents and charitable donations.
(h) Current account surplus
Visible balance + invisible balance = current account
balance (i) Consequences

A current account surplus may be taken to be a sign

(f) UK external assets and liabilities of economic strength, but a large surplus may be
considered to be disadvantageous because:
This covers short-term and long-term capital
movements and flows to and from reserves. It is made (1) it involves an opportunity cost in terms of
up of two sections: forgone higher living standards;
(2) it results in an injection of demand into the
(1) Transactions in external assets, comprising: economy, possibly contributing to demand-pull
(a) UK direct and portfolio investment overseas; inflation;
(b) lending to overseas residents; (3) it is likely to increase the money supply,
(c) drawing on (+) and additions to (-) the which may contribute to inflationary pressures;
reserves; (4) it may make the country unpopular with
(d) intergovernmental loans made by the UK and countries in deficit.
subscriptions to international lending bodies.
(2) Transactions in external liabilities, comprising: (ii) Measures to eliminate a current account
(a) overseas direct and portfolio investment in the surplus
UK;
(b) borrowing from overseas residents by UK (1) Revalue the currency: this will increase export
residents and banks; prices and lower import prices.
(c) intergovernmental loans to the UK, foreign (2) Introduce a reflationary fiscal and/or
currency borrowing from banks overseas and monetary policy, which will increase demand for
transactions with the IMF. imports.
(3) Reduce or abolish import controls.
Transactions in external assets + transactions in
external liabilities = net transactions (i) Current account deficit
(i) Consequences
(g) The balancing item (1) A current account deficit causes a welfare
The balancing item represents the net total of errors gain, since the country, consumes more than it
and omissions in the other items. The BoP always produces.
 work out economicgsietoncg soit Gs >:

(2) A country will eventually be unable to cover a states that a devaluation improves the current account
current account deficit by drawing on reserves. balance if the combined price elasticities of demand
(3) A leakage in domestic demand. for exports and imports are greater than 1. The J effect
(4) A decrease in the money supply. in Figure 25.1 shows that a devaluation initially
causes a deterioration in the current account balance
(A to B) before demand and supply adjust to the new
(ii) Measures to correct a current account
prices of exports and imports (B to C)
deficit

(1) Impose or increase import controls Current

account
(protectionism) to switch expenditure from balance
imports to home-produced goods. (£ millions)

2 Introduce a deflationary fiscal and/or

monetary policy to reduce demand for imports
and stimulate exports by lowering domestic
demand. Months
(3) Encourage exports by, say, zero rating VAT on
exports.
(4) Devalue the currency: this will decrease
export prices and raise import prices.

(j) The Marshall-Lerner condition Figure 25.1 The J effect

A devaluation of the pound sterling results in the

following:

(1) An immediate deterioration in the BoP because 25. 2ive study

of:
(a) an immediate rise in the price of imports but a example 25.P
constant quantity of imports bought;
(b) a fall in the price of exports but a constant A study of the sae performance of local businesses,
quantity of exports bought. including an analysis of changes in their performance.
(2) A longer-term improvement in the BoP as:
(a) UK consumers buy fewer imports;
(b) foreign consumers buy more exports. 25. 3 Dae apPonse
The overall long-run effect of a devaluation of sterling
depends on the Marshall-Lerner condition, which example252

Balance of payments figures in £ millions GDP at constant

factor cost
Investment index
Year Exports Imports Services ncome Transfers (1990 = 100)

1988 80 346 101 826 3.935 4 424 23 518 97.3

1989 92 154 116 837 3 361 3 388 24 578 99.4
1990 101 718 120 527 3 689 981 24 896 100.0
1991 103 413 113 697 3 708 oaeg 21 383 97.9
1992 107 343 120 447 4 089 4 293 25 109 97.4
1993 121 414 134 623 4 942 3 062 25 106 99.4
i —— —— ——

Sources: Economic Trends, Annual Supplement, 1995, CSO; The Pink Book 1994; Monthly Digest of Statistics, February
1995
 rK OU micg #intefpational trade and government policy

(a) Inthe context of the balance of payments, what The table does not show a consistent pattern. In three
is meant by investment income? (3 marks) years GDP and the current account position move in
(b) Calculate: opposite directions and in two years they move in the
(1) the visible balance; same direction.
(2) the invisible balance;
(d) Economic theory would suggest that GDP and the
(3) the current account balance. (6 marks)
current account balance are likely to move in opposite
(c) What do the data show about the relationship
directions, so that a rise in GDP would be
between changes in economic activity, as
accompanied by a deterioration in the current account
indicated by changes in GDP at constant cost,
of the balance of payments. This is because an
and the current account balance? (6 marks)
increase in economic activity, unless generated by an
(d) Are your findings in (c) in accord with what the
increase in exports (export-led growth), is likely to
relationship economic theory would lead you to
suck in imports and divert goods from the export to
expect? (6 marks)
the home market. However a fall in economic activity
(e) What effect would a rise in economic activity
would tend to reduce the demand for imports and
abroad be likely to have on the current account
divert goods from the home to the overseas market.
position of the UK balance of payments?
The data is not entirely consistent with this view.
(4 marks)
Although the deficit did decline markedly at the start
Solution 25.2 of the recession it is surprising that relatively large
deficits were experienced in both years of the
(a) Investment income refers to profits, interest and
recession. Part of the answer for the not entirely
dividends. It is the amount UK citizens earn on their
consistent pattern may be found by examining the rate
overseas financial and physical assets minus the
of change in GDP. In 1990 GDP rose and the current
amount overseas citizens earn on UK assets. Included
account position improved. However what was
in this category are, for example, dividends earned by a
occurring in 1990 was a slowdown in economic
UK citizen on shares in a French company, interest paid
growth from 2.2% in 1989 to 0.6%. In 1992 GDP fell
on a loan made by a UK bank to a Canadian company
and the current account position deteriorated.
and profits earned by a UK company based in Spain.
However the fall in GDP declined from 2.1% in 1991
(b) to 0.5% in 1992.
(£ millions) (e) A rise in economic activity abroad, unless export
Visible Invisible Current account
led, is likely to improve the UK balance of payments.
Year balance balance balance
With higher incomes overseas consumers are likely to
1988 —21 480 4 863 =—16617
purchase more UK goods and services. In addition,
1989 —24 683 ZA — D212
1990 —18 809 —226 —19 035 with buoyant home markets, overseas producers may
199] —10 284 2 108 —8 176 compete less rigorously abroad. This may enable UK
1992 —13 104 BINS: —9 831 producers to sell more in the UK and overseas.
1993 —13 209 2 898 — 10311

(Cc)
GDP at Direction Current Direction
questions
constant of change account of change
factor cost balance
index (£ million)
Year (1990 = A favourable movement in the terms of trade occurs
100) when:
1988 97.3 —16617 A the price of exports rises relative to the price of
1989 99.4 T —22512 J imports
1990 —-100.0 i -19035 T B. the ratio of export to import earnings increases
1991 97.9 Jt ~8 176 ‘4
1992 97.4 L —9 831 L C_ the volume of exports rises relative to the volume
1993 99.4 . —10311 L of imports £
Note: Direction of change on current account: J = deficit getting D the current account of the balance of payments
larger: T = deficit getting smaller. moves into surplus
 work out ee ee 27

Example 25.4 Example 25.7

The following figures show the UK’s terms of trade:
£ million
eee se.0 1991: 100.2
Visible exports 2560
1989: 98.8 1992: 101.4
Visible imports 2620
1990: 100.0 1993: 103.9
Transfers 50
Source: Monthly Digest of Statistics, December 1994. Interest, profits and dividends 70
Services 90
Which of the following could account for the
Net transactions alt
movement in the terms of trade shown in the table:
A Export prices fell faster than import prices
What is the current account balance?
B_ Export prices rose faster than import prices
A —£60m B £50m C £150m D £210m
C Import prices rose while export prices remained
In which of the following circumstance is a
constant
devaluation most likely to improve the visible
D Export prices fell while import prices remained
balance?
constant

Example 25.5 Example 25.8

In which of the following circumstances is a
Which of the following items would appear as a credit
devaluation most likely to improve the visible
item in the invisible balance of the UK balance of
payments? : balance?
Demand for imports: |Demand for exports:
A The spending of UK tourists in France
A price elastic price elastic
B The hiring of a UK ship by a Dutch oil company
B price inelastic price elastic
C The purchase of UK government bonds by French
C price inelastic price inelastic
residents
D sprice elastic price inelastic
D The purchase by a German company of a china
factory in Worcester
Example 25.9
Example 25.6 The following table shows a country’s national
income and domestic expenditure for three years:
Exports Imports
Year 1 Year 2 Year 3
Price per Number of Price per Number of
unit units unit units
National income 600 660 720
(£000s) (000s) (£000s) (000s)
Consumer spending 360 360 390
Government spending 180 180 180
Year 1 20 20 25 8 Investment 120 120 120
Year2 40 12 40 6
In which year(s) will a balance of trade deficit be
What changes took place in the terms of trade and the
balance of trade between years | and 2? experienced?
A land3 B 2and3
Terms of trade Balance of trade:
C 1 only D 2 only
A improved improved
B___simproved worsened
C _-worsened improved Example 25.10
D worsened worsened
Measures designed to improve a country’s current
account balance may be either expenditure-reducing
or expenditure-switching. Which of the following is
an example of an expenditure-reducing policy?
A Devaluation
 Pc eational trade and government policy

B A credit squeeze Solution 25.5 Answer: B

C_ The granting of export subsidies
The invisible balance includes services, interest,
D The imposition of import controls
profits and dividends and transfers. A credit item on
the invisible balance is one that represents money
Example 25.11 being paid to a UK resident or a firm in the UK,
whereas a debit item represents a payment to a foreign
Which of the following will appear in the external
resident by a UK resident. If a Dutch oil company
assets and liabilities section of the UK balance of
hires a UK ship, money will be paid from the
payments?
Netherlands to the UK.
A Support costs of UK embassies abroad
A = represents a debit item in the UK invisible
B_ Lending to Nigerian companies by British banks
balance as it involves money going out of the UK to
C Interest earned on UK funds held in American
France.
banks
C and D = are credit items in the net transactions
D Profits earned by British subsidiaries in Argentina
section.

Example 25.12 Solution 25.6 Answer: A

The income elasticities of demand for imports and The terms of trade in year 1 were:
exports in four countries are given below. Which index of export prices 100
country’s balance of payments position will benefit
Index of import prices ;
most from a world recession?
20.000
Income elasticity of Income elasticity of x 100
= 80
Me 5 000
Country demand for imports demand for exports
and in year 2:
A 1.8 0.8
B es 1.2 40 000
x 100 = 100
C 1.0 1.6 40 000
D 0.8 2.0
Thus there has been an improvement in the terms of
trade in the period shown.
The balance of trade in year 1 was value of exports
to objective (price X value) — value of imports (price X volume)
in £000s:
<¥ Ta
400(20 x 20) — 200(25 X 8) = 200
Solution
25.3 Answer: A
and in year 2:
A favourable movement in the terms of trade occurs
when the index rises. This situation occurs when the 480(40 x 12) — 240(40 X 6) = 240
price of exports rises in relation to the price of The balance of trade has improved with an increase
imports. This may result from, for example, a rise in in the surplus of £40 000.
the price of exports and/or a fall in the price of
imports or even export prices falling by a lesser extent Solution 25.7 Answer: C
than import prices.
The current account balance is the visible balance
plus the invisible balance, i.e. —£60m (visible exports
Solution 25.4 Answer: B minus visible imports) plus £210m (net transfers + net
The figures in the table show a favourable movement interest, profits and dividends + net
in the terms of trade, i.e. the number has become services) = £150m.
higher. A favourable movement occurs when the price
Solution 25.8 Answer: A
of exports rises in relation to the price of imports.
A, C and D = In each case there would be an A devaluation is most likely to improve the balance of
unfavourable movement in the terms of trade. trade position when demand for both exports and
 work out economi anc yme

imports is price elastic — the Marshall—Lerner A, C and D => would all appear in the invisible
condition. balance section of the balance of payments.

