05 Economic Principles

Business Management
ABE STUDY MANUAL

Study Manuals business growth
Diploma in
ECONOMIC PRINCIPLES AND THEIR APPLICATION TO BUSINESS

Business Management
ECONOMIC
PRINCIPLES AND
THEIR APPLICATION
TO BUSINESS
The Association of Business Executives

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i
Diploma in Business Management
ECONOMIC PRINCIPLES AND THEIR APPLICATION

TO BUSINESS
Contents
Unit Title Page
Introduction to the Study Manual v
Syllabus vii
1 The Economic Problem and Production 1

Introduction to Economics 2
Basic Economic Problems and Systems 4
Nature of Production 6
Production Possibilities 11
Some Assumptions Relating to the Market Economy 14
2 Consumption and Demand 17

Utility 18
The Demand Curve 21
Utility, Price and Consumer Surplus 24
Individual and Market Demand Curves 25
3 Demand and Revenue 27

Influences on Demand 29
Price Elasticity of Demand 33
Further Demand Elasticities 36
The Classification of Goods and Services 38
Revenue and Revenue Changes 40
4 Costs of Production 49
Inputs and Outputs: Total, Average and Marginal Product 50
Factor and Input Costs 55
Economic Costs 64
Costs and the Growth of Organisations 64
Small Firms in the Modern Economy 68
5 Costs, Profit and Supply 73

The Nature of Profit 74
Maximisation of Profit 77
Influences on Supply 84
Price Elasticity of Supply 89
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Unit Title Page
6 Markets and Prices 97

Nature of Markets 99
Functions of Markets 101
Prices in Unregulated Markets 102
Price Regulation 106
Defects in Market Allocation 108
The Case for a Public Sector 112
Methods of Market Intervention: Indirect Taxes, Subsidies and Market
Equilibrium 113
Using Indirect Taxes and Subsidies to Correct Market Defects 118
7 Market Structures: Perfect Competition versus Monopoly 125

Meaning and Importance of Competition 126
Perfect Competition 127
Monopoly 133
8 Market Structures and Competition: Monopolistic Competition and

Oligopoly 141
Monopolistic Competition 142
Oligopoly 144
Profit, Competition, Monopoly, Oligopoly and Alternative Objectives for
the Firm 150
9 The National Economy 155

National Product and its Measurement 156
National Product 162
National Expenditure 164
National Income 166
Equality of Measures 167
Use and Limitations of National Income Data 168
National Product and Living Standards 171
10 Determination of National Product: The Keynesian Model of Income

Determination and the Multiplier 175
Changes in Consumption, Saving and Investment 176
Government Spending and Taxation 180
Changes in Equilibrium, the Multiplier and Investment Accelerator 181
The Role of the Government in Income Determination:
the Government's Budget Position and Fiscal Policy 188
11 Macroeconomic Equilibrium and the Deflationary and Inflationary

Gaps 191
National Income Equilibrium and Full Employment 192
The Basic Keynesian View 192
The Deflationary Gap 193
The Inflationary Gap 196
The Aggregate Demand/Aggregate Supply Model of Income
Determination 199
Financing Fiscal Policy: Budget Deficits and Public Sector Borrowing 207
The Limitations of Fiscal Policy 210
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Unit Title Page
12 Money and the Financial System 213

Money in the Modern Economy 214
The Financial System 216
The Banking System and the Supply of Money 220
The Central Bank 222
Interest Rates 224
13 Monetary Policy 229

Options for Holding Wealth 230
Liquidity Preference and the Demand for Money 232
Implications of the Interest Sensitivity of the Demand for Money 234
Changes in Liquidity Preference 237
The Quantity Theory of Money and the Importance of Money Supply 238
Methods of Controlling the Supply of Money 240
Monetary Policy and the Control of Inflation 241
14 Macroeconomic Policy 245

The Major Economic Problems 246
Policy Instruments Available to Governments 249
Policy Conflicts and Priorities 254
Supply-side Policies 255
15 The Economics of International Trade 261

Gains from Trade and Comparative Cost Advantage 262
Trade and Multinational Enterprise 265
Free Trade and Protection 268
Methods of Protection 272
International Agreements 275
16 National Product and International Trade 281

International Trade and the Balance of Payments 282
Balance of Payments Problems, Surpluses and Deficits 289
Balance of Payments Policy 293
17 Foreign Exchange 297

International Money 298
Exchange Rates and Exchange Rate Systems 300
Exchange Rate Policy 306
Macroeconomic Policy in Open Economy 307
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Introduction to the Study Manual

Welcome to this study manual for Economic Principles and their Application to Business.
The manual has been specially written to assist you in your studies for the ABE Diploma in
Business Management and is designed to meet the learning outcomes specified for this
module in the syllabus. As such, it provides a thorough introduction to each subject area and
guides you through the various topics which you will need to understand. However, it is not
intended to "stand alone" as the only source of information in studying the module, and we
set out below some guidance on additional resources which you should use to help in
preparing for the examination.
The syllabus for the module is set out on the following pages and you should read this
carefully so that you understand the scope of the module and what you will be required to
know for the examination. Also included in the syllabus are details of the method of
assessment – the examination – and the books recommended as additional reading.
The main study material then follows in the form of a number of study units as shown in the
contents. Each of these units is concerned with one topic area and takes you through all the
key elements of that area, step by step. You should work carefully through each study unit in
turn, tackling any questions or activities as they occur, and ensuring that you fully understand
everything that has been covered before moving on to the next unit. You will also find it very
helpful to use the additional reading to develop your understanding of each topic area when
you have completed the study unit.
Additional resources
 ABE website – www.abeuk.com. You should ensure that you refer to the Members
Area of the website from time to time for advice and guidance on studying and
preparing for the examination. We shall be publishing articles which provide general
guidance to all students and, where appropriate, also give specific information about
particular modules, including updates to the recommended reading and to the study
units themselves.
 Additional reading – It is important you do not rely solely on this manual to gain the
information needed for the examination on this module. You should, therefore, study
some other books to help develop your understanding of the topics under
consideration. The main books recommended to support this manual are included in
the syllabus which follows, but you should also refer to the ABE website for further
details of additional reading which may be published from time to time.
 Newspapers – You should get into the habit of reading a good quality newspaper on a
regular basis to ensure that you keep up to date with any developments which may be
relevant to the subjects in this module.
 Your college tutor – If you are studying through a college, you should use your tutors to
help with any areas of the syllabus with which you are having difficulty. That is what
they are there for! Do not be afraid to approach your tutor for this module to seek
clarification on any issue, as they will want you to succeed as much as you want to.
 Your own personal experience – The ABE examinations are not just about learning lots
of facts, concepts and ideas from the study manual and other books. They are also
about how these are applied in the real world and you should always think how the
topics under consideration relate to your own work and to the situation at your own
workplace and others with which you are familiar. Using your own experience in this
way should help to develop your understanding by appreciating the practical
application and significance of what you read, and make your studies relevant to your
personal development at work. It should also provide you with examples which can be
used in your examination answers.
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And finally …
We hope you enjoy your studies and find them useful not just for preparing for the
examination, but also in understanding the modern world of business and in developing in
your own job. We wish you every success in your studies and in the examination for this
module.

September 2008
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Unit Title: Economic Principles and Their Unit Code: EEPAB

cons
Application to Business
Level: 5 Learning Hours: 160
Learning Outcomes and Indicative Content:
Candidates will be able to:
1. Explain the problem of scarcity, the concept of opportunity cost,

the difference between macroeconomics and microeconomics
and the difference between normative and positive economics
1.1. Explain the problems of scarcity and opportunity cost. Explain

how these concepts are related using numerical examples
and a production possibility frontier
1.2. Explain what is meant by free market, command and mixed
economies. Discuss, using real world examples, the relative
merits of these alternative regimes
1.3. Explain what is meant by microeconomics and
macroeconomics. Discuss the differences between these
areas. Explain the meaning and implications of the ‘ceteris
paribus’ assumption in microeconomics
1.4. Explain what is meant by normative and positive economics.
Discuss the differences between these terms
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2. Explain the theory of consumer choice using the concept of

utility, individual demand and market demand. Explain the
concept of elasticity in relation to different types of good and firm
behaviour through an understanding of the revenue function.
Solve numerical problems involving elasticity
2.1. Explain the concept of utility. Explain what is meant by marginal

utility, utility maximisation and the property of diminishing
marginal utility, using diagrams and numerical examples
2.2. Explain the relationship between individual utility and individual
demand for a good, using examples where required
2.3. Solve numerical problems relating to marginal utility and utility
maximisation based on utility or consumption data
2.4. Identify the difference between individual and market demand
2.5. Explain the reasons for movements along or shifts in demand
curves
2.6. Identify the formulae for, and explain what is meant by, own-
price, cross-price and income elasticities of demand. Discuss
factors which affect each of these elasticities
2.7. Solve numerical demand elasticity problems using demand
information
2.8. Explain, in words, diagrams and with reference to demand
elasticities, what is meant by each of the following: normal
goods, bads, inferior goods, Giffen goods, luxury goods,
complements and substitutes. Identify real world examples of
each of these
2.9. Examine, using diagrams and numerical examples, the
relationship between total revenue, average revenue and
marginal revenue and between marginal revenue and the
elasticity of demand for a profit-maximising firm. Discuss how a
profit-maximising firm might respond to information about
demand elasticities
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3. Discuss the theory of costs, explaining the differences and

relationships between the various types of cost and
distinguishing between the short- and long-run. Solve numerical
problems based on cost information. Explain the concept of
profit maximisation and solve problems using diagrams and data.
Explain the link between a firm’s supply curve and its cost
functions. Explain and contrast, in words and with diagrams, the
concepts of economies of scale and returns to scale
3.1. Explain, with reference to appropriate examples, the difference

between fixed and variable factors of production
3.2. Identify the formulae for, and explain what is meant by, fixed
cost, variable cost, marginal cost, average cost and total cost.
Solve numerical and/or diagrammatic problems using cost data
3.3. Explain, using an appropriate diagram, the relationship between
average and marginal cost
3.4. Explain, using appropriate examples, the difference between
fixed cost and sunk cost
3.5. Explain, using words, diagrams and numerical examples, how a
firm reaches its profit maximising choice of output with reference
to marginal cost and marginal revenue. Solve diagrammatic
and numerical problems of profit maximisation
3.6. Explain using diagrams how a firm chooses whether or not to
stay in operation or leave the industry in the short- and long-run.
3.7. Explain how a firm’s supply curve is derived from an analysis of
its cost functions. Explain the reasons for movements along
and shifts in supply curves
3.8. Identify the formula for the elasticity of supply. Examine the
effect of changes in the elasticity of supply on the diagram of a
supply curve. Solve numerical problems for the elasticity of
supply based on data
3.9. Explain what is meant by economies and diseconomies of scale
and relate these concepts to the long-run average cost curve.
Explain what is meant by increasing, constant and decreasing
returns to scale. Explain, using real world examples, how each
of the above might arise. Compare and contrast the concepts of
returns to scale and economies of scale
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011860
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ABE, ABE Study Manual – Economic Principles and their Application to

Business, ABE
Sloman J, Economics (2002), Pearson Higher Education

ISBN: 0273655744
Taylor M, Mankiw N, Economics (2006), Thomson Learning

ISBN: 1844801330
xvi
1
Study Unit 1
The Economic Problem and Production
Contents Page
Introduction to Economics 2
A. Basic Economic Problems and Systems 4

Some Fundamental Questions 4
Choice and Opportunity Cost 5
B. Nature of Production 6
Economic Goods and Free Goods 6
Production Factors 6
Enterprise as a Production Factor 7
Fixed and Variable Factors of Production 8
Production Function 8
Total Product 9
C. Production Possibilities 11
D. Some Assumptions Relating to the Market Economy 14

Consistency and Rationality 14
The Forces of Supply and Demand 14
Basic Objectives of Producers and Consumers 15
Consumer Sovereignty 15
© ABE and RRC

2 The Economic Problem and Production
How to Use the Study Manual

Each study unit begins by detailing the relevant syllabus aim and learning outcomes or
objectives that provide the rationale for the content of the unit. For this unit, see the section
below. You should commence your study by reading these. After you have completed
reading each unit you should check your understanding of its content by returning to the
objectives and asking yourself the following question: "Have I achieved each of these
objectives?"
To assist you in answering this question each unit in this subject ends with a list of review
points. These relate to the content of the unit and if you have achieved the objectives or
learning outcomes you should have no trouble completing them. If you struggle with one or
more, or have doubts as to whether you really do understand some of the key concepts
covered, you should go back and reread the relevant sections of the unit. Ideally, you should
not proceed to the next unit until you have achieved the learning objectives for the previous
unit. If you are working with a tutor, he/she should be able to assist you in confirming that
you have achieved all the required objectives.
Objectives
The aim of this unit is to explain the problem of scarcity, the concept of opportunity cost, the
difference between macroeconomics and microeconomics and the difference between
normative and positive economics.
When you have completed this study unit you will be able to:
 explain the problems of scarcity and opportunity cost
 explain how scarcity and opportunity cost are related using numerical examples and a
production possibility frontier
 explain what is meant by free market, command and mixed economies
 discuss, using real world examples, the relative merits of these alternative regimes
 explain what is meant by microeconomics and macroeconomics and discuss the
differences between these areas
 explain the meaning and implications of the ceteris paribus assumption in
microeconomics
 explain what is meant by normative and positive economics and discuss the
differences between these terms.
INTRODUCTION TO ECONOMICS
The study of economics is important because we all live in an economy. Our well-being is
closely related to the success, or otherwise, of both the economy in which we live and that of
all the other economies in the world. Whether people have jobs or are unemployed, the kind
of work people do, the things they produce, how much they are paid, what they purchase,
how much they consume, and the influence of the government on economic activity are the
subject matter of economics. The study of economics is important for a proper
understanding of business. This is because we are all consumers and will be workers for a
large part of our lives, so that what we do determines how well business does. The study is
important for business because often common sense is not a good guide to how a firm
should operate to get the best out of a particular situation. What the study of economics
reveals is that in many situations what is obvious is not always correct and what is correct is
not always obvious.
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The Economic Problem and Production 3
A sound knowledge and understanding of economics is essential for understanding the

business environment and business decision-making. Economics is regarded as a science
because it is based on the formal methods of science. It uses abstract models, mathematical
techniques and statistical analysis of markets and economies. The aim is to test and apply
theories to advance our understanding of both how economies work and the business
environment. If you have not studied economics before there is no need to worry if you do
not like mathematics, graphs and equations. This Study Manual provides an introduction to
the study of economics, and its application to business, and maths and equations are kept to
a minimum.
Positive and Normative Economics
In the study of economics, because it is a science, an important distinction is made between
positive and normative statements. Science is based on theories which are used to make
predictions about how some aspect of physical reality works. Successful theories are ones
that yield useful predictions and insights into reality. More precisely, successful theories yield
predictions that are not refuted when put to the test using real data. Theories that fail to
predict correctly are not "good" theories; they are not useful and are unlikely to survive the
course of time. Likewise, theories that only predict some things accurately some of the time
tend to be replaced or refined. This is how science progresses.
Statements and predictions that can be tested, to see if the theories from which they are
derived should be accepted or rejected, are called positive statements. Positive economics is
concerned with such statements: it seeks to understand how economies function by using
theories that can be tested in the real world and rejected if they make false predictions.
Positive economics is concerned with "what is" not with "what should be".
In contrast statements about how the world, or an economy, should be changed to make it
better are based on opinions rather than facts. Such statements cannot be proved or
disproved using the methods of science. For example, the statement that an increase in the
price of petrol will lead to a reduction in the sale of petrol is an example of positive
economics. The statement may be right or wrong: the way to find out is to test the prediction
using real world data on petrol sales and the price of petrol. On the other hand, the
statement that the government should subsidise the price of petrol to help people on low
incomes is a normative statement. Some people may agree with the statement but others
may disagree, because it is based on a value judgement. There is no scientific way of
"proving" that it is the correct thing for the government to do. That is, even if we all shared
the same values and agreed that the government should help people on low incomes, it
does not follow that reducing the price of petrol is the best way to help them. Although this is
a simplification, positive economics is concerned with facts while normative economics is
concerned with opinions.
The Methods of Economic Analysis: the Ceteris Paribus Assumption
The economic behaviour of individuals is complex. The behaviour of consumers and firms
interacting in markets is even more complex. The economic decisions and interactions
between all the consumers and firms in the economy, with the added complication of actions
by the government, make for mind-bending complexity. Economic theory deals with such
complexity by using a useful assumption when developing models of economic behaviour,
analysing markets and government economic policy. It makes use of the ceteris paribus
assumption. This is a Latin expression which means holding other things constant.
An example is the easiest way to illustrate what it means. Suppose the government of a
country has increased the amount of tax it charges on each litre of petrol sold. You have data
on the price and the quantity of petrol purchased each day before the tax was increased. You
collect data on the quantity of petrol purchased each day following the increase in tax. What
your data shows is that the quantity of petrol sold each day has now fallen. Can the fall in the
sale of petrol be attributed to the increase in the amount of tax on petrol? It may seem
© ABE and RRC

obvious that the answer is yes. But this would only be a correct inference if it could be shown
that none of the other things affecting the demand for petrol had changed at the same time
as its price increase due to the government's tax. For example, if the price of cars had been
increased at the same time or the price of food had just increased people might have had
less to spend on petrol. In other words to study the relation between a change in one factor
on another it is necessary to be able to rule out other possible influences operating at the
same time. This is where the assumption of ceteris paribus comes in useful. Assuming all
other things remain constant, economics is able to demonstrate that for normal goods an
increase in their price will lead to a fall in demand.
Microeconomics and Macroeconomics
The functioning of an economy involves the decisions of millions of people as well as the
interactions between them. I want to go to town to do some shopping. Should I walk, catch a
bus or take my car? If I choose to walk the bus company, the local fuel station and the city
centre car park will all be affected: they will have less revenue than if I had decided not to
walk to town. Add up all the similar decisions made by thousands or tens of thousands of
people a day in just one city, and the revenue implications become significant. If many
people decide to switch from using cars to walking or taking a bus because this is better for
the environment, then the local fuel station may go out of business and the council and local
businesses may suffer a significant fall in revenue. The fuel station closing means
unemployment for some people. Reduced council revenue from the car park could mean
less support for local amenities. Scale up this example to the entire multitude of decisions
taken by all of the people in an economy in a single day, and you can start to appreciate the
complexity of the process, and that is just in a day! To make the study of economics more
manageable the subject is divided into microeconomics and macroeconomics.
Microeconomics ("micro" from Greek, meaning small) considers the economic behaviour of
individuals in their roles as consumers and workers, and the behaviour of individual firms. It
also involves the study of the behaviour of consumers and firms in individual markets.
Microeconomic policy includes the different ways in which governments can use taxation,
subsidies and other measures to affect the behaviour of consumers and firms in specific
markets rather than the economy as a whole. Macroeconomics ("macro" again from Greek,
meaning large) considers the working of the economy as a whole. It deals with questions
relating to the reasons why economies grow, undertake international trade and investment,
and experience inflation or unemployment. Macroeconomic policy involves the different fiscal
and monetary means through which governments can influence the level of economic activity
in an economy. Microeconomics is studied in the first seven units of this subject.
Macroeconomics and macroeconomic policy is studied in the remaining units.
A. BASIC ECONOMIC PROBLEMS AND SYSTEMS

Some Fundamental Questions
Economics involves the study of choice. The resources of the world, countries and most
individuals are limited while wants are unlimited. Economics exists as a distinct area of study
because scarcity of resources or income forces consumers, firms and governments to make
choices. Economics is concerned with people's efforts to make use of their available
resources to maintain and develop their patterns of living according to their perceived needs
and aspirations. Throughout the ages people have aspired to different lifestyles with varying
degrees of success in achieving them; always they have had to reconcile what they have
hoped to do with the constraints imposed by the resources available within their
environment. Frequently they have sought to escape from these constraints by modifying
that environment or moving to a different one. The restlessness and mobility implied by this
conflict between aspiration and constraint has profound social and political consequences
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but, as far as possible, in economics we limit ourselves to considering the strictly economic
aspects of human society.
It is usual to identify three basic problems which all human groups have to resolve. These
are:
 what, in terms of goods and/or services, should be produced
 how resources should be used in order to produce the desired goods and services
 for whom the goods and services should be produced.
These questions of production and distribution are problems because for most human
societies the aspirations or wants of people are unlimited. We often seem to want more of
everything whereas the resources available are scarce. This term has a rather special
meaning in economics. When we say that resources are scarce we do not mean necessarily
that they are in short supply – though often, of course, they are – but that we cannot make
unlimited use of them. In particular when we use (for example) land for one purpose, say as
a road, then that land cannot, at the same time, be used for anything else. In this sense,
virtually all resources are scarce: for example your time and energy, since you cannot read
this study unit and watch a football match – or play football – at the same time.
Choice and Opportunity Cost

Since human wants are unlimited but resources scarce, choices have to be made. If it is not
possible to have a school, hospital or housing estate all on the same piece of land, the
choice of any one of these involves sacrificing the others. Suppose the community's priorities
for these three options are (in order) hospital, housing estate and then school. If it chooses
to build the hospital it sacrifices the opportunity for having its next most favoured option – the
housing estate. It is therefore logical to say that the housing estate is the opportunity cost of
using the land for a hospital.
Opportunity cost is one of the most important concepts in economics. It is also one of the
most valuable contributions that economists have made to the related disciplines of business
management and politics. It is relevant to almost every decision that the human being has to
make. Awareness of opportunity cost forces us to take account of what we are sacrificing
when we use our available resources for any one particular purpose. This awareness helps
us to make the best use of these resources by guiding us to choose those activities, goods
and services which we perceive as providing the greatest benefits compared with the
opportunities we are sacrificing. This cost will be a recurring theme throughout the course.
You may have been wondering how a community might decide to choose between the
hospital, housing estate and school. Which option is chosen depends very much on how the
choice is made and whose voices have the most power in the decision-making process. For
example, you are probably aware that changing the structure of many of the bodies
responsible for allocating resources in the health and hospital services in Britain has led to
many strains and disputes. One reason for this was the transfer of decision-making power
from senior medical staff to non-medical managers, whose perception of the opportunity
costs of the various options available was likely to be very different from that of the medical
specialists.
Throughout history societies have experimented with many different forms and structures for
decision-making in relation to the allocation of the total resources available to the community.
Through much of the twentieth century there has been conflict between the planned
economy and the market economy. In the planned economy decisions are taken mostly by
political institutions. In the market economy decisions are taken mainly by individuals and
groups operating in markets where they can choose to buy or not to buy the goods and
services offered by suppliers, according to their own assessment of the benefits and
opportunity costs of the many choices with which they are faced. As the century drew to its
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close it was market economies that were in the ascendancy, and this course is concerned
mainly with the operation of markets and the market economy. At the same time we need to
recognise that market choices have certain limitations and social consequences which
cannot be ignored. All the major market economies have important public sectors within
which choices are made through various kinds of non-market institutions and structures, and
economics is able to make a significant contribution to understanding these.
B. NATURE OF PRODUCTION
Economic Goods and Free Goods
The term "goods" is frequently used in a general sense to include services, as long as it
does not cause confusion or ambiguity. It is used in this wide sense in this section.
Goods are economic if scarce resources have to be used to obtain or modify them so that
they are of use, i.e. have utility, for people. They are free if they can be enjoyed or used
without any sacrifice of resources. A few minutes' reflection will probably convince you that
most goods are economic in the sense just outlined. The air we breathe under normal
conditions is free, but not when it has to be purified or kept at a constant and bearable
pressure in an airliner. Rainwater, when it falls in the open on growing crops, is free, but not
when it has to be carried to the crops along irrigation channels or purified to make it safe for
humans to drink. Free goods are indeed very precious and people are becoming increasingly
aware of the costs of destroying them by their activities, e.g. by polluting the air in the areas
where we live.
Production Factors
Since there are very few free goods most have to be modified in some way before they
become capable of satisfying a human want. The process of want satisfaction can also be
termed "the creation of utility or usefulness"; it is also what we understand by "production". In
its widest economic sense, production includes any human effort directed towards the
satisfaction of people's wants. It can be as simple as picking berries, busking to entertain a
theatre queue or washing clothes in a stream, or as involved as manufacturing a jet airliner
or performing open heart surgery.
Production is simple when it involves the use of very few scarce resources, but much more
involved and complex when it involves a long chain of interrelated activities and a wide range
of resources.
We now need to examine the general term "resources", or "economic resources", more
closely. The resources employed in the processes of production are usually called the factors
of production and, for simplicity, these can be grouped into a few simple classifications.
Economists usually identify the following production factors.
 Land
This is used in two senses:
(a) the space occupied to carry out any production process, e.g. space for a factory
or office
(b) the basic resources within land, sea or air which can be extracted for productive
use, e.g. metal ores, coal and oil.
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 Labour
Any mental or physical effort used in a production process. Some economists see
labour as the ultimate production factor since nothing happens without the intervention
of labour. Even the most advanced computer owes its powers ultimately to some
human programmer or group of programmers.
 Capital
This is also used in several senses, and again we can identify two main categories:
(a) Real capital consists of the tools, equipment and human skills employed in
production. It can be either physical capital, e.g. factory buildings, machines or
equipment, or human capital – the accumulated skill, knowledge and experience
without which physical capital cannot achieve its full productive potential.
(b) Financial capital is the fund of money which, in a modern society, is usually
needed to acquire and develop real capital, both physical and human.
Notice how closely related all the production factors are. Most production requires some
combination of all the factors. Only labour can function purely on its own, if we ignore the
need for space. A singer or storyteller can entertain with voice alone, but will usually give
more pleasure with the aid of a musical instrument and is likely to benefit from earlier
investment in some kind of training. The hairdresser requires at least a pair of scissors!
Much of economic history is the story of people's success in increasing the quantity and
quality of production through the accumulation of human capital and the development of
technically advanced physical capital. I can dig a small hole in the ground with my bare
hands, but creating the Channel Tunnel between Britain and France has required a vast
amount of very advanced physical capital together with a great deal of human skill and
knowledge.
Modern firms depend for their survival and success on both their physical and their human
resources. While some may feel that the current trend to replace the business term
"personnel management" by "human resource management" is in some degree
dehumanising, others welcome it as a sign that firms are recognising the importance of
employee skills as human capital.
Enterprise as a Production Factor

All economic texts will include land, labour and capital as factors of production. There is not
quite such universal agreement over what is often described as the fourth production factor,
which is most commonly termed enterprise.
The concept of enterprise as a fourth factor was developed by economists who wished to
explain the creation and allocation of profit. These economists saw profit as the reward
which was earned by the initiator and organiser of an economic activity. This was the person
who had the enterprise and special quality needed to identify an unsatisfied economic want,
and to combine successfully the other production factors in order to supply the product to
satisfy it.
In an age of small business organisations, owned and managed by one person or family, this
seemed quite a reasonable explanation. The skilled worker who gives up secure and often
well-paid employment to take the risks of starting and running a business is most likely to be
showing enterprise. Such a person is prepared to take risks in the hope of achieving profits
above the level of his or her previous wage. Many modern firms have been formed in the
recent past by initiators, innovators and risk takers of the kind that certainly fit the usual
definition of the business entrepreneur. Their names appear constantly in the business
press. Few would wish to deny that profit has been and often remains the spur that drives
them.
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Nevertheless this identification of enterprise in terms of individual risk-taking raises a great

many problems when we attempt to apply it generally to the modern business environment.
Much contemporary business activity is controlled by very large international and
multinational companies such as Microsoft, Toyota, Sony, Philips and Unilever. Who are the
entrepreneurs in such organisations? Are they rewarded by profits? How do these
companies recruit and foster enterprise? You, yourself, may work in a large organisation.
Can you reconcile the traditional economic concept of enterprise as a factor of production
with your observations of the structure of your company?
No one doubts the importance of enterprise and profit in modern business. However their
traditional explanation in terms of the fourth production factor is at best incomplete and at
worst actually dangerous, in that it may be used to justify the very large salaries which
company chief executives seem able to award themselves in Britain and the USA.
We shall return to the question of profit in Study Unit 5.
Fixed and Variable Factors of Production

Both economists and accountants make an important distinction between production factors,
based on the way they can be varied as the level of production changes. To take a simple
example, suppose you own a successful shop. Initially you do not employ anyone but soon
find you do not have time to do everything, and are losing sales because you cannot serve
more than one customer at a time. So, you employ an assistant. This gives you more time
and flexibility and allows you to buy better stock; your monthly sales more than double. You
employ another assistant and again your sales increase. You realise, however, that you
cannot go on increasing the number of assistants since space in your shop is limited and you
can only meet demand in a small local market. You begin to think about opening another
shop in another area.
This example helps to illustrate the difference between a production factor which you can
vary as the level of production varies, i.e. a variable factor, and a factor which you can only
move in steps at intervals when production levels change, i.e. the fixed factor. In our
example the variable factor is the assistants (labour) and the fixed factor is the shop, i.e.
land (space) and capital (the shop building and equipment).
In most examples at this level of study it is usual to regard capital as a fixed factor and
labour as a variable factor. Although it is not possible to have a fraction of a worker we can
think in terms of worker-hours and recognise that many workers are prepared to vary the
number of hours worked per week. It is more difficult to have half a shop and even if a shop
is rented rather than bought, tenancies are usually for fixed periods. It is more difficult to
reduce the amount of fixed factors employed than the variable factors. When a machine or
piece of equipment is bought it can only be sold at a considerable financial loss.
This distinction between fixed and variable production factors is very important, particularly
when we come to examine production costs in Study Unit 4. It also gives us an important
distinction in time. When analysing production, economists distinguish between the short run
and the long run. By short run they mean that period during which at least one production
factor, usually capital, is fixed, e.g. one shop, one factory, one passenger coach. By long run
they mean that period when it is possible to vary all the factors of production, e.g. increase
the number of shops, factories or passenger coaches. Sometimes you may find the short
and long run referred to as short and long term. This is not strictly correct, but the difference
in meaning is slight and not important at this stage of study.
Production Function
We can now summarise the main implications of our recognition of factors of production. We
can say that to produce most goods and services we need some combination of land, capital
and labour. At present we can leave out enterprise as this is difficult to quantify. In slightly
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more formal language we say that production is a function of land, capital and labour. Using
the symbols Q for production, S for land, K for capital and L for labour, (with  for function)
this allows us, if we wish, to use the mathematical expression:
Q  (S, K, L)
For further simplicity we can use the assumption of ceteris paribus, which was explained in
the introduction to this unit: we can hold constant the role of two factors of production, land
and capital, and concentrate on labour as the only variable input into the production process.
That is, as previously noted, we can regard capital and land as fixed and labour as a variable
factor.
Total Product
In this section we examine what happens when a firm increases production in the short run,
when the firm's available capital and land is fixed and when the only variable factor into the
production process is labour. Once again we can take a simple example of a small firm
which has a single factory building (land), and a fixed number of machines (capital), installed
in its factory. The only way the firm can increase output in the short run is to increase its use
of labour. For simplicity we can use the term worker as a unit of labour, but you may wish to
regard a worker as a block of worker-hours which can be varied to meet the needs of the
business.
Suppose the effect of adding workers to the business is reflected by Table 1.1, where the
quantity of production is measured in units and relates to a specific period of time, say, a
month. The amount of capital and land employed by the business is fixed. The quantity of
production measured here in units produced per month and shown as a graph in Figure 1.1,
is, of course, the total product. In this example total product continues to rise until the tenth
worker is added to the business; this worker is unable to increase total product. This is no
reflection on that particular worker who may, in fact, be working very hard. It is simply that,
given the fixed amount of capital, no further increase in productive output is possible. The
addition of an eleventh worker would actually cause a fall in production. It is not difficult to
see why this could happen.
Table 1.1: Number of workers and quantity of production
Number of workers Quantity of production

(units per month)
1 30
2 70
3 120
4 170
5 220
6 260
7 290
8 310
9 320
10 320
11 310
Suppose the factory has five different machines, each one of which makes a different
component for the finished product. Suppose also that each machine is designed to be
operated by two workers. When only one worker is employed he or she will have to waste a
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lot of time moving between each machine and will not be able to work each machine to its
full capacity. Adding a second worker will reduce the time wasted moving between machines
and lead to a more than proportional increase in output. As more workers are employed the
machines can be progressively operated more efficiently, with two workers to each machine
and less and less time wasted by workers moving from one machine to another. As the
number of workers employed in the factory increases total product also increases, but at a
diminishing rate. Once ten workers are employed then each machine is being operated at its
optimum capacity. Adding more workers will not increase production but may actually cause
it to fall, as workers start to get in the way of each other and slow the speed of the machines.
th
This is shown in Figure 1.1 by the fall in total product from 320 to 310 when the 11 worker is
employed with the fixed number of machines in the factory. Each additional worker's
contribution to total product is termed the worker's marginal product. Marginal product is the
difference in the total product which arises as each additional worker is employed.
Figure 1.1: Total product
Units of 350
production
(per month) 10 Total
300 20
product
30
250
40
200 50
150 50
100 50
50 40
30
0
0 1 2 3 4 5 6 7 8 9 10 11
Workers
Notice how marginal product changes as total product rises: one worker alone can produce
30 units but another enables the business to increase production by 40 units and one more
by 50 units. However, these increases cannot continue and the additional third, fourth and
fifth workers all add a constant amount to production. Thereafter, further workers, while still
increasing production, do so by diminishing amounts until the tenth worker adds nothing to
the total. At this level of labour employment production has reached its maximum, and the
eleventh worker actually provides a negative return – total production falls. Perhaps people
get in each other's way or cause distraction and confusion. If the business owner wishes to
continue to expand production, thought must be given to increasing capital through more
machines and, at some point, increasing the size of the factory building to accommodate
additional machines and workers. Short-run expansion at this level of capital has to cease.
Only by increasing the fixed factors can further growth be achieved.
This example is purely fictional – it is not based on an actual firm; but neither is the pattern of
change in marginal product accidental. The figures are chosen deliberately to illustrate some
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of the most important principles of economics, the so-called laws of varying proportions and
diminishing returns. It has been constantly observed in all kinds of business activities that
when further increments of one variable production factor are added to a fixed quantity of
another factor, the additional production achieved is first likely to increase, then remain
roughly constant and eventually diminish. It is this third stage that is usually of the greatest
importance, this is the stage of diminishing marginal product, more commonly known as
diminishing returns. Most firms are likely to operate under these conditions and it is during
this stage that the most difficult managerial decisions, relating to additional production and
the expansion of fixed production factors, have to be taken.
It must not, of course, be assumed that firms will seek to employ people up to the stage of
maximum product when the marginal product of labour equals zero, or on the other hand,
that they will not take on any extra employees if diminishing returns are being experienced.
The production level at which further employment ceases to be profitable depends on
several other considerations, including the value of the marginal product. This depends on
the revenue gained from product sales, and the cost of employing labour, made up of wages,
labour taxes and compulsory welfare benefits. The higher the cost of employing labour, the
less labour will be employed in the short run and the sooner will employers seek to replace
labour by capital in the form of labour-saving equipment.
You should give some thought to the implications of this production relationship for business
costs. We will return to it again in Study Unit 4 when we examine costs and the firm's supply
curve.
C. PRODUCTION POSSIBILITIES
If individual firms are likely to face a point of maximum production as they reach the limits of
their available resources, the same is likely to be true of communities whose total potential
product must also be limited by the resources available to the community, and by the level of
technology which enables those resources to be put to productive use.
This idea is frequently illustrated by economists through what is usually termed the
production possibilities frontier (or curve), which is illustrated in Figure 1.2.
The frontier represents the limit of what can be produced by a community from its available
resources and at its current level of production technology. Because we wish to illustrate this
through a simple two-dimensional graph we have to assume there are just two classes of
goods. For simplicity, we can call these consumer goods (goods and services for personal
and household use) and capital goods (goods and services for use by production
organisations for the production of further goods).
Because resources are scarce in the sense explained earlier in this study unit, we cannot
use the same production factors to produce both sets of goods at the same time. If we want
more of one set we must sacrifice some of the other set. However, the extent of the sacrifice
(i.e. the opportunity cost) of increasing production of each set is unlikely to be constant
through each level of production, since some factors are likely to be more efficient at some
kinds of production than others. Consequently the shape of the frontier curve can be
assumed to reflect the principle of increasing opportunity costs, shown in Figure 1.2. In this
illustration the opportunity cost measured in the lost opportunity to produce (say) arms is
much less at the low level of (say) food production of 2 billion units than at the much higher
level of 9 billion units.
The curve illustrates other features of the production system. For example, the community
can produce any combination of consumer and capital goods within and on the frontier but
cannot produce a combination outside the frontier – say at E. If it produces the mixtures
represented by points A, B or C on the frontier all resources (production factors) are fully
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employed, i.e. there are no spare or unused resources. The community can produce within
the frontier, say at D, but at this point some production factors must be unemployed.
Figure 1.2: The production possibilities frontier
Production of 10
capital goods
(billion units) 9 A
8
B
7
6 D E
4
C
3
0
0 2 4 6 8 10 12
Production of consumer goods

(billion units)
To raise production of consumer goods from 2 to 3 billion units involves sacrificing the
possibility of producing 0.3 billion units of capital goods. However when production of
consumer goods is 9 billion units, an additional 1 billion units involves the sacrifice of 1.6
billion units of capital goods.
The shape of the curve is based on the principle of increasing opportunity costs.
We can, of course, turn the argument round. If we know that some production factors are
unemployed, e.g. if people are out of work, farmland is left uncultivated, factories and offices
left empty, then we must be producing within and not on the edge of the frontier. The
community is losing the opportunity of increasing its production of goods and services and is
thus poorer in real terms than it need be. If, at the same time, some goods and services are
in evident inadequate supply – e.g. if there are long hospital waiting lists, many families
without homes, some people short of food or unable to obtain the education or training to fit
them for modern life – then the production system of the community is clearly not operating
efficiently to meet its expressed requirements. Unfortunately it is easier to state these facts
than to suggest remedies. There have been very few, if any, examples throughout history of
fully efficient production systems where the aspirations of the community have been served
by maximum production of the goods and services that the community has desired.
Although generally used in relation to the economy as a whole, the production possibilities
(sometimes written as "possibility") curve can also be used to illustrate the options open to a
particular firm. In this case the shape of the curve need not always follow the pattern of
Figure 1.2. It might be that if the firm devoted all its resources to the production of one good
(in economics the word "good" is used as the singular of "goods") instead of more than one
then it would be able to use them more efficiently. They would then gain from what will later
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be described as increasing returns to scale. In this case the curve would be shaped as in
Figure 1.3.
Figure 1.3: Another production possibilities curve
Quantity
of Y The production possibilities curve for
a firm gaining increased efficiency by
concentrating on one product.
0
Quantity of X
Yet another possibility is that the firm could switch resources without any gain or loss in
efficiency, i.e. it would experience constant returns from scale in using its resources. In this
case the curve would be linear (a straight line) as in Figure 1.4.
Figure 1.4: A linear production possibilities curve
Quantity
of Y
The production possibilities curve for
a firm which is neither more nor less
efficient when it switches resources
from one product to another.
0
Quantity of X
© ABE and RRC

D. SOME ASSUMPTIONS RELATING TO THE MARKET

ECONOMY
Consistency and Rationality
Although we recognise that all people are individuals, and it is usually impossible to predict
with complete certainty what actions any individual will take at any given time, nevertheless it
is possible to predict with rather more confidence what groups of people are likely to do over
a period of time. On this basis it becomes possible to estimate, for example, how much
bread will be consumed in a certain town each week or month. A supermarket manager does
not know what any shopper will buy when that shopper enters the store, but can estimate
how much, on average, the total number of shoppers will spend on any given day in the
month. The manager will also know how much is likely to be spent on each of the many
classes of goods stocked. Patterns of spending will change of course, but the changes are
not likely to be random when applied to large groups. There will be trends that will enable
projections to be made into the future with some degree of confidence. As groups, therefore,
people tend to be consistent and to behave according to consistent and predictable patterns
and trends.
People are also assumed to be rational in their behaviour. Again, we are all capable of the
most irrational actions from time to time, but if we behave in a normal manner we are likely
to display rational economic behaviour. For example, suppose if given the choice between
cornflakes and muesli for breakfast we choose cornflakes, and if given the choice between
muesli and porridge we choose muesli. Then, if we are rational, and offered the choice
between cornflakes and porridge, we would be expected to choose cornflakes, because we
prefer cornflakes to muesli and muesli to porridge. It would be irrational to choose porridge in
preference to cornflakes if we have already indicated a preference for muesli over porridge
and for cornflakes over muesli.
If we accept consistency and rationality in human behaviour then analysis of that behaviour
becomes possible. We can start to identify patterns and trends and measure the extent to
which people are likely to react to specific changes in the economic environment, such as
price, in ways that we can identify, predict and measure. If we could not do this the entire
study of economics would become virtually impossible.
The Forces of Supply and Demand

In studying the modern market economy we assume that the economic community is large
and specialised to the extent that we can realistically separate organisations which produce
goods and services from those that consume them. We are not studying village subsistence
economies which can consume only what they themselves produce. Most of us would have a
rather poor standard of living if we had to live on what we could produce ourselves. We can
of course be both producer and consumer, but the goods and services we help to produce
are sold and we receive money which enables us to buy the things we wish to consume.
As individuals and members of households we are therefore part of the force of consumer
demand. As workers and employers we are part of the separate force of production supply.
Right at the start of your studies it is important to recognise that supply and demand are two
separate forces. These do of course interact (in ways that we examine in later study units)
but essentially they exist independently. It is quite possible for demand to exist for goods
where there is no supply, and only too common for goods to be supplied when there is no
demand, as thousands of failed business people can testify. As students of economics you
must never make the mistake of saying that supply influences demand or that demand
influences supply.
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Basic Objectives of Producers and Consumers

In a market economy we assume that all people wish to maximise their utility. This is
simplified to suggest that producers seek to maximise profits, since the object of production
for the market is to make a profit and, if given the choice between producing A or B and if A
is more profitable than B, we would expect the producer to choose to produce A.
At the same time consumers can be expected to devote their resources, represented by
money, to acquiring the goods and services that give them the greatest satisfaction. This is
not to say that we all spend our money wisely, or eat the most healthy foods or wear the
most sensible clothes. We perceive satisfaction or utility in more complex ways. Economists,
as economists, do not pass judgments on the wisdom or folly of particular consumer wants.
They recognise that a want exists when it is clear that a significant group of people are
prepared to sacrifice their resources to satisfy that want.
When this happens there is demand which can be measured and which becomes part of the
total force of consumer demand.
Unfortunately this does not stop some groups of people from seeking to dictate what the rest
of the community should or should not want, consume or enjoy. This is a problem of all
human societies and is beyond the scope of introductory economics. When Shakespeare's
Maria in Twelfth Night accused the pompous Malvolio with the damning question "Dost thou
think because thou art virtuous there shall be no more cakes and ale?" she was speaking for
the market economy in opposition to the planners who would decide for the rest of humanity
how to conduct their lives.
Consumer Sovereignty
Although the separation between supply and demand as two different forces has been
stressed, the market economy operates on the assumption that, of these forces, consumer
demand is dominant. The market production system is demand led: supply adjusts to meet
demand. In this sense the consumer is sovereign. Producers who cannot sell their goods at
a profit fail and disappear from the production system. Profit is the driving force of the
production system: profit is achieved by the ability to produce goods that people will buy at
prices that people will pay, while enabling the producer to earn sufficient profit to stay in
business – and to wish to stay in business. However strong the demand for goods, if they
cannot be produced at a profit they will not, in the long run, be supplied.
If you have lived all your life in a market economy none of this will seem strange to you. But
to someone who has lived in a command economy (where production decisions and the
quantity, quality and distribution of consumer goods have all been determined by the
institutions of the state) the full implications of consumer sovereignty, particularly the
implications for individual firms operating in a competitive market environment, can be very
hard to grasp.
In the next five study units we shall be very largely concerned with different aspects of the
forces of demand and supply and how they interact, or sometimes fail to interact, in the
market economy.
© ABE and RRC

Review Points
Before you begin your study of the next unit you should go back to the start of this one and
check that you have achieved the learning objectives. If you do not think that you understand
the aim and each of the objectives completely, you should spend more time rereading the
relevant sections.
You can test your understanding of what you have learnt by attempting to answer the
following questions. Check all of your answers with the unit text.
1. What is the difference between microeconomics and macroeconomics?

