UNIT 7- The Price System and Macroeconomy

Chapter 30- Utility

Chapter 30.1: Utility and Diminishing Marginal Utility
Utility- Utility is the measure of the level of happiness or satisfaction someone
derives from the consumption of a good or service.
It is assumed that utility can be measured in units, the same way goods
consumed can be determined.

Measures of satisfaction:
1) Total utility- the overall satisfaction derived from the consumption of all
units of good over a period of time
2) Marginal utility- the additional utility derived from consuming one
more unit of a particular good.

Law of Diminishing Marginal Utility suggests that “as consumption of goods

increases, the marginal utility will get smaller”.

Chapter 30.2: Equi-Marginal principle

The equi-marginal principle: A consumer is said to be in equilibrium when it is
not possible to switch expenditure from good A to good B to increase total
utility.

MU/P for Good A = MU/P for Good B= MU/P for Good C…

MU= marginal utility
P= price for goods
A, B, C = different products

In this case, the consumer has allocated income in a way that maximizes total
utility, resulting in consumer equilibrium.
The equi-marginal principle is based on these assumptions:
1) The consumer has limited income
2) The consumer will always behave rationally
3) The consumer seeks to maximize their utility
Chapter 30.3: Derivation of an individual
demand curve
Marginal Utility can be used to explain how an
individual’s demand curve is derived.
As the price of a good decreases, the consumer’s
purchasing power increases, which increases the
utility derived from the consumption of the good.

Chapter 30.4: Limitations of Marginal Utility Theory and

Assumptions of Rational Behavior
Limitations of the Marginal Utility Theory:
1) It assumes that consumers can put their wants in rank order
2) It assumes that consumers can assign a value for the satisfaction derived
from the consumption of a good
3) It assumes that consumers behave rationally when it comes to
purchasing decisions

In the real world, utility isn’t the only factor that influences what a consumer
purchases, there are other factors that we must consider.

Chapter 31: Indifference curves and budget lines

Chapter 31.1: Indifference curves
Consumers will only buy a product when it is
something they want or prefer when having
to choose between alternatives.
Consumer preferences can be represented by
indifference curves.

An indifference curve shows all the possible

combinations of two goods that give the
consumer equal satisfaction/utility.
The slope of an indifference curve shows the
extent to which consumers can substitute one
good for another.
Indifference curves should not overlap or intersect with each other as that
would indicate that the consumer is being irrational in their choices and does
not get maximum utility from consumption.

The indifference curve slopes downwards to indicate that a fall in the quantity
consumed of Good Y is accompanied by a rise in the amount consumed of Good
X, given the same level of satisfaction.
Higher indifference curves represent higher levels of satisfaction.
The marginal rate of substitution is the rate at which a consumer is willing to
substitute one good for another.

Consumers are restricted in what they can buy due to their limited disposable
income and the prices of goods. These two principles of consumer behavior are
brought together with a budget line.

Chapter 31.2: Budget Lines

A budget line shows numerically all possible combinations of 2 goods, a
consumer can purchase with the given income and given prices of goods.

There would be a shift in the budget line if the price of Good X or Good Y
changes while the income is unchanged.
If the price of Good X falls, a rational consumer would substitute Good X for
Good Y, and buy more of Good X. This is known as the substitution effect of
price change.
If the price of Good X falls, the consumer would have more money to spend on
other goods, which means real income has increased, which means the
consumer could buy even more of Good X. This is known as the income effect
of price change.

Chapter 31.3: The income and substitution effects of a price

change
Income Effect:
1) As the price of a product goes down, the purchasing power of a consumer
increases
2) This allows people to buy more with the given budget
3) For normal goods, demand rises with an increase in real income

Substitution Effect:
1) A fall in the price of Good X makes it relatively cheaper compared to its
substitutes
2) Some consumers will switch to Good X leading to higher demand
3) Much depends on whether products are close substitutes

If income increases:
1) This will allow the consumer to choose a better combination of Good X
and Good Y.
2) More of each could be consumed if both are normal goods.

If the increase in income results in less consumption of one of the goods,

that indicates the good is inferior.

If income falls:
1) The budget line shifts downwards in a parallel way.
2) This would indicate that both are normal goods and less of each will be
consumed
3) In case of an inferior good, there will be an increase in
consumption of this good.

Giffen good is an inferior good for which demand falls if the

price of the good falls and demand increases as the price of
the good increases.
The substitution effect is always positive, whereas the income effect can be
negative or positive depending on the type of the good.

Chapter 32-Efficiency
Chapter 32.1: Introduction to Efficiency
Economic Efficiency: Where scarce resources are used most efficiently to
produce maximum output.
Efficiency represents the best possible solution to the fundamental economic
problem.

Economic Efficiency consists of:

1) Productive efficiency- Firms want to produce at the lowest possible
costs. A firm is productively efficient when it is making the best use of
resources at the lowest possible cost
2) Allocative efficiency- Firms produce a combination of goods and
services that provide consumers with maximum utility. It gives
consumers maximum utility at their current level of income. It
represents the additional benefit derived from the consumption of one
more unit of a particular good.

Marginal cost is the cost of producing one more unit of a particular good and it
represents the opportunity cost of the resources used to produce this last unit.
When the price is equal to the marginal cost, the consumers are prepared to
pay what it costs to produce the last unit.

Chapter 32.2: Conditions needed for productive efficiency

Productive efficiency can be demonstrated using a firm’s average cost curve.
A productive possibility curve can also be used to show productive efficiency, it
can be shown on the boundary of the
curve.
Competition can lead to productive
efficiency as firms are constrained to
produce at the lowest costs to be
competitive and have the incentive
to profit.
A failure to produce at the lowest possible cost would lead to bankruptcy in a
competitive market.
A firm is productively efficient if it produces Q quantity at P price in the long
run. A firm would have to minimize costs to be productively efficient.
Firms would have to produce at the lowest possible point on their average cost
curve in the long run, which is point P.

Chapter 32.3: Conditions needed for allocative efficiency

Allocative efficiency exists when the marginal cost of production is equal to the
price of the product. The price paid by the consumer is representative of the
economic cost of producing the last unit and ensures that the right amount of
product is being produced.

It is not possible to show allocative efficiency on a production possibility

frontier.
In a competitive market, firms are constrained to produce the products that
consumers most desire relative to their cost of production.

Firms can easily be motivated to produce productively as it allows them to aim

for the greatest profit, which would lead to the greatest possible demand and
in return great profits and revenue, If firms do not do so, other firms will do
this. Failing to produce products that provide consumers with the highest
utility will lead to firms shutting down.
In allocative efficiency, the price of the product = marginal cost of production.

Chapter 32.4: Pareto Optimality

Pareto Optimality: According to the concept, it is impossible to make someone
better off without making someone worse off.
This represents the best situation for allocation of resources.
For example, in the PPC, without producing less of a product, we cannot
produce more of another product, that is the state of Pareto Optimality.
If the allocation of resources is not Pareto optimal, there is a scope for
improvement. Any improvement in efficiency may require some form of
compensation to be paid to the consumers who are worse off.
Chapter 32.5: Dynamic Efficiency
Dynamic Efficiency: It is a form of productive efficiency that benefits a firm
over time. Resources are reallocated in such a way that output increases
relative to the increase in resources.
Dynamic efficiency is achieved when firms respond to the changing needs of
the market by introducing new production processes in response to
competitive pressures.

For example, through excess profits, firms

can invest in technology along with
research and development which helps
lower prices.
Dynamic efficiency is a long-run concept.
This type of investment can have high
initial costs and the payback comes later.
When the firm is dynamically efficient, the
long-run cost curve shifts downwards.

Chapter 32.6: Market failure

Market failure exists when a market is left at its own devices without
government intervention, so it fails to allocate scarce resources efficiently.
It exists when supply and demand in a market do not lead to productive or
allocative efficiency.

Consequences of Market Failure:

1) where there are externalities in the market
2) The provision of merit and demerit goods
3) the provision of public goods and quasi-public goods
4) Information failure
5) adverse selection and moral hazard
6) abuse of monopoly power in the market
Chapter 33: Private cost and benefits, externalities
and social costs and benefits
Chapter 33.1: Externalities
Externalities: A transaction between a producer and a consumer for a good
should only involve and affect those involved, a problem arises when someone
not involved in the economic activity is affected.
Those not directly involved are called third parties.

The side effects on third parties can be negative or positive.

A negative externality occurs when the side effects have a negative impact or
damaging impact on the third parties, involving unexpected costs to them.
A positive externality occurs when the side effects provide unexpected benefits
to the third parties.

Chapter 33.2: Types of costs and benefits

Types of Costs and Benefits:
1) Private Costs and Benefits are experienced by people directly involved in
the decision to take a particular action. Private costs and benefits are
experienced by producers or consumers of the goods and services.
2) External Costs and Benefits are a consequence of externalities that arise
from a particular action. External costs and benefits are not paid for, and
the advantages are not accrued by those responsible for the action,
instead, the third parties experience these benefits and costs.
3) Social Costs and Benefits are the total costs and benefits experienced by
society as a whole.
Social Costs = Private Costs + External Costs
Social Benefits = Private Benefits + External Benefits

A problem arises when the private costs aren’t equal

to the social costs or the private benefits do not
match the social benefits.
The external costs and benefits distort the efficient
allocation of resources and for this reason, the
market fails to allocate resources efficiently.
If private costs and private benefits are equal to social costs and social benefits,
there will not be any externalities which is the ideal situation.

Chapter 33.3: Negative and Positive Externalities of

Production and Consumption

Negative Production Externalities: These are

spillover effects that occur as a result of
production.

A production externality occurs because there are

additional costs imposed on the community.

Negative externalities of production cause market

failure as there is a misallocation of resources.

Overproduction is causing deadweight welfare loss which is a loss in welfare

due to inefficient resource allocation.

Positive Production Externalities: These are

benefits to the third party and are created by
producers of the goods and services.

Negative Consumption Externalities: These are

created by consumers as a consequence of their
use of products that affect third parties.
Positive Consumption Externalities:
These are spillover effects of the consumption of
a good or service on others.

Chapter 33.4: Asymmetric Information and moral hazard

Asymmetric Information: When one party in the market has some information
that another party does not have.

The underconsumption of merit goods and the overconsumption of demerit

goods are because consumers make choices based on imperfect information.
The quality of information available to consumers varies and can lead to
misallocation of resources.
If a buyer lacks full information, there is a tendency to overestimate the
benefits of consumption of that product.

-Types of Asymmetric Information:

1) Adverse Selection occurs when buyers or sellers have more information
about product quality than each other (hidden characteristics)
2) Moral Hazard occurs when one party takes actions that the other party
cannot observe but affects both of them (hidden actions)

Chapter 33.5: Uses of costs and benefits analysis in analyzing

decisions
Cost-Benefit Analysis: A method of
decision-making that takes into account the costs
and benefits involved.
It takes a long view and a wide to assess whether a
project should go ahead.
 This wide view comes from the need to take social costs and social benefits
as many economic projects can produce substantially controversial side
effects, where externalities fall upon people and communities without
connection with the particular project.
This method seeks to involve all of the costs and benefits, not just private
costs and benefits.
It also provides a shadow price for costs and benefits where no market price
is available.
Shadow Price: one that is applied when no established market price is
available. For example, side effects of pollution

- Development of Cost-Benefit Analysis:

Stage 1: Identification of all relevant costs and benefits- this involves
establishing the private costs, private benefits external costs, and external
benefits.
Stage 2: Putting a relevant monetary value on all costs and benefits
Stage 3: Forecasting future costs and benefits- This applies to projects that
have long-term term impact, Economists use statistical forecasting
techniques
Stage 4: Decision Making, interpreting cost-benefit analysis- if benefits are
more than costs, the project is taken forward, not vice-versa.
This is decided through the benefit-cost ratio (net benefits against net
costs)

These stages provide a clear framework for decision-making where market

mechanisms are not fully functional.

Chapter 34: Types of costs, revenue, short-run and

long-run production
Chapter 34.1: Introduction to Production
The demand for land, labor, capital, and enterprise comes from producers who
wish to use them to make goods and services.

Producer: A firm whose demand for factors of production is derived from the
needs of operating factories.
The task for producers is to combine factors of production in an effective way
to be efficient, competitive, and profitable in the world market.
They have to either find the least cost or most
efficient combination of labor and capital to
produce the given quantity of output.
Firms have to choose between alternative
production methods.

Isoquant joins points that give a particular level of

output when different combinations of production
methods are used for labor-intensive or
capital-intensive)

Chapter 34.2: Short-Run Production Function

In terms of factors of production, labor is the usual variable factor of
production in the short run; all others are fixed.

Short Run Production Function:

In terms of factors of production, labor is the usual variable factor of
production in the short run, all other factors are fixed.
A graph that shows the relationship between the quantity of factor
inputs(labor/workers) and the total product or output produced is called the
production function.

Marginal Product is the increase in total product that occurs from an additional
unit of input.
As the number of workers increases, output increases at a decreasing rate, and
the marginal product declines. This concept is known as a diminishing return
and is referred to as the law of diminishing returns/law of variable
proportions.
Average Product is the measure of labor productivity and is calculated by using
this formula: 𝑡𝑜𝑡𝑎𝑙 𝑝𝑟𝑜𝑑𝑢𝑐𝑡/𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑤𝑜𝑟𝑘𝑒𝑟𝑠 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑.

Chapter 34.3: Short-Run Cost Function

Short Run Cost Function:
A firm has particular objectives such as profit maximization (the difference
between total revenue and total costs is at a maximum.)

A firm and its entrepreneur must consider all the costs of the factors of
production involved in the final output.
There are the private costs directly incurred by the owners.
Production may create external costs for others but these are not taken into
account by the firm.
A firm is an economic organization that transforms factor inputs such as raw
materials with capital equipment, labor, and enterprise to produce goods and
services for the market.

Fixed Costs and Variable Costs

There are two types of short-run costs:
1) Fixed costs (FC) are the costs that are independent of output. At zero
output, any costs that a firm has must be fixed.
Some firms are where capacity is fixed, where capacity is fixed, or where
the product is perishable.
It would be advisable to produce a large output to reduce all unit costs or
to sell all available capacity to make the firm more likely to cover total
costs.
 2) Variable Costs (VC) include all the costs that are directly related to the
level of output like labor and raw materials or component costs.
These costs are incurred directly in the production process.

- Total, average, and marginal costs

There are five types of short-run costs:
1) total costs (TC)
2) average fixed cost (AFC)
3) average variable cost (AVC)
4) average total cost (ATC)
5) marginal cost (MC)

Total cost (TC) = total fixed cost (TFC) + total

variable cost (TVC)
Average fixed cost (AFC) = total cost/output
Marginal cost = change in total cost/change in output

Marginal cost is the addition to the total cost when making one extra unit of
output.

The most important cost curve for the firm is the average total cost (ATC)
which shows the cost per unit of output.
The decision to increase output will raise the total cost, marginal cost will be
positive as extra inputs are used and firms will only be keen to increase output
when the expected sales revenue outweighs the extra cost of production.

Rising marginal cost is also an indicator of the law of diminishing returns, as

more of the variable factors are added to the fixed ones, the contribution of
each extra worker to the total output will begin to fall.
The diminishing marginal returns cause the marginal and average variable
costs to rise.

- The shape of the short-run average cost and marginal cost curves
The shape of the short-run ATC is the result of the interaction between the
average fixed cost and the average variable cost.

As the firm’s output rises, the average cost

will fall because the total fixed cost is being
spread over an increased output
The variable cost will rise because of
diminishing returns to the variable factor.
This will outweigh the effect of falling AFC,
causing ATC to rise, which results in the
classic ‘U’ shape of the ATC curve because of
the law of diminishing returns.

Chapter 34.4: Long-run production function

The short-run is a period in economies when at least one of the factors of
production is fixed, which tends to be easiest to change is labor.
The factor that takes the longest to change is capital.

All factors of production are variable in the long run, this gives the firm much
greater scope to vary the respective mix of its factor inputs so that is producing
at the most efficient level.
If capital becomes relatively cheaper than labor or a new production process is
invested, which is likely to increase productivity, firms can then reorganize
how they produce.
With labor, it is easy to know the costs, but it is more difficult to estimate costs
for the other factors of production, the best combination of factors can be
arrived at as their price varies.

Firms should aim to be in a position where:

For firms to be able to do this, all factors of production must be variable.

It is possible to derive the long-run production function for a firm by
Constructing an isoquant map using the principles of a production function.

The map shows the different combinations of labor and capital that can be
used to produce various levels of output, from which it is possible to read off
the combinations of labor and capital that could produce these output levels.

- Returns to scale
As production increases, relatively less capital and labor are required per unit
of output, this is referred to as increasing returns to scale, as production
expands further, increasing amounts of capital and labor are needed to
produce, which is indicated by the increasing width of the gap between the
isoquants, indicating decreasing returns to scale
In the long run, labor and capital can be varied, the actual mix will depend
upon their prices
Isocosts are lines of constant relative costs for factors of production.
Each of the isocosts shown has an identical slope.

In deciding how to produce, the firm will be looking for the most economically
efficient or least-cost process, this is obtained by bringing together the
isoquants and isocosts, so linking the physical and economic sides of the
production process.

The point where the isocost is tangential to an isoquant represents the best
combination of factors for the firm to employ, the expansion path or long-run
production function of the firm can be shown by joining together all of the
various tangential points and is therefore useful from a longer-term planning
perspective.

In practice:
- it is challenging for firms to determine their isoquants, they do not have
the data or the staff know how to do this.
- it is also assumed that in the long run, it is possible to switch factors of
production, which may not always be as easy.
- some employers may be reluctant to switch labor and capital- they may
feel that they have a social obligation to their workforce and will not
alter their production plans with a change in relative factor prices.

Chapter 34.5: Long-run cost function

In the long run, the firm can alter all of its inputs, using greater quantities of
any factors of production, it is now operating on what is known as a larger
scale, and all of the factors of production are variable in the long run.

In the very long run, technological change can alter the way the entire
production process is organized, including the nature of products themselves,
which shifts the firm’s product curves upwards and its cost curves downwards
since firms are more efficient as a consequence of new technologies.
A firm can find a way of lowering its cost structure over time, by increasing the
amount of capital used relative to labor, with a consequent increase in
productivity.

- Shape of the long-run average cost curve

The long-run average cost (LRAC) curve shows the least cost combination of
producing any given quantity of output.

The LRAC curve is a flatter U-shaped curve compared to the SRAC and is
indicative of experiencing falling long-run costs over time, which allows a
firm to lower its prices without sacrificing profit.

The shape of the LRAC is driven by a

series of short-run situations, as
output increases, so does the scale of
the firm’s operations.
The LRAC curve is the lowest possible
average cost for each level of output
where the factors of production are all
variable, but this doesn’t mean that
the firm is producing at the minimum
point on each of its SRAC curves.

- Minimum efficient scale

A firm that is producing at its optimum output in the short run and with the
lowest average cost, in the long run, has maximized its efficiency, which is
known as minimum efficient scale (the lowest level of output at which costs
are minimized)

In industries, where the minimum efficient scale is low there will be a large
number of firms, and there will be competition between a few large players if
the minimum efficient scale is high.
Chapter 34.6: Internal and External Economies and
Diseconomies of Scale
The shape of the LRAC is used to explain economies of scale.
A firm experiences economies of scale if costs per unit of output fall as the
scale of production increases, which is shown by the downward-sloping
section of the LRAC curve.

If a firm gets increasing returns from using its factors of production, it can
produce more goods with smaller quantities of factors of production, which
means the firm is producing at a lower average cost.

Specialization and the division of labor are an obvious source of economies of

scale as workers become increasingly efficient in the tasks that they carry out.

The shape of the LRAC slopes upwards after the minimum point, because
beyond a certain size, a firm’s costs per unit of output may increase as the size
of output continues to increase, this is called diseconomies of scale.

- Economies of scale and decreasing average costs

Economies of scale occur when average costs decrease as the firm increases its
output by increasing its size or scale of operations.
Economies of scale can only accrue to a firm in the long run, internal
economies of scale are benefits gained by a firm due to its own decision to
produce on a larger scale.

They occur because the firm’s output is rising proportionally faster than the
inputs, which means that the firm is getting increasing returns to scale, if the
increase in output is proportional to the increase in inputs, the firm will get
constant returns to scale and the LRAC will be horizontal.

If the output is less than proportional, the firm will see diminishing returns to
scale or diseconomies of scale.
The advantage for a firm in benefiting from economies of scale is a reduction
in the long-run average cost as the scale of output increases, which can occur
in various ways:
- Technical economies refer to the advantages gained directly in the
production process through more efficient production methods, some
production techniques only become viable beyond a certain level of
output.

- Purchasing economies occur as firms increase in scale, they increase

their purchasing power with suppliers, through bulk buying they can
purchase supplies cheaper, so reducing average costs.

- Marketing economies occur as large-scale firms can promote their

products and pay lower rates for advertising, savings in logistics costs,
transport, and warehousing costs can be reduced as well, where
customers require these services on a large scale.

- Managerial economies: in large-scale firms, managerial economies

occur as a result of specialization, and experts can be hired to manage
operations, finance, human resources, sales, and IT systems.
For small firms, these functions have to be carried out by a multi-task
manager, cost savings are expected to accrue where specialists are
employed.

- Financial economies: large-scale firms usually have better and cheaper

access to borrowed funds than smaller firms because the perceived risk
to the lender is lower.