Solution 25.9 Answer: C Solution 25.12 Answer: A

The country will have a deficit on the balance of trade In a world recession, incomes are likely to fall. To
when its total demand (consumer gain the most benefit from a world recession, the
spending + government spending + investment) demand for a country’s exports should be income
exceeds its output (NY). inelastic. Thus a fall in income results in a smaller
percentage fall in the demand for its exports. In
¢ In year | output is 600 but demand is 660, so there
contrast its imports should be income elastic, so that a
will be a deficit of 60.
fall in domestic income results in a greater percentage
¢ In year 2 output is 660 and so is demand.
fall in the demand for imports. If income elasticity of
Therefore there will be equilibrium.
demand for imports is 1.8 — i.e. elastic — and income
¢ In year 3 output is 720 and demand is 690, so
elasticity of demand for exports in 0.8 — i.e. inelastic —
there will be a surplus of 30.
a fall in income will result in a greater reduction in
import expenditure than in export earnings. Thus a
Solution 25.10 Answer: B current account deficit would be reduced or a surplus
increased.
Expenditure-reducing measures seek to improve a
country’s current account position by reducing the
demand for all goods and services, both domestic and
foreign. The fall in demand for imports will reduce Cp eke
import expenditure and the fall in demand for home- Example 25.13
produced goods may encourage forms to switch
production from the home to the foreign market. Assess the measures a government may use to correct
In contrast expenditure-switching measures aim to a deficit on the current account of the balance of
improve the current account balance by switching payments. (25 marks)
from foreign to the home country’s goods and ¢ Briefly explain what is meant by a deficit on the
services, i.e. from imports to domestic goods and current account of the balance of payments.
from another country’s exports to the home country’s * Concentrate on three main measures of improving
exports. the current account balance.
A credit squeeze is a measure designed to reduce * Examine both the internal and external effects of
the demand for all goods bought by the home the measures.
country’s residents.
A => is an expenditure-switching measure
encouraging residents of the country to switch from Solution 25.13
buying imports to buying domestically produced The current account section of the balance of
goods and foreigners to switch from buying their own payments covers visible and invisible exports and
products or other countries’ products to buying the imports. A deficit on the current account balance
devaluing country’s products. means that the country’s population is spending more
on goods and services from abroad than it is earning
from the sale of goods and services abroad.
Solution 25.11 Answer: B
The measures a government will adopt to correct a
The external assets and liabilities section of the deficit will be aimed at increasing income earned
balance of payments includes investment into and out and/or reducing expenditure abroad. In considering
of the UK, lending to and borrowing abroad, which policies to adopt, a government will consider
intergovernmental lending and borrowing, drawing on the cause of the deficit and the advantages and
and additions to the reserves. Lending to Nigerian disadvantages of the measures.
companies by British banks would appear as a One possible measure, provided the government is
transaction in external assets. not committed to keeping the currency within set
 rk out econor National trade and government policy

margins, is devaluation. This will mean lowering the Import controls may provoke retaliation from other
price of exports in terms of foreign currencies and countries and their use may be restricted by
raising the price of imports in terms of the home membership of trade blocs, e.g. the European Union
currency. It is essentially an expenditure-switching and international organisations such as the World
measure, changing relative prices. Trade Organisation.
However, whether the policy will be successful in Among other measures a country may employ are
terms of improving the current account position will encouraging exports by, for instance, giving
depend on whether there is elastic demand for favourable loans to exporters and encouraging other
imports, elastic demand for exports, elastic supply of countries to remove some of their import restrictions.
exports, lack of import restrictions abroad and a low
domestic marginal propensity to import, among other
Example 25.14
factors.
Lowering the value of the currency will affect not (a) Explain what is meant by a surplus on the
only a country’s external trade position, but also its current account of the balance of payments and
internal position. If exports rise and imports decline briefly discuss how it might arise. (7 marks)
there will be a net injection into the circular flow of (b) Why may a government seek to eliminate such a
income, and national income should rise by a multiple surplus? (6 marks)
amount. This should stimulate output and (c) What measures could a government implement
employment. However there may be inflationary to achieve such an objective? (12 marks)
effects arising from the increase in import prices and
e Define a surplus on current account.
the net injection. While devaluation is associated with
¢ Discuss the main motives for eliminating a
an increase in domestic economic activity, deflation is
surplus.
associated, in the short term at least, with a reduction
¢ Discuss revaluation, reflation and other measures
in economic activity. Deflation involves reducing
to eliminate a surplus.
demand by restrictive fiscal and/or monetary policy.
For instance a government may increase taxation in
the expectation that, if people’s disposable income Solution 25.14
declines, they will buy fewer imports. The higher the
(a) A surplus on its current account means that a
income elasticity of demand for imports the greater
country is earning more abroad than it is spending.
the effect will be. It will also be expected that demand
This could arise as a result of a surplus on its visible
for the home country’s products will decline, so home
balance and invisible balance, a visible balance
producers will be forced to try to export more of their
surplus exceeding an invisible deficit or an invisible
output. The interest rate may also be pushed up to
surplus exceeding a visible deficit.
deflate the economy. If deflation also reduces inflation
A country may be earning more from the sale of its
the current account position will be further improved
visible and invisible exports than it is spending on
by the increase in price competitiveness. However
visible and invisible imports, for a number of reasons.
deflation may, even if only in the short term, have an
The country’s goods and services may be price
adverse effect on employment and growth.
competitive. They may be marketed very effectively,
An alternative to deflation is the imposition of
be of a high quality and provide, for example, good
import controls, either a general system or on selected
after sales service. Incomes abroad may be rising,
industries. Import controls may prevent dumping,
which will increase demand. Incomes at home may be
assist infant (sunrise) industries, allow sunset
relatively low, which would keep down the demand
industries to decline gradually, improve the terms of
for imports whilst forcing domestic producers to sell
trade and, of course, correct a current account deficit.
more abroad. The removal of import restrictions
However import controls may prove to be
abroad would also enable the country to sell more
inflationary. This is because imports are included in
exports.
the retail price index, costs of production will rise if
imported raw materials continue to be used and if (b) A country may wish to eliminate a surplus in
unions press for wage rises to compensate for higher order to improve the standard of living of its
prices. UK firms may also be able to raise prices and inhabitants. If a country has been experiencing a large
remain competitive with more expensive imports. current account surplus over a number of years, then
 work out economi ance o ments 231

the opportunity cost involved is the goods and imports are cheaper and these count in the retail price
services it could have bought with the currency it has index. There may also be a reduction in the costs of
been earning. production for home producers, as imported raw
If a country has been experiencing large current materials and components will be cheaper. The rise in
account surpluses there may be pressure on it from the price of exports may force domestic exporters to
other countries to reduce or eliminate the surplus. cut their costs in order to remain competitive.
Measures a government may take to achieve this may Domestic producers selling in the home market will
not only restore its current account equilibrium, but also have to keep their prices low in order to compete
also help deficit countries achieve current account with cheaper imports. However there is the possibility
equilibrium. A country trying to reduce a surplus is that foreigners may raise the price of their goods in
likely to buy more abroad and sell less. Considerable the knowledge that they may still be competitive.
pressure has, in the past, been put on Germany and Reflationary fiscal and/or monetary measures
Japan to reduce their surpluses. will increase the demand for all products. For
A country may also eliminate a surplus to reduce instance an increase in government spending will
inflationary pressures. A surplus can result in an result in a multiple rise in national income and, hence,
injection of demand into the domestic economy and demand. More imports will be purchased and the
an increase in the money supply. increase in domestic demand for home-produced
goods may divert goods from the export to the home
(c) One possible measure to eliminate a surplus may be market.
implemented with the prime objective of reducing A country may also seek to increase expenditure on
inflationary pressures. A revaluation of the currency imports by removing or reducing import restrictions.
upwards will mean that more foreign currency will be For instance lowering tariffs will reduce the price of
obtained for the same value of the home currency. The imports on the home market and will result in an
home country’s exports will be more expensive in terms increase in expenditure on imports. Subsidies on
of foreign currency, while its imports will be cheaper in domestic products could also be removed.
terms of the domestic currency. The revaluation is likely In addition, encouragement for exporters could be
to result in an increase in import expenditure and a fall reduced or removed. For instance banks may no
in export revenue, assuming elastic demand for exports longer be directed to give preference to exporters
and elastic demand for imports. when lending, and indirect taxation may be imposed
An increase in the value of the currency means that or increased on exports.
26.1 Fact sheet one fixed rate to another. Depreciation means that
the value has fallen because of market forces. In
(a) The foreign exchange rate both cases £1 would buy fewer units of another
currency.
The exchange rateisthe price of one currency in
¢ <A revaluation of sterling occurs when the UK
terms of another currency. An exchange rate can be
bilateral (£/$) or multilateral (a basket of currencies
government raises the value of the pound from one
fixed rate to another. Appreciation means that the
such as the trade weighted sterling index.
value has risen because of market forces. In both
¢ A devaluation of sterling occurs when the UK cases £1 would buy more units of another
government lowers the value of the pound from currency.

Table 26.1 The demand for and supply of the pound sterling

£s are demanded by fs are supplied by

Foreign residents wishing to buy UK UK residents wishing to buy imports

exports and pay for UK services and pay for foreign services

People wishing to invest in the UK UK residents wishing to invest abroad

Those wishing to take advantage of a Those wishing to take advantage of a

future rise in the value of the pound future rise in the value of another
currency

Governments wishing to add sterling to their Governments wishing to replace the sterling in
reserves their reserves with other assets

AUK government wishing to raise the A UK government wishing to lower the

value of the pound value of the pound

Foreign governments wishing to lower Foreign governments wishing to raise

the value of their currencies the value of their currencies
 aa

work out econoric

¢ A Eurocurrency is any currency deposited in a buying and selling currencies when necessary.
financial institution outside its country of origin, (2) Adjustable peg is when the exchange rate is
e.g. French francs deposited in a bank in maintained within agreed margins around a
Singapore. central parity but with the possibility that the
¢ The London Foreign Exchange Market consists of central parity may be changed.
all those who deal in foreign exchange but have no (3) Crawling peg is a form of adjustable peg where
formal meeting place. the central parity can be changed regularly on the
¢ The spot market is that part of the foreign basis of the previous trend in the exchange rate.
exchange market concerned with the buying and (4) Managed floating is when the government
selling of currencies for immediate use. occasionally intervenes in the exchange market to
¢ The forward market is concerned with agreeing stabilise the exchange rate or move it in a desired
the price of a currency now to buy or sell in the direction.
future. (5) Free floating occurs when the exchange rate is
¢ Arbitrage is movements of funds to take determined by demand and supply, without
advantage of differences in exchange or interest government intervention.
rates, and this quickly eliminates any such
differences.
¢ The purchasing power parity theory suggests that
(c) The exchange rate mechanism
the prices of goods in countries will tend to equate
(ERM)
under floating exchange rates so that people will
be able to purchase the same quantity of goods in The ERM is an adjustable peg system that involves
any country for a given sum of money. EU countries maintaining the value of their currencies
within limited margins but being allowed to float their
currencies against non-member currencies. If a
(b) Exchange rate systems currency within the ERM begins to move outside its
(1) A fixed exchange rate is one that is maintained at margins, its government is expected to bring it back
a certain level (parity or par) by the government into line by:

Value of Value of
Value of
currency currency
currency

0 Tim e 0 Time
(a) (b) (c)

Value of Value of
currency currency

0 Time 0 Time
(d) (e)

peg
Figure 26.1 Exchange rate systems: (a) fixed; (b) floating; (c) managed floating; (d) crawling peg; (e) adjustable
 nelfstiona trade and government policy
ut out econ@n
(1) buying or selling its currency; (b) the Bundesbank president stating that the
(2) changing its interest rate; value of the pound was too high;
(3) seeking to realign its central parity with the (c) concern over whether France would sign the
agreement of the other members. Maastricht Treaty;
(d) speculation.