2. How does the assumption of ceteris paribus help in trying to understand economic
relationships?
3. Is the following statement an example of a positive or a normative statement?
"The government should provide free health care for everyone."
4. Is the following statement an example of a positive or a normative statement?
"When more and more units of a variable production factor are added to a fixed
quantity of another factor, the additional production achieved is likely, first, to increase,
then to remain roughly constant and eventually to diminish."
5. "For a given size of its budget, the government of a country can only increase its
expenditure on education if it reduces its expenditure on roads or defence".
Which of the following economic concepts is illustrated by this statement?
(a) normative economics
(b) opportunity cost
(c) microeconomics
(d) marginal product.
6. Can you name a country that has a planned economy? Is your own country a market
economy or a mixed economy?
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17
Study Unit 2
Consumption and Demand
Contents Page
A. Utility 18
Meaning of Utility 18
Total and Marginal Utility 19
Maximising Utility from Available Resources 20
B. The Demand Curve 21

What is a Demand Curve? 21
Use and Importance of Demand Curves 22
General Form of Demand Curves 23
C. Utility, Price and Consumer Surplus 24
D. Individual and Market Demand Curves 25
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18 Consumption and Demand
Objectives
The aim of this unit is to explain the theory of consumer choice using the concept of utility,
individual demand and market demand.
 explain the concept of utility
 explain what is meant by marginal utility, utility maximisation and the property of
diminishing marginal utility, using diagrams and/or numerical examples
 explain the relationship between individual utility and individual demand for a good,
using examples where required
 solve numerical problems relating to marginal utility and utility maximisation based on
utility or consumption data
 identify the difference between individual and market demand.
A. UTILITY
In this unit we introduce the demand curve. The concept of the demand curve is one of the
most important concepts used in economics. This is because it provides one of the two keys
required to understand how markets work. For this reason it is of great importance for all
businessmen and businesswomen. We begin by explaining the concept of utility.
Meaning of Utility
Economists have always faced problems in explaining clearly why people are prepared to
make sacrifices to obtain many of the goods and services which they evidently wish to have.
In a market economy this difficulty can be stated as "Why do we buy the things we do buy?"
Very often we do not "need" them in the strict sense that they are necessary to our survival.
In fact our basic needs are really very small, compared with all the things on which we might
spend our money in advanced market economies. We can talk in terms of "wants" and
recognise that there seems to be no limit to these wants. We also have to recognise that at
any given time we are likely to want some things more than others.
What then is the quality that goods must possess that makes us want to acquire them?
Clearly this will differ with different goods. Some may be pleasant to eat, some attractive to
look at, some warm to wear and so on. The one general term we can apply to all goods and
services is that they provide us with utility. This does not necessarily mean that they are
useful in the sense that they help us to do something we could not do before we had them. It
simply means that we perceive in them some quality that makes us willing to make some
degree of sacrifice (usually of money) in order to acquire them.
Can we then measure this utility? In an absolute sense, the answer is almost certainly "No".
Some economists have proposed adopting a measure called a "util" but no-one, not even the
European Commission, has yet proposed that we mark all goods to show how many "utils"
they contain. It is more practical to think in terms of money value, since most of us measure
the strength of our desire to buy something in terms of the price we are prepared to pay for
it. Therefore when an estate agent asks a potential house buyer, "How much are you
prepared to offer for this house?" the agent is, in effect, asking the buyer to indicate the
value of the utility which the house has for him or her.
More often we find ourselves making comparisons of utility. This arises partly because of the
basic economic problem of unlimited wants and scarce resources, so that ranking our wants
so we can decide what we can afford to buy is, for most people, an almost daily occurrence.
But it also arises because, in modern advanced economies, there is likely to be a range of
© ABE and RRC

Consumption and Demand 19
different goods to satisfy any particular want. If I want to travel by public transport from
Birmingham to Glasgow I could do so by motor coach, by train, or by air. My want is to get
from Birmingham to Glasgow, and three options offer the utility to satisfy this want. Each
involves different sacrifices of money and time and offers different associated utilities of
convenience and comfort. My choice will depend on the resources available to me (how
much money I can afford to pay and how much time I have) and on my valuation of the utility
afforded by each option. Notice, further, that this utility is not an absolute quality but depends
on why I want to make the journey. If it is part of a holiday then I might prefer the coach or
train. If I am attending a business meeting from which I hope to achieve a financial benefit
and need to be fresh and alert, then the air option is likely to offer the greatest utility –
greater, probably, than the price of the fare.
All this may seem very involved, but an appreciation of utility and how it can influence our
actions can be a very great help in understanding the true nature of economic demand.
Total and Marginal Utility

Our valuation of the utility provided by any good depends on how strongly we want to acquire
it. While there may be several elements involved in this, e.g. we find it attractive or useful, or
think it will impress our friends or neighbours, one factor that is always relevant is the
amount of that or a similar good we already possess. Suppose I have enough spare cash at
the end of the week to buy either a pair of trousers or a pair of shoes but not both, though I
would like both. If I already have an adequate supply of trousers for the next few months but
do not have any spare shoes then, assuming that their prices are roughly similar, I am likely
to buy the shoes. This does not mean that I always value shoes more highly than trousers
but that, considering what I already have at the present time, I perceive greater utility in
some additional shoes than in additional trousers.
By now, especially if you have remembered the explanation of marginal product in Study Unit
1, you will recognise that I have just given an example of marginal utility, i.e. the change in
total utility for a good or group of goods when there is a change in the quantity of those
goods already possessed.
Most of the important decisions relating to the demand for goods and services are influenced
by valuations of marginal utility compared with the prices of these goods. The more pairs of
trousers I possess the less value am I likely to place on obtaining more, and the more likely I
am to spend my available money on other things of comparable price whose marginal
utilities are higher.
Willingness to buy thus depends on the comparison of marginal utility with price, and so to
some extent it is reasonable to value utility in terms of price. To return to the original house
buyer example, if the buyer says to the agent, "My highest offer is £100,000", then for this
buyer the value of the marginal utility of the house is £100,000. If this is the buyer's only
house then, of course, it is also the total utility.
We must also bear in mind that money itself has utility. Suppose I am saving money for a
major holiday or for an expensive durable (long lasting) good such as a house or furniture.
Then I may place a high value on money savings and be less inclined to buy trousers and
shoes, as long as I have enough of these for my immediate needs. If my income is secure
and rising, my valuation of the marginal utility of money could be low and I am more likely to
spend it on goods. If my job is not secure and redundancy or retirement is a serious
possibility, my valuation of the marginal utility of money is likely to rise, and I will spend less
on goods and services. You can easily see the implications of this for the general demand for
consumer goods during periods of economic uncertainty, when people think they are likely to
have less money in the future. Just as the marginal utility of a good diminishes as the
quantity already possessed rises, so marginal utility rises as the quantity of a good already
possessed falls – or is expected to fall – in the near future.
© ABE and RRC

Maximising Utility from Available Resources

This relationship between total and marginal utility can be illustrated in a simple graph as in
Figure 2.1.
Figure 2.1: Marginal and total utility
MU
Total utility 100 3
5
90 7
80 8
70 11
As total utility
60 rises, marginal
16
utility (MU)
50 dimishes
40 20
30
30
20
10
0
0 1 2 3 4 5 6 7 8 9 10
Quantity
Suppose I have no use for more than eight pairs of trousers. This number would provide
maximum utility to which we can give a hypothetical numerical value of, say, 100
(representing 100 per cent of the total), but clearly the largest marginal utility would be
provided by the first pair. After this purchase the marginal utility of each additional pair
diminishes, as indicated by the figures under MU to the right of the vertical axis. The total of
100 is reached with the eighth pair. If I have a ninth, no further utility is added – the total
remains at 100. Should I receive a tenth pair my total utility actually falls: perhaps they take
up space in my wardrobe I would rather have for something else.
Does this then mean that I should aim at keeping eight pairs of trousers all the time? Not
necessarily, since Figure 2.1 takes no account of other important considerations, which
include:
 the price of trousers, i.e. the sacrifice I must make to buy them
 my desire for other goods and services, i.e. other marginal utilities (I would not, for
example, be too pleased to have eight pairs of trousers if I possessed only one shirt,
nor would trousers satisfy my hunger if I did not have enough food to eat)
 how much money I have, i.e. my marginal utility for money.
Only when all these are taken into account would it be possible to estimate how many pairs
of trousers would represent, for me, the best total to try and achieve.
Assuming rationality, in the sense explained in Study Unit 1, the most satisfactory quantity of
trousers for me would be where my marginal utility gained from the last £1 spent on trousers
© ABE and RRC

just equalled the marginal utility per £1 spent on all other available goods and services, and
where this also equalled the marginal utility of money. On the assumption that we are valuing
utility in monetary terms, the marginal utility of the last £1 of money equals 1.
Putting this statement a little more formally as an equation and using the symbols MUA to
denote the marginal utility for the good A, MUB for the marginal utility for the good B, PA for
the price of A, PB for the price of B and so on, we can say that consumers achieve a position
of equilibrium in their expenditure when for them:
MU A MUB MUN
   1 (which equals the marginal utility of money)
PA PB PN
In this state of equilibrium consumers cannot increase their total utility from all goods and
services by any kind of redistribution of spending. Spending more on A and less on B, for
example, would mean that the marginal utility of A would fall and so be less than that of the
marginal utility of B (which would rise) and be less than the marginal utility of other goods,
including money. Also the utility gain from A would be less than the utility lost from B so total
utility would have fallen. No one rationally spends £1 to receive less than £1's worth of utility.
You may object that this kind of reasoning takes no account of actions such as making
contributions to charity, but our use of the term "utility" does embrace such gifts. Presumably
we give to a charity because the act of giving to a use we perceive as worthy affords us
satisfaction. Therefore it has utility and can be regarded in the same way as other forms of
spending. Of course this means, as charities and the organisers of national charitable events
have discovered, that giving to charity is also subject to diminishing marginal utility. "Aid
fatigue" is the term sometimes used for this.
B. THE DEMAND CURVE

What is a Demand Curve?
So far in this study unit we have considered some of the consequences of price and income
changes for the amounts of goods purchased. The general, and in most cases "normal"
relationship between price and quantity changes, is frequently illustrated by graphing the
anticipated amounts of a good that people can be expected to buy, in a given time period, at
a series of different prices within a given price range. This produces a demand curve.
Bear in mind that the demand curve is a simple two-dimensional graph. It shows the
relationship between just two variables – the price of a good and the quantity of that good
that we believe is likely to be purchased over a given time period.
In concentrating on just price and quantity we make the assumption that all other possible
influences on demand (quantities of possible purchases) are held constant. These other
influences, including income and prices of other goods, will be considered again in the next
study unit. For now we can conveniently ignore them. Our concern, for the moment, is with
price.
This graph in Figure 2.2 shows the market demand for a good, let's call it X, over the range
of prices £12 to £5. That is, it shows how all the consumers in the market for good X vary
their weekly purchase of this good as its price rises or falls in the price range £5–£12. It is
the market demand curve for the good X.
© ABE and RRC

Figure 2.2: A demand curve
Price 13
(£ per unit) 12
11
Demand for x at prices
10
from £5 to £12 per unit
9
8
7
6
5
4
40 50 60 70 80 90 100 110 120
Quantity (units of x) per week
This example illustrates the general shape of the demand curve and the normal relationship
between price and quantity demanded of a product. If all other influences remain constant,
we would expect the quantity demanded to rise as price falls and to fall as price rises. Notice
that, in our example, we have made the following assumptions:
(a) The price of all other goods and services remains constant as the price of good X
changes. That is, we are making use of the simplifying ceteris paribus assumption
once again.
(b) The incomes of consumers also remain constant when the price of good X changes.
(c) Another point to remember is that we are considering here a flow of demand related to
a set period of time. It is always necessary to do this. We cannot compare a weekly
amount at one price directly with a monthly amount at another. When we change one
variable – here price – to analyse its effect on quantity, we have to keep all other
elements constant, including the time period to which the stated quantity relates. In our
example, this period was a week.
Use and Importance of Demand Curves

As you will see as you progress through this course, the demand curve is used extensively in
economic analysis. The price-quantity relationship is one of the most important things we
need to know when considering sales of products. A firm must know the likely result of a
change in price, because any alteration in quantity demanded will affect the total sales
revenue.
Governments also need to know the probable effects of any change in a tax imposed on
products. Because such a tax will influence price, the price-quantity relationship is again an
important issue. If a government is considering an increase in a tax such as value added tax,
which influences a very wide range of goods, it needs to know what extra total revenue it can
expect to gain from the tax increase. It cannot assume that quantities consumed of all goods
affected will remain the same; it must take into account the probable changes in quantity
demanded that will result from the changes in price.
© ABE and RRC

General Form of Demand Curves

At this stage of study, you will meet demand curves chiefly in relation to general analytical
problems. Actual figures are then less important than the general shape and slope of the
curves. It is therefore normal to draw general curves, in which price and quantity are denoted
simply by letters. For reasons that will become clearer in later study units, it is simpler to
draw what are called "linear curves" (i.e. straight-line graphs) for part only of the full price
and quantity range. This is because, for most purposes, we are concerned only with a limited
range of possible prices and quantities. When there are special reasons for departing from
these normal practices, we shall explain them. Examples of typical general demand curves
are given in Figures 2.3 and 2.4.
Notice that in Figure 2.3 a given change in price appears to produce a greater change in
quantity demanded than in Figure 2.4. This assumes that both figures are drawn to the same
scale. You must remember that the steepness of a demand curve will be affected by the
scale of the (horizontal) X-axis, and graphs must be drawn to the same scale, so that
comparisons can be made.
It is a convention or general rule in economics that price per unit is measured on the vertical
axis or Y-axis, while quantity in units per period of time is measured along the horizontal axis
X-axis. It is often customary to label the axes simply "Price" and "Quantity".
Figure 2.3: General demand curve
Price D
(£ per unit) An increase in price from Op
to Op1 reduces quantity
demanded from Oq to Oq1
p1
p
O q1 q
Quantity
(units per time period)
© ABE and RRC

Figure 2.4: Another demand curve
Price
D
(£ per unit)
Here, the change in quantity
demanded brought about by
the change in price is
smaller than in Figure 2.3
p1
p
O q1 q Quantity
(units per time period)
C. UTILITY, PRICE AND CONSUMER SURPLUS

The idea of utility is not too hard to grasp. We recognise that we will only buy something if
(for us) it satisfies a want. In other words, if it is of some use to use: for us it possesses
utility. We can also appreciate that the utility we perceive for one more unit of a good
depends on how much of that good we already have. Suppose I have some apple trees in
my garden. In a year when, for some reason, the trees bear very little fruit, I value highly the
few apples that do grow and will go to some trouble to pick them carefully when they are
ripe. However, in another year the same trees may fruit abundantly and produce more
apples than I really want. In that year I may not bother to pick them all, and may allow some
to stay on the trees or lie on the ground. Thus, to me, the value of the apples depends on the
quantity available and is equal to their marginal utility – the usefulness to me of some
additional apples to those I already have.
The same principle applies if I have no trees at all and I have to buy apples or any other
goods. I will only pay the price to obtain them if this price is not more than the value of their
marginal utility. This idea gives us a means of putting a monetary value on marginal utility.
Let us say that I like to eat apples but do not have to do so; other fruit readily is available. I
will only buy them at a price I consider reasonable. Suppose that, in a particular week, I see
that apples are priced at 160p per kilo. This to me is dear, and above my valuation of the
utility of a kilo of apples. I do not buy any. Next week the price has fallen to 120p per kilo, but
I still think this is too dear and again I do not buy. The third week the price has fallen to 100p
per kilo. I give this more thought but, in the end, still do not buy. By the fourth week, the price
has fallen to 80p per kilo, and this time I am prepared to buy a kilo. My marginal utility for
apples is such that 80p is the highest price I am prepared to pay for a kilo of apples. I can
thus put a value on my marginal utility for a kilo of apples: it is 80p.
Suppose now that the next time I visit the store the price of apples has fallen yet again and it
is now 60p. Again I buy a kilo. The value of my marginal utility for a kilo of apples has
remained at 80p and I would have been prepared to pay 80p, but the price asked by the
store was only 60p, so this is what I paid. Consequently I gained a surplus of 20p. The value
of my sacrifice was less than the value of the additional utility I gained: the difference was a
surplus to me.
© ABE and RRC

Figure 2.5: Demand curve – consumer surplus
Price
The shaded area represents the
consumer surpus at price Op. It
is enjoyed by those consumers
who could be prepared to a price
above Op – i.e. those up to Oq.
Demand
O q Quantity
Since the price of 60p per kilo was below my valuation of the marginal utility of a kilo of
apples I might decide to buy two or perhaps three kilos. In this case I was valuing the
marginal utility of the additional amount bought above my usual quantity at less than the 80p
but still now below 60p. If, as seems likely, most consumers react in this way, then we have
no difficulty in accepting the general shape of the demand curve outlined in the previous
section: that is people are prepared to buy more of a good at a lower than at a higher price.
These ideas are illustrated in Figure 2.5, which shows a normal demand curve for a product
the price of which is "p" on the graph. The fact that the demand curve extends to prices
higher than p indicates that there are consumers who are willing to pay a higher price.
However, if the price charged is p, then these consumers achieve a surplus which is
represented by the shaded area.
The demand curve is downward sloping to indicate that more of the product will be bought as
the price falls. This follows the assumption that most people will buy more of a product if they
think the price is favourable. Marginal utility diminishes as the quantity already possessed
rises. So, to sell more, the supplier is likely to have to reduce price. Remember that, as
always, when considering the effect of one change we make the assumption that other
things remain unchanged. In practice they will not, and in the next study unit we recognise
this. My valuation of the marginal utility of apples will change if I discover that the store has
received a large consignment of nectarines and peaches and is selling these at prices
around my marginal utility for these fruits.
D. INDIVIDUAL AND MARKET DEMAND CURVES

Although we do not think in these terms every individual has their own individual demand
curve for each of the goods and services they are interested in consuming. How do we know
this? Because ask any person how much they would like to buy of something at a particular
price and you will get an answer! Knowledge of an individual's demand curve is required to
answer questions relating to how a particular individual is likely to react to the change in the
price of a good or service. However, for many purposes what interests economists, firms and
governments is not how a specific individual will respond to a change in the price of a good
(say because the government has put a tax on the price of the good), but how all consumers
in the market for the good respond to the change in its price.
© ABE and RRC

For example, suppose a firm making bottled fruit juice drinks is faced with an increase in
costs due to an increase in the price of fresh oranges. How much will the firm's weekly sales
of its bottled orange drink fall if it passes on its increase in costs and puts up the price of its
orange drink? To answer this question the firm needs to know what the market demand
curve for bottled orange drinks looks like.
The market demand curve for a good or service is the horizontal summation of all the
separate individual demand curves for the good or service. What this means is that the
quantity demanded at different prices by each person is combined with the quantity
demanded by all the others in the market, to give the total quantity demanded at each and
every price. This is illustrated in Figure 2.6 for a simplified market with only two customers.
Figure 2.6: Demand curve illustrating horizontal summation
Individual A Individual B Individual A + B

Price Price Price
P1 P1 P1
Qa Quantity Qb Quantity Qa+Qb Quantity
Review Points
relevant sections.
1. Why would a person who likes chocolate, who has just consumed five bars, be
unwilling to pay as much for a sixth bar of chocolate as they did for the first bar?
2. What is consumer surplus?
3. What factors are assumed constant when constructing an individual's demand curve
for a good?
4. What information would you need to have to construct the market demand curve for a
good?
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27
Study Unit 3
Demand and Revenue
Contents Page
A. Influences on Demand 29
Flow of Demand 29
Product's Own Price 29
Prices of Other Products 30
Income Available for Spending 30
Price and Availability of Money and Credit 30
Market Size 30
Advertising or Marketing Effort 30
Taste 31
Expectations 31
Special Influences 31
Summary of Influences 31
The Relative Importance of Influences 31
Shifts in the Demand Curve 32
Some Further Considerations 32
B. Price Elasticity of Demand 33

Calculation 33
Influences on Price Elasticity of Demand 35
C. Further Demand Elasticities 36

Income Elasticity of Demand 36
Influences on Income Elasticity of Demand 36
Cross Elasticity of Demand 37
Influences on Cross Elasticity of Demand 37
The Importance of Elasticity Calculations 37
D. The Classification of Goods and Services 38

Normal Goods 38
Inferior Goods 38
Giffen Goods 38
Luxury Goods 39
Bads 40
(Continued over)
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28 Demand and Revenue
Substitutes 40
Complements 40
E. Revenue and Revenue Changes 40

Total Revenue 40
Average Revenue 42
Marginal Revenue 43
Marginal Revenue and Price Elasticity 47
© ABE and RRC

Demand and Revenue 29
Objectives
The aim of this unit is to: explain the concept of elasticity in relation to different types of good
and firm behaviour through an understanding of the revenue function; solve numerical
problems involving elasticity.
 explain the reasons for movements along or shifts in demand curves
 identify the formulae for, and explain what is meant by, own-price, cross-price, and
income elasticities of demand and discuss factors which affect each of these
elasticities
 solve numerical demand elasticity problems using demand information
 explain, in words, diagrams and with reference to demand elasticities, what is meant
by each of the following: normal goods, bads, inferior goods, Giffen goods, luxury
goods, complements and substitutes
 identify real world examples of each of these
 examine, using diagrams and numerical examples, the relationship between total
revenue, average revenue and marginal revenue and between marginal revenue and
the elasticity of demand for a profit- maximising firm
 discuss how a profit-maximising firm might respond to information about demand
elasticities.
A. INFLUENCES ON DEMAND
Flow of Demand
The demand curve which we identified in Study Unit 2 illustrates the quantities of a product
that a group of consumers are prepared to buy at a range of possible prices. We must
remember that these quantities are always related to a time period. Demand is seen in terms
of a flow of purchases over a stated time. For example a greengrocer may want to know the
weekly quantity of apples he can sell at a price of 80p per kilo, and compare this with the
weekly quantity he could sell at 90p per kilo. The time is not always shown in simple demand
graphs, but we must not forget its importance. It is not much use being able to sell 100 kilos
instead of 50 kilos if it takes three times as long to do so.
If we clearly understand this idea of demand flow, remembering the points we made in Study
Unit 2, we can go on to identify the various influences which affect that flow.
Product's Own Price

This is regarded as the most important influence on demand: normally, we expect a rise in
price to lead to a fall in quantity demanded, and a price fall to produce a rise in quantity.
Therefore in general we can accept that, if all other considerations are equal (which they
seldom are), people will prefer to pay a lower price rather than a higher price for a product
the quality of which they know and accept.
We should also recognise that expectations of future price movements can influence current
demand. If people expect prices to rise next week, they will if possible prefer to buy now at
the lower price. On the other hand, this may be regarded as a temporary distortion of
demand which will have little effect over a longer period of time. If the longer-term effect is
not taken into account, it might look as though demand was rising as prices rose – when in
fact people had taken the view that a price rise today was likely to be followed by further
rises tomorrow, and were acting accordingly.
© ABE and RRC

If a new product is introduced to the market, there is likely to be an effect on other goods.
For instance the introduction of cheap electronic calculators destroyed the demand for slide
rules. On the other hand the development of portable radios and personal stereos also
created a demand for the associated (complementary) product – the batteries needed for
their operation. If a major product is introduced and becomes popular enough to absorb a
significant part of personal income, then people will reduce purchases of other products
which they may consider less desirable. There may be no obvious association between the
desired product and the one neglected. For example, a person who decides to pay for a part-
time degree course to enhance career prospects may think it worthwhile to spend less on
entertainment or to put off replacing a car or furniture.
Prices of Other Products

Sometimes, two products are clearly associated – petrol and motor oil or motor car tyres, for
instance. A rise in petrol costs may lead to a fall in the use of cars and hence to reductions in
demand for oil and tyres. Even when products are not directly linked, a change in the price of
one may still influence a wider demand. If a man smokes heavily and is unable to check his
habit, a rise in tobacco prices will lead him to spend less on a wide range of other products.
In the same way, a rise in mortgage interest will force families to spend less on other goods.
Income Available for Spending

For the majority of goods and services, i.e. for normal goods, we would expect the change in
demand to be in the same direction as the change in income. But for some inferior goods,
the changes would be in the reverse direction, so that a rise in income produces a fall in
demand and vice versa.
Notice that a good is inferior only if it is perceived as offering less satisfaction for a particular
type of want. Thus, as a normal means of transport a motorcycle may be perceived as
inferior to a car even though, as a piece of engineering, it may be superior. Suppliers may be
able to revive demand for an inferior good by changing its appeal; adapted and marketed as
a sporting and leisure good the motorcycle has enjoyed such a demand revival, and as such
is often bought by people who also possess cars.
Price and Availability of Money and Credit

Many goods are bought with the help of borrowed money (credit). Money and credit have an
influence on demand separate from the effect of income. If the cost of credit (i.e. the rate of
interest) rises there is likely to be a reduction in demand for the more expensive goods.
Market Size
Many factors can change market size. A firm selling clothes to teenagers will benefit from
any increase in the numbers of teenagers in the population. Specialist shops selling babies'
and children's wear will suffer from a declining birth rate. Market size can be increased by
improvements in communications and technology. The development of the Internet has
greatly increased the market area open to many consumer-goods firms. Increased foreign
travel by people from a country can extend the demand and market area for foreign wines
and foods in that country. Improved techniques of refrigeration extended the market for
frozen vegetables.
Advertising or Marketing Effort

Very few products sell themselves. Most have to be marketed, and the more extensive the
advertising effort, the more that is likely to be sold. Some marketing specialists suggest that
there is a direct relationship between a firm's share of market advertising and its share of
© ABE and RRC

market sales. Certainly, it is the volume of advertising in relation to competitors' advertising

that is likely to be important.
Taste
This is a quality difficult to define. People's desire to buy products is the result of many
influences, not all of which are fully understood. Fashions change, and these changes
cannot always be caused by advertising. The successful firm is often the one that is able to
make an accurate prediction of changes in fashion and taste.
Expectations
Expectations of future changes in any of the previously mentioned influences can affect
present demand. For example, people expecting rising prices will buy now rather than later.
On the other hand, if they fear unemployment and falling incomes, they will cut down their
present spending. Notice that these reactions may actually help to bring about the feared
future changes.
Special Influences
Certain products may be subject to special influences other than the ones we have already
mentioned. The demand for soft drinks or for waterproof clothing, for instance, will be
influenced by weather conditions. The demand for private education in an area will be
influenced by the reputation of State-owned schools in that area.
Summary of Influences
All these influences on demand for a product can be expressed in a form of mathematical
shorthand. Thus, we can say that:
Q  (Po, Pa, Yd, N, A, T).
This simply means that the quantity demanded of any product (Q) is a function () of (is
dependent upon) its own price (Po), the prices of other goods (Pa), disposable income (Yd),
market size (N), marketing effort (A), and customer taste (T).
The Relative Importance of Influences

Of course the relative importance of these influences varies for different products, and it is
necessary for suppliers to estimate this if they are to avoid damaging errors. For example, if
price is not of first importance, a price reduction will simply reduce revenue and profit. In
such a case perhaps the supplier would have more to gain from increases in price and
advertising expenditure.
Suppliers can attempt to estimate the relative importance of the demand influences by
recording and measuring the effect of those, such as price and advertising, under their
control, and also noting the effects of other measurable changes such as movements in
average incomes. Much information may also be gained from market research, e.g. by
asking people why they favour certain brands and what their reactions would be to price
movements. In some cases, shopping simulations can be staged with people given a certain
amount of money and then asked to spend it on a range of goods displayed in a store. The
scientific study and calculation of demand functions from information gained from all
available sources is known as econometrics. In some cases these studies have resulted in
calculations that have proved remarkably accurate, but in other cases have been less
successful. There are many things that can go wrong in the estimation of future demand!
Business decisions still have to be made against a background of market uncertainty.
© ABE and RRC

Shifts in the Demand Curve

A normal two-dimensional graph can cope with only one influence in addition to quantity
changes. For this reason, because the normal demand curve relates quantity to the
product's own price, a change in quantity demanded brought about by a change in one or
more of the other influences must be represented graphically by a shift in the whole demand
curve.
Suppose there is an increase in disposable income which increases the quantity demanded
at each price within a given range. This effect can be shown as in Figure 3.1, where the price
remains constant at Op but the increase in income has shifted the curve from DD to D1D1, so
that the quantity demanded at Op rises from q to q1. A fall in income or a decline in taste for
example would produce the reverse result, i.e. a shift from D1D1 to DD.
Remember always to distinguish a movement along a demand curve produced by a change
in price (all other influences remaining unchanged) as shown in Figure 3.1 from a shift in the
whole curve, showing that demand has moved at all prices within the range under
consideration.
Figure 3.1: A shift in the demand curve
Price D1
D Demand curve moves from DD to D1D1.
Price stays constant, but quantity
demanded moves from Oq to Oq1.
D1
D
O q q1 Quantity
Some Further Considerations

It has been argued that the "normal" influences we have identified do not tell the full story,
and that a fuller understanding of social psychology can give further insights into consumer
behaviour. For example, supermarket chains are well aware of the importance of impulse
buying, when goods are skilfully displayed. There is also a recognised "snob" effect, when
goods may be bought because they are expensive and they appear to be indicators of the
owner's wealth and status. While these considerations are interesting and are clearly of
importance to marketing specialists, we can include them under the more general headings
of advertising and taste, for the purposes of general analysis of consumer demand.
© ABE and RRC

B. PRICE ELASTICITY OF DEMAND

We have now seen that there is a definite relationship between price and quantity changes.
This is most important for practical studies of price and sales movements, because it
determines how sales revenue responds to changes in selling price. We need to have a
precise way of measuring and analysing the various possible relationships between demand,
price and sales revenue. Because demand is seen as stretching and shrinking in response
to price movements, the concept we use is called the price elasticity of demand.
Calculation
Price elasticity of demand can be denoted by the symbol Ed. It is the relationship between a
proportional change in quantity demanded and a proportional change in price, such that:
Ed  proportional change in quantity demanded ÷ proportional change in price, or
Q P
Ed  
Q P
where: P  price of the product
Q  quantity demanded of the product
Q  a small change in Q and
P  a small change in P.
As explained earlier, for the great majority of goods a rise in price leads to a reduction in
quantity demanded and a fall in price leads to an increase in quantity demanded. Thus the
change in quantity is the reverse of the change in price. One of the changes will be negative,
indicating a reduction: thus the value of Ed will also be negative. However, to simplify
exposition the negative sign is often omitted when talking and writing about demand
elasticity, but it must always be remembered that the relationship is usually negative.
When the calculation of price elasticity of demand produces a result in which the proportional
change in quantity is greater than the proportional change in price, we say that demand is
price elastic.
 When the calculation of price elasticity of demand produces a result in which the
proportional change in quantity is less than the proportional change in price, we say
that demand is price inelastic.
 When the calculation of price elasticity of demand produces a figure of –1, i.e. when
the proportional change in quantity is equal to the proportional change in price, we say
that demand has unitary elasticity.
For example, suppose we have the following demand elasticity estimates: the price elasticity
of demand for fish is 0.9, that for washing powder 0.3, and that for eggs 0.02. All three of
these demand elasticities are price inelastic (i.e. less than 1), but fish is clearly much more
price sensitive than eggs. Note that while the demand for washing powder is price inelastic,
for a particular brand of washing powder it might well be price elastic, say around 1.3. Do not
forget that each of these elasticity estimates involves an inverse relationship so that the
numbers have a negative sign.
One important feature of price elasticity of demand is that it changes as price changes.
Consider the demand curve shown in Figure 3.2.
© ABE and RRC

Figure 3.2: Change in price elasticity as demand changes
Price (P) 12 D
£
10 B
6 A
2 C
D
0
0 2 4 6 8 10 12
Quantity (Q)
At point A:
Q 1 P 1 Q P
 ;  ; therefore,  and Ed  –1
Q 6 P 6 Q P
Price elasticity of demand is unity, and so demand is neither elastic nor inelastic.
Here, revenue remains the same at both prices because the change in price produces
exactly the same proportional change in quantity (the size of the ratio Q/Q is the
same as the size of the ratio of P/P):
Revenue at price 5.5 (i.e. 5.5 x 6.5)  revenue at price 6.5 (i.e. 6.5 x 5,5)  35.5
At point B:
Q 1 P 1 Q P
 ;  ; therefore,  and Ed is greater than 1
Q 2 P 10 Q P
Demand is price elastic.
The size of the ratio of Q/Q is greater than the size of the ratio of P/P, so a reduction
in price at B results in a more than proportional increase in quantity demanded, and
there will be an increase in total revenue:
A price reduction from 10.5 to 9.5 increases revenue from 15.75 to 23.75.
A firm in this position will increase revenue by reducing price, but lose revenue if it
increases price.
At point C:
Q 1 P 1 Q P
 ;  ; therefore,  and Ed is less than 1
Q 10 P 2 Q P
© ABE and RRC

Here, the position is completely reversed and Ed is less than 1, so demand is price
inelastic.
The size of the ratio Q/Q is less than the size of the ratio of P/P, so a reduction in
price here results in a less than proportional increase in quantity demanded, and there
is a fall in total revenue:
A price reduction from 2.5 to 1.5 reduces revenue from 23.75 to 15.75.
A firm in this position will lose revenue by reducing price, but gain revenue by
increasing price.
The point of greatest possible revenue on any linear demand curve is where price elasticity
is at unity (where Ed  –1) – i.e. at A.
Notice also that the calculations shown in this illustration are made around the midpoint of
each change. Calculations made in this way are called "arc elasticity". They are the correct
way to measure price elasticity, unless we are able to use the necessary mathematical
techniques to calculate "point elasticity" at a particular point on the demand curve. For all but
very small changes, point elasticity calculations will show different results depending on
whether we assume a price rise or a price fall, and this is confusing and inaccurate. You can
test this for yourself if you compare the calculation for a price rise from £9.50 to £10.50 with
a price fall from £10.50 to £9.50.
Influences on Price Elasticity of Demand

We have seen that the price elasticity of demand can be expected to change as price
changes, so that the product's own price can normally be regarded as an influence on its
elasticity. The important point is whether buyers are likely to pay much attention to the price
when deciding whether to buy, or if other influences are more important. These influences
may include current fashion or social attitudes, strong habits (even addiction, in some cases
such as tobacco smoking) or the need to buy in order to achieve some other desired
objective, such as buying petrol in order to drive to work.
If the product price is only a relatively small amount compared with normal income, then
price is likely to be less important than the other influences affecting demand, which is thus
likely to be price inelastic. Toothbrushes, matches, and shoe polish are all examples of
products likely to be price inelastic. Here, high relative price changes at normal price levels
are unlikely to weigh heavily with consumers, because annual spending on these items is
only a very small part of total income. Other influences, e.g. social attitudes (toothbrushes),
smoking decline, the move away from coal fires (matches), and development of non-leather
shoes (polish), are likely to be much more important.
We must also be careful to distinguish between the demand elasticity for the class of product
and that for a particular brand of the product. My decision whether or not to buy household
soap is not likely to be greatly influenced by a 10 per cent rise in its price. However when I
am actually making my purchase, I am quite likely to compare the prices of two brands and
choose the cheaper, assuming that I do not think one is superior in quality to the other. Thus,
demand for a product can be price inelastic, whereas demand for a specific brand of the
product can be price elastic. This difference can often be seen in foods. Families may keep
to a tradition of the Sunday joint of meat and pay roughly the same price for this each week,
thus showing a demand price elasticity of around unity (i.e. –1). However, the choice of
which meat to buy can be very much influenced by its price, so that we can expect the
demand price elasticity for pork, beef and lamb, and certainly for some particular cuts of beef
and lamb, to be higher than unity, especially if the general level of all meat prices has been
rising.
© ABE and RRC

C. FURTHER DEMAND ELASTICITIES

The general concept of elasticity can be applied to any of the influences on demand. If you
think about the concept, you will realise that it is simply the ratio of a proportional change in
quantity demanded to the proportional change in the influence considered to be responsible
for that change in quantity. The only limiting element in using elasticity is that the influence
must be capable of some sort of precise measurement or evaluation. This makes it difficult
to produce a definite calculation for changes in taste or fashion for instance, as this is very
difficult to measure. The most commonly used elasticities, in addition to the product's own
price, are those for income and for other prices.
Income Elasticity of Demand

Income elasticity of demand relates to proportional change in quantity demanded to the
proportional change in disposable income of customers for the product.
It can be denoted by Ey, so that
Ey  proportional change in quantity demanded ÷ proportional change in disposable
income.
This may be positive or negative, because there may be an increase in demand following an
income increase or a fall in demand. If the income and quantity changes are in the same
direction, then the figure for Ey is positive. If the changes are in the opposite directions to
each other, then the figure carries the negative sign (). A rise in income usually leads to a
rise in demand, but demand for some goods may fall. In many countries in recent years the
demand for bicycles has fallen as incomes rise and people switched to cars. Such goods are
known as inferior goods.
Notice that we are referring here to "disposable income", i.e. the income left to the consumer
after compulsory deductions have been taken. The most important of these deductions are
income tax and National Insurance contributions. We may also include contributions to
pension schemes or to trade unions or professional bodies, where membership is necessary
for employment.
In recent years, some economists have argued that we should really be thinking in terms of
"discretionary income". This is the income that is left from disposable income after all the
regular and largely essential household payments, over which the individual has very little
control, have been made. The deductions which would be made to arrive at discretionary
income would be such items as rent or mortgage interest repayments, water and sewerage
charges, essential fuel charges (gas and/or electricity) and possibly the cost of travelling to
and from work. When these items have all been allowed for, the amount of discretionary
income (the income that people are genuinely free to spend as they choose) is usually very
small in relation to the original gross income.
Influences on Income Elasticity of Demand

The following influences are likely to increase a product's income elasticity of demand:
 A high price in relation to income. If a period of saving is required before purchase is
possible, or if consumers have to borrow money to obtain a product, then demand can
increase only when an income rise makes this possible.
 If goods are preferred to "inferior" substitutes, then people may be ready to buy more
of these when income increases make this possible.
 Association with a higher living standard than that currently enjoyed is likely to lead to
rising demand when incomes do rise.
© ABE and RRC

In general, the more highly-priced durable goods (household machines, motor vehicles, etc.)
and services are more likely to be income elastic than the staple items of food and clothing.
We do not usually buy twice as much of these if we receive double our former income. On
the other hand, our spending on holidays may increase by far more than double. Increased
spending on motor transport is also associated with rising incomes. Although we have been
considering income rises, very similar comments apply to income reductions. Holidays and
motor cars are often the first things to be sacrificed in the face of a sudden drop in income.
Cross Elasticity of Demand

Cross elasticity of demand relates the proportional change in demand of one product to the
proportional change in price of another:
Ex  proportional change in quantity demanded of X ÷ proportional change in price of Y.
Again, the demand movement may be in the same or the opposite direction to the price
movement, and the same rules for negative signs apply.
If two products are substitutes for each other, we can expect a rise in price of one to lead to
a rise in demand for the other. Beef and pork are in this position, or meat and fish.
However if the two products are linked together, e.g. petrol and motor car tyres, then a rise in
price in one leads to a fall in demand for the other, and Ex carries the negative sign ().
Influences on Cross Elasticity of Demand

The more close substitutes a product has, the more likely it is to react to changes in price of
any of those substitutes. The demand for coach travel reacts to changes in rail fares. In the
UK the link became closer when motorways cut down the times of road journeys between
the major cities, and long-distance coaches became more directly comparable with intercity
trains. Brands of goods are normally much more cross elastic with each other than the good
itself is with other goods. We are not unduly influenced by other price movements when we
decide how much soap to buy, but we are much more ready to switch to a competing brand
when there is a rise in the price of the brand we normally buy.
In the same way, the intensity of negative cross elasticity depends on how closely products
are associated with each other. For people in England, the demand for suntan lotion is likely
to rise if the price of air travel and holidays in the sun falls.
The Importance of Elasticity Calculations

