Economics Final Exam Study Guide Preface: How to Do Well on the IB Exam: General Advice o Start preparing well

l in advance. Do not wait until the last minute, or until this study guide is complete. o Know your key terms; you will need to define them. So, write out a glossary (or use the glossary provided) and test yourself to check that you know the definitions. o Know your graphs and practice drawing them out; it is not enough to look them over in the textbook and expect to remember them. Make sure your labels are as accurate as possible and you include correct relationships between plotted variables. To understand the graphs, you need to understand the theory behind them. o Know examples for all major topics that we cover; the examples should be as current and relevant as possible, and should depend on the subject area you are focusing on (recall your commentary articles and LDC projects as a starting point). o When in doubt, do past papers without access to notes or your textbook (or write a textbook yourself); you need to get a sense of timing and pacing on each set of questions. o The more specific you can get in your answers, without sacrificing efficiency or the big picture, the better-quality your analysis will be. o Do not avoid certain topics altogether; you will need to address every syllabus section at some point; revise the main topics in the course. Do not rely on the hope that certain topics will not appear on the exam. o Practice your evaluation (more on this later). Advice for Exam Papers: o General Advice: Points are allocated for defining key terms; never forget to do so (at least, define the keywords of the question) Always provide as many suitable graphs as you need to communicate your ideas clearly. Accurately label all of the axes and curves and show correct relationships between variables. If something shifts, use arrows to show the shift. Refer to your graphs in your text; they should not be a separate component for the points. More graphs are usually better than one busy graph that requires some serious effort to decipher. Draw your graphs as neatly as possible; if you have time, use pencil and then shade in with ink to be able to make corrections. Use colors (but not red) to show shifts in curves, if you are so inclined. Make sure our diagrams are large enough to be accurately interpreted and incorporate all necessary information.

Your graphs should not be redundant; every new diagram should introduce a new concept that you had not previously examined in the question. A table may, in some cases (e.g. when evaluating tax regimes) also count as a diagram, although you should avoid using one as your main diagram whenever feasible. When introducing a graph, you essentially commit to it; unless you explain it within the framework of the question, you are likely to lose marks. Write like an economist: show off your skills in writing answers to exam questions as precisely as possible. Refer to examples whenever possible (this includes simple numerical examples, but, when possible, your examples should come from real life and be as nonhypothetical and clear as possible). If you are not sure as to what a question demands, skip the question; it is better to be sure that you know exactly what the question demands than to take a guess at what seems to be an easier question. Stylistically, break your responses into paragraphs: a wall of text approach may piss off some graders. Dont come into the exam with ready-made answers; know your theory, but be ready to tailor your responses to the demands of the question. To structure your answer, define the key terms of the question as soon as possible and explain them. Add some graphs, and you are probably mostly done; without key terms, though, it is difficult to show understanding. Otherwise, you are liable to go jumping from idea to idea, without getting anywhere far in your response. Do not make unsubstantiated assumptions- explain your reasoning whenever feasible. Link your written response to your diagrams and the specific demands of the question. Paper 1: The Essay Worth 20% (25%) of the final grade at HL (SL). You have 4 questions to choose from and need to do one in one hour. All questions are divided into 2 sections: o Part A: 10-mark short answer o Part B: 15-mark detailed answer and evaluation Carefully consider each question offered and make the right choice based on what you know best from the syllabus. o If no single question seems right, choose the question whose evaluation you are more comfortable with (15 points > 10 points, obviously)

Read the question carefully, and write an answer that is clearly relevant to the question. It is the quality, not the quantity, of your answer that you are graded on. If you are worried about digressing, plan before you write; if you dont take too much time to plan, this will work in your favor. You are not graded on grammar, but a clear approach, especially on the essay component, is all-important. Manage your time effectively and cover main points before entering into too many details. If at all possible, link parts A and B together (but keep them separate on the page!) As you are evaluating in Part B, include a conclusion at the end of your essay. This helps to add structure to your answer, leads to greater clarity and allows you to point-maximize. Stick to the f*cking question. Dont start going off on a tangent by applying all the vaguely-familiar theory you know. Part A: Distinguishing between economic concepts or explaining a particular concept/theory. You are graded on: o Clear understanding of the specific demands of the question o Relevant economic theory clearly explained and developed o Relevant terms clearly defined o Where appropriate, diagrams have been included and explained o Where appropriate, examples have been used o No major errors. Part B: Evaluating a particular ec. policy/theory- a step beyond simple explanation. o You do not need to repeat definitions from Part A,but you may need to define some more terms. o If your graphs from part A are relevant, you can refer back to them; however, if you will be extending your response to them, it is best to redraw them and add the necessary info. o If you are asked to distinguish between cyclical and structural unemployment in Part A and then asked to evaluate policies that reduce unemployment in Part B, you would need new diagrams in addition to those from Part A to make a convincing argument. o To do well on Part B, you are graded on: Clear understanding of the specific demands of the question Relevant economic theory clearly explained and developed

Relevant terms clearly defined Where appropriate, diagrams have been included and explained Where appropriate, examples have been used Evidence of appropriate evaluation No major errors.

Paper 2: Short Response: Worth 20% of the final grade; HL only. You have 6 questions, you choose three, you have an hour to answer the questions you choose. You will be given reading time; use it to decide which questions you are best prepared to answer and develop a plan of attack for each question. Read the questions carefully so that you are sure which theory is the most pertinent. The short response questions are similar to Part A of Paper 1; you will be asked to explain a concept/theory or distinguish b/w related concepts. Your answers should all include key definitions, diagrams and relevant examples. Ask yourself whether you have put all of the above components into your paper. The odds that you will get a question that does not call for a diagram (even a simple PPF) are very, very slim. Always include at least one graph. The mark-scheme is the same as for Part A of the extended response. Work efficiently and manage your time well; take 20 minutes for each answer. If you spend too long on the first two questions and fail to answer the third, youre pretty much screwed. If you feel the need, keep a watch by you when taking the test and do as much practice as you can. Paper 3: Data Response: Worth 40% of the final grade (HL)/ 50% (SL). There are five questions available; you are required to do three. You have two hours. All 5 questions will follow the same format; there will be a set of data (either an article or visual data, or both) and a set of four sub-questions: o Part A: Definitions of two words in the text. Each definition is two points; dont waste time writing verbose definitions. o Parts B and C: Application of a specific piece of theory; worth 4 points each. In the majority of cases, you should draw a graph; sometimes the graph will be alluded to in the question, and sometimes, you will need to decide on the right diagram to use.

Be sure to label axes with the variables given in the text; try to be as un-hypothetical as possible. Carefully assess what the question is asking; you are under the gun and should not write more than is necessary to answer the question in Parts B and C. Always make use of your text to support your theory; also, make your diagrams large to not piss off your examiner. Very occasion, you may need to use the data to perform a calculation of some sort and interpret your results. o Part D: Application of information from the text and evaluation of issues related to the text. This is worth 8 marks and is the most important part of the question. Dont forget the information from the text; use quotations and data (when available) in your answers. Also, the essential here is to evaluate (more on evaluation below). Your reading time is essential for Paper 3; skim the questions and pinpoint those that you know the most about. Do not choose questions based on definitions; it is much more important to be able to provide good short answers and evaluation. Annotate the text to make yourself familiar with the data. Manage your time effectively; you have 40 minutes per question, so keep on pace. If you know your definitions and diagrams, parts A, B and C should be quick, leaving you with a lot of time to evaluate.

How to Evaluate: o You will be asked to evaluate in part B of your long response and part D of your data response questions. Unless you can evaluate effectively, you will not score high. On the other hand is a good indicator of what evaluation is, although, by itself, such statements are too simplistic. You should: Compare advantages and disadvantages of your issue or policy; this is a step in the right direction, but not quite enough. You also need to make a conclusion about the relative weight of your arguments and counterarguments. Identify the most important causes/consequences/arguments, and present them as such, justifying your reasoning. If asked to evaluate the consequences of a policy, explain several consequences and conclude that the most important consequence is o There is no single right answer to an evaluation question; defend your decision with economic theory, however.

When evaluating a controversial issue, be familiar of the arguments and counterarguments of the divergent viewpoints. When evaluating advantages and disadvantages, state which outweighs the other, explaining your reasoning for the decision. When evaluating a normative proposition (e.g. protectionism is the best way to protect domestic employment), you could explain the ways in which protectionism could prevent domestic job losses, but also consider why it might not be an effective solution for fixing the problem. Depending on the length of the question, you can (and should!) go into quite a few arguments and counterarguments. If asked to evaluate an economys performance using data, you can evaluate whether a country is achieving the standard macro. policy objectives, assess the validity of the data, and examine the time-frame in which the data figures. When evaluating a text, keep an eye out for biases (e.g. strong freemarket tendencies of the author); if you comment on these, your evaluation may become more effective. Evaluation also includes a consideration of the ways in which an ec. theory may not always be applicable to reality. After giving a list of points, prioritize the arguments: make a conclusion stating which point is the most (or least) significant and explain why. o In your conclusion, summarize your most important arguments from the body of the text; make sure your conclusion is specific to the real-life situations (if on Paper 3) considered Long-run vs. Short run: The long run consequences of a policy may be very different from the short run consequences; you are evaluating if you distinguish between the two time periods. Consider the issue from the point of view of different stakeholders (for example, domestic producers, foreign producers, consumers, high- and low- income people, the govt). Where Candidates Screw Up: o Poor time management: you have a limited amount of time per paper; plan accordingly: Paper 1: Take a few minutes to plan, and do not take too long answering the Short Answer. Paper 2: Choose the three questions that you will be answering during your reading time, and manage your time such that you answer each question in approx. 20 minutes. Paper 3: Choose at least 2 of your questions during the reading time, and choose the third when writing time begins, if necessary. Answer each question in approx. 40 minutes.

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Reading the question carelessly: Dont base your entire answer on the few key words that you see immediately, and dont spew random theory on the page; you are being graded on specific understanding of the demands of the question, so you may get marked down for inaccuracy even if your theory is essentially correct, in such a case. Imprecise use of key terms: Learn correct and precise definitions, or risk getting marked down. This is an economics class; thus, lay definitions will not get you very far. Lack of examples/poor use of examples: To score high, include relevant real-life examples; in Paper 3, refer to the data given to you in addition to your theory. Lack of diagrams/poor use of diagrams: Quite self-explanatory; use a graph even if the question does not specifically ask for one (99% of the time, there will be a graph that will fit the question), and label your diagrams correctly. Take enough space that your ideas are as clear as possible. of an IB page is an appropriate size, with an explanation on the side. Do not put your diagrams at the end of an answer or the end of the exam; always include them where they are most relevant to your theory. When in doubt, sketch your diagrams in pencil and then use ink, to avoid making preventable errors. Use a ruler; it makes your examiners life that much easier. Learn the correct labels for diagrams; most significantly, dont mix up micro. and macro. labels. Also, choose your labels with respect of what you are trying to say, and be as specific as possible without wasting time on labeling; if it saves you time in your written answer, time spent labeling is not time wasted. When you shift a curve, indicate the shift with your labels (e.g. D1->D2). Do not invent innovative diagrams in the middle of the exam. Use axes to provide information (e.g draw dotted lines from the equilibrium points to the axes and note the variable; note this information in the written explanation) When you shift a curve, use arrows to show the direction of the change (both on the graph and on the axes). Make sure you understand the relationships that the diagrams show. A theory may lend itself to a non-linear diagram (eg. a poverty cycle); draw such a diagram neatly and clearly, and describe in words the relationship that the diagram shows. Such diagrams should be used mainly for support (e.g. a poverty cycle could be used with a PPF, but should not usually stand alone). Ineffective Evaluation: See above, on evaluation. Not following instructions: On Paper 3, use the information given to you in the text; to help you, annotate the text (underline specific key phrases or statistics, for instance). Abbreviating everything: Unsubstantiated abbreviations will not get you very far on the exam; only use clearly-accepted abbreviations (e.g. MNC, GDP), and only abbreviate after having written each term at least once in full.

`Making sweeping generalizations in your answers: Economic concepts are usually composed of many aspects; if you generalize, odds are good that you will be inaccurate/imprecise- for example, stating that all LDCs experience massive corruption is factually inaccurate, while discussing the problems of aid without reference to types of aid is imprecise, as many types of aid, with different problems, exist. Using arrows instead of the words increase and decrease (or, in an earlier version of this study guide, the symbols ^ (increase) and / (decrease): This practice is just lazy writing. Not explaining econ. relationships: A common mistake is to state that a change in one econ. variable will lead to a change in another variable, but never explain why this is so. Tell the story. Try not to repeat yourself unnecessarily, as that represents a waste of your precious time.

Chapter I: Introduction to Economics Economics is a social science (a study of how people and societies interact with each other) which is concerned with rationing systems and the allocation of scarce resources to fulfill consumers infinite wants. Although the Earth and all of its resources are finite (they will eventually deplete), the wants of humans are infinite. We must use the finite resources to produce the goods and services that we want/need; therefore, the quantity of goods and services that can be produced is finite, and all of our needs and wants cannot be satisfied at once. o Needs: goods and services that we must have to survive (e.g food, shelter, clothing) o Wants: things that we would like to have, but which are not necessary to our survival (e.g tablet computers to play Tetris on). o Goods: physical objects that are tangible (can be touched); e.g. enriched uranium, potatoes. Specific types of goods include: Capital (producer) goods: man-made goods used to produce other goods, which are not bought for final consumption (e.g. hammers, combine harvesters). Consumer goods: Goods bought for final consumption. o Consumer durables: Consumer goods that are consumed over an extended period of time (e.g. TVs) o Consumer non-durables: Consumer goods that are consumed immediately, or over a short period of time (e.g. TV dinners). o Services: intangible items that people may purchase (e.g healthcare) There is a conflict between the finite resources available and our infinite needs and wantspeople cannot have everything they desire and some rationing system (an economy) for allocating scarce resources must be in place.

All goods that have a price are relatively scarce (they are scarce relative to peoples demand for them, and the price is there to ration them). For example, although cars are commonplace, they are economically scarce because they have a price, which makes some people unable to afford them, however much they may want one. Their ability to purchase a car is limited by the amount of money they have and the cars price, which rations the available cars. Any good/service that has a price and is being rationed is an economic good (as opposed to a free good, such as atmospheric air (discounting externalities; clean air is not a free good, as there is an opportunity cost involved in removing pollutants)). Therefore, scarcity in economics is different from its everyday definition. Since people do not have infinite incomes, they must choose whenever they purchase goods and services as to how to allocate their finite financial resources and choose between alternatives. The above results in all economic decisions having an opportunity cost (the next best alternative foregone when an economic decision is made). Opportunity cost: something that is given up to have something else. Opportunity cost is never a monetary cost. As long as economic resources are used in the production of a good/service, a cost is involved, even if a price is not. If a good/service has an opportunity cost it is relatively scarce and therefore, an economic good. Free goods do not have an opportunity cost when they are consumed, as they are unlimited in supply; e.g. we do not have to give up anything else in order to breathe. Free goods do not have prices and are not relatively scarce. Therefore, in economics, choices have to be made. These can be expressed as a series of three questions (the basic economic problem): o What should be produced and in what quantities, using our scarce resources? This has to be decided for all economic goods. o How should things be produced? There are many ways of producing things and different combinations of resources that can be used (e.g. capital intensive vs. labor intensive, organic farming vs. industrial farming) o Who should things be produced for? Those who can afford them, or some other allocation system? How will a nations GDP be distributed? All rationing systems must answer these questions. There are two main rationing systems: the free market and the planned economy. All economies, both in MDCs and LDCs, must answer these questions (e.g. in a choice between military expenditure and a functioning healthcare system- both in the US and in Somalia). Factors of Production: the four resources that allow an economy to produce its output o Land: the surface area of the Earth, as well as all natural resources coming from the Earth (both basic raw materials and cultivated products). Some natural resources are renewable; others are non-renewable. o Labor: The human FoP- the physical and mental contribution of the existing workforce to production. Investment in human capital (the value of the workforce) is also classified as factoring into this FoP.

Capital: The FoP that comes from the investment in physical capital (man-made goods used to produce other goods- this includes manufactured resources, tools, machinerye.g. hammers), and infrastructure: the large-scale public systems that are necessary for a countrys economic activity, including a nations roads, railroads, hospitals, schools, power plants and telecommunications, accumulated through investment, usually by the government. Improving infrastructure would lead to increased potential growth and probably development. o Management (Entrepreneurship): The organizing and risk-taking FoP- entrepreneurs organize the other FoPs to produce goods/services, using their personal finds and the funds of investors in the hopes of making a profit (which is not guaranteed, and investments may be lost- thus, risk is involved) Production Possibility Curves are used by economists to show the concepts of scarcity and opportunity cost, inter alia. o A PPF shows the maximum combination of goods/serviced that can be produced in an economy at a given time, if all resources are fully and efficiently employed and the state of technology is fixed (the PPF represents potential output). o A PPF illustrates a two-good economy and is displayed as a curved, convex graph; this demonstrates the relationship that, as more of one good is produced, increasing amounts of the other good must be sacrificed to produce each marginal unit of the good being produced. This relationship is due to a version of the Law of Diminishing Returns that assumes that some FoPs are better adapted to the production of certain goods/services than others; as a consequence, increased production of one good will cause progressively larger decreases in the production of the other good, as the resources that are least efficient at the production of the alternate good (and thus contribute least to output) are diverted first. If returns are constant, however, the PPF is a straight line; as resources are transferred from one good to another, the amount of output sacrificed in the production of one good and gained in the production of the other is constant. o On a PPF graph, if all FoPs are dedicated to building schools (at point X), Y schools will be produced, but no roses will be produced. Point Y shows the opposite situation. At Point Z, FoPs are shared between production of schools and roses; the points on the PPC show the possible combinations of output. At full employment, it is impossible to produce more roses without producing fewer schools; the opportunity cost of the roses is the number of schools not built. The PPC is a curve because not all FoPs used to build schools and grow roses are equally efficient; as we move towards point Y, where fewer schools are built, it is unlikely that the workers used to building schools will be very skilled at growing roses; at point Z, however, the economy will be at its most productive, as workers will be able to specialize in the industry in which they work most efficiently.

Thus, the PPF illustrates opp. cost: as the economy switches production from Good X to Good Y, resources producing Good X are sacrificed to produce Good Y; the opp. cost of an increase in Y is the foregone production of some units of X. If an economy is producing within the PPF, not all FoPs are used or allocated efficiently. This is always the case in reality, as some FoPs are always unemployed at any given time (especially labor); therefore, in this situation, more of one good could be produced without producing less of another. Point W is inside the PPC and represents actual output. If there is a movement in the PPC from W to A (towards the PPCs edge), actual growth has occurred A point outside the PPC is unattainable unless the quantity/quality of FoPs, or the level of technology, increases and the PPC moves outwards, or unless intl trade occurs.. Any outwards movement of the PPC is an increase in potential output, and therefore, potential growth (eg. due to increases in the quantity of raw materials, tech. improvements, improvements in labor/capital productivity, etc). This does not also mean that actual growth has occurred, which would require a movement of the current point of actual output towards the new PPC A fall in the quantity of FoPs causes an inward shift of the PPC (e.g due to war/natural disasters) Utility: a measure of usefulness and pleasure from consuming a product. o Total utility: the total satisfaction gained from consuming a certain quantity of a product. o Marginal utility: the extra utility gained from consuming one additional unit of the product. Marginal utility usually falls as consumption increases, up to a point where a person may get sick or suffer side effects, in which case marginal utility would ultimately become negative. o In theory, the free market will work to maximize the utility of all private economic agents. o An interesting related point is that, while water is more essential than diamonds, people are willing to pay rel. more for diamonds than for water; this is due to the scarcity of diamonds and thus, their high marginal utility; however, while the marginal utility for water tends to be rel. lower, the total utility is high, as far more diamonds than water can be consumed.

Chapter 2: Rationing Systems and Additional Definitions Economics is a large discipline that can be split up into various sections; there are a number of ways in which this is done: o Microeconomics and Macroeconomics Microeconomics: The study of smaller, discrete economic agents and their reactions to changing conditions (e.g. the study of how consumers make decisions about demand and expenditure, how individual firms make decisions on what to produce and how much, and how individual industries are affected by government regulation)

Macroeconomics: The study of all economic activity in a national economy (e.g. inflation, unemployment, and income distribution in an economy) Positive and Normative Economics: Positive statement: A statement that is objective and can be proven right or wrong by examining the facts (e.g. the unemployment rate at a given time) Normative Statement: A subjective statement based on opinion; cannot easily be proven or disproven. Such statements often contain words such as should, too little, too late, and require evaluation based on theory. Positive economics deals with questions that are capable of being proven correct or incorrect Normative economics deals with areas of the subject open to belief, opinion and interpretation. While confidence is easier in positive economics, it is more interesting to examine normative questions (although conclusions may be misleading) (e.g. business cycle theories) Economics and Model Building: Economists build models to test and illustrate their theories; these models may be manipulated to see what the outcome will be if one of the variables changes. This method of holding all variables but one constant is known as ceteris paribus, all else being equal in Latin. When economists test the effect of one variable on another, they need to be able to isolate the effect of one variable by assuming no other variables have changed (e.g. when analyzing the effect of a change in wages, they assume that taxes have not increased). Economists nearly always make assumptions, which it is important to be aware of. o An example of an economic model is the circular flow model, which shows the relationship between households and firms in a national economy. In the model, households serve two functions: they consume goods and services, and are the owners of the FoPs used to produce goods and services. Firms are the productive units in the economy that turn the FoPs into goods/services. Firms and households combined represent the private sector:

the sector of the economy controlled by private individuals. Services are intangible products that can be either consumed immediately (e.g. a haircut) or over time (e.g. insurance). The circular flow model can also be expanded to account for the public sector (government), the net foreign sector and the financial sector. The government has a number of roles. It is responsible for law and order, national defense, adjusting the economy to achieve economic policy objectives, and directly providing certain goods and services (e.g. water, electricity, healthcare). Rationing Systems (Economic Systems): Planned vs. Free-Market Economies: o Economics is the study of rationing systems; since FoPs are relatively scarce, a way of rationing the FoPs and the goods and services produced by them must exist. o In theory, two archetypes of rationing system exist: Planned economies (e.g. North Korea): In a planned (command) economy, decisions on what to produce, how to produce, and who to produce for are undertaken by a central body (the government). All resources are collectively owned; government bodies arrange all production, set wages and prices through central planning. Decisions are made (theoretically) on the behalf and in the interests of the people (the motive for production is social welfare, as opposed to profit). o In a pure planned economy, market forces are nonexistent. o In theory, planned economies allow the govt to influence the distribution of income towards greater equality and, by determining which goods are produced, can prevent the production of sociallyundesirable goods. The quantity of decisions to be made, data to be analyzed and FoPs to be allocated is immense, making central planning difficult. Because of the need to accurately plan for future

events, the task becomes near-impossible to complete efficiently. In many planned economies in the world today (e.g. China), elements of the free market are becoming increasingly common and even encouraged (e.g. the inflow of FDI) Free-Market Economies (e.g. Hong Kong): In a free-market (private enterprise or capitalistic) economy, price (determined by supply and demand) rations goods and services. All production is in private hands and market forces set wages and prices in the economy. The economy should be rel. efficient, with few surpluses and shortages. Individuals make independent purchasing decisions in their own self-interest (and seek to maximize their utility), and producers (who seek to maximize profits) then decide whether they are prepared to provide the products; their decisions are based on the likelihood of profit. o If demand changes, for instance, quantity supplied will change to compensate. If tastes change for one product vs. its substitute, shops will have a shortage of the more popular product and a surplus of the less popular product. As a consequence, they will increase price for the popular product, reducing QD, and raise the price of the unpopular product, increasing its QD. Producers (ceteris paribus) will receive the signal through the higher price that greater profit can be made by producing the popular good, and will therefore have the incentive to prioritize production of the popular good over the unpopular good. FoPs will have been reallocated in favor of the popular good. Finally, the increased price rations the popular good among consumers, as the good scarce relative to consumer demand. Thus, a change in consumer demand sends signals to producers through price, which ultimately makes sure that the wishes of consumers are met (in theory) as efficiently as possible. The free market is therefore self-righting.

When consumers and producers work to their own self-interest (theory goes), the market produces the best possible outcome for both. Adam Smith referred to this concept as the invisible hand of the market, and the notion has been used to justify non-interventionist economic philosophies. o The profit motive provides firms with an incentive to reduce costs and be innovative. o However, resources may sometimes take a long time to be reallocated from the production of one product to that of another, which will likely negatively impact the stakeholders involved. o The free market only maximizes community surplus if there are no market failures or imperfections; however, in practice, numerous forms of market failure exist. In order for free markets to be effective, most of the following conditions are often assumed to be necessary: o Law and order o Stable pol. systems, property rights, neutral legal systems, currency stability. o Trust in institutions and firms o Social mobility o Free access to information In reality, all economies are mixed economies (some of the rationing decisions are made by the govt, while some are made by market forces); what is different is the degree to which an economy incorporates free market vs. command policies. There is a spectrum on which we can place countries. Government intervention is essential in reality, as some dangers exist to unrestricted free-market activity; however, the longterm trend since the mid-1970s has been towards a more market-oriented allocation of resources (including privatization of nationalized firms and incentives to increase the involvement of the private sector). Note that traditional economic systems still exist in some LDCs, and involve activities such as gift-trading and barter Some of the disadvantages of planned/free market economies include: Disadvantages of a free-market economy: o Demerit goods (goods that are harmful to people- e.g. drugs) will be over-provided due to high demand, high prices and a high profit motive

Merit goods (goods that provide often-intangible benefits for consumers- e.g. healthcare) will be underprovided, as they will only be produced for those who can afford them (or not at all) o Public goods (which are non-excludable and nonrivalrous) will not be provided at all, as there is no incentive for private firms and individuals to shoulder the high costs of provision given the relatively very small private benefits of doing so. o Resources may be used up too quickly and the environment may be damaged by pollution, as firms seek to profit-maximize and minimize costs. o Prices for certain goods (e.g. agricultural commodities) are often unstable, reducing firms ability to plan effectively and potentially causing incomes to be volatile. o Some people will not be able to look after themselves (e.g. the very old and very young), and will not survive. o Large firms may grow to dominate industries, leading to inefficiency, high prices and excessive power. Disadvantages of a planned economy: o Production, investment, trade and consumption, even in a small economy, are too complicated to plan efficiently, often leading to bureaucracy and inefficiencies; resources will be misallocated, leading to surpluses and shortages. o Because there is no price system, resources will not be allocated efficiently; arbitrary decisions will not be as effective as supply and demand. o Incentives may be distorted. Workers with guaranteed employment and managers who gain no share of the profits will have no incentive to work efficiently; output/quality/variety of goods sold may suffer. Due to lack of competition, production is unlikely to be productively or allocatively efficient. o In practice, planned economies have tended to encourage corruption, weak governance, loss of trade, a lack of incentives, and policy conflicts. o Governments might not share the same aim as the people, but may implement unpopular/corrupt plans through raw power.

 Transition Economies: Economies in the process of moving from a centrally planned economic system towards a more market-oriented economic system (e.g. Poland, in the 1990s). o Some countries that were once chiefly centrally planned (mostly in Eastern Europe) have been moving towards a more market-oriented economic structure. Some problems that these countries face have included increased crime rates, initially inefficient/corrupt governments, collapse of inefficient state-owned industries, difficult currency reform, and a reduction in welfare/unemployment, as well as social security/healthcare benefits by the government, as well as overall government expenditure. Economic Growth: o Gross Domestic Product = National Income = The total value of all final goods and services produced in an economy in a given year. o GDP can be found in three ways: By looking at the value of the output of all goods and services by an economys firms. By looking at the total planned expenditure on goods and services by consumers, firms, the government and the net foreign sector By looking at the total incomes earned by households for allowing firms to use their FoPs. It is not pragmatically possible to measure the values of all FoPs used; this method is not attempted. o To not overstate the value of GDP when comparing between two or more years, any increase in average price level caused by inflation is ignored; nominal GDP is converted into real GDP. Real = having compensated for the effects of inflation o If real GDP increases from one year to another, the economy has grown (more goods and services- more stuff- is being produced); however, if the population has grown by the same proportion, per capita GDP (real GDP divided by population) will not have increased. Thus, a more accurate statistic for measuring economic progress is GDP/capita. o Because it is an aggregate and a money measurement, economic growth tells us little about the welfare of a country. A countrys economy may grow because of expansion in military spending, for instance, and Joe on the street will not really be better off. o Economic growth, in the sense of an increase in real GDP is actual, as opposed to potential growth (movement within the PPC towards its outer edge, as opposed to outward shift of the PPC). Economic Development:

Unlike growth, economic development measures welfare, or well-being, or the quality of life, as defined by some agreed-on indicator (e.g. education, health and social indicators) in addition to raw money figures. The Human Development Index (HDI) is the most well-known development index; it measures national income per capita, adult literacy, average years of schooling and life expectancy at birth. HDI is calculated for a country and gives a value between zero and one (the maximum end of the scale) HDI>.8: High Human Development .5<HDI<.8: Medium Human Development HDI<.5: Low Human Development These boundaries are arbitrary and do not mean that there are large differences between countries on either side. Sustainable development: Many economists believe that growth cannot be sustained indefinitely into the future at current levels, as environmental degradation is occurring and non-renewable resources are being used up at an unsustainable rate. A possible solution to this issue is sustainable development (development that meets the needs of the present without compromising the ability of future generations to meet their own needs). To develop sustainably, countries should manage and conserve their resources and avoid harming the environment, as this will prevent future growth. Countries should limit their growth, and how they wish to achieve it, in the present to ensure healthy growth prospects in the future. At the same time, if LDCs are forced to achieve sustainable development, their ec. growth could be slowed and the environmental consequences of allowing low levels of income, in the medium to long term, could be just as harmful, if not more so.

Chapter 3: Supply and Demand (The Market Forces) Market: A place where buyers (demand) and sellers (supply) meet. o In a free market, prices are determined directly and solely by interaction of demand and supply; however, govts may intervene to manipulate the relationship between demand and supply, and thus alter the allocation of resources. A fall in price may be caused by a decrease in demand or increase in supply. Demand: The quantity of a good or service that consumers are willing and able to purchase at a given price, in a given time period. o The operative phrase is willingness and ability- it is not enough for consumers to merely want a given good/service (otherwise, economic theory dictates, demand would be infinite at any price); they must also have the financial means to purchase it (the

ability to buy). This is known as effective demand and can be shown on a demand curve. The Law of Demand: As the price of a product falls, the quantity demanded (QD) of that product will usually increase, ceteris paribus (all else being equal; that is, if price changes, but all other factors, the determinants of demand, are assumed to remain constant). o This relationship can be illustrated graphically or using a table (a demand schedule). As a result of the Law of Demand, the demand curve is usually drawn as sloping downwards. o The QD of a good normally increases as the price falls (a fall in price usually leads to an increase in QD). On the graph, price is placed on the y-axis, and quantity is placed on the x-axis. This is counterintuitive, as price is the independent variable and QD is the dependent variable (but is nonetheless necessary for the mathematics of HL microeconomics to function). So, dont question it. o When graphed from plotted data, demand curves are usually convex to the origin (due to varying elasticity of demand); however, they are usually drawn as straight lines for simplicity. o A change in a goods price causes a change in QD and a movement along the existing demand curve; this is in contrast to the effect of a change of the other determinants of demand. o The Law of Demand occurs for three reasons: The Income Effect: When a products price falls, consumers real income (the amount of goods and services that their income will buy) increases; thus, people will be likely (more willing and able) to buy more of the product, as a larger proportion of their income will now remain unspent after having purchased the same quantity of the product as beforehand. Due to the higher real income, consumers will have greater purchasing power; if a good is normal, consumers will want to buy more of it due to the income effect. However, if it is inferior, consumers will want to switch to higher-quality substitutes as income rises. o Thus, the income effect may act in opposition to the substitution effect; however, the substitution effect is rel. larger and consumers do end up demanding more at lower prices, overall. The Substitution Effect: When a products price falls, the product will become rel. more attractive to people than other products whose prices have remained unchanged; it is likely that consumers will buy more of the product as a substitute for relatively more expensive products that were previously purchased. The Law of Diminishing Marginal Utility: Each extra unit of a good/service consumed will eventually give less utility; thus, consumers will only be willing to purchase more goods if they cost less.

This principle applies to the overall market demand curve, as it is a summation of all individuals demand curves for the product in question. The Determinants of Demand: o A number of factors determine demand and cause a left/rightward shift in the demand curve. When examining determinants of demand, we always make the ceteris paribus assumption; if we do not, the analysis becomes too complex and potentially unreliable (this applies to most economic analysis, including that on your exam papers). The most important determinants of demand are: Income: There are 2 types of products to consider when determining how a change in income affects the demand for a good/service. These are: Normal Goods: For most goods, as income rises, demand for the good at any price will rise (YED>0) and the demand curve will shift to the right; these goods are called normal goods (e.g. newspapers). The size of the shift in demand will depend on the YED of a good, with necessities displaying smaller shifts than luxuries. Inferior Goods: If a good is considered inferior, then demand for the product will fall as income rises (the demand curve will shift left; less will e demanded at any price) and the consumer begins to buy higherpriced substitutes in lieu of the inferior good (e.g. cheap wine, supermarket brand products). When income reaches a certain point, the consumer will only be buying the superior goods, and QD=0 (the demand curve will disappear). The Price of Other Products: There are three possible relationships between products: Substitute Goods: If products are substitutes for each other (the relationship between them being competitive demand), a change in price of one product will lead to an equidirectional (the opposite of inverse; I invented the word) change in demand for the other product (XED>0); if the price of a good rises, demand for its substitute will shift right, and vice versa. This is because some consumers will switch from the more expensive good to its relatively cheaper substitute (even though the price of the substitute is unchanged, its QD changes because of the shift in demand) o Examples of substitute goods include tea and coffee, Coke and Pepsi, HD-DVD and Blu-Ray, Xbox 360 and PS3 Complementary Goods: Complements are products that are often purchased together (e.g. printers and cartridges, beer and pretzels) and are said to be in joint demand. If products are complements of each other, a change in price for one of the products will lead to an inverse change in its demand; if the price of good rises, demand for its

complement will shift left (QD decreases) and vice versa. This is because, if a good changes in price, consumers willingness and ability to purchase its complements will be affected (even though the price of the complement is unchanged, its QD changes because of the shift in demand). Both cases involve a movement along the demand curve for the product under consideration, and a shift in the demand curve for its complement/substitute. Unrelated Goods: If products are unrelated, a change in the price of one product will have no effect on the demand for another product (YED=0; e.g. marijuana and sea anemones. Tastes and Preferences: For the most part, this determinant is self-explanatory. Marketing may alter consumers tastes and preferences, and firms attempt to influence tastes to shift demand for their product right. A change in tastes in favor of a product leads to more being demanded at any price. Other (macroeconomic) factors may also influence demand for a good/service, in addition to the ones above; these include: Population size: if the population increases, the demand for most products will shift right. Changes in age structure of the population: If the age structure of the economy changes, this will affect demand for certain products; an aging population will result in increased demand for cardiac bypass surgery and reduced (left-shifting) demand for skateboards. Changes in Income Distribution: If income distribution becomes more equal (e.g. via progressive taxation), the demand for normal goods (0<YED<1) may increase (rightward shift in demand) Changes in availability of credit: If the cost of borrowing money falls due to a decrease in the interest rate, credit will be more widely available, and consumption of durable goods (e.g. houses) will increase. Government Policy Changes: Changes in direct tax rates (e.g. income tax) will affect consumers disposable income, and hence, demand. In addition, regulations mandating/banning/restricting use of certain products (e.g. bike helmet laws, smoking restrictions) will affect demand in related markets. Seasonal changes: These will lead to changes in demand patterns in the economy (e.g. demand for ice cream and beach towels falls in the winter) The (Very Simple) Distinction Between a Movement and a Shift in the Demand Curve: o A change in the price of a good causes a movement along the existing demand curve (as price is located on one of the axes of a demand graph); a change in any of the determinants of demand will always cause demand to physically shift either left or right.

Exceptions to the Law of Demand: o Giffen Goods (One of the two Bigfoots of economics; the other is a diseconomy of scale): A unique type of inferior good, the QD of which rises as price rises. The key to understanding Giffen goods is poverty; a Giffen good will necessarily be a very inferior, necessity good (e.g rice and noodles in rural China). There is much debate as to whether they exist (I personally believe they do not, at least in the long run), and if they do, they are necessarily rare and will be eliminated if poverty diminishes. When the price of the Giffen good falls to the very poor (theory goes), they will likely buy less of the good and use their increased real income to buy higherquality products, which they can now afford; likewise, if the price of the good rises for the very poor, they will buy more of it as they are unable to afford higher quality products (the Giffen good is a staple with no substitutes). Thus, the income effect of a price increase may outweigh the substitution effect, leading to the perverse demand curve. However, this relationship can equally well be explained through the properties of inferior goods (demand shifts left as incomes increase) and the substitution effect (if prices of all foodstuffs rise, relative to the real income of the poor, they will switch over from the more expensive substitute foodstuffs to the staple good). o Veblen Goods: Goods for which the QD increases as price rises due to snob value (e.g. Louis Vuitton handbags). Some products get more popular as their price rises due, in part, to conspicuous consumption: getting satisfaction from being seen by others to consume more expensive products. As the price of a Veblen good rises, people with high incomes begin to buy more of the product due to ostentation. A typical Veblen good, when graphed, will resemble a sideways parabola. At low prices, a Veblen good will have a normal demand curve (QD falls as price rises); however, as price continues to rise, the good will ultimately achieve snob value status, and further price increases will begin to cause QD to increase. o Expectations and the Bandwagon Effect It is often argued that there are times where QD rises as price rises due to expectations of what will occur to prices in the future. In some cases (e.g. house prices, share prices) an increase in prices causes consumers to jump on the bandwagon if they believe prices will rise in the future. However, this relationship can also be explained (an explanation which I tend towards) by progressive rightward shifts in demand. A famous example of speculative demand in history was Tulipmania, in 1636 Holland. Supply: The willingness and ability of producers to produce a given quantity of a good/service at a given price in a given time period.

Again, the operative phrase is willingness and ability. It is not enough for producers to be willing to produce a good/service; they must also have the financial means to do so (the ability to supply); this is known as effective supply, which is shown on a supply curve. The Law of Supply: As the price of a product rises, the quantity supplied (QS) of the product will usually increase, ceteris paribus. o As a result of the Law of Supply, the supply curve of a product normally slopes upwards; this relationship may either be illustrated using a table (supply schedule) or graphically. Once again, price is on the y-axis, and quantity is on the x-axis. Supply curves are usually curved and increase in steepness as price rises (due to differing values of PES, as well as diminishing returns, because supply = marginal cost). However, for ease of analysis, they are usually drawn as straight lines. o As with demand, a change in the price of the product itself will cause a change in the QS of the product and a movement on the existing supply curve (because at higher prices there will be more potential profit to be made, granting an incentive to increase production- in a PCM, producers will also e attracted to enter the market), while a change in the determinants of QS will cause a left/rightward shift in the supply curve. The Determinants of Supply: A number of factors determine supply and cause a left/rightward shift of the supply curve. Whenever we examine any of the determinants, we make the ceteris paribus assumption, to prevent analysis from becoming complex to the point where the precise shift in supply due to any one determinant cannot be estimated. These include: o Cost of FoPs: If the cost of an FoP increases (e.g. if wages increase), costs in the industries using that FoP will increase, reducing the ability of firms to supply as many units of the product at any price and shifting supply left. Conversely, a fall in production costs will enable firms to increase supply, which shifts right. Especially on ag. markets, costs will vary according to weather conditions. In addition, better management can make FoPs mare productive, decreasing their costs. o Price of Substitutes in Production Often, producers have a choice as to what they will produce (e.g. a physics lab can create dark matter and antimatter using the same particle collider; a dairy can make (rather more realistically) butter and cheese). If the price of a substitute in production rises, due to increased demand, it may be that the producer will be attracted by the higher prices and aim to supply more of the substitute in production (XES>1). This leads to a movement along the supply curve for the substitute in production and a leftward shift in the supply curve of the original good (and vice versa, if the price of the substitute in production decreases). A rise in the price of a substitute of production causes an increase in QS (q>q1); some producers will supply less of the original good, as they are manufacturing the substitute in production; supply of the original good

shifts left (S>S1), even though the price of the original good remains constant. o Sometimes, goods will be produced jointly (e.g. beef and leather, copper and silver); in this case, if a higher price leads to an increase in the QS of beef, the supply of leather will shift right, as more leather is now produced at any price. o The State of Technology: Improvements in the state of technology in an industry should cause supply to increase (shift right); if technology actually worsens (which is unlikely), supply will shift left. This may happen as a result of natural disasters/war. o New Firms Entering the market: If a firm enters the market, industry supply will increase. o The Aims of Producers: If firms choose to produce in a more environmentally sustainable/socially responsible manner (e.g. by using environmentally-sourced raw materials), their prod. costs rise, and the supply curve will shift left. o Govt Intervention: In many cases, govts interfere in markets in ways that alter supply. Examples include: Indirect Taxes: Taxes on goods/services added to the price of a product. Because they force up the price of a product at any price, supply shifts left by the amount of the tax. Less of the product will be supplied at any price. Subsidies: Payments made by the government to firms per unit of output produced, decreasing production costs. This shifts the supply curve downwards by the amount of the subsidy; more of the product will be supplied at any price. The (Very Simple) Distinction Between a Movement and a Shift in the Supply Curve: o A change in the price of a good causes a movement along the existing supply curve (as price is located on one of the axes of a supply graph); a change in any of the determinants of supply (e.g. an increase in rent) will always cause supply to physically shift either left or right; more/less will be supplied at any price.

Chapter 4: Microeconomic Equilibrium When demand and supply interact, a state of equilibrium results. In economics, equilibrium occurs whenever the variables being studied are in a state of rest, in the absence of outside disturbance. My laptop is in equilibrium on my desk until it is dropped (and goes into disequilibrium, until it falls to the ground- a new equilibrium situation); economic variables can change in an analogous way. o Economists study the reasons for which equilibriums change and use the knowledge in policymaking and evaluation to predict changes in equilibrium caused by certain actions. On a standard demand and supply graph, equilibrium occurs at the price and output where supply intersects demand; at that point, the amount of a product consumers are willing and able to purchase is equal to the amount producers are willing and able to supply. The equilibrium is often known as the market-clearing point, as it is the point where all output produced in the market is sold, with no surpluses or shortages.

Once the market is in equilibrium, it will stay in equilibrium until an outside disturbance affects demand and supply. The equilibrium in a free market is self-righting: any attempt to move away from it without an outside disturbance will result in it returning to its original position. o If producers attempt to raise price above equilibrium, the quantity demanded will fall and the quantity supplied will rise, as producers/consumers are more/less willing and able to provide/purchase the product at the higher price. There is excess supply of Qd>Qs, as more is being supplied than demanded at the higher disequilibrium price. To eliminate the surplus, producers will need to lower prices; as they do so, quantity demanded (QD) will fall and quantity supplied (QS) will rise, until QS=QD once again, at the equilibrium; the situation is therefore self-righting if the price is raised for no external reason. o Likewise, if producers decide to lower the price below the equilibrium price, the quantity demanded will rise and the quantity supplied will fall, as consumers/producers are more/less willing and able to purchase/provide the product at the lower price. There will be excess demand (Qd->Qs) on the market; more is being demanded than supplied at the existing price than at equilibrium. To remove this shortage, producers will need to increase prices; as they do so, QD will fall and QS will rise, until QS=QD at the equilibrium price once again (the higher price rations the good). Once again, the situation is self-righting. o In general, these trends explain the price mechanism: if demand for a product increases, for instance, there will be excess demand at the old price; the price will rise, reducing the QD and rationing the product, the higher price will act as an incentive for existing firms to increase output, and firms outside the industry will receive the signal to join the industry. The Effect of Changes in Demand and Supply on Equilibrium: o Equilibrium may be moved by any outside disturbance. In the case of supply and demand, this would be a change in one of the determinants of supply or demand, which would cause either curve to shift. For instance, when incomes increase, demand for holidays will increase; ceteris paribus, demand for holidays will shift right. When this occurs, price initially stays at Pe (equilibrium price); thus, Qe units continue to be supplied, but QD now increases to Q2; there is excess demand at the former equilibrium price. To eliminate the shortage, price must rise until QD=QS once again at a new equilibrium, at a price of (P1, Q1), where Q1 units are both demanded and supplied. Whenever demand or supply shift, the market will (if left alone) adjust to a new equilibrium price. Price Controls: o Although it is relatively efficient, the free market does not always lead to optimum outcomes for producers or consumers, or for society as a whole; the govt may feel that

the market equilibrium does not lead to a socially desirable outcome; thus, intervention will focus on the adjustment of the price and/or quantity of a good towards a more socially optimal outcome; there are issues of market failure implicated here. Governments often intervene in individual markets in order to: Establish maximum prices (price ceilings) A government may set maximum prices below market equilibrium, preventing producers from raising the price above the ceiling. Maximum prices are usually set to protect consumers, normally in markets for necessities and/or merit goods (goods that are beneficial to society, but would be underprovided were the market allowed to operate freely. o Venezuela set max. prices in agri. And food markets to ensure low-cost food for the poor; NYC set price ceilings on rent to attempt to provide affordable housing. o If a government were to establish a price ceiling in a market with equilibrium (Pe,Qe), a problem would arise. At the price ceiling (Pmax), Qd units are demanded, but only Qs units are supplied; Qs>Qd- there is excess demand on the market. If the government does not intervene further, consumption of the product will actually fall (Qe->Qs), despite the lower price. o Due to the excess demand and shortages, black (parallel) markets may arise, where the product is sold at a price somewhere between official market price and equilibrium price; queues may also form at shops and producers may have to begin directly allocating and rationing their output. Since these problems are unfair to consumers, the govt may need to eliminate/reduce the shortage. Besides rationing the good, which is inefficient and pol. unpopular, it has two options for doing so: Option I: It could attempt to shift demand left, creating a new equilibrium at Pmax, but this would limit consumption, which defeats the intention of the price control. Option II: It could attempt to shift supply right, until equilibrium is reached at Pmax, with more supplied and demanded than at equilibrium, through a variety of ways: The provision of subsidies to encourage producers in the industry to produce mere

Direct provision of the product by the government, which would increase the supply (not very effective, as Stalin found, with agricultural markets) If the government has stocks of the product, it an release some of the stocks onto the market; this is impossible, however, with perishable goods. If the govt is able to shift the supply of the product right, equilibrium will be reached at (Pmax, Qd); however, this may well mean that the govt incurs a cost, especially in the case of a subsidy, as well as an opportunity cost (e.g. if the govt subsidizes the corn industry, it may have to raise taxes or divert funds from healthcare). In addition, this approach would nullify the usefulness of the price control. Establish minimum prices (price floors) A govt may set a minimum price above equilibrium price, preventing producers from reducing their sales price below the floor. Minimum prices are set for one of two reasons: To attempt to raise incomes for producers of goods/services that the govt believes are important (e.g. agricultural products); they may be helped because their prices are subject to many fluctuations, as well as foreign competition. o Agricultural producers in particular face two major problems: the price of ag. goods have suffered a long-term decline, and prices in the SR tend to be very unstable; this leads to unstable incomes for farmers. o Ag. prices in the SR are unstable because: The necessary nature of food makes PED inelastic. Because it is often difficult to keep stocks and crops take a long time to grow, supply is inelastic in the SR. Supply is vulnerable to sudden shifts (e.g changes in weather patterns). As demand for ag. products is inelastic, farmers earn more in bad years than good ones; with a fall in supply, prices, and thus revenues, increase. To protect workers via minimum wages, to ensure that they earn enough to maintain a reasonable standard of living. o Minimum wage policies: Aim to help the lower-paid

May increase incentives to work in the economy and cause labor supply to increase Theoretically will always cause disequilibrium unemployment The effect of min. wage policies on unemployment depends on: o How far above equilibrium the min. wage is set. o The wage-elasticities of supply and demand for labor; the greater the values of WED and WES, the greater the impact of the min. wage on unemployment. Might deter FDI. The increase in wages might, additionally: Increase the demand for goods and services, and thus for labor. Increase labor morale and productivity. If a government institutes a price floor on a market, price will rise (Pe>Pmin), which is theoretically intended to increase revenue for producers (and will work, if PED is inelastic). However, a problem arises, as, at Pmin, Qd is demanded, while Qs is supplied (Qd<Qs); we have a situation of excess supply. If the govt does not intervene further, consumption will fall (Qe->Qd), while the product will be more expensive. The excess supply causes problems, as producers will have surpluses that they cannot get rid of; they will be tempted to contravene the price controls and sell their stocks illegally for a lower price (between Pmin and Pe). To maintain the min. price, the govt will likely need to intervene by buying up the surplus products at Pmin, thus shifting demand for the product right until a new equilibrium is reached at (Pmin,Qs); the new demand curve would be: D+govt buying. The govt can then store the surplus, destroy it, or attempt to export it; however, storage is expensive, destruction would be wasteful, and, while selling abroad is usually possible, it often angers foreign governments, who claim that products are being dumped on their markets, harming local producers. In some cases, farmers are guaranteed a min. price and paid to let land that could have been used for production lie fallow; they are paid the price for the estimated

harvest and nothing is grown. This costs the same for the govt, but avoids waste, dumping and storage costs. There will be an opp. Cost involved whenever govts spend in a given area; in this case, the cost of buying and storing surpluses must be paid, and the govt may need to limit expenditure in another area or raise taxes. The min. price could also be maintained through quotas, which restrict supply such that it does not exceed a certain quantity; this would keep price at Pmin, but would limit the number of producers who would receive that price. o Quota: A physical limit to production set by the govt (e.g. EU restrictions on fishing catch volumes). o A quota may be graphed with a supply/demand diagram, with supply being normal until some quantity below the equilibrium quantity, and subsequently perfectly inelastic, as no more may be produced past that point; in effect, supply will intersect demand above market equilibrium, at a higher price Pmin and lower quantity Qquota. o The main advantage of a quota is that the total amount of the quota may be subdivided into tradable permits for producers, providing an incentive to keep output limited. Also, the government could attempt to advertise the product to increase demand for it, or, possibly, restrict imports of the product through protectionist policies (increasing demand for dom. Products). If govts protect firms via min. prices, problems are likely: firms may think that they do not need to produce as efficiently as they should, leading to inefficiency and resources being wasted; firms could also be producing more of the protected product than they should, at the expense of products they could produce more efficiently. Institute price support/buffer stock schemes (e.g. the EU crop support mechanism) This action is undertaken by govts to stabilize prices, usually in markets for commodities (essentially, raw materials), whose prices are usually unstable. For instance, agricultural prices fluctuate according to season, plant disease, weather, insects, etc. Even if conditions are perfect, and there is a bumper crop, the largescale increase in market supply would depress prices, affecting the incomes of all producers. Poor weather would drive prices up, but this would only benefit those farmers who did not lose their crops. Therefore, producers of ag. commodities face volatile prices.

The fluctuation in mineral prices is due to large changes in demand caused by trends in the global economy. If world income grows, demand for mineral rises, Increasing price for commodity producers (a positive situation, as they gain more revenue). However, economic downturns have a similarly large negative impact on mineral commodity producers, as demand for their products falls. Both demand and supply shifts cause instability in commodity markets, making planning difficult for producers and possibly reducing standards of living during economic downturns for producers and their societies. To avoid these risks, a govt may wish to institute a buffer stock scheme, in which a price band with a max. and min. price are set; the govt then intervenes in the market whenever market forces cause the price of the product to move outside of the band. o If there is a bumper crop, supply will rise, and price will fall. If it falls below the band, the government will buy up the excess supply, increasing demand and causing price to return to within the band. The surplus would have to be stored. o If there is poor weather or pest problems, however, and supply falls, increasing the price above the permissible band, there would be excess demand (a shortage) of the product at the maximum price; to rectify this, the govt will intervene by releasing some of its stocks of the product and shifting supply back right, such that the price returns within the band. o There are many problems associated with a buffer stock scheme (related to the problems of minimum price schemes). Buffer stock schemes will only be effective with non-perishable goods, which must still be stored appropriately; storage costs are likely to be high. In addition, as technology continues to improve, there may be persistent surpluses that must be bought by the govt, putting financial pressure on the scheme, especially if few bad seasons occur. Choosing the price band may also be problematic, as producers will want it as high as possible, leading to persistent surpluses. The buffer stock scheme also entails administration costs. If the band is set too high (as is the case in the EU, due to pol. pressure), the govt is constantly buying up produce surpluses. The problem is likely to increase as tech. improves and the equilibrium price decreases, moving outside of the original price band.

To raise finances for the intervention, taxes may need to be increased, and/or alternate spending projects, which may be more important to society, may need to be curtailed. Institute guaranteed-price schemes: In this scheme, the govt guarantees a price above equilibrium for farmers, at which price farmers produce. The market clearing price for the quantity produced is lower than the market equilibrium; thus, the govt ends up paying a subsidy to farmers equal to the guaranteed price minus the sales price. o By allowing the market to clear, this system means that the govt no longer needs to maintain stocks of crops. Institute commodity agreements (eg. the International rubber Organization, OPEC) Commodity agreements are international buffer stock schemes for a particular commodity; they are mainly instituted to help LDCs that are dependent on the export of a few commodities for export revenue, where low commodity prices can limit growth and development. o The usual aim of a commodity agreement is for commodity exporters to be able to control the supply, and thus the price, of their commodities. o Although several commodity agreements have been set up, none has thus far been successful due to the above problems and lack of cooperation among members; in addition, as commodity agreements may result in higher prices for consumers, they may decrease econ. efficiency. Demand and Supply Issues: o If supply exceeds demand along the full length of both curves (i.e. there is no equilibrium), the good will not be produced- the highest price consumers are willing to pay is lower than the minimum price producers need to supply. o If the health service is nationalized, and free at the point where care is given, supply is nevertheless fixed at a certain level (there is only a set number of medical personnel/equipment available at any one time). Given that there is no price, there is excess demand; the only way to ration healthcare, then, is via planning and queues. As the population ages, the problem of long waiting lists for operations will likely increase, especially since new technology increases demand for as well as supply of operations, since more treatment options become available.

Chapter 5: Elasticities

Elasticity: A measure of the responsiveness of one variable to a change in one of its determinants. o We may examine the elasticities of demand and supply in terms of our discussion of microeconomics. Elasticity of demand: A measure of how much the demand (or quantity demanded, depending on the elasticity) changes when there is a change in one of the determinants of demand. There are three significant elasticities of demand that we will consider: o Price Elasticity of Demand (PED): a measure of how much the QD of a product changes in response to a change in the products price. PED is calculated using the formula: single variable): . The negative value indicates that there is an inverse relationship between P and QD (i.e. the demand curve slopes downwards, as we would expect it to); the sign of an elasticity value gives us the nature of the relationship between the two variables, but does not show the actual elasticity (which is given by the number). Because most demand curves are downward-sloping, economists usually simplify matters by ignoring the negative sign and stating PED as a positive figure; this is obviously not the case for Giffen and Veblen goods, however. Thus, PED for the firm would be 1.5. However, if the calculation results in a positive PED value, we deal with a perverse demand curve. The Range of Values for PED: Possible values for PED range from 0 to infinity; the two extreme values are theoretical, and the real values lie between. If PED=0, a change in the products price will not cause any change in the QD; the % change in QD would be 0, as would the value at the top of the PED equation. As 0/x=0, PED=0, no matter the % change in price. A demand curve with PED 0 is perfectly inelastic: completely unresponsive to price changes; at any price, the QD will be fixed at Q. If PED=infinity, the formula stops making mathematical sense, as we are dividing by zero, so the relationship can best be explained graphically. In this case, demand is said to be perfectly elastic; at the market price, the demand curve extends forever and the QD is thus infinite. o However, if price is raised or lowered, even by an infinitesimal amount, QD will fall to 0, an infinite change; the value on top of the PED equation would therefore be infinity. Since . . If you are like me and cannot for the life of you remember the formula for % change, it is (for a If a firm decreases its price by 10% and sees an increase in QD of 15%, its

infinity/n=infinity, PED will be infinite, no matter the percentage change in price. These extreme values for PED are, once again, purely theoretical and no products on any markets (firm theory is a different matter) possess a PED of zero or infinity. Most products have PED between the two extremes; the range of PED values is usually split into three categories. o Inelastic Demand: [0<PED<1]. If a product has price-inelastic demand (e.g. alcohol, public transport), a change in the products price will lead to a less-than-proportionate change in QD. If the price of a product with inelastic demand is raised, QD will not fall by as much; as a result, the firms revenue would increase. Graphically, inelastic demand curves are relatively steeply-sloped. The changes in revenue resulting from an increase/decrease of price anywhere along the demand curve where PED<1 can be illustrated by drawing revenue boxes; if this is done, it is clearly shown that the revenue boxes before a price increase (a+b) < (a+c), the revenue boxes after the price increase. The firm loses some revenue, as fewer units are being sold due to lower consumer demand (lessened willingness/ability to purchase), but this decrease is more than made up for by the increase in price of all units sold; the firms total revenue rises as a consequence. If a firm has inelastic demand and wishes to increase its revenue, it should raise the price of the product. o Elastic Demand: [1<PED<infinity]. If a product has price-elastic demand (e.g. cars, TVs), a change in its price will lead to a greater-than-proportionate change in its QD; thus, if price is raised, QD will fall by relatively more, and the total revenue earned by the firm (price of units sold x quantity of units sold) will decrease. Graphically, elastic demand curves are relatively gradual-sloped. The changes in revenue resulting from an increase in price anywhere along the elastic portion of the demand curve may be shown using revenue boxes; if this is done, it becomes evident that the revenue boxes before a price increase (a+b)>(a+c), the revenue boxes after a price increase.

The firm gains some revenue, as more units are being sold due to higher consumer demand (increased willingness/ability to purchase), but this increase outweighed by the decrease in price of all units sold; the firms total revenue falls as a consequence. If a firm has elastic demand at the point at which they are producing and wishes to increase revenue, it should lower the price of its product. o Unit Elastic Demand: [PED=1]. If a product has unit elastic demand, a change in its price leads to a proportionate, opposite, change in the QD. Thus, if price is raised by a certain %, QD will fall by the same %, and vice versa. o When PED=1 between two points, total revenue gained by the firm (price x quantity) will not change. A rectangular hyperbola (which is shown by any function y=a/x, x>0, a>0) has unitary PED at every point; price x quantity at any point is constant (the revenue boxes have the same area; if the revenue does not change when price changes, PED is necessarily = 1). The Mathematics of Elasticity: o Elasticity is empathically not a measure of the demand curves slope; for a straight-line demand curve, PED falls as price falls. PED is elastic on the top half of the demand curve, inelastic on the bottom half of the demand curve, and unitary at the midpoint between the demand curves x- and y- intercepts. The value of PED decreases as we move down the demand curve; this is logical as goods with a lower price have relatively more inelastic demand than more expensive goods, as they represent a smaller portion of consumers real income. Consumers would be less likely to defer the purchase of a pack of chewing gum whose price has increased 5% than the purchase of a Porsche whose price has increased by the same amount. Determinants of PED: o Different products will have different values of PED (e.g. the PED for gasoline may be 0.5, while the PED of a holiday package might be 2.3), depending on a number of determinants, which include: The number and closeness of substitutes available: This is the most important determinant of PED. The more substitutes there are for a product, the more elastic

demand for the product will be. Also, the closer the substitutes available, the more elastic the demand. If there are a large number of brands of a particular product, the increase in one brands price would cause many consumers switching over to a cheaper (almost identical) substitute. Thus, the demand for a product that is highly differentiated (as in an MCM) tends to be price elastic. Necessity of the product and how broadly it is defined: Food is a necessary product: if we do not eat, we die; therefore, the demand for food is very price inelastic. However, if we define food more narrowly (e.g. fruit), we would find demand to be more elastic, as there are many alternatives (e.g. meat). If we divide fruit more narrowly and consider the demand for kiwi, we will find that it is even more price elastic, as consumers can easily switch form one type of fruit to another. When we consider kiwi produced by different plantations, demand will be still more price elastic. Necessity will vary from consumer to consumer; different people have different tastes and necessity is often subjective. o For instance, kielbasa will have much more inelastic PED in Poland than in Saudi Arabia, where pork products border on cultural taboo. Necessity also includes the addictive effects of drugs, as they are habit forming. For alcoholics and chain smokers, alcohol and cigarettes will have very inelastic demand. The Time-Period Considered: As the price of a product changes, it takes consumers time to change their purchasing and consumption habits; thus, demand is more price inelastic in the short run and more price elastic in the long run. For instance, if heating prices rise, there is initially little consumers can do to avoid paying the higher price, especially in winter-time; however, as time passes, many consumers may switch to alternate methods of generating heat;

for example, they may install wood or coalburning stoves. Thus, PED for central heating may be inelastic in the short run, but more elastic in the LR. The Percentage of Income Spent on the Good: Goods that d not represent a large proportion of consumers income (e.g. salt) will have rel. inelastic PED, as consumers will not be very receptive of price changes; by contrast, durable goods and holidays represent a greater % of income and households are more likely to search for the best prices; these goods have more elastic PED.

PED is used for: o Determining pricing policy: if demand is price inelastic, firms will increase price to increase revenue; if it is price elastic, firms will decrease price to increase revenue. o Firms can use PED for planning; by knowing the PED of their product, firms can plan the quantity of goods to produce, the number of people to employ, and the impact of price changes on cash-flow. o PED is used by firms wishing to price-discriminate, in setting the appropriate price for each market segment. o PED can be used to estimate the impact of a change in supply on consumer spending, producer revenue, and income. o PED and Taxation: Governments need to be aware of the possible consequences of indirect taxation (e.g. sales taxes) on products; if the government taxes a product, its price will rise and its QD will fall, which may affect employment in the industry concerned. If the demand for the product is price-elastic, the imposition of a tax (and resulting price increase) will lead to a greater-thanproportionate fall in the QD of the product; the industry in question will contract to a large degree and may be forced to lay off workers, increasing unemployment in the economy. Since governments do not usually wish to increase unemployment, they usually place indirect taxes on products with inelastic demand, such that the QD will not fall by a significant amount, and the industry will not be forced to lay off as many workers.

Cross-Elasticity of Demand (XED): A measure of the responsiveness of the demand for one product (X) to a change in the price of another product (Y). XED is calculated using the formula: XED= .

If a firm producing pizza finds that its demand has decreased by 5% as a result of a competing burger stand lowering its prices by 10%, the XED of its pizzas against the competitors burgers is XED= .