- External economies of scale

External economies of scale are

particular benefits received by all firms
in an industry as a direct consequence of
the growth of industry as a direct
consequence of the growth of that
industry.
External economies of scale may be one reason for the trend toward the
concentration of rival firms in the same geographical area.

The advantages include:

- availability of a pool of skilled labor
- convenient supply of components and services from specialist producers
that have grown up to provide for all firms in that area
- greater access to knowledge and research
- better transport infrastructure can come from the general expansion of
firms
- lower logistics costs for all firms

- Diseconomies of scale
A firm can expand its scale of output too much, with the result that average
costs start to rise, and efficiency is compromised which is indicative of
diseconomies of scale.

Internal diseconomies of scale can occur due to

- problems of management co-ordination of large complex organizations
- size
- poor communication leads to lower morale in the workforce
- workers may feel like they are a small insignificant part of a big
organization

External diseconomies of scale can be seen in the form of:

- traffic congestion which increases distribution costs
- land shortages and rising fixed costs
- shortages of skilled labor and rising variable costs

Chapter 34.7: Total, Average, and Marginal Revenue

Revenue is the payment firms receive when they sell the goods and services
that they have produced, also referred to as sales.
Revenue is expressed over a time of months or years.
There are three revenue concepts:
- Total revenue (TR) represents the sales of a firm (TR= price x quantity)
- Average revenue (AR) is the revenue per unit of output sold (AR= total
revenue/quantity)
- Marginal revenue is the additional revenue arising from the sale of an
additional unit of output (MR= change in total revenue/change in
quantity)

It is important to understand the type of market in which a firm operates.

In a competitive market, the firm has no control over the price of its goods the
firm is a price taker.
The firm’s demand curve will be horizontal and its revenue will depend on the
amount of goods sold.
The market demand curve will be downward sloping.

In any other type of market, the firm is a price

maker, if the chooses to increase output, the
price is expected to increase, and as output
changes- so do price and revenue.
The extent of the change in revenue will
depend on the price elasticity of demand.

The firm’s demand curve is its average revenue

curve, marginal revenue will always be below
average revenue since the firm can only sell
more goods by reducing price.
Chapter 34.8: Normal, subnormal, and supernormal profit
Profit is total revenue less total costs.
The money paid out to factors of production is included in total costs but there
must also be an allowance for anything owned by the entrepreneur and used in
the production process such as loans that may have been made available to the
business, which must be estimated.

The concept of opportunity cost is relevant as the entrepreneur may ask for
capital that could have been used elsewhere at no risk, this would have earned
an income.

An entrepreneur will expect a minimum level of profit to reflect what could

have been earned elsewhere with the resources available, which is known as
normal profit.
Normal profit is the minimum return that a firm must receive to remain in
business.
Profit = total revenue - total costs (+ normal profit)

Any profit over and above normal profit is known as supernormal profit (total
profit-normal profit)
Firms enter markets where supernormal profits are being earned.

Subnormal profit is where the profit that is earned by a firm is less than the
normal profit, a firm may decide to withdraw from a market in the long run.

Chapter 35- Different Market Structures

Chapter 35.1: Market Structures and their Characteristics
The term market structure describes how goods and services are supplied by
firms in a particular market
It describes the characteristics of a market in terms of:
- the number of buyers and sellers
- the nature of products and whether they are differentiated
- the ease of entry into the market
- the extent to which all firms in the market have the same information
Perfect competition is an ideal market structure where there are many firms
and freedom of entry into the industry with all firms producing identical
products.
Firms are price takers and there is perfect information for all firms in the
market.
The other market structures are collectively referred to as imperfect
competition.
- Monopolistic competition is where there are many firms and freedom of
entry into an industry but, unlike perfect competition, firms have some
control over the product and its price, firms are price makers.

- Oligopoly is where few firms have market power to erect barriers to

entry to deter competition from new firms, the products can be
wide-ranging.
Firms are price makers as they have some control over price depending
on the market power of other competitors.

- A monopoly is where there is a single seller in the market, there is just

one firm producing a good or service for an entire market, which is
referred to as a pure monopoly.
A monopolistic industry may consist of one firm that dominates the
market due to it having a very large market share, barriers to entry into
the market are substantial due to patents and other restrictive methods
that prohibit competition.
A monopoly is a price maker and there is limited information about how
the firm operates.

A particular form is a natural monopoly, where long-run average costs are

lower when there is just one firm in the industry.
Railways are an example of a natural monopoly in many economies
The concentration ratio can be used to identify the type of market structure as
it is a measure of the combined market shares of the biggest firms in the
market.
concentration ratio: market size of top firms/total size of market x 100%

Chapter 35.2: Barriers to entry and exit

The existence of substantial barriers to entry into an industry differentiates
oligopoly and monopoly from monopolistic competition and perfect
competition.

- Barriers to entry
Barriers to entry are a range of obstacles that deter or prevent new firms from
entering a market to compete with existing firms.
Barriers to entry give firms a degree of market power, and the decisions can be
made by existing firms without the risk of their market share or price being
challenged from outside.

There are legal barriers, market barriers, and cost barriers that help reduce
new competition in existing markets, as these make it harder for new firms to
enter the markets, due to saturation and the range of products provided by
existing firms or patents that prevent new firms from using similar technology
without which cost of production is higher and it becomes unprofitable to
enter markets.
Existing firms can exploit customers and enjoy market power.
Economies of scale can be barriers because existing large producers can
produce at a lower average cost than those just starting up.
It allows large firms to cut their price to eliminate any high-cost producers,
which is known as predatory pricing.

It may be possible for existing firms to hide the existence of supernormal

profit by using limit pricing, which involves firms deliberately setting a low
price and temporarily abandoning profit maximization as their objective to
deter new entrants.
It may be in the interest of all firms to do this and it becomes a form of
collusion (an anti-competitive action by producers)

Some firms may have monopoly access to raw materials, components, or

returns outlets which will make it difficult for new entrants to make an impact.
Vertically-integrated manufacturing businesses, where a firm is a specialist in
different stages of production, will be protected by the fact that their rivals’
costs will be higher.

- Barriers to exit
If a firm is shutting down, then costs such as research and development costs
cannot be recovered.
The resources are not easily transferred to other uses.
The sunk costs that cannot be easily recoverable act as a barrier to exit from
the existing industry as capital investment will be lost.

It is the risk of entering and the high cost of failure that deters potential
entrants.

Chapter 35.3: Performance of Firms in Different Market

Structures
The efficiency of different market structures in the short and long run is
determined by
- Price
- Revenue
- Output
 - Profits

Perfect Competition
- Some buyers and sellers have perfect knowledge of the market
conditions and the price that is charged.
- No individual firm has any influence on the market price, firms are
described as being price takers, and the ruling price is determined by the
forces of market demand and output of all firms
- The products are homogeneous or identical, they are all of the same
quantity and are identical in the eyes of the consumer.
- There is complete freedom of entry into and exit from the market
- All firms and consumers have complete information about products,
prices, and means of production

Agriculture is the only industry that comes anywhere near the theoretical
model.

In perfect competition, the firm cannot influence the market price, and
individual firms make only a small contribution to output that no change in
their output can significantly affect the total supply.
The demand curve facing the firm is therefore perfectly inelastic at the market
price.
The marginal revenue is also equal to the price or the average revenue.
The only decision to be made by the firm is the amount of output to be
produced, depending on the production costs.
The firm will aim to maximize profits, the chosen output will be where
marginal revenue equals marginal costs, because the revenue from the last
unit of output is equal to the opportunity cost of producing it.

If the total cost of producing an output is lower than the total revenue, then the
firm is making a supernormal profit, if TC=TR, then the firm will be breaking
even and making a normal profit.

Costs can be higher than the revenue, a firm may be about to exit the industry,
or a firm can continue production making short-run losses, as long as the
price received by the firm covers the AVC, usually the cost of paying the wage
bill and buying the materials for production, this is the shut-down price (a
firm will stop production when price falls below average variable cost)

The firm would be making a loss equivalent to the amount of fixed costs.
When the price is less than AVC, if the firm continues to produce, it will be
making a loss even greater than its fixed costs.

In perfect competition, profits are maximized where MR=MR, the MC curve

shows the level of output that a firm is willing to supply at a range of prices.

When the revenue is lower than costs in the

long run, firms will leave the industry and
many firms leaving would result in a reduction
of the overall market supply.
The loss of firms will raise the market price,
giving the rest a chance to continue producing
and make a normal profit.

In the long run, firms can only supply the

market if they can cover all of their costs and
make a normal profit.
The minimum supply for the firm will be the optimum output where average
costs are the lowest.

In perfect competition, firms will only make different amounts of profit from
each other if they have different cost structures, their behavior is strictly
limited and the only way to boost profit would be to increase productivity and
lower average total cost.

Supernormal profit will only be a feature of perfect competition in the short

run because its existence will act as an incentive for the entry of new firms.
The absence of barriers to entry means that the total supply in the market will
rise, diminishing supernormal profit.

The long-run equilibrium is where the only firms left are the most efficient,
making a normal profit.
Firms hold no market power, supernormal profit has competed away, and the
only firms that continue to participate in the market, in the long run, are
productively and allocatively efficient.

Monopolistic competitive
Monopolistic competition is the market structure closest to the model of
perfect competition because of the large number of competing firms.

Monopolistic competition has the following characteristics:

- there is a large number of buyers and sellers
- there are few barriers to entry into the market
- it is easy for firms to recoup their capital expenditure on exit from the
market
- consumers face a wide choice of differentiated products
- each firm has a slight degree of monopoly power in that it controls its
brand through quality and physical differences.
- firms have some influence on the market price and are price-makers

Each firm is competing with a large number of similar producers.

The demand curve facing the individual firm will be downward-sloping but
relatively price-elastic because of the availability of substitutes.
Firms have the option to reduce their prices to increase total revenue
They can make a supernormal profit in the short run, but the key restraint on
their power is the free entry of competitors.

In the long run, profit-maximizing firms will only be able to achieve normal
profit covering all the production costs and the opportunity cost of capital.

The behavior of firms in this market structure lies in the concept of product
differentiation, the development of a strong brand image must be seen as an
act of investment on the part of the individual firm, which highlights the
important roles that advertising and promotions play in this market structure.

Marketing shifts the firm’s demand curve to the right at the expense of
competitors but will also reduce the price elasticity of demand if the
consumers feel there are fewer close substitutes, which is known as brand
loyalty as consumers will not shift back to rival products.
This competitive tool is taken up by all firms.

If advertising is not effective for all firms, those who are successful might take
advantage of their greater market share and brand loyalty to charge a higher
price, these firms would increase their sales revenue and by doing so move to
the portion of the demand curve where price elasticity of demand is elastic.

The constraint on the firm is that there is a freedom of entry into the market,
which threatens the existence of supernormal profit in the long run, and by a
combination of market and product innovation, individual firms can postpone
the long-run equilibrium if the total market is growing.
There are a large number of competitors using a combination of price
competition and non-price competition (added value) to increase their
market power.

Oligopoly
Oligopoly is defined as a market situation where the total output is
concentrated in the hands of a few firms, it is possibly the most realistic model
of a market structure, but the theory doesn’t provide definite predictions
regarding the price and output of the firm that exist in every other model.

An effective oligopoly can exist in a competitive industry, even when a few

firms dominate the market.

An oligopoly has the following characteristics:

- the market is dominated by a few firms
- the decisions taken by firms are interdependent, firms must decide their
market strategy to compete with close rivals, but they must also try to
anticipate their rivals’ reactions.
- there are high or substantial barriers to entry
- the products may be differentiated or undifferentiated
- the uncertainty and risks associated with price competition may lead to
price rigidity

The difficulty in studying oligopoly is that behavior can follow two very
different routes, there is aggressive competition in some industries, while in
others there is a suggestion of cooperation or collusion.

Oligopolists are price makers, but one of the dangers of using this tactic is that
the firm can be drawn into a price war.
An oligopolist would only start a price war if its costs of production were
significantly lower than those of its rivals.

A price war may be the natural outcome of events, such as overcapacity in the
industry or the entry of new firms, it could also be a defensive tactic where an
oligopoly is losing market share to its rivals.
If firms are highly diversified, a firm may be prepared to sacrifice profits by
cutting the price in an attempt to increase or even retain market share.
Profits from some of its activities may be used to cover short-term losses
elsewhere in the business.

The traditional model of oligopoly is

known as the kinked demand curve which
is used to explain how firms react to each
other’s behaviour.
The model assumes that oligopolistic firms
are interdependent, the behavior of any
one firm impacts the behavior of all others
in the market, and there is no collusion
between firms.

If a firm increases its price, this will not be followed by all firms as they have
little to gain since their revenue is likely to fall.
If the price is reduced, there will be the same reaction from all firms because
revenue will be compromised.

The oligopolist’s best position at the kink, any changes in costs will not lead to
a price increase, prices will tend to stay the same and to change little over time,
which results in price rigidity in the market as indicated within the limits.

It is argued that the model shows the kink at a certain price and output level
which has been chosen arbitrarily, where the kink should be, is unknown.
It doesn’t represent how firms behave in real oligopolistic markets, price
competition can be intense as firms battle to retain market share and to
combat threats from new entrants.

The uncertainty surrounding the outcome of competitive tactics means that

firms may prefer non-price competition.

The oligopolist will be better off concentrating on non-price competition to

increase revenue:
- advertising and promotions
- product innovation - the attempt to make the products more appealing
to consumers
 - brand proliferation - where the firm produces lots of brands to saturate
the market and leaves no gaps for rivals
- market segmentation - producers may decide that there are markets
where the consumers have different characteristics and needs, and
products will be adapted according to maximize sales
- process innovation - reduces average costs, allowing the firm to cut the
price without sacrificing profits

Profit-maximizing strategies may be replaced by other objectives, like

satisfying shareholders, profit-satisfying, maintaining market share, etc.

- Collusion in oligopolistic markets

There are situations where large firms find that it is in their interest to
co-operate with rivals, in an industry with high research and development
costs and rapid technological change.
In such industries, it is in the interest of all firms to share their knowledge and
agree on technical standards, perhaps taking part in joint ventures.

Collusion is the opposite, as it is an anti-competitive action by producers,

informal collusion is not illegal and usually takes the form of price leadership,
where firms automatically follow the lead of one of the groups.

The objective is to maximize the profits of the whole group by acting as a

single seller, the price leader is invariably the dominant firm and has sufficient
market power to determine a price change that other firms follow.

A cartel is a formal price or output agreement between firms in an industry to

restrict competition.
There are other price leadership models, such as using a typical firm as the
benchmark for price, this will only change if a rise in costs affects the profit
margin.

Monopoly
A pure monopoly is where a single firm controls the entire output of the
industry.
Monopoly is also used to describe a situation where one firm has a very large
share of the market.
Monopolies are at the opposite end of the spectrum to perfect competition.
It can only occur when a firm has a dominant position in terms of its market
share.

A monopoly has the following characteristics:

- a single seller
- no close substitutes
- high barriers to entry
- the monopolist is a price-maker

A monopoly is protected from competition by the barriers to entry.

A single firm or pure monopolist faces a downward-sloping market demand
curve.
In this situation, it can decide on the price to change or the quantity to supply,
but not both.
There may be situations where the monopolist is unable to make supernormal
profit despite having market power, like where fixed costs are so high that the
necessary price would be outside the range that consumers can afford.
It may be that all the monopolist can hope for is that revenue covers
production costs.

A profit-maximizing monopolist
would choose the output where
MC=MR, this output will be over the
price range where demand is price
elastic and will be sold at the price
consumers are willing to pay, if the
total revenue is higher than the
production costs, it will make a
supernormal profit.

In a monopoly, there is no distinction between the short-run and the long-run

because of the barriers that prevent the entry of competitors, there is no
economic incentive for the monopolist to move away from the
profit-maximizing output.
Price discrimination can increase the monopolist’s profits, as it occurs when
the monopolist chooses to split the output and sell it at different prices to
different consumers.

Natural Monopoly
A natural monopoly is a market situation where a monopolist has
overwhelmed cost advantage.
In theory, this can occur where a monopoly has sole ownership of a resource or
where past ownership of capital resources means that it is difficult and
extremely expensive for competitors to duplicate these factors of production,
it would also be wasteful to do so.

In these cases, fixed costs are a very

high percentage of total costs, as
output increases, average fixed costs
will decline, offering the prospect of
substantial benefits to be gained from
economies of scale.

A natural monopoly has a falling

long-run average cost curve, indicative
of continuing economies of scale.

Chapter 35.4: Comparison of monopoly with perfect

competition
The equilibrium price and out of a
monopolist charging a single price in a
market free of government intervention
versus what would occur in a perfectly
competitive industry.
A monopoly’s conduct and performance
are undesirable compared to firms in
more competitive markets.
Comparing the two equilibrium positions, we understand that:
- the price in a monopoly is higher than that in perfect competition
- the monopoly output is lower than in perfect competition
- the monopolist is making a short-run and long-run supernormal profit
- the firm in perfect competition is productively efficient, producing
optimum output, it is also allocative efficient where price=marginal cost
- the monopolist captures consumer surplus and turns it into supernormal
profit
- the monopolist is productively efficient, producing less than the
optimum output in the search of extra profit and the price charged is
well above marginal cost and so it is not allocatively efficient.
- if a perfectly competitive industry was turned into a monopoly, there
would be a welfare loss, in addition to greater allocative inefficiency.

There are inefficiencies when comparing the equilibrium positions of a

monopoly and a perfectly competitive industry, which are:
- consumer surplus in a monopoly is less than in perfect competition due
to the higher price that is charged by a monopolist.
- producer surplus in a monopoly is greater than in perfect competition
because the monopolist’s higher price and lower output have taken away
some of the consumer surplus.
- the deadweight loss is the sum of the loss of total consumer surplus and
producer surplus which is shown in the shaded areas, the deadweight
loss is significant because the monopolist is gaining at the expense of
consumers by converting some of the consumer surpluses into producer
surplus.

The criticisms of real-world monopolies based on a comparison with perfect

competition may not be valid for two reasons:
1) Perfect competition is a theoretical ideal.
To have more relevance, the monopoly must be compared with more
real-life models of monopolistic competition and oligopoly, as these
models are characterized by productive and allocative inefficiency
They may also involve a waste of resources in competitive advertising.

2) The perfectly competitive model is drawn on the assumption that the

costs in a monopoly will be the same as in perfect competition, which
 ignores the possibility that a monopolist can achieve internal economies
of scale that reduce unit costs, after which a monopoly can charge lower
prices than would occur in perfect competition, this makes consumers
better off, even if the monopolist is making supernormal profit.

These are the positive aspects of a monopoly in certain circumstances:

- a monopolist cannot always make a supernormal profit, it depends on
how high its costs are.
In situations where fixed costs are so high relative to the total costs that
the market price only just covers average costs, in which case, the
monopolist would make a normal profit

- the concept of supernormal profit must be considered carefully, the

uncertainties of profits, in the long run, are criticized in competitive
markets, a monopolist can plan future investment and finance it through
what are guaranteed profits, which may offer customers better products
and greater security to the workforce.

- the investment may take the form of process innovation, implementing

new techniques of production with the objective of lower unit costs.

- the profit can be used to finance product innovation, which will add to
the consumer welfare in the future, through improvement in the
product’s performance or through widening consumer choice.

- if the benefits of economies of scale and greater investment are passed

on to consumers, it could be argued that they have gained from the
existence of supernormal profit.

The absence of competition in state-owned monopolies makes them less

efficient, based on the argument that firms with a guaranteed market can be
complacent.
Monopolies suffer from X-inefficiency which is a type of productive
inefficiency.
X-inefficiency means that the firm is not producing at the lowest possible cost
for a given level of output, the monopolist’s costs are higher than they would
be in competitive firms.
Monopolists do not have the same control
over costs, there may be too many workers or
capital is not being used efficiently, which
suggests that some investment may take the
form of erecting barriers to maintain
supernormal profit, which adds to costs in
the short-run and be at the expense of
efficiency.

The inefficiencies can be outweighed by the

benefits of economies of scale that lower
average costs.

Monopolies operate in ways that lead to inefficiency or consumer exploitation

but investigation of monopoly practices is difficult and each case must be
judged on its own merits, it shouldn’t be assumed that monopolies are always
harmful, the perfect of a monopolist may be different from that of firms in
oligopolistic markets.

Chapter 35.5: Contestable Markets

A contestable market is a market where entry is free and exit is costless.
Contestability increasingly features in many markets throughout the world, a
contestable market is seen as a set of conditions that can apply in any of the
three imperfect market structures.

Deregulation occurs when barriers to entry into an industry are removed, and
any changes to the structure of transport and other former public sector
industries incorporate provisions for contestability.

A market is contestable if potential competitors can influence the conduct of

firms currently in the market.
These include similar firms, not operating in the market or new firms that
could set up if they saw an opportunity to gain market share and operate
successfully.
Potential firms have to assess the extent to which the likely gains from market
entry exceed the costs of entry, barriers to entry and exit are crucial in
determining whether the market is contestable.
 A perfectly contestable market is one where entry and exit are free or costless.
This has to be the case if potential competitors are not at a relative
disadvantage compared with firms already operating in the market.
If entry is not free, new firms will experience higher costs, suffer from a lack of
access to technology, and be unable to compete effectively because of the
brand loyalty that has been built up by firms already in the market.

