IGCSE ECONOMICS

SYLLABUS CODE: 0455

Assessment overview.
All candidates take two components. Candidates will be eligible for grades A* to G. All candidates
take:
Paper 1. Multiple Choice [MCQs], 30 marks, 30%, 45 minutes. Candidates answer all 30 questions.

Paper 2. Structured Questions. 90 marks, 70%, 2 hours 15 minutes. Candidates answer one
compulsory question (section A) and three questions from a choice of four (section B).

Assessment objectives. The assessment objectives (AOs) are:

AO1 Knowledge and understanding Candidates should be able to:
• show knowledge and understanding of economic definitions, formulas, concepts and theories
• use economic terminology.

AO2 Analysis Candidates should be able to:

• select, organise and interpret data
• use economic information and data to recognise patterns and to deduce relationships
• apply economic analysis to written, numerical, diagrammatic and graphical data
• analyse economic issues and situations, identifying and developing links.

AO3 Evaluation Candidates should be able to:

• evaluate economic information and data
• distinguish between economic analysis and unreasoned statements
• recognise the uncertainties of the outcomes of economic decisions and events
• communicate economic thinking in a logical manner.
Definition of Economics.
Economics is a social science that focuses on the production, distribution, and consumption of goods
and services, and analyzes the choices that individuals, businesses and governments, make to allocate
resources.

Assuming humans have unlimited wants within a world of limited means (resources), economists
analyze how resources are allocated for production, distribution, and consumption.

*Lionel Robbins defines Economics as, ‘a social science which studies human behaviour as a
relationship between ‘ends’ and scarce ‘means’ which have alternative uses’.

Economics is divided into two branches: Microeconomics and Macroeconomics.

Microeconomics
Microeconomics studies how individual consumers and firms make decisions to allocate resources. It
focuses on how people, households, or businesses respond to changes in price and why they demand
what they do at particular price levels.

Microeconomics also analyzes how and why goods are valued differently, how individuals make
financial decisions, and how they trade, coordinate, and cooperate.

Macroeconomics
Macroeconomics is the branch of economics that studies the behavior and performance of an
economy as a whole. Its primary focus is the recurrent economic cycles and broad economic growth
and development.

It focuses on foreign trade, government fiscal policy (taxes and spending) and monetary policy
(money supply), unemployment rates, the level of inflation, interest rates, the growth of total
production (output) etc.

Basic Economic Problem

It is the problem of limited resources in relation to human unlimited needs and wants. Human wants
are infinite but the ‘means’ (resources) with which to satisfy these human wants are finite. As a result,
we are then forced to make choices as to which wants should be satisfied and which want should be
left unsatisfied.

Scarcity: A lack of something (in this context, resources).

CHOICE. Choice means choosing one thing among alternatives. Choice is inevitable because of the
multiplicity of wants but limited resources.
Opportunity Cost. It is defined as ‘the next best alternative that is sacrificed/forgone/given up
each time a choice is made. It could also be seen as the value of a forgone activity or alternative
when another item or activity is chosen. Opportunity cost is relevant to: consumers, producers,
workers and to government.

Example 1 (Government). The government has a certain amount of money and it has two
options: to build a school or a hospital, with that money. The govt. decides to build the
hospital. The school, then, becomes the opportunity cost as it was given up. In a wider
perspective, the opportunity cost is the education the children could have received, as it is
the actual cost to the economy of giving up the school.

Example 2: (Consumer). When the consumer buys a Croissant, the opportunity cost is what could
have been bought instead of a Croissant. This could be a bottle of Cola, a Pretzel, or some French
Fries.

Example 3: (Businesses). Funds used to make payments on loans, for example, cannot be invested in
stocks or bonds, which offer the potential for investment income. Similarly, if a firm decides to
spend an amount on employing labour, it will be giving up the opportunity to spend that amount on
capital equipment. It is important to note that, businesses in answering the three basic economic
questions of, ‘what to produce, how to produce (production methods) and for whom to
produce’will all involve an opportunity cost.

Example 3. (Student). You have to decide whether to stay up and study or go to bed and not
study. If you chose to go to bed, the knowledge and preparation you could have gained by
choosing to stay up and study is the opportunity cost.

Classification of goods.
Economic goods. Are those which are scarce in supply and so can only be produced with an
economic cost and/or consumed with a price, in other words an economic good is a good
with an opportunity cost. All the goods we buy are economic goods, from bottled water to
clothes.

Free goods. A free good is a good needed by society but available with no opportunity cost. It is a
good without scarcity. For example, air is a free good, because we can breathe it as much as we want.
By breathing, we do not diminish the available resource for other people. Water is usually another
free good. If you live by a river, you can take water without reducing the amount available to others.
Though in some areas, water can become scarce in drought conditions –then water is no longer a
free good.

Note: a good may be given away for no charge (e.g. healthcare is free at the point of use) However, it
is not a free good because there is an opportunity cost – in this case, healthcare is paid for out of
taxes.
Private Good. Are goods and services produced and sold through markets by private sector
businesses. Profits can be made from them.

These goods have two characteristics.

*Rivalry - Indicates that one person's consumption of a product reduces the amount available for
consumption by others or prevents simultaneous consumption by other consumers .

*Excludability - This means that producers can prevent some people from consuming the good or
service based on their ability or willingness to pay.

Also, private goods have an opportunity cost, if we use resources to produce a bottle of Coca-Cola,
we cannot use that glass, sugar and water to produce other goods.

These goods are provided in a free market

Public Good. Are goods and services that benefit all members of society, and which are often
provided free through public taxation.

A public good has two characteristics:

*Non-rivalry – consuming the good doesn’t reduce the amount available to other people.

*Non-excludable – once provided you can’t stop anyone consuming it.

Examples of public goods include street lights, law and order, roads and national defence.

Typically, public goods are not provided in a free market because firms cannot charge people directly

and there is scope for `free-riding’ on other people paying for it.

Note: Goods provided by the public sector (government) are not necessarily public goods. E.g.

government provide education, but education is a merit good, not a public good)

Merit goods.

This is a good where people underestimate the benefits of consuming. This may be due to poor
information or overvaluing present happiness (e.g. going to party rather than studying. Merit goods
usually have positive side effects (positive externalities); for example, with education, if people gain
qualifications, they can earn a higher salary, but the whole economy benefits from their high
productivity and their skills. Eg. Education is a merit good. People underestimate benefits of studying
and so there is under-consumption.

Note Merit goods may be provided in a free market – but in insufficient quantities.

Demerit Goods

Are goods that have negative side effects (negative externalities) associated with either their
production or consumption. Most often, people may be unaware of the costs or choose to ignore
them. For example, cigarette smoking. If you smoke it gives passive smoking to others., Alcohol
consumption etc.

Complementary Goods.

Goods which are used together, e.g. Tennis balls and tennis rackets, mobile phones and mobile
phone credit for making calls, car and petrol
Substitute goods.

Substitute goods are two alternative goods that could be used for the same purpose. e.g. Pepsi and
Coca-cola, chicken and turkey. If the price of one good increases, then demand for the substitute is
likely to rise.

Normal goods.

Are a type of goods whose demand shows a direct relationship with a consumer’s income. It means
that the demand for normal goods increases with an increase in the consumer’s income. Example,
travelling by personal car instead of using public transport.

Inferior goods. An inferior good is a good whose demand decreases when consumer income rises. It
show an inverse relationship with consumer’s income. When your income rises you buy less Tesco
value bread and more high quality organic bread.

The Factors of Production

Definition. These are economic resources used in the production of goods and services.
Resources are also called ‘factors of production’ (especially in Business). They are:

• Land: all natural resources that exist on the earth’s surface. This includes lakes,
rivers, forests, mineral deposits, climate, soil etc.
• The reward for land is the rent it receives.
• Land is fixed in supply. This is because the amount of land in existence stays the
same. But in relation to a country or business, when it takes over or expands to a
new area, you can say that the supply of land has increased, but the supply is not
depended on its price, i.e. rent.
• The quality of land depends upon the soil type, fertility, weather and so on.
• Mobility. Land is geographically immobile because it can’t be moved around. But
since it can be used for a variety of economic activities, it is occupationally
mobile.

• Labour: All the human resources available in an economy, both mental and
physical efforts and skills of workers/labourers that is used in the production
process.
• The reward for labour is wages/salaries.
• The supply of labour depends upon the number of workers available (which is in
turn influenced by population size, number of years of schooling, retirement age,
age structure of the population, attitude towards women working etc.) and the
number of hours they work (which is influenced by number of hours to work in a
single day/week, number of holidays, length of sick leaves, maternity/paternity
leaves, whether the job is part-time or full-time etc.).
• The quality of labour will depend upon the skills, education and qualification of
labour.
• Labour mobility can depend upon various factors. Labour can achieve high
occupational mobility (ability to change jobs) if they have the right skills and
qualifications.
 • It can achieve geographical mobility (ability to move to a place for a job)
depending on transport facilities and costs, housing facilities and costs, family and
personal priorities, regional or national laws and regulations on travel and work
etc.

• Capital: All the man-made resources available in an economy that can be used
in the process of production. All man-made goods (which help to produce other
goods – capital goods) from a simple spade to a complex car assembly plant are
included in this.
• The reward for capital is the interest it receives.
• The supply of capital depends upon the demand for goods and services, how well
businesses are doing, and savings in the economy (since capital for investment is
financed by loans from banks which are sourced from savings).
• The quality of capital depends on how many good quality products can be
produced using the given capital. For example, the capital is said to be of much
more quality in a car manufacturing plant that uses mechanisation and
technology to produce cars rather than one in which manual labour does the
work.
• Capital mobility can depend upon the nature and use of the capital. For example,
an office building is geographically immobile but occupationally mobile. On the
other hand, a pen is geographically and occupationally mobile.

• Enterprise: the ability to take risks and run a business venture or a firm is
called enterprise. A person who has enterprise is called an entrepreneur. In short,
they are the people who start a business. Entrepreneurs organize all the other
factors of production and take the risks and decisions necessary to make a firm
run successfully.
• The reward to enterprise is the profit generated from the business.
• The supply of enterprise is dependent on entrepreneurial skills (risk-taking,
innovation, effective communication etc.), education, corporate taxes (if taxes on
profits are too high, nobody will want to start a business), and regulations in
doing business and so on.
• The quality of enterprise will depend on how well it is able to satisfy and expand
demand in the economy in cost-effective and innovative ways.
• Enterprise is usually highly mobile, both geographically and occupationally.

All the above factors of productions are scarce because the time people have to spend
working, the different skills they have, the land on which firms operate, the natural resources
they use etc. are all in limited in supply; which brings us to the topic of opportunity cost.

Production Possibility Curve Diagrams (PPC)

It shows the maximum combination of two goods that can be produced by an economy with all the
available resources and technology. It can also be called a production possibility frontier (PPF) or
Production possibility boundary (PPB)
Because resources are scarce and have alternative uses, a decision to devote more resources
to producing one product means fewer resources are available to produce other goods.
The PPC diagram above shows the production capacities of two goods- wheat and cotton-
against each other. When 200 units of wheat is produced (point A), 300 units of cotton can
be produced. But when the units of cotton increases to 400 (point B), only 160 units wheat
can be produced. Note, the reverse will be true. Any point of production along the PPC is
attainable given the country’s existing resources. The economy can move between points on
a PPC simply by reallocating resources between the two goods. Now let’s see dia. 2.

If the economy were producing at point Z, which is inside/below the PPC, the economy is
said to be inefficient, because it is producing less than what it can.
Point W, outside/above the PPC, is unattainable because it is beyond the scope of the
economy’s existing resources. In order to produce at point W, the economy would need to
see a shift in the PPC towards the right.
For an outward shift to occur, an economy would need to:

• Discover or develop new raw materials. Example: discover new oil fields
• Employ new technology and production methods to increase productivity
• Increase labour force by encouraging birth
• Immigration
• Increasing retirement age etc.
An outward shift in PPC, that is higher production possibility, will lead to economic growth.

In the same way, an inward shift can occur in the PPC.

This can be due to:

• War and natural disasters, that erode infrastructure and kill the population
• very low investment in new technologies will cause productivity to fall over time
• running out of resources, especially non-renewable ones like oil or water
An inward shift in the PPC will lead to the economy shrinking which is referred to as a
recession.
Changes in the slope of the PPC

If there is a change in the quantity and quality of resources, which are specific to the
production of one type of good, then the entire PPC will not shift to the right, but only the
slope will change.

E.g. Technological improvement in the production of product B has caused the maximum
number of product B to increase, but the maximum number of product A doesn’t change. It
can also be the other way around i.e. where the slope moves vertically upwards indicating an
increase in the maximum number of product A.

How is opportunity cost linked to PPC?

Individuals, businessmen and the government can calculate the opportunity cost from PPC diagrams.
In the above example, if the firm decided to increase production of good Y from 500 to 750, it can
calculate the opportunity cost of the decision to be 250 units of good X (as production of good Xfalls
from 1000 to 750). They are able to compare the opportunity cost for different decisions.

THE ALLOCATION OF RESOURCES

The Role of Markets in Allocating Resources
Economy: an area where people and firms produce, trade and consume goods and services.
This can vary in size- from your local town to your country, or the globe itself.
Resource allocation: the way in which economies decide what goods and services to
provide, how to produce them and who to produce them for.
These questions- what to produce, how to produce, and for whom to produce – are termed
‘the basic economic questions’. In short, resource allocation is the way in which economies
solve the three basic economics questions.

Market is any set of arrangement that brings together all the producers and consumers of a
good or service, so they may engage in exchange. Note that, a market does not necessarily
require for the buyers and sellers to come into physical contact. Example: a market for soft
drinks, a market for labour, a market for stocks and shares.
Demand
Demand refers to the quantity of goods and services that consumers are willing and able to
buy at a given price and at a given time period.

A simple demand curve.

A normal demand curve slopes downwards from left to right indicating that as price falls,
consumers will be more willing and able to pay at low than at higher prices. Here, a decrease
in price from 80 to 60 has increased its quantity demanded from 300 to 500 and vice versa.

The law of demand states that, an increase in price leads to a decrease in quantity
demanded, and a decrease in price leads to an increase in quantity demanded, all other
factors held constant (the ceteris paribus assumption).
*Note that this is an inverse relationship between price and demand. However it’s worth
noting that an increase in demand leads to an increase in price and a decrease in demand
leads to a decrease in price. But the law of demand is drawn in respect to the price having to
affect demand.

Effective demand
It is where the willingness to buy a product is backed by the ability to pay. If the willingness
of a consumer to consume a product isn’t backed by their ability to pay a price, then that is
just a want because their demand is not effective (not complete.) For example, when you
want a laptop but you don’t have the money, it is called demand. When you do have the
money to buy it, it is called effective demand.
*The effective demand for a particular good or service is called quantity demanded.

Difference between change in demand and change in quantity demanded.

Changes in quantity demanded.

It occurs due to changes in prices, all other factors remaining unchanged (ceteris paribus),
causes changes in the quantity demanded. A change in price causes a movement along
the demand curve. It can either be contraction (less demand) or expansion/extension
(more demand)

Contraction in demand. Occurs when quantitydemanded falls as a result of an increase in

price, ceteris paribus. In the diagram below, an increase in price from $10 to $12
causes an upward movement along the demand curve, and quantity demand falls
from 55 to 40. We say this is a contraction in demand.
Extension or Expansion in demand . Occurs when quantity demanded rises due to an increase
in price, ceteris paribus. A fall in price from $10 to $7, on the diagram, leads to an
expansion in demand. As price falls, there is a movement downwards along the
demand curve and more is bought (55 to 75).

A change in price doesn’t shift the demand curve – we merely move from one point
of the demand curve to another.

Individual demand is the demand from one consumer, while market demand for a product is the
total (aggregate) demand for the product, or the sum of all individual demands of consumers in a
market/economy.

CHANGES IN DEMAND
Changes in demand occur when changes in all other factors, ceteris paribus (price remaining
unchanged) cause shifts in the demand curve, either to the right (outwards) or to the left
(inwards).

a) Increase in demand.

a) Decrease in demand.
Factors that cause shifts in a demand curve:
• Consumer incomes: a rise in consumers’ incomes increases demand, causing a shift to right.
Similarly, a fall in incomes will shift the demand curve to the left.
• Taxes on incomes: a rise in tax on incomes means less demand, causing a shift to the left;
and vice versa.
• Price of substitutes: Substitutes are goods that can be used instead of a particular product.
Example: tea and coffee are substitutes (they are used for similar purposes). A rise in the
price of a substitute causes a rise in the demand for the product, causing the demand curve
to shift to the right; and vice versa.
• Price of complements: Complements are goods that are used along with another product.
For example, printers and ink cartridges are complements. A rise in the price of a
complementary good will reduce the demand for the particular product, causing the demand
curve to shift to the left; and vice versa.
• Changes in consumer tastes and fashion: for example, the demand for DVDs have fallen since
the advent of streaming services like Netflix, which has caused the demand curve for DVDs
to shift to the left.
• Degree of Advertising: when a good is very effectively advertised (Coke and Pepsi are good
examples), its demand rises, causing a shift to the right. Lower advertising shifts the demand
curve to the left.
• Change in population: A rise in the population will raise demand, and vice versa.
• Other factors, such as weather, natural disasters, laws, interest rates etc. can also shift the
demand curve.

Supply
Supply is the quantity of goods and services which producers (businesses) are willing to make
and sell at different prices within a given period of time.
*The amount of goods or services producers are willing to make and supply is called quantity
supplied.
*Market supply refers to the amount of goods and services all producers supplying that
particular product are willing to supply or the sum of individual supplies of all producers in a
market/economy.

*The law of supply states that an increase in price leads to an increase in supply, and a
decrease in price leads to a decrease in supply (there is a positive relationship between
price and supply.
 However it’s also worth noting that, an increase in supply leads to a decrease in price
and a decrease in supply leads to an increase in price.

NOTE: The law of supply is established with respect to changes in price, not supply,
hence the difference).

A supply curve.

A normal supply curve slopes upwards from left to right indicating how suppliers respond
positively to an increase in price.
*Note that there is a positive/direct relationship between price and supply. That is, when
price rises supply rises and vice versa.

Here, an increase in price from 60 to 80, has increased the quantity supplied from 500 to
700.

Difference between a change in supply and a change in quantity

supplied.
Changes in quantity supplied. Occurs when changes in price, other factors remaining
unchanged, causes movements (up and down) along a supply curve.

a) An increase in quantity supplied

It is an increase in supply due to an increase in price, without changes in other factors
causing suppliers to supply more at each and every price than they did before. Here, there is
an extension in supply.

b) A decrease in quantity supplied. It occurs due to a fall in price, without the changes in
other factors causing a contraction in supply.
 • A higher price causes an extension along the supply curve (more is supplied)
• A lower price causes a contraction along the supply curve (less is supplied)

Changes in supply.
Changes in supply are as a result of changes in all other factors (non-price
influences) that can affect supply, price remaining unchanged (ceteris paribus
assumption). Changes in these factors will cause shifts in the supply curve.

(a) An increase in supply. It is a rise in the supply for a product due to the changes in
other factors (excluding price) causing a shift to the right from (S– S1). In this example, there
is a rise in the supply of a product from 500 to 700, without any change in price.

(b) A decrease in supply. Refers to a fall in the supply for a product due to the changes in
other factors (excluding price) causing a shift of the supply curve to the left from (S – S1). In
this case, a fall in supply from 500 to 300, without any changes in price is also shown.
.
Factors that cause shifts in supply curve:
• Changes in cost of production: when the cost of factors to produce the good falls, producers
can produce and supply more products cheaply, causing a shift in the supply curve to the
right. A subsidy*, which lowers the cost of production also shifts the supply curve right.
When cost of production rises, supply falls, causing the supply curve to shift to the left.
• Changes in the quantity of resources available: when the amount of resources available
rises, the supply rises; and vice versa.
• Technological changes: an introduction of new technology will increase the ability to produce
more products, causing a shift to the right in the supply curve.
• The profitability of other products: if a certain product is seen to be more profitable than the
one currently being produced, producers might shift to producing the more profitable
product, reducing supply of the initial product (causing a shift to the left).
• Other factors: weather, natural disasters, wars etc. can shift the supply curve left.

Market/Equilibrium price.

The market equilibrium price is the price at which the demand and supply curves in a given
market meet or intercept or are equal. In this diagram, P* is the equilibrium price.

Disequilibrium price is the price at which market demand and supply curves do not meet or
are not equal. In the diagram, it is any price other than P*.
Changes in the equilibrium price.

In this diagram, two disequilibrium prices are marked- 2.50 and 1.50.
At a price above the equilibrium, (2.50), the demand is 4 while the supply is 10. There is
excess supply relative to the demand as suppliers respond to the high price by supplying
more but consumers less willing to buy at the high price. When the price is above the
equilibrium price, a surplus is experienced. (Surplus means ‘excess’).