The Range of Values for XED: XED explains the relationship between products. Unlike PED, where most products have a negative value of PED, the value of XED may be positive or negative, and the sign is important, as it tells us the relationship between the two products in question. If XED is positive, the two goods in question are substitutes for each other. Products that are close substitutes will have a higher positive value than products that are more distant substitutes. Two brands of the same product will have a high positive value for XED; a relatively small increase/decrease in the price of one will lead to a greater-thanproportionate increase/decrease in demand for the competing good. o Close Substitutes: XED>1 o Remote Substitutes: 0<XED<1 If XED is negative, the two products in question are complements; products that are very close complements will have a lower negative value than more distant complements (e.g. products bundled together vs. products sold in the same shop). If there is a strong negative value for XED, a small increase/decrease in the price of one product will lead to a greater-than-proportionate decrease/increase in the demand of the complement. o Close Complements: XED<-1 o Remote Complements: -1<XED<0 Some products (e.g. horseshoes and hand-grenades) are not related (except in Green Day songs); an increase in the price of one will have no effect on the demand of the other; XED=0 and the two products are considered unrelated. Graphically, XED may be plotted with the price of good Y on the Y axis and the QD of good X on the X-axis. In all cases, the graphs will reflect the proportionality of the change in the demand of good X to the change in the price of good Y; read them accordingly. For strong substitutes, the demand curve for Good X [D(x)] slopes upwards and is gradually-sloped. For remote substitutes, D(x) slopes upwards and is steeply sloped.

For strong complements, D(X) slopes downwards and is gradually-sloped For remote complements, D(x) slopes downwards and is steeply-sloped. Firms need to be aware of the XED for their products, as it is essential that they know the probable impact of the demand for their products of any price changes by competitors; likewise, they will want to know the impact of any of their own price changes on the demand for the competitors product. o In addition, firms that produce complementary goods (e.g. power tools and accessories) need to be aware of the effect of the price changes that they make on one product on the demand for the complements that they produce. Income Elasticity of Demand (YED): A measure of the responsiveness of the demand of a product to a change in consumers incomes. It is calculated using the formula: YED= . . If a consumers income increases by 10% and she increases her spending on snowy-white cocaine by 20%, her YED for cocaine, YED= The Range of Values for YED: As with XED, the sign obtained from the equation is important, as it tells us whether the product we are examining is a normal or an inferior good. Recall that the demand for a normal good rises as income rises and demand for an inferior good falls as income falls. o For normal goods, YED is positive; demand increases as income rises; the higher the figure (ignoring the sign), the greater the relationship between demand and income. If the % increase in QD is less than the % increase in income 0<YED<1 and the good is income-inelastic. If the % increase in QD is greater than the % increase in income, YED>1 and the good is income elastic. o Necessity goods tend to have low (positive) YED; the demand for them will change little as income rises, as people feel that they already have enough of the necessity good if they are doing any better than subsisting, and will not increase consumption. o Superior goods (e.g. holidays abroad, yachts) are income-elastic (YED>1); the demand for them increases significantly as income rises. As people satisfy their needs, they begin to purchase nonessential products (wants; e.g. holidays), in greater numbers. o Inferior (and Giffen) goods (e.g. supermarket-brand products, public transport) have negative YED; the demand shifts left as

income increases, since people start to switch expenditure from the inferior goods they had been buying to better-quality goods that they can now afford (e.g. demand for supermarket-brand detergent falls as incomes rise). An Engel curve shows the relationship between income and the demand for a product as incomes rise; as income in a country rises over time, the demand for a normal good may initially increase, then become constant, and finally begin to fall as consumers begin to buy superior substitutes instead. Uses of income elasticity: o YED can determine what goods firms should produce/stock; as the econ. grows, firms may wish to stop producing as many inferior goods. o Firms can use YED to plan production and employment requirements as the economy grows. o YED can help firms estimate any pot. changes in demand (e.g. if incomes grow abroad, they may be able to expand into new markets). Price Elasticity of Supply (PES): A measure of the responsiveness of the QS of a product to a change in its price. PES can be calculated using the equation: PES= If the price at which a firm can sell its product increases (due to increased demand) by 10%, and the quantity supplied of the product increases (because the firm is willing and able to produce more of the product at the higher price) by 15%, the PES of the firms product is PES= =1.5.

The value of PES will be positive in the overwhelming majority of cases. The Range of Values of PES: The possible range of values of PES spans from 0 to infinity. Unlike PED, both extreme values occur regularly throughout the study of economics. o If PES=0, a change in the price of a product will have no effect whatsoever on the products QS. Thus, the % change in QS would equal 0, as would the value at the top of the PES equation. As 0/x=0, PES=0 no matter the % change in price. A supply curve with PES=0 is referred to as perfectly elastic; it is completely unresponsive to price changes. Thus, the supply curve, when graphed, will be vertical at a given quantity of output, regardless of the price. In the very short run (a.k.a. the immediate time period), it is impossible for firms to increase supply immediately,

regardless of the increase in price, and supply would be perfectly inelastic until new FoPs could be employed; thus, perfectly inelastic supply is possible in reality. A PES value of infinity brings up the prickly issue of division by zero, and can best be explained graphically. In this case, supply is considered perfectly elastic; the supply curve extends forever at market price and the QS is infinite. However, if price falls below market price, even by the smallest amount, QS will fall to 0, an infinite change. Thus, the value on top of the PES equation would be infinity; as infinity/x=infinity (though a smaller infinity!), PES would be infinite regardless of the percentage change in price. In international trade, the supply of commodities (e.g. wheat) available to a country for import is assumed to be infinite- the consumers in the country can purchase any quantity of the commodity that they wish, so long as they are prepared to pay the world market price. Thus, the market in the country will have a perfectly elastic World Supply curve at the world price. Regular products have PED values between 0 and infinity; we will now examine these values , the range of which is usually split into three categories: Inelastic Supply [0<PES<1]: If a product has inelastic supply, a change in its price leads to a less-thanproportionate change in its QS. Elastic Supply [1<PES<infinity]: If a product has elastic supply, a change in its price leads to a greater-thanproportionate change in its QS. Unit Elastic Supply [PES=1]: If a product has unit elastic supply, a change in its price leads to a proportionate change in its QS. Graphically, inelastic supply curves are steeply-sloped and elastic supply curves are gradually-sloped. Any supply curve that passes through the origin will have PES=1 along its entire length, regardless of its actual gradient, because the % change in price will always be equal to the % change in QS. This is a mathematical relationship that holds for all supply curves passing through the origin. Any supply curve that intersects the vertical axis will have elastic PES along its entire length-the % change in

price will always be lesser than the % change in QS; this is a mathematical relationship. Any supply curve that intersects the horizontal axis will have inelastic PES along its entire length- the % change in price will always be greater than the % change in QS; again, this is a mathematical relationship.

Determinants of PES: Different products will have different values of PES (e.g. the supply of soda may be elastic, while the supply of cotton will likely be inelastic). A number of determinants influence the value of PES of a product. These include: o How much costs rise as output is increased: If total costs rise significantly as a producer attempts to increase QS, it is likely that the producer will not increase QS in response to a small increase in price; thus, PES for the product will be relatively inelastic; large price increases would be required In order for an increase in QS to be worthwhile. However, if total costs do not rise quickly as output rises, the producer will be able to easily raise QS and take advantage from the slow increase in costs to benefit from higher prices, potentially making more profits. TC will not rise quickly if a firm has significant amounts of spare capacity and if the cost of FoP inputs does not rise quickly as the firm uses more of them. o Spare Capacity: If firms operate at full capacity, supply will be price inelastic; the more spare capacity exists, the greater the PES can be, as firms may increase output more easily in response to a price change. Ease of storing stocks: if it is easy to stock goods, if price increases, a firm can sell its stocks, and thus supply may be quite elastic, even in the SR; in the case of goods that cannot be stored easily (e.g. francium), supply will be more inelastic. o Type of good: Time lags in the production of certain goods pay make supply of them more inelastic (even perfectly inelastic), even in the SR; this is esp. true for ag. markets. o Number of producers on the market: the more producers there are, the easier it is for the industry to increase output in response to a price increase; industry supply will be more elastic with a greater number of firms. o Factor mobility: The easier it is for resources to move into the industry, the more elastic supply will be.

Length of the production period: The quicker a good is to produce, the more elastic the PES; mfg. supply curves tend to be far more elastic than ag. supply curves. The time period considered: The amount of time over which PES is measured will affect its value- in general terms, the longer the timespan considered, the more elastic supply will be. In the very short run, firms cannot increase their supply very much, if at all, as price increases, as they cannot immediately increase the number of FoPs they employ; PES will thus be very inelastic (generally approx. 0) In the short run, firms will be able to increase the quantity of some FoPs (eg. Raw materials, labor) but will not be able to increase the quantity of all FoPs (e.g. factory size and number of machines may be fixed). Supply will be more price-elastic than in the immediate time period (generally inelastic, however). In the long run, firms are able to increase the quantity of all FoPs they employ; therefore, supply will be much more elastic (PES>1, generally). Also, over time, firms can invest in training and more equipment, and more firms can join the industry, rendering supply more elastic.

Chapter 6: Indirect Taxation and Subsidies When governments tax products or subsidize firms, demand and supply on the relevant markets will be affected; we will now consider these effects and how they are influenced by the relative price elasticities of the good in question. The Effect of an Indirect Tax on Demand For, and Supply Of, A Product: o Indirect tax: A tax imposed on consumers expenditure (e.g. taxes on alcohol). Indirect taxes are placed on particular products, and must be paid by firms to the government (although some of the tax burden will be passed on to consumers). Indirect taxes increase costs for the firms in question and thus shift the supply curve for the product left by the amount of the tax (e.g. $1, 10%). Due to this shift, firms will be willing and able to supply less of the product at any price. Two types of indirect taxes need to be considered: Specific tax: a fixed amount of tax imposed on a product (e.g. $1/unit). Graphically, specific taxes shift the supply curve upward by the same amount (the amount of the tax) at any point along its length. Ad valorem tax: An indirect tax on a proportion of the sales price of a product (e.g. a VAT of 22.5% on consumer goods). Graphically, an ad valorem tax shifts the supply curve by a progressively greater amount as

price increases (moving right along the supply curve); the new supply curve begins to diverge from the old supply curve at higher prices, because a proportion, rather than a fixed amount, of the price is handed over to the government. When an indirect tax is imposed on a product, it will affect consumers, producers, the government, and the market as a whole. We can analyze supplyand-demand diagrams to answer the following questions: What will happen to the products market price? What will happen to producers revenue? How much revenue will the government receive? What will happen to market size, and thus employment? If we assume that a government imposes a specific tax on a product with normal supply and demand, we obtain the following (graphical) situation: The market is initially in equilibrium where supply (S) = demand (D). After the tax is imposed, S shifts left by the amount of the tax. While producers would like to keep output constant at free-market equilibrium output, while raising market price by the amount of the tax (such that consumers shoulder the full burden of the tax), this would result in a surplus (QS>QD) on the market. To clear the surplus, price would rise until a new equilibrium is reached (S+tax=D), at a higher price and lower QD than before the tax. o Because price for consumers has risen, they shoulder part of the burden of the tax (Pe->P1, the difference in price between the two equilibriums). o However, consumers do not cover the full burden of the tax; therefore, producers are forced to pay a portion of the tax to the government from the revenue that they had been receiving before the taxs imposition; they now receive C per unit, where C may be found by tracing a line from the old equilibrium vertically downwards to the firms original supply curve (S). The burden of the tax to producers is whatever cost increase they cannot pass on to consumers; (Pe-C). In total, producers pay tax equal to (P1-C) to the government per unit produced. Burden of taxation: The proportion of the tax paid by the producer or the consumer. Due to the tax, producer revenue falls from Pe x Qe to C x Q1. Because market sales and market size decrease (Qe->Q1 units), the level of employment in the industry in question may be affected, as firms may be forced to lay off workers.

o o o

The government receives tax revenue equal to (P1-C) x Q1. If PED=PES, the burden of the indirect tax will be shared evenly between producers and consumers. However, the share of the tax burden for producers and consumers will vary based on the relative values of PED and PES for the product, as will government revenue and the effect of the tax on market size. On a market where PED for a product is relatively more elastic than the products PES (where PED>PES), the imposition of a specific tax will still shift S upwards by the amount of the tax. While producers would like to pass on the full burden of the tax to consumers by producing the equilibrium quantity at a price increased by the amount of the tax, they cannot do so, as a surplus ensues. Due to the relatively elastic demand curve, price will need to fall by more than half of the amount of the tax before a new equilibrium is reached at (S+tax=D) and the surplus is cleared. In this case, producers cannot pass on much of the tax burden to consumers, as the relatively elastic demand signifies that too many consumers would stop purchasing the product (and turn to substitutes) if the price increases substantially. Thus, the market price of the product increases by less than half of the amount of the tax, and consumers contribute less than half of the total amount of the tax ((P1-Pe) x Q1, or (P1-Pe per unit). As a result, producers need to shoulder most of the tax burden themselves. As producers need to contribute to the tax using some of the revenue that they were earning beforehand, they now only receive C per unit sold (where C is the price corresponding to Q1 on the firms supply curve prior to the tax). Producers contribute the majority of the tax ((Pe-C) x Q1, or (Pe-C) per unit). As a consequence of the tax, producer revenue falls (Pe x Qe -> C x Q1) by a larger amount (as a proportion) than in the case where PED=PES. Because fewer units are now sold due to elastic demand, but the amount of the tax is the same (assuming you have followed along from the previous situation), the government receives tax revenue ((P1-C)

x Q1), which is lower than in the situation where PED=PES. The market size decreases from one producing Qe to one producing Q1 units, again affecting employment in the industry in question (on a greater scale than the case where PED=PES). Where PED>PES, the tax burden is greater on producers than consumers due to the difference in the elasticities values. On a market where demand is relatively more price inelastic than supply (PED<PES), the imposition of an indirect tax, which shifts S left (S->S1), can easily be predicted. While producers would like to pass on the full burden of the tax to consumers by producing at the original equilibrium output and raising the price by the amount of the tax, this would create a surplus on the market, which would only clear once price decreases, by less than half of the amount of the tax, to a level where (S+tax=D), at a new equilibrium. Because demand is price-inelastic relative to supply, and relatively few consumers would stop buying the product if the price were raised, producers will be able to pass on more than half of the burden of the tax to consumers. The price of the product for consumers would rise substantially (Pe->P1); consumers will therefore contribute a total of ((P1-Pe x Q1) towards payment of the tax, which is a majority of the total tax. Meanwhile, producers need to contribute the remainder of the tax out of the revenue that they had been receiving before the imposition of the tax. As a result of the tax, producers only receive C per unit (C being, once again, the point on the pre-tax supply curve corresponding to the output level Q1. Thus, they contribute ((Pe-C) x Q1, or (Pe-C) per unit) towards the tax, while retaining revenue equal to (C x Q1). The government receives tax revenue equal to ((P1-C) x Q1, or (P1-C) per unit). As demand is relatively priceinelastic, consumers purchase relatively more units as a result of the tax than they would in a market where PED=PES; the government is thus able to earn high revenue from the tax.

Market size decreases, as the market is producing Q1, instead of Qe, units, which, as should be abundantly clear by now, will affect the level of employment on the market. In this case, the burden of taxation will fall more heavily on consumers than on producers. o We may derive some general rules as to the incidence of indirect taxes for consumers and producers from the above situations: 1. On markets where PED=PES, the burden of an indirect tax would be equal for producers and consumers of the product. 2. On markets where PED>PES (demand is relatively elastic), the burden of an indirect tax will be greater on producers than on consumers. 3. On markets where PED<PES (demand is relatively inelastic) for a product, the burden of an indirect tax would be greater on consumers than on producers. o Thus, governments tend to place indirect taxes on products with relatively inelastic demand (e.g. cigarettes); as QD falls by a less-than-proportionate amount to price, the government is able to gain high revenue, while not causing large decreases in employment (and possibly reducing negative externalities from the production/consumption of the taxed products) o Note that, when the govt increases taxes on products, revenue will not increase if demand and supply are relatively elastic; although the tax per unit is higher, the fall in the quantity of goods sold reduces overall govt revenue. o To maximize tax revenue, the govt can broaden the tax base (i.e. tax more goods/services); by taxing more goods, consumers will have a harder time finding cheaper alternatives, thus making demand for the taxed goods more inelastic. The Effect of a Subsidy on the demand for, and supply of, a product: o (Unit) Subsidy: A specific amount of money paid by a government to a firm, per unit of output produced (e.g. EU cotton subsidies). o A government might subsidize a product for a number of reasons, of which the main ones are: 1. To lower the price of necessities (e.g. food) to consumers. By imposing the subsidy, the government hopes to increase consumption of the product by allowing for a lower price. 2. To guarantee the supply of products considered necessary in the national economy; either of goods classified as necessities (e.g. an emergency food

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supply, electricity), or of products whose production guarantees the employment of many people, to avoid the social and economic problems of high unemployment. 3. To enable producers to compete with imports from abroad, protecting the home industry. 4. Possibly, to protect cultural traditions that would be endangered if a culturally-significant industry (e.g. wine-makers) were to decline. If a subsidy is granted to producers on a given market, the supply curve for the product will shift right by the amount of the subsidy, as the subsidy reduces firms costs, rendering them more willing and able to supply more of the product at any price. As with indirect taxes, the amount of the subsidy passed on to consumers through lower prices, and the amount retained by producers, will depend on the respective values of PED and PES on the market. Although percentage subsidies may be occasionally granted, they are rare; hence, this study guide will focus exclusively on unit subsidies and their effects. Assuming that demand and supply are normal, the granting of a subsidy on a product will shift S for the product right by the amount of the subsidy to S-subsidy. Producers lower prices and increase output until a new equilibrium on the market is reached (D=S-Subsidy), at a lower price (P2 vs. Pe) and higher output level (Q1 vs. Qe) than the free-market equilibrium. As a result of the subsidy, price does not fall by as much as the per-unit amount of the subsidy (Pe->P2, which is higher than P1, the point on S1-subsidy corresponding to the output level Qe). Producer revenue increases ((Pe x Qe -> D x Q1), where D is the subsidized price that the firms receive for producing a unit of output; D=P2+Subsidy). While consumers pay P1 x Q1 for their purchases, the rest of the firms revenue ((D-P2) x Q1) is paid to them by the government through the subsidy on each of the Q1 units produced; this is the total cost to the govt of the subsidy. Obviously, the money for the subsidy cannot materialize out of thin air, and there is an opportunity cost involved with the subsidy. The government may need to either divert money from other expenditure projects (e.g. infrastructure, education) or raise taxes. As a result of the subsidy, consumers are able to purchase the original Qe units at a lower price, saving them the expenditure ((Pe-P2) x Qe); however, due to the lower price, they also purchase (Qe->Q1) additional units, spending (P2 x (Q1-Qe)) extra. Total consumer expenditure may either rise or fall, depending on the relative savings and extra expenditure. In a market where demand is relatively price elastic and supply is relatively price inelastic (PED>PES), the subsidy will have the same overall effect: the supply curve will shift right (S->S-Subsidy), and producers will lower prices and increase output until a new equilibrium is achieved.

The price of the subsidy to consumers, however, will fall by less than half of the amount of the subsidy. If the whole price were to be passed on, price would need to decrease to P1 (at which point there would have been a shortage). Producer revenue increases ((Pe x Qe -> D x Q1), where D is the subsidized price that the firms receive for producing a unit of output; D=P2+Subsidy). While consumers pay P1 x Q1 for their purchases, the rest of the firms revenue ((D-P2) x Q1) is paid to them by the government through the subsidy on each of the Q1 units produced. Again, both consumption of the product and producer revenue increase; the consumers do not benefit from a large price fall, but, as demand is relatively price-elastic, this nevertheless translates into a large increase in consumption. Finally, in a market where demand is relatively price-inelastic and supply is relatively price-elastic (PED<PES), a unit subsidy would, once again, cause supply to shift right by the amount of the subsidy (S->S-Subsidy). The producer is able to lower prices and increase output until a new equilibrium is reached where (S-Subsidy=D). The price to consumers would fall significantly, by more than half of the amount of the subsidy. If the whole subsidy were passed on, price would need to fall to P1, which would, once again, provoke a shortage (excess demand). Producer revenue rises as a result of the subsidy, from (Pe x Qe) to (D x Q1). Consumers pay (P2 x Q1) for the product, while the government pays the producers the remainder of their revenue ((D-P1 x Q1) in the form of the subsidy. Consumption of the product increases, as does producer revenue. While the consumers benefit from a relatively large price fall, consumption increases by a less-than-proportionate amount because demand is relatively price-inelastic. We can derive a set of rules related to the effects of granting of subsidies on producers and consumers in different markets: On markets where PED=PES, the products price will fall by half of the amount of the subsidy. On markets where PED>PES, the products price will fall by less than half of the amount of the subsidy. On markets where PED<PES, the products price will fall by more than half of the amount of the subsidy. In all cases, consumption will rise and producer revenue will increase. A number of issues need to be considered when a government grants a subsidy to an industry; these include: The opportunity cost of government spending on the subsidy in terms of alternate expenditure projects. Whether the subsidy would foster inefficiency among firms by allowing them to be less competitive Although a subsidy may lower prices for consumers, they might be paying the same cost indirectly through higher taxes- how is the subsidy being funded?

Will the subsidy damage the sales of unsubsidized foreign producers? The agricultural subsidies of the US and EU have been heavily criticized, as they lead to over-production which severely reduces the ability of small farmers in LDCs to compete on world markets and earn a living. In addition, developed countries may often dump their products in LDCs by selling them below their production costs (not to mention, below the local market price); this is the point at which the Doha Round of WTO negotiations has hit a brick wall (so much for a solution from there!)

Chapter 7: Costs, Revenue and Profit (A Lot of Definitions) This chapter is an introduction to the Theory of the Firm, which studies the different types of behavior for firms in the markets in which they operate, and the nature of competition in different markets. o The fundamental concepts of Firm Theory are costs, revenues and profits. o In firm theory, all factors of production are assumed to be homogeneous (which is an unrealistic assumption) Cost Theory: o Some Definitions: The Short Run (SR): the period of time in which at least one FoP is fixed; all production occurs in the SR. The Long Run (LR): the period of time in which all FoPs are variable, but the state of technology is fixed. All planning takes place in the LR. The Very Long Run: Where the state of technology is variable. The Very Short Run: Where all FoPs are fixed (and the supply curve for the industry is perfectly inelastic) o In the SR, a firm will not be able to quickly increase the quantity of its fixed FoPs. Often, the fixed FoP is land, or some form of capital, but it may also sometimes be a highly specialized type of labor (e.g. a fast-breeder reactor overseer). If a firm wishes to increase output in the SR, it can only do so by applying more units of its variable FoPs to the fixed FoPs it already possessing, while planning ahead to change the number of fixed FoPs it has. The length of the short run is dependent on the time it takes to increase the quantity of the fixed FoP; this will vary between industries. Whereas a street kebab seller may have cooking utensils (capital) as a fixed FoP, and its short-run will be the time taken to run to the store and buy more utensils (3 hours), a nuclear power company is constrained by the number of power plants that it has; its short run may therefore last for years. If a firm plans ahead to change its number of FoPs, all FoPs are assumed variable as plans are being made- the firm plans in the long run. As soon as the fixed factors are changed, the firm is back in the shortrun, though with a different number of fixed FoPs; the only way to

increase output would once again be through applying more units of variable FoPs to the fixed FoPs. Definitions and Equations Related to Cost Theory: Total Product: the total output a firm produces using its fixed and variable FoPs within a given time period (bear in mind that output in the SR can only be increased by applying more units of the var. FoPs to the fixed FoPs; the x-axis of the graph, when TP is plotted, is therefore quantity of *insert variable FoP here+). Average Product: the output produced, on average, by one unit of the variable FoP. AP= , where V is the number of units of the variable FoP employed. Marginal Product: the extra output produced by applying an extra unit of the variable FoP to production. MP = , where dTP is the change in total output

(units produced) and dV is the change in the number of units of the variable FoP employed. Productivity: Output/worker. Can be increased through more training, more capital equipment, better management and improved technology Total product, when graphed, never crosses the x-axis: you cannot produce -554 fake plastic trees, for example. The point of inflection (where the concavity changes) on the TP curve occurs at the maximum point of the MP curve; ,after that point, diminishing returns set in. When the marginal is positive, the total increases; when it is negative, the total falls. When MP is above AP, the average gets pulled up (which makes mathematical sense); conversely, where MP is below AP, the average is dragged down; therefore, the maximum AP occurs where MP intersects AP The Law of Diminishing Returns is composed of two subcomponents: The hypothesis of eventually diminishing marginal returns: As extra units of a variable FoP are added to a given quantity of a fixed FoP, the output gained from each additional unit of the variable FoP will eventually diminish. The hypothesis of eventually diminishing average returns: As extra units of a variable FoP are added to a given quantity of a fixed FoP, the output/unit of the variable factor will eventually diminish. Both hypotheses examine the same relationship from different angles; the entire relationship is based on common sense. While adding units of a variable FoP will initially make production more efficient; for example, because adding more units of labor will allow workers to specialize in a particular task and therefore be more efficient at that one task, at a certain point, production will start becoming less and less efficient because, to use the limited quantity of fixed FoPs, the variable FoPs begin to get into each others way (for example, at a countertop) and production therefore becomes less

efficient. However we measure diminishing returns (Dim. Marg. Returns/Dim. Avg. Returns) inefficiency will eventually occur. o The Law of Diminishing Returns is only effective in the short run, as it is assumed that at least one FoP is fixed. Short-Run Costs: o Firms face different types of costs when producing their output of goods/services. We can separate costs into several categories, depending on their origin: Total costs: the complete costs of producing output. We use three measures: 1. Total fixed cost: the total costs of the fixed FoPs that a firm uses in a given time-span. Since the number of fixed assets is constant in the short-run, TFC is also constant and does not vary according to output. o TFC=(# of fixed assets)(cost of each fixed asset) 2. Total variable costs: The total cost of the variable assets a firm uses in a given time period. TVC increases as a firm uses more of the variable FoP. o TVC=(# of variable factors)(cost of each variable factor) 3. Total Cost: the total cost of all fixed and variable FoPs used to produce a certain output) o TC=TFC+TVC Average costs: costs per unit of output; we use three measures: 1. Average Fixed Cost: Fixed cost/unit of output. AFC= , where q is the total output. Because TFC is constant, AFC always falls as output increases. 2. Average Variable Cost: Variable cost/unit of output. AVC= . AVC tends to fall as output increases, and starts to rise again as output continues to increase. This is due to the Law of Diminishing Average Returns. As more of the variable FoPs are applied to the fixed factors, output/unit of the variable factor eventually falls; thus, the cost/unit of output eventually begins to rise o AVC tends to be U shaped; on average, the variable factor becomes more productive at first, then becomes less productive; AVC falls when the var. FoP is more productive and rises when the var. FoP is less productive. 3. Average Total Cost: Total cost/unit of output. ATC=AFC+AVC= . For the same reason as AVC, ATC tends to fall as output increases, and start to rise again as output continues to increase.

Marginal Cost: The increase in the total cost of producing an extra unit of output. MC= .

MC tends to fall as output increases, and start to rise again as output continues to increase; this is due to the Law of diminishing marginal returns. As more variable FoPs are applied to the fixed FoPs, the extra output per unit of the variable factor eventually falls, and so the extra cost/unit of output eventually begins to rise. The ATC, AVC and MC curves are closely connected. Quite simply, MC intersects AVC and ATC at the curves minimum points (this is mathematically justified by the relationship between marginals and averages (see above)). AFC falls as output increases, and (since it is the gap between AVC and ATC), ATC and AVC converge as output grows. Include these relationships in your graphs. The MC curve is inversely related to the MP curve in the SR; when MC increases, MP falls, and vice versa. o When each marginal variable FoP is more productive, less of their time (or man-hours, as the case may be) is needed to produce an additional unit of output; assuming wages are constant, marginal product will rise and marginal cost will fall (and vice versa, when the variable FoP is less productive). Overhead/Sunken Costs: Costs that entrepreneurs incur when opening a business that they wont expect to regain when they leave the business (e.g rent, raw materials, and depreciated capital- in general, whatever cannot be sold if the business closes). Typical costs faced by firms include raw materials, labor, depreciation of capital, and the cost of capital. Costs in the Long Run: The long run is the planning stage; in the long run, entrepreneurs are free to adjust the quantity of all FoPs used, and are only restrained by the level of technology. In the long run, we examine what happens to costs when all FoPs have been increased to increase output. What we find is different in theory than in practice. In theory, the long-run avg. cost curve is an envelope curve (it envelops all possible SRAC curves for a firm- an infinite number of possible SRAC curves). A firm can only produce on one SRAC curve at a time, however (production occurs in the SR). o The lowest possible cost of producing the output occurs on the SRAC curve that is tangent to the LRAC curve at its minimum point (the point on SRAC is also a point on LRAC).

If demand increases and the firm wishes to increase output, it can do so in the short run by employing more FoPs and moving along SRAC; this may be at a lower or higher cost/unit than before (due to diminishing returns). The firm will know that they would be able to produce the output more cheaply, though, by adjusting their fixed FoPs in the long run; when this eventually occurs, the SRAC curve will shift towards a position where it is more optimally situated on LRAC. On each individual SRAC curve, the lowest possible cost of producing the desired output will always be the point where SRAC is tangent to LRAC (because LRAC is an envelope curve). Therefore, readjustment of fixed FoPs to move along the LRAC curve is in the interest of a firm that wants to produce at minimum cost. The envelope curve represents all the possible combinations of FoPs that could be used to produce differing outputs for the firm. LRAC is the boundary between attainable and unattainable unit cost levels for the firm; if possible, the firm will always like to be producing at points on LRAC to minimize average costs; however, this may only be possible in the LR. Some more definitions: Increasing returns to scale: when a given % increase in all FoPs will lead to a greater-than-proportionate % increase in output, reducing LRAC; thus long-run unit costs fall as output increases With increasing returns to scale, if the amount of FoPs a firm uses is doubled, its output will more than double. Constant returns to scale: when a given% increase in all FoPs will lead to a proportionate % increase in output, keeping LRAC constant; thus, long-run unit costs are held constant as output increases;. Decreasing returns to scale: when a given% increase in all FoPs will lead to a less-than-proportionate % increase in output, increasing LRAC; thus, long-run unit costs rise as output increases;. Long-run costs may increase/decrease as output rises because of: Economies of Scale: Any decreases in AC caused by a firm altering all of its FoPs to increase the scale of its output; these lead to a firm experiencing increasing

returns to scale, but are not increasing returns to scale. While returns to scale are an FoP/output issue, economies of scale are an FoP/cost issue. Although increasing returns to scale contribute to economies of scale, the latter is a relationship involving cost, rather than product. With internal economies of scale, SRAC moves downwards along LRAC as it shifts right; with external economies of scale, the entire LRAC curve shifts downwards. A firm may benefit from a number of economies of scale when expanding output: Specialization: In small firms with few managers, management often has to take on roles for which the managers are not ideallt suited, leading to higher unit costs; as firms expand, their management may specialize in areas such as production, finance and marketing, and therefore become more efficient. Division of labor: breaking a production process down into small, repetitive, efficient subcomponents; as firms get bigger, they are often able to divide labor up and reduce unit costs (e.g. a factory organizing an assembly line). Also, if a production process cannot be subdivided, the cost/unit will be high if fewer units are produced, and increasing output would decrease unit costs in the LR. Increased dimensions (spatial economies): if a storage container is doubled in size, the volume will more than double, making storage costs cheaper/unit. Linked processes: if machines produce at differing output levels, buying more of a certain type of machine to increase output may allow a firm to synchronize production. Risk-bearing economies: by diversifying into multiple markets, a firm will likely face more stable demand; sudden falls in demand in one area will likely be offset by increases in demand

elsewhere. Demand is more predictable and a firm need not keep high levels of stocks, reducing stockholding costs. Bulk buying: As firms increase in scale, they are often able to negotiate larger discounts with suppliers; this reduces input costs and thus, their unit costs of prod. Financial economies: large firms can raise financial capital much more easily and cheaply as smaller firms, as they are considered less of a risk in terms of repayment, and may get lower interest rates on loans. Transport economies: large firms carrying out bulk orders may be charged less for delivery than smaller firms; as firms grow, they might develop transport fleets, allowing them to cut out the middleman (and the associated profit margin) on transport. Large machines: some machinery is too large and expensive to be owned by small businesses (e.g. a combine harvester for a small farmer). While small businesses may have to hire out such equipment, paying a profit margin, when they need it, once they grow to a certain size, it will be feasible for them to have their own machinery, reducing unit costs of prod. Promotional economies: Most firms attempt to advertize their products; the costs of promotion, however, tend not to increase by the same proportion as a firms output (e.g. firms may overdub ads for foreign markets). If a firm doubles output, it is unlikely to double advertizing expenditure, and the cost of promotion/unit output falls; this situation applies to other fixed costs as well (e.g. insurance). Diseconomies of Scale: Any increases in LRAC caused by a firm altering all of its FoPs to increase the scale of its output. Diseconomies of scale lead to a firm experiencing decreasing returns to scale.

With internal diseconomies of scale, SRAC moves upwards along LRAC as it shifts right; with external diseconomies of scale, the entire LRAC curve shifts upwards. There are several sources of diseconomies of scale a firm can experience: Control and communication problems: As firms grow in scale, the management will find it harder to coordinate the firms activities, which may lead to increases in unit costs due to inefficiency; likewise, greater size may lead to increased likelihood of communication breakdowns as firms increase in size, also eventually causing unit cost increases. Alienation and loss of identity: As firms grow, it may be that both workers and managers may begin to feel alienated and lose their sense of belonging and loyalty to the firm; if this happens, it is likely that they will work less efficiently, forcing up unit costs of production. All of the above economies/diseconomies of scale relate to unit cost increases/decreases encountered by a single firm; they are internal (dis)economies of scale. A further group of (dis)economies of scale are external (dis)economies of scale, which occur at industry level and affect unit costs of individual firms. External economies of scale: If an industry grows in a certain geographical area, universities may start offering programs relating to the skills required in the industry. The graduates of the firms would be ready to work in the industry, lowering training costs for firms and making them more efficient. Also, if many firms produce in one area, they can share technology and resources, and specialist suppliers could emerge. If suppliers increase in size and benefit from economies of scale, this will cause external economies of scale for the industries they supply.

External diseconomies of scale: when an industry develops rapidly and intense competition between firms for FoPs forces up prices of the FoPs, and thus the unit costs of all firms in the industry. Minimum Efficient Scale: The first level of output at which unit costs of prod. are minimized. SRAC curves are U shaped because of diminishing returns, which also explains the shape of the AVC curve (dim. Avg. returns) and the MC curve (dim. Mar. returns). LRAC curves are U-shaped in theory due to the existence of (dis)economies of scale In reality, there has been no solid evidence of a firm being so large that diseconomies of scale outweigh economies of scale in the long run; actual long-run cost curves may be L-shaped.

Revenue Theory: o Revenue: the income a firm receives from selling its products over a given time-span. Revenue can be measured in several ways: Total Revenue: The total amount of money a firm receives from selling a certain amount of goods/services in a given timespan. TR=price X quantity. Average Revenue: The revenue a firm receives per unit of sales. AR= o . Marginal Revenue: The extra revenue a firm gains for producing one additional unit of output in a given timespan. MR= .

When output increases, two cases involving what happens to revenue as output increases can be considered. Revenue when price does not change with output (where PED is infinite): If a firm does not need to (or cannot) lower prices as output rises and wishes to sell more of its product, it faces a perfectly elastic demand curve. This situation is purely theoretical, but is used in models of PCMs and, by extension, other market structures. o A firm with perfectly elastic demand will be very small relative to the industry, and is able to increase output without affecting total industry supply, and therefore price, in any significant way. The firm can sell all of its output at the same price. o When graphed, if PED is perfectly elastic, price, AR, MR and demand are all the same. TR increases at a linear rate as output increases, as MR is constant (Calculus, folks!)

Revenue when price falls when output increases (when the demand curve slopes downwards/PED falls as output increases)- revenue graph for a monopolistic firm. In the case where price falls as output increases, TR, MR and AR show a very different set of relationships. If a firm wants to sell more units and is big enough to control the sales price, it will need to lower the price if it wants to increase QD. o The firm faces the demand curve for the industry, which is downward-sloping. o In a monopolistic market, D=AR, which falls as output rises, since the price must be lowered to sell more units. o MR also falls as output rises, but at a greater rate than AR (due to calculus- integration, folks). The MR curve is twice as steeply sloping as the AR curve and intersects the X axis at the midpoint between the origin and where demand intersects the x axis; at the point where TR is maximum and PED on the demand curve = 1. o Proof: MR slopes twice as steeply as AR: Assume (by Occams Razor) that the TR curve can be modeled by the simplest curve that is concave downward and symmetric around its maximum point, p=-q(q-z)=-(aq^2-qz), where z is the intercept of AR with the q-axis, as well as a zero of TR. Taking the derivative of TR (MR): MR= -2aq+z. Then, D=AR: p=-aq+z (where z is also the vertical intercept of the demand curve, such that it is able to slope downwards in the first quadrant; q=z, because of the fact that AR is an average based on TR/output, and must therefore cross the y-axis at the same point as MR [mMR=-2a]=[2(mAR=-a)]. QED. This relationship holds for all downward-sloping AR curves and the MR curves associated with them. MR is below AR because, to sell more products, the firm must lower the price of all products sold, losing revenue for those it could have sold for a higher price in order to gain revenue from extra sales. For a downward-sloping D curve, TR rises at first but eventually starts falling as output increases. This is because extra revenue gained from dropping the price and selling more units is outweighed by the revenue loss from the units that now need to be sold at a lower price.

When MR is negative, TR will fall. There are several important relations between PED, MR, AR and TR. Knowledge of these relationships is used by firms trying to assess the impact of a change in pricing on their revenue If a firm raises price and PED<1, total revenue will increase as the increase in price causes a relatively larger fall in QD- the increase in price will more-thancompensate for the fall in QD; firms with inelastic PED should raise price to maximize revenue If the firm raises price and PED>1, the firm will lose revenue as the increase in price will cause a prop. Greater fall in QD; the increase in price will not fully compensate for the fall in QD. Firms with elastic PED should lower price to maximize revenue. When PED=1, revenue is already maximized, and firms wishing to maximize revenue should keep prices unchanged This technique can also be applied in reverse: the price elasticity of a demand curve may be found by analyzing changes in revenue as price changes

Profit Theory: o Economists and accountants calculate profit in different ways. Both are in agreement that profit is total revenue-total cost. However, economists also include the opportunity cost of the owner of the firm in cost calculations; if the entrepreneur could be making more money in alternative business ventures, and cannot cover their opportunity cost in the long-run, economic theory assumes that they will close the firm down and move on. The opportunity cost is the difference between a firms survival and non-survival. Total profit = total revenue total cost (incl. opportunity cost, fixed costs and variable costs. o If total revenue = total cost, a firm is making normal profit, and there is no incentive for firms to leave/enter the industry. Normal profit: The level of profit necessary to keep resources in their present use in the LR. o If total revenue > total cost, a firm is making abnormal profit (profit in excess of operation costs + opportunity cost); there is an incentive for firms to enter the industry, if they are able to. o If total revenue < total cost, a firm is making a loss; since the opportunity cost is not being covered, if a firm makes a loss in the long run, the entrepreneur will close down the firm and move to the next-best occupation. o We need to consider three different scenarios: 1. The Shut-down Price

Firms may continue to operate in the short run even if they are making a loss; also, firms may shut down in the SR and reopen later. Let us examine these two cases: o A firm can shut down in the SR and produce nothing, employing no FoPs to do so. Thus, it will only lose its total fixed costs (which are unavoidable in the SR- e.g. rent, interest repayments). Opportunity cost is counted as a fixed cost; it is therefore not being covered either. o This may be better than producing and not getting enough revenue to cover variable costs (thus losing fixed costs as well as those var. costs that have not been covered) o If a firm fails to cover variable costs with the revenue that it gains, it is better off shutting down in the SR, as the firm loses more (fixed costs + part of var. costs) by producing than by not producing (losing just the fixed costs). o If a firm is barely covering its variable costs (and just losing the fixed costs), they will lose the same amount whether they produce or not. It is likely that the firm will remain in business to maintain continuity of production, pleasing customers, and to maintain employment of workers and usage of inputs, pleasing workers and suppliers. o If a firms revenue more than covers its variable costs, they would lose more by not producing (loss of all of the fixed costs) than producing (loss of some of the fixed costs) in the SR. The firm would produce in the SR. However, if a firm is making losses in the SR, it cannot do so forever. Whether they continue producing or not in the SR, the firms need to plan ahead in the LR to change their combination of FoPs and devise a situation where they may cover all of their costs and make normal profits. If they still cannot do so, they will shut down permanently. o The Shut-Down Price: The level of price that enables a firm to cover its var. Costs in the SR; the price where MC=AVC; if price does not cover AVC, the firm will shut down in the SR. On a graph, production would occur at the price where MC=AVC , in this situation. Many firms (especially businesses with seasonal demand) will shut down in the SR at times when their revenue will not cover their variable costs; this may contribute to seasonal unemployment in the regions affected.

The Break-Even Price: The price at which a firm is able to make long-run normal profit (break even)- it will cover all costs, including its opportunity cost. The break-even price occurs where MC=ATC; if a firm cannot cover average total costs in the LR, it will shut down permanently. In the SR, then, the firms supply curve is equivalent to the MC curve (which represents the additional cost of producing an extra unit of output; given a particular cost/price, the MC curve shows how much is supplied) above the intersection with AVC (the short-run shut-down price); above that price, the firm would produce in the SR. In the LR, the firms supply curve is equivalent to the MC curve above the intersection with ATC (the breakeven price; if a firm cannot make at least normal profit in the LR, it will not produce). The Profit-Maximizing Level of Output It is usually assumed that firms wish to maximize profits as their main aim. If this is so, firms need to know what output level to produce at in order for profits to be maximal. If a firm finds that, at its present output level, MC<MR, it is clear that the firm could increase its profits by producing more. In a PCM (perfectly elastic demand curve), MC intersects MR at 2 points. However, at the first point where this occurs, losses are maximized and profits minimized. Because MC>MR for every unit up until that unit of output, the firm has made the greatest possible loss. Between the 2 points of intersection, the firm makes a profit from every unit as MR>MC; therefore, it makes the greatest overall profit (so long as the profit between Q1 and Q2 is greater than the initial loss, this will be an abnormal profit- it can, however, also be a loss) where MC=MR for the second time. Because MC>MR again after the 2nd point of intersection, every additional unit beyond that output will be produced at a loss, and total profit will begin to decline; in this case, the firm should scale back output if it wants to profit-maximize. To profit-maximize, firms will want to produce every single output unit that contributes more (or an equal

amount) to total revenue than to total cost (therefore, all units of output for which MR>MC; the firm will make a profit on the sale of any such unit). When the marginal revenue from selling a unit equals the marginal cost of producing it, the firm is either profit-maximizing or lossmaximizing (see above); no further profit or loss can be made. PROFIT IS MAXIMIZED WHERE MC = MR! Because firms want to maximize, not minimize pofits, we disregard the left portion of the MC curve in diagrams, and only the profit-max output is shown. If a firm wishes to maximize its profits, it should produce at the output level where MC=MR from below. In a monopoly, profit is also maximized where MC=MR; to find the price, we examine the D curve to see how much consumers will be willing/able to pay for this output. To show profit on the diagram, an AC curve is added (which intersects the MC curve at its minimum point). The profit max. output is noted q and the price is noted p; the profit per unit for producing q units is the difference between AR and AC. A revenue box can be drawn to show whether the firm is making normal profit, abnormal profit, or a loss. This will depend on the position of the AC curve, which can be moved to show what we want. In general (AR-AC)xTotal Output gives the total profit made by a firm. If AC intersects MC at an average cost lower than market price, the firm makes abnormal profit; is this occurs where AC=P, the firm makes normal profit; if it occurs where AC>P, the firm makes a loss. However, in reality, firms may not want to profit maximize (not everyone has studied, or wishes to follow, conventional economic theory). Other aims followed by entrepreneurs are: Revenue maximization: entrepreneurs often see maximal revenue as a sign of success; if this is so, they might wish to maximize revenue by producing where MR=0. This will occur (by mathematics) above the profit-max output level. This may be because:

Consumers value companies with increasing sales and are more likely to buy from them; by contrast, consumers are rarely aware of firms economic profit. o Fin. institutions may be more willing to lend to firms with increasing sales. o Salaries of employees and managers may be linked to sales, providing an incentive to revenue-maximize. Sales maximization: likewise, entrepreneurs my gauge their success by their sales volume. If this is so, they will produce above the profit-max output level and not realize they can make more profit by charging a higher price and selling less. Alternately, a firm may wish to increase SR sales to drive out competition from a market and gain high market share. Having done so, they may attempt to profit-maximize. Large firms are also less vulnerable to takeovers and salaries of managers and employees are often linked to the size of the firm. Firms will sales-maximize by producing at the highest possible output level consistent with long-run normal profit and being able to remain on the market (i.e. where AR=AC). Environmental aims: Entrepreneurs will sometimes be prepared to pay higher prices for raw materials to ensure that they originate from an environmentallyfriendly source, or one where labor is not exploited. They may, for instance, buy Fairtrade goods, at a higher cost, to support suppliers from LDCs (e.g. the Body Shop, before being incorporated, attempted to sell products from animalfriendly sources). Satisficing: There are theories that doubt whether most entrepreneurs profitmaximize in reality. It is argued that, if people own firms, they will work hard enough to cover their own opportunity costs (make normal profit) but will not, in most cases, push themselves further. Often, firms are not run by the people who own them; while shareholders may own a firm, managers will run it. This can lead to conflicting objectives. The managers (who generally have much freedom in decisionmaking) would not have a strong incentive to maximize the firms profits beyond a level that would please the shareholders (who are often not well informed of the firms performance) and allow them to retain their jobs. As a consequence, they satisfice (portmanteau of satisfy and suffice). o Typical objectives that managers are likely to pursue, instead of attempting to profit maximize, include: Salary maximization: As salaries are more often linked to sales than to profit, managers may seek to maximize either sales volume or sales revenue.

Employment maximization: This makes managers feel more powerful and important; employment maximization may be an aim for firms producing using labor-intensive methods of production- e.g. Vietnamese shoes factories- due to insufficient access to capital). Investment: Again, this makes managers feel more powerful (e.g. Mr. Waddells Super-Factory example). Gaining additional benefits (e.g. new offices, first class travel, multimillion bonuses while the firm files for bankruptcy, etc.) Alternately, a satisficing firm may attempt to reconcile the interests of different groups within the organization; the overall objectives of the organization will be a result of bargaining, discussion, and negotiation between production units, unions, workers communities, and departments. The end result is likely to be a compromise which reaches a satisfactory conclusion (or not- see Dilbert) but which does not maximize anything; the firm aims to satisfice these different groups and still function.

Chapter 8: Perfectly Competitive Markets As a social science, economics relies on building models to try to explain how things work and predict the possible outcomes of the economic situations being studied. Perfect competition is a model used as a starting point to explain the theory of the firm; it is theoretical and based on precise assumptions. o Despite its theoretical nature, it is very important as it serves as the basis for further models, if the theoretical assumptions underpinning it are relaxed. This allows us to make more realistic models of real-life market structures. Perfectly competitive markets are based on a set of assumptions. These are: o The industry is made up of a very large number of firms o Each firm is so small, relative to the industrys size, that it cannot alter its own output to have a noticeable effect on the output of the industry as a whole; a single firm cannot affect the supply curve of the industry and thus the price of the product- individual firms must sell at the price set by supply and demand in the entire industry, if they wish to maximize profit (by producing where MC=MR=Equilibrium Market Price). Individual firms are price takers. o The firms are all profit maximizers. o The firms all produce homogeneous products- it is not possible to distinguish between goods produced by the different firms in the industry; there are no brand names and no marketing to attempt to differentiate goods from each other.

Firms are completely free to enter and leave the industry; firms already in the industry cannot stop new firms from entering it and are free to leave the industry, if they so choose. There are no barriers to entry or exit. o All producers and consumers have perfect market knowledge- producers are fully aware of market prices, costs in the industry and the workings of the market; consumers are fully aware of market prices, quality of products, and availability of goods. The level of technology is therefore constant, as producers are fully aware of the technological improvements that their competitors put into place. Resources are perfectly mobile; thus, firms cannot maintain a competitive advantage over each other in the long-runl Although the model is theoretical, come real markets come close to being PCMs; most notably, agricultural markets. o For example, wheat farms in the EU There are some large wheat farms in the EU, which are small compared to the entire wheat industry. An individual farm could increase its wheat supply to a great extent before impacting overall EU wheat supply A single farm cannot change wheat prices in the EU, as it cannot shift the industry supply curve. The farm has to sell at whatever the existing market price for wheat is. Wheat is a commodity, and cannot be distinguished from one farm to another (in theory). However, although firms are relatively free to enter/eave the industry, there are significant costs involved with either, which may affect firms decisions. o Also, it is unlikely that producers and consumers will have perfect market knowledge (however open the flow of information is); thus, the EU wheat industry is not a perfect PCM (but comes close) Demand curves for the industry and the firm in a PCM: o Individual firms in a PCM are price takers; they must sell at the market price and cannot affect the market price. We can therefore make assumptions about the demand and supply curves for the industry and PCM firms. A PCM industry will have normal demand and supply curves; we expect producers to supply more, and consumers to demand less, at higher prices; thus, demand slopes downward and supply slopes upward; equilibrium occurs at point (P, Q) where D = S. PCM firms have to sell at the industry price, P (they are price takers)- if they try to raise prices, consumers will simply buy the good from another firm, since the goods are homogeneous in looks and quality, and perfect information exists. If they want to lower prices, on the other hand, they would be acting irrationally, as they would not be able to maximize profits.

If a firm sells at the industry price, it can sell however much it wants; as it increases output it does not affect the industry supply curve or alter the goods market price. If the firm can sell all that it wishes at price P (the equilibrium price), its demand curve is perfectly elastic at that price. Thus, the firm has to take the price set by the industry Profit Maximization for a PCM Firm o Firms maximize profits at the output level where MC=MR. When plotted on a diagram, we can see that the firm takes the price P from the industry and, because demand is perfectly elastic, P=D=AR=MR. Profit is maximized where MC = MR at output level/ unit time q. In a PCM, P=MC, because of profit maximization; MC is therefore equal to the industry supply curve. Although the scale of the price axis is the same for both firm and industry, this is not the case for the output/unit time (quantity) axis- the quantity q is very small compared to actual industry output, and would not register on the axes for the industry (if it could, it would be large enough to shift the supply curve and alter the industry price) PCM Profit and Loss Situations only possible in the Short Run o Short Run Abnormal Profits: In this case (when plotted; see graph inset) the firms in the industry are making abnormal profits in the short run; this could be caused by a SR increase in demand or supply- they are more than covering their total costs, including opp. costs. If a firm sells at the industry price P and maximizes profits by producing where MC=MR, the average cost C is lower than the average revenue P; the firm makes an abnormal profit of (P-C)/ unit o Short Run Losses In this case (see graph inset) the firms in the industry are making short-run losses (not covering their total costs). If a firm sells at the industry price P and maximizes profits by producing at MC=MR when AC is fully above the demand curve, the cost/unit exceeds the average revenue; the firm makes a loss (C-P)/unit. Although the firm is making a loss, it still produces at profit-max output, as any other output would result in a greater loss; in effect, they are loss-minimizing. The Unsustainability of the Above Two Situations in the Long Run: o If firms make either SR abnormal profits or SR losses, other firms begin to react and the situation begins to change until long-run equilibrium is reached. o SR Abnormal Profits to LR Normal Profits:

When a firm is making abnormal profits, the situation cannot continue very long. Since there is perfect market information and no barriers to entry, firms outside the industry that could also produce the good will start to enter the industry, attracted by the chance of making abnormal profits; because firms are relatively small, this will have little initial effect- however, as more and more firms enter the industry, attracted by abnormal profits, the industry supply curve will start shifting right. Thus, industry price will fall- because PCM firms are price-takers, the price they charge will begin to fall, and their demand curves will shift downwards- the abnormal profits will eventually be competed away. At the point where firms are no longer making abnormal profits, AC = AR because AR has shifted downwards. The firms are now making normal profits. The entrepreneurs are satisfied as they cover their opportunity costs; however, new firms are no longer attracted by abnormal profits and the industry is in long r un equilibrium; no-one will enter or leave. In effect, the industry grows in size, although the output of each individual firm contracts. o SR Losses to LR Normal Profits: Conversely, when a firm is making losses, it cannot continue to do so for long in a PCM. After a time, some firms in the industry will begin to leave because they are not covering opportunity costs; at first, this will have no real effect, as the firms are rel. small; however, over time, this will cause industry supply to shift left as firms leave the industry, unable to make normal profit. When this occurs, industry price will rise to ration the industrys output. As the firms in the industry are price takers, the price they charge will start increasing and their demand curves will shift up, reducing the losses they have been making. The process will continue as long as firms in the industry are making losses- eventually, however, the industry supply curve reaches the point where AR=AC (because the increase in price has been shifting the AR curve upwards) Because revenue/unit = cost/unit, firms are now making normal profits o Entrepreneurs are now satisfied, as they are exactly covering all costs, including opp. Costs- there would be no reason to leave the industry, as the firm could not do better elsewhere. However, no firms are making abnormal profits; the industry is in long-run equilibrium, with no firms entering/leaving. o The outcome is a decrease in the industrys size, and an increase in the output produced by each individual firm in the industry. Long-run equilibrium in a PCM

Thus, in the long-run, firms in a PCM will make normal profits; even if they were making short-run losses/abnormal profits, the industry will adjust with firms entering/leaving until a normal profit situation is reached. o In this case, there is no incentive for firms to enter/leave the industry; equilibrium will persist until either the industry demand curve or the costs faced by firms changes. If this does occur, firms will either face abnormal profits or losses, and the industry will again adjust, with firms entering/leaving until long-run equilibrium is restored. Productive and Allocative Efficiency in a PCM o Productive Efficiency- one of the measures used by economists to judge the efficiency of a firm. A firm is productively efficient if it produces at the lowest possible unit cost (average cost). At the output where AC=MC, a firm is able to produce at the most efficient level of output (lowest average production cost)- this output level is known as the productively efficient level of output. This is because MC always intersects AC at the lowest point. o If a firm is producing at productive efficiency (as in long run equilibrium in a PCM) they are combining their FoPs as efficiently as possible and resources are not wasted through inefficient use o Allocative efficiency- also known as the socially optimum level of output. Allocative efficiency occurs when firms are producing the optimal mix of goods and services required by consumers. While price reflects the value consumers place on a good and is shown on the demand (average revenue) curve, marginal cost reflects the cost to society of all the resources involved in producing an extra unit of the good, including the normal profit needed for the firm producing to stay in business. If price > MC, consumers would value the good more than it cost to make it; to achieve allocative efficiency in this case, output should be expanded (in the opposite case, where the cost to firms of producing a good/service is greater than the products value to consumers, firms should restrict output) If both sets of stakeholders arrive at the ideal combination, output will expand to the point where price = MC If MC>price, society will be using more resources to produce the good than consumers value, and output will fall. Allocative efficiency occurs when cost to producers = value for consumers (MC=AR), assuming no external costs and/or benefits exist; this can be established both for a firm in a PCM and for a monopoly. Allocative efficiency is important to economists as if a firm is producing at an allocatively efficient output level, assuming no externalities exist on the market, it is in a situation of Pareto optimality, where it is impossible to make someone better off without making someone worse off (this opens the doors for study of market failure)

Dynamic Efficiency: Results from improvements in technical/productive efficiency which occur over time (e.g. new production methods, new management methods). Dynamic efficiency increases with innovation, R+D, and investment in human capital. SR Productive and Allocative Efficiency in a PCM o If a firm is making abnormal profits in the SR in a PCM, although they may produce at the profit-max. level of output, where MC=MR and the Allocatively efficient level of output, where MC=AR, they are not producing at the productively efficient output level (where MC=AC) o Likewise, if a firm is making SR losses in a PCM, although they produce at the lossminimizing output level MC=MR and the allocatively efficient output level MC=AR, they are not producing at the productively efficient output level where MC=AC. o However, if a PCM firm is making normal profits (in the long run), it will profit-maximize at the lowest point of the LRAC curve; because we assume perfect market knowledge exists, all firms will face the same cost curves, so they will all sell at the same price, minimizing AC by producing where MC=AC. All PCM firms making normal profit thus produce at the allocatively efficient level of output, where MC=AR.

Chapter 9: Monopolies Assumptions of the model of a monopolistic market: o There is only one firm producing the product so the firm IS the industry and shares the industrys demand curve o Barriers to entry exist, which prevents new firms from entering the industry and maintains the monopoly o In most cases, the monopoly will have developed high levels of brand loyalty via branding and lack of significant competition. o As a result of the barriers to entry, the monopolist will be able to make abnormal profits in the LR (or a loss in the LR) Whether a firm actually is a monopoly depends on how broadly an industry is defined. Microsoft may have a near-monopoly on operating systems, but it does not have a monopoly on all software. Likewise, a local shop has a monopoly on neighborhood sales, but it is not the only shop in the world, and if the area is widened, the shop loses its monopoly. The more important question is not whether or not a firm has a monopoly, but rather how much monopoly power the firm has. To what extent is the firm able to set its own prices without worrying about competition, and to what extent can it keep people out of the industry? The strength of a firms monopoly power will depend on the number and closeness of competing substitutes available. For instance, a metro company has a monopoly on underground travel, but faces competition from other forms of public transport (buses, taxis, etc) o Although not necessarily monopolies (they could be members of an oligopoly), firms with over 25% of market share are assumed to possess market power. Sources of monopoly power:

A monopoly may continue to be the only producer in an industry if it can prevent other firms from entering the industry through barriers to entry. These include: Economies of scale: As we know, firms gain cost advantages as their size increases (known as economies of scale). Things such as specialization, bulk buying, and financial economies may lead to cost savings and lower unit costs. If a monopoly is large, it will experience economies of scale; any firm wishing to enter the industry will probably have to start up relatively small and will not have the economies of scale of the monopolist. Even if the new firm were to start up at the same size as the monopolist, it would lack technical, managerial, promotional and research and development economies of scale. Without equal economies of scale, the would-be entrant into the market would not be able to compete with the monopolist, who would reduce price to the level of normal profits. At that price, the new entrant would be making losses, as its AC would be higher. The lack of economies of scale thus acts as a deterrent to firms that might want to compete with the monopolist Control over supplies :if a monopolist controls supplies in an industry, other firms will not be able to enter. Natural monopolies: Some industries (usually utilities; e.g. an energy company, a landline phone company) are classified as natural monopolies, if there are only enough economies of scale in an industry to support one firm This may be shown graphically using a tilted LRAC curve. In this case, the monopolist is the industry, and has demand curve D. The position and shape of the LRAC curve the monopolist is facing is set by the economies of scale the firm is experiencing; the minimum efficient scale is ar an output higher than total industry demand. The monopolist can make abnormal profits by producing an output between the points of intersection of D and LRAC as AR>AC for that interval. If another firm enters the industry, the firm takes demand from the monopolist and the monopolists demand curve would shift left; as this situation will be the same for both firms, the two firms would both be in a position where neither can make normal profit; therefore, both will shut down, because their LRACs would be above AR for any output level. o In this industry, LRAC, shaped by the monopolists economies of scale, will only give abnormal profit if the monopolist can satisfy all demand on the market; the market will only support one firm. Real-life examples include utilities companies. Legal Barriers: In some cases, a firm may be given a legal right to be the only producer in an industry (to be a monopoly). This is the case with patents, which give a firm the right to be the only producer of a product for a number of years

after its invention. When the patent expires, other firms will be allowed to produce and sell the product. Patents exist to encourage invention; if individuals/firms invest in research and development, only to find that they were copied as soon as they succeeded, there would be little incentive to innovate. However, if a firm knows that its invention will be temporarily protected with a monopoly, they will be more likely to invest in R+D (in theory). Patents, copyrights and trademarks are an example of intellectual property rights- IP refers to creations of the mind; they guarantee the creators of ideas the rights to own ideas. Patents are prevalent in the pharmaceutical industry. Another example of legal barriers is where a national government grants the right to produce a good to a single firm, by setting up a nationalized industry (e.g. a postal service, the Swedish Govts monopoly on casinos in Stockholm) and banning other firms from entering the industry, or selling the right to be the sole supplier to a private firm (e.g. the right for a mobile firm to be the only mobile service provider in an area, banning other firms). Sunken costs: The higher the costs that firms need to pay when entering an industry, without expecting to recoup them when leaving the industry, the greater the disincentive for firms to enter the market and the higher the barriers to entry. Brand Loyalty: A monopolist may produce a product that has gained much brand loyalty. The consumers think of the product as the brand (e.g. Garmin, to Google). If brand loyalty is very strong, new firms may be dissuaded from entering the industry as they feel that they will not be able to produce a product sufficiently different to counteract the strong brand loyalty. Product differentiation: By making their product seem very different from competing products via marketing/branding, a firm can establish a monopoly position. Control over retail outlets so competitor cannot get their products to markets. Anticompetitive behavior: A monopolist may attempt to stop competition by adopting restrictive practices (both legal and illegal). For instance, a monopoly should be in a position to start a price war if another firm enters the industry. The monopoly can lower its prices to a loss-making level and should be able to sustain losses for a longer time than the smaller entrant, forcing the firm off of the market. The mere knowledge of this possibility may dissuade firms from entering the market. Microsoft engaged in uncompetitive behavior by bundling proprietary applications into the Windows OS, slowing growth of competing services. Demand and Profit-Maximizing Output in a Monopoly The monopolist is the industry; therefore, the monopolists demand curve is the industrys demand curve, which slopes downwards. The monopolist can control

either the output level or the price, but not both at once. It is not the case that monopolists can charge what price they like and continue selling products; they must lower price to sell more, and, because they are profit maximizers, they will produce at the price corresponding to MC=MR (assuming that the monopolist does not price discriminate) In each case, the monopoly is gaining revenue from the sale of the extra unit but losing revenue on the ones before, whose price has been lowered; hence, MR is below AR along its entire domain. Possible Profit Situations in Monopoly: If a monopolist is able to make abnormal profits in the SR and has effective entry barriers, other firms cannot enter the industry and compete away the abnormal profits being earned. The monopolist is thus able to make abnormal profits in the LR, as long as the entrance barriers hold out. This can be illustrated graphically [See Inset] A monopolist will NOT always earn abnormal profits. If it produces something for which there is low demand, it will not earn abnormal profits. If a monopolist makes SR losses, it has the option of shutting down temporarily (if it is not covering variable costs) or temporarily continuing to produce. It would plan ahead to see whether LR changes could be made so that it could at least earn normal profits. If this is not possible, the monopolist will close down the firm and the industry would cease to exist. If AC>AR for all output levels, the firm will not cover costs in the LR. As nothing can be done to rectify the situation, this is an industry where no firms are willing to produce; i.e. there would be no industry. Efficiency in Monopoly: Unlike perfect competition, the monopolist produces at an output level where neither Allocative nor productive efficiency is achieved. The monopolist produces at a profit-maximizing level of output, which is restricted to force up the price and to maximize profit. The productively efficient level of output AC=MC and the allocatively efficient level of output of MC=AR are not attained. Advantages and Disadvantages of Monopoly and Perfect Competition Although both market forms are theoretical, economists debate the relative merits and demerits of PCMs and monopolies. Advantages of monopolies vs. PCMs o Monopolies may be able to achieve large economies of scale through sheer size. Monopolies do not have to be large, but if the industry is large, the monopolist should gain substantial economies of scale. If this pushes MC down, the monopolist may be able to produce at a higher output and lower price than in a PCM. The idea of relative price and output in a monopoly is highly debatable.