The fewer barriers to entry and the lower the cost of entry, the more
contestable will the market be.
The exit must also be costless, which means that in the perfectly contestable
market, firms will have no sunk costs (when they leave the market, they can
resell any assets that they have used without loss).
If this isn’t possible, then potential entrants might be put off from entering a
market, and sunk costs would be seen as a barrier to entry.

The result of costless entry and exit is that contestable markets are
characterized by what is known as ‘hit and run’ entry.
If a firm is attracted to enter a market due to the high levels of profits being
earned by existing firms, on entry; a firm would take a share of the profits but
then leave once profit levels fell back to normal.
In this way, firms are unable to earn a supernormal profit in the long run.

A market is perfectly contestable where:

- there is a pool of potential entrants seeking to enter the market
- entry and exit are costless
- all firms are subject to the same regulations and state of technology
- Mechanisms are in place to prohibit limit pricing, as existing firms have
lower costs than potential entrants
- firms already in the market are vulnerable to ‘hit and run’ competition\

In theory, as long as the entry is free and exit is costless, any market structure
could meet the requirements of a perfectly contestable market:
- monopolistic competition has few barriers to entry, due to non-price
competition, it takes small firms time to build up a customer base to
obtain brand loyalty.
In this type of market, there are barriers to entry in the form of licensing
and regulatory requirements.
 - in oligopolistic markets, there are high barriers to entry, particularly in
the form of capital costs of entry and expenditure that are essential to
build up market share.

- monopoly power can be obtained through a parent or legal right to

operate in the market, where this is the case; the market will not at all be
contestable.
In other monopolistic situations, there could be an opportunity for new
firms to enter, but the cost of entry will certainly not be costless.

In each of the market structures, there could be a high degree of contestability

depending on the cost of entry and exit from the market.

If there are no barriers to entry, a new

firm moving into the market can have
a major effect on the monopolist’s
profit.
The monopolist makes a supernormal
profit at a given output and price.
If the market is perfectly contestable,
and there are no barriers to entry or
exit, these supernormal profits would
be a signal for new firms to move into
the market.

As a result, the monopolist’s price and profit are reduced, while it produces the
same level of output to maximize the volume of sales, normal profit will be
earned since average costs equal average revenue.

In theory, a perfectly competitive market is most similar to a perfectly

contestable market because there are no barriers to entry and exit, and when
this is the case in a perfectly contestable market:
- only normal profits are earned in the long run
- firms are not able to apply cross-subsidization
- prices cannot be set below average cost to deter new entrants
- allocative efficiency and productive efficiency are being achieved
- the number of firms in the market doesn’t matter
Chapter 36- Growth and Survival of Firms
Chapter 36.1: Reasons for different sizes of firms
Small firms only employ less than 10 people in 90% of the business, which is
typical in most economies, although in low and middle-income countries, the
percentage is even higher.

Small firms are mainly found in the service sector, in retail, food production,
automotive, and personal and business services.
There is a recent trend in many economies for small knowledge and
research-oriented firms to provide services for much larger manufacturing
companies.

There are many reasons why so many small firms exist in a world where
market power lies with large multinational companies, some of which are as
follows:
- there are economic activities where the size of the market is too small to
support large firms
- the firm may involve specialist skills possessed by very few people
- where the product is a service- such as lawyers, accountants,
hairdressers, dentists, and small shops, the firm will be small to offer
the customers personal attention for which they will pay a higher price.
- small firms may be the big firms for tomorrow, although the number of
small firms is huge, only a very small percentage of them grow to
become big businesses.
- the entrepreneur may not want the firm to get bigger because extra
profit is not the only objective and growth might involve a loss of control
over the running of the business.
- recession and rising unemployment can trigger an increase in the
number of business start-ups as former employees try to become
self-employed.
- small businesses may receive financial help under government
enterprise schemes because of their job creation and local growth
possibilities.
- the increased access to technology through the internet and electronic
devices has made small businesses more efficient and more able to
compete with larger ones.
For large firms, such as multinational companies, growth is strongly linked
with the pursuit of profit.
The motives behind a large firm’s growth include the following:
- the desire to achieve a reduction in long-run average costs through the
benefits of economies of scale, which allows firms to compete more
effectively with rivals because they can afford to cut prices without
sacrificing profits, this has often been the main motive for mergers and
acquisitions for large corporations, they gain economies of scale by bulk
buying, giving them a competitive edge in global markets.

- to achieve a bigger market share to boost sales revenue and profits, this
is referred to as a monopoly motive, but it could be a defensive strategy
to maintain market share in anticipation of action by rivals.
there is a strong argument that only big firms can compete in markets
where multinationals are present in the global market.

- to diversify the product range, a multi-product firm has the advantage of

being able to spread business risks, if one branch of its activity is
stagnating or going into decline, there will still be the revenue from
others to keep the firm afloat.
firms see new business opportunities in related areas, large firms can
use the same production facilities keeping the costs down, which are
known as economies of scale.

- to capture the resources of another business, firms may realize that

resources are being under-utilized in another firm and that the real
value of the firm is currently above its accounting valuation.
the resulting takeovers and mergers can lead to the firm being brought
back into profit or being broken up because the sum of the parts sold
separately is greater than the current valuation of the whole enterprise,
it is sometimes called ‘asset stripping’ and the cash received from the
sale can be put into improving the core business.
Chapter 36.2: Internal and External Growth of Firms
Firms can grow in two main ways, firms can grow through:
- Internal growth: a firm decides to retain some of the profit rather than
pay it out to the owner, it is put back into the business in the form of new
investment to increase the productive capacity.
This is likely to occur in capital-intensive activities where the market is
expanding, the timing will be influenced by the stage of the business
cycle, with most investments occurring when the national economy is
approaching a boom period.

- External growth: the business expands by joining with others via

takeovers or mergers, the objective in a takeover bid is to buy sufficient
shares from the owners of the firm to get 51% of the total and have
control of the business.
A merger has the same result, a new larger legal entity, but the word
‘merger’ implies less of a struggle and that both parties have agreed to
the action
Mergers may be more numerous when there is a downturn in the
economy or when there is a shrinking market and firms are left with
excess productive capacity.

Both types of growth can take place at the same time.

External growth may be quicker and cheaper route for firms than internal
growth, especially when there are high fixed costs.
It may be cheaper for a company to buy assets of another than to expand
existing operations, this is likely to involve less risk if the oil company pursues
internal growth as it may be uncertain as to what reserves it has available.

Firms also grow through diversification where firms produce or sell a range of
different products because this tends to spread risk or exploit an opportunity
in the market.
Chapter 36.3: Integration
Integration refers to how the individual parts of a firm come together, which
could be through:
- A merger, where two firms agree to join up with each other
- An acquisition or purchase whereby one firm takes over control of
another

There are three identified methods of integration:

- Horizontal Integration is a process or strategy used by firms to
strengthen their position in an industry, it involves the merger or
acquisition of a business that is in the same sector of an industry.
In such cases, the outcome is one of expansion, the prime motive for this
growth is to reap the benefits of economies of scale, research and
development costs can be pooled, production plants can be rationalized,
and marketing costs reduced.

It can also lead to access to new markets, increasing market power, and
by reducing competition, the opportunity to make abnormal profits.
The danger is that this sort of growth may sometimes be blocked by
governments who are concerned about possible monopoly abuse.

- Vertical Integration is where a firm grows by moving into a forward or

backward stage of its production process or supply chain, such as
manufacturers moving to retail (forward), or taking control over some of
its supplies (backward).

It has various benefits including improved security and quality of

supplies and reduced supply chain costs, but there are disadvantages
such as higher costs if the newly acquired businesses are not effectively
integrated which can be a major problem with any merged operation.

- The external growth of a conglomerate differs from the two forms of

integration so far, as growth comes from the purchase of unrelated
businesses.
The rationale is to spread risk, each of the companies in a conglomerate
is independent with its board of directors, and many are multinational
companies.
 Losses from poorly performing subsidiaries can be offset by profits from
elsewhere in the group and if losses persist then the subsidiary can
always be sold.
The diversity of a conglomerate means that the group can be difficult to
manage strategically.

Chapter 36.4: Cartels

A cartel is a formal agreement between member firms in an industry to limit
competition.
The agreement may involve fixing the quality to be produced by each cartel
member or by fixing the price for which the product is sold.
Other restrictions may also be applied, a cartel maximizes profits in the same
way as a monopolist.
The cartel will weaken if there is a disagreement over the target price or the
production quotas allocated to each member.

The long-term survival of a cartel depends upon the high barriers to entry but
there are threats to a cartel, such as:
- the possibility of a price war, whereby one firm breaks rank to capture a
bigger market share
 - if some members have higher costs than others, resulting in fewer
profits due to the agreed fixed price
- if there is no dominant member that has the power to control others
- legal obstacles such as in the EU and USA where cartels are illegal since
they restrict competition and do not act in the best interest of consumers

Chapter 36.5: The principal-agent problem

In making decisions about the growth of firms, it is assumed that those who
make the decisions have the authority to do so.

In small firms, this is most likely to be the owner or partners who agree on how
growth might or might not occur, they have the authority to act.
In large firms, especially those with shareholders, a gulf in decision-making
between firms’s management and ownership can arise, which is known as the
principal-agent problem.

This occurs when one person (the agent) makes decisions on behalf of another
person (the principal).
The agent through day-to-day involvement in the firm has more information
than the principal, this is also an example of asymmetric information and
moral hazard.
The problem is that the principal is unaware of how the agent will act, the
principal is also not sure that the agent will act in the principal’s best interests.

In the case of a firm’s growth, the agent may have plans and a strategy that
differ from those of the principal, the agent may decide to act in their interest
and if successful, the agent stands to gain prestige and enhance their career
development.
The principal is not aware of what the growth plans involve, this is called
agency cost.

The principal-agent problem is an example of market failure that occurs

because of information failure, the principal should be the one in the best
position to determine a firm’s future growth which is often not so and leads to
the misallocation of resources.
Chapter 37- Differing Objectives and Policies of
Firms
Chapter 37.1: The Traditional Profit-Maximizing Objective
Economists generally assume that firms will seek to maximize their profits.
Profit maximization involves achieving the greatest difference between the
total revenue and total cost (including normal profit).

A firm making the minimum level of normal profit is said to be producing at

break-even output, no supernormal profit is being made.
Most firms will seek to make supernormal profits as a reward for taking risks,
even if it is only in the short run.

If the firm produces up to the point where the cost of making the last unit is
just covered by the revenue from selling it, then the profit margin will have
fallen to zero and total profits will be at their greatest.

A firm producing an output to the

left of Q is sacrificing potential
profit and can raise total profit by
increasing its output, because each
further unit sold adds more to the
revenue than it does to costs.
A firm producing at the right of Q is
making a loss on each successive
unit, which will lower the total
profit.
It would be better off, cutting back to Q where MC=MR where normal profit is
being earned.

There are several reasons why firms do not operate at the profit maximization
level of output:
- it is difficult to identify this output, the firm may simply work out the
average total cost and then add on a standard profit margin to determine
the selling price, this cost-plus pricing technique is unlikely to result in
maximum profit.
 - short-term profit maximization may not be in the long-run interest of
the firm, since firms with large market shares wish to avoid the
attention of government regulatory bodies.
- large supernormal profits may attract new entrants into the industry,
especially where there are low barriers to entry.
- high profits may damage the relationship between the firm and its
stakeholders, such as consumers, and the firm’s workforce as they may
see senior managers and shareholders earning large returns.
- profit maximization may not appeal to the management, who have
different objectives to the shareholders- high profits might trigger
action by the firm’s rivals and the firm could become a target for a
takeover bid, which is another example of the principal-agent problem.

Chapter 37.2: Other Objectives of Firms

Dissatisfaction with the traditional assumption of profit maximization has led
to several alternative objectives being put forward to explain how firms
behave.

These objectives are known as managerial or behavioral objectives of firms:

- Survival
In some situations, firms may have a short-term objective of survival, which
involves minimizing losses, this is most likely where a firm is facing serious
unexpected external threats such as the loss of its best customer or a downturn
in the economy due to external shocks.

Survival in such circumstances becomes a priority to allow the firm to develop

a revised strategy to stay in business.
There is a limit to the time and to the scale of losses that can be tolerated.
If the firm is not covering its variable costs, then closure would seem to be the
only sensible outcome.
If variable costs (but not total costs) are being recouped, then the firm can
continue in business for longer so that it can try to map out a retrieval strategy.

- Profit satisficing
Profit-satisficing occurs when a firm seeks to make a reasonable or minimum
level of profit, sufficient to satisfy the shareholders but also to keep the
stakeholders satisfied, such as the workforce or consumers.
The firm is seen as a set of interest groups, each with its objectives which may
change over time.
Workers may expect pay rises and improvements in working conditions which
may raise costs, consumers may expect to see prices falling if there are rival
producers.
This is a long way from the profit-maximizing theory as firms may choose to
sacrifice some potential short-term profits to satisfy these expectations.

If the firm’s shareholders are divorced from the control of the firm, there may
be a conflict of interest.
The management’s motives may be concerned with growth rather than profit.
Managers may place importance on comfortable working conditions, job
security, status, and fringe benefits.
Time and money spent on these issues can raise costs and if the firm has close
rivals, it may make management more cautious because the risk of failure will
threaten their job security and career advancement prospects.

Profit satisficing can also be a feature of firms that have enjoyed a high market
share over a long time.
Complacency can lead to firms losing focus on their cost structure and failing
to devote resources to either product or process innovation, which can lead a
firm to a loss of profits or if extreme, exit the market.

- Sales maximization
This objective is to maximize the volume of sales rather than the total revenue
from sales.
Sales maximization will lead to greater output than in the case of revenue
maximization.
The firm would increase output to the break-even output where the total
revenue just covered the total cost, a higher output than this implies a
loss-making behavior.

The only situation where loss-making would be possible is where the firm
could use the profit from one part of the firm to offset losses made elsewhere
which is known as cross-subsidization.
Sales can be maximized where a firm follows an objective of growth
maximization through increasing market share.
The benefits of economies of scale can apply when a firm acquires or merges
with a competitor.

The deliberate cutting of prices to make a loss might be a strategy to deter new
entrants into the market, which is called predatory pricing and can be used to
force a rival firm out of the market.

- Revenue maximization
Revenue maximization is an alternative theory of a firm’s behaviour, related to
the principal-agent problem.
The separation of management from ownership, especially in large firms, can
result in a firm’s objective changing.

Senior managers tend to be more interested in increasing sales and

maximizing revenue from sales.
Managerial salaries and bonuses are usually based on total revenue, not
profits, sales can be easily and regularly monitored, and it is more difficult to
measure profits.
In principle, production will continue to the point where marginal revenue
equals 0 which means that a firm with a revenue maximization objective will
produce a higher output than a firm with a profit-maximizing objective, this
firm may produce where MC>MR provided MR>0 since total revenue will
increase.

Chapter 37.3: Other Objectives of Firms

Price discrimination is a pricing policy, that can be used by any firm to increase
its profits by reducing consumer surplus and converting it into producer
surplus.
The only exception is in perfect competition.
To price discriminate, the firm must have some control over price, its demand
curve must be downward-sloping.
 - Conditions for effective price discrimination
These are three recognized types of price discrimination:
- First degree: this is a situation where the firm sells each unit of a product
to a different consumer, charging each the price (ideally the maximum)
that they are willing to pay.
The price is unique to that transaction, there is also no immediate
chance of a resale, the demand curve in all such cases is the same as the
marginal revenue curve, this indicates that the marginal revenue is equal
to the price.

- Second degree: this type of price discrimination where consumers are

only willing to purchase more of a product if the price falls as more and
more units are bought, which means that a higher price is charged for
the first unit followed by a lower price as successive units are purchased.
A type of discounting takes place as the quality purchased increases.
The consumer benefits, as does the firm whose output, total revenue,
and profit can be expected to increase.

- Third degree: this is the most common form of price discrimination, it

requires firms to actively discriminate between consumers and is based
on the presumption that groups of consumers have a different price
elasticity of demand.
If consumers have a low inelastic demand, this demand is not
price-sensitive.

Consumers with a low price elasticity of demand need the product and can be
expected to pay a higher price for it than consumers whose demand is more
price elastic.
The overall outcome is not entirely predictable, the firm’s revenue and profits
should increase, otherwise, discrimination is pointless, the problem is that
some consumer groups benefit yet others do not because of the higher prices
they have to pay.

- Consequences of price discrimination

A monopolist can use price discrimination to produce at a profit when
competitive friends or a monopoly charging a single price cannot cover costs.
The profit maximization output, the total revenue, the total cost, loss.
 If the output was sold separately for a price
consumers would pay for each unit, the
revenue generated would lead to supernormal
profit.
The monopolist has effectively taken the
consumer surplus and turned it into producer
surplus or profit.
As long as the consumers are prepared to pay
the higher price, there is no consumer
exploitation, the competitive market price
would generate losses and there would be zero
output in the long run.

If the firm wishes to split the market up into different segments and charge
different prices, it must have a mechanism for keeping the markers separate, it
must also avoid the possibility of consumers buying at a low price and then
selling the product at a higher price.
Price discrimination will only work where consumers have a different
willingness to purchase have a different willingness to purchase or have
different price elasticities of demand for the product.

Price discrimination has certain advantages and disadvantages for firms and
consumers, it results in an improvement in allocative efficiency but this is
achieved by converting consumer surplus into profit, from an equity
standpoint, this is a disadvantage to consumers.

Chapter 37.4: Other Pricing Policies

Other types of pricing policies may be used within specific market structures

- Limit pricing
Limit pricing is a pricing policy that is applied in monopolies and oligopolies, it
involves firms setting a lower short-run price to deter new firms from entering
their market.
This market may even be contestable, these firms might have been attracted by
the supernormal profits that were being earned.
At this new price, the established firm no longer maximizes profits, but this is
only to be expected for a short time.
The lower price effectively acts as a barrier to entry, a monopolist or
oligopolist needs to increase output or the services provided to such a level that
a new firm cannot make a profit.
These tactics will likely deter the new firm from entering the market.

- Predatory pricing
Predatory pricing occurs when a firm feels threatened when a new firm enters
a market.
The established firm responds by setting a price that is so low that the new
firm has no alternative but to match it.
The new firm cannot make a profit, in time, the new firm will be forced out of
the market, and the established firm will put its prices back to their former
level.

Two established firms can apply predatory pricing in a market.

If one firm believes its rival is gaining market share, it can cut prices to protect
its market share, if these cuts are deep enough and sustained over time, the
rival firm may be forced to leave the market.

- Price leadership
Price leadership is a common feature of an oligopolistic market, all firms in the
market accept the price that is set by the leading firm which is often the firm
with the largest market share or is the brand leader, they alter their prices in
line with those of the leader.
It is seen as a way of avoiding price competition yet maximizing total profits
for all firms while allowing various forms of non-price competition to prevail.

When the leading firm announces a price increase,

all firms follow, it is the same when a price fall is
announced, smaller rivals are forced to follow the
fall in price to retain market share.
The downside is that since their costs are higher,
matching a price decrease could result in sustained
losses and the eventual exist of small rivals from
the market.
If there are two firms in the market and one of them is the lower-cost producer
and price leader, it maximizes profits where MC=MR.
The other firm is compelled to lower it price with lower profits due to its higher
costs of production.
UNIT 9- The macroeconomy
Chapter 41- The circular flow of income
Chapter 41.1: The multiplier
The multiplier shows the relationship between an initial change in spending
and the final rise in GDP.
The multiplier effect occurs because a rise in expenditure will create income,
some of which will be spent and create more income

Closed Economy:
In a closed economy, there are two sectors: households and firms
There is only one withdrawal (savings) and one injection (investment)

Equilibrium income occurs when aggregate expenditure (the total amount

spent in an economy at different levels of income) equals output and injections
equal withdrawals.

- Closed economy with a government sector:

With this model, there is an extra injection (government spending) and
extra withdrawal (taxation)
- Open economy with a government sector:
This is the most realistic mode as it includes all sectors of the economy
(households, firms, government sector, and foreign trade sector) and is
an open economy.

Having three propensities to withdraw is likely to mean that the

multiplier will be smaller. There will be more injections and more
opportunities for GDP to change.

- The average and marginal propensity to save

When an individual or country has a low income, most of the disposable
income has to be spent on current needs.
This means consumption may exceed income with people in countries
drawing on past savings or borrowing, this is called dissaving.

When income rises, some of it can be saved. Saving is defined by

disposable income less consumption.

As income increases, the savings and Average Propensity to Save can

change.

As income rises, the Marginal Propensity to Save also rises.

- The average and marginal propensity to consume

The main influence on consumption is disposable income.
As income rises, total spending also increases but the proportion of
disposable income spent falls.
 - The average and marginal rates for tax
The average rate of tax is the proportion of income taken in tax.
The marginal rate of tax is the proportion of extra income taken in tax.

- The average propensity to import

The average propensity to import is the amount of income spent on
income.

National Income Determination:

The level of national income is determined when aggregate demand meets
aggregate supply.
This is when aggregate expenditure equals output.
Aggregate expenditure is made of consumption, investment, government
spending, and net exports (exports-imports)

If aggregate expenditure exceeds output, the firms will produce more.

They will employ more factors of production and GDP will rise.
If aggregate expenditure is less than output, firms will reduce output, so
output will change until it matches expenditure.
- The effect of changing aggregate demand on national income
A change in the total spending on a country’s goods and services will
result in national income changing by the size of the injection times the
multiplier.
The rise occurs in stages, with those who receive higher incomes from an
increase in government spending purchasing goods and services from
others.
Other people who will gain more income will spend more until leakages
from the circular flow equal the initial injection.
A rise in income will lead the GDP to fall. A decision to save will lead to less
savings because higher savings can reduce income and the ability of
households to save.