At a price below the equilibrium, (1.50), the demand is 10 while the supply is only 4. There is
excess demand relative to supply because consumers are more willing to buy at a low price
but suppliers are less willing to sell. When the price is below the equilibrium price, a
shortage is experienced.
(This shortage and surplus is said in terms of the supply being short or excess demand
respectively)

Note that the market price is also called the market clearing price because it is at this price
that the surpluses and shortages will be cleared through a fall and a rise in price respectively.

Changes in demand and supply on market/equilibrium price.

Change in demand (increase)

A shift in the demand curve could occur due to any factor other than price. For example, if a good
becomes more fashionable, better quality, fall in incomes or if there is an increase in the price of a
substitute. All these factors will cause demand to shift to the right. A shift in the demand curve to the
right will lead to a different equilibrium. It will lead to both higher price and higher quantity traded,
as suppliers respond to the higher price by moving along their supply curve upwards.
*Note the shift of the curve could also be to the left i.e decrease in demand. (Try to draw it and see
what will happen in the market price).

An increase in demand leads to a higher price and a higher quantity of good demanded and

supplied (traded).

Change in supply (decrease)

If there is a fall in the supply of good, this will push up the equilibrium price and lead to a fall in the
equilibrium quantity traded. This is because, at the higher price, consumers will move along their
demand curve, upwards (contraction) as they will demand less than they did before.
Supply and demand in the long-term

Supply and demand are constantly changing. In the short-term, a higher price may lead to a small
fall in demand. However, in the long-term, consumers may respond in a different way. Rather than
just paying for more expensive petrol, they may switch to buying an electric car. Therefore, in the
longterm demand will be more elastic (more sensitive) to a change in price.

Long-term shift
In the short term, there is a rise in demand, causing a rise in price. However, firms respond by
investing in increasing capacity. Therefore, in the long-term, there is a shift in supply to the right.
Therefore, the price doesn’t rise.
For example, we have seen rapid growth in demand for personal computers, but there has been an
equivalent rise in supply of computers so prices haven’t risen as it stays at p1.

Price Elasticity of Demand (PED)

The PED of a product refers to the numerical measure of the degree of responsiveness of
the quantity demanded to changes in the price of a product.

Formular:
 PED (of a product) = % change in quantity demanded / % change in price

For example, calculate the price elasticity of demand of Coca-Cola from this diagram

PED= [(500-300/300)*100] / [(80-60/80)*100] = 66.67 / 25 = 2.67

In this example, the PED is 2.67 (elastic)

* When PED value is greater than 1, demand is said to be price elastic.
* When PED value is less than 1, demand is said to be price inelastic.
* When PED value is equal to 1, demand is said to be unitary/unit.

Price elastic demand. Occurs when the % change in quantity demanded for a product is
higher than the % change in its price. This means, a change in price makes a higher change
in quantity demanded. Their values are always above 1.
Price inelastic demand. Occurs when the % change in quantity demanded is lesser than the
% change in price... A change in price makes a smaller change in demand. Their values are
always below 1

Unitary price elastic demand. Occurs when the % change in quantity demanded and price
are equal, that is, value is 1.

Infinitely/perfectly price elastic demand. Occurs when the quantity demanded changes
without any changes in price itself. This product can only be demanded at one particular
price. Their values are infinite.
Perfectly price inelastic demand. Occurs when the price changes have no effect on quantity
demanded whatsoever. The quantity demanded is unresponsive to changes in price. Goods
which are inelastic tend to have some or all of the following features:

1. They have few or no close substitutes, e.g. petrol, cigarettes.

2. They are necessities, e.g. if you have a car, you need to keep buying petrol,
even if price of petrol increases
3. They are addictive, e.g. cigarettes.
Their elasticity is 0.

Factors that affect PED

• No. of substitutes: if a product has many substitute products it will have an elastic demand.
For example, Coca-Cola has many substitutes such as Pepsi and Mountain Dew. Thus a
change in price will have a greater effect on its demand (If price rises, consumers will quickly
move to the substitutes and if price lowers, more consumers will buy Coca-Cola).
• Time period: demand for a product is more likely to be elastic in the long run. For example, if
the price rises, consumers will search for cheaper substitutes. The longer they have, the more
likely they are to find one.
• Proportion of income spend on commodity: If a product takes more of consumers’ income,
then their demand for such products will be elastic. For example, Luxury goods such as cars
will have a high price elastic demand as it takes up a huge proportion of consumers’ incomes.
On the other hand, demand will be price inelastic if the proportion of consumers’ income
spent on it is less. Example newspapers, matches.
• Whether the good is habit forming. Consumers are also relatively insensitive to changes in
the price of habitually demanded products. Most demerit goods are addictive and habit
forming, hence are often inelastic in demand.

USEFULNESS OF PRICE ELASTICITY OF DEMAND.

Producers can calculate the PED of their product and take a suitable action to make the
product more profitable.
Revenue is the amount of money a producer/firm generates from sales, i.e., the total
number of units sold multiplied by the price per unit. So, as the price or the quantity sold
changes, those changes have a direct effect on revenue.

Usefulness to Producers.

1. Pricing Policy:
The knowledge of price elasticity might help a producer to analyze the impact of changes in
price levels on the demand for its product and consequently on its revenue.

The producers can use this to decide the price of the product

If the demand of the product is price elastic, by lowering its price they would earn greater
revenue. If the demand of the product is price inelastic, by raising its price they would earn
greater revenue.

2. Indirect taxes:
Furthermore, the producers could use the knowledge of price elasticity of demand to decide
whether to bear high proportion of indirect taxes themselves or pass it on to consumers in the
form of high price.

If demand is elastic, producer’s bear high proportion of tax and charge low price.
If demand is inelastic, producers can pass a high proportion of tax in the form of high prices
to consumers.

3. Helps producers to analyse the effect of a subsidy:

Benefits of subsidy given by the government can also be analyzed by the price elasticity of
demand. If the demand of the product is price elastic then the producers could get a greater
benefit of the subsidy given by the government. This is because the subsidy will reduce costs
and price hence increasing sales and profits.

4. Enables businesses to price discriminate. This is another area where price elasticity of
demand plays an important role. Price discrimination refers to charging different prices to
various customers for the same product. Those consumers whose demand is inelastic can be
charged a higher price than those with more elastic demand.
Usefulness of PED to governments.
Helps in the formulation of taxation policies
The concept of price elasticity of demand is important for formulating government policies,
especially the taxation policy. Government can impose higher taxes on goods with inelastic demand,
whereas, low rates of taxes are imposed on commodities with elastic demand. Therefore,
knowledge of elasticity of demand can help governments to raise revenue
Used to control production and consumption of demerit goods. If governments want to control the
consumption of products that are harmful or have high negative externalities, they would succeed
but charging high taxes on goods that have an elastic demand as the tax will raise their prices and
quantity demanded will fall by a much greater percentage.

Enables governments to determine export prices. A country/government may fix higher prices for
export products with inelastic demand. However, if demand for such goods in the importing country
is elastic, then the exporting country will have to fix lower prices. This can enable them to increase
the sale of exports

Price Elasticity of Supply (PES)

The PES of a product refers to the numerical measure of the degree of responsiveness of
quantity supplied to changes in the price of a product.

 PES of a product= %change in quantity supplied / %change in price

Similar to PED, PES too can be categorized into price elastic supply, price inelastic supply,
perfectly price inelastic supply, infinitely price elastic supply and unitary price elastic supply.
(See if you can figure out what each supply elasticity means using the demand elasticities
above as reference, and draw the diagrams as well!)

Factors that affects PES

• Time of production: If the product can be quickly produced, it will have a price elastic supply
as the product can be quickly supplied at any price. For example, juice at a restaurant. But
products which take a longer time to produce, such as cars, will have a price inelastic supply
as it will take a longer time for supply to adjust to price.

• Availability of resources: More resource (land, labour, capital) will make way for an elastic
supply. If there are not enough resources, producers will find it difficult to adjust to the price
changes, and supply will become price inelastic

• Number of producers: More producers mean that the output can be increased more easily.
Thus supply is more elastic.

• Ease of storing stocks: If goods can be stocked with ease and have a long shelf life, the supply
will be elastic, otherwise inelastic. For example perishable goods such as fresh flowers,
 vegetables have comparatively inelastic supply because it is difficult to store them for longer
periods.
• Improvement in Technology: In industries where there is a rapid improvement in technology,
the PES of such goods will be more elastic as compared to industries where there is not much
improvement in technology.

Market Economic System

In a market economic system or free market economic system, all resources are allocated by
the market – private producers and consumers; that is, there is no or very little government
intervention in resource allocation. (There are virtually no economies in the world that
follow this system – there is a government control everywhere, although Hong Kong and
Singapore do come close.

Features:
• All resources are owned and allocated by private individuals.
• Government refrains from regulating markets. It instead tries to create very businessfriendly
environments and any intervention is mostly limited to protecting private property. The
demand and supply fixes the price of products. This is called price mechanism.
• What to produce is solved by producing the most-demanded goods for which people spend
a lot, as their only motive is to generate a high profit.
• How to produce is solved by using the cheapest yet efficient combination of resources –
capital or labour- in order to maximise profits.
• For whom to produce is solved by producing for people who are willing and able to pay for
goods at a high price.

Advantages:
• A wide variety of quality goods and services will be produced as different firms will compete
to satisfy consumer wants and make profits. Quality is ensured to make sure that consumers
buy from them. There is consumer sovereignty.
• Firms will respond quickly to consumer changes in demand. When there is a change in
demand, they will quickly allocate resources to satisfying that demand, so as to maintain
profits.
• High efficiency will exist. Since producers want to maximise profits, they will use resources
very efficiently, producing more with less resources.
• Since there is hardly any government intervention in the form of regulations, taxes and fines,
firms will be motivated to start and run businesses.
Disadvantages: [course book p. 31]
• Only profitable goods and services are produced. Public goods* and some merit goods* for
which there is no demand may not be produced, which is a drawback and affects the
economic development.
• Firms will only produce for consumers who can pay for them. Poor people who cannot
spend much won’t be produced for, as it would be non-profitable.
• Only profitable resources will be employed. Some resources will be left unused. In a market
economy, capital-intensive production is favoured over labour- intensive production because
it’s more cost-efficient and this can lead to unemployment.
• Harmful (demerit) goods may be produced if it is profitable to do so.
 • Negative impacts on society (externalities) may be ignored by producers, as their sole motive
is to keep consumers satisfied and generate a high profit.
• There is tendency for firms to gain monopoly power. A firm that is able to dominate or
control the market supply of a product is called a monopoly. They may use their power to
restrict supply from other producers, and charge consumers a high price since they are the
only producer of the product and consumers have no choice but to buy from them.

Market Failure and Government Intervention

Before we dive into what market failure is, let’s get familiar with some terms related to
market failure:

*Public goods: goods that can be used by the general public and consumption by one person
does not exclude all other consumers. Their consumption can’t be measured, and thus
cannot be charged a price for (this is why a market economy doesn’t produce them).
Examples are street lights and roads.
*Merit goods: goods which create a positive effect on the community and ought to be
consumed more. Examples are schools, hospitals, food. The opposite is called demerit goods
which includes alcohol and cigarettes
*Subsidies: Financial grants made by governments to firms to assist them lower their cost of
production in order to lower prices for their products. This will enable more consumers to be
able to afford.
External costs (negative externalities) are the negative impacts on society (third-parties)
due to a production or consumption decision. Example: the pollution from a factory, passive
smoking.
External benefits (positive externalities) are the positive impacts on society due to
production or consumption decision. Example: better roads in a neighbourhood due to the
opening of a new business, an inoculation against a disease protects all others who would
have caught the disease.
Private costs are the costs to the producer and consumer due to a production and
consumption decision respectively. Example: the cost of production, satisfaction from
smoking or the price paid to purchase a cigarette.

Private benefits are the benefits to the producer or consumer due to production and
consumption respectively. Example: the better immunity received by a consumer when he
receives a vaccine.
Social Costs. Social cost is the total cost to society from producing or consuming a
good/service. It includes private costs plus any external
costs. SC = External costs (EC) + Private Costs (PC)
Social Benefits. It is the total benefit to society from producing or consuming a
good/service. Social benefit includes all the private benefits plus any external benefits
of production/consumption. SB = External benefits (EB) + Private benefits (PB)

Market Failure
Market failure occurs when the price mechanism fails to allocate resources efficiently. This is
the most disadvantageous aspect to the market economy.

Causes of market failure are:

• When social costs exceed social benefits (especially where negative externalities (external
costs) are high).
• Over-provision of demerit goods like alcohol and tobacco: the external costs arising from
demerit goods are not reflected in the market and so they are overproduced.
• Under-provision of merit goods such as schools, hospitals and public transport, since the
external benefits of these goods are not reflected in the market, they are under produced.
• Lack of public goods such as roads, bus terminals and street lights: since their consumption
cannot be measures and charged a price for, they are not produced by the private sector.
• Immobility of resources: when resources cannot move between their optimal uses and thus
are not used to the maximum. For example, when workers (labour) don’t have occupational
or geographic mobility.
• Information failure: when information between consumers, producers and the government
are not efficiently and correctly communicated. Example: a cosmetics firm advertises its
products as healthy when it is in fact not. The consumers who believe the firm and use its
products might suffer skin damage.
• Abuse of monopoly* powers: monopolistic businesses may use their powers to charge
consumers a high price and only produce products they wish to, since they know consumers
have no choice but to buy from them.
*Monopoly: a single supplier who supplies the entire market with a particular product,
without any competition. Example: public utilities like water, gas and electricity in many
countries are provided by their respective governments with no other producer allowed in
the market. Note that a monopoly in the public sector may be good to consumers because
they do not have a profit motive. However, they may produce low quality products.

2.11 – Mixed Economic System

In a mixed economic system, both the market and government intervention co-exist.
Examples include almost all countries in the world. This is because it overrides all the
disadvantages of both the market and planned economies. It identifies the importance of
the price mechanism in operating an efficient resource allocation and also the role of the
government in correcting any market failures.
Features:
• both the public and the private sector exists
• Planning and final decisions are made by the govt. while the market system can determine
allocation of resources owned by it, along with the public organizations.
Advantages: [course book. p.31]
• The govt. can provide public goods, necessities and merit goods. The private businesses can
provide profitable and most-demanded goods (luxury goods, superior goods). Thus, everyone
is provided for.
• The govt. will keep externalities, monopolies, harmful goods etc. in control.
• The govt. can provide jobs in the public sector (so there is better job security).
• The govt. can also provide financial help to collapsing private organizations, so jobs are kept
secure.
Disadvantages:
• Taxes will be imposed, which will raise prices and also reduce work incentive.
• Laws and regulations can increase production costs and reduce production in the economy.
• Public sector organizations will still be inefficient and will produce low quality goods and
services.

The specific ways in which the government, in a mixed economic system, can
correct market failures (Government intervention) page.

• Legislation and regulation – the government can make laws that regulate market activity, for
example, prohibit smoking in public (which would cause a negative externality). One
important kind of legislation the govt. can undertake is price controls – setting a minimum
price or maximum price on goods.
•

Minimum price or price floor is set to control a decreasing tendency of price. The minimum
wage laws in many countries are an example of minimum price. The government sets the
minimum wage above the existing market equilibrium wage, to ensure that all workers get a
basic minimum wage to sustain them. But even as low-income workers now get better
wages, the higher wage will cause the demand for labour to contract, as shown in the
diagram to the left. There will also be higher supply of labour (workers who want work)
because of higher wages. A reduced demand and increased supply will cause excess supply of
labour i.e., unemployment.
 Maximum price or price ceiling. It is set to control an increasing tendency of price. It is
usually set on rent (this is called rent control), to ensure that low-income tenants can afford
to rent homes. But as a result of the lower rent, landlord will stop renting more homes,
causing supply to contract, as shown in the diagram to the left. At the same time, lower rent
will increase the demand for homes. A reduced supply of homes and higher demand for them
will cause a shortage of supply in relation to demand.

• Direct provision of merit and public goods – since there is little incentive for the price
mechanism to supply these goods, governments usually provide them. For example, free
education, free healthcare, public parks. One way the govt. can do this is by nationalising
certain products it considers essential to be provided by a governing authority, rather than
the market. For example, in India, the government operates the only railway network
because only it can provide cheap services to its millions of poor, daily passengers.

• Taxation on products – imposing a tax on products (indirect taxes) with negative externalities
can discourage its production and consumption. For example, a tax on tobacco will make it
expensive to produce and consume. In the diagram below, a tax has been imposed on a
product, causing its supply to shift from S to S1. The price rises from P to P1 because of the
additional tax amount, and the quantity traded in the market falls from Q to Q1.

• Subsidies – a subsidy is a grant (financial aid) on products that have a positive externality.
Subsidising, for example, cooking gas for the poor, will increase the living standard of the
population. In the diagram below, a subsidy has been imposed on a good, causing its supply
to shift from S to S1. It results in a fall in price from P to P1 and subsequently, an increase in
the quantity traded in the market from Q to Q1.
 • Provision of public goods. These goods tend not to be provided in a free market because
there is no financial incentive for firms to provide goods that people can enjoy for free.
Governments can provide national defence, law and order, roads etc and pay for it out of
general taxation.
• Provision of merit goods. Merit goods are under-consumed in free-market because people
underestimate the personal benefits and/or ignore the external benefits. This leads to an
underprovision of health care and education. Government intervention to provide free
education can lead to a significant improvement in the quality of life for people who are
educated. There are also many positive externalities to the rest of society. A well-educated
society can improve labour productivity and economic growth.
• Shift consumer behaviour. The consumption of demerit goods like alcohol, tobacco and
opiates can cause personal costs and significant social costs (e.g. crime). If the government
identifies damaging goods, they can slowly change consumer behaviour – such as using
higher tax, advertising campaigns and behavioural economics, e.g. making cigarettes difficult
to buy with unappealing packets.

• Tradable permits – firms will have to buy permits from the government to do something, for
example, pollute at a certain level, and these can be traded among firms. Since permits
require money, firms will be encouraged to pollute less.

• Extension of property rights – one of the main reasons for pollution in public spaces is that it
is public – it does not harm a specific private individual – the resource is the government’s
who cannot charge compensations easily. So the government can extend property rights
(right to own property) of public places to private individuals. This will
effectively privatise resources, create a market for these spaces and then individuals can be
fined for polluting

• International cooperation among governments – governments work together on issues that

affect the future of the environment.

As you can see, market failure can be corrected by governments in a variety of ways and the
presence of a government is quite indispensable in any modern economy. Planned
(government-only) economies are too inefficient and free market (no government)
economies result in market failures. So a mixed economic system tries to balance both sides.

Disadvantages of government intervention in an economy. Course book, P. 32.

• Political incentives: this occurs when there is a clash between political, economic and social
(because a government is a political entity with political incentives). For example, even
though mining companies cause a lot of environmental damage, the government may
encourage and promote their activities to gain political and financial support from them.
• Lack of incentives: in the free market, individuals have a profit incentive to innovate and cut
costs, but in the public sector, such an incentive is absent since the government will pay them
salaries regardless of their performance. So, even as the government provides certain public
and merit goods directly to the people at low costs, they tend to be very inefficient.
• Less choice. Often government intervention in the economy (e.g. nationalisation of
industries) has been associated with less choice. Government produced services have a
 monopoly. Command economies, often have very little choice as government decide what to
produce, not based on consumer preferences hence, less satisfaction.
• Time lags, information failure: these are some of the government failure arising because of a
lack of incentive. Government offices and employees don’t have an incentive to provide
timely services or give accurate information and this leads to very inefficient systems.
• Welfare effects of policies: government policies such as taxation and welfare payments
distort the market. This means that such policies will influence demand and supply in the
economy and cause markets to move away from the efficient points produced by a market
system. For example, high corporate taxes will deter companies from expanding their
operations and making more profits or deter new enterprises from entering the market.
Unemployment benefits given out by the government may cause people to stay unemployed
and receive free benefits instead of working.

Barter

Barter is an act of exchange involving goods and services without the use of money or any other
monetary medium. It involves goods and services being exchanged for others.
Disadvantages

1 The problem of double coincidence of wants.

It is necessary for a person who wishes to trade his good or service to find some other person
who is not only willing to buy his good or service, but also possesses that good which the former
wants. For example, suppose a person possesses a horse and wants to exchange it for a cow. In
the barter system he has to find out a person who not only possesses a cow but also wants a
horse.

2 Lack of a common measure of value. Another difficulty under the barter system relates to the
lack of a common unit in which the value of goods and services should be measured. Even if
the two persons who want each other’s goods meet by coincidence, the problem arises as to
the proportion in which the two goods should be exchanged.
3 Indivisibility of certain goods.

The barter system is based on the exchange of goods with other goods. It is difficult to fix
exchange rates for certain goods which are indivisible. Such indivisible goods pose a real
problem, under barter. A person may desire a horse and the other a sheep and both may be
willing to trade. The former may demand more than four sheep for a horse but the other is not
prepared to give five sheep and thus there is no exchange.