In a PCM, equilibrium price and quantity occur where demand=supply; however, if the industry is a monopoly with significant economies of scale, the MC curve may be substantially below the perfect competition MC curve (=the industry supply curve) If this is the case, the monopolist, producing where MC=MR, will produce a greater quantity than in a PCM at a lower price. o A second advantage may be that a monopoly will have higher levels in research and development than a PCM; firms in a PCM are relatively small, and so many cannot easily invest in R+D. However, a monopolist making supernormal profits is in a better situation to use the profits to fund R+D, which benefits consumers, who have better products and more choice in the LR, as products are no longer differentiated. o Third, because of their size and possible cost-efficiency, monopolies could be beneficial in terms of employment and the production of goods for export. o Fourth, by being able to offer products at greater output volumes and more competitive prices than PCM firms, monopolies can contribute to the disappearance of niche markets for obsolete products; while this may not be a benefit to firms producing the niche products, this can, in the long-run, improve the level of technology in use in the econ. Disadvantages of monopolies vs. PCMs o If significant economies of scale do not exist in a monopoly, the monopoly might restrict output and charge a higher price than in a PCM. If this is the case, then the monopolist will produce where MC=MR; however, this will occur below, and more expensively, than the productively efficient level of output (MC=Supply = AR=Demand) that would be achieved in a PCM. Thus, often, higher prices and lower output would exist under a monopoly. o The high profits of monopolists may be seen as unfair, esp. by competitive firms or those on low incomes. The scale of the problem depends on the size and power of the monopoly; the post offices monopoly is not as important as the nuclear power plants monopoly. By contrast, firms in a PCM can only make normal profits in the LR. o The fact that firms in a PCM can gain abnormal profits in the SR by becoming more efficient than other firms grants an incentive

for firms to innovate and be competitive; this incentive is arguably absent in a monopoly. There are three problems associated with monopolies vs. perfect competition: They are productively and allocatively inefficient They can charge higher prices for lower output levels They can exercise anticompetitive behavior to retain monopoly power. Thus, monopolies can act against the public interest. As a result, all governments have laws to reduce monopoly power.

Chapter X: Monopolistic Competition: Monopolistic competition is a theory of market structure that illustrates a market between the two extremes of a PCM and a monopoly; it s a more realistic model that can more accurately be applied to reality. A monopolistically competitive market (MCM) is a market where many competing firms exist, each with some degree of market power. The term monopolistic derives from the fact that each firm in an MCM has some ability to set its own prices. The theory of monopolistic competition assumes that: o The industry is made up of a fairly large number of firms. o Each firm in the industry is small relative to the industrys size; thus, the actions of one firm are unlikely to greatly affect its competitors; the firms assume that they can act independently of each other. o Firms are completely free to enter and leave an industry; there are no barriers to entry and exit (in reality, in a MCM, barriers to entry/exit will exist, but will tend to be fairly low- the cost of renting out a venue and purchasing simple equipment, perhaps) The only theoretical difference between a PCM and MCM is that, in an MCM, there is product differentiation (when a good/service is perceived to be different from other goods/services in some way). Products may be differentiated based on brand name, packaging, color, appearance, design, quality, skill level required to use the product, and so forth. o Examples of MCMs include the auto-repair industry in the UK, the plumbing industry, electronics stores in NYC, and mom-and-pop grocery stores. Although the assumptions of a MCM do not appear very different from those of a PCM, they lead to a markedly different market structure; as products are differentiated, there will be some degree of brand loyalty (some of the customers will be loyal to the product even if the price goes up a little vs. competitors prices, perhaps because they believe that the higher price is a sign of higher quality or skill). o Due to brand loyalty, producers will have some element of independence when deciding on price; thus, they are, to an extent, price makers, who can produce at any point along a downward-sloping, albeit elastic, demand curve, owing to the availability of many substitutes in consumption.

Graphically, a MCM in the short run resembles a monopoly, but has markedly more elastic demand=AR curve. The MR curve is below AR and twice as steeply sloped; the firm will produce at an output and price level corresponding to the profit maximizing condition, MC=MR. Possible Short-Run Profit and Loss Situations in an MCM: o As in a PCM, it is possible for firms in an MCM to make abnormal profit in the SR; this occurs when AC is below AR at the point where the profit-maximizing output level occurs (where production takes place). The graph is analogous to a monopoly graph in a similar situation, with the caveat that it examines the short run, rather than the long run. If, when the firm produces at the profit-maximizing level of output MC=MR, the cost per unit (AC) is less than the selling price p, the firm makes abnormal profit. It is also possible for an MCM firm to make losses in the SR; in this case, AC is wholly above AR (the firm is losing money, on average, for every unit produced) at the profit-maximizing output level MC=MR; however, this time its unit cost (AC) at that point exceeds the price; the amount of loss incurred can be shown using a revenue box. Long-Run Equilibrium in Monopolistic Competition o Whether firms are making SR losses or abnormal profits, because there are very low barriers to entry/exit in the industry, there will be a long-run equilibrium, where all firms in the industry make normal profits. If the firms in the MCM are making abnormal profits, firms from outside the industry will be attracted to the industry. Because no significant barriers to entry exist, the other firms will be able to join the industry in the long run. As they enter, they will take business away from existing firms, shifting their demand (and, by extension, MR) curves left. Conversely, if firms in the MCM are making SR losses, some of them will leave, because the barriers to exit are also insignificant. The remaining firms will find that demand for their product has increased (shifted right) as they start to pick up business from the leaving firms. Both of these situations can be illustrated graphically; remember, though, to have both the D=AR and MR curves shift, to preserve the relationship between them. Because of this characteristic, the shift is not the standard shift that we have been seeing thus far; rather, it is an increase (if demand shifts right) or decrease (if it shifts left) of the PED along the entire D=AR or MR curve, coupled with an upward/downward shift of the vertical/horizontal intercepts of the two distinct curves; this will be determined by the fact that, in the long run, demand needs to be tangent to AC at one point exactly, as this is the point where the firms in the industry will be making normal profits.

As a result of these properties, it is not uncommon for similar shops spring up in an area at around the same time (e.g. sushi bars in Warsaw). Attracted to high consumer demand, compared to average cost, many caterers were attracted to open new sushi bars after the success of the initial restaurants; eventually, the demand for all sushi restaurants in Warsaw will be divided, and decrease; however, as demand continues to be strong, more restaurants will open, with each attempting to differentiate its product from that of competitors (e.g. by staying open longer, offering theme nights, having live bands play, etc.- this process is known as non-price competition. Whatever the short-run situation, in the LR, firms in an MCM will end up making normal profits (with AC tangent to AR at the profit-maximizing level of output; at that point, cost/unit is exactly equal to the price/unit). Each firm is exactly covering its costs, incl. its opportunity costs, and there is no incentive for firms to enter or leave the industry (as external firms are aware that their entry will lead to losses for all participants on the market, including themselves). The table below examines how closely the sushi restaurants in Warsaw represent a MCM: Characteristics of Monopolistically Sushi Restaurants in Warsaw Competitive Markets Very Large Number of Firms Condition Met Each Firm Very Small Relative to Condition Met Market Size Goods are Differentiated Condition Met (via different menus, emphasis on different types of sushi) No Barriers to Entry/Exit Very low barriers to entry/exit (low capital costs, little special expertise required, large economies of scale are unlikely, some brand loyalty Perfect Information Fairly open (through restaurant guides, the Internet, etc), but not perfect Abnormal Profits Possible in the SR but More and more sushi restaurants will not the LR be set up as long as the existing ones earn abnormal profit; the market will eventually adjust towards normal profit (although this may take more time than the strict theoretical definition of the long run) Productive and Allocative Efficiency in an MCM o We know that a firm is producing at a productively efficient output level if it produces where at the lowest possible unit cost, where AC=MC (AC is minimized). o Allocative efficiency is achieved at the output level where MC=AR (the socially optimum level of output, assuming no externalities exist on the market)

In both the short run and the long run, an MCM firm producing at the profit maximizing level of output will not produce at the productively efficient or the allocatively efficient level of output. Instead, it will produce at a higher price and lower output than in either of the optimal output situations. Monopolistic Competition In Comparison with Perfect Competition: o Unlike in a PCM, where firms are able to profit maximize while being productively and allocatively efficient in the LR, MCM firms in the long run are neither productively nor allocatively efficient. However, although MCM firms do not produce where industry supply=MC intersects industry demand=AR (nor do they produce at the lowest per-unit cost, MC=AC), the inefficiency is not due to the firm using its market power to artificially restrict output and increase price, as in a monopoly. Rather, the inefficiency is the result of the tastes and preferences of consumers, and their desire for variety. It is therefore hard to argue that, even with Allocative inefficiency, consumers are worse off in a MCM than in a PCM, as the difference is in the desire of consumers to purchase differentiated products. Rather than having perfect competition, where consumers pay lower prices for a homogeneous product, MCMs allow consumers to have choice; hence, they are prepared to pay more for the products.

Chapter 11: Oligopolies o An oligopoly is a market structure where a few firms dominate an industry (e.g. the US steel industry). o The industry does not necessarily need to have a small number of firms; however, the key to an oligopoly is that a large share of the industrys output is produced by a small number of firms. What constitutes a small number is variable, but a common indicator of the concentration of firms in an industry is known as the concentration ratio (CRx, where X represents the number of largest firms- for instance, CR(4) expresses the market share (or percentage of output) of the four largest firms in the industry). The higher the %, the more concentrated the market power of the four (or eight, although CR(4) is the most commonly-used measure) largest firms on the market is. While the lines between the concentration of market share/sales in different industries and market forms are open to interpretation, a commonly-held view is: CR(4)=0- Perfectly Competitive Market 0<CR(4)<45- Monopolistic Competition 45<CR(4)<95- Oligopoly 95<CR(4)<100-De Facto Monopoly

CR(4)=100- Theoretical Monopoly For instance, CR(4) in the US malt industry is 90%, even though there is a total of 160 malt-producing firms. In the frozen seafood industry, by contrast, CR(4) is 19%, with over 600 firms on the market; thus, the malt industry is an oligopoly, while the seafood industry is in monopolistic competition. Firms may gain greater market share quickly through takeovers and/or mergers of other firms. We distinguish between three concepts: o Horizontal integration: Mergers/takeovers between firms at the same stage of the same prod. process; this leads to a firm gaining market share in a single industry (e.g. a gas station buying out a competitor). o Vertical Integration: Mergers/takeovers between firms at different stages of the same of the prod. process; depending on the industry, this could lead to firms gaining market share indirectly, by cutting out the middleman and thus gaining economies of scale and being able to expand LR output (e.g. the Big Three car companies buying auto parts factories). o Conglomerate Integration: Mergers/takeovers between firms performing distinct prod. processes (e.g. the modus operandi of Unilever and Procter & Gamble); this does not directly lead to greater market share in either industry, but may provide stability benefits (risk-bearing economies of scale). Oligopolies may be very different in nature. While some produce nearly identical products (e.g. OPEC with gasoline), where the product is impossible to differentiate, but the sellers are different, some produce highly differentiated products (e.g. cars) and still others produce slightly-differentiated products, but spend money on advertizing to convince consumers to buy their products (e.g. cosmetics). In most oligopolies, distinct barriers to entry exist; usually the economies of scale or brand loyalty of the larger firms. However, this is not always the case, and some oligopolies feature low barriers to entry (this effect is explained by contestable market theory) The key feature of all oligopolies is interdependence. Whereas, in PCMs and MCMs, the firms are all too small relative to the industrys size to be able to influence the market, oligopolies feature a small number of large firms dominating the industry. Because of the small number of firms, each firm needs to closely consider its competitors actions. Interdependence tends to foster collusion to avoid surprises and unwanted outcomes; if firms can collude and act as a monopoly, they can maximize industry profits.

However, firms in oligopoly may also want to fiercely compete with each other in a bid to gain the greatest market share. Oligopolies tend to be characterized by price rigidity: prices in oligopolies tend to change much less than those in PCMs. Even when there are production-cost changes, oligopolistic firms often leave prices unchanged. Collusive and Non-Collusive Oligopoly: Collusive Oligopoly: A situation where the firms in an oligopolistic market collude to charge the same prices for their profits, in effect acting as a monopoly, and divide up any abnormal profits that may be made. There are two types of collusion: o Formal Collusion: A situation where firms openly agree on the price they will all charge (or, more rarely, on market share or marketing expenditure). A formally collusive oligopoly is often known as a cartel; since formal collusion usually results in higher prices and lower output for consumers, this is usually deemed to be against consumers interest, and so collusion is illegal in a majority of countries. If a countrys anti-trust authority finds that firms have been engaging in anticompetitive behavior such as price-fixing agreements, it will impose fines or attempt to break up the cartel. However, formal collusion between governments is much more difficult to regulate and may be tolerated; the prime example is OPEC (the Organization for Petroleum Exporting Countries), which sets production quotas and prices on world oil markets. o Tacit Collusion: A situation where firms in an oligopoly charge the same price without formally colluding. This is not extremely difficult; a firm may charge the same prices as all other firms by examining the prices of the dominant firm on the market, or of their primary competitors; there are elements of game theory involved, but it is not necessary for firms to communicate to charge the same prices. In both formal and tacit collusion, the firms behave like a monopolist (a single producer), charge the monopoly price, make LR abnormal profits (or a LR loss!), and share them according to market share (e.g. by setting production quotas). Graphically, a collusive oligopoly is analogous to a monopoly.

Oftentimes, the colluding firms erect barriers to entry via limit pricing: charging the highest possible price without allowing entry; entry is prevented as firms realize that, if they joined the industry, the price would be driven down and they would make a loss. o However, there is an incentive for individual producers (e.g. Venezuela, in OPEC) to cut prices and exceed the quota to gain additional profit at the expense of the other colluding countries. Unless an effective policing mechanism is in place to prevent firms in a CO from producing in excess of production quotas, at lower prices, cartels tend to break down due to the incentive to cheat. o Collusion is likely if: There are only a few firms, making it easier for them to check on each other and share information. Effective communication and oversight means that attempts at cheating can be identified early on. Stable cost and demand conditions mean that quotas are easy to allocate and measure, and the policy is easy to administer. Similar production costs mean that firms are able to make similar profits. Non-Collusive Oligopoly: A situation where the firms in an oligopoly do not collude, and thus must be aware of the reactions of other firms when making pricing decisions. The behavior of firms in non-collusive oligopoly is strategic behavior; because they must take into account all of the possible actions of their rivals in their planning. To explain how non-collusive oligopolists behave, economists apply game theory (which is outside the scope of the syllabus, but heres a Wikipedia article about it: http://en.wikipedia.org/wiki/Game_theory). o Assume that a firm in an NCO is deciding whether or not to lower prices. If another firm in the NCO decides to lower prices by an equal amount to compete, then both firms (assuming they are identical) will have lost the same proportion of revenue; neither would be in a strategic advantage over the other. If the competing firm did not lower prices, it would be unable to compete against the original firm and thus would lose revenue; the same would happen if the competing firm were to lower its own prices. Although the optimum strategy would be for both firms to keep prices constant, if a firm decides to lower price

(hoping for an optimum outcome for itself), competitors would also lower prices to deny the original firm its strategic advantages; a price war may begin, and both firms would lose revenue as the firms attempt to undercut each other in an attempt to gain market share. Hence, the firms are better off maintaining rigid prices. One explanation of the situation in a non-collusive oligopoly (NCO) is the kinked demand curve; although this theory has been questioned, it does a reasonable job at modeling a NCO market. The models fundamental assumption is that a firm only knows one point on its demand curve; the point where it is producing at any one time (shown on the graph as the point on the demand curve where the upper, elastic portion of the demand curve joins with the lower, inelastic portion of the demand curve). The reason why this point is graphed the way it is involves strategic behavior and the reactions a firm would get from competing firms in the NCO if it were to raise its price. If a firm raises its price, it is unlikely that competitors will follow suit and raise theirs; thus, a significant amount of demand would be lost to the other firms. This implies that demand would be rel. elastic above point A, as a rel. small increase in price would lead to a greater-than-proportionate increase in QD as some consumers switch to the competitors substitute products. Conversely, if the firm were to lower prices, it is likely that competitors would follow in an attempt to retain market share. In point of fact, they would attempt to undercut the first firms price in an attempt to regain lost sales and gain market share. Thus, demand would be more inelastic below Point A; a decrease in price is unlikely to lead to a large increase in QD. Because of these expectations, the demand curve will be kinked around Point A. The firm will also possess a MR curve that bas a vertical

section (usually marked BC), as each part of the MR curve must (mathematically) slope twice as steeply as the two parts of the AR curve. The rule of thumb to use is that MR must intersect the horizontal axis at the midpoint between the horizontal intercept of AR and the origin. To draw the graph, first draw the bottom portion of AR, then extend AR using a dashed line towards the x-axis. o Place Point A at some point along AR. Draw the associated dashed MR curve to the dashed AR curve; these curves will serve as the basis for the bottom portion of your graph. o Fill in your dashed lines- draw an elastic section of the demand curve from the Y axis to point A, then extend the demand curve to the X axis along your dashed line. o Likewise, approximate the MR curve to a point directly below Point A, and continue it vertically downwards towards your dashed MR curve; the two should meet at Point C. o Finally, fill in the dashed MR curve between C and the X axis. The kinked demand curve explains why price rigidity tends to occur in a non-collusive oligopoly; there are three reasons: o Firms are afraid to raise prices above the current market price, as other firms will not follow and they will lose sales, and possibly profit. o Firms are afraid to lower prices below the current market price, as other firms will follow, undercutting them and creating a price war that may harm all firms in the NCO (including the first firm to lower prices) o The shape of the MR curve means that, if MC were to rise, MC could still = MR; the firms, being profit maximizers,

would not change their prices or outputs; this can be shown graphically. Tf we assume that the firm is operating where MC=MR on the lowest portion of the vertical segment of MR, they are profit-maximizing by producing as many units as they could if marginal costs were higher, at the same price that they would be selling at, were MC at the upper portion of the MR curves vertical segment. MC could rise as high as the top of the vertical MR segment and the firm would still be profit-maximizing by producing the same output and selling it for the same price. Thus, even if costs change significantly, the market is likely to remain stable. o Non-Price Competition: Because oligopolistic firms tend not to compete in terms of price (either because they are colluding with each other or because the market structure prevents large price fluctuations from occurring, or because they know that a price war would imply a significant reduction in their profits), the concept of non-price competition is all-important. Many types of non-price competition exist; these include brand names, advertizing, special features, competitions, celebrity promotion, sponsorship, free delivery and after-sales service. Oligopolies tend to have very high marketing and advertizing expenditures, as firms try to develop brand loyalty and reduce PED for their products. While this may be seen as a misuse of scarce resources, and may mislead or create barriers to entry due to demand for competing products becoming more inelastic and shifting left, as well as due to the fact that advertisement increases entry costs for new firms, it is also possible that the competition between oligopolistic firms grants consumers increased choice. The behavior that firms undertake to guard and expand market share serves to increase barriers to entry for new firms; many of the branded goods we consume daily are produced by MNC oligopolies (Coke, Pepsi, Nike, Unilever, etc. etc.) that fiercely compete with each other on nearly every significant market worldwide, even though most consumers are not aware of the fact.

Price leadership models beyond the kinked demand curve model illustrate cases where a single firm leads other firms in pricing decisions; the leading firm changes price, and others follow (e.g. UPS and FedEx in the US). The decision to follow a price leader may be clearly agreed upon between firms or may occur tacitly. Dominant firm price leadership: The case where the industry price is set by the leading firm on the market, which the smaller firms will be reluctant to challenge, for fear of losing market share. Barometric firm price leadership: The case where industry price is set by the firm believed to predict future market conditions most accurately.

Chapter 12: Pareto Optimality, Price Discrimination and Contestable Markets (An Appendix to Firm Theory) Consumer and Producer Surplus: o Any existing (unregulated) market for goods/services will feature a demand curve and a supply curve and, economic theory assumes, production will take place where demand meets supply, at some price p and quantity q (the exact values of which will be determined by market forces. However, because the demand curve slopes downwards, there will be consumers who were willing and able to pay a higher price than the market equilibrium price for the product (in fact, this applies to every consumer except for the consumer willing and able to buy at the lowest price). Those consumers who were prepared to pay more for the good/service do not have to pay more; they pay the equilibrium price and keep whatever extra money they were prepared to pay; as a result, they make a gain vs. their expectations. Likewise, because the supply curve slopes upwards, at the market equilibrium point, all sales but that of one marginal unit could be taking place at a lower price, as some producers would be willing and able to supply their product at a price lower than market equilibrium. This means that most producers will make a gain vs. the lowest price they were prepared to produce the product for on the output that they produce, as they sell for a greater price than what they were willing to accept. Therefore, at market equilibrium, both consumer surplus (the extra utility (satisfaction) gained from consumers purchasing a product at a lower price than they were willing to pay) and producer surplus (the excess of actual earnings that a producer makes from a given quantity of output, over and above the amount the producer would be prepared to accept for that output) are maximized. o We say that, at equilibrium, marginal private costs equal marginal private benefits; thus, assuming no externalities, the free market brings about allocative and social efficiency.

Graphically, consumer surplus is equal to the area under the demand curve and above the equilibrium price, while producer surplus is equal to the area above the supply curve and below the equilibrium price. A mathematical note: market equilibrium occurs where marginal consumption intersects marginal output, or, in firm theory terms, where average revenue (representing the price per unit output at a given output level, which is determined by and equivalent to the demand curve of the industry, is equal to marginal cost (the extra cost to producers of producing an extra unit of output; in effect, equivalent to the supply curve. Calculus, people. At least know the basics.) Price Discrimination: A situation where a producer sells the exact same produce to different people at different prices (differential pricing). o Price discrimination is a method for firms to convert consumer surplus into revenue. o For instance, even though two seats on a plane may be identical to each other, a child ticket is likely to be priced more cheaply than an adult ticket by the airline. o In order for a firm to be able to price discriminate, three conditions must be met: The producer must have some ability to set prices; therefore, the market must be imperfect. The greater the price-setting ability of the producer, the easier it is for price discrimination to occur; thus, it is most often found in monopolies and oligopolistic markets, less often in oligopolistic competition, and never (be definition) in a PCM, where perfect market information is available. The consumers must have different PEDs for the product; if they do not, they would not be prepared to pay different prices for the product and price differentiation would not occur. By definition, a consumer with rel. inelastic demand for a product will be more willing and able to pay a higher price than a consumer with relatively elastic demand; PED is (among other things) a measure of how important a product is to consumers. The producer must be able to separate consumers, such that they are not able to buy the product and sell it to another consumer (and partake in arbitrage). If this were not the case, the consumers who can the product at a low price would resell it to those who were paying the higher price, at some price between the two prices; this destroys the producers ability to effectively price discriminate, as a (black) market equilibrium is restored. Producers may separate markers in a variety of ways, including: o Time: Consumers are often willing to pay higher prices at certain times than at others; for instance, early morning rail travel might be a near-necessity for commuters, who will be prepared to pay a higher fare than a slacker who works the afternoon shift at McDonalds. The consumers PED is more inelastic than that of the slacker; thus, the train company charges higher profits during rush hour than during off-hours.

Age: Firms may charge different prices based on consumers ages; children and the elderly are often charged lower prices than adults. This is because the two groups have lower incomes, and their PED is more elastic as a consequence. o Gender: Firms may charge different prices for men and women. Assuming that the firms are not sexist, but want to maximize profits, they will charge lower prices for the gender that is less interested, on the whole, in the activity in question, and therefore have a more elastic demand (e.g. women being charged lower ticket costs at sports games) o Income: Firms may charge higher prices to consumers with higher incomes, as the wealthier consumers are, the more inelastic their demand for the product, which they can afford more easily than poorer consumers. o Branding: Some firms sell their products under their own brand name, as well as under a supermarkets brand name, at a lower price; although the products are identical, the supermarket brand will have much less brand loyalty, and therefore, more price-elastic demand. o Geographical Distance: Firms often sell products at differing prices based on geographical region; this is possible so long as the cost of transferring the product (to partake in arbitrage) is higher than the price differential; if this is so, consumers cannot gain money by reselling the product in the region where the price is higher, because they need to contend with transport costs that erode their profit margin. For instance, CDs are sold at a cheaper price in the US than in the EU, as PED for CDs varies between the two regions, and transport costs between the regions are greater than the price differential. o Types of Consumer: Firms may sell at different prices to different users (e.g. market traders charging tourists higher prices than locals, museums offering lower entrance fees to the unemployed, power companies discriminating between industrial users and households). In all of these cases, the rates reflect the differing PED of various groups of consumers. If the above three conditions do not exist, price discrimination is impossible. It is easy to confuse price discrimination (which relies on differing values of PED among groups of consumers) with sales promotion. For examples, clubs may let girls in for free in order to attract them to their particular club out of a desire to attract guys to get crunk on their premises, rather than to take advantage of a difference in PED between guys and girls (which might not exist).

There are three degrees (levels) of price discrimination that must be considered; these are: First-degree price discrimination occurs when each consumer pays the exact price he/she is willing and able to pay for a product. This is how hagglers in a bazaar (e.g. in Egypt) operate when trying to get the best price possible from consumers. On a supply and demand graph, it can be shown that, if a firstdegree price discriminator (FDPD) is successful at bargaining with consumers and sells his product at the highest price each consumer is prepared to pay, they can increase their revenue from (equilibrium price x equilibrium quantity) to (equilibrium price x equilibrium quantity + consumer surplus region). By discriminating, the FDPD has eliminated the consumer surplus region. Also, since the extra revenue received from each unit sold above market equilibrium is exactly equal to the price of the unit, D=AR=MR. Second-degree price discrimination (SDPD) occurs when a firm charges different prices to consumers depending on how much they purchase (e.g. bulk buying, utility fees, cell-phone call fees). Producers may charge a high price for the first x units, those that consumers are expected to need to purchase, and then a lower price for any extra units consumed. This can be shown graphically using a set of revenue boxes along a demand curve; while the first units may be priced at some price x, any subsequent units will be priced at the lower price y; the resulting graph resembles a histogram, in effect. Third-degree price discrimination (TDPD) occurs when consumers are identified in different market segments, and a separate price that recognizes the different values of PED on the market is charged for each individual market segment. TDPD is the most common form of price discrimination. A typical situation of price discrimination would be a business charging two separate ticket prices for children and adults; graphs showing D=AR and MR curves (the latter twice as steeply-sloping as their respective associated D=AR curves) for each market segment may be drawn. The children have more price-elastic demand (D(C)) than do the adults (D(A)), as they have lower incomes. The management knows that they will need to charge children less than adults. They can separate their market into segments if the students need to show some form of student ID before they are allowed to buy a cheaper ticket. We assume that the firm in question wishes to profit-maximize; having made this assumption, we may combine the two MR for both market segments on one graph; MR(C+A) is shown as a kinked concave demand curve (with a relatively inelastic upper portion and a relatively elastic lower portion) on the combined graph. When the MC curve for the firm

as a whole is added to the graph, the profit-maximizing level of output can be established. o When the marginal cost (not the price) corresponding to this output level is applied to the graphs of the individual market segments, it becomes possible to determine the profitmaximizing position in each segment by tracing a vertical line up to the demand curve from the point on the MR curve where MC=MR for each market segment. o We should find that profits are maximized if the firm sells tickets at a higher price to the group with relatively priceinelastic demand, and at a lower price to the group with relatively price-elastic demand. In TDPD, a market may be broken up into more than two segments, but the general principle is unchanged: there may be many prices and discounts offered (e.g. senior citizen, veteran, etc.), but each will take into account the differing PED of the relevant groups and all represent TDPD. Whatever the degree, price discrimination has both advantages and disadvantages, depending on the firm and stakeholders in question. The firm clearly benefits from price discrimination: o Price discrimination allows a producer to gain a higher amount of revenue from a given amount of sales; this occurs before consumer surplus is eroded. o Price discrimination may, over time, allow a producer to increase the scale of output and benefit from economies of scale, which could benefit everyone by lowering AC and price in all market segments. o Through price discrimination, a firm may be able to drive out competitors from a market with elastic PED. If a firm can price discriminate, it may use the profits gained from its more price-inelastic market segment to undercut competitors in the price-elastic market segment by offering a lower price. This is especially true in intl trade, where a firm may face inelastic demand domestically and more elastic demand abroad. Price discrimination may allow the exporter to be very competitive on international markets. According to the WTOs anti-dumping stipulations for global trade, firms may not sell (dump) their products abroad at below the costs of production. However, exporting firms

are allowed to sell at prices lower than the importing countrys domestic prices, thus undercutting local competition on the market. Consumers may also benefit from price discrimination: o Price discrimination could allow some consumers to purchase products that they would have not been able to afford beforehand, when all consumers were paying the same price and wealthier consumers were not paying part of the cost of the service to poorer consumers. Lawyers and doctors often charge wealthy consumers large fees in order to be able to provide treatment to the poor at little/no cost. o Price discrimination allows some consumers to purchase a product at a lower price than they would have had to pay, were the producer not able to secure higher prices from others (e.g. some of you will benefit from lower tuition because the difference will be made up by tuition paid by foreign/out-ofstate students) o Price discrimination usually increases total output in a market; the product is more widely available. o Price discrimination may lead to economies of scale, lower unit costs, and thus lower prices for consumers in all market segments (especially if the profits gained from PD are reinvested into R&D). However, consumers may also be disadvantaged by price discrimination: o Any consumer surplus on the market will be lost when price discrimination is initiated o Some consumers will pay more than the price that they would have been charged in a non-discriminated market; this could be seen as unfair, depending which groups are being affected. Contestable Market Theory: An extension of the theory of market forms, focusing on the probability that new firms will enter the market in the future, rather than what the current market structure is. o A firm may have a temporary monopoly in an industry, but if the likelihood that other firms will be attracted to the industry in the future is high, the firm is likely to keep prices low and make normal profits, in order to discourage entry by potential competitors. In theory, many contracted firms (our school cafeteria seems an insidious exception) will be aware that, if a competitor offered lower prices, their

contractor could easily end cooperation with them, breaking their monopoly on the small market granted to them by the contractor. It is likely that the existing firm will keep prices reasonable and quality high to discourage the possible entry of competing firms; the firm acts as though it were in a competitive market, even though it is not. Conversely, if there is little risk of competitors entering the industry due to effective and long-term entry barriers, we can expect higher prices and lower-quality goods. Cont. Market Theory states that the likelihood of entry by competing firms onto a market is mostly determined by their entry costs (costs a firm must pay to establish itself in an industry- e.g. the cost of building offices and hiring employees) and exit costs (the FoPs that cannot be sold for other uses if a firm leaves an industry- also known as sunken costs of entry). Whereas a travel agent, who can sell his office, would have very low exit costs, a power plant will face much higher exit costs because of the difficulty in selling their specialized (and possibly obsolescent) equipment. Contestable Market: A market where barriers to entry are low, firms entering the industry and established firms face similar costs, and firms would be able to get back their entry costs (less depreciation) when they leave the industry. The lower the entry and exit costs, the more contestable a market will be. If a market is contestable, the existing firm(s) (in a monopoly/oligopoly, respectively) on the market are more likely to charge lower prices than the SR profit-maximizing price; they would not want potential competitors to enter the market and compete away their products. Thus it is potential, rather than actual, competition on markets that leads to pricing and output decisions.

Chapter 13: Market Failure Community Surplus: o When a market is in equilibrium, with no external influences or effects, it is in a state of Pareto optimality (a situation where it is impossible to make someone better-off without making someone worse-off; this does not necessarily imply that everyone is equal). o If a market is Pareto optimal, it is also socially efficient (a situation where community surplus is maximized). Community surplus: the welfare of society, composed of producer surplus and consumer surplus.

On a market with no external influences, community surplus is maximized at the market equilibrium where supply intersects demand at some price P and some quantity Q. Given this market situation, there is no other combination of price and quantity on the market that would lead to a more sociallyefficient outcome (greater community surplus). Thus, the market is Pareto efficient and ultimately allocates resources, such that no one could be made better-off without making someone else worse off. In theory, the free market usually leads to an optimum allocation of resources and maximizes community surplus. o As the supply curve is equivalent to the MC curve, and represents the marginal cost of producing the product to the whole community (given no externalities exist), we refer to it as marginal social cost (MSC). o The demand curve is determined by marginal utility (the benefit to the whole community resulting from one extra unit of a product; in a socially-efficient free market, demand equals marginal social benefit (MSB). Market Failure: Any situation where the free market fails to allocate scarce resources efficiently. o In reality, markets are imperfect, for a variety of, as well as factors that prevent resources from being allocated in a socially-optimal manner. If this is the case, community surplus is not maximized; we refer to this as market failure. o When markets fail, governments are usually expected to intervene in order to reduce the market failure and move towards optimal resource allocation. o The most important reasons for market failure, as well as the options that governments have for correcting the relevant markets in those situations, are outlined below: Imperfect Competition: Monopolists, and other imperfect markets, restrict output to push up prices and maximize profits (where MC = MR). Thus, they do not produce at the socially efficient output level (where MC= AR). Any imperfect market will fail to equate MSC and MSB; this may be shown by drawing a simplified monopoly graph, with MC depicted as a straight-line supply curve. The market failure does not correct itself, as the monopolists barriers to entry prevent competition and grant the firms in question market power (ability to set prices).

Because profits are maximized where MC=MR, the level of output produced will be lower than the socially-efficient level of output, and the price of the good will be higher than the socially-efficient price (at market equilibrium). As a result, there is a loss of consumer surplus, shown by the triangle between the free market price, the monopolists output level and the demand curve, as well as a shift of producer surplus from the area shown by the triangle between the free market price, the monopolists output level and the supply curve, to the area (P1P0)xQ0. Because community surplus has fallen from the maximum, the market is no longer socially efficient, as Q1->Q* units are not being produced (even though MSB>MSC), resulting in a welfare loss equivalent to the sum of the two triangles; market failure has occurred. Governments may reduce this welfare loss by intervening in several ways. They may legislate to make markets more competitive, by passing laws preventing takeovers or mergers that give an individual firm more than a certain market share. They may also take laws preventing mergers and takeovers that would increase the market share of a specified number of largest firms in an oligopoly beyond a certain threshold. They may regulate newly-privatized industries, which are at particular risk of becoming monopolies, in terms of price and quality of service provision, as well as reduction of entry barriers and encouragement of competition. They may promote contestable markets by reducing the administrative costs to entry/exit of new firms onto markets. They may set up regulatory bodies to investigate markets where monopoly power is being used against the public interest. These bodies are empowered to take action (or recommend that the govt do so) if the public interest is demonstrably harmed. If the bodies find that monopolies have acted against the public interest, the offending firms could be split up into competitive parts, fined, or their managers could face imprisonment. Lack of Public Goods:

Public good: a good that is non-excludable and non-rivalrous, and would therefore not be provided on the free market. If a good does not have both of these characteristics, it is not a public good. o Note that, for a private good, if one unit is consumed by one person, it cannot be consumed by anyone else. A pure public good is a good that is completely non-excludable and non-rivalrous (e.g. flood defense, national defense) o A good is non-excludable if it is impossible to limit its consumption once it has been provided; for instance, a private company building a flood barrier would also build it for people who had not paid for it. This is known as the free-rider problem; using economic logic, no individual will pay for a public good, as they will hope that someone else will do it. o A good is non-rivalrous if one persons consumption of it does not prevent others from consuming it as well. Whereas, if a person eats a bagel, no one else can eat the bagel and gain utility from it, there is practically no limit to the number of people a flood barrier in a certain area could protect. The private benefit of public goods is likely to be very small relative to their cost, although the total social benefit of the public good will be large (most likely, larger than the private cost). Thus, there is no incentive for private individuals to provide public goods; for the above reasons, public goods would not be provided on the free market, despite their benefits to society, which results in market failure. The notion of a public good is debated; a number of goods considered public (e.g. lighthouses could theoretically be provided on the free market to an extent (e.g. street lighting, lighthouses) as they may have large benefits for private individuals. These goods are sometimes called quasi-public goods. o Governments may attempt to reduce this market failure by: Providing the public good themselves (usually the case with natl defense, flood defense, roads and other infrastructure). The use of taxpayer money to fund provision distributes the cost among a large group of people who would not have been prepared to pay individually. Subsidizing private firms, covering all costs, to provide the good.

Under-Supply of Merit Goods: Merit goods: goods that are considered to provide positive benefits to both those who use them and society in general, and therefore should be consumed to a greater degree. However, they will be underprovided by the market and underconsumed. o Public schools are merit goods, as are healthcare and sports and entertainment facilities. o Merit goods often, though not always, are assoc. with pos. externalities; however, as the definition of a merit good depends on social, rather than economic, factors, our views on what a merit good is/is not may change over time. o Governments will attempt to increase supply, and thus consumption, of merit goods; the method will depend on the relative importance of the merit good. If the merit good is very important (eg. Education, healthcare) the govt will usually provide it directly or subsidize them such that they are available at no direct cost to the consumer (or legislate such that consumption of them becomes mandatory). The goods still do have a cost; the cost, however, is shared among taxpayers. As merit goods decrease in importance, they will be subsidized to a lesser degree; although sports and entertainment facilities may be seen as providing positive benefits to consumers and society, they are relatively less important than education and healthcare, and providers will likely receive smaller subsidies. Over-Supply of Demerit Goods: Demerit goods: Goods considered bad for both their consumers and society as a whole, which the government would like people to consume less of, or not at all. Demerit goods are oversupplied by the free market, and thus over-consumed. o Examples of demerit goods include hard drugs, tobacco, alcohol, and child porn. o Demerit goods are often, though not always, assoc. with neg. externalities. o Governments may attempt to reduce supply and/or demand for demerit goods; if a demerit good is considered very harmful (e.g. cocaine), the government will make them illegal; however, they will not completely disappear, as black markets will arise, due to the chance of making high profits by fulfilling the demand for the goods.

Less harmful demerit goods will usually be taxed, with more harmful goods (e.g. alcohol) being taxed rel. more than less harmful goods (e.g. petrol). In addition to the above solutions, as consumption of merit/demerit goods is greatly influenced by consumer choices, education and information can be effective solutions. Externalities: Costs/benefits to third parties incurred by the consumption/production of a good/service that are not accounted for in the cost of the good/service to firms and/or private consumers. If the effects of the externality are harmful, we refer to a negative externality; there is an external cost that must be added to the private costs of the producer/consumer to reflect the true cost to society. If the externalitys effects are beneficial, we deal with a positive externality; there is an external benefit that the consumption/production of a good/service would grant, were it consumed/produced at a socially efficient output level. MSC = Marginal Private Cost +- Marginal External [Cost/Benefit] of production. o If no externalities of consumption exist for a good, MSC = MPC; the MPC is the private supply curve of the industry, based on production costs. MSB = Marginal Private Benefit +- Marginal External [Cost/Benefit] of consumption. If no externalities of consumption exist, then MSB=MPB; MPB is essentially the private demand curve of consumers. If no externalities exist in a market, MSC=MSB and we maximize community surplus; the market is socially efficient. If externalities exist, MSC =/= MSB at market equilibrium, and market failure (inefficient allocation of societal resources) occurs. o When analyzing externalities, we apply the ceteris paribus assumption: to prevent our analysis from becoming too complex, we focus on the effect of a single externality on the market. Note, though, that the prod./cons. of a good/service could have both neg. and pos. effects on third parties (e.g. a beekeeping firm that causes some atmospheric pollution).

Externalities may be split into two broad categories. There is considerable debate on the subject, but the Editor believes that externalities of production are graphically equivalent to externalities of consumption. o Negative Externalities (External Costs) are incurred when the production/consumption of a good/service creates external costs that harm third parties. o Firms, basing their decisions on private costs and benefits and disregarding the negative external effects of the product, will produce more output than is socially optimal. These mainly relate (in production) to environmental problems, such as a factory dumping pollutants into a river, which indirectly harm local fishermen; the cost to society is greater than the cost of producing the product to the firm, which creates external costs over and above its private costs. Although consumers may gain some benefit from consuming the product, the externality arises when we consider the costs to society (e.g. lung cancer) that their consumption incurs. Thus, we examine MSC, rather than MSB. In consumption, negative externalities usually involve health hazards or pollution; e.g. secondhand smoke from cigarettes, air pollution and traffic congestion from cars, noise pollution from airplanes. To reduce the negative externality, less of the good in question needs to be consumed, and the price of the good should rise. Graphically, this may be illustrated with the MSC curve being above the MPC curve (MSC>MPC); this is because there is an extra cost to society caused by the pollution or health problems created by production/consumption of the product, which is not factored into the costs of the firms producing the product. The firm, only interested in its private costs, will produce at free market equilibrium (a higher output than the socially optimum level Q*, where MSC=MSB; thus, market failure occurs as societys resources are misallocated: too much of the good is produced at too low a price). We thus have a welfare loss equal to the triangle between MSC, MPC, Q* and Qe, as MSC>MPC for those units.

In a free market, the situation would continue, as profitmaximizing firms will only consider their private costs; it is up to the govt to rectify the problem. These include: Taxing the offending firms to increase their MPC towards the socially optimum output level. If the tax exactly covers the MEC, the government has internalized the externality; if this is not the case, the tax will reduce the welfare loss, but not eliminate it- the welfare loss will simply occur at a lower level than in the unregulated free market. o If the government imposes a tax (e.g. landfill taxes, pollution taxes, and carbon taxes), MPC will shift towards the socially optimum output level, while raising the price to consumers. o The government may gain significant revenue (if PED for the product <1), which may be used to correct some of the negative effects of the externality. However, when PED<1, taxes do not manage to reduce QD by a large amount; while governments gain revenue, QD does not fall to the socially efficient level. In addition, specific taxes are often regressive; the incidence of the tax lies more heavily on poorer consumers than wealthier consumers; income inequality may be widened. Also, if taxes are raised too high, people will start looking for other sources of supply; for instance, buying cigarettes abroad and illegally importing them. Thus, a black market for the product may form. o Although taxes are seen as an effective solution for negative externalities, use of them may be problematic as it is

difficult to measure pollution (the size of the externality), and thus the welfare that can be regained by use of the tax, accurately. o It is also difficult to establish which firms are the main causes of the externality and to what extent each firm should be penalized. o If a firm imposes a tax on its products to reduce neg. externalities, the prices of the products rise; if the products are exported, they will become less competitive. o Finally, taxes may not stop the negative effects from occurring altogether, and may invite black market activity and . Legislating to ban the offending product/activity, or restricting the offending firms output in some way (eg. by setting output quotas). This could involve laws enforcing environmental standards for producers; to meet standards, firms will need to spend money, increasing MPC. o However, a ban/restriction could lead to job losses (which would heavily affect shareholders and employees in the industry) and decrease consumption of the product, which may sometimes have been valuable (e.g. automobiles). Also, the cost of establishing and policing laws may outweigh the cost of the externality. o Setting the level of a quota is difficult; it is easy for govts to under/overestimate the extent of the market failure and thus not guarantee the soc. efficient outcome. o All forms of regulation tend to be expensive, and some may be difficult to enforce effectively. o Even if fines/restrictions are imposed, firms may be reluctant to limit pollution

if the private benefits of continued pollution outweigh the cost imposed by the regulation. o Because habit-forming goods have inelastic demand, governments can gain much more revenue by taxing the product than banning it. o Also, bans tend to be politically unpopular, and may jeopardize a political partys reputation among, for instance, smokers or drinkers. Even if governments impose partial bans on the activity (e.g. smoking bans in clubs), the decisions are usually highly controversial. Issuing tradable emission permits for pollutants; a market-based solution to negative externalities of production (e.g. permits for air pollution, fishing quotas). The permits are issued by the govt and allow firms to pollute up to a certain level; firms may buy, sell and trade permits among each other. o At present, tradable permits are one of the main means of response to market failure. o The govt decides on a set optimal level of pollution permitted per year and splits this total into a number of licenses, each allowing a given level of pollution, which it allocates to different firms (in effect, a quota on the amount each firm may pollute). o The market comes into effect; the firms have an incentive to pollute little as possible, as they may trade permits with each other; thereby, environmentally efficient firms gain revenue, while heavily polluting firms face high costs). Firms that pollute below their allotted quota may earn money by selling their unused permits to polluting firms, which are in effect

charged for their high pollution levels. This raises polluting firms MPC. By selling permits, rel. efficient firms may also be in a better position to overcome periods of lower activity/ short-term lossmaking; also, rel. efficient firms may expand output by buying permits from rel. less efficient firms. A problem with this solution is that it does not lead to a reduction of pollution below the allowable level. Firms pay the costs of polluting, but some firms may continue to pollute heavily. The government must also decide on an acceptable pollution level and take on the difficult task of regulating firms pollution levels, to prevent fraud. Tradable permits are used in the EU to reduce greenhouse gas emissions, in accordance with the Kyoto protocol, an agreement to cut global emissions of GHGs to 5% below 1990 levels. The treaty has been ratified by 163 countries, not including the US or Australia. LDCs are not required to reduce emissions, but they are in a position where they can be given tradable permits if they implement GHG reduction policies; developed economies are allowed to meet their carbon quotas by purchasing permits from the LDCs that have earned them. Any such intl agreements to limit pollution are politically difficult, with negotiations often taking a long time; also,

as the agreements are difficult to enforce, there is an incentive for countries to cheat. Enforcing property rights (rights to own or use assets); if individuals have the right to clean air, for instance, and this right may be enforced through courts, polluters may be forced to reduce emissions and/or pay fines via the legal system. o This approach is only effective in societies where prop. rights are easily enforceable; this is often not the case in LDC and centrally planned (and some transition) economies. Providing education as to the risks of purchasing/consuming a certain product, or funding negative advertisement against the product to reduce demand and shift MPB left. o However, this may be expensive, although revenue from indirect taxes may be used to fund the measures. Also, such measures may not be as effective as purely economic incentives in reducing consumptions; for example, some teens continue to smoke despite education campaigns and seem prepared to accept the dangers of smoking. Positive Externalities (external benefits): positive effects on third parties resulting from the consumption/production of a good/service. Again, we distinguish between externalities of production (e.g. employee training, which is a cost to the firm, but provides benefits both for its efficiency and for that of other firms in the industry, which do not need to spend as much on training, if the workers are hired by them, or the positive environmental effects of beekeeping); society has gained relatively more from the training than the firm has gained, and externalities of consumption (arising from the consumption of, for instance, healthcare; if people are healthier, they will not pass on

illnesses to others and the economy as a whole will become more productive). Another important example: education, which is tremendously valuable to any society, as well as outdoor concerts, vaccinations and deodorant. In both cases, we illustrate a positive externality by showing that the MPB to society is greater than the MSB for individual consumers (and, by extension, producers) of the product. The externality exists as there is an unrealized potential welfare gain shown by the triangle bounded by MPB, MSB, Qe and Q*, where MSB>MSC. Resources are misallocated because, were consumption to increase (Q1-Q*) social welfare would increase. The market fails as the true benefits to society are underestimated by market agents acting in their private interests (private individuals and firms fail to take into account the marginal external benefit of the prod./cons. of the product). If a government wishes to reduce a positive externality by increasing consumption (increasing output, as well as price, to give firms an incentive to produce more of the product), it has a number of options: Subsidizing firms offering the good/service; if this were to happen, prod. costs would be lowered until Q* is achieved via MPC shifting right (the magnitude of the shift depending on the subsidy per unit). For some important goods (healthcare, education, national defense), the subsidy may entirely cover all of the consumers direct costs. Direct free provision of the good/service is also an option. This solution is problematic as it is difficult for the govt to estimate the subsidy level deserved by each firm (a problem of information arises), as well as the rel. costs, benefits and external effects for stakeholders. Also, the subsidy implies high costs (which may render such a solution impossible in LDCs, reducing their ability to benefit from the reduced positive externalities), as well as an

opportunity cost in terms of govt spending in other areas, which could be more valuable. o In addition, if demand is price-inelastic, the price decrease caused by the subsidy will have a less-thanproportionate effect on consumption; the effectiveness of the subsidy in these cases may be limited. Legislating and thereby making certain behaviors mandatory (e.g. mandatory health checkups, compulsory education until age 16); however, this solution is likely to be ineffective unless the govt can provide the services free of charge to consumers. Providing vocational training through State-run training centers/ apprenticeship programs. The problem here is that the costs of the solution would be high, the trainers may lack the technical expertise of established firms, and firms may be dissuaded from offering private training. Using positive advertizing to encourage consumers to consume more of the product by informing them of its benefits, thus shifting MPB right towards Q*. There may be a high cost involved with the advertizing, and, although the ads may be beneficial in the LR, they may take time to be effective, minimizing SR benefits. Passing legislation mandating vaccinations, health screenings or education; this will only succeed if the govt provides the services free of charge. Consumers often resent such laws, seeing them as an infringement on their civil liberties. The extent of the govt intervention will depend on the size of the externality; in the case of merit goods (education/healthcare) the potential benefits are usually massive; economic growth largely depends on the productivity of labor, which depends on the level of healthcare and education of the workers. Thus, a priority of govts is usually an effective system for the provision of education and healthcare, whether through direct provision or through a subsidized private sector (which differs from country to country).

Other Causes of Market Failure: These tend to be less significant than the ones above, though still have a tangible effect on markets. Immobility of FoPs: In a theoretical perfect market, resources move freely between producers, via changes in factor prices. In reality, this does not happen as easily; there are shortages of FoPs and time lags, which cause delays when resources are reallocated between industries. o For example, a service industry could be booming in one region, and a mfg. industry declining in another. In theory, resources will leave the mfg. industry for the service industry due to the ability to make greater profit; however, workers may be limited by the high costs of moving, and a lack of skills necessary for the new jobs; alternately, they may not be aware that the new opportunities exist due to lack of information. o As a result of the occupational and geographical immobility, structural unemployment occurs; factor costs are higher than they theoretically should be, and there are unemployed resources in certain areas. o To correct this type of market failure, govts adopt supply-side policies, increasing labor-market flexibility and/or creating jobs. They will also encourage retraining schemes. Imperfect Information: In theory, in a perfect market, both consumers and producers will have perfect market knowledge; this is not the case in reality. Decisions (e.g. pricing decisions) are often made based on incomplete information, making it difficult to avoid externalities and leading to market failure. o This is especially true for durable goods, which consumers do not often buy, and thus have less knowledge of (e.g. houses, cars). Producers need to estimate demand over time, and thus set an average price to cover various possibilities. This average price may, at various times, be above or below market equilibrium. o Govts may attempt to improve the flow of information to correct the market failure; this is, however, costly and may not be possible for all markets. Income Inequality: The free market often leads to large differences in income between different groups in the economy; Pareto optimality =/= equality. This is often seen as a market failure by society, which may be rectified via progressive taxes, which

redistribute income in favor of poorer social groups, and transfer payments to the benefit of lower-income groups. Instability: The free market leads to instabilities in many markets; in agriculture, for instance, shifts in supply due to natural occurrences (e.g. the weather) can lead to major price changes. o To avoid this, the govt may implement some form of price- or income-support scheme. o On a macro. level, the econ. often goes through cycles of booms, recessions, troughs, and recoveries; the govt may use demand-management policies to reduce this instability. Short-Termism: On markets, short term decisions with severe longterm consequences are often made. o The private sector is often blamed for pursuing short-term profit, while causing long-term problems; firms may consume resources in the short term at a rate that does not permit sustainable growth and development in the future. o The public sector (govt) may intervene in the workings of markets in the short term to gain favorable political results before elections, although such intervention may be against the best interests of society. By intervening for political purposes, they cause market failure. In addition, regulatory agencies can be influenced by the firms that they are intended to oversee (e.g. via lobbying, campaign financing) and then operate on the behalf of the firms, rather than the public interest.

Chapter XIV: Economic Growth: Measuring National Income Whereas microeconomics (our focus thus far) was the study of individual markets, macroeconomics is the study of a national economy. o Macroeconomists are concerned with the allocation of a nations resources, as concentrated around five main variables. These variables are at the core of macroeconomics, and are associated with macroeconomic policy objectives; they are given below: Variable Associated Policy Objective Economic Growth (GDP) Steady Rate of Increase of GDP; desirable as growth is often associated with higher living standards Employment Low Unemployment Rate; desirable due to unemployments high social costs Price Stability Low and Stable Inflation Rate; desirable due to the high costs of inflation for the

achievement of other macro. goals External Stability Favorable Balance of Payments Position; desirable due to the pot. high LR costs of current account deficits. Income Distribution Equitable distribution of income; desirable in terms of social justice and potentially human development o In macroeconomics, the most significant consideration is an economys total output level, also known as the economys national income. This level of output may be measured in several ways. The Circular Flow of Income Model: o We return to the simplified model of the national economy introduced earlier. In the models basic form, there were two sectors: households (the people who buy the nations output of goods/services and own all FoPs in the economy, and who are paid by firms for the use of their FoPs) and firms (the institutions that hire FoPs from households and use the FoPs to produce the nations output of goods and services. o The main forms of payment by firms to households for each FoP are given below: Land: Rent Labor: Wages Capital: Interest Entrepreneurship: Profits o These relationships may be illustrated using a simple double-loop circular flow diagram, with households supplying FoPs, receiving payment for them, and purchasing goods/services with the income received, and firms using the households FoPs to produce goods and services, selling them to households and paying households for their FoPs. o This model is a simplification; in reality, households and firms do not follow this simplified behavior pattern. Households (and firms) do not immediately spend all of the income and profits received, as the model suggests. Rather, households can save some of their income in banks or other financial institutions, foregoing current consumption to allow for (increased) consumption in the future. Saving is a leakage from the circular flow, as it is income received, but not used to finance expenditure on goods and services. If households do not buy the entirety of the firms output, the firms will have unsold stocks of goods and will reduce their output to compensate, using fewer FoPs and paying less income to households. Thus, saving will cause the amount of income circulating in the economy to fall. However, firms will have access to the savings of households by borrowing money from financial institutions (e.g. by taking out a loan for capital). They can use this money to increase their capital stock a thus, their output; this increase in the capital stock is known as investment and represents an injection into the circular flow; it involves income that

does not directly stem from household expenditure on goods and services. Investment allows the amount of income circulating in the economy to rise. o Even though adding investment and saving to the model makes it more realistic, the mode is still limited; in reality, there are other sources of injections and leakages of income (sectors) in the economy. o If households import goods and services from abroad, some of their income leaves the circular flow; imports are a leakage as they represent expenditure of income not returning to firms. Conversely, if people in foreign countries purchase a countrys exports of goods and services, income is injected into the circular flow: exports represent an income source not directly originating from domestic households. Exports will not necessarily equal imports; most countries have trade imbalances. o Likewise, households and firms (the private sector) are not the only active domestic economic agent. The government (public) sector collects some of the income earned by households and firms in the form of taxes; taxes are thus a leakage from the circular flow. Governments spend money in the economy on infrastructure, education, subsidies, healthcare, etc. Government spending on goods and services represents an injection into the circular flow. Government spending is not necessarily equal to tax revenue; most governments will run deficits (spend more than they earn) to deliberately influence the level of leakages and savings in the economy, thereby affecting the level of national income. Transfer payments (payments to individuals that are not a result of an increase in output- e.g. unemployment benefits, social security) are a category of government expenditure that is not included as an injection into the circular flow. Governments tax the income of households and transfer some of this income to others; as we deal with an income transfer, rather than income in exchange for output, this spending is not an injection. o The circular flow model can be enhanced by factoring in the above three additional sectors. However, even this model is a simplification of a complete economy. We can draw several conclusions from the circular flow model: The economy is in equilibrium where injections = leakages If leakages rise, without a corresponding increase in output, GDP will fall to a new equilibrium- less income will be circulating. Likewise, if injections rise without a corresponding increase in output, the economy will move to a new equilibrium. Measurement of National Income

National income is usually measured using gross domestic product (GDP) (see definitions, below). Three different methods are used to calculate GDP: The output method: measures the actual value of all goods produced by firms in an economy; this is calculated by summing the value added by all firms in the economy. At every stage of a production process, we deduct input costs, such that we do not double count inputs. The data is usually grouped according to production sectors: the primary sector (agriculture and mining), the secondary sector (mfg.) and the tertiary sector (services). Alternately, the value of all final goods and services produced in an economy could be summed, to obtain (theoretically) the same figure. The income method: measures the value of all incomes earned by households for the use of their FoPs in an economy. This typically includes: Wages and salaries Self-employed income Trading profits Rent, including imputed rent: the rental value of owner-occupied housing is estimated and included. Interest Less stock appreciation (if stocks increase in value over the year, their value becomes exaggerated) The expenditure method: measures the value of all planned expenditure on all goods and services in the economy, including: Expenditure by households (consumption) Expenditure by firms (investment) Government expenditure Net exports (spending by foreigners on exports domestic spending on imports). Note that GDP will not directly decrease from an increase in imports; however, neither will it rise. Thus, we also count export expenditure as consumption of goods and services, to keep the accounting clear. Note that, if no one buys the goods that firms produce and firms have unsold stocks, we count the stocks as if the firm had bought them itself. Each approach measures national income differently by examining different data sets. However, as they measure the same thing, the GDP values will necessarily be equal. GDP: The total value of all final goods and services produced in an economy in a given year or the total value of all planned expenditure in an economy in a given year (GDP=Y=AD+C+I+G+(X-M)). The above definitions reflect the output and expenditure methods of GDP accounting, respectively; both are correct and accepted.

In theory, regardless of the method used, accounting will result in the same final figure; whether we call it national income, national expenditure or national output. o In practice, however, the data used to calculate each of the three values will come from many different sources, leading to inaccuracies and imbalances in the final values. o Often, inaccuracies may result from the timing of data collection; figures may need to be revised when more data becomes available.

GDP versus GNP: o A third definition of GDP, in addition to those above, is useful to draw comparisons between GDP and GNP. GDP (3): the total of all economic activity in a country, regardless of who owns the productive assets. If LG, a Korean MNC, begins production in Poland, the value of its output will count towards the Polish GDP, as the production is carried out on Polish territory. Gross National Product (GNP): the total income earned by a countrys factors of production, regardless of where the assets are located. In the above example, LGs output will be recorded under Koreas GNP, as Koreans, rather than Poles, can be said to own the firms assets (GNP is an inherent simplification). Thus, GNP= GDP + income earned from assets abroad [property income from abroad] income paid to foreign assets earned domestically. Note that income earned from assets abroad [property income from abroad] income paid to foreign assets earned domestically is usually known as net property income from abroad. Thus, o GNP=GDP+ net property income from abroad. GNP versus Net National Product (NNP): o Over the course of a year, a countrys capital stock will depreciate (lose some of its value), due to factors such as mechanical wear and tear as capital is used, obsolescence of capital due to new technologies, and damage to capital. Capital gets used up; however, GDP/GNP does not take this fact into account. o The measure that does is NNP. NNP = GNP capital depreciation. o While NNP is a more realistic picture of a countrys true economic activity, it is very difficult to measure depreciation in practice. Thus, gross figures are much more widely used. Nominal versus real GDP: o In order to compare a countrys GDP from one year to the next, we need to compensate for the fact that inflation will likely have increased prices in the economy; if this occurs,

the GDP value will be overstated. GDP will have risen, even if economic activity had stayed constant. o To get a true picture of economic activity over time, we adjust the nominal GDP ( the GDP value at current prices) and adjust it for inflation using a GDP deflator (an expanded version of the Consumer Price Index). The resulting value is known as real GDP (GDP adjusted for inflation). Real GDP = Nominal GDP adjusted for inflation It is necessary to use real figures to compare GDP, or other economic variables, over time, such that price changes do not distort the information. GDP per capita: o The easiest natl income statistic to measure; it is a measure of economic output per person and a rudimentary indicator of economic welfare. GDP per capita = total real GDP/ population size. o While the total economic activity of a country is measured using the simple GDP figure, GDP per capita is used as a starting point for judgment of the economic progress of a country in comparison to other countries in terms of raising living standards (e.g. Chinas GDP is larger than that of Canada, although China is far less developed and poorer; the GDP/capita figures account for this fact). Why National Income Statistics are Gathered: o While definitions of national income statistics are straightforward, the task of data collection, undertaken by natl statistics agencies, is complicated and expensive. Every country has an agency that cooperates with the UN System of National Accounts, gathering national income data which serves as: An indicator of a governments progress in achieving economic policy objectives. Economic growth (an increase in the real GDP of a country over time) is an objective for many governments; analysts use natl income statistics to judge the success of the govt in achieving its policy objective of increased growth. Govts use the statistics to develop policies. Economists use the data to develop economic models and predict future economic trends. Businesses use the data to forecast future demand. If real data is used, economic performance over time may be evaluated. Because rising GDP/capita is often associated with rising living standards, people use natl income data as a basis for evaluating the quality of life/ standard of living/ economic development of a countrys population. Natl income statistics are often used as a basis for comparison between countries. Limitations of the Data: o Given the usefulness of natl income statistics and their many applications, the possible limitations of the data become significant in terms of their accuracy, suitability for comparisons and appropriateness for evaluating living standards. Limitations include:

Inaccuracies: The data used to calculate natl income statistics comes from a wide range of sources, including tax claims, output data and sales data. As a result, figures become more accurate over time, as more data is collected. Statisticians calculating national income attempt to make their data accurate; while this is usually the case in developed countries, it is less so in LDCs, despite work by the UN SNA to improve data collection methods and thus, the validity of comparisons. As the price of most goods has decreased over time due to tech. improvements, the value of GDP may be shown to have decreased (ceteris paribus), even though the quality of the goods (e.g. the number of features) may have improved. Regional variations: GDP/capita figures only report the total ec. activity of a country per inhabitant; as a result, they mask regional inequities and may not be an accurate indicator of the overall welfare of a countrys population. Likewise, GDP/capita figures fail to account for inequitable income distribution within a country; although GDP/capita may be high, a majority of the income could be in the hands of a wealthy few. Un(der)recorded Economic Activity and Informal Markets: Natl income statistics can only account for officially-recorded economic activity; they do not include DIY work or other work done at home, but usually include the same work if it is done by a paid firm, even if the output is identical. o This is most significant in LDCs, where much economic activity occurs informally and is unrecorded (e.g. subsistence agriculture- farmers growing their own food). Although estimates of this value are made, GDP figures are likely undervalued, making comparisons difficult. In addition to DIY and subsistence farming, a class of activities known as the hidden economy goes unrecorded; this includes activities that are off the books because they are illegal (e.g. drug trafficking, smuggling of untaxed cigarettes from the Ukraine into Poland) as well as normally legal activity that is done illegally (e.g. work done by illegal immigrants). o In addition, some work is not recorded as people want to evade paying a portion of their taxes. If there are high taxes on tobacco (or other indirect taxes), smokers may buy their cigarettes on the black market; likewise, high income taxes and health and safety regulations provide an incentive for firms to hire workers unofficially, and for people to understate their true income by not declaring a proportion of their work. o Statisticians try to estimate the size of the hidden economy in each country (http://www.havocscope.com/). For the most

part, countries with high tax burdens have a higher amount of hidden economic activity, but the fact that different degrees of the hidden economy exist in different countries, as well as the fact that they are estimates, increases the complexity of accurate GDP calculation. External Costs: GDP figures do not take into account the costs of resource depletion; this is recorded as an increase in GDP, but there is no measure to account for the loss of natural resources, or for the external costs of air/water pollution and congestion, even though these factors will compromise the quality of life as the economy grows. Living costs: Raw GDP figures are difficult to use as an indicator of welfare, as they do not reflect the cost of life within a given country; to somewhat compensate for this disparity, economists may use Purchasing Power Parity figures in a common currency (usually the US$), which account for cost differences between countries. However, if certain goods are produced on a local scale or are not traded and lack international equivalents, fully accurate comparisons may be impossible to make. Quality of Life Concerns: GDP may grow if people work longer hours or take fewer holidays, earning higher incomes but enjoying a lower quality of life. GDP also does not account for community service/ volunteer work; even though such activities are a social benefit, they may be discouraged in the pursuit of econ. growth. Likewise, tougher pollution restrictions may reduce output but increase quality of life. Problems of Valuation: some output (e.g. natl defense, healthcare) does not have a market price; while the value of the services is expected to be equal to their cost, this figure may be over- or undervalued. Composition of Output: A large portion of a countrys GDP may consist of goods that do not benefit consumers (e.g. defense goods, capital)- if this is so, growth may not lead to higher living standards. In addition, GDP accounting does not take into account the physical volume or quantity of the products produced, only their financial value; thus, rel. high GDP figures might mask unemployment if most of the GDP growth is a result of small, lucrative manufacturing or service industries. Likewise, GDP figures do not distinguish between expenditure on capital goods, which allow for increased production and consumption in the future, and consumer goods, which allow for increased consumption in the present. Problems of Comparison of GDP Statistics Between Countries:

The income figures of both countries need to be converted into a common currency; as the value of the ER may frequently change (usually more than once per year), it may be difficult deciding what ER to use. Accounting methods vary between countries, which can alter GDP calculation methods. It is important to consider inflation and nominal incomes; a country may have lower nom. incomes, but lower prices. Factors such as climate should be considered: while one country may need to produce heating or irrigation, for instance, another may not (e.g. Norway and Saudi Arabia) The composition of output may vary greatly between countries, making exact, point-by-point comparisons difficult. Income distribution is likely to vary between the two countries. Some economies have more barter trade and/or greater illegal markets than others.