(d) Advantages of the ERM The UK government has stated it will only rejoin the
ERM if there is:
Membership of the ERM can confer a number of
advantages on a country. It: (1) greater convergence of monetary policy in the
EL,
(1) provides greater discipline to reduce inflation as a
(2) a stronger mechanism for helping currencies that
fall in the exchange rate cannot be used to restore
come under pressure;
international competitiveness;
(3) ahealthy UK economy.
(2) gives the country a greater say in EU matters;
(3) helps to provide greater predictability of
exchange rates within the EU, which in turn (g) International liquidity
should promote trade in the EU; International liquidity is an asset that is acceptable in
(4) makes monetary union easier to achieve; settling international debts. Internationally acceptable
(5) discourages destabilising speculation; assets are kept in countries’ reserves. Forms of
(6) increases the chance of inflation rates converging. international liquidity are:

(1) Gold.
(e) Disadvantages of the ERM (2) Foreign currencies
The disadvantages of membership include: (3) Reserve positions at the IMF, i.e. the ability to
borrow from the IMF.
(1) less opportunity to use the exchange rate as a (4) Special drawing rights (SDRs), which are issued
policy tool, e.g. it cannot be reduced to increase by the IMF and have been specifically created to
employment; act as international liquid assets. They are
(2) reduced independence of monetary policy, e.g. a allocated to member countries on the basis of
government may have to raise its interest rate to their quotas, and their value is expressed in terms
prevent the value of its currency falling below the of a weighted basket of five leading currencies.
lower margin, even if this conflicts with domestic
objectives;
(3) some currencies are more volatile than others and
(h) Problems of international
therefore are subject to more and wider
liquidity
fluctuations in demand and supply — this makes The two current major problems are:
them harder to maintain within the agreed
(1) Shortage of international liquidity.
margins.
(2) Which form international liquidity should take.
Some economists have suggested the following:
(f) UK membership of the ERM (a) Increased use of gold. This view overlooks
the opportunity cost of using gold, and its
The UK joined the ERM in October 1990 at a central
inelastic supply. Some economists suggest the
parity of 2.95 Deutschmarks. It left on 16 September
demonetarisation of gold, i.e. ceasing to use
1992 ‘Black Wednesday’ because:
gold as a form of government money.
(1) the value of the pound had been set too high and (b) Increased reliance on foreign currencies.
hence was difficult to maintain; However this would mean that the growth of
(2) the government wanted to be free to lower the world reserves would depend on national
interest rate to reflate the domestic economy; policies. There may be a risk of
(3) the value of the pound had come under downward destabilisation via movements from
pressure due to: weakening to strengthening currencies.
(a) arise in German interest rates; (c) Adoption of completely freely floating
 work out eco s*° exc rates

exchange rates. This would eliminate the need

for reserves.
(d) Increased government cooperation between
central banks in order to make more effective
nt of the impact of exchange rate changes
use of existing reserves through coordinated
on local businesses.
intervention.
(e) Increased use of SDRs.

(i) International organisations

(1) The /nternational Monetary Fund (IMF) was set
up in 1944. Its main aims include:
(a) facilitating the expansion and balanced Yen’s Unstoppable Rise
growth of world trade;
(b) promoting assistance to member countries
Threatens to End in Disaster
with balance of payments difficulties; But the bubble is bound to burst
FFICIALS in Tokyo have
(c) promoting exchange rate stability. all but abandoned their because of the imminent collapse
efforts to hold down the of the current-account surplus.
Member countries pay a quota based on their value of the yen after it soared Import volumes are growing 10%
national income and share of world trade. The spectacularly to 88.7 to the dollar more rapidly than export volumes
last week. and will grow even faster when
purpose of quotas is to make available a pool of Foreign analysts now believe Japan’s recovery picks up.
foreign currency that can be borrowed by member the yen will remain at historically The underlying strength of the
high levels for at least another 12 Japanese economy is powerfully
countries in tranches, i.e. percentages of their months. Despite the serious drag revealed in several recent studies
which show that Japanese compa-
quotas. The right to the first 25%, or gold tranche, that this rate of exchange is
nies will still be able to make use-
putting on Japan’s recovery, the
is automatic but the right to subsequent tranches Bank of Japan appears to have no ful profits, albeit reduced ones, if
plans to cut the official discount the exchange rate strengthens by
is subject to increasing conditionality. another 5%.
rate (currently at a historic low of
(2) The International Bank for Reconstruction and 1.75%) or continue its unilateral “Even with the yen—dollar rate
at 85, we believe economic recoy-
effort to prop up the dollar. In the
Development, which is more commonly known as past eight months the Bank of ery will continue,” says Dick Bea-
the World Bank. It was established in 1945 to Japan has bought more than $14 son, economist with James Capel
billion in a futile effort to support Pacific in Tokyo. JP Morgan esti-
help member countries recover from the Second the ever-weakening dollar and mates that between 3% and 5% of
expected profits will be wiped off
World War. It now gives long-term loans to slow the yen’s rise. As the Bank’s
dollar holdings have ballooned to the 1994 corporate results as a
member countries for high priority infrastructure, $125 billion, the value of the dol- result of the yen falling from 98 to
lar has slumped more than 10%. 90 to the dollar. Toyota, the
agricultural, industrial and educational projects. largest Japanese carmaker and
Authorities in Tokyo last week
(3) The International Finance Corporation (a member were blaming hedge-fund specula- exporter, has announced it is los-
tors such as George Soros for the ing Y1 billion (€£6.6m) in annual
of the World Bank group) was set up in 1956 to sales for every one-yen drop in the
strengthening of the yen, but more
encourage private sector development by fundamental economic factors dollar exchange rate.
were also at work. A Japanese “Tt remains highly unlikely that
providing share and loan capital for companies, current-account surplus of $129 the Bank of Japan will cut the
encouraging local capital markets and promoting billion last year, continuing ODR (official discount rate) or
restrictions on a wide range of that America’s Federal Reserve
the international flow of private capital. imports and a tight monetary poli- will take the Fed Funds rate high-
er in response,” says Beason.
(4) The International Development Association lends cy all contributed to make the yen
one of the world’s strongest cur- Source: Garth Alexander, The Sunday Times,
at low, subsidised interest rates to less developed rencies. 12 March 1995.

countries. It too is a member of the World Bank

group.
(a) Why would a rise in the value of the yen put a
(5) The World Trade Organisation (WTO) replaced (5 marks)
‘drag’ on Japan’s recovery?
GATT (the General Agreement on Tariffs and
(b) Draw a diagram to show the effect of the Bank
Trade) in January 1955. It polices and administers
of Japan buying dollars and explain what it is
the rules that govern world trade.
showing. (4 marks)
(c) Explain what has caused the value of the yen to
rise. (5 marks)
(d) What is meant by a current account surplus?
(2 marks)
 iNational trade and government policy

(e) What may cause a country to import more from the sale of visible and invisible exports than is
goods? (4 marks) spent on visible and invisible imports. Export revenue
(f) What may enable companies to make exceeds import expenditure.
‘useful’ profits despite a rise in the exchange
(e) There are a number of factors that could cause a
rate? (5 marks)
country to import more goods. Domestic output may
be increasing so more raw materials may be
Solution 26.2 purchased from abroad. Higher incomes are likely to
result in increased demand for overseas finished
(a) A rise in the value of the Japanese yen will
manufactured goods and services. The price
increase the price of Japanese exports in terms of
competitiveness of overseas products may rise, their
foreign currency, and reduce the price of Japanese
quality improve or they may be marketed more
imports in terms of yen. This is likely to reduce the
effectively.
sales of Japanese goods both at home and abroad,
More imports may be purchased if import
which in turn is likely to reduce output and
restrictions are reduced or removed. A rise in the
employment. So a rise in the value of a currency can
value of the currency is also likely to result in more
reduce the level of economic activity in a country.
imports being purchased.
(b) To purchase dollars the Bank of Japan will sell
(f) A rise in the exchange rate will reduce the price
yen. This will increase the supply of yen, lower its
competitiveness of domestic goods at home and
price and increase the quantity trade on foreign
abroad. However a domestic company may still
exchange markets.
continue to make normal or even supernormal profits
in a number of circumstances. It may be able to cut its
Price of 2 s costs and hence lower its prices to keep its market
yen in 4
dollars
share and maintain profit levels. It may also be able to
improve its marketing or the quality of its products, so
they will still be demanded even at a higher relative
P
price. In overseas and home markets the company
P, may not experience a significant change in its profit
margin if the demand for its products is inelastic.

D 26.4 Objective questions

0 or 0. Quantity of yen Example 26.3 —
On the foreign exchange market the value of the
pound depreciates from £1 = $1.5 to £1 = $1. Ifa UK
(c) The value of the yen rose because of the high and
export firm allows the price of its goods to reflect this
increasing demand and decreasing supply. Speculators
depreciation, by what percentage will the price in the
had been purchasing yen in the expectation that it
USA of a £20 000 good change?
would rise in the future. The country had a large
A +50% B +10% C —20% D —333%
current account surplus so demand by foreigners to
purchase yen to buy exports exceeded the sale of yen
by the Japanese to buy imports. Supply of the yen was Example 26.4
also reduced by restrictions on imports and tight
The following diagram shows the market for sterling.
monetary policy — both of which would have caused
If the government wishes to maintain the exchange
the Japanese to buy fewer imports and hence sell
rate at OP it should:
fewer yen.
A buy XY sterling
(d) The current account of the balance of payments is B_ buy XZ sterling
the visible balance plus the invisible balance. A C sell XY sterling
current account surplus means that more is earned D sell XZ sterling
 work out ecopeetr ext era 37

Price of , B_ A decrease in overseas investment by UK residents

fin
Deutschmarks
C A surplus on the current account of the balance of
payments
D Support of the pound sterling by the Exchange
Equalisation Account

Example 26.9
Which of the following is a possible disadvantage of a
fixed exchange rate?
A Reserves will have to be held
Quantity of £s B_ There will be frequent changes in the value of the
currency
C Trade may be diminished because of exchange rate
Example 26.5 uncertainty
Under a freely floating exchange rate system, which D There will be an absence of external pressure to
of the following will cause an appreciation of the control inflationary pressures
pound sterling?
A Arise in French interest rates Example 26.10
B_ An increase in Japanese tourist expenditure in The exchange rate between country X and country Y
London is £1 = £2.0. To be as well off in country Y, a citizen
C An increase in speculative sales of sterling of country X earning £24 000 per annum would need
D The purchase by a British company of a to earn £72 000. What is the purchasing power parity
controlling interest in a company in Germany between the $ and £?
A 5:1 B 4:1 ,ele Ee D 2:1
Example 26.6
Example 26.11
A British shirt manufacturer sells 60 shirts per week
in the USA when the price is £10 per shirt and the The diagram below shows the market for the pound
exchange rate is £1 = $1.5. The US market has a unit sterling.
elasticity of demand for these shirts. If the sterling
price is unchanged, what is the maximum number of
Price of
shirts the manufacturer can sell in the USA if the fs in $s
exchange rate changes to £1 = $2?
A 40 B 45 C 60 D 80

Example 26.7
Which of the following will impose downward
pressure on the pound sterling? +

A A fall in US interest rates 0 Quantity of £s

B A reduction in German import duties
C A reduction in UK investment abroad The initial equilibrium position is X. If there is an
D A reduction in foreign tourists coming into the UK increase in overseas investment by British companies,
will the new equilibrium position be A, B, C or D?