4 Difficult in Storing Value.

Under the barter system it is difficult to store value. Anyone wanting to save real capital over a long
period would be faced with the difficulty that during the intervening period the stored commodity
may become obsolete or deteriorate in value. As people trade in cattle, grains, and other such
perishable commodities, it is very expensive and often difficult to store and to prevent their
deterioration and loss over the long period.
5 lack of portability. Some items couldn't be easily carried around.

6 Lack of specialisation

Another difficulty of the barter system is that it is associated with a production system where
each person is a jack-of-all trades. In other words, a high degree of specialisation is difficult to
achieve under the barter system.

The abovementioned difficulties of barter have led to the evolution of money. Money solves the
problems created by the barter system.

Money and Banking

Money
It is anything that is generally accepted in any society as medium of exchange of goods and

services and for the settlement of debts. It is the medium in which prices and values are

expressed. In the 21C, money is not limited to notes and coins. Money includes; cheques,

credit cards, debit cards, cryptocurrencies, emerging technologies such as cybercash, e-

cash, smart cards etc.

Why do we need money? We need money in order to exchange goods and services with one
another. This is because we aren’t self-sufficient – we can’t produce all our wants by
ourselves. Thus, there is a need for exchange.

Characteristics of money
Durability
Durability. Objects used as money must withstand physical wear and tear.

Portability
People need to be able to take money with them as they go about their business.

Divisibility
To be useful, money must be easily divided into smaller denominations, or units of value.

Uniformity
Any two units of money must be easily uniform or the same in what they will buy. For example,
twenty-dollar bills are all the same size and shape and value; they are very uniform.
Limited Supply
Money must be available only in limited quantities
Acceptability
Everyone must be able to exchange the money for goods and services

The functions of money:

• Money is a medium of exchange. This means that money acts as an intermediary between
the buyer and the seller. Instead of exchanging accounting services for shoes, the accountant
now exchanges accounting services for money. This money is then used to buy shoes. To
serve as a medium of exchange, money must be very widely accepted as a method of
payment in the markets.
• Money is a unit of account. Money acts as a unit of account by allowing us to compare and
state the worth of different goods and services. This means that it is the ruler by which other
values are measured.
• Money is a store of value. Holding money is a much easier way of storing value. You know
that you do not need to spend it immediately because it will still hold its value the next day,
or the next year. In a barter system, we saw the example of the shoemaker trading shoes for
accounting services. But she risks having her shoes go out of style, especially if she keeps
them in a warehouse for future use—their value will decrease with each season. Shoes are
not a good store of value. However, it is important to note that when prices rise, this
function of money can be distorted as its value falls.
• Money is a means of deferred payment. This means that if money is usable today to make
purchases, it must also be acceptable to make purchases today that will be paid in the
future. Loans and future agreements are stated in monetary terms and the standard of
deferred payment is what allows us to buy goods and services today and pay in the future.
Deferred payments are purchases on credit – where the consumer can pay later for the
goods or service they buy. This wasn't the case with the barter system of trade as some
goods were highly perishable and others (agricultural products) were very much subject to
weather changes.
Banking
Banks are financial institutions that act as an intermediary between borrowers and savers. It
is the money we save at banks (commercial bank) that is lent out as loans to other
individuals and businesses. Two main types of banks are;

a) Commercial banks are those banks that have many retail branches located in
most cities and towns and they act as an intermediary between borrowers
and savers. Example: HSBC, standard bank, millennium Bim etc.

Functions of a commercial bank:

• Accept deposits in the form of savings.
• Aid customers in making and receiving payments via their bank accounts.
• Give loans to businesses and private individuals.
• Buying and selling shares on customers’ behalf.
• Provide insurance (protection in the form of money against damage/theft of personal
property).
• Exchange foreign currencies.
• Provide financial planning advice.

b) The central bank that governs all other commercial banks in a country and it is
owned and controlled by government. It sits at the centre of the banking
system in an economy. Example: The Reserve Bank of India (RBI), the Bank of
Mozambique, the Bank of England etc.

Functions of a central bank:

• It prints issues out notes and coins of the national currency.
• It manages all payments relating to the government.
• It manages national debt. Central banks can issue and repay public debts on the
government’s behalf.
• It supervises and controls all the other banks in the whole economy, even holding their
deposits and transferring funds between them.
• It is the lender of ‘last resort’ to commercial banks. When other banks are having financial
difficulties, the central bank can lend them money to prevent them from going bankrupt.
• It manages the country’s gold and foreign currency reserves. These reserves are used to
make international payments and adjust their currency value (adjust the exchange rate). •
It operates the monetary policy in an economy. (This will be explained in a later chapter)

Households
Disposable income is the income of a person after all income-related taxes and charges have
been deducted.
Spending (Consumption)
The buying of goods and services is called consumption. The money spent on consumption
is called consumer expenditure.
People consume in order to satisfy their needs and wants and give them satisfaction.

Factors affecting consumption:

• Disposable income: the more the disposable income, the more people consume.
• Wealth: the more wealthy (having assets such as property, jewels, company shares) a person
is, the more he spends.
• Consumer confidence: if consumers are confident of keeping their jobs and their future
incomes, then they might be encouraged to spend more now, without worries.
• Interest rates: if interest rates provided by banks on saving are high, consumers might save
more so they can earn interest and thus consumer expenditure will fall.

Saving
Saving is income not spent (or delaying consumption until some later date). People can save
money by depositing in banks, and withdraw it a later date with the interest.

Factors affecting saving:

• Saving for consumption n: people save so that they can consume later. They save money so
that they can make bigger purchases in the future (a house, a car etc.). Thus, saving can
depend on the consumers’ future plans.
• Disposable income: if the amount of disposable income people have is high, the more likely
that they will save. Thus, rich people save a higher proportion of their incomes than poor
people.
• Interest rates: people also save so that their savings may increase overtime with the interest
added. Interest is the return on saving; the longer you save an amount and the higher the
amount, the higher the interest received.
• Consumer confidence: if the consumer is not confident about his job security and incomes in
the future, he may save more now.
• Availability of saving schemes: banks now offer a variety of saving schemes. When there are
more attractive schemes that can benefit consumers, they might resort to saving rather than
spending.

Borrowing
Borrowing, as the word suggests, is simply the borrowing of money from a
person/institution. The lender gives the borrower money. The lender is usually the bank
which gives out loans to customers.

Factors affecting borrowing:

 • Interest rates: interest is also the cost of borrowing. When a person takes a loan, he must
repay the entire amount at the end of a fixed period while also paying an amount of interest
periodically. When the interest rates rise, people will be reluctant to borrow and vice versa.
• Wealth/Income: banks will be more willing to lend to wealthy and high-income earning
people, because they are more likely to be able to repay the loan, rather than the poor. So
even if they would like to borrow, the poor end up being able to borrow much lesser than the
rich.
• Consumer confidence: how confident people feel about their financial situation in the future
may affect borrowing too. For example, if they think that prices will rise (inflation) in the
future, they might borrow now, to make big purchases now.
• Ways of borrowing: the number of ways to borrow can influence borrowing. Nowadays there
are many borrowing facilities such as overdrafts, bank loans etc. and there are more credit
(future payment) options such as hire purchases (payment is done in instalments overtime),
credit cards etc.

Expenditure patterns between income groups

The richer people spend, save and borrow more amounts than the poor.
The poor spend higher proportions of their disposable income, especially on necessities,
than the rich.
The poor save lesser proportions of their disposable income in comparison with the rich.

Labour Market
Labourers need wages to satisfy their wants and needs.

Payments for labour:

• Time-rate wage: wage given based on the no. of hours the employee has worked.
Overtime wages are given to workers who have worked extra no. of hours, which
will usually be 1.5 times or even twice the normal time rate.
• Piece-rate wage: wage given based on the amount of output produced. The more
output an employee produced, the more wage he/she earns. This is used in
industries where output can be easily measured and gives employees an incentive
to increase their productivity.
• Salary: monthly payments made to workers, usually managers, office staff etc.
usually in non-manual jobs.
• Performance-related payments: payments given to individual workers or teams of
workers who have performed very well. Commissions given to salespersons for
selling to a targeted no. of customers is a form of performance-related pay.

What affects an individual’s choice of occupation?

• Wage factors: the wage conditions of a job/firm such as the pay rate, the prospect
for performance-related payments and bonuses etc. will be considered by the
individual before he chooses a job.
• Non-wage factors: This will include:
• hours of work
• holiday entitlements
 • promotion prospects
• quality of working environment
• job security
• Fringe benefits (free medical insurance, company car, price discounts on company
products etc.)
• Job satisfaction
• training opportunities
• distance from home to workplace
• pension entitlement

The demand for labour

Labour demand is the number of workers demanded by firms at a given wage rate. Labour
demand is called ‘derived demand’, since the level of demand of a product determines that
industry’s demand for labour. That is, the higher the demand for a product, the more labour
producers will demand to increase supply of the product.

When the wage increases, the demand for labour contracts (and vice versa).

The supply of labour.

Labour supply is the number of workers available and ready to work in an industry at a given
wage rate. When the wage rate increases, the supply of labour extends, and vice versa.

We also know that as the number of hours worked increases, the wage rate also increases.
However, when a person get to a very high position and his wages/salary increases highly,
the number of hours he/she works may decrease. This can be shown in this diagram, called a
backward-bending labour supply curve where at very high wage rates, workers tend to
substitute work for leisure. CEOs and executive managers at the top of the management
tend to have backward-bending labour supply curves.
Just like in a demand and supply curve analysis, labour demand and supply will extend
and contract due to changes in the wage rate. Other factors that cause changes in
demand and supply o f labour will result in a shift in the demand and supply curve of
labour.

Factors that cause a shift in the labour demand curve:

 • Consumer demand for goods and services: the higher the demand for products, the higher
the demand for labour.
• Productivity of labour: the more productive labour is, the more the demand for labour.
• Price and productivity of capital: capital is a substitute resource for labour. If the price of
capital were to lower and its productivity to rise, firms will demand more of capital and
labour demand will fall (labour demand curve shifts to the left).
• Non-wage employment costs: wages are not the only cost to a firm of employing workers.
Sometimes, employment tax, welfare insurance for each employee etc. will have to be paid
by the firm. If these costs increase, firms will demand less labour.

Factors that cause a shift in the labour supply curve:

• Advantages of an occupation: the different advantages a job can offer to employees will
affect the supply of labour- the people willing to do that job. Example: if the number of
working hours in the airline industry increases, the labour supply there will shift to the left.
• Availability and quality of education and training: if quality training and education for a
particular job, say pilots, is lacking, then the labour supply for it will be low. When new
education and training institutes open, the labour supply will rise (labour supply curve shifts
to the right).
• Demographic changes: the size and age structure of the population in an economy can affect
the labour supply. The labour supply curve will shift to the right when more people come
into a country from outside (immigration) and when the birth rate increases (more young
people will be available for work).

Why would a person’s wage rate change overtime?

Stages in the working life of an individual worker.

As a beginner, the individual would have a low wage rate since he/she is new to the job and
has no experience. Overtime, as his/her experience increases and skills develop, he/she will
earn a higher wage rate. If he/she gets promoted and has more responsibilities, his/her
wage rate will further increase. When he/she nears retirement age, the wage rate is likely to
decrease as their productivity and skills are likely to weaken.

Wage Differentials

Why do different jobs have different wages?

• Different abilities and qualifications: when the job requires more skills and qualifications, it
will have a higher wage rate.
• Risk involved in the job: risky jobs such as rescue operation teams will gain a higher wage
rate for the risks they undertake.
• Unsociable hours: jobs that require night shifts and work at other unsociable hours are paid
more.
 • Lack of information about other jobs and wages: Sometimes people work for less wage rates
simply because they do not know about other jobs with higher wage rates.
• Labour immobility: the ease with which workers can move between different occupations
and areas of an economy is called labour mobility. If labour mobility is high, workers can
move to jobs with a higher pay. Labour immobility causes people to work at a low wage rate
because they don’t have the skills or opportunities to move to jobs with a higher wage.
• Fringe benefits: jobs which offer a lot of fringe benefits have low wages. But sometimes the
highest-paid jobs are also given a lot of fringe benefits, to attract skilled labour.

Why do wages differ between people doing the same job?

• Regional differences in labour demand and supply: for example, if the demand in an area for
accountants is very high, the wage rate for accountants will be high; whereas, in an area of
low demand for accountants, the wage rate for accountants will be low. Similarly, a high
supply of accountants will cause their wages to be low, while a low supply (scarcity) of
accountants will cause their wages to be high. It’s the law of demand and supply!
• Fringe benefits: some firms which pay a lot of fringe benefits, will pay less wages, while firms
(in the same industry) which pay lesser fringe benefits will have higher wages.
• Discrimination: workers doing the same work may be discriminated by gender, race, religion
or age.
• Length of service: some firms provide extra pay for workers who have worked in the firm for
a long time, while other firms may not.
• Local pay agreements: some trade unions may agree a national wage rate for all their
members – therefore all their members (labourers) will get a higher wage rate than those
who do the same job but are not in the trade union. This depends on the relative bargaining
power of the trade union.
• Government labour policies: wages will be fairer in an economy where the government has
set a minimum wage policy. The government’s corporate tax policies can also influence the
amount of wage firms will be willing to pay out.

Other wage differentials:

• Public-private sector pay gap: Public sector jobs usually have a low wage rate. Their wages
are lower than that of the private sectors because low wages can be compensated for by the
public sector’s high job security and pension prospects.
• Economic sector: workers in primary activities such as agriculture receive very low wages in
comparison to those in the other sectors because the value of output they produce is lower.
Further still, workers in the manufacturing sector may earn lesser than those in the services
sector. But it comes down to the nature of the job itself. A computer engineer in the
manufacturing sector does earn more than a waiter at a restaurant after all.
• Skilled and unskilled workers: Skilled workers have a higher pay than unskilled workers,
because they are more productive and efficient and make lesser mistakes.
• Gender pay gap: Men are usually given a higher pay than women. This is because women
tend to go for jobs that don’t require as much skill as that is required by men’s jobs
(teaching, nursing, retailing); they take career breaks to raise children, which will cause less
experience and career progress (making way for low wages); more women work part-time
than full-time. Sometimes, even if both men and women are working equally hard and
effectively, discrimination can occur against women.
 • International wage differentials: developed countries usually have high wage rates due to
high incomes, large supply of skilled workers, high demand for goods and services etc.; while
in a less-developed economy, wage rates will be low due to a large supply unskilled labour.

Division of Labour/Specialisation
Division of labour is the concept of dividing the production process into different stages
enabling workers to specialise in specific tasks. This will help increase efficiency and
productivity. Division of labour is widely used in modern economies. From the making of
iPhones (the designs, processors, screens, batteries, camera lenses, software etc. are made
by different people in different parts of the world) to this very website (where notes, mind
maps, illustrations, design etc. are all managed by different people).

Advantages to workers:
• Become skilled: workers can get skilled and experienced in a specific task which will help
their future job prospects
• Better future job prospects: because of the skill and training they acquire, workers will, in
the future, be able to get better jobs in the same field.
• Saves time and expenses in training Disadvantages to workers:
• Monotony: doing the same task repetitively might make it boring and lower worker’s
morale.
• Margin for errors increases: as the job gets repetitive, there also arises a chance for
mistakes.
• Alienation: since they’re confined to just the task they’re doing, workers will feel socially
alienated from each other.
 •

Lower mobility of labour: division of labour can also cause a reduced mobility of labour.
Since a worker is only specialised in doing one specific task(s), it will be difficult for him/her
to do a different job.
• Increased chance of unemployment: when division of labour is introduced, many excess
workers will have to be laid off. Additionally, if one loses the job, it will be harder for
him/her to find other jobs that require the same specialisation.
Advantages to firms:
• Increased productivity: when people specialise in particular tasks, the total output will
increase.
• Increased quality of products: because workers work on tasks they are best suited for, the
quality of the final output will be high.
• Low costs: workers only need to be trained in the tasks they specialise in and not the entire
process; and tools and equipment required for a task will only be needed for a few workers
who specialise in the task, and not for everybody else.
• Faster: when everyone focuses on a particular task and there is no need for workers to shift
from one task to another, the production will speed up
• Efficient movement of goods: raw materials and half-finished goods will easily move around
the firm from one task to the next.
• Better selection of workers: since workers are selected to do tasks best suited for them,
division of labour will help firms to choose the best set of workers for their operations.
• Aids a streamlined production process: the production process will be smooth and clearly
defined, and so the firm can easily adapt to a mass production scale.
• Increased profits: lower costs and increased productivity will help boost profits.
Disadvantages o firms:
• Increased dependency: The production may come to a halt if one or more workers doing a
specific task is absent. The production is dependent on all workers being present to do their
jobs.
• Danger of overproduction: as division of labour facilitates mass production, the supply of
the product may exceed its demand, and cause a problem of excess stocks of finished
goods. Firms need to ensure that they’re not producing too much if there is not enough
demand for the product in the first place.
Advantages to the economy:
• Better utilisation of human resources in the economy as workers do the job they’re best at,
helping the economy achieve its maximum output.
• Establishment of efficient firms and industries, as the higher profits from division of labour
will attract entrepreneurs to invest and produce.
• Inventions arise: as workers become skilled in particular areas, they can innovate and invent
new methods and products in that field.
Disadvantages to the economy:
• Labour immobility: occupational immobility may arise because workers can only specialise
in a specific field.
• Reduces the creative instinct of the labour force in the long-run as they are only able to do a
single task repetitively and the previous skills they acquired die out.
• Creates a factory culture, which brings with it the evils of exploitation, poor working
conditions, and forced monotony.

Trade Unions
Trade Unions are organizations of workers that aim at promoting and protecting the
interest of their members (workers). They aim on improving wage rates, working conditions
and other job-related aspects.

The functions of a trade union:

• Negotiating improvements in non-wage benefits with employers.
• Defending employees’ rights.
• Improving working conditions, such as better working hours and better safety measures.
• Improving pay and other benefits.
• Supporting workers who have been unfairly dismissed or discriminated against.
• Developing the skills of members, by providing training and education.
• Providing recreational activities for the members.
• Taking industrial actions (strikes, overtime ban etc.) when employers don’t satisfy their
needs. These are explained later in this topic.
Collective bargaining: the process of negotiating over pay and working conditions
between trade unions and employers.

When can trade unions argue for higher wages and better working conditions?

• Prices are rising (inflation): the cost of living increases when prices increase and workers will
want higher wages to consume products and raise their families.
• The sales and demand of the firm has increased.
• Workers in other firms are getting a higher pay.
• The productivity of the members has increased.

Industrial disputes
When firms don’t satisfy trade union wants or refuse to agree to their terms, the members
of a trade union can organize industrial disputes. Here are some:

• Overtime ban: workers refuse to work more than their normal hours.
• Go-slow: workers deliberately slow down production, so the firm’s sales and profits go
down.
• Strike: workers refuse to work and may also protest or picket outside their workplace to
stop deliveries and prevent other non-union members from entering. They don’t receive any
wages during this time. This will halt all production of the firm.

Impacts of trade unions.

Advantages to workers:
• Workers benefit from collective bargaining power by being able to establish better terms of
labour.

• Workers feel a sense of unity and feel represented, increasing morale.

• Lesser chance of being discriminated and exploited.
Disadvantages to workers:
 •

Workers might get lesser wages or none if they go on strike – as the output and profits of
the firm falls and they refuse to pay.
Advantages to firms:
• Time is saved in negotiating with a union when compared to negotiating with individuals
workers.
• When making changes in work schedules and practices, a trade union’s cooperation can help
organise workers efficiently.
• Mutual respect and good relationships between unions and firms are good for business
morale and increases productivity.
Disadvantages to firms:
• Decision making may be long as there will be need of lengthy discussions with trade unions
in major business decisions.
• Trade unions may make demands that the firm may not be able to meet – they will have to
choose between profitability and workers’ interests.
• Higher wages bargained by trade unions will reduce the firm’s profitability.
• Businesses will have high costs and low output if unions organise agitations. Their revenue
and profits will go down and they will enter a loss. They may also lose a lot of customers to
competing firms.
Advantages to the economy:
• Ensures that the labour force in the economy is not exploited and that their interests are
being represented
Disadvantages to the economy:
• Can negatively impact total output of the economy.
• Firms may decide to substitute labour for capital if they can’t meet trade unions’ expensive
demands, and so unemployment may rise.
• Higher wages resulting from trade union activity can make the nation’s exports expensive
and thus less competitive in the international market
In modern times, the powers of trade unions have drastically weakened. Globalisation,
liberalisation and privatisation of economies are making markets more competitive. Firms
have more incentive to reduce costs of production to a minimum in order to remain
competitive and profitable. Therefore, it is much harder for unions to force employers to
increase wages. Most unions operating nowadays are more focused on bettering working
conditions and non-monetary benefits.

Classification of Firms

Firms can be classified in terms of the sectors they operate in and their relative sizes.