Chapter 15: Introduction to Economic Development While natl income statistics provide important information about the economic activity of a country and form the basis for assessing the countrys economic growth, growth (an increase in the real output of the economy over time) is a one-dimensional concept. Traditionally, economists have assumed that increased output, along with the parallel processes of industrialization, is equivalent to economic development (an increase on the quality of life in an economy over time, as measured by [the HDI or some other development index]). o This is not a reasonable/correct assumption, and a new field, developmental economics, has arisen to take this fact into account. Developmental economics postulates that econ growth does not equal economic development, a far more complex, multidimensional (and subjective- economists have different views on the meaning of development) concept. Some of the objectives of economic development are reduced poverty, public provision of education and healthcare, and the guarantee of civil liberties, political participation, and law and order. o Due to this multidimensionality, development is difficult to measure. Economists have derived several ways to measure economic development, including: The Human Development Index; the measure proposed by the UN Development Program. One of the aims of the HDI is to reemphasize that people and their capabilities should be the ultimate criteria for assessing the development of a country, rather than economic growth. The HDI is an index composed of three variables representing quantifiable development goals. These are:

A long and healthy life, as measured by life expectancy at birth (assuming that those who live longer have benefitted from greater health) o Education, as measured by the adult literacy rate, as well as primary, secondary and tertiary school enrolment. o Standard of living, as measured by GDP/capita (converted at PPP US$). When combined, the three indicators give an HDI value between 0 and 1, with higher values representing greater development. Countries are classified into three categories according to their HDI: o High Human Development: HDI > .800 o Medium Human Development: .500 < HDI<.800 o Low Human Development: HDI<.500 How the HDI information is used: o Prior to the establishment of the HDI, GDP/capita had been used as a measure of economic development, under the flawed assumption that higher GDP translated directly into higher living standards. o However, if we compare a countrys HDI ranking with its GDP/capita, we may find that countries have not always been successful in translating the benefits of GDP growth into development. While Norway has the worlds highest HDI, it is third in terms of GDP/capita. Conversely, while Saudi Arabia is ranked 44th for GDP/capita, it is ranked 77th (!) for HDI. It has a GDP/capita slightly higher than that of Argentina (which is a high human development country) while being a medium human development country. Had we used the simple GDP/capita figure, we would have made misleading conclusions about either country. On the other hand, the HDI figure allows us to compare how effectively countries have emphasized human development in policymaking. Other Development Indicators: o HDI is not sufficient as a guide to a countrys econ. development, but it is more adequate than the raw GDP figure. However, the HDI excludes many other components of human development, and is just an average that can mask inequalities b/w urban and rural areas, men and women, and different ethnic groups.

To address this fact, there are several other composite indicators, as well as single indicators (indicators that measure one variable) that attempt to measure the other dimensions of devt. These include: The Gender Related Development Index (GDI): Along with HDI, the UNDP attempts to analyze data to present HDI values for different groups; one such measure is the GDI, which looks at the same indicators as the HDI but considers the discrepancies between men and women. Gender inequality in a country will result in a GDI figure that is lower than the HDI. The GDI is essentially HDI adjusted for gender inequalities. The Gender Empowerment Measure (GEM): One aspect of devt is the creation of opportunities, self-esteem and freedom for all people; thus, it is valuable to measure whether economic development in a country is helping to create freedoms and opportunities for women. The UNDP therefore calculates the GEM, which measures the extent to which women may actively participate in politics and the economy. The GEM examines the number and percentage of women in leadership, managerial and parliamentary positions, technical and professional jobs (essentially, their participation in the workforce and their share of GDP). A high value (values range from 0 to 1) indicates a higher level of gender empowerment for women. If a country has a high low GEM value in relation to its GEM value, it is implied that the access to basic needs, education and health is not creating better opportunities for women. The Human Poverty Index (HPI): The UNDP also measures the level of deprivation and poverty occurring in a country. While HDI measures the achievements of a country in three variables, the HPI focuses on the proportion of people deprived of the

opportunity to reach a basic level in each area; it is a composite index and examines indicators comparable to those of the HDI; these are: Equivalent HPI Measure Illustrating Deprivation in meeting the Goal Long and Life % of people healthy life expectancy who do not at birth reach age 40 Education Literacy and % of adults school who are Enrolment illiterate Ability to meet GDP/Capita % of pop. basic needs without access to safe water + % of children who are underweight for their age While HDI represents development achievements for an average inhabitant of a country, HPI measures how evenly the benefits of development are spread within a country. HPI is expressed as a %, with a higher % expressing a higher level of deprivation and poverty. Two countries may have very similar HDI, but differing GDI values. This would suggest that the benefits of development are spread more evenly in some countries than others. The Lorenz Curve and Gini Coefficient: o This is a measure of income inequality in an economy; inequality can be graphed using a Lorenz curve, which uses data about national income collected from surveys and divided into ascending shares of national income, and presents them graphically; the share of total Development Goal HDI Measure

GDP going to each class of households is calculated. The data can be presented using a Lorenz curve, on which the X axis shows the cumulative % of the total population, divided into quintiles, while the Y axis shows the cumulative $ of total income earned in the economy. The graph also features the line of absolute equality, which indicates a perfectly equal distribution of income (x% of the population earns x% of the income). o Each country has its own Lorenz curve based on income data; the further away a countrys Lorenz curve from the Line of Absolute Equality, the more unequal the income distribution. o An indicator that summarizes the information given by the Lorenz curve is the Gini coefficient (derived from the Lorenz curve; it is the ratio between the area between the line of absolute equality and a countrys Lorenz curve to the area beneath the line of absolute equality. The higher the Gini index, the less equal the distribution of income. o Although a reduction in inequality might be an important devt goal, a countrys development progress cannot be evaluated solely on the basis of the Gini Coefficient. While low-income countries tend to have more income inequality than high-income countries, there is no hard-and-fast correlation between the level of development of a country (as measured by HDI) and its Gini index.

Also, it would be incorrect to assume that more equality is necessary to raise living standards. If GDP rises and income inequality remains the same, the poorest will still receive a larger amount than they had previously (they receive the same percentage share of a larger amount). While the UNDP calculates the composite HDI based on three key indicators, there are numerous single indicators that measure different dimensions of development, including: Indicators to measure the ability to live a long and healthy life: Infant mortality rates Under-five mortality rates Maternal mortality rates % of children underweight for their age Population with sustainable access to an improved water source Population with sustainable access to sanitation. Population undernourished Number of one-year-olds immunized against TB. Number of doctors per 1000 of the population Indicators to measure ability to acquire knowledge: Enrolment in each level of education. Literacy rates Internet users per 1000 people Telephone mainlines per 1000 people

As a corollary: energy consumption per capita. The Genuine Progress Indicator: Another View of Human Development: For various reasons listed above, GDP is not a good indicator of living standards, and the emphasis for development economics is therefore the measure of human development in less developed countries. The Genuine Progress Indicator (as well as other related indicators, such as the Net Economic Welfare indicator) is an alternative measure of welfare established specifically to measure human development in more developed countries; it attempts to measure whether a countrys growth (increase in the value of the national output of goods produced) has actually led to greater welfare for the people. It adds a measure of non-monetary benefits, such as the benefits of household and volunteer work, to the GDP, and attempts to deduct the many external costs of economic growth from the GDP figure. The deducted costs include: o Environmental damage: Air, water and noise pollution Loss of farmland and natural habitats Resource depletion Ozone depletion o Social costs: Family breakdown

Crime and personal security costs Loss of leisure time o Commuting costs o Cost of automobile accidents. While such variables are difficult to quantify, the realization that rising GDP does not correspond to rising welfare means that economists must look for ways to measure the consequences of growth, such that both MDCs and LDCs can aim for equitable and sustainable growth.

Chapter 16: Aggregate Demand and Demand-Side Policies The macroeconomic concepts of aggregate supply and aggregate demand may be treated as extensions of the microeconomic concepts of supply and demand. Aggregate demand (total planned expenditure on goods and services, at a given price level, within a given period of time) is the foundation of macroeconomic analysis. Graphically, the AD curve closely resembles the demand- curve; it is downward-sloping. However, whereas the demand curve (a microeconomic concept) shows the relationship b/w the price of a good and its quantity demanded for a single market, macroeconomics considers the functioning of the economy as a whole. Thus, the AD curve is an aggregate of all goods and services demanded. The AD graph has a measure of the average price level of all goods and services in the economy, instead of simply price, on the y-axis, and the total value of all goods and services in an economy, adjusted for inflation (real national output=real national income=real national expenditure= real GDP) instead of simply quantity on the x-axis; graphically, this is usually labeled real output or real GDP. The AD curve therefore shows the inverse relationship between the average price level and real output in the entire economy of a country; at a lower average price level, more output is demanded. However, the Law of Demand does not apply on an aggregate level; we can explain the downward trend through: o The Wealth Effect: While the nominal value of money is fixed, its real value is based on the average price level. As the avg. price level decreases, the same nominal amount of money will be able to purchase more of an economys output than had been previously possible. As price level falls, consumers are wealthier, which encourages expenditure. o The Interest Rate Effect: The quantity of money demanded in the economy is dependent on the avg. price level; a high price level denotes that it takes a large amount of

currency to make purchases. Consumers thus demand large amounts of currency when prices are high. When average prices are low, consumers demand relatively little currency as it takes a small amount of currency to make purchases. Thus, consumers keep a large amount of currency in the bank, increasing the supply of loanable funds. As a result, as the price level decreases, the interest rate on loans decreases, increasing demand for investment and thus total national output. o The Exchange-Rate Effect: This effect is related to the interest-rate effect; because, when the avg. price level falls, interest rates fall, the currency decreases in value as investors become relatively more likely to invest their financial capital abroad, as the relative return on financial investment abroad increases. This causes a fall in the domestic exchange rate relative to foreign currency; this means that it becomes relatively more expensive to import, and exports become relatively more competitive internationally. Thus, net exports rise as the price level decreases, causing AD to increase at lower price levels; as domestic investment abroad increases, the balance of payments remains neutral. The differences in the graphs indicate the difference between the microeconomic demand curve and the macroeconomic AD curve. Thus, in constructing the AD curve, we examine demand from all possible sectors of the economy; this gives us the components of AD, which comprise: o Consumption: Total planned expenditure by consumers on dom. products. In looking at consumer demand of goods, we distinguish b/w 2 types of goods: Durable Goods: Goods used by consumers over an extended time period (eg. cars, TVs, houses). Non-Durable Goods: Goods used by consumers immediately or within a rel. short timespan (e.g. Big Macs, toilet paper, newspapers). o Investment: Total planned additions by firms to the capital stock of the economy. Firms have three types of investment: Replacement investment: Expenditure on capital in order to maintain the productivity of existing capital Induced Investment: Expenditure on capital in order to increase output in response to higher demand in the economy Autonomous Investment: Expenditure on capital in order to increase output, independent of the level of demand in the economy. o In general, firms will invest autonomy if the expected rate of return from the investment exceeds borrowing costs; this depends on expected costs, revenues, and productivity of/from the capital. We also distinguish between [optional, though useful] Planned Investment: The level of investment that firms intend to undertake at the beginning of the time period considered

Actual Investment: The level of investment which has occurred at the end of the period. If firms fail to see their stocks, actual investment will exceed planned investment Capital Stock: All the goods in an economy that are man-made and used to produce other goods/services (e.g. cars, computers, offices). Thus, macroeconomic investment is not equivalent to financial investment (the purchasing, sale and lending of assets); although this is referred to as investment colloquially, it is actually saving, as income leaves the circular flow. o Government Expenditure: May occur on a variety of levels (local -> federal), and represents spending on a wide variety of goods and services, which commonly includes health, education, security, transport, welfare and housing). The amount of govt spending depends on the govts policy objectives. o Net exports: Exports: Domestic products purchased by foreigners. When firms sell exports to foreigners, the export revenue enters the country Imports: Products purchased from foreign producers When imports are bought, an outflow of imp. expenditure occurs. Net Exports: Total planned export revenue less total planned import expenditure in an economy (usually noted as (X-M). The net figure may be either negative (export revenue is lower than import expenditure) or positive (import expenditure is lower than export revenue); however, in national income statistics, imports are also added as consumption, to reflect the fact that imports most often enter a country through domestic firms and/or the dom. govt, and that the actual output of the economy is independent of the amount imported. Aggregate Demand can be summarized using the formula C+I+G+(X-M). o When the avg. price level in the econ. falls (PL0->PL1), the level of output demanded by consumers *C+, firms *I+, the govt *G+ and the net foreign sector *X-M] increases (Y1-Y2). o Economists use different, equivalent labels for the x-axis (e.g. natl income, natl expenditure, real GDP). Be consistent with whichever one you use and be sure to distinguish between your label and quantity, which is a microeconomic concept in a single market. Changes in AD: o A change in price level will cause a movement along the AD curve b/w real output levels; a change in any of the components of AD will cause AD to shift left (AD falls, if the component decreases) or right (AD rises, if the component increases). Changes in the Components of AD:

Consumption changes are caused by: Changes in income: Income is the most sig. determinant of consumption; as incomes rise, people have more money to spend on products, and consumption rises. In a growing economy with rising GDP, consumption, and thus AD, will increase. Changes in interest rates: Spending on non-durable goods is carried out with consumers income (the day-to-day money earned); however, some of the money used to buy durable goods consists of bank loans. When people borrow money, they must pay interest on the loan to the bank; the interest rate may be understood as the price of loanable funds in the econ. o If interests rates rise, borrowing will likely fall (as the cost of borrowing rises). Consumption will fall, leading to a fall in AD. o An example of interest rates affecting AD is the housing market; to buy a house, consumers often take out mortgages. If interest rates increase, mortgage repayments rise and people will be able to spend a smaller prop. of their income on other goods and services; consumption will fall. o Also, if the IR rises, saving will become more attractive; people would rather earn money by depositing their incomes in the bank than spend on goods/services. Consumption will also fall as a result. o An increase in IRs leads, ceteris paribus, to a fall in consumption; conversely, a fall in IRs leads to a rise in consumption, ceteris paribus; it becomes rel. more attractive to purchase durable goods and services using loaned funds and less attractive to save money in banks, where the return on investment falls. Also, mortgage repayments may fall, leaving more money to spend on goods/services. Changes in Wealth: The amount of consumption depends on the amount of wealth consumers have. o Income: The money private individuals earn o Wealth: The assets private individuals own, including physical assets (e.g. housing, gold jewelry) and monetary assets (e.g. govt bonds, shares in companies, bank savings). Two main factors affect the level of wealth in the econ.: o Changes in housing prices: As house prices rise across the econ., consumers feel more wealthy and will likely feel confident

enough to increase consumption by saving less/borrowing more. o Changes in the value of stocks/shares: Many consumers hold shares in companies; if their value rises, consumers will feel wealthier, encouraging them to spend more. They may also sell the shares and use the earnings to finance consumption. Changes in Expectations (Consumer Confidence): If people are optimistic about their econ. future, they are likely to spend more now (e.g. if they believe they can find better jobs soon due to the booming economy, they will be more likely to take out a loan or use up savings). o High consumer confidence will likely lead to high consumption levels. However, if people expect econ. conditions to worsen, they will likely reduce present consumption to save for the future. If inflation is expected to rise, consumers will consume more in the present, possibly causing an inflationary spiral. Economists measure consumer confidence and use a consumer confidence/sentiment index to summarize the results. An increase in the index implies that confidence, and thus cons. and AD, is rising. Inflation: With inflation, the purchasing power of savings is reduced, and people may have to save a greater prop. of their incomes if they wish to maintain a given level of savings. Consumers income: As income increases, consumers are likely to save more and spend less out of each additional unit of currency received (marginal propensity to consume is lower at higher incomes). Discretionary vs. Contractual Savings: With contractual savings (e.g. a retirement plan), consumers agree to save a certain amount each month; with discretionary savings, consumers have the choice to save or not to save. Relative incomes: Consumer expenditure will be influenced by their past expenditure patterns, as well as those of their neighbors; in the short run, a household will not scale back consumption if incomes decrease as it has become accustomed to higher levels of spending and seeks to keep up with the Joneses Changes in exchange rates: an increase in the value of a countrys currency will, ceteris paribus, make exports less competitive abroad, decreasing AD; the converse is also true. Income distribution: as income is redistributed more equitably, consumption will likely rise as the low income groups MPC is rel. higher than that of wealthier groups.

An interesting note (the paradox of thrift): If households try to save more of their income, they may end up saving exactly the same amount as before; if they save more of their money, AD decreases, leading a fall in the level of real GDP. Although they save a greater proportion of their income, in a 2-sector economy, their total savings will be the same total amt. as before (for equilibrium, planned leakages must equal planned withdrawals, which remain constant).

Investment changes are caused by: Interest rates: To invest, firms need money; while some of that money originates from their Retained profits, some is borrowed; the level of borrowing is affected by the interest rate. If money is borrowed, an increase in borrowing costs will cause the investment level to fall; also, if interest rates are high, firms may prefer to save their retained profits to earn higher returns, rather than use them for investment. There is an inverse relationship between interest rates and the level of investment; this can be shown on an investment schedule, which has the interest rate on the Y axis and the investment level on the X axis. o A decrease in interest rates will decrease the incentive to save and borrowing costs (as there are now more projects with a higher rate of return than the borrowing cost), leading to an increase in borrowing and thus investment; an increase in IRs will have the opposite effect. Interest rates will depend on: o How long the loan is for: longer-term loans constitute a greater risk and are priced at higher IRs o Risk: The riskier the project, the greater the IR charged will be o The cost of setting up a loan; there are scale benefits for the bank of setting up fewer large loans rather than more smaller loans. o Demand of loanable funds from: Households, to buy consumer durables Firms, to invest the government, to finance a budget deficit o Supply of loanable funds from: Peoples willingness to save (and thus provide loanable funds to banks) Banks ability to lend (which may be affected by minimum reserve requirements, etc.)

Changes in GDP: As GDP rises, cons. tends to rise; if this occurs rapidly, the prod. capacity of firms will be put under pressure, making it likely that firms will invest in new capital to meet the increase in demand; this is induced investment. Investment accelerates as GDP rises (more on the accelerator effect later). Technological Change: A dynamic economy will feature a quick rate of tech. change; to keep up with tech. advances and remain competitive, firms will need to invest. Expectations/ Business Confidence: Businesses make investment decisions largely based on their future expectations and confidence in the ec. climate. o Firms are unlikely to invest to increase their pot, output if cons. demand is likely to fall in the future. o If businesses are confident about the ec. climate and expect demand to rise, they will invest (autonomously) to increase output and productivity and thus meet projected demand. o Economists usually measure business confidence and publish their results in the form of a business confidence index.\ Govt expenditure changes are caused by: The amount and nature of govt spending depends on the aims of the govt; if the govt has committed to subsidizing an industry, govt spending will rise, as will happen if the govt decides to spend to correct market failure. Education and healthcare improvements may see increased spending on schools and clinics. The govt may also deliberately pursue policies to adjust the level of AD in the econ. To perform both of these tasks, govts may run budget deficits (spend more than they receive in revenue). Alternatively, the govt may run a surplus, whereby its expenditure is lower than its revenue. This often implies lower levels of expenditure, and thus AD. Net export changes are caused by: Exports: Goods/services bought by foreigners. If foreign incomes rise, their consumption of imports from Home will rise; thus, domestic exports rise as foreign economies grow (this is evident between China and Germany). Similarly, as foreign countries grow, their investment expands; this will involve some measure of imported capital, causing increases in dom. capital good exports. Imports:

When a countrys GDP rises, increases in consumption will result; it will necessarily be the case that some of those goods and services will be imported. Likewise, as GDP rises, investment is likely to rise. Part of the capital goods (or components thereof) purchased will be imported; thus, as GDP rises, so does import expenditure. If GDP falls, there will be reduced spending on all goods and services, including imports. Thus, net exports depend on both domestic and foreign GDP growth trends. Protectionist measures and other limits to the physical ability of consumers and firms to import and export goods, as well as the countrys relative exchange rate, will also affect net exports.

Chapter 16-A: Demand-Management Policies Govt Demand Management Policies: o Govts have two broad sets of policies available to influence the level of AD in the econ. These are: Fiscal Policy: The set of govt policies relating to its spending and taxation rates. Both direct taxes (on income) and indirect taxes (on expenditure) can be raised/lowered to alter the level of disposable income consumers possess. Govts use expansionary fiscal policy to increase AD and contractionary fiscal policy to lower AD; this is known as a governments fiscal stance, which will depend on the discretionary stabilizers that the government has in place: o Discretionary Stabilizers: Actions deliberately undertaken by the govt to stabilize the econ (e.g. taxation rate changes, changes in govt expenditure). To stabilize the economy, in a slump, the govt will usually try to reflate the economy by increasing AD; in a boom, it will usually try to deflate the economy by reducing AD. o Expansionary Fiscal Policy: If the govt wishes to encourage increased consumption, and thus AD, it can lower income taxes to increase disposable income. If a govt wishes to encourage greater investment, it can lower corp. taxes to increase firms after-tax profits and thus investment; this will also likely increase AD Govts may increase their spending to improve or increase public services; this has a direct effect on AD. Govts gain revenue from:

Taxes Privatization proceeds Profits of nationalized industries Dividends from govt shares in private enterprises Using Tax Changes Compared to Spending Changes: Tax changes: Can be introduced and have an effect quite quickly Tax cuts can increase incentive to invest and work, and thus may have supply-side effects. However: o Tax changes are an indirect method; the govt may not be able to predict how consumers will react to a tax cut: they may save most of the extra money received. Spending Changes: Govt spending can be targeted at specific industries/regions Expenditure directly increases AD and has full multiplier effects, compared to a tax cut, where some of the money can be saved in the first round of spending However: o There is a time lag before the budget gets approved and spending actually takes place; there may be a long delay between the decision to increase spending and implementation. Spending is difficult to control, because: o Some items of expenditure are difficult to reduce (e.g. education, healthcare); demand for them is constantly increasing. People expect higher standards; thus, it is pol. unwise to crack down on these items. o Factors beyond a govts control may place an added burden on health services or defense expenditure.

Commitments to other countries and intl organizations (e.g. the EU) are not easy to end. Financing a Deficit: To finance its deficit, a govt can sell: Treasury bills (short-term borrowing by the govt); the bills are essentially IOUs which are redeemed after three months. Bonds: Longer term debt (longer-term IOUs) The Central Bank can lend money to the govt. If a deficit exists, the govt is putting more money into the economy than it is taking out; this will increase the money supply. If, however, the govt sells debt to the non-bank public, this will take excess money out again; the overall effect may be neutral. If the govt sells long-term debt to banks, their liquidity will be reduced (as they have exchanged cash for the bonds), which may decrease lending, offsetting the increase in money supply. Treasury bills are so liquid that they will not significantly affect lending; thus, money supply will increase, if they are used. The National Debt: The total debt of the govt, which grows whenever the govt runs a deficit, as the govt is borrowing more money. The govt needs to pay back the national debt, plus interest, from future revenues (eventually) If the natl debt consists entirely of borrowing within one country, the govt is simply transferring money from one group to another. To pay off a group it owes interest to, it borrows from another group; the money remains within the economy. If the govt borrows from abroad, the interest needs to be paid to people outside of the country; thus, the natl debt can become a burden. Note that a problem of twin deficits (whereby a budget deficit causes an external deficit) may arise, as increases in govt spending and reductions in taxation will cause an increase in import expenditure relative to export revenue; this will not occur, however, if the econ. has

spare capacity and the increases in spending are met by increases in dom. output. As output increases, dom. incomes increase; thus, the budget deficit will be able to be funded from dom. savings. Finally, if capital is not perfectly mobile, an increase in govt spending will increase IRs, increasing savings and reducing investment; thus, private sector funds would be available to fund the deficit. Problems of Fiscal Policy: Time lags: any changes in policy will take time to work through the economy, by which point the policy may not be needed and may actually be detrimental. Fiscal policy may also be too inflexible in the face of changing ec. conditions (e.g. spending increases are straightforward enough, but spending cuts may be highly unpopular). Information problems: it is difficult to know the exact position of the economy and the size of the multiplier or accelerator. Budget deficits could potentially lead to intl indebtedness and/or higher tax rates in the LR. Fiscal Drag: If the govt keeps spending and taxation rates are constant, it will have a deflationary effect on the econ.: as households and firms earn more, they will end up paying more tax to the govt. Crowding Out (See Chapter 20) Consumption may not be sensitive to tax changes; e.g. consumers may save any increases in disposable income rather than spend a proportion of it. Govt intervention often increases AD by too much/ too little due to time lags and poor information; this can destabilize the econ. Keynesian Fiscal Policy: The economy will not nec. be in equilibrium at full employment output; govt intervention is required to reach full employment when in a recession Fiscal policy is more effective than mon. policy By having a deficit, the govt can increase AD and achieve Yf

Fiscal policy can be used to stabilize growth. o Neoclassical Fiscal Policy: Fiscal policy is not effective at fine-tuning the economy Expansionist fiscal policy is inflationary There is a need to reduce govt spending, borrowing and taxation as a % of GDP Mon. policy is more effective than fiscal policy. Monetary Policy: The set of official policies governing the money supply and the level of interest rates in an economy. The level of money supply in the economy is not directly in the IB syllabus; however, the effect of interest rates on AD is. o Many different IRs exist in any economy; private commercial banks may offer competitive financing (e.g. low mortgages). Although banks are regulated by the govt, they are free to set such rates themselves. o Discount Rate (base rate, prime rate) The interest rate used as a tool of monetary policy, at which a countrys central bank offers liquidity to commercial banks. The central bank is not a commercial bank; rather, it acts as the govts banker and controls money supply in an economy. In some countries, the govt controls the CB; however, in most developed countries, the CB is an independent entity mainly responsible for maintaining low and stable inflation rates in the econ. Changes in the discount rate are an important indicator of overall mon. policy as they set the tone for all borrowing and lending in the economy; to make a profit, commercial banks will need to set their private interest rates above the discount rate. Even though the CB is largely independent, we usually consider its activities part of a govts mon. policy. Changes in the discount rate affect the level of AD in the economy: To increase AD, the central bank might lower the DR, reducing the cost of borrowing and increasing both cons. and investment; this is expansionary (loose) mon. policy.

By contrast, to operate contractionary (tight mon. policy and reduce AD, the CB will increase the base rate. Functions of the Central Bank: Banker to the govt- provides an account for the govt and manages the natl debt through the sale of bonds, redeeming (buying back) debt when it has matured. Pays interest for the govt on debt and holds debt itself. supports fin. institutions as a lender of last resort, providing liquidity when necessary. Holds deposits and will lend funds to commercial banks Controls the natl currency; usually the sole power to issue currency. The actual quantity of currency is dependent on how much people want to hold in bank deposits/cash. Agent for the govts ER policy; holds official currency reserves and will buy and sell currency for the govt Oversees the fin. system, licenses deposit takers in the UK and regulates various fin. services. Instruments and Objectives of Mon. Policy: The objective of mon. policy is usually to control inflation; because this relies on increases/decreases in the interest rate, it is a demand-management policy that also has ramifications for ec. growth. In the early 1980s, govts mainly attempted to do this by controlling banks lending; from the mid-1980s, the govt has used the interest rate as the main policy instrument; this is aimed at controlling demand for, rather than supply of, money. Money is liquid, but does not earn a rate of return; if people hold money, they do not earn interest. Thus, the IR is the opp. cost of holding money; if the IR is high, the desire to hold money will be reduced- if low, there will be less incentive to switch out of money into other assets. The money supply (and thus, interest rate) is controlled by: Open-market operations: The CB selling govt debt (treasury bills in the short term, bonds in the long term), which the buyer pays for by

writing out a check on their banks. The banks honor this check by paying the CB, reducing their reserves, their ability to lend, and increases the IR. o Bonds have fixed returns per year; thus, the lower the value of a bond, the higher its return rel. to its value. o If households and firms as if they have too much liquidity (i.e. they are holding too much money), they will want to switch into bonds; this will increase the price of bonds and lower their rate of return. The process will continue until the price of bonds has increased, and the rate of return on bonds fallen, to a point where there is not further desire to switch away from money (both the bond market and the money market are in equilibrium). Thus, if the interest rate is set too high, there is excess money supply, leading households to buy bonds until a new equilibrium is reached. Likewise, if the IR is set too low, there is excess demand for money; households sell bonds, leading to a fall in their price and increase in their rate of return, until both financial markets return to equilibrium. o If banks are left short of cash as a result of OMOs, they may need to borrow cash from the CB; as they are competing for scarce loanable funds, the interest rate increases, making borrowing rel. more expensive. o The CB may also change its discount rate to affect overall interest rates. By influencing interest rates, the CB also influences demand for money.

Liquidity (reserve) ratios: By forcing a bank to keep more funds in reserve, the CB can restrict comm. bank lending, but banks may find ways around the restrictions. Funding: converting short-term govt debt into longer-term debt; by exchanging long-term debt with banks in return for short-term debt, the CB reduces banks liquidity and ability to lend. Special deposits: banks can be forced to deposit a certain % of their liabilities in the CB (often without interest); the CB may also restrict how much banks are allowed to lend (quantitative controls) and who they are allowed to lend to (qualitative controls) Moral suasion: The CB can make it known whether it would like more or less lending; bankers often heed the CBs advice/wishes. An increase in the money supply, due to any of the above methods, will have the following effects: o On money markets: If money supply (which is giveni.e. constant, as the level of money in an economy is set by central banks) increases, there is excess liquidity at the old IRs; households attempt to shed this liquidity by moving out of money into other bonds and assets, bidding up the price of bonds and reducing their return (the interest rate). The process continues until bond prices are high enough, and IRs low enough, that there is no further incentive to move out of money; the financial markets are back in equilibrium. o On capital goods markets:

The lower IR will increase the amount of investment: as borrowing costs have fallen, more investment projects are now profitable; the extent of the increase in investment will depend on the interest-rate elasticity of investment. On consumer markets: When investment increases, so does AD; if the econ. is below Yf, output and employment will increase. By contrast, if the economy is at Yf, an inflationary gap and upwards pressure on prices will occur, without a LR output increase. If prices do increase, so will nom. GDP, increasing the transactions demand for money. This will in turn raise interest rates and bring AD back down (i.e. a one-off increase in money supply will create forces that reduce inflationary gaps and hence inflation), assuming that the money supply is held constant and not increased again; if the money supply is increased at the same rate as inflation, the price increases can continue. Thus, if demand for money increases, households will switch out of assets into money, selling their bonds. This reduces the price of the bonds and increases their rate of return (the IR); the process continues until no further incentive to move out of bonds

exists. Such a trend should cause investment to fall, by an amount determined by the interest-elasticity of investment, leading to a fall in AD. Problems of Monetary Policy and Using Interest rates: Banks may hold reserves in excess of the minimum reserve requirement, causing the policy to have no impact on lending. Attempts to curtail certain types of lending will lead to more lending of a different type or by different organizations (Goodharts Law) Mon. policy can be undermined by disintermediation (firms borrowing and lending directly to/from each other, esp. when the CB intervenes on financial markets) Interest rates affect many factors at once; thus, IR adjustments are often seen as a blunt macro. policy; a CBs IR decisions apply to all institutions and aspects of an econ. Changes in IR are likely to affect the ER; using higher IRs to discourage borrowing my increase the value of the ER, making dom. firms uncompetitive. Borrowing by households and firms is likely to be affected. Monetary policy may take years to take full effect; unless the CB plans its policies carefully, the policies impact may come too soon or too late. However, because mon. policy is rel. easier to implement and manage than fiscal policy, it is the preferred demand-side policy for most govts; between approx. 1980 and 2008, the main use of fiscal policy was perceived to be supply-side improvements (tax incentives and reductions in benefits). Thus, fiscal policy is likely to be more effective than mon. policy if: Money demand is interest-elastic (such that changes in money supply have little effect on IRs) Investment is interest-inelastic. The above conditions closely reflect Keynesian views on the economy. In general, govts following Keynesian policies believed that:

Govt intervention via fiscal policy (often by running a budget deficit) is often necessary to bring the economy towards full employment; in addition, they believed that fiscal policy could be used to fine-tune the economy to stabilize growth. By contrast, govts influenced by neoclassical views of the economy have believed that: Fiscal policy was less effective than mon. policy, and ineffective at fine-tuning the economy. Expansionary fiscal policy is inflationary in the LR; thus, govt spending, taxation, and borrowing as a % of GDP should be reduced.

Chapter 17: Aggregate Supply The supply side of the economy is important in macroeconomic analysis, as it shows the overall prod. capacity of the economy. Aggregate Supply: The total amount of goods and services that all industries in the economy will produce at any given price level. o AS may be seen as the sum of all supply curves of all of the industries in the economy. o In macroeconomic analysis, we distinguish between short-run and long-run AS: Short-Run AS: o Graphically, the short run AS curve resembles a micro. supply curve in that it slopes upwards; there is a pos. relationship b/w the price level and the output level a countrys industries will supply. As with an AD diagram, price level is given on the y-axis while real GDP is given on the x-axis. At any given price level, industries will supply a certain output level. In the short run (which is defined, in macroeconomics, as the time-period where FoP prices, especially wages (the price of labor) are constant; thus, each SRAS curve is drawn for a given nom. price level), if firms want to increase output level, firms will face higher avg. prod. costs when producing a higher output. To produce more, firms might have to provide incentives to workers for them to be available to produce the output; this is usually done via overtime pay (which is greater than regular wages; hence, avg. costs for firms rise) By the Law of Diminishing Returns, marginal and avg. costs will rise as output increases in the SR. Thus, in the SR, an increase in output will cause AC to rise; industries will pass this on to consumers via a higher price. Hence, SRAS slopes upwards; an increase in output level (Y0->Y1) will be accompanied by an increase in price level (P1->P2) o Shifts in SRAS:

The SRAS curve shows the relationship between avg. price level and real output in the economy (assuming ceteris paribus; i.e. factor costs are ass. to be constant) A change in price level causes a change in the output level and results in a movement along SRAS; this is similar to the micro. supply curve, where a price increase leads to an increase in QS, shown as a movement along the S curve) Just as with the micro. S curve, a change in any other determinant of SRAS than the avg. price level will cause the entire SRAS curve to shift; these shifts are sometimes called supply-side shocks. If SRAS increases, the SRAS curve shifts right; if SRAS decreases, the SRAS curve shifts left. The most straightforward explanation for supply-side shocks is that they are factors that cause changes in prod. costs. o As in micro. analysis, an increase in prod. costs causes an increase in SRAS, while a decrease in prod. costs causes a decrease in SRAS. Prod. costs typically change as a result of the following: o Changes in wage rates: Any increase in wages (for example, due to new min. wage laws, or the occurrence of successful collective bargaining in mfg. industries, where unions usually lobby for good conditions and wages for workers) will lead to an increase in prod. costs to firms, and thus a fall in AS. o Changes in raw material costs: For a change to have an effect on SRAS, we ass. a change in the price of significant, widely-used raw materials has occurred. While an increase in bismuth prices would affect rel. few industries (implying that aggregate prod. costs in the economy may not increase by enough to affect SRAS), a change in oil prices would affect almost all industries, as oil is widely used in most prod. processes, and thus almost certainly cause a shift in SRAS o Govt taxes and subsidies may also affect SRAS (causing it to shift left/right, respectively), if they are applied to the majority of industries in the economy. o Changes in import prices: If the capital/raw materials used by a countrys industries are imported, a rise in import prices will increase prod. costs. This can occur due to changes in the ER of a countrys currency (e.g. if the Euro falls in value, the import price of the raw material/capital used by European producers will become rel. greater, raising prod. costs in the Eurozone).

Short-Run Macroeconomic Equilibrium: o The economy will operate where AD=AS. At this avg. price level and output level, all of the output produced by a countrys producers is consumed; thus, there is no incentive for prod. to alter output or prices. Long-Run Aggregate Supply o Economists hold various theories as to the shape of the LRAS curve; there are two main schools of thought regarding its appearance and function (the Keynesian school and what is often called the neoclassical school- the term monetarist is applied, sometimes erroneously, to this school, as well) o The differing shapes of the LRAS curve lie at the basis of controversies concerning appropriate govt economic policies b/w the two schools. o Keynesian LRAS: The Keynesian LRAS curve shows three possible phases; these are, in order of increasing natl output: The Depression Phase: In this view, LRAS is perfectly elastic at low levels of ec. activity; producers in the econ. can raise real output without incurring higher average costs (or increases in the avg. price level) due to the existence of spare capacity in the economy. o Spare Capacity: The existence of high levels of unused FoPs (e.g. unemployed labor, underutilized capital). o Firms can potentially produce far more than they are producing at the moment. Should there be demand for increased output, the unutilized FoPs can be employed to their full capacity (e.g. idle machines can be put into use and unemployed workers given jobs) at constant avg. costs More can be produced at the same price level; workers are willing to work at the given wage and marginal product is constant; thus, MC is also constant. The Transitional Phase: As the economy approaches its potential output (Y(f)), the available FoPs in the economy become rel. scarce; as producers continue trying to increase output, they will have to bid for increasingly scarce FoPs. o Higher prices of FoPs mean higher costs for prod, and the price level will rise to compensate for the higher costs. In this region, LRAS slopes upwards. o The nearer the economy gets to full employment, the more difficult it will be for firms to attract scarce resources, and the greater the increase in costs (and thus the price level) for each increase in output will be; AS becomes progressively more inelastic.

The Full Employment Phase: As the economy reaches its full capacity (Yf; the full employment level of output), it is impossible to increase output any further, as all FoPs are fully employed; thus, LRAS is perfectly inelastic at the economys potential output. o The full-employment level of output is a tricky concept; full employment does not mean that no unemployment exists; rather, it is the output level where the efficiency of FoP use is maximized. In terms of unemployment, full employment connotes that the number of jobs in an economy is equal to or greater than the number of people actively seeking work. Neoclassical LRAS: Neoclassical economists believe that LRAS is perfectly inelastic at the fullemployment output level; thus, the economys pot. output is dependent on the quantity/quality of FoPs, rather than on the avg. price level. The LRAS curve, in this view, is independent of price level; if the price level rises or falls, long-run output does not change. Shifts in LRAS: As a countrys FoPs are constantly changing (usually, increasing in quantity or quality), we should expect to see steady increases in its LRAS; this represents pot. economic growth. An outward shift in a countrys LRAS means that its prod. potential has increased; thus, a rightward shift in LRAS is equivalent to an outward shift of the countrys PPF. This shift can be shown from both the Keynesian and Neoclassical perspective; with the Keynesian perspective, note that LRAS shifts directly right; it does not also shift downwards. As a result, in both cases, the full employment output level should increase. LRAS will shift right if there is an improvement/increase In the quality/quantity of a countrys FoPs; e.g. tech. advancements may increase the productivity of capital, improvements in education may increase the productivity of labor, immigration may increase the quantity of labor, lower benefits may increase incentives to work, lower nom. wages may increase incentives to hire, investment due to lower interest rates may lead to a larger capital stock, and discoveries of raw materials may increase the quantity of goods that can be produced. All of the above factors will shift LRAS outward. Supply-Side Policies: Govt policies that are put into place to increase the LRAS of an economy. The main goal of supply-side policies is to increase pot. econ. output by increasing the quantity/improving the quality of FoPs.

We can divide the policies into two categories: market-oriented and interventionist policies: o Market-oriented supply-side policies: These policies focus on allowing markets to operate freely, with minimal govt intervention; these policies are designed to increase the incentives for labor to be more productive and efficient, and to increase the incentives for firms to increase productivity. The most prominent such policies include: Reductions in income taxes: if people work harder and make more money, they may need to pay higher taxes as they attain higher income levels. o This may act as a disincentive to work; if taxes are reduced, the incentive for labor to work harder and be more productive may increase, thus increasing the economys pot. output. o In addition, at lower avg. tax rates, the opp. cost of not working, as opposed to working, increases; more people will therefore seek employment if dir. taxes are lowered. Reductions in corporate taxes: If businesses are allowed to keep more of their profits, they will have more money for investment; as investment entails additions to the capital stock of the economy, pot. output will increase. o In addition, if businesses know that they will be able to keep a larger share of their profits, rather than give them to the govt in taxes, they will have more incentive to produce efficiently. o It is interesting to note that, while Keynesians focus on the macroeconomic effects of taxation and govt expenditure, neoclassical (supplyside) economists tend to focus on its micro. effects (e.g. disincentives to invest/work)

Reductions in trade union power: Trade unions may often push wages up too high and increase prod. costs to firms. Thus, a reduction in union power will reduce the ability of unions to negotiate disequilibrium wages and should lower prod. costs for firms. This should cause pot. output to increase. o However, as the existence of unions protects workers from exploitation, reduced union power may result in abuses of workers rights by firms. o A note on unions: Trade unions are organizations founded to represent employees, protect their interests, and bargain on their behalf; by joining a union, employees gain increased bargaining power and benefit from collective bargaining. o Unions will typically bargain over issues such as pay, working conditions, and training. o Unions must decide whether to maximize wages of existing workers (which is likely to reduce employment), maximize the total wage bill, or maximize employment. To simultaneously maximize employment and wages, unions must aim to increase productivity, such that the demand got labor shifts right; they may do so by lobbying for better working practices. o Unions can affect the average real wage rate by: Improving productivity: By negotiating for better conditions and protecting the workforce, unions may increase output.

Using industrial power (e.g. the threat of strikes) to force employers to pay more. Restricting supply of labor (e.g through closed shops in industries and firms; as only union workers are allowed to be employed under closed shop conditions, labor supply decreases and the wage rate consequently increases). o The power of trade unions in the economy as a whole depends on: The number of union members, expressed as a proportion of the total labor force. The legal environment: govts often take measures to reduce union power (e.g. by making them more accountable for their actions and preventing industrial action without a secret ballot). Reduction in govt expenditure; depending on the degree to which crowding out effects the economy, this should mean that less money needs to be borrowed by the govt and more remains available for the private sector; however, this approach may end up harming programs that benefit society (e.g. education, healthcare). Reduction/elimination of min. wages: Likewise, it can be argued that because govt-set minimum wages keep labor prices above their free-market level, abolition of the minimum wage would also lower prod. costs and thus decrease LRAS. o While this may lead to overall economic growth, it will reduce living standards for minimum-wage workers and is thus often seen as a harsh policy.

Reduction in unemployment benefits: If the unemployed are given generous benefits by the govt, they may have less of an incentive to find employment. o Market-oriented supply-side economists would recommend that unemployment benefits be reduced to encourage unemployed people to take the available jobs in the economy; this policy is only appropriate if jobs are actually available. Deregulation: If govts have heavily regulated business operations, this may increase overall prod. costs, reducing AS in the econ. o A reduction in the number/severity of regulations (deregulation) will lower firms costs and increase AS; this will especially be the case if regulations on new firms entering the market are decreased. o However, this may include reductions in regulations on employee safety or environmental standards, which can have severe neg. consequences for workers and the environment. Privatization: The sale of public, govt-owned firms to the private sector, e.g by contracting out (selling off public-sector activities to the public sector), deregulation to allow for greater competition, and sale of govt-controlled assets to private shareholders. o Examples of privatized industries include British Airways, Japan Post, and Telekomunikacja Polska. o Arguments Against Privatization: Privatization, if executed poorly, may lead to the replacement of state monopolies with private monopolies.

Privatized firms are often sold below their value to ensure that shares are sold. To address these problems, many countries have set up watchdog bodies to monitor privatized utility industries; the utilities must meet the conditions of their operating license, which is intended ensure that they are not abusing their monopoly power; prices of the services may also be controlled. If a nationalized monopoly is divided into several more competitive components, there may be a loss of economies of scale and a net increase in costs/prices due to duplication of resources. When firms are privatized, the govt can no longer directly control the externalities arising from their operation. In industries that require high levels of investment (e.g. coal mining), private firms may not be able to raise the funds needed to expand capacity. Arguments for Privatization: Organizations run by the public sector are often inefficient, as the govt will usually finance them despite any losses that they make. Privatization may be popular with voters, who are able to acquire shares cheaply. As the govt no longer needs to subsidize (ideally), public spending is reduced.

Privatization provides a one-off increase in govt revenue. Privatization should encourage competition and competitiveness. Organizations in the public sector are often run for political ends (e.g. to maintain high employment), at the expense of efficiency. Shareholders may provide a better method of control over managers activities than the govt; this leads to better decision-making and increased efficiency. Increased share ownership may encourage entrepreneurship. Employees and managers in newly-privatized firms will have a greater incentive to innovate, in order to remain competitive. o According to market-oriented economists, privately-owned profitmaximizing firms will be much more efficient and productive than govt-run firms; they will have more incentive to increase pot. output. All of the above market-oriented supply-side policies emphasize the reduced role of the govt in the economy and the importance of allowing all markets, esp. labor markets, to operate freely. Their most significant drawback is almost always the potential high cost in terms of welfare of negatively affected workers, at least in the short run. Interventionist Supply-Side Policies: These policies are based on the notion that the govt has a fundamental role to play in actively encouraging growth, and include: Education and training: To consistently increase the quality of labor, it is the responsibility of the govt to ensure that ed. and training facilities

are geared to providing the skills and knowledge necessary for a dynamic economy. o This relates to both the skills and knowledge needed by young people entering the labor force and the retraining of workers to help them adapt to changing ec. circumstances. o Such training can occur in schools, universities, training institutions and apprenticeship programs. Research and development: It is important that an economys firms be able to stay up-to-date with tech. developments, develop new prod. techniques and constantly seek improved prod methods. o All of the above may increase a countrys pot. output, but all involve extensive R&D spending. o Govts may encourage R&D by firms by offering tax incentive to innovative firms (e.g. by allowing firms to not pay taxes on the retained profits used for R&D; this is known as a tax credit. o Firms may be reluctant to spend on R&D if they know that they will not be able to benefit fully from their spending; govts can thus encourage R&D by guaranteeing IP rights (e.g. patents, copyrights). o Govts may also finance R&D directly in public universities and research facilities. Provision of Infrastructure: The prod. potential of an economy will be enhanced by improved infrastructure (e.g. better transportation and communications) Encouragement of an entrepreneur culture (e.g. via university degrees for management). Workfare programs: A govt may opt to provide the unemployed with simple, low paying jobs which generally benefit society (e.g. garbage

disposal, basic construction) in lieu of providing unemployment benefits for those who are able to work; this avoids some of the pot. problems with the disincentive effects of welfare schemes. Improved Information: Govts can finance trade fairs to facilitate the sharing of expertise and info. among a countrys firms. All of the above interventionist policies have significant costing implications and govts must consider the opp. costs of such spending. The benefits of interventionist supply side policies will likely be more evident in the long term than in the short term.

Chapter 18: Macroeconomic Equilibrium National income is equivalent to the output level that a country produces and is a key sign of the economys health. The actual output level, and its corresponding price level, are determined by the interaction of AD and AS. The equilibrium level of national output (macroeconomic equilibrium): The point where AD=AS. o Since we distinguish between SRAS and LRAS, we have both a short run and a long run macroeconomic equilibrium. o Macroeconomic equilibrium is closely related to unemployment and inflation, and the associated policy objectives; joblessness and rapidly rising (or falling!) price levels are significant macroeconomic problems. o Short-Run Equilibrium Output: The economy is in SR equilibrium where AD = SRAS. Graphically, this situation resembles the short-run equilibrium for an industry, although the axis labels differ. When an economy is in SR equilibrium, producing an output level Y at a price level P, the output produced by all firms is exactly equal to total demand in the economy; there is no reason for producers to alter output levels. Because AD=AS, there is no inflationary/deflationary pressure (upward/downward pressure on the price level). As long as AD and AS remain constant, the economy remains in equilibrium. o Long-Run Equilibrium Output: Occurs where AD = LRAS. Given that economists disagree on the shape of the LRAS curve, we distinguish between Keynesian and Neoclassical long-run equilibrium output. Keynesian Long-Run Equilibrium Output:

As we know, long-run macro. equilibrium occurs where AD=AS. According to Keynesians, the equilibrium level of output may occur at various levels of real GDP. Significantly, they believe that the economy can be in LR equilibrium at an output level below the fullemployment level of natl income (Y(f)). This will be the case if the economy operates where there is spare capacity; in this view, the equilibrium level of output depends mainly in the level of AD in the econ. If AD intersects the region of the LRAS curve where spare capacity exists, the equilibrium output level will occur at an output Y below Y(f) at a price level of P. Keynesian LRAS can be perfectly elastic due to the existence of spare capacity, with high levels of unused FoPs (unemployed workers, underutilized capital, etc.) In this case, the equilibrium level of output will occur below full-employment output; a deflationary gap exists: o Deflationary Gap: A situation whereby the level of AD in the econ. is insufficient to buy up the economys potential (full-employment) output. This case is also known as an output gap and, though not easily measurable, can be shown as the distance from a point inside a countrys PPF to a point on the curve. o In the Keynesian view, AD can increase such that real output increases w/o any consequent increase in price level. o If AD intersects LRAS where the curve is perfectly elastic (i.e. spare capacity exists), and AD rises, real output will initially rise with no corresponding change in price level, as producers can employ the unused FoPs to increase output without corresponding cost increases; thus, there is no inflationary pressure.

If AD increases further, to the transitional region on LRAS, the economy begins to experience inflationary pressure, as available FoPs become scarcer and their prices are bid up. The price level thus rises (P0->P1) to compensate producers for higher costs. o If the economy operates at full employment, and AD increases, the outcome will be purely inflationary; output does not increase, and the only change is an increase in price level. This is because it is impossible for the econ. to expand output further in the LR, given the existing FoPs. o An increase in AD on the fullemployment phase of LRAS will not increase output; the econ. cannot produce output beyond the fullemployment output level. The only result is an increase in the avg. price level. Thus, an inflationary gap occurs. Inflationary Gap: A situation where the level of AD cannot be satisfied given the available resources. As a result, price level rises to allocate the scarce resources among the competing components of AD: consumers, producers, the foreign sector and the govt. Demand-Side Policies: The Keynesian perspective of the different poss. positions of the econ. leads to the conclusion that the long-run equilibrium level of output does not nec. occur at Y(f), and that the economy can rest in equilibrium at an output level below Y(f).

This implies that the govt has an important role to play in the economy, as it can intervene to steer the econ. towards Yf via demand-side (demandmanagement) policies, mainly via fiscal and monetary policy. o Expansionary policies are used to increase the equilibrium output level by increasing AD; as increases in real output imply increases in demand for labor, such policies are intended to reduce unemployment. o Contractionary policies are used to decrease AD to reduce inflationary pressure caused by increases in the avg. price level. Neoclassical Long-Run Equilibrium Output: o Acc. to neoclassical economists, the economy will always move towards long-run equilibrium at Y(f). Thus, LR equilibrium occurs where AD meets the vertical (perfectly inelastic) AS curve. Thus, any changes in AD will only affect the price level; an increase in AD (AD1->AD2) causes price level to increase (P1->P2) w/o any increase in real GDP. In the neoclassical perspective, the transition from short-run to long-run is significant. Keynesians and neoclassical economists agree on the shape of the SRAS curve, but neoclassical economists argue that the economy will move automatically (i.e. without govt intervention, as neoclassical economists believe in free markets) towards long-run equilibrium. In this view, there may be a SR increase in output if AD increases, but the econ. will always return to LR equilibrium at full-employment output. The neoclassical perspective can be shown using a combination of the LR and the SR using an AD/AS diagram. Initially, the econ is at longrun equilibrium at Yf, where AD=LRAS=SRAS. o If AD increases (AD0->AD1) due to changes in any of the determinants of

AD, output will increase along SRAS (Yf>Y1) in the SR (i.e. there will be an inflationary gap- firms are producing beyond their normal capacity output). Acc. to neoclassical economists, this is only possible in the SR; output can increase along SRAS if workers are paid overtime wages as a short-term solution to firms excess demand for labor; however, as the econ. was at full-employment output to begin with, no unemployed resources exist. In attempting to increase output, the firms in the econ. compete for increasingly scarce labor and capital and, as the diagram shows, the increase in AD causes price level to increase(P1->P2). The increase in the price level means that prices in the entire economy have, on average, increased, as prices of the rel. scarce FoPs used by firms to produce the output now demanded increase. The rise in price level means that the costs faced by firms will increase as FoP (esp. raw materials, labor and capital) prices have increased. When prod. costs rise, SRAS shifts left (SRAS->SRAS1); although firms were willing to supply a higher output level due to the higher prices that they received in the SR, the higher cost of prod. means that no real gain is made, and firms reduce output back to Y(f). The

final result is that output returns to Yf at the higher price level P2. Assume the econ. is originally at equilibrium where AD=SRAS=LRAS, at output level Yf and price level P0. If AD falls (AD->AD1) due to changes in any of the determinants of AD, natl output will fall (Yf->Y1), as will price level (P0>P1), as, with the old nom. wages and a lower avg. price level, real wages will have increased, ultimately leading to an excess supply of labor. In the SR, the economy will produce at less than Yf (i.e. there will be a deflationary gap), but the fall in price level means that FoP prices in the economy have fallen. Thus, firms prod. costs fall, and this results in a rightward shift in SRAS (SRAS1->SRAS2). The shift will occur until the econ. returns to long-run equilibrium at Yf, at the lower price level P2. If FoP costs increase in the SR, SRAS will shift left (SRAS->SRAS1) as prod. costs have risen. The avg. price level rises (PL0->PL1) while output contracts (Y0>Y1); this illustrates stagflation (inflation combined with lower output and employment). Acc. to neoclassical economists, if the govt does not intervene, the econ. will return to LR equilibrium; unemployment will put downward pressure on nom. wages, reducing costs and causing SRAS to shift back to SRAS(0) at the full employment output level. Keynesians, however, argue that this adjustment is likely to take a long time, as nom. wages

are sticky downwards. The govt could also intervene by increasing money supply (lowering interest rates) and thus boosting AD; this reflationary action will cause AD to shift right (AD->AD1), causing the econ. to return to Yf at a higher avg. price level (PL1>PL2). The above three cases illustrate the neoclassical perspective of long-run macroeconomic equilibrium, with the important conclusion that long-run equilibrium output is always equal to Yf, and that the economy will move towards this equilibrium without govt intervention as a result of market forces. Acc. to the model, an increase in AD will be purely inflationary in the LR; thus, there is no role for the govt to play in trying to steer the economy towards Yf. Although there may be deviations from Yf in the SR, neoclassical economists do not see a role for the govt in filling these gaps; they recommend leaving the econ. to market forces, rather than using demand-side policies.

Changes in LRAS: A countrys LRAS is based on the quantity/quality of its FoPs, which change. Thus, Yf also changes. As potential growth occurs, LRAS shifts right; the pot. output of the econ. increases. o A country seeking to increase the rate of econ. growth and full employment output will use supply-side policies to increase the quantity/improve the quality of its FoPs. The impact of such policies largely depends on the view of the econ. that one takes. Keynesians believe that the impact of an increase in LRAS will depend on the initial position of long-run equilibrium of the economy. If the economy operates where spare capacity exists, the increase in LRAS will have no effect on equilibrium output.

The econ. is initially in equilibrium at Y below Yf; an increase in LRAS increases the pot. of the econ. to produce at a higher output level, but the AD is insufficient to buy up this potential and equilibrium will remain at Y. While Keynesian economists do not underestimate the importance of supply-side policies in achieving growth, this emphasizes the Keynesian view that the govt must intervene if the econ. is operating below Yf. Neoclassical economists believe that an increase in LRAS will have an entirely favorable effect; there will be an increase in the full employment income level (Yf>Yf1) and a fall in the price level (P->P1); this is why Neoclassical economists are often called supply-side economists. Acc. to this view, supply-side policies are the most effective way of achieving a countrys marco. goals. o Combining the two perspectives, a successful strategy for sustained, stable ec. growth is a balance between demand-side and supply-side policies, such that AD can be allowed to increase, as long as increases in the supply-side of the economy balance the increase out. Most devd economies can only sustain 2-3% before inflation accelerates; thus, govts may need to moderate demand-side policies such that AD does not become too high or too low, while using supply-side policies to ensure that the growth caused by rising AD is sustainable at low inflation rates. Macroeconomics: Keynesian and Neoclassical Perspectives: In general, Keynesian economists believe that: o Markets, esp. labor markets, do not clear and are slow to adjust without external intervention. o An economy can be in equilibrium below Yf, if demand is deficient, leading to involuntary cyclical unemployment. o Govts can and should intervene to stabilize the economy if it is below Yf. o Fiscal policy is more effective than mon. policy, and control of the economys growth to prevent excessive cyclical fluctuations is the best way to achieve ec. growth.

Inflation is usually caused by cost-push and demand-pull factors. o The move from SRAS to LRAS is slow, as nom. wages are slow to adjust. In general, Neoclassical economists believe that: o Markets adjust quickly and allocate resources effectively, and expectations adapt very quickly. o Economies tend towards Yf in the LR, as prices and wages change quickly o Inflation is generally caused by money supply growth in excess of GDP growth; reducing the growth rate of money supply will lead to lower inflation without more unemployment in the LR. Inflation makes firms uncompetitive, discourages investment, and thus must be kept under control; to do so, govts must control the money supply. Govts should limit intervention in the economy as a whole to controlling inflation by limiting money supply growth. o The adjustment from SRAS to LRAS is quick; nom. wages are quick to adjust.