Example 26.8
Example 26.12
Which of the following would be likely to cause a
decrease in the UK’s reserves under a fixed exchange If a UK company keeps the German price of its
rate? exports unchanged after a fall in the value of the
A The issue of SDRs by the IMF pound the result will be:
sate outErica npational trade and government policy

A a decrease in the value of German sales valued in is 60 X $15 = $900. The change in the exchange rate
sterling will cause the US price to rise to $20. As elasticity of
B an increase in the value of German sales valued in demand for the shirt is unity, a rise in price will cause
sterling an equal percentage change in demand and total
C a decrease in the demand for its products in revenue will remain constant. Thus, as total revenue is
Germany $900 and each shirt sells for $20, the number of shirts
D an increase in the demand for its products in sold is $900/$20 = 45.
Germany

Solution 26.7 Answer: D

26.5 Solntions to objective Downward pressure on the pound sterling can arise as
a result of an increase in the supply of sterling and/or a
decrease in the demand for sterling. Fewer tourists
coming into the UK would reduce demand for sterling.
Originally the £20 000 good would have sold in the A =A fall in US interest rates is likely to cause a
USA for £20 000 X $1.5 = $30 000. After the rise in the value of the pound, as fewer UK citizens
depreciation it will sell for £20 000 X $1 = $20 000. will invest in the USA and more foreigners will
This is a reduction of invest in the UK, as opposed to the USA.
($10 000/$30 000) X 100 = 333%. B = If Germany reduces the taxes it places on
imports the UK should be able to export more to
Solution 26.4 Answer: D Germany, and hence the demand for sterling will
increase.
At the exchange rate 0P, demand for the currency C =A reduction in UK investment abroad would
exceeds supply by amount XZ. To prevent the reduce the supply of sterling on the world markets
exchange rate rising the government would have to and hence increase its price.
sell amount XZ to ensure that supply matches demand
at this artificially low price.
Solution 26.8 Answer: D
Solution 26.5 Answer: B If the EEA is supporting the pound it will buy up
An appreciation of the currency will occur if there is sterling. Most probably it will use foreign currencies
an increase in demand for the currency and/or a in its reserves to do this.
decrease in supply of the currency. A rise in Japanese A = The issue of SDRs by the IMF will increase
tourist expenditure in London would mean an increase the reserves of member countries, including the
in Japanese demand for sterling. UK.
B =A decrease in overseas investment by UK
A => Arise in French interest rates may result in a
residents may, in the short term, reduce the amount
shift in investment finance from the UK to France.
UK residents wishing to invest in France will of money going abroad, and hence may enable less
change pounds into francs, thereby increasing the money to be drawn from the reserves or more
supply of sterling. Fewer foreigners will wish to money added to the reserves.
invest in the UK and so the demand for sterling C = Acurrent account surplus will mean more
will fall. money being earned abroad than is spent abroad
C = Selling sterling increases supply and hence and some of this may be added to the reserves.
causes a fall in the price of the pound.
D = If UK residents buy more imports, more Solution 26.9 Answer: A
sterling will be sold to gain foreign currency, so
To maintain a fixed exchange rate, the authorities may
again the supply of sterling will increase.
have to buy the currency and to do this it will be
necessary to hold reserves. Keeping reserves involves
Solution 26.6 Answer: B
an opportunity cost.
The initial price of a $10 shirt in the USA is B, C and D => Discouragement of trade, absence of
£10 X $1.5 = $15. Sixty are sold, so the total revenue external pressure to control inflationary pressures and
 work out eco s*° exc r

frequent changes in the exchange rate are claimed by ¢ Make use of the concept of price elasticity of
some economists to be disadvantages of a floating demand.
exchange rate.
Solution 26.13
Solution 26.10 Answer: C
Depreciation means a fall in the value of a currency in
The purchasing power parity theory states that the terms of another currency or currencies under a
exchange rate between currencies will be such that the floating exchange rate system. It is caused by an
purchasing power of the money will be the same in increase in the supply of the currency and/or a fall in
both countries, i.e. the amount that can be purchased demand for the currency.
with the money concerned. If, in order to be as well A depreciation will mean that exports, in terms of
off in country Y, a citizen earning £24 000 needs to foreign currency, will be cheaper, while imports, in
earn £72 000, the value of the currencies is $3 to £1 in terms of pounds, will be more expensive. A
terms of what the currencies will buy. Thus the depreciation not only makes exports more price-
official exchange rate is not reflecting the purchasing competitive, but also increases the competitiveness of
power of the respective currencies. those UK products sold on the home market that
compete against imports.
In the short term the demand for both imports and
Solution 26.11 Answer: C
exports will be inelastic, as there will not be time for
An increase in overseas investment by UK companies the pattern of demand to change. However if the
will mean that more sterling will be exchanged into demand for exports is elastic, then total revenue
foreign currencies to invest abroad. The supply of earned from exports should rise, as the fall in price
sterling will increase, causing price to fall and will cause a greater percentage rise in demand. Also,
demand to expand. The supply curve shifts to the expenditure on imports should decrease, since a rise
right, intersecting the original demand curve at C. in their price will cause a greater percentage fall in
demand. The Marshall Lerner condition states that if
depreciation of a currency is to improve the balance of
Solution 26.12 Answer: B payments position, the elasticity for exports and
A company can take advantage of a fall in the value of imports must be greater than one.
the currency either by allowing the foreign price of its Exporters may take advantage of the fall in the
product to fall, thereby raising demand for it, or by currency either by allowing the price of their goods to
leaving the foreign price constant. The latter option fall in foreign markets or by keeping their prices
will result in an increase in its revenue measured in its constant, raising their sterling profit margins.
own currency. For example, if initially £1 = 10 marks, If the depreciation results in a rise in export revenue
then a £6 good would sell in Germany for 60 marks. and a fall in expenditure on imports, there will be a
If, when the exchange rate falls to £1 = 5 marks, the net injection in the circular flow of income. This will
company keeps the price in Germany at 60 marks, it cause national income to rise by a multiple amount.
will receive £12 per good when it changes its earnings If more exports are sold, fewer imports are
from marks into pounds. purchased and NY is rising, then employment is also
likely to rise. This will occur unless there is already
full employment or underemployment or unless a rise
in output results entirely from increased capital or
changes in technology.
While it is believed that the demand for UK exports
is elastic, it is more doubtful whether some of the
Discuss the effects on the UK economy of a other conditions required for a depreciation to
depreciation in the sterling exchange rate. (25 improve the balance of payments position will be met.
marks)
If the demand for exports and imports is inelastic,
¢ Explain the meaning of depreciation. then a fall in the value of the pound will result in more
¢ Examine the internal and external effects of a being spent on imports and less being earned from
depreciation. exports. This will cause a deterioration in the balance
 ational trade and government policy

of payments position and will result in a leakage from Price of

francs in
the circular flow. Deutschmarks

Even if the demand for exports is elastic, the

country may not benefit if the supply of exports is
inelastic. For instance, if there is full employment it
|
Upper band
may be difficult to meet any extra demand. The
beneficial effects of a depreciation may also be Central parity

affected by other countries devaluing their currencies. Lower band

A depreciation can accelerate inflation both directly

and indirectly. Imports are counted in the retail price
index, and a rise in their price will, ceteris paribus,
raise the RPI. Also, home producers may raise their
price because of increases in the cost of imported raw 0 Quantity of francs
materials and components and/or because they can do
so while still remaining competitive against more
against the ECU and other member countries’
expensive imports. Trade unions may be stimulated to
currencies. It is permitted to fluctuate by a given
press for wage rises, since higher import prices will
percentage either side of the central parity. Initially
probably increase the cost of living.
this was 2.25%, although some countries were
Investment in the UK may be discouraged,
allowed a wider margin of 6%. In August 1993 the
especially if it is thought that there will be a future fall
bands were widened to 15%. Figure 1 shows the
in the value of the pound. Some countries that have
central parity, the upper and lower bands, and the
kept sterling in their reserves may decide to change to
price of the French franc being within the bands.
other currencies, and this will put increased pressure
If a currency moves too far away from its central
on the pound.
parity, its government is expected to intervene by
The effects of a depreciation are uncertain and may
buying its currency if it is moving towards the lower
be beneficial or adverse, depending on a number of
band, and selling its currency if it is moving towards
factors, including the elasticity of demand for exports
the upper band. If this does not work the government
and imports.
would be expected to raise its interest rate to raise the
value of its currency or lower its interest rate to reduce
Example 26.14 the value of its currency.
If both these measures are unsuccessful and the
(a) Explain how the ERM works. (10 marks)
central parity appears to be out of line with market
(b) Discuss why the UK entered and left the ERM.
forces, agreement of the other member countries
(15 marks)
would be sought to realign the currency.
¢ Include a diagram.
(b) The UK entered the ERM in October 1990. In
¢ Explain measures that can be used to keep
part this move was a step, albeit a hesitant one,
currencies within the bands.
towards greater economic and monetary union, but the
¢ Consider both immediate and fundamental reasons
main motive behind UK membership was the desire to
for the UK’s departure.
gain the advantages of a more fixed exchange rate
system. With less opportunity for the exchange rate to
fluctuate, greater certainty is created and exporters
Solution 26.14
and importers find it easier to plan for the future.
(a) The exchange rate mechanism (ERM) is part of There is also greater pressure on the government and
the European Monetary System, which was firms to control inflation, and this was perhaps the
established in 1979 with the aim of increasing main benefit the government was seeking. In a
exchange rate stability between the member countries floating exchange rate system, if domestic inflation
of the EU and thereby encouraging trade between the occurs the exchange rate will float down, which will
members. restore firms’ competitiveness in overseas markets. —_
The ERM is an adjustable peg system. Each This is not possible to the same extent in an adjustable
currency in the ERM has a central rate (called parity) peg system, and if firms wish to stay competitive in
 work out acopeet aod ae

export markets they will have to kéep price rises the government was unable to hold the value of the
down. pound and the UK left the ERM.
Membership of the ERM became a central part of More fundamental reasons for the UK’s departure
the government’s anti-inflation policy. However this were the government’s desire to gain more control
may itself have contributed to the UK’s departure over its monetary policy and concerns over the
from the ERM. A number of economists argued that operation of the ERM. The government had wanted to
the UK entered the ERM with an overvalued pound. cut the rate of interest to stimulate economic activity
The advantage of a high pound value is that it puts and reduce unemployment. However its ability to do
downward pressure on inflation. However an this was constrained by its membership of the
artificially high pound value is difficult to sustain and ERM. A cut in UK interest rates would have tended to
this is what the UK found in 1992. cause an outflow of money from UK financial
The UK left the ERM on ‘Black Wednesday’, 16 institutions to financial institutions in, for example,
September 1992. The immediate reason for the Germany. This would have caused the supply of
departure was the significant increase in the sale of sterling to increase, thereby putting downward
sterling on foreign exchange markets throughout the pressure on the pound.
world caused by the relatively high German interest There was also increasing awareness of the fact
rate, fears that France would not sign the Maastricht that, if the ERM was to work, the economies of the
Treaty, and a growing belief that the pound was member countries would have to converge. This was
overvalued. The Bank of England tried to prevent the not occurring in the early 1990s, when some member
downward fall in the value of the pound by large-scale governments were seeking to reduce inflation and
purchases of sterling and raising the interest rate by 5 others were seeking to promote output and
percentage points in two days. As speculation built up employment.
 following:

(1) Low level of investment.