Chapter 41.2: Components of Aggregate Demand and their

Determinants
The main influence on household spending is income.
The rate of interest can also affect how much households spend.
A rise in the rate of interest will increase the opportunity cost of spending aa
household could gain more by saving, but borrowing would be expensive.
Households may not be able to borrow as much if commercial banks reduce the
amount they are willing to lend.

Expectations also affect consumption as the decision to spend will be adjusted

if households think their income will rise in the future.

The distribution of income also affects consumption. If income becomes more

unevenly distributed, consumption will fall as richer households will spend a
smaller proportion of their income.

- The consumption function

The relationship between consumption and income and saving and
income can be investigated through the consumption function as it
indicates how much households will spend at different levels of income.

- The savings function: autonomous and induced saving

The saving function is the opposite of the consumption function and is
the relationship between income and saving and can be used to work out
how much and what proportion of income households will save at
different levels of income.

Autonomous dissaving: how much of their savings people will draw on

if income is zero.
- Investment: autonomous and induced investment
Investment is influenced by changes in income, so consumer demand,
the rate of interest, technology, the cost of capital goods, expectations,
and government policies.
Firms buy capital goods to produce goods and services. If households are
likely to buy more consumer goods, firms will increase their output and
they need more capital goods to do so.

A high rate of interest may discourage investment. Firms will find it

expensive to buy capital goods, they may have a higher return on
investment if they save instead of buying capital goods.
A higher rate of interest will also reduce consumer demand and profit
generated.

Advances in technology introduce new products and new capital goods

which have a higher productivity. Such changes encourage firms to buy
more capital goods. A rise in the price of capital goods will reduce
investment as well.

Expectations also are the main reason why investments are unstable as
firms may assume during a recession or an economic downturn, it is
unprofitable to invest in capital goods.

Government spending can influence investment as well as changing the

rate of corporate tax and giving subsidies, and the government can cut
income tax. This could increase disposable income which will encourage
firms to increase their output.
Autonomous investment: investment made independent of income.
Induced investment: investment made in response to changes in
income.
 If income and demand increase, firms will buy more capital goods and
will continue to add to their stock if GDP rises.

The accelerator:
The accelerator theory focuses on induced investment and emphasizes the
volatility of the investment.
It states that investment depends on the rate of change in income and that a
change in GDP will cause a greater proportional change in investment.

If GDP is rising at a constant rate, the induced investment will not change
because firms will continue to buy the same amount of machinery each year to
expand capacity but a change in income can significantly affect investment.

An increase in demand for consumer goods does not always result in a greater
percentage change in demand for capital goods.
For example, firms will not buy more capital goods if they have spare capacity
or do not expect the consumer demand to last.
Firms may not be able to buy capital goods if those industries work close to
capacity.
With advances in technology, the capital-output ratio also changes, with fewer
resources needed to produce a given output.

- Government Spending
Government spending may increase during an economic downturn
hoping to prevent the economy from experiencing a recession.
A government may inject more into the circular flow of income to ensure
the aggregate demand is sufficient to achieve a high level of employment
and an increase in a country’s output.

Government spending as a percentage of a country’s GDP is higher

where governments think there is a chance of market failure.
Increases in population size may also put upward pressure on
government spending as a fall in death rate would demand more
spending on elderly care and medical facilities and an increase in net
immigration may increase the need for state-financed housing whilst
providing tax revenue as tax base increases.
 A government will also spend after natural disasters and military
conflicts.

- Net Exports
The key influences on net exports are the relative price and quality
competitiveness of the country’s products and incomes at home and
abroad.
The relative price competitiveness is influenced by the country’s relative
productivity, relative inflation rate, and exchange rate.

A country with rising productivity more rapidly than others, low

inflation, and an exchange rate falling in value is likely to see an increase
in its price competitiveness and net exports, as a result.
Quality competitiveness will usually rise if there is an increase in net
investment and an improvement in educational standards.

A country will usually be able to sell more exports if other countries

experience a rise in their GDP. This is because the countries’s purchasing
power will increase.
A country is particularly likely to benefit if its firms produce products
with a high-income elasticity of demand as the country’s income
increases, its households, and firms are likely to buy more imports.

Chapter 41.3: Full Employment Level of National Income and

the Equilibrium Level of National Income
Economies do not often operate at the full employment level of national
income.
At any time, they may be producing where total spending is above or below
that needed for national income to equal potential output.

- Inflationary and Deflationary Gaps

In the short run, an economy may not achieve full employment.
An inflationary gap will occur if aggregate expenditure exceeds the
potential output of the economy.
 Not all demands can be met in this situation, as there are not enough
resources to do so. As a result, the excess demand drives up the price
level.

A government may seek to reduce an

inflationary gap by cutting its spending or
raising taxation to reduce aggregate
expenditure.

The equilibrium level of GDP may also be

below the full employment level. In this
case, it is said to be the deflationary gap.

The Keynesian solution to a deflationary gap is

increased government spending financed by
borrowing.
Chapter 42- Economic Growth and Sustainability
Chapter 42.1: Actual and Potential Economic Growth
Actual economic growth occurs when output increases.
It can be achieved as the result of greater utilization of existing resources or as
a result of the utilization of more resources.

For an economy to continue to grow, potential economic growth must occur.

Potential economic growth is an increase in the productive capacity of the
economy.

For potential economic growth to lead to higher output, the rise in productive
potential must be utilized.
Chapter 42.2: Positive and Negative Output Gaps
The difference between the actual and potential output is known as the output
gap.
A negative output gap is caused by a lack of aggregate demand.
When there is a negative output gap, there will be unemployed resources and
the economy will not be producing the full amount it is capable of producing.

An economy may experience a positive output gap when an economy is

producing more than its maximum potential.

Output may be beyond the maximum potential for a while because, in response
to high aggregate demand, machinery may be worked continuously, without
maintenance being undertaken and workers may be persuaded to work long
hours of overtime.
This cannot be sustained since at some point, machines have to be serviced or
repaired and workers will want to reduce the number of hours of overtime they
work.

Chapter 42.3: The business cycle

Output gaps arise during a business cycle.
Economies can grow smoothly over time but there can be periods when there
are notable fluctuations in real GDP.
A country’s real GDP can grow at a faster rate than expected and it can
experience a slower, or even negative economic growth.

Fluctuations in the growth of actual output around the trend growth in

productive potential are known as the business cycle.

- The phases of the business cycle

1) The upturn: the economy is growing at a faster rate. Households
and firms are optimistic. Consumption grows with households
expecting their incomes to rise. Higher profit and increased bank
lending cause investment to rise with some high-risk projects
being undertaken. Employment is also likely to rise.
2) The peak: the economy is experiencing a positive output gap. The
high level of aggregate demand is likely to result in inflation and
balance of payments difficulties.
3) The downturn: the economic growth rate decreases and negative
economic growth may occur. Households and firms become less
optimistic about future economic prospects. Saving rises, some
high-risk firms go out of business and net investment falls.
4) The trough: the economy may experience a recession or
depression (the fall in real GDP that lasts several years). There will
be a negative output gap.
The trend real GDP is expected to rise as each year there are usually
improvements in education and advances in technology.

- The causes of the business cycle

Fluctuations in aggregate demand and fluctuations in aggregate supply.
Business confidence makes aggregate demand vary significantly as if
firms become more optimistic about the future, they will increase their
investment.
Higher investment is an injection into the circular flow. This causes a
multiple increase in GDP. The high GDP is likely to cause an increase in
investment.

The interaction of the multiplier and the accelerator can result in a large
rise in aggregate demand.
If firms become pessimistic, the multiplier and the accelerator will act in
reverse, causing a downward spiral in the aggregate demand.

Changes in the money supply can also result in fluctuations in aggregate

demand. If the money supply grows faster than the country’s output,
investment and consumption are likely to rise.

Large fluctuations in aggregate supply can result from supply-side

shocks. There might be a significant technological advance that has a
noticeable impact on productivity and costs of production.
These supply-side shocks can be both positive and negative.

- The role of automatic stabilizers

Automatic stabilizers offset fluctuations in economic activity.
They reduce the rise in GDP during an economic boom and reduce
the fall in GDP during a recession.
Automatic stabilizers do this by reducing the growth in aggregate
demand during an upturn and economic boom and increasing
aggregate demand during at least part of a downturn, especially
during a recession.
Chapter 42.4: Policies to promote economic growth
To promote actual economic growth and reduce a negative output gap, a
government will try to increase aggregate demand.
To do this, a government will use either an expansionary fiscal policy or an
expansionary monetary policy.

Expansionary fiscal and monetary policies will increase real GDP and reduce
the negative output gap but the policies will either not increase aggregate
demand enough or will increase it too much. This may result in demand-pull
inflation while resulting in actual economic growth if the government
underestimates the size of the multiplier and households and firms will be
worried about economic prospects and reluctant to spend more if the
government overestimates.

To promote potential economic growth, a government will have to encourage

an increase in aggregate supply. It will use supply-side policy tools to do this.
It could provide subsidies to firms to train their workers. A better-trained labor
force will increase productivity and raise productivity capacity.
There is a possibility workers may become trained in skills that will not be
demanded in the future.
Higher government spending on training schemes usually increases
productivity.
Higher government spending will add to aggregate demand and could increase
both actual and potential economic growth.

Chapter 42.5: Inclusive Economic Growth

Inclusive growth: economic growth that is distributed fairly across society
and creative opportunities for all

There are two key aspects to the benefits of economic growth being distributed
fairly.
- In monetary terms, will all experiencing a rise in income
- In non-monetary terms, with all experiencing an improvement in
facilities like healthcare.
Creating opportunities for all means generating more job opportunities,
creating an opportunity for all workers to experience better working
conditions and opportunities for all to live safely.

- Impact of economic growth on equity and equality

Economic growth in some countries and some periods has created
greater equity and a more even distribution of income.
The benefits of economic growth in some cases, have not always been
shared equally or fairly.

Economic growth involves change. Some new industries are created but
others disappear. Those workers who are occupationally and
geographically immobile may become unemployed.
Economic growth can also be accompanied by a widening of the pay gap.

Gig economy: a labor market based on short-term contracts because

workers in insecure jobs, with fewer rights and no guaranteed working
hours rose during a period of recession.

Economic growth has been accompanied by widening income inequality.

- Policies to promote inclusive economic growth

Policies to promote inclusive economic growth seek to spread the
benefits and opportunities created by economic growth more evenly.
- Redistribution of income using progressive taxes and transfer
payments
- Improved access for all to high-quality education should raise
employment opportunities and pay
- A relatively high national minimum wage to ensure those in work
can enjoy a good quality of life
- Anti-discrimination legislation so that no group is excluded from
the benefits of economic growth
- Improvement in transport and communication links to reduce
geographical immobility of labor and regional differences in
income
- trade union legislation that gives trade unions greater power to
protect workers’ rights
 - legislation against slavery and child labor to ensure that
vulnerable groups are not exploited

Chapter 42.6: Sustainable Economic Growth

Sustainable economic growth is economic growth that can continue over
time.
This is because social divisions, lack of access by some to good quality
education, housing, and healthcare, and environmental damage can threaten
an economy’s ability to continue producing higher output.

- Using and conserving resources

Using natural resources can increase economic growth, in the short run.

Cutting down trees in a rainforest, hunting animals in a wildlife reserve,

or increasing the amount of gas extracted from gas fields can increase
output and create jobs, it can also increase exports and improve the
current account position on the country’s balance of payments.
The higher output can increase tax revenue and that can be used to
improve the infrastructure and education, which can further generate
economic growth.
Maintaining rainforests and wildlife in a reserve may encourage tourists
to visit the country, but it can also help the environment by absorbing
carbon dioxide.
Conserving resources also enables future generations to benefit from
them and may mean that resources can be sold at higher prices in the
future.

Several factors may influence the decision to use or conserve resources:

- Consideration of whether demand for the products created by
resources is likely to increase or decrease in the future
- Conversation of a resource is advisable if the country does not
currently have a competitive advantage in producing the related
product but they may have it in the future.
- If the country has serious debt problems, it may feel forced into
using the resource now.
 - Impact of economic growth on the environment and climate change
Economic growth can harm the environment and increase the speed of
climate change.
Higher output of manufactured goods can also result in the emission of
greenhouse gases.
The growth of the tertiary sector can damage the environment and
contribute to global warming.
More tourism can also lead to the destruction of areas of natural beauty
and coral reefs.

The consumption of what is produced can also create environmental

problems.
Economic growth can improve environmental conditions and reduce the
pace of climate change if cleaner energy sources are developed and more
resources are devoted to planting trees, for example.

- Policies to mitigate the impact of economic growth on the environment

and climate change
- subsidize cleaner sources of energy (subsidies do involve an
opportunity cost and may not always encourage efficient use of money)
- provide information on the damage that certain activities can cause to
the environment. This can persuade people to change their behavior and
governments have recently been using the nudge theory to design how
they give this information
- pass legislation to ban or restrict the production or consumption of
certain products.
- tax firms that create pollution - this is based on the polluted pays
principle as that turns external costs into private costs. It has the
potential to move a market closer to its socially optimum level of output
and some of the finance raised can be used to compensate those who
have suffered.
It is difficult to assess the cost of externality to the environment and tax
may also be regressive and output will change if other countries don’t
impose a similar tax.
- use pollution permits

Chapter 43- Employment and Unemployment

Chapter 43.1: Full Employment
Full employment is the highest level of employment possible
Full employment is often considered to be achieved when the unemployment
rate falls to 3%, although the rate may vary between countries.

At any particular time, some people may be experiencing a period of

unemployment as they move from one job to another job.

Chapter 43.2: Equilibrium and disequilibrium unemployment

Equilibrium unemployment is unemployment which exists when the
aggregate demand for labor equals the aggregate supply of labor.
At this point, there will be no pressure for the real wage to change.
Those willing and able to work at the current wage rate will have jobs.
Some people who are a part of the labor force will not have a job, because they
are not willing to accept jobs at the current wage rate, lack information about
job vacancies, do not have the skills and qualifications required or are not able
to move to where the work is.

Voluntary Unemployment: unemployment that arises when workers are not

willing to work at the current wage rate.
Voluntary, frictional, and structural unemployment arise due to problems on
the supply side.

Keynesian economists argue that the labor market can be in disequilibrium for
long periods.
The disequilibrium unemployment is unemployment that arises when the
aggregate supply of labor is greater than the aggregate demand for labor at
the current wage rate and is equivalent to cyclical unemployment

The wage rate can stay above the equilibrium level for several reasons
- Aggregate demand for labor fell but the real wage rate remains
unchanged because workers resist wage cuts.
- The wage rate might also have been pushed up above the equilibrium
level by trade union action or by the government setting a national
minimum wage.

Lowering the wage rate could result in lower aggregate demand and lower
aggregate demand for labor.

An economy can experience both equilibrium and disequilibrium

unemployment at the same time.
Chapter 43.3: Voluntary and Involuntary Unemployment
Voluntary unemployment occurs when workers choose not to accept jobs at
the current wage rate.
They could be employed but they prefer to remain unemployed until they can
gain a job with a higher wage rate.
Involuntary unemployment arises when workers are willing to work at the
current wage rate but cannot find a job.

Most structural and cyclical unemployment is involuntary unemployment

Some frictional unemployment like search unemployment may be voluntary.
Workers may take longer looking for a better-paid job if the wage they can
currently get is close to or below any unemployment benefit they could receive.

Chapter 43.4: The Natural Rate of Unemployment

The natural rate of unemployment exists when the labor market is in
equilibrium with the aggregate demand equaling the aggregate supply of
labor but economists think the economy will move back in the long run which
is consistent with a constant rate of inflation.

The factors that determine the natural rate of unemployment in a country are
supply-side factors:
- The value of unemployment benefits relative to the value of low pay
- National minimum wage legislation
- The quality of education and training
- How workers are affected by periods of unemployment
- The quality and quantity of information about job vacancies and workers
skills and qualifications
- The degree of labor mobility

- Policy implications of the natural rate of unemployment

To reduce the natural rate of unemployment, a government will seek to
increase both the willingness and ability of workers to work at the current
wage rate
- Widen the gap between low pay and unemployment benefits by cutting
unemployment benefits and the basic rate of income tax
- Remove any restrictions on the amount firms can pay their workers
 - Improving education and training as a more skilled labor force is likely
to find it easier to switch from one job to another and suffer less from
structural unemployment.
This can help reduce unemployment caused by hysteresis
(unemployment causing unemployment due to workers becoming
deskilled and demotivated when they are out of work for a long time)
- Firms may also be reluctant to employ someone who has been out of
work for some time as they think the long-term unemployed will have
lost the work habit and may have to be retrained at the firm’s expense.
- Increase the quantity and quality of information about the job market.
- Improve labor mobility (the ability of workers to change where they
work and in which occupation)
- Increase the flexibility in the labor force.

Chapter 43.5: Patterns and Trends in Unemployment

Unemployment is not evenly spread.
It will be higher in declining industries and declining occupations.
It is different in different regions because of differences in transport links,
infrastructure, and housing costs.

Firms may be reluctant to employ young workers because of their lack of

experience and the need to train them.
There is discrimination in the labor market as well so many experience a
higher-than-normal average rate of unemployment.

An increase in the number of unemployed and the rate of unemployment will

be a concern for the government.
If unemployed people stay unemployed for some time, concerns are with
losing work habits and experiencing hysteresis

Chapter 43.6: Patterns and Trends in Employment

- Industrial structure: employment has moved from the primary sector to
the secondary sector and then the tertiary sector.
- The proportion of women in the workforce: the general trend for
women to form an increasing proportion of the workforce.
 These include a rise in pay for women, more job opportunities, increases
in qualifications, greater provision of childcare, and reduction of gender
discrimination.
- Employed and self-employed (those working for themselves): Most
people work for others. Employers decide the working hours, and tasks
they perform but a high proportion of workers are self-employed
- Full-time/Part-time: the proportion of people who work full-time and
part-time varies over time. Some people choose to work part-time for
other commitments, others are forced to work part-time because
full-time jobs aren’t available, this happens during an economic
downturn.
- Employment in a formal and informal economy: Workers in former
employment are protected by employment legislation, but those in
informal employment are not covered. Trade unions do not represent
them and are unlikely to receive employment benefits like sickness
benefits and pensions.
- Secure and Insecure employment: More workers are becoming
employed in the gig economy, these workers don’t have definite working
hours and do not receive sickness benefits or pensions. Some workers
like having the ability to choose where and when they work, others work
because they can’t find stable employment. The unreliability of their
work leads to experiencing difficulties in making economic decisions.
- Private and Public Sector Employment: the relative quality and
availability of private and public sector employment varies from country
to country. The proportion of workers in the private sector has increased
due to privatization.

Chapter 43.7: The Forms of Labor Mobility

Labor mobility is the ability of labor to move from one occupation to another
or from one location to another.
There are two forms of labor mobility:
- Occupational mobility: the ability of labor to move from one occupation
to another.
- Geographical mobility: the ability to move for a job in a different
location.
 There may be unemployed workers in one area of the country and job
vacancies for which they have skills and qualifications, in another part of
the country or another country.

- Factors Affecting Occupational Mobility

- Quality of education and training: the better educated and trained
workers are, the more different types of occupations they are likely to be
able to do.
- Information available: if workers can move smoothly from
occupations that are experiencing decreases in demand to those
increasing in demand, they need to know where job opportunities are.
- Barriers to entry and exit: professional bodies and trade unions may
seek to restrict supply to an occupation to drive up the wage rate.
Workers may also have signed long-term contracts which may make it
difficult to move from one occupation to another.
- Time: the longer the time, the more opportunities workers will have to
gain the training, qualifications, and skills to gain a job in another
occupation.

- Fact0rs affecting geographical mobility

- the price and availability of housing: workers may not be able to move
to jobs in another location if there is a lack of housing in the location.
- information available: as with occupational mobility, workers need to
know where the vacancies are, details about the pay being awarded, and
other aspects of the job.
- Personal ties: workers may be reluctant to leave members of their
extended family to move to another location.

- Factors affecting movement between countries

- immigration controls: moving to and working in another country may
be restricted on work visas and permission to stay.
- language barriers: workers may not be able to take up a job in another
country because they may not speak the language.
- cultural barriers: workers may find the culture of the country
unattractive.
 - differences in pay and cost of living: workers may find that they are
better off by being unemployed in their home country than moving to a
job in another country.

Chapter 43.8: Policies to Reduce Unemployment

To reduce cyclical unemployment, a government will use expansionary fiscal
policy tools to increase aggregate demand
- A reduction in indirect or direct taxes to increase consumer expenditure
- A cut in corporate tax to stimulate investment
- An increase in government spending

Monetary tools that can be used:

- Reduce the rate of interest to increase consumer expenditure and
investment
- Increase the money supply to increase consumer expenditure and
investment
- Lower the exchange rate to increase net exports through intervention in
the foreign exchange market or formal devaluation

The extent to which expansionary fiscal or monetary policy tools may increase
employment will depend on several factors.
The rise in aggregate demand may not be very large if consumers and firms are
worried about the future or if firms expand their output capacity by buying
capital equipment that requires a few extra workers to operate.

Fiscal and monetary policies also have a time lag. By the time unemployment
has been recognized as a problem, policy tools have been decided upon and put
into action, and other components of aggregate demand may have started to
increase.