The calculation of elasticities is not just of academic interest. Anyone who wishes to predict
accurately the effect of changes in price or income on revenue and on quantities bought
needs to have a clear idea of elasticity and its calculation.
If a business manager thinks that a price rise will always increase sales revenue, then he or
she needs to be reminded that this is far from being true. A price rise when demand is price
elastic will, as you have seen, reduce total sales revenue.
Governments making changes in income or expenditure taxes must be able to calculate their
effects on demand. If they do not, then their predictions about the results of the tax change
are likely to prove badly out of line with reality.
A government wishing to increase its tax revenue will tend to choose goods for which the
demand is price inelastic – tobacco for example, or petrol. However if it goes on increasing
the tax, the time will eventually come when demand becomes price elastic. Any further
increase will result in a reduction in sales revenue and a fall in tax receipts. This can be seen
by referring to Figure 3.2, where a price rise from 5 to 7 (for example) will move the good to
that part of the demand curve where price rises produce a reduction in total revenue.
© ABE and RRC

Price elasticity of demand can also change as a result of other influences. If, for example,
there is a long-term trend away from smoking, we can expect demand for cigarettes to
become price elastic at lower price levels in the future.
If governments wish to influence consumer demand by price changes, they are likely to try to
make demand more price elastic by ensuring that suitable substitutes are available for the
target product. For instance, to reduce consumption of leaded petrol, the availability and
demand for unleaded petrol must be encouraged, and vehicle engines must be capable of
easy and cheap conversion to unleaded petrol. They may wish to support any tax changes
by changes in the law, perhaps requiring all new vehicles to be adapted to use unleaded
fuel.
D. THE CLASSIFICATION OF GOODS AND SERVICES

In this section we provide a summary of what we have said concerning elasticities. We do
this by examining how the properties of demand curves and the different measures of
elasticity can be used to classify goods and services, in ways that are helpful when analysing
market situations for firms' pricing decisions and in product development and marketing
strategies.
In economics goods can be classified as being:
 normal goods
 inferior goods
 Giffen goods
 luxury goods
 bads
 substitutes
 complements.
Normal Goods
The vast majority of goods and services in the world are normal goods. The demand curve
for normal goods slopes downwards from left to right. As explained previously, the defining
characteristic of a normal good is that it has a positive income elasticity of demand. A luxury
good is a special case of a normal good in that it is a good with a positive and high income
elasticity of demand. As incomes increase the demand curves for normal goods shift
outwards to the right as shown in Figure 3.1.
Inferior Goods
The demand curve for an inferior good also slopes downwards from left to right. The defining
characteristic of an inferior good is that it has a negative income elasticity of demand. As
incomes increase the demand curves for normal goods shifts inwards to the left, indicating
that less is demanded at each price. In contrast, a reduction in incomes will shift the demand
curve for an inferior good to the right.
Giffen Goods
Giffen goods (named after named after Sir Robert Giffen, who is attributed as first
suggesting the existence of such goods) are a special case of inferior goods. A person's
demand for inferior goods decreases, ceteris paribus, as their income increases and
increases as their income decreases. That is, as we have said, inferior goods have a
negative income elasticity of demand. For people on very low incomes their demand for a
© ABE and RRC

good may actually increase as the price of the good increases. This is because the rise in
price reduces their real income to such an extent that they cannot afford to buy sufficient of
more preferred goods. Real income refers to the quantity of goods and services a person
can buy with their money income. If I have £300 a week to spend and the prices of all the
things I buy each week double, my real income falls because I can now only buy half the
quantity with my £300.
The demand curve for Giffen goods slopes upwards from left to right, unlike the demand
curve for normal goods, with more demanded at a higher price than at a lower price. The
negative real income effect associated with the rise in price outweighs the desire to buy less
because of the higher price.
In practice Giffen goods are rare. Examples are the types of food items that form an
important part of the daily diet of people on very low incomes. Potatoes, bananas or rice, as
a source of carbohydrate, are the main daily foods for many of the world's most
impoverished people. Depending on their tastes, and their incomes, they may supplement
their consumption of one of these sources of carbohydrate with some meat or fish and/or
vegetables. But if the price of potatoes rises significantly, some people may be so poor that
they can no longer afford to buy potatoes, and fish and vegetables. Faced with a choice
between feeling hungry because they can only afford very, very small amounts of potatoes,
fish and vegetable on their plate or feeling full because of a large plate of potatoes, they may
buy more potatoes despite their higher price.
Strictly the term "Giffen" applies only when the "inferior" income effect created by a change
in price is more powerful than the normal price substitution effect which leads people to
switch their expenditure in favour of goods as they become relatively cheaper. However it is
often used more widely whenever demand appears to rise as price rises for whatever
reason. There are a number of other possible explanations for this behaviour. For example,
people may (rightly or wrongly) associate price with quality, e.g. for tomatoes, and prefer to
pay a little more in anticipation of obtaining a more satisfactory fruit. If there were some other
trusted mark of quality, the normal price-quantity relationship would hold. Demand may also
rise for a work of art which people think is gaining acceptance in the art world. If people think
that the price is going to rise even more in the future, they may buy the work of art as an
investment and not simply because they get pleasure from looking at it. In this case, we are
really dealing with a different product. In yet more cases, the rise in demand is just the result
of other influences as described in this study unit, and these are proving more powerful than
the influence of price on its own.
Luxury Goods
Luxury goods are usually high-priced goods, often with a well-known brand name. In marked
contrast to Giffen goods, the income elasticity for luxury goods is positive, as it is for normal
goods. As people's real incomes increase we observe that the pattern of their demand
changes: they start to buy goods that they did not purchase when their incomes were low.
The demand curve for luxury goods is downward sloping, as for normal goods, but the whole
demand curve shifts outwards to the right as consumers' real incomes increase. This
rightward shift of the demand curve for luxury goods is very pronounced. This is because in
the case of luxury goods the income elasticity of demand is not just positive but it is greater
than one. If a person had an income elasticity of demand for a particular good of say 3, this
would imply that their demand for the good would increase by 300 per cent if their income
doubled.
Although the demand curve for some goods that appear to be luxury goods can be upward
sloping, like that for a Giffen good, meaning that demand increases as price rises, the
economic reason for this is different to that for Giffen goods. In fact, it is better to call these
goods "snob" goods, to indicate that they are a special case of luxury goods. The demand
for snob goods increases as their price increases for the reason that people attach
© ABE and RRC

importance to their price as a desirable, possibly the most desirable, characteristic of owning
and using the good. Does a £10,000 bottle of wine taste that much better than a similar wine
costing £100? The answer does not matter for some people: they are buying the £10,000
bottle of wine as a statement or display of their wealth, and the very high price is the thing
that shows this! You should be able to think of similar examples involving some makes of
luxury car, watches, trainers and ladies' fashion.
Bads
"Bads" are simply those things that we would rather not have but which may nevertheless
exist, and be consumed in the sense that people have no choice but experience them.
Examples include atmospheric pollution, water pollution, noise and crime. By definition there
are no demand curves for bads, at least for most people. The concept is still useful,
however, because it explains why communities and governments may take action to
intervene in markets to reduce or eliminate the production of certain goods and services that
are associated with the production of bads, e.g. manufacturing equipment which causes a
high level of pollution.
Substitutes
As explained in an earlier section, when the relationship between the demand for one good
and the price of another, as measured by their cross-price elasticity of demand, is positive
the two goods are referred to as substitutes. That is, an increase in the price of one of the
two goods will lead to an increase in the demand for the other. Conversely, a decrease in the
price of one will lead to a decrease in demand for the other. For example, a decrease in the
price of digital cameras will lead to a decrease in the demand for traditional film-based
cameras.
Complements
As explained earlier, when the relationship between the demand for one good and the price
of another, as measured by their cross-price elasticity of demand, is negative the two goods
are referred to as complements. That is, an increase in the price of one will lead to a
decrease in the demand for the other. For example, a large increase in the price of cars will
lead to a decrease in the demand for petrol.
E. REVENUE AND REVENUE CHANGES

We have seen that there is a definite relationship between price and quantity changes. This
is most important for practical studies of price and sales movements. We now need to study
the different concepts of revenue used in economics and the relationship of revenue and the
elasticity of demand.
Total Revenue
In general revenue refers to the money received from the sales of a product. For this reason,
the term "sales revenue" is often used. To have any practical meaning, revenue should also
be related either to a time period or to a definite quantity of goods sold. For example, a
shopkeeper may refer to her weekly sales revenue (the total amounts of sales achieved in a
week) or to her revenue from the sales of n pairs of shoes or k kilos of potatoes. A statement
that her revenue is £y means nothing, unless we can relate it to some quantity of time.
Revenue will not always increase as more goods are sold – this will be the case only if a firm
can continue to charge the same price, regardless of quantity it sells. If I make leather belts
and can sell all the belts I can make at a standard price of £5, then my total revenue is
always £5 multiplied by whatever quantity I sell.
© ABE and RRC

This can be shown in the form of a total revenue curve, as in Figure 3.3.
Figure 3.3: Total revenue curve
120
Revenue Total Revenue
£ Curve
100
80
60 Revenue at quantity
20 per week  £100
40
20 Revenue at quantity
10 per week  £50
0
0 5 10 15 20 25
Number of belts sold per week
If all belts can be sold at £5 each, total revenue continues to increase at a constant rate
However, if I continue to produce more and more belts, there will come a time when
customer resistance sets in. I shall have difficulty in finding more people who value belts at
this price of £5, i.e. the marginal utility of which is at least £5. When this time comes, I may
still find more people who are willing to pay £4.
Now, in developed market economies shopping conditions are such that shoppers expect all
goods to be priced, so I cannot leave my belts without any price ticket attached and hope to
sort out from the people who visit my shop those willing to pay £5 and those willing to pay
£4. If I want to sell more belts and am willing to charge £4, then I must charge this price to
everyone. If I continue to produce even more, I might then find that to sell the increased
quantity I have to charge £3. If I go on doing this, I am likely to find that my total revenue
starts to fall.
Suppose I find that total revenue rises if I reduce the price from £5 to £4, but falls if I reduce
the price to £3. This will happen if the reduction from £4 to £3 does not produce enough
additional sales to make good the loss suffered when I charge £3 to those people who would
still have bought at prices of £5 or £4. My sales schedule at the three prices might be as in
Table 3.1.
Table 3.1: Sales schedule for belts
Price per belt Number of belts I can Total revenue

sell per month
£5 200 £1,000
£4 280 £1,120
£3 340 £1,020
© ABE and RRC

This effect can be shown in the form of a simple graph but this time the turning point can be
seen (Figure 3.4). If I try to reduce the price still further, below £3, I shall lose even more
revenue.
Figure 3.4: Revenue from sale of belts
1200
Revenue
£ (part of) Total Revenue Curve
1100
1000
900
800
700
600
140 160 180 200 220 240 260 280 300 320 340 360
Average Revenue
We are going to use the term "average" in its most common sense: the average revenue is
the total revenue divided by the quantity of goods sold. If a shop's weekly revenue from
selling broccoli is £600 and it sells 300 kilos in the week, the average revenue of the broccoli
sold is £2 per kilo.
If all goods are sold at the same price in the given time period – as, say, with our leather
belts – then the average revenue is the same as the price. The average revenue curve for
the belts is shown in Figure 3.5.
Figure 3.5: Average revenue curve for belts
Price per belt/ 5

Average revenue
Average Revenue Curve and
£
Demand Curve
2
140 160 180 200 220 240 260 280 300 320 340 360
© ABE and RRC

Notice in this case that the average revenue curve is really just the same as the demand
curve. This will always be the case where all items sold in the time period are sold at the
same price, i.e. where there is no price discrimination between different customers.
In most market conditions a firm's average revenue curve is identical with its demand curve
and the two terms can be used interchangeably.
Figure 3.6: Horizontal average revenue curve
Price per kilo 3

The shopkeeper can sell any quantity up to
£ 700 kilos per week at the price of £2 per kilo
2
Demand and Average
Revenue Curve
0
0 100 200 300 400 500 600
Kilos of broccoli sold per week
To return to our shopkeeper selling broccoli at £2 per kilo: let us suppose that she is selling
every kilo for £2 and that she finds she can sell as much broccoli as she can handle at that
price. She does not need to reduce her price to increase quantity sold from 200 kilos per
week to 300 or 400 or even 500 kilos. The average revenue curve in this case is still the
same as the demand curve, but it reflects this increasing quantity sold at a constant price.
This produces the horizontal line graph shown in Figure 3.6.
Marginal Revenue
If a firm is able to maintain a constant price as it increases output, then the additional
amount it receives for each extra unit sold is of course that unit's price. In this case the price,
which is the same as average revenue, is also the same as the change in total revenue
resulting from the sale of the extra unit. The change in total revenue brought about by a
small or unit change in the quantity flow of sales is known as the marginal revenue.
Marginal revenue is not always the same as the price or average revenue. Remember the
example of the leather belts.
There, an increase in sales from 280 to 340 belts per month produced a fall in total revenue.
For the change in this output range, the marginal revenue must be negative. The reason is
the same as for the fall in total revenue – in order to increase sales, the price had to be
brought down. In this case, the revenue gained on the additional quantity sold was not
enough to make good the revenue lost for customers who would have been prepared to buy
at the higher price.
A simple example will show how marginal revenue can change when price has to be reduced
in order to increase the quantity sold. Look at Table 3.2. There are some important features
to note about this table. The marginal revenue column has its figures placed midway
between the rows. This emphasises that the marginal revenue relates to the change from
one output level to the next.
© ABE and RRC

Table 3.2: Change in marginal revenue when price is reduced
Number of TV sets Price per set Total revenue Marginal revenue

sold per week £ £ £
1 600 600
550
2 575 1,150
500
3 550 1,650
450
4 525 2,100
400
5 500 2,500
350
6 475 2,850
300
7 450 3,150
250
8 425 3,400
200
9 400 3,600
150
10 375 3,750
100
11 350 3,850
50
12 325 3,900
0
13 300 3,900
50
14 275 3,850
On a graph, the marginal revenue is also plotted midway between the output levels. This is
shown in Figure 3.7.
© ABE and RRC

Figure 3.7: Change in marginal revenue when price is reduced
Marginal700
revenue
£ 600
500
400
Marginal Revenue
Curve
300
200
100
0
0 2 4 6 8 10 12 14 16
-100 TV sets sold per week
Look carefully at the price and marginal revenue columns in Table 3.2. Notice that, as each
additional TV set is sold, the price (average revenue) falls £25. The fall in marginal revenue
for each additional set is exactly double this – £50.
In Figure 3.8, we see the marginal and the average revenue curves together.
Figure 3.8: Marginal and the average revenue curves
Price, average
700
and marginal At each price, marginal revenue
revenue is halfway between the price axis
600 and the average revenue
£
500
Average
Revenue
400
300
Marginal
200
Revenue
100
0
0 2 4 6 8 10 12 14 16
-100 TV sets sold per week
© ABE and RRC

Notice that, at each price level, the marginal revenue is exactly halfway between the price
axis and the average revenue. Although Figure 3.8 does not continue the average curve until
it meets the quantity axis, we can deduce where it would meet if continued in the same
straight line. It would meet the quantity axis at 25 TV sets – twice the marginal revenue
quantity when marginal revenue equals zero, thus indicating that this supplier would be able
to dispose of only 25 sets, even if he did not charge any price at all (i.e. give them away).
The average revenue curve cannot of course pass below the quantity axis, as we do not
expect suppliers to pay customers to take their goods. However the marginal revenue curve
can pass into the negative area of the graph, and so indicate quantities where continued
price reductions would result in an actual fall in total revenue. We can see this clearly from
Table 3.2. Marginal revenue remains positive until 12 sets are sold. The increase from 12 to
13 sets does not change total revenue at all, so marginal revenue here is zero. If we
continue to reduce price and sell 14 sets, then total revenue falls to £3,850 and marginal
revenue indicates the loss as £50.
The total revenue curve for Table 3.2 is shown in Figure 3.9. Compare this with Figure 3.8
and see how the marginal revenue relates to the total revenue at the various numbers of TV
sets sold.
Figure 3.9: Total revenue curve
Total 4000 £3,900

revenue
£
Total
3000 Revenue
2000
Total revenue is at its
maximum (£3,900) between
12 and 13 sets per week.
If more than 13 sets are
1000 sold, total revenue starts to
fall – i.e. marginal revenue
is negative.
0
0 2 4 6 8 10 12 14 16
TV sets sold per week
This example has illustrated an important rule. Whenever we have a linear average revenue
curve (i.e. where there is a constant relationship between price and quantity changes
resulting in a straight-line graph) then the marginal revenue curve is also linear (a straight
line) and always bisects (cuts into two equal halves) the horizontal distance between the
price/revenue axis and the average revenue curve.
© ABE and RRC

Marginal Revenue and Price Elasticity

For a downward sloping linear demand curve, the relationship between the average revenue
curve and the marginal revenue curve shown in Figure 3.8 is related to the concept of price
elasticity of demand in a precise way. If you refer back to Figure 3.2, point A is the point at
which elasticity has a value of unity (-1), and it has been demonstrated that the demand
curve is inelastic throughout its range above its mid-point at A. If you construct the marginal
revenue curve for this demand curve, it will bisect the horizontal distance between the
vertical axis and the demand curve and intersect the quantity axis at a quantity of 6. This
point is vertically below the mid-point A. That is, marginal revenue is exactly zero at the point
of unit elasticity on the demand curve. It follows from this that marginal revenue is only
positive when demand is inelastic.
Recall, as shown in Figure 3.7, that the marginal revenue curve can extend below the
horizontal axis because it is possible for marginal revenue to be negative. If a firm is
operating on the elastic section of its demand curve its marginal revenue is negative and it
can increase its total revenue by moving up its demand curve.
The full significance of the relationship between elasticity and marginal revenue will become
apparent in Study Unit 5 when the decision rule that firms must use to maximise their profits
is explained.
© ABE and RRC

Review Points
relevant sections.
1. What is the difference between a movement along a demand curve and a shift in the
demand curve?
2. Other things remaining unchanged, will an increase in income shift the demand curve
for a normal good to the:
(a) left or
(b) right?
3. If the cross-price elasticity of demand between two goods is positive are the two
goods:
(a) substitutes or
(b) complements?
4. What is marginal revenue and how does it change as a firm reduces its price?
5. Complete this statement:
The other name for a firm's demand curve is its ………..
6. A firm is currently selling its product at a price that lies on the inelastic part of its
demand curve. In this situation can the firm increase its sales revenue by:
(a) increasing its price or
(b) decreasing its price?
7. If a firm's marginal revenue is negative is it operating on:
(a) the elastic part of its demand curve or
(b) the inelastic part of its demand curve?
8. To maximise the revenue from placing a sales tax on a good should a government
place the tax on a good for which demand is:
(a) inelastic or
(b) elastic?
© ABE and RRC

49
Study Unit 4
Costs of Production
Contents Page
A. Inputs and Outputs: Total, Average and Marginal Product 50

Factors of Production and Costs 50
Total Product 50
Marginal Product of Labour 52
Average Product of Labour 54
B. Factor and Input Costs 55

Fixed Costs 56
Variable Costs 57
Total and Average Costs 57
Marginal Costs 59
Long-run Costs 62
C. Economic Costs 64
D. Costs and the Growth of Organisations 64

Returns to Scale 64
Economies of Scale 65
Diseconomies of Scale 66
External Economies 67
The Law of Diminishing Returns, Returns to Scale and Economies of Scale 67
E. Small Firms in the Modern Economy 68

Economies of Scale 68
Services 69
The Role of Small Firms in the Economy 70
© ABE and RRC

50 Costs of Production
Objectives
The aim of this unit is to: discuss the theory of costs, explaining the differences and
relationships between various types of cost and distinguishing between the short and long
run; solve numerical problems based on cost information; explain and contrast, in words and
diagrams, the concepts of economies of scale and returns to scale.
 explain with reference to appropriate examples, the difference between fixed and
variable factors of production
 identify the formulae for, and explain what is meant by, fixed cost, variable cost,
marginal cost, average cost and total cost
 solve numerical and/or diagrammatic problems using cost data
 explain, using an appropriate diagram, the relationship between average and marginal
cost
 explain, using appropriate examples, the difference between fixed cost and sunk cost
 explain what is meant by economies and diseconomies of scale and relate these
concepts to the long-run and short-run average cost curve
 explain what is meant by increasing, constant and decreasing returns to scale and,
using real world examples, how each of the these might arise
 compare and contrast the concepts of returns to scale and economies of scale.
A. INPUTS AND OUTPUTS: TOTAL, AVERAGE AND

MARGINAL PRODUCT
Factors of Production and Costs
In Study Unit 1 we examined how the factors of production – land, labour and capital –
contributed to total production. We also saw that some factors could be regarded as fixed
and others could be regarded as variable. This distinction helped to provide us with the
important distinction between the short run, when at least one significant production factor
was fixed, and the long run, when all factors could be varied.
Total Product
We begin in this section by repeating part of Study Unit 1 and examining what happens when
production increases in the short run, when the production factor capital is fixed and when
the factor labour is variable. Once again we can take a simple example of a small business
which is able to increase its use of labour. For simplicity we can use the term "worker" as a
unit of labour, but as remarked before you may wish to regard a worker as a block of worker-
hours which can be varied to meet the needs of the business.
Suppose the effect of adding workers to the business is reflected by Table 4.1, where the
quantity of production is measured in units and relates to a specific period of time, say, a
month. The amount of capital employed by the business is fixed.
© ABE and RRC

Costs of Production 51
Table 4.1: Number of workers and quantity of production
Number of Quantity of production

workers (units per month)
1 30
2 70
3 120
4 170
5 220
6 260
7 290
8 310
9 320
10 320
11 310
The quantity of production (measured here in units produced per month) which is shown as a
graph in Figure 4.1 is of course the total product. In this example total product continues to
rise until the tenth worker is added to the business. This worker is unable to increase total
product. Given the fixed amount of capital, no further increase in productive output is
possible. The addition of an eleventh worker would actually cause a fall in production.
Figure 4.1: Illustrating total product
Units of 350
Production
per month
300 Total
Product
250
200
150
100
50
0
0 2 4 6 8 10 12
Workers
© ABE and RRC

Marginal Product of Labour

Now examine the amount of change to the total product as each additional worker is added
to the business. Table 4.2 shows this change in the third column, which is headed marginal
product. Strictly speaking, this is the marginal product of labour because it results from
changes in the amount of labour (workers) added to the business.
Table 4.2: Adding marginal product of labour
Number of Quantity of Marginal product

workers production of labour
(units per month) (additional units per month)
0 0
30
1 30
40
2 70
50
3 120
50
4 170
50
5 220
40
6 260
30
7 290
20
8 310
10
9 320
0
10 320
10
11 310
The marginal product of labour is the change in total product resulting from a change in the
amount of labour employed. It is called marginal because it is the change at the edge; the
term "marginal" is used in economics to denote a change in the total of one variable which
results from a single unit change in another variable. Here the total is quantity of production
resulting from changes in the number of workers employed.
The marginal product column shows the difference in the total product column at each level
of employment. Notice that the marginal value is shown midway between the values for total
product and the number of workers. This is because it shows the change that takes place as
we move from one level of employment (i.e. adding an additional worker) to the next. In
Figure 4.2 the marginal product is represented by the vertical distance between each step in
production as each worker is added.
The sum of the marginal product values up to each level of worker is equal to the total
product at that level.
© ABE and RRC

Figure 4.2: Illustrating marginal product
Units of 350
Production
per month 10
300 20
Total
Product
30
250
40
200 50
150 50
100 50
50 40
30
0
0 2 4 6 8 10 12
Workers
Notice how the value for marginal product changes as total product rises: one worker alone
can produce 30 units but another enables the business to increase production by 40 units
and one more by 50 units. There are many ways in which this increase might be achieved,
e.g. by specialisation and by freeing the manager to improve administration, purchasing and
selling. However, these increases cannot continue and the additional third, fourth and fifth
workers all add a constant amount to production. Thereafter, further workers, while still
increasing production, do so by diminishing amounts until the tenth worker adds nothing to
the total. At this level of labour employment production has reached its maximum, and the
eleventh worker actually provides a negative return – total production falls. Perhaps people
get in each other's way or cause distraction and confusion. If the business owner wishes to
continue to expand production, thought must be given to increasing capital through more
buildings and/or equipment. Short-run expansion at this level of capital has to cease. Only by
increasing the fixed factors can further growth be achieved.
As remarked in Study Unit 1, this particular example is purely fictional – it is not based on an
actual firm: but neither is the pattern of change in marginal product accidental. The figures
are chosen deliberately to illustrate some of the most important principles of economics, the
so-called laws of varying proportions and diminishing returns. It has been constantly
observed in all kinds of business activities that when further increments of one variable
production factor are added to a fixed quantity of another factor, the additional production
achieved is likely first to increase, then to remain roughly constant and eventually to
diminish. It is this third stage that is usually of the greatest importance, this is the stage of
diminishing marginal product, more commonly known as diminishing returns. Most firms are
likely to operate under these conditions. It is during this stage that the most difficult
managerial decisions, relating to additional production and the expansion of fixed production
factors, have to be taken.
© ABE and RRC

Of course it must not be assumed that firms will seek to employ people up to the stage of
maximum product when the marginal product of labour equals zero, or on the other hand
that they will not take on any extra employees if diminishing returns are being experienced.
The production level at which further employment ceases to be profitable depends on
several other considerations, including the value of the marginal product. This depends on
the revenue gained from product sales, and the cost of employing labour, which is made up
of wages, labour taxes and compulsory welfare benefits. The higher the cost of employing
labour, the less labour will be employed in the short run and the sooner will employers seek
to replace labour by capital in the form of labour-saving equipment.
Average Product of Labour

The average product of labour employed is found simply by dividing the total product at any
given level of employment by the number of workers (or some unit of worker-hours). For
reasons which by now should be starting to become apparent to you, the average product of
labour, though a measure easily understood and used by many business managers and their
accountants, is less important than the marginal product. However, Table 4.3 adds average
product to our earlier statistics, and Figure 4.3 shows both marginal and average product in
graphical form.
Table 4.3: Adding average product
Number of Quantity of Marginal product of Average product of

workers production labour labour
(units per month) (units per month) (units per month)
0 0
30
1 30 30.00
40
2 70 35.00
50
3 120 40.00
50
4 170 42.50
50
5 220 44.00
40
6 260 43.33
30
7 290 41.43
20
8 310 38.75
10
9 320 35.56
0
10 320 32.00
10
11 310 28.18
© ABE and RRC

Figure 4.3: Marginal product and average product curves
Units of 60
Production
50
40
Average Product
of Labour
30
20
Marginal Product
10
of Labour
0
0 2 4 6 8 10 12 Workers
(labour units)
-10
-20
th
The falling marginal product curve intersects the average product curve at about the 5
worker. Average product then starts to fall because for more workers marginal product is
below average product.
Notice the relationship between average and marginal product. Average product continues to
rise until it is the same as the falling marginal product, then it falls. This must happen as can
easily be proved mathematically, and you can see it for yourself if you take any set of figures
where marginal product continues to diminish.
B. FACTOR AND INPUT COSTS

The payments made to the owners of production factors in return for their use in the process
of production are of course the costs of production, which the production organisation (firm)
has to pay in order to produce goods and services. More strictly these are termed the private
production costs. These factor payments, in very general terms, are rent to the owners of
land, interest to the owners of capital and wages to the providers of labour. Disregarding
land for the sake of using very simple models, we can, initially, regard capital as the major
fixed production factor and labour as the variable factor.
© ABE and RRC

Fixed Costs
Fixed costs are the costs of the fixed factors, i.e. those elements which are not being
increased as production or output is being raised. The total fixed costs for a given range of
output can be illustrated in the simple graph shown in Figure 4.4.
Figure 4.4: Total fixed costs
Cost 16,000
£
14,000
12,000
Total Fixed Costs
10,000
8,000
6,000
4,000
2,000
0
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150
Output (units per week)
Examples of fixed costs include rent for land or buildings, rental charge for telephone or
telex, business rates, salary of a manager, and fees for a licence to make use of another
company's patent. All these costs can change, but the point is they do not change as
production level changes. The cost has to be met, whatever the level of output and sales.
The graph of average fixed costs, i.e. total fixed costs divided by the number of units of
output produced, is shown in Figure 4.5. This is based on the fixed costs of £10,000
assumed in Figure 4.4. Notice the steep fall at the lower levels of output, and the much more
gentle slope of the curve at higher levels. Between 140 and 150 units of output per week, the
fall in average fixed costs is only from approximately £71 to £67.
Figure 4.5: Average fixed costs
Cost 1,000
£ 900
800
700
600
500
400
300
200 Average Fixed Costs
100
0
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150
© ABE and RRC

Variable Costs
The behaviour of variable costs depends on the pattern of production returns. If production is
rising faster than the input of variable elements, then costs are increasing less than
proportionally to the rise in output. This is because each extra unit of input is adding more to
production than it is to cost. This is possible at the lower levels of production represented by
the section of graph 0a in Figure 4.6.
Later, costs are likely to rise in the same proportion as output – this being the stage of
constant returns, shown between output levels 0a and 0b. Then, as we reach the level of
diminishing returns, costs rise faster (more steeply) than production. This is shown beyond
level 0b.
Figure 4.6: Total variable costs
Cost 24000
£
22000
Total
20000 Variable
Costs
18000
16000
14000
12000
10000
8000 Diminishing returns

Cost rise: Cost rise:
6000 £7,500 for £9,500 for
45 units 25 units
4000 Increasing
returns
2000 Constant returns
(£100 per unit)
0
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150
0 a b
Total and Average Costs

If we combine fixed and variable costs, we obtain total costs. So, if we combine Figure 4.4
(which shows total fixed costs) with Figure 4.6, we obtain the graph of total costs. This is
© ABE and RRC

Figure 4.7: Total cost curve
Cost 35000
£
30000 Total Costs

(fixed + variable)
25000
20000
15000
Fixed Costs
10000
5000
0
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150
From the total costs we can obtain average total costs, simply by dividing the total by each
successive level of output. Average total costs are often referred to just as average costs.
Figure 4.8 shows the graph of average total costs, which has been derived from the total
cost curve shown in Figure 4.7.
Figure 4.8: Average total costs
Cost 1100
£
1000
900
800
700
600
500
400 Average Total Costs
300
200
100
0
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150
© ABE and RRC

Notice how the shape of the average cost curve at the lower levels of output is very similar to
that of the average fixed cost curve in Figure 4.5. This is because, at these levels, fixed
costs form a high proportion of total costs. As fixed costs become a smaller proportion of
total costs, the curve falls much less steeply. In this illustration, it reaches its lowest point a
little below the 110 units per week output level and then begins to rise, as variable costs
become steeper in response to diminishing returns to scale.
This is the typical shape of the curve in the short run (that is, while "fixed" costs remain the
unchanged). Because it falls to a minimum point and then rises, it is often referred to as the
"U-shaped" average cost curve, although as you can see, a more accurate description is that
of an L with its toe turned upwards. Only if there are particularly severe increasing costs
(diminishing returns) to scale, and fixed costs are a very small proportion of total costs, will
the second half of the "U" be at all steep; the efficient firm should never allow itself to reach
this position.
The modern firm is more likely to have a high proportion of fixed to total costs, because of
the swing from labour to labour-saving machinery. This movement is described as production
becoming more and more capital-intensive. In this case, we can expect the average total
cost curve increasingly to resemble the average fixed cost curve.
Marginal Costs
You have already met marginal product, marginal utility and marginal revenue – the change
in total output, utility or revenue as output changes. You will not then be surprised to know
that marginal cost is the change in total cost as output changes. Once again, we relate this
change to a single unit of output so that, if we are moving in steps of ten (as in our cost
example so far), we shall have to divide any change from one forward step to the next by
ten.
Table 4.4 is a table of total (fixed plus variable) costs which correspond to our previous
graphs. In this table, further columns have been added to show the change in total cost
between each output step of ten units per week, and then division by ten to produce the
marginal cost. Notice that the figures of the marginal cost column have been placed midway
between the figures of the other columns, to emphasise that they relate to a change from
one output level to the next.
© ABE and RRC

Table 4.4: Cost table
(1) (2) (3) (4)

Quantity Total cost Changes in total cost Marginal cost
from one quantity (column 3 divided by 10)
level to the next
(units per week) £ £ £
0 10,000
100
10 11,000 1,000
60
20 11,600 600
40
30 12,000 400
100
40 13,000 1,000
100
50 14,000 1,000
100
60 15,000 1,000
100
70 16,000 1,000
100
80 17,000 1,000
115
90 18,150 1,150
135
100 19,500 1,350
165
110 21,150 1,650
210
120 23,250 2,100
275
130 26,000 2,750
355
140 29,550 3,550
445
150 34,000 4,450
On a graph, the marginal cost is plotted at the midpoints of the various output levels. You will
see that this has been done in Figure 4.9, which illustrates the marginal costs shown in Table
4.4.
© ABE and RRC

Figure 4.9: Marginal costs
Cost 500
£
400
Marginal Costs
300
200
100
0
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150
In Figure 4.10, the marginal cost graph has been combined with the average cost graph.
Notice where these two curves intersect.
The rising marginal cost curve cuts the average cost curve at roughly 110 units per week.
This is the output level which we have already noted as the lowest level of the average total
cost curve. This illustrates a rule that you must remember: the rising marginal cost curve
always cuts the average cost curve at its lowest point. If you think a little, you will see that it
must do that. If the cost of the last unit to be produced is less than the average up to that
point, then the new average will be a little lower. If the cost of the last unit is higher than the
average up to that point, then the new average will be a little higher.
Experiment with some simple figures and you will see that this must always be true.
Remember this relationship, and always show the correct intersection when you draw
graphical illustrations.
© ABE and RRC

Figure 4.10: Marginal cost and average cost
Cost 1100
£
1000
900
800
700
600
500
Average Cost
400 Marginal Cost
300
200
100
0
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150
Long-run Costs
In the long run all factors of production may be increased: no costs are completely fixed. In
practice of course the factors which are fixed in the short run will be increased in definite
stages, perhaps when a new factory is built or when new technology introduced, etc. The
graph of fixed costs in the long run, therefore, appears as in Figure 4.11.
Figure 4.11: Fixed costs in the long run
Costs
£
Long-run fixed costs
Output
The effect of this on the average total cost curve in the long run is shown in Figure 4.12.
© ABE and RRC

Figure 4.12: Effect of long-run fixed costs on total cost
Costs
£ The steps result from the increases
in fixed costs as output is increased
Long-run Average Total Costs
Output
The "flat" part of the average cost curve is prolonged. The question is whether this merely
stretches the average cost curve – delaying the point of eventual diminishing returns and the
rise of the U shape – or whether it can be continued indefinitely, in order to prevent the U
shape completely and make the long-run average cost curve L-shaped.
The relationship between short-run and long-run average cost curves is sometimes shown
as in Figure 4.13. This emphasises the fact that one reason for the increase in fixed factors
and costs is to overcome the effect of short-run diminishing returns.
Figure 4.13: Relationship between short-run and long-run average cost curves
Costs As diminishing returns are experienced in the short run, fixed

£ factors are increased and the firm can continue to increase
output without serious long-run diseconomies of scale.
Short-run Average
Cost Curves
Output
© ABE and RRC

C. ECONOMIC COSTS
We are now beginning to see production costs from a variety of angles.
 Opportunity Costs
These were identified in Study Unit 1. They may be defined as the cost of using
resources in one activity measured in terms of the lost opportunity of using them to
produce the best alternative that had to be sacrificed.
 Absolute Costs
These are the full costs of the factors used in the activity under consideration. They
may be measured in monetary terms but the real absolute cost is best measured by
the actual quantity of factors used, e.g. the amount of land or the numbers of people
employed.
 Private Costs
These are the costs actually paid by the producer to the owners or providers of the
production factors employed. They are the costs usually taken into account by the
accountant and are measured in monetary terms, since the accountant has to account
for the use of whatever finance has been entrusted to the production organisation. We
have been looking at these costs in this study unit and have also examined the
important distinction between fixed and variable costs.
 External Costs or Social Costs
These are the indirect costs imposed on other firms or individuals as a consequence of
the process of production by firms. Because these costs are imposed on others in
society they are also known as social costs to distinguish them from private costs.
Producers have to pay for the direct costs they incur in production (their private costs),
but do not take account of the external costs they may also be imposing on society.
The main source of such external costs is pollution of the environment. If an electricity
supply company burns coal or gas to generate electricity the company pays the market
price for the coal or gas it burns as its main input into the production of electricity (its
main variable factor of production). Unfortunately for society, and the world
environment, the large-scale burning of coal or gas not only generates electricity, it
also releases large amounts of pollution into the atmosphere, especially carbon which
is a major factor in global warming. Unless governments take action to deal with this
problem, by imposing taxes on the use of combustible fuels to generate electricity, the
social cost is not taken into account by electricity producers when they decide which
fuel and how much of it to use.
We will look at these issues in more detail in Unit 6.
D. COSTS AND THE GROWTH OF ORGANISATIONS

Returns to Scale
We have already seen the results of increasing inputs of a variable factor when at least one
other production factor is held constant. We saw that this was likely to bring about first
increasing, followed by constant and then diminishing marginal returns. However we have
also pointed out that, in the long run, all factors can be increased: there is the possibility of
economies of scale resulting for the continued growth in size of the firm. We must now look
at this possibility more closely, but first we must be clear as to the meaning of returns to
scale when all factors are being increased. If a given proportional increase in factors results
in a larger proportional increase in output, then the firm is enjoying increasing returns, or
© ABE and RRC

economies of scale. For example this would be the case if a 10 per cent increase in factor
inputs produced a 20 per cent increase in production output.
If the proportional increase in output is the same as the proportional increase in factor inputs
(e.g. when a 15 per cent increase in factors produces a 15 per cent increase in output) then
the firm is experiencing constant returns. However if a 15 per cent increase in factor inputs
produces less than a 15 per cent increase in output (only 10 per cent, say) then the firm is
suffering decreasing returns, or diseconomies of scale.
Economies of Scale
Real scale economies, as defined here, should be distinguished from purely pecuniary or
monetary economies. The latter do not represent a more efficient use of factors; rather they
are the result of the superior bargaining power of the large firm in the market. For instance, a
large customer can often gain discounts greater than can be justified on the grounds of
savings in delivery or distribution costs. Or workers in some large firms may be willing to
accept a lower wage in return for what is believed to be greater security of employment or
the social prestige of working for a famous organisation. Real economies – the genuine
efficiencies in the use of production factors resulting from growth in the scale of activities –
can be identified in the following main areas.
 Labour Economies
Labour economies result from greater opportunities for the division of labour which
increase with the skills of the workforce, save time and allow greater mechanisation.
The automated assembly line in modern motor vehicle assembly is an extreme
example of this.
 Technical Economies
Technical economies result chiefly from the use of specialised capital equipment.
Large firms are able to make use of equipment that could not be fully employed by
smaller operations, and large firms are also able to support reserve machines to avoid
disruption following breakdown. A small firm, using three machines, adds one-third to
its capital cost if it tries to add a further machine to keep in reserve. A large firm
employing 20 machines adds only one-twentieth if it decides to do likewise.
 Marketing Economies
Very great economies are available from large-scale advertising. A television
commercial using top stars is very expensive to make, but the cost per potential
customer is very low if essentially the same film can be shown in several different
countries. Large firms can also afford to keep very skilled marketing specialists fully
employed.
 Financial Economies
Large firms are able to obtain finance from markets that are denied to small firms, and
multinationals can raise money in many different countries. Nevertheless, although
financial economies still exist, we do have to recognise that finance markets have, in
recent years, become more responsive to the needs of smaller enterprises.
 Distribution and Transport Economies
Transport movements and the location of depots can be carefully planned by large
organisations, so that vehicles and storage space are used efficiently.
 Managerial Economies
Managerial economies arise from the employment of specialised managers and
managerial techniques. However many of these techniques have been developed in
order to overcome the problems of managing large organisations, and many
© ABE and RRC

economists suggest that managerial economies of scale are often exaggerated and
difficult to achieve in practice.
Diseconomies of Scale
Diseconomies of scale are usually associated with the problems arising out of the
management and control of large organisations. Formal communication systems are
necessary but are expensive to maintain. Whereas the manager of a small organisation can
see what is going on around him or her in the course of daily work, the manager of a large
firm may have to establish an inspection system to obtain equivalent information – which is
unlikely to be as reliable.
There can also be a loss of control over managers at the lower levels of the managerial
pyramid. These managers may then pursue their own private objectives (e.g. building up the
power of their own department) at the expense of efficiency and profitability.
So diseconomies of scale are mostly managerial. If diseconomies just balance economies,
e.g. when a 10 per cent increase in factor inputs produces the same 10 per cent increase in
production output, the long-run average cost curve will have the L shape of Figure 4.14. If
economies of scale continue roughly to balance diseconomies, this shape may be retained
over a long period. However if diseconomies start to rise substantially, then the long-run
average cost will again start to rise.
Figure 4.14: Long-run average cost curve
Costs
£
Long-Run Average Costs
Minimum Efficient Output

Scale
Notice here the position of what is called the minimum efficient size (or scale) (MES), also
known as the minimum optimum scale (MOS). Up to this output level there are significant
gains from internal economies of scale. Firms operating below the MES are at a cost
disadvantage when competing against those operating up to or beyond that size. However
beyond the MES further cost savings are not significant, and there is no cost advantage in
further growth. On the other hand the shape of the curve can change as firms learn how to
overcome sources of inefficiency, in particular managerial inefficiency, especially when new
managerial skills and communication technology are introduced. It is possible to control very
© ABE and RRC

large firms today in ways that would have been impossible half a century ago. Jet travel and
modern telecommunications, not to mention computers and microelectronics, have
transformed management techniques.
External Economies
The economies of scale listed earlier all apply to the individual firm; they are known as
internal economies of scale. There are other economies that are external to the firm. These
arise when an industry grows large or when business firms congregate in a particular area.
External economies usually arise from the development of specialised services available to
many firms. For example, an area containing numbers of small engineering companies may
provide opportunities to support one or more specialised toolmakers. Each engineering
company can call on the specialist, without having to carry the full cost of having its own
specialised department. External economies help small firms to survive in competition with
larger organisations. However, if one or two companies become dominant and they
internalise these economies by setting up their own specialised departments which they are
large enough to keep fully employed, then the external economies may be lost to the smaller
firms, which can then no longer survive in the market.
The Law of Diminishing Returns, Returns to Scale and Economies of Scale