(a) Indicators of development
eh
(2) Low level of saving.
Possible indicators include: (3) Narrow tax base
(4) Dependency on a narrow export base.
(1) Real GDP capital. (5) Unfavourable terms of trade.
(2) MEW. (6) International debt, some arising on past loans.
(3) HDI. (7) High dependency ratio.
(4) Average life span. (8) Low level of education.
(5) Consumer durables per head.
(6) Access to health services.
(7) Proportion of labour force employed in different (d) Development strategies
sectors.
(8) Infant mortality. A developing country can seek to increase its output
by using one or a combination of strategies. These
(b) Characteristics of development include:

Developing countries usually share most of the (1) Promoting export-led growth.
following characteristics: (2) Developing infant manufacturing industries.
(1) Low real income per capita. (3) Improving productivity in the primary sector.
(2) Low capital to labour ratio. (4) Using overseas aid to improve infrastructure,
(3) Low level of literacy. education and health systems.
(4) High birth rate.
(5) High infant mortality.
(6) Low productivity. (e) Overseas aid
(7) Poor industrial and social infrastructure. ¢ Bilateral aid is assistance from one government to
(8) High proportion of the population employed in another.
agriculture. ¢ Multilateral aid is channelled through
international organisations and charities to a
(c) Constrains of development number of countries. ;
A developing country may experience problems * Tied aid is given on condition that the funds are
increasing its output and productivity because of the used to purchase goods made in the donor country.
 work out economics ¢ p mic

Countries give aid for the following reasons: 27.3 Data response
(1) Commercial: tied aid increases the exports of the
donor country. As the assisted country becomes BOSE: MESRie vie

more prosperous it will tend to buy more goods

from ‘friendly’ countries.
(2) Political: aid is given to win the support and
cooperation of strategically important countries. Developing countries’ populations
are growing more quickly than
(3) Altruism: charitable concerns such as Oxfam are those of industrial countries.
motivated by a concern for others. Unless their output also grows
faster, their relative real GDP per
head will fall. In 1985-94, those
in Asia, the Middle East and
(f) Problems of overseas aid Europe raised output fast enough
to avoid this. But while GDP per
head soared in Asia by an average
Less developed countries argue for trade on more of 6.3% a year, in the Middle East
favourable terms than aid, because: and Europe it edged up by only
0.3% a year. Income per head fell
in both Africa (down by 0.7% a
(1) Aid may involve political interference. year) and Eastern Europe (5.1%).
(2) Aid may be inappropriate if, say, it promotes
capital-intensive projects when labour-intensive
activities are better suited to the economy. RICH AND POOR
(3) Loans impose future interest and repayment
Of the 24 emerging economies
burdens, particularly if debts must be repaid in tracked by The Economist, Hong
foreign currency. Kong has the highest income per
head, $21,670 in 1993 (at pur-
(4) Tied aid involves a loss of freedom of choice. chasing-power parity). India’s,
(5) Aid in the form of products depresses the price of $1,250, was the lowest.
those goods in aided countries. Producers are then Source: The Economist, 11 March
1995, p. 162.
unable to sell their own output at a profit.
x

27.2 study

An investigation into the causes of the rapid growth of

China and the impact this is having on the Chinese
economy.

(a) Which part of the developing world experienced

the most rapid growth between 1985 and
1994? (2 marks)
(b) Give two reasons for the high birth rate in many
developing countries. (2 marks)
(c) Explain how the income per head figures in the
second chart were compared. (3 marks)
(d) Which members of the EU had a GDP per capita
below the OECD average? (2 marks)
(e) What economic characteristics are shared by the
countries in second highest and second lowest
ranking of GDP per person? (7 marks)
(f) Give three ways by which a developing country
could increase its GDP per capita. (6 marks)
ayentheonli ole aleasionsa trade and government policy

(g) Which areas of the world do you think are Western European countries, the United States, Japan
included in ‘rich industrial areas’? (3 marks) and the countries of Australasia, but this could change
in the future.

Solution 27.2

(a) Asia experienced the most rapid growth between

27.4 Objective questions
1985 and 1994. A number of Asian countries
Example 27.3
witnessed rapid growth in this period, including
China, India, Korea and Singapore. Multilateral aid is aid:
A from one country to another
(b) The birth rate in a number of developing countries
B_ from one country directly to a number of other
is high because of high infant mortality rates (which
countries
lead people to expect that only a proportion of their
C from one country to a number of other countries
children will survive), lack of knowledge about and
via an international agency
means by which to practice birth control, the
D from a group of countries to one country with
proportion of the population who are of childbearing
conditions attached
age and the perceived need to have children so as to
be looked after when old.
Example 27.4
(c) The GDP per capita figures were compared by
using purchasing power parity. This involves Which of the following is not usually a characteristic
calculating the price of a given basket of goods in of a developing country?
different countries and then using this as a basis upon A High infant mortality
which to convert currencies. For example if the same B A high level of obesity
basket of goods cost £90 in the UK and $108 in the C A low level of literacy
US, GDP figures would be converted at the rate of D A low level of real GDP per capita
£1 = $1.2.

(d) Both Portugal and Greece had GDP per capita Example 27.5
figures below the OECD average.
In the poorest countries of the world most of the
(e) Singapore and China share a number of economic population is employed in:
characteristics. They both have relatively high A the primary sector
population densities but they also have high annual B_ the secondary sector
growth rates. They both draw on ideas from outside C the tertiary sector
and are experiencing inward investment from D the quaternary sector
overseas. In addition both have relatively high
expenditure on secondary education and both are
Example 27.6
making advances in high-tech industries, albeit with
China a later comer onto the scene, but a later comer Exports from developing countries traditionally have:
with tremendous potential. A price elasticity of demand greater than one
B price elasticity of supply greater than one
(f) There are a number of ways in which a
C income elasticity of demand less than one
developing country could develop, but none of these
D cross-elasticity of demand of zero
are easy to achieve. The country could devote more of
its resources to education and training in an attempt to
improve long-term growth. It could encourage inward Example 27.7
investment from overseas to raise domestic
Middle-income economies that are developing rapidly
employment and to learn new methods and ideas. It
and gaining an increasing share of export markets are
could also seek overseas assistance and possibly
known as:
impose import restrictions. All these methods have
A lesser developed countries
their advantages and their costs.
B_ newly industrialised countries
(g) Currently ‘rich industrial countries’ include the C Third World countries
 work out economics A MS

D Fourth World countries ‘ A Encouraging domestic firms to use the best raw
materials irrespective of the country they come
Examples 27.8 and 27.9 refer to the following
from
diagrams, which show the age distribution of the
B_ Replacing imports from high-cost countries with
populations of four countries.
imports from low-cost countries
A B C Using exports to buy manufactured imports rather
Age Age than agricultural products
D Using tariffs and other forms of trade restriction to
replace imports with domestic goods

Example 27.12
Which international organisation makes loans to poor
countries at concessionary rates?
Male Female Male Female
A IDA B_ IFC C IMF D WTO

Cc D
Age Age

27.5 Solutions to objective

quashone:
~ Solution 27.3 Answer: C

Multilateral aid comes mainly from international

Male Female Male Female
organisations such as the International Development
Association.

Example 27.8 Solution 27.4 Answer: B

Which diagram (A, B, C or D) most accurately
Options A, C and D are all common features of a
depicts developing economy?
developing country. Due to the low levels of food
consumption in development countries, obesity is
Example 27.9 unlikely to be a problem — it is, however, becoming an
Which diagram (A, B, C or D) most accurately increasing problem in developed countries.
depicts developed economy with a constant birth rate?
Solution 27.5 Answer: A
Example 27.10
In the poorest countries most of the population are
What is likely to be the main motive for a country
employed in agriculture. As economic development
giving tied aid to another country? proceeds more of the population will move into the
A To increase the exports of the donor country
secondary sector and then into the tertiary and
B_ To increase the international competitiveness of
quaternary sectors.
the recipient country
C To increase the choice of the recipient country in
terms of the products it can buy Solution 27.6 Answer: C
D To increase the birth rate of the recipient country,
Developing countries often export agricultural
thereby reducing the average age of the population
products. These usually have income inelastic demand
since as income rises, the demand for foodstuffs rises
Example 27.11 by only a small amount. Food also usually has
One possible development strategy is import inelastic demand and inelastic supply (price) — options
substitution. What is meant by import substitution? A and B. As one country’s food and other products
 ational trade and government policy

will compete with other countries’ exports, cross- infant industry argument. The intention is to replace
elasticity of demand will not be zero. imported manufactured goods with home-produced
manufactured goods.

Solution 27.7 Answer: B

Solution 27.12 Answer: A
Newly industrialised countries, e.g. South Korea, are
experiencing significant rises in GDP and are The International Development Agency provides low-
becoming major competitors in the export markets for interest loans to development countries that often find
manufactured products. it difficult to obtain loans from other sources. These
A, C and D = Lesser developed countries and loans are usually for government projects or for
Third World countries are poor countries with low per private sector projects supported by the government.
capita incomes, lack of human capital and a number B => The International Finance Corporation seeks
of other common features. Fourth World countries are to promote private sector development by building up
the world’s poorest countries, e.g. Bangladesh. countries’ capital markets and providing share and
loan capital.
C = The International Monetary Fund seeks to
Solution 27.8 Answer: B
promote world trade, to help countries in balance-of-
Developing countries tend to have a high birth rate trade difficulties and to encourage exchange rate
and a high death rate. As a result the base of the stability.
population pyramid is broad and the top narrow. D = The World Trade Organisation seeks to reduce
trade restrictions and to promote world trade.

Solution 27.9 Answer: A

Developed countries tend to have both a low birth rate

and a low death rate. Consequently the upper regions
of the population pyramid are almost as broad as the
base. The vertical slope of the pyramid indicates a
. (a) Why do the prices of primary products tend to be
constant birth rate.
unstable? (10 marks)
C and D = also show developed countries, but the
(b) Is specialisation in the production of primary
V-shaped base of the pyramid suggest that the birth
products a good method of encouraging
rate is falling.
economic development? (15 marks)

¢ Consider elasticities of demand and supply.