The Business Cycle: o In MDC economies, we generally observe a pattern where periods of rising growth are followed by periods of slowing and sometimes falling growth; this is known as the business cycle (trade cycle) Business Cycle: The periodic fluctuations in a countrys econ. activity measured by changes in real GDP. The phases of the business cycle are known as boom, recession, trough and recovery; while the fluctuations are highly irregular in practice, we illustrate the business cycle using a standard periodic cycle. In the recovery phase, AD increases and the scale of total output expands. Consumption and investment rise, resulting in higher levels of AD and GDP. o To meet the increased AD, firms take on more workers; thus, unemployment falls. The newly-employed workers spend their incomes on durable goods and the process repeats itsekd. However, capacity constraints in the econ. will eventually slow down growth rates and lead to inflationary pressure. o GDP will reach its highest level at the peak of the cycle (the boom). However, demand for money for investment will likely increase interest rates; the combination of higher inflation and

higher interest rates will ultimately cause consumption and investment to fall. This is the beginning of the recession phase of the cycle. Recession: Two consecutive quarters of negative GDP growth (i.e. falling real GDP). During a recession, consumption and investment fall; falling AD will lead to firms laying off workers- thus, unemployment rises. If more people are unemployed, still less consumption will occur; low levels of demand result in low inflation rates, and potentially deflation. At some point, the contraction will come to an end; this is known as the trough phase. Output cannot continue to fall indefinitely, as there will always be some employed people to maintain a given level of consumption, foreigners will demand exports, govts will run deficits in order to spend, and people will be able to use savings to finance consumption. The low demand for money will lead to low IRs; thus, AD will eventually increase, the economy will enter the recovery phase, and the cycle will perpetuate. The second diagram is at a higher level of real GDP than the first, and each boom is higher than its precedent. This illustrates the fact that economies go through periodic real GDP fluctuations around their long-term potential growth trend (in the simplified diagram, the periodic actual output curve increases symmetrically along the potential growth rate). The periodic growth fluctuations are known as the actual output line, while the economys long-term potential is shown as a steady rise in output (the potential growth rate that the economy can sustain over time; this is not sustainable development!) Output gap: The difference between pot. and actual output. Output gaps may be negative or positive. If negative, the economy is producing below pot. output and unemployment is likely to be an issue; if positive, the economy is producing above pot. output (i.e. beyond capacity) and inflation is likely to be an issue. o This relationship illustrates the possible short-run tradeoff between inflation

and unemployment in macroeconomics. When operating below potential, unemployment will be a problem, while, when operating above potential, inflationary pressure (a rising rate of inflation) will occur. There are no straight answers as to the length and magnitude of a typical business cycle; one theory (among many) speculates that a countrys business cycle may be related to its electoral cycle (the political business cycle theory). o Acc. to the theory, a govt will stimulate the econ. with expansionary policies to create a boom before an election, and put into place less-popular contractionary policies after having been elected. Such policies are often criticized, as they can widen the magnitude of the cycle, with higher unemployment and inflation levels than there would be, were the economy left on its own. In addition, the political business cycle, though compelling, is likely not the only explanation for the occurrence of business cycles; another theory is the multiplier/accelerator model. o In practice, it is difficult to tell which phase of the business cycle the economy is in, as the various indicators of a countrys economic health are not synchronized with the business cycle, and it is therefore difficult to establish causal relationships between the various indicators. We distinguish between: Leading indicators: Give an indication that an expansion/contraction may occur in the future (e.g. business confidence, house purchase trends) Coincident indicators: Show when an expansion/contraction is occurring (e.g. sales data) Lagging indicators: Follow the expansion/contraction (e/g/ unemployment; firms are reluctant to lay off workers until they are convinced that the economy is in a recession, and are slow to re-hire workers until they are convinced that the econ. is recovering). Business Cycles and International Economics: o During an expansionary phase, when GDP is rising, an economy tends to purchase more imports of goods/services, as income is

a major det. of consumption, and consumption rises as incomes rise; much of what consumers purchase is likely to be imported. Even if the final products are produced domestically, they will most likely be produced with subcomponents/raw materials of foreign origin. Thus, as incomes rise, import spending is likely to rise. Also, as inflationary pressure builds during an expansion, the process of a countrys exports rise, making its exports less competitive on world markets and usually leading to a fall in export revenue. Thus, in an econ. expansion, import expenditure rises and export revenue may fall, worsening the balance of trade in goods and services and potentially the curr. acc. balance. During a contractionary phase, the opposite occurs; import spending may fall as people can afford fewer imported goods/services; exports may become more competitive internationally due to lower prices, which usually leads to greater export revenues; thus, the curr. acc. balance may improve. Four of the five macroeconomic policy objectives of govts are linked to the business cycle; as it is difficult to achieve all of the goals simultaneously, there exists conflict b/w policy objectives, thus: Goal: Expansion: Contraction: Ec. Growth Achieved: GDP Not achieved: GDP rises falls Low Unemployment Achieved: more Not achieved: workers are workers are laid needed to off when less produce the output is growing output demanded Low and Stable Not achievedAchieved: inflation Inflation Rates inflationary falls pressure builds Favorable Balance of Not usually Achieved: the curr. Payments Position achieved- the ac. improves. balance of trade usually worsens

The Multiplier: o If the govt decides to fill a deflationary gap by increasing expenditure, the final increase in AD will exceed the amount initially spent.

Any increase in AD will result in a prop. larger increase in natl income, assuming spare capacity exists. This is explained by the multiplier effect, which is closely related to the circular flow model of natl income. Govt spending and private investment are injections into the circular flow; any injections are multiplied through the econ. as people receive a share of the income and spend a portion of what they receive. If a govt spends $100 million building schools, the money goes to many people as payment for the FoPs that they provide; this includes income for labor provided on the project (e.g. by plumbers and architects) as well as payments to providers of capital and raw materials (e.g. concrete, steel, minerals, water and electricity). The $100 million ends up as income for those who provided the FoPs for the construction project; these people can either save the income, spend some of it on foreign goods/services, pay some to the govt as taxes, and spend the rest on dom. goods and services. In the first three cases (all three withdrawals from the circular flow), the income leaves circulation; the money that is spent within the economy becomes the income of a new set of consumers, who behave the same way: pay some as tax, spend some on imports, save some, and spend the rest on dom. goods/services. During each round of spending, some income is withdrawn from the circular flow and some is re-spent. If the govt spends $100 million on the economy and the marginal propensity to withdraw (the proportion of every additional unit of income received that consumers will spend on imports, pay as taxes, or save; MPW=marginal propensity to save + marginal rate of taxation + marginal propensity to import) is 40%. o Thus, the remaining income (60% of all additional income) is spent on dom. goods and services; this is known as the marginal propensity to consume: Marginal Propensity to Consume: The proportion of every additional unit of income received that consumers will spend on dom. goods/services. o In our example, when the govt spends its $10^8, it goes to architects, plumbers, capital suppliers, etc, who cause a leakage of $4x10^7 from the circular flow via imports, taxes and savings. The rest is spent on a wide range of dom. goods and services (e.g. food, clothing, entertainment, repairs). The recipients of this $60 million behave likewise, with 40% ($3.6x10^7) remaining in the circular flow and being re-spent and the rest leaking from the circular

flow. This process continues until, after an infinite number of rounds of spending, there is no income from the original injection in circulation. The final addition to GDP, once the money has been spent and re-spent, amounts to $250 million (2.5x the value of the original expenditure). Thus, the multiplier in our example = 2.5; any injection into the circular flow would contribute 2.5x its amount to GDP. The multiplier may be found using a series of formulas, using the values of the marginal propensity to consume or the marg. prop. to withdraw. . In an economy with mpc=0.5, the multiplier is equal to 1/.25 = 4; if $50 000 is invested, GDP will increase by $200 000, in total. Any change in withdrawals from the circular flow will alter a countrys multiplier; if taxation rates increase, the multiplier will decrease, if savings rates decrease, the multiplier will increase, and if mpm falls, the multiplier will increase (and vice versa, in all of the above cases). The multiplicative effects of a round of spending can be shown using an AD/AS diagram, with progressively smaller rightward shifts in AD. If a govt plans to intervene to fill a deflationary gap, it must be aware of two things: An estimate of the gap between equilibrium output and Yf. An estimate of the value of the multiplier, such that it can judge the increase in AD necessary to inject into the economy such that the gap is filled. o Determinants of the size of the multiplier: If the economy is open, rather than closed, consumers will purchase imports, reducing the amt. of money passed on at each stage of the mult. process; i.e. MPC decreases, reducing the multiplier.

Interest rates: Higher IRs may encourage more saving and less spending, reducing the multiplier. Tax rates: With higher tax rates, more of each pound is given to the govt and less is spent on dom. goods/services, reducing the multiplier. Marginal propensity to import depends on: Relative prices of UK and foreign goods: to a large extent, this will be dependent on the ER. Quality of the goods and services produced dom. and abroad. Incomes (both domestic and foreign) Interest rates: If overseas rates are high, domestic residents will want to save abroad and money will leave the economy; as the currency will decrease in value, however, import expenditure may eventually fall to compensate. Speculation: If people think the dom. currency will fall in value, thet will sell it now and buy foreign currency (and vice versa). The difficulties in estimating either of these values illustrate a limitation of govt fiscal policy aimed at managing AD in the econ.

The Accelerator Effect: o Firms must always engage in replacement investment to replace capital that is depreciating. Depreciation: The loss of value by capital equipment over time

Assuming that firms are working at full capacity and spending a constant amount on investment to maintain the level of existing capital, a rise in GDP will cause investment to accelerate. Income is a determinant of consumption; thus, when GDP rises, ceteris paribus, consumer demand will rise. If firms are producing at capacity, but wish to increase output to meet rising demand, they will need to increase the level of investment to increase capacity; thus, they will have the incentive to invest in new capital equipment to meet the increase in demand. This is known as induced investment; firms are induced to buy new equipment to expand capacity. Induced investment is also counted as net investment, as it represents investment beyond the level needed to replace depreciated capital. o Gross investment: The total level of investment. o Net investment: Investment which causes an increase in the capital stock, rather than simply replacing depreciated capital. Assume that a firm manufactures bongs, with an annual demand of 200 000 units/year, and operates 20 machines to meet this demand. Each machine costs $20 000, and the firm must replace 1/10 of its machines per year due to depreciation (the level of technology, and thus the capital/output ratio, is assumed to be constant and capital is assumed to be homogeneous). For a more realistic example, take dishwasher and steel-manufacturing firms with Illinois. o If AD rises such that demand for bongs rises by 5% to 210 000 units, the firms existing machinery is not able to produce the extra amount of bongs; thus, if the firm wishes to meet this demand, it will need to invest in new capital. o To maintain the original capital/output ratio of 10:01, the firms will need a total of 21 machines. Usually, the firm spends $40 000 on machines to replace depreciated capital; due to increased demand, however, the firm is induced to invest in one additional machine; thus, investment rises by 50% to $60 000 worth of capital. A reasonably small (5%) increase in demand has led to a 50% increase In investment; investment thus accelerated when demand rose. o Conversely, if the level of demand faced by a firm begins to stagnate, the demand for investment will decrease, even if the demand for bongs is still increasing, because fewer new machines in induced investment are needed to supply the output. As this will mean that capital producers face severe cutbacks in demand, thereby likely losing significant amounts of revenue, they may be forced to lay off

workers, whose demand for bongs will fall. If demand for bongs falls by enough that QD returns to its original level, the bong producer would no longer partake in induced investment, and the capital producer would need to lay off increasingly more workers. In addition, if demand falls by enough that the firm has excess unused capital (which the model assumes is not initially the case), they may not need to partake in replacement investment, either, reducing the revenue of the capital producer to 0. If this cycle continues, the economy is likely to go into a recession, with falling levels of income due to lower revenues in both the bong-making and capital-making firms. However, because some replacement investment will eventually need to occur, the recession will eventually end as firms begin investing in capital again. Likewise, as the induced investment is subject to the multiplier effect, any increases in induced investment will affect GDP still further. This is known as the multiplier/accelerator effect and can explain the upward momentum in the recovery phase of the business cycle (the same relationship in reverse, as explained above, can also explain the movement of an economy into a recession caused by falling AD). Thus, the level of induced investment will be dependent on the rate of change of natl income: when GDP rises rapidly, firms will want to meet increasing demand by expanding their capacity; however, when GDP growth rates fall, businesses will no longer need to add to capacity; investment will return to the original replacement level. On an AD/AS diagram, the crucial relationship to note is the effect of increased (or slowing!) GDP growth on interest rates; in the first case, AD will shift to the right by progressively larger amounts as demand for investments rises. In the latter case, however, AD will shift right by prog. smaller amounts as investment stalls and may eventually shift left as the econ. enters a recession. Limitations of the Accelerator Model:

Firms often have stocks; if demand increases, they can release stocks, rather than produce more after having invested. The capital goods industry may not be able to increase supply; even if firms want to buy more machines, they may not be able to, esp. in the SR. With tech. changes, the capital/output ratio may change and firms may not need to invest as much as before Firms need to be convinced that the increase in demand is long-term; otherwise, they may be reluctant to invest and will try to meet demand using overtime.

Chapter 19: Inflation and Deflation Inflation o One policy objective that a govt can pursue is price stability (a low and stable inflation rate) o Inflation: A persistent increase in the avg. price level in the economy, as measured by the Consumer Price Index. The operative word is persistent; a single increase in prices is not inflation, as inflation is a sustained increase in the price level. Inflation is NOT simply an increase in the price of a particular good/service. We recognize several types of inflation: Creeping inflation: slowly increasing inflation rates (e.g 5%->6%) Strato-inflation: High rates of inflation (e.g. 10%-50%). Hyperinflation: Extremely high inflation rates (e.g. thousands of %; Hungary in 1945). o Costs of inflation: The reason that govts wish to have low inflation rates is b/c there are several significant neg. consequences of high levels of inflation, which include: Loss of purchasing power: If the inflation rate is 3%, the avg. price of all goods and services in the economy has risen by 3%; if incomes remain constant, consumers will be unable to buy as many goods/services as they had before the increase in avg. price level. o There is a fall in real income; thus, there is a decrease in the purchasing power of income, due to inflation. o If incomes are linked to the inflation rate, such that workers are offered cost-of-living increases in line with rising inflation, they may not face a fall in real income; this is the case for many jobs, esp. if strong unions exist. o However, many jobs do not offer the security of inflation-linked incomes, either b/c workers are on fixed incomes or b/c they are self-employed.

Inflation reduces the purchasing power of their incomes, and thus their living standards; income may be redistributed in a way that runs counter to govt policy. o Inflationary expectations are important, in this case; even when peoples incomes are linked to inflation, they can be neg. affected if the actual inflation rate is higher than the expected rate (e.g. if inflation is predicted at 1% and is actually 2%, workers with inflation-linked incomes that rise 1% will still suffer a loss of purchasing power). Decrease in the value of money, reducing its effectiveness as a: o Medium for exchange: people become less willing to exchange their goods/services for money, reducing the effectiveness of markets. o Store of value: With inflation, money loses value at a greater rate; people will become less willing to hold on to money, often purchasing assets instead, reducing the supply of loanable funds available for investment. o Unit of account: With inflation, it becomes more difficult to measure the value of products in terms of money o Standard of deferred payment: If money decreases in value, people will be less willing to accept it as payment after a job is completed, as it will be worth less by that time; this occurrence will have neg. ramifications for ec. growth. Detrimental effect on saving: If money is saved in a bank at a nominal interest rate lower than the inflation rate, the real interest rate (interest rate adjusted for inflation; i.e. nominal interest rate minus inflation rate) will be negative; the savings would lose purchasing power over time. o In this case, consumers would be better off spending their money than saving it, as it will have lost some purchasing power. o Thereby, inflation discourages saving; if people do save money, rather than spend on consumption, they might buy fixed assets (e.g. land, gold), whose value is not as strongly affected by inflation. Thus, there are fewer savings available for investment in the economy, which has neg- implications for ec. growth. Detrimental effect on interest rates: Commercial banks earn money by charging interest on loans. If there is a high inflation rate, banks raise

nominal IRs (thereby deterring consumption and AD) to ensure that the real IR that they receive remains positive. Detrimental effect on intl competitiveness: If a country has higher inflation rates than its trading partners (ceteris paribus), its exports will be less competitive and imports from lower-inflation trading partners will become rel. more attractive; this may lead to lower export revenue and higher import expenditure, worsening the trade balance, and may worsen unemployment in export industries and dom. industries competing with imports. Uncertainty: Firms may be discouraged from investing not only due to a fall in availability of savings and higher nom. interest rates, but also due to uncertainty as to future price and cost changes; this will negatively impact ec. growth. Labor unrest: This may occur if workers feel that their wages/salaries are not keeping pace with inflation, and may cause disputes b/w unions and mgmt. Shoe-leather and menu costs: With inflation, it is likely that consumers will need to search for good returns on their savings to protect their earnings from inflation; these are known as shoe-leather costs. Menu costs are the added costs to firms of changing prices in advertisements and displays. Many of the costs of inflation depend on whether inflation is anticipated or unanticipated; volatile inflation makes it difficult for firms and individuals to plan and predict costs in the short and medium term. o With volatility, businesses and households will take steps to protect their interests; this will likely result in reduced rates of growth combined with increases in unemployment, as consumption and production are reduced to safe levels. Deflation: A persistent fall in the avg. price level in the economy. o Two broad explanations for a fall in the price level exist, which economists use to classify good deflation and bad deflation: Good deflation: The situation where deflation occurs as a result of supply-side improvements and/or increased productivity. An AD/AS diagram can be used to show that an increase in LRAS can result in an increase in real output and a fall in avg. price level. o If the real output level increases, we can add. that there is a lower level of unemployment as more workers are needed to produce the higher output level. Bad deflation: The situation where deflation is caused by deficiencies in AD. Another simple AD/AS diagram may illustrate that a fall in AD will cause a decrease in price level as well as a decrease in real output.

If real output decreases, it is ass. that unemployment levels will rise, as firms need fewer workers to satisfy the lower demand. Both causes of deflation will lower the avg. price level; however, the first is pos. as it results in an increase in real GDP and a fall in unemployment, while the second is neg. as it results in a fall in real output and a rise in unemployment. DO NOT confuse deflation with a falling inflation rate; again, this is where it pays off to know your calculus. Inflation is the situation where the first derivative of the avg. price function is positive; i.e. avg prices are increasing, deflation occurs when the first derivative of the avg. price function is negative (i.e. falling prices), and disinflation occurs when the inflation rate is falling (i.e. the rate at which the rate at which prices are changing is falling; the second derivative of the average price level function) When disinflation occurs, prices fall at a lower rate than they had been falling at previously. Costs of Deflation: Although consumers may be pleased, at first, to see falling prices, many problems are associated with a persistent fall in the price level; it may well be that the costs of deflation exceed those of inflation. Costs include: Unemployment: The single greatest issue associated with deflation; if AD is low, businesses are likely to lay off workers, which may lead to a deflationary spiral: if prices fall, consumers will put off the purchase of durable goods as they will want to wait until prices drop still further. This is known as deferred consumption and is rational- to an extent. Deferred consumption will further reduce AD; if households become pessimistic about their ec. future, cons. confidence will fall. Low cons. confidence will likely further depress AD, and a deflationay spiral will perpetuate. Deleterious effect on investment: Where deflation exists, businesses make less profit, or make losses, as their nom. costs rise, while nom. prices are constant in the SR; this may lead to layoffs. In addition, business confidence will likely be low, which will likely result in reduced investment. This has neg. implications for future ec. growth. Costs to debtors: Anyone who has taken a loan (including mortgages for housing) suffers due to deflation as the value of their debt rises. If profits are low, it may be too difficult for businesses to repay loans, and many bankruptcies may occur; this will further worsen business confidence and may perpetuate a deflationary spiral. The danger of a liquidity trap(a situation where monetary policy- either decreases in the IR or increases in money supply- fails to stimulate an economy) occurring increases, as expectations of falling returns on investment, as well as decreased consumer and business confidence, make consumers and producers less willing to take out a loan, even when IRs fall significantly (a large-scale decrease in interest-rate elasticity of investment occurs).

Due to these costs, govts will often want to reduce deflation; the most common way that this is done is through expansionary demand-management policies, used to stimulate consumption, lending, or govt expenditure. In brief, any policy that encourages consumers to spend, rather than save, their money should reduce deflation by causing AD, and thus avg. price level to rise; this can be shown on an AD/AS diagram. Causes of Inflation: o These can be divided into three main types; these are: Demand-Pull Inflation: Inflation that occurs as a result of increasing AD in the economy, usually due to expansionary govt policies and/or increased consumer spending (e.g. due to increased cons. confidence). When illustrated on a Keynesian AD/AS diagram, this can occur when the economy approaches Yf and AD increases (due to changes in any of its determinants), or when the economy is at Yf and AD increases. o If there is a small amount of spare capacity in the econ. an increase in AD will cause both price level and real output to rise. o At full employment, where no spare capacity exists, the economy cannot expand output to meet increasing AD; in this case, any increase in AD will be purely inflationary, as FoP prices are bid up by competing producers, but no further goods can be produced using the total FoPs. o In each case, an increase in AD pulls up the avg. price level; the reasons for the increase could be due to changes in any components of AD; for instance, due to a high level of cons. confidence, causing consumption to increase, or due to rising demand for a countrys exports due to rising GDP abroad, or due to an increase in govt expenditure, etc. Cost-Push Inflation: Inflation that occurs as a result of an increase in prod. costs. An increase in prod. costs causes SRAS to shift left (SRAS1->SRAS2, if one were to graph it), resulting in an increase in avg. price level and a fall in real GDP. o The causes of cost increases derive from the respective costs of a countrys FoPs. Increases in inflation due to increases in labor costs are referred to as wage-push inflation. Increases in the costs of dom. capital, components or raw materials (e.g. due to suppliers gaining monopoly power via mergers and takeovers) also increase firms prod costs, creating cost-push pressures.

If a govt places indirect taxes on important raw materials, cost-push inflation may also occur. Inflation due to increases in the costs of imported capital, components or raw materials is referred to as import-push inflation. A fall in the value of a countrys currency, whether intentional or due to market forces, can cause import-push inflation, as a lower ER renders imports of capital, raw mats. and components more expensive, increasing prod. costs for most firms. Inflationary Spirals (Demand-Pull and Cost-Push Inflation Combined) Regardless of the source of the price level increase, inflation is problematic as it tends to perpetuate itself. This can be shown using an AD/SRAS diagram. If AD increases due to increased wealth in the econ. (e.g. due to rising house prices) then, if the econ. is near full employment, the increase in AD leads to demand-pull inflation and a rise in avg. price level (p1->p2). o The higher price level means that costs of FoPs, and thus prod. costs, rise. Also, because of price level increases, workers will negotiate higher wages, further increasing prod. costs. As a result of cost-push pressures, SRAS will shift left (SRAS1->SRAS2), further raising the price level (p2->p3). This is not the end of the cycle: higher nom. wages may give households the illusion that they have more spending power and encourage increases in consumption, further increasing AD (AD2->AD3) and price level (p3->p4); the inflationary spiral perpetuates itself. Inflation due to excess mon. growth: Monetarist economists (an offshoot of the Neoclassical school) have identified a further cause of inflation. Quoth Milton Friedman (an adherent to this view): Inflation is always and everywhere a monetary phenomenon. o Monetarists believe that the link between money supply and AD is not only indirect via IRs and investment, but also direct (i.e. given excess liquidity, households and firms spend more on goods/services) o Monetarists argue that excess increases in the money supply by govts are the leading cause of inflation (while rising costs and AD can cause temporary bursts of inflation, a long-term price

increase can only be sustained if the money supply is expanding). If money supply increases (which can be shown on a loanable funds diagram), the interest rate (price of money) will decrease, encouraging higher consumption of durable goods and investment and thus causing AD to rise. Acc. to monetarists, if the income velocity of circulation (the avg. number of times that one unit of currency must be spent in one year to buy up the economys output) and the number of transactions of final products are constant, then the quantity of money and avg. price level are directly related; i.e. an increase in money supply will cause an increase in avg. price level. IVC will be constant if the rate at which money is spent does not change by much over time. The number of transactions on final products will be constant when the econ. is near Yf, which implies that the output level and thus number of transactions in the econ. cannot rise significantly, esp. in the LR. As monetarism is a branch of Neoclassical economics, we use the neoclassical AD/AS diagram to illustrate this point. As money supply increases, AD shifts right (by a relatively large amount, as investment is, for monetarists, interest-elastic and not vulnerable to changes in expectations); because the econ. rests in equilibrium at Yf in the LR, increases in AD due to increases in money supply are purely inflationary, causing pricelevel increases (P1->P2). The Keynesian response to this theory is that the IVC can change (with more money circulating, people will be more likely to hold on to money) and that an increase in money supply could lead to greater output, rather than be purely inflationary (i.e. when spare capacity exists).

Reducing Inflation: o The appropriate inflation-reduction policies depend on the type of inflation; as demandpull inflation is caused by excess AD, an appropriate response would be a reduction in AD; the govt could use deflationary fiscal policy (increase taxes and lower govt expenditure) and/or deflationary mon. policy (raise interest rates and contract money supply). There are problems associated with such policies; first, they are highly pol. unpopular- the electorate is unlikely to be happy to accept higher taxes if their disposable income and level of cons. is reduced. A reduction in govt spending will harm a number of groups in the country, which may reduce pop. support for the govt.

Higher IRs will also harm debtors (anyone who has taken out a loan/mortgage in the economy), as repayments on the loans will increase- a further cause of the policies unpopularity. Thus, a govt concerned about re-election will be reluctant to combet inflation using those methods. However, mon. policy is carried out by central banks which, in most industrialized countries, are independent bodies whose main goal is the maintenance of a low and stable inflation rate. o In many countries, the CB sets an explicit target rate of inflation and uses changes in IRs to keep inflation within the targeted range.; other central banks, incl. the ECB and the Fed, have implicit target inflation rates; thus, the target rate that the CBs choose is not officially stated. Central banks are usually independent because govts tend to use mon. policy to pursue SR pol. objectives, which may result in persistently high inflation rates as govts running for reelection are reluctant to adopt contractionary policies (eg. raise IRs) to fight inflation. o As a result of greater CB independence and inflation targeting, many countries have successfully avoided high inflation rates. o Targeting inflation, whether implicitly or explicitly, s beneficial as it reduces inflationary expectations; as long as people have faith in the CBs ability to contain inflation, they will not expect higher inflation rates and will not make demands for wage increases out of line with predicted inflation rates. This will keep labor costs from rising explicitly, thus suppressing cost-push inflationary pressure. o The more independent the CB, the more likely it is that prices will be stable. If inflationary pressure builds up and inflation rises, one solution is an increase in IRs. CBs keep a close watch on signs of inflation and are ready to raise IRs to reduce inflationary pressure; while a govt may be reluctant to do so, a CB can make the pol. unpopular choice as it is appointed, rather than elected. o In the past, price and wage controls were used to control inflation (this strategy was, in fact, effective, if executed correctly; e.g. in Nazi Germany under Schacht); however, it is very unpopular nowadays as it involves direct govt intervention on markets. Specifically, the goal of this policy was to control price and wage growth rates. However, the policies could be

easily circumvented via illegal markets, extra benefits for workers, overtime and holiday-pay fraud, prevented firms for attracting the labor they needed through higher wages, and caused industrial relations problems, as well as sudden surges in wages and prices (pot. causing inflation) when the policies were loosened If inflation is due to high import costs, increasing the value of the currency will reduce import prices and demand for dom. exports; however, this strategy may have consequences for dom. employment. Nowadays, mon. policy is considered the most effective demand-management policy and IR changes are seen as the best weapon against inflation. Fiscal policy may not be as effective as mon. policy in fighting inflation as it is difficult for govts to lower spending or taxes due to their commitments to the public; even if this were possible, it would take a long time for the cuts to have any effect on price level. If inflation is of a cost-push nature, deflationary demand-side policies may reduce avg. price level, but they will also lower real GDP and likely cause unemployment to rise. In this case, demand-mgmt policies are less effective than supply-side policies. However, if inflation occurs, it is often difficult to distinguish demand-pull from cost-push factors, and policymakers will likely attempt a range of solutions; indeed, a balance between the two types of policies is desirable, as increased output produced at a lower cost allows an economys prod. capacity to expand without causing accelerating inflation. Monetarists, who believe that inflation is caused by excess monetary expansion, see a plain solution: the money supply should not increase by more than the increase in real GDP (if GDP rises by x%, the money supply should also rise by x%). o If the growth of money supply exceeds GDP growth, too much money chases too few goods, and prices will rise to allocate the scarce output. It is in

practice difficult for govts and/or CBs to control the money supply in the economy; the ways in which this is possible are discussed above (Chapter 16). Measurement of Inflation: o It is necessary to have some accurate measure of the increase in avg. price level. The most-commonly-used statistic that measures inflation is the Consumer Price Index (occasionally referred to as the Retail Price Index). Not all prices change by the same amount over a given time-period; e.g. the price of sugar may increase by 15% while wood prices may rise by 2%. Neither measurement is representative of the rate of change of average prices in the econ. Although the exact statistical methods of measuring inflation differ between countries (e.g. some countries may consider indirect taxes and mortgage repayments, while others may not), the central concept is the same: statisticians choose a representative basket of consumer goods and services and measure how the price of this basket changes over time. When the price of the basket increases, the implication is that the avg. price level has risen. o A representative basket of goods and services does not include all goods and services consumed; the number of data makes measurement of inflation by that method impossible. o Instead, the countrys statistical agency compiles a list of the typical cons. goods/services consumed by the avg. household. The items are grouped into categories, and their prices are measured each month to calculate the change in the price of the basket. It is changes in the avg. price of the basket of goods and services that are reflected by the CPI. The index is weighted by the proportion of the average consumers income spent on each category to account for the varying degrees of necessity/importance of the goods/services. For instance, changes in housing, transportation and food prices are weighted much more heavily than changes in clothing and recreation prices. The weight given to each category represents the proportion of the typical households income that is spent on goods/services from

that category; this will invariably affect CPI calculations. The components and weighting of the basket are determined by household surveys and will change along with consumption patterns, with items being added and removed. The baskets price is measured by collecting prices form retail outlets throughout the country, and a natl avg. price (the CPI) is determined; thus, changes in CPI reflect the headline inflation rate (the most commonly used measure of inflation in a countrys economy). Problems Involved with Measurement of Inflation: Measuring inflation using the CPI has one major limitation: while the basket of products used represents the consumption patterns of the typical household, this measure will not be applicable to all people; purchasing habits vary greatly. For instance, the cons. pattern of a family with children will be very different from that of an elderly couple or that of a Bachelor Frog. Inflation within a country may vary by region; although regional inflation figures are published, the national measure is by far the most widely-used, although it may not accurately reflect conditions in a part. area. o If the natl avg. is used as the basis for wage negotiations or pension changes, these might not accurately reflect living costs in certain regions and for certain groups. o This will be harmful if the group has a higher cost of living than suggested by the natl avg and benefit those whose living costs are less than the natl avg. Errors in data collection may limit the accuracy of the final results; because collecting the prices of all goods bought by households in all possible locations is impossible, it is necessary to take sample items from a sample of cities and retail outlets. The multiple sampling will likely lead to inaccuracies; the larger the sample, the more accurate the results, but thorough measurements entail a significant time investment and financial cost. Statisticians try to account for changing cons. habits by making changes to the basket; items are added and removed to be more representative of typical demand patterns.

However, the adjustments take a good deal of time, and if the items in the basket are changed, the ability of analysts to draw comparisons in price levels between time periods becomes more limited. This is complicated by changes in quality of goods over time: when a computer company upgrades a computer, for instance, the quality of the product improves, and its price may rise to reflect the improvement. o If the computer is in the CPI basket, the price change will contribute to a higher estimated inflation rate, even though the product had been altered. Countries measure inflation in different ways and include different components, pot. making intl comparisons problematic. Prices may change for non-sustained reasons. For instance, seasonal variations in the prices of food or volatile commodity prices may lead to anomalous and misleading changes in CPI. o Statisticians attempt to avoid such distortions by identifying a core rate of inflation that uses the data from the CPI but omits food and energy prices. The CPI only measures changes in consumer prices, but other price changes are also important in judging the progress and prospects of an economy. o Thus, economists also measure changes in prices for producers and commodity prices (one such specific measure is the GDP deflator, used to adjust the natl income of a country for inflation). These measurements provide economists with a forecast of possible cost-push pressures.

Chapter XX: Unemployment A low level of unemployment is one of the main macro. goals of any govt. Unemployment s a significant issue, and a low and falling unemployment rate is usually seen as a sign of improved econ. health. There are several key points and issues associated with unemployment that are worth mentioning: o Unemployment essentially means joblessness, although the actual definition is far more nuanced. o A change in the unemployment rate of even 0.1% is considered newsworthy. o The unemployment rate is affected by the rate of job creation in the econ. o The number of jobs created will vary between industries (e.g. mfg., services) and demographics (e.g. men, women). o While a country will publish a natl unemployment rate, the rates in different regions will vary from the natl avg.

Many factors, incl. raw material costs, ERs and intl ec. conditions, will affect the unemployment rate. o The unemployment rate will affect wage rates. Unemployment: The incidence of people of working age who are without work, available for work, and actively seeking employment. o Unemployment Rate: The number of people who are unemployed expressed as a percentage of the total labor force [Note: NOT the population]. o Total Labor Force: The economically active population: those who are of working age and are either employed or actively seeking employment. The working age, which varies b/w countries, is the specified age at which people are legally allowed to start work and receive retirement benefits. Anyone outside of this age is not part of the workforce. Students currently in school, as well as stay-at-home parents, retirees and those who choose not to work, or are unable to work, do not actively seek employment; thus, they are not part of the workforce. Although they do not have jobs, these groups are not considered unemployed, as they are not seeking employment and thus not in the labor force. As a result, it is difficult to measure the size of the labor force and the unemployment rate. Each country has its own natl system for measuring unemployment; information is usually gathered from natl censuses and surveys, along w/ admin. records and soc. security info. There may be inaccuracies in such data, and the specific definition of unemployment is inconsistent from country to country. o For instance, unemployment may be based on the people registered as unemployed (labor force survey; e.g. in Austria), or as the number of people receiving unemployment benefits (claimant count; e.g. in Belgium). In the UK, unemployment is defined as those who are in receipt of unemployment benefit and who are able to undertake any suitable work, excluding groups such as school-leavers and members of the labor force over 60 who are unemployed but not in receipt of unemployment benefits. o Even with those approaches, accurate measurement of true unemployment rates is difficult; e.g. the incentive to register as unemployed will depend on the availability and size of unemployment benefits. A person who is not entitled to any benefits has no incentive to register as unemployed.

In addition, the statistics omit the incidence of discouraged workers: those who have been unemployed for long enough that they have given up searching for a job, are no longer eligible for benefits, and are no longer part of the labor force.

Distribution of Unemployment: Besides the measurement difficulties, a further limitation of the unemployment rate is the fact that, as it is a natl average, the official unemployment rate (much like the headline inflation rate) is likely to gloss over inequalities among different groups in the econ. The national rate, therefore, is not an entirely accurate basis for making conclusions about different groups of people. Some of the typical disparities that exist among different groups of people in a country include: o Geographical disparities: Unemployment will likely vary quite markedly among regions in a country, as most countries have regions that are more prosperous than others; inner city unemployment, for instance, is likely much higher than suburban unemployment. o Age disparities: Unemployment rates in the under-25 age group are usually higher than natl averages due to frictional unemployment. o Ethnic differences: Ethnic minorities often face higher unemployment rates than the natl avg; this may be due to differences in educational opportunities, language/cultural barriers or, in some cases, discrimination and prejudices from employers. o Gender disparities: Unemployment rates among women tend to be much higher than rates for men in many MDCs due to differences in education, employer discrimination, or other social factors. Costs of Unemployment: Govts prioritize the reduction of unemployment levels b/c employment represents a sig. cost to the econ. The costs of unemployment increase the longer people are unemployed; the costs below are those of long-term unemployment The associated costs can be broken down into categories: Costs of unemployment to the unemployed themselves: The unemployed face several major costs. First they receive less income than they would if they were employed, even assuming that they qualify

for unemployment benefits; if no benefits are available, the situation is even worse. o A reduction in income implies a lower living standard for the unemployed and pot. also for their families. o The costs worsen the longer the people are unemployed; it is likely that a person who remains unemployed will become increasingly dejected and suffer from stress, and pot. anxiety and depression. Erosion of mental health can lead to relationship breakdowns and, on a broader level, higher suicide rates. Costs of unemployment to society: the social costs of unemployment are most apparent in areas with high levels of poverty, high crime and vandalism rates, increased gang activity, etc. While these problems are not entirely due to unemployment, researchers have found correlations between them and high unemployment rates. Costs of unemployment to the econ. as a whole: A PPF can be used to show the key econ. problem created by unemployment: if actual output is less than pot. output because some portions of the labor force are unemployed, the economy is foregoing poss. output, operating at a point within the PPF. o This loss of output, and income to the unemployed, will neg. affect the econ. as a whole. For instance, there is an opp. cost involved in govt spending on unemployment benefits. If the unemployed, who have lower incomes, pay less direct tax and consumer fewer goods (which are indirectly taxed), the govt loses pot. revenue; consumption also falls, decreasing AD and possibly beginning a positive feedback cycle. Thus, the govt may need to spend more money to resolve the soc. problems created by unemployment, which is in itself costly. Factors Affecting the Level of Unemployment: At any given moment, a number of people will be unemployed; this is referred to as the pool of unemployment. This pool will be in a constant state of change, as, at any time, some people become unemployed, while others gain employment. o The level of unemployment depends on the relationship between these two trends. If more people are becoming unemployed than gaining jobs, the unemployment level will rise; if more jobs are created, and more people are taking up jobs than losing jobs, unemployment will fall. These

movements are known as inflows and outflows into/from the pool of unemployment. Inflows into the pool of unemployment: People who have lost their jobs People who have resigned People who have left school but not yet found work People trying to return to work after having left it (e.g. stay-at-home parents returning to the workforce) Immigrants who have not yet found work. Outflows from the pool of unemployment: People who find jobs People who retire People who go (back) into education People who choose to stay at home and look after family. Emigrants to other countries People who give up the search for jobs. [Note: Other than the first point, the people are no longer listed as unemployed because they have left the labor force: they are no longer of working age, available for work and actively seeking employment o The inflows and outflows to/from the pool of unemployment affect the supply of labor in an economy at a given time; this, along with demand for labor, will determine employment and unemployment levels in an econ. Causes of Unemployment: Unemployment may be classified in two broad categories, which relate closely to the causes of unemployment. These categories are equilibrium and disequilibrium unemployment; to analyze each type, an understanding of the macroeconomic labor market is necessary. The labor market for an economy can be shown using a diagram, on which the Y-axis represents the price of labor, as measured by the avg. real wage rate. Average real wage rate: The avg. level of wages, adjusted for inflation. The X-axis represents the total quantity of labor in the economy; thus, the labor market represents demand and supply for all labor in the economy. Demand for labor is a derived demand, as firms only demand labor due to demand for the actual goods and services that they produce.

Thus, the demand curve, which is curved and slopes downwards, is called the aggregate demand for labor, as it includes the demand for all labor involved in the prod. of an economys output, rather than that for a specific type of worker. ADl includes demand for assembly line workers, school directors, porn stars, etc. The ADl curve shows the total demand for labor at any given avg. wage rate; the curve slopes downwards because, at a lower wage level, producers are more willing and able to take on more labor, and the QD for labor thus increases. o As the wage level increases, firms attempt to reduce the amount of labor that they use by laying off less-necessary workers and/or exploiting capital-intensive prod. methods. o ADl will shift right if: Labor, on average, becomes more efficient and thus less expensive (e.g. through increased use of capital, better training, and more effective management). If AD rises in the economy; i.e. if consumers, other firms, the govt, or foreigners demand more of an economys output. The aggregate supply of labor curve shows the total number of an economys workers that are willing and able to work in the econ. at any given wage rate; as the avg. wage rate increases, more people are willing to work; thus, ASL slopes upwards and is curved. o ASl is determined by: The flexibility of labor markets: how easy it is for firms to hire/fire employees. The size of the labor force (thus, the population size, the working age, and the retirement age; note that this does not preclude some unemployment from occurring). Working conditions and job security in the economy (this cuts both ways: with better working conditions and job security, people will be more willing and able to supply their labor, but firms may be less willing or able to employ the workers due to the probable increase in costs). The degree of information about jobs in the economy The ability of workers to take on particular jobs within the economy (e.g. there may be too many coal miners in the economy, or too few IT geeks).

Wages and job conditions in other countries which workers can emigrate to. Attitudes to work (e.g. attitudes towards women (and gays!) serving in the military). Tax rates on the incomes of employees. Note that an individual taking on a job incurs an opp. cost in the form of foregone leisure time; the decision whether or not to work will depend on the income and substitution effect. For example, if average real wage rates increase, The opportunity cost of leisure rises, as employees give up more money for every hour they are not working than they had been beforehand. Workers will, to an extent, substitute leisure for work. As more money is earned for every hour worked, an employee may feel that he or she can now work less hours and still earn a satisfactory amount of income. Usually, the substitution effect outweighs the income effect and people will want to work more hours when the wage increases; however, in practice (not shown by the ADl/ASl model), the income effect outweighs the substitution effect at high real wage rates and people may decide to work less when the wage increases; this would create a backward-sloping ASl curve. The labor market is in equilibrium where ADl=ASl; although it resembles any micro. supply and demand model, it is a macro. model, as it describes aggregates in the econ. The equilibrium wage rate is established by the interaction of ADl and ASl and usually noted We. In practice, labor markets are imperfect to some degree, due to several reasons, listed below; these reasons are potential causes of unemployment: o Imperfect information: Workers may not know what jobs are available o Immobility: workers may not be able to move from one job to another due to occupational or geographical immobility. We distinguish between: Occupational immobility: the situation where people cannot move from one job to another because they lack the right skills or do not know that the job exists. Geographical immobility: The situation where workers have difficulties moving between jobs in different parts of the country (e.g. because they may have children in

education, family and friends in their current location, or moving is too expensive due to removal costs and housing prices). o Employers may not be profit maximizers; they may pay more than they need to. Also, employees may not be rational in the economic sense: they may stay with a company which offers lower wages than other firms out of loyalty. o There may be monopoly buyers (monopsony in a particular type of labor; e.g. Springfield Nuclear Power Plant and reactor technicians) or monopoly sellers (closed-shop unions) on labor markets in the economy. o Exploitation: The situation where employees are paid less than their value; this often occurs if many employers in strong bargaining positions exist in the economy (e.g. if they are monopsonists-the major employers in significant industries). The labor market is a key element of the econ. and its ability to clear, which depends on the flexibility of wages, is important; if AD falls and there is an excess supply of labor, in a perfectly competitive world, nom. wages will fall and the labor market will clear; the econ. will remain at Yf. However: o Unions may fight any decrease in wages. o Wages are often negotiated in advance and may take time to fall; if wages do not fall, there could be extended periods of high disequilibrium unemployment. o While neoclassical economists believe that nom. wages and prices are flexible, and thus the econ. tends towards full employment, Keynesians believe nom. wages and prices are not always flexible and labor markets, as well as the economy as a whole, do not necessarily clear; the economy may be in equilibrium below Yf. Disequilibrium unemployment (sometimes known as involuntary unemployment): A situation where some condition prevents the labor market from clearing (reaching equilibrium); this form of unemployment is considered involuntary as workers are willing and able to accept jobs at the given real wage rate, but no job is available for them. Two types of disequilibrium unemployment exist: Real-Wage (Classical) Unemployment: Disequilibrium unemployment caused by trade unions, minimum wages and govt intervention interfering with the labor market (e.g. unemployment as a result of Pennsylvanias min. wage law. o This form of unemployment reflects the neoclassical view that, if unions negotiate wage rates above equilibrium, or if govts set

wages above equilibrium at the enforced wage level W1, ASl > ADl and unemployment (Qd->Qs) is created. In effect, this situation represents a surplus of labor on the market; unemployment is caused by there being more workers that seek jobs than firms are willing and able to hire at the imposed wage rates. The unions or the govt prevent the market from clearing. o Solutions to real-wage unemployment: The solution to real wage unemployment is clear; if unions are preventing labor markets from clearing, the govt could reduce their ability to negotiate higher wages; if the min. wage prevents the barket from clearing, it could be reduced or abolished. Both of the above represent supply-side policies. Several problems with these solutions exist. First, reduction of union power may be difficult. Further, such policies would, in effect, harm low-income workers the most; while high income workers are largely unaffected, the reduction of minimum wages will reduce income and living standards for min. wage workers. The policy could thus worsen income inequality in the econ. Cyclical (demand-deficient) unemployment: Disequilibrium unemployment caused by cyclical downturns in the economy (e.g layoffs during the 2008 Recession). o As the econ. moves into a period of slowing/neg. growth (e.g. a recession), AD tends to fall as consumers spend less on goods/services; thus, ADl will also fall as firms scale back production. o If the labor market is initially in equilibrium with an equilibrium wage level We, and the econ. slows down, ADl shifts left as firms reduce their output (ADl->ADl1). If labor markets functioned perfectly, the avg. real wage would fall (We->W1); however, this is not the case as wages are sticky downwards; while wages can easily increase, it is less likely that real wages will fall. This is due to several reasons: firms realize that paying lower wages will lead to discontent and reduced motivation among workers, which would reduce productivity and would be undesirable; in addition, firms may not be able

to reduce wages due to labor contracts and union power. o Thus, wages will likely remain stuck up at We, ASL will exceed ADl, and unemployment (Qs->Qd) will be created. o This form of unemployment is sometimes called Keynesian unemployment, as Keynes observed that, when an econ. operates well below Yf, high unemployment is a likely occurrence. o Solutions to cyclical unemployment: As the problem is due to a low level of AD, the solutions to this type of unemployment are expansionary demand-side (fiscal or monetary; increasing govt expenditure, lowering direct taxes or interest rates) policies by the govt which aim to provide more jobs. Equilibrium Unemployment (sometimes known as voluntary unemployment): The situation where unemployment exists, despite the labor market being in equilibrium (i.e. no cyclical or real-wage unemployment is occurring). This occurs as other types of unemployment occur even when the labor market is in equilibrium. At labor-market equilibrium, the number of job vacancies is the same as the number of people seeking work. o Where there is no disequilibrium unemployment, then, the economy is at full employment in terms of labor. o However, while jobs exist, people may be unwilling/unable to take the available positions. o Arguably, all equilibrium unemployment is voluntary, as: Frictional unemployment is voluntary, because people have decided to search or another job. Seasonal unemployment is voluntary because people have chosen to take a job in which they are only seasonally employed; they could take other work in the off-season. Structural unemployment is arguably voluntary if workers who have left a job in a declining industry are unwilling to accept a job at a lower wage rate in another industry. Although not equilibrium unemployment, real-wage unemployment may be seen as voluntary as workers or unions have decided to push up wages and volunteered some workers for unemployment.

o o

To illustrate this situation, we introduce a new curve to our labor-market diagram, showing the total labor force. While the ASl curve shows the number of people willing and able to work at every given wage rate, there will be, at any given time, more people looking for jobs than people who are willing and able to take the jobs available. While, at We, Qe people are willing and able to take jobs, unemployment equal to the distance between ASL and TLF at We (Qe->Q1) exists. What the diagram shows is that, because no labor-market disequilibrium exists, jobs are available, but (Qe->Q1) people are unwilling/unable to take them. For instance, even if job vacancies in the service industry exist, unemployed assembly-line workers are unable to accept the jobs as they lack the necessary skills; alternatively, if jobs are available at McDonalds, unemployed bankers might be unwilling to take them out of pride. Finally, jobs may be available in an industry, but imperfect information could restrict unemployed peoples access to them. In each of the above cases, the unemployed workers are unable (the assembly-line workers) or unwilling (the bankers) to take the available jobs. The ASL and TLF curves converge at higher wage rates; this is common sense- at low wage rates, fewer workers are willing to work; some people would rather be unemployed than take the available jobs. As the real wage rate rises, more people are willing to take the available jobs and the gap b/w the two curves decreases. Natural Unemployment: The sum of the three main types of equilibrium unemployment (frictional unemployment, seasonal unemployment, and structural unemployment). An economy is at full employment when the only employment that exists is natural unemployment. The common feature to all three types of natural unemployment is that jobs exist, but people are unwilling or able to take them. The solutions to each type of nat. unemployment are thus designed to increase the willingness and ability of the unemployed to

take the available jobs. As a result, ASl will shift right. o These solutions are thus labor marketoriented forms of supply-side policies, as they are designed to improve quality/increase quantity of labor. Again, we distinguish b/w market-oriented and interventionist supply-side policies. The interventionist policies rely on govt involvement on labor markets, while the market-oriented policies emphasize the importance of allowing the labor market to function freely without intervention. Frictional Unemployment: The short-term unemployment that occurs when people are in between jobs, or have left education and are waiting to take up their first job (e.g. college graduates looking for a job). This type of unemployment is clearly natural, as it is natural for people to leave jobs in the hope of finding better ones. Thus, it is not generally seen as a neg. outcome in a dynamic economy. If people leave a job, the ass. is that they will find a job where they can be more productive; as soon as such members of the LF get a job, they will be able to contribute more to the econ. Solutions to frictional unemployment: o Although frictional unemployment is not a serious problem in an economy, as it is short-term in nature, govts may act to reduce this level of unemployment if they believe that people remain unemployed for an unacceptably long time. Some economists argue that people have little incentive to find a job if the unemployment

benefits available to them are generous and allow them to take their time when looking. Thus, free-market economists argue that govts should lower unemployment benefits to encourage unemployed workers to take the available jobs, rather than allow them to wait for a better one to come along. If unemployment benefits were reduced, the unemployed workers may become more willing to work, thus shifting ASl right. o Sometimes the frictionally unemployed remain out of work because they are not aware of existing vacancies. In this case, frictional unemployment can be reduced by improving information flows between employers and the unemployed via job fairs, news papers, the Internet, and employment counselors; this represents a more interventionist solution. Seasonal Unemployment: Unemployment caused by demand for certain types of workers falling at certain times of the year. This is a natural occurrence in many countries (e.g. many construction workers are laid off during the winter in Poland, and farmers cannot harvest crops during winter). Seasonal unemployment is common in tourism: ski instructors will be unemployed in the summer and many lifeguards will be unemployed in the winter. Solutions to seasonal unemployment: o Such unemployment can be reduced by encouraging workers to take different jobs in the off season; for example.

via reduced unemployment benefits and greater information flows. Structural Unemployment: Unemployment caused when changes in the structure of an economy cause a permanent fall in demand for a particular type of labor (e.g. the collapse of the Walloon coal industry). This is by far the worst type of equilibrium unemployment, but is natural in a growing economy, where newer, dynamic industries (e.g. IT, services), will replace jobs in the mfg. sector (e.g. coal mining), causing unemployment. Structural unemployment is harmful as it results in long-term unemployment: people who lose their jobs in one area lack the skills to take the newly-created jobs (they lack the occupational mobility to change jobs). In addition, jobs may be created in one type of the country, while unemployment is concentrated in another region. If structural unemployment occurs on a rel. small scale (e.g. Flint, MI), it is known as regional unemployment, and the workers lack the geographical mobility required to seek employment elsewhere. Several causes of structural unemployment exist: o New technologies can make certain types of labor unnecessary. By definition, automation reduces demand for labor (e.g. ATMs largely replaced human bank tellers). This is known as technological unemployment. o Demand for a part. type of labor may fall due to lower-cost labor abroad. For instance, there is less demand for auto workers in the US as a result of competition with foreign manufacturing plants whose costs are lower, resulting in higher unemployment in the US auto industry.

Changes in consumer tastes can lead to a fall in demand for a part. type of labor; e.g. people in some areas, when given the choice, tend to consume alternatives to fossil fuel energy due to the neg. externalities involved with fossil fuel combustion; as demand for fossil energies has fallen in those countries, unemployment in coal mining has increased. Interventionist solutions to structural unemployment: The key to these solutions is increasing the occupational mobility of people, such that they become more able to take available jobs. o A long-term solution is educating people to be more occupationally flexible- as people in MDC economies will often have to change jobs several times in their lives, an ed. system teaching the skills required to adapt to rapidly changing ec. conditions would reduce structural unemployment. o Another strategy to improve occ. mobility is expenditure on retraining programs to help workers acquire the skills necessary to find new, stable jobs. Govts could also subsidize firms that provide training for their workers. o Govts could provide information about job vacancies and help the unemployed with job applications in industries that they are unfamiliar with. o If jobs exist in some regions but not others, govts might provide subsidies/tax breaks to encourage unemployed people to move to those areas, enhancing geographical mobility. o Govts (e.g. Germany, Austria) can support apprenticeship programs that

teach pot. workers the skills needed to enter the LF. o These solutions have two main disadvantages: first, they likely involve a high opp. cost as govts will have to forego spending in other areas or raise taxes to afford the strategies. Second, the policies are not very effective in the short term. Market-Oriented Solutions to Structural Unemployment- the key to this set of solutions (mainly supply-side policies) is increasing incentives for people to take up available jobs: o Market-oriented solutions for structural unemployment broadly resemble those for frictional unemployment: if govts reduce unemployment benefits or income tax, the unemployed may have a greater incentive to take up available jobs, by increasing the opp. cost of not working (this is only effective, however, if jobs that meet their skills do, in fact, exist) o Market oriented economists feel that govt intervention and labor regulations reduce labor market flexibility and discourage firms from hiring workers. They would argue that deregulation of labor markets (e.g. by loosening hiring/firing regulations by loosening legislative barriers) would create an incentive for firms to hire more workers, thereby reducing unemployment. The govt could legislate, for instance, to reduce barriers to people accepting jobs (e.g. closed-shop factories). o The cost of such policies falls on two groups. First, those who lose unemployment benefits will have lower

living standards, and the policy may increase income inequality in the econ. Second, labor market regulations are often put into place to protect workers from unfair treatment (e.g. being fired w/o due cause) and grant them decent working conditions (e.g. reasonable hours, vacation time, occupational safety). If labor markets are deregulated, working conditions for labor may worsen. Although unemployment might fall and GDP might rise, there may be a high cost to the workers themselves; again, this can contribute to income inequality, where the benefits of growth are not shared by all. Solutions to Regional Unemployment: o This set of policies, which aims to reduce unemployment and increase incomes in depressed regions/areas, contains varying degrees of marketoriented and interventionist elements, and includes: Subsidies and tax concessions: are often used to encourage new firms into the area and to encourage existing firms to hire more people. Provision of facilities in depressed areas (e.g. better infrastructure) Adjustment of tax rates such that firms in richer areas are taxed rel. more than those in less wealthy areas, creating an incentive to divert production,

and thus employment, to depressed regions. Regulation: the govt can make it more difficult for firms to expand in wealthier areas and easier for them to expand in poorer areas. Creation of enterprise zones (e.g. in Detroit): small districts in urban areas, which provide major incentives for firms setting up there (e.g. tax exemptions, less bureaucracy) Relative Effectiveness of Demand-Side and Supply-Side Policies in Reducing Unemployment: The solutions to unemployment are dependent on the type of unemployment; if an economy is experiencing cyclical unemployment due to an econ. downturn, demand-management policies would be suitable. o Several concerns relating to such policies arise: in order to use expansionary fiscal policy, govts may need to run budget deficits, spending more than their intake in revenues. This is not nec. a problem, esp. in the SR, but may lead to fiscal problems in the LR. If govts reduce taxes, consumers will not spend all of their additional disposable income, rendering the increase in AD rel. lower than with an expenditure increase, esp. as consumer confidence is usually low in a recession, making saving rel. attractive; this tends to depress AD. If govts lower IRs to encourage spending, there is no guarantee that consumption and/or investment will increase, esp. if there is low business confidence, as is often the case in a recession. Even when successful, there will likely be a lag before these policies come into full effect; it is possible that AD will increase after the economy had recovered, causing the stimulus to be inflationary. Another problem with the solutions is that, even at Yf, there will still be natural unemployment, which is best countered by supply-side policies.

Using demand-side policies against natural unemployment would be unsuccessful, as the economy is producing near Yf at full employment, rendering any further AD increases inflationary. In practice, it is difficult for policymakers to distinguish b/w the diff. types of unemployment, esp. as an economy usually suffers from several types of unemployment at once. Thus, govts usually use a mix of demand-side policies (to manipulate interest rates, narrowing business cycle fluctuations and reducing output gaps) alongside supply-side policies (to ensure that labor is skilled and flexible enough to adapt to changing ec. conditions, such that LRAS and ASl continuously shift right). Neoclassical and Keynesian Views of Unemployment: o Neoclassical economists believe that nom. wages and prices are flexible and adjust quickly, so that the real wage is at the right level to quickly achieve LR equilibrium in the labor market, which clears quickly and is either at or approaching Yf, even during periods of slowed or falling ec. growth. Thus, all employment is voluntary, acc. to this view. o Keynesians believe nom. wages are slow to adjust (e.g. due to money illusion, fixed contracts, or a desire by employers and workers for LR wage stability); thus, the real wage may not adjust to clear the labor market, leading to some involuntary (cyclical/demand-deficient) unemployment. Acc. to Keynesians, the issue of downward wage stickiness in a recession could take a long time to resolve itself, justifying govt intervention on labor markets. Crowding Out: A situation where govt expenditure financed by real borrowing from a fixed supply of loanable funds (i.e. deficit expenditure financed by loans) causes a decrease in privatesector consumption and investment (e.g. [arguably] the UK public sector in the 1960s). o As the money supply is fixed, by borrowing money through the sale of bonds and treasury bills to fin. institutions (who then sell them to potential savers), the govt increases demand for the loanable funds in the economy. Supply of loanable funds (which represents the total amount of savings available to fin. institutions in the econ.) is perfectly inelastic; thus, the only effect of the increase in demand for loanable funds by the govt (D0->D1) is an increase in the interest rate (i1->i2); thus, the price of

money, and therefore, the cost of borrowing money to consume durable goods/invest, increases. On an investment schedule, it is clear that the higher interest rate will decrease firms willingness and ability to invest (as the cost of investment- the interest rate- rises (I0->I1)). The higher interest rate causes AD to decrease (this may be shown on an AD/AS diagram, with an initial increase in AD followed by a subsequent, smaller fall in AD); while the govt attempted to stimulate AD by increasing govt expenditure, the higher IR caused interestsensitive private investment to fall (private investment was crowded out). The extent to which crowding out occurs is (surprise, surprise) hotly contested. o Keynesians believe that investment is motivated mainly by the need to replace depreciated capital and match increases in consumer demand. As firms have little choice in either task, investment is interest-inelastic and an increase in IRs will decrease investment by a less-than-proportionate amount. AD will not be greatly affected. In addition, because, below full employment, firms can fall back on stocks of products and reserve capital, Keynesians argue that crowding out is unlikely to occur below Yf. o Neoclassical economists, on the other hand, argue that firms tend to invest autonomously, choosing to expand their capacity and scale of output to become more competitive, and thus defer investment until interest rates fall, as they seek to minimize costs. Thus, investment is interest-elastic; an increase in IRs will reduce investment by a greater-than-proportionate amount, AD will significantly decrease (perhaps to the point where the increase in govt spending is fully canceled out), and thus crowding out is a major problem of increased govt spending. Economists have suggested two further forms of crowding out: Physical crowding out: If an economy is near its prod. capacity, increased spending on govt projects could see resources (esp. labor) diverted from the private sector to the public sector (the neoclassical school would argue that this effect causes an efficiency loss) Psychological crowding out: A situation where the private sector worries about what it sees as too much govt intervention in the econ.- fearing future tax increases, the private sector may delay/cancel certain projects.

Chapter 21: Phillips Curves Two major macroeconomic policy objectives are low and stable inflation rates and low unemployment levels. As should be utterly predictable by now, there is much debate as to the relationship between these two ec. problems. The Phillips Curve: An economic model which suggests that there is an inverse relationship between the inflation rate and the unemployment rate in the economy. o The original Phillips curve presented the argument that there was an inverse relationship between the rate of change of nominal wages (wages not adjusted for inflation) and the rate of unemployment. The reasoning behind the model was that, at low unemployment rates, firms would need to pay higher wages to attract labor. Conversely, if unemployment was high, workers would be competing with each other to obtain the available jobs, keeping the level of nom. wages offered rel. low. During an econ. expansion, when more output is demanded and more workers are needed, wages rise more quickly than they would in the case of a contraction in ec. activity and lower AD. The rate of change of money wages could actually become negative- wages could fall at high unemployment rates as workers would be willing to accept the higher wages rather than remain unemployed. The relationship was later adapted using data from many countries and revised to establish an inverse relationship b/w the inflation rate and unemployment rate of the economy, due to the fact that, as wages represent a large share of firms costs, wage changes contribute directly to changes in the price level. The resulting Phillips curve can be inexactly approximated by the equation y=(1/x)-1, with the inflation rate on the Y axis and the unemployment rate on the X axis o In the short run, a Phillips Curve will intersect the horizontal axis at the natural rate of unemployment. This graph shows a tradeoff between inflation and unemployment; the inflation rate would need to rise in order to achieve a fall in unemployment, and vice versa; as one variable decreases, the other increases. o Thus, if a govt aims to reduce unemployment, this can be done at the expense of a higher inflation rate; if the govt wishes to reduce inflation, it will need to allow the unemployment rate to increase. In theory, an economy could operate at any point along its Phillips curve, with govt intervention managing the economys position acc. to its policy objectives. o AD/SRAS diagrams can be used to illustrate the tradeoff; assume the econ. is initially at equilibrium at real output Y and

price level P. If the govt wishes to increase employment, it could use demand-side policies to cause AD to increase (AD0>AD1). The policies will result in an increase in output (Y->Y1), which is produced by hiring more workers; thus, unemployment is ass. to fall. The converse of this change is a higher price level (P>P1, i.e. increased inflation *as the govt must spend some money to boost AD, and the higher levels of demand increase prices]). In addition, workers could become more confident b/c the econ. is doing well, and it may become more difficult for employers to find new employees; thus, cost-push inflation could also occur due to higher employment). This follows the relationship set out by the Phillips curve, and can be plotted on a Phillips curve as a movement along the curve towards higher inflation rates. The existence of a clear inflation/unemployment tradeoff was supported by data until the 1970s; since then, however, the incidence of stagflation (rising inflation without corresponding decreases in unemployment; e.g. in England, 1973-75) due to oil price shocks and factor costs (which led to increased use of expansionary policies by the govt to reduce unemployment, setting off an inflationary spiral) began to suggest that the relationship was no longer valid; according to the PC, inflation and unemployment could not worsen simultaneously. Long-Run Phillips Curves: Monetarist economists criticized the original PC as, according to their analysis, no tradeoff between inflation and unemployment is possible in the long run. This is consistent with the Neoclassical view of LRAS, which shows that the econ. will automatically tend towards long-run equilibrium at Yf. Assume that the econ. is in LR equilibrium at point A, where SRPC (a short-run Phillips Curve) intersects the economys vertical LRAS at a given time. o Assume also that the labor market is in equilibrium, such that the only existing unemployment is natural. Assume inflation is constant.