The shape of a firm's average cost curve in the short run is determined by its fixed factors of
production, usually machinery, buildings or land, and the unavoidable operation of the law of
diminishing returns. At some point as a firm tries to squeeze out yet more output from its
fixed physical capacity by application of additional workers and materials, it will start to
experience diminishing marginal product and its unit cost of production will start to rise at an
increasing rate. The firm's short-run average cost curve will thus always turn up at some
point and have a U shape. The downward sloping portion of the U-shaped cost curve is not
due to economies of scale, because the scale or size of the firm is fixed in the short run.
Likewise, the upward sloping portion of the U-shaped cost curve is not due to diseconomies
of scale, because the scale or size of the firm is fixed in the short run. The shape is
determined by what happens to the marginal product of successive inputs of variable factors
to a fixed factor – the law of diminishing returns.
Economies and diseconomies of scale relate to what happens to a firm's average or unit cost
of production as the firm increases its output by expanding the availability of all the factors of
production it needs. That is, economies and diseconomies determine the shape of a firm's
long-run average cost curve. If a firm benefits from economies of scale, as it expands in the
long run it experiences increasing returns to scale as its average cost of production falls. In
contrast, if a firm suffers from diseconomies of scale, as it expands it will experience
decreasing returns to scale as its average cost of production increases. These relationships
are summarised in Table 4.5.
Table 4.5: Relationships between economies of scale, returns to scale and unit costs
Neither economy nor Constant returns Constant unit

 
diseconomy of scale to scale cost
Increasing returns Decreasing unit

Economy of scale  
to scale cost
Decreasing Increasing unit

Diseconomy of scale  
returns to scale cost
© ABE and RRC

E. SMALL FIRMS IN THE MODERN ECONOMY

It is sometimes assumed that because of economies of scale, large firms are always likely to
be more efficient and produce at lower cost than small firms. If this were true, small firms
would be much less numerous than they are. Of course, one reason for their survival is that
the definition of a small firm tends to change in time. As the average size of the firm grows,
so firms which would have been considered large become classified as small. Moreover, if
we take as the main qualification to be considered a small firm, the requirement that the
whole enterprise is controlled by a small group of employer-managers, continued advances
in technology, including information technology, enable one or two people to control larger
enterprises. This means many more firms can now grow larger but remain, in fundamental
respects, small.
Economies of Scale
A closer look at economies of scale shows that large firms are not always inevitable. If we
assume that the typical successful large company has an L-shaped cost curve, this can still
cover a number of different possibilities.
Figure 4.15 shows two possible long-run average cost curves. It shows that each reaches a
point where further cost reductions as output increases are very small. As noted in the
previous section, this point is known as the minimum efficient size: it is reached at 0b for
industry B and 0a for industry A. We would therefore expect firms in industry A to be rather
larger than in industry B. There is no further significant advantage for firms when they grow
beyond these points.
Of course this minimum efficient size must be related to the size of the market. If for
example industry B served a much larger market than industry A, then we would expect
many more firms competing in B than in A. Some world markets have room only for a very
few firms. Here, fixed costs are very high and only very large organisations can consider
entry. The oil industry is an example of this.
Figure 4.15: Long-run average costs for A and B
Costs
£
Industry A
Industry B
0 b a Output
© ABE and RRC

In contrast, the manufacture of many kinds of plastic household fittings does not require very
expensive equipment, and many small firms are able to compete successfully in the market.
The general term "economies of scale" also covers both internal and external economies,
and it is only internal economies that favour large firms. External economies, such as
specialised services, are available to all firms in an area or industry, and these often help
small firms to survive. It is when the number of small firms drops below the level necessary
for the survival of the specialist as an independent organisation that all the remaining small
firms are faced with severe problems, and may have to disappear.
Special services to industry – such as industrial cleaners, photographers, and designers –
often serve a restricted market and are likely to remain small. This is especially likely to be
true if the service is localised. The service may only be needed occasionally by any one firm,
but when it is needed the need is urgent and someone has to be found very quickly. Small
local firms are better placed to provide a satisfactory service than a large national
organisation.
The MES is not the only determinant of the size of firm likely to be found within an industry.
The attitudes, abilities and objectives of owners or senior executives play an important part.
In the UK Marks and Spencer became a national retail chain in a period when most retail
shops were small family firms, as did other high street retailers such as W H Smith,
Woolworths and Boots. We can always expect to find some large firms in sectors when small
firms form the majority.
At the same time we are also likely to find small firms in industries where the MES is large,
apparently implying that only very large firms could survive. This may be because they serve
a specialist niche which forms a small part of a larger market. Industry definitions can be
misleading. For example the term "motor industry" covers activities ranging from motor
vehicle assembly to the manufacture of small, specialised components. These activities are
not really comparable and the MES for a component manufacturer could be much smaller
than for vehicle assembly. Nevertheless it is the giant corporations which dominate the
industry. If one of these fails, large numbers of the satellite firms which supply goods and
services to it are also likely to fail. If the dominant firms all prosper, the satellites also
flourish.
Services
Services generally tend to be smaller than manufacturing organisations, although there are,
of course, some very large service firms developing in activities such as law, accounting and
business consultancy. On the other hand, these large firms tend to serve large-scale
customers. A leading international accountant is not really suited to do the books of the small
corner shop. In any case, the shop would not be able to pay the accountant's fees. There will
always therefore be small local firms of accountants, solicitors and so on. If any of these
meet problems they cannot handle themselves, then they may be able to call on the
specialist services of the giant.
As the service sector (including the rising leisure services) of the economy grows, so the
scope for small firms continues to increase. As already suggested, new technology based on
the microchip and the microcomputer/personal computer is enabling the small firm to
achieve a level of administrative efficiency that would have seemed impossible only a short
while ago. A business owner who can afford to spend around one to two thousand pounds
on a personal computer, software packages and a printer can maintain accounting and
secretarial services with just one or two people. In contrast the same standard of service
would have required an office of 15 or more people 30 or so years ago – or a very expensive
mainframe computer complete with specialist programmer.
© ABE and RRC

The Role of Small Firms in the Economy

The part of the business sector that contains the small to medium-sized enterprises (SMEs
for short), employing between 5 to 250 workers, is now recognised to be the main source of
employment in most economies. Large firms tend to be visible to the public not only because
of their physical size but because they usually have well-known brand names which are
promoted at home and abroad by extensive marketing. But in most countries the number of
very large firms is small in comparison to the very large number of SMEs. Not only do SMEs
provide the main source of employment, they also turn out to be the most important source
of entrepreneurial development and innovation in both products and processes in the
economy. Very large companies may have large research and development (R & D)
departments, and very large budgets devoted to R & D, but the evidence is that such activity
is also subject to diseconomies of scale and inefficiency. In modern dynamic economies the
main source of innovation tends to be the SME sector, and not the very large companies,
especially the state-owned or controlled firms. The importance of SMEs for the health and
growth of economies, as well as the source of most jobs, has been recognised by
governments in many countries and policies have been introduced to support and promote
the development of SMEs.
Traditionally, the small-firm sector has been seen as the seedbed of enterprise and the
nursery in which tomorrow's giants are reared. The microcomputer industry itself is an
example. It was not the giant computer monopolists that produced the microcomputer, but
brilliant electronics engineers and programmers working on their own initiative. There will
always be scope for the entrepreneurial genius as evidenced by such companies as
Microsoft, Apple and Google.
In recent years the earlier tendencies which resulted in large firms internalising specialised
activities have been reversed. Specialist departments which had proved difficult to keep fully
employed have been closed, and in many cases the specialists have been helped to form
their own businesses, supported with contracts from their former employers. These newly
independent firms are once again able to provide their specialist services to large and small
organisations. This trend has been developed further by the growth of outsourcing and "off-
shoring" of business functions to external specialist providers.
New communications technology is leading to a revival of a very old form of enterprise –
what may be seen as a collection of independent firms, all working under the overall
guidance of a central, largely marketing, organisation. Computer software production is often
produced on this basis, with self-employed programmers producing software to detailed
requirements set by the central marketing body.
Although the life expectancy of the majority of small firms continues to be short, there are
nearly always people willing to fill the gaps left by the casualties. The small firm sector as
such continues to exist, and the record of innovation and enterprise from small firms
compares favourably with the large corporations. A healthy and dynamic economy requires a
diversity of firms of all sizes and activities. Most large organisations have occasion to rely on
the services of small firms: often they use them to fulfil contracts which are too small for
them to carry out profitably, but which are necessary to retain the goodwill of valued
customers. Moreover the continued existence of smaller rivals can often be a healthy
reminder to large corporations that they are neither immortal nor indispensable. The growth
of own-brand labels developed by the large supermarket chains has provided openings for
many smaller manufacturers, who could not otherwise have hoped to compete with the
established food corporations.
The flexibility and versatility of the modern market economy depends on the existence of
many different sorts and sizes of organisation, and this diversity is essential to the
maintenance of high living standards and wide employment opportunities.
© ABE and RRC

Review Points
relevant sections.
1. Explain why a firm's short-run average cost curve is U-shaped.

2. Explain why some firms' long-run average cost curve is downward sloping.
3. From the alternatives listed, complete the following:
total cost ÷ total output 
(a) fixed cost
(b) marginal cost
(c) average cost.
4. Which of the following alternatives is marginal cost is defined as:
(a) the total cost of producing an additional unit of output
(b) the addition to total cost from producing an additional unit of output
(c) total variable cost divided by output
(d) the cost saving from economies of scale as a firm increases its output?
5. Which of the following will not lead to an economy of scale as a firm expands in size:
(a) a reduction in external costs
(b) large-scale advertising
(c) financial economies
(d) transport and distribution economies?
6. A firm expands and doubles its factory size, number of employees and the number of
machines and vehicles it uses in production. As a result of this increase in size its
average cost of producing each unit of output falls by 20 per cent. Is this an example
of:
(a) a diseconomy of scale
(b) the law of eventual diminishing returns
(c) increasing returns to scale
(d) a U-shaped short-run average cost curve?
© ABE and RRC

© ABE and RRC

73
Study Unit 5
Costs, Profit and Supply
Contents Page
A. The Nature of Profit 74

Profit as a Factor Payment 74
Normal and Abnormal Profit 74
Profit as a Surplus 75
Summary of Explanations of Profit 76
B. Maximisation of Profit 77
Calculation 77
Profit Maximisation 81
Do Firms Maximise Profits? 82
When to Stop Producing 83
C. Influences on Supply 84
Costs and Supply 84
Supply Curve 86
Other Influences on Supply 87
Effect of Other Influences on Supply Curve 88
Relative Importance of Supply Influences 89
D. Price Elasticity of Supply 89

Calculation of Elasticity 89
Elastic and Inelastic Supply Curves 90
Elasticity of Supply in the Long Run 93
© ABE and RRC

74 Costs, Profit and Supply
Objectives
The aim of this unit is to: explain the concept of profit maximisation and solve problems using
diagrams and data; explain the link between a firm's supply curve and its cost functions.
 explain, using appropriate examples, the difference between fixed cost and sunk cost
 explain, using words, diagrams and numerical examples, how a firm reaches its profit-
maximising choice of output with reference to marginal cost and marginal revenue
 solve diagrammatic and numerical problems of profit maximisation
 explain using diagrams how a firm chooses whether or not to stay in operation or leave
the industry in the short and long run
 explain how a firm's supply curve is derived from an analysis of its cost functions
 explain the reasons for movements along and shifts in supply curves
 state the formula for the elasticity of supply
 explain the effect of changes in the elasticity of supply on the diagram of a supply
curve
 solve numerical problems of the elasticity of supply based on data.
A. THE NATURE OF PROFIT

The simplest definition of profit is that it is the excess of revenue over cost. This is a little
deceptive, because in practice it is not always easy to decide what is revenue and what is
cost. There are also problems arising from changes in the value of property. For example,
the value of a building may rise or fall for reasons that have nothing to do with the trade
carried on in that building. However at this stage it is convenient to overlook problems of this
kind, and keep to the idea of profit as the excess of the revenue gained by selling products
over the cost of producing those products.
Nevertheless this definition does not satisfy the economist's desire to explain why profit
exists and what its economic function really is; and here we come up against two rather
conflicting ideas. On the one hand there is what might be called the traditional view of profit
as a payment to a factor of production, just as wage is the payment to labour or rent the
payment to capital. On the other hand there is the view that profit is surplus which remains
when the payments to production factors have all been made. Both views present difficulties
as we shall now see.
Profit as a Factor Payment

Although considered by many as being rather old-fashioned and difficult to reconcile with
modern realities, this is the view which still dominates most of the basic economics
textbooks. As far as it is possible to tell, it also represents the thinking of most of today's
examiners of economics in the professional examinations. You must therefore take it into
account. Attempts to reconcile the idea of profit as a factor payment with the reality – that it
is both very uncertain and subject to all kinds of pressures, as well as being impossible to
predict or guarantee – have resulted in the development of the concepts of "normal" and
"abnormal" profit.
Normal and Abnormal Profit

Here profit is seen as a payment to a fourth factor of production, the factor "enterprise".
Enterprise is provided by entrepreneurs, people who take economic risks by organising and
© ABE and RRC

Costs, Profit and Supply 75
combining the other factors to produce goods and services for sale in the markets. Normal
profit is thus frequently described as the reward to the entrepreneur – an attractive idea, but
one which raises many difficulties.
 How do we quantify "normal"? The usual answer to this question is to suggest that it is
the minimum necessary to keep the entrepreneur in the market. However, this surely
depends as much on conditions in other possible markets as on the amount of profit
available in the one under scrutiny. Firms that have been operating in a particular
market for a lengthy period, or which operate in that market only, face greater costs of
transfer to another market than newcomers, especially those which already operate in
many markets. Thus, the minimum required to keep firm A in the market is unlikely to
be the same amount as that sought by firm B. As economics has become more and
more precise, scientific and mathematical, fewer people have been prepared to accept
a concept as vague and unquantifiable as "normal" profit, in this sense.
 Who is the entrepreneur entitled to normal profit? The early economists who developed
the concept were accustomed to markets containing small, individually owned and
controlled firms, so that the entrepreneur who was the driving force behind the firm
was usually identifiable without much trouble.
However modern markets are dominated by large, corporate organisations with clear,
bureaucratic, managerial structures. The success of this type of enterprise may lie as
much in the ability of managers to reduce risks as to take them. While individual
managers may be expected to show enterprise in their work, this is rarely rewarded
directly with a proportionate share in profits – even if the profit attributable to the
enterprise shown could be calculated. The statistical profit of the organisation belongs
legally to the ordinary shareholders, who are specifically denied any right to share in
management and who rarely have much detailed knowledge of the activities of the
organisation. When we further recognise that modern large public companies are likely
to operate in many markets in many countries, we have to agree that all this is
impossible to reconcile with the definition of normal profit.
However if it is accepted that there is such a thing as normal profit then this implies that
there can be "abnormal" profit. Some textbooks do in fact describe all profits above the
normal as abnormal. Others, clearly unhappy at the emotive implications of this term, use
the less derogatory "supernormal". In either case, the impression is usually given that firms
should not be permitted to earn profits above normal.
Instead of either abnormal or supernormal, some writers have referred to what they call
"pure profit", by which they appear to mean any surplus over and above all payments to
factors including the normal profit due to the entrepreneur.
Profit as a Surplus
If we see profit not as a factor payment but as a surplus remaining after the production
factors have been paid for, the question then arises as to who owns, or should own, this
surplus.
To Marxist economists the answer is clear. Economic value is created by human labour,
without which there can be no economic activity. The berries growing wild on the bush
belong to the picker, whose labour of picking has turned them into food. Thus any surplus
created by work belongs to those who carry out the work. Therefore profit, to the Marxist who
does not recognise a separate entrepreneur, belongs to the workers. However, the Marxist
recognises that in the modern capitalist society where production is organised by the owners
of capital and, in the Marxist view, for the benefit of the owners of capital, profit, is in
practice, allocated to the owners of capital.
If this view is accepted, profit, not interest, becomes the payment to the owners of capital. To
the Marxist, the fact that it is paid to the owners of capital rather than to the rightful owners,
© ABE and RRC

the contributors of labour, is the result of the domination of capital over labour in the modern
capitalist society.
In support of this view it is possible to point to company law, which provides that a company's
profit belongs to the company's shareholders or, more precisely, to the contributors of the
"risk capital" or "equity", the ordinary shareholders – in American terminology, the common
stockholders. There is no legal requirement that the company should share its profits with
the suppliers of labour (employees) or with the suppliers of loan capital, who receive their
agreed rate of interest.
Still largely accepting this concept of profit as a surplus, other economists, some of whom
belong to what has been called the "Austrian school", take a very different view of its
economic function. They see it as the driving force of the modern economy and the incentive
which has been largely instrumental in bringing about the enormous improvement in general
living standards in the market economies over the past two centuries. They see the striving
for profit as the force that produces new products, new production technology, new forms of
business organisation and new uses for basic resources. The profit that produces this
economic energy and invites people of all kinds to take risks with their own resources of
money, time and futures, is not "normal profit" but the largest possible profit that can be
made in the circumstances within which business operates. There is no need to distinguish
between normal and abnormal profit. All profit is necessary to stimulate future economic
activity and to provide the investment finance necessary to make the activity possible and
raise the level of technology.
Unlike Marxists, the economists who take this view do not see profit as being stolen from
workers, nor do they see any need for labour to be given only the lowest possible wage.
Indeed for business enterprise to succeed, goods and services have to be sold to workers
whose incomes are well above subsistence levels, who have disposable incomes and the
freedom to choose how to spend these incomes and who expect to have rising incomes.
Workers therefore benefit from profitable economic activity by earning rising wages.
Summary of Explanations of Profit

One economist who recognised the various ways in which profit has been explained was the
great American writer and teacher, Professor Samuelson. He identified six distinct "views",
which can be summarised as follows:
(a) Profit is seen as a balancing item and a result of accounting conventions but should
properly be seen as a return to one or more of the production factors. For example,
most of what accountants show as the "profit" of the majority of small family firms
would better be described as the proprietor's wage for his or her physical and mental
effort and interest on his or her personal savings invested in the business.
(b) The second view sees profit as a reward to "enterprise and innovation" and a return for
the temporary monopoly achieved by being first in the field with a successful new
commercial idea.
(c) The third sees profit as a reward for successful risk-taking. Although willingness to take
risks does not always (or often) bring compensating profits, it is usually the hope of
earning such profits that provides the spur to help business people overcome their
natural inclination to avoid risk.
(d) The fourth view simply takes the third view further; profit is a positive incentive to "coax
out the supply of risk-bearing capital". It is the high return sought by providers of what
is often known as "venture capital".
(e) The fifth view regards profit as a return to monopoly, whether natural or achieved by
artificial means. It is this association of abnormal profit with monopoly that has
coloured so much teaching about business profits and objectives.
© ABE and RRC

(f) The sixth view recognises the Marxist explanation of profit as surplus value which, for
Marx, was properly the reward of the labour that created the value but which, in a
capitalist economy, is appropriated by the owners of capital.
Clearly there is no simple or generally agreed explanation of the economic function of profit,
though most would agree that both profit and a spirit of enterprise are extremely important
elements in modern market economies.
B. MAXIMISATION OF PROFIT
Calculation
We can arrive at the amount of profit for any given level of output in at least two ways. We
can calculate total revenue and total cost and find the difference, or we can calculate the
average revenue and the average cost, find the difference and multiply this by the quantity
sold.
We shall first consider profit as the difference between total revenue and total cost. Suppose
we return to the example of the last study unit and assume that all units of the product are
sold at a given market price of £210 per unit. Costs remain as before. We can now show
total revenue and cost columns for each range of output up to 150 units per week – as in
Table 5.1.
Table 5.1: Total cost and total revenue
Quantity Total Cost Total Revenue

(output level  £210)
(units per week) £ £
0 10,000 0
10 11,000 2,100
20 11,600 4,200
30 12,000 6,300
40 13,000 8,400
50 14,000 10,500
60 15,000 12,600
70 16,000 14,700
80 17,000 16,800
90 18,150 18,900
100 19,500 21,000
110 21,150 23,100
120 23,250 25,200
130 26,000 27,300
140 29,550 29,400
150 34,000 31,500
From this table we can see that revenue exceeds total cost at output levels 90 to 130 units
per week. At all other output levels, total costs are greater than total revenue, so losses
would be suffered.
Table 5.2 shows the profit at each output level.
© ABE and RRC

Table 5.2: Profit at different output levels
Quantity Profit
£
90 750
100 1,500
110 1,950
120 1,950
130 1,300
The position is illustrated in Figure 5.1, where the shaded area represents the profit
produced when total revenue is greater than total cost.
Figure 5.1: Profit in terms of total revenue and total cost
Cost/ 36000
Revenue/
Profit (£) 32000 Total Cost
28000 The shaded areas show the profit where Total

total revenue exceeds total cost Revenue
24000
20000
16000
12000
8000
4000
Profit
0
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150
Units Per Week
The same position is shown by the average cost and price/average revenue curves of Figure
5.2. In this case however the shaded area does not represent the total profit, but the profit
per unit of output. Total profit would be given by multiplying the profit per unit by the number
of units produced.
In this example, the firm is selling all units at a given price, so that the total revenue curve
continues to increase – though this does not of course mean that it is possible to make a
profit at output levels above 130 or so units per week.
© ABE and RRC

Figure 5.2: Profit in terms of average revenue and average cost
(£) 600
550
Average Cost
500
450
400
350
300
250
Average Revenue
200
 Price
150
100
50
0
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150
Units Per Week
We saw in an earlier study unit that the revenue position could be rather different where the
firm had to reduce price in order to increase output. Such a situation is illustrated in Figure
5.3. No specific figures are shown here – this is a general model – and it shows that the firm
can make profits at all output levels between Oa and Ob.
These levels, where total revenue just equals total cost, are called the break-even output
levels or sometimes break-even points.
It is often more convenient to show the average cost and revenue curves (see Figure 5.4).
If we assume that the firm is selling all units at any given output level at the same price (i.e.
is not discriminating between different customers over price) then the average revenue curve
is also the price/output curve (i.e. the demand curve). In this model, we can also see that the
firm makes profits between output levels Oa and Ob. This is the quantity range where
average revenue is greater than average cost.
© ABE and RRC

Figure 5.3: Break-even output levels
Revenue/
Cost (£)
Total Revenue
Total Cost
Oa and Ob are called

break-even output levels
O a b
Output
Figure 5.4: Profits, average cost and average revenue
(£)
Profits are made between
output levels Oa and Ob
Average Revenue (Price)
Average Cost
O a b
Output
© ABE and RRC

Profit Maximisation
So far we have seen the output levels where profits are made, but we have not yet identified
the output level where the largest possible (maximum) profit can be made. However, if we
refer back to our profit table, we see that there are two points where profits are at their
largest – at output levels of 110 and 120 units per week. Here, total profit stays at £1,950. If
the firm wants to make the largest possible profit, it can choose either of these two levels. It
is not unusual for profit to have a rather "flat top" and stretch across two stages in this way.
In other cases it can peak at a single stage.
Now look back at Table 4.4 in the Study Unit 4, which showed marginal costs. Bearing in
mind that we assumed the firm to be selling at a constant price of £210, look at the marginal
cost column. We have explained that, when the firm can sell at a constant price at all levels
of output, the price is also the average revenue and the marginal revenue. Thus, in this
case, the firm's marginal revenue is £210. If you look down column 4, you will see that the
marginal cost is £210 at the midpoint, representing the change from output level 110 to 120
units per week. This is precisely the output range where profits are at their highest level, i.e.
£1,950.
This is no accident. It illustrates the general rule that profits are always maximised at the
output levels where marginal cost is equal to marginal revenue.
The general position is illustrated in Figures 5.5 and 5.6. Figure 5.5 shows the case where
average revenue equals marginal revenue (constant price at all output levels) and Figure 5.6
shows the sloping average revenue curve with the marginal revenue curve in the correct
position, as we explained before.
Figure 5.5: Profit maximisation – marginal revenue equals average revenue
Revenue/
Cost
Profits are maximised at Ob
Marginal Revenue 
Average Revenue
Marginal
Cost
O a b c
Quantity
© ABE and RRC

Figure 5.6: Profit maximisation
Revenue/
Cost
Profits are maximised at Ob
Marginal Cost
Marginal
Revenue
Average Revenue
O a b c
Quantity
In both cases, the argument is the same. It does not matter whether the marginal revenue
curve slopes or not. If the firm produces at output level Oa, i.e. below the level where
marginal cost equals marginal revenue, it would pay it to increase output because the
revenue received for each additional unit is greater than the cost of producing that unit. If the
firm is producing at output level Oc, above the level where marginal cost equals marginal
revenue, then it will pay it to reduce output because revenue lost for each unit of output
sacrificed is less than the cost of its production. Only at output level Ob, where marginal cost
equals marginal revenue, will it pay the firm to stay at the same level. It cannot then increase
profit by any change in quantity produced. This is the level where profits are maximised.
This is a most important rule which you should remember carefully, i.e. to maximise profits
the firm produces at the output level where marginal cost is equal to marginal revenue.
Do Firms Maximise Profits?

It is often argued that we should not automatically assume firms do seek to maximise profit.
It is suggested that they may have other objectives, e.g. to maximise revenue, to increase
output or to achieve a given share of the market, or simply to please and reconcile the
conflicting objectives of shareholders, managers and employees.
All this may be true – many firms may not be seeking to maximise their profits. Many may
not have sufficient information about market demand and their costs to maximise profits
even if they wished. On the other hand, this does not rule out our view that the profit-
maximising output level and the rule for achieving this are matters of very great importance
for an understanding of business decisions. The firm may decide to sacrifice some profit in
order to pursue some other objective, but it should know how much profit is being sacrificed.
An assumption of profit-maximising behaviour is an essential starting point for the analysis of
the business organisation. As long as we recognise that it is not necessarily the finishing
point, then we can accept this assumption at this stage of our studies unless there is a very
good reason to do otherwise.
© ABE and RRC

When to Stop Producing

Firms are in business to make a profit. What should a firm do if it cannot make any profit?
When should a firm close down and leave the market?
The answer to these questions is straightforward for the longer-term period. If a firm cannot
cover all its costs and operates at a loss it will quickly become insolvent and cease
production. But should a firm always cease production if it runs at a loss? The answer is not
in some circumstances.
There are conditions in the short run when a firm should continue to produce, despite not
being able to cover all its costs. This is because if it were to cease production its loss would
be even greater. To understand how this can happen it is necessary to return to a
consideration of a firm's costs. A firm's total cost of production consists of two components,
fixed costs and variable costs. Variable costs are the wages of staff, the cost of the materials
used in production and the cost of energy, such as electricity or fuel oil. Clearly, if a firm
stops production it no longer needs such variable inputs and can immediately reduce its
costs accordingly. The same is not true for the firm's fixed costs.
Fixed costs can include such things as an annual property tax or business rate on a firm's
factory or offices, the annual rent paid to the owner of the buildings or land used by the firm,
contracts to hire machinery or vehicles, and even annual employment and salary contracts
for some of the senior or technical staff. All of these costs have one thing in common: they
are agreed or known in advance. Contracts are signed and require payments to be made for
an agreed period which could be months or several years. If the firm ceases production it is
still contractually obligated to go on paying these fixed costs, unless the terms of agreement
allow it to cancel its contracts, or the contracts come up for renewal. Thus in the short run a
firm is faced with costs even if it produces nothing. This fact has an important implication for
the firm's decision to cancel or continue production in the short run, even when it knows that
it will stop producing in the long run. Provided a firm can cover its variable costs of
production and make some contribution to its fixed costs it should continue to produce in the
short run. By continuing to produce the contribution it makes to its fixed costs it reduces the
magnitude of its loss. That is, if a loss is unavoidable in the short run, a smaller loss is
preferable to a larger loss. Despite the fact that it involves a loss this is actually another
example of profit maximising behaviour in the sense that the firm is minimising its loss which
is the best thing it can do in the situation it faces.
Figure 5.7 illustrates the logic of such a decision. In the graph the firm's average fixed cost
curve falls continuously from left to right, because as it increases production its fixed costs
are spread over more and more units of output and become less and less significant. The
firm's average variable cost curve has the usual U-shape, reflecting the law of eventual
diminishing returns. The firm's average total cost curve is the sum of its average fixed cost
and average variable cost. Because average fixed cost becomes smaller and smaller as
output increases the average total cost and average variable costs curves move closer and
closer together at higher levels of output. The firm's marginal cost curve is also shown in the
graph. To determine the firm's profit maximising level of output we also need to know its
marginal revenue curve. Suppose, for ease of exposition, that the firm is operating in a
market situation where it can sell every unit of output at the same price. In this case its
marginal revenue curve is a horizontal straight line at the level of the market price. It is also
its average revenue curve.
In Figure 5.7 the profit maximising point where MC equals MR occurs at a price which is
below the firm's average total cost. If its average revenue is less than its average cost it also
follows that its total revenue must be less than its total cost and production is making a loss.
Nevertheless, it still makes sense for the firm to continue to produce output OQe in the
short-run, despite its loss, because at that output level it is covering its average variable
costs and part of its fixed costs. Its optimum output is OQe because it minimises its loss in
© ABE and RRC

the short run. In the longer run all costs are variable and the firm will cease production
unless the market price increases to a level at which its total revenue exceeds its total costs.
Figure 5.7: Loss-making production
Costs and Average

Revenue Marginal Total Cost
(£) Cost
Average
Variable
Cost
Price AR  MR
Average
Fixed Cost
O
Qe Output
We can now derive a decision rule for firms regarding whether they should continue or cease
production in the short run even when production is unprofitable. A firm should continue to
operate at a loss in the short term provided its average revenue exceeds its average variable
cost. That is, by choosing to produce anywhere in the range between its average variable
cost and its average total cost, the difference between them being average fixed cost, the
firm is recovering some of its fixed costs and reducing the magnitude of its unavoidable loss
in the short run.
C. INFLUENCES ON SUPPLY
Costs and Supply
If we accept that business firms exist to make profits, then we can recognise that there must
be a close link between costs, profits and the willingness of firms to produce the goods and
services that consumers wish to buy. After all, profit is the difference between revenue and
costs, so that at any given price the amount of profit will depend on production costs. If price
remains constant and costs rise, then profit falls and we can expect firms to be less willing to
supply goods and services. Similarly, if costs remain unchanged and price rises, then profits
will rise and firms will wish to supply more in order to secure the increased profit.
We thus have no difficulty in accepting the link between costs and the amount that firms are
prepared to supply at a given price or range of prices. If we accept the aim of profit
maximisation, then we can be a little more precise than this.
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Suppose a firm is seeking to maximise profits and can sell all it can produce at the ruling
market price. Suppose too that this market price can change. What will then be the firm's
response? Look at Figure 5.8. The profit-maximising firm will seek to produce at that output
level where marginal cost is equal to price, i.e. at quantity Oq at price Op, at Oq 1 at price
Op1, and Oq2 at price Op2.
Figure 5.8: Profit-maximising output levels
Price/
Cost The profit-maximising firm will seek to
produce at the output level where
marginal cost equals price
P2
Possible
P1
Prices
P
Marginal
Cost
O q q1 q2
Quantity
Thus we can see that the firm will increase the quantity it is willing to supply as price
increases – and, conversely, reduce quantity as price falls – and that the actual change in
quantity will be governed by the marginal cost curve.
Therefore under conditions of perfect competition, the individual firm's supply curve is its
marginal cost curve. Consequently, the market supply curve is derived from the sum of the
marginal cost curves of all the firms operating within the market.
This argument continues to hold good when we abandon the assumption of the firm
accepting the market price. If a firm faces a downward-sloping demand curve for its product,
and hence a downward-sloping marginal revenue curve, we still get the same increase in
quantity following the marginal cost curve if we again move the marginal revenue curve
outwards, further from the point of origin. This is shown in Figure 5.9.
Notice though that Figure 5.9 is drawn on the assumption that the average revenue curve is
moving outwards evenly and with its slope unchanged. There is no guarantee that this will
ever happen in practice. If the slope of the average revenue curve changes, then so too will
the slope of the marginal revenue curve, and there will no longer be the smooth increase in
quantity suggested by Figure 5.9. For this reason, we cannot say that, in imperfect markets,
the market supply curve will represent the sum of the marginal cost curves of the individual
firms. Nevertheless, the general link between supply and marginal costs remains, although it
is unlikely to be as direct as in perfect competition.
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Figure 5.9: Movement of marginal revenue curve
Revenue/
Cost Movement of the marginal revenue curve
following increases in demand and price
results in an increase in the quantity
supplied by a profit-maximising firm
Marginal Cost
O q q1 q2 Quantity
mr mr1 mr2
Here again, a movement of the marginal revenue curve produces a shift in quantity supplied,
in accordance with the marginal cost curve.
If you wish you can add the average revenue curves to this graph, and thus show the prices
corresponding to the three quantity levels Oq, Oq1 and Oq2. Remember the relationship
between average and marginal revenue, and remember that price will be shown by the
vertical line from any given quantity level to the average revenue curve.
Supply Curve
If we accept the view that firms will seek to increase the quantity supplied if price increases,
and reduce it if price falls, then we can produce a supply curve showing the amounts
involved. A supply curve can be for an individual firm – in which case, assuming profit-
maximising objectives, it will be the marginal cost curve – or for all firms supplying a
particular product, where it will be made up of the sum of the marginal cost curves of all the
firms supplying the product.
However the supply curve is formed, we can accept that its general shape will be as in
Figure 5.10. This shows the general assumption that more will be supplied as the price rises
– all other influences remaining the same.
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Figure 5.10: A general supply curve
Price
S
P1
P A general supply curve.

As price rises, more is supplied
O q q1
Quantity
Other Influences on Supply

The concept of the supply curve reflects the view that price is one of the most important
influences on the quantity supplied. However there are other influences, and these are
mostly concerned with the cost of production and with profits. Remember that in a market
economy, the great driving force for supply is profit, so anything that affects profit will affect
supply. In very broad terms, since profit is the difference between revenue and costs, supply
will be directly affected by anything affecting revenue, price and costs.
We can summarise some of the most important influences as follows:
 Costs of Factors and Other Inputs
Any change in costs, with price staying constant, will change the profit expectations
and will thus influence decisions regarding supply. For the profit-maximising firm, a
change in variable costs will change the marginal cost curve, and so change the supply
schedule. Examples of factor costs include wages, land and property rents, interest
rates on capital, basic material prices and the prices of fuel and power. Any of these
may also affect the prices of intermediate products and services required by the firm,
and so further influence supply.
 Changes in Taxes
If a government tax is charged at any stage of production or on the profits of the
business, then any change in the tax rate will affect the profits anticipated from supply,
and thus affect supply intentions. An increase in a production tax, such as value added
tax, will have the same effect as an increase in factor costs; it will tend to reduce the
quantity that firms are willing to supply at all prices in a given range.
 Changes in Technology
By technology is meant the methods of combining factors and inputs in order to
achieve production. An improvement in technology, which allows a given level of
production to be achieved with fewer factor inputs or with a different combination of
factors, so that the total cost is lower, will tend to increase the quantity likely to be
supplied at all prices within the range. Some types of technology may be possible only
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if production is required on a large scale. This can have a marked effect on supply.
Thus, small-scale supply may be possible only at much higher prices than large-scale
supply, when the different technology becomes worthwhile. The result may be to shift
the whole supply curve when production reaches the critical level required for the
large-scale technology.
 Efficiency of the Firm
Multinational production of similar products has shown that firms in country A can
sometimes produce more from a given combination of labour and capital than similar
firms in country B, even though production methods and levels of technology are all
much the same. Differences in the productivity of labour and capital (the amount
produced per unit of labour and capital) must, in these cases, be caused by differences
in managerial efficiency or in the conditions under which people work. In some cases,
the movement of managers from one country to the other makes little difference to the
gap in factor productivity. The causes of these differing levels of efficiency are not fully
understood, but they do help to explain why large multinational firms tend to prefer
some countries to others. A change in the level of business efficiency will of course
influence supply.
 Changes in Relative Profitability of Products
If a firm can produce either product X or product Y from similar factors, machines and
skills, and if it becomes more profitable to produce Y, then the firm is likely to switch its
production activities from X to Y. This may happen if the firm normally makes X, but the
price of Y rises while the price of X stays the same.
There can be other causes of production switches. If there are numbers of firms able
to choose between producing X or Y, and the market for Y suddenly disappears,
perhaps because of a political decision, then firms previously making Y will have to
switch to X if they wish to remain in business. The result will be to increase the supply
of X at all prices.
Effect of Other Influences on Supply Curve

All these changes can be illustrated by a movement of the whole supply curve, indicating a
change in supply intentions throughout the given price range. Such a shift in the supply
curve is illustrated in the general graphical model of Figure 5.11.
Figure 5.11: A shift in the supply curve
Price
S S1
P1
P0
A shift in the supply curve from
SS to S1S1 indicates a change
in the supply intentions at all
S prices in the range OP to OP1
P
S1
O q q0
Quantity
© ABE and RRC

A shift of this type may follow a change in one or more of the influences as previously
described. Moreover, several influences may be operating in different directions. For
example, a tax increase may be depressing supply intentions while an improvement in
technology is raising them. The final result depends on the relative strength of the
influences. It is not easy to analyse these effects through simple graphical models. This is
why more advanced studies make rather more use of algebraic models which can be easily
handled by computers, and why you should begin to become familiar with functional
expressions such as the following.
Qs  (P, C, T, v, y, πo)
where: Qs  quantity of a product supplied
P  product's price
C  factory and input costs
T  business taxes
v  level of technology
y  level of business efficiency
πo  relative profitability of products.
This simply states that quantity supplied is a function of, or is dependent on, the various
influences symbolised.
Relative Importance of Supply Influences

As with demand, different products will be affected to different degrees by the various
influences on supply. In the case of supply, much will depend on the methods of production
and the ease with which producers can respond to changes in factor costs and availability as
well as in technology. Consequently, it is easier to assess the relative importance of the
influences on supply than those on demand. A careful study of production technology and
relative factor costs will indicate which are likely to have the most impact on producer
intentions. A production process heavily dependent on labour (labour-intensive) will be more
responsive to changes in wage levels than one that is highly mechanised or automated and
thus capital-intensive. On the other hand, production which is highly capital-intensive will be
more vulnerable to changes in interest rates, since much capital is likely to be borrowed in
one form or another. The potential costs of changing production levels tend to be greater
with capital-intensive production methods.
D. PRICE ELASTICITY OF SUPPLY

Calculation of Elasticity
The concept of elasticity, which we applied to demand, can also be applied to supply.
However, here it is usually only price elasticity with which we are concerned. The method of
calculating supply elasticity is exactly the same as for price elasticity of demand, i.e.
proportion al change in quantity supplied
supply elasticity of a product (Es) 
proportion al change in the product' s price
or
Qs P PQs
Es   
Qs P Qs P
Notice that the value of Es is always positive (i.e. greater than zero). This is because the
change of quantity is in the same direction as the change in price.
© ABE and RRC

Figure 5.12 shows an example of a simple supply elasticity calculation.
Figure 5.12: Supply elasticity calculation

Price (£) 16
14 £13.50 £1.35 P
12 Here QS  10 QS  100

P  £1.35 P  £13.50
10 10
units
8 QS
6
13.50 x 10
4 ES  1
100 x 1.35
2 S
0
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140
Quantity supplied
Notice here that figures for both P and Q are obtained from the midpoint of the change in
price and quantity, so that the calculation is the same for both a rise and a fall in price.
Notice also that the result of this particular calculation is that Es equals unity (1).
If you calculate values for Es at any other price level on this curve, you should obtain the
same results. The reason for this is explained shortly.
Elastic and Inelastic Supply Curves

Price elasticity of demand was shown to change as price changed. A rather different position
arises in the case of supply elasticity. We said that the value of Es for the supply curve of
Figure 5.12 would always be 1. This is because the curve starts at the point of origin.
A simple proof follows, relating to Figure 5.13. The proof assumes a knowledge of simple
geometry.
© ABE and RRC

Figure 5.13: Proof of Es = 1
Price
S
 can be any angle.
As long as the curve passes through O, then ES  1
P1
P
P 1

O
Q Q Quantity
From Figure 5.13:

P P
θ  θ1,  tanθ and  tan θ1
Q Q
so,
P P

Q Q
But,
Q P Q P P Q
Es      
Q P Q P Q P
so,
P P
 1
Q Q
and
Es  1
A supply curve which passes through the vertical (price) axis is elastic, and one which
passes (or, if extended, would pass) through the horizontal (quantity) axis is inelastic. This
holds regardless of the slope of the curve, and it applies to the whole curve when this is
linear (i.e. forms a straight line).
These statements can be proved by the same method as in Figure 5.13. Do not worry if you
cannot prove them yourself – just remember the position. Examples are given in Figures
5.14 and 5.15.
© ABE and RRC

Figure 5.14: An elastic supply curve
Price
P1
P P
ΔQ ΔP
ES  
S Q P
ΔQ ΔP

Q P
ES  1
Q
O q q1
Q Quantity
Figure 5.15: An inelastic supply curve
Price S
P1
P
P ΔQ ΔP
ES  
Q P
ΔQ ΔP

Q P
P ES < 1
Q
O q q1
Q Quantity
When the curve is non-linear, the important point is the direction of the tangent to the curve
at the price level under consideration. This is shown in Figure 5.16.
© ABE and RRC

Figure 5.16: A non-linear supply curve
Price
S
For the non-linear supply

curve, tangents show elasticity.
At A, supply is elastic, as the
tangent cuts the vertical axis.
At B, supply is inelastic, as the
tangent cuts the horizontal
axis. B
A
S
O
Quantity
Elasticity of Supply in the Long Run

The main influence on the elasticity of supply is the speed with which producers can respond
to changes in cost, price and profitability. Few firms can alter their production plans
immediately when basic materials, capital and labour have already been committed to them.
However as time goes on plans can be changed, workers can be hired or fired, and new
machines bought or old ones scrapped.
The speed and ease with which production plans can be changed depends on the nature of
the production process. As a general rule processes (such as services) which are labour-
intensive can be changed more quickly than those that are capital-intensive. Workers,
especially if they are part-time, can have their working hours increased or reduced and the
number of workers employed can be changed; whereas capital-intensive processes, such as
motor-vehicle assembly lines, still have to pay costs of capital even when equipment is no
longer used. It may therefore be better to maintain production as long as variable costs are
covered by sales revenue and there is some contribution to unavoidable fixed costs, rather
than suffer the heavy losses of a major production change. However when the decision has
to be made to reduce production the consequences can be swift and far-reaching, with large
numbers of workers suffering redundancy.
We can say then, that supply will be inelastic in the short run and elastic in the long run.
What constitutes short run and long run depends on production methods. Nevertheless,
supply is unlikely to be completely inelastic even in the very short term, as some adjustment
is usually possible. Even the motor-assembly track can be speeded up or slowed down in a
matter of hours, in response to a managerial decision.
The change in elasticity over time is illustrated in Figure 5.17.
© ABE and RRC

Figure 5.17: Change in elasticity over time
Price
S
S1
S2
Supply response over time:

at prices above OP, supply
becomes more elastic as
producers are able to
change production in
P response to changes in
price, costs or profitability.
O
Quantity
Review Points
relevant sections.
1. Which is the simplest definition of profit?