Firms are classified into the following three categories based on the type of operations
undertaken by them:

• Primary: all economic activity involving extraction of raw natural materials. This includes
agriculture, mining, fishing etc. In pre-modern times, most economic activity and
employment was in this sector, mostly in the form of subsistence farming (farming for self-
consumption).
 • Secondary: all economic activity dealing with producing finished goods. This includes
construction, manufacturing, utilities etc. This sector gained importance during the industrial
revolution of the 19th and 20th centuries and still makes up a huge part of the modern
economy.
• Tertiary: all economic activity offering intangible goods and services to consumers. This
includes retail, leisure, transport, IT services, banking, communications etc. This sector is
now the fastest-growing sector as consumer demand for services have increased in
developed and developing nations.

Firms can also be classified on the basis of whether they are publicly owned or privately
owned:

• Public: this includes all firms owned and run by the government. Usually, the defence, arms
and nuclear industries of an economy are completely public. Public firms don’t have a profit
motive, but aim to provide essential services to the economy it governs. Governments do
also run their own schools, hospitals, postal services, electricity firms etc.
• Private: this includes all firms owned and run by private individuals. Private firms aim at
making profits and so their products are those that are highly demanded in the economy.

Firms can also be classified on their relative size as small, medium or large depending on the
output, market share, organisation (no. of departments and subsidiaries etc.).

Small Firms

A small firm is an independently owned and operated enterprise that is limited in size and
in revenue depending on the industry. They require relatively less capital, less workforce
and less or no machinery. These businesses are ideally suited to operate on a small scale to
serve a local community and to provide profits to the owners.

Advantages of small businesses:

• Independence: owner(s) are free to run the business as he/she pleases.

• Control: the owner(s) has full control over the business, unlike in a large business where
multiple managers, departments and branches will exist.
• Flexibility: small businesses can adapt to quick changes as the owner is more involved in the
decision-making.
• Better communication: since there are fewer employees, information can be intimated
easily and quickly.
• Innovation: small businesses can tend to be innovative because they have less to lose and
are willing to take risks.

Disadvantages of small businesses:

 •

• Higher costs: small firms cannot exploit economies of scale – their average costs will be
higher than larger rivals.
Lack of finance: struggles to raise finance as choice of sources of acquiring finance is limited.
• Difficult to attract experienced employees: a small business may be unable to afford the
wage and training required for skilled workers.
• Vulnerability: when economic conditions change, it is harder for small businesses to survive
as they lack resources.

Small firms still exist in the economy for several reasons:

• Size of the market: when there is only a small market for a product, a firm will see no point
in growing to a larger size. The market maybe small because:
• The market is local – for example, the local hairdresser.
• the final product maybe an expensive luxury item which only require small-scale production
(e.g. custom-made paintings)
• Personalised/custom services can only be given by small firms, unlike large firms that mostly
give standardised services (e.g. wedding cake makers).
• Access to capital is limited, so owners can’t grow the firm.
• Owner(s) prefer to stay small: a lot of entrepreneurs don’t want to take risks by growing the
firm and they are quite satisfied with running a small business.
• Small firms can co-operate: co-operation between small firms can lead them to set up
jointly owned enterprises which allow them to enjoy many of the benefits that large firms
have.
• Governments help small firms: governments usually provide help to small scale firms
because small firms are an important provider of employment and generate innovation in
the production process. In most countries, it is the medium and small industries that
contribute much of the employment.

Growth of Firms

When a firm grows, its scale of production increases. Firms can grow in to ways: internally
or externally.

Internal Growth/Organic Growth

This involves expanding the scale of production of the firm’s existing operations. This can
be done by purchasing more machinery/equipment, opening more branches, selling new
products, expanding business premises, employing more workers etc.

External Growth
This involves two or more firms joining together to form a larger business. This is called
integration. This can be done it two ways: mergers or takeovers.

A takeover or acquisition happens when a company buys enough shares of another firm
that they can take full control. The firm taken over loses its identity and becomes a part of
what is known as the holding company. A well-known example would be Facebook’s
acquisition of WhatsApp in 2014.

A merger occurs when the owners of two or more companies agree to join together to
form a firm.

Mergers can happen in three ways:

1. Horizontal Integration: integration of firms engaged in the production of the same

type of good at the same level of production. Example: a cloth manufacturing company
merges with another cloth manufacturing company.

Advantages:

• Exploit internal economies of scale: including bulk-buying, technical economies,

financial economies.
• Save costs: when merging, a lot of the duplicate assets including employees can be
laid off.
• Potential to secure ‘revenue synergies’ by creating and selling a wider range of
products.
• Reduces competition: by merging with key rivals, the two firms together can
increase market share.

Disadvantages:

• Risk of diseconomies of scale: a larger business will bring with a lot of managerial
and operational issues leading to higher costs.
• Reduced flexibility: the addition of more employees and processes means the need
for more transparency and therefore more accountability and red tape, which can
slow down the rate of innovating and producing new products and processes.

2. Vertical Integration: integration of firms engaged in the production of the same

type of good but at different levels of production (primary/secondary/tertiary). Example: a
cloth manufacturing company (secondary sector) merges with a cotton growing firm
(primary sector).

• Forward vertical integration: when a firm integrates with a firm that is at a later
stage of production than theirs. Example: a dairy farm integrates with a cheese
manufacturing company.
• Backward vertical integration: when a firm integrates with a firm that is at an
earlier stage of production than theirs. Example: a chocolate retailer integrates with
a chocolate manufacturing company.
Advantages:
•

• It can give a firm assured supplies or outlets for their products. If a coffee brand
merged with coffee plantation, the manufacturers would get assured supplies of
coffee beans from the plantation. If the coffee brand merged with a coffee shop
chain, they would have a permanent outlet to sell their coffee from.
• Similarly, one firm can prevent the other firm from supplying materials or selling
products to competitors. The coffee brand can have the coffee plantation to only
 •

supply them their coffee beans. The coffee brand can also have the coffee shop
chain only selling coffee with their coffee powder.
• The profit margins of the merged firm can now be absorbed into the merging firm.
• The firms can increase their market share and become more competitive in the
market.

Disadvantages:

• Risk of diseconomies of scale: a larger business will bring with a lot of managerial and
operational issues leading to higher costs
• Reduced flexibility: the addition of more employees and processes means the need
for more transparency and therefore more accountability and red tape, which can
slow down the rate of innovating and producing new products and processes
• It’s a difficult process: The firms, when vertically integrated, are entering into a stage
of production/sector they’re not familiar with, and this will require staff of either firm
to be educated and trained. Some might even lose their jobs. It can be expensive as
well.

3. Lateral/Conglomerate integration: this occurs when firms producing different type of

products integrate. They could be at the same or different stages of production. Example: a
housing company integrates with a dairy farm. Thus, the firm can produce a wide range of
products. This helps diversify a firm’s operations.

Advantages:

• Diversify risks: conglomerate integration allows businesses to have activities in more

than one market. This allows the firms to spread their risks. In case one market is in
decline, it still has another source of profit.
• Creates new markets: merging with a firm in a different industry will open up the firm to
a new customer base, helping it to market its core products to this new market.
• Transfer of ideas: there could be a transfer of ideas and resources between the two
businesses even though they are in different industries. This transfer of ideas could help
improve the quality and demand for the two products.
Disadvantages:

• Inexperience can lead to mismanagement: if the firms are in entirely different industries
and have no experience in the other’s industry, cooperating and managing the two
industries may be difficult and could turn disastrous.
• Lose focus: merging with and focusing on an entirely new industry could cause the firm
to lose focus of its core product.
• Culture clash: as with all kinds of mergers, there could be a culture clash between the
two firms’ employees on practices, standards and ‘how things are done’.
Scale of Production

As a firm’s scale of production increases its average costs decrease. Cost saving from a large-
scale production is called economies of scale.
Internal economies of scale are decisions taken within the firm that can bring about
economies (advantages). Some internal economies of scale are:
• Purchasing economies: large firms can be buy raw materials and components in bulk because
of their large scale of production. Supplier will usually offer price discounts for bulk purchases,
which will cut purchasing costs for the firm.
• Marketing economies: large firms can afford their own vehicles to distribute their products,
which is much cheaper than hiring other firms to distribute them. Also, the costs of advertising
is spread over a much large output in large firms when compared to small firms.
• Financial economies: banks are more willing to lend money to large firms since they are more
financially secure (than small firms) to repay loans. They are also likely to get lower rates of
interest. Large firms also have the ability to sell shares to raise capital (which do not have to be
repaid). Thus, they get more capital at lower costs.
• Technical economies: large firms are more financially able to invest in good technology, skilled
workers, machinery etc. which are very efficient and cut costs for the firm.
• Risk-bearing economies: large firms with a high output can sell into different markets (even
overseas). They are able to produce a variety of products (diversification in production). This
means that their risks are spread over a wider range of products or markets; even if a market
or product is not successful, they have other products and markets to continue business in.
Thus, costs are less.

External economies of scale occur when firms benefit from the entire industry being large.
This may include:

• Access to skilled workers: large firms can recruit workers trained by other firms. For example:
when a new training institution for pilots and airline staff opens, all airline firms can enjoy
economies of scale of having access to skilled workers, who are more efficient and productive,
and cuts costs.
• Ancillary firms: they are firms that supply and provide materials/services to larger firms. When
ancillary firms such as a marketing firm locates close to a company, the company can cut costs
by using their services more cheaply than other firms.
• Joint marketing benefits: when firms in the same industry locate close to each other, they may
share an enhanced reputation and customer base.
• Shared infrastructure: development in the infrastructure of an industry or the economy can
benefit large firms. Examples: more roads and bridges by the govt. can cut transport costs for
firms, a new power station can provide cheaper electricity for firms.

Diseconomies of scale occur when a firm grows too large and average costs start to rise.
Some common diseconomies are:

• Management diseconomies: large firms have a wide internal organisation with lots of
managers and employees. This makes communication difficult and decision-making very slow.
Gradually, it leads to inefficient running of the firms and increases costs.
 •

• Too much output may require a large supply of raw materials, power etc. which can lead to
shortage and halt production, increasing costs.
• Large firms may use automated production with lots of capital equipment. Workers operating
these machines may feel bored in doing the repetitive tasks and thus become demotivated
and less cooperative. Many workers may leave or go on strikes, stopping production and
increasing costs.
• Agglomeration diseconomies: this occurs when firms merge/acquire too many different firms
producing different products, and the managers and owners can’t coordinate and organise all
activities, leading to higher costs.
• More shares sold into the market and bought means more owners coming into the business.
Having a lot of owners can lead to a lot of disputes and conflicts among themselves.
• A lot of large firms can face diseconomies when their products become too standardised and
less of a variety in the market. This will reduce sales and profits and increase average costs.
A firm that doubles all its inputs (resources) and is able to more than double its output as a
result, experiences increasing returns to scale.
A firm that doubles all its inputs and fails to double its output as a result, experiences a
decreasing or diminishing returns to scale

Firms and Production

Demand for Factors of Production.
Some factors that determine the demand of factors of production:

• The demand for the product: if more goods and services are demanded by consumers, more
factors of production will be demanded by firms to produce and satisfy the demand. That is,
the demand for factors of production is derived demand, as it is determined by the demand
for the goods and services (just like labour demand).
• The availability of factors: firms will also demand factors that are easily available and
accessible to them. If the firm is located in a region where there is a large pool of skilled
labour, it will demand more labour as opposed to capital.
• The price of factors: If labour is more expensive than capital, firms will demand more capital
(and vice versa), as they want to reduce costs and maximize profits.
• The productivity of factors: If labour is more productive than capital, then more labour is
demanded, and vice versa.

Labour-intensive and Capital-intensive production

Labour-intensive production is where more labourers are employed than other factors, say
capital. Production is mainly dependent on labour. It is usually adopted in small-scale
industries, especially those that produce personalised, handmade products.
Examples: hotels and restaurants. Advantages:
 • Flexibility: labour, unlike most machinery can be used flexibly to meet changing levels of
consumer demand, e.g., part-time workers.
• Personal services: labour can provide a personal touch to customer needs and wants.
• Personalised services: labourers can provide custom products for different customers.
Machinery is not flexible enough to provide tailored products for individual customers.
• Gives feedback: labour can give feedback that provides ideas for continuous improvements in
the firm.
• Essential: labour is essential in case of machine breakdowns. After all, machines are only as
good as the labour that builds, maintains and operates them...
Disadvantages:

• Relatively expensive: in the long-term, when compared to machinery, labour has higher per
unit costs due to lower levels of productivity.
• Inefficient and inconsistent: compared to machinery, labour is relatively less efficient and
tends to be inconsistent with their productivity, with various personal, psychological and
physical matters influencing their quantity and quality of work.
• Labour relation problems: firms will have to put up with labour demands and grievances. They
could stage an overtime ban or strike if their demands are not met.

Capital refers to the machinery, equipment, tools, buildings and vehicles used in production. It
also means the investment required to do production.

Capital-intensive production is where more capital is employed than other factors. It is a

production which requires a relatively high level of capital investment compared to the labour
cost. Most capital-intensive production is automated (example: car-manufacturing).
Advantages:

• Less likely to make errors: Machines, since they’re mechanically or digitally programmed to do
tasks, won’t make the mistakes that labourers will.
• More efficient: machinery doesn’t need breaks or holidays, has no demands and makes no
mistakes.
• Consistent: since they won’t have human problems and are programmed to repeat tasks, they
are very consistent in the output produced.
• Technical economies of scale: increased efficiency can reduce average costs Disadvantages:

• Expensive: the initial costs of investment is high, as well as possible training costs.
• Lack of flexibility: machines are not be as flexible as labourers are to meet changes in demand.
• Machinery lacks initiative: machines don’t have the intuitive or creative power that human
labour can provide the business, and improve production.

Production and Productivity

A firm combines scarce resources of land, labour and capital (inputs) to make (produce) goods
and services (output).
 •

Production is thus, the transformation of raw materials (input) to finished or semi-finished

goods and services (output).
In other words, production is the adding of value to inputs to create outputs. It is the
production that gives the inputs value.

Some factors that influence production:

• Demand for product: the more the demand from consumers, the more the production.
• Price and availability of factors of production: if factors of production are cheap and readily
available, there will be more production.
• Capital: the more capital that is available to producers, the more the investment in
production.
• Profitability: the more profitable producing and selling a product is, the more the production
of the product will be.
• Government support: if governments give money in grants, subsidies, tax breaks and so on,
more production will take place in the economy.

Productivity measures the amount of output that can be produced from a given amount of
input over a period of time.
Productivity = Total output produced per period / Total input used per period

Productivity increases when:

• more output or revenue is produced from the same amount of resources

• The same output or revenue is produced using fewer resources.
(Labour productivity is the measure of the amount of output that can be produced by each
worker in a business).

Factors that influence productivity:

• Division of labour: division of labour is when tasks are divided among labourers. Each labourer
specializes in a particular task, and thus this will increase productivity.
• Skills and experience of labour force: a skilled and experienced workforce will be more
productive.
• Workers’ motivation: the more motivated the workforce is, the more productive they will be.
Better pay, working conditions, reasonable working hours etc. can improve productivity.
• Technology: more technology introduced into the production process will increase
productivity.
• Quality of factors of production: replacing old machinery with new ones, preferably with
latest technologies, can increase efficiency and productivity. In the case of labour, training the
workforce will increase productivity.
• Investment: introducing new production processes which will reduce wastage, increase speed,
improve quality and raise output will raise productivity. This is known as lean production.
Firms’ Costs, Revenue and Objectives
Costs of Production
Fixed costs (FC) are costs that are fixed in the short-term running of a business and
have to be paid even when no production is taking place. Examples: rent, interest on
bank loans, insurance premium, property tax. These costs do not depend on the
amount of output produced.
Average Fixed Cost (AFC) = Total Fixed Cost (TFC) / Total Output

Variable costs (VC) are costs that are variable in the short-term running of a business
and are paid according to the output produced. The more the production, the more the
variable costs are. Examples: wages, electricity bill, cost of raw materials. Average
Variable Cost (AVC) = Total Variable Costs (TVC) / Total Output

Total Costs (TC) = Total Fixed Costs (TFC) + Total Variable Costs (TVC)

Average cost or Average total Cost (ATC) is the cost per unit of output. Average
Total Cost (ATC) = Total Cost (TC) / Total Output or
Average Cost (AC) = Average Variable Cost (AVC) + Average Fixed Cost (AFC)
 •

(Remember ‘average’ means ‘per unit’ and so will mean dividing the particular cost by the
total output produced. In the graphs above you will notice that the average variable costs and
average total costs first fall and then start rising. This is because of economies of scale and
diseconomies of scale respectively. As the firm increases its output, the average costs decline
but as it starts growing beyond a limit (optimum output) the average costs rise).

Let’s calculate some costs in an example:

Suppose a TV manufacturer produces 1000 TVs a month. The firm’s fixed cost in rent is $900 a
month, and variable cost per unit is $500. What would its TFC, TVC, AVC, AFC, AC and TC be, in
a month?

No. of units of TVs produced = 1000

Total Fixed Costs for one month = $900

Average Fixed Cost = $900 / 1000 = $0.9 per unit

Variable Cost of producing one unit of TV = $500

Total Variable Costs for producing 1000 TVs in a month = $500 * 1000 = $500,000 Average
Variable Cost = $500,000 / 1000 = $500 (AVC is the same as VC per unit!)

Total Costs = Total Fixed Costs + Total Variable Costs ==> $900 + $500,000 = $500,900
Average Costs = Total Costs / Total Output ==> $500,900 / 1000 = $500.9 or
Average Costs = AFC + AVC ==> $0.9 + $500 ==> $500.9

Revenue
Revenue is the total income a firm earns from the sale of its goods and services. The more
the sales, the more the revenue.
Total Revenue (TR) = No. of units sold (Sales) * Price per unit (P)
Average Revenue = Total Revenue (TR) / No. of units sold (Sales) (= price per unit (P)!)
Suppose, from the example above, a TV is sold at $800 and the firm sells all the units it
produces, what is the firm’s Total Revenue and Average Revenue, for a month?
No. of units sold (Sales) in a month = No. of units produced in a month = 1000
Total Revenue = Sales * Price ==> 1000 * $800 = $800,000
Average Revenue = Total Revenue / Sales = $800,000 / 1000 = $800

Objectives of Firms
Objectives vary with different businesses due to size, sector and many other factors.
However many business in the private sector aim to achieve the following objectives.

• Survival: new or small firms usually have survival as a primary objective. Firms in a highly
competitive market will also be more concerned with survival than any other objective. To
achieve this, firms could decide to lower prices, which would mean forsaking other objectives
such as profit maximization.
• Profit: profit is the income of a business from its activities after deducting total costs from
total revenue. Private sector firms usually have profit as a primary objective. This is because
profits are required for further investment into the business as well as for the payment of
return to the shareholders/owners of the business.
• Growth: once a business has passed its survival stage it will aim for growth and expansion. This
is usually measured by value of sales or output. Aiming for business growth can be very
beneficial. A larger business can ensure greater job security and salaries for employees. The
business can also benefit from higher market share and economies of scale.
• Market share: market share can be defined as the sales of a firm in proportion to total market
sales. Increased market share can bring about many benefits to the business such as increased
customer loyalty, establishment of brand image etc.
• Service to the society: Some operations in the private sectors such as social enterprises do not
aim for profits and prefer to set more social objectives. They aim to serve society by aiding
society financially or otherwise.
A business’ objectives do not remain the same forever. As market situations change and as
the business itself develops, its objectives will change to reflect its current market and
economic position. For example, a firm facing serious economic recession could change its
objective from profit maximization to short term survival.

Market Structure
Competitive Markets
Firms compete in the market to increase their customer base, sales, market share and profits.

Price competition involves competing to offer consumers the lowest or best possible prices of
a product.
Non-price competition is competing on all other features of the product (quality, after-sales
care, warranty etc.) other than price.
 •

Informative advertising means providing information about the product to consumers.

Examples include advertising of phones, computers, and home appliances etc. which include
specific information about their technical features.
Persuasive advertising is designed to create a consumer want and persuade them to buy
the product in order to boost sales. Examples include advertisements of perfumes, clothes,
chocolates etc.

Pricing Strategies
What can influence the price that producers fix on a product?

• Level and strength of consumer demand.

• The amount of competition from rival producers in the market.
• The cost of production and the level of profit targeted.