The monetarists state that the SRPC is ineffective due to rational expectations. That is, people expect inflation to remain constant and negotiate pay increases based on the expected rate. If the govt decides to reduce unemployment through expansionary demand-side policies (e.g. increases in govt expenditure), AD would increase, as would demand for labor and wage rates. To ration the rel. scarce natl output, however, the inflation rate would also rise. In the SR, unemployment would fall as workers who were unprepared to take jobs at prior wage levels become attracted by what they believe to be higher wages, and the econ. moves left along SRPC (an increase in employment at the expense of inflation); in addition, labor becomes cheaper, in real terms, for firms, who hire more workers. However, these are higher nominal wages; real wages have not risen, and workers may actually be worse-off than previously in real terms. The workers have thus suffered from money illusion. o When the workers realize their wages have not actually risen, they leave their jobs and unemployment goes back to the natural rate, though at a higher inflation rate- alternately, if workers demand wage increases in line with the new inflation rate, firms may need to lay off workers in an attempt to cut costs; o The econ. does not return to its initial position; now that inflation is higher, people expect prices to continue rising at the higher rate and negotiate pay increases accordingly. o As a result, SRPC shifts upwards such that the econ. is in LR equilibrium where the Natural Rate of Unemployment=SRPC. Unemployment has returned to the natural rate at a higher inflation rate

This shift only happens in the LR due to money illusion, expectations of inflation at the earlier rate, and labor contracts in the SR. Any renewed attempt to use demandside policies to reduce unemployment below the natural rate will only lead to higher inflation and a move to another SRPC further up at the intersection of the NRU and the prevailing inflation rate. To maintain employment above the NRU, the govt would need to progressively increase inflation so that employees would be fooled; for money illusion to be effective in the LR, it is assumed that employees must have adaptive expectations and base their view on future inflation rates on what has occurred in the past. However, according to the monetarists, employees expectations are rational and based on a prospective estimate using all information available to them at the moment; for example, if workers believe that the govt will reduce inflation in the future, they will reduce wage demands quickly; thus, the economy returns to long-run equilibrium within a rel. short timespan. Natural rate of unemployment: The rate of unemployment consistent with a stable rate of inflation. For this reason, the NRU has also been referred to as the NAIRU (the non-accelerating inflation rate of

unemployment); the rate of unemployment at which inflation is correctly anticipated, and the labor market is in equilibrium. As long as govts do not use expansionary fiscal policy, inflation will not accelerate at the NRU; however, if such policies are used, inflation wll accelerate. The Long-Run Phillips Curve is vertical at the natural rate of unemployment; thus, it is functionally equivalent to the LRAS curve in analysis. o At any time, there may be a SR tradeoff b/w inflation and unemployment, but the economy will always return to the NRU in the LR. o Govts cannot reduce the NRU via demand-side policies; thus, the NRU is the unemployment rate that occurs when the econ. is at Yf and the labor market is in equilibrium. o This is not to say that long-run unemployment rates cannot be reduced altogether; rather, the key point is that supply-side, rather than demand-side policies, are the key to reducing NRU. Supply-side policies will shift LRPC left (LRPC->LRPC1); this is equivalent to a rightward shift in LRAS or an outwards shift in the PPF of a country. This confirms our earlier conclusions about reduction of unemployment: although demand-side policies can reduce cyclical unemployment, they do not affect, in the LR, frictional, seasonal and

structural unemployment (components of NRU). Although estimates of the NRU are made, their accuracy is uncertain; however, the rate varies over time and between countries. Differences b/w countries are due to supply-side factors (e.g. the size of unemployment benefits, union power, labor regulations, wage-setting practices). Countries with more benefits and greater regulation tend to have higher NRU; thus, marketoriented supply-side policies are often recommended to reduce NRU.

Chapter 22: Distribution of Income One of the characteristics of free-market economies is unequal income distribution (e.g. the CEO of a company will likely earn more than his secretary). Inequality occurs to different extents in different countries; the reasons for differences in income and consequences of inequality are multiple, and are the subject of massive political, economic, etc. debate. It is often argued that large amounts of income inequality are unfair; people with low income will experience rel. low living standards and fewer opportunities than those with high income. o Indeed, some may live in absolute poverty (a state where they do not have access to the basic necessities to sustain life). o Others may live in relative poverty (a state where their living standards are well below some specified average for their country; this is often characterized by an inability to take part in the typical activities of society). o One reason for low incomes is socioeconomic: being born into a low-income household and experiencing little opportunity (e.g. education, adequate healthcare, the ability to wait until adulthood before finding employment) to escape the conditions associated with poverty. Another reason is low human capital, which keeps people in low-paying jobs; unemployment may also cause low incomes. All of the above causes are heavily debated. Further, labor market conditions, differences in bargaining power, certain tax and benefit structures (i.e. regressive taxation, lack of benefits), discrimination

(both positive and negative), household composition, the low earnings of the unemployed and differing levels of qualifications also cause income inequality. Even if income inequality is seen as unfair, standard economic theory shows that higher income serves as an incentive for people to work harder; if people did not believe that their work would allow them to increase their human capital/efficiency and grant them the opportunity to earn higher incomes (the argument goes), this would negatively affect the supply-side of the economy, resulting in lower overall ec. activity levels. Pure economic theory will not give an answer as to how much inequality is acceptable/desirable; this is a normative issue. However, it is true that market economies do lead to income inequality, and that govts may use fiscal policy to affect income distribution in an economy. This may be done through: Taxation: Governments at all levels impose numerous taxes for numerous reasons. o Taxes may serve to reduce the consumption of goods that create neg. externalities, reduce the consumption of imports and protect local industries, manage the level of AD in the entire economy, or- significantly- change the distribution of income. Direct taxes: Taxes on the income/wealth of individuals, or on firms profits. o The various forms of taxable household income include employment income, interest on savings and dividends on shares; social security contributions are also direct taxes. o Some of this income is directly collected from employers, while some is charged based on annual tax returns. Thus, theoretically, such taxes are unavoidable, as households and firms are obliged to declare their full income to the govt and be taxed on it accordingly. Indirect taxes (expenditure taxes, consumption-based taxes, e.g. the Goods and Services Tax, the VAT, excise taxes): Taxes which the consumer pays to the seller or producer of a product, who then pays the tax to the govt. o In theory, indirect taxes are avoidable, as consumers may choose whether to buy the good in question or not, and in what quantities. o Governments vary indirect tax rates on different goods and services, with necessities and merit goods (e.g. bread) taxed at much lower rates than luxury products and demerit goods (e.g alcohol).

We can classify the above two tax systems into three categories, depending on their effect on distribution of taxpayers incomes: Progressive Taxes: A system whereby, as income rises, a greater proportion of income is paid in tax (e.g. tax systems in the US and Australia). o Many govts use progressive taxes as the main way of redistributing income from higher to lower earners; usually, there is a certain threshold below which income is not taxed. Very low-income people may oftentimes not need to pay any direct tax. o If income moves beyond this minimum, however, an increasing percentage of income will be paid to the govt, with larger percentages being taken in tax at higher incomes. It is important to note that we deal with a marginal tax rate for each income bracket in the prog. tax system: a person with an income of $ 100 000 might not be taxed anything for the first $ 10 000, and subsequently be charged increasing rates on all income which falls within subsequent tax brackets. This results in an average tax rate that is lower than the marginal tax in the highest bracket ones income falls under. However, the average tax rises as income rises; thus, the tax is progressive. o Note that, in reality, most progressive tax systems are much more complex than simple brackets. The biggest complication stems from tax deductions and the calculation of taxable income. Tax deductions allow people to reduce their taxable income if they spend on particular things, or partake in particular activities. For instance, if a worker commutes to work, the govt might deduct commuting costs from his taxable income, reducing the amount of tax that he pays, to encourage people to find work and to reduce unemployment; however, the precise mechanics of tax deductions vary from country to country. o A prog. tax means that higher income people pay higher taxes, and can lead to redistribution of income to the less well-off. Regressive Tax: A system whereby, as income rises, the proportion of income paid in tax (avg. tax rate) falls. o Specific taxes are an example of a regressive tax rate; a $1 cigarette tax will represent a larger share of the real income of a

construction worker than that of a bank manager. The tax is regressive as a higher proportion of income is paid at lower incomes. o Regressive taxes may be a good source of govt revenue and discourage consumption of demerit goods, but they can worsen income inequality. Proportional Tax: A system whereby the proportion paid in tax is constant for all income levels (e.g. the Estonian tax system). o Many countries are attempting to introduce proportional direct taxes, where the same % of tax is paid at all income levels; there are several advantages of the policy: First, taxation is usually a hugely complex process, with much room for error and manipulation; thus, govts may earn less revenue than predicted as people find ways to evade paying taxes. Second, taxes may have a disincentive effect on working; it is possible that high tax rates discourage people from working harder, moving into higher-paying jobs and taking risks, as they will be reluctant to pay higher taxes on their gains. If taxes were constant, a supply-side incentive to work, and therefore, to increase labor supply, would be created (the argument goes). Transfer Payments: a policy whereby the govt uses tax revenue to redistribute income and provide assistance to different groups in the economy to improve living standards. While transfer payments are not included as income in GDP accounting as they do not represent payment for the prod. of a good/service, they are payments made to increase the income of particular groups in the economy. Examples include child support, pensions, unemployment benefits and subsidies to producers. Other Govt Policies to Affect Income Distribution: Minimum wage policies are used to ensure workers are paid what is determined to be a fair wage; govts may also legislate that firms pay social benefits, such as some level of medical insurance or pensions, to workers. Both of these policies redistribute income from firms to workers. o In addition, govt-sponsored training programs are help workers find gainful employment and thus improve their living standards.

Evaluation of Income Redistribution Policies: o The question of income redistribution is loaded; while many agree that the govt is responsible for ensuring a reasonable standard of living for citizens, this is a problematic issue for many reasons, including the debate as to what constitutes a reasonable standard. o Neoclassical economists tend to argue against active govt intervention in income redistribution, as it interferes with market forces and may result in inefficiencies; this view argues that optimal resource allocation occurs in free markets; thus, govt taxation should be minimized. Arguments for this view include that: If firms need to pay social security and insurance for workers, this will provide a disincentive in terms of hiring and contribute to unemployment. High taxes may discourage entrepreneurship and possibly encourage entrepreneurs to leave a country in search of more favorable tax environments. High taxes have negative effects on overall ec. growth due to their disincentive effects, whereas lower taxes would encourage ec. activity, leading to an overall increase in output that would benefit everybody. If people lose unemployment benefits when they begin work and are taxed on their income, their total income falls when they start working, creating a disincentive to work. o In general, this view does not hold that the govt has no role in the economy; rather, it argues that taxes should be limited to financing the obligations of the govt to maintain property rights, reducing the effects of market failure, providing an adequate security system and judiciary and promoting competition, rather than redistribution of income. o A good tax system should: Have horizontal equity: people in the same circumstances pay the same amount Have vertical equity: taxes should be fair in terms of rich and poor Be cheap and simple to administer Be difficult to evade and convenient to pay Be easily understood by taxpayers Have limited disincentive effects on working o If GDP starts to grow, the prog. tax system acts as an automatic stabilizer; as more people will now be paying a higher rate of tax; thus, the level of disposable income is less than it would be without a govt- this will dampen the effects of the boom; simply, transfer payments will reduce the effects of a recession. When incomes fall, some people will be entitled to benefits which will keep consumption and incomes above freemarket levels. As the marginal rate of taxation increases, however, the multiplier will decrease; any change in injections will have a smaller cumulative effect. The Laffer Curve: o The view that higher taxes create a disincentive effect and ultimately negatively affect govt revenues may be illustrated using a Laffer curve, which shows the relationship between direct tax rates (on the x-axis) and govt revenues (on the y-axis).

A Laffer curve is concave downwards along its full length and displays two prominent characteristics: If the direct tax rate is 0%, the govt would gain no money in tax revenue; thus, tax revenue is 0 at a 0% tax rate. If the direct tax rate is 100%, there would be no incentive to work and thus no income for the govt to tax; thus, tax revenue would also be 0 at a 100% tax rate. The points in between demonstrate the view that higher direct taxes will eventually cause people to work less hard (or not at all; high taxes may discourage work altogether for certain individuals), thus earning less income and paying less in taxes. According to this theory, an initial increase in the direct tax rate from 0% will increase tax revenue, but further increases will eventually cause tax revenue to fall. It follows that, if tax rates are above the rate corresponding to the maximum tax revenue, the govt could increase revenue by lowering the direct tax rate. This would encourage people to work harder, and firms to expand, as they would keep a greater share of their earnings. The model suggests that there is an optimum tax rate at which govt revenue is maximized; this level will vary from country to country, and is not usually 50% (the tradeoff between revenues and disincentives is not proportional.

Chapter 23: Reasons for International Trade International trade: the exchange of goods and services between countries. There are a number of significant gains from international trade that economists emphasize: o Lower prices: The main gain from trade, and main reason for trade, is the ability to buy goods at a lower price than the domestic price; consumers benefit by gaining access to cheaper products and producers may purchase raw materials and semi-mfg. at a lower cost; this should lead to an increase in economic efficiency. Prices may be lower in some countries than others due to access to natural resources, differences in quality and availability of labor, capital, and the level of technology. The lower prices can be explained by comparative advantage theory. o Greater choice: Trade allows consumers to have a greater variety of products; they now have access to products produced internationally, in addition to the domestic market. o Differences in resources: Different countries possess different resources; to acquire the resources that it needs to produce its output, but does not possess (e.g. gold, rare earth metals, oil), a country may have to trade and import the commodities they lack. To do so, they will also need to export goods and services to gain foreign currency with which they can buy the required resources.

Some countries (e.g. Japan) have few natural resources, and are dependent on trade for growth, and economic survival and well-being; they have to import most natural resources. However, they are able to fund this by maintaining high export levels. o Economies of Scale: When firms begin to produce for an international market, the market size, and thus demand, will increase, and the level of production and output will increase to compensate. The increased production levels should lead to economies of scale being achieved; production should become more efficient (or, at least, not become less efficient). Also, expanded production allows for increased specialization; when firms are large, individuals may specialize in narrow, specific tasks (e.g. Head of Accounting), and should become more knowledgeable and efficient at those tasks. Larger production units may also lead to greater division of labor (where a production process is broken down into a number of small, simple, repetitive steps that workers (or robots!) can specialize in, thereby achieving a high level of efficiency. In addition, if countries specialize in the production of certain commodities (e.g. petrochemicals in Bahrain), there will be cost benefits (technical economies of scale) from acquiring knowledge and expertise; this is known as moving down the learning (LRAC) curve Trade, and with it, larger markets and production units, should enable production in a countrys export industries to become cheaper and more efficient in the LR, make producers more competitive, and lead to a reduction in LRAC. o Increased Competition: Trade may lead to increased competition, as domestic firms are forced to compete with foreign firms. This should lead to increased efficiency and innovation, and could likely lead to increased quality, variety, and a lower cost of goods and services for consumers. o There are political, social, and cultural gains to be made from increased trade bringing countries closer together; this is perhaps most visible with the European Union. Putting together the above six points, it is clear that there are large-scale gains to be made from trade; it is fair to conclude that, for the reasons listed above, trade can be a major contributor to a countrys econ. growth. Where trade will occur is dictated by comparative advantage theory, which attempts to determine which goods a country should produce for export and which it should import, to gain the maximum benefits from trade. o Absolute Advantage: A country is said to have an absolute advantage in the prod. of a good/service if it can produce it using fewer overall resources than another country.

If two countries produce two goods with the same amount of resources, the country with the greater output in any one good has the absolute advantage in that good. Reciprocal Absolute Advantage: A situation where either of the countries trading has an absolute advantage in the production of one product In this case, the question of which goods should be imported and which exported by each country is straightforward: the countries should specialize in the products they have an abs. adv. in; this will maximize the amount produced by each country and, after trade, both countries will gain. o Assuming constant returns to scale, doing so will cause output in both countries to double, in excess of the prior output; total output of both products should rise, following specialization. Comparative advantage: a situation where a country can produce a good at a lower opportunity cost than another country; that country has to give up fewer units of the alternate good in producing a certain good than its trading partner. Comparative advantage theory is used where the relatively more straightforward reciprocal absolute advantage theory is inapplicable. It has been mathematically proven that trade could be beneficial for both countries, even if one had the abs. adv. in the production of all products being traded. Comparative advantage theory is based on the opportunity cost of production. In a case where one country produces both goods traded more efficiently (in terms of resources) than its trade partner, it will most likely not have a comparative advantage in the production of one of the products; they would have to give up more units of one of the goods than the producer with the absolute disadvantage in order to increase output of the other good Thus, absolute advantage does not imply that a country necessarily has a comp. adv. In the production of a good/service. According to comp. adv. theory, each country should specialize in the good that it has the com. adv. in; each country will then consume the amount of output that they wish and trade the remainder for the alternate product. Assuming the two countries trading face different opp. costs, then, if they specialize acc. to comp. adv, both should be able to consume at some point outside their PPFs (i.e. beyond what had been possible before trade was occurring). This situation can be illustrated using simplified linear PPF curves for each country. If the scale of the axes is the same, and one country has the abs adv. in the prod. of both goods, the comp. adv. for the better producer occurs where the distance between the PPCs is largest, while the comp. adv. for the less efficient producer occurs where the distance between the PPCs is smallest.

This is not a mathematical justification (which would rely on the relative gradients of the lines, as it is the gradients of the lines that show the respective opp. costs, which are assumed to be constant); it is simply a useful trick for graphing comp. adv. Assume that two countries are trading in TVs; they also produce cotton. The opp. cost of producing 1 TV for Country A is 3 units of cotton; the opp. cost of producing 1 TV for Country B is 2 units of cotton. Both countries will benefit from trade if the ratio of exchange between TVs and cotton is anywhere between 1TV=2 units of cotton and 1TV=3 units of cotton; between the two countries, production will be maximized if trade occurs at the midpoint of these two ratios; i.e. if 1TV is traded for 2.5 units of cotton, and 1 unit of cotton is traded for 2/5 TV. o In each country, the opportunities for the second good are reciprocal to those for the first good (in our example, 1/3:1 and :1, units of cotton: TV, respectively). Comparative advantage theory is effective only if the opp. costs faced by the countries are both different; if the countries face the same opp. costs (if the PPFs had the same gradient), there would be no reason for trade to occur. Comparative advantage is largely based on a countrys access to FoPs; a country that possesses good-quality arable land may have a comp adv. in agricultural products, a country with much low-skilled labor may develop a comp. adv. in labor-intensive mfg, and a country with numerous universities and educated labor may develop a comp. adv. in Ponzi schemes. A country with favorable climate and nice beaches (which counts as land, rather than climate. Silly book.) may develop a comp. adv. in tourism. The abundance of a given FoP will make its cost relatively lower than that of other FoPs, allowing the opp. cost of the goods and services produced using the FoP to be lower than in other, less well-endowed countries. Comp. Adv. Theory is based on several assumptions, which tend to limit its applicability to the real world. These include: As in PCMs, it is ass. that producers and consumers have perfect market knowledge and are aware of where the lowest-priced goods are purchasable. It is assumed that there are no transport costs; however, this is evidently not the case in reality, and the existence of transport costs can erode a countrys comp. adv, reducing its competitiveness and the potential gains from trade. It is often assumed that the model is limited to 2 goods producing 2 products; however, this is not always true: the theory may be extended to more countries and products, and it is still possible to determine

where the comp. adv. lies, and the use of computer programs facilitates multi-country, multi-product analysis. It is assumed that costs do not change and returns to scale are constant (with no economies or diseconomies of scale); however, the existence of economies of scale would likely increase a countrys comp. adv, as relative prod. costs fall by ever more, whereas the existence of diseconomies of scale may eventually undermine some of the gain to be made from trade. The model does not take into account the external costs/benefits of the production of the two countries output. It is assumed that no barriers to trade exist; this is clearly not the case in reality, as govts often use tariffs, subsidies, quotas and administrative measures to restrict imports from abroad. It is ass. that the goods being traded are homogeneous (e.g. bananas, uranium-238). However, problems arise with differentiated goods (eg. consumer durables), as the differences in the products design render proving that a country has a comp. adv. in their production much more difficult. It is ass. that FoPs stay within the country (but are perfectly mobile within each country); however, it may be the FoPs, rather than the goods, that move between countries; for instance, MMCs in developed countries might outsource production to LDCs by investing capital, enabling prod. of goods there rather than exporting finished products produced domestically. Labor may also migrate from low- to high-wage countries. Despite its limitations, comp. adv. theory is at the core of intl trade theory and is effective at explaining patterns of trade. Countries that specialize in production of goods in which they have a lower opp. cost than other countries can maximize their potential gains from trade.

Chapter 24: Free trade and Protectionism: Free Trade: A situation where trade between countries occurs when no protectionist barriers to trade put into place by govts or intl organizations exist. Goods and services are allowed to move freely across borders. Arguments for Protectionism: o Although there are clear benefits to trade for the countries involved, countries do not trade freely, and protect their economies from imports, for several reasons, the arguments for which are not always valid. Some of the arguments for protectionism include: Protecting domestic employment: At any time in an economy, some industries are in decline (sunset industries), as they cannot compete with foreign

industries. If the industries are relatively large, their collapse would lead to high structural unemployment, and govts often attempt to protect the industries to avoid the unemployment. However, the argument is not very sound, as it is likely that the protectionism will only prolog the industrys continued decline. Although there will be SR social costs, it could be better to let the resources employed in the industry move into expanding sectors of the economy. However, often, the neg. externalities of a rapidly declining major industry may be great enough that a govt feels obligated to intervene and protect the market. Protecting the economy from low-cost labor: It is often said that the main cause of declining domestic industries is the low-cost labor of exporting countries, and that the economy should be protected from imports produced in countries where labor costs and wages are much lower. o While trade may greatly benefit the economy as a whole, the benefits are often spread widely, while the costs in terms of job losses tend to be concentrated in a few industries; the job insecurity in mfg. industries in the West is due to workers fears that they will lose their jobs to workers in emerging markets; thus, unions may lobby vigorously for protection against foreign imports. o It is especially likely that the govt will protect industries seen as traditionally important, despite the economic circumstances having changed. For instance, the US steel industry often negotiates favorable tariffs to protect itself against steel imports from Asia. However, this argument is uneconomic, as it goes against the theory of comp. adv, as it means that domestic consumers pay higher prices than they should and that production in the protected economy would be at an inefficient level. The country wishing to export would lose trade, leading to economic harm, and the importing country would lose out on some of the benefits of trade and specialization. o Comparative advantage changes over time, and countries that presently have the comp. adv. in the prod. of a good are unlikely to retain it indefinitely into the future (for instance, the US did once have a comp. adv. in steel). As relative factor costs in different countries change, it is important that resources should move as freely as possible from sunset industries, where comp. adv. is declining, to industries where it is growing.

Supply-side policies focusing on labor markets emphasize the importance of making labor flexible enough to adapt to changing economic conditions, putting some responsibility on govts to help workers who have lost their jobs due to increased competition from foreign countries with a comp. adv. in the production of labor-intensive goods. Protecting infant (sunrise) industries: Many govts argue that industries that are just developing do not have the economies of scale of their larger competitors abroad. The domestic industry would not be competitive against imports until it can gain the cost advantages of economies of scale. Thus, the industry may need to be protected against imports until it becomes large enough to compete on an equal footing. However, this argument may be flawed: most devd countries have ready access to expansive financial capital markets and thus large amounts of financial capital (especially since the advent of globalization); thus, it is possible that there is no basis for the notion that industries in devd countries would set up in a relatively small way, and thus not benefit from economies of scale. o With access to capital markets, it is difficult to assume that industries would not be founded at the most efficient possible size; e.g. Saudi Arabia has expanded into petrochemicals through partnerships with leading MNCs; the resulting factories are some of the worlds largest, and benefit from extensive economies of scale. o However, for LDCs, which often lack access to sophisticated capital markets, the infant industry argument for protectionism is justifiable. However, whether they are politically powerful enough to implement protectionist measures without complaints from developed countries and the WTO is debatable. Avoiding the risks of overspecialization: Govts may wish to limit overspecialization, as it means that a country could become dependent on the export of one or two products; any change in world markets (for instance, changes in technology reducing the demand for a commodity, the introduction of new products, or abrupt changes in supply and demand) for the products might seriously impact the countrys economy. Alternately, a govt may want to avoid the possible diseconomies of scale that could arise due to excessive specialization of a countrys industries. This is especially the case in LDCs, which are often forced to overspecialize in a select few export commodities (primary products); the introduction of synthetic materials, for instance, and the over-supply of

textiles on the world market (which reduced prices) severely harmed Bangladeshs textile industries at one point. This point is relatively unarguable; it does not promote protectionism, but rather, points out the potential risks of overspecialization for natl economies. Strategic reasons: Govts often argue that certain crucial industries need to be protected, as they would be needed for strategic purposes in the case of a war (e.g. agriculture, steel, power generation); the argument goes that these industries would need to be protected to stay competitive. This argument may be valid to an extent, if the risk of war does exist; however, it is usually overstated: it is unlikely that many countries will be cut off from all supplies if they go to war. The argument may be mostly an excuse for protectionism. Political reasons: Govts may occasionally wish to limit trade with certain countries as a form of pol. punishment (e.g. for irreconcilable ideological differences); however, unless the sanctions are followed through by multiple countries, this form of punishment may not be very effective. In addition, if the sanctions are too harsh, it is the people in the country being punished, in addition to the offending govt, who may be harmed. Anti-dumping measures: Dumping: the selling by a country of large quantities of a product on foreign markets at a price below the cost of its production (e.g. EU exports of subsidized dairy products to LDCs in Africa). o The EU often dumps its agricultural surpluses on LDC markets, harming local producers by lowering their revenue. Where countries can prove that they have suffered severe economic harm from dumping, they are allowed by WTO rules to impose anti-dumping measures to reduce the damage. However, it is difficult to prove that a foreign industry has been guilty of dumping; in addition, a govt that subsidizes a dom. industry may be itself guilty of dumping, as the price at which the subsidized goods are exported does not reflect dom. producers production costs. If dumping does occur, then, a negotiated settlement between govts, rather than protectionist measures, may be the better solution. There is always the risk that protectionism may incite retaliatory measures by foreign governments, further reducing the benefits to consumers in producers in all countries involved.

Protecting product standards: A country may wish to impose safety, health, or environmental standards on imported products, to ensure that the imports match the standards of domestic goods and to reduce the effect of negative externalities and/or demerit goods on the dom. economy (e.g. the EU ban on hormone-injected US beef). This argument is valid as long as the concerns themselves are valid; however, many of the reasons given for bans when standards are not met are simply veiled protectionist measures (e.g. US cattle farmers have complained that EU authorities had no conclusive evidence that the hormone-treated beef constituted a health risk for consumers). Where product standards are disputed, the exporting country may resort to retaliatory protectionism and trade sanctions to protect its position on the market. Raising government revenue: In many LDCs, tax collection is difficult, and govts impose tariffs (import taxes) on products to gain revenue; according to the IMF, approx. 15% of all revenue of the LDCs originates from import duties. This is not as much an argument for protectionism per se, but a means of gaining revenue; in effect, the import duties represent a tax for consumers in the country who purchase imports. Correcting a balance of payments deficit: Govts sometimes impose protectionist measures to reduce import expenditure and thus improve a balance of trade deficit, whereby a country spends more on imports of products than it earns from its exports of products. This is only effective in the SR, and does not address the actual problem, reducing the symptoms, though not the root cause of the deficit. If countries do so, they are likely to invite retaliatory protectionist measures from the countries that they export to. Arguments against protectionism: o These are closely related to the reasons for trade (discussed above), and include: Protectionism may raise the cost of purchasing imports for domestic consumers and producers. Protectionism leads to less choice for consumers, and therefore decreased economic efficiency. Competition would lessen if foreign firms were kept out of a country; dom. firms may become inefficient and uncompetitive without an incentive to minimize costs; likewise, innovation may be reduced. Protectionism distorts comp. advantage, leading to an inefficient allocation of world resources; specialization is reduced, decreasing the pot. level of the worlds output. Governments may choose target industries for protection based on political aims, rather than the best interests of the national economy.

Protectionism may incite retaliatory measures/trade wars from competitors abroad. For the above reasons, protectionism may hinder economic growth. Types of protectionism: o A number of methods to protect a dom. economy from imports exist. To examine them, it is worth considering a countrys situation if it were trading freely in a particular commodity (e.g. marijuana). We may then consider how different protectionist measures will alter the free trade situation. If there is no foreign trade, domestic farmers would produce Qe ounces of weed at the equilibrium price Pe. If the market is open and trade occurs, the situation changes; consumers may import as much weed as they want, if they are prepared to pay the world price. Thus, the supply curve faced by importers (S(world)) is perfectly elastic and assumed, in our case, to be below equilibriumotherwise, no importing would occur). With free trade, the market price of weed decreases to Pw (the world price); at this price, dom. producers are only prepared to supply Qs tons of weed; however, the quantity demanded (Qd)of weed would be higher; the excess demand would be satisfied by (Qs->Qd) units of imported grass. Domestic consumers get to smoke (Qe->Qd) more weed than at autarkic equilibrium, at a lower price. The different protectionist measures that the govt could employ on the weed market include: Protective tariffs: indirect taxes charged on imported goods. As we have seen, any tax placed on a good shifts its supply curve upwards (left) by the amount of the tax; in the case of a tariff, world supply will shift upwards, as it is foreign producers, rather than dom. producers, who are being taxed. o Before the tariff is imposed, Qd tons of weed are consumed at the world price Pw. Domestic production was Qs and imports were (Qs->Qd). o When the tariff is imposed, S(world) shifts upwards by the amount of the tariff, raising the market price (Pw->Pw+Tariff). As the price has risen, total QD falls (Qd->Qd1). o Domestic producers are able to increase production (Qs->Qs1); their revenue increases from (Pw x Qs) to (Pw+t x Qs1). Foreign producers supply the rest (Qs1->Qd1). They receive Pw+t, but must pay the tariff to the govt; thus, their revenue falls (Pw x (Qs->Qd)) to (Pw x Qs1-> Qd1), and the govt receives tariff revenue ((Pw -> Pw1) x (Qs1-> Qd1). o Importers must pay a higher price for the imported good; in the case of weed, the higher price will be passed on to hash brownie bakers and joint manufacturers that buy the imported

weed. If a country imposed a tariff on clay, the price of clay bongs for consumers would rise as well, as the tariff would cause producers prices to rise. If the bong-maker is an exporter, the tariff will reduce the competitiveness of their exports abroad. o Tariffs are the usual anti-dumping measure; if a country proves that dumping has occurred, it can place a tariff on the imported goods to raise their prices, eliminating the cost advantages of the foreign producer. o There are two further outcomes: (Qd1->Qd) ounces of weed are no longer demanded; consumers keep the amount k that they would have spent on the weed, but there is a dead-weight loss of consumer surplus [welfare] f (the triangle between D, Qd and Qd1), as the weed is no longer consumed. After the tariff, (Qs->Qs1) tons of weed are produced by rel. inefficient dom. producers, as opposed to efficient foreign producers; while the foreign producers would produce this quantity for a minimum revenue (Qs->Qs1 x Pw), the domestic producers require a revenue of (Qs->Qs1 x Pw+S, where S is the supply curve at any given point on the interval). This additional region represents a misallocation of world resources and a loss of world efficiency; this is another deadweight welfare loss. Quotas: Physical limits on the quantity or value of goods that can be imported into a country (e.g. the EUs import quotas on Chinese mushrooms). The imposition of a quota is graphically similar to the imposition of the tariff, although the mechanics are rather different: o Before the quota was imposed, Qd tons of weed are consumed at the world price Pw. Domestic production was Qs and imports were (Qs->Qd). o When the quota is imposed, S(world) shifts upwards by an amount that reflects the limit on imports from abroad; for instance, S(world) will increase until imports from abroad are limited to (Qd1->Qs1 units), raising the market price (Pw>Pw+Quota), to clear the excess demand that arises. As the price has risen, total QD falls (Qd->Qd1). o Domestic producers are able to increase production (Qs->Qs1); their revenue increases from (Pw x Qs) to (Pw+q x Qs1). Foreign producers supply the rest (Qs1->Qd1); they are unable to import more than the amount of the quota. They receive Pw+q

for their output; their revenue thus changes to (Pw x (Qs->Qd)) to (Pw+q x Qs1-> Qd1); this is usually a decrease in revenue, but theoretically does not have to be. The govt receives no revenue from the quota. o Once again, there are two areas of dead-weight welfare loss incurred by the quota: (Qd1->Qd) ounces of weed are no longer demanded; consumers keep the amount k that they would have spent on the weed, but there is a dead-weight loss of consumer surplus [welfare] f (the triangle between D, Qd and Qd1), as the weed is no longer consumed. After the quota, (Qs->Qs1) tons of weed are produced by rel. inefficient dom. producers, as opposed to efficient foreign producers; while the foreign producers would produce this quantity for a minimum revenue (Qs->Qs1 x Pw), the domestic producers require a revenue of (Qs->Qs1 x Pw+S, where S is the supply curve at any given point on the interval). This additional region represents a misallocation of world resources and a loss of world efficiency; this is another deadweight welfare loss. Subsidies: payments by the government to firms in a particular industry, per unit of output (e.g. US export subsidies for cotton). If the govt subsidizes firms to increase their competitiveness, the domestic supply curve will shift downwards by the amount of the subsidy. Continuing with our weed example, the effect of a subsidy for dom. weed producers is: Before the subsidy was granted, Qd tons of weed were consumed at the world price Pw. Domestic production was Qs and imports were (Qs>Qd). When the subsidy is granted, S(domestic) shifts downwards by the amount of the subsidy to S(d)+Subsidy. The market price remains at P(w); thus, QD remains constant. However, dom. producers are able to increase production (Qs->Qs1), as they now receive Pw+subsidy per unit produced. Their revenue thus increases from (Pw x Qs) to (Pw+s x Qs1). Foreign producers supply the rest of the weed (Qs1->Qd), receiving ((Qs1->Qd) x Pw) in revenue. The govt pays the subsidy, equal to (Pw->Pw+s x Qs1). o As with a tariff, (Qs->Qs1) tons of weed are produced by rel. inefficient dom. producers, as opposed to efficient foreign producers; while the foreign producers would produce this quantity for a minimum revenue (Qs->Qs1 x Pw), the domestic

producers require a revenue of (Qs->Qs1 x Pw+S, where S is the supply curve at any given point on the interval). This additional region represents a misallocation of world resources and a loss of world efficiency; this is another deadweight welfare loss. o However, there is no consumer surplus loss, as the market price of weed does not change. Consumers are indirectly affected by the opportunity cost in terms of govt spending on projects besides the subsidy and potentially higher taxes, if the subsidy is funded from tax revenue. Voluntary Export Restraints (VERs): agreements between exporting and importing countries in which the exporter limits the quantity of exports below a certain level; this is usually done to avoid legal restrictions and retaliatory protectionism in the importing country. VERs are now illegal, but could have been reached at government or industry level. Administrative Barriers: When goods are imported, there is usually a fair amount of red tape that has to be undertaken. If administrative processes are difficult or time-consuming, they can act as a barrier to imports. For instance, making importers fill out mountains of paperwork before their goods can cross the border will slow down imports and raise costs for the importer, as will a large amount of required legal work, or the designation of specific ports of entry for products that may e difficult to reach or more expensive. Health, safety and environmental standards: If restrictions are placed on the types of goods permitted for sale on domestic markets, or on the methods used in manufacture, and the regulations apply to imports, they may act as a barrier to trade. While it is important that countries are able to guarantee the quality of the products sold and prevent the entry of unhealthy/unsafe goods, it is important that they be legitimately concerned with product standards, rather than simply protecting dom. industries. Also, LDC exporters may find it difficult to pass muster with product standards, as they may find it difficult or prohibitively expensive to gain the certification required to prove that they meet the standards. The costs of certification may make it difficult for such countries to successfully exploit their comp. adv. Embargoes: Complete bans on all imports from a given country, which act as an extreme version of a quota and usually serve as political punishment. Complete embargoes are rare; more commonly, countries impose economic sanctions against an offending country, limiting the exports/imports of key products as political punishment, or to exert political pressure. Exchange Controls: govts will occasionally place limits on the amount of money which can be exchanged for foreign country; however, this tends to not be very effective, as illegal currency markets arise.

Nationalistic Campaigns: Govts will sometimes run marketing campaigns to encourage people to buy dom. goods instead of imports (e.g. the Buy American campaign in the US), in order to increase demand for dom. goods and preserve domestic jobs; this is essentially moral suasion- the government links consumption of imports to domestic job losses. The World Trade Organization: an international organization that sets the rules for global trade and resolves trade disputes between member-states. The WTO succeeded the General Agreement on Tariffs and Trade in 1995 and now has 153 member-states. The WTO/GATT, among other things, is credited with reducing the average manufacturing tariff from a post-War high of 40% to around 4%. o All WTO nations are required to confer most favored nation status to one another; thus, usually, trade concessions granted by one WTO country to another must also be granted to all other WTO members. o Aims of the WTO: The WTO aims to increase international trade by lowering trade barriers among member-states and providing a forum for negotiation; the WTOs functions include: Administration of WTO trade agreements Handling trade disputes among member-states Monitoring natl trade policies Providing technical assistance and training for LDCs Cooperating with other intl organizations o The WTO operates on a system of trade negotiation rounds, which originally (under GATT) were mainly related to tariff reduction, but later included issues such as antidumping legislation and, most recently, development goals. o The current round of negotiations is the Doha Round or Doha Development Agenda, which mainly covers agricultural tariffs, other tariffs, trade and the environment, antidumping, subsidies, competition policy, government transparency and intellectual property. No conclusive agreement has yet been reached in the eight years of negotiations; negotiations have been suspended several times due to an inability to decide upon fundamental issues. There are two key concerns: The US and EU are being urged to reduce their agricultural subsidies to improve market access for LDCs. Devd countries want the larger LDCs to lower their barriers to imports of MFGs. Despite a consensus that these measures will increase growth worldwide, there has been no success at reaching a compromise thus far. Evaluation of the WTO: Success or Failure? o This is a contentious question, and IB wants us to know both sides of the debate. Let us summarize the arguments of the proponents and critics of the WTO (I deleted most of my snarky comments- make your own minds up!): The WTO claims that its work is beneficial in numerous ways:

The system helps to promote world peace; the freer trade is, the less likely it is for countries to enter into conflict (tell that to the 1914 European empires). Disputes are handled constructively, and there is a forum for discussions to take place. Rules make trade easier, and small countries have an equal say, gaining from collective bargaining with the larger countries. Free trade reduces living costs for most consumers Freer trade grants consumers more choice of products, and better quality of products. Trade raises incomes and stimulates growth. The system encourages good government. However, critics of the WTO have raised a number of important objections to the claims: The WTO supposedly operates on a consensus basis, with equal decision-making power for all members; however, many important decisions get made in informal negotiations between wealthier nations; LDCs are often excluded from crucial decision-making. The WTOs decisions may not be fully effective, as many MDCs have shifted to subtler forms of protectionism, including subsidies and administrative barriers, to protect domestic firms. Many LDCs cannot afford to participate in all negotiations or even to be represented at the WTO; their interests are not represented. The WTOs General Agreement of Trade and Services calls for the privatization of crucial services (merit goods and natural monopolies), including: childcare, care for the elderly, sanitation, park maintenance and postal services. Low-paid workers and poor communities will be less able to afford these services, and will consequently suffer. Free trade may not improve the life of ordinary people, being instead skewed towards benefitting the wealthy. WTO treaties can be seen as biased towards the interests of MNCs and rich nations; for instance: o Rich countries are allowed to maintain high tariffs and quotas in certain products, stopping LDC imports. o Agriculture is heavily protected in MDCs, while LDCs are pressured to open their markets, usually resulting in lower revenues among local firms, which face higher costs and are unable to compete against imports from MDCs. o IP regulations ban LDCs from incorporating technology originating in MDCs into their systems; this is slowing, for example, the fight against AIDS.

The increasing number of non-tariff barriers (e.g anti-dumping legislation) that favors MDCs in allowing them to protect against foreign imports. In the quest for free trade, health, safety and environmental issues are often abandoned, to the detriment to society and the environment; animal rights activists have also accused the WTO of encouraging behavior such as inhumane animal trapping, overfishing, and industrial agriculture.

Chapter 25: Economic Integration Economic Integration: a process whereby countries coordinate and link their economic policies. o As the degree of economic integration increases, international trade barriers decrease and fiscal and monetary policies become more closely harmonized. Globalization: the increased integration of national economies into global (trans-national) markets, prompted by liberalized capital and trade flows, advances in information technology, and decreases in intl transport costs. o Globalization has been occurring for centuries, but notably increased in pace since the 1980s due to the emergence of modern communication systems and the expansion of MNCs, and the growth rate of world trade far exceeds, at present, the growth rate of world output. Multinational corporations: Companies that produce in more than one country; they have played the crucial role in the process of globalization by taking advantage of differences in costs between countries when producing (e.g. Procter&Gamble, Unilever, BP, Vodafone). o MNCs may produce components of a product in several countries where production is cheapest, assemble it in yet another country, and sell it halfway across the world (the process of integrated international production). o MNCs are associated with foreign direct investment: long-term overseas investment by firms. The contribution of MNCs to globalization and global ec. growth, including in LDCs, cannot be overestimated. Trading Blocs: groups of countries that join together under some form of agreement to increase trade between themselves and/or gain economic benefits from cooperation on some level; this process is economic integration. o We may distinguish between 6 primary stages of economic integration: 1. Preferential Trading Areas: trading blocs that give preferential access to certain products from certain countries, usually through the reduction, though not elimination, of tariffs. The EU and many of its former colonies participate in a PTA agreement, wherein the EU guarantees regular supply of raw materials and the former colonies gain preferential access to EU markets and access to price-stabilizing funds for commodity markets.

2. Free Trade Areas: Agreements made between countries, where the countries agree to trade freely amongst themselves, but are able to trade with countries outside the FTA however they wish. Thus, members of a free trade area may retain contradictory trade policies towards countries outside the FTA, while maintaining free trade amongst themselves; this means that they can maintain differing levels of tariffs, and enter into separate FTAs and embargoes, independently of each other. An example of an FTA is NAFTA, established in 1995 between the US, Canada, and Mexico; following a series of staggered tariff reductions, nearly all trade in NAFTA is now tariff free, and production processes have become more specialized in each of the three countries as a result. o Other examples include EFTA (the EU + Iceland, Norway, Switzerland and Liechtenstein) and the South Asia Free Trade Agreement. FTAs are politically straightforward, as they do not infringe on the ability of member-states to freely conduct economic policy, but administratively complex, as MNCs outside the free trade area may abuse the system by establishing factories in countries where entry barriers for semi-manufactured goods are lowest (or simply importing through countries where they face the lowest tariff barriers), and thus avoiding the higher tariffs that they would have needed to pay when directly exporting to the products final destination, leading to a decrease in tariff revenue. While this is usually illegal, it is difficult and expensive to police in practice. 3. Customs Unions: Agreements between countries, whereby the countries agree to free trade among themselves, as well as common external tariff barriers against any importers. If a country outside a customs union wishes to import into the customs union, it faces the same tariff barriers (agreed upon by all customs union members) no matter which country the goods enter from. Thus, customs unions are administratively simple, as it is more difficult for external exporters to take advantage of differences in protectionist measures, but politically complex, as the common tariff barriers must be decided on by the unions members. All common markets and economic and monetary unions are also customs unions; thus, the EU is a customs union, as is East African Community (Kenya, Uganda and Tasmania) and Mercosur (in South America). 4. Common Markets: Customs unions with common policies on product regulation, which allow for free movement of products, capital and labor.

The best-known example of a common market is the EU; however, a second common market that is presently being established is the Caribbean Community, which unites 15 member-states, and will eventually include an economic and monetary union. 5. Economic and Monetary Union: A common market with a common currency. The best-known example is the Eurozone, consisting of EU countries that have adopted the Euro. 6. Complete Economic Integration: The final stage of economic integration, where the member-states would relinquish individual control over economic policy, enter full monetary union, and completely harmonize fiscal policy; the EU is moving towards this form of integration. Evaluation of Trading Blocs: o The extent of the advantages and drawbacks of trading blocs is largely dependent on the degree of economic integration. The benefits of belonging to a trading bloc resemble those of free trade, and include greater market size, larger export markets, economies of scale (as firms operate in a larger market and may be able to increase output and sales and reduce unit cost), increased competition, lower prices for consumers, (possibly) greater bargaining power and better external trading conditions for members of the trading bloc, and greater choice and efficiency. With reduced barriers to trade and freer movement of people and capital, skills and knowledge may spread more quickly. A consolidated social, regional and monopoly policy may allow member-states to harmonize their ec. activity to a greater degree than was poss. beforehand. The consequences are likely to not be even; some domestic producers will gain more from the trading bloc than others. The large market size may attract FDI from outside the trading bloc, especially from countries that would like to expand their presence on the market in the future. Trading blocs may foster increased political stability and cooperation, and trade negotiations are easier between trading blocs than individual states. However, while trading blocs foster trade creation among members, they also discriminate against non-member producers, which may stall WTO negotiations (as seen with the Doha Round). This may, in turn, foster the creation of more trading blocs, which may undermine free trade rules and limit the potential global gains from liberalized trade; in addition, trade diversion may occur if common external tariffs are in place. This will disadvantage LDCs more than MDCs, as LDCs usually lack international bargaining power.

In addition, the cost of administering the trading bloc may be high, and, as firms within the trading bloc expand, it is possible, though unlikely, that they will encounter diseconomies of scale. In addition, it is possible that firms in countries entering the trading bloc may find themselves uncompetitive, go out of business, and cause structural unemployment in the SR Finally, as member-states may be expected to pay contributions towards the administration of the trading bloc, the decision to pursue greater ec. integration may be pol. unpopular. Obstacles to Economic Integration: o When economic integration occurs, there are various reasons why countries may be disadvantaged; these include: Economic integration reduces a countrys political sovereignty; if integration reaches the customs union stage, political decisions begin to be made by a central, transnational body, reducing the power of the domestic government (e.g. the European Parliaments directives for member-states); this is politically unpopular, and may rile up nationalists. Economic integration reduces economic sovereignty; if integration reaches the stage of a customs union, economic decisions begin to be made centrally. Governments and citizens may not wish to relinquish their right to make decisions on economic matters, such as interest rate changes. Integration into a common market may force a country to change its economic policies; several EU countries have had to reduce taxes in order to encourage workers to remain employed domestically, due to the low opportunity cost of finding work in member-states with lower taxes. The greater the level of econ. integration, the more control member-states relinquish over polit. and econ. affairs. Trade Creation and Trade Diversion: o Trade Creation: A situation where a countrys accession to a customs union leads to transfer of production from high-cost to low cost producers; an advantage of greater economic integration (e.g. Mexico benefitting from increased trade and specialization thanks to NAFTA). If a country has a comparative advantage in the production of a good, but is constrained by high tariff barriers, (returning to our free-trade diagrams) it exports a reduced (Qs1->Qd1) ounces of marijuana into the customs union, while the customs union produces (0->Qs1) ounces of marijuana itself; on entering the customs union, the tariff is removed, and the exporter can make full use of its comparative advantage in marijuana production. This leads to an increase in exports to (Qs->Qd) and a decrease in the importers production to Qs ounces. Trade is created because (Qd->Qd1) more ounces of weed are now

consumed, leading directly to an increase in consumer surplus equal to the consumer welfare-loss triangle. There is a movement from high- to low-cost producers, as Qd->Qd1 units of weed are now being produced by the relatively more efficient country. Although the importing countrys producers may have lost out, there is a world welfare gain as fewer resources are misallocated. This is usually a two-way process; it is highly likely that imports of other products that the customs union has a comparative advantage in (e.g. cocaine) will increase with freer trade. Trade diversion: The situation where the entry of a country into a customs union leads to production of a good/service transferring from low-cost to high-cost producers; a disadvantage of increased economic integration (e.g. the relative decline of Vietnamese imports in Poland due to Polands entry into the EU). Let us assume that our favorite drug-country has been producing meth, and also importing meth from Methtopia, which has the comparative advantage in the drug. However, once it joined the customs union, Marijuania had to place a tariff on Methtopian exports, because the EU had one in place. Before entry into the customs union, Marijuania would produce Qs units of meth domestically and import the rest (Qs->Qd). However, once the new tariff is established upon its entry into the CU (as is required by the agreement), Methtopian meth becomes more expensive than meth from the customs union; thus, Marijuania will now produce (Qs1) units of meth itself and import the rest (Qs1->Qd1) units from the customs union. Overall QD of meth will decrease by (Qd1->Qd) units, leading to a loss of consumer surplus (our usual shaded triangle). There is also a movement from low-cost to high-cost meth producers, as (Qs>Qs1) units of meth, formerly produced by rel. efficient Methtopian producers, are now produced by rel. inefficient Marijuanian producers. Although Marijuanian producers will have gained, a global welfare loss will occur due to resource misallocation. Moreover, the production of (Q2->Q2) units of meth has been diverted to the rel. inefficient customs union, increasing the scale of trade diversion and global welfare loss; this is a disadvantage of economic integration.

Chapter 26: Exchange Rates Exchange rate: The value of one currency In terms of another currency (e.g. 1 euro = 3 PLN means that the price of Euro in PLN is 3 PLN) o It is the external value of a currency (what the currency is able to buy abroad); the internal value of a currency is concerned with dom. expenditure and depends on the price level.

Currencies are traded on the foreign exchange market (Forex), the worlds largest market in terms of cash movements; Forex includes trading of foreign currencies b/w govts, central banks, commercial banks, financial institutions and MNCs. o People and import/ export firms will buy currencies from banks and foreign exchange offices to conduct international transactions. Foreign exchange brokers will in turn be used by banks to supply needed currencies and to cash-in unneeded currencies. Finally the central banks of trading countries may intervene on the currency market by adding to the foreign reserves in order to adjust the exchange rate. Exchange rate systems: o A number of different exchange rate systems operate worldwide; the way a country manages its exchange rates is known as its exchange rate regime, of which there are three main types; these are: o Fixed exchange rates: An exchange rate regime where the value of the currency is fixed (pegged) to the value of another currency, the average value of several currencies, a commodity, or a selection of commodities (e.g. the Argentinan Peso). As the value of the variable the currency is pegged to changes, the government is obliged to adjust the currencys value accordingly. Deciding on and maintaining the currencys peg is usually the role of a countrys central bank (or government). If the value of a currency in a fixed ER is raised, we speak of a revaluation of the currency; if it is lowered, we deal with a devaluation; these terms are specific to fixed ER regimes and are only used in reference to changes in fixed ERs. Note that currencies always change in value rel. to other currencies; the pound can appreciate against the yen, for instance, but depreciate against the dollar. The usual mechanism for a fixed ER regime is similar to a buffer-stock scheme; the currency is allowed to float within a very narrow range of values, and the central bank intervenes by buying/selling its own currency on the foreign exchange market when its currency leaves the band set by the peg. o The Central Bank may also manipulate interest rates to encourage/discourage investment in the country (which will affect upward/downward pressure on the ER) o In the long run, governments might intervene using fiscal policies, supply-side measures and protectionism to adjust national income in order to increase or decrease exports and citizens propensity to import. The central bank could also borrow from the International Monetary Fund. The IMF was created to aid countries having difficulty keeping a stable exchange rate. When a countrys currency falls, and the central

bank runs out of foreign exchange to buy up the home currency, the central bank can borrow funds from the IMF to get over the crisis o To discourage speculation (e.g. George Soros in the UK, in 1992), governments/central banks do not publicize the limits of the peg, but they do exist. A further, less effective, mechanism for a fixed ER is a straightforward peg, where the dom. currency is fixed at a certain rate to a foreign currency. o Using this method, it is very difficult for govts to settle on a suitable ER that limits the scale of currency black markets; however, the strategy is theoretically very simple, and is often used in LDCs. Floating Exchange Rates: An exchange rate regime where the value of a currency is determined solely by supply of, and demand for, it on Forex; there is no govt intervention to influence the currencys value (e.g. the US Dollar, since 1971). In a floating exchange rate system, perfect information is an important issue. Graphically, the market for a currency is illustrated as a supply-and-demand diagram, with price of Currency X in Currency Y on the vertical axis (make sure to get your labels right). The demand and supply curves are normal; demand slopes downwards and represents the demand for the local currency by holders of the foreign currency, and supply slopes upwards, indicating the supply of the local currency, originating from its citizens and assets. The exchange rate is set by market equilibrium, where QS=QD. If a currency in a floating ER regime increases in value, we refer to an appreciation of the currency; if it decreases in value, we deal with a depreciation of the currency; these terms are specific, and limited to changes in a currencys value under a floating ER regime; do not confuse the terms with devaluation and revaluation, which are not applicable in this case. If a currency appreciates against another currency (for sake of argument, the Zloty against the Euro), the price of Eurozone goods in Zlotys decreases (though their value remains the same); this means that the purchasing power of the Zloty has risen, and a given amount of Zlotys may now buy relatively more Eurozone goods. Conversely, in the Eurozone, the appreciation of the Zloty against the Euro is simultaneous with a depreciation of the Euro against the Zloty; the two movements are exact mirrors of each other (which is only logical; changes in one exchange rate will be met by inverse changes in the other ER. Causes of a free-market change in exchange rates:

Several factors will influence demand and supply on currency markets; using our Euro and Zloty example, let us examine the demand for Zlotys by Euro-holders outside of Poland. Euroholders will buy PLN on Forex in order to: Buy exports of Polish goods and services, and travel to Poland Invest in Poland (long-term capital movements, usually through FDI or portfolio investment) Save money in Polish banks and fin. institutions Speculate on the Zloty in the hope that the currency will increase in value in the future; these are short term cap. movements known as hot money. Thus, demand for the Zloty (which is to a very large extent a derive demand) will rise if: Demand for Polish goods and services increases; for example, if: Polish inflation rates are relatively lower than Eurozone inflation rates (OK, ridiculous example, due to the EU; in fact, pretend Poland is not in the EU for this section), making Polish goods and services relatively cheaper than EU products. An increase in incomes in the EU, which shifts AD right, increasing demand for imports from Poland, occurs. A change in tastes in the EU in favor of Polish products, occurs (e.g. due to better quality, increases in foreign incomes, or increases in tourism). Polish investment prospects improve (e.g. due to sound public finance practices by the Polish govt); note that slow growth will have the opposite effect, as it is often seen as a sign of ec. weakness) Polish interest rates increase, making saving more attractive in Poland than in EU fin. insts. EU speculators think that the Zloty will rise in value in the future, so they purchase it now; if they are correct, they will be able to resell the Zlotys when they are worth more and make a financial gain.

An increase in demand for the Zloty will shift the currencys demand curve right, causing the Zloty to appreciate; each Zloty can be exchanged for a larger amount of Euros. o The elasticity of demand for a currency is dependent on the PED for dom. goods and services; the more elastic this value of PED, the more elastic the demand for the currency. Supply of the Zloty on Forex (continuing with our example) will be determined by a converse set of factors; the Zloty will be supplied when Poles wish to: o Buy Eurozone goods and services and travel to the Eurozone o Invest in Eurozone firms (both FDI and portfolio investment) o Save money in Eurozone banks and fin. institutions o Make money by speculating on the Euro, in the hope that it will increase in value. In all of the above cases, Poles will need Euros, and will need to exchange PLN to acquire Euros, increasing PLN supply on Forex; thus, supply increases of PLN on Forex will be caused by: o Poles increasing demand for EU goods/services, exchanging more PLN for Euros; this could be due to: Polish inflation rates being rel. higher than those in the EU, making EU products relatively less expensive than domestic products. An increase in incomes, and thus AD, in Poland, which increases Polish demand for imports from the EU (inter alia). A change in tastes in favor of EU products in Poland (e.g. because EU products are of better quality, or Polish incomes rise, or Polish tourism to the EU increases). o An improvement in US investment prospects o An increase in EU interest rates, making saving rel. more attractive there than in Poland o Speculators in Poland thinking that the Euro will gain in value against the Zloty; they sell PLN now and buy Euros- if they are correct, they will be able to buy US$ again when they are less expensive, and thus make a financial gain. If the supply of PLN on Forex increases, the supply curve for PLN will shift right and the Zloty will depreciate; each zloty will be exchangeable for a smaller amount of Euros. Managed Exchange Rates: Exchange rate regimes where the government maintains a band of in which the currency is allowed to fluctuate (much as in a fixed ER), but with the band set at an arbitrary level. The government/central bank is free to adjust the

band (realign the currency) in the long run, if either upward or downward pressure on the band becomes too intense (in which case, the currency is fundamentally over- or undervalued), to account for changing economic conditions. This ER regime exists because completely fixed rates cause a problem of inflexibility, since economies have different fundamentals such as growth rates and inflation rates. In the long run it could be very costly for a country with a weakening currency to defend its links with other countries. o In reality, no currency is fully fixed or free-floating, and all ER regimes exist on a spectrum; even where governments try to be non-interventionist, the currency may sometimes be subject to severe fluctuations and the monetary authority will feel obliged to intervene. Likewise, frequent changes in a floating ER cause uncertainty and reduced business confidence, and govts may be forced to intervene to stabilize the exchange rate; thus, most free-floating ER regimes are, in reality, dirty float ER systems, with some govt intervention. Advantages/Disadvantages of High/Low ERs: o The actual level of the ER will influence the economic situation of a country; hence, governments intervene to influence the value of the ER. The respective advantages/disadvantages of a high/low ER are: Possible advantages of a high ER: Downward pressure on inflation: If the value of an ER is high, the price of finished imported goods and imported semi-mfgs, raw materials and component will be rel. low; this will lead to lower costs/prices for firms/consumers. The lower import prices will put pressure on domestic producers to be competitive and keep prices low. More imports can be bought: If the value of the ER is high, each unit of the currency will buy more foreign currency; thus, more foreign products (including visible imports and services- e.g. tourism) can be bought. As import prices will fall rel. to export prices, (ceteris paribus) an improvement in the terms of trade (though not the balance of trade) will occur. Increased efficiency of domestic producers: The high ER will threaten their intl competitiveness; they will be forced to lower costs and become more efficient to remain competitive. While this may result in layoffs and unemployment, there are other means by which efficiency, and thus greater econ. productivity (potential growth) can be achieved. Possible Disadvantages of a High ER: Damage to Export Industries: If the value of the ER is high, export industries may have difficulties selling their products, whose prices will

be rel. high, abroad; this could lead to unemployment in those industries. Damage to Domestic Industries: With greater levels of (now rel. cheaper) imports being purchased, dom. producers may find that the increased competition lowers demand for their products; this may further increase unemployment as firms scale back. o It is difficult for govts to predict and plan for the effects of the high ER, as the consequences are likely to be asymmetrically distributed across industries and regions in the economy. Possible Advantages of a Low ER: Greater Employment in Export Industries: If the value of the ER is low, exports will be rel. less expensive and thus more competitive abroad, leading to greater employment in export industries. Greater Employment in Dom. Industries: The low ER will make imports increasingly expensive; this may encourage dom. consumers to purchase relatively cheaper dom. produced goods, rather than imports; this may also boost employment. Possible Disadvantages of a Low ER: Inflation: A low value of the currency will make imported final products, as well as raw materials and components, more expensive; this will increase costs of production for firms as well as prices for consumers, leading to higher prices in an economy and, in all probability, inflation. Thus, a high value of a currency may be good to fight inflation, but may cause unemployment problems (and possibly hinder growth), while a low value of a currency will increase employment, but may worsen inflation. Conflict between policy objectives, people. Government Measures to Intervene on Forex: o Governments may wish to intervene on currency markets and influence the value on their currency for several reasons; they may wish to: Lower the ER to reduce unemployment Raise the ER to combat inflation Maintain a fixed ER Avoid large fluctuations in a floating ER Achieve rel. ER stability to improve business confidence Improve a balance of trade deficit (where spending on imported products exceeds revenue received from exports of products). o Whatever the case may be, there are two main methods for governments to manipulate the ER of their currency: Using reserves of foreign currencies to buy and sell its own currency: If a govt wishes to increase its currencys value, it can use its foreign reserves to buy its

own currency on Forex, increasing demand for the currency and forcing up the ER. Likewise, if a govt wishes to lower the value of its currency, it can buy foreign currencies on Forex using its own currency; to do so, the govt uses its own currency, increasing its supply on Forex. This causes the ER to be forced down. Changing interest rates: If a govt wishes to increase its currencys value, it can raise interest rates in the country; this will make dom. interest rates rel. higher than foreign interest rates and should attract fin. investment from abroad; to put money into the country, investors will need to buy the local currency, increasing the demand for it, and thus, the ER. Likewise, if a govt wishes to lower its currencys value, it may lower interest rates in the country, making dom. interest rates rel. lower than those abroad and making fin. investment abroad rel. more attractive; to invest abroad, local investors would need to buy foreign currencies, exchanging their own currency and increasing its supply on Forex, lowering the ER. Advantages and Disadvantages of Fixed/Floating ERs: o Whichever ER regime a country operates, there will be associated advantages and drawbacks; these include: Advantages of a fixed ER: A fixed ER should reduce uncertainty for all econ. agents in a country; businesses will be able to plan ahead, knowing that predicted costs and prices for intl trade and export will not change by much; this should encourage investment and trade in the econ. If ERs are fixed, inflation may have a harmful effect on demand for imports and exports; thus, the govt will have an incentive to take sensible measures to keep inflation as low as possible, in order to maintain business competitiveness on foreign markets; in addition, firms will have an added incentive to keep costs as low as possible in order to be competitive. In theory, the existence of fixed ERs should (by definition) reduce speculation on foreign exchange markets; however, in reality, this has not always been the case, as speculators have destabilized fixed ER systems for speculative gain. Drawbacks of a fixed ER: The govt is compelled to maintain the fixed exchange rate; as the main way of doing so is through manipulation of interest rates and control of money supply, if the ER is in danger of falling, the govt will need to increase interest rates to increase demand for the currency. This will, however, have a deflationary effect on the economy, lowering demand

and increasing unemployment; the policy objective of low unemployment may need to be sacrificed. To keep the ER fixed and instill confidence on Forex, the govt will need to maintain a war chest of foreign reserves to ensure that it can defend its currency by buying and selling foreign currencies. Setting the level of the fixed ER is not simple; many variables, which will change over time, need to be considered. If the rate is miscalculated, export firms may not be competitive abroad; if this is so, the ER may need to be recalculated, but this will again involve difficulties in estimation. A country that fixes its ER at an artificially low level may create international disagreement; a low ER will give the countrys exports an advantage on world markets, which may be seen as unfair trade. This may lead to economic disputes or retaliatory protectionism. Meanwhile, an ER that is fixed at an artificially high rate is likely to reduce the competitiveness of dom. firms. Under a fixed ER, mon. policy becomes more difficult; any change in IRs is likely to lead to unwanted inflows/outflows of currency and put pressure on the currency (e.g. if the govt tries to control the money supply, the resultant higher IRs will encourage inflows on the cap. acc. and increase the money supply again. o Thus, deflationary fiscal policy (e.g. higher taxes, lower spending) may be the only policy option available to govts for curing demand-pull inflation; lower demand will also reduce demand for money and thus IRs, leading to capital outflows which reinforce the contractionary fiscal policy but may put pressure on the currency. The same situation in reverse applies for expansionary fiscal policy. Advantages of a floating ER: Because the ER does not need to be maintained at a certain level, interest rates are freed up as a dom. mon. demand-side policy tool (e.g. for controlling inflation). In theory, a floating ER is self-adjusting, and will keep the current account balanced; for instance, if there is a current account deficit, demand for the currency is low, as export sales are most likely low, and its supply is high, as demand for imports is likely relatively high. o This should mean that, in the long run, the market will adjust, as the ER will fall. As a consequence, exports should become relatively less expensive and more competitive, imports relatively more expensive, and the current account balance

should right itself, if the Marshall-Lerner condition (PED(exports)+PED(imports)>1) is met. Because foreign reserves are not needed to stabilize the currency, it is not necessary to maintain high levels of foreign exchange or gold. Imported inflation is prevented: if one country has higher inflation, then, under a fixed ER system, its trading partner becomes more vulnerable to import-push inflation via higher import prices, as the currency is not self-writing (e.g. China, in recent years). A floating ER possibly reduces speculation, as the risk of large losses may deter speculators. In a floating ER, an increase in money supply will reduce IRs, boosting dom. expenditure and leading to outflows of currency on the cap. acc., and thus a fall in the value of the currency, which will boost exports, leading to a further increase in AD. o Alternatively, a contractionary mon. policy will increase IRs and reduce AD; the higher IRs will lead to capital inflows and cause the currency to appreciate; this further reduces AD. Thus, in a floating ER regime, monetary policys effectiveness is amplified. Disadvantages of a floating ER: Floating ERs tend to cause uncertainty on intl markets; businesses attempting to plan for the future may find it difficult to accurately predict costs and revenues (although businesses may hedge against ER movements by buying/selling currencies in the future in forward currency markets to reduce the risk). Investment is more difficult to assess, and volatile ERs will reduce intl investment levels, as risk/return calculation becomes more difficult. In reality, more factors than demand and supply for products and investment affect floating ERs; such factors include speculation, govt intervention and unplanned world events (e.g. the Japanese earthquake and tsunami). Thus, they do not necessarily self-adjust to correct current account problems; in particular, speculation may lead to largescale ER changes. Govts are permitted looser controls over their economies (e.g. they do not have to ensure that do. inflation is in line with that of other countries to ensure that their firms are competitive, as their currency is free to depreciate) A floating ER may worsen existing inflation rates; if a country has high inflation relative to other countries, its exports will be less competitive and its imports more expensive; demand for the currency, and thus the ER will fall to compensate-while its goods will become competitive again, at least initially, this could lead to even higher import prices of

finished goods, raw materials and subcomponents, which may exacerbate cost-push inflation. Fiscal policy is less effective in a floating ER regime, as contractionary fiscal policy reduces income, and thus demand for money and IRs, leading to an outflow on the cap. acc. This in turn causes a depreciation of the ER which raises AD. The same situation in reverse applies for expansionary fiscal policy. Advantages/Disadvantages of a Single Currency/Monetary Union: o Since 1999, the Eurozone is an example of a monetary union; all existing EU members are eligible to join the Eurozone if they meet certain economic and monetary requirements. New EU members must take action to eventually adopt the Euro. o Specifically, to join the Eurozone, countries must: Have inflation rates no more than 1.5% above those of the three countries in the EU with the lowest inflation. Have interest rates on long-term bonds at no more than 2% above the average of the three countries with the lowest interest rates. The budget deficit should not exceed 3% of the GDP at market prices. The national debt should not exceed 60% of the GDP at market prices. The exchange rate must have been stable for the preceding two years, with no realignments or excessive intervention. o The European Central Bank manages the Euro; there are several advantages and disadvantages to participating in the Eurozone. Advantages of a monetary union: A single currency reduces transaction costs and facilitates administration, as countries within the Eurozone do not need to exchange currencies, and pay commission, when trading. Within the Eurozone, businesses no longer need to worry about exchange rate fluctuations and thus changes in rel. costs and prices; this reduces risk and increases business confidence among member-states. It is easier for firms to compare prices between members of a monetary union, as they do not need to constantly convert figures using the latest ER data. Firms within the monetary union are forced to control inflation or risk becoming uncompetitive. Firms within the monetary union gain increased access to markets, due to the removal of all barriers to trade (including currencies); firms may now benefit from significant economies of scale. FDI may be attracted to the monetary union due to lower transaction costs, reduced uncertainty, and large size of the common singlecurrency market. Drawbacks of a monetary union:

With a single currency, a single body sets interest rates for all memberstates; thus, individual countries lose their ability to set interest rate levels and adopt an independent mon. policy, leading to a loss of sovereignty over monetary policy. The benefits of a monetary union may be spread unevenly within a country, which could potentially worsen income inequality. In a mon. union, it is not possible for one country to depreciate/devalue its currency to ease a balance of trade deficit; all countries are required to maintain the same ER against non-member states. There is a cost of transition from national currencies to a single currency for governments, who need to physically change currencies, as well as firms (menu costs) and potentially, regional unemployment; however, this is mostly a one-off cost. Purchasing-Power Parity Theory: An economic theory that argues that, in the long run, ERs should move towards a level that would equalize the prices of an identical basket of products in the two countries being compared; it equates the LR exchange rate with relative inflation rates in each country. o The theory states that ERs will be in LR equilibrium where the rate allows people in different countries to buy the same basket of goods with an equal amount of money (this comes down to the Law of One Price: in an efficient market, identical products will have the same price). o Assume that the actual ERs between two countries are equivalent to the PPP ERs (e.g. if a Big Mac can be bought for L1 in the UK and $1.8 in the US, the ER is L1=$1.8). If, because of inflation, prices rise by more in the UK than in the US, the PPP exchange rate will decrease, and theory suggests that the actual exchange rate will eventually also decrease, as UK Big Macs will have become more expensive (note, though, in reality, that we will not be dealing with a single good. Just a silly example) There would be rel. increased demand for US imports in the UK, and the supply of L on Forex should increase; likewise, demand for UK goods in the US should decrease, and demand for the L should fall; the pound should depreciate relative to the $ until the PPP ER is reached. o If inflation rises by x% in a country, the currency should fall in value by x%, ceteris paribus. o PPP theory is useful in drawing comparisons between countries; however, it is simplistic in the sense that ERs are not only affected by demand and supply for/of products; in reality, speculation, business confidence, govt intervention and world events may mean that the theoretical long run is never achieved, due to the accumulation of short-run fluctuations. The actual ER is unlikely to ever reach the optimum PPP ER.