Solution 27.10 Answer: A
¢ Include a cobweb diagram.
Tied aid is often given with the intention of increasing ¢ Consider price fluctuations, income elasticity of
demand for the donor’s goods. Indeed the aid may be demand, and competition,
given on condition that the recipient buys a certain
quantity or value of the donor country’s goods.
Solution 27.13
B and D = are very unlikely motives.
C = By its very nature, tied aid limits the recipient (a) The price of primary products tends to fluctuate
country’s choice of which goods to buy and where to by a significant amount because both demand and
buy them from. supply are inelastic, because supply can change by
large and unexpected amounts and because it takes
time to adjust output in line with price changes.
Solution 27.11 Answer: D
Primary products, including commodities and
To switch from producing mainly primary products to agricultural products, tend to have inelastic demand.
mainly manufactured goods, i.e. to industrialise, some For example many items of food may be regarded as
developing countries believe that manufacturing necessities and some primary products are perceived
industries will need to be developed behind tariff as having few close substitutes, e.g. gold.
walls. This is so that they can be protected until they The supply of primary products is inelastic as they
can take full advantage of economies of scale — the can take time to grow or extract and process. With
 work out economics ¢ dewefo

S (b) It is widely considered that reliance on the

Price S; production of primary products is not a good way of
encouraging economic development. As has been
shown above, the prices of primary products tend to
be volatile. This creates uncertainty about income for
producers and often leads to damaging changes in
P income. For example an increase in supply will tend
to lead to a significant fall in price and a reduction in
revenue. Similarly, whilst a decrease in supply, which
P,
raises price, will benefit some producers it will not
help, for example, those farmers whose crop has
failed. This last point is connected with another
problem encountered in many primary product
markets — the difficulty of controlling supply. For
example favourable weather conditions could lead to a
bumper supply of apples, which will lower their price.
D Developing countries also have to compete in
agricultural markets with developed countries, many
0 Q Q, Quantity
of which give significant protection to their
agricultural industries.
both inelastic demand and supply any change in the Over time world incomes usually rise and demand
conditions of demand and/or supply will have a for agricultural products, in contrast with
significant impact on price. Figure 1 shows an manufactured products, is income inelastic so
increase in supply causing price to fall. producers of manufactured products gain at the
The influence of weather conditions and diseases expense of primary products. Non-oil primary
on agricultural products and new discoveries and products have seen a relative decline in their prices
speculation in commodity markets means that supply over time.
can change by significant amounts. Fluctuations in income and hence economic activity
As it takes time to put primary products on to the can have a significant impact on the price of
market, demand and price conditions may have commodities. For instance a recession in developed
changed. Producers may base their output decisions countries will reduce the demand for petroleum.
on the prices prevailing in the previous season and Petroleum has the advantage over some primary
this may lead to a shortage or a surplus. This tendency products in that it can be stored, However, as with
for prices to move around the equilibrium can be other primary products, problems can be encountered
illustrated by a cobweb diagram. Figure 2 shows a in operating producer cartels. There is a tendency for
convergent cobweb with price and output moving some members to break agreements in an attempt to
towards the long-run equilibrium. gain a competitive advantage.
Primary producers also have the problem of trying
Price
to increase their market power because of the
difficulty of product differentiation in primary markets.
In recent years the Third World countries that have
seen the most rapid growth, e.g. China and South
Korea, have been building up their manufacturing
industries.

Example 27.14
(a) Explain what is meant by net emigration.
(3 marks)
(b) Why do most developing countries experienc e
Quantity net emigration? (7 marks)
0
4 ono g i tions trade and government policy

(c) What are the effects of net emigration on on the size of the net emigration. The country may
developing countries? (15 marks) move nearer to its optimum population size. However
the size of the labour force is likely to be reduced as
¢ Keep the definition brief.
most of the emigrants will tend to be of working age.
¢ Consider both the advantages and disadvantages
This may place a greater burden of dependency on
of net emigration.
remaining workers. Those who leave may be the more
able and enterprising workers, which would reduce
the overall quality of the remaining workforce. Also, a
Solution 27.14
shortage of particular skills, e.g. medicine, may be
(a) Net emigration means that more people are created if it is mainly workers from particular
leaving a country than entering it. It arises when categories who emigrate.
emigration exceeds immigration and results in a net The sex distribution of the population is likely to be
loss of people from the country. affected as it is usually men who emigrate. Those who
emigrate often send money home to relatives and, in
(b) Most developing countries experience net
the case of a number of developing countries,
emigration because of their relatively low income
transfers of money from people who have emigrated
levels, low job opportunities and low educational
abroad form a significant credit item in their balance
prospects. Some emigrants will initially go abroad to
of payments.
attend educational courses and then stay on. Others,
John Kenneth Galbraith has suggested that
unable to find jobs at home or dissatisfied with the
emigration from developing countries can be a
wages on offer, will leave the country to gain
significant force in economic development. He argues
employment abroad. For example a number of people
that in addition to sending back money to relatives,
from India and Pakistan are working in Gulf State
emigrants send back ideas about the methods of
countries. Related to higher incomes abroad,
production used abroad and the quality of life enjoyed
obviously, are higher living standards and, in some
there. People in the developing countries can copy
cases, better welfare provisions. Some emigrants will
these methods and can start to demand the goods,
leave in search of asylum from political or religious
education, health provisions etc. enjoyed by those in
persecution.
developed countries. Dissatisfaction with the quality
The number of people who emigrate will be
of their living standards may induce people to place
influenced not only by their willingness to leave but
greater pressure on their governments to adopt
also by the willingness of other countries to grant
appropriate development strategies. Galbraith believes
them entry.
that emigration will break the acceptance of poverty
(c) There are a number of possible economic effects in developing countries and relieve the pressure of
of net emigration, although of course they will depend overpopulation.
 ¢ Governments may have a number of other macro
objectives, such as a more equitable distribution of
income. This requires state intervention through
progressive taxation, income-related benefits etc.
There are three stages of government policy: ¢ Governments may also have a number of micro
(1) Objectives: The aims of government policies.
objectives, such as protection of the environment
or efficiency in the allocation of resources.
(2) Targets: variables through which the government
attempts to achieve its objectives.
(3) Instruments: policy tools over which the (c) Macroeconomic policies
government has control and are implemented to A central issue in macroeconomics is whether or not
influence target variables. markets automatically bring about equilibrium. If the
free operation of market forces automatically results
in a full employment level of national income with
(b) Economic objectives stable prices and economic growth, there is no need
Governments have four main macroeconomic aims: for government intervention to achieve equilibrium.
However, if the economy is unstable or slow to reach
(1) High employment.
satisfactory equilibrium, government economic
(2) Price stability. policies will be required. These include:
(3) Balance of payments equilibrium.
(4) Economic growth. (1) Monetary policy: the two main instruments are

Table 28.1 Examples of government policies

Policy Instrument Target Objective

Monetary Interest rate Bank lending Price stability

Fiscal Government spending Aggregate demand Employment
Regional Selective grants Location of firms Growth
Exchange rate Exchange rate Price of exports Balance of
and imports payments
Supply side Supply side Labour mobility Growth
 ational trade and government policy

changes in the money supply and interest rates. achieving objectives. New classical economists
(2) Fiscal policy: the two main instruments are favour measures such as reductions in tax rates or
changes in government spending and taxation. policies that reduce market distortions. These
(3) Prices and incomes policy usually involves a limit include:
on price rises and rises in incomes, particularly (a) increasing the gap between earnings from
wages. employment and the job seekers’ allowance
(4) Regional policy, where government measures to reduce voluntary and search
help influence the location of industry and people. unemployment;
(5) Exchange rate policy, which involves the (b) increasing, through training, the quality and
government managing the exchange rate to flexibility of the labour force;
achieve its aims — it may also be regarded as a (c) privatising nationalised industries to make
form of monetary policy. them subject to market forces;
(6) Import controls, where, for example, tariffs are (d) removing government restrictions to increase
used to reduce or stabilise imports. the efficiency of markets (deregulation);
(e) reducing the monopsony power of unions.

(d) Fiscal policy

Fiscal policy covers any measure that changes the (f) Government failure
timing, amount or composition of government
Government failure occurs when government
expenditure and/or taxation.
intervention does not improve the allocation of
¢ Direct taxes are taxes on income and wealth. resources. All governments experience problems in
¢ Indirect taxes are taxes on expenditure. managing the economy because:
e As income rises a progressive tax takes a higher
(1) There may be a conflict between policy
percentage of it in tax, a proportional tax takes the
objectives. For instance, increased government
same percentage and a regressive tax takes a
spending may increase employment and growth
smaller percentage.
but result in rising prices and a deficit in the
* Government spending covers spending on
current account of the balance of payments.
government investment projects, running
Tinbergen’s rule states that a government needs to
government services and transfer payments.
have at least one instrument to achieve each
¢ a budget deficit arises when government
objective. Fiscal policy can be directed at
expenditure exceeds government revenue.
unemployment, exchange rate policy can be
¢ <A cyclical deficit is caused by a downturn in
directed at the current account of the balance of
economic activity.
payments, etc.
¢ A structural deficit is caused by a planned change
(2) Governments are faced with political constraints.
in government spending and/or taxation.
For instance restrictive monetary policy may
cause such high interest rates that mortgage
(e) Policy approaches payers refuse to vote for the government.
(3) Resistance from trade unions and professional
(1) Keynes argued that aggregate demand is the chief
bodies may act as a constraint.
determinant of output and employment. Therefore
(4) Policy instruments are interdependent. For
demand management through macroeconomic
example increased government spending may
policies is the best method of achieving policy
result in a rise in the PSBR and interest rates.
objectives.
(5) Policy instruments can also become objectives,
¢ Reflationary policies increase AD. thereby reducing their flexibility. For example
¢ Deflationary policies decrease AD. exchange rates and the money supply.
(6) There may be time lags between recognising a
(2) New classical economists generally argue that problem, deciding on the policy and then
supply is the chief determinant of output and implementing that policy. In the meantime
employment. Therefore microeconomic policies economic relationships may change. For example,
that increase supply are the best method of if a government tackles unemployment by
 work out economics ¢ ging the no 251

reducing taxation, only to find that demand is (f) From which sources can the government
rising anyway, this policy reinforces the cycle borrow? (4 marks)
rather than acting countercyclically.
(7) The economy may not respond in the way
Solution 28.2
anticipated. For example entrepreneurs may react
to rises in demand by increasing prices rather (a) The main form of government tax revenue is
than output. income tax, which in 1993—94 accounted for 21% of
(8) Some target variables are difficult to define. For total revenue.
example it is difficult to know which assets to
(b) Direct taxes are taxes on the income of
include in a measure of the money supply.
individuals and firms. Income tax, national insurance
(9) External shocks, e.g. a world recession, may
contributions and corporation tax are all examples of
undermine government policies.
direct taxes.

jative study (c) VAT revenue could increase if the rate of VAT
increased, the number of goods subject to VAT was
widened or if consumer expenditure rose.

An investigation into alternatives to state pensions as (d) Expenditure on law, order, protective services and
a way of providing for the elderly. defence are forms of ‘regrettable’ expenditure. They
do not cause living standards to rise. Increased
expenditure on these items is usually undertaken to
keep up with rising crime and perceived increases in
threats to national security.

(a) What is the main source of government tax (e) Social security expenditure is likely to fall with
revenue (2 marks) increased economic activity. With higher output
(b) Identify three direct taxes. (3 marks) unemployment is likely to fall and this would reduce
(c) What could cause, overtime, VAT revenue to government expenditure on the job seekers’
increase? (4 marks) allowance, income support and housing benefit. This
(d) Identify one form of government may have a significant impact on the level of
expenditure that could be classified as government expenditure as total social security
‘regrettable’. (2 marks) expenditure accounts for nearly a third of all
(e) Which forms of government expenditure are government spending.
likely to fall with an increase in economic Increased economic activity is likely not only to
activity? (10 marks) reduce government spending on, for example, social

Sources of revenue Expenditure

Income tax Debt

21% interest
7% Social
security
Borrowing Other 32%
17% services
18%

Transport
National 4%
insurance
Corporation contributions
tax 14%
Law, order —
5% and protective Health
services 13%
Excise 5%
duties Defence
9% Business rates, 8% Education
council tax and 14% 12%
community charge
8%