Price skimming: When a new and unique product enters the market, its producers charge a
very high price for it initially as consumers will be willing to pay more for the new product. As
more competitors begin to launch similar products, producers may lower prices. Apple’s
iPhones are good examples – they are very expensive at launch and get cheaper overtime.
Penetration pricing: when producers set a very low price which encourages consumers to try
the product, helping expand sales and increase loyalty. This way, the product is able to
penetrate a market, especially useful when there are a lot of existing rival products. Netflix,
when it first started out as a DVD rental service, used penetration pricing ($1 monthly
subscription!) to encourage customers to try their service which helped it create a large
customer base.
Destruction pricing (predatory pricing): prices are kept very low (lower than the cost of
production per unit) in order to ‘destroy’ the sales of existing products, as consumers will turn
to the lowest priced products. Once the product is successful, it can raise prices and cover
costs. India’s Reliance Jio, a telecom company, was accused of predatory pricing during its
initial launch years. Predatory pricing is illegal in many countries as it creates a non-
competitive business environment and encourages monopoly practices.
Price wars happen when competing firms continually trying to undercut each other’s prices.
Cost-plus-pricing: this involves calculating the average cost of producing each unit of output
and then adding a mark-up value for profit.
Price = (Total Cost/Total Output) + Mark-up.
This ensures that the cost of production is covered and that each unit produces a profit.

Perfect Competition
In a perfectly competitive market,
- there will be many sellers and many buyers – a lot of different firms compete
to supply an identical product-
- As there is fierce competition, neither producers nor consumers can influence
market price – they are all price takers.-
 - If any firm did try to sell at a high price, it would lose customers to competitors.
If the price is too low, they may incur a loss. – - There will also be a huge
amount of output in the market.
Advantages:
• High consumer sovereignty: consumers will have a wide variety of goods and services to
choose from, as many producers sell similar products. Products are also likely to be of high
quality, in order to attract consumer m
• Low prices: as competition is fierce, producers will try and keep prices low to attract
customers and increase sales.
• Efficiency: to keep profits high and lower costs, firms will be very efficient. If they aren’t
efficient, they would become less profitable. This will cause them to raise prices which would
discourage consumers from buying their product. Inefficiency could also lead to poor quality
products. Disadvantages:
• Wasteful competition: in order to keep up with other firms, producers will duplicate items;
this is considered a waste of resources.
• Mislead customers: to gain more customers and sales, firms might give false and exaggerated
claims about their product, which would disadvantage both customers and competitors.

Monopoly
Dominant firms who have market power to restrict competition in the market are called
monopolies. In a pure monopoly, there is only a single seller who supplies a good or service.
Example: Indian Railways. Since customers have no other firms to buy from, monopolies can
raise prices – that is they are able to influence prices as it will not affect their profitability.
These high prices result in monopolies generating excessive or abnormal profits. Note:
Prices are much higher in a private monopolies than in a public monopoly
Monopolies don’t face competition because the market faces high barriers to entry –
obstacles preventing new firms from entering the market. That is, there might be high startup
costs (sunk costs), expensive paperwork, regulations etc. If the monopoly has a very high
brand loyalty or pricing structures that other firm couldn’t possibly compete with, those also
act as barriers to entry.

Disadvantages:
• There is less consumer sovereignty: as there are no (or very little) other firms selling the
product, output is low and thus there is little consumer choice.
• Monopolies may not respond quickly to customer demands.
• Higher prices.
• Lower quality: as there is little or no competition, monopolies have no incentive to raise
quality, as consumers will have to buy from them anyway. (But since they make a lot of profit,
they may invest a lot in research and development and increase quality).
• Inefficiency: With high prices, they may create high enough profits that, costs due to
inefficiency won’t create a significant problem in their profitability and so they can continue
being inefficient.
Why monopolies are not always bad?
• As only a single producer exists, it will produce more output than what individual firms in a
competition do, and thus benefit from economies of scale.
 •

• They can still face competition from overseas firms hence, may become efficient producing
high quality output.
• They could sell products at lower price and high quality if they fear new firms may enter the
market in the future.

Macroeconomic Aims of Government The

Role of Government
The public sector in every economy plays a major role, as a producer and employer.
Governments work locally, nationally and internationally. Here are the roles they play in the
economy:

• As a producer, it provides, at all levels of government:

• Merit goods (educational institutions, health services etc.)
• Public goods (streetlights, parks etc.)
• Welfare services (unemployment benefits, pensions, child benefits etc.) • Public services
(police stations, fire stations, waste management etc.)
• Infrastructure (roads, telecommunications, electricity etc.).
• As an employer, it provides at all levels of government, employment to a large population,
who work to provide the above mentioned goods and services. It also creates employment by
contracting projects, such as building roads, to private firms.
• Support agriculture and other prime industries that need public support.
• Help vulnerable groups of people in society through redistributing income and welfare
schemes.
• Manage the macro economy in terms of prices, employment, growth, income redistribution
etc.
• Governments also manage its trade in goods and services with other countries by negotiating
international trade deals.

Government Macroeconomic Aims/OBJECTIVES.

The government’s major macroeconomic objectives are:

1 Economic Growth: economic growth refers to an increase in the gross domestic product
(GDP) or the amount of goods and services produced in the economy, over a period of time.
More output means economic growth. Economic growth is an important macroeconomic
objective because it enables increased living standards, improved tax revenues and helps to
create new jobs. But if output falls over time, it will cause an economic recession (negative
economic growth) which can cause:
• fall in employment, incomes and living standards of the people
• fall in the tax revenue the govt. collects from the sale of goods and services and from
incomes, which will, in turn, lead to a cut in govt. spending
• fall in the revenues and profits of firms
 • Low investments, that is, people won’t invest in production as economic conditions
are poor and they will yield low profits.

2 Price Stability: inflation is the continuous rise in the average price levels in an economy
during a time period. Governments usually target an inflation rate it should maintain in a year,
say between 2 to 3%. If prices are low and stable, consumers and businesses can be able to
plan consumption and production way ahead. That is, it creates some form of certainty in the
economy. If prices rise too quickly it can negatively affect the economy because it:
• reduces people’s purchasing powers as people will be able to buy less with the money
they have now than before
• causes hardship for the poor
• increases business costs especially as workers will demand higher wages to support
their livelihood
• Makes products more expensive than products of other countries with low inflation.
This will make exports less competitive in the international market.

3 Full Employment: It is the tendency where a majority of both skilled and unskilled
workers in an economy, that is, those within the working age group are employed, but there is
however, a considerable number of people who are unemployed. This small proportion of
those who are out of work act as a check to rising wages for those in work. This helps to
control inflation. If there is a high level of unemployment in a country, the following may
happen:
• the total national output (goods produced) will fall
• government will have to give out welfare payments (unemployment benefits) to the
unemployed, increasing public expenditure while income taxes fall – causing a budget
deficit
• Large unemployment causes public unrest and anger towards the government.

4 Balance of Payments Stability: The Balance of Payments is a record of a country’s

transactions with the rest of the world. It shows the receipts from trade.
Economies export (sell) many of their products to overseas residents, and receive incomes.
They also import (buy) goods and services from other economies, and make investments in
other countries. These are recorded in a country’s Balance of Payments (BoP).
Exports > Imports = Surplus in BoP
Exports < Imports = Deficit in BoP
All economies try to balance this inflow and outflow of international trade and payments and
try to avoid any deficits because:
• if it exports too little and imports too much, the economy may run out of foreign
currency to buy further imports, pay its debts and manage its exchange rate.
• A BoP deficit causes the value of its currency to fall against other foreign currencies
and make imports more expensive to buy, while a BoP surplus causes its currency to
rise against other foreign currencies and make its exports more expensive in the
international market.

5 Income Redistribution: To reduce the inequality of income among its citizens, the
government will redistribute incomes from the rich to the poor (progressive tax) by imposing
 •

taxes on the rich and using it to finance welfare schemes for the poor. All governments
struggle with income inequality and try to solve it because:
• widening inequality means higher levels of poverty
• Poverty and hardship restricts the economy from reaching its maximum productive
capacity.

Conflict of Macroeconomic Aims

When a policy is introduced to achieve one macroeconomic aim, it tends to conflict with one
or more other aims. In other words, as one aim is achieved, another aim is undone.
Let’s look at some conflicts of government macroeconomic aims.
Full Employment v/s Price Stability
Low rates of unemployment will boost profits of businesses and incomes of workers. This rise
in incomes, mean higher demand and consumption in the economy, which causes firms to
raise their prices– resulting in demand pull inflation. Also, as unemployment falls, it can put
upward pressure on wages, leading to cost push inflation. This is probably the most
prominent policy conflict in the study of Economics.

Economic Growth & Full Employment v/s BoP Stability

Once again, as incomes rise due to economic growth and low unemployment, people will
import more foreign products and consume relatively less domestic products. This will cause a
rise in imports relative to exports and a deficit may arise in the balance of payments.

Economic Growth v/s Full Employment

In the long run, when economic growth is continuous, firms may start investing in more
capital (machinery/equipment). More capital-intensive production will make a lot of people
unemployed.

Budget
A government budget is an annual financial statement which outlines the estimated
government expenditure and expected government receipts or revenues for the forthcoming
fiscal year. Depending on the feasibility of these estimates, budgets are of three types --
balanced budget, surplus budget and deficit budget.

A budget surplus. A government budget is said to be a surplus budget if the expected

government revenues exceed the estimated government expenditure in a particular financial
year. This means that the government’s earnings from taxes levied are greater than the
amount the government spends on public welfare. A surplus budget denotes the financial
affluence of a country but, it can trigger a slowdown of the economy if this surplus is very
large.
A budget deficit. A government budget is said to be a deficit budget if the estimated
government expenditure exceeds the expected government revenue in a particular financial
year. A deficit budget helps generate additional demand and boost the rate of economic
growth. Here, the government incurs the excessive expenditure to improve the employment
rate. This results in an increase in demand for goods and services in the economy.
This type of budget is best suited for developing economies, such as India. Especially helpful in
times of recession.

A balanced budget. A government budget is said to be a balanced budget if the estimated

government expenditure is equal to expected government receipts in a particular financial
year. A balanced budget does not ensure financial stability at times of economic depression or
deflation. Advocated by many classical economists, this type of budget is based on the
principle of “living within means.” They believed the government’s expenditure should not
exceed their revenue.

Government spending
Governments spend on all kinds of public goods and services, not just out of political and
social responsibility, but also out of economic responsibility. Government spending is a part of
the aggregate demand in the economy and influences its well-being. The main areas of
government spending includes defence and arms, road and transport, electricity, water,
education, health, food stocks, government salaries, pensions, subsidies, grants etc.

Reasons governments spend:

• To supply goods and services that the private sector would fail to do, such as public goods,
including defence, roads and streetlights; merit goods, such as hospitals and schools; and
welfare payments and benefits, including unemployment and child benefits, pensions etc.
• To achieve supply-side improvements in the economy, such as spending on education and
training to improve labour productivity.
• To spend on policies to reduce negative externalities, such as pollution controls.
• To subsidise industries which may need financial support, and which is not available from the
private sector, usually agriculture and related industries.
• To help redistribute income and improve income inequality.
• To inject spending into the economy to aid economic growth.

Effects of government spending

• Increased government spending will lead to higher demand in the economy and thus aid
economic growth, but it can also lead to inflation if the increasing demand causes prices to
rise faster than output.
• Increased government spending on public goods and merit goods, especially in infrastructure,
can lead to increased productivity and growth in the long run.
 •

• Increased government spending on welfare schemes and benefits will increase living
standards, and help reduce inequality.
• However too much government spending can also cause ‘crowding out’ of private sector
investments – private investments will reduce if the increase in government spending is
financed by increased taxes and borrowing (large government borrowing will drive up interest
rates and discourage private investment).

Tax
Governments earn revenue through interests on government bonds and loans, incomes from
fines, penalties, escheats, grants in aid, income from public property, dividends and profits on
government establishments etc.; but its major source of revenue comes from taxation. Taxes
are a compulsory payment made to the government by all people in an economy.

There are many reasons for levying taxes in an economy:

• It is a source of government revenue: if the government has to spend on public goods and
services it needs money that is funded from the economy itself. People pay taxes knowing that
it is required to fund their collective welfare.
• To redistribute income: governments levy taxes from those who earn higher incomes and
have a lot of wealth (progressive tax.) This is then used to fund welfare schemes for the poor.
• To reduce consumption and production of demerit goods: a much higher tax is levied on
demerit goods like alcohol and tobacco than other goods to drive up its prices and costs in
order to discourage its consumption and production. Such a tax on a specific good is called
excise duty.
• To protect home industries: taxes are also levied on foreign goods entering the domestic
market. This makes foreign goods relatively more expensive in the domestic market, enabling
domestic products to compete with them. Such a tax on foreign goods and services is called
customs duty.
• To manage the economy: as we will discuss shortly, taxation is also a tool for demand and
supply side management. Lowering taxes increase aggregate demand and supply in the
economy, thereby facilitating growth. Similarly, during high inflation, the government will
increase taxes to reduce demand and thus bring down prices. More on this below.

Classification of Taxes
Taxes can be classifies into direct or indirect and progressive, regressive or proportional.

Direct Taxes are taxes on incomes. The burden of tax payment falls directly on the person or
individual responsible for paying it.
• Income tax: paid from an individual’s income. Disposable income is the income left after
deducting income tax from it. When income tax rise, there is little disposable income to spend
on goods and services, so firms will face lower demand and sales, and will cut production,
increasing unemployment. Lower income taxes will encourage more spending and thus higher
production.
 • Corporate Tax: tax paid on a company’s profits. When the corporate tax rate is increased,
businesses will have lower profits left over to put back into the business and will thus find it
hard to expand and produce more. It will also cause shareholders/owners to receive lower
dividends/returns for their investments. This will discourage people from investing in
businesses and economic growth could slow down. Reducing corporate tax will encourage
more production and investment.
• Capital gains tax: taxes on any profits or gains that arise from the sale of assets held for more
than a year.
• Inheritance tax: tax levied on inherited wealth.
• Property tax: tax levied on property/land.
Advantages:

• High revenue: as all people above a certain income level have to pay income taxes, the
revenue from this tax is very high.
• Can reduce inequalities in income and wealth: as they are progressive in nature – heavier
taxes on the rich than the poor- they help in reducing income inequality.
Disadvantages:

• Reduces work incentives: people may rather stay unemployed (and receive govt.
unemployment benefits) rather than be employed if it means they would have to pay a high
amount of tax. Those already employed may not work productively, since for any extra income
they make, the more tax they will have to pay.
• Reduces enterprise incentives: corporate taxes may demotivate entrepreneurs to set up new
firms, as a good part of the profits they make will have to be given as tax.
• Tax evasion: a lot of people find legal loopholes and escape having to pay any tax. Thus tax
revenue falls and the govt. has to use more resources to catch those who evade taxes.

Indirect Taxes are taxes on goods and services sold. It is added to the prices of goods and
services and it is paid while purchasing the good or service. It is called indirect because it
indirectly takes money as tax from consumer expenditure. Some examples are:
• GST/VAT: these are included in the price of goods and services. Increasing these indirect taxes
will increase the prices of goods and services and reduce demand and in turn profits. Reducing
these taxes will increase demand.
• Customs duty: includes import and export tariffs on goods and services flowing between
countries. Increasing tariffs will reduce demand for the products.
• Excise Duty: tax on demerit goods like alcohol and tobacco, to reduce its demand.
Advantages:

• Cost-effective: the cost of collecting indirect taxes is low compared to collecting direct taxes.
• Expanded tax-base: directs taxes are paid by those who make a good income, but indirect
taxes are paid by all people (young, old, unemployed etc.) who consume goods and services,
so there is a larger tax base.
• Can achieve specific aims: for example, excise duty (tax on demerit goods) can discourage the
consumption of harmful goods; similarly, higher and lower taxes on particular products can
influence their consumption.
• Flexible: indirect tax rates are easier and quicker to alter/change than direct tax rates. Thus
their effects are immediate in an economy.
Disadvantages:
 •

• Inflationary: The prices of products will increase when indirect taxes are added to it, causing
inflation.
• Regressive: since all people pay the same amount of money, irrespective of their income
levels, the tax will fall heavily on the poor than the rich as it takes more proportion of their
income.
• Tax evasion: high tariffs on imported goods or excise duty on demerit goods can encourage
illegal smuggling of the good.

Progressive Taxes are those taxes which burdens the rich more than the poor, in that the rate
of taxation increases as incomes increase. An income tax is the perfect example of
progressive taxation. The more income you earn, the more proportion of the income you have
to pay in taxes, as defined by income tax brackets.
For example, a person earning above $100,000 a month will have to pay a tax rate of 20%,
while a person earning above $200,000 a month will have to pay a tax rate of 25%.

Regressive Taxes are those taxes which burden the poor more than the rich, in that the rate
of taxation falls as incomes increase. An indirect tax like GST is an example of a regressive tax
because everyone has to pay the same tax when they are paying for the product, rich or poor.
For example, suppose the GST on a kilo of rice is $1; for a person who earns $500 dollars a
month, this tax will amount to 0.2% of his income, while for a richer person who earns
$50,000 a month, this tax will amount of just 0.002% of his income. The burden on the poor is
higher than on the rich, making its regressive.

Proportional Taxes are those taxes which burden the poor and rich equally, in that the rate of
taxation remains equal as incomes rise or fall. An example is corporate tax. All companies
have to pay the same proportion of their profits in tax.
For example, if the corporate tax is 30%, then whatever the profits of two companies, they
both will have to pay 30% of their profits in corporate tax.

Qualities of a good tax system (the canons of taxation):

• Equity: the tax rate should be justifiable rate based on the ability of the taxpayer.
• Certainty: information about the amount of tax to be paid, when to pay it, and how to pay it
should all be informed to the taxpayer.
 • Economy: the cost of collecting taxes must be kept to a minimum and shouldn’t exceed the tax
revenue itself.
• Convenience: the tax must be levied at a convenient time, for example, after a person receives
his salary.
• Elasticity: the tax imposition and collection system must be flexible so that tax rates can be
easily changed as the person’s income changes.
• Simplicity: the tax system must be simple so that both the collectors and payers understand it
well.

Impacts of taxation
Taxes can have various direct impacts on consumers, producers, government and thus, the
entire economy.

• The main purpose of tax is to raise income for the government which can lead to higher
spending on health care and education. The impact depends on what the government spends
the money on. For example, whether it is used to fund infrastructure projects or to fund the
government’s debt repayment.
• Consumers will have less disposable income to spend after income tax has been deducted.
This is likely to lead to lower levels of spending and saving. However, if the government spends
the tax revenue in effective ways to boost demand, it shouldn’t affect the economy.
• Higher income tax reduces disposable income and can reduce the incentive to work.
Workers may be less willing to work overtime or might leave the labour market altogether.
However, there are two conflicting effects of higher tax:
Substitution effect: higher tax leads to lower disposable income, and work becomes
relatively less attractive than leisure – workers will prefer to work less.
• Income effect: if higher tax leads to lower disposable income, then a worker may feel the need
to work longer hours to maintain his desired level of income – workers feel the need to work
longer to earn more.
The impact of tax then depends on which effect is greater. If the substitution effect
is greater, then people will work less, but if income effect is greater, people will
work more
• Producers will have less incentive to produce if the corporate taxes are too high. Private firm
aim on making profits, and if a major chunk of their profits are eaten away by taxes, they
might not bother producing more and might decide to close shop.

Fiscal Policy
Fiscal policy is a government policy which adjusts government spending and taxation to
influence the level of economic activity in the economy. Fiscal policy helps the government
achieve its aim of economic growth, by being able to influence the demand, spending and
investments in the economy. It also indirectly helps maintain price stability, via the effects of
tax and spending.
The main instruments of monetary policy are, Government spending (G) and Taxes.
 •

There are two types of fiscal policy.

Expansionary fiscal policy. It is one where government spending is increased and at the time,
taxes are cut (both on incomes and on profits). It is designed to stimulate the economy and is
most often used during a recession, times of high unemployment or other low periods of the
business cycle. The goal of expansionary fiscal policy is to put more money in the hands of
consumers so they spend more (high aggregate demand) and stimulate the economy.

Contractionary fiscal policy. Here the government raises taxes and cuts spending. As
consumers pay more taxes, they have less disposable income to spend, and economic
stimulation and growth slows down. It is used to slow economic growth, such as when
inflation is growing too rapidly due to high aggregate demand.

Monetary Policy
Monetary policy is a government policy that controls money supply in an economy in order
to attain growth and stability. It is usually conducted by the country’s central bank and
usually used to maintain price stability, low unemployment and economic growth.
• The main instrument of monetary policy is interest rate. There
are two types of monetary policy.

Expansionary monetary policy. It is where the government increases money supply by

cutting interest rates. Low interest rates will mean more people will resort to spending rather
than saving, and businesses will invest more as they will have to pay lower interest on their
borrowings. Thus, the higher money supply will mean more money being circulated among
the government, producers and consumers, increasing economic activity. Economic growth
and an improvement in the balance of payments will be experienced and employment will
rise.
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Contractionary monetary policy. It is a policy instrument where the government decreases

money supply by increasing interest rates. Higher interest rates will mean more people will
resort to saving rather than spending, and businesses will be reluctant to invest as they will
have to pay high interest on their borrowings. Thus, the lower money supply will mean less
money being circulated among the government, producers and consumers, reducing
economic activity. This helps slow down economic growth and reduce inflation, but at the
cost of possible unemployment resulting from the fall in output.