Chapter 27: Balance of Payments and the J-Curve Effect

The Balance of Payments Account: A record of the value of all transactions between the residents of one country and the residents of all other countries in the world over a given period of time (usually one year, although monthly figures are also collected). o The balance of payments shows a countrys payments and receipts from its relations with other countries, and is usually subdivided into two parts, listed below; as their names vary, the most common names will be used. The Current Account: A measure of the flow of funds from trade in goods and services, plus all other flows of income; it is usually subdivided into three parts: The Balance of Trade in Goods (The Visible Trade Balance, the Merchandise Account Balance, the Balance of Trade): A measure of the revenue received from exports of tangible (physical) goods (e.g. boxes of Mac n Cheese, hair driers) minus the expenditure on imported tangible goods over a given timespan; it includes trade in all tangible goods. o Exports: When an international transaction relating to goods and services leads to an inflow of money into a country. o Imports: When an international transaction relating to goods and services leads to an outflow of money from a country. o Balance of Trade Surplus: A situation where export revenue exceeds import expenditure (e.g. Germany). o Balance of Trade Deficit: A situation where import expenditure exceeds export revenue (e.g. the US, for the past 30 years). o The Balance of Trade will be affected by increases/decreases in the value of the economys currency; see the discussion on the Marshall-Lerner Condition, below. o In addition, any changes in the balance of trade will affect AD, as import expenditure and/or export revenue (the two components of Net Exports) will have risen/fallen. Conversely, in a country with high marginal propensity to import, an increase in AD will significantly increase import expenditure, moving the curr. acc. towards a deficit. The Balance of Trade in Services (the invisible balance, the services balance, net services): A measure of the revenue received from the export of services (e.g. tourism, banking, and exotic dancing) minus the expenditure on imports on services over a given timespan. o An Italian tourist on holiday would be spending money that amounts to an invisible export for the host country (money coming in) and an invisible import to the Italian economy (money leaving). Net income flows- usually split into two sections:

Net investment incomes (net factor income from abroad): A measure of the net monetary movement of profit, interest and dividends entering and leaving a country over a given timespan as a result of financial investment (from) abroad. If domestic firms have foreign branches, any profits being repatriated count as a credit to the current account balance; likewise, profits remitted by foreign firms operating within the country would count as a debit to the current account. If domestic residents and institutions invest in foreign financial institutions, any interest on the financial investments will be a credit towards the current account; likewise, any outgoing payment of interest to foreign investors will count as a negative item. If domestic residents and institutions purchase shares in foreign companies, any dividends received on the shares will be a current account credit; likewise, any dividends paid by domestic firms to foreign shareholders would count as a current account debit. o Net Transfers of Money (Current Transfers, Net Unilateral Transfers from Abroad): Payments made between countries when no goods/services change hands- at a govt level, this includes foreign aid and grants; at an individual level, it includes remittances of earnings by foreign workers to their home country or private gifts sent between people in different countries. Current Account Balance = Balance of Trade in Goods + Balance of Trade in Services + Net Income Flows Any of these accounts, as well as the entire current account, may be in surplus/deficit at any one time (e.g. there could be a deficit on the trade balance but a surplus on net income flows); the current account balance is an overall balance of all of its components. The Capital Account: A measure of the buying and selling of assets between countries; it measures the net change in foreign ownership of domestic assets. The capital account is sometimes referred to as the financial account or subdivided into a financial account and a capital account; for simplicity, IB refers to the buying and selling of all assets internationally as the current account. Capital Account Surplus: The case where foreign ownership of dom. assets rises more quickly than dom. ownership of foreign assets; thus, more money enters than exits a country.

Capital Account Deficit: The case where domestic ownership of foreign assets grows more quickly than foreign ownership of domestic assets; thus, more money leaves than enters a country. Assets: Property that can be owned and has value- including land, real estate, govt bonds, treasury bills, bank deposits, shares, foreign currency, derivatives, etc. o Assets can be classified in several ways; for instance, we distinguish between: Assets that represent ownership; e.g. purchasing property, businesses, or stocks and shares- in all cases, the asset is expected to have a positive return in the future by increasing in value over time- the investment is not necessarily repaid, and a pos. return is not guaranteed; the buyer of the asset takes a risk. Assets that represent lending: e.g. treasury bills, bonds, savings deposits- in these cases, the investor lends money in order to purchase the asset, expecting a positive return (interest) on the investment and eventual repayment; these assets represent borrowing and lending on an intl scale. Foreign direct investment (investment by MNCs in another country) Portfolio investment: Investment in stocks and shares Other investment (e.g. currency transactions) o The capital account also includes changes in the official reserve account (the stores of gold and foreign reserves kept by governments); it is movements into and out of this account that ensure that the balance of payments will always balance out to zero; the official reserve account will show the degree of govt intervention on exchange rate markets. If there is a surplus on all other accounts combined, the official account total will decrease; if there is a deficit on all other accounts combined, the official reserve account will increase; it is net changes in the official reserve account over the timespan considered that balance the accounts. For instance, if, at the given ER, there is excess demand for a currency, the govt will need to sell the currency to keep the ER constant. This is entered as a negative number under official financing on the curr. acc. Likewise, if at the given ER there is excess supply of the currency, the govt will need to buy the currency to

keep the value constant; this is entered as a pos. number under official financing. If there is no official financing, demand for a currency will always equal supply of the currency (i.e. inflows = outflows), and the official reserve account balances out at zero. In a free-floating ER regime, this item will automatically balance the curr. acc. with the cap. acc; the ER automatically changes until the supply of the currency equals the demand for the currency. In a fixed ER regime, govt intervention will ensure that this item balances the curr. acc. with the cap. acc.; if the govt is ineffective in doing so, the two accounts will balance through unofficial (illegal) foreign exchange markets. o In reality, the accounts will never perfectly balance, as too many individual transactions occur for measurement to be exact; some transactions will be unrecorded when figures are put together- thus, a balancing item (a.k.a. net errors and omissions/ statistical discrepancy) will be used to ensure that the accounts balance. As more data becomes available, trading accounts are revised and the balancing item decreases in size. The total capital account balance should be the inverse of the current account balance; the balance of payments should always sum up to zero (thus, if there is a current account surplus, the capital account must be in deficit, and vice versa; one account effectively pays for the other. One result of sustained economic growth is usually increasing demand for imports of goods and services; thus, economic growth may cause the current account to worsen: a country will need to borrow heavily from abroad (either literally or by attracting investment) from abroad to finance its international expenditure; this may not be sustainable indefinitely. Consequences of Current and Capital Account Imbalances: A deficit or surplus in the capital or current account will have economic consequences that we can consider:

Consequences of a current account deficit: If the current account is in deficit, the cap. acc. will need to be in surplus to balance out the deficit. This has one of three implications: o Foreign reserves may be used to increase the cap. acc. and thus regain balance with a curr. acc. deficit- if reserves are taken from the official reserves account, they are a pos. entry into the cap. account; however, no country can fund long term curr. acc. deficits indefinitely from its reserves, which will eventually run out. o A high level of buying of assets for ownership can be used to fund the curr. acc. deficit- foreign investors may purchase dom. assets (including property, shares and firms); inflow into the cap. acc. funds the curr. acc. deficit. As it is a sign of foreign confidence in the dom. economy, it is not usually assumed harmful; however, if foreign ownership of dom. assets becomes too great, economic sovereignty may be endangered, and if confidence decreases, foreign investors may abruptly withdraw their assets elsewhere (more so with hot money than long-term investment). Selling the assets would result in an increase in the supply of the dom. currency and a decrease in its value. o The deficit may be financed by high lending from abroad; if this is so, high interest rates will need to be paid, causing short-term economic harm and further increasing the curr. acc. deficit in the future. Also, private and public lenders may withdraw their money and place it elsewhere if investment prospects worsen, leading to massive selling of the currency and a sharp fall in the ER. Consequences of current and cap. account surpluses: If the capital account is in surplus, the following is likely: o A curr. acc. surplus allows a country to have a cap. acc. deficit by building up its official reserve account or purchasing assets abroad; however, one countrys surplus is anothers deficit, which may lead to protectionism from countries with trade deficits. o A curr. acc surplus usually causes the currency to appreciate on Forex as it implies an increase in demand for the currency (however, at the same time, demand for exports is relatively low, so this may be a moot point). If this occurs, at least in the

SR, imports will become cheaper, reducing inflation, but exporters will be harmed by higher prices. One countrys surplus is anothers deficit; the country with the deficit may introduce protectionist measures, possibly harming dom. industries. Dutch Disease Effect: If a country generates a curr. acc. surplus by exporting natural resources (e.g. natural gas in Holland, North Sea oil in Britain), the increase in foreign demand for the natural resources may cause the ER to appreciate, making dom. companies less competitive. If the ER is fixed, a curr. acc. surplus will increase the dom. money supply (a surplus means that there is excess demand for the currency, so the authorities must sell currency); the increase in the money supply could lead to inflation. A cap acc. surplus, based on the purchase of assets for ownership is almost always a positive outcome and allows a current account deficit (and more gains from importing products); however, if the cap. acc. surplus is based on high levels of borrowing from abroad (usually as a matter of necessity, to fund a current account deficit), the economy may be in serious trouble due to debt and interest repayments. The Magnitude of a Current Account Deficit/Surplus: Two ways of interpreting the magnitude of a curr. acc. deficit/surplus exist; first, its total value may be considered (e.g. a deficit of $109 billion); however, the figure becomes more meaningful when placed into context with the countrys GDP- a current account deficit of a given size would mean much less to the US than to Burkina Faso, for instance. The burden of the deficit depends on ability to pay; this is not as great a concern when a country has a curr. acc. surplus, although possible problems with the appreciation of the currency may arise in the SR. The major problem is when current account deficits reach a certain % of a countrys GDP and become difficult to manage effectively. Methods of correcting a persistent current account deficit: Although a current account deficit may be based on cyclical factors in the shortterm, a sustained current account deficit is most likely caused by structural factors within the economy in question. For instance, an economy may produce goods un-competitively (at a rel. higher opp. cost than competitors), or may produce goods that are not demanded by dom. consumers and/or foreign consumers (e.g. nuclear weapons).

This is usually more of a problem under a fixed ER regime, compared to a floating ER regime; in a floating system, the external value of the currency falls, making exports competitive again. By contrast, in a fixed system, the deficit would need to be offset by inflows on the cap. acc. or govt intervention to buy up excess currency (which cannot continue indefinitely, as the countrys foreign reserves are limited). When govts attempt to correct a current account deficit, they may adopt two sets of policies: Expenditure-switching policies: any govt policies that attempt to divert consumption of imports towards dom. produced goods; if successful, import expenditure will fall and the curr. acc. deficit will improve. This is accomplished through: o Depreciation/devaluation of the currency: If the govt adopts policies to reduce the ER, exports should become cheaper and imports- more expensive; depending on the PED of imports and exports (the Marshall-Lerner Condition applies) the curr. acc should improve as export revenues rise and import expenditure falls. Although a depreciation of the currency is assumed to occur as an automatic response to a curr. acc. deficit in a free-floating ER regime, a govt operating a fixed ER regime will need to determine the amount the currency needs to be devalued; this may lead to inefficiency if the government mis-estimates the appropriate amount by which the currency should decrease in value. o Protectionist measures: the govt may attempt to restrict imports via quotas, tariffs, embargoes, and administrative/health and safety barriers. If the price of imports rises and/or they become less widely available (the two go hand in glove; the rationing function applies), domestic consumers will switch a portion of their expenditure towards domestic products, away from imports. However, govts are often reluctant/unable to use protectionist measures as they may incite retaliation and violate WTO agreements; also, protectionism reduces competition and encourages inefficiency- it is not a viable long-term solution. Expenditure-Reducing Policies: any govt policies that attempt to reduce overall expenditure in the economy, shifting AD left; if this occurs, expenditure on all products (including imports) should fall, and

the curr. acc. deficit should improve. The size of the fall in imports will depend on marg. prop. to imports. o However, a conflict between policy objectives arises; deflating the economy may reduce the current account, but will also lead to a fall in growth rates and employment; thus, it is a difficult decision to make. Examples of this policy type include: Deflationary fiscal policy: Increasing direct tax rates and/or reducing govt expenditure; both are pol. unpopular and a govt may be reluctant to adopt such policies. Deflationary mon. policy: Increasing the interest rate and/or reducing money supply. The higher interest rate should attract foreign investment, as foreigners put money into fin. institutions, attracted by higher rates; this will cause a cap. acc. improvement, which will offset the curr. acc. deficit; however, this policy will also be pol. unpopular as higher interest rates will increase domestic debt repayments. The higher borrowing costs due to higher interest rates may act as a disincentive to dom. investment and limit pot. growth. In some cases, supply-side policies may be beneficial in correcting a curr. acc. deficit, by expanding the potential output of a country, increasing productivity, improving the quality of output, and encouraging investment, innovation and competition by reducing protectionist barriers, thus allowing the economy to produce its exports in a more competitive manner. In most cases, a package of policies will be used to manage a curr. acc deficit; for instance, a depreciation of the currency will cause consumers to switch consumption to dom. goods; however, if dom. industries are near full capacity, they cannot produce enough in response to the policy, resulting in inflation. o Thus, the govt may intervene by deflating the economy (expenditure-reducing) to provide capacity for expenditureswitching to occur; the two policies are complementary. The econ. costs of reducing a curr. acc. deficit suggest the importance of preventing its occurrence; to avoid these costs, many govts actively promote exports (e.g. via official trade missions and advertizing), hoping to develop new markets. The Marshall-Lerner Condition:

In theory, if a countrys currency decreases in value, exports will increase (they become less expensive abroad) and imports will decrease (they become more expensive domestically); this should improve a countrys curr. acc, but this is not always the case. The effect of a price change on expenditure and revenue depends on PED; export prices may fall due to depreciation of the currency and, acc. to the Law of Demand, QD will increase; however, whether export revenues increase depends on foreigners PED for exports. Likewise, the price of imports will rise if a currencys value falls; according to the Law of Demand, QD will fall, but whether this will lead to decrease in import expenditure depends on PED for imports. The Marshall-Lerner Condition tells us how successful a depreciation/devaluation of a countrys ER will be at improving a curr. acc. deficit in the balance of payments. The Condition states that: reducing the value of the ER will only be successful if the total of the PED for exports and imports is greater than one; A fall in the exchange rate will reduce a curr. acc. deficit if: o PED(exports)+PED(imports)>1 This can be explained via price elasticity of demand; if demand for exports was price inelastic and price fell due to a fall in the ER, the QD of exports would increase by a less-than-prop. amount, leading to a decrease in export revenue. o Likewise, if the price of imports rose due to a fall in the ER, and demand for imports was price inelastic, the QD of imports would decrease by a less-than-prop. amount, increasing import expenditure; both factors would worsen the curr. acc. deficit. One of the determinants of PED is the timespan being considered; demand becomes more elastic over time. This applies to demand for imports and exports. o Based on actual data, in almost all cases, short-run PED values for exports and imports are lower than long-run values; this corresponds to theory. o Whereas few countries meet the Marshall-Lerner Condition in the SR, most would meet the condition in the LR. The J-Curve Effect: o If a govt faces a curr. acc. deficit, it may reduce the ER of its currency to make exports rel. less expensive and imports rel. more expensive; if this happens and the MarshallLerner condition is met (PED(exports)+PED(imports)>1), the curr. acc. deficit will improve. This is not the case in the SR and the curr. acc. deficit worsen before it improves; this is known as the J-curve effect, which shows the effect of the lowering of an ER on a curr. acc. deficit over time.

If the govt lowers the ER, the price of exports will fall, but, because of imperfect communication, other countries will not immediately realize that export prices have fallen; also, other countries may be locked into contracts for goods/services with suppliers that cannot be broken quickly. Thus, PED(exports) will be inelastic in the SR and export revenue will fall by prop. more than the increase in QD, increasing the curr. acc. deficit (this can be plotted on a graph). Likewise, import prices will have risen, but purchasers of imports will take time before they switch to domestic substitutes; they may also be tied into contracts and will need to wait until they expire before moving on to other suppliers. o Thus, in the SR, PED (imports) will also be inelastic and import expenditure will rise, as prices rise by prop. more than the decrease in QD, further contributing to the worsening of the curr. acc. However, PED for exports and imports increases over time; after q certain time where the curr. acc. worsens, PED for exports and imports will increase to a point where the Marshall-Lerner Condition is satisfied, as cons. and prod. abroad will switch to the cheaper imports from Home, and as dom. consumers change their expenditure patterns toward dom. goods/services; henceforth, the less expensive exports and more expensive imports should decrease import expenditure and increase export revenue and improve the curr. acc. balance. By the same token, a balance of payments surplus may be reduced via a revaluation/appreciation of the currency (along with removals of import controls and expansionary demand-side policies, which increase demand for imports). Note that, in the very long run, the curr. acc. could worsen again, a the higher import prices could cause cost-push inflation and make dom. goods/services uncompetitive abroad. Thus, a depreciation/devaluation of the currency may only be a temporary solution to long-term curr. acc. deficits. Also, one countrys surplus is anothers deficit: if a depreciation leads to a fall in import expenditure, the country that produced the imports will suffer falling GDP; if Home exports to those countries, its exports may also suffer. Falling income levels may reduce inflationary pressure in those countries, making goods from Home appear more expensive and poss. mitigating some of the benefits of the ER policy.

Chapter 28: Terms of Trade

Terms of trade are a distinct concept from the balance of trade in visible goods, discussed earlier; it is easy to confuse the two, but do not do so. Deteriorating terms of trade are one of the major problems faced by LDCs; this has a specific meaning in context, and does not simply mean that they experience difficulty in trade. Terms of Trade: An index that shows the value of a countrys average export prices relative to their avg. import prices; o Terms of Trade= The weighting of the idices of avg. export and import prices reflects the rel. importance of diff. goods and services to the countrys export rrevnue and import expenditure. Assume the ToT index is initially set at 100. o If export prices rise and import prices stay constant, or if export prices rise by prop. more than import prices, or fall by prop. less than import prices, there is an improvement in the ToT; a countrys exports will buy more imports than they had in the past (this has been the case, for instance, in India, as the economy has progressed to exporting manufactures and, increasingly, services). o Conversely, if import prices rise and export prices remain constant, or if export prices fall by prop. more than import prices, or rise by prop. less than import prices, there is a deterioration in the TOT; a countrys exports will buy fewer imports than they had in the past (e.g. the economy of Chad). o Note that the terms improvement and deterioration are relative; a country may face deteriorating terms of trade for a time and still face a net long-term improvement in the ToT. In addition, whether a deterioration or improvement in the ToT is good or Bad will depend entirely on the relative composition of a countrys exports and imports (the terms in themselves are unnecessarily loaded). o If the ToT improve, a given quantity of exports will buy more imports than before. We usually refer to a basket of standard export and import products; if the price of a basket of exports falls (ceteris paribus), the country will need to sell more exports to keep imports constant. Short-Run and Long-Run Causes of Changes in a Countrys ToT: o Short-run changes in the ToT may be caused by: Changes in the conditions of demand and supply if the demand curve for exports shifts, the price of exports will change. This will likely be in response to prices of competitive goods in other countries, which affect export

competitiveness, changes in income (and thus AD) in importing countries, and changes in tastes and preferences for the products exported. Likewise, changes in supply will also affect export prices; if a number of countries experience increased supply of a product (e.g. because of good weather conditions, wine prices dropped in Australia), its price will fall. The effect of such a change on the ToT depends on the overall importance of the good as an export. Changes in rel. inflation rates: If inflation rates in one country are higher than in another, their export prices will begin to rise; although this causes an improvement in the ToT, the countrys exports become less competitive. Changes in ERs: a change in the value of a countrys currency will cause a change in export prices rel. to import prices; this will occur either due to market forces or via govt intervention on Forex. o Long-run changes in the ToT are mainly caused by: Income changes- rising incomes, esp. in MDCs, lead to increased demand for secondary and tertiary products (manufactured goods and services), whose YED tends to be elastic; this affects the rel. prices of the products; the ToT of MDCs, which produce more secondary and tertiary products, tend to improve rel. to the ToT of LDCs, many of which are dependent on primary product exports, which usually have inelastic YED. The result is a change in world trade patterns. Long-run improvements in productivity will lead to gradually deteriorating ToT, as real prices will not rise significantly; however, the countrys exports would be more competitive abroad and the result will be positive, if demand for exports is elastic. Elasticity of Demand for Imports and Exports: o The concept of elasticities is very relevant to the discussion of ToT; to effectively analyze ToT changes, we must consider the PED for imports and exports. PED for exports (the measure of the responsiveness of the QD of exports to a change in price): PED If demand for exports is price-elastic, a change in avg. export prices will lead to a greater than proportional change in their QD; this would be good for a country with falling export prices, since QD would rise by prop. more than the decrease in price and export revenue would thus increase. o Most exports are price-elastic in the long run (PED(exports)>1); however, this is not the case for most commodities (e.g. oil, coffee, sugar, rice, copper, rubber, cotton, etc.) PED for imports (the measure of the responsiveness of the QD of imports to a change in price): PED

If demand for imports is price-inelastic, a change in import prices will lead to a less-than-proportionate change in demand for them; this would harm a country with falling import prices, as QD of imports would fall by rel. more than the increase in price, causing revenue to decrease. o Most imports are price-elastic (PED(imports)>1), especially in the long-run; however, commodity imports tend to have inelastic PED. How beneficial is an improvement in the ToT? o An improvement in the ToT is not necessarily a positive outcome, as it may affect a countrys current account balance in adverse ways. The outcome will depend on the reason for the improvement; possible reasons for improvement include: Increase in demand for a countrys exports: A number of factors may increase demand for a countrys exports. o If prices in other countries rise, domestic exports become rel. more competitive. o If incomes abroad rise, the countries demand for domestic exports (imports, from their perspective) will rise. o Consumers tastes and preferences may change in favor of domestic exports. When demand increases, average export prices rise, while the quantity of exports demanded and supplied also rises. This leads to an improvement in the ToT and an increase in total export revenue. In addition, this will improve the current account balance. o Thus, an improvement in the ToT, when caused by an increase in demand for exports, leads to an improvement in the curr. acc. balance. Higher export prices caused by dom. inflation: Rel. export prices may rise if a country is experiencing relatively higher inflation than its trade partners. If this is so, the ToT will improve; whether or not the ToT improvement leads to an improvement of the curr. acc. balance depends on the PED of the countrys exports. o Assume that the demand curve is normal and has the usual relationship with MR and TR. The value of PED on a demand curve falls as price falls; there will be an inelastic and an elastic region on the demand curve (and demand will be unitary elastic where MR = 0). If demand for exports is price-inelastic (price is on the lower half of the demand curve), an increase in price will cause a less-than-prop. decrease in QD and export revenue will rise; this can be illustrated using revenue boxes and will improve the curr. acc. balance.

Thus, an improvement in the ToT, when caused by inflation, causes an improvement in the curr. acc. balance when export demand is priceinelastic. If demand for exports is price-elastic (price is on the upper half of the demand curve), an increase in price will cause a greater-than-prop. decrease in QD; total export revenue will fall. Again, this can be illustrated using revenue boxes; this will depreciate the curr. acc. balance. Thus, an improvement ToT, when caused by inflation, causes a depreciation in the curr. acc. balance when export demand is price-elastic. Hence, we can draw two conclusions about real-world situations: PED for most exports tends to be elastic; for the majority of exported products, there is much intl competition; thus, demand tends to be elastic . In general, commodities face inelastic demand; as a result, most MDCs will likely be on the elastic portion of their demand curve for exports. Even if demand is on the inelastic portion of the demand curve, if rel. high inflation rates continue, export prices will eventually move into the elastic region of the demand curve. Overall, then, an improvement in the ToT due to inflation usually causes a deterioration in the curr. acc. balance. The Significance of Deteriorating ToT for LDCs: o Deteriorating Terms of Trade: A situation where avg. export prices fall relative to average import prices. o Although there are vast differences LDCs, most (though not all) LDCs are dependent on the export of one or two commodities for export revenue and foreign exchange. The degree to which this occurs varies, however: While the % of Chads export revenue from primary products is 95%, this figure is as low as 22% for Cape Verde, which exports services (tourism). We distinguish between non-oil exporting LDCs (e.g. Mail, Ethiopia), oilexporting LDCs (e.g. Angola, Yemen), manufactures exporting LDCs (e.g. Bangladesh, Nepal) and services-exporting LDCs (e.g. Cape Verde, the Maldives).

Thus, the problems facing different groups of LDCs come from differing sources; we will focus on the problems facing non-oil exporting LDCs that mainly export commodities; some of their growth and devt barriers are related to ToT. There has been a long-run downward trend in commodity prices since the early 1970s, due to: Increases in the supply of commodities, mostly caused by technological improvements (e.g. agricultural yields have risen exponentially over the last century due to fertilizers, pesticides, mechanization, botanical research and GMOs). Technology has allowed for the extraction of more minerals and more efficient mining techniques. The advent of synthetic replacements for natural commodities (e.g. synthetic rubber, plastics, man-made fabrics) has led to a slow increase in demand for the commodities concerned. As LDCs have become richer and incomes have risen, demand for commodities has not greatly changed; their YED is inelastic. At the same time, as incomes rise, demand for mfg. and services (which tend to have more income-inelastic demand) increases; thus, demand for commodities has risen by less than demand for other products. Ag. policies in MDCs have harmed world ag. markets- price support schemes in the EU and US have led to rel. high prices there and overproduction by local producers; subsidies have also led to overproduction. The surplus crops are sold on world markets, pushing down ag. prices. Therefore, LDCs often accuse MDCs of dumping ag. products on the world market to the detriment of the LDCs ag. industries. The tech. improvements of the last 50 years have led to miniaturization of products (e.g. large computers being replaced by laptops and iPads). Miniaturization and improvements in plastics have led to a fall in demand for commodities traditionally used to produce and package manufactured products. As a result, over time, demand for commodities has increased by rel. less than supply of commodities; there has not been a fall in demand for commodities, but the combination of low YED, increased use of synthetic substitutes and miniaturization have led to rel. small increases in demand. Meanwhile, ag. policies in MDCs and tech improvements have led to large increases in commodity supply; as a result, average commodity prices have fallen. Because the ToT index is based on a weighted avg. index of export prices, countries dependent on commodities will see a fall in the index of export prices and a deterioration in their ToT.

The consequence of the deterioration in the ToT is a worsening of the current account, because demand for commodities tends to be priceinelastic, overall. Although demand for a commodity from a single source may be quite elastic, as many alternate producers exist, the commodity as a whole has very few substitutes and is a necessity for the production of some products. o In addition, as supply is also rel. inelastic for most commodities (due to time-lags in production and/or difficulties in the efficient extraction of capital-intensive minerals), any shift in supply or demand can lead to major changes in commodity prices, and thus price volatility and large-scale changes in the ToT. This can be shown on a revenue box diagram: the fall in average export prices when PED <1 leads to a fall in export revenues. We may also consider the effect on imports: if export prices fall, import prices rise relative to the price of exports (i.e. deteriorating ToT). The imports of LDCs are usually necessities (e.g. raw materials, manufactured components, capital, food), which are not always available domestically but are required for growth; thus, demand for them is price-inelastic; in addition, as these products tend to have higher YED than do commodities, their prices are likely to increase at a high rate relative to the decrease in commodity prices. On a revenue-box diagram, a rise in import prices when demand is inelastic leads to an increase in export expenditure. The deterioration of the ToT of LDCs that depend on commodity exports has several harmful effects: LDCs have to sell increasingly more exports to maintain import expenditure constant; this is harmful enough, but to do so, LDCs must increase supply of exports, depressing commodity prices further in a vicious spiral. Many LDCs are heavily indebted; falling export prices and thus export revenue increase the difficulty of debt servicing, leafing, in extreme cases, to countries needing to increase borrowing and going further into debt to pay off debt. o This vicious spiral is related to the previous one: to repay their debt, many LDCs have to increase output of the commodities they have a comp. adv. in, increasing supply and depressing price. To increase supply of commodities and thus export revenue, some LDCs have overused their resources, resulting in neg. externalities (e.g. erosion, deforestation, desertification); this is not sustainable in the long run.

To produce more commodities, LDCs need to purchase capital from abroad, as they usually cannot produce it domestically. However, since import prices are relatively high, this is usually difficult without going into debt; thus, it may not be possible for an LDC to even increase commodity output significantly. While the overall trend in commodity prices over the past 50 years has been a decrease, there have been occasional short-run upward movements in most commodity prices. Although petroleum, being more highly demanded than other commodities, is a unique case, the short-term upswings in price for most commodities can be explained by the growing world economy and increased demand from newly-industrializing countries. These trends may give some short-term benefits to commodityexporting LDCs, although the sustainability of the price increases in the LR is uncertain. The upswings also demonstrate the volatility of commodity prices; as a consequence, commodity exporters are vulnerable to external circumstances, and their export revenues can fluctuate significantly, making effective govt planning for the future difficult. Not all LDCs are the same, and not all LDCs depend on commodity exports; however, deteriorating TOT also adversely effects manufactures-exporting LDCs, which depend heavily on the export of labor-intensive textiles, whose prices are also decreasing, for export revenue; they also experience deteriorating ToT, although their prices tend to be more stable. The oil exporters have benefited from the overall increase in oil prices; given that demand for oil is inelastic, their export revenues have increased (whether or not this has led to increased development is a different matter.

Chapter 29: Characteristics of LDCs Devt economics is an extremely important, growing field in economics. The UN recently estimated that 80% of the worlds population lived in developing countries. There is a fundamental distinction between economic growth and economic development, which informs the definition of developing/less developed countries (LDCs). As a starting point of devt, we need to consider what makes a country an LDC. Common Characteristics of LDCs: o It would be useful for economists if all LDCs displayed the same characteristics; if this were so, it would be easy to classify them and develop solutions to their problems. Although this is not the case in reality, development economists have come up with a list of common characteristics of most, though not all, LDCs; these include:

Low living standards, characterized by low (real) incomes (per capita), inequality, poor health (low life expectancy) and inadequate education (low levels of literacy): In LDCs, low living standards tend to be experienced by most of the population. The main indicators of low living standards are very high poverty rates (very low incomes), high levels of inequality, poor housing, low health standards, high infant mortality rates, malnutrition, and lack of access to education. Low levels of productivity (output/person): These are common in LDCs, mostly due to low education, standards, low levels of health in the workforce, lack of investment in capital, and lack of access to technology. High pop. growth rates and dependency burdens: LDCs tend to have higher birth rates that, on average, are more than double the rates in MDCs. This is a potential problem as, when pop. growth rates exceed GDP growth rates, GDP/capita falls (which is indicative of greater poverty levels) o Crude birth rate: The annual number of live births per 1000 of the population; the world average is 20.15, but this number approaches 50 in some LDCs; most MDCs have figures below 15/1000. High crude rates in LDCs translate into high dependency rations; as many children are born, there are many people aged less than 15 in LDCs. Those of working age (between ages 15 and 64) need to work to support a larger population of children than those of similar age in MDCs. o However, MDCs also have larger proportion of the population above age 64, who also need to be supported by the workforce. o Dependency Ratio: the percentage of those who are nonproductive, usually those below 15 and 64 , expressed as the percentage of those of working age (between 15 and 64); thus: Dependency Ratio: . MDCs tend to have lower dependency ratios than LDCs, due to the high % of the population below age 15; however, they tend to have low % of the population above age 64, due to low life expectancy at birth caused by poor healthcare. In some LDCs (e.g. Uganda), dependency ratios are particularly high due to the death toll from HIV/AIDS. High and Rising Unemployment and Underemployment Rates: o

LDCs tend to have rel. high unemployment and underemployment levels, usually (officially) between 9% and 16% of the workforce; however, it is difficult to measure unemployment accurately in an MDC economy, let alone in an LDC. Thus, we must consider three additional groups in the unemployment figures: o The discouraged unemployed: Those who have been unemployed for so long that they have given up the search for a job and no longer appear in the statistics. o The hidden unemployed: those who work for a few hours per day on a family farm/business/trade and therefore do not appear as unemployed in the statistics. o `The Underemployed: Those who would like full-time work, but can only find part-time employment, often informally and illegally; low wages and output/worker are the usual consequences of underemployment in an econ. o Only when the above groups are combined can the full extent of unemployment in LDCs begin to be understood; although accuracy is impossible, a reasonable estimate of unemployment in most LDCs is around 40%.; the high birth rates in LDCs only stand to worsen the situation over time. Substantial dependence on agricultural and commodity exports: This issue is prevalent in LDCs and has everything to do with deterioration terms of trade; it is discussed in Chapter 28, above. Prevalence of imperfect markets and limited information: The trend in LDCs in the last 20 year has been towards market-oriented growth (the Washington Consensus), which has been promoted by the IMF and World Bank; however, this is problematic as, while marketled strategies work rel. well in MDCs with efficient markets, many LDCs face imperfect markets and market knowledge. LDCs lack many of the factors necessary for market efficiency. They lack: o A functioning banking system, which enable and encourages savings and investment (a necessary prerequisite for growth, acc. to the Harrod-Domar Model). o An effective legal system, which ensures that business takes place in a fair and structured way. o Many LDCs lack transparency in government, often leading to inefficient governance and potentially high levels of corruption. o Adequate infrastructure, which would enable commodities and finished products to move around the country, and onto intl markets, efficiently and at low cost.

Accurate information systems for producers and consumers, often leading to imperfect information, resource misallocation, and misinformed economic decisions. Dependence and Vulnerability in intl relations: In almost all cases, LDCs are dominated by devd countries due to the polit. and econ. power of the MDCs; in addition, they are dependent on MDCs for trade, investment, aid, and access to technology. o Thus, it is not possible for most LDCs to isolate themselves from world markets. For these reasons, LDCs are vulnerable internationally, and are often dominated and harmed by the decisions of devd countries, which they cannot contest. o As a consequence, LDCs only account for 20% of the volume of intl trade; this figure is inflated by high oil prices. o Some economists argue that LDCs should begin to negotiate in a bloc, much like a trade union, and gain from collective bargaining. o All of the above characteristics of LDCs are also barriers to growth and, possibly, devt. Diversity among LDCs: o Despite the usefulness of a list of common characteristics, no two LDCs are the same; LDCs display diversity in a number of areas: Resource endowment: There is a tendency to assume that all LDCs are poorly endowed with physical and human resources; this is not necessarily the case, however. While human resources are often undernourished, poorly educated and low-skilled (there are low levels of human capital), physical resource endowment varies immensely among LDCs (e.g. Angola possesses oil and diamonds, and Bangladesh has no significant natural resources after the replacement of jute by synthetic textiles, yet both are LDCs). o However, a lack of physical resources does not imply that a country cannot be successful; Japan and Singapore both have few resources, yet both are economically powerful. Much depends on how the LDCs resources are maintained and used. Historical background: A large proportion, though not all, LDCs were once colonies of MDCs (e.g. Rwanda has been colonized, while Ethiopia has not, excepting a brief period before and during WWII); however, the impact of this trend on LDCs varies greatly; much depends on the duration of colonization and whether independence was achieved peacefully or violently. Some countries (e.g. Singapore) have benefitted from colonization, while others (e.g. D.R. Congo) have not.

It is unarguable that the historical differences b/w LDCs set them apart from each other socially, politically and economically. Geographic and Demographic Factors: LDCs vary greatly in terms of geographical and population size; some LDCs (e.g. China, India) are huge, with large populations, while others (e.g. Nauru, Swaziland) are small and have small populations. It is not the case that all LDCs have large populations (compare China to Djibouti, for instance). Ethnic and religious breakdown: LDCs have a wide range of ethnic and religious diversity; high levels of diversity within a country may increase the risk of political unrest and conflict (e.g. the Rwandan Genocide, the Tamil rebellion in Sri Lanka). However, some LDCs are relatively ethnically and religiously homogeneous (e.g. Morocco). The structure of industry: It is often assumed that all LDCs depend on the production and export of primary products; while this may often be true, and a large number of LDCs are typical in this respect, other countries (e.g. Bangladesh and Nepal) export mfg. products, and a group of others (e.g. Cape Verde) mainly export services (tourism). Per capita income levels: It is often assumed that all LDCs have very low GDP/capita; however, there are marked differences in /capita income between LDCs. Mauritius has a GDP/capita 20.5 times that of Sierra Leone, yet is still considered an LDC. Political Structure: LDCs have very different political structures from one another, including: o Democracies (e.g. Brazil) o Monarchies (e.g. Brunei) o Military Rule (e.g. Myanmar) o Single party states (e.g. Syria) o Theocracies (e.g. Iran) o Transitional political systems, as a result of conflict/civil war (e.g. Somalia) Many sub-structures exist within the above broad structures; e.g. democracies can be subdivided into presidential systems, parliamentary republics, etc. Because the political systems of LDCs are so diverse, it is difficult to establish universal solutions for human devt.

To conclude, while some common characteristics among LDCs exist to a certain extent, there are also significant differences; it is risky to generalize and imply that all LDCs are the same.

Chapter 30: Sources and Consequences of Growth and Development Econ. growth is often confused with econ. development; also, just because a factor causes economic growth does not imply that economic devt will improve; it is possible that the quest for growth may lead to a reduction in development (e.g. workers working longer hours, or in more dangerous conditions). We need to consider the sources and econ. consequences of growth, and the main sources of development, in order to be able to discuss barriers to growth and devt and strategies to promote growth and devt. Economic Growth: o The distinction between potential and actual growth is of key importance: Potential Growth: A situation where the quality/quantity of a countrys FoPs increases; this causes a rightward shift of LRAS and an outward shift of the PPF Actual Growth: A situation where more real output is produced; this causes a movement towards the curve on a PPF and an increase in real output on an AD/AS diagram. Sources of Economic Growth: The sources of growth broadly fall under four headings, as follows: Natural Factors: o Anything that increases the quantity/quality of an FoP will lead to potential growth; increasing the quantity of land available is difficult, although the Netherlands and Singapore have been quite successful in doing so via land reclamation. o However, this will only have a small effect on total land area, and thus productive capacity, unless the land area is small to begin with (e.g. Singapore, where land reclamation led to a land increase of 20%; if the same increase were to have occurred across the strait, in Malaysia, the total increase in land through landfill would increase land area by 0.03%). o Natural factors will largely determine a countrys comparative advantage in the production of agricultural vs. non-agricultural goods and services; the better-endowed a country is in certain natural factors (e.g. soil, climate), the more resources it can commit to agriculture before suffering from diminishing returns. o Most countries attempt to improve the quality of their natural FoPs, rather than quantity (e.g. via fertilizers, more efficient zoning, improved ag. techniques, irrigation, and vertical expansion of cities- e.g. Hong Kong). Human Capital (Labor) Factors:

The quantity of labor can be increased either by encouraging pop. growth or increasing immigration levels; however, most LDCs would not want to increase pop. size (as, although a larger population increases productive potential, it often reduces GDP/capita, esp. when human capital is low) and, even if they were, the process is long-term. o Most emphasis is thus placed on improving the quality of labor, mainly via improved healthcare and education (e.g. through the development programs in Mali), vocation training and retraining programs. In addition, the provision of clean water and sanitation can greatly improve the health (and thus quality) of human capital; these actions, however, entail an opp. cost for the govt in terms of alternate spending projects (e.g. investment in physical capital/infrastructure). o In addition, encouragement of entrepreneurship (eg. through higher-education scholarships or decreased bureaucracy) can also contribute to ec. growth. Physical Capital, Social Capital and Technological Factors: o Econ. growth may be achieved by improving the quantity/quality of physical capital (e.g. factory buildings, machinery, shops, vehicles) or social capital (e.g. schools, roads, hospitals, houses) In LDCs, physical capital investment is often centered on the agricultural sector, which suffers from volatile prices and deterioration terms of trade. o The quantity of physical capital is dependent on savings rates, dom. investment, govt involvement, and FDI; the quality of capital is improved via higher education, R&D and access to foreign tech. and expertise. o By definition, investment involves foregoing some portion of current consumption for increased consumption in the future; growth may thus be achieved by encouraging savings and investment. Tech. change and investment tend to go hand in hand, as firms gain the incentive to upgrade their capital stock. o We refer to two concepts (as with the Accelerator effect): Capital Widening: A situation where extra capital is used with an increased amount of labor, but capital-toworker ratios remains constant. Thus, total production will rise, but productivity (output/worker) will remain constant.

Capital Deepening: A situation where the amount of capital per worker increases, often as a result of tech. improvements. Capital widening results in increases in productivity as well as total production. o Advancements in physical capital enabling (improved) extraction of primary products (e.g. improved oil drilling techniques)may be very important for growth, as they will increase the quantity of an FoP (in effect, land). Institutional Factors: o Certain institutional factors are a prerequisite for meaningful ec. growth. These essential factors include adequate banking and legal systems (to provide the savings and environment necessary for high levels of investment to occur), a good education system, infrastructure, and political stability (internal and external); some of these factors are also sources of ec. devt. Burkina Fasos attempt to reform the legal system could lead to growth via an improvement of institutional factors. In many LDCs, investment opportunities do not exist for small businesses run by the poor, and savings may leave through capital flight rather than be channeled into investment opportunities, hindering efforts to reduce poverty. o To achieve ec. growth, the promotion of entrepreneurship and organizing factors is also necessary. Consequences of Ec. Growth: The consequences of higher levels of growth may be pos. or neg., and include the following: Higher incomes: Higher growth rates lead to (ceteris paribus) higher GDP/capita, which should, to an extent, improve living standards for the population; the end effect will depend on the level of income equality. o Higher GDP will benefit many, due to higher incomes and higher living standards; however, some groups may see little to no improvement in income. Improved Ec. Indicators of Welfare: o Historically, ec. growth has clearly led to higher averages in terms of econ. indicators of welfare (e.g. life expectancy, schooling, literacy rates)- this might not be the case for all sectors of the population. In most countries that have experienced ec. growth, HDI has increased; there is a positive association between growth and HDI. Although other factors aside from GDP/capita contribute to an improvement in HDI, there

is evidence suggesting that one consequence of growth may be an improvement in welfare, as defined by HDI. Note that ec. growth is cumulative: a country with a slightly higher LR potential growth trend may be far ahead of other countries in terms of national income within several decades; this is the main cause of the inequity between countries worldwide. However, in the short term, newly industrializing LDCs are capable of achieving much higher growth trends than MDCs, as the new industries are developed from scratch, at rel. low levels of income, which can be quickly increased. If the rate of population growth exceeds the rate of GDP growth (as is often the case in LDCs), GDP/capita may actually fall, resulting in a decrease in HDI and connoting a decrease in ec. welfare. Higher govt revenues: o Even if tax collection is rel. inefficient (the case in many LDCs), increased GDP should lead to increased govt tax revenues; if this is so, the govt will be in a better situation with the provision of infrastructure and essential services (e.g. education, healthcare). Creation of inequality: o Usually, economic growth achieved via market-oriented initiatives leads to increases in inequality along with GDP increases (the rich get richer and the poor, relatively poorer). Even if the poor receive slightly more income, the gap between rich and poor usually grows (as does the cost of living, which may significantly worsen the situation of the poor), as the rich receive most of the gains. Over time, this may be accentuated, and the concept of a trickle-down effect (higher spending by the rich eventually benefitting the poor) is especially voodoo economics in LDCs, even more so than in MDCs. In order for growth to occur, a high-income sector of the population with rel. high marg. prop. to save must emerge to finance investment; it is unlikely that all, or the majority, of the population of a growing LDC will belong to that sector; this trend is a direct cause of income inequality in industrializing LDCs. Low levels of human capital in certain regions or demographics, which lead to an inability of some

sectors of the population to contribute to economic growth, may also worsen income inequality in LDCs. Neg. externalities and lack of sustainability: o In both MDCs and LDCs, the quest for ec. growth often leads to neg. externalities, such as pollution; as incomes rise, car and airplane usage increases, and more goods are imported over long distances. o This behavior creates neg. externalities of cons. and prod. (the market prices of the goods do not reflect the full social and environmental costs of the goods). o Deforestation caused by clear-cut agriculture, logging, and use of natural wood for fuel, soil degradation, over-farming, hazardous waste buildup from factories and landfills, water and air pollution, overpopulation, and loss of biodiversity are all consequences of growth (however, it can be argued that lack of growth is equally harmful, and that the only satisfactory solution is sustainable development) Sector change: As incomes rise, the economy is likely to produce more products that are rel. income elastic (e.g. high-tech manufactured goods, IT services); thus, the composition of the economy will likely change over time from agriculture/low-skilled manufactures-based production towards a more diversified balance of goods and services that requires high human capital and higher incomes. o Urbanization: In order for these changes to occur, production will become more concentrated in urban areas due to external economies of scale and incomes being rel. higher in cities than in rural areas (causing migration of former rural workers), which will grow in size and population. Climate Change: o As economies grow, so does demand for energy; factories and houses all consume energy and, to meet this demand, huge increases in fossil fuel consumption have occurred. Along with rising pollution levels, fossil fuel consumption results in large-scale greenhouse gas emissions, contributing to global warming. Although the exact consensus is uncertain, the Intergovernmental Panel on Climate Change concluded that mean global temperatures could decrease by 1.55.8 degrees Celsius by 2100. The net effect of climate change is very negative; there may be massive destruction of habitats and ecosystems

due to their inability to adjust to changing climate patterns. The human effects of climate change will most affect LDCs, and include: Increased precariousness of access to safe water sources; even now access to safe water is not guaranteed for over 1 billion people. Tropical diseases may spread further north The frequency and intensity of droughts in many Asian and African LDCs, and flooding will likely become intensified in temperate and humid regions. Food production in the tropics and subtropics will likely suffer; although agriculture could get easier in the extreme north and south, this is not guaranteed to improve food security worldwide. Millions of people may be displaced by rising sea levels; this includes coastal areas and lowlying island nations (e.g. Nauru) The concept of uneconomic growth has gained some prominence lately; it is said to occur when increases in production come at an expense in resources and wellbeing greater than the value of the items made. Based on the definition, growth based on current consumption patterns is unsustainable and uneconomic; we may refer to a sort of intergenerational inequity, whereby current generations use up disproportionately many non-renewable resources and create negative externalities that will likely compromise living standards of future generations. Sources of Economic Development: Some factors are sources of economic development, while also contributing to growth: Education: o Improvements in education improve the well-being of the population, both of the educated themselves and society as a hole (education provides external benefits). o Although it leads to a more efficient workforce, it also has further benefits; with increased education, people are better able to read and communicate, increasing the likelihood of

reform, political participation and social change;. Changing attitudes may lead to the realization of several development aims, including the following: Improvements in the role of women in society: Women are empowered by education, and high correlations between womens education, child survival rates, and decreasing fertility rates. Fertility rate: the number of live births per 1000 women of child-bearing age. The role of women in society is hugely significant to devt, and the promotion of the political, social and economic role of women is a major devt objective. Improvements in the level of health: Improvements in education and literacy rates improve health levels in society; as people, esp. women, are able to communicate more fully, they become increasingly aware of some of the health risks that they face, as well as of healthcare opportunities available to them. Individuals may read and be informed about diseases such as HIV/AIDS and the danger of poor sanitation and nutrition. In addition, they are able to learn about opportunities for preventive measures such as water filtering and inoculations. Healthcare: o Greater healthcare levels, esp. when combined with greater ed. opportunities, will improve levels of ec. devt. Although many factors affect life expectancy, there is a strong correlation, supported by HDI figures, between healthcare and life expectancy. Although many factors can affect a single outcome, it is unsurprising that countries that spend a higher prop. of GDP on healthcare tend to have a higher life expectancy. This may be seen when comparing the % of GDP spent on healthcare and life expectancy at birth in Australia and Syria; Australia, which spends 9.55 of 590 billion USD on healthcare, has significantly higher life expectancy than Syria, which spends 5.1% of 60 billion

USD on healthcare; also, HDI is much higher in Australia than in Syria. We may also observe a close correlation between life expectancy and education, but this trend may be difficult to fully justify given the many other possible variables involved. Infrastructure: the essential facilities and services that are necessary for economic activity (e.g. roads, airports, sewage treatment, water systems, railways, telecommunications and other utilities). o Improvements in infrastructure will lead to increased growth as well as devt; e.g. better roads allow children to get to school, and goods to be transported at lower cost to potential buyers. o If it is universal, sewage treatment improves public health, as does an adequate water system; any improvement in infrastructure will, in some way, improve quality of life. Political stability: o Politically stable countries are more likely to attract FDI and aid, and domestic savings and profits are more likely to remain in a more stable country. Increased access to FDI could contribute more to growth than devt, but increased access to aid will increase devt. With pol. stability, citizens are more likely to have an input in the political system; govt planning is likely to be more structured and long-term, and the law will likely be more enforceable. All of the above factors will lead to higher living standards for the population.

Chapter XXX: Barriers to Growth and Development Many barriers to growth and devt hold back the economic progress of LDCs. They are most easily understood when separated into several categories; however, many of the barriers are very closely interconnected. Some of the barriers to economic progress are barriers to economic growth, some are barriers to development, and some hinder both. We can break down barriers to growth and development into: o Institutional Barriers: Insufficient Provision of Education: One of the Millennium Development Goals is to ensure that, by 2015, children everywhere, boys and girls alike, will be able to complete a course of primary schooling.

While progress in provision of education, esp. at the primary level, has been made, over 115 million children of primary school age still do not attend school worldwide. o 80% of these children are in Southeast Asia and Sub-Saharan Africa. Provision of education is vastly expensive, and funding may not be sufficiently available in the countries affected. o In addition, there may be large disparities in access to ed. within a country, with urban areas receiving a greater share of ed. funding than rural areas. o Family economic conditions may prevent children from going to school, if the parents cannot afford to educate their children and/or the children are needed to earn an income as child laborers to support their families. o For the most part, it is children from poor households and families where the mother received no formal education who do not attend school. o Secondary school enrolment tends to be much lower than primary school enrolment, because of the increasing necessity, as children mature, of earning an income (the single greatest obstacle to school attendance), This is a barrier to both growth and development, as education is an important development aim, and an uneducated workforce tends to be inefficient (quality of labor is relatively low) Insufficient Healthcare Systems: LDCs have made much progress in terms of training medical personnel, building clinics and hospitals, and providing immunizations and public health services (e.g. sanitation, improved access to safe water). Infant mortality rates have fallen worldwide, life expectancy has increased, more children are immunized than ever before, and maternal mortality rates are falling. Nonetheless, LDCs still need to achieve considerable progress in providing healthcare, as a large disparity between LDCs and MDCs exists. o For instance, low life expectancy at birth in Niger, Nigeria, and Namibia is indicative of a lack of adequate healthcare provisions. This is a barrier to both growth and development, as the health of the population is an important development goal and an unhealthy population is more likely to contract diseases (quality and possibly quantity [in the long run] of labor decreases).

Lack of Infrastructure: One of the greatest barriers to growth (and devt) facing LDCs is lack of essential infrastructure. o Infrastructure: The essential facilities and services necessary for ec. activity to occur. We can identify certain forms of infrastructure that LDCs are likely to lack in sufficient quantities: Transport infrastructure: Roads Railways Seaports Airports Public Transport Pavements (Improved roads) Public Utilities: Electricity Gas Water supply Sewers Public Services: Police Service Fire Service Education infrastructure Health infrastructure Waste disposal Communication Services: Postal system Telecommunications Radio/Television o The lack of any of the above will harm the ability to achieve ec. growth by constraining the economys supply side; if goods cannot be transported internally due to poor roads, or exported due to the lack of a seaport, trade, and thus growth, is limited. o If power supplies are intermittent and unreliable, production is harmed. o If communication channels are poor or nonexistent, the ability to coordinate and plan ec. activity is limited. Due to limited infrastructure, resources may be poorly used or misallocated. o Limited infrastructure also hinders devt prospects; poor roads and transport may make access to schools and hospitals difficult

(although this is not the only obstacle in terms of education and healthcare). An underdeveloped communications network limits the ability of people to learn about and participate in wider communities (including political parties and trade unions). The availability of gas and energy is important to households in terms of cooking and food preservation, while sanitation and safe water are crucial for public health to improve. Weak institutional framework: Another major barrier to growth is the inadequacy of the legal framework necessary to support ec. activity; we can consider two main areas: o The legal system: In many LDCs, the legal system is ineffective; where this is so, contracts cannot be created and enforced and property rights cannot be upheld. Property rights: A basket of legal rights that allow people to own and benefit from private property, if the law supports them. They include: o The right to own assets (e.g. land, buildings) o The right to establish the use of assets (e.g. being able to add sanitation to a house) o The right to benefit from assets (e.g. by renting out land) o The right to sell assets o The right to exclude others from using or taking over assets. If a person cannot guarantee his/her ownership of property, they will have no incentive to improve the property, as the property can be lost and the investment- wasted. If property rights cannot be enforced, as in many LDCs, investment and growth will be severely reduced (however, property right enforcement is not a silver bullet for economic growth).

The Financial System: Developed and independent financial institutions are necessary for growth to occur; they are, however, often underprovided in LDCs. Most LDCs have dual financial markets: The official market is small and usually dominated by foreign commercial banks that often have an outward-oriented emphasis for operations and restrict lending to foreign businesses. The unofficial markets are illegal and unregulated; their main operation is to lend money at high interest rates to those desperate and poor enough to need to borrow it. Microcredit initiatives offer a potential solution to this discrepancy, and a possible way to reduce this barrier to growth and development. Saving is necessary (according to common sense and the Harrod-Domar Growth Model) for funds for investment to be available; investment is necessary for sustained growth. Saving is difficult enough in countries with high poverty rates, but becomes near impossible if no place to save money that is safe and offers a high rate of return exists. Where fin. institutions are weak and untrustworthy, people with investment income tend to buy assets (e.g. livestock) or invest their money outside the country (capital flight). Fin. services are necessary for development, as well (at they allow the poor to manage their assets and allow them to increase in value). Thus, the difficulties associated with saving and borrowing are a significant barrier to both growth and devt, and make it very difficult for low-income people to escape poverty. Ineffective Tax Structure and Informal Markets: Tax revenue provides govts with the means to finance nec. public services (e.g. education, healthcare)and improve the economys infrastructure. If the govt does not receive enough tax revenue, it will not eb able to perform its obligations effectively.

It is difficult for govts to collect tax revenue in LDCs; there are several reasons for this. o First, due to tax exemptions and inefficiency and corruption in the administration, less than 3% of people in LDCs pay income tax, vs. 60-80% in MDCs. Second, corporate tax revenues tend to be low, as there is relatively little corporate activity in LDCs (although it is rising) and LDCs often offer tax incentives to encourage domestic corporate activity and attract FDI. Third, the main sources of revenue in LDCs are export, import and excise taxes, as they are rel. easy to collect at the moment where goods pass borders. o However, it is only possible to gain much tax revenue in this way if a country is heavily involved in foreign trade. o The WTO, with its emphasis on liberalized trade, has negative implications on countries that gain significant revenue from tariffs. Finally, tax systems in LDCs tend to be inefficient, byzantine and corrupt; when combined, these elements mean that people can often evade the taxes they owe. In addition, in LDCs, much ec. activity occurs on informal markets (the size of informal markets as a % of GDP is far greater in MDCs than in LDCs); informal markets are growing worldwide. o Large informal markets also lead to decreased tax revenues for govts in LDCs. If incomes are not recorded, as they are earned informally, no tax will be paid on the incomes. Lower tax revenues make it more difficult for govts to promote growth and achieve devt aims. o Further, workers in informal markets tend to be unprotected, and are poorly paid, with low job security, poor working conditions and no social care. o Productivity on informal markets tends to be low; workers are often low-skilled rural migrants with low human capital. Political Instability and Corruption: These are barriers to both growth and development. o Political instability causes uncertainty and, in extreme cases, complete econ. breakdown (as an example, consider the civil wars in Sudan that have caused significant deaths and displacement of the population).

The conflicts have led to poor economic performance, high poverty rates and low living standards for the majority of the population. With conflicts, the likelihood of attracting FDI and aid decreases. Several LDCs, mostly in Africa, are experiencing armed conflicts along ethnic, religious and political lines; the death toll, damage to infrastructure, loss of investment and aid and political instability have all severely harmed growth and devt in those countries. Corruption: The dishonest exploitation of power for personal gain. Corruption is a major challenge for growth and devt, and is most prevalent where: Govts (esp. dictatorships) are not accountable to the people. Govts spend large amounts of money on largescale capital investment projects Official accounting practices are not wellformulated or controlled. Govt officials are not well-paid Elections are not well-controlled or nonexistent (i.e. there is no democracy) The legal structure is weak Freedom of speech is lacking Many of these conditions are found in LDCs, which may explain the high level of corruption most LDCs experience. Forms of corruption include fraud, bribery, extortion, patronage and nepotism. Corruption is likely to have several negative effects on growth and devt: Electoral corruption means that the wishes of the people are not heeded. If a government that has not been voted on by the majority is in power, it is unlikely to adopt policies that will benefit the people. Corruption reduces the effectiveness of the legal system; if people can buy their way out of trouble, there will be an incentive to act illegally.