Figure 28.1 Government receipts and expenditure 1 993-94

100.
Note: As a result of rounding and omission of minor items, percentages do not add up to
Source: HM Treasury.
 pers oror ics @ -. national trade and
government policy

security but also to raise tax revenue as more people C Increasing labour retraining schemes
will be in work and incomes will rise. This is likely to D Increasing government payments to the
reduce any PSBR the government is running, and may unemployed
even turn it into a PSDR. Hence debt interest
payments may fall.
It is also possible that increased economic activity Example 28.6
will reduce crime levels, thereby enabling expenditure Which of the following is an example of an automatic
on law, order and protective services to decline. stabiliser?
(f) The government can borrow from the Bank of A Child benefit
England. This is often referred to as resorting to the B_ Defence expenditure
printing press. It can also borrow from the retail C Education expenditure
banking sector. In both cases the borrowing will lead D The job seekers’ allowance
to an increase in the money supply. It can borrow
from overseas, either in sterling or in a foreign
Example 28.7
currency. However most government borrowing is
from the non-bank private sector. A government is faced with both demand-pull
inflation and a deficit in the current account of the
balance of payments. Which of the following policy
28.4 Objectiv measures might simultaneously reduce both
problems?
-Examp
eee
Re
A Devaluation B_ Revaluation C Reflation
D Deflation
Which of the following policies would a government
adopt to reduce both a surplus in the current account
of the balance of payments and inflation? Example 28.8
A Revalue the currency
B_ Increase income tax An example of a restrictionist monetary instrument is:
C Raise interest rates A an increase in direct taxation
D Impose import controls B_ a tight prices and incomes policy
C the conversion of long-term government debt into
short-term government debt
Example 28.4 D aswitch of government borrowing from the
Which combination of events might cause a banking sector to the non-bank private sector
government to lower interest rates and reduce direct
Examples 28.9 and 28.10 are based on the following
taxation? information. A country has a progressive income tax
A A deficit in the current account of the balance of system. The first £6000 earned is tax-free. Thereafter
payments and inflation
the next £18 000 of earned income is taxed at 25%
B_ A surplus in the current account of the balance of
and all taxable income above that is taxed at 50%.
payments and inflation
C A surplus in the current account of the balance of
payments and unemployment Example 28.9
D A deficit in the current account of the balance of
A person earns £20 000. What proportion of this
payments and unemployment
income is paid in tax?
A 50% B 25% C 175% D j5o%
Example 28.5
According to a supporter of supply-side economics,
Example 28.10
which of the following measures is most likely to
reduce unemployment? What is the marginal rate of tax paid when a person’s
A Increasing the money supply income rises from £24 000 to £24 001?
B_ Increasing public sector investment A 0.8 B 0.5 £03 D 0.1
 work out economics eggaetiing Mee
Bonof 3

Example 28.11 Solution 28.4 Answer: C

Which of the following is an example of fiscal policy? Lowering interest rates and reducing direct taxation
A Changes in interest rates will increase demand in the home economy. This is
B Changes in employees’ National Insurance likely to stimulate domestic output and employment.
contributions The increase in demand is also likely to increase
C A change from expansionary to restrictionist open- imports and possibly reduce exports (as home
market operations producers switch from foreign markets to the home
D Achange from a floating to a managed exchange market). This will reduce a current account surplus
rate and enable the home country to enjoy more goods and
services.

Example 28.12
Solution 28.5 Answer: C
The diagram below shows government spending to be
autonomous at a level of G. The initial tax structure is Supporters of supply-side economics urge the use of
T and the initial level of National Income is OY. The microeconomic incentives to raise output and
full employment level of national income is OY;,. A employment. They believe that, if the quantity and
new tax structure of 7, is introduced. quality of factors of production are improved and
markets operate more efficiently, growth and increases
Tax in employment will follow. Retraining schemes
revenue/
government should increase the productivity of labour.
spending
A = Supply-side economists believe that increases
in the money supply, if greater than the increase in
output, lead to higher prices but not to higher
employment in the long term.
B = Increasing public sector investment will
increase demand. Supply-side economists argue that
governments should concentrate on increasing
aggregate supply.
D = Increasing government payments to the
0 ¥ Ye
unemployed would narrow the gap between
National income
unemployment income and income from employment.
The change in taxes shows: Supply-side economists favour the opposite course of
A deflationary fiscal policy at OY action — ensuring that workers are better off in work.
B_ an expansionary fiscal policy at OY They believe that this will make people seek
C an increase in the budget deficit at OY employment more quickly and settle for lower wages.
D an increase in the budget surplus at OY;,
Solution 28.6 Answer: D

to objective Automatic stabilisers offset changes in NY, without

any direct change in government policy. If NY is
falling, total expenditure on the job seekers’
allowance will rise. This increase will reduce the fall
in demand, and hence will act countercyclically.
Revaluing the currency is likely to result in A, B and C = will not adjust automatically with
expenditure on imports rising and export revenue changes in NY. They are adjusted as a result of
falling. This will reduce a current account surplus. government decision and action.
Inflationary pressure is likely to be reduced, since
revaluation will reduce import prices, and imports Solution 28.7 Answer: D
count in the retail price index. Domestic producers are
also likely to limit price rises in order to remain Deflation involves reducing demand, usually by
competitive at home and abroad. means of fiscal and/or monetary policy. This should
awWork out ec onSisrid
i:
ational trade and government policy
a

reduce demand-pull inflation. It should also reduce a taxed at 50%, i.e. £0.5 will be taken in tax. So the
current account deficit by reducing expenditure on marginal rate of tax is 0.5.
imports and possibly stimulating exports as a result of
the fall in domestic demand.
Solution 28.11 Answer: B
A => Devaluation should assist the current account
position, but may increase inflationary pressures as a Fiscal policy involves changes in the amount, timing
result of the rise in export earnings and a rise in and/or composition of government spending and
import prices. taxation. National Insurance contributions are a form
B = Revaluation should reduce inflation by of direct taxation.
lowering import prices, but it is likely to have an A and C = are examples of monetary policy.
adverse effect on the current account balance as a D = is an example of exchange rate policy, which
result of the fall in import prices and the rise in export can also be regarded as a form of monetary policy.
prices.
C = Reflation means increasing demand, and this
Solution 28.12 Answer: A
is likely to have an adverse effect on both the current
account position and inflation. The new tax structure will result in a smaller budget
deficit at OY than tax structure 7. This will reduce
demand.
Solution 28.8 Answer: D
B = An expansionary fiscal policy at OY would
When the government borrows from the retail banks, have been shown by arise in the gap between
e.g. by selling treasury bills, it increases their liquid government expenditure and taxation.
assets and hence their ability to lend. In contrast, C = The budget deficit has fallen rather than risen
when the government borrows from members of the at OY.
non-bank private sector it merely makes use of D = At OY,, the budget surplus is smaller than with
existing money. Switching borrowing from the taxation structure 7. There has been a decrease in the
banking to the non-bank private sector will tend to budget surplus.
reduce bank lending and hence reduce monetary
expansion.
A => An increase in direct taxation is a deflationary
fiscal policy.
B = A prices and incomes policy is a direct 28.6 Essays
government policy influencing incomes.
C = Issuing more short-term government debt is Example 28.13
an expansionary policy, since this will increase the
Should there be a shift from direct towards indirect
supply of liquid assets
taxation? (25 marks)

¢ Define direct and indirect taxes.

Solution 28.9 Answer: C
¢ Consider the advantages and disadvantages of
A person who earns £20 000 will have £6000 tax-free both indirect and direct taxation.
income and a taxable income of £14 000. The tax paid
on this will be 25%, i.e. £3500. So the proportion
Solution 28.13
income paid in tax is:
Direct taxes, e.g. income tax and corporation tax, are
£3500
see eal: 1.5% levied directly on a person’s or firm’s income or
£20 000
wealth. On the other hand indirect taxes, e.g. VAT and
excise duty, are taxes on goods and services and are
paid to the government through a third party. They are
Solution 28.10 Answer: B
sometimes referred to as expenditure or outlay taxes.
A person earning £24 000 will have £18 000 taxable The argument for moving the tax base towards _
income and hence will be in the 25% tax bracket. If greater reliance on indirect taxes and less reliance on
the person’s income rises by £1, this extra £1 will be direct taxation is based on the disadvantages of direct
 work out economics ¢ ging the nomy

taxes and the advantages of indirect taxes. certain goods by reducing the amount of tax levied on
It is claimed by some economists that direct them. When indirect taxes are placed on goods for
taxation, particularly at a high level, acts as a which the private costs of production are below the
disincentive to effort. However studies have shown social costs, resources may be reallocated in a way
that few people (less than 10%) change the hours they that increases total economic welfare.
work when income tax rates are altered and that as However increasing the percentage of tax revenue
many work fewer hours as work more hours. accounted for by indirect taxation may give rise to a
A high level of corporation tax may discourage risk number of disadvantages. Indirect taxes are
taking and may discourage investment, since most regressive, since they take a higher percentage of the
investment is financed by retained profits. Direct income of the poor than of the rich. This is thought to
taxation may also reduce the savings of individuals, be one of the main disadvantages of indirect taxation,
since the rich save more than the poor and savings and although certain categories of goods may be zero-
may effectively be taxed twice: once when the income rated, the poor are less well protected than under
is earned and then when interest is received on the direct taxation.
part of income that is saved. Indirect taxes may be inflationary as a rise in
In addition to reducing the disadvantages arising indirect taxes will cause a rise in prices. They may
from direct taxation, a country would gain more of the also distort consumers’ patterns of expenditure and
advantages of indirect taxation by shifting the tax the allocation of resources. If, prior to the imposition
base. Indirect taxes are relatively cheap to administer of an indirect tax consumers were maximising their
and collect. For instance manufacturers and traders do total utility, then the tax would reduce consumer
most of the administrative work involved in VAT. satisfaction.
Indirect taxes can also be adjusted more quickly Some economists would also argue against shifting
than direct taxes. While direct taxes can be changed at the tax base, on the grounds that the advantages of
budget time and may involve complex revision of, for direct taxes are greater than those of indirect taxes.
example, PAYE codings, indirect taxes can be Direct taxes provide a high yield, and they are certain
changed relatively quickly. and convenient since most are deducted at source.
Indirect taxes are difficult to evade as they are They also have a stabilising effect, since during times
included in the price of the good. They may provide of recession tax revenue will fall, while during periods
more freedom of choice in terms of payment, of rising incomes tax revenue will rise. Direct taxes
although if a wide range of goods are taxed, this may also have the advantage of equity as most are
not be a significant advantage. Nevertheless it is progressive, so those who are most able to pay bear
thought that many people are unaware of the amount the greater burden.
of tax they are paying when they buy goods, and this The main arguments advanced for moving towards
may reduce the resentment they feel about paying a greater reliance on indirect taxation are a reduction
taxes. in the disincentive effect and economy of collection.
Some economists argue that indirect taxes do not However, because of the relative merits and demerits
discourage effort, since the taxes are linked to of each, the government will continue to rely on both
spending rather than earning. However if certain forms of taxation.
goods, e.g. cars and colour TVs, are highly taxed, this
may place them out of the reach of people who would Example 28.14
have been prepared to work longer hours to buy them. (a) Explain what is meant by discretionary fiscal
Indirect taxation can help to regulate the economy. policy. (4 marks)
At times of high demand, spending on goods will go (b) How may discretionary fiscal policy influence
up, which will cause the revenue from indirect aggregate demand? (5 marks)
taxation to go up, which in turn will reduce demand, (c) What problems may be experienced in the
although in real terms the burden of specific taxes will conduct of fiscal policy? (16 marks)
fall with inflation.
Indirect taxes can also be used for specific aims. * Define discretionary fiscal policy and distinguish
Particular goods may be taxed in order to discourage between it and automatic stabilisers.
the consumption of those goods, to protect domestic ¢ Consider the effect of expansionary and
industries and even to encourage the production of contractionary fiscal policy.
 rK out econ icg@intermational trade and government policy