The money supply is the total value of money available in an economy at a point of time.
The government can control money supply through a variety of tools including open market
operations (buying and selling of government bonds) and changing reserve requirements of
banks.
The interest rate is the cost of borrowing money. When a person borrows money from a
bank, he/she has to pay an interest (monthly or annually) calculated on the amount he/she
borrowed.
Interest rate is also the returns earned from saving money.
NOTE: (The interest on borrowing is higher than the interest on deposits, helping the banks
make a profit).
Higher interest rates will discourage borrowing and therefore, investments; it will also
encourage people to save rather than consume (fall in consumption also discourage firms
from investing and producing more).
Lower interest rates will encourage borrowing and investments, and encourage people to
consume rather than save (rise in consumption also encourage firms to invest and produce
more).
The monetary authority (central bank) of the country cannot directly change the general
interest rate in the economy. Instead, it changes the interest rates of borrowing between
the central bank and commercial banks, as well as the interest on its bonds and securities.
These will then influence the interest rate provided by commercial banks on loans and
deposits to individuals and businesses.

Supply-side Policy
Supply side policies are microeconomic policies aimed at increasing supply and productivity
in the economy, to enable long-term economic growth. Some of these policies include:
• Public sector investments: investments in infrastructure such as transport and communication
can greatly help the economy by making the flow of resources quick and easy, and facilitate
faster growth.
• Improving education and vocational training: the government can invest in education and
skills training to improve the quality and quantity of labour to increase productivity.
• Spending on health: accessible, affordable and good quality health services will improve the
health of the population, helping reduce the hours lost to illnesses and increasing productivity.
• Investment on housing: as more housing spaces are built, the geographical mobility of the
population will increase, helping increase output.
• Privatization: transferring some public corporations to private ownership will increase
efficiency and increase output, as the private sector has a profit-motive absent in public
sector.
• Income tax cuts: reducing income tax will increase people’s willingness to work more and earn
more, helping increase the supply in the economy.
• Subsidies are financial grants made to industries that need it. More subsidies mean more
money for producers to produce more, thereby increasing supply.
• Deregulation: removing or easing the laws and regulations required to start and run
businesses so they can operate and produce more output with reduced costs and hassle,
encouraging investments.
• Removing trade barriers: the govt. can reduce or withdraw import duties, quotas etc. on
imports so that more resources, goods and services may be imported to increase productivity
and efficiency in the domestic economy. It can also reduce export duties to increase export of
resources, goods and services to other nations, thereby encouraging domestic firms to
increase production.
 •

• Labour market reforms: making laws that would reduce trade union powers would reduce
business costs and increase output. Minimum wages could be reduced or done away with to
allow more jobs to be created. Welfare payments like unemployment benefits could be
reduced so that more people would be motivated to look for jobs rather than rely on the
benefits alone to live. These will not only increase the incentive to work but also increase the
incentive to invest.
For example, India, in the early 1990’s undertook massive privatisation, liberalisation and
deregulation measures; abolishing its heavy licensing and red tape policies, allowing private
firms to easily enter the market and operate, and opening up its economy to foreign trade by
reducing the excessive trade tariffs and regulations. This led to a period of high economic
growth and helped India become the emerging economy it is today.

Supply-side policies have the direct effect of increasing economic growth as the productive
capacity of the economy is realised. In doing so, it can also create more job opportunities and
help reduce unemployment. Trade reforms will also enable to it to improve its balance of
payments.
However, the reliance on public expenditure and tax cuts mean that the government may run
large budget deficits. Deregulation and privatisation will also reduce government intervention
in the economy, which may prompt market failure.

Economic Growth
Economic growth is an increase in the amount (quantity) of goods and services produced per
head of the population over a period of time.
The total value of output of goods and services produced is known as the national output.
This can be calculated in three ways: using output, income or expenditure methods.
GDP (Gross Domestic Product): It is the total market value of all final goods and services
provided within an economy by its factors of production in a given period of time. Nominal
GDP: It is the value of output produced in an economy in a period of time, measured at their
current market values or prices is the nominal GDP.
Real GDP: It is the value of output produced in an economy in a period of time, measured
assuming the prices are unchanged over time. This GDP, in constant prices, provides a
measure of the real output of a country.
GDP per head/capita: this measures the average output/ income per person in an economy.
Since this takes into account the population, it provides a good measure of the living
standards of an economy.

GDP per capita = GDP / Population

An increase in real GDP over time indicates economic growth as goods and services
produced have increased. It indicates that the economy is utilizing its resources better or its
productive capacity has increased. On a PPC, economic growth will be shown by an outward
shift of the PPC, which is also called ‘potential growth’. ‘Actual growth’ occurs when the
economy moves from a point inside the PPC to a point closer to the PPC.
This diagram shows ‘actual growth’ as the economy realizes its potential growth. In order to
experience potential economic growth, the PPC would have to shift outwards.

Causes of economic growth

• Discovery of more natural resources: more resources mean more the production capacity.
The discovery of oil and gas reserves have enabled a lot of economies (Norway, Saudi Arabia
etc.) to grow rapidly.
• Investment in new capital and infrastructure: investment in new machinery, buildings,
technology etc. has enabled firms and economies to expand their production capacities.
Investment in modern infrastructure such as airports, roads, harbours etc. have improved
access and communication in economies, helping in achieving quicker and more efficient
production.
• Technical progress: New inventions, production processes etc. can increase the productivity of
existing resources in industries and help boost economic growth.
• Increasing the quantity and quality of factors of production: A larger and more productive
workforce will increase GDP. More skilled, knowledgeable and productive human resources
thus help increase economic growth. Similarly, good quality capital, use of better natural
resources, innovative entrepreneurs all aid economic growth in the long run.
• Reallocating resources: Moving resources from less-productive uses to more-productive uses
will improve economic growth.

The benefits of economic growth:

• Greater availability of goods and services to satisfy consumer wants and needs.
• Increased employment opportunities and incomes.
• In underdeveloped or developing economies, economic growth can drastically improve living
standards and bring people out of poverty.
• Increased sales, profits and business opportunities.
• Rising output and demand will encourage investment in capital goods for further production,
which will help achieve long run economic growth.
• Low and stable inflation, if growth in output matches growth in demand.
• Increased tax revenue for government (as incomes and spending rise) that can be invested in
public goods and services.

The drawbacks of economic growth:

 •

• Technical progress may cause capital to replace labour, causing a rise in unemployment. This
will be disastrous for highly populated underdeveloped and developing economies, pulling
more people into poverty
• Scarce resources are used up rapidly when production rises. Natural resources may get
depleted over time.
• Increasing production can increase negative externalities such as pollution, deforestation,
health problems etc. Climate change is a consequence of rapid global economic growth.
• If the economy produces over its productive capacity and if the growth in demand outstrips
the growth in output, economic growth may cause demand pull inflation
• Economic growth has also been accused of widening income inequalities in developing
economies, because rich investors and businessmen gain more than the working class and
poor during growth – the benefits of growth are not evenly distributed. This will cause relative
poverty to rise.

*Governments aim for sustainable economic growth which refers to a rate of growth which
can be maintained without creating significant economic problems for future generations,
such as depletion of resources and a degraded natural environment.

Recession
Recession is the phase where there is negative economic growth, that is real GDP is falling.
This usually happens after there is rapid economic growth. High inflation during the boom
period will cause consumer spending to fall and cause this downturn. Workers will demand
more wages as the cost of living increase, and the price of raw materials will also rise, leading
to firms cutting down production and laying off workers. Unemployment starts to rise and
incomes fall.

Causes of recession:
• Financial crises: if banks have a shortage of liquidity, they reduce lending and this reduces
investment.
• Rise in interest rates: increases the cost of borrowing and reduces demand.
• Fall in real wages: usually caused when wages do not increase in line with inflation leading to
falling incomes and demand.
• Fall in consumer/business confidence: reduces both supply and demand.
• Cut in govt. spending: when government cuts spending, demand falls.
• Trade wars: uncertainty in markets, and thus businesses will be reluctant to invest during a
trade war, causing supply to fall.
• Supply-side shocks: e.g. rise in oil prices cause inflation and lower purchasing power.
• Black swan events: black swan events are unexpected events that are very hard to predict. For
example, COVID-19 pandemic in 2020 which disrupted travel, supply chains and normal
business activity, as well consumer demand, has caused recessions in many countries.
Consequences of recession:
• Firms go out of business: as demand falls, firms will be forced to either reduce production to a
level that is sustainable or close shop.
• Unemployment: cuts in production will cause a lot of people to lose work.
• Fall in income: cuts in production also causes fall in incomes.
 • Rise in poverty and inequality: unemployment and lack of incomes will pull a lot of people
into poverty, and increase inequality (as the rich will still find ways to earn).
• Fall in asset prices (e.g. fall in house prices/stock market): recessions trigger a crash in the
stock markets and other asset markets as investors’ and consumers’ confidence in the
wellbeing of the economy during a recession falls. The shares owned by investors will be worth
less.
• Higher budget deficit: due to falling consumption and incomes, the government will see a fall
in tax revenue, causing a budget deficit to grow.
• Permanently lost output: as firms go out of business and employment falls, it results in a
permanent loss of output, as the economy moves inwards from its PPC.

If the economy was producing at A on its PPC, a recession will cause production to fall to B.

Policies to promote economic growth

Expansionary fiscal and monetary policies (demand-side policies) and supply-side policies.
These policies described in the previous sections can be employed to promote economic
growth, depending on the nature of the problems that are holding back the economy from
growing. For example, if it is the poor quality of human capital (labour) that is preventing the
economy from achieving its maximum productive capacity, the government should invest in
education and vocational training centres to improve the quality of the labour force and
increase productivity. If it is a lack of effective demand causing slow growth, the government
should focus on cutting income taxes, indirect taxes and interest rates to boost spending
.
Effectiveness of such policies:
• Demand-side policies that increase the rate of growth above the long-run trend rate will cause
inflation and quickly lead to a recession if not controlled.
• Supply-side policies can take considerable time to take effect. For example, if the government
invested in better education and training, it could take several years for this to lead to higher
labour productivity.
• In a recession, supply-side policies won’t solve the fundamental problem of deficiency of
aggregate demand. Increasing the flexibility of labour markets and encouraging investment
may help to some extent, but unless there is sufficient demand, firms will be reluctant to
increase production and make new investments.

Employment and Unemployment.

 •

Some terms to be familiar with while we’re discussing employment:

Labour force – the working population of an economy, i.e. all people of working age who are
willing and able to work.
Dependent population – people not in the labour force and thus depend on the labour force
to supply them with goods and services to fulfil their needs and wants. This includes students
in education, retired people, stay at home parents, prisoners or similar institutions as well as
those choosing not to work.
Employment is defined as an engagement of a person in the labour force in some occupation,
business, trade, or profession.
Unemployment is a situation where people in the labour force are actively looking for jobs
but are currently unemployed.
All governments have a macroeconomic objective of maintaining a low unemployment rate.

Full Employment is the situation where most of the people in the entire labour force are
employed, with a considerable number out of work to act as a check to rising wages. Full
employment does not mean 0% unemployment rate.

Changing patterns and level of employment

Over time, patterns and levels of employment change. It could be due to the effects of the
business cycle that every economy goes through from time to time (growth and recession). It
could be due to the changes to the demographics (population- age and gender) of the
country. It could also be due to structural changes (dramatic shifts in how an economy
operates). Let’s look at some ways in which this happens:

As an economy develops, it undergoes a structural change as output and employment shifts

from primary sector to manufacturing and then to the tertiary (services) sectors. This can be
seen in rapidly developing countries like India where there employment in agriculture and
allied industries are rapidly falling and people are moving towards the fast-growing service
sector, especially IT and retail.
In the same way, employment moves from the informal sector (formally unrecognised trades
such as street vending- output is not included in GDP and incomes are not taxed) to the
formal sector (recognised – included in GDP and taxes) as economies develops. People who
previously worked as street vendors may work in registered firms, as the economy develops.
Overtime, as an economy develops, the labour force also sees an increase in the proportion
of female labour. As social attitudes become progressive and women are encouraged to
work, more women will enter the labour force and contribute to growth.
Similarly, as the country develops, the proportion of old people may increase in proportion to
young and working people (because death and birth rates fall). This will cause the labour force
to shrink and cause a huge burden on the economy. Japan is now facing this problem as their
birth rates are falling and it is up to a shrinking labour force to support a growing dependent
senior population.
As economies become more market-oriented (government enterprises and interventions
decline), the economy will naturally see a large proportion of the labour force shift to the
private sector.

Measuring unemployment
Economies periodically calculate the number of people unemployed in their economies, to
check the unemployment rate and see what policies they should implement to reduce it if it is
too high. They can do this in two ways:

• Claimant count: unemployed people can file for unemployment claims (benefits/allowances
provided to the unemployed job seekers) by the government. The government can count the
total number of unemployment claims made in the economy to measure unemployment.
• Labour surveys: economies conduct surveys among the entire labour force to collect data
about it. This will include data on the number of people unemployed.

Unemployment rate = number of people unemployed / total no. of people in the labour force

Problems with measuring employment.

Under-employment: people may be officially classed as employed but they may be working
fewer hours than they would like. For example, they may have a part-time job, but want a full-
time job. This is considered as unemployment because they may not fulfil the working hours
needed to be considered employed.
Inactivity rates: the long-term unemployed may become discouraged and leave the labour
market completely. In effect they are not working, but they are classed as economically
inactive rather than unemployed. So, the unemployment rate can be understated.

The causes/types of unemployment

• Frictional unemployment: this occurs as a result of workers leaving one job and spending time
looking for a new one. This type of unemployment is short-lived.
• Cyclical unemployment: this occurs as a result of fall in aggregate demand due to an economic
recession. When demand falls, firms will cut their production and workers will lose their jobs.
There will be a nation-wide rise in unemployment.
• Structural unemployment: this occurs due to the long-term change in the structure of an
economy. Workers end up having the wrong skills in the wrong place – causing them to be
unfit for employment. This can be explained by dividing it further:
• Technological unemployment: this has rose in recent times as industrial robots, machinery
and other technology are being substituted for labour, leaving people jobless.
• Sectoral unemployment: unemployed caused as a sector/industry declines and leave its
workers unemployed.
• Seasonal unemployment: this occurs as a result of the demand for a product being seasonal.
For example, the demand for umbrellas will fall in non-monsoon seasons, and so workers in
umbrella manufacturing firms will become unemployed over those seasons.
 •

• Voluntary unemployment: when people choose not to work for various reasons – they want
to pursue higher education, would like to take a break etc. Because they’re not actively looking
for work, voluntarily unemployed people do not belong to the labour force!

The consequences of unemployment

• People will lose their working skills if they remain unemployed for a long time and may find it
even harder to find suitable jobs. As people remain unemployed, their incomes will be low,
and living standards will fall.
• Unemployment will also lead to poverty, homelessness and ill health and encourage people to
steal and commit other crimes to make money– crime rates will rise.
• People losing skills is not just detrimental to the unemployed individuals but also to firms who
may employ these people in the future. They will have to retrain these workers.
• Firms will have to pay redundancy payments to workers they lay off.
• Workers will be demotivated as they fear they could lose their jobs, especially in a recession.
• As firms lay off workers, they will be left with spare capacity- utilised machinery, tools and
factory spaces, leading to higher average costs.
• Due to low incomes, people’s purchasing power/consumption will fall, causing demand to fall.
• People will need to rely on charity or government unemployment benefits to support
themselves. These benefits are provided from tax revenue. But now, as incomes have fallen
tax revenue will also fall. This might mean that people remaining in work will have to pay more
of their income as tax, so that it can be distributed as unemployment benefits to the
unemployed. The burden on tax-payers will rise.
• Public expenditure on other projects such as schools, roads etc. will have to be cut down to
make way for benefits. There is opportunity cost involved here.
• The economy doesn’t reach its maximum productive capacity, i.e., they are economically
inefficient on the PPC. The economy loses output.

Policies to reduce unemployment

Both demand-side policies and supply-side policies help reduce unemployment. Demand-side
policies will address the unemployment caused by demand deficiency (cyclical) while the
supply-side measures will curtail structural and frictional unemployment.

• Expansionary policies to increase demand: expansionary fiscal policies like cutting down taxes
and increasing government spending (which also creates jobs) and expansionary monetary
policies like cutting interest rates will help boost demand in the economy, to keep production
and employment high. However these will take effect only with a time lag.
Cutting tax rates won’t help if people don’t have confidence in the economy and prefer to
save. Similarly, cutting interest rates will also be ineffective if banks are unwilling to lend to
businesses, due to low confidence in the economy.
• Depreciate the exchange rate: as the currency depreciates, the country’s exports will become
cheaper and so export demand from abroad will increase, helping boost production and
employment in the export industries.
• Control inflation: higher inflation causes firms to lay off workers to reduce costs. So if the
government tries to control inflation via monetary tools (increasing interest rate), it will help
reduce firm costs and increase employment. But there is also the argument that as
employment rises, incomes will also rise, driving up prices again.
 • Cutting unemployment benefits to provide incentive to work: many people don’t work
because they are comfortable living off the unemployment benefits provided by the
government. Cutting down on these benefits, will persuade them to look for work and earn.
But this would of course, go against the welfare principle of the government.
• Restricting imports and encourage exports: a lot of unemployment occurs when good quality
and cheaper foreign products put domestic industries out of business. Controlling imports
using import tariffs and quotas will encourage domestic firms to emerge and increase
production and thus increase employment. Similarly, easing controls on labour intensive
export industries will open up new job opportunities. However such protectionist measures
can harm the country in the long-run as efficient competition from abroad reduces.
• Cutting down minimum wages: minimum wages increase firms’ labour costs and so they will
lay off workers. Lowering the minimum wages will encourage firms to employ more labour.
• Training/Retraining: structural employment issues can be eliminated by retraining the
unemployed in skills required in modern industries. This will also improve occupational
mobility. This is very expensive when done on a large scale across the economy, requiring
training centres to be built, and trainers to be employed. The benefits of providing skills and
training will only be reaped in the long-term.
• Promote industries in unemployed areas: a lot of employment is created when government
provide subsidies and tax breaks for new industries which set up shop in certain backward
regions.
• Increase geographical mobility of labour: frictional unemployment is caused because people
can’t move around to find good jobs. The government can improve labour mobility by
investing in transport and housing services.
• Provide information: frictional unemployment can be eliminated to an extent by making
information available about job vacancies to the unemployed through job centres,
newspapers, government websites etc.

Inflation and Deflation Inflation

Inflation is the general and sustained rise in the level of prices of goods and services in an
economy over a period of time.
For example, the inflation rate in UK in 2010 was 4.7%. This means that the average price of
goods and services sold in the UK rose by 4.7% during that year.

Inflation is measured using a consumer price index (CPI) or retail price index (RPI).
The consumer price index is calculated in this way:
• A selection of goods and services normally purchased by a typical family or household is
identified and placed in an imaginary basket.
• The prices of these ‘basket of goods and services’ will then be monitored at a number of
different retail outlets across the country including online retailers.
• The average price of the basket in the first year or ‘base year’ is given a value of 100.
• Weights are then attached to each item in the imaginary basket. Weights will depend on how
much of consumer income is spent on each item in the basket.
• The average change in price of these goods and services over the year is calculated by
multiplying the weights by their average price change in each year.
 •

• If it rises by an average of 25%, the new index is 125% * 100 = 125%. If in the next year there is
a further average increase of 10%, the price index is 110% * 125 = 137.5%. The average
inflation rate over the two years is thus 137.5 – 100 = 37.5%

Causes of Inflation/types of inflation

• Demand-pull inflation: inflation caused by an increase in aggregate demand is called demand-
pull inflation. This is also defined as the increase in price due to aggregate demand exceeding
aggregate supply. Demand could rise due to higher incomes, lower taxes etc. The demand
curve will shift right, causing an extension in supply and a rise in price.
• Cost-push inflation: inflation caused by an increase in cost of production in the economy. The
cost of production could rise due to higher wage rate, higher indirect taxes, higher cost of raw
materials, higher interest on capital etc. The supply curve will shift left causing a contraction in
demand and a rise in price.
• A lot of economists agree that a rise in money supply in contrast with output is the key
reason for inflation. If the GDP isn’t accelerating as much as the money supply, then there will
be a higher demand which could exceed supply, leading to inflation.
• Imported inflation

The consequences of inflation

• Lower purchasing power: when the price level rises, the lesser number of goods and services
you can buy with the same amount of money. This is called a fall in the purchasing power.
When purchasing power falls, consumers will have to make choices on spending.
• Exports are less internationally competitive: if the prices of exports are high, its
competitiveness in international markets will fall as lower priced foreign goods will rival it. This
could lead to a current account deficit if exports lower (especially if they are price elastic).
• Inflation causing inflation‘: during inflation, the cost of living in the economy rises as you have
to pay more for goods and services. This might cause workers to demand higher wages
increasing the cost of production. If the price of raw materials also increase, the cost of
production again increases, causing cost-push inflation.
• Fixed income groups, lenders, and savers lose: a person who has a fixed income will lose as he
cannot press for higher wages during inflation (his/her real wages fall as purchasing power of
his/her wages fall). Lenders who lent money before inflation and receive the money back
during inflation will lose the value on their money. The same amount of money is now worth
less (here, the people who borrowed gain purchasing power). Savers also lose because the
interest they’re earning on savings in banks does not increase as much as the inflation, and
savers will lose the value on their money.
•

Policies to control inflation

• Contractionary monetary policy that will reduce demand: contractionary monetary policy is
the most popular policy employed to curtail inflation. Raising interest rates will discourage
spending and investing (as cost of borrowing rises) and reduce the money supply in the
economy, helping cut down on demand. However, this will depends a lot on the consumer and
business confidence in the economy. Spending and investing may still continue to rise as
confidence remains high. Another drawback to this policy is that, it takes considerable time
before having an effect.
• Contractionary fiscal policy that will reduce demand: raising taxes will discourage spending
and investing and cutting down on government spending will reduce aggregate demand in the
 economy, helping bring down the price level. However, this is an unpopular policy only
employed when inflation is severe.
• Supply side policies: supply-side policies such as privatisation and deregulation hope to make
firms competitive and efficient, and thus avoid inflationary pressures. But this is a long-term
policy only helping to keep the long-term inflation rate stable. Sudden surges in inflation
cannot be addressed using supply side measures
• Exchange rate policy: Appreciating the domestic currency can lower import prices helping
reduce cost-push inflation arising from expensive imported raw materials. It also makes export
more expensive, helping lower the export demand in the economy as well as creating
incentives for exporting firms to cut costs to remain competitive.