Corruption leads to unfair resource allocation; if contracts go to the highest bidder, rather than the most efficient producer, market failure occurs and resources are being misallocated; corruption often shields inefficient produces by protecting them from competition. Bribes increase businesses costs, both in cash terms and in terms of management negotiation time; this will lead to higher prices. Corruption reduces trust in an economy; as a result, countries may experience difficulties attracting FDI, which is often diverted to less corrupt countries. Corruption increases the risk of contracts being violated; this acts as a deterrent to investment, both domestic and foreign. Corruption encourages the diversion of funds by officials to capital projects where bribes are more likely; this tends not to be in important areas (education and healthcare, mostly), and thus reduces the quality of the govts services for the population. Corruption often means that officials will disregard regulations (e.g. construction/environmental laws); this can be harmful to individuals and the country as a whole. o Conversely, a corrupt govt could impose regulations that are to the disadvantage of the people of a country for political reasons. The monetary gains from corruption are often moved out of the country; this is a form of capital flight and reduces the capital available for dom. investment. The constant paying of bribes reduces the ec. well-being of ordinary citizens.

Unequal Income Distribution: Although all countries have income inequality, the gap between the rich and the poor is generally greater in LDCs than in MDCs. High income inequality can be a barrier to growth for several reasons:

There tend to be low levels of saving, as the poor save a very small proportion of their incomes. Low savings lead to low investment and low growth. o The rich tend to dominate politics and the economy; thus, policies in favor of the rich tend to be followed and pro-poor growth (growth that leads to a reduction in some agreed measure of poverty) may not occur. o High income inequality in LDCs tends to result in the rich moving large amounts of funds out of the economy (capital flight). o Also, a large % of goods purchased by the rich are imports, whose consumption does not help the dom. economy. o Thus, although we often link income inequality to low levels of development, it can also lead to low growth. International Trade Barriers: Overdependence on primary products, adverse terms of trade, and the consequences of a narrow range of exports: While the share of mfg. produced by LDCs as a % of world trade is growing, many LDCs are dependent on primary products for much of their export revenues. o When commodity prices are rising, this may be beneficial, as it will increase growth rates and, if the revenues are used to finance education, healthcare and infrastructure, can set off a positive cycle in terms of growth and devt. o However, if prices fall, the economies experience deteriorating ToT; current account deficits will increase and it will be difficult for the LDCs to finance current expenditure and necessary imports. Unless they can change the pattern of their export trade, the countries that are dependent on a narrow range of primary exports will find it difficult to gain much growth through trade. Regardless of the types of goods exported, if a country is dependent on a narrow range of exports, if faces ec. vulnerability and uncertainty. o Economic growth in a country reliant on tourism, for instance, will be damaged if terrorism damages the global tourist trade. A country specializing in one or a few products will also be vulnerable to natural disasters, crop diseases, and other factors outside of its control. o LDCs dependent on low-skilled MFG exports were harmed when China joined the WTO and sharply increased textile supply on world markets, driving down prices.

Protectionism in intl trade: Protectionism: Any economic policy aimed at supporting dom. producers at the expense of foreign producers. Protectionist measures by MDCs against exports from LDCs may be very harmful; if the measures prevent the LDCs from exploiting their comp. adv. and exporting to MDCs, their ability to gain export revenue and foreign exchange will be severely hindered. Protectionism in primary product markets is especially harmful to LDCs; for instance, massive US cotton subsidies encourage farmers to produce more, depressing world cotton prices and exporting their surplus to LDCs that do not benefit from subsidies. o This is immensely damaging for LDC producers and markets, as the lowered world price decreases the ability of local producers to gain revenue. o Other markets affected by large-scale subsidies include dairy, corn, sugar, grains and rice. o As the products are sold at lower prices than their unsubsidized prod. costs, dumping occurs; small scale farmers in LDCs are deprived of the ability to earn a living- a significant barrier to devt. o An important related issue is tariff escalation: Tariff escalation: A situation where the rate of tariffs on goods increases with the degree that the goods are processed. An importing country can thereby protect its processing and mfg industries by putting lower tariffs on imports of raw materials and components and higher tariffs on processed and finished goods. In extreme cases, the MDCs import the low-tariff raw materials, process them, adding value to the goods, and export the finished products. Tariff escalation is a significant issue for LDCs in terms of access to markets as it creates a disincentive in terms of diversification towards processing raw materials domestically, instead of exporting them; the higher tariffs will make the exported processed goods uncompetitive. Tariff escalation can trap LDCs as exporters of raw materials; the EU partakes in tariff escalation on rice markets, whereby the tariff

on milled rice is nearly twice as high as that on un-husked rice. o Not surprisingly, the EU mostly imports husked rice (2/3 of all rice imports), with imports of the rel. more expensive processed rice being much lower. o Thus, tariff-escalation is successful in reducing the imports of the more processed good; the final processing of the rice is thus done within the EU. o Since processing and marketing add the highest value to the product in terms of the selling price, the EU makes the largest gains from rice production (rather than the LDC suppliers). o Ideally, the LDC producers would like to diversify into processing rice (through vertical integration), but the tariff escalation removes the pot. benefits. o Tariff escalation is common on sugar, meat, fruit, coffee, cocoa and tobacco markets. o International Financial Barriers: Indebtedness: A major barrier to growth and devt in LDCs, especially due to the need to repay the debt or face escalating compound interest. Indebtedness is covered in more detail in Chapter XXXIII) Capital Flight: Capital Fight: A situation where money and other assets flow out of a country to seek a safe haven abroad; LDCs (e.g. Zaire, now the Dem. Rep. of Congo) have suffered heavily from capital flight since the 1970s. Three main causes of capital flight common to many LDCs exist: o If the dom. fin. markets are unsafe and citizens feel that their capital would not be safe in dom. fin. institutions, they will move it abroad to a more reliable country. o Corruption in govts leads to the siphoning off of funds, both dom. funds and FDI, and the removal of those funds to numbered accounts abroad. o Currency instability encourages citizens to move money out of the country and into an economy with a more stable currency.

The repatriation of profits by MNCs arguably constitutes capital flight, as the money sent out by the companies cannot be used internally. Capital flight has many harmful effects on LDC economies If money is outside a country, it cannot be used to develop the country. If money is outside a country, it cannot be taxed and the govt loses pot. tax revenue. Capital flight reduces govts ability to pay employees decent wages, which forces the employees towards corruption and bribetaking. Increases in capital flight lead to greater poverty, and thus social unrest and pol. instability. In many cases, LDCs lose more resources through capital flight than they do through debt repayment; for example, Africa is actually a net creditor with the world; the value of accumulated assets that left Africa via capital flight exceed the total value of Africas external debt. Another form of capital flight is human capital flight (brain drain); the emigration of talented and educated individuals from one country to another. The usual cause of brain drain are better employment opportunities and higher living standards abroad. Emigration is sometimes forced by dom. unrest, lack of dom. opportunities, and low heath and safety standards. o Iraq and Iran suffer heavily from human cap. flight due to political instability. Brain drain typically occurs in profession where a university education is needed (e.g. engineers, doctors, scientists) Human capital flight represents an investment in higher education that gives no return to the country where the education was funded It also means that valuable personnel are not available domestically to promote growth and devt and results in lower dom. tax revenue.

On the other hand, emigrants from LDCs often send back money (remittances), which can greatly help recipient families escape poverty.

Non-Convertible Currencies: Many LDCs have non-convertible currencies (currencies that are only usable domestically and are not accepted for exchange on Forex); e.g. the Egyptian Pound. o Most LDCs operate a fixed ER regime, where the dom. currency is pegged to a more acceptable currency (usually the US$) at a certain rate. However, LDCs usually lack the foreign reserves and expertise to maintain the peg, leading to an over- or undervalued currency (and thus, again, non-convertibility at the official ER) Thus, a black market for the convertible currency will usually arise, which may be very harmful for the economy; in some cases (e.g. Zimbabwe), the dom. currency may become almost unacceptable domestically, damaging local and intl trade. o Non convertibility reduces likelihood of trade; traders and foreign investors would be taking a greater risk dealing with the LDC and are likely to go elsewhere to do business. Social and Cultural Barriers: A number of social and cultural barriers to growth and devt in LDCs exist; it is, however, difficult to be general about them, as cultural traditions vary from region to region and emphasize different sets of moral codes and values; in addition, the extent of their effect is relatively subjective (e.g. one cannot make a truly strong case that dietary taboos are harmful to the growth of any one economy). o Some points, however, are almost universal and rel. unarguable: Certain cultures disapprove of discussing sex, especially with the young (this ranges from red-state America to Mali and Uganda). This may lead to a lack of appropriate advice in countries where HIV/AIDS is epidemic, slowing progress in combating the disease. In many LDCs, especially in Africa, lack of knowledge about HIV/AIDS is a major devt barrier.

In all but 2 LDCs, women have a lower literacy rate than men, spend less time in school in all but 14, and earn, overall, significantly lower incomes than men. In most societies, religious, social and cultural traditions make the role of women very different (usually, inferior) to that of men. As women are expected to marry, raise children, work in the home, etc. their potential for ec. activity is limited. Deprivation of ed. is a major barrier to devt for women, as is the loss of freedom to seek employment outside of the family. The greatest untapped resources in the world, then, may be women. Thus, many NGOs focus on women as a devt priority. o Increasing the number of educated women will expand a countrys labor force, allowing pot. output to increase. In addition, some people may distrust banks and financial institutions, and thus be reluctant to save.

Poverty Cycles: o Poverty is usually measured in two ways: Relative poverty: A situation where a person does not reach some specified level of income (e.g. 50% of average annual earnings). The level of relative poverty in a country will depend on this specified level of income, which will depend on who is setting it; the figures are thus prone to being altered for political purposes (e.g. a govt attempting to show a fall in poverty by setting the level of 40% of the median income, an opposition party attempting to embarrass the govt by stating the level at 60% of the median income). Thus, the whole concept is relative and, to some degree, subjective Absolute poverty: A situation where a person does not receive enough income to purchase the basic necessities for survival. The absolute poverty line is the level of income sufficient to purchase items such as basic clothing, food and shelter. This enables us to make worldwide comparisons, if we first use PPP exchange rates to account for varying living costs. The abs. poverty line used by the World Bank is $1 (PPP)/day; if a person is below this level, they are considered to be in absolute poverty. o The World Bank has also issued figures for $2 (PPP)/day.

Many of the barriers to growth and devt are connected in a cyclical fashion; thus, countries may be caught in poverty traps. Poverty trap: Any linked combination of barriers to growth and devt that forms a cycle that is self-perpetuating unless it can be broken. A typical poverty trap is the poverty cycle (development trap). A poverty trap that illustrates how low incomes perpetuate low incomes, causing low growth, is given below: o Low incomes (lead to) Low levels of savings and very high MPC (lead to) Low levels of investment (lead to) o Low ec. growth (leads to) Low incomes (etc.) A poverty trap that illustrates how low incomes perpetuate low incomes, harming economic devt, is shown below: o Low incomes (lead to) Low levels of ed. and healthcare (lead to) Low levels of human capital (lead to) o Low productivity (leads to) Low incomes (etc.)

Chapter XXXII: Growth and Development Strategies Do not confuse models and strategies for economic growth and devt (in particular, do not give growth models in the place of development strategies). Growth models, growth strategies and devt strategies are very different from each other: o Growth models: Theoretical frameworks that explain how growth has occurred in the past, and suggest ways by which growth can be achieved. o Growth strategies: Economic policies and measures designed to increase GDP o Devt Strategies: Ec. policies and measures designed to improve the standard of living in a country (i.e. increase the level of human devt) Ec. growth does not translate directly into devt, but if it can generate extra income for govts, firms and people, it may lead to devt, depending on how the income is used. Growth Models o The Harrod-Domar Growth Model: The Harrod-Domar growth model is used by economists to identify factors affecting the GDP growth rate. At its simplest, the model states that the ratio of GDP growth is determined by the natl savings ration and the capital-to-output ratio in the econ. Thus: Capital to Output Ratio: The expenditure on capital as a ratio of the output gained from capital.

More sophisticated versions of the model also account for capital depreciation, stating that a greater rate of depreciation will lower growth rates. If the model is correct, we can say that the rate of ec. growth may be increased by one of two factors: o Increasing the savings rate in the economy: if savings rise, econ theory suggests that this can lead to an increase in investment; as this increase represents a greater capital stock, which in turn should lead to greater real output and greater GDP. Since a prop. of the increased income will be saved, we will have a cycle, which should lead to increased growth, thus: Increased incomes (lead to) o Increased savings (lead to) Increased capital stock (leads to) Increased Output (leads to) Increased Incomes (etc.) Although the theory is relevant when applied to MDCs, there are problems when it is applied to LDCs- in theory, all a country needs to do to achieve growth is increase the savings ratio (as a greater numerator in our formula results in a greater overall value) However, raising savings ratios in LDCs is difficult; most LDCs have very low MPS due to poverty, as people spend most of their incomes on consumption of necessities o Furthermore, weak and insecure local fin. institutions imply that the income that people do have is spent on assets (e.g. land, livestock) o In some cases, savings leave the country through capital flight and profit repatriation. o This combination of weak fin. infrastructure, high consumption and capital flight makes it difficult to increase savings rates in LDCs o Reducing capital/Output ratios in the economy (increasing the efficiency of capital use: As this measure would decrease the

denominator, the theory suggests that this measure will increase the growth rate. However, increasing capital efficiency is never easy, esp. in LDCs, due to a shortage of educated and skilled labor (made worse by brain drain), as well as deficient infrastructure (e.g. poor roads in Cameroon) and possibly cultural factors, all of which imply that new capital will not be used efficiently. In addition, it is possible that the addition of capital to an economys productive facilities will eventually incur diminishing returns. Moreover, a lack of skilled managers means that entrepreneurship will be limited, which is likely to limit efficiency. Due to low incomes, R&D is likely to be underfunded in LDCs, thereby reducing efficiency, and access to foreign technology (a further way of reducing capital/output ratios) is expensive and thus often unavailable to LDCs. In addition, due to capital flight and the existence of other determinants of AD than investment, many countries that experience growth do not benefit from increased savings. The Lewis Model (Structural Change Model, Dual Sector Model): The main focus of the model is on structural change: the movement of a traditional agrarian economy, with a small mfg. sector, towards a more modern structural balance with greater mfg. and service sectors. The model ass. that a large ag. sector with a surplus of labor and a small, productive mfg. sector exist. o The surplus labor in the ag. sector is not productive and thus moves to the mfg. sector, attracted by wages that are higher than in the ag. sector, but which are fixed, as labor supply is high. o Entrepreneurs in the mfg. sector will make profits as their prices are above the fixed wage rates; the theory ass. that the profits will be reinvested, increasing the (homogeneous) capital stock. o Thus, the prod. capacity of the mfg. sector will increase and demand for labor will grow; more workers will be employed from the surplus ag. labor, entrepreneurs profits will increase and be reinvested, and the cycle will perpetuate until all surplus ag. labor is employed in the mfg. sector

o o

A structural change has taken place away from the traditional agrarian model and towards industrialization. The Lewis Model presents, in a simplified manner, the process of industrialization undergone by the current MDCs; however, there are limitations to its use as a model for growth in LDCs; these include: The model ass. that entrepreneurs will keep adding homogeneous capital; however, it is likely that entrepreneurs would actually invest in tech. advanced, labor-saving capital; this will reduce the increases in employment. While the Lewis model claims that this will slow the pace of growth, in reality, the increased levels of capital may actually contribute to growth (see the Harrod-Domar Growth Model). The model ass. that all profits are reinvested; however, capital flight is a common problem in LDCs and it is likely that a large % of the profits will leave the economy, reducing investment and slowing growth. The model ass. that a pool of surplus rural labor exists; however, urban migration and the promise of jobs in cities mean that in many LDCs, there is high urban unemployment and little surplus of labor in rural areas; thus, the model seems to fail in practice. The model ass. that mfg. wage rates are constant; however, the influence of collective bargaining, imposed wage scales and higher wages offered by MNC tends to lead to wage increases, even where there is unemployment; this may reduce profits level and the ability to reinvest.

Growth Strategies: o Export-Led Growth: Export-Led Growth: An outward-oriented growth strategy, based on openness and increased intl trade. Growth is achieved by increasing exports and export revenue, as a leading factor in an economys AD. This, in turn, should lead to higher incomes and, eventually, growth of domestic industries in addition to growth of export industries. The country concentrates on producing/exporting products that it has a comp. adv. in.

To achieve export-led growth, it is ass. that a country will need to adopt policies which include: o Liberalized trade: opening domestic markets to foreign competition, in order to gain access to foreign markets in return. o Liberalized capital flows; reduced FDI restrictions o A floating ER o Investment in provision of infrastructure to allow trade to occur o Deregulation and minimal govt intervention. This list of policies associated with export-led growth is largely theoretical; in reality, countries that adopt an outward-oriented strategy do not nec. adopt all of these policies. LDCs usually export commodities and/or mfg. (although some export tourist services). There is a crucial distinction between the export of commodities and mfg. as an engine for growth: o Many LDCs depend on commodity exports for export revenue; however, commodity prices (with the exception of oil some metals) have suffered long-term price decreases due to increases in supply and rel. smaller increases in demand. This, combined with protectionism in MDCs, means that export-led growth based on commodity exports is unlikely to succeed. o The focus of ELG is usually on increasing mfg. exports; the Asian Tigers (Singapore, Indonesia, South Korea, etc.) largely owe their success to this strategy. These countries were extremely successful in exporting products based on low-cost labor, in which they had a comp. adv. Over time, the countries composition of exports has shifted from low-skilled laborintensive mfg. towards more sophisticated goods requiring capital intensive prod. methods and more highly skilled workers; improvements in ed. systems were essential to this change. While ELG may seem like an obvious route to success in achieving ec. growth, there are a number of problems associated with the strategy: o The success of the Asian Tigers since the mid-1960s has led to increased protectionism in MDCs against mfg. from LDCs; unions and workers in MDCs argue that they cannot compete with imports from low-wage LDCs and that free trade was unfair to them.

They often lobby their govts to put tariffs and quotas on the lower-priced goods. Price increases due to tariffs effectively remove the comp. adv. of the exporting LDCs; tariff escalation also reduced the ability of the LDCs to export processed goods/services, forcing many to export primary products and lower-skilled mfg. instead. The theoretical assumptions of the requirements for export-led growth were not nec. met in the countries that had been successful with the strategy. Many economists have argued that the role of the state in successful export-led growth is vital and that minimizing govt intervention is not the best way to proceed. In the Asian Tigers, govts played an important role by providing infrastructure, subsidizing output via low credit terms from central banks, and promoting savings and tech. improvements. In addition, govts adopted policies that protected dom. industries that were not yet able to compete on export markets; this illustrates the infant industry argument for protectionism. This is an area of debate, and, while many economists agree that govt intervention in the Asian Tigers was vital, others argue that state intervention actually slowed growth rates. If countries attempt to kick-start export-led growth via FDI, the MNCs may become too powerful in a country, leading to problems. The role of MNCs and FDI will be discussed later. Free-market export-led growth may worsen income inequality within a country; if this is so, ec. growth may occur at the expense of devt. According to World Bank statistics, the LDCs that have globalized following 1980 (e.g. Argentina, China, India, Mexico), becoming more fully integrated in the intl economy via trade and capital-flow liberalization (thereby becoming outward-oriented economies) have experienced annual growth rates much higher than those in the LDCs that have pursued inward-oriented strategies.

Import-Substitution Industrialization: An inward-oriented growth strategy that states that a country should, whenever possible, produce goods domestically instead of importing them. This should mean that the dom. industries producing the goods will be able to grow, as will the economy, and the country will be competitive intlly as its firms gain economies of scale. This strategy is the opposite of ELG and is not supported by economists who promote the advantages of free trade according to comp. adv. as the most effective growth strategy. For the strategy to work, the following needs to occur: The govt needs to organize the selection of goods to produce domestically; historically, this has involved labor-intensive, low-skilled mfg. (e.g. clothing, shoes). Subsidies need to be granted to encourage dom. industries. The govt needs to implement a protectionist system with tariff barriers to restrict imports from abroad. The advantages and disadvantages of ISI include: Advantages: o ISI protects jobs on dom. markets, as foreign firms are prevented from entering and competing. o ISI protects local culture and traditions by limiting foreign influence on the econ. o ISI protects the economy from the power, and possible harmful influences, of MNCs. Disadvantages: o ISI may only protect jobs in the SR; in the LR, growth may be lower due to decreased efficiency, which may lead to lower jobcreation rates. o ISI means that a country does not enjoy the benefits of comp. adv. and specialization, and thus produces inefficiently instead of importing from rel. efficient foreign producers (trade diversion occurs) o ISI may lead to dom industry inefficiency due to the lack of competition to stimulate competitiveness and R&D spending. o ISI may lead to high inflation rate due to dom. AS constraints o ISI may incite retaliatory protectionism from other countries. The main countries to adopt ISI were in Latin America (esp. Brazil, Mexico and Argentina); some former colonies in Africa and Asia (e.g. Kenya) also initially adopted ISI strategies. The policies showed some success in the 1960s-70s, but started failing in the early 1980s, due to govt overspending and thereby indebtedness and an

inability to repay their loans; by the mid-1980s, many of the ISI countries were forced to turn to the IMF for help. The Washington Consensus: Washington Consensus: A set of 10 common policy reforms seen by the IMF, World Bank, and US Treasury Department as necessary for ec. growth in the 1990s. Latin American countries seeking ec. help with the IMF were strongly encouraged to adopt the policies, which included, o Fiscal discipline (balanced budgets) o Redirection of expenditure from subsidies to basic ed. and healthcare. o Lowering of marg. tax rates and broadening on the tax base. o IR liberalization o Trade liberalization o A competitive (i.e. floating) exchange rate o Liberalization of FDI inflows o Privatization o Deregulation o Securing of Property rights By the end of the 20th Century, the Washington Consensus reforms were increasingly criticized by numerous economists. o Critics of the Washington Consensus claim that the reforms allow MNCs easy access to cheap labor markets in LDCs; thus, MNCs may produce cheap products which are sold for high prices in MDCs. While the MNCs make high profits, the workers in LDCs gain rel. little. According to this view, the Wash. Consensus has not led to high ec. growth in Latin America; instead, there have been ec. crises and increased debt. The policies have led to increased income inequality and (it could be argued) exploitative working conditions, thus working against the goal of ec. devt. Recently, many Latin American countries (e.g. Venezuela) have become very critical of the Wash. Cons. and moved back towards an ISI growth strategy, which seems to have brought some success in terms of growth, Foreign Direct Investment: FDI: Long term investment by private MNCs in countries overseas.

FDI usually occurs via MNCs building new facilities or expanding existing plants in foreign countries (known as greenfield investment). Alternatively, MNCs merge with or acquire existing firms in foreign countries. Approximately 80 000 MNCs with 730 000 affiliates operate worldwide. FDI flows rapidly increased in the 1990s, a sign of the significant role that FDI has played in world ec. integration and globalization. o FDI flows fell sharply in 2001 and 2008, due to recessions, but they rebounded shortly afterwards, largely due to an increase in flows to LDCs (which accounted for 36% of all FDI inflows in 2004). o There are imbalances in the levels of FDI inflows worldwide; while China received 9.4% of all FDI inflows in 2004, Africa as a whole received only 2.8%. o The US is the largest recipient of FDI (14.8% of all inflows), followed by the UK and then China. MNCs are attracted to LDCs for several reasons: o The countries may be rich in nat. resources (e.g. oil, minerals), which MNCs have the tech. and expertise to extract. The top FDI recipients in Africa (Angola, Nigeria, Sudan) are all wellendowed in resources. o Some LDCs (Brazil, China, India) represent huge and growing markets; if MNCs are located directly in the markets, they have much easier access to a large number of pot. consumers. With rising incomes, demand for consumer goods rises and MNCs wish to be there to satisfy the demand. o Labor costs are much lower than in MDCs; lower prod. costs allow firms to sell their final products at lower prices and make higher profits o Govt regulations in many LDCs are less severe than those in MDCs, making it easier for companies to set up and significantly reducing prod. costs. Many LDC govts also offer tax breaks to attract FDI; over the past 15 years, both MDCs and LDCs have adopted policies favorable to FDI (e.g. decreases in corporate tax rates). o The possible advantages and drawbacks of LDCs receiving FDI from MNCs include: Possible Advantages of FDI: From the Harrod-Domar Growth Model, a nec. condition for growth are increased savings;

LDCs, however, often suffer from savings gaps, which may be filled by FDI; this may lead to ec. growth. MNCs provide employment and, often, ed. and training; this may improve the skill levels and managerial capabilities of the workforce. MNCs allow LDCs greater access to R&D, tech. and marketing expertise, which may enhance industrialization. Increased employment and incomes may have a multiplicative effect on GDP growth in the host country. The host country may gain tax revenue from the MNCs profits, which can be used to achieve more growth through investments in infrastructure or improvements in public services (which may also lead to ec. devt) If MNCs buy existing companies in LDCs, they theoretically inject foreign capital into the economy and increase AD In some cases, MNCs may improve the phys. or financial infrastructure of an economy, or act as a spur for the host govt to do so in order to attract FDI. MNCs may provide lower prices for products and more choice in the host country; they may be able to provide necessities that are unavailable domestically, and they will usually produce more efficiently than domestic nationalized firms (e.g. the govt mining monopoly in Burkina Faso). Thus, there are vast gains to be made from FDI; China is a case in point: Although treating FDI in isolation from other variables is difficult, FDI most likely played a major role in Chinas ec. growth since 1978, when China began attempts to attract FDI as a growth strategy. Much of Chinas export volume is produced by foreign firms. Through joint ventures with MNCs, Chinese firms have grown rapidly and

successfully, and China is now the source of a large outflow of FDI. As china grows, so does its demand for natural resources; thus, much of Chinas outgoing FDI is investment in resource extraction. Possible Drawbacks of FDI: Although MNCs provide employment, they often bring in their own management teams and use the cheap low-skilled labor for basic production, offering little to no ed. and training. o This limits host countries ability to gain new technologies. Sometimes, MNCs may become too powerful within a country due to their size, and gain large tax breaks and/or subsidies, reducing pot. govt income in LDCs. o MNCs may also have too much influence internationally; their incomes and size allow them to influence WTO and IMF policy decisions. MNCs practice transfer pricing, whereby they sell goods and services between divisions and subsidiaries of the company in different countries to take advantage of differing corp. tax rates. o Thus, LDCs that have lowered tax rates to attract FDI gain little revenue from their policies, and MDCs also lose pot. tax revenue. o This represents a large total revenue loss to govts, as approx. 1/3 of world trade is composed of sales between different branches of firms. o Govts have laws to prevent firms from abusing their ability to use transfer pricing to minimize tax payments, but these are difficult to monitor and enforce, esp. in LDCs. MNCs may situate themselves in countries where environmental legislation is ineffective, reducing their private costs while creating

external costs; while this is good for the MNC, it harms the environment of the host country. o Likewise, MNCs may set up in countries with weak labor laws, allowing exploitation of local workers via low wage rates and poor working conditions. MNCs may enter a country in order to extract natural resources (e.g metals, minerals- copper mining firms in Bolivia), strip the resources and leave. o This may lead to unrest as host country nationals see the profits from their resources sent out of the country to foreigners. MNCs may employ capital-intensive prod. methods to make use of abundant natural resources; this will not greatly improve employment in the host country. o It is argued that MNCs should use appropriate technology, where production methods are aligned with the available resources, allowing for growth that directly benefits lowincome people by providing employment and incomes. o Since LDCs usually have a large supply of cheap labor, the argument goes that labor-intensive prod. methods would be more appropriate. o In addition, the goods that many MNCs produced are intended solely for export markets, as local demand for them is negligible; thus, the direct benefits of increased output might not take effect in the LDC. In most cases, when MNCs buy host-country firms, the owners of the purchased firms are paid in shares from the MNC; thus, the actual money is unlikely to be used in the LDCs economy.

MNCs may repatriate profits, transferring them back to the firms country of origin; this may represent a form of capital flight. While FDI is a pos. factor for ec. growth, the main concerns with FDI relate to the poss. neg. effects of MNCs on sustainable devt. The extent to which MNCs can contribute to sust. devt. depends on the type of investment and the ability of host govts to appropriately regulate the MNCs behavior and use the benefits of the investment to achieve devt aims. The main concerns related to MNC activity have always been possible exploitation of workers, child labor, the possible inability of workers to unionize, and business practices leading to present or pot. environ. damage. The existence of the Internet and global NGOs, however, is making it difficult for MNCs to conceal activities that contribute to these problems from the public. As most MNCs do not want to be seen as a source of problems and want to promote their image, firms are increasingly likely to develop .corporate social responsibility policies, to show that they are acting responsibly and e and promoting sust. devt. Companies regularly publish and advertize their CSR policies, in particular, as related to human rights, employee rights, env. protection and community involvement. o The extent to which these policies are actively carried out and their actual effects on workers, the environment, and host communities is uncertain; however, the policies are usually a step in the right direction.

Development Strategies: o Fairtrade Organizations: In many LDCs, low world prices for commodities, high profits for middlemen, tariff escalation and poor working conditions render it impossible for many poor

workers to earn a living income; in addition, the rules of the international trading system are generally in favor of MDCs, which can compete easily due to economies of scale and have been able to maintain key tariff barriers. Fairtrade schemes are an attempt to ensure that food (and occasionally smallscale mfg.) producers in LDCs receive a fair deal when selling their products. If consumers are aware of the harsh/unfair conditions facing producers, they may be willing to buy from sources that pay a fair price to producers. Fairtrade Labeling Organization International coordinates Fairtrade programs in over 20 countries; the schemes aim to help poor farmers and landless workers. Fairtrade Labeling has led to the rapid expansion of the Fairtrade movement since the 1980s. In this system, products can be certified (and labeled, giving consumers confirmation that the producers of the products they purchase were paid a fair price) if they meet FLO standards. FLO regularly certifies hundreds of producers and firms in over 50 African, Asian and Latin American LDCs, and offers fair trading conditions to over one million workers, farmers and families. The criteria for a good to be FLO approved are as follows: o The product must reach the trader through as few intermediaries as possible (preferably, none). o The product must be purchased at or above the Fairtrade minimum price: a guaranteed price that covers costs of sustainable production (prod. costs plus the provision of a living income) o The producer receives a premium if the product is certified as organic. o The trader must commit to a log-term contract, granting the prod. security. o The prod. has access to credit from the trader, on request, of up to 60% of the purchase price. o Where ag. goods are involved, the product must come from sources managed democratically; if it comes from plantations, the workers must benefit from intlly recognized employment standards including unionization, and there must be no use of child labor. o The producer must produce the good using sustainable farming methods. o The trader must pay a Fairtrade premium to the producer; the producers use the funds to aid local community development by funding projects of their choice (usually education, healthcare

o o

or other social schemes); the producers are accountable to FLO for appropriate use of the funds. Fairtrade certified products include many ag. goods, incl. bananas, cocoa, coffee, fruit, honey, rice, sugar, tea and wine; non-food products include cotton, cut flowers and sports balls. Although the price of Fairtrade products may sometimes be higher than that of products from standard sources, many consumers are willing to pay in order to contribute to better conditions for LDC producers. Sales of Fairtrade products are increasing internationally, as firms become more aware of their increasing popularity. As Fairtrade emphasizes the provision of a living income, security, proper working conditions, sustainable prod. and local community devt, it is a strategy that leads to devt as well as growth.

Microfinance Schemes: In LDCs, the poor find it almost impossible to access trad. banking and fin. systems due to a lack of assets to use as collateral, unemployment, and a lack of savings. If they are able to borrow money, it is often through black markets, at exorbitant interest rates. Microfinance schemes are specifically geared towards low-income borrowers; they provide small loans, savings accounts and often insurance to the poor. Microcredit: The provision of small loans to those who lack access to trad. sources of finance. o Microcredit schemes were originally developed in LDCs, in the mid-1970s (e.g. the Grameen Bank in Bangladesh). o Usually, micro-credit is given to the poor to allow them to start up micro-enterprises (small-scale businesses- e.g. market stalls, rice wine-making facilities). o The loans give protection against unexpected occurrences and seasonal problems, and help families gain a regular income, start to gain wealth and thus, escape poverty, without encumbering the poor with much debt; interest on microloans tends to be low, although some for-profit microcredit enterprises charge interest rates in excess of 60%, and occasionally 100%. Microcredit is often given along with financial and technical education programs centered around the needs of the recipients, which increase the level of human capital

With microcredit, local economies in MDCs can become more diversified and more resilient with respect to market changes and deteriorating ToT. Women are the main recipients of micro-credit, as they are a better credit risk; they are more likely to pay back loans. Women are usually responsible for caring for children; thus, any reductions in womens poverty will translate into welfare improvements for children, Microfinance has allowed more poor children to go to school. In addition, when women take loans and begin to earn an income, their socioeconomic status increases.

Chapter XXXIII: Aid and Indebtedness (Foreign) Aid: Any assistance iven to a country that would not have been provided via normal market forces. Aid may be provided to LDCs in order to: o Help people who have experienced natural disasters or war o Help LDCs achieve ec. devt o Create/strengthen pol./strategic alliances o Fill the savings gap that exists in LDCs and thus encourage investment o Improve the quality of human capital in an LDC. o Improve tech. levels o Fund specific devt projects o Create markets to export to in the future (the economic reason for aid) Many ways to categorize aid exist, although we draw an immediate distinction between two forms: o Official Aid: Aid organized by a govt or official govt agency o Non-Official Aid: Aid organized by a non-government organization (e.g. Oxfam). We can also classify aid under two main headings, as well as by types of aid that come under both headings. The headings are, respectively: o Humanitarian Aid: Aid given to alleviate short-term suffering caused by events such as wards, natural disasters, or wars (e.g. relief efforts after the Haiti earthquake). Humanitarian aid can take sev. forms, but is usually presented as grant aid Grant aid: Aid provided as a gift (often in the short term) which does not have to be repaid by the recipient. The three main forms of humanitarian grant aid are: o Food aid: The provision of food from donor countries or money to pay for food, incl. money paid for transport, storage, and distribution of the food.

Medical Aid: The provision of medical services and products from donor countries, as well as money to facilitate med. services (e.g. NGOs that provide antiretroviral drugs). o Both forms of grant aid may be classified as official or nonofficial, depending on their origin. Development Aid: Aid given in order to alleviate poverty in the LR and improve the welfare of individuals. Devt aid given by natl governments and intergovernmental organizations is often referred to as Official Devleopment Assistance (ODA) Official Development Assistance: o [Informal Definition]: Aid provided by govts on concessional terms, sometimes in the form of grants, and sometimes as Soft loans o [Formal Definition]: Flows to LDCs provided by official agencies, incl. state and local govts, or by their executive agencies, each transaction of which meets the following criteria: It is administered with the promotion of ec. devt and welfare of LDCs as its main objectives It is concessional in character and consists of a grant element of at least 25% (calculated at a 10% discount rate). o Bilateral aid: ODA provided directly by individual govts to LDCs via official aid agencies (e.g. USAID). o Multilateral Aid: Aid provided by intergovernmental organizations (e.g. the IMF, UN agencies, the World Banks International Bank for Reconstruction and Development), the funds for which are provided by MDCs. The intergovernmental agencies decide where the aid is most needed and where it would be most effectively used. For instance, the World Bank IBRD grants soft loans to LDCs in support of specific devt projects, incl. provision of education, healthcare, improvements in ag., pollution reduction, and improvements in infrastructure. Such loans are often conditional: the recipient country may need to agree to certain policy changes before receiving the loan (e.g. environmental regulations, tariff reduction)

In 1970, the UN General Assembly adopted a resolution agreeing that MDCs should spend 0.7% of their GDP on ODA. However, in 2011, many countries are still far from this target. Types of ODA: Soft loans (concessional loans, long-term loans): Loans that are usually repayable by the LDC over a long time period (10-20 years). The loans are sometimes repayable in foreign currency, sometimes in local currency, and sometimes in a combination of the two. LDCs would prefer loans repayable in their local currency, as they would not need to use valuable, and scarce, foreign currency. Soft loans tend to have very low interest rates and be repayable over a longer time-period than a standard commercial loan. Soft loans may come via official (bilateral or multilateral) or non-official aid, although the latter is by far the rarer type. Tied Aid: Grants/loans given to an LDC on the condition that the funds be used to buy products from the donor country. Project Aid: Money given for specific projects in LDCS, often given as grant aid (which requires no repayment); e.g. aid for the construction of wells in Ghana. The projects are usually intended to improve infrastructure, and the aid funds are often supplied to LDCs by the World Bank. Technical Assistance (Sometimes classified as a subset of project aid): Aid intended either to raise the level of technology in LDCs by bringing in foreign technologies and technicians who can instruct on its use, or to raise the quality of human capital by providing training facilities and expert guidance, or offering scholarships such that managers and technicians can study abroad (e.g. US assistance with farming techniques in Malawi). Commodity Aid: Grant aid given to countries to increase productivity in LDCs by providing funds to purchase commodities incl. consumer items, semi-mfg. goods and industrial raw materials.

Approx. 25% of the aid to Bangladesh takes this form and provide necessities (e.g. chemicals, fertilizer, concrete, steel, pumps, and capital equipment). Most forms of devt aid fall under the official (both bilateral and multilateral)/non-official binary.

Concerns about Aid: While humanitarian aid is generally seen as necessary and important in alleviating short-term suffering, research suggests that no sig. correlation b/w the level of aid given to a country and the GDP growth rate exists. There are several concerns as to the use of aid as a means of poverty reduction: In many LDCs, the govt in power may not nec. have the welfare of the maj. of the pop. at heart; thus, when aid is received, it often goes to a small sector of the population (usually wealthy city dwellers and/or high-ranking officials). o In the majority of cases, the benefits of untargeted aid do not work their way through the economy; the trickle-down effect is particularly ineffective in LDCs. o Where there is extreme corruption, aid often leaves the country via capital flight almost as soon as it enters. o In addition, if the aid money props up such govts, a transition towards a more democratic use of pol. and econ. power may be slowed. Aid is sometimes given for pol. reasons rather than being given to countries where it is most needed; it is argued that MDCs often give aid to the countries that are of pol. or econ. interest to them. o As a result, the poorest countries in the world often receive less aid than people in middle-income countries (for instance, Japan has given aid to Nicaragua and St. Kitts and Nevis to influence their vote in favor of a repeal of commercial whaling bans). Tied aid is generally not as effective as untied aid; the LDC is unable to look for the least expensive goods/services, but has to buy (usually) more expensive goods/services from the donor country, which fosters inefficiency. o Tied aid creates no employment or extra output in the LDC, as no expenditure takes place there; the imports may also harm dom. producers, if they replace dom. products. Tied aid is often pol. motivated, and arguably represents a veiled subsidy to producers in the donor country; the provision of tied aid, however, has fallen

within the past decade, and it is now illegal in some countries (e.g the UK). While short-term food aid provision during a famine may be essential, long-term provision of large quantities of food may reduce ag. prices in the LDC and worsen local farmers ability to earn an income. A potentially more effective policy to help farmers in LDCs would be the reduction of ag. subsidies in MDCs, which exceed total aid flows by a factor of 6. LDCs may become dependent on aid in the LR, reducing their incentive to innovate and poss. fostering a welfare mentality, whereby LDCs believe that aid will always be available to them. In reality, if govts need to reduce their own deficits, aid expenditure is often one of the first items of spending to be cut, and is thus often unreliable for LDCs. Aid may prop up inefficient policies and agencies (e.g. corrupt legal institutions) that hamper economic progress in the long run. Aid may sometimes maintain uncompetitive industries in a recipient countrys economy, leading to resource misallocation. Some LDCs have industries that could quickly become competitive on intl markets; in their case, it may be better to concentrate on opening the markets to trade in order to gain greater growth rates through exports. Some economists argue that aid is skewed in favor of industrialization, which may cause income and development gaps between industrial workers and trad. ag. workers; in addition, aid-fueled industrialization that is too rapid may cause significant neg. externalities. Aid is often only available if the LDC agrees to adopt certain ec. policies; donors have argued that aid will only be effective if given to countries that adopt the sound ec. policies of the Washington Consensus (market-oriented liberalization, privatization, and deregulation), said to promote ec. growth. These policies may be more in the interests of MDC govts and MNCs than in the interests of LDCs, and the policies may worsen income inequality, as well as reduce social safety nets and levels of public services, however. People and govts in MDCs may be showing signs of aid weariness; they are beginning to believe that problems in their

own economies may be more important than those of LDCs; this may reduce aid flows over time. o Aid, esp. official aid, may not always get where it is needed due to corruption, inefficiency, lack of information and capital flight. o If technical assistance is not provided, LDCs may lack the necessary skills and knowledge to carry out aid projects efficiently. o Loan repayments on fin. aid may lead to massive indebtedness in LDCs. o Despite the above concerns, in the poorest LDCs, private investment is often not an option and aid may be the only solution; wars, low human capital, corruption and lack of infrastructure often render attracting foreign investment impossible. In these cases, directly targeted aid, esp. from NGOs (which are usually less pol. motivated), may be the only viable option for achieving growth and devt; however, aid will not be effective in the LR without responsible governance that emphasizes economic progress. Non-Governmental Organizations: o NGOs have come to play a major role in intl devt- although it is difficult to generalize about NGOs due to their diversity in size, nationality, outlook, goals, income, and success, most NGOs operating internationally aim to promote (sustainable) human devt and humanitarian ideals. They often work to provide emergency relief after natural disasters or provide long-term devt assistance. Examples of intl NGOs include Oxfam, the Mercy corps, Greenpeace, Amnesty, and Mdecins sans frontires. NGOs carry out two main activities: planning and implementation of specific, targeted policies in LDCs and lobbying to influence public policy in areas such as poverty reduction, workers rights, human rights, and the environment. Some NGOs concern themselves with one of the above activities, while some carry out both via fund- and awareness-raising. This can result in public pressure on govts to affect the amount and emphasis of official aid given, and may influence consumers spending patterns such that better working conditions and sust. devt are promoted (e.g. encouraging consumption of Fairtrade products). As NGOs involves themselves directly with issues in the field, they can develop a deeper understanding of the challenges facing the poor than many official aid donors have.

Thus, they can combat poverty directly, often working in areas where official aid does not reach, with groups that may be isolated from official aid (e.g. stateless refugees). Much of the work of NGOs focuses on direct cooperation with the poor to enhance their human capital. This may be accomplished via literacy programs, health education, AIDS prevention programs, ag. extension schemes, microcredit offerings, immunization and vocation training. Many NGOs focus on women in particular; raising womens incomes and status is a major milestone for achieving overall ec. devt.

Indebtedness: o A high level of debt repayments that LDCs need to make on previously-borrowed money is a major barrier to growth and devt in developing countries. o To understand indebtedness, it is worth examining the historical causes of the Third World Debt Crisis. Before the 1970s, the level of borrowing by LDCs was low and tended to consist of bilateral official soft loans at low interest rates. In 1973, OPEC steeply raised oil crisis, leading to a massive increase in oil revenues in oil-exporting countries (and tore apart many mixed economies based on Keynesian principles, though that is a different story). The revenues (known as petro-dollars) were deposited in Western comm. banks; IRs fell sharply as the supply of loanable funds greatly increased. To make profits, the banks needed to lend the OPEC money to third parties; however, the money supply was so great that the usual borrowers did not take the full amount; thus, banks offered loans to LDCs, which began to borrow money at regular interest rates, rather than the prior soft rates. The loans were only repayable in hard currencies, rather than the local currencies of the LDCs. o The key to the Third World Debt Crisis was (according, at least, to this left-leaning editor) that commercial banks wished to continue making profits throughout the 1973-75 recession without considering the consequences of their actions to lenders (much like credit cards were offered for free to unemployed college students in the lead-up to the 2008 Financial Crisis). Thus, although the banks lent huge sums, they did not monitor the moneys destination and use. Unfortunately, little of the money was spent on devt; most LDC govts of the time were corrupt and/or

dictatorial, and the money went into large, failed infrastructure projects (e.g. highways in the Sahara desert), armaments, and private bank accounts of dictators, generalissimos, and corrupt officials. Although borrowing in LDCs grew at an alarming rate, they managed to keep up with payments throughout the 1970s, as high inflation rates worldwide made real interest rates low. Also, world demand for commodity exports was rel. high, as were export prices; thus, LDCs had enough foreign reserves on hand to manage repayments. However, in 1979, OPEC increased oil prices again, which contributed to a second worldwide recession; this contributed to a sharp fall in demand for commodities. For sev. reasons, incl. falling commodity prices, many LDCs found it very difficult to service their debt and, in 1982, Mexico defaulted on its loans- it was no longer able to pay the debt plus interest. o This sparked fears of a contagion effect on intl credit markets, esp. as several other LDCs followed Mexico in defaulting; in response, the IMF made it official policy to lend to countries that needed a bailout, on the condition that they adopted structural adjustment policies, which included: Encouraging trade liberalization by lifting import/export barriers Encouraging primary product (esp. ag. and mineral) exports. Devaluing the currency. Encouraging FDI Privatization of nationalized industries. Reducing govt expenditure to ensure that govt budgets were balanced Austerity measures (reductions in social expenditures)

Charging for basic services (e.g ed./healthcare). Removing subsidies and price controls Improving governance (decision- and policymaking processes) and reducing corruption levels. These policies reflect the views of the Washington Consensus; as such, many are supply-side policies. The IMF has argued that demand-management policies are difficult to organize effectively in LDCs. However, after having come under more recent criticism, SAPs have also emphasized the need for more efficient and progressive tax systems, where the wealthy are expected to contribute a share of their incomes and assets. The SAPs were heavily criticized by many devt economists and LDC govts; although they may have successfully reduced inflation, improved the efficiency of markets in LDC economies, lowered budget deficits, reduced public ownership of firms and reformed ER policies, serious costs (esp. to the poor) were involved, including: Reduction in govt-provided services (e.g. education, healthcare), which could potentially lead to unrest, economic disruption and falling growth rates due to decreasing AD, at least in the SR. Increasing unemployment Falling real wage rates

Increased prices of necessities following removal of subsidies. Due to the above, many LDCs experienced de-development, as reflected by higher malnutrition, declining school attendance, and increasing infant mortality. Although the SAPs may have led to long-term growth, the short-term costs to the poor were tremendous. In addition, the SAPs represent a rather formulaic approach to ec. growth, and do not reflect other possible paths to ec. progress. At present, many LDCs still suffer from indebtedness, leading to debate about the importance of debt relief; many argue that LDCs debts should be reduced/canceled. One reason in favor of debt relief relates to the inability of many LDCs to service debt (pay back the original debt plus interest); some countries are failing to meet interest repayments, not to mention the original debt (e.g. Nigeria borrowed $17 billion, paid back $18 billion, and owes $34 billion); this debt escalation is widely considered unfair. Another reason is that debt servicing reduces the ability of govts to spend on other areas of the econ, a case of opp. cost that is detrimental in two ways: First, it slows ec. growth (e.g. as govts lack the funds to invest in infrastructure). Second, it slows devt, as govts cannot afford provision of essential services (e.g. Malawi spends more on debt servicing than on healthcare provision).

Debt relief will release money, enabling govts to finance devt objectives This relationship can be illustrated using a spending possibilities line, a simple diagram similar to the PPF. If a govt has a given amt. of revenue, it must choose b/w competing uses of the money, which include debt servicing, infrastructure investment, and human capital investment via ed. and healthcare expenditure. The SPL has debt servicing on one axis and expenditure on human capital on the other axis; if a govt is granted debt relief, it will move along its SPL away from debt servicing and towards human capital investment. A further reason for debt relief involves odious debt (debt incurred by a regime and used for purposes that do not reflect the peoples interests. As dictators in LDCs have used much of the borrowed money for individual purposes, providing few real benefits to residents (who need to repay the debt), much of the debt incurred by LDCs technically qualifies as odious debt. The argument goes that the lenders of the money (comm. banks, intl fin. institutions, and MDCs) were equally at fault in making the loans. As such, they should not expect repayment. Economists have suggested that intl debt is associated with boomerangs that come back to hit MDCs; debt creates problems for MDCs in terms of

worldwide environmental damage, drug imports, higher taxes, higher unemployment, illegal immigration and higher conflict levels. Thus, it is argued that MDCs would benefit from debt relief, as well, allowing them to experience higher growth rates. In addition, rising incomes in LDCs create demand for MDC exports; thus, MDCs may also benefit from debt relief. In 1996, the IMF and World Bank launched the Highly Indebted Poor Countries Program, which works with the poorest debtor countries to reduce their external debt; the majority of the 40 countries involved are in Africa. As with the SAPs, assistance via HIPC is contingent upon the govts in the countries in question meeting certain agreed ec. goals, which are still closely based on Washington Consensus policies and controversial. Debt relief can be extremely effective in promoting growth and devt; however, it is not a silver bullet for assuring the success of LDCs.

Market-Led vs. Interventionist Growth Strategies o To conclude, we examine the weaknesses of market-led and interventionist growth and devt strategies. o As always, the same two schools of thought come into conflict; Keynesian and Neoclassical economists have differing views on the role of govts in achieving intl econ. progress. o Market-led growth strategies (free-market policies, neo-classical policies, neoliberal policies): Policies designed to minimize the role of govts and maximize the free operation of markets. Examples include export-led growth, growth via FDI, privatization, deregulation, and the World Bank and IMFs SAPs and Poverty Reduction Strategy Papers. o Interventionist growth strategies: Policies implicating the active role of govts and manipulation of the workings of markets to achieve ec. growth.

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Examples include ISI, protectionism, ER intervention, regulation, nationalization of industries and govt promotion of certain export industries and products. For about 30 years since the end of WWII, the main emphasis in terms of growth and devt strategies was govt planning over the long term. However, outside of MDCs, the policies were often difficult to implement and did not lead to entirely sustained growth and devt, because of problems that arose: Public sectors in many LDCs (esp. India and China) grew too large, leading to red tape, overstaffing, and inefficiency; together with growing pol. instability, this provided opportunities for the growth of corruption. The many nationalized industries tended to be loss-making and inefficient, and sometimes led to hidden unemployment. Govt spending tended to be excessive, leading to large budget deficits and thus the need for borrowing and increases in money supply, causing high inflation rates. Much of the expenditure was on unsuccessful large infrastructure projects. In the 1980s, a movement towards free-market, supply-side govts in MDCs saw a realignment of govt policy and a change in paradigms on the best way to achieve growth and devt in LDCs; along with ec. policy changes in MDCs, the change of direction was influenced by: The Third World Debt Crisis: As many LDCs needed to borrow money from the IMF, which would only grant loans on the condition that LDCs implemented SAPs, to avoid defaulting on loans, many LDCs adopted market-based policy initiatives. The transition of the USSR and satellite states towards market-based economies (early 1990s) had two effects: First, it acted as a signal that central planning was not effective as a growth and devt strategy Second, it removed fin. support for several LDCs aligned with the Eastern Bloc, forcing them to seek support elsewhere (often, with the IMF and World Bank) The perceived success of the Asian Tigers (Japan, Singapore, Taiwan, Hong Kong, S. Korea), who appeared to have successfully adopted export-led growth and encouraged FDI, influenced thought on the ways to achieve high growth rates. Thus, LDCs were encouraged to reduce the role of the govt in their economies and adopt a more outward-oriented approach to ec. growth, generally including: Freeing up dom. markets by eliminating price controls and subsidies, and increasing competition. Liberalizing intl trade by eliminating trade barriers and encouraging FDI.

Specializing according to comparative advantage; for most LDCs, this meant specialization in primary products, which incurred the risk of deteriorating terms of trade. Privatizing nationalized industries. Reducing govt expenditure to eliminate budget deficits. However, as time progressed, a number of problems with the adoption of a purely market-oriented approach have arisen: Infrastructure is unlikely to be created via a market-based approach and most LDCs lack the infrastructure to adopt such an approach, which would require some future planning and govt intervention. Although MDCs promote trade liberalization, they do not liberalize all trade; protectionism in MDCs renders it difficult for LDCs to compete on a fair basis. In recent years, LDCs (led by the BRIC bloc) have been cooperating with each other to gain influence in trade negotiations. The success of the Asian Tigers did not occur w/o govt intervention; the govts in question were very interventionist in specific areas, esp. in infant industries that needed protection before being able to compete on world markets. The Asian Tigers also invested significant amounts of money into ed. and healthcare, which is nowadays discouraged by World Bank and IMF policies. Although a market-based approach may lead to high growth in the LR, the poor suffer SR costs, as unemployment rises, as do prices of necessities, and the provision of public services falls. As the measures will neg. affect low-income people worse than other groups, income inequality will worsen. Free market strategies tend to be concentrated on the urban, mfg. sectors of an economy, increasing the divide b/w urban and rural areas, as well as rural poverty, and leading to rural-urban migration, which has created large slums in many major LDC cities due to a lack of employment opportunities for uneducated workers in urban areas. Govts may liberalize capital flows, but pol. instability means that many countries are unable to attract the FDI necessary to fill savings gaps and achieve growth. Thus, solutions to growth and devt will lie in a combination of approaches which will vary between countries. As the IMF discovered, a one-size-fits-all policy, esp. one that is ideologically-motivated, is generally ineffective. To conclude, we summarize some of the conditions believed to be necessary for both ec. growth and ec. devt in LDCs by many economists: Trade justice, such that LDCs trade on a fair basis with MDCs and are not hampered by protectionist policies. Debt relief, to release funds for investment in phys. and human capital.

Free operation of dom. markets, but only once the markets have reached a competitive size and are sufficiently supported by infrastructure, high-quality labor, and tech. and managerial expertise. Encouragement of political stability and good governance and elimination of corruption. Effective, targeted aid that leads to pro-poor growth, such that aid flows are directed at policies which encourage growth leading to a fall in poverty.

Appendix 1: IB Economics Markscheme Glossary Abnormal profits (HL) see supernormal profits Actual growth is an increase in real output for an economy over time. It is measured as an increase in real GDP. Aggregate demand is the total spending in an economy consisting of consumption, investment, government expenditure and net exports. Aid is official aid is provided to a country by another government or governmental organization such as UN or EU. tied aid is granted on the condition that it is used to buy goods or services from the donor country. Allocative efficiency (HL) exists where price is equal to marginal cost (or marginal social cost) and resources are allocated in such a way that neither too much nor too little is produced from societys point of view. Anti-dumping is government legislation [= the imposition of tariff] against the selling of imported goods at a price below their production costs Appreciation is an increase of the value of the currency, expressed in terms of another currency, in a floating exchange rate system. Average costs (HL) is the total cost divided by the quantity produced. Business cycle is the periodic fluctuations in real national income/output/GDP around the productive potential or long term trend of the economy. Its stages are slump/trough, recovery/expansion, boom and recession. Centrally planned economy is an economic system where resources are allocated by the government or a central planning authority Comparative advantage (HL) implies that one country is able to produce a good at a lower opportunity cost than another.

Consumption is spending by individuals and households on domestic consumer goods and services over a period of time. Current account (balance) is a record of the revenues earned from the export of goods and services and the expenditure on imports of goods and services.

current account deficit is where the value of total imports of goods and services are greater than the value of total exports of goods and services current account surplus is where revenues from the exports of goods and services are greater than the spending on the imports of goods and services. Cross elasticity of demand is the responsiveness of the demand for one good to a change in the price of another good. Crowding out (HL) is a situation where the government spends more (government expenditure) than it receives in revenue (mainly taxation), and needs to borrow money, forcing up interest rates thereby reducing investment and consumption Demand is the quantity of goods and services that consumers are willing, and able to buy at each possible price (over a given period of time). Depreciation is a fall in the value of one currency against another currency in a floating exchange rate system. Developing countries are characterized by low per capita income high rates of poverty low standard of living low HDI ranking/value

Dumping is the selling of a good in another country at a price below its cost of production. Economic growth increased real output for an economy over time and it is measured by an increase in real GDP OR it is an increase in the potential output of the economy where the PPC shifts outwards. Economic development is a broader concept than economic growth involving welfare improvements to the standard of living including health, education and shelter. Economies of scale (HL) are a fall in long run unit costs that comes about as a result of a firm increasing its scale of operations. Equilibrium price is the market-clearing price, set where Demand equals Supply.

Exchange rate is the price of one currency expressed in terms of another, preferably with an example. Externalities are . negative externalities they are costs to a third party caused by the production, or consumption of a good (or service) or that they occur when MSC is greater than MSB in the market for a good or service.

Factors of production are the four types of resources used in the production process: land, labor, capital (and possibly entrepreneurship / management / enterprise). Fiscal policy is the use of government spending and taxation to to shift the AD curve. Floating exchange rate is where the exchange rate (i.e. price of one currency in terms of another) changes according to the market forces of demand and supply. Foreign direct investment is the establishment of production units by multinational companies in a foreign country. Free good is unlimited in supply and has no opportunity cost Free trade exists where there is trade between different countries without government intervention/regulation. Free trade area is an agreement whereby there is free trade among member countries, but each member can maintain its own trade barriers in trade with non-member countries GDP or national output is the total value of all final goods and services produced in an economy in a given time period (usually one year). GDP per capita is a measure of real output/ income/ expenditure in the economy in one year per head of the population. real GDP or real output is the value of all final domestic goods and services, adjusted for inflation. Gini Coefficient is a measure of inequality in the distribution of income. Human resources are the labor force of a country. Import substitution policies are designed to encourage the domestic production of goods, rather than importing them. The strategies encourage protectionism. Income elasticity of demand is the measure of the responsiveness of demand of a good or service to a change in income.

Indebtedness is the amount of money that a country owes to other countries and/or international institutions. Indirect taxation is an expenditure tax or a tax levied on goods and services imposed by the government.

Infrastructure involves essential facilities and services such as roads, airports, sewage treatment, railways, telecommunications and other utilities typically provided by the government. Inflation is a sustained increase in the general or average level of prices. Inflationary gap refers to inflationary pressure created by the current (or SR) equilibrium being above the full employment (or LR) equilibrium. Informal markets refer to markets in which economic activity is not officially measured/ recorded. Interest rates is the price of capital or the price of borrowed/loaned money, usually expressed as a percentage. Investment is expenditure by firms on capital equipment and is an injection into the economy. Inward-oriented policies see import substitution Managed exchange rates is a system where the exchange rate is determined by market forces, but the government/Central Bank intervenes from time to time in order to keep it within a certain band (= range). Market is the interaction between buyers and sellers in order to exchange goods or services (to make an economic transaction). Market economy is an economy where resource allocation is determined mainly by market forces of demand and supply. Maximum price is the upper limit imposed by the government below which the price may not fall. A maximum price is usually set below the equilibrium to aid relatively poor consumers. Merit goods are goods or services with strong positive externalities] that would be under-provided by the market and so under-consumed. Minimum price is the lower limit imposed by the government below which the price may not fall. A minimum price is usually set above the equilibrium to aid farmers. Monetary policy is a demand-side policy with the Central Bank using changes in the money supply or interest rates to affect AD.

Monopolistic competition is a market when there are many buyers and sellers, producing differentiated products, with no barriers to entry. Multinational corporations are companies that have productive units in more than one country. Multiplier (HL) is the ratio of the induced change in national income to the increase in the level of injections and it is equal to the reciprocal of the mps + mpt + mpm.

NGOs are non-government organizations that exist to: promote sustainable economic development and/or humanitarian ideals.

Nominal is the value of an economic variable that has not been adjusted for the effects of inflation. Normal profit (HL) is the amount of revenue needed to cover the total costs of production, including the opportunity costs. (Official) foreign (currency) reserves are reserves of foreign currencies held by the Central Bank or the government of a country. Oligopoly is a market where few large firms dominate the industry, with at least one other characteristic such as interdependency of firms, high barriers to entry, homogeneous or differentiated product with example, imperfect information. collusive oligopoly is where a few firms act together to avoid competition by resorting to agreements to fix prices or output. Opportunity cost is the cost of an economic decision in terms of the next best alternative foregone. Poverty cycle involves low incomes which lead to low savings and low investment which ensure low incomes in the future. Potential growth is an increase in the potential output of an economy through an increase in the quantity/quality of resources Price elasticity of demand is a measure of the responsiveness of quantity demanded to a change in the price of the good. Price discrimination (HL) exists when a producer charges a different price to customers for an identical good or service.

Product differentiation (HL) is where a producer attempts to distinguish her product from those of competitors, with the aim of making demand less price elastic. Productive efficiency (HL) exists when production is achieved at lowest cost per unit of output. This is achieved at the point where average total cost is at its lowest value.

Progressive tax is where the higher the level of income, the higher the percentage of taxation that is paid (or the higher the average rate of taxation). Property rights give people a legal right to own property/assets. Quotas are import barriers that set limits on the quantity or value of imports into a country.

Real price is the nominal price of a good or service adjusted for inflation. Recession is at least two consecutive quarters of negative economic growth. Resource allocation is concerned with how resources (land, labor, capital and management) are distributed in an economy. Regressive taxes is where the proportion of income paid in tax falls as the income of the taxpayer rises or where the average rate of tax falls as income rises. Unemployment is people of working age (those in the labor force) actively seeking work at the current wage rate but cannot find one. unemployment rate is the number of workers without a job, who are willing and able to work, expressed as a percentage of the workforce. Subsidy is a payment made by the government to producers in order to reduce the costs of production or to increase output. Supernormal profits (HL) refer to a situation where all costs, including opportunity cost, are more than covered by revenue, OR profits that are above the level that is sufficient to keep the firm in an industry. Supply is the willingness and ability of producers to produce a quantity of a good at a given price (in a given time period). Supply-side policies they are policies designed to shift the AS curve to the right. They may include tax cuts, reductions in welfare payments, promotion of training etc. Sustainable development is the development needed to meet the needs of the present generation without compromising the ability of future generations to meet their own needs. Structural unemployment is long term unemployment that occurs when there is a mismatch between the skills of unemployed workers and the jobs available or that exists as a result of rigidities in the labor market. Tariff is a tax on imports. Terms of trade deterioration is where the average price of exports falls relative to the average price of imports, or making it more expensive to buy imports, in terms of exports that need to be sold.

Trade cycle: see Business cycle Tradeable permits are permits to pollute, issued by a governing body, which sets a maximum amount of pollution allowable. Firms may trade these permits for money. Wage is the payment for labor/working

real wage is the payment for labor/working adjusted for inflation. World Bank is an international organization whose main aims are to provide aid and advice to developing countries, as well as reducing poverty levels. World Trade Organization is an international body that encourages the reduction of trade barriers between its member nations.