e Cover major areas of government failure, e.g. time standard rate of income tax, designed to raise
lags, and relate them to fiscal policy. spending. This may take two to three months to come
into or take effect, by which time gross pay and
demand may be rising anyway. So the policy will be
Solution 28.14
contributing to the cycle rather than acting
(a) Discretionary or active fiscal policy is when the countercyclically.
government takes a positive decision to alter The use of fiscal policy may have different effects
government spending or taxation to alter demand. on different government objectives. A contractionary
This contrasts with automatic stabilisers, which come fiscal policy may reduce inflation and a deficit in the
into effect when tax revenue and government current account of the balance of payments, but may
spending change independently of any deliberate have an adverse effect on employment and grants.
government action. There is the possibility that the economy may not
respond as anticipated to discretionary fiscal policy.
(b) The level of aggregate demand could be raised by
For instance a government may raise income tax in
an expansionary policy. This could involve an
order to reduce spending. However spending may not
increase in government spending and/or a reduction in
fall, or may not fall significantly if, for example,
taxation. An expansionary or reflationary fiscal policy
people choose and are able to work overtime to
would represent a net injection into the circular flow
maintain their current spending patterns and/or if
and would cause NY to rise by a multiple amount. It
people choose to reduce saving rather than spending.
may be used to reduce a deflationary gap.
A fiscal policy measure may also have undesirable
A deflationary or contractionary fiscal policy will
effects on other policy instruments and variables, or
result in a multiple fall in NY and will involve a fall in
may itself be constrained by these. A rise in
government expenditure and/or a rise in taxation. This
government spending, that is not financed by taxation
may be introduced in order to reduce or eliminate an
may increase the money supply and/or raise interest
inflationary gap.
rates. The latter may reduce private sector investment,
(c) There are a number of problems that may be which may, at least in part, offset the expansionary
encountered with fiscal policy. Some forms of effect of the increase in government spending. The
government spending may not be easy to change. For former may contribute, according to monetarist
instance a government committed to improving analysis, to inflation.
educational standards may find it difficult to reduce When past governments increased government
spending on education. Also, it will be difficult to spending to increase demand they encountered
reduce spending on a long-term investment project difficulties with the current account position of the
once it is underway. balance of payments. This resulted in ‘stop—go’ cycles
— i.e. governments adopted expansionary policies,
Tax revenues may be difficult to predict. When the whereupon NY and expenditure on imports rose, so
government alters indirect taxation it has to estimate deflationary fiscal policies were adopted to restore
the price elasticity of demand. An even more difficult current account equilibrium.
calculation may prove to be the multiplier. If the Monetarists claim that an expansionary fiscal policy
government gets this wrong, it may inject too much or aimed at increasing employment and growth will have
too little spending into the economy. an impact on prices rather than output if it is based on
There is also likely to be a time lag involved with increasing aggregate demand. They also consider that
fiscal policy, which means that the government has to fiscal policy may have very uncertain effects, as it is
be able to forecast accurately future changes in difficult to predict future changes in economic
economic variables. For instance a government may variables. They believe that monetary policy is more
announce in a November budget a reduction in the important and effective.
A B
Abnormal Balance of payments 223-4
losses 72 Balance of trade 224
profits 70 Balancing items 224
Absolute Bank multiplier 187
advantage 214 Birth rate 126
income hypotheses 160 Black
Activity rate 126 economy 151, 153
Ad valorem 30 markets 153
tax 30 Broad money 189
Adjustable peg 233 Business cycle 179
Ageing population 126
Aggregate demand 159, 166, 176-7 Cc
Aggregate Capacity 172
monetary demand 166 Causal unemployment 196
supply 166, 168-9, 176-7 Ceteris paribus 1,21
Aid 243 Cobweb theory 30, 37, 247
Allocative Command economy 3-4, 7-8
efficiency 82,117 Common Agricultural Policy 29, 216
inefficiency 79 Common market 215
Appreciation of sterling 232 Comparative advantage 214
Arbitrage 233 Competition policy 92, 97-8
Autonomous consumption 160, Competitive supply 22
185 Concentration ratios 70
Average Conditions of demand 12
cost pricing 61 Conditions of supply 22
costs 27, 61-2 Consumer
product of labour 53 expenditure 13-14
propensity toconsume 160 surplus 13
propensity tosave 161 Consumption 160
rate of tax 161 function 160

ZT
258ework out economicsi Index,

Contestable market 83 Equity (fairness)

Cost-benefit analysis (CBA) 119 criteria 118
Cost-plus pricing 83 principle 118
Cost-push inflation 203 Eurocurrency 233
Crawling peg 233 European Union 215
Credit creation multiplier 187 Excess
Cross-elasticity of demand 41 demand 29, 37
Customs union 215 supply 29, 37
Cyclical unemployment 196 Exchange
control 215
D equalisation 187
Death rate 126 rate 232
Declining industries 215 rate mechanism 233
Deindustrialisation 100 rate parities 233
Demand and supply analysis 12-20 External growth 64
Demand curve 12, 18-19
movements 12 F
Demand-deficiency 196 Factor immobility 133
Demand for money 114 Factors of production 1,53
Demand-pull inflation 204 Financial intermediaries 187
Demerger 64 Fiscal
Demerit goods 119 drag 204
Demography 126 policy 250, 256
Dependent populations 245 Fixed costs 56
Depreciation of sterling 232 Floating exchange rates 233
Derived demand 106 Flow value 180
Devaluation of sterling 232 Footloose industry 99
Development 242 Foreign exchange market 232
areas 242 Forward market 233
Differentiated products 76 Free goods 1
Direct taxation 250, 254 Free market economy 3-4,7
Discounting 119 Free trade area 215
Discrimination 133 Frictional unemployment 196
Diseconomies of scale 56 Full
Disequilibrium 194 capacity 173,176
Double-counting 151 employment 194
Funding 188
E
Economic efficiency principle 117 G
Economic goods 1 Giffen good 13,20
Economic growth 179-85 Gini coefficients 109
Economic problem | Government failure 118, 250
Economic rent 106, 113 Green
Economic systems 3 economics 120
Economic union 215 taxes 120
Economies of scale 54-5 Gross domestic product 150
Education 141 Gross investment 160
Efficiency criteria 82, 117 Gross national product 150
Elasticity 39
of demand 35, 39-52, 81 H
of supply 35, 39-52 Health care 141-2
Embargo 215 Horizontal integration 64, 67
Empirical 1 Horizontal merger 64, 67
Environmental economics 119 Housing 141, 146-7
Equilibrium 29 Human capital 144
unemployment 194 Human development index 153
 we pence In

hyperinflation 203 London foreign exchange market 233

Hypothesis 1 Long-run average cost curve 56, 62

I M
Immobility of labour 133 MO 186
Imperfect competition 88 M4 186
Import Maastricht Treaty 216
controls 220 Macroeconomic
penetration 220 aims 249
prices 220 objectives 249
restrictions 220 policies 249
Imports 220 Macroeconomics 249
Income 108 Marginal cost curve 27,79
effects’ 13 Marginal cost pricing 27,79
elasticity of demand 41, 44, 50 Marginal
method 150 costs 27
Indirect taxation 30, 37, 254 efficiency of capital 161
Induced consumption 185 product of labour 53
Industrial inertia 99 propensity toconsume 160
Infant industries 215 propensity toimport 161
Inflation 203 propensity to save 161
Inflationary gap 204 propensity totax 161
Injections 171 rate of tax 161
Instruments 249 utility 13,17, 19
Integration 64 Market
Interest 107 concentration 70
rates 188 economy 3-4,7
Internal growth 64 failure 118, 122
International Bank for Reconstruction and penetration pricing 83
Development 235 structure 70
International Monetary Fund 235 supply curve 21
International trade 11,214 Marshall—Lerner condition 225
Investment 161, 165 Measurable economic welfare 152,
Invisible balance 224 156-7
Involuntary unemployment 195 Measure of value 186
Medium of exchange 186
J Mergers 64, 69
Jeffect 225 Merit goods 118, 123
Joint supply 22 Microeconomics 1
Minimum lending rate 188
K Minimum wage 138
Kaldor-Hicks test 118 Mixed economy 3-4,7
Keynesians 114 Model 1
Monetary
L aggregates 188
Labour market failure 133 base control 188
Law of diminishing marginal utility 13 policy 188, 250
Leakages 171 policy instruments 188
Lender of last resort 187 policy targets 188
Liabilities 187 Money 186
Limit pricing 83 illusion 204
Liquid asset ratio 188 measures 189
Liquidity 115 multiplier 187
preference 115 national income 152
trap 108 supply 193
Loanable funds (classical) 107 Monopolies 94
260=work outEconomics *Index

Monopolistic competition 72 elasticity of supply 23, 42, 51

Monopoly 73 index 203
profits 73 instability 31-2
Monopsony 137 makers 76
Multinational corporation 101 mechanism 3
Multiplier 165, 171 Prices and incomes policies 205
effect 105,171 Private good 123
MV=PT 204 Privatisation 93-4, 97
Producer price index (PPI) 203
N Producer surpluses 22
National income 150 Production possibility 2,7, 10, 184
accounts 150-1 frontier 2,7, 10, 184
Natural change in population 126 Productive
Natural rate of unemployment 196 capacity 172,176
Negative efficiency 82,117
equity 142 Profit maximisation 71, 82, 87-8
externality 120 Profits 70, 106
Net domestic product 150 Protectionism 215
Net investment 161 Public goods 118, 123
Net migration 126 Public sector borrowing 189
Net national product 150 Purchasing power parity 233, 239
Nominal national income 152 Pure economic rent 102
Normal profits 70
Normative economics 1,6 Q
Qualitative lending guidelines 188
O Quantitative controls 188
Objectives 249 Quasi-rent 102
Offer curve of labour 130 Quotas 215
Open market operations 188
Opportunity cost 1,3 R
Optimum population 126 Real
Output 53 national income 152
Overpopulation 245 rate of interest 192
Regional
P problem 100
Pareto unemployment 196
criteria 118 Relative income hypothesis 160
optimal allocation 118 Rent 106
Participation rate 126 Residual error 150
Pensioners’ retail price index 203 Resource allocation 1
Perfect competition 70-5, 78 Retail price index (RPI) 203
Perfectly competitive markets 78 Revaluation of sterling 232
Perfectly contestable market 83 Revenue 60
Permanent income 160
Phillips curve 177-8, 197, 205 S
Population 245 Savings 160-1
growth 245 function 161
pyramid 245 Search unemployment 196
pyramids 126, 245 Shortrun 53
size 245 Skimming pricing 83
Precautionary motives 107 Slumpflation 203
Predatory pricing 83 Small firms 64-5
Price Social
deflator 152 benefits 117
discrimination 82 costseul 17
elasticity of demand 39, 48-9 marginal benefit 118
 «3 .
a

works6Ut econdmicsi® Index 261

tia ack i ies
ASS ee 2ere :

marginal cost 118 revenue curve 75, 81

welfare 117 utility 13,19
Socially efficient output 117-20 Trade cycle 179
Spare capacity 172 Trade unions 1334, 135
Special deposits 188 Transactions motive 107
Special drawing rights 234 Transfer earnings 101, 112
Specific tax 30 Transport 142
Speculative motive 107
Spot market 233 U
Stagflation 203 Unemployment 194
Standard economic regions 104 rate 194
Standard for deferred payments 186 Utils 13
Standards of living 157-8
Stock Vv
appreciation 150 Value added tax (VAT) 30, 37
figure of 194 Variable costs 60
value 126, 180 Vertical
Store of value 186 integration 64
Structural unemployment 196 merger 64-5
Substitution effects 13 Visible balance 224
Supply 21,29 Voluntary unemployment 196
curve 21, 27-8
curve, movements 21, 25-6 Ww
Wage differentials 127
4b Wage rate 128
Takeover 64 Wage-price spiral 203
Targets 249 Wage-wage spiral 203
Tariffs 215 Wages 108
Tax incidence 30 Wealth 108
Tax and price index (TPI) 203 Weight-gaining industries 99
Technical efficiency 82,117 Weight-losing industries 99
Terms of trade 223 Welfare economics 117
Theories 1 Welfare loss triangle 118
Theory of contestable markets 83 Withdrawals 171
Tolls 143 Working population 245
Total World Bank 235
cost curve 75
GostSiay J) xX
revenue 40, 81 X-inefficiency 82
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