Deflation
Deflation is the general fall in the price level of goods and services in an economy over a given
time period.
Deflation is also measured using CPI, but instead of showing figures above 100, it will show an
index below base year’s price, 100, denoting a deflation. For example, a drop in the average
prices of the basket of goods in a year is 10%, the deflation will be 100 – (90% * 100 = 90%) =
10%.

Causes of deflation

• Aggregate supply exceeding aggregate demand: when supply exceeds demand, there is an
excess of output in the economy not consumed, causing prices to fall.
• Fall in demand the economy: during a recession, a fall in demand in the economy causes
general prices to fall and cause a deflation.
• Labour productivity has risen: higher output will lead to lower average costs, which could
reflect as lower prices for products.
• Technological advance has reduced cost of production, pulling down cost-push inflation.

Consequences of deflation
• Lower prices will discourage production, resulting in unemployment.
• As demand and prices fall, investors will be discouraged to invest, lowering the output/GDP.
• Deflation can cause recession as demand and prices continue to fall and firms are forced to
close down as enough profits are not being made.
• Tax revenue of the government will fall as economic activity and incomes falls. They might be
forced to borrow money to finance public expenditure.
• Borrowers will lose during a deflation because now the value of the debt they owe is higher
than when they borrowed the money.
• Deflation will increase the real debt burden of the government as the value of debt money
increases.

Policies to control deflation

• Expansionary monetary policy to revive demand: cutting interest rates will encourage more
spending and investment in the economy which will stimulate prices to rise. However, if
interest rate is already at a very low point where decreasing it any further won’t increase
spending, because people still prefer to save some money and pay off debts, and banks are not
 •

willing to lend at a very low interest rate, (this situation is called a liquidity trap), then cutting
interest rates will have no effect on spending.
• Expansionary fiscal policy to revive demand: increasing government spending in the economy,
especially in infrastructure will help raise demand, along with cuts in direct taxes. The money
for this expenditure can be created via quantitative easing (selling government bonds to the
public).
• Devaluation: devaluing the currency through selling domestic currency and/or increasing the
money supply will cause export prices to fall, encouraging production of exports, resulting in
higher demand; and also increase prices of imported products which will raise costs and prices
for products in the economy.
• Change deflation expectations: when a deflation is expected, businesses won’t increase wages
and consumers won’t pay higher prices (because they expect prices to fall in the future). This
will cause the deflation they expected. But if the monetary authorities indicate that they
expect higher inflation, firms will pay their workers more and consumer will spend more now,
avoiding a deflation.

Living Standards
Living standards or standards of living refer to all the factors that contribute to a person’s
well-being and happiness

Measuring Living Standards.

Standards of living can be measured in different ways/using different indicators.

1. GDP per head/capita:

This measures the average income per person in an economy.
Real GDP per capita = Real GDP per head / Population

Merits of using GDP per capita to measure living standards:

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

Limitations of using GDP per capita to measure living standards:

• It takes no account of what people can buy using their incomes. A country with a high GDP
per head may be no better off than a country with a low GDP per head, if there are far fewer
products to choose from.
• Similarly, GDP doesn’t consider changes in technology that can have a large impact on living
standards. Machines might have replaced jobs causing more joblessness and deteriorating
living standards.
 • Distribution of income is very unequal in reality, so the GDP per head isn’t some people might
be very rich while others very poor, but the GDP per head will only give the average incomes.
• Real GDP excludes the unpaid work people do at home, for charities, for voluntary
organizations etc. Thus, it understates the total output.
• GDP also doesn’t differentiate between the positive and negative values economies place on
different output/expenditure. For example, if the output rises because the sales of tobacco,
alcohol or pornographic materials have increased, it might show in the records as a rise in GDP
per head but might not actually make people better off. Similarly, GDP might rise if the
government has to spend massively to rebuild the economy after a natural disaster, which
doesn’t mean living standards have risen.
• This measure doesn’t consider leisure activities, health and education levels, environmental
quality etc. – measures that determine people’s happiness and well-being.
• GDP only measures output – not how it actually affects people’s living standards and how it is
used in society.
• The official GDP figures can be overstated due to technical errors or by political manipulation
to look good, and give a wrong picture of living standards.

2. Human Development Index (HDI):

Used by the United Nations to compare living standards across the globe, the HDI combines
different measures into a single index to give a HDI value from 0 (lowest) to 1 (highest). These
are:

• Income index, measured using the average national income – GNI per head, adjusted for
differences in exchange rate and prices in different countries (purchasing power parity).
• Education index, measured by how many years on average, a person aged 25 will have spent
on education (mean years of schooling) and how many years a young child entering school can
be expected to spend in education in his entire life (expected years of schooling).
• Healthcare index: measured by average life expectancy at birth.

The benefits of using HDI to measure living standards:

• It takes into account some major indicators of living standards.

• It recognises that it is not just output or income that determines living standards, but social
factors too.
• It is a useful method to compare global living standards– it shows clear patterns of living
standards.
• It is very useful and reliable measure since it’s produced by the UN and is thus also widely
used and recognised.

The limitations of HDI to compare living standards

• It combines a set of separate indicators into one, so a country with good literacy rates and
living standards but poor life expectancy can have a low HDI value.
• There are wide divergences in HDI within countries
• GNI per head doesn’t say anything about inequalities in income and wealth within countries.
 •

• It doesn’t consider other factors such as environmental quality, access to safe drinking water,
political freedom, and crime rates etc. which are also important indicators of living standards.
• The HDI information for all countries may not be available such as war-struck countries
where official government records are not kept or normal lives have been disrupted.

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

See the full list at http://hdr.undp.org/en/content/2019-human-development-index-ranking

3. Genuine Progress Indicator (GPI) P. 376

The GPI metric was developed out of the theories of green economics genuine progress indicator
(GPI) is a metric used to measure the economic growth of a country. It is often considered an
alternative metric to the more well-known gross domestic product (GDP) economic indicator. The GPI
indicator takes everything the GDP uses into account but adds other figures that represent the cost of
the negative effects related to economic activity, such as the cost of crime, cost of ozone depletion,
and cost of resource depletion, among others. The Genuine Progress Indicator is an attempt to
measure whether the environmental impact and social costs of economic production and
consumption in a country are negative or positive factors in overall health and well-being.

The GPI nets the positive and negative results of economic growth to examine whether or not it has
benefited people overall.

Advantages of Using GPI

1. GDP doesn’t take into account negative externalities of growth. Higher GDP may lead to a
large rise in pollution, crime and congestion leaving people with lower economic welfare and
lower levels of happiness. Therefore, GDP can be misleading as an account of economic
welfare.
2. By focusing on a wider measure of economic indicators, it encourages policymakers to think
in broader terms of economic welfare and not just crude GDP statistics.
3. Encourages long-term planning. i.e. sustainable growth rather than short-term measures
which increase GDP at expense of damaging the environment.

Disadvantages of Using GPI

• Many non-economic variables such as the value of leisure time/environment are very
subjective and it can be difficult to assign an economic value. GDP is simpler and gives less
normative results.
• Not useful for judging the state of the business cycle.

Conclusion
Rather than GDP vs GPI, it is useful to use both and see them as complementary indexes. GDP will
always have a use for economic accounting. However, it clearly has limitations. Using an additional
measure such as GPI helps to give a better understanding of real economic development.
Reasons for differences in living standards and income
distribution within and between countries
These have been discussed above in the merits and limitations of using GDP per capita and
HDI. More will be discussed in the coming chapters. Some other reasons are discussed
below

Difference in living Standards within a country:

There can be variations in living standards within a country. An excellent example of this is
the high living standards in the Indian state of Kerala which has a HDI index of 0.779 while
the poorest state of Bihar stands at 0.567 (2018). Some causes for this are:
• Regional variances in income and consumption.
• Major type of sectors/jobs: manufacturing and services heavy regions will have higher
incomes, education and health services compared to agricultural regions.
• Local government provisions of education and health.

Difference in living Standards between countries:

• Productivity of industries: more productive industries yield more output and incomes.
• Major industries: what makes countries like Qatar and Norway achieve some of the world’s
highest per capita incomes is that their income comes mostly from their petroleum industries
which produce and export a highly demanded scarce resource.
• Population: dense populations lower per capita income and put pressure on scarce resource
• Ability of citizens pay taxes: higher tax-base and taxable incomes allow governments to invest
in infrastructure and welfare programmes.
• Provision of health and educational facilities.
• Variety of goods/services produced: if citizens can choose from a wide variety of products,
living standards rise. Western countries like the US enjoy this.
• War, crime and natural disasters: war-struck countries of Asia, the high crime rates of Latin
America and frequent natural disasters in island countries, drive down their living standards as
they damage infrastructure and put people in hardship.

Poverty
Absolute poverty: the inability to afford basic necessities needed to live (food, water,
education, health care and shelter). This is measured by the number of people living below a
certain income threshold (called a poverty line).
Relative poverty: the condition of having fewer resources than others in the same society. It is
measured by the extent to which a person’s or households financial resources fall below the
average income level in the economy. Relative poverty is basically a measurement of income
inequality since a high relative poverty should indicate a higher income inequality.
 •

Causes of poverty
Unemployment: when people are unemployed and have to go without income for a long
time, they may end up having to sell their possessions, consume less and go and into
poverty.
• Low education levels: this means that people are uneducated, unskilled and unable to find
better jobs, keeping them in poverty.
• The size of family: more family members with only a few people earning, means more costs of
living, pulling the family into poverty if they’re not earning much.
• Age: older people are likely to have more health problems and be less suitable for further
employment, causing poverty. Young people are still employable and may find ways to earn an
income.
• Poor government support for basic services.
• Poor health: ill mental and physical health is both a cause and result of poverty.
• Overpopulation: high population density will put pressure on scarce resource and the
economy may not be able to produce and provide for everyone, causing poverty.
• Minority group/ethnicity/migrants: will face discrimination from bureaucrats, employers and
the society at large and so won’t be able to access and enjoy all services. E.g.: African
Americans in the US tend to be poorer than their white counterparts.
• Gender: women usually face discrimination, especially in employment and end up being
poorer than men.

Policies to alleviate poverty.

• Introduce measures to reduce unemployment: an expansionary fiscal/monetary policy will
increase aggregate demand and increase employment opportunities. Income and standards of
living will rise.
• Impose progressive taxes: income taxes are progressive, that is, they increase as income
increases. Imposing these will mean that people on higher incomes will pay a large percentage
of their incomes as tax and help reduce relative poverty.
• Introduce welfare services: money from taxes can be provided as income support to people
with very low incomes. It can also be used to provide free or low-cost homes, healthcare and
education.
• Introduce minimum wage legislation to raise the wage of low-paid employees.
• Increase the quantity and quality of education.
• Attract and invite inward investments from firms abroad to provide jobs and incomes for
people.
• Overseas aid could be gained from foreign governments and aid agencies. This will include
food aid, financial aid, technological aid, loans and debt relief.

Population
Population is the total number of people inhabiting a specific area. Two-hundred years ago,
the world population was just over a billion, now it is about 7.7 billion, with China and India
having populations above 1 billion each! It is projected to hit 10 billion by 2056.
Factors that affect population
• Birth rates: the average number of children born in a country each year compared
to the total population of an economy is known as the birth rate. This is usually
expressed as the number of births for every 1000 people in the population.

Why do different countries have different birth rates?

• Living standards: improved quality and availability of food, housing, clean water
and medical care result in fewer babies dying. Countries where children often die
due to poor living standards have higher birth rates (people have more children
fearing that some of their children might die. These children can then work to
produce food and earn incomes).
• Contraception: increased use of contraception and legalisation of abortion have
reduced birth rates in developed countries.
• Customs and religion: many religious beliefs don’t allow the use of contraceptive
pills, so birth rates in those communities rise. In developed economies it is now less
fashionable to have large families, so birth rates have fallen.
• Changes in female employment: more females in developed countries entering the
labour force has resulted in falling birth rates since they do not want motherhood
to affect their careers.
• Marriage: in developed countries, people are tending to marry later in life, so birth
rates have reduced.
• Death rates: the number of people who die each year compared to every 1000
people of the population is the death rate of an economy.

Reasons for differing death rates in different economies:

• Living standards: just as birth rates, death rates also tend to be very high in
lessdeveloped economies due to lack of good-quality food, shelter and medical
care. Malnutrition remains the major cause of high death rates in these countries.
In developed countries, the major causes of death include lifestyle diseases, mostly
caused by unhealthy diets.
• Medical advances and heath care: lack of medical care and infrastructure in
lessdeveloped countries continue to be a cause for high death rates.
• Natural disasters and wars: hurricanes, floods, earthquakes and famine due to lack
of rain and poor harvests, and wars and civil conflicts increase death rates.
• Net Migration: migration refers to the number of people entering (immigration)
and leaving (emigration) the country. Net migration measures the difference
between the immigration and emigration to and from an economy. A net inward
migration will increase the working population of the economy, but can put
pressure on government’s finances as demand for housing, education and welfare
increase. A net outward migration may increase the income per capita (if the
emigrants send money to families back home) and thus the HDI, but can result in
loss of skilled workers.

Reasons for differing net migration in different economies:

• Living standards: people move to countries where living standards are high which
they can benefit from.
 •

• Employment/wages: people migrate mainly to seek better job opportunities.

Widespread unemployment and low wages in the home country will cause people
to move to countries with better employment opportunities and higher wages.
• Climate: very cold or very warm countries/regions will face more emigration than
other countries.

Population structure
The structure of a population can be analysed using:
Age distribution: the number of people in each age-group.
Falling birth and death rates mean that the average age in developed countries are rising
whereas in developing and less-developed economies, high death and birth rates result in
low average ages. The median age in developed Monaco is highest at 53.1 while in
underdeveloped Niger it is just 15.3.

Consequences of an ageing population:

• The workforce will decline and there will be much dependence on the tax-paying
population to fund the welfare of old people.
• Increase in demand for products for old people including healthcare.
• The government will have to spend more on housing, old age welfare schemes etc.
• Old people are less mobile and so the economy will be slow to adapt to new
technologies.
• Gender distribution: the balance of males and females. The sex ratio measures the
no. of males to the no. of females (the global sex ratio is 101:100; while Arab
countries have sex ratios as high as 2.87, island countries register low sex ratios).
Since the average female lives longer than the average male, there are more
females in the older age-groups than males. Gender imbalance is an excess of
males or females and is caused by
• Wars killing many young males
• Violence towards females (honour killings, rapes)
• Sex-specific immigration – more males immigrate to a country looking for work

Consequences of changes in the gender distribution:

• having more females will encourage birth rates to rise and increase population
growth
• more females in employment will increase productivity
• more females in education and employment will increase living standards
• a more balanced gender distribution can aid better social equality as social attitudes
towards women in education and employment become progressive

Population pyramids display the age and gender distribution of an economy. The vertical
axes show the age groups and the horizontal axes show the gender groups- males on the left
and females on the right.
 • Geographic distribution: where people live. 90% of the world population live in
developing countries. This puts a lot of pressure on scarce resources in these
countries. About half of the world population live in urban areas, and this continues
to rise, which has helped increase production and living standards but resulted in
rapid consumption of natural resources and high levels of pollution and congestion.
• Occupational distribution: what jobs people work in? In developed economies,
more people work in the service sector while in less-developed economies, most
people work in agriculture. In developing economies, there is a huge migration of
workers from primary production to manufacturing and service sectors. Female
employment and self-employment are also rising, which will add to production and
higher living standards.

An optimal population is one where the output of goods and services per head of the
population is maximised. An economy is underpopulated when it does not have enough
labour to make the best use of its resources; and it is overpopulated when the population is
too large given the resources it has.

Effects of increasing population size

• Increases size of the home market and thus potential for increase in aggregate
demand in the long-run.
• Higher demand and incomes will lead to more economic growth and expansion.
• Increased supply of labour.
• Puts more pressure on already scarce resources, especially land.
• More capital goods will have to be produced to sustain and satisfy the needs and
wants of the enlarged population.
• Fall in rate of productivity in line with the law of diminishing returns – too many
people working on limited resources means low productivity.
• Shift of employment and output from the primary sector towards the services
sector because land for primary activities is fixed, but want for services is practically
 •

infinite as population grows, and the emergence of mechanisation and technologies

will force people out of the primary sector.
Congestion of urban centres: as population and incomes rise, people will move to cities and
towns which will become crowded. There will be need for heavy transport, communications,
housing, waste management infrastructure spending.

Developed and Less-developed Economies

Economic development refers to the increase in the economic welfare of people through
growth in productive scale and wealth of an economy. Governments aim for their countries to
expand from developing economies to developed economies.
Developed countries are characterised by high GDP per capita, high life expectancy, high
literacy rate, a stable or dwindling population growth, excellent infrastructure, and high levels
of foreign investments, excellent healthcare, high productivity, and a relatively large tertiary
sector. Example: Japan
Under-developed economies or less-developed economies are characterised by very low
GDP per capita, high population growth, poor infrastructure, healthcare and education,
low literacy rates, low levels of foreign investments, poor productivity, and a relatively
large primary sector. Example: Somalia
Developing economies are countries that are becoming more developed through expansion
of the industrial sector and fewer people suffering the extremes of poverty. They may attract
high levels of foreign investments and will be undergoing major economic shifts towards the
tertiary sector. However they may still have a low standard of living, owing to high
population growth. Example: India

The reasons for low economic development

• Over-dependence on agriculture: farming is the most common work in less-developed
economies. Most people work to feed themselves and their families and sell off any surplus.
This means that there is little or no trade happening, which results in poor incomes, no
economic growth or development.
• Domination of international trade by developed economies: the wealthier developed
economies have exploited poorer countries by buying up their natural resources at low prices
and selling products made from them in international markets at higher prices. Rich countries
also protect their industries by paying subsidies to domestic producers, increasing global
supply, and in turn, lowering prices. Poor economies cannot compete with these very low
prices, and they lose their jobs and incomes.
• Low levels of savings because of low incomes and widespread poverty.
• Lack of capital: low incomes in under-developed economies lead to a lack of savings that could
be invested in industries.
• Poor investment in infrastructure: good infrastructure in transport, health and education is
essential for growth and development.
• High population growth: rapidly expanding populations (due to high birth rates) in less
developed countries will reduce the real GDP/income per head.
• Wars and conflicts deplete resources: there is little scope for development when the country
is a war zone.
 • Corrupt and/or unstable governments: causes neglect of economy and citizens’ welfare The
opposites are true for developed economies.
*Some development indicators that are used to measure how developed an economy are:
- GDP per capita,
-population living on less than $1 a day,
-life expectancy at birth,
-adult literacy rate,
- Access to safe water supplies and sanitation,
-proportion of workers in different sectors of production etc.

International Specialization
Specialisation is when a nation concentrates its productive efforts on producing a limited
variety of goods and services in which they’re really efficient and productive at and have an
advantage over other economies in.
For example, due to the existence of vast oil and gas reserves in the region, Middle-Eastern
countries concentrate their production on petroleum and have made a fortune off of it.

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

Absolute advantage: when one country can produce more efficiently than another either by
producing more of a good or service with same amount of resources or producing the same
amount of a good or service with fewer resources.
For example, India has an absolute advantage in operating call centres because of its
abundant and cheap labour force, compared to western countries.