To reduce frictional and structural unemployment, a government is likely to

introduce supply-side policy tools.
It may increase information on the job market. It could reduce unemployment
and reduce unemployment benefits and income tax rates to increase the
reward from working and so encourage people to spend less time between jobs.
Improved education and training may increase worker’s occupational mobility
and reduce structural unemployment.
Trade union reforms may stop trade unions from pushing the wage rate above
the equilibrium wage rate levels and stop industrial action. This may increase
the efficiency of the country’s labor and product markets.

Some supply-side tools can take a long time to have an effect.

There is also the risk that workers may not respond as expected, and if the
cause of unemployment is a lack of aggregate demand, the policy tool may
make the situation worsen.
A cut in the income tax may reduce structural, frictional, and cyclical
unemployment but there is no guarantee that it will encourage people to work
more actively.
If there is a lack of jobs available, the unemployed would not be able to find
them anyway.
If there are no available suitable vacancies, a cut in unemployment benefits
will reduce consumer spending, which could result in cyclical unemployment.

Chapter 44- Money and Banking

Chapter 44.1: Introduction to Money
Money is an item people use to buy and sell goods and services.
It also carries several other functions.

Bank notes and coins are usually used for smaller purchases.
Money is bank deposits is the main form of money, it is transferred from one
person to another by direct debit, credit cards, and smartphones.

Cryptocurrencies allow people to make and receive money online, person to

person, without the need for a commercial bank. They are also not regulated by
central banks.
The best-known and most-used cryptocurrency is Bitcoin, which was
introduced in 2009. People can get bitcoins by accepting them in payment,
buying them on special websites, or carrying out tasks in the Bitcoin system
(known as mining). People use cryptocurrencies to make payments, hoping
they will rise in value but the demand and supply determine the value and
constantly fluctuate.
 - Functions of Money:
The best-known function of money is to buy and sell goods and services but it
also carries out three other functions.
1) medium of exchange: we sell goods and services for money, and we use
the money we receive to buy other goods and services, this overcomes
the need for the double coincidence of wants (a situation where two
people each have something the other wants)
2) store of value: money enables people to save, they can keep any money
they receive from selling for future use.
3) unit of account: this is also known as a measure of value, money enables
the value of different items to be compared as prices expressed in money
terms.
4) standard of deferred payment: money enables people, firms, and the
government to buy and sell in the future.

- The characteristics of money:

1) generally acceptable: if people are not prepared to accept an item
in exchange for products, as a store of value and standard of
deferred payment, if it will not act as money.
2) recognizable: people have to identify the item as money, and
central banks make the country’s notes and coins distinctive.
3) portable: it must be easy to carry money around, bank notes are
very light and coins are not too heavy.
Transferring money from one account to another account can be
done electronically and so does not involve having to carry
anything.
Even using credit and debit cards to transfer money involves
carrying very light objects.
4) divisible: any form of money must be divisible into units of
different value.
5) homogenous: each unit of money must be identical.
6) limited in supply: if there is an unlimited supply, it would have no
value.
 7) not easy to counterfeit: if it was easy to counterfeit money, it
would lose its value, central banks have built-in special features to
their bank notes to prevent counterfeiting.

Chapter 44.2: The money supply

The money supply is the total amount of money in an economy.
The money supply consists of currency in circulation + relevant deposits.

Governments measure the money supply to gain information about trends in

aggregate demand, and the state of financial markets and to help them in
determining the direction of monetary policy.

There are two main measures of money supply:

1) Narrow money: this is money that is used as a medium of exchange and
consists of notes in circulation and cash held in banks and in balances
held by commercial banks as the monetary base
2) Broad money: this consists of the items in narrow money + a range of
items that are concerned with money’s functions as a store of value.

Chapter 44.3: The quantity theory of money

Aggregate demand is influenced by the money supply and can influence the
money supply.

The quantity theory of money seeks to explain how changes in the money
supply can have an impact on the economy.
This is based on the Fisher Equation: MV=PT (MV=PY) where M is the money
supply, V is the velocity of circulation, P is the price level and T/Y is the
transactions or output of the economy.
Both sides of the equation have to equal each other since both sides represent
the total expenditure in the economy.

- Keynesian and Monetarist theoretical approaches

Keynesians are economists whose ideas are based on the work of John
Maynard Keynes.
They believe if left to market forces, there is no guarantee that the
economy will achieve a full employment level of GDP.
 They think that the level of GDP can deviate from the full employment
level by a large amount and for long periods.
They favor government intervention to influence the level of economic
activity.
They argue that if there is high unemployment, the government uses a
budget deficit to increase aggregate demand.
They believe a government can assess the appropriate amount of extra
spending to inject into the economy in such a situation.
The avoidance of unemployment is a key priority.

For monetarists, the control of inflation is seen as the top priority for a
government.
They argue that inflation is the result of excessive economic growth of
the money supply, so they believe that the main role of the government
is to control the money supply.
They also maintain that attempts to reduce unemployment by increasing
government spending will only succeed in raising inflation in the long
run.
They think that the economy is inherently stable unless disturbed by
erratic changes in the growth of the money supply.

Chapter 44.4: Functions of commercial banks

Commercial banks (high street banks and retail banks) carry out a range of
functions:
- They provide deposit accounts for their customers.
- demand deposit: where consumers can make and receive payments
- saving deposit account: this account is used as a way of saving money,
this is a bank account that pays interest and may require a notice to be
given before a withdrawal can take place.

- They hold a range of assets, like cash, government securities, and

equities.
- They make most of their profit from lending.
Bank customers are usually allowed to overdraw their deposit account by
a certain value.
They can also ask for an overdraft (permission to spend more than is in a
demand deposit account).
 The customer is charged interest on an overdraft
- A loan has to be agreed with a commercial bank.
It is usually for a particular purpose and a set amount of time.
Interest has to be paid on the full value of the loan, whether it is used or
not.
The interest is normally lower than on an overdraft.

The proportion of liquid assets to total deposits that commercial banks keep
is known as the reserve ratio.

- Objectives of Commercial Bank:

Commercial banks have three main objectives:
1) Profitability
2) Liquidity
3) security

Commercial banks aim to achieve high profits for their shareholders mainly by
lending.
This objective conflicts with its other two objectives and a balance has to be
achieved between the three objectives.
Commercial banks have to achieve a certain level of liquidity and security.
They need to have enough liquid assets such as cash and short-term securities
that will soon be turned into cash, to meet the expected request by their
customers to withdraw their money in cash.
These liquid assets are not very profitable. No money is earned on holding cash
and commercial banks also aim for security.
They have to convince their customers that they are financially sound and to
achieve this aim, they try to ensure they have sufficient financial capital to
cover their risker loans.

A commercial bank will keep some assets that are liquid but not very profitable
and some that are profitable but not very liquid.
It may also keep some of its profits in care some of its borrowers do not repay
thief loans or firms it buys shares in go out of business.
Chapter 44.5: Causes of changes in the money supply
- An increase in commercial bank lending
- An increase in government spending financed by borrowing from
commercial banks
- An increase in government spending financed by borrowing from central
bank
- The sale of government bonds to private sector financial institutions
(quantitative easing)
- More money entering than leaving the country

- Commercial banks and credit creation

When commercial banks lend, they create money, this is because when a
bank gives a long, the borrower’s account is credited with the amount
borrowed.
Banks are in a powerful position to create money because they can create
more deposits than they have cash and other liquid assets.

When people make payments, they use credit cards, debit cards, and
online transfers and these means of payment involve a transfer of money
using entries in the records that banks keep of their customer’s deposits
rather than paying out cash.

They have to be careful when calculating what liquidity ratios to keep.

The ratio can be set by a central bank when it is called a reserve ratio.
The lower the proportion of the liquid assets commercial banks keep,
the more they can lend.
They have to be able to meet their customers’ demands for cash if they
miscalculate and keep too low a ratio, or if people suddenly start to cash
more of their cash, there is a risk of a run on the banking system.

Customers have to believe there is enough cash and liquid assets to pay
out all their deposits, which may not be the case in practice.

- Bank Credit Multiplier

By estimating what reserve ratio to keep a bank will be able to calculate
its bank credit multiplier.
 Bank Credit Multiplier: the process by which banks can make more
loans than deposits available.
For this, a commercial bank will take into account its reserve ratio.
= 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑛𝑒𝑤 𝑎𝑠𝑠𝑒𝑡𝑠 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑/𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑙𝑖𝑞𝑢𝑖𝑑 𝑎𝑠𝑠𝑒𝑡𝑠
= 100/𝑙𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜

- Reserve Ratio
The reserve ratio helps a bank calculate how much it can lend.
The bank first works out the possible increase in its total liabilities.
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑙𝑖𝑞𝑢𝑖𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 Χ 𝑏𝑎𝑛𝑘 𝑐𝑟𝑒𝑑𝑖𝑡 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟
To work out the changes in loans (advances), the change in liquid assets
is deducted from the change in liabilities (including deposits given to
those putting in the liquid assets).

In practice, a bank may not be as much as the bank credit multiplier

implies it can be because there may be a lack of households and firms
wanting to borrow or a lack of credit-worthy borrowers.
If banks persist in lending to borrowers with poor credit ratings, the risk
of default is high and can have serious consequences on a bank’s
liability.

A bank is likely to change its reserve ratio if people alter the proportion
of their deposits they require in cash, if other banks alter their lending
policies, or if the country’s central bank requires banks to keep a set
reserve ratio.

A central bank may seek to influence commercial banks’ ability to lend.

It may engage in open market operations which involves the central
bank buying or selling government securities to change bank lending.
If the central bank wants to reduce bank loans, it will sell government
securities.
The purchasers will pay by drawing on their deposits in commercial
banks and so cause the commercial banks’ liquid assets to fall.

- Capital ratio
The capital ratio is a commercial bank’s available financial capital
expressed as a percentage of its riskier assets.
 It includes retained profits and newly issued shares.
Government securities are normally assumed to carry no risks, but some
loans can be considered risky if the economy gets into difficulties.

The higher the capital ratio a commercial bank has, the more
unexpected losses it can experience without going out of business.
The capital ratio is designed to protect the bank’s customers in the event
of a financial crisis and to promote the banking sector's stability by
discouraging excessive risk-taking.

- Role of Central Bank

- it issues banknotes
- authorizes the minting of coins
- it is the bank of the commercial banks
- commercial banks keep deposits in the central bank which enables the
commercial banks to make and receive payments from other commercial
banks and to withdraw money when needed.
- the central bank will also lend to commercial banks if they face
financial difficulty.
- acts as a banker to the government
- implements the government’s monetary policy

- Government deficit financing

If the government spends more it raises in taxation, it will have to
borrow which is organized by the central bank.
If the central bank borrows, on behalf of the government, by selling
government securities, including National Savings certificates to the
non-bank private sector (non-bank firms and the general public), it will
use existing money.
The purchasers will draw money out of their bank deposits and the rise
in liquid assets resulting from increased government spending will be
matched by an equal fall in liquid assets as money is withdrawn.

If a budget deficit is financed by borrowing from commercial banks or

the central bank itself, the money supply will increase.
When the government borrows from the central banks, it spends money
drawn out of its account kept at the central bank.
 This spending will increase deposits in commercial banks and their
liquid assets, with more liquid assets, they will lend more.

Commercial banks will also be able to lend more if the government

borrows from them by selling them short-term government securities.
This is because these securities count as liquid assets and can be used as
the basis of loans.

- Quantitative Easing
When the rate of interest is very low, a central bank may decide to try to
increase aggregate demand by in the use of quantitative easing.
This involves a central bank buying both government and private
securities, of different maturities from financial institutions, including
commercial banks.

In return for the securities, the central banks credit the accounts of
commercial banks.
With more assets, the commercial banks will lend more.
This should increase the money supply and reduce the short-term and
long-term interest rates.
These changes may increase investment and consumer expenditure,
along with aggregate demand and economic activity.
This method has also been used to help markets that are in difficulties.

- Changes in the balance of payments

The total currency flow refers to the total net outflow and inflow of the
money resulting from international transactions, as recorded in the
different sections of the balance of payments.

If export revenue imports expenditure, money will flow into the country
on the trade balance.
Exporters will deposit the money into the country’s commercial banks
which leads to a multiple increase in the money supply.
Chapter 44.6: Effectiveness of policies to reduce inflation
Contractionary monetary and contractionary fiscal policy can be used to reduce
inflation.
Supply-side policy can be used in the case of cost-push inflation.
Increased spending on training can raise labor productivity and reduce labor
costs or reduce the upward pressure on labor costs.
Lower corporate tax may encourage firms to buy more efficient capital
equipment, which also puts downward pressure on price rises.

The effectiveness of these policies in reducing inflation depends on several

factors:

- The type of inflation needs to be correctly identified

It can be a cost-push, arising when the economy is operating at less than full
employment.
If the government introduces contractionary monetary and fiscal policies, the
fall in aggregate demand may not have much impact on the price level but
could increase unemployment.
It is often difficult to distinguish between cost-push and demand-pull
inflation because once inflation is underway, it is usually a mixture of
cost-push and demand-pull inflation.
Some policy tools can help both types of inflation in the long run.
An increase in government spending on education and training may increase
demand-pull inflation in the short run, but can reduce cost-push inflation by
raising productivity and lowering costs of production, it would allow the
economy to sustain larger increases in aggregate demand without
experiencing inflation.

- Governments and central banks make estimates of future inflation rates,

the further they are into the future, the more uncertain these forecasts are.
It might be predicted that demand-pull inflation is accelerating and will cause
a problem.
There is no guarantee that such a forecast is right and if it is, it will take time to
decide on the appropriate policy tool, implement it, and for households and
firms to react.
By the time these changes occur, the inflation rate may have fallen and any
policy tool designed to reduce aggregate demand may just increase the severity
of any downturn.

- There may be limits on the policy tools a government can use.

Any country may be reluctant to raise its income tax rate if it thinks this will
encourage some of its skilled workers to emigrate and discourage
multinational companies from setting up in the country.
A government may also want to spend more on infrastructure to reduce
cost-push inflation, but may be reluctant to raise tax rates and may lack
willing lenders.

- A government may decide that inflation is the result of the money supply
growing faster than output, but it can be difficult to control the growth
of the money supply.
This is because commercial banks have a profit incentive to increase their
loans and they are inventive in getting around any limits on bank lending.

- The reaction of firms and households is one of the main influences on

the effectiveness of anti-inflationary policies.
Contractionary monetary and fiscal policies may be introduced to lower
demand-pull inflation.
This will occur at a time when households and firms are likely to be optimistic
about the future, a rise in interest, may not reduce consumption and
investment, and it may cause people to work more hours to maintain their
living standards rather than reduce their spending.
There is also no guarantee that if a government trains or provides subsidies for
firms to train workers, that firms will have the capital equipment that can take
full advantage of the workers' new skills and if the productivity of workers
rises by less than their wage rates, costs of production will still rise.
 - The monetary transmission mechanism
This is the process by which a change in monetary policy works through the
economy via a change in aggregate demand to the price level and the real GDP.
There are several links in this process
- An increase in the money supply may lower the interest rate, which in
turn may increase aggregate demand
- Higher aggregate demand may increase output or the price level.

Chapter 44.7: The Liquidity Preference Theory

The demand for money is explained by liquidity preference which is a
Keynesian concept that explains why people demand money.
There are three main motives for households and firms to hold part of their
wealth in money form:
- Transactions motive: this is the desire to hold money to make everyday
purchases and meet everyday payments.
The amount of money held by a household or firm is influenced by the
income received and the frequency of the income payments.
The more income received and the more frequently the payments are
received, the higher the amount that will be held.

- Precautionary motive: firms and households hold rather more of their

wealth in money form than they anticipate they will spend.
This is so that they can meet unexpected expenses and take advantage of
unforeseen bargains.

- Speculative motive: this is interest elastic.

Households and firms will hold what are called idle balances when they
believe that the returns from holding financial assets are low.
They may decide to hold government bonds (these are the government
securities that represent loans to the government.
The price of government bonds and the rate of interest move in opposite
directions.
Households and firms are likely to hold money when the price of bonds
is high and expected to fall because they will not be forgoing much
interest and they will be afraid of making a capital loss.
The speculative demand for money will be low when the price of bonds is
low and the rate of interest is high.
Transactions and precautionary motives for holding money are interest
inelastic, the demand for holding money for speculative motive is interest
elastic.
Money resources held for the transactions and precautionary motives are
sometimes, referred to as active balances as they are likely to be spent soon.
They are relatively income inelastic, a rise in the rate of interest will not result
in households and firms significantly cutting back on their holdings for money
for transactions and precautionary reasons.

Chapter 44.8: Interest Rate Determination

Keynesians argue that the rate of interest is determined by the demand and
supply of money.
They assume that the supply of money is determined by the monetary
authorities and fixed in the short run.

An increase in the money supply will cause a fall in the rate of interest.
The rate of interest falls because the rise in money supply will result in more
households and firms having higher money balances that they want to hold
and they use some to buy financial assets.

A rise in demand for government bonds will cause the price of bonds to rise
and so the rate of interest to fall.
 - The liquidity trap
It is expected that an increase in the money supply will cause the rate of
interest to fall, Keynes described a situation where it would not be
possible to drive down the rate of interest by increasing the money
supply as the liquidity trap.
It could occur when the rate of interest is very low and the price of bonds
is very high, speculators would expect the price of bonds to fall in the
future, so if the money supply was to be increased they would hold all the
extra money.
They would not buy bonds for fear of making a capital loss, and because
the return from holding such securities would be low.

- Loanable Funds Theory

This theory suggests that the rate of interest is determined by the
demand for and supply of loanable funds.

The demand for loanable funds is the demand for money to borrow.
Households borrow money to purchase cars and houses, firms may demand
loanable funds because they are in financial difficulties or more commonly
because they want to invest.
The government may also want to borrow if it has a budget deficit.

The demand for loanable funds slopes down from left to right as borrowing
and the rate of interest are inversely related.
The lower the rate of interest, the more likely that economic agents will
borrow more.

The supply of loanable funds comes from savings, the more money that is
saved, the more money there will be available to lend.
The supply of loanable funds curve slopes up from left to right as savings and
the rate of interest are directly related.
The higher the rate of interest, the more likely economic agents will save as
they will gain a higher return.

This theory suggests that an increase in

savings will result in a rise in the supply of
loanable funds and a fall in the rate of
interest.
UNIT 10- Government Macroeconomic
Intervention
Chapter 45- Government Macroeconomic Policy
Objectives
Chapter 45.1: Inflation
Governments aim for low and stable inflation.
A range of factors influences this rate of inflation:
- Inflation rate of other countries: a country’s firms may import raw
materials or capital goods from a country experiencing high inflation.
If it cannot source these from elsewhere, the country’s production costs
will rise which is likely to push up the country’s inflation rate.

- A government and central bank’s ability to implement

anti-inflation policy tools is also influenced by what other
governments and central banks are doing.
If a government raises its income tax rates and other countries do
not, the country may lose some of its skilled workers, and
multinational companies may be discouraged from setting up in
the country.
A rise in a country’s interest rates above that of rival countries may
attract an inflow of money into the country’s banks.
This may push up the country’s exchange rate, which may help to
lower inflation but can reduce the international competitiveness of
the country’s products.

Chapter 45.2: Balance of Payment Stability

Governments usually aim for the total of credit items in the current account of
the balance of payments to equal the total of debit items in the long run.
There are several reasons for this:
- A current account deficit reduces aggregate demand and can result in
external debt.
- A current account surplus can be inflationary and can involve an
opportunity cost of forgone imports.
 - Large changes in the current account balance can lead to fluctuations,
which results in changes in the exchange rate.
- Moving from a large current account deficit to a smaller deficit or
current account surplus and then back to a large deficit can cause the
exchange rate to rise and then, fall.
- Changes in the exchange rate can create uncertainty and such
uncertainty can reduce investment and economic growth.

Chapter 45.3: Unemployment

Governments seek to keep unemployment low and of short duration.
The quicker the unemployed can return to work, the less output will be lost and
the lower government spending on unemployment benefits will be.

If workers experience only short periods of unemployment, they may not lose
much income.
They are also likely to take advantage of many training or technological
developments and advances in working practices.

Chapter 45.4 Economic Growth

Governments may aim for economic growth or an increase in the economic
growth rate if the economy has been experiencing a negative output gap.

To achieve this, it may use expansionary fiscal and expansionary monetary

policy.
If the national output does rise, unemployment is likely to fall but there is a
risk that demand-pull inflation may occur if aggregate demand increases too
much.
The effect on the current account of the balance of payments of an increase in
national output is uncertain.
There may be a rise in exports but more raw materials and capital goods may
be purchased to assist in the production of goods and services, the rise in
income will be spent on imported goods and services.

Higher output may not be sustainable if it causes a depletion of non-renewable

resources and damages the environment.
Governments promote potential economic growth by using supply-side
policies.
Expanding productive capacity should reduce the chances of an economy
experiencing demand-pull inflation.
By keeping down rises in costs of production, an increase in productive
capacity may increase international competitiveness and improve the balance
of payments performance.
Improvements in education and training will increase the skills of workers,
which should make them more attractive to employers, but if the demand for
goods and services workers could produce is lacking, they will not be
employed.
Support for technological improvement is likely to create some new jobs but
also end the need for other jobs.