(i) The rate of interest paid to savers.
(ii) The excess of revenue over cost.
2. To maximise profits which output level should the firm produce at?
(i) Average cost is equal to average revenue.
(ii) Marginal cost is equal to marginal revenue.
(iii) Total cost is equal to total revenue.
(iv) Marginal cost is equal to average cost.
3. Which does the following formula calculate:
(i) the elasticity of demand for a good or
(ii) the elasticity of supply of a good?
proportion al change in quantity supplied Qs P PQs
  
proportion al change in the product' s price Qs P Qs P
© ABE and RRC

4. Does elasticity of supply measure the responsiveness of a firm's supply to changes in:
(i) the market price of its product or
(ii) its rate of profit?
5. Is the main influence on the elasticity of supply the speed with which producers can
respond to changes in:
(i) the slope of their supply curve or
(ii) cost, price and profitability?
6. Is the general shape of a firm's supply curve:
(i) downward sloping or
(ii) upward sloping?
7. Firms will supply more output if they think it will lead to an increase in their:
(i) sales
(ii) profit
(iii) elasticity of supply
(iv) elasticity of demand?
8. A firm should cease production in the short run if its selling price does not enable it to
cover all its:
(i) average fixed costs
(ii) average variable costs?
© ABE and RRC

© ABE and RRC

97
Study Unit 6
Markets and Prices
Contents Page
A. Nature of Markets 99
The Economic Good 99
Market Area 100
Communications and Transport 100
Conditions of Supply and Demand 100
B. Functions of Markets 101

Information 101
Establishing Price 101
C. Prices in Unregulated Markets 102

Definition of Unregulated Markets 102
Equilibrium Price 102
Changes in Intentions – Shifts in the Curves 103
D. Price Regulation 106

Reasons 106
Effects of Price Controls 106
E. Defects in Market Allocation 108

External Costs and Benefits 108
Public Goods 110
Inequalities of Income 111
Market Power of some Large Suppliers 111
Deficiencies in the Supply of Public Goods 111
F. The Case for a Public Sector 112

Education 112
Health Care 112
(Continued over)
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98 Markets and Prices
G. Methods of Market Intervention: Indirect Taxes, Subsidies and Market

Equilibrium 113
What are Indirect Taxes and Subsidies? 113
Effect on Supply 114
Effect of Tax on Price 115
Subsidies 116
Government Use of Indirect Taxes 117
H. Using Indirect Taxes and Subsidies to Correct Market Defects 118
© ABE and RRC

Markets and Prices 99
Objectives
The aim of this unit is to: explain the concept of market equilibrium and examine, using
demand and supply analysis, the effects of changes in economic factors upon equilibrium
price and quantity; explain the difference between private and social costs, and examine the
consequences of externalities for the market equilibrium; examine the effects of various
types of government intervention on market outcomes.
 explain, in words and diagrams, the concept of equilibrium in a supply and demand
model, and the process by which equilibrium is reached
 examine the effects of changes in market conditions (for example a change in the price
of a substitute good, a change in consumer income, an increase in advertising
expenditure, the introduction of new cost-reducing technology) which lead to shifts in
the demand and/or the supply curve upon the equilibrium; explain the importance of
elasticity to the impact of such changes
 draw supply and demand curves based on data and solve for the equilibrium price and
quantity
 explain the meaning of positive and negative externalities, and the distinction between
private and social costs and benefits
 identify real world examples of externalities and discuss how they arise
 demonstrate the effects of externalities on the market equilibrium using demand and
supply analysis and identify the social costs associated with the distortions caused by
externalities
 demonstrate how taxation policy can be used to remedy problems caused by
externalities and discuss the merits of a tax approach relative to possible alternative
policies
 examine, using appropriate diagrams, the effects of taxes and subsidies on the market
equilibrium, identifying the burden/benefits of taxation/subsidies on consumers and
producers
 examine, using appropriate diagrams, the effects of quotas, price ceilings and price
floors on the market price and quantity traded.
A. NATURE OF MARKETS
In economics, a market is an area within which the forces of demand and supply for a
particular "economic good" can communicate and interact, so that the "good" can be
transferred from suppliers to buyers.
This definition contains a number of important elements which have to be considered
whenever we analyse a particular market or compare one market with another. Let us look at
these elements.
The Economic Good

A good is any benefit which accords utility to people, and to obtain which they are prepared
to sacrifice scarce resources. The term "utility" is chosen because it avoids the idea that
there has to be any particular virtue in the good. If people want something and are prepared
to make some sacrifice of their resources (usually represented by money) to obtain it, then
we assume they gain utility from it, even if it does them actual harm. Thus economists may
analyse the markets for tobacco or heroin.
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The good can be a physical object, such as a motor car, or it can be a service. It can be a
consumer good, an intermediate good, a capital good, or a factor of production. In this
course we are concerned chiefly with consumer and production factor markets.
We must be careful to give a precise definition of any market we are considering. The total
market for motor cars contains a number of subsidiary markets – e.g. for sports cars or
saloon cars. We must always distinguish the market for the whole class of product from that
for a particular brand or other subdivision. Thus, the market for the Mini Metro is distinct from
the market for small cars – which, in turn, is distinct from that for private cars and from the
market for personal transport as a whole.
Confusion sometimes arises when we are concerned with the price elasticity of demand for a
product. The class or product may be price inelastic, whereas a particular brand may be
price elastic. For example, petrol in general may be price inelastic, but the price of K's petrol
can be price elastic. The motorist has to have petrol, but she may have the choice of a
number of filling stations offering a variety of petrol brands at different prices, and she may
also be prepared to go a few miles out of her way to obtain the cheapest brand of petrol.
Market Area
We need to examine the market area when considering the conditions of a particular market.
The area is that within which communication takes place, and not simply where final
negotiation is arranged. A sale of antiques or fine paintings may take place in a small room in
London. However beforehand catalogues may have been sent to dealers throughout the
world, and many foreign buyers may be represented by their agents when the sale or auction
actually takes place. In contrast, a small retail shop may be concerned with a market area
restricted to a few streets or a single housing estate. The goods it sells may be available in
other shops serving different market areas nearby.
Communications and Transport

The extent of the market is really determined by the efficiency of communications and the
ability to transport the goods from seller to buyer. X does not really have a choice between
goods A and B if he does not know that B exists, or if he has no means of comparing price or
quality. Thus, if I am buying tomatoes on one side of the town, I cannot really compare them
with those on sale on the other side of the town, even if someone tells me that they are
several pence cheaper. I need to be sure that they are products of similar quality.
Some markets have developed very precise descriptive terms. The use of these terms, for
example in some of the basic commodity exchanges, enables buyers and sellers to know
exactly what quality goods are being traded.
There can be an effective market only if it is possible to transfer the product from seller to
buyer. Any barrier to transfer will limit the market area.
Conditions of Supply and Demand

There can be a market only if there are suppliers able to deliver the goods at the time
agreed, and buyers with the necessary resources to acquire them.
The good does not necessarily have to be in existence at the time it is traded, as long as
there is a guarantee that it will be available when and where agreed. The ability of certain
commodity markets to trade in crops not yet grown, or metals not yet mined, is well known;
but a manufacturer can also agree to sell goods not yet made, and a few authors can even
sell books not yet written! However, both buyer and seller must have a clear idea of the
product that is to be delivered. The more precise the definition of a product, the easier it is to
sell in this way.
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The desire to buy must also be realistic. Many of us would like to possess an ocean-going
cruiser or a private aeroplane; but few of us have the resources to acquire and operate
them.
B. FUNCTIONS OF MARKETS
A market has other purposes, apart from providing the means whereby a good is transferred
from supplier to buyer.
Information
The market serves to convey information about the conditions of supply and demand. I may
go to a furniture store, not just to buy a piece of furniture but to see what furniture is
available and at what price. The better the communication system within the market, the
more information I can gain about what can be bought – and the more chance I have of
achieving full utility from my purchase.
This communication function works both ways. The market also informs actual and potential
suppliers about the strength and pattern of demand – about what people want to acquire and
what level of price they are prepared to pay. Suppliers need this information in order to plan
production.
The problem from the supplier's point of view is often that the information comes too late.
The supplier has to make supply decisions before accurate information is available. The
supplier wants to know today what market conditions are going to be like tomorrow. The
impossibility of achieving accurate forecasts all the time is one of the main sources of
business risk.
Establishing Price
Arising out of the two-way communication function is a further most important function – that
of establishing the price at which the buyer is willing to buy and the supplier willing to supply.
How this may be achieved is the subject of much of the rest of this study unit.
It is such an important function of the market that some large firms ensure that certain
markets continue to operate only because they need a reliable mechanism for price-setting.
The large manufacturing companies do not really need to buy metal on the London Metal
Exchange – they can obtain all they need direct from suppliers. But they do need to know the
conditions of demand and supply in the main areas where metal is bought and sold. By
keeping the metal exchange in operation, they obtain this information, which provides a
price-setting mechanism and so helps to reduce some of the uncertainties which they have
to face in obtaining essential materials.
© ABE and RRC

C. PRICES IN UNREGULATED MARKETS

Definition of Unregulated Markets
The term "unregulated" here means not subject to any price-setting regulation. An
unregulated market can be subject to detailed regulations regarding the conditions of
payment and transfer and the procedures for settling disputes. However these assist rather
than impede the free communication of buying and supplying intentions, and allow them to
interact in order to establish a market price. An unregulated market is thus one in which the
forces of supply and demand are free to interact, without any form of outside price control.
We tend to think of regulation in terms of control by the State or its agencies, but of course a
market can be controlled in other ways. Certain local antiques auctions are reputed to have
been controlled by rings of dealers who agree not to bid against each other and to share
purchases among themselves after the auction. This is not an unregulated market! The
prices paid for goods at such an auction are not "market" prices because they do not reflect
the true conditions of demand.
Equilibrium Price
The equilibrium price is the one at which the intentions of suppliers are just matched by the
intentions of buyers, i.e. where the amount of the good demanded is just equal to the
amount provided. In this state there is no pressure from either supply or demand to move
away from this price, so the market forces are in a state of rest – in equilibrium.
We have examined the concepts of supply and demand schedules and curves. If we put
supply and demand schedules and curves together, we can arrive at the equilibrium price,
i.e. the market price.
Suppose we have the supply and demand schedules for the (fictitious) product Whizzo, as
set out in Table 6.1 and illustrated in Figure 6.1.
Table 6.1: Supply and demand schedules for Whizzo
Price per kilo Quantity (kilos per week)
£ Producers willing to supply Consumers willing to buy
1.50 200 700

2.00 300 675
2.50 400 650
3.00 500 625
3.50 600 600
4.00 700 575
4.50 800 550
5.00 900 525
© ABE and RRC

Figure 6.1: Supply and demand for Whizzo
£
per
kilo 5 Equilibrium price  £3.50
Equilibrium quantity 
600
4 Supply
2
Demand
0
200 300 400 500 600 700 800 900
Quantity (kilos per week)
We can see from the schedules and the graph that it is only at price £3.50 (600 kilos per
week) that the intentions of producers and buyers are the same. At any higher price,
producers will be supplying more than buyers are willing to buy. At any lower price,
producers will not be supplying enough Whizzo to meet demand. The equilibrium price is
£3.50, and 600 kilos per week the equilibrium quantity. As long as neither set of intentions
changes, there is no incentive for any movement away from this price and quantity, once it is
achieved.
Changes in Intentions – Shifts in the Curves

We can show the concept of equilibrium price and quantity in a general graphical model, as
in Figure 6.2.
Figure 6.2: Equilibrium price and quantity
Price D S
S D
O q
Quantity
© ABE and RRC

Here, equilibrium price is Op and equilibrium quantity Oq – the price and quantity level where
the supply and demand curves intersect. We can develop this approach to analyse the result
of movements in the supply and demand curves.
(a) Change in Either Demand or Supply
Look at Figure 6.3. Here there is a shift in buyers' intentions, caused perhaps by a
change in taste, supported by an increase in advertising. The result is a movement of
the demand curve from DD to D1D1.
In this model, supply intentions remain unchanged. The result is an increase in the
equilibrium price and quantity from Op, Oq to Op1, Oq1.
We can use the same technique to illustrate the effect of a shift in suppliers' intentions.
This is shown in Figure 6.4, where supply falls from SS to S1S1. Demand intentions
remain unchanged (DD) and the equilibrium price and quantity move from Op, Oq to
Op1, Oq1.
Price rises and quantity traded in this market falls.
Figure 6.3: Movement of the demand curve
D1 S
Price
D
p1
S D1
D
O q q1
Quantity
Figure 6.4: Movement of the supply curve
Price D S1
p1
S1
S D
O q1 q
Quantity
© ABE and RRC

(b) Change in Both Demand and Supply

So far we have considered only a possible shift in demand or supply. In practice, a
movement in one is likely to influence the other through the effect on price and
quantity.
Suppose there is a major increase in demand, represented by a movement of the
demand curve in Figure 6.5, from DD to D1D1. This shift, if supply remains unchanged
at SS, results in an increase in equilibrium price from Op to Op1, and in quantity from
Oq to Oq1.
Now suppose that this increase in quantity makes it worthwhile for one or more
producers to develop new production methods, so that the good can be mass-
produced at a lower unit cost. The result, after a time interval, is to shift the supply
curve from SS to St1St1. Here the t  1 indicates a change in time period.
The new supply schedule, combined with the increased demand, produces a fresh
equilibrium price and quantity at Opt1, Oqt1. We have the apparently unusual result of
an increase in demand resulting in a reduction in market price. Note however that this
can happen only when given some rather special assumptions about the stage of a
product's development and the possibility for change in supply conditions.
Figure 6.5: Movement of both the demand and supply curves
Price D1
S
D
p1
St+1
p
pt+1
S D1
St+1
D
O q q1 qt+1
Quantity
Normally, we expect an increase in demand to raise equilibrium price and quantity. This is
the direct effect. The later reduction in price can result only from a shift in the supply curve,
indicating a completely new set of supply conditions.
A somewhat similar process can be initiated by a change in technology, allowing mass-
production at a reduced price. Here, there is first a shift outwards in the supply curve.
Demand then rises but not enough to stop the price from falling. Consider the market for
mobile phones in this light.
© ABE and RRC

D. PRICE REGULATION
Price regulation refers to the imposition of a minimum or a maximum market price by
government decree or international agreements/organisations, such as OPEC. A maximum
price is set by the imposition of a price ceiling. A minimum price is set by the imposition of a
price floor.
Important applications of such price ceilings and floors include minimum wage legislation,
maximum prices for some food items and/or fuel, maximum prices for rented
accommodation, and minimum and maximum prices for some commodities in international
markets.
Reasons
If price and quantity will always move to equilibrium provided economic markets are left
alone, we must ask why governments and other agencies should ever wish to intervene. In
practice, there are several reasons, of which the following are among the most common.
(a) Social Unacceptability
If the price resulting from an unregulated market were considered to be socially
unacceptable, as causing hardship or conflict in the community, attempts might be
made to control it. This could happen in a period of food shortage caused by war
and/or climatic disaster, and also if there were a shortage of housing in urban areas
sufficient to cause hardship and increase risks of disease, crime and other social evils.
(b) Incomes of Producers
Attempts might be made to maintain high prices if it were desired to raise the income
of producers and their employees. This is one of the motives of the European Union's
Common Agricultural Policy (CAP).
(c) Stability of Supply
Some markets are notoriously unstable because of unplanned variations in supply,
caused by weather and other circumstances beyond the control of producers. In these
cases, attempts may be made to control prices to ensure greater stability in the
market.
Effects of Price Controls

If prices are controlled without any attempt to control demand and/or supply at the same
time, the result can be the opposite of that intended. This is illustrated in Figure 6.6.
© ABE and RRC

Figure 6.6: Supply surplus and shortage
Price
Supply
P1
P2
Demand
O qs2 qd1 q qd2 qs1 Quantity
Looking at the diagram, if price is fixed at p1, quantity supplied (qs1) is more than that
demanded (qd1), and there is surplus production.
If price is fixed at p2, quantity demanded (qd2) is more than that supplied (qs2), and there is a
shortage.
Only at price p will quantity supplied equal quantity demanded.
Here, we see that any attempt to fix prices at a level other than the market equilibrium price
of p will produce either surplus production (fixed price p1 > p) or a shortage (fixed price p2 <
p).
We are forced to the conclusion that on their own, price controls are ineffective.
Governments and other bodies must identify the real problem and seek to solve that. For
instance, if the problem is lack of adequate supply (say food or housing shortage), then the
government must either increase supply, e.g. by making additional payments (subsidies) to
suppliers, or by entering the market as a producer or importer. If these remedies are
impossible, the government must ration the available supply among consumers in a way that
the community regards as acceptable.
Such measures may be effective, at least for a time, though they may be expensive to
administer and police. The government or other agency must decide whether the social
benefits to be gained from market regulation justify the cost and opportunity costs of the
resources used in maintaining the regulations. Care must also be taken to ensure that the
regulations themselves do not discourage suppliers to the extent that the basic objects of the
policies are defeated. The heavy bureaucracy created by many schemes in the so-called
planned or socialist economies often significantly discourages total production. If the problem
is excess supply, then the government may seek either to stimulate demand (e.g. by
reducing prices through the payment of subsidies), or to reduce supply by encouraging or
paying producers to leave the market (as in the case of European Union measures to reduce
European milk and wine supplies).
© ABE and RRC

The most difficult problems often involve unplanned fluctuations of supply, when the plans of
regulatory bodies can be upset by (say) unusually good or bad crops owing to weather
conditions. If there are fairly regular cycles of overproduction or underproduction, and
demand is reasonably constant, and if it is possible to store the crops, then the government
can apply a mixture of controls over prices and production combined with purchases of
overproduction to keep in store for release in periods of underproduction. However, it is
found that the guaranteed prices that usually form part of such policies lead inevitably to
steady increases in production. The government then finds itself storing quantities of goods
that it has little hope of ever releasing for resale, except at very low prices to people in other
parts of the world. It may even have to give away some of the surplus produce. Such policies
then become a heavy burden on taxpayers and lead to hostility from the community.
It is clear that governments which embark on market-intervention policies may, and often do,
find that they become involved in increasingly difficult and expensive measures that do very
little to solve the problems they were meant to eliminate.
There are other reasons why governments may choose to intervene in the market to alter
the resultant market equilibrium.
E. DEFECTS IN MARKET ALLOCATION

In very many cases, unregulated markets and the price system are effective and efficient
ways of allocating resources. Also, as we saw in the previous section, some forms of well-
meaning government intervention can actually make worthy social objectives more difficult to
achieve. Nevertheless, this does not mean that unregulated markets are always perfect. The
existence of some defects is widely accepted and we will now consider the main ones.
External Costs and Benefits

External costs and benefits are also referred to as "externalities". Externalities or external
effects are very important because they give rise to "merit goods", "demerit goods" and
"public goods".
External Costs
Not all the costs of factors used in the production process are paid by the producer as
private costs. For example, suppose that during a dry summer, a farmer watered his crops
with water pumped from a canal. As a result, the canal level fell and it could no longer be
used by waterway travellers. Unless the farmer paid compensation to the travellers, it is clear
that they would be contributing to the costs of the farmer's production. Because these costs
are being paid by people external to the production process, they are called "external costs".
We can think of many examples of such costs, for instance road users who incur additional
fuel and machine-wear costs resulting from motorway delays. If these delays are caused by
repairs needed to make good damage brought about by heavy lorries travelling at high
speeds, then other road users are contributing to the costs of transporting goods by these
lorries. If a proportion of the cost of road repairs is paid from general taxation, then all
taxpayers are contributing to the costs of road travel – even those tax payers who rarely
travel at all.
Other examples of external costs include the poisoning of rivers by industrial waste, the
pollution of sea coasts by waste oil discharged by oil tankers, the sickness and early deaths
of workers from industrial diseases. The list is almost endless, and you can probably add to it
from your own observation. Some costs may even be borne by later generations. The most
serious example of an external cost confronting the world today is that of global warming,
caused by atmospheric pollution from the continued and excessive burning of oil and coal.
© ABE and RRC

The existence of an external cost associated with the consumption of a good such as alcohol
or cigarettes means that the social benefit is less than the private benefit from consumption.
Such goods are examples of demerit goods. Because consumers ignore the negative
externalities or social costs created by their consumption of such goods, they are
overproduced and over-consumed in a free market without government intervention.
External Benefits
In contrast, it is possible for people to receive benefits from production towards the cost of
which they have not contributed. These are external benefits. If a large firm builds modern
roads or provides other transport facilities which are then available for use by the general
community, then that community gains external benefits. If a business firm provides a good
canteen and housing for its workers and, by improving standards of housing and welfare,
improves the health of workers and their families, then this, too, is an external benefit. We
are well aware of cases where firms cause damage to the environment, but there are also
cases were firms improve the environment by renovating property, creating sports grounds,
or even parks.
The existence of an external benefit associated with the consumption of goods/services such
as health care and education means that the social benefit is greater than the private benefit
from consumption. Such goods are examples of merit goods. Because consumers ignore the
positive externalities or social benefits created by their consumption of such goods, they are
underproduced and under-consumed in a free market without government intervention.
Economics of Externalities
It might be thought that economists would favour external benefits and dislike external costs.
In fact, economic theory suggests that all externalities distort the use of resources, and that
even external benefits are probably better provided in other ways. The danger of external
costs can easily be recognised. For example, if road users, especially heavy goods vehicle
users, do not pay the full costs of their road use but pass some of these on to the rest of the
community, then the relative costs of transporting goods by road – as opposed to by rail or
water – are distorted in favour of road. Consequently, goods are carried by road transport at
a higher cost to the community than it would have paid if they had been carried by other
means, say by rail. The community is not making the most efficient possible use of its
available resources, and its living standards are lower than they would otherwise be because
some production is being lost. Moreover, in situations of this type, the problem tends to be
self-worsening. If road transport is artificially cheap, then goods are diverted to road from
rail. Road services are overcrowded, and there is pressure to devote more land to roads.
Rail services are underused. Agricultural and residential land is lost to roads to carry traffic
which could otherwise have been carried by substitute services.
This is what we mean when we say that externalities distort the use of scarce economic
resources.
Externalities and the Government
What can be done about externalities? Does the community just have to accept their
existence? Clearly neither the producers who are able to pass costs to others, nor the
buyers of their goods or services who obtain reduced prices because of the reduction in
private costs, are likely to volunteer to pay more unless they are obliged to do so. They could
not do so as individuals in competitive markets. Only governments, acting on behalf of the
community as a whole and reacting to political pressures, can take effective measures. The
options open to government are the following:
 Legislate to make actions considered undesirable illegal, and enforce the law. In a
democracy such laws must be acceptable to the community as a whole; care must be
taken to ensure that desirable benefits are not lost and that the cost of law
enforcement is not out of proportion to the costs avoided.
© ABE and RRC

 Legislate to ensure that producers behave in a socially acceptable way and follow
practices designed to avoid the undesirable external costs. Water and sewerage
companies may be required to achieve certain minimum standards. The costs of
complying with the law thus become private costs and part of the production cost which
must be met by users of the goods and services. All producers then become subject to
the same requirements so that none can gain a competitive advantage by not
complying with the standards. If producers have to compete with foreign imports the
government will have to ensure that these imports are subject to the same minimum
standards.
 Impose special taxes designed to make some products very expensive and so
discourage their use. There are several objections to this course of action. The
government might start to rely on the revenue from the taxes and so take care to keep
them at a level where the products are still bought and used; the taxes may well then
cease to deter or reduce the external costs. Alternatively the government might impose
very high taxes with the result that there is widespread tax evasion; the cost of
collecting the tax and punishing evaders then rises to impose additional burdens on the
community.
 Pay subsidies to suppliers to reduce the market price paid by consumers and thereby
encourage increased consumption of merit goods. Alternatively, the State may take
overproduction and ensure, through legislation, that all the relevant consumers are
provided with the socially optimal level of the good or service. For example,
compulsory school education is provided by governments in many countries.
 Clearly it is more desirable to try and ensure that external costs are removed
altogether rather than that they should simply become private costs. Even if employers
are forced to pay adequate compensation to workers whose lungs are damaged by
dusty manufacturing processes, the workers still suffer. However, if manufacturers are
required to have efficient dust extraction equipment, private costs are increased but
the health of the workers is improved. At the same time care must be taken to ensure
that external costs are not simply exported. For example, one way of dealing with
dangerous gases might be to ensure that they are expelled through very high
chimneys, but unfortunately these may simply redirect the gases to another country for
that country to bear the cost.
There is no universal and simple method of dealing with externalities. On the whole it does
appear that the market economies have been more successful in controlling and reducing
undesirable external costs associated with environmental pollution than have the old
command economies. This is probably because in the more open and consumer-orientated
societies, producers and government have had to be willing to respond to pressures from the
public when that public has been determined to eliminate socially unacceptable practices.
Public Goods
Merit and demerit goods are produced in a free market, without government intervention; the
problem is that either too little or too much is produced. Too few merit goods are consumed
in a free market because consumers ignore the external benefits associated with such
goods. In contrast, there is over-consumption of demerit goods in a free market because
consumers ignore the external costs. In the case of "public goods" the market failure is that
the goods are not produced at all if left to the free market.
Most goods and services, including merit and demerit goods, are private goods and services
in the sense that if they are consumed by one person their availability is correspondingly
reduced, and one person's consumption cannot be consumed by another person. Public
goods are different. Pure public goods are defined as those goods or services which have
the characteristic that one person's consumption does not reduce the amount available for
consumption by others.
© ABE and RRC

The alternative, and more revealing, way of looking at this characteristic is to note that if
such a good or service is provided for just one person the supply is also freely available for
consumption by others! What this means is that whoever pays for the production of the good
or service is providing the same benefits for all others in society free of charge. The
consequence of this is that no one is prepared to provide such a good or service because
they are unable to recoup some of the cost by charging others for their consumption of the
benefits. Thus public goods are not provided in a free market without government
intervention. Although there are very few if any examples of pure public goods, national
defence and lighthouses are examples of goods that have many of the features of a public
good.
Inequalities of Income
One of the virtues claimed for the unregulated market is that it makes the consumer
sovereign and that resource allocation responds to demand pressures. However, if we
imagine that consumers influence allocation by votes cast when they buy or refrain from
buying goods and services, we have to admit that some consumers have more votes than
others and large numbers have very few votes. Markets respond quickly to those groups
which have the most purchasing power. This does not always ensure that resources are
allocated in ways that meet the social expectations of the community.
It has always been difficult to ensure that the poorest sections of the community are
adequately housed. Normal commercial suppliers of housing are unwilling to meet this
demand because the people concerned cannot afford to pay the full "economic costs" of
housing, i.e. it is not usually possible to make a profit from providing housing for the poor. It
is much more profitable to provide second homes for the wealthy. Not only does this offend
against many people's ideas of social justice, but the housing problem rebounds against the
community. The community is faced with extra costs because inadequate housing leads to
poor health, disease, crime and a wide range of social problems that become a charge on
the taxpayers. Only the State can intervene to improve housing for the poor. It cannot do so
simply by holding down rents. It has to promote supply either by setting up State suppliers or
by subsidising private suppliers so that supply becomes profitable.
Market Power of some Large Suppliers

Consumers may not always be as powerful as introductory economic theory suggests. Later
we will learn about markets dominated by large firms. If such firms become very powerful,
they can influence both supply and demand through controlling the goods allowed into the
market and by heavy advertising. Governments of most large market-economy nations are
often accused of failing to take action to check the sale of tobacco and alcohol – both of
which are potentially dangerous to health and society – because of the power of the tobacco
and alcohol producing companies. Even more notorious is the extremely powerful gun lobby
in the USA.
Deficiencies in the Supply of Public Goods

The market economy operates on the principle of self-interest. Consumers wish to maximise
their own utility and producers their profit. In most cases this works to the public benefit but
not always. If it is in no one's interest to provide a community or public good, it will not be
provided without the intervention of the political machinery of the State. Public sewers, public
roads and transport, police and social services, even fire services, fall into this class. The
community clearly needs adequate services but left to the market only the wealthy would
attempt to purchase their own, and the community as a whole would be subject to the risk of
contagious diseases, unchecked crime and fires.
© ABE and RRC

F. THE CASE FOR A PUBLIC SECTOR

In noting the defects of the market economy as a means of allocating resources we have, in
effect, made a case for a public sector within which the State, through its political structures,
makes good the gaps and deficiencies of the unregulated market. The State can ensure that
there is a minimum standard of housing for those with low incomes, build roads and
establish communication systems. It can build sewerage systems and a system for piped,
clean water, and provide police and fire services. It can provide a health and education
service to ensure that all who are sick obtain medical care regardless of income and all
children achieve a minimum level of education essential for survival in the modern world.
In communities with high living standards the question then arises as to how far State
provision should go in the provision of public goods which at some stage tend to become
private goods.
Let us take a closer look at two particular, high-profile issues.
Education
Most would accept the need for all to receive a basic education, but this does not necessarily
mean that all who wish to do so should have the right to free education to doctorate level.
Since there is evidence that, on average (but not, of course, for all individuals) there is a
correlation between income level and length of time spent in full-time education, then
education beyond the minimum represents a personal capital investment; many would argue
that such education should be paid for by those who will benefit from it. Counter arguments
are that the community benefits from the contribution of its most highly skilled and educated
members (e.g. brain surgeons). The community should therefore pay to obtain the maximum
potential from its scarce human resources; also those who earn high incomes normally pay
the most taxes and thus pay eventually for the education they have received. There is no
clear right or wrong answer to this debate, but you can see that the precise boundaries
between the public and private sector in the supply of goods such as education are not clear-
cut and the matter is arguable.
Health Care
Another area of public controversy is the provision of health care. The community clearly
needs a health service, if only to defend itself against dangerous diseases which could
quickly become plagues if large numbers of people could not afford treatment. Most people's
ideas of social justice would accept that a person stricken by accident or sickness should
receive treatment regardless of income. However, should this mean that all forms of
treatment should be available for all regardless of income? Should the diseases of greed
and overindulgence be given the same care as those of poverty and ignorance? If people
can afford to pay for additional treatment or for more comfortable treatment, or non-urgent
treatment at times that suit them rather than at times that suit a bureaucratic administration,
is there any reason why they should not do so? No one passes moral judgment on those
who choose to spend their income on exotic holidays rather than a fortnight at Benidorm, yet
many pass such judgment on those who prefer to pay for a private room when they are in
hospital instead of sharing a public ward.
Clearly many of the arguments surrounding health care involve emotionally charged value
judgments resulting from past social injustices and history, but there are also serious
economic considerations involved. The economist is concerned with the allocation of scarce
resources, and we have to recognise that resources devoted to health care are scarce. The
march of technology and medical science has made possible cures and treatments
unimaginable when the National Health Service commenced in the 1940s. Open heart and
transplant surgery require a massive investment in resources but benefit only a relatively few
people. The proportion of old people is far greater than in the 1940s and the demands they
© ABE and RRC

make for health care are proportionally much greater also. Not even the most wealthy and
advanced nation can provide all the resources that would be required to give immediate
treatment to all those wanting it. Difficult allocation decisions have to be made and are made
daily.
It can be argued that a private health system which permits scarce resources to be allocated
on the basis of ability to pay, or by virtue of employment in a company that provides health
insurance as part of its remuneration, is diverting resources from areas of greater personal
or social need. One person suffers pain so that a consultant can earn a private income
treating a less urgent patient in a private hospital. On the other hand it can be argued that
the private health service brings in resources that would otherwise not be available. The
consultant is willing to work for a relatively low level of pay from the National Health Service
because he or she can have the additional income from private patients. Without this, the
best surgeons would possibly go to countries where earnings were higher. Private hospitals
relieve the public health service of many patients and reduce its need for expensive capital
equipment. The debate can again continue with no clear right or wrong.
The basic problem is really one of allocation of scarce resources: the public versus private
health service is only part of a much larger economic and social issue which concerns to
whom, how and on what basis resources should be allocated for health care. How should the
community decide what proportion of available scarce resources should be devoted to the
technically brilliant feats of surgery which bring acclaim to surgeons and enable them to
attend conferences abroad, and how much to the unglamorous, humdrum work of caring for
the mentally ill for whom there is no hope of cure and little chance of international laurels for
the carer? The unregulated market will not provide an answer, nor will a medical service
subject to all the usual human vanities and frailties. The answer must eventually come
through the political machinery of the community and the quality of the answer will reflect the
health of that machinery.
Similar issues can be applied to virtually every other public sector and public utility service,
and you should give some thought to the allocation problems inherent in, say, police, fire,
water, and housing services.
G. METHODS OF MARKET INTERVENTION: INDIRECT

TAXES, SUBSIDIES AND MARKET EQUILIBRIUM
What are Indirect Taxes and Subsidies?
Governments often influence markets through taxes and subsidies.
 An indirect tax is one that is not levied directly on individuals or organisations but is
applied at some stage in the production or distribution of goods or services. It therefore
affects prices and so is paid indirectly, through price, by consumers and income-
earners. For this reason indirect taxes are often referred to as expenditure taxes and
are listed as such in the British national accounts which appear in the annual
publication known as the Blue Book of National Income and Expenditure.
 Direct taxes are those levied directly on income or wealth as it is created and are paid
by the income-earner or wealth-earner to the government. The economic implications
of direct taxes are considered later in the course.
At this stage it should be clear to you that anything that influences market price will have
consequences for both supply and demand, with the result that the final consequences of a
tax may not be what the government intended.
Sometimes, of course, a tax may be imposed with the deliberate intention of influencing
supply or demand. More often it is levied as just another way to raise the revenue that
© ABE and RRC

governments imagine they need, and they seek to have as little effect as possible on the
production system. In practice, any tax must have an impact, as we shall see.
A subsidy can be seen as a reverse or negative tax. It is a payment to a producer or
distributor, so that its effect is to increase supply. So to judge the effects of a subsidy, simply
reverse the arguments presented in relation to the tax – but remember of course, that in
order to pay a subsidy, the government has to have revenue, and its main source of revenue
is tax. Generally, then, a subsidy paid to A means that B and C have to be taxed. The
harmful effects of the tax may outweigh any beneficial effect of the subsidy.
Effect on Supply
The effect on supply of an indirect tax being imposed is illustrated in Figure 6.7. This shows
a supply curve SS, indicating that production can range from 200 units per week at a price of
£4 to 800 units at a price of £10.
Figure 6.7: Effect of an indirect tax on supply
Price S1
(£) 11
S
10
£1 increase in tax
9
8
£1 increase in tax
7
6
S1
5
S
4
0 300 500 600 700 800

100 200 400 900
Units per week
Suppose a new tax is imposed at £1 per unit. To supply 500 units per week, producers
wanted a price of £7 per unit. After the imposition of the tax, the producers still want to
receive £7, but to get this, the price has to rise to £8 to include the £1 per unit that now has
to be paid to the government. Similarly, to keep production at 700 units per week, the price
has to rise from £9 to £10 per unit.
Imposition of the tax thus moves the supply curve to the left (SS to S1S1). The vertical
distance between the curves represents the amount of the tax.
Of course, a subsidy paid to the producer moves the supply curve to the right because the
argument is exactly reversed.
In Figure 6.7 the after-tax supply curve S1S1 is parallel to the before-tax curve of SS. This
suggests that the tax or tax increase is flat rate, i.e. the same at all price levels. In practice
indirect taxes such as VAT depend on value and are sometimes known as ad valorem taxes.
Usually we would expect the tax to be expressed as a percentage of value or price, and its
© ABE and RRC

amount will therefore increase as price rises. In such cases the gap between the two supply
curves will increase at the higher prices as illustrated in Figure 6.8.
Figure 6.8: The effect on supply of an increase in an expenditure tax of 20%
Price 120
(£) £20 increase
110
in tax
100
90 The effect on
suppliers’ intentions
80 of an increase in an
expenditure tax of
70 20%
60
£10 increase
50 in tax
40
30
20
10 £2 increase
0
0 100 200 300 400 500 600 700 800 900 1000
Quantity (Units)
Although suppliers will seek to recover the full amount of any additional expenditure tax from
buyers there is no guarantee they will succeed in raising the price sufficiently to achieve this.
The extent to which they can recover the tax or have to absorb it in their total costs through
the more efficient use of their production resources depends largely on the strength of any
price resistance shown by buyers. If buyers cease to buy the product at the increased price
suppliers must reconsider their position. The possible consequences of this interaction
between suppliers and buyers are examined later.
Effect of Tax on Price

We have just seen how the supply curve was likely to shift as a result of a change in an
indirect tax or subsidy. For the likely effect on market price however, it is also necessary to
take account of the conditions of demand, since it is unlikely that the producer's efforts to
recoup the tax by adding this to the price will leave the quantity demanded in the market
unchanged.
Look now at Figure 6.9. Here we show the movement of the supply curve from SS to S1S1
(resulting from the increase in tax) and the demand curve DeDe. The equilibrium price moves
up (from Op to Op1) but by an amount less than the increase in tax. The amount supplied to
the market falls from Oq to Oq1 and the output/quantity fall is greater than the price rise.
© ABE and RRC

Figure 6.9: Effect of tax increase on supply and demand
S1
S
Price
De Increase
in tax
P1
P
Increase De
in tax
S1
S
O q1 q Quantity
Now look at Figure 6.10. Here we have the shift in supply curve SS to S1S1 and a demand
curve D1D1. Again we have an increase in equilibrium price (Op to Op1) and a reduction in
quantity supplied (Oq to Oq1). This time however, the reduction in quantity is less than the
increase in price.
Figure 6.10: Effect of tax increase on supply and demand, price less elastic
Price D1 S1
S
Increase in tax
P1
P
Increase
in tax
S1
D1
O q1 q Quantity
Why the difference in the two situations? You will have noticed that the curve D1D1 is much
steeper than DeDe. This reflects that demand in Figure 6.9 is more price elastic than demand
in Figure 6.10. The two illustrations show that the more price elastic the demand for a
product is, the smaller will be the market-price increase following an increase in indirect tax,
and the greater will be the cutback in supply to the market.
© ABE and RRC

This is after all really common sense. Price elasticity indicates the degree of responsiveness
of quantity demanded to any change in price.
Subsidies
The effect of a subsidy will be the exact reverse of that of a tax. Instead of the movement of
the supply curve from SS to S1S1, there is an increase in supply at all prices, i.e. as from
S1S1 to SS, and there will be a reduction in market price, as from Op1 to Op. Such a
reduction is likely to have been the main government objective in arranging the subsidy,
particularly if the good is a "socially worthy" one such as a basic food in a time of shortage,
housing, or a merit good such as education or health care.
Remember also that the new supply curve need not be exactly parallel to the original before
the tax or subsidy change. If the tax or subsidy increases with value, i.e. is an ad valorem tax
or subsidy, the gap between the curves will increase as price rises, as shown in Figure 6.8.
Government Use of Indirect Taxes

If the government increases indirect tax on goods which are price elastic, it will not receive
much extra tax but it will depress demand. If it imposes the tax on goods which are price
inelastic, it will not have much effect on output but the government will collect more tax
revenue.
If you now consider how price changes affect a person's pattern of expenditure and
discretionary income you will realise that the effect of the tax may go further. Suppose there
is a general increase in indirect tax on all goods. Some will be demand price inelastic, and
their pricing will increase without much reduction in the amount supplied and bought. The
buyers are paying more for nearly the same quantity of goods. This means they have less
income to spend on other goods – they will have to cut purchases of goods which are price
elastic.
The unfortunate producers of price-elastic goods will suffer a double blow. They will suffer a
drop in demand from the tax increase and not be able to increase price by anything like the
full amount of the tax, and they will suffer a further drop in demand because consumers'
discretionary incomes have fallen. It is no surprise that business bankruptcies began to
increase rapidly in the UK after a general increase in VAT.
We have so far assumed that these taxes would be used either to increase government
revenues or to reduce consumer demand if the government believed that excess demand
was causing inflation. There is however another aspect of government policy that is
beginning to appear: this is the control of pollution, now recognised as a significant problem.
An indirect tax on expenditure could be used as an instrument to reduce demand, and hence
the production or use of something that was believed to be a source of pollution. An example
would be an additional tax on petrol to discourage the use of motor vehicles. However, as
the demand for petrol is price inelastic then the tax will not have much effect on vehicle use
but will reduce consumer incomes available for spending on other goods. One of the main
reasons why demand for petrol for car use is price inelastic is because of the lack of
satisfactory substitutes. As motor vehicle ownership has increased the demand for and
supply of public transport has fallen; and as public transport provision falls and its price rises,
so even more people are induced to use their own private cars.
We therefore conclude that a "pollution tax" on petrol would fail in its objective unless the
government also made provision for (and probably subsidised) alternative public transport, at
least in urban areas where cars are used for travel to work and for relatively short journeys.
If the government also wished to discourage car use for longer journeys it would need to
provide alternatives, probably in the form of subsidised rail travel combined with local
transport to convey people from the main railheads. A tax is a very blunt instrument, and a
government wishing to influence consumer behaviour needs to take many aspects into
© ABE and RRC

account. It is not sufficient simply to increase the price of the good whose use it wishes to
discourage.
Reverting to our general discussion of the effects of taxes on prices we have not taken into
account differing elasticities of supply. This is because supply reactions will take place over a
period of time. If suppliers can react by cutting back supply fairly quickly, then there will be
further effects on market price. You can examine these for yourself by changing the supply
curve to make it more elastic in Figures 6.9 and 6.10.
H. USING INDIRECT TAXES AND SUBSIDIES TO CORRECT