Comparative advantage: when one country can produce a good at a lower opportunity cost
(in terms of other goods and services being forgone) than another country. It takes into
account the opportunity cost incurred in producing each good.
For example, India may have an absolute advantage in operating call centres (against
Philippines), but it has lower opportunity costs in other IT industries, than Philippines. Thus,
Philippines has, in recent years, seen a growing call centre industry while India has seen
theirs decline.
Note: you are not required by the syllabus to know the terms ‘absolute advantage’ and
‘comparative advantage’, but only the principles.

Advantages of international specialisation:

• Economies of scale and efficiency: just like specialisation by individuals, countries can
specialise in what they do best, and this leads to efficiency and economies of scale. It can
therefore increase output while reducing costs. When more countries specialise, world
output increases.
 •

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

Disadvantages of international specialization:

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

Globalisation, Free Trade and Protection.

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

Multinational Corporations (MNCs)

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

Advantages to home country:

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

Advantages to host country:

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

Disadvantages to home country:

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

Disadvantages to host country

• Domestic businesses may not be able to compete with MNC’s efficiency, low costs, and low
prices and brand image, and may be forced to close shop.
• MNCs may not act ethically or in a socially responsible way, especially by taking advantage of
weak countries who gain a lot from the MNCs presence in their country. For example,
exploiting workers with low wages and poor working conditions in a country where labour
laws are weak.
•

• MNCs may be accused of imposing their culture on the host country, perhaps at the expense
of the richness of local culture.
• Profits earned by MNCs may be remitted back to the MNC’s home country rather than being
reinvested in the host economy.
• MNCs may make use of transfer pricing and other tax avoidance measures to reduce the
profits on which they pay tax to the government in the host country.
FREE TRADE AND PROTECTION

Free trade is when there are no restrictions for trade between economies.

The advantages of free trade:

• Allows countries to benefit from specialisation: if there was no international trade, then
countries wouldn’t be able to specialise – that is, they would have to become self-sufficient
by producing all the goods and services they require themselves. Total output would lower
and costs would rise. With specialization and free trade, output, incomes and living
standards will improve.
• Increases consumer choice: consumers can now enjoy a variety of products from around the
globe.
• Increases competition and efficiency: international trade means that there will be more
competition among firms in different countries. This would help increase efficiency.
• Creates new business opportunities: free trade will allow businesses to produce and sell
goods for overseas consumers and expand and grow their operations by doing so. Profits
and revenue would rise.
• Enables firms and economies to benefit from the best workforces, resources and
technologies from around the world.
• Increases economic inter-dependency and thus fosters cooperation and reduces potential
for international conflicts.

The disadvantages of free trade:

• Free trade may reduce opportunities for growth in less-developed economies and threaten
jobs in developed economies. Small businesses in developing countries may not be able to
compete with larger foreign firms. Established businesses in developed countries may lose
market share as new firms keep entering the market. The US has seen considerable
unemployment in manufacturing sectors since China joined the WTO and flooded
international markets with their cheap products.
• Causes rapid resource depletion and climate change as more resources are used up by
firms.
• Exploitation of workers and the environment: free trade has allowed firms to relocate to
countries with lower costs (usually lower wages), where workers and the environment can
be exploited (as health, safety and environmental laws in such countries are likely to be
relaxed).
• Income inequality worsens: multinational firms and consumers have dominated the
international supply and demand. This means that the rich keep getting richer (by buying
and selling more products) while the poor lose out on products and resources.

Protection. It involves the use of trade barriers by governments to restrict international

market access and competition. Trade barriers include:
• Tariffs: these are indirect taxes on imported (or exported) goods that make them more
expensive, imposed in order to discourage domestic consumers from buying them.
• Subsidies: government allows subsidies to domestic producers so that they can increase
their output and reduce costs and in turn reduce prices, in the hope that consumers will be
encouraged to buy inexpensive domestic goods rather than imports.
 • Quotas: this is a limit on the number of imports allowed into a country in a given period.
Restricting supply will push up their market prices and discourage consumption of those
imports.
• Embargo: this is a complete ban on imports of a good to a country.
• Excessive quality standards: imports may only enter a country after extensive quality checks
which will be costly and so foreign producers will be discouraged to sell their products in the
country, reducing imports.

Reasons for protection:

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

Consequences of protection:

• They restrict consumer choice.

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

Foreign Exchange Rates

The foreign exchange rate is the value or price of a currency expressed in terms of another
currency. For example, £1 = $1.2.
This exchange rate will be used when these countries trade and need to convert money. So
if a person were to convert £100 into dollars, he would get $120 (100 * 1.2).
The foreign exchange rate of each currency is determined by the market demand and
supply of the currency.
• Demand for the a currency, say the pound sterling, exists when foreign consumers want to
buy and import goods and services from the UK, when overseas companies buy pounds to
invest in the UK etc. Here, the UK’s currency is being demanded abroad.
• Supply of a currency, say the pound sterling, exists as UK consumers want to buy and import
goods and services from other countries, when UK companies buy foreign currencies to
invest abroad. Here the UK’s currency is being supplied abroad.
• The price at which demand and supply of the currency equals is the equilibrium market
foreign exchange rate value of a currency against another currency. An increased supply and
decreased demand causes the exchange rate to fall, while a decreased supply and increased
demand causes the exchange rate to rise.

Causes of foreign exchange rates fluctuations:

• Changes in the demand for exports and imports: when a country’s import value is greater
than its export value (which is a deficit), it means that more of their currency is being
supplied (going out) than being demanded. The exchange rate for the country’s currency will
fall. If there is a surplus in the current account, the exchange rate will rise.
 • Inflation: if the inflation in a country is higher than that of other countries it trades with, the
price of that country’s goods in the international market will be higher compared to goods
from other countries. The demand for the country’s goods will fall and the so the currency
demand will also fall, causing a fall in exchange rate.
• Changes in interest rate: if a country’s interest rate rises, overseas residents may be keen to
save or invest money in that country. The demand for the currency will rise, and the
exchange rate will rise. If interest rates fall below that of other countries, the currency will
fall in value as overseas demand falls.
• FDI/MNCs: globalisation and economic activities of multinational companies mean that
investment in overseas production plants requires the use of foreign currencies. For
example, a US company with factories in UK needs to pay its labour with pound sterling, not
with the US dollars, increasing the demand for the pound. Thus, inward FDI will boost the
demand for a currency and increase its foreign exchange value. In contrast, outward FDI will
increase the supply of a currency and cause its foreign exchange rate to fall.
• Speculation: foreign exchange traders and investment companies move money around the
world to take advantage of higher interest rates and variations in exchange rates to earn a
profit. As huge sums of money are involved (known as ‘hot money’), this can cause exchange
rate fluctuations, at least in the short run. If speculators lack confidence in the economy they
will withdraw their investments in that country, thereby causing a fall in the value of the
currency. In contrast, high confidence in the economy will invite investments and raise the
foreign exchange value of the currency.
• Government intervention: government intervention in the foreign exchange market can
affect the exchange rate. For example, if greater demand for British goods causes a rise in
the value of the pound, the Bank of England (UK’s central bank) can sell their reserves of
pound sterling in the foreign exchange market to increase its supply and cause a fall in its
value.

A rise in demand for the domestic currency (or a fall in supply – shift of supply curve to the left)
causes its exchange rate to rise
A fall in demand for the domestic currency (or a rise in supply – shift of supply curve to the right)
causes its exchange rate to fall

Consequences of foreign exchange rate fluctuations:

• A fall in the foreign exchange rate causes import prices to rise and export prices to fall. A
fall in the foreign exchange rate, of say the pound, means that now you have to pay more
pounds when you’re importing an American good to the UK, for example. If the initial
exchange rate is $1 = £0.8, and the original price of the good was $2, you’d have to pay £1.6
($2 * £0.8) to buy the good. Now, suppose the exchange rate falls to $1 = £1 (a pound is now
worth lesser dollars), you’d have to pay £2 ($2 * £1) to buy the good.
Similarly, a fall in the foreign exchange rate of the pound means that now you’ll to get fewer
dollars when you’re exporting a British good to America. Using the initial exchange rate as
described above, an export initially costing £2 means American consumers will have to pay
$2.5 (£2 / £0.8) to buy it. After the exchange rate falls, they will have to pay only $2 (£2 /
£1).
• A rise in the foreign exchange rate causes import prices to fall and export prices to rise. A
rise in the foreign exchange rate, of say the pound, means that now you have to pay fewer
pounds when you’re importing an American good to the UK, for example.
If the initial exchange rate is $1 = £0.8, and the original price of the good was $2, you’d have
to pay £1.6 ($2 * £0.8) to buy the good. Now, suppose the exchange rate rises to $1 = £0.5 (a
pound is now worth more dollars), you’d have to pay only £1 ($2 * £0.5) to buy the good.
Similarly, a rise in the foreign exchange rate of the pound means that now you’ll get more
dollars when you’re exporting a British good to America. Using the initial exchange rate as
described above, an export initially costing £2 means American consumers will have to pay
$2.5 (£2 / £0.8) to buy it. After the exchange rate rises, they will have to pay $4 (£2 / £0.5).
• Now, if the country’s export and import demands are price elastic (relatively more sensitive
to price changes), a fluctuation in the exchange rate and the subsequent changes in the
prices of exports and imports will change the demand for them.
A fall in exchange rate will make imports expensive and exports cheap, so import demand
and spending will fall and export demand and spending will rise.
A rise in the exchange rate will make imports cheaper and exports expensive, so import
demand and spending will rise and export demand and spending will fall.
• Hence, we can conclude that when PED > 1 (elastic), a fall in foreign exchange rate will
improve the trade balance (reduce deficits) of the country as exports will rise relative to
imports.
• On the other hand, when PED < 1 (inelastic), a rise in foreign exchange rate will worsen the
trade balance (but reduce surplus) of the country as imports will rise relative to exports.
EXCHANGE RATE SYSTEMS.
Floating Foreign Exchange Rate
This is an exchange rate that is determined freely by market demand and supply
conditions, and so will fluctuate regularly.
The rise in the value of one currency against others, on a floating exchange rate is known as
appreciation of the currency.
The fall in the value of one currency against others, on a floating exchange rate is known as
depreciation of the currency.

Advantages:
• Automatic Stabilisation: any disequilibrium in the balance of payments would be
automatically corrected by a change in the exchange rate. For example, if a country suffers
from a deficit in the balance of payments, then the country’s currency should depreciate.
This would cause the country’s import demand to fall (as imports become expensive) and
export demand to rise (as export prices fall). The balance of payments equilibrium would
therefore be restored. Similarly, a surplus would be eliminated as the currency appreciates.
• Frees up internal policy: a floating exchange rate allows a government to pursue internal
policy objectives such as full employment and growth, not having to worry about balance of
payments imbalances as they will be automatically adjusted.
• Insulated from external changes: a floating exchange rate helps to insulate a country from
inflation elsewhere. If a country were on a fixed exchange rate then it would ‘import’
inflation through higher import prices. A floating exchange rate would automatically adjust
demand and supply in the economy and avoid such external disturbances.
• Don’t need too much foreign reserves: under a floating exchange rate system, there is no
need to maintain reserves to deliberately change the exchange rate. These reserves can
therefore be used to import capital goods in order to promote faster economic growth.

Disadvantages:
• Uncertainty: since currency values fluctuate constantly, businesses, investors and
consumers will be uncertain about the economy and its future. They may lose confidence in
the economy if it fluctuates too rapidly.
• Lack of Investment: the uncertainty introduced by floating exchange rates may discourage
direct foreign investment. They will prefer to invest in countries with fixed exchange rate
systems where they can effectively predict economic conditions and act accordingly.
• Speculation: the day-to-day fluctuations in exchange rates may encourage speculative
movements of ‘hot money’ from country to another, thereby causing more exchange rate
fluctuations.
• Lack of Discipline: the need to maintain an exchange rate imposes a discipline upon the
national economy, which is absent in a floating exchange rate regime. With a floating
exchange rate, short-run problems such as domestic inflation may be ignored until they lead
to a crisis.
Fixed Foreign Exchange Rate
A fixed exchange rate is one that is fixed and controlled by the central bank, acting on behalf
of the government of the country. The central bank will intervene in the market by buying
and selling its currency in the foreign exchange market to maintain a fixed exchange rate.
A deliberate fall in the value of a fixed exchange rate is called a devaluation.
A deliberate rise in the value of a fixed exchange rate is called a revaluation.
Advantages:
• Certainty: since the currency value is kept in check, there will be more certainty in the
economy and businesses, consumers, investors and governments won’t have to worry about
the effects of automatic changes in exchange rate.
• Stability encourages investment: a fixed exchange rate provides greater certainty and
encourages firms to invest. One of the reasons Japanese firms are reluctant to invest in UK is
because the pound works on a flexible exchange rate (unlike the Euro which is on a fixed
system), causing uncertainty about the economy.
• Keep inflation low: depreciation of a currency can cause inflation as demand, prices and
costs for firms rise. On a fixed exchange rate, firms have an incentive to keep cutting costs to
remain competitive.
• Balance of Payments stability: since the exchange rate is not determined by market forces,
sudden changes in the balance of payments will be eliminated, keeping it stable instead.

Disadvantages:
• Conflict with other macroeconomic objectives: the goal to maintain a fixed exchange rate
may conflict with other macroeconomic objectives when the government intervenes with its
policies. For example, if it raises interest rates to remove the pressure of the currency to fall,
economic growth might be adversely affected.
• Less flexibility: in a fixed exchange rate, it is difficult to respond to temporary shocks. For
example, if the price of oil increases, a country which is a net oil importer will see a
deterioration in the current account balance of payments. But since the country operates a
fixed exchange rate, it cannot devalue the currency too much and thus cannot make an
effective intervention to improve the current account.
• Risk of overvaluation or undervaluation: it is difficult to know the right rate to fix the
exchange rate at. If the rate is too high, it will make exports uncompetitive. If it is too low, it
could cause inflation. It is difficult to ascertain the opti mum foreign exchange rate.

Current Account of Balance of Payments

The Balance of payments is a record of all the monetary transactions between residents of
a country and the rest of the world over a given period of time. It is divided into three main
accounts: the current account, the capital account and the financial account.
(In the explanation below, we’ll look at the balance of payments from the point of view of
the UK)
The Current Account
The Current account records the following:

• The visible trade (in goods)

• The invisible trade (in services)
• Net income received or made in payment for the use of factors of production (
also called net primary income):
• income debits (outflows) include wages paid to overseas residents working in the
UK, interests, profits and dividends paid out to overseas residents and firms who
have invested in the UK
• income credits (inflows) include wages paid to UK residents working overseas,
interests, profits and dividends earned by UK residents and firms on investments
they have in other countries
• income received – income paid = net income received
• Net current transfers, which include payments between governments for
international cooperation and other transactions that involve payments for non-
productive activities (also called net secondary income):
• debits (outflows) will include financial aid, donations, pension payments etc. paid
to overseas residents and foreign governments, and tax and excise duties paid by
UK residents on foreign purchases
• credits (inflows) will include financial aid, donations, grants, pension payments
etc. received from overseas residents and foreign governments, and tax and
excise duties paid by overseas residents on UK purchases
• transfers received – transfers paid = net transfers

A current account example:

$
(billion)
Item
Visible exports (Xv)
784.2

Visible imports (Mv)

1230.4

-446.2
Balance of trade (Xv – Mv =A)

Invisible exports (Xi)

286.4
 219.9
Invisible I mports (Mi)

Balance on services (Xi – Mi =B)

66.5

Net primary income (C)

21.0

Net secondary income (D)

-58.6

Current account balance (A + B +

C + D)
-417.3

Current Account Deficit

When the financial outflows in the current account exceed the financial inflows, the current
account is in deficit.

Causes:

• Higher exchange rate: if the currency is overvalued, imports will be cheaper and therefore
there will be a higher quantity of imports. Exports will become uncompetitive and therefore
there will be a fall in the quantity of exports.
• Economic growth: if there is an increase in aggregate demand and national income
increases, people will have more disposable income to consume goods. If producers cannot
meet the domestic demand, consumers will have to imports goods from abroad. Thus faster
economic growth enables the possibility of a current account deficit developing.
• Decline in competitiveness: if export industries are in decline and cannot compete with
foreign countries, the exports fall, ushering in a deficit. This is a major reason for many
countries today experiencing current account deficits.
• Inflation: this makes exports less competitive and imports more competitive (cheaper).
• Recession in other countries: if the country’s main trading partners experience negative
economic growth then they will buy less of the country’s exports, worsening the current
account.
• Borrowing money: if countries are borrowing money from other countries to finance their
expenditure and growth, current account deficits will develop.

Consequences:
• Low growth: a deficit leads to lower aggregate demand and therefore slower growth.
Unemployment: deficit can lead to loss of jobs in domestic industries as demand for exports
is low and demand for imports is high.
 • Lowers standard of living: in the long run, persistent trade deficits undermine the standard
of living as demand and income fall, especially if the net incomes and transfers show a
negative balance.
• Capital outflow: currency weakness can lead to investors losing confidence in the economy
and taking capital away.
• Loss of foreign currency reserves: countries may run short of vital foreign currency reserves
as more foreign currency is being spent on imports and foreign currency revenues from
exports is falling.
• Increased Borrowing: countries need to borrow money or attract foreign investment in
order to rectify their current account deficits. In addition, there is an opportunity cost of
debt repayment, as the government cannot use this money to stimulate economic growth.
• Lower exchange rate: a fall in demand for exports and/or a rise in the demand for imports
reduces the exchange rate. While a lower exchange rate can mean exports becoming more
price-competitive, it also means that essential imports (such as oil and foodstuffs) will
become more expensive. This can lead to imported inflation.
The severity of these consequences depends on the size and duration of the deficit.
Persistent deficits can harm the economy in the long-run as low export growth causes
unemployment.

Correcting a current account deficit

• Do nothing because a floating exchange rate should correct it: if there is a trade deficit, a
depreciation will occur as more currency is being spent than received. Depreciation will
make imports more expensive and exports cheaper. As a result, domestic demand for
imports will fall and foreign demand for exports will rise, reducing the deficit.
• Use contractionary fiscal policy: a government can cut public expenditure and increase
taxes to reduce total demand in the economy, which will reduce demand for imports and
improve the trade balance. However, a fall in demand may affect firms in the economy who
may cut output and employment in response.
• Use contractionary monetary policy: a higher interest rate will attract more direct inward
investments and nullify the trade deficit. Higher interest rates will also make borrowing from
banks more expensive and increase the incentive to save, thus discouraging consumers from
spending. The govt. can also devalue the exchange rate to improve export competitiveness
and demand.
• Protectionist measures: these measures reduce the competitiveness of imports, thereby
making domestic consumption more attractive. For example, tariffs raise the price of
imports while quotas limit the amount of imports in the economy.

Current Account Surplus

When the financial inflows in the current account exceed the financial outflows, the current
account is in surplus.
Causes:
• Improved competitiveness: exports may have become more price-competitive in the
international market, due to perhaps, better labour productivity or low prices.
• Growth in foreign countries: export demand may have risen due to trading partners
experiencing growth and higher incomes.
• High foreign direct investment: strong export growth can be the result of a high level of
foreign direct investment.
 • Depreciation: a trade surplus might result from a currency depreciation.
• High domestic savings rates: high levels of domestic savings and low domestic consumption
of goods and services cause more products to be exported and imports to fall.
• Closed economy: some countries have a low share of national income taken up by imports,
perhaps because of a range of tariff and non-tariff barriers.

Consequences:
• Economic growth: net exports is a component of GDP, so a rise in exports and incomes will
cause economic growth.
• Appreciation: as exports increase, the demand for the currency increases and therefore the
value of the currency increases, which will make imports cheaper and exports more
expensive and cause its demand to fall leading to an eventual deficit in the long run.
• Employment: since exports have increased, jobs in the export industries will have increased
too.
• Better standards of living: higher net incomes, transfers and export revenue make the
country’s citizens better off.
• Inflation: higher demand for exports can lead to demand-pull inflation. This can diminish the
international competitiveness of the country over time as the price of exports rises due to
inflation.

Correcting a current account surplus:

• Do nothing because a floating exchange rate should correct it: if there is a trade surplus ,
an appreciation will occur as more currency is being demanded. An appreciation will make
imports cheaper and exports expensive. As a result, foreign demand for exports will fall and
domestic demand for imports will rise, reducing a trade surplus.
• Use expansionary fiscal policy: increasing public expenditure and cutting taxes can boost
total demand in an economy for imported goods and services.
• Use expansionary monetary policy: lower interest rates will make borrowing from banks
cheaper and increase the incentive to spend, thus encouraging consumers to spend on
imports and correct a trade surplus.
• Remove protectionist measures: reducing tariffs and quotas cause imports to rise and close
a surplus in the current account.

THE END.
WISHING YOU THE BEST IN YOUR STUDYOF
IGCSE ECONOMICS.
REMEMBER THIS, ‘’ PROPER PREPARATION PREVENTS POOR
PERFORMANCE. P5’’.

PREPARED BY T. CYPRIAN.