Chapter 45.5: Economic Development

The challenge of development is to improve the quality of life.
In the world’s poorest countries, a better quality of life would be possible
through higher incomes but countries also need better education, higher
standards of health and nutrition, less poverty, a cleaner environment, more
equality of opportunity, greater individual freedom, and a rich cultural life.

There is a much broader view of development than one confined to increases in

GDP.

Chapter 45.6: Sustainability

Rapid economic growth may be achieved but at the expense of the living
standards and the quality of life of future generations if it results from the
reckless use of resources.
All economies are more concerned with achieving sustainable development,
this occurs when output increases in a way that does not harm the needs of
future generations.
More use could be made of renewable resources in preference to
non-renewable resources and improvements in technology may both increase
output and reduce pollution.
Chapter 45.7: Redistribution of wealth and income
Governments take some money from the rich and use it to help those on low
incomes either in the form of cash benefits or in the form of provision of goods
and services such as subsidized housing or free healthcare.

Those who are on low incomes also receive more benefits from an extra dollar
that the rich would have received if they kept the dollar.
The extent to which governments redistribute income varies because they have
different views on how significant can be the disincentive effect to work and
enterprise of progressive taxation.

Chapter 46- Links between macroeconomic

problems and their interrelatedness
Chapter 46.1: The relationship between the internal and
external value of money
The internal value will fall as a result of inflation, each unit of currency will buy
less in the domestic market.
If the internal value of a country’s money falls as a result of a rise in its
inflation rate above that of rival countries.
This will lead to the demand for the country’s currency falling as foreigners
buy fewer of the country's exports, and the supply of currency on the foreign
exchange market will rise as more imports are purchased.
The reduced demand and higher supply of the currency will cause a
depreciation.
A change in the external value of the currency- the exchange rate, will affect
the internal purchasing power of a country’s money.
A fall in the exchange rate will raise the price of a country’s imports in terms of
the home currency.
This will directly and indirectly reduce the value of the country’s money.
Each unit of the currency will buy fewer of the expensive finished imported
products.
Purchasing power may also be reduced as a result of the increase in the price of
imported raw materials and reduction in competitive pressure, driving up the
prices of domestically produced products.

A fall in the internal value leads to a fall in the external value of money and
vice versa.

Chapter 46.2: The relationship between the balance of

payments and inflation
If a country’s inflation rate rises above that of its main competitors, its price
competitiveness will fall.
Export revenue will decline while import expenditure rises and the current
account balance will deteriorate.

An increase in a current account surplus may cause inflation as net exports are
making an increasing contribution to aggregate demand and more money will
be flowing into the country than leaving it.
This upward pressure on the domestic price level and downward pressure on
the internal value of the currency may be short-lived because an increasing
current account surplus may cause a rise in the exchange rate.

An appreciation may reduce the surplus and inflation rate as the price of
imported products will fall and there will be more pressure on domestic firms
to keep their prices low.

A net inflow on the financial account may reduce a country’s inflation rate if
multinational companies bring in advanced technology and increase
competitive pressure within the economy.
Chapter 46.3: The relationship between growth and inflation
A high inflation rate is likely to reduce a country’s economic growth rate.
This is because net exports are likely to fall which results in lower aggregate
demand that reduces the country’s output and reduces the growth of the
country’s output.

The effect of economic growth on inflation is more uncertain as a rise in actual

economic growth may be accompanied by cost-push or demand-pull inflation.
As more is produced, there will be more competition for resources, including
workers which will raise their prices.
Higher output also increases income and aggregate demand.
The gap in the growth of the two will become more acute as the economy
approaches full employment level.
Potential economic growth can reduce inflation, as it enables aggregate
demand to increase without pushing up the price level and it can reduce the
costs of production.
Advances in technology can enable a higher output to be produced per factor
input.

Chapter 46.4: The relationship between growth and balance

on payments
Economic growth may be export-led which means it is largely the result of an
increase in net exports.
Higher net exports will cause a multiple increase in GDP.
In this case, economic growth will be accompanied by an improvement in the
current account of balance of payments, there can also be this positive
relationship if there is potential economic growth.
In this case, the price competitiveness and the quality competitiveness of the
country’s products could increase.

However, there is the possibility of an inverse relationship, in the short run if

firms may purchase raw materials from other countries to produce a higher
output if some of the output is exported, the initial rise in imports may be
matched by an increase in exports.
An increase in the current account surplus will increase aggregate demand
which can cause actual economic growth.
A rise in exports can lead to a significant increase in the national income as
well.

Chapter 46.5: The relationship between inflation and

unemployment
- The Phillips Curve
Bill Phillips analyzed historical data on the relationship between changes
in unemployment and money wages (taken as an indicator of inflation)
and found an inverse relationship.

A fall in unemployment may cause higher inflation due to extra aggregate

demand and the possible upward pressure on wages.
The traditional Phillips curve is downwards sloping from the left to the right.
It is steeper at high rates of inflation, indicating that a fall from a shallow rate
of unemployment to an even lower rate will result in a significant rise in
unemployment.
The curve becomes much flatter as employment increases, indicating that
reducing unemployment from a very high rate may not have much impact on
the price level and that a high rate of unemployment may be accompanied by
deflation.

It also suggests that a government can select its best combination of

unemployment and inflation and can trade off the two.
The curve will shift to the right if the rate of inflation associated with any given
unemployment rate increases.
If workers hold out for higher wages because they expect inflation will be
higher or because workers become less skilled, the curve will shift outwards.
Improvements on the supply side of the economy will shift the curve to the left.

- The expectations-augmented Phillips Curve

The traditional Phillips curve is supported by Keynesians but questioned
by monetarists.
They argue that while there may be a short-run trade-off, in the long
run, government policy tools to increase aggregate demand will have no
impact on unemployment but will only succeed in raising the inflation
rate.
Milton Friedman developed the expectations-augmented Phillips curve
The position of this line is determined by the natural rate of
unemployment.

An increase in aggregate demand does not succeed in reducing

unemployment but creates inflation and moves the economy onto a
higher short-run Phillips curve.
Firms expand their output and more people are attracted into the labor
force as a result of higher wages but firms realize their costs have risen
and their real profits are unchanged, they will cut back on their output
and some workers will realize their real wages have not risen and leave
the labor force.
Chapter 47- Effectiveness of policy options to meet
all microeconomic objectives.
Chapter 47.1: The effectiveness of fiscal policy with different
macroeconomic objectives

-Economic growth and low unemployment and balance of payments stability

and price stability

Expansionary fiscal policy can increase actual economic growth and reduce
cyclical unemployment.
However, the higher aggregate demand can increase demand-pull inflation
and can increase a deficit on the current account of the balance of payments.

Contractionary fiscal policy can improve two of the macroeconomic objectives

but also can threaten or worsen the other two.
A lower aggregate demand may help a government achieve low inflation and a
balance on the current account of the balance of payments.
This may be at the expense of higher cyclical unemployment and lower actual
economic growth.

- Crowding out and crowding in

There is a debate as to whether higher government spending always results in

higher aggregate demand.
Some economists argue that higher government spending, financed by
increased borrowing, reduces funds available to lend to the private sector and
drives up the rate of interest.
The reduction in the funds available and the rise in the rate of interest reduces
consumption and private-sector investment, and increased public-sector
spending crowds out private-sector spending.
The higher interest rate can also attract foreign financial investment which
could increase the exchange rate and reduce net exports.
Keynesians reject the idea that crowding out occurs, they argue that crowding
in occurs, higher government spending will raise GDP by a multiple amount,
and the higher income will increase saving, which will provide the funds
available to lend.
The higher income will also encourage a rise in consumption and investment,
which would mean that higher public-sector spending can increase
private-sector investment.

- Unexpected responses
There is no certainty as to how households and firms will respond to changes
in fiscal policy.
A cut in income tax rates and corporate tax may not increase consumption and
investment if households and firms expect that the tax rates will soon be
reversed.

- Time Lags

Due to the time lags involved in fiscal policy, there is a risk that the policy may
act to reinforce the business cycle rather than counter it.
An economy may be entering a recession, the government will take time to
recognize the problem, decide on the policy tools it should use, and implement
them, it will also take time for households and firms to react to the changes.
By the time all the changes have occurred, the economy may be experiencing
an economic boom, and expansionary fiscal policy will have an impact when
the negative output gap has been closed and a positive output is occurring, the
fiscal policy measures adopted will add to inflationary pressure.

- Difficulties in reversing an increase in government spending

Fiscal policy is the main policy used to redistribute income and promote
development.
Progressive taxes and transfer payments move money from the rich to those
on low incomes.
Government spending on state healthcare and state education can also benefit
those on low income and raise life expectancy and educational performance.
There is a risk, that an increase in transfer payments may reduce the incentive
for the unemployed to seek work and the unemployed and their children may
experience greater poverty in the long run than if they have accepted a
low-paid job now.
Being in employment can increase workers’ skills and their chance of getting a
higher-paid job in the future.

- Laffer Curve
The Laffer curve shows that when tax rates are high, raising them further will
be counterproductive.
Laffer drew the curve to support his view that a cut in tax rates may increase
tax revenues by stimulating both total economic activity, because of the
greater incentive effect and declared economic activity.

At the tax rate of 0%, there will be no revenue, there

will also be no tax revenue at a rate of 100% as
workers will not be prepared to work if all their
income goes into tax.

The curve suggests there is a tax rate that will

generate the most tax revenue, raising the tax rate
beyond the point would reduce tax revenue as it will
discourage work and encourage tax evasion.

The curve also suggests that, apart from where the

tax revenue is maximized, the same tax revenue is received at two different tax
rates.
Empirical evidence also suggests that belief in the Laffer curve can result in
government failure.

Chapter 47.2: The effectiveness of monetary policy with

different macroeconomic objectives

- Economic growth and low unemployment and balance of payment

stability and price stability
Expansionary monetary policy may promote economic growth and may
reduce unemployment but this type of policy can increase demand-pull
 inflation and increase a deficit on the current account of the balance of
payments.

- Time Lag
There is a time lag with both monetary policy and fiscal policy.
Monetary policy tends to have a shorter time lag than which exists with
fiscal policy.
It takes less time to change the rate of interest than to draw up changes
in taxes and government spending and to pass these changes into
legislation.

- How commercial banks respond

Monetary policy has to be carried out through the commercial bank
system.

The central bank may raise the interest rate charges to commercial
banks to borrow from it.
The commercial bank may not pass on this increase in the interest rate
they charge their customers if they think that keeping lending at a high
level will generate more profit.
There is no guarantee that quantitative easing will be successful.
The central bank can buy financial assets from commercial banks in
return for cash.
This will increase commercial banks’ liquid assets and their ability to
lend.
If commercial banks are pessimistic about the future, they may be
reluctant to lend more as they will worried about the ability of borrowers
to repay the loans.

- Liquidity Trap
Qualitative easing has been adopted when interest rates have been low.
One limit on monetary policy is that a reduction in the interest rate may
have little impact when it is already low.
A liquidity trap may occur.
- Influence of changes in other countries
A central bank’s ability to change its interest rate is also limited by what
other central banks may want to raise its interest rate to discourage
borrowing.
If other central banks cut their interest rates or keep their cut their
interest rates or keep their interest rates low, the country’s firms may
borrow from abroad.
Foreigners may also put more money into the country’s commercial
banks to gain a higher interest rate.
This will increase the assets of the country’s commercial banks and their
ability to lend.

- Unexpected responses
As with fiscal policy, it is difficult to predict how households and firms
will respond to changes in monetary policy.
At times of optimism, a higher interest rate may not discourage
consumption and investment.

- Demand and Supply-Side shocks

The success of both fiscal policy and monetary policy depends on the
ability of government and central bank officials to assess current
macroeconomic performance and future private-sector economic
activity.
Both types of policy can also be thrown off course by demand and
supply-side shocks.
A central bank may forecast an economic boom and may raise its interest
rate so that it can reduce the growth of aggregate demand.
If there is a global recession during the time it takes for the changes in
the interest rate to affect aggregate demand, the economy may
experience a more severe recession.

- Mobility of financial investment

With increasing mobility of financial investment, it can be difficult for a
country to operate an interest rate that is significantly different from
rival countries.
If a country reduces its rate of interest to a level noticeably lower than
that of its rival countries, hot money may flow out of the country.
 A rise in interest may discourage foreign direct investment as it would
raise foreign firms’ costs and the firms may expect demand to fall in the
country.

- Co-ordination
Fiscal policies and monetary policies must be coordinated.
A government’s attempt to boost economic growth may fail if the central
banks increase the interest rate.

Chapter 47.3: The Effectiveness of Supply-side Policy with

Different Macroeconomic Objectives

Supply-side policy measures can be divided into those that are market-based
and those that are interventionist.

- Market-based supply-side policy

Market-based supply-side policy includes tools that increase the role of
market forces: cuts in direct tax, cuts in unemployment benefits,
privatization, deregulation, and labor market reforms.

Cuts in direct tax and unemployment benefits seek to raise aggregate

supply by increasing incentives to work and be entrepreneurial.
Privatization, deregulation, and labor market forces are aimed at raising
aggregate supply by increasing competition and reducing the cost and
effort involved in complying with government rules and regulations.

These can increase economic growth and reduce inflation but may
conflict with the objectives of redistribution of income and lower
unemployment.
It may reduce economic growth rather than increase it.

Cuts in income tax and unemployment benefits are likely to transfer

money from people on low incomes to the rich rather than the other way
around.
Privatization has resulted in some individuals and groups who have
bought out state-owned industries becoming very rich.
 Some privatized firms have increased the price of their products, taking
a higher proportion of the income of people on low incomes.
Labor market reforms, which reduce the power of trade unions, and
deregulation in the form of the removal of a national minimum wage can
also reduce the relative pay of those on low incomes.

Cuts in income tax and unemployment benefits will increase the gap
between paid employment and transfer payments but they will not
necessarily increase employment and growth.

There may not be job vacancies, the unemployed may lack the skills and
qualifications to take those job vacancies that do exist or the jobs may be
in different areas for the unemployed.
Workers may decide to maintain their current disposable income and
take more leisure time.

Privatization may not necessarily increase efficiency and lower costs of

production because it doesn’t guarantee increased competition.
A state-owned industry may be sold off as a monopoly.

The removal of rules and regulations may also increase the chances of
monopolies occurring, and the removal of health and safety rules may
damage the health of workers and result in accidents.
These effects could reduce labor productivity and economic growth.

- Interventionist supply-side policy

The interventionist supply-side policy involves the government taking a
larger role in the economy.
Its policy tools include government spending on education, training,
infrastructure, and support for technological improvement.

Spending on education and training can take some time to have an effect
but if they are successful, they have the potential to improve all the
macroeconomic objectives.
They can increase actual and potential economic growth, reduce
inflation, improve the current account of the balance of payments,
 reduce unemployment, increase development, and reduce income
inequality.

The education and training may be in areas that will not be in demand in
the future.
Workers may also not take up training opportunities.

Improvements in infrastructure and technology can help a government

achieve its macroeconomic objectives but the risk that building more
roads and airports may create more air and noise pollution and reduce
development may result in structural unemployment.

Chapter 47.4: The effectiveness of exchange rate policy with

different macroeconomic objectives
There are reasons why exchange rate policy may not be successful in achieving
all the macroeconomic objectives.

- Balance of payments stability, economic growth, and low

unemployment against price stability
A government can lower the exchange rate to improve the current account of
the balance of payments, increase economic growth, and reduce
unemployment.
Lower export prices may increase demand for exports and export revenue.
Higher import prices may lower demand for important and reduce import
expenditure.
Higher net exports will raise aggregate demand which can increase output and
create more jobs, but a lower exchange rate may cause cost-push inflation and
demand-pull inflation as the price of imported raw materials and capital goods
will rise.
The competitive pressure on domestic firms to keep down rises in their costs of
production will be reduced and the increase in net exports will raise aggregate
demand which could result in demand-pull inflation if the economy is
approaching full employment.

To reduce inflation, a government may seek to raise the exchange rate.

A higher exchange rate results in higher export prices and lower import prices
which has the potential to reduce aggregate demand and lower costs of
production, but can increase a deficit on the current account of the balance of
payments, reduce economic growth, and increase unemployment.

- Factors that limit the effectiveness of exchange rate policy

1) Price elasticity of demand: the effect of changes in the prices of
exports on export revenue and changes in the price of imports on
import experience will depend on the price elasticity of demand.
If the demand for exports is elastic, a rise in the price of exports
will cause export revenue to rise.

2) Speculation: under the floating exchange rate system, a

government may instruct a central bank to sell the country’s
currency to bring about a depreciation but if there is a strong
speculation that the currency will rise in value, price sector
purchases of the currency may be greater than the central bank
sales of the currency.

3) Objectives of other countries: the government of other countries

may object to a government seeking to lower its exchange rate if
they think it is doing this to gain a competitive advantage for its
products, the rise in the price of imported raw materials and
capital goods may also soon erode any competitive advantage
gained.

4) Availability of foreign currency: a central bank may want to raise

the exchange rate if inflationary pressure is building up, its ability
to do this may be restricted by a lack of foreign currency to
purchase the currency.

5) Actions of other central banks: a country’s exchange rate is

influenced by the actions of the central banks of other countries.
Chapter 47.5: The Effectiveness of International Trade Policy
in Different Macroeconomic Objectives
A government may promote free international trade by removing any
government restrictions on imports and exports.
This can increase economic growth by allowing greater advantage to be taken
of comparative advantage.

Some governments favor trade protectionism, this approach can help protect
employment, build up infant industries, and discourage dumping.

Some factors that can limit the success of trade protection include:
- Firms can become dependent on the protection
- Other governments may retaliate leading to a trade war
- Membership of a trade bloc may prevent the government from imposing
trade restrictions on other members

Chapter 47.6: The problems arising from conflicts between

policy objectives
The decision as to which policy tools a government will use is influenced by the
risk that these may conflict with policy objectives.

- Low unemployment and economic growth against price stability

Government expansionary fiscal and monetary policy tools designed to
either reduce unemployment/increase the economic growth rate may
increase the rate of inflation.
If the government seeks to reduce demand-pull inflation by using
contractionary fiscal and monetary policy tools, it will reduce the
economic growth rate and increase the unemployment rate.

A government may seek to avoid these policy conflicts by introducing

supply-side policy tools that may reduce inflation and unemployment
rates, and increase economic growth rate.

- Low inflation against balance of payments stability

A conflict may also arise between the aims of low inflation and a
reduction in a current account deficit.
 A central bank may raise the rate of interest, this will not only increase
unemployment but there will also be a knock-on effect on the balance of
payments position and the exchange rate.

A rise in the interest rate is likely to lead to an appreciation in the

exchange rate, this could worsen the current account position but may
attract hot money flows.

- Redistribution of incomes against economic growth

There may be a conflict between creating greater income equality and
stimulating economic growth.
Making income taxes more progressive and increasing benefits to
low-income groups may discourage effort and enterprise, and may
reduce foreign direct investment.
There is a possibility that raising the living standards of the poor may
improve the health and education of part of the labor force and raise
productivity.
Effort and enterprise may be more influenced by wage rates and profit
levels than tax rates.
Foreign direct investment may be attracted despite relatively high tax
rates if demand in the country is increasing and the country’s workers
are becoming more skilled.

- Number of policy tools

To avoid conflicts between policy objectives, a government may employ
a separate policy tool for each objective.
A government may cut income tax to reduce unemployment while it may
devalue the currency in a bid to improve the current account position.
The government uses a combination of fiscal, monetary, and
supply-side policy tools.
Chapter 47.7: Government Failure in Macroeconomic Policies
There are several reasons for government macroeconomic failure
(government invention reducing rather than increasing economic
performance)

- Miscalculating the size of the multiplier

If a government understates the size of the multiplier, it may increase its
spending by too much, this may result in swapping one problem, a negative
output gap with another, a positive output gap.

- Time lags
In the case of several policy tools, there may be a series of time lags.
There may be a delay before the government recognizes that inflationary
pressure is building up - a recognition lag.

There may be an implementation lag- the time it takes to draw up and

introduce a policy tool such as a rise in income tax

There is then the time it takes for the policy tool to influence the behavior of
households and firms- a behavioral lag

By the time a policy tool does have an impact on economic behavior, the level
of economic activity may have changed, which may make the policy tool
inappropriate.
The government may seek to use fiscal and monetary policy tools to offset the
effects of the business cycle, but these measures sometimes reinforce the
business cycle rather than acting counter-cyclically.

As well as there being a delay before households, workers and firms react to
policy tools, there is the possibility that they may not respond in the expected
way.
During an economic boom, a central bank may raise the rate of interest in the
expectation that it will encourage saving and discourage borrowing.
If households and firms are optimistic about the future, they may continue to
borrow and spend.
- Desire to win elections
Some elected governments may be tempted to introduce popular policy
tools when elections are approaching, measures such as an increase in
government spending on pensions, may win votes but not necessarily
improve economic performance.

- Pressure groups and corruption

Government policy tools may be influenced by powerful pressure groups
and there is the possibility of government corruption.
Past attempts to reduce class sizes increase resources in education and
improve healthcare were hindered by corrupt government officials who
stole money from government budgets.
UNIT 11- International economic issues
Chapter 48- Policies to correct disequilibrium in the
balance of payments
Chapter 48.1: The components of the balance of payments
The balance of payments records all economic transactions between residents
and non-residents during a given period.
The balance of payments account consists of the current account, the capital
account, and the financial account.
It also includes net errors and omissions (balancing item)

For some countries, the financial account is the largest component of the
balance of payments.