MARKET DEFECTS
In this section we consolidate the preceding explanation and analysis by looking at how a
government can use indirect taxes and subsidies to correct the market failures that result
from externalities, the underconsumption of merit goods and the over-consumption of
demerit goods.
If the consumption of a good or service is associated with a positive externality the demand
curve for the good will fail to take this into account, and will only reflect the private benefits
enjoyed by consumers. That is, individuals only consider their private benefit from
consuming the good and the market demand curve measures the marginal private benefit
derived from the good. In this case, because of the positive social benefit, the marginal
social benefit curve will lie to the right of the demand curve. Such a good is a merit good and
the position of the two curves is shown in Figure 6.11.
Figure 6.11: The marginal social benefit curve and positive externalities
(merit goods)
Benefits
and costs
Supply
£s
Positive
externality
Marginal Social
Benefit
Demand
(Marginal Private Benefit)
Output
Conversely, if the good is a demerit good, its marginal social benefit curve will lie to the left of
its demand curve because of its negative externality. This is shown in Figure 6.12.
© ABE and RRC

Figure 6.12: The marginal social benefit curve and negative externalities
(demerit goods)
Benefits
and costs
Supply
£s
Negative
externality
Demand
(Marginal Private
Marginal Benefit)
Social Benefit
Output
A similar situation prevails with the negative externalities that can arise with production. The
supply curve for a good or service only takes account of the private costs incurred by the
producer of the good. The social costs created by any negative externalities during the
process of production, such as water or atmospheric pollution, are ignored by the firm. In this
case the firm's supply curve, which measures the marginal private cost of production, lies
below the marginal social cost curve that adds the cost of the negative externality to the
private costs. This is shown in Figure 6.13.
Figure 6.13: The marginal social cost curve and negative externalities
Benefits Marginal Social

and costs Cost
£s
Supply
(Marginal Private
Cost)
Negative
externality
Demand
Output
© ABE and RRC

In some cases the production process for a good or service creates a positive externality and
the firm's supply curve fails to reflect the social cost of producing the good. For example, the
smelting of aluminium involves large amounts of energy and creates waste heat. In the UAE
the waste heat from the aluminium plants is used to distil sea water into fresh water that is
then used for irrigation. Unfortunately such examples of positive externalities in production
are much less common than the negative externalities due to pollution. Figure 6.14 illustrates
the situation in which production creates a positive externality and the marginal social cost
curve lies below the supply curve.
Figure 6.14: The marginal social cost curve and positive externalities
Supply
Benefits (Marginal Private Cost)
and costs
£s
Marginal Social
Cost
Positive
externality
Demand
Output
Now we can combine the curves shown here and analyse the action required from
government to correct the market failures that result from externalities in production and
consumption. Figure 6.15 illustrates how a subsidy can be introduced when the marginal
social benefit from a good exceeds the marginal private benefit. In the absence of a
government subsidy, the free market equilibrium is where the demand and supply curves,
which are also the marginal private benefit and cost curves, intersect at point E. At this point
too little is being produced and consumed when account is taken of the marginal social
benefits. The private market equilibrium quantity is Q1 which is less than the socially
optimum level of output Q2, determined at the point where the marginal private and social
costs are equal, point G.
© ABE and RRC

Figure 6.15: Subsidies and the socially optimum production level
Benefits Supply = Marginal Private Cost (MPC)

and costs
£s
MPC – Subsidy of GH per unit
G
H
Marginal Social
Benefit (MSB)
Demand = Marginal Private Benefit
Q2 Q1 Output
To achieve the socially optimum level of production and consumption (Q 2), where the
marginal social benefit equals the marginal private cost of production at G, the government
should pay firms a production subsidy of GH per unit produced. The subsidy is equal to the
value of the externality which is the difference between the marginal social and marginal
private benefits at point G.
In the situation where there is a negative externality in production, because the marginal
social cost of production exceeds the marginal private cost, firms overproduce the good in
relation to the socially optimum level of production and consumption. Output, if left to the free
market is Q1, which exceeds the social optimum level of Q2. To correct the market failure the
government needs to make firms take account of the negative externality they are
responsible for creating. The solution in this case is to impose an indirect tax on each unit of
output equal to the difference between marginal social and private costs at the point where
the marginal social cost curve intersects the marginal private benefit curve. This requires a
tax of EF per unit. This is illustrated in Figure 16.16.
© ABE and RRC

Figure 6.16: Taves and the socially optimum production level
Benefits Marginal Social Cost (MSC)

and costs + unit tax of EF per unit
£s
Supply = MPC
Demand = MPB
Q2 Q1 Output
Review Points
This is one of the most important units in the Study Manual. If you have not mastered its
content you are unlikely to be able to achieve a satisfactory level of understanding of
economics. Because of the fundamental role of the forces of supply and demand in the
determination of prices in markets, and their significance for the behaviour of firms, and
government intervention in markets, you need to make absolutely certain that you fully
understand the content of this unit if you want to pass the examination in this subject.
It is absolutely vital, before you continue with the next study unit, that you should go back to
the start of this one and check that you have achieved the learning objectives and feel
confident in undertaking demand and supply curve diagram analysis. If you do not think that
you understand fully each of the learning outcomes you should spend more time reading the
relevant sections.
You can test your understanding of what you have learnt, and your ability to use demand
and supply curve analysis, by attempting to answer the following questions. Check all of your
answers with the unit text.
1. In a free market, is the equilibrium market price determined by:

(i) demand alone
(ii) supply alone
(iii) the interaction of demand and supply
(iv) government intervention?
2. If the supply curve is upward sloping, other things remaining unchanged, will a
rightward shift in market demand result in:
(i) a decrease in the equilibrium price and quantity supplied, or
(ii) an increase in the equilibrium price and quantity supplied?
© ABE and RRC

3. If the demand curve is downward sloping, other things remaining unchanged, will a
rightward shift in the supply curve result in:
(i) a decrease in the equilibrium price and an increase in the quantity supplied, or
(ii) an increase in the equilibrium price and quantity supplied?
4. The following diagram shows the initial equilibrium position, Q1, in the market for a
normal good and a second demand curve D2.
Price
Supply
D2
D1
0
Q1 Q2 Quantity of output
Could the rightward shift in the demand curve be the result of:
(i) a decrease in the price of a substitute good
(ii) an increase in the incomes of consumers
(iii) the introduction of an indirect tax on the good by the government?
5. Explain the meaning of the following:
(i) externality
(ii) social cost
(iii) social benefit.
6. If consumption of a good yields a positive external benefit, is the good referred to as:
(i) a demerit good, or
(ii) a merit good?
7. In the absence of intervention by the government, if the social marginal cost of a good
exceeds its marginal private cost is the good:
(i) overproduced
(ii) under-consumed?
© ABE and RRC

8. Explain the meaning of the following:

(i) price floor
(ii) price ceiling
(iii) output quota.
9. The following diagram shows the free market equilibrium position, Q1, for a merit good.
Price
Supply = marginal
private cost =
marginal social cost
A
P2
P1
D2 = marginal social benefit
B D1 = marginal private benefit
0
Q1 Q2 Quantity of output
To achieve a socially optimal level of production and consumption of the good should
the government intervene in the market and:
(i) pay producers a subsidy of AB per unit
(ii) tax producers AB per unit produced
(iii) impose a price ceiling of P2
(iv) impose a price floor of P1?
© ABE and RRC

125
Study Unit 7
Market Structures: Perfect Competition versus Monopoly
Contents Page
A. Meaning and Importance of Competition 126
B. Perfect Competition 127

Definition 127
Conditions for Perfect Competition 128
Movement towards Equilibrium in Perfectly Competitive Markets 129
Views on Perfect Competition 132
Profit Maximisation as a Result of Perfect Competition 132
C. Monopoly 133
Definition 133
Sources of Monopoly 133
The Monopoly Model 134
Is Monopoly Good? 135
© ABE and RRC

126 Market Structures: Perfect Competition versus Monopoly
Objectives
The aim of this unit is to: explain the profit-maximising outcomes under monopoly and
perfect competition in the short and long run; identify the differences between the two market
structures; examine the effects of changes in government policy upon these markets.
 identify, using diagrams, the characteristics of perfect competition at the firm and
industry level and identify, in numerical and/or diagrammatic examples, equilibrium
price, firm and/or industry quantity, profit, marginal cost, average cost, marginal
revenue and average revenue
 examine, for perfect competition, the effects of changes in the conditions of the
industry upon the market equilibrium in the short and long run and discuss the
mechanism by which the industry moves from the short-run to the long-run equilibrium
and discuss the welfare implications of perfect competition
 identify, using diagrams, the characteristics of monopoly and explain the relationship
between average and marginal revenue, and identify, in numerical and/or
diagrammatic examples, equilibrium price, output, profit, total cost, total revenue,
marginal cost, average cost, marginal revenue and deadweight loss
 examine, for monopoly, the effects of changes in the conditions of the industry upon
the market equilibrium in the short and long run and discuss the welfare implications of
monopoly with reference to the deadweight loss triangle and X-inefficiency
 discuss the merits of policy alternatives aimed at reducing the social cost of monopoly
 solve basic diagrammatic and numerical problems under monopoly and perfect
competition
 identify and discuss real world examples of industries with similar characteristics to the
models of perfect competition and monopoly.
A. MEANING AND IMPORTANCE OF COMPETITION

"Competition" is one of those simple words which are common in everyday speech. We all
assume we understand what it means, but when we try and explain it, it starts to present
problems. Ask yourself what benefits you think you get from competition as a consumer.
Suppose you think in terms of being able to buy from different suppliers, and being able to
choose from a variety of different but broadly similar goods – for example choosing shoes of
different styles, sizes, quality and price ranges. Perhaps you think of having some power as
a consumer to bargain over price, or awareness that some suppliers will charge lower prices
than others. Notice that the word that recurs constantly when most of us think about
competition is choice. You and I, as consumers, value the ability to choose between a range
of goods, different prices and different standards of quality and service.
Because of the buyers' ability to choose and apply pressure on prices, we expect
competition to oblige producers and distributors to use their resources efficiently and keep
production and distribution costs low. Competition is usually thought to be a very powerful
force to ensure production efficiency.
Competition is thus widely believed to be a desirable feature of markets. Most of the major
modern market economies have legislation and institutions concerned with preserving or
increasing competition. The Treaty of Rome, the founding treaty of the European Economic
Community – now the European Union – contains a strong commitment to competition and
the prevention of attempts to limit it.
© ABE and RRC

Market Structures: Perfect Competition versus Monopoly 127
Economists have generally been in favour of competition as a force likely to increase the
efficient use of scarce resources, and they have developed a concept of perfect competition
which we shall examine in this study unit. However more recently they have recognised that
traditional views of competition have limitations, and that the pressures on business firms are
more complex than have sometimes been believed in the past. There is also a recognition
that increased competition can sometimes have consequences that are not beneficial to
consumers, or which are not socially very desirable. In particular, competition may be
harmful, or at least lead to a socially suboptimal outcome, if firms take no account of the
existence of positive and negative externalities in production, and their impact on the
environment.
So we must be careful in our assessment of the benefits of competition, and be prepared to
be critical when examining some of the traditional economic models of competitive markets.
These models have been developed in the belief that the degree of competition in a market
is likely to influence the behaviour and performance of firms operating in it. In this study unit
we look at some of the best known models; these provide an essential starting point for
understanding the often complex markets existing in modern economies. However, we must
be equally careful in our assessment of competition that we do not impose our values of
what is good or bad for society on others who may have different values. It is also important
to note the influence of technology on markets and competition. For example, the rapid
growth of modern low cost communications and knowledge sharing in the form of mobile
phones and the Internet have significantly increased competition, both in markets within
countries and between countries. Indeed, the Internet has made the economists' ideal model
of perfect competition a much more real description of how many markets now work in the
real world.
B. PERFECT COMPETITION
Definition
Our first theoretical model covers the situation where the economic market operates in its
purest or most perfect form. Perfect competition is the state of affairs existing in a market
totally free from imperfections in the communication and interaction of the economic forces
of supply and demand.
Some writers like to make a distinction between perfect or ideal markets and perfect
competition, in addition to the distinction between the market as an area and competition as
a condition found in that area. They suggest that the conditions for perfect competition are
satisfied when the individual firm is a "price-taker", i.e. when it can sell all that it can produce
at the market price, which by itself it cannot alter, and when buyers are indifferent as to
which seller's product they buy at that price. Such a very limited set of requirements would
be satisfied when firms in an industry were subject to a regulated price set by a government
or some other regulatory body which had powers to buy goods unsaleable in the market.
This would certainly not be a perfect market.
For true perfect competition to exist, it seems more realistic to stipulate that sellers must be
free to enter and leave the market, so that total supply can change and bring about the
equilibrium position. Just to establish a market price through some form of price regulation
would not produce the same result, unless the regulating body is very sensitive to demand
shifts, and production plans can be adapted quickly.
So it seems that full operation of perfect competition can be achieved only in a perfect
economic market, and to put too much emphasis on differences between the two does not
really help very much in our analysis of the main market forces.
© ABE and RRC

Conditions for Perfect Competition

These can be summarised as follows:
(a) Goods must be Homogeneous
This means that in the perception of the buyer, all units of the goods offered by all
suppliers are equally acceptable. The buyer is indifferent as to which unit he or she
receives, as long as it conforms to any description adopted by, and understood in, the
market.
Notice that it is the perception of the buyer that is important. Suppose two large retail
stores make an arrangement with a manufacturer to be supplied with canned baked
beans in plain tins. The manufacturer supplies beans of the same type and quality to
each retailer in the plain cans quite impartially. However, each store adds its own label
to the cans and sells the beans under completely different brand names and at slightly
different prices. The products are physically the same, but they are not homogeneous,
because the public perceives them as different and competing products.
(b) Perfect Transport and Communications
All consumers in the market must have the same information. Suppliers must have
access to the same information about production factors and the technical conditions
of production. No producer is in a more favoured situation than any other.
(c) Price Established Only by Market Forces
No producer and no buyer is able to influence the price by his or her own actions, nor
by actions agreed with other producers or buyers. There is no degree of monopoly
power in the market.
(d) Economic Motives Only
The actions of suppliers and buyers are influenced only by economic motives. If buyers
or sellers are influenced by a desire to support a charity or a political party the market
will not be purely economic, however worthy the social motives.
Economic rationality in a market economy assumes an underlying self-interest and a
desire to maximise benefits that can be gained from available scarce resources. For
the consumer this means maximising utility, as defined in Study Unit 2, while for
producers it is usually interpreted as wishing to maximise profit – an objective
examined later.
(e) No Barriers Limiting Market Entry and Exit
Suppliers and buyers must be free to enter and leave the market as they choose and
as they are guided by considerations of profit and utility. This is a very important
element in any competitive market and in some modern models of market behaviour,
notably that of contestable markets, it is the most important consideration.
Barriers to market entry and exit may be "natural", i.e. arising out of the nature of the
goods or the production process, or "artificial", i.e. arising out of market regulations.
Natural barriers are highest when production requires large amounts of highly
specialised capital, e.g. oil exploration and extraction or motor vehicle assembly. Only
firms with access to very large amounts of finance can enter these markets. Once this
capital has been acquired, the firms are committed to staying in the market, since exit
would usually involve very large financial losses. Natural barriers are low when little
specialised capital or skill are needed to commence production.
When natural barriers are low established producers may seek to protect themselves
from new entry by building artificial barriers. These barriers may be membership of a
trade or professional association (entry to which may require a long period of
© ABE and RRC

apprenticeship), education or high membership fees. It is not unknown for established

traders to prevent new entry illegally by the use of force, as in the case of ice cream
selling in some areas and, of course, street trading in illegal drugs.
The lower the barriers, both natural and artificial, the more contestable the market; the
theory of contestable markets suggests that contestability is a powerful force
determining the behaviour of suppliers in a market. If producers know that they can
easily be challenged by new competitors, they will behave as if they were subject to
competition because they will not wish to provide incentives for new firms to come into
the market. Such incentives would include supernormal profit or the existence of
buyers who were dissatisfied with existing goods, standards of service or prices.
Consequently we would expect a perfectly contestable market to exhibit most if not all
the characteristics of perfect competition.
Movement towards Equilibrium in Perfectly Competitive Markets

We can now examine the behaviour of firms operating under conditions of perfect
competition.
If we assume that the firm is experiencing diminishing marginal returns and can sell all it can
produce at the market price, over which it has no control, then it will have average and
marginal cost curves and an average revenue curve as shown in Figure 7.1. Since all units
of the good are sold at the same price whatever the firm's sales level, price will equal
average revenue and will also be the same as marginal revenue.
Figure 7.1: Marginal cost, average cost and marginal revenue
Price/Cost Marginal cost
Average cost
d
C
Marginal revenue
P
Shaded area  loss b  average revenue
 price
O q Output
Suppose the price resulting from the interaction of supply and demand in the market as a
whole is Op; then there is no level of output at which the firm can produce at a profit.
At all levels of output price, average revenue is below the average cost curve. However, the
profit-maximising condition of marginal cost equals marginal revenue is also the loss-
minimising condition, so the best output for the firm to choose is at Oq where marginal cost
equals marginal revenue. At this output level, average cost at Oc is higher than average
revenue at Op, so the firm suffers a loss equal to the shaded area (cdbp).
© ABE and RRC

Given the conditions for perfect competition, if this is the situation faced by one firm, it is the
situation of all firms subject to the same market information and technology. Firms cannot
continue indefinitely suffering losses. Some will withdraw from the market (remember that
unrestricted entry and exit is another condition of this market) because they are less able to
withstand losses or they have other markets they can enter. As supply declines, so the total
market supply curve will move to the left, as shown in Figure 7.2.
Figure 7.2: Market supply curve moves left
S1 If firms suffer losses at price Op

Price D
some withdraw from the market.
Market supply falls from Oqm to
S Oqm1 and equilibrium price rises
from Op to Op1 as supply shifts
p1 from SS to S1S1.
S1 D
S
O
qm1 qm Output
The market equilibrium price then rises – assuming that demand remains unchanged.
Supposing the equilibrium price moves up from Op to Op1, this produces the situation for the
individual firm illustrated by Figure 7.3.
Figure 7.3: Market equilibrium price rises
Price/Cost
Marginal cost
Average cost
Shaded area  Profit Marginal revenue

P1
 average revenue
 price
C
O q Output
© ABE and RRC

Now we see that the average revenue at Op1 is higher than average cost at Oc, and the firm
is enjoying profits, represented by the shaded area. Notice that once again the most
profitable output to aim at is at Oq, where marginal cost is just equal to marginal revenue.
Now, given our earlier assumptions, all firms are making profits. If we have defined cost to
include a normal return to all production factors (including some return to enterprise in the
form of a minimum profit to keep firms in the market and provide necessary capital
investment) then this shaded area profit is an additional or abnormal profit, resulting only
from the special market opportunities.
Owing to perfect communication and free entry, new firms will enter the market to take
advantage of these profits. Supply will now increase – the supply curve will move to the right
and equilibrium price will fall.
Suppose it falls to a position between Op and Op1, say to Ope where price/average revenue
is just equal to average cost. Now the individual firm is in the position illustrated in Figure
7.4. Here, there is neither abnormal profit nor loss. We assume that the firm's costs include
an element of normal profit, which can be defined as a fair return to the firm's enterprise, or
sometimes as that amount of profit which is sufficient to keep firms operating in that market.
This normal profit is included therefore in the average cost curve. There is no incentive for
firms to move into or out of the market: there is no reason why supply should shift – and, as
long as demand remains unchanged, there is no reason for any movement in this equilibrium
balance.
Figure 7.4: Perfect competition
Price/Cost
Average cost
Pe
MR  AR  Price
Marginal cost
O q Output
It is on the basis of this kind of argument that textbooks and examiners sometimes make
much of the distinction between short-run equilibrium in perfect competition where abnormal
profits or losses can be experienced, and long-run equilibrium where only "normal" profits
(included in the average total cost curve) are possible. However, we should stress that these
are really only partial equilibrium positions relating to supply alone. The model says nothing
about influences on demand which is often far from stable. A shift in demand will be quickly
reflected in a shift in supply to readjust output to the new market price. Consequently, in
markets where demand is inherently unstable – as in the stock and commodity exchanges –
long-run equilibrium may never be reached as suppliers are constantly adapting to the
shifting market environment.
© ABE and RRC

Views on Perfect Competition

Economists often favour perfect competition on the following grounds:
 The elimination of abnormal profit, as shown in Figure 7.4 (compare to Figure 7.3).
 Efficient use of resources. Notice that, in equilibrium, the bringing together of price and
marginal cost and the elimination of abnormal profit means that producers will produce
when the average cost curve is at its lowest point (where marginal cost equals average
cost). There is then a tendency to encourage producers to reduce average costs as
much as possible. This is equivalent to making the most efficient use of resources.
 Price is equal to marginal cost. Price is the money value of the utility gained by the last
or marginal consumer, i.e. marginal utility. When marginal cost equals marginal utility,
as in perfect competition, the cost of producing the last unit is just equal to the value of
the utility given by that unit to its consumer. If this were true in all cases, then the total
cost of production would equal the total value of utility received. It is suggested this
would be the best possible use of all resources.
Not everyone accepts these arguments, and you should consider the contents of this section
in conjunction with the discussion of monopoly, later.
One of the arguments against perfect competition is that it prevents producers from making
the profit necessary to provide funds for investment and research, to find better ways of
producing goods. Another argument is that competition can be wasteful, as resources are
doing the same things. If there were fewer competing firms, total costs could be reduced and
some resources freed to produce something else.
Firms dislike perfect competition because, as indicated earlier, prices are unstable. If
communications are good, then supply can adapt very quickly to price changes caused by
changes in demand. The result is that prices are constantly adapting to new equilibrium
positions – as with the Stock Exchange, which is still the common textbook example of a
market which is close to perfect competition. In the Stock Exchange, prices change daily,
and even hourly.
Manufacturers cannot tolerate swiftly-moving prices like this – they could survive in such a
market only if they could keep changing the prices paid for production factors, including the
wages paid to workers. Trade unions have sought to achieve stable jobs – and, preferably,
rising wages. Producers then want stable – and, preferably, rising – prices. Those
economists who argue for perfect competition in the consumer interest, and then argue for
stable wages and secure employment, are being illogical. These two conditions cannot exist
together.
So perfect competition may or may not be ideal from a purely economic viewpoint. It is
certainly far from ideal from a social standpoint.
Profit Maximisation as a Result of Perfect Competition

Notice that the only output enabling the firm to survive in the equilibrium condition illustrated
in Figure 7.4 is where marginal cost equals marginal revenue. The removal of abnormal
profit ensures that the average cost curve is at a tangent to the average revenue curve, and
as this is horizontal, it follows that the average cost curve must be at a tangent at its lowest
point, i.e. where average cost equals marginal cost.
This is what is meant by saying profit maximisation is a survival condition resulting from
perfect competition. Only by achieving this profit-maximising output can the individual firm
avoid losses. Whether it achieves this intentionally or by trial and error does not matter;
failure to achieve it means eventual failure to exist in the market.
© ABE and RRC

C. MONOPOLY
Definition
Monopoly is the opposite extreme to perfect competition. It exists when there is only one
supplier for a particular product and there are no close substitutes for that product.
Again, we have to be careful how we define the product. For example, the Post Office has a
monopoly in the delivery of low-price letter mail in Britain. However it does not have a
monopoly in personal and business communication, and in recent years the volume of letter
mail has declined in the face of competition from the telephone, fax and from private firms of
leaflet distributors. It now faces more competition from email and Internet services.
Historically almost all monopolies are subject to destruction by the onward march of
technology.
Sources of Monopoly
Monopoly can arise in three ways: by operation of the law, by possession of a unique
feature, or by the achievement of market control.
(a) Operation of Law
This is a very old source of monopoly power. Kings used to sell monopolies in Europe
to raise money: they sold people the right to be sole suppliers of a necessary product,
such as salt, in a given area. The monopolist could rely on the support of the King's
officers to protect his monopoly, and the profits he could make more than covered the
fee he had to pay for his position.
Today, some countries may grant a company the right to be sole supplier of a product
or service (e.g. telephones) in return for some measure of State inspection and control
over profits and prices. In Britain, before 1979, it was usual for such monopolies to be
public corporations under public ownership and control. This has been changed by the
privatisation programme, which has resulted in a policy of separating regulation from
operation. Some important public utilities are now legally companies in the private
sector (e.g. British Telecom and British Gas), but are subject to government influence
as a shareholder, and regulation by separate bodies (OFTEL and OFGEM
respectively). (OFGEM is also the electricity regulator and water industries are
regulated by OFWAT.)
A more limited monopoly power is granted under patent and copyright laws, which are
similar in most countries. The idea of a patent is that the inventor of a new idea shares
his or her knowledge with the State for the public benefit, in return for a monopoly
control over the use of the idea for a limited number of years. If rival suppliers are
unable to develop a competing product without breaking the patent, this form of
monopoly can be very valuable – for example the monopoly enjoyed for some years by
the Polaroid instant film-developing process.
(b) Possession of a Unique Feature
Individuals have monopoly control over the supply of their own skills, and this may be a
source of considerable profit. The top footballers, tennis players and entertainers are
monopolists of this type. When the skill lies in producing something written or
recorded, then the monopoly position is protected by copyright laws – which, however,
modern technology has made more difficult to enforce.
(c) Market Control
It is difficult to achieve total monopoly over supply without the protection of the law,
although it is not unknown – especially in the production of some intermediate
products. For a number of years, all the valves for pneumatic tyres on British motor
© ABE and RRC

vehicles were produced by one manufacturer. Such a monopoly rarely lasts very long.
When a large rival decides to challenge the monopolist, there is little that can be done
to prevent this.
The Monopoly Model

The model has been developed to explain the outcome of a monopoly not subject to any
special legal protection or control. It assumes that the firm is pursuing a profit-maximising
objective, and that it is able to make abnormal profits.
Figure 7.5 : Monopoly
Price/Cost
Revenue
Marginal cost
Average cost
P
C
Pw
Average revenue
Marginal revenue
O q qw Output
A monopolist's output is the total market supply, and the demand for its product is the total
market demand. The firm will thus face a downward-sloping demand curve. If we assume
that it is not practising price discrimination, then this curve will be the price/average revenue
curve. The graphical model is shown in Figure 7.5.
The profit-maximising monopolist will produce at output Oqπ, where marginal cost equals
marginal revenue, and will charge price Op. Abnormal profit is represented by the shaded
area. The average cost is Oc, so Op  Oc is the average profit earned on each unit of
product sold.
If the firm were to set price to equal marginal cost, which is the position desirable from the
consumer viewpoint, it would produce output Oqw and charge the lower price Opw. This is
why the profit-maximising monopolist is said to restrict output and increase price in
comparison with a firm operating in a competitive market. Is it the case that monopoly is
worse than competition and operates against the public interest?
© ABE and RRC

Is Monopoly Good?
There is much evidence that large firms with considerable market power may not maximise
profits but may pursue quite different objectives, such as growth or sales revenue
maximisation. The average cost curve was drawn on the basis that abnormal profit was
being made. There is nothing in the model itself that says that the average cost curve must
be this shape and in this position. We can move it up or down without affecting the other
curves, and so alter the profit quite legitimately.
In short, the model proves nothing. It simply illustrates the assumptions made. Notice that, if
we drop the profit-maximising requirement, we can allow the firm to increase output and
reduce price, and so come closer to the consumer-benefiting output level of Oqw. This would
also reduce average cost and allow the firm to make more efficient use of its resources.
In answer to the charge that monopoly is against the public interest because it restricts
output and raises price, the following arguments are often put forward in defence of
monopoly:
(a) The monopolist's size and ability to produce for the whole market enables it to achieve
economies of scale, so that costs are actually lower than they would be under perfect
competition.
(b) The monopolist employs professional managers who make more efficient use of
available resources than small owner/managers, who often lack managerial skill.
(c) The monopolist does not maximise profits but is content with just a satisfactory level of
profit.
(d) Some element of abnormal or monopoly profit (normal profit is considered to be
included in the firm's costs as for perfect competition) is desirable, so that the firm can:
(i) spend money on research and gather funds for further capital investment;
(ii) have the incentive to take risks and innovate, and sometimes suffer losses that
would cripple smaller firms.
The position where a monopolist is actually able to charge lower prices than would be
possible under perfect competition is illustrated in Figure 7.6. Here, for simplicity, constant
average total costs have been assumed and the monopolist's cost curve is below that of
small firms by reason of economies of scale and improved technology. Assuming that the
monopolist seeks to maximise profits, the appropriate price will be Pm, still higher than the
perfectly competitive price of Pc. However, this could be reduced if the monopolist had some
other objective such as maximising growth or revenue. The revenue-maximising price (Pr),
i.e. the price applicable to producing at the quantity level where marginal revenue is zero,
and therefore total revenue is at its maximum, is lower than the perfectly competitive price of
Pc. Notice that, unlike the firm under perfect competition, the monopolist can charge a range
of prices, depending upon the firm's objectives, and still make a profit.
© ABE and RRC

Figure 7.6: Price and output under perfect competition and monopoly
Price,
Revenue,
Cost
Pm
Pc Average cost (Perfect Competition)

Pr
Average cost (Monopoly)
Average revenue
(Demand)
O Qm Qe Qr Quantity
Marginal
revenue
The argument really boils down to a question of performance. Does the monopolist behave
against the community interest or does it achieve levels of efficiency beyond the capacity of
small firms operating in highly competitive markets? There is no clear answer. As the
extreme cases of monopoly are fairly rare in practice, examination is usually made of
markets which approach monopoly conditions.
If the demand curve faced by the monopolist shifts, this will alter the marginal revenue curve
and consequently the profit-maximising output and price. However, we cannot assume that
the demand curve will simply move outwards parallel to the old one. It is possible that its
slope may change, becoming steeper or less steep. Consequently, while normally we would
expect an increase in demand at all prices to lead to an increase in monopoly price
(assuming costs remained unchanged), we cannot be absolutely sure of this. Try
experimenting with differently sloped average revenue curves. Remember that the marginal
revenue must bisect (cut into two equal halves) the horizontal distance between the average
revenue curve and the revenue (vertical) axis. You will find that there are changes that could
produce a reduction in the profit-maximising price!
X-Inefficiency
The problem with the preceding arguments is that they assume that monopolists are
efficient. The evidence is that large organisations, not just large firms with considerable
market power, are inefficient when compared with smaller organisations and firms in
competitive market situations. For example, large government departments and government-
owned firms are notoriously inefficient. The UK National Health Service (NHS) is the third
largest single organisation in the world (based on its number of staff). While the NHS is
wonderful when you are in need of medical attention, many studies show that it is
measurably inefficient and cost ineffective in comparison with both public and private health
care providers in many other countries.
© ABE and RRC

The concept of X-inefficiency is used to explain the economic inefficiency of large

organisations. At its simplest, X-inefficiency is a measure of the excess cost of production of
a unit of output of a good or service by an organisation over the cost of producing the same
output in the most efficient available organisation. Take an industry with two firms producing
the same type and quality of good. Assume the two firms are of different sizes but there are
no economies of scale. One firm has a unit cost of production for the good of £3 per unit,
while the other firm has a unit cost of production for the same good of £4. The second firm is
X-inefficient in comparison with the first firm. Its degree of X-inefficiency is 30 per cent. X-
inefficiency in all types of organisations is ultimately the result of managerial failure.
The lack of the drive provided by the profit motive, and the threat of bankruptcy and closure
for failure to keep costs down, means that bureaucratic organisations tend to be larger than
necessary with far too many employees. They are also resistant to change, and tend to
defend old, established or traditional ways of operation and prevent innovation, especially
when such innovation would mean reducing the number of staff. The main reason for this
inefficiency is the lack of an incentive in terms of a reward structure for workers to be
efficient in carrying out their jobs. Workers are paid regardless of their individual work effort,
usually simply on the basis of their hours at work. The absence of monetary reward or clear
promotion prospects for working harder and/or longer than other workers means that most
staff will behave in the same way, and follow human nature by taking things easy. Likewise if
there is no reward for innovation in the way work is done or changing how departments are
organised to reduce cost and increase output, there is likely to be an absence of change.
The problem is made worse by another feature of bureaucratic organisational structures in
relation to the reward structure for managers. In many bureaucratic organisations,
managers' pay and promotion prospects are directly proportional to the number of staff they
have working for them. This means that mangers who increase efficiency and can deliver the
same or more output with fewer staff damage their own pay and promotion prospects! The
incentive structure is perverse, and rewards inefficient managers who can add to their
department size and budget by demanding more and more workers to deliver the same or
less output. Thus bureaucracies tend to be both cost inefficient for a given state of
technology, and prevent or slow down technological innovation. The entire economy of the
former Soviet Union was organised as a giant state bureaucracy and, not surprisingly,
eventually collapsed because it was unable to match the efficiency and innovation that is a
distinguishing feature of more market-orientated economies. It is difficult, if not impossible, to
think of any modern consumer good or industry that originated in the former Soviet Union or
China. Personal computers, mobile phones, the Internet and most consumer electronic
goods all originated from the competitive environment in market economies and not from
large bureaucratic organisations. It is no surprise that the economic transformation and
success of China in global markets is a consequence of the reform programme introduced in
the country in the late 1980s. In this process individuals were encouraged to start their own
businesses and many state bureaucratic firms were broken up and privatised and
encouraged to compete with each other in return for profit.
The concept of X-inefficiency is very important when evaluating the case for and against
monopoly. Most arguments in defence of monopoly are based on the economies of scale in
production that very large firms may experience, and the capacity of these firms to innovate
resulting from their superior ability to fund and undertake research and development. But
large firms are subject to the failings of large bureaucratic organisations. That is, the
economies of scale that large firms (especially monopoly firms) are supposed to reap
assume that they do not suffer from X-inefficiency. If increasing the size of a firm significantly
leads to a reduction in unit costs of 25 per cent through technical and marketing economies
of scale, but managerial slack resulting from bureaucratic complexity leads to a 30 per cent
increase in its costs, the larger firm is less cost efficient not more cost efficient than smaller
firms. Studies of efficiency in research and development (R & D) activity, and the sources of
innovation in both processes and products, also show that large organisations suffer from X-
© ABE and RRC

inefficiency in undertaking R & D and are not the main source of process innovation in
modern economies.
The advantages of monopoly are:
 lower prices than in competitive markets due to economies of scale
 larger expenditure than competitive firms on R & D
 more innovation due to large expenditure on R & D
 high level of investment expenditure because of large profits.
The disadvantages of monopoly are:
 higher prices than in competitive markets due to persistence of excess profit
 cost reducing advantage of scale economies outweighed by cost increases due to X-
inefficiency
 wasteful expenditure on R & D and low productivity of R & D expenditure due to X-
inefficiency
 no incentive to innovate because of high monopoly profit and absence of competition
from other firms
 no incentive to investment in new production process and products because of existing
high monopoly profit and absence of competition from other firms
 lack of customer focus – limited choice and poor product quality due to lack of
competition.
© ABE and RRC

Review Points
relevant sections.
1. List the key assumptions of the economic model of a perfectly competitive market
structure.
2. Why is a perfectly competitive market regarded as the ideal form of market structure?
3. How has the growth of the Internet affected competition in markets? Is eBay an
example of perfect competition?
4. Explain the key characteristics of a monopoly industry. Can you identify any real world
examples of a monopoly firm?
5. Using an appropriate diagram, outline the model of monopoly.
6. Compare the predictions, including equilibrium price, profit and deadweight loss, of the
monopoly model of market structure with those of the model of a perfectly competitive
market structure.
7. What is X-inefficiency? Why is it found in bureaucracies as well as large firms? Can
you identify examples of X-inefficiency in any organisations with which you are
familiar?
© ABE and RRC

© ABE and RRC

141
Study Unit 8
Market Structures and Competition: Monopolistic
Competition and Oligopoly
Contents Page
A. Monopolistic Competition 142

Main Features 142
General Model 142
Comment 143
B. Oligopoly 144
Price Competition 144
Price Stickiness 144
Kinked Demand Curve 145
Limitations of the Kinked Demand Curve Model 147
Price Leadership 148
Collusive Behaviour 149
C. Profit, Competition, Monopoly, Oligopoly and

Alternative Objectives for the Firm 150
© ABE and RRC

142 Market Structures and Competition: Monopolistic Competition and Oligopoly
Objectives
The aim of this unit is to: explain the kinked demand curve model of oligopoly and the model
of monopolistic competition; discuss the idea of collusion and identify the factors that affect
the stability of a collusive arrangement; compare the predictions of these models with those
of monopoly and competition.
 discuss the general characteristics of an oligopoly industry and identify the
characteristic similarities and differences between oligopoly models and the models of
perfect competition and monopoly
 identify, using the appropriate diagram, the characteristics of the kinked demand curve
model of oligopoly
 identify the equilibrium price, output and profit in the kinked demand curve model
 explain why the kinked demand curve model predicts price stability and discuss the
limitations of this model
 identify, using the appropriate diagram, the characteristics of the model of
monopolistic competition
 identify the equilibrium price, output and profit in the model of monopolistic competition
in the short and the long run
 discuss the meaning of collusion in the context of an oligopoly, examine the factors
that aid or hamper the ability of firms to collude and discuss the implications of these
findings for policy makers concerned with maximising social welfare
 discuss the price, output and welfare implications of oligopoly models relative to the
models of monopoly and perfect competition.
A. MONOPOLISTIC COMPETITION
Main Features
Monopolistic competition still retains many of the features of perfect competition –
unrestricted entry to and exit from the market, good (but not perfect) communication and
transport conditions, motivation by economic considerations only, and the perception by
buyers that the products of the various firms are good substitutes for each other.
It is in this last point that monopolistic competition differs from perfect competition. Although
the products are considered to be good substitutes, they are not homogeneous. Buyers do
express preference for one seller's product as opposed to another's.
Sellers seek to increase this preference by differentiating their product through branding
(giving it distinguishing features) and especially by advertising. The greater the degree of
preference they can establish, the stronger the brand loyalty and the greater the freedom
gained by the supplier from the need to follow the market price for that class of product.
Success brings an increased degree of market power and a reduction in price elasticity of
demand.
General Model
However in the general model of monopolistic competition, we assume that the individual
firm is not able to achieve a high degree of price inelasticity, so that the demand curve for
the individual product has only a fairly gentle slope: there is still a high degree of
substitutability between competing brands. This prevents the individual firm from making
© ABE and RRC

Market Structures and Competition: Monopolistic Competition and Oligopoly 143
monopoly profits. It is still closely governed by the market price for the class of product. The
result is shown in Figure 8.1.
In outline the features of this model are:
 There is no abnormal or monopoly profit: average cost equals price/average revenue
at Op and, as for perfect competition and monopoly, it includes an element of normal
profit.
 At the profit-maximising output of Oq, average cost is still falling to its minimum at Oc,
where average cost is equal to marginal cost – the output level where the rising
marginal cost curve cuts the bottom of the average cost curve.
 Price (at Op) is above marginal cost (Om) at the profit-maximising output Oq.
Price is thus higher and output lower than would be the case if price were to be equal to
marginal cost, as in perfect competition. The lack of monopoly profit is the result of
competition and the ability of firms to enter and leave the market.
Figure 8.1: Monopolistic competition
Price/Cost/
Revenue
Marginal cost
p
c Average cost
m Average revenue
Marginal revenue
O q Quantity
Comment
It can be argued that this market structure is not really in the best interests of either
consumers or business firms, for the following reasons:
 Price is higher and output lower than would be the case with perfect competition.
 The firm is not making the best use of its resources, since average cost is still falling
at output Oq, as we saw.
 Profits are confined to the normal minimum required to keep firms in the market – the
amount included in our definition of costs for the purposes of these market models.
They cannot achieve the profits needed for investment and research or the high output
levels necessary for economies of scale.
© ABE and RRC

That said, it is also argued that consumers are prepared to accept these additional prices
and costs in return for the benefits they receive through greater choice of product – the
ability to choose between competing brands and competing suppliers. This competition may
also lead to improvements in product quality and design as well as services to the
consumer.
We can expect firms operating in such market conditions to seek to increase their monopoly
power and make their product-demand curves less elastic. They will do this by brand
advertising, by securing favourable treatment from distribution organisations or through
technical improvements in their products. They may be able to keep an advantage by
securing patent protection or keeping processes secret from their competitors.
B. OLIGOPOLY
Oligopoly is the market structure where supply is controlled by a few firms which are large in
relation to the market size. Very often the firms are also large by any standards, and are
likely to be oligopolists in several markets. (For example, Unilever is a very large company
which supplies major brands of many grocery products, including Marmite, Flora, Hellman's
and PG Tips and washing products including Surf and Persil.)
Oligopoly is now commonly found in the advanced industrial countries and a great deal of
attention is paid to it. However there is no single model which can be held to apply under all
circumstances.
Price Competition
One influence that is thought to be important is the extent to which the products are in price
competition with each other. If there is little price competition and if consumers are not
thought to choose brands on the basis of comparative price (i.e. if cross elasticity of demand
is low) then each oligopolist has a high degree of monopoly control over the demand for his
own product.
This will of course depend chiefly upon whether the products are regarded by consumers as
homogeneous or whether they consider each brand to be distinct and different. You might
think it is unlikely that consumers will find much to choose between, say, various brands of
plain, salted crisps. Cross elasticity of demand between the brands is thus likely to be high
when the crisps are on sale in similar distribution outlets. If there are price differences,
customers will choose according to price.
In these circumstances, suppliers may seek to operate in different sections of the market,
e.g. through different supermarket chains or in hotels and pubs rather than retailers. They
may also seek to differentiate their products through such devices as flavour or by
developing novelty shapes or other related products. You may be familiar with various
products which have been developed by the four major firms in this market.
A full study of oligopoly is likely to embrace problems of prices and non-price competition,
and even the question of how far firms may collude together to limit the extent of
competition between established firms and to protect themselves against possible
newcomers to the market.
Price Stickiness
Efforts have been made to produce models based on traditional assumptions of profit
maximisation. One such model seeks to explain the observed tendency that the prices of
some goods in oligopolistic markets remain steady in spite of fluctuations in the prices of
basic commodities. This "stickiness" is apparent in more normal, less inflationary times. For
© ABE and RRC

example, the price of bars of chocolate in some markets remains constant in spite of
frequent movements in the prices of the basic materials required for chocolate manufacture.
This particular feature of an oligopolistic market for a product still regarded as fairly
homogeneous (in spite of brand advertising) has given rise to the model known as the
kinked demand curve.
Kinked Demand Curve

Suppose the current and "sticky" price of a product is £1 per unit. This is the price that
customers have come to expect. If one oligopolist supplier tries to increase the price, rival
producers will be reluctant to follow. They will keep their prices the same and gain market
share at the expense of the price raiser. However if the oligopolist reduces the price, the
other suppliers are obliged to reduce their prices also to prevent his encroaching on their
market share.
Thus there is a kink around the price of £1 in the demand (unit price or average revenue)
curve faced by the individual oligopolist. At higher prices the curve is more elastic, due to the
loss of market share, than at lower prices, where all market shares stay the same. You can
see the general shape of such a kinked curve in Figure 8.2.
Figure 8.2: Kinked curve
Price
per At price £1 the oligopolist has
unit difficulty changing price. At
higher prices he loses market
share. At lower prices all
£1 oligopolists in the market keep
the same share but lose
revenue.
O q Quantity
Now consider possible revenues resulting from this condition, in Table 8.1.
© ABE and RRC

Table 8.1: Possible revenues
Price per unit Quantity Total revenue Marginal revenue

(Change in TR)
£ units per time period £ pence
1.40 0 0.00
130
1.30 10 13.00
110
1.20 20 24.00
90
1.10 30 33.00
70
1.00 40 40.00
60 or 20
0
0.80 50 40.00
40
0.60 60 36.00
80
0.40 70 28.00
120
0.20 80 16.00
160
0.00 90 0.00
The kink in the average revenue curve, shown in Figure 8.3, occurs at the price of £1 and
the quantity level of 40 units. At prices above £1, demand falls off at the rate of ten units for
each 10p rise in price. At prices below £1 however, demand falls by only five units for each
10p rise in price, i.e. the unit price has to fall 20p to enable the oligopolist to gain a quantity
increase of ten units.
The change in the slope of the average revenue (price) curve results in a similar change in
the slope of the marginal revenue curve and you can see that there are two possible
marginal revenues at the quantity level of 40 units. The higher (60p) results from the
continuation downwards of the upper part of the curve, whilst the lower (20p) results from
the upward continuation of the lower part of the curve. This is clearer on the graph but you
should be able to work out the same results from the table. Remember the marginal revenue
levels in the table belong to the midpoints of the quantity changes. The lower curve is
changing at the rate of 40p for each ten units; the upper curve is changing at the rate of 20p
for each ten units.
© ABE and RRC

Figure 8.3: Quantity level at which profits are maximised
140
Price/
130
Revenue
120
110
100
90
80
70
60
MC1
50
40
30
AR
20 MC2
10
0
-10 0 10 20 30 40 50 60 70 80 90 Q
-20
-30
-40
-50
-60
-70 MR
-80
Limitations of the Kinked Demand Curve Model

The implication of this model is that short-term fluctuations of variable and hence marginal
costs will not lead the profit-maximising oligopolist to change his price or output. You can
see in Figure 8.3 that the quantity level at which profits are maximised (i.e. where MC1 and
MC2 equals MR) is 45, at which level the market clearing price is 100p. Marginal cost can
fluctuate anywhere between MC1 and MC2 without altering the profit maximising position.
Remember however, that this model depends on an assumption of profit-maximising
behaviour for the oligopolist and a high degree of substitution between products. This
produces the reactions from competing oligopolists that we have described (i.e. refusal to
follow a price increase but matching a price reduction). It is not a general model of oligopoly
and does not tell us how the "sticky" price is arrived at in the first place. There are too many
behavioural assumptions for the model to be entirely satisfactory.
The model does not hold up during periods of severe price inflation, when we would expect
firms to follow their rivals' price rises but not any price reductions which they will not expect
to be maintained because of rising costs. Nor does it hold when there is a dominant firm
acting as a price leader in the market.
© ABE and RRC

Price Leadership
Another tendency observed in some oligopolistic market situations is for the few firms in the
market to follow the price movements of one firm, the price leader. Such leaders can be:
 The least-cost firm, which can oblige competitors with higher costs to follow its prices,
even though they cannot maximise their own profits at the levels it sets.
 A firm which is typical of others in the market and which becomes a barometer of
market conditions. If this firm feels that a price change is necessary, then it is probable
that others will feel the same.
 The largest and the dominant firm in the market. The most common model of this
situation assumes that this firm, because of its size and the economies of scale it can
achieve, is able to achieve lower costs than the others. The lower its costs compared
with the other firms' costs the greater will be its market share and, consequently, its
dominance in the market. This model is illustrated in Figure 8.4.
Figure 8.4: Price leadership model
The market is shared between the

Price Price dominant firm and smaller firms. The
Revenue Revenue lower the costs of the dominant firm
Cost (£) Cost (£) the greater its share of the market
D Market
demand
Supply of
smaller firms
Marginal cost of
Ss
dominant firm
Ps Dd
Pd Demand for
dominant firm
Po
D Dd
O qs  qd  O qd 
Marginal revenue
of dominant firm
The market is shared between the dominant firm and smaller firms. The lower the costs of
the dominant firm the greater its share of the market.
The dominant firm model makes the following assumptions:
 The dominant firm is aware of the total market demand curve and the cost conditions,
and hence the supply curve, for the smaller firms in the market.
 The objective of the dominant firm is to maximise profits.
In Figure 8.4 the demand curve DD is the demand curve for the market and SsSs is the
supply curve for the smaller firms. At price Po these firms are unwilling to supply to the
market; it is their minimum price. At price Ps the smaller firms are able and willing to supply
the full market demand at that price.
This knowledge allows the dominant firm to estimate its own demand curve, which is made
up of market demand at each price less the amount which the smaller firms are able to
supply. Thus the demand for the dominant firm's product is nil at price Ps but it is the same
© ABE and RRC

as market demand at prices Po and below. Between these two prices the dominant firm is
able to supply the balance between market demand and supply from the smaller firms.
On the assumption of profit maximisation the dominant firm will wish to supply quantity q d,
which is the quantity at which its marginal cost is equal to its marginal revenue. At this
quantity level the dominant firm's market clearing and profit maximising price is Pd. If it
charges this price the other firms will have to follow, and market demand at this price is
shared on the basis of qd to the dominant firm and qs to the smaller firms.
Notice that if you raise the dominant firm's marginal cost curve then you will reduce qd and
increase qs. However, if you lower this curve you will increase the market share going to the
dominant firm, which is thus able to maintain its dominance as long as it is able to keep its
costs lower than those of the smaller firm. We may assume it is able to achieve this through
economies of scale, a higher level of technical knowledge and managerial skill, and by its
superior power to secure low prices in the factor markets.
Collusive Behaviour
Another distinguishing feature of oligopolistic market situations is collusion between firms in
the industry. Although such behaviour, which includes price fixing (agreements to fix a
common price), is illegal in many countries, the nature of oligopolistic market situations
lends itself to collusive behaviour and agreements. Competition reduces prices and profits,
which is why it is beneficial for consumers and the success of economies, but it makes life
hard for the managers of companies and their owners who would prefer higher profits. In
perfect competition the very large number of firms in the market makes it difficult for firms to
get together and fix the market in their own interest. Oligopoly is different: because of the
small number of firms, each one knows the others it is competing against. More importantly,
each knows that if it changes its price, or any of the non-price features of its marketing, it will
have an effect on the other firms' markets share and they will take action to restore their
position. That is, oligopoly market situations involve interdependence between the behaviour
of firms. Equally, the small number of firms in the market means that the owners/managers
can easily arrange to meet and agree that if they stopped competing, reduced their outputs
and set a common price, then they would all make more profit and have a quieter life!
Recognising the independent nature of their price and output decisions, and the danger of a
price war resulting from each firm trying to increase its market share/profits, leads firms in
oligopolistic markets to collude and act as if they were one firm with monopoly power.
Such behaviour is more common than you might think: it often involves firms in different
countries because many global markets, such as cement, steel and air cargo transport, are
oligopolistic in nature. In the EU, where such collusive agreements are illegal, the
Competition Commission has been successful in prosecuting firms which have fixed the
price of glass, cement, plasterboards and vitamins. The US government has achieved a lot
of success in fining firms for entering into collusive agreements.
Competition authorities try to prevent or break up collusive agreements between firms, to
protect consumer interests against the monopoly exploitation such collusion is intended to
achieve. Fortunately for consumers such collusive behaviour also contains the seeds of its
own destruction, although it may take several years for the seeds to bear fruit, and
consumers still lose out during this period. The instability of collusion in oligopoly and the
reasons why collusion agreements break down include:
 The incentive for each member of a price-fixing and/or market sharing cartel
agreement between firms to cheat on the other members. Once the cartel has set an
agreed price, each firm will gain more sales and profit if it secretly cuts its own price
below the agreed price. This will be done on the assumption that the other firms in the
cartel obey the rules and keep their price at the agreed fixed level. Since every firm
will reason in this way, each firm in the cartel has an incentive to secretly lower its
© ABE and RRC

price and/or try to sell more than its allocated share in another firm's market. The
result of this individually rational behaviour by each firm is that they collectively destroy
the price fixing and/or market sharing agreement!
 Firms in the cartel are reluctant to share full information about their true costs, prices,
sales and profit, or they give false information. This can lead to disagreements
between members and lack of confidence that other members are sticking to the rules
of the cartel. In turn this can lead to members responding to real or imagined rule
breaking by other members by breaking the rules themselves.
 Firms in an oligopolistic market situation recognise that their price and output
decisions are interdependent. The significant implication of this is that the normal
relationships between price changes, and the consequent changes in sales and sales
revenue, depend not just upon the elasticity of the firms demand curve. These
relationships also depend upon how other firms respond to a firm in the market
changing its price, as shown in the kinked demand curve model. This interdependence
creates uncertainty for firms that have to determine their production and pricing
decisions on the basis of game theory. The decision making is of the form: "If I
increase my price tomorrow by 10 per cent what will be the consequences for the
other firms in the industry? How will they react? Will I still gain if they only decide to
respond by increasing their prices by 5 per cent? What if my main competitor
responds by reducing rather than matching my price increase?" Each firm is in a game
situation: think about the card players in a game of poker for a similar example. In
such a situation it is highly likely that at some point one firm will make a decision to
change its price and output, based on its assumption about the response of the other
firms, and get it wrong. In this situation the market is unstable. A price war is a likely
consequence, even when firms have a collusive agreement, if at least one firm to the
agreement thinks that it can come out the winner in such a situation.
 Another reason for the instability of collusive agreements exists when such
agreements are illegal. There is the incentive for one member to avoid legal
prosecution, and a very large fine, by obtaining immunity from prosecution by being
the first to spill the beans to the competition authority about the existence and details
of the cartel. This is known as "whistle-blowing".
C. PROFIT, COMPETITION, MONOPOLY, OLIGOPOLY AND

ALTERNATIVE OBJECTIVES FOR THE FIRM
In the discussions of perfect competition and monopoly, we noted that whereas under
perfect competition long-term survival depended on the firm maximising its profits, whether
or not this was its conscious objective, under monopoly the firm could survive without
actually maximising profits. As long as it made a satisfactory profit it was able to pursue
other objectives. We now develop this point more fully.
Any firm which possesses a substantial degree of market power as a producer and which is
large in relation to the total size of the market in which it operates, will have a product
demand curve which is downward sloping. If the firm is successful, it is also likely to be able
to make profits above the minimum needed to keep it in the market. Its position may
therefore be represented by a model similar to that usually used for monopoly as in Figure
8.5.
This model assumes that the firm does not practise price discrimination, so that its product
demand curve is also its average revenue curve. Assuming that its market power allows it to
make profits above the minimum, there will be a substantial range of output levels and
prices between which it can make profits. This, in Figure 8.5, is the range between output
level A (price PA) which is the lower break-even point where the falling average cost just
© ABE and RRC

equals average revenue, and output level C (price PC) which is the higher break-even point
where the rising average cost just equals average revenue.
Figure 8.5: Oligopoly/monopoly model
Price
Revenue
Cost
Pa
Demand  Average revenue
Marginal cost
Pb
Average cost
Pc
Pd
Marginal
revenue
Quantity
O A B C D (Output level)
The firm in this situation can pursue objectives other than profit maximisation as long as it
operates within this profit range, but, as the model suggests, the range can be very wide.
A number of alternative theories of the firm have been developed and each of these is
based on different assumptions about firms' behaviour. For convenience we can identify two
broad groups of theories – those that replace profit maximisation by an assumption that
firms seek to maximise something else, and those that abandon any idea of maximisation in
the belief that firms seek to pursue several objectives at the same time and cannot therefore
hope to optimise any one. Before looking at these alternative theories, which may have
much more relevance for monopoly and oligopoly firm behaviour than for firms in
competitive markets, it must be clearly understood that no firm has a future unless it can
cover its costs. That is, all firms need profit to survive in the longer term. The assumption
that all firms seek to maximise their profit is made to enable the development of models of
firm behaviour. This assumption is simply the extreme limit of what all firms must do in
reality if they want to survive. What the alternative theories do is provide additional rather
than alternative insights into how firms might behave in practice provided they are profitable
in the long-term.
© ABE and RRC

(a) Alternative Maximising Theories

Baumol, an American economist, has suggested that firms seek to maximise revenue,
subject to making a minimum profit defined as that level of profit needed to retain the
support of the firm's shareholders and the financial markets. In Figure 8.5 the
revenue-maximising output level is at D, where marginal revenue is O (at the top of
the total revenue curve). However in this model quantity D lies beyond the second
break-even point of C, so the firm could not reach D without suffering a loss. If it were
to try to maximise revenue subject to achieving minimum profit, it would have to
produce at an output level somewhere between B and C and charge a price between
PA and PB.
A British economist, Marris, has argued that firms seek to maximise their rate of
growth (expansion), subject to preserving their share values at a level where the firm
can hope to be reasonably safe from the fear of being taken over. If the firm grows too
fast, its profit rate tends to fall and this depresses the share value and brings the risk
of takeover. Too slow a rate of growth is also likely to bring the firm to the notice of
take-over raiders, so the firm has to balance the desire for growth with the need to
maintain profits.
There are similarities in the Baumol and Marris theories. Both agree that the firm's
objectives are really established by its professional managers, who are free to control
the firm as long as they keep the shareholders satisfied with their dividends and the
financial markets satisfied with their profits. Profit remains important – no one doubts
that in a market economy – but it is not maximised to the exclusion of other aims that
meet managerial ambitions. Managers like to operate in large firms because size
brings prestige, high salaries and a range of other benefits, so these are pursued, to
some extent at the expense of the profits belonging to shareholders. In the Baumol
theory, revenue is seen largely as a way of measuring growth. The Marris argument is
slightly more complex and stresses growth more directly.
Another American economist, Williamson, developed another kind of maximisation,
but quite cleverly combined this with the idea that the firm pursued several objectives
at the same time. Again agreeing with the idea that managers were the real controllers
of the firm, Williamson argued that they sought to maximise managerial utility. This
utility was a combination of the pursuit of profit, growth (measured by the number of
people employed), and managerial perks (all the various expenses, benefits, etc. that
movement up the business managerial ladder tends to bring).
(b) Satisficing Theories
The rather ugly word "satisficing" has been coined to express the idea that firms
pursue several different objectives at once. Whereas no one objective can be
achieved to complete satisfaction, the firm aims to pursue each to a degree of
tolerable semi-satisfaction, i.e. it "satisfices" without fully satisfying. The idea was first
given clear expression by the American economist, Simon, in an influential book,
Administrative Behaviour. Simon argued that in practice, firms could not, even if they
wished, hope to maximise anything. Rather, they reacted to problems as they arose,
and aimed to keep all those involved in the firm reasonably satisfied so that the firm
could continue to exist.
Following the reasoning of Simon, this idea was developed into a more formal
Behavioural Theory of the Firm by two more American economists, Cyert and March
(in a book with that title). In this theory the firm is seen as a coalition between
shareholders, managers and customers, all of whose support is needed to hold the
coalition together. To achieve this support, the firm has to pursue multiple objectives,
such as profit, sales growth, market share and products to satisfy customers as well
as the needs of production managers, but no one objective can be pursued to the
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exclusion of the others. The firm has to develop a set of behavioural principles to
enable it to hold the coalition together and guide managerial decision-making.
Various other attempts have been made to explain business behaviour, but there is no
general agreement as to whether the traditional assumption of profit maximisation should be
abandoned and, if so, what should replace it. The alternative theories sometimes seem to
describe actual business behaviour more realistically, especially in relation to large
oligopolists. Firms do pursue growth, often at the expense of profits, takeover battles are
commonplace and the salaries and prestige of top business managers appear to bear little
relationship to the profitability of the companies they manage.
On the other hand, an economic theory of the firm should be concerned not only with how
firms actually do behave but also how they should behave, if the economic goals of
technical and allocative efficiency are to be achieved. Unfortunately, the alternative theories
appear to suggest that if firms operate as they predict, they are likely to be less efficient in
the full economic sense than if they pursue profit maximisation – the desire to make the
largest achievable profit consistent with market conditions. One thing that has to be
remembered always is that profit maximisation does not mean making very large and
antisocial profits, but simply the largest profit possible under prevailing market conditions.
Profit maximisation under perfect competition suggests lower profits than satisficing
behaviour in an oligopolist market. A market economy appears to operate more efficiently
when firms seek to maximise profit. Consequently, most economists continue to work with
profit-maximising models, whilst fully recognising that firms do frequently depart from profit-
maximising behaviour in practice.
Review Points
check that you have achieved the learning objectives. If you do not think that you
understand the aim and each of the objectives completely, you should spend more time
rereading the relevant sections.
1. Outline the main features of the model of monopolistic competition.

2. How does the equilibrium of a firm in a monopolistically competitive market differ from
that of the firm in a situation of perfect competition or that of monopoly?
3. Identify some examples of a market structure that resemble that of the economic
model of monopolistic competition.
4. Explain the characteristics of an oligopoly industry. Identify some examples of
oligopoly market situations.
5. Using appropriate diagrams, explain the kinked demand curve.
6. List some of the forms of collusion undertaken by firms in an oligopoly industry.
7. Explain why collusive arrangements between firms in an oligopoly tend not to be
sustainable in the longer run.
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© ABE and RRC

155
Study Unit 9
The National Economy
Contents Page
A. National Product and its Measurement 156

Flows of Production and Money 156
Flow of Production and Consumption 157
The Consumption Function 158
Modifications to the Basic Flow 159
National Product, Income and Expenditure 160
National Income – Treatment of Taxes and Subsidies 160
B. National Product 162

Avoiding Double Counting – Value Added 162
Gross Domestic Product 163
Trends in Domestic Product 163
C. National Expenditure 164

Calculation of GDP 164
Gross and Net National Product 165
D. National Income 166
E. Equality of Measures 167
F. Use and Limitations of National Income Data 168

Reasons for Introduction of National Accounts 168
Helping to Solve Economic Problems 168
Making Comparisons 168
Limited Accuracy 169
Value to the Community 169
Changing Money Values 170
H. National Product and Living Standards 171
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156 The National Economy
Objectives
The aim of this unit is to evaluate national income as a measure of societal well-being and
derive it through its various methods of measurement.
 compare and contrast expenditure, income and output measures of national income
 explain the distinction between gross domestic income and gross national product
 demonstrate an understanding of nominal and real measures of national income
 identify the different treatment of taxes, subsidies and transfer payments in the national
income accounts
 explain how national income per capita is measured and the limitations of relying upon
this measure
 recognise other, non-economic, aspects of well-being
 explain how broader indices of well-being work, for example, the Human Development
Index.
A. NATIONAL PRODUCT AND ITS MEASUREMENT

Flows of Production and Money
In this study unit we start to examine the national economy as a whole. We see this in terms
of one large market, in which total or aggregate demand from the whole of the community is
satisfied by total production. We are thus concerned with totals or aggregates in this part of
the course. When we have gained an understanding of the national system, we can begin to
see its interrelationship with the wider international economy.
We are concerned chiefly with modern industrial economies – or with agricultural economies
organised on an industrial basis (e.g. states such as Denmark or the Republic of Ireland).
Some of the important assumptions which we shall be making will be valid for these
economies but would have less relevance for subsistence agrarian economies, organised
around self-sufficient local communities, or for completely state-regulated socialist
economies.
Data on aggregate economic activity in the UK is published each year in the United Kingdom
National Accounts (the publication which is also called the Blue Book). One of the key sets of
data in the accounts is that for gross domestic product (GDP for short). In the UK National
Accounts GDP is defined as "the sum of all economic activity taking place in UK territory".
Economic activity is explained as follows:
"In its widest sense it could cover all activities resulting in the production of goods and
services and so include some activities which are very difficult to measure. For
example, estimates of smuggling of alcoholic drink and tobacco products, and the
output, expenditure and income directly generated by that activity, have been included
since the 2001 edition of the Blue Book."
(United Kingdom National Accounts – The Blue Book 2006, page 8)
Economic activity or production generates output and:
"this economic production may be defined as activity carried out under the control of an
institutional unit that uses inputs of labour or capital and goods and services to produce
outputs of other goods and services. These activities range from agriculture and
manufacturing through service producing activities (for example financial services and
hotels and catering) to the provision of health, education, public administration and
© ABE and RRC

The National Economy 157
defence: they are all activities where an output is owned and produced by an
institutional unit, for which payment or other compensation has to be made to enable a
change of ownership to take place."
(United Kingdom National Accounts – The Blue Book 2006, page 8)
Flow of Production and Consumption

The national economic concepts we use assume that:
 Production and consumption are separate – production being organised by business or
government organisations, and consumption being decided by individuals, families and
households. The family is thus seen as purely a consumption and social unit, and not
as a production/consumption/social unit, as it would be in an agrarian (farming)
economy.
 Most of the goods and services produced are exchanged through a market system,
with households paying money to buy products, and firms paying money for the use of
production factors.
 A proportion of production is organised by the state and its agencies, and paid for by
revenue raised by the state from the community.
This system can be illustrated in the form of two circular flow diagrams, see Figure 9.1. One
shows the flow of goods and services – the productive activities of production factors (Figure
9.1(a)), while the other (Figure 9.1(b)) shows the counter-flow of money which oils the really
important flow of production and consumption. Notice that for simplicity, we use the terms
"firms" for production organisations, and "households" for the individuals and families who
consume what is produced. These diagrams assume that the total volume of production is
immediately and totally consumed, i.e. there is nothing to enlarge or diminish this continuous
circular flow.
Notice that firms are seen as hiring the production factors, which are owned by households,
which then supply the labour, capital and land employed in production, and purchase the
goods and services produced.
Figure 9.1(a): Flow of goods and services and Figure 9(b): Flow of money
(a) Flow of production and consumption
Firms
Employ Produce
Factors of production Goods and services:

(land, labour, (capital) total production
Factor markets Product market
Households
© ABE and RRC

(b) Counter Flow of Money
Firms
Pay Receive
Factor rewards Revenue from sale of

(rent, wages, interest) goods and services
Incomes Expenditure
Households
The Consumption Function

If, for simplicity, we imagine an economy where there is no foreign trade, no taxation and no
government spending, then we can say that total income is either spent (consumed) or not
spent (not consumed). If we then define savings as income that is not spent or consumed,
then we can make the proposition that income (Y) is either consumed (C) or saved (S), i.e.
that:
YCS
Given this proposition and retaining our simplified model of the economy, we can then see
that any increase in income is apportioned between consumption and saving. The amount of
any increase in income which is consumed is often referred to as the marginal propensity to
consume. It may also form the basis for an equation which helps us to determine the level of
consumption for any given level of national income. For example, we may say that:
C  300  0.75Y
This is then termed the consumption function. The term "function" will be familiar to you from
your study of mathematics and quantitative methods.
Given this function, i.e. the direct relationship between total consumption and total income,
we can calculate values for C for any level of Y. For instance, if:
Y  1,000, then C  300  0.75  1,000  1,050
At this level, people are trying to consume more (1,050) than their total income (1,000) and
will have to use up past savings or borrow from another country. At the income level (Y) of
4,000:
C  300  0.75  4,000  3,300
This means that savings will equal 700, i.e. 4,000  3,300.
In this example, the 300 is a constant; it is the minimum amount of consumption required by
the community, whatever the level of income. Total consumption is made up of this minimum
plus a proportion of total income. The greater the marginal propensity to consume, the
higher will be the proportion of total income that is consumed at any given income level. If
the marginal propensity to consume remains the same at all income levels, then this will also
be the proportion of Y that is consumed in the equation.
© ABE and RRC

Modifications to the Basic Flow

We must now modify some of the assumptions made in the basic circular flow concept. The
main modifications we need to make are to take into account the following factors:
(a) Not all the income received by households is immediately spent on goods and
services; some income is saved.
(b) Another part of total income of households is not actually spent on goods and services
but handed over to government authorities as taxation, either taken directly from
income or indirectly when certain goods and services are purchased. At this stage, all
forms of taxation are considered together. We shall examine forms of taxation later.
(c) Yet another portion of income is spent on goods and services produced by other
national economies, i.e. it is spent on imports from other countries.
(d) Firms enter the general flow as buyers of goods and services, such as factories,
machines and research, in their efforts to increase their capacity to produce. We call
this investment or capital accumulation.
(e) The government must be seen as a separate force which produces goods and
services on behalf of the community as a whole – e.g. it builds roads, schools and
hospitals, and it provides forces to maintain law and order and defence against
external aggression. We can combine all these activities under the heading
government expenditure.
(f) Firms supply other countries with exports of their products. Trade is a two-way
process.
We can regard modifications (a) to (c) as leakages from the main flow of economic activity,
because they reduce the purchasing power of total incomes. We can regard (d) to (f) as
injections into the flow, because they increase total purchasing power and demand. This
concept of leaks from and injections into the main flow is illustrated in Figure 9.2.
Figure 9.2: Leaks and injections into the main flow
Firms
Injections of Leaks from income:

expenditure
Business Savings
investment Main
Taxation
Government Circular
expenditure Flow Imports
Exports
Households
© ABE and RRC

National Product, Income and Expenditure

This total flow of economic activity, modified by injections and leaks, can be given the
general term national product. This is the term used chiefly today, and it serves to emphasise
that it is the total production of goods and services that is the really important matter. This is
the total flow as seen in our first illustration (Figure 9.1(a)). The counter-flow of money in the
second diagram (Figure 9.1(b)) can be seen as both the total income of households and as
the total expenditure of households.
Notice that these three – total product, total income and total expenditure – are all really
describing the same essential flow. They can be regarded as equal – provided that the total
amount of leakages from income (savings, taxes and imports) is equal to the total amount of
injections of expenditure (from investment, government spending and exports).
At the moment, we shall assume that this equality does exist and that total production equals
total income equals total expenditure. Thus, if we use P to denote total product, Y to denote
total income, and E to denote total expenditure, we can say that:
PYE
We therefore need to examine each of these aspects of the flow more carefully.
National Income – Treatment of Taxes and Subsidies

It is useful here to examine more closely the treatment of taxes and subsidies in the national
income summary accounts calculated from incomes and from expenditure.
The national account actually show two versions of gross domestic product based on
expenditure. One, at market prices, takes no account of expenditure taxes or subsidies paid
to producers. This measure shows the totals of spending at the prices actually paid "in the
market". The other measure of GDP is calculated by deducting the total value of expenditure
taxes and other indirect taxes and adding back the total of subsidies paid to producers. This
measure is commonly referred to as the "factor cost" measure as it shows the "true" cost of
production of output, since indirect taxes are not a true cost of production despite the fact
that they appear as part of the cost when the goods and services are purchased. Likewise
subsidies reduce the prices paid for goods and services below their true cost of production.
However the UK National Accounts are now constructed in accordance with the 1995
European System of Accounts (ESA95) and the term (but not the concept) "factor cost" is no
longer used. The term "basic prices" is now used in place of factor cost.
The difference between factor cost and basic prices involves the distinction between those
indirect taxes that are levied on each unit of output, and those indirect taxes, such as the tax
on vehicles, which are levied on producers (the production process). This is not a difference
you need worry about: if you prefer, you can continue to use the term "factor cost" instead of
"basic prices" to refer to national output net of indirect taxes and plus subsidies. However,
when looking at the UK National Accounts you will have to remember that the term "factor
cost" is rarely used today.
A national product based on basic prices is the one normally used. It is considered to be the
fairer reflection of true expenditure on goods and services. After all, total expenditure
includes government spending on final consumption, and much of this is paid for from
expenditure taxes. If we value GDP at market prices, then we are in effect including
expenditure taxes twice – once when they are paid by the consumer, and once when they
are used to pay for goods and services by the various government bodies. Similar
adjustments need to be made to take account of subsidies. These are payments made by
government to producers and have the effect of reducing market prices. To obtain the true
cost of goods and services any subsidies need to be added back. An explanation of the
meaning of basic prices is given in the Blue Book.
© ABE and RRC

"These prices are the preferred method of valuing output in the accounts. They reflect
the amount received by the producer for a unit of goods or services, minus any taxes
payable, and plus any subsidy receivable on that unit as a consequence of production
or sale (i.e. the cost of production including subsidies). As a result the only taxes
included in the price will be taxes on the output process – for example business rates
and vehicle excise duty – which are not specifically levied on the production of a unit of
output. Basic prices exclude any transport charges invoiced separately by the
producer."
(United Kingdom National Accounts – The Blue Book 2006, page 9.)
The Blue Book also explains the meaning of purchasers’ or market prices:
"These are the prices paid by the purchaser and include transport costs, trade margins
and taxes (unless the taxes are deductible by the purchaser)."
(United Kingdom National Accounts – The Blue Book 2006, page 9.)
The treatment of direct (mostly income and profits) taxes appears on the surface to be rather
different, but the effect is the same – i.e. to ensure that total incomes are a fair reflection of
the incomes actually earned in the course of producing the national product.
Income and profits taxes are not deducted from employment incomes, nor are they deducted
from the trading profits of companies and the trading surpluses of government-owned
bodies.
The gross incomes, profits and surpluses are the true incomes actually paid by the
production organisations.
On the other hand, no account is taken in the summary totals of incomes from pensions,
unemployment benefits or other state welfare payments. These incomes are not received in
return for a contribution to production. They are transfer payments – being transfers from the
income of a contributor to the production process to someone who is a "non-producer". (No
moral judgment is intended here. The non-producer may have been a valuable past
producer, or he or she may become a valuable future producer. Our concern is to arrive at a
true valuation of production in the year of account.)
The accounts do of course include the incomes of those in the employment of state
organisations, even though their incomes may have been paid for out of income taxes. This
does not matter – the incomes of state employees are earned in return for their work which
is included as part of total production, and the process is no different, in principle, from any
other use of income to provide an income to another in return for goods or services. If I use
part of my income to pay for my daughter's dancing lessons, then those payments are
included again in the accounts as part of the dancing teacher's income. If part of my income
is taken from me to pay the salary of a teacher in my daughter's comprehensive school, then
again, these payments are included in the national accounts. The only difference is that the
state directs what I shall pay towards teaching in the school, whereas I choose whether or
not to pay for the dancing lessons. In each case, the payments are made in return for
services which contribute towards the production of the national product. What is not
included as a further income is the payment made out of my taxes towards the
unemployment benefit paid to my unemployed nephew. His income is not earned in the
course of producing anything, and it is ignored, as though it were a voluntary contribution
from me to him.
© ABE and RRC

B. NATIONAL PRODUCT
Avoiding Double Counting – Value Added
The national product is the sum of the values of all the goods and services produced by a
community within a recognised time period – normally a calendar year. However, we cannot
simply add up the values of all goods and services produced by all business organisations in
the country. If we did this, we would be counting some things more than once. For example:
a set of screws may be made by firm A, sold to firm B which makes timing equipment, which
in turn is sold to firm C – a motor-vehicle assembler. The completed vehicle is then sold to
firm D, a motor distributor.
The final price of the vehicle includes the cost of the screws but, if we added up the total
value of the products sold by firms A, B, C and D, we would find that we had counted the
screws four times.
One possibility might be to add up only the value of the products sold by the final distribution
firm, but this might not give us a very accurate result. This is because our motor distributor
does not always know whether they are selling to a householder, or to a small business firm
which will use the vehicle for business purposes and include its cost in the value of the
goods or services it produces. There would also be considerable problems of allowing for
goods imported and exported.
The solution actually adopted is to count the "value added" to inputs by all firms producing
outputs. This is now much easier than in the past, because of the introduction of value added
tax (VAT). All firms paying the tax are in effect also reporting their value added to the taxation
authorities. In very simple terms, the value added by each firm is the difference between the
revenue it obtains from selling its product and the cost of all goods and services purchased
from other firms. In this way, the screws of our original example are counted only in the value
added of firm A. They are excluded from the totals obtained from firms B, C and D. Notice
that value added includes the cost of labour employed by each firm in adding value to the
inputs it purchases.
We shall go on to show how public sector spending contributes to the gross national product.
However, there is a reservation that should be made when we consider the public sector.
This concerns what are often called transfer payments. For example consider what happens
when a person receives unemployment benefit or some similar social security benefit. This is
not a payment made in return for work performed or services provided. It is a transfer to the
unemployed person through taxation from the income earned by people in employment. If
we counted the unemployment benefit into the national product in addition to the full income
of those who in effect are making the transfer, then we would be double-counting the
amount. Incomes are counted as part of national product only if they are earned by some
contribution to economic activity, e.g. by employment or by making capital available to
government or business. Payments received by way of transfer through taxation are not
included in the total – though, of course, they have to be taken into account when we
examine how the total national product or income is distributed.
A similar transfer payment within the private sector takes place when parents give pocket
money to their children. The income has been earned by the parent and is simply transferred
to the child. Total national accounts thus do not include children's pocket money! Of course,
the transfer payments taking place through the public sector are much larger, and it is
important that we understand why they should be excluded from the final totals.
© ABE and RRC

Gross Domestic Product

The figures published in the Blue Book show total product figures classified by categories of
industry and service. The following table is adapted from the Blue Book 2006 and shows the
figures for 2004.
Table 9.1: Gross domestic product by industry: gross value added at basic prices
2004
Industry sector
£ million
Agricultural, forestry and fishing 10,323

Mining and quarrying including oil and gas extraction 21,876
Manufacturing 147,469
Electricity, gas and water supply 17,103
Construction 64,747
Distribution and hotels 160,594
Transport, storage and communication 79,279
Financial intermediation (net), real estate, renting and
294,350
business activities
Public administration and defence 55,280
Education, health and social work 137,603
Other services 55,543
Gross value added (GDP): all industries at basic prices 1,044,165

(Basic prices is almost the same as the old factor cost
method of measurement)
Total domestic output of products represents the gross value added by all the economic
activity of the community, measured from the output of business and government
organisations. This figure is termed gross domestic product (GDP). The basis on which this
figure is valued does not include indirect taxes and government subsidies, so that it is valued
at "basic prices", i.e. at the cost of the factor inputs, not at the prices paid by final
consumers.
Trends in Domestic Product

The largest item in the domestic product in 2004 was that relating to financial and business
services, a sector which accounted for over 28 per cent of the domestic product, outstripping
manufacturing (under 14 per cent) which for years had been the largest sector. The decline
in manufacturing's share of total product has been continuing for many years as services of
all kinds have assumed an increasing importance. This is a trend that is common to all the
old industrial countries of North America and Western Europe. It reflects both rising living
standards in these countries, where people spend an increasing proportion of incomes on
services instead of goods, and changes in the pattern of world production. (Look at the
goods manufactured in the Pacific Rim countries of Japan and South East Asia.)
If you compare the figures in Table 9.1 to those of previous years, you will also notice the
rise in the proportion of product accounted for by education, health and social work. This has
occurred for a number of reasons: changes in technology affecting the work performed and
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equipment used by these services; the age structure of the population as the rising numbers
of older people put more pressure on the health services; and changes in economic and
social conditions, with the expansion of education to cope with the demands of the modern
technology-based society and of social work to cope with the casualties of that society.
The relative growth of services at the apparent expense of manufacturing does not mean
that manufacturing is no longer important to economies such as that of Britain. It is still
extremely important, not only because the financial and business services need a strong
manufacturing base for their own development, but also because it still provides a very large
share of the wealth of the community. Manufacturing has of course changed. It is no longer
made up of simple "metal bashing", but is based on complex, computer-aided processes
often involving very high levels of technology. The borderline between the new
manufacturing processes and services is often rather vague. Assembling a computer is
clearly a manufacturing process. However designing the software and systems that control
the computer and all the other equipment in the factory depends on the services of teams of
designers and programmers, who would not think of themselves as working in
manufacturing.
Further developments may also be slightly exaggerating the trend away from manufacturing
towards services. The old-style manufacturing firm employed many groups of workers in-
house, such as caterers and designers and those performing other commercial service
activities. Today these jobs are more likely to be carried out under contract by specialised
services firms, but they are still actually performed for the manufacturing firm and its
workers. These statistics, like all others, need to be interpreted with some caution and
against a background awareness of what is actually happening on the ground.
C. NATIONAL EXPENDITURE
Calculation of GDP
The main items of total expenditure were identified earlier as the main flow of household
consumption plus the injections of business investment, government spending and export
demand. The concept is reflected in the Blue Book totals which, in the 2006 edition,
identified the national product by category of expenditure in 2004, as follows:
Table 9.2: National product by category of expenditure for 2004
Category of expenditure £ million, current prices
Consumption expenditure 761,484
Central government consumption 152,325
Local government consumption 98,383
Total gross capital formation 199,310
Total domestic expenditure at current prices 1,211,502
Consumers' expenditure is the same as the household expenditure already explained. Total
central and local government spending is shown exclusive of capital investment. For
example, it includes the running costs of the Health Service but not the cost of building
hospitals. This capital investment or formation is combined with private sector investment to
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produce the fourth item in the table, "total gross capital formation". The sum of these
categories of expenditure is total domestic expenditure.
This figure is not the same as domestic product calculated from industrial and government
output, because of the effect of imports and exports. Consumer and other spending will
include spending on goods and services produced in other countries (imports), but will not
include the value of goods and services sold to other countries. However, when we add on a
figure of £298,694 million for exports, and deduct £333,669 million for imports, we obtain the
total for gross domestic product calculated from expenditure of £1,176,527 million at market
prices. This is not the same as the figure calculated from value added (production) by
industrial sector given earlier because that figure was at basic prices (factor cost if you like).
The basis of the valuation of production is at basic prices (factor cost), because the effect of
taxes and subsidies on expenditure has been removed. If we add to the figure of £1,044,165
million for gross value added at basic prices given earlier (Table 9.1) the Blue Book figures
for indirect taxes, and subtract the figure for subsidies, we will arrive at gross domestic
product at market prices. This used to be referred to as the "factor cost adjustment": in 2004
£139,642 million taxes less £7,280 million in subsidies, a total factor cost adjustment of
£132,362 million. This is the amount by which gross domestic product, measured at current
market prices, would be overvalued by the effects of taxation and subsidy. Factor cost gives
the true value of the production factors used to produce the total product. Thus in 2004:
Gross value added at basic prices  £1,044,165 million
Adding back taxes on expenditure  £139,642 million
Subtracting subsidies  £7,280 million
Gives us gross domestic product at market price  £1,176,527 million.
Gross and Net National Product

The Blue Book makes two further adjustments to the GDP total. These are given next.
(a) An allowance for "net property income from abroad": earnings of British organisations
operating in other countries less the amount earned in the UK by foreign-owned
organisations. Actually the relevant figures have to be adjusted for compensation of UK
employees received from abroad and paid abroad, i.e. migrant workers remitting part
of their earnings back home. They also have to be adjusted for taxes paid to the rest of
the world and subsidies paid overseas. In 2004 there was a net inflow of this income of
£26,525 m and when this is added to gross domestic product at market prices it gives
us a total of £1,202,075 m. This is known as the gross national income at market
prices.
(b) An allowance for "capital consumption": the using up of capital investments made in
past years (e.g. the deterioration of roads, factories, machines, computers, etc.). In
2004, this was estimated to total about £128,427 m. Thus, when this figure is deducted
from the gross domestic product of £1,176,527 m, there remains a total for net
domestic product of £1,048,100.
In a similar way, if we deduct the figure for capital consumption from gross national income
at market prices we obtain net national income at market prices. If net national income at
market prices is converted to basic prices, adjusted for indirect taxes and subsidies, we
arrive at the figure for net national product at basic prices which is the measure termed
national income in the national income accounts.
In practice, the figure most commonly used for international comparisons etc. is that for
gross national product – largely because the capital consumption figure has to be estimated
and different countries use different methods of estimation.
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D. NATIONAL INCOME
We noted earlier that total factor incomes suffered leaks from savings, taxes and import
spending before they were transformed into expenditure. The main Blue Book totals do not
in fact show these items directly, although they can be calculated from figures published in
the book. Instead, they show the gross national product by category of income. The totals
are of gross incomes, so they include taxation, savings and money which will be spent on
imports. The categories of income are as in Table 9.3.
Table 9.3: UK national income categories of income 1995-2006

The main components of income leading to gross domestic product at market prices.
Seasonally adjusted; £ million at current prices.
Gross Other Gross

Gross value Taxes on Statistical
Compensation operating income domestic
YEAR of employees surplus of added at products and discrepancy
Total
2 product at
1 factor cost production less (income)
Total corporations market prices
Total subsidies Total
Total Total*
1995 386035 174186 69372 629593 93487 0 723080

1996 403887 191345 76301 671533 97372 0 768905
1997 429967 200659 80449 711075 104806 0 815881
1998 466080 205944 81806 753830 111880 0 865710
1999 495793 207971 86723 790487 121458 0 911945
2000 532179 210488 87842 830509 128422 0 958931
2001 564194 211196 97352 872742 130555 0 1003297
2002 587396 235819 97468 920683 135110 0 1055793
2003 616893 257629 102494 977016 141229 0 1118245
2004 648717 280180 106183 1035080 149216 0 1184296
2005 686805 282320 114149 1083274 151618 -916 1233976
2006 723143 301093 121304 1145540 159377 -1344 1303573
* Note that the figures given in the final column differ slightly from those given for GDP at market prices
in the rest of this unit because they are based on revised data.
1 Quarterly alignment adjustment included in this series.
2 Includes mixed income and the operating surplus of non-corporate sector less the adjustment for
financial intermediation services indirectly measured (FISIM).
Source: ONS online statistics 2008
Notice that the categories of income correspond broadly to the rewards to factors of
production. Compensation of employees (income from employment) is the return to labour,
although this may also include some return to business owners' capital in the case of the
income of the self-employed. Gross operating surpluses of corporations correspond to profit
of private companies and government organisations (including public corporations). These
surpluses may be seen as the reward to capital.
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The table also shows that the sum of all the incomes generated in an economy within a year
are equal to the gross value added at factor cost of all the economic activity that takes place
in the economy. The addition of taxes on products and production less subsidies, plus an
adjustment for any statistical discrepancy between the production and income methods of
measuring national output, gives us the figure for total GDP at market prices, shown in the
final column.
As we are concerned with incomes earned within the country, we do not have to make any
adjustments for imports and exports.
E. EQUALITY OF MEASURES
Notice that the Blue Book – and countries other than the UK use similar calculations – takes
care to emphasise the equality (or, more strictly, the identity) of the three measures by:
(a) ensuring that each is brought to the same total, where necessary by the device of a
"statistical adjustment"; and
(b) labelling each set of summary accounts as "National or Domestic Product" – thus
stressing that it is the same flow of activity that is being measured, whether by
category of expenditure, category of income or class of industry.
This also emphasises that it is real output, i.e. the flow of actual goods and services, that is
important, rather than the flow of money through income and expenditure patterns.
Thus, the national account supports the concept of national product and its circular flow.
Remember that total gross incomes were distributed by households as: consumer
expenditure, savings, taxation and spending on imports.
At the same time, total expenditure received additions (injections) from investment,
government spending, and spending on exports by foreign countries. Bearing in mind that
total income and total expenditure are different ways of looking at what is, essentially, the
same flow, we can use symbols to state an equation. We have already used E for total
expenditure and Y for total income. In addition to these, it is usual to make use of the
following:
S  savings
I  investment
T  taxation
G  government spending
C  consumer expenditure
X  exports
M  imports.
Using these symbols, we can now say that:
YCSTM
and
ECIGX
Remember that Y  E, so that:
CSTMCIGX
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Consumer spending (C) is common to both sides of this equation, so that we can expect the
remaining elements of total income and total expenditure to preserve the equality:
STMIGX
This is a proposition which is of very great importance in our analysis of national product,
and we shall be analysing its implications in some detail later.
F. USE AND LIMITATIONS OF NATIONAL INCOME DATA

Reasons for Introduction of National Accounts
The detailed calculation and publication of annual national product figures is a practice with
only a relatively short history. United Kingdom figures have been compiled regularly only
since the early 1950s. If the nation managed to survive fairly successfully through the
centuries before 1950 without national accounts, why do we attach so much importance to
them today?
The answer is twofold. In the first place, the national product concept based on the circular
flow of economic activity is relevant only to an industrial economy, and the UK could be
called such only from around 1850 onwards. The realisation that the periodic economic
problems arising out of industrial activity could not be measured and properly understood
unless accurate figures were available, led eventually to acceptance by the government of its
duty to prepare these figures.
The second part of the answer lies in the changed economic role of the government. After
the Great Depression of the 1930s, there was a widespread belief that the government could
and should seek to become involved in some degree of economic planning. If a government
is to try to manage the national economy, it needs national accounts, just as much as
business managers need business accounts for the firms they are seeking to control.
Helping to Solve Economic Problems

The existence of national accounting figures also helps us to understand how an economy
actually works. Without precise figures, we can only guess at such issues as the influence of
interest rates on savings or of income levels on consumption. When we have continuous
records of interest rates, savings, incomes and consumption over a reasonable number of
years, then we can produce evidence of cause and effect.
The more we know about the workings of a modern economy, the more hope there is that
action can be taken to produce results that are beneficial to the community, and that
solutions can be found for the great problems which beset industrial societies, such as mass
unemployment and price inflation.
Making Comparisons
Accounting records make comparisons possible. We can find out whether the economy is
operating more or less effectively than in the past, or more or less efficiently than the
economies of other countries. As we shall see in the next section, care has to be taken in
making comparisons but, without national accounting figures, no comparison is possible at
all. For example, when we look at the UK experience over the last decade in the light of, say,
the West German experience over the same period, we can see that there have been very
different results arising from different policies and objectives.
One very practical use for national income figures is as a basis for a number of United
Nations calculations. Member contributions to some UN institutions depend on their national
product. National income and product figures are the starting point for many UN
investigations designed to improve the economic and social performance of poorer
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countries. However, we have to accept that too much reliance should not be placed even on
the best national accounts, and they should not be used, except with very great care, for
purposes for which they were never intended.
Limited Accuracy
It is clearly impossible to compile details of all the many economic activities in a modern
community. The desire to evade taxes is one of many reasons why some activities remain
firmly hidden from official eyes. The extent of the hidden (or black) economy in some
countries is sometimes put as high as 20–50 per cent of the official economy! Business
organisations come and go, and it is not easy to estimate the size of activity in new
industries or the extent to which older activities may be declining. We have seen that the
three measures of the British national product can be made to balance only with the help of
a statistical adjustment. Considering the huge amounts involved the proportional differences
that have to be reconciled are remarkably small. In countries able to devote fewer resources
to statistical services the margin of error is likely to be rather greater.
Remember that we are dealing with large aggregates or total figures, and these can conceal
very wide variations. For example, if on the basis of our accounts we say that the average
income per head of the population is £x, we should not imagine that the majority of people
will be earning that figure. Some will be earning much more and some much less. Some of
the richest people in the world come from the poorest countries. For a developing country,
any average is likely to be very misleading in view of the very great social, regional and other
differences that exist.
Some countries may have an interest in ensuring that figures are not too accurate. A country
hoping to obtain maximum help from, and make the smallest possible contribution to, United
Nations institutions will wish to keep its national income figures as low as possible.
There is also the problem of comparing accounts when these are prepared in different
national currencies. International figures are usually converted to United States dollars at
official rates of exchange. Such official rates are often very different from the rates ruling in
unofficial currency markets.
Value to the Community

So far, we have identified problems of calculation. Even if all the calculations and estimates
were completely accurate, some important economic activities would not be included at all in
the accounts. The most commonly-quoted example of a major omission is that of the
contribution made to economic and social welfare by unpaid mothers, and others who
perform services within the family. In the same way, official figures ignore unpaid voluntary
activities within local communities and amateur sporting activities.
The way in which production, especially service production, is valued may cause further
problems. Where goods and services are distributed through unregulated markets, we
accept that market price is a fair method of arriving at their value. However where the state
is the sole provider of a service and the sole employer of the factors used to produce that
service, then we cannot be sure that the recorded value bears any relation to the value to the
community – or to their value in another country where similar services are distributed
through the market system.
Hospital charges in the USA, where there is a free market in health care, are higher than in
the UK, where the National Health Service is the main supplier, and nurses earn more in the
USA than in the UK. In Britain, charges in private commercial and language schools are
higher than in the state-controlled colleges of further education. These differences make fair
comparisons extremely difficult.
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Changing Money Values

Any comparison or calculation is likely to rely on money as a measuring device. However,
measuring any product with money is a bit like measuring a metre of cloth with an elastic
rule. Money itself does not keep a constant value. Its value is eroded by price inflation. The
rate at which prices increase (or sometimes decrease) differs greatly over time and from
country to country. The rate of change in prices in a country can be measured using price
indices, and in many countries various price indices are compiled for this purpose. These
cannot be entirely accurate, and the longer the period over which comparisons are made,
the less reliable the figures become.
In the UK National Accounts allowance for changes in the value of money is incorporated
into the figures. This is done by a process of price adjustment referred to as the "chained
volume measurement method". The resultant figures are referred to as "real values"
because they measure actual changes in output rather than changes resulting solely from
changes in prices. This makes it possible to look through "the veil of money", and observe
and compare "true" changes in output or income. Thus in seeking to establish the true extent
to which economic progress is taking place in an economy over time it is necessary to use
measures of real GDP or real national income. If the population of a country is also
increasing it is necessary to express measures of real income or product on a per capita
basis (real GDP per capita equals total real GDP/total population, and real national income
per capita equals total real national income/total population).
Summary of National and Domestic Income and Product Relationships
You may find it helpful at this point to see in summary form how the different national
accounting concepts and terms used in the UK National Accounts we have discussed are
related.
GDP  gross domestic product (or income) at market prices
less primary income payable to non-residents
plus primary income received from the rest of the world
equals
GNI  gross national income at market prices
(this is equal to the sum of gross primary incomes received by resident institutional
units and sectors of the economy)
and
real GDP (GDP converted from money value using the chained volume measurement
method)
plus trading gain
equals
RGDI  real gross domestic income
plus primary real incomes received from the rest of the world
less real primary incomes payable abroad
equals
RGNI  real gross national income (converted from money value using the chained
volume measurement method)
plus real current transfers from abroad
less real current transfers abroad
equals
RGNDI  real gross national disposable income
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The money and real values for the economy's measures of GDP, GDI, and GNDI are
converted to their equivalent net values, NDP, NDI, and NNDI, by subtracting the estimate
for capital consumption or depreciation.
For example, GDP less fixed capital consumption gives NDP. Because of the difficulty of
calculating accurate measures of an economy's annual depreciation in its capital stock – its
capital consumption – estimates of GDP are the most widely used measures of an
economy's economic activity and the most reliable for comparisons between countries. For
example:
GNI minus capital consumption equals NNI  national income
and
RGNI minus real capital consumption equals RNNI  real national income.
H. NATIONAL PRODUCT AND LIVING STANDARDS

All the points outlined in the previous section suggest that we should be very careful indeed
if we use national product or national product per capita or per head (total national product
divided by the number of people in the country) figures for the purposes of measuring living
standards. We should take particular care when we make comparisons between countries
with different economic and social systems, or attempt to measure changes over long
periods of time.
Imagine an extreme case – an attempt to compare average living standards between 1888
and 2008. There was no radio, television, mobile phones, personal computers, portable
music players such as iPods, or motor cars and aircraft in 1888! These are so fundamental
to the pattern of life today that we cannot really even begin to make any sensible
comparison. At best, we can only compare different aspects of life, e.g. working conditions,
for particular groups of workers.
Moreover, when we talk about the standard of living, there are important aspects that cannot
be measured in terms of economic activity. A person may have a higher real income if
employed in 2008 than their father had in 1988, but if they are unemployed and have little
prospect of employment, is their standard of living any higher? Opportunities for travel, for
changing employment, freedom of speech and religion, freedom to walk the streets without
fear of violent crime, arbitrary arrest or political coercion, all these are elements in the
standard of living which are not included in any gross national product calculations. The
matters of working hours and leisure time are also ignored. There is also the environment.
Some countries attach great importance to protecting their environment and preventing
pollution and other actions that degrade the physical environment. In other countries the
environment may be ignored in both private and government decisions, and the physical
environment may be so damaged and polluted that it damages people's health and reduces
living standards. Standard measures of national income take no account of environmental
damage and differences in the quality of the environment between countries. Some countries
today, such as China and India, are achieving very high rates of real economic growth using
conventional measures of national income, but at the expense of large scale damage to their
physical environments (including their supplies of water). Material living standards measured
by real GDP per capita can increase at the same time as the quality of life deteriorates and
the former is the cause of the latter.
Economists are sometimes accused of placing too much weight on measures of quantity and
on money values, and not taking sufficient notice of quality and the values that money
cannot measure. Increasingly however, economists are recognising the limitations of the
concepts and measures they use. As long as we bear these in mind, then we can make
effective use of national accounts and recognise that these are an essential starting point for
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any study of national economy. We would not expect a set of company accounts to tell the
full story of a large business enterprise but equally, if we wanted to examine the enterprise,
we would be foolish not to include in that examination a very close scrutiny of the company
accounts. In the same way, we find a great deal of invaluable information in the national
accounts of a country.
Table 9.4 summarises the factors that need to be taken into account when using official
measures of national income or GDP to compare changes in living standards over time in a
country or between countries at the same time:
Table 9.4: Key factors using official measures to compare changes in living standards
Income comparisons over time in a Income comparisons between different

country countries at the same point in time
Correct for changes in the level of prices Compare like with like and use real value
over time – use real value measures by measures of GDP or national income.
adjusting money values for
inflation/deflation.
Allow for changes in the size of the Compare like with like and adjust for
population – use real income per capita differences in size of population by
measures by dividing real GDP or real comparing real GDP or real national
national income by total population. income on a per capita basis
But need to recognise that real GDP per But need to recognise that real GDP per
capita is an average measure and ignores capita is an average measure and ignores
how actual income levels per head are how actual income levels per head are
dependent on the distribution of income. dependent on the distribution of income.
Allow for changes in the distribution of Recognise that differences in the

income over time in making conclusion distribution of income between countries
based on changes in real GDP per capita affect conclusions based on a direct
comparison of living standard measures
such as real GDP per capita.
Allow for improvement in the quality of Allow for differences in the quality of similar
goods and services over time and the goods and services, and the availability of
introduction of totally new goods and different goods and services, between
services. countries at the same time.
Need to take account of changes in Need to take account of differences in the

measures of the quality of life including quality of life between countries including
health care, life expectancy, education and health care, life expectancy, education and
literacy, political freedom, press freedom, literacy, political freedom, press freedom,
corruption, environmental pollution. For corruption, environmental pollution. For
example, the Human Development Index. example, the Human Development Index.
© ABE and RRC

Review Points
relevant sections.
1. What is meant by the circular flow of income? How does the circular flow of income in
a closed economy differ from that in an open economy?
2. Explain the output, income and expenditure approaches to the measurement of gross
domestic product (GDP).
3. Describe the main components of total expenditure or demand in an economy.
4. Explain how indirect taxes and subsidies are accounted for when we calculate an
economy's GDP at basic prices (or factor cost) from the components of total final
expenditure.
5. Explain the distinction between real and current price (nominal) measures of national
output, product and income.
6. What is the term used to distinguish real from current price (nominal) measures of
national output, product and income in the UK National Accounts – Blue Book?
7. Why are measures of national economic performance such as GDP or GNI not
necessarily good guides to the standard of living or well-being in a country?
© ABE and RRC

© ABE and RRC

175
Study Unit 10
Determination of National Product: The Keynesian Model of
Income Determination and the Multiplier
Contents Page
A. Changes in Consumption, Saving and Investment 176

Equilibrium Conditions 176
Pressures Leading to Equilibrium 177
Pressures to Change Equilibrium 178
B. Government Spending and Taxation 180
C. Changes in Equilibrium, the Multiplier and Investment Accelerator 181

Equilibrium, Savings and Investment 181
Change in Investment and Change in National Income 182
The Investment Multiplier 184
More Realistic Multiplier 184
Change in the Marginal Propensity to Save and the Paradox of Thrift 185
The Investment Accelerator 186
The Business Cycle 187
D. The Role of the Government in Income Determination: the Government's

Budget Position and Fiscal Policy 188
© ABE and RRC

176 Determination of National Product: The Keynesian Model
Objectives
The aim of this unit, in conjunction with Study Unit 11, is to explain the determination of the
equilibrium levels of national income using the Keynesian macroeconomic model in a closed
and open economy and demonstrate how this can be of use to businesses.
When you have completed this study unit and Study Unit 11 you will be able to:
 interpret, graph, and solve simple numerical examples of the form
Y  C  I  G  (X  M)
 explain how variations in the marginal propensity to save, consume, and import affects
the closed and open economy multiplier
 compare and contrast inflationary and deflationary gaps using Keynesian cross
diagrams
 discuss the components of government fiscal policy and explain how changes in these
components affect the equilibrium level of national income
 make judgements about the factors that determine the effectiveness of fiscal policy
 explain the implications of fiscal policy for government borrowing (Public Sector
Borrowing Requirement).
A. CHANGES IN CONSUMPTION, SAVING AND

INVESTMENT
In this study unit we introduce the basic model of national income determination and the
concept of the multiplier. These form the framework for analysing the process of determining
the level of total or aggregate output in an economy, and the concept of macroeconomic
equilibrium. The Keynesian model of national income determination and the concepts of the
multiplier and macroeconomic equilibrium provide: the framework for understanding the
means by which governments can use fiscal policy; the power of governments to tax and
spend in the economy; and the power of governments to alter the levels of output and
employment in the economy. This is such an important part of the syllabus, and a
challenging one when studied for the first time, that the topic is studied in this study unit and
in Study Unit 11. This means that the learning outcomes detailed in this unit can only be
achieved fully after you have completed your study of both units.
Equilibrium Conditions
We should now remind ourselves of the conditions necessary for national product, income
and expenditure to be in equilibrium. Remember the term "equilibrium" refers to a state of
rest where there are no pressures acting to disturb and change the balance of forces.
Earlier, we suggested that there would be equilibrium when total income was equal to total
expenditure in the economy, and that this implied:
CSTMCIGX
where:
C  personal or household consumption
S  savings
T  taxation
M  imports
I  business investment
© ABE and RRC

Determination of National Product: The Keynesian Model 177
G  government spending
and X  exports.
If we remove C from each side of the equation, we are left with:
Putting this another way, we could say that total leaks or withdrawals from income equal total
injections or additions to aggregate expenditure.
Equilibrium suggests that the state of rest remains for a period of time, so that we should
take successive time periods into account. If, for simplicity, we use the symbols:
W  total withdrawals (S, T, M) and
J  total injections (I, G, X),
then, using the usual symbols t, t1, t2, etc. for successive time periods, we can say that a
total national product in equilibrium implies that:
W t  Jt+1  W t+1  Jt+2, and so on.
Pressures Leading to Equilibrium

It seems reasonable to question why a national economy should achieve and maintain this
form of equilibrium. If we examine the processes operating within the economy, we can see
that there are strong pressures likely to produce such a state. For simplicity, we shall at this
stage omit imports and exports from our analysis.
To begin with, we shall also omit taxation and government spending. We are now
considering only savings and investment. However we shall reintroduce consumption.
Consider the graph shown in Figure 10.1. Expenditure intentions at the various national
income levels are recorded in the curve C  I. Remember that we have reduced total
spending to consumption and investment, for our present purposes.
Assuming that the scales of both axes are the same, then the 45 dotted line represents all
points where total income just equals total expenditure. Remember too that when
expenditure equals income, both are also equal to total output.
The graph illustrates that there is only one level of income where total income, output and
expenditure are in fact equal – i.e. where national product is in equilibrium.
This is at the income level Oye, where the intentions curve intersects the dotted 45 line.
However what happens if this equilibrium is disturbed?
(a) Lower National Income
Suppose national income is at the lower level Oy1, where intentions are trying to
achieve a higher level of spending than that possible from current total output.
At level Oy1, the combined demand from households (C) and business firms (I) is
higher than total output.
It cannot be satisfied at the current level of output. Some firms will have stocks of
goods produced earlier, and they will be able to sell from these stocks. Others, finding
that they have more customers than goods to sell, will ration sales by putting up the
price or promising delivery at a future date. Actual consumption and investment will
thus be lower than intended, as some would-be buyers are disappointed, but also
money spending will be raised by the increased prices of goods.
© ABE and RRC

Figure 10.1: The national product in equilibrium
National
expenditure
(E) and
intended
expenditure
CI
45
O Y1 Ye Y2 National income (Y)
(C  S)
Increased money spending will feed into increased money incomes, and so the money
value of national income will move up towards Oye. We can also expect that firms,
facing high demand and good profits from rising sales, will seek to increase production.
They will hire more labour and pay more wages in order to do this. This will tend to
push up production towards Oye. There will be an upward pressure to achieve at least
the money level of Oye, even if this still leaves many spending intentions unsatisfied.
(b) Higher National Income
We can apply this reasoning in reverse if national income happened to move out of
equilibrium to the higher level Oy2. Here, more is being produced than people want to
buy. Warehouse stocks rise, and customers are not around to buy the goods and
services on offer. Traders needing money to meet current expenses will cut prices to
achieve sales. Firms, seeing stocks of unsold goods rise, will reduce production, lay off
workers and cut overtime working. Incomes will fall through declining wages and falling
business profits. There will be a movement downwards towards the equilibrium level
Oye. Only at this level will there be no pressures for moving either up or down, because
only here does total income equal total output equal total expenditure.
Pressures to Change Equilibrium

If we look again at Figure 10.1, we can see that this is only a stable equilibrium, lasting over
successive time periods, if the curve of C  I remains unchanged. The higher we raise the
C  I curve, the greater will be the level of Oye.
So although there are strong pressures to bring national income to equilibrium, there may
also be forces operating to change the position of the C  I curve, and so change the
equilibrium. In order to understand these forces, we need to examine more closely the
decisions that lead to any given level of desired or intended household consumption and
desired or intended business investment.
© ABE and RRC

(a) Influences on Aggregate Consumption and Saving

Remember that we have dropped imports and exports from our simplified model, and
at the moment we are ignoring taxes and government spending. Therefore all income
can be considered to be made up of consumption and saving. To emphasise this, we
adopt a wide definition of saving, seeing it as any income (net of tax) not consumed.
Thus for each unit of income:
CSI
or, S  I  C
Why then do people spend on consumption and why do they save? We can identify
the following motives:
(i) They spend because they have income available for spending and perhaps
because they expect future incomes to rise.
(ii) They spend because there is credit available.
(iii) They may also spend because they expect prices to rise and the cost of credit
may be less than the amount of the expected price rise.
(iv) Pressure to spend may also come from advertising and the marketing efforts of
firms wishing to maintain high levels of production and sales. Social attitudes
may also encourage a high level of spending, especially in a period when the
level of social security payments is high and money is losing its value and
discouraging saving.
(v) On the other hand, saving may be encouraged and spending discouraged by
falling incomes and rising unemployment, by controls on credit and the
expansion of money, and by expectations that prices may fall.
(vi) People may also be forced to spend less and save more in order to pay off or
reduce the burden of past debts after a period of high spending. This tendency
was clearly evident during the early years of the 1990s after the spending and
house purchase boom of the 1980s.
(vii) The depressed, low consumption years of the early 1990s also showed the
importance of house purchase as a foundation for general household
consumption. When house purchase and building activity is high and people are
moving homes, they also spend on house furnishings, household equipment and
so on. When there is little activity in the housing market all these associated
household consumer durable markets are depressed. Employment and incomes
fall in the affected industries and the economic depression deepens.
(viii) Savings may also be contractual, i.e. people undertake to save regular amounts
out of income through schemes arranged with insurance companies, building
societies, etc. The motives for contractual saving are to provide for retirement,
for substantial future purchases, for precautionary motives, or simply because of
social habit – the belief that saving is a moral duty.
Some of these motives correspond with the influences on the demand for products,
which we identified in earlier study units. The general influences on total or aggregate
spending and saving can change over time, so that the amount saved from any given
volume of income can also change. Relationships between the amount consumed and
saved and total incomes are examined later in this unit.
© ABE and RRC

(b) Business Production and Investment

Just as (leaving aside government spending, taxes, and foreign trade) we find that total
income is either spent on consumption or saved, so we see total production as being
sold either for consumption or for investment or capital accumulation. Here we have a
slight problem: we cannot, in practice, distinguish between the purchase of new
equipment to replace old and worn-out equipment, and that purchased to increase
productive capacity. Moreover, some equipment may also be acquired simply to
replace labour, with no significant increase in production planned or desired. Also,
when we define investment in terms of production not sold for consumption, this
includes stocks of goods.
So not all total investment could really be called "productive investment", able to
increase the ability of business organisations to produce more. Yet, it is productive
investment that really interests us. For simplicity, at this stage we shall assume that all
or most investment does have a productive element (after all, most firms replace
machines with better machines). This enables us to link the desire of firms to invest
with their desire to produce more output. Thus, we can suggest that the main motive
for investment is the belief of business firms that it will be in their interests to increase
productive capacity. They are more likely to believe this if:
(i) current consumer demand is rising and expected to continue to rise
(ii) current profits are rising and expected to continue to rise
(iii) the cost of investment is falling and expected to continue to fall – the main
element in this being the level of interest rates charged on borrowed finance.
Notice here that the influences on the level of investment are mostly not directly related
to the level of current income. So for our purposes at this stage, we do not regard the
level of investment as being dependent on income levels. This is in contrast to the level
of saving which, provided other influences are constant, is directly related to the level
of income.
Note that business firms, in making investment decisions, stress the importance of estimates
of future revenues related to present costs and how these are affected by expectations of
future demand levels and the costs of capital (linked to market rates of interest). You should
remember that investment decisions involve making judgments about the future, about future
markets and about future economic conditions and government policies. The future can
never be forecast with accuracy, but the greater the degree of uncertainty about the future,
the higher are the risks of business investment and the less the amount of investment
undertaken. Political uncertainties and lack of confidence in the government can be as
damaging to investment as market uncertainties; in practice the two are closely related.
B. GOVERNMENT SPENDING AND TAXATION

We now return to government spending and taxation, and seek to examine the relationship
which exists between these. Of course taxation is the main source of government revenue,
and if a government pursues a policy of a "balanced budget" (i.e. if it seeks to spend only
what it earns through revenue), then the amount of spending must be governed by the
amount of taxation received.
However, if a government does not believe that it must maintain this balanced budget, then
the level of spending is released from the constraint of taxation and depends solely on policy
decisions made by government ministers. We cannot therefore know what the influences on
this spending are, unless we know the policy objectives of the government. Possible
objectives and the economic ideas underlying different policies will be examined later.
© ABE and RRC

You may wonder how a government can escape from the constraint of its taxation revenues
in deciding how much to spend. The answer lies in its power to borrow, and this power is
itself a major influence on the economy. If the government borrows from the public directly,
e.g. through national savings certificates and bonds, it will simply transfer income from the
private to the public sector. If however it borrows from the banks, then it will be creating
money. This is a difference that will have some significance for economic policies.
Taxation must come, either directly or indirectly, from income. It may come directly from
taxes on private incomes and company profits, or indirectly through taxes on expenditure,
such as value added tax. Since consumption expenditure levels depend on income levels,
we can say that the total level of taxation is dependent on income.
C. CHANGES IN EQUILIBRIUM, THE MULTIPLIER AND

INVESTMENT ACCELERATOR
Equilibrium, Savings and Investment
If we assume once more that we have an economy where the government has a balanced
budget, so that taxation equals government spending, and imports just balance exports, then
we can concentrate again on savings and investment. Under these conditions, national
income will be in equilibrium when savings equal investment. This is illustrated in Figure
10.2. Another way to illustrate this same concept is shown in Figure 10.3. This enables us to
concentrate solely on savings and investment and to see the effect of changes more clearly.
Remember that investment is not regarded as directly dependent on the level of income, and
so is represented by a line parallel to the national income axis. However savings are
dependent directly on income levels, and can be expected to rise as incomes rise: the
savings curve is thus shown as positive sloping. Of course this slope must be less than 45,
because such an angle would indicate that each additional £1 of income was entirely saved
– an unlikely situation.
Figure 10.2: National income in equilibrium
Investment Savings
and savings
i Investment
+
o National
 e income (Y)
Once again, we see that there is one income level where savings will just equal investment,
and this is the level that national income will tend to move towards. This is shown as Oe in
Figure 10.2. Actual savings will tend to equal actual investment, even though the savings
intentions of households and the investment intentions of business firms are not the same.
Remember that it is consumption that tends to bring them together. Firms will seek to
"produce for consumption" that level of output which they believe households will "buy for
© ABE and RRC

consumption". Remember too that prices, and stock levels, may change as national income
moves into equilibrium.
Now let us see what happens when there is a change in the level of investment. Look at
Figure 10.3. Here investment rises, at all income levels, from Oi to Oi1. As a result, we see
that the equilibrium level of income, where actual investment equals actual savings, moves
up from Oe to Oe1.
Figure 10.3: A rise in investment
Investment Savings
and savings
i1 Investment 1
i Investment
+
o National
 e e1 income (Y)
Change in Investment and Change in National Income

We shall now examine the relationship between a change in investment, as just described,
and the change in total national income which results from the new equilibrium level. Look
now at Figure 10.4.
Figure 10.4: Increase in the level of investment at all income levels
Investment
and savings b
i1 Investment 1
i Investment
c
+
o National
 e e1 e2 income
a
This shows an increase in the level of investment at all income levels, from Oi to Oi1, but now
we have two savings curves – ab and cd. Given the savings curve ab, the increase in
investment lifts the equilibrium level of national income from Oe to Oe1, but, if the savings
curve is cd, then the same increase in investment produces the larger income increase from
Oe to Oe2.
© ABE and RRC

We can now state the following.

 An increase/decrease in investment will increase/decrease the equilibrium level of
national income.
 The amount of increase/decrease in national income brought about by the change in
investment will depend on the slope of the savings curve – i.e. on the amount of any
increase in income which is saved.
The more acute the angle of the savings curve, the less is the increase in savings from each
additional £1 of income. What is really being represented in this diagram is the multiplying
effect of an initial increase in business investment. Suppose that firm A decides to buy an
additional machine. This stimulates activity from the machine manufacturer, who increases
production and pays additional incomes to his workers. In turn, the workers decide to
increase their spending, which stimulates more activity from other firms, and so on. We can
visualise successive "rounds" of increased activity, but as some part of each "round" of extra
income is saved, the next round is slightly smaller than the last, until the increases become
too small to be significant, and the progression comes to an end.
The less the amount saved, the greater will be the total increase. For example, suppose
there is an initial increase of 100. The following table shows how this may be multiplied.
In column A, three-quarters of each extra round of income is consumed and one-quarter
saved, and in column B, four-fifths is spent on consumption and only one-fifth saved.
Table 10.1: Effect of different rates of saving
A B
(savings 1/4) (savings 1/5)
Initial 100 100

2nd round 75 80
3rd round 56 64
4th round 42 51
5th round 32 41
Total so far 305 336
These figures are rounded. If we were to produce completely accurate figures and carry on
the tables, we would find that A would arrive at a total of 400 and B at a total of 500. Using a
calculator, you can test this for yourself. These figures should suggest something to you.
 An initial increase of 100, increased by successive additions of three-quarters, arrives
at a final total of 400.
 An initial increase of 100, increased by successive additions of four-fifths, arrives at a
final total of 500.
Putting this another way, if the amount saved or held back from each successive increase is
one-quarter, then the initial increase is multiplied by four; if the successive increases are
reduced by one-fifth, the initial increase is multiplied by five. It looks as though the
multiplying effect is the reciprocal of the amount held back from each successive increase.
Indeed this is the case.
© ABE and RRC

The Investment Multiplier

This is the term given to the ratio of the change in income to any given change in the level of
investment when national income equilibrium has been restored. In symbols, this can be
expressed very simply as:
ΔY
Ki 
ΔI
where:
Ki is the investment multiplier
Y is the change in national income and
I is the change in investment.
The value of the investment multiplier is the inverse of the amount of each successive
increase in income which is saved:
1 1
Ki  
s 1 c
where:
s  proportion of extra income that is saved and
c  proportion of extra income that is spent on consumption.
A more correct definition of s and c would really be the "marginal propensity to save" and the
"marginal propensity to consume".
More Realistic Multiplier

So far, we have considered the multiplying effect only in terms of investment and savings,
having assumed that the government spends only its taxation revenue and that total exports
equal total imports. These assumptions are rather unlikely in modern industrial economies,
so a more realistic (and much smaller) multiplier has to take these injections and withdrawals
into account.
We can show this in Figure 10.5. This shows an increase in total injections (investment,
government spending and exports) and a withdrawals curve. The total withdrawals from
income are made up of savings, taxation and imports, so that the propensity to withdraw (w)
is now the total of the propensities to save, to tax and to import:
wstm
This more realistic multiplier is the ratio of the change in national income to the change in
injections which brought it about, and it is the inverse of the propensity to withdraw:
ΔY 1 1
K  
ΔJ w s + t + m
Suppose that, out of each additional £1 of national income, £0.1 is saved, £0.3 is taxed and
£0.2 spent on imports. Then:
s  0.1; t  0.3; m  0.2
so
w  (s  t  m)  0.6
K then is 1/w which here is 1/0.6  1.67. This is a very much smaller value than the
investment multiplier which, in this example, would have been 10.
© ABE and RRC

Figure 10.5: Effect of injections and withdrawals
Injections/
Withdrawals
Withdrawals (W)
Injections (J1)
J1
J  W
J
Injections (J)

0
 Y National income
Change in the Marginal Propensity to Save and the Paradox of Thrift

The slope of the savings function (curve) depends on the marginal propensity to save. If
people start to save a smaller proportion of their incomes, i.e. spend a higher proportion,
then the curve becomes less steep as each additional £1 of income gives rise to a little less
saving. If they start to save a larger proportion, i.e. spend a smaller proportion of income,
then the curve becomes steeper, subject to a maximum of 45 if the scales on both axes are
the same, because each £1 of additional income produces a larger amount of saving though
not, we assume, more than the extra income.
This observation has given rise to what has become known as the paradox of thrift which is
that the more a community tries to save the less it may actually save. This paradox is
illustrated in Figure 10.6.
The original equilibrium condition of the national income is represented by Oe0 where the
level of investment and savings are represented by I0 and Os0 respectively, i.e. the level
where the saving function S0 intersects the investment level of I0. Then, for some reason
such as a growing fear of unemployment and economic recession or misguided government
policy trying to encourage greater "thrift" and "good housekeeping" in the community, people
generally start to save more and spend less from their incomes. The saving function
becomes steeper and moves, say, to S1. The equilibrium level of national income falls to Oe1.
Business firms face declining sales and rising stock levels so they cut back their production
and invest less in productive equipment. The level of investment falls to I t+1. At this lower
level the national income falls further to the equilibrium level where Ost+1 equals It+1 at Oet+1.
At this new equilibrium the level of saving has also fallen to Ost+1.
© ABE and RRC

Figure 10.6: Paradox of thrift
Investment
Saving £m
S1
SO
SO IO
St  1 It  1

0
 et  1 e1 e0
National income £m
Thus, the attempt by the community to save more has resulted in the community actually
saving less, because the total level of aggregate income has fallen. Remember this is the
result for the community as a whole. Some individual households will have increased their
savings, but others will be saving less because they have suffered loss of income and may
well be unemployed as a result of the fall in national income and aggregate investment. This
is the paradox of thrift in action. This is one case where the macroeconomy (the economy as
a whole) behaves differently from the microeconomy (individual firms and households). A
virtue for the individual is not necessarily a virtue for the whole community, a concept that
some influential politicians have found difficult to grasp.
This example also illustrates the possibility that the fear of recession can become self-
fulfilling. If people anticipate that their incomes are likely to fall in the future and start to save
more and consume less, their actions can lead to reduced production, investment and
employment.
The Investment Accelerator

We have seen that an increase in national income can be induced by a net injection, made
up of an increase in the combined forces of investment, government spending and exports.
However, if we return to the case of a country in which the government believes in a
"balanced budget" (will not spend more than its taxation revenue), where international trade
is depressed and there is unlikely to be any net increase from international trade, then we
are again left with investment as the main motivating force, other than consumer demand
itself.
Now, suppose people do start to consume a higher proportion of their incomes for some
reason (the savings curve swings to the right, as in a move from ab to cd in Figure 10.4).
Consumer demand therefore starts to rise. Suppose also that, at the old level of consumer
spending, all business equipment was fully used. If business firms believe that consumer
demand is on an upward trend, they will wish to increase their productive capacity: to do this,
they need to purchase more equipment. There is thus an increase in productive investment.
© ABE and RRC

The principle underlying the theory of the investment accelerator is that there is a constant
ratio of investment capital to the total output that is produced, and that this ratio is greater
than 1:1. If total demand (and therefore output) is constant, firms will only invest to replace
worn-out equipment. However when demand rises, firms will replace old equipment and
purchase new, so that the increase in investment is greater than the rise in output desired to
meet the rise in demand. But investment will only continue to increase if demand and the
output it encourages goes on increasing at a faster rate. If the rise in demand levels off or if
demand falls investment will stop increasing or fall. The precise changes to investment will
depend on the ratio of investment capital to output and on any time lags between observed
changes in demand and business investment decisions.
We have seen that this increase in investment will itself have a multiplying effect on national
income, and hence on consumer demand. Initially, the expectations of business firms
become self-fulfilling, as their own investment induces the expected rise in consumer
spending. Moreover, a quite modest increase in initial consumer spending can have a very
great effect on investment spending, as the following rather simplified example will illustrate.
Example:
Let us assume that one machine in the shoemaking industry is capable of producing 10,000
pairs of shoes in a year, that the life of a machine is ten years, and that the industry uses
100 machines, producing a total of 1,000,000 pairs of shoes per annum. Each year, one-
tenth of the machines will have to be replaced, so there is a demand for ten new machines a
year.
What will happen if the demand for shoes increases by 10 per cent? This increase in
demand means that 1,100,000 pairs of shoes will be required, and this means that 100
machines must be used. The industry will therefore order for this year 20 new machines – 10
in order to replace those worn out, and 10 additional ones to cope with the new demand. The
demand for machinery will thus increase by 100 per cent because of a mere 10 per cent
increase in demand for consumer goods.
It is the surge in increased investment spending that gives the accelerator its name.
However there is a danger here. If consumption continues to rise at a constant rate, then
investment, after the initial burst, will stay the same. In order that net productive investment
should increase, consumption has to continue to increase at a faster rate. If it starts to level
off, then investment will fall away. Firms do not need to buy more machines if their
production capacity is sufficient to cope with expected demand. A fall in net investment now
starts the accelerator in reverse – it becomes a decelerator, forcing a decline in national
income. This decline has been caused by nothing more than a levelling of demand and a
consequent halt in new business investment.
The Business Cycle

We now have an explanation for the periodic tendency for an economy to expand and
decline – to boom and become depressed – which has been a feature of all industrial
economies. This cyclical tendency for boom and depression has been described as "the
business cycle". Notice that it is explained in terms of consumer demand and business
investment, and it assumes that the government is neutral – pursuing a policy of keeping a
balanced budget.
The accelerator assumption of a fixed investment capital to output ratio has been criticised
on the ground that it very much oversimplifies the business demand for investment, and
ignores a number of important and relevant influences. These include the pace and nature of
technological change, competition from foreign producers and changes in the management
and use of labour. All these can change the capital to output ratio and the desire to invest at
any given time. The basic theory also assumes that firms typically operate at full machine
capacity, whereas most of the evidence suggests that it is more normal for firms to operate
© ABE and RRC

with some spare capacity, which is used to even out fluctuations in investment. The theory
also ignores the influence of the capital market which can have a major effect on the volume
and timing of investment. For these and many other reasons earlier hopes that the theory
would provide the key to smoothing out the business cycle have proved much too optimistic.
D. THE ROLE OF THE GOVERNMENT IN INCOME

DETERMINATION: THE GOVERNMENT'S BUDGET
POSITION AND FISCAL POLICY
Although it is helpful to examine the model of income determination and the multiplier
process using diagrams, it is also possible to express the model in equation form and solve
the equations to determine the equilibrium level of national income. Let us consider the case
of a closed economy for simplicity. That is, the economy does not trade with the rest of the
world, so that we can ignore imports and exports in the circular flow of income.
We can describe the model of the closed economy with government as follows:
YCIG
C  50  0.8Yd
I  500
G  1000
Here Y refers to national income, and C, I and G refer, respectively, to consumption,
investment and government expenditure. Yd refers to disposable income and the tax rate (t)
on income in the economy is 20 per cent or 0.2. That is, instead of simply assuming that
government taxation is a fixed sum of money for the whole economy, we have made the
much more realistic assumption that the government sets the rate of income tax and its total
tax revenue is an increasing function of income. Combining the above equations we can
solve for the equilibrium level of national income as follows:
Y  50  0.8(Y  0.2Y)  500  1000
Y  0.8Y  0.16Y  1550
Y  0.64Y  1550
Y  0.64Y  1550
0.36Y  1550
Ye  1550/0.36  4305.5
The formula for the multiplier K is now:
1
K
1  c(1  t )
where c is the marginal propensity to consume and t is the marginal rate of income tax.
Inserting the values given above for the model we obtain:
1
K
1  0.8(1  0.2)
K  1/(1  0.64)
K  1/0.36  2.78
© ABE and RRC

Now that we have "solved" this system of equations (our model for the equilibrium level of
national income and the value of the multiplier) we can see how much more efficient it is to
use this approach than relying on diagrams. Suppose the economy is facing a downturn in
demand in the economy, due to falling overseas demand for its exports; then the government
may decide to boost demand by increasing its own expenditure in the economy, (increasing
its injection, G). What would be the consequence of an increase in the level of government
expenditure of 500?
The change in income is found as follows:
∆Y  500  K  500  2.78  1390
And the new, higher, equilibrium level of national income is:
Ye  4305.5  1390  5695.5
Such analysis is important to governments seeking to understand the workings of their
country's economy and manage the level of aggregate demand for the public good. It is also
important for business decisions. For example, suppose a foreign firm is just about to start
investing in a new factory to produce consumer goods in an economy, like the one described
in the previous simple model: it sees that the country's exports are declining and that the
economy is likely to go into recession with rising unemployment. This would clearly not be a
good time to invest in the country because the new factory would find it difficult to meet its
planned sales targets if the economy was going into recession. The foreign firm might decide
to delay (or worse) cancel the building of the factory. However, if it learns that the
government is going to increase its spending, and its budget deficit, by an additional 500 to
offset the fall in demand due to declining exports, the foreign firm can work out that this will
boost demand in the economy by 1390 and lead to an increase in employment. In this case
the firm is likely to decide to go ahead with its decision to build the new factory.
In practice of course nothing is ever this simple. If increased government expenditure alone
could cure unemployment and increase national income, there would be no poor countries in
the world! The limitations of government in the economic management of the economy
through fiscal policy are considered in the next study unit.
© ABE and RRC

Review Points
check that you have achieved those learning objectives covered in this unit. If you do not
think that you understand these objectives completely, you should spend more time
1. What condition is satisfied in the economy when C  I  G  X  C  S  T  M?

2. What is the investment multiplier?
3. What is the formula for the simple investment multiplier?
4. All other things remaining unchanged, how will an increase in the marginal propensity
to save affect the equilibrium level of national income?
5. You are given the following information about a closed economy:
YCIG
C  50  0.8Yd
I  500
G 1000
where Y refers to national income, and where C, I and G refer respectively to
consumption, investment and government expenditure. Yd refers to disposable income
and the tax rate (t) on income in the economy is 20 per cent or 0.2.
(a) Calculate the equilibrium level of national income.
(b) Calculate the value of the multiplier for this economy.
6. With reference to the economy described by the equations in question 5, what would
be the new equilibrium level of national income if the government increased its level of
expenditure from 1000 to 2000?
7. You are asked to give advice to an overseas businessman who is considering investing
in the economy described in questions 5 and 6. How will the government's
announcement that it is going to increase its expenditure affect the businessman's
decision to invest in the economy?
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191
Study Unit 11
Macroeconomic Equilibrium and the Deflationary and
Inflationary Gaps
Contents Page
A. National Income Equilibrium and Full Employment 192

Earlier Views – Equilibrium Produces Full Employment 192
B. The Basic Keynesian View 192
C. The Deflationary Gap 193

Possible Causes 193