- Financial account
The financial account forms a large part of some countries’ balance of
payments.
It records movements of funds into and out of the country.

It is made of four parts:

1) Direct investment covers building a factory in another country and
the takeover of an existing firm in another country (debit terms),
the setting up of a new plant or the takeover of a firm in the
country by a foreign firm (credit items).
2) Portfolio investment includes the purchase and sale of
government bonds and shares that do not involve legal control of a
firm
3) Other investments cover shorter-term movements of financial
investment including bank deposits, bank loans and
inter-government loans that move between countries.
4) Reserve assets are made up of the government’s holdings of gold,
and foreign exchange reserves.
Reserves are kept to settle international debts and to influence
the value of the foreign exchange rate.
Additions to the reserves are shown as debit items, while
reductions to the reserves are shown as credit items because if the
central bank of a country sells some of its foreign currency, the
country will be gaining its currency in exchange, so there will be a
flow of currency in the country.

- financial account deficit

A financial account deficit will give rise to an inflow of
profits, interest, and dividends in the future years, the
deficit may be short-term- resulting from hot money
flowing out of the country in search of higher interest rates
and in the expectation that other currencies may rise in
value.
It is more of a concern if it results from a long-term lack of
confidence in the country’s economic prospects, such a
concern may result in capital flight when the country’s
residents move their money from domestic to foreign banks
and the countries’ firms move some production abroad.

The movement of funds and production out of the country

reduces tax revenue and reduces potential employment
economic growth.
A financial account deficit may also result in depreciation in
the exchange rate.

- financial account surplus

A financial account surplus arises when more direct and
portfolio investment and loans enter the country than leave
it, due to foreigners being impressed by the country’s
economic prospects.

A financial account surplus can have several advantages

- It can finance a deficit on the current account of the
balance of payments
- It can also create employment in the country and raise
the country’s economic growth

- In the long run, it can result in more money flowing

out of the country in the form of profit, interest, and
 dividends, this may result in a deficit in the primary
income balance of the current account unless offset by
an increase in the country’s direct and portfolio
investment and loans abroad.

- Capital account
For most countries, the capital account is a relatively small part of the
balance of payments, it includes non-produced, non-financial assets
like government debt forgiveness, money brought into and taken out of
the country by migrates, the sales and purchases of copyrights, patents,
trademarks and mineral rights.

- Net errors and omissions

The balance of payments as a whole must have a balance because the
credit item has to be matched by the corresponding debit item.

More and better quality information is likely to become over time, so the
size of net errors and omissions figures usually declines.
The value of current deficits experienced by some countries should be
matched by the value of current account surpluses experienced by other
countries but due to mistakes and items being left out, this is not the
case.

Chapter 48.2: Effect of fiscal, monetary and supply-side,

protectionist, and exchange rate policies on the balance of
payments
A government and its central bank may use a range of policies to influence the
components of its balance of payments.

It could use contractionary fiscal/contractionary monetary policy to reduce

demand for imports and encourage firms to switch some of their products to
the export market.
Supply-side policy measures may be introduced to promote greater
international competitiveness.
A protectionist policy may be used to reduce demand for imports largely by
seeking to replace spending on imports with spending on domestically
produced products.
Changes in the exchange rate can be implemented to affect the price of exports
and imports and so the trade balance, this may only have a short-term effect
on the current account balance.

An exception may be a government deciding to stop maintaining an exchange

rate that is set above or below the market value if the central bank has kept an
exchange rate above its equilibrium level, the high export prices and low
import prices may have led to a current account deficit and allowing the
country’s exchange rate to increase to its market rate may reduce the country’s
deficit.

Depending on the measures adopted, fiscal policy, monetary policy, and

exchange rate policy can be used to reduce either a deficit or a surplus on the
current account of the balance of payments, supply-side policy would only be
used to try to reduce a current account deficit and protectionist policy can also
reduce a deficit.

Pursuing another macroeconomic policy objective introduces a policy

measure, that has an unintended consequence for the balance of payments, if a
government may lower income tax in an attempt to reduce unemployment but
some of the increase in spending created may go on imports which would
increase a current account deficit.

If a government wishes to increase its country’s economic development or to

finance a deficit on the current account, it may aim for a surplus on the
financial account of the balance.
- Attracting multinational companies to set up in the country may
increase employment and income growth.
- Selling shares in the country’s firms to foreigners will provide funds for
the firms to expand
- Borrowing from abroad may help cover the cost of imported raw
materials and capital goods which may reduce a current account deficit
in the long run.
 - To attract a net inflow of direct investment, portfolio investment and
bank loans, a government will aim for macroeconomic stability

The main type of policy it is likely to use is supply-side policy.

A rise in the quantity and quality of the country’s resources that result from
improvements in education, training, infrastructure and technology is likely to
prove attractive to foreign investors.
Trade union reform may make multinational companies more willing to invest
in the country if the reform results in a fall in industrial action.
Privatization may also increase the opportunity for foreign direct investment.

A government may impose a tariff on imports or increase an existing tariff to

encourage domestic consumers and firms to switch to buying domestic
products, this works most effectively when domestically produced substitutes
of high quality are available.

Chapter 48.3: Expenditure-switching and

expenditure-reducing policies
Two broad-based policy approaches can be used to correct an imbalance of
payments.
- Expenditure-switching policy
An expenditure-switching is any action taken by a government that is
designed to persuade purchasers of goods or services, to buy more of
that country’s goods and services and less of the goods and services of
other countries.
This includes any policy designed to persuade foreign households and
firms to buy more exports from the domestic economy.

They are not designed to reduce the total spending in a country but to
redirect, or switch spending to the country’s products rather than those
produced in other countries.
The intended impact is a fall in import expenditure and a rise in export
earnings.
The most commonly used policies for this are supply-side, protectionist
and exchange rate.
 A government may increase spending on infrastructure to reduce the
cost and price of domestic products, impose import tariffs to reduce
demand for imports or instruct its central bank to lower the exchange
rate to lower export prices and raise import prices.

- Expenditure-reducing policy
An expenditure-reducing policy is any action taken by a government
that is designed to reduce the total level of spending in an economy.

An expenditure-reducing has two effects:

- Reduction in spending, which will mean that there will be fewer
purchases of imported goods and services
- The domestic producers will find that their domestic market is
reduced, as a result, domestic producers may try to make up for
the decrease in domestic sales with an increase in sales abroad.

The effect of an expenditure-reducing policy may be a fall in imports and a rise

in exports.
Fiscal policy and monetary policy can be used as expenditure-reducing
policies.
A government could raise taxes and cut its spending, a central bank could
reduce the money and increase the rate of interest to reduce spending in the
economy.

Chapter 49-Exchange Rates

Chapter 49.1: Measurement of exchange rates
- Nominal and real exchange rates
The nominal foreign exchange rate is the price of one currency in terms
of another currency.

A real exchange rate takes price changes as well as exchange rate

changes into account to assess changes in the competitiveness of a
country’s products in global markets.
A fall in a country’s foreign exchange rate would be expected to make its
exports more price-competitive. Still, if the country is experiencing a
relatively high inflation rate, export prices may be increasing.
 A real exchange rate compares the relative prices of two countries’
products:
𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 𝑥 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥÷ 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥

The real exchange rate may rise as a result of an appreciation or an

increase in the country’s relative inflation rate.
As the country’s products are more expensive relative to its competitors,
the country is likely to import more and export less.
The real exchange has more of an impact on the current account balance
than the nominal exchange rate as it reflects international price
competitiveness.

- Trade-weighted exchange rate

A country trades with several other countries and its currency may rise in
value against some countries while falling against others.
A trade-weighted exchange rate is a measure, in index form, of the price
of a currency against a basket of currencies, these are weighted
according to the relative importance of the countries in the country’s
trade.

Chapter 49.2: Determination of exchange rates

Exchange rates can be determined by a government, but the free market forces
of demand and supply, or by a combination of the two.

- Fixed exchange rate system

In a fixed exchange rate, the price of the currency is determined by the
government.
The central bank will maintain the rate by direct intervention or by
trying to influence the market demand for and supply of the currency.

Direct intervention will include the central bank buying or selling the
currency, it may try to influence the market demand and supply by
changing the rate of interest.
If there is a downward pressure on the exchange rate because the supply
of the currency is increasing on the foreign exchange market, the central
bank is likely to buy the currency, the central bank will also increase the
rate of interest, this may attract hot money flows with people buying the
currency to place into accounts in the country’s financial institutions.

It is easier for a central bank to maintain a

fixed exchange rate if that rate is close to
the long-run equilibrium rate value of the
currency because it will only have to
offset in the short-run and possibly
relatively small fluctuation.

If the exchange rate is overvalued, the

central bank may be in danger of running
out of reserves trying to keep the
exchange rate at a level that does not reflect its marketplace.

A disadvantage of the fixed exchange rate is the need to keep reserves,

this involves an opportunity cost, as the foreign exchange or gold could
be used for another purpose, there is also a risk that a government may
sacrifice other policy objectives to maintain the fixed exchange rate- like
raising the interest rate may reduce aggregate demand and increase
unemployment.

A reduction in the value of a fixed exchange rate to a lower level is known

as devaluation.
When the government raises the exchange rate to a new, higher fixed
rate, a revaluation occurs.

A fixed exchange rate creates certainty which can promote international

trade and investment, a foreign firm may be more willing to set up a
branch in the country if it knows how much any revenue it earns will be
worth in its currency.

A fixed exchange rate also imposes discipline on a government to keep

inflation low, so that a loss of international price competitiveness does
not put downward pressure on the exchange rate.
 - Managed system
A managed system combines features of a floating exchange rate and a
fixed exchange rate system.
It usually involves a government allowing the exchange rate to be
determined by market focus within a given band, which has upper and
lower limits.

If the exchange rate is within the limits,

no action will be taken, but if demand
for currency rises, the central bank will
sell the domestic currency to increase
supply and keep the exchange rate
within the desired band.

Chapter 49.3: Revaluation and devaluation of a fixed exchange

rate
A revaluation occurs when a government raises the exchange rate to a new,
higher fixed rate, this will be maintained by a government as if there is
downward pressure on the currency- the central bank will buy the currency,
using some of its reserves, it might raise the interest rates.

A devaluation is a reduction in the price of the currency arising from a

government’s decision to maintain it at a new lower level.
If there is upward pressure on the new, lower exchange rate, the central bank
will sell its currency, the increased supply of the currency on the foreign
exchange market may keep the price low, and it may also lower the interest
rate to reduce demand for the currency and increase its supply.

Devaluation and revaluations occur for two main reasons:

- the current exchange rate is not sustainable, it results in surplus or
shortages of the currency in the foreign exchange market
- devaluations and revaluations are used as policy tools
Chapter 49.4: Changes in the exchange rate under different
exchange rate systems
A floating exchange rate will change when there are changes in the market
forces of demand and supply.

Demand for the currency may rise because:

- Increase in demand for a country’s goods and services
- Increases in direct and portfolio investment in the country
- Speculation that the currency will rise in price.

Supply of the currency will decrease because:

- A country buys fewer imports
- Invests less abroad
- Expectations that the currency will rise in price

A fixed exchange rate does not often change.

A change when it does occur is the result of a government decision, a
government t will devalue its currency if the government thinks it cannot
maintain its current price.
If the market forces are putting downward pressure on the price of the
currency, there is a risk that the central bank will run out of reserves that can
be used to buy the currency, a government may also be reluctant for its central
bank to raise the interest rate to encourage hot money flows because the
higher interest rate could reduce economic activity.

A government may also devalue the currency to increase the international

competitiveness of its products to reduce a current account deficit, increase
economic growth and reduce unemployment.

A government may instruct its central bank to bring about a revaluation of the
currency if it thinks there is too much upward pressure on the currency.
The government may not want to sell large quantities of its currency to keep
the exchange rate down to its target rate as this action may add to the money
supply.
A government may also revalue its currency to reduce inflationary pressure, a
higher exchange rate will reduce the price of imports, which can increase the
pressure on domestic industries to become more internationally competitive.

Chapter 49.5: The effects of changing exchange rates on the

external economy
The effect of a change in the exchange rate on the current account balance will
be influenced by the price elasticities of demand for exports and imports.

The requirement for the combined elasticities to exceed 1 for the trade
balance of the current account balance to be improved by a change in the
exchange rate is known as the Marshall-Lerner condition.

The greater the combined PED for exports and imports, the smaller will be the
fall in the exchange rate required to improve the current account position, if
the PED is less than 1, a revaluation of the exchange rate would be the
appropriate policy strategy.

The J-curve effect is related to the Marshall-Lerner condition.

A fall in the exchange rate will actually worsen the current account position
before it starts to improve it because, in the short run, demand for imports and
exports may be relatively inelastic.

It takes time to recognize that

prices have changed and then to
search for alternative products.
In the long run, demand becomes
more elastic and the current
account position may move from a
deficit into a surplus.

A higher exchange rate may increase a current account deficit or reduce a

current account surplus, but the outcome will depend mainly on the price
elasticities of demand for exports and imports.
 The Marshall-Lerner condition and
J-curve work in reverse.
A current account surplus will only
be reduced if the sum of the price
elasticities of demand for exports
and imports is greater than 1.

A rise in the exchange rate may

increase a current account surplus
in the short run before reducing it in
the longer run.

Chapter 50- Economic Development

Chapter 50.1: How Economies are classified in terms of
development and National Income
Economies can be classified according to their development
Economies with high economic development usually have high incomes,
mature markets, high standards of living and high levels of productivity.

Some economists divide countries into developed and developing economies.

Developed economies are usually taken to be those with a high income per
head, well-established economic institutions, advanced technological
infrastructure and a strong tertiary sector.
Developing countries are thought to have lower income per head, reliance on
fewer products, a larger primary sector, and lower productivity.

- Classification according to income

The World Bank uses GNI per capita to classify every country as
low-income, lower-middle-income, upper-middle-income, or
high-income

Classifying economies according to income levels is relatively

straightforward and can help to identify those economies in need of help
and assistance from aid providers.
 Some economies have a low income per head
Several economies with a low income per head suffer from poverty cycles

Chapter 50.2: Other indicators of living standards and

economic development
Economists use a wide range of indicators to assess living standards and
economic development.
Monetary- such as GDP, GNI, NNI, and purchasing power parity (PPP)
Non-Monetary: infant mortality rates and number of doctors per 1000 of the
population etc.

- Composite indicators
1) Human development index: this takes into account, GNI per head,
education, and health care.
Measures of income, education, and life expectancy are included as
it is thought that people’s welfare is influenced not only by the
goods and services available to them but also by their ability to
lead a long and healthy life and to acquire knowledge.

The HDI value for a country shows the distance a country has to
cover to reach the maximum value of 1.
Countries are divided into very high human development, high
human development, medium human development, and low
human development.
A country’s ranking by HDI doesn’t always match its ranking in
terms of GNI per head.
 2) Measurable Economic Welfare: the measure seeks to give a fuller
picture of living standards by adjusting GDP figures to take into
account other factors that have an impact on living standards.

Factors that improve living standards, including increased leisure

time, are added to the GDP figure.
Factors that reduce living standards, such as environmental
damage are deducted.
It is difficult and expensive to measure the value of non-marketed
goods and services.

3) Multidimensional Poverty Index: it measures indicators of living

standards (cooking fuel, sanitation, drinking water, electricity,
housing, assets) education, and health.

The six indicators of living standards are given a total weighting of

33%, the two indicators of education are given a total weighting of
33% and the two indicators of health are given a total weighting of
33%.

A household is considered to be multidimensionally poor if they

are deprived in at least 33% of the weighted indicators, which
means a family would be regarded as poor if it has lost a child or
another child is not attending school.

MPI aims to help countries understand why people are poor and
why some stay poor even when income rises, it can help
governments and international organizations target the poorest
groups in a country, and assess and coordinate national
development plans.

- The Kuznets Curve

The Kuznets curve is a U-shaped curve
that suggests that as an economy
develops, incomes become more
unevenly distributed, and then after a
 certain income level is reached, income becomes more evenly
distributed.

The reason why it is thought there will be an initial rise in income

inequality is that as an economy develops there will be a movement of
labor from low-paid and low-skilled agricultural jobs to higher-paid and
more-skilled manufacturing jobs.

The curve doesn’t explain the rise in income inequality in high-income

economies.

Chapter 50.3: Comparison of economic growth rates and

living standards
Changes in real GDP, GNI, and NNI are used to calculate the economic growth
rates.
In comparing economic growth rates over time and between countries, care
has to be taken over several issues:
- shadow economy: undeclared economic activity (underground
economy).
People seek to evade paying taxes and the economic activity is illegal.
Some ideas of the shadow economy can be found by measuring any gap
between GDP as measured by expenditure and income methods because
people will be spending income they have not declared.

If the size of the shadow economy is relatively constant, the rate of

economic growth may be calculated reasonably accurately, but even a
shadow economy can make international comparisons of economic
growth difficult because the sizes of the shadow economy vary between
economies and are influenced by the marginal rates of taxation, the
penalties imposed for illegal activities and tax evasion, the risk of being
caught and social attitudes towards different illegal activities.

Official GDP figures cannot provide an accurate measure of output and

changes because of low levels of literacy, non-material goods and
services, and the difficulties of measuring government spending.
 With low levels of literacy, it will be difficult for the government to
gather information about all economic activity as some people will be
unable to fill out tax forms and others will fill them inaccurately, so
estimates will have to be made for some output.

Estimates also have to be made for non-marketed goods and services,

the GDP figures only include marketed goods and services, that is goods
and services that are bought and sold and so have a price attached to
them.
Goods and services that are produced and that are either not traded or
exchanged without money changing hands go unrecorded.
The proportion of goods and services that people produce for themselves
and the amount of voluntary work undertaken vary over time and
between countries.

The nature of economic growth should be considered too: a very high

rate of economic growth may initially appear to be very impressive but it
may not be possible to sustain this for any length of time if
non-renewable resources are depleted and pollution is created that
reduces the fertility of the land and the health of the labor force.

- Comparison of living standards over time

Real GDP per head figures have traditionally been used as one of the
main indicators of living standards.
Real GDP is not evenly distributed so it may rise but that won’t mean
everyone will be better off.

The change in real GDP may not reflect the true change in the quantity of
goods and services that households can enjoy if the level of undeclared
economic activity changes over time

To assess the changes in living standards, changes in the type of

products produced, and how they are made to be considered.
 More consumer goods and services such as
housing, food, clothing, and transport raise
people’s living standards.
A shift of resources from consumer products
to capital goods will enable more consumer
goods to be produced and enjoyed but in the
long run only.

In the short run, if the economy is operating

at the frontier of its production possibility
curve, such a move will cause people to enjoy
fewer consumer products.

As access to more and higher-quality products rises, the desire for even
more and better products may increase at an even faster rate.

Real GDP measures the quantity of output produced but not the quality,
output could rise but if the quality of what is produced declines then the
quality of people’s lives is likely to fall.
Working conditions tend to improve over time and working hours fall.

Although workers tend to enjoy improved working conditions over time,

the quality of the environment in some countries declines as a result of
pollution and deforestation.
A decline in the environmental conditions will lower living standards,
but not necessarily real GDP, if more resources have to be devoted to
cleaning up the environment, real GDP will increase while living
standards decline.

- Comparison of GDP per head and living standards between countries

The citizens of a country with a higher GDP per head are likely to enjoy
higher living standards than people living in a country with a lower real
GDP per head, but this is not always the case.

To compare living standards between countries it is important to convert

real GDP into a common currency.
 To avoid the comparison being distorted by exchange rates take into
their purchasing power parity.

Even if a country is found to have a higher real GDP per head than
another country using purchasing power parities, it doesn’t mean that
its population will enjoy higher living standards.
If income is very unevenly distributed, only a small number of
households may benefit from a high average income.

When assessing living standards between countries, consideration must

be given to factors that are not measured in real GDP per head like:
- Working hours
- Working conditions
- Fear of crime
- Freedom of thought

Chapter 51- Characteristics of countries at different

levels of development
Chapter 51.1: Population growth and structure
Government statisticians and demographers measure how populations have
changed and make predictions about future populations and their structures.

- Birth rate: the number of live births per thousand of the population in
one year
- Death rate: the number of deaths per thousand of the population in one
year
- Infant mortality rate: the number of deaths of children aged under one
per thousand live births in one year
- Net migration: the difference between immigration and emigration

The birth rate is sometimes referred to as the crude birth rate as it provides
only basic information on births, it doesn’t give details on the age of those who
are giving birth.
The death rate includes the death of children aged under one year, although
countries also measure these separately in the infant mortality rate.
If the birth rate exceeds the death rate, a country is said to experience a natural
increase in population- the number of live births exceeding the number of
deaths.

A country’s population size can be influenced by external migration (migration

into and out of the country)
If immigration into the country is greater than emigration out of the country,
the country is said to experience net immigration or positive net migration.

- Causes of changes in population

As countries develop, the growth in their populations tends to decline.
While their death rate decreases, their birth rates fall at a greater rate.
Better healthcare, education, sanitation, housing, and nutrition contribute to
people living longer.
A decline in infant mortality, increased cost of bringing up children, and an
increase in women’s participation in the labor force usually result in a decline
in the birth rate.

Some countries with a high income per head and high development experience
a natural rate of decrease in population.
Several economies still experience a rise in population because they attract net
migration.
People may want to move to the country to gain a higher income and to enjoy a
higher living standard.

Low development is often associated with high rates of population growth, this
is due largely to increases in population size with the birth rate exceeding the
death rate.

There are several reasons for the birth rate to be high in low-income
economies:
- Need to have children to support parents in their old age
- Lack of availability of methods of birth control
- The relatively low costs of raising children
- Lack of education for women
High infant mortality rates encourage families to have more children as they
will not expect all of them to survive.

The higher birth rate of countries with low development results in a relatively
low average age of the population, this creates a high proportion of dependent,
non-productive members of the population.
Dependency ratios - the proportion of the economically inactive compared to
the labor force
This means that a proportionally small working population has to produce
enough goods and services to sustain not only themselves but also a large
number of young people who are economically dependent upon them.

As income per head, education, and healthcare start to rise, the death rate
initially tends to fall more rapidly than the birth rate, then the death rate starts
to fall more slowly with the decline in birth rate overtaking the decline in the
death rate.
High development does not eliminate the population problems but brings new
problems like an ageing population which arises from a decreasing birth rate
and a decreasing birth rate, dependency ratios are high because there is a high
proportion of old people who are reliant upon the productive proportion of the
population for support.
With people living longer, the cost of health care and pensions have been rising
and to reduce the cost of pensions, a lot of economies have increased the
retirement age.

- The optimum population

The optimum population is said to exist
when output per head is the greatest,
given existing quantities of the other
factors of production and the current
state of technical knowledge.

As the population grows, it can make

better use of the stock of other factors of
production such as land and capital
because increasing returns are enjoyed as the population grows.
If the population is below the optimum level, the country can be described as
underpopulated.
When the population is beyond the optimum level and decreasing returns are
experienced, the country is overpopulated.

The state of technical knowledge is constantly improving and the quality of the
other factors also continuously changes so that the optimum population for a
country is not fixed.

- Level of urbanization
Countries with a low income per head tend to have a relatively high proportion
of their populations living in rural areas, they also have rapid rates of
rural-urban migration which can put pressure on infrastructure, housing, and
schools in urban areas.

Most countries with a high income per head already have the majority of their
populations living in urban areas which results in relatively little growth in the
urban population of high-income economies.
People move from urban areas to rural areas as technological advances allow
people to work from home.

Chapter 51.2: Income distribution

Income is unevenly distributed because income-generating assets, especially
land, are owned by a few people which results in great extremes of wealth and
poverty.

The transition of economies from centrally planned to market economies has

increased inequality as a small number of people have benefited enormously
from the new opportunities that have resulted.

The Gini coefficient is one of the measures of income

inequality.
The Lorenz curve (a diagram illustrating the extent of
income or wealth inequality) illustrates income
inequality.
On the vertical axis, the cumulative percentage of income or wealth is plotted
and on the horizontal axis, the cumulative percentage of income is calculated.

Gini coefficient: is a numerical measure of the extent of income inequality.

Chapter 51.3: Economic structure

- Employment in different sectors of the economy
As the population growth and structure and income distribution change as
countries develop, their economic structure can also change.

Countries with high income per head and high development tend to have most
of their labor force employed in the tertiary sector.
Economies with lower income per head and development typically have a high
dependence on the primary sector, which makes these economies vulnerable to
the forces of nature, they are dependent on agricultural products for their
exports and natural disasters can wipe out their foreign currency earnings.

As an economy develops, the contribution to employment and GDP of the price

sector tends to decline.
The secondary sector becomes the major source of employment and as the
economy develops further, the tertiary sector usually makes the largest
contribution to employment.

Sometimes, employment moves to a

greater extent from the primary sector to
the tertiary sector than to the secondary
sector when there is a growth in tourism
or service sectors.
It is also possible that a smaller
proportion of the economy’s labor force
may be employed in the primary sector in
a country with high development, but the
total value of the sector’s output may
increase given higher labor and capital
productivity.
 - Pattern of trade at different levels of employment
In the case of many economies with low development and low income
per head, primary products account for most of the export revenue
earned, which makes them vulnerable in their trading relations because
demand and supply can change significantly.
If demand decreases due to a health scare, supply may increase due to a
good harvest.
These changes mean that the market for primary products is subject to
frequent and large fluctuations in price.

The demand for many primary products is inelastic, as world income

rises there is little impact on the demand for primary products.
The demand for manufactured goods is income elastic, as primary goods
tend to become relatively cheaper than manufactured goods.

Those countries that are dependent upon agricultural products may

receive relatively low prices for their exports while having to pay
relatively high prices for their imports.

Countries with high development and high income tend to export mainly
manufactured goods and services, they also tend to export a wide range
of products.
Some low-income countries rely heavily on exporting a narrow range of
products.

Chapter 52- Relationship between countries at

different levels of development
Chapter 52.1: International aid
Low-income and middle-income countries that need to borrow find it
relatively expensive to do so.
Several countries have requested aid (assistance given to other countries on
favorable terms) which takes several forms- grand, a loan at reduced interest
rates, technical assistance, or direct provision of goods and services.
Aid can be tied or untied, bilateral or multilateral
Tied aid is aid that comes with conditions - a grant may be provided that is
spent on buying products from the donor country.
Untied aid is aid given without conditions.
Bilateral aid is aid given by one country to another country
Multilateral aid is given by countries to international organizations such as the
World Bank and United Nations agency, which then is distributed to other
countries.

- Reasons for giving aid

The difference between the countries that would be expected to receive the
most aid and those that actually do reflects the different reasons for giving aid.

Tied, bilateral aid may be given to promote the industries of the donor country.
A government may seek to increase the growth of an infant industry by
requiring the recipient country that receives the aid to spend on products from
its country.
Tied aid directly increases demand for the donor country’s exports but untied
aid may also be given in the hope of increasing the donor country’s exports.
If aid does promote economic growth in the recipient country, it is likely to
result in the recipient country buying more imports, and it may be inclined to
buy from the donor country’s industries if good relationships have built up as a
result of the aid giving.

A motive behind some bilateral aid is to gain political influence, a recipient

government may feel obliged to support the donor country in its disputes with
another country or countries, like imposing trade restrictions on another
country and putting pressure on the recipient country to do the same.

Both bilateral and multilateral aid may be given to influence the economic
policies of the recipient government, it may give aid to another country on
condition that it ends the use of child labor or that it reduces its budget deficit.

Both bilateral and multilateral aid can be given for humanitarian motives, that
is out of desire to do good.
This is usually the case with crisis aid, that is given to save lives during natural
disasters and famines.
Governments and international organizations can also recognize that the
development of other countries can increase global GDP and international
trade, also reduce the risk of negative external shocks.

- The effects and importance of aid

Aid can help the recipient country experience increases in its income per
head and development.
Aid can provide the investment, the finance, for education, healthcare,
and new industries that the recipient country may be lacking.

Investment may not be easy for some low-income and middle-income

countries to achieve which may be because of the lack of savings and the
lack of financial institutions to channel those savings that do not exist
from lenders to entrepreneurs wanting to establish new firms and to
expand the output of existing firms, there may also be a shortage of
entrepreneurs.

If investment can be encouraged, a

virtuous cycle (the links between an
increase in investment, increase in
productivity, increase in income, and
increase in saving) may be created.

Many countries rely heavily on aid.

Heavy reliance on aid can have several disadvantages
- some forms of aid can result in countries becoming increasingly
indebted
- in some cases, low-income and middle-income countries transfer
more money to high-income countries in terms of interest on past
loans (even if given on favorable terms) than they are currently
receiving on aid.
- advice given and policies suggested by international organizations
are not always suitable given the conditions in low-income and
middle-income countries- it may not be the best advice to
 recommend an economy use capital-intensive methods when it
has a shortage of capital but lots of labor
- requiring a government to cut spending on primary education to
cut a budget deficit may harm an economy’s development and
longer-term economic growth prospects.

Chapter 52.2 Trade and Investment

International trade can be dominated by high-income countries.
The terms of trade are more likely to benefit high-income countries since they
can exercise more power in trade negotiations, which results in low-income
countries and some middle-income countries being forced to concentrate on
primary products.

- Trade
The governments of low-income countries and some middle-income countries
often argue for trade rather than aid, they argue for trade on fair terms.
There are several reasons why international trade can act as an engine for
growth, it can improve supply conditions and can reduce costs, which can lead
to a more efficient product:
- economies of scale become possible because of the larger market
- the increased competition encourages domestic entrepreneurs to
innovate and look for new techniques of production.
- trade leads to a transfer of skills and technology from high-income to
low-income and middle-income economies
- specialization and trade increase incomes and so provide increased
savings which can be used for investment.

Trade may also stimulate demand, the expansion of production to cater to the
export market may increase employment, and the result will be an expansion
of spending power in the home market that will create demand for domestic
output.

Low-income countries have tended to specialise in primary products, they

have specialised in agricultural products that have been at a disadvantage in
trading relations since the prices of manufactured goods and services over
time.
This is for three main reasons:
- the income elasticity of demand for primary products is low so as world
incomes have risen, there has been little extra demand for agricultural
products and demand has shifted to manufactured goods and services.
- producers of manufactured goods in high-income economies have an
element of monopoly power, which they have used to maintain high
prices.
- subsidies provided to farmers put downward pressure on global
agriculture prices, it is claimed that subsidies have deflated the global
price and have given farmers an unfair competitive advantage.

As trading patterns have been seen by some governments as exploitative,

several countries have adopted import substitution policies and attempted to
diversify their economies.
They have tried to prevent imports of manufactured goods from high-income
countries to develop their manufacturing industries.
Some have gone for export-led growth, the secondary sector is becoming more
important in low-income and middle-income economies and some are gaining
a comparative advantage in industries formerly dominated by high-income
economies.

- Investment
Investment flows between countries in search of profits, interest, and
dividends, many low-income and middle-income countries have a deficit on
the current account of their balance of payments, which requires a surplus on
the financial account to cover it and is a reason why the governments of
low-income and middle-income countries seek to attract direct and portfolio
investment from other countries.

Much investment initially went from high-income countries, but there has
been an increase in investment, from what are called emerging economies
(economies that are making quick progress toward becoming high-income
economies)- these are economies that have high rates of economic growth and
are expected to have high rates of return while carrying a greater risk that
investment in high-income countries.
Chapter 52.3: The Role of Multinational Companies
One way that low-income and middle-income countries can achieve a rise in
investment is to attract multinational companies.
A multinational company is defined as a firm that operates in more than one
country.
An MNC is a business with a parent company based in one country but with
production or service operations in at least one other country.

MNCs can bring in new technology, and new ideas, add to GDP and exports,
and may generate employment.
The impact of foreign direct investment (FDI) (the setting up of production
units or the purchase of existing production units in other countries) from
MNCs has been substantial.
It has been particularly significant in the bauxite, alumina, petroleum, and
natural gas industries, there has also been considerable FDI in sugar, tourism,
and utilities.

For several reasons, not all MNCs are well-liked in the countries where they
invest.
MNCs may not create higher employment and higher incomes if they replace
domestic firms, they may deplete non-renewable resources and may create
pollution.
They send most of their profits back to their home countries and may employ
foreign rather than home labor, some of the products they sell may not
improve people’s living standards.
MNCs put pressure on governments to pursue policies that are beneficial to
them but not to the economies in which they are producing.
The mobility and considerable economic powers of MNCs mean they often
negotiate favorable tax breaks and exemptions from some environmental laws.
Several MNCs also develop monopsony power and use this power to drive down
the price they pay to the host countries’ suppliers of raw materials.

- Foreign direct investment

Through their activities, MNCs provide FDI to the countries in which
they operate, this is an investment that is necessary to produce a good or
service in a foreign country, FDI involves capital flows between
countries.
 Low-income and some middle-income countries lack savings to finance
investment, foreign direct investment can overcome this shortfall;
MNCs can purchase capital equipment and help to develop the country’s
infrastructure.

Some countries attract large large inward flows of FDI, these tend to be
countries that are expected to grow rapidly and so provide large markets
for the MNCs’ products or ones with low costs of production or abundant
supply of raw materials.

There are a range of measures that governments take to attract:

- low corporation tax
- good education system
- few rules and regulations for firms
- government subsidies

Chapter 52.4: The causes and consequences of external debt

External debt includes loans that have not been repaid and interest payments
on loans which have not been made to foreign banks, foreign governments,
and international organizations.

There are four main reasons why countries get into debt
- the country has a structural current account deficit, the country may
spend more on imports than it earns from its exports, or may have a net
outflow of primary and secondary income.
- the country may have been overconfident in the value of loans it could
repay
- the country may not have made good use of the funds it borrowed- a
government estimate that investing the loan in building up a new
industry may give a return and if miscalculated, the government has
problems making the interest payments.
- unexpected events can occur- there can be an unforeseen depreciation of
the exchange rate, which would be likely to increase the debt repayments
as interest is usually paid in dollars, there may also be negative demand
and supply-side shocks, like there may be a global recession reducing
 demand the country’s exports or a natural disaster reducing the supply
of its exports and creating a need for greater assistance.

External debt can be a major obstacle to future economic development,

repaying the debt can divert funds away from improving the welfare of the
population and increasing the economy’s growth potential.

A high level of external debt can make it difficult and expensive for
low-income and middle-income countries to attract more funds for
development, a country’s credit rating may be reduced, resulting in the
country’s being charged a higher interest rate.

Some governments reduce their ability to borrow more in the future by

defaulting (refusing to pay) on past loans, these governments may consider
that: avoiding cutting spending on education and healthcare may be more
important than meeting their obligations to repay loans.

Chapter 52.5: The Role of the IMF and the World Bank
- International Monetary Fund
The International Monetary Fund (IMF) was set up in 1944 to help promote the
health of the world economy.

The primary aims of the IMF include:

- to promote international monetary cooperation
- to facilitate the expansion and balanced growth of international trade
- to promote exchange rate stability
- to assist in setting up a multilateral system of payments
- to make resources available (with adequate safeguards) to members
experiencing balance of payments difficulties

These activities have been central to the development of global trade since a
stable system of international payments and exchange rates is necessary for
trade to take place between two countries.
In carrying out these responsibilities, the organization has three main
functions:
- surveillance
- technical assistance
- lending
These promote global growth and economic stability by encouraging countries
to adopt sound economic policies and lending is used when member countries
experience difficulties in financing their balance of payments.

- World Bank
Established in 1944, its initial aim was to help rebuild European countries
devastated during World World II.

This organization has set two goals for the world to achieve by 2030:
- end extreme poverty by decreasing the percentage of people living on
less than $1.90 a day to no more than 3%
- promote shared prosperity by encouraging income growth of the bottom
40% for every country.

The World Bank offers support to low-income and middle-income countries

through internal investment payments such as building new roads, improving
infrastructure, and constructing new health facilities.

The five institutions in the World Bank are:

- International Bank for Reconstruction and Development (IBRD)
- International Development Association (IDA)
- International Finance Corporation (IFC)
- Multilateral Investment Guarantee Agency (MIGA)
- International Centre for Settlement of Investment Disputes (ICSID)

The IBRD assists middle-income countries and creditworthy poorer countries

while the IDA focuses on the poorest countries.
Grants are only provided to the world’s poorest economies
Loans cover areas such as:
- Health and education- to enhance human development in a country by
improving sanitation
- Agricultural and rural development - for irrigation programs and water
supply projects
- Environmental protection - for reducing pollution and for ensuring that
there is compliance and pollution regulation
- Infrastructure - roads, railways, electricity
- Governance - for anti-corruption reasons

Loans tend to be linked to conditions that involve wider-reaching changes

being made to the economic policies of the recipient economies.
The policy prescriptions which include privatization, deregulation, and trade
liberalisation are based on increasing the role of market forces, this may
increase efficiency, which would increase productive potential but it may
increase income inequality and may not work- if the problem that is holding
back development is not too much government intervention but market failure
and lack of financial markets.

Chapter 53- Globalization

Chapter 53.1: What is globalization?
Globalization involves the world becoming one market as a result of a
reduction in the barriers to the movement of goods and services, direct and
portfolio investment, and workers.

Households buy products from a wide range of countries, stock exchanges sell
shares and government bonds throughout the world and MNCs spread their
production throughout the world.
There are currently more restrictions on the movement of workers, but several
countries are heavily reliant on migrant labor and within trade blocs, there is
usually the opportunity for workers to work and stay in any member country.

- The causes of globalization

1) advances in communications and technology which has made it easier
for firms to keep in contact with their production plants from a greater
distance and to co-ordinate the production process across the world
 which has resulted in growth in the number and influence of MNCs, it
has also made it easier for households to buy products and firms to sell
their products to countries throughout the world.
2) advances in technology are improvements in transport, greater speed,
more reliability and lower cost of transport have made it cheaper and
easier to move parts between factories and for households to buy goods
from other countries.
3) removal of some trade restrictions- removing tariffs enables firms to
compete on more equal terms which promote international trade
4) removal of restrictions on the countries in which a firm can base part of
its production, some countries still have some limits on foreign firms
buying domestic firms or foreign firms setting up in the countries but
these limits have declined over time.

- Indicators of globalization
Globalization can be measured in many different ways:
- consider how world trade has grown in comparison to world output, the
world trade to world output ratio is also examined.
- a connected indicator is the exports to GDP ratio of different countries
which indicates how integrated individual countries are in the global
economy.
- flows of portfolio and direct investment can be examined, and this can be
measured for an individual country or the world
- flows of migrant workers and international migration figures are also
considered.

- The consequences of globalization

Globalization can drive economic growth, it can encourage countries and
regions within those countries, to specialize in what they are best are
producing, a country that makes better use of comparative advantage
should increase global output which can increase living standards.

Where firms in different countries are allowed to compete on more equal

terms, through the removal of trade restrictions lower transport costs,
and lower prices which would increase consumer surplus, consumers
may also benefit from a greater variety of products.
 The free movement of direct and portfolio investment has the potential
to reduce income inequality between countries - if an MNC is set up in a
low-income country, it may help to raise productivity and wages
throughout the country.

There are potential disadvantages to globalization:

- it can create structural unemployment because while opening up
an economy to greater international competition will cause some
industries to expand, some industries will decline and if workers
who lose their jobs are immobile, they may remain unemployed
for some time
- countries are more susceptible to demand and supply-side shocks
when they become more closely linked with other economies,
these may be negative shocks, a natural disaster in a major
supplier of a country’s raw materials could disrupt the output of
one of its important industries
- the free flow of portfolio and direct investment will create a risk
that it can be withdrawn quickly, which causes a negative
multiplier effect
- The increase in competition from countries and greater mobility of
factors of production can constrain domestic government policy, if
other governments are setting low tax rates, it may make it
difficult for a government which wants to spend more to reduce
poverty in the country, there could be a reduction in the provision
of social welfare
- It can make it difficult for a government to implement stricter
pollution controls, as some MNCs may threaten to leave the
country
- It creates a need for international co-ordination of policies which
is not easy to achieve.

Chapter 53.2: Trade Blocs

A large part of the breaking down of barriers to trade and the movement of
portfolio and direct investment, and workers between countries takes place
within trade blocs.
There are several types of trade blocs (a regional group of countries that have
entered into trade agreements)
A trade bloc is a regional grouping of countries that have preferential trade
agreements between member countries.

The following are four of the main trading blocs:

- Free trade areas
In a free trade area, the governments of the member countries agree to remove
trade restrictions between each other.
The members can determine their external trade policies towards
non-members and do not share a common external tariff.
E.g.: between the U.S. and Canada. and Mexico (USMCA)

- Customs Union
A customs union goes a stage further than a free trade area in terms of
economic integration.
Along with removing trade restrictions between members, members of a
customs union agree to impose a common external tariff with non-members.
These countries impose the same tariff on goods being imported from outside
the trading bloc, they share tariff revenues and coordinate some trading
policies.
E.g.: South African Customs Unions (SACU) - Botswana, Lesotho, Namibia,
South Africa, and Eswatini.

- Monetary Union
A monetary union includes even more economic integration, in which
restrictions are usually removed on the movement of not only goods and
services but also capital and labor.
The aim is to create a single market across members.
The key feature of a monetary union is that the member countries all use the
same currency and follow the same monetary and exchange rate policies

Chapter 53.3: Trade creation

Membership of a trade bloc may result in trade creation, which occurs when
the removal of tariffs allows members to specialize in those products in which
they have a comparative advantage- more expensive domestic products can be
replaced by imports from another member country that are lower in price.
The efficient firms within the trade bloc will be able to sell to a larger market
and this may enable them to lower prices even further because they would be
able to take greater advantage of economies of scale.

Consumers gain from the lower

price and the greater quantity
consumed.
Domestic producers lose as their
sales fall, and they gain a lower
price but they may be shifting
resources to making products that
have become more price
competitive, relative to those of
member countries, because of the
removal of tariffs.

Trade creation permits both imports to be purchases more cheaply but also
additional exports to be sold as other members lose their tariff protection, the
domestic govermnet will lose out on tariff revenue but there is nevertheless a
welfare gain.

The lower price increase consumer surplus and reduces producer surplus and
tariff revenue.

Chapter 53.4: Trade Diversion

Trade diversion occurs when membership of a trade bloc results in a country
buying imports from a less efficient country within the trade bloc rather than
from a more effecient country outside the trade bloc.
It results in a less efficient allocation of resources.

Efficient outside the trade bloc may lose as they are

not able to trade on equal terms, a country joining
the trade bloc may also lose, the trade is diverted to
a member country, the price to consumers falls, and
the quantity consumed rises, consumer surplus
increaees, producer surplus reduced but this time,
tariff revenue will fall and welfare will be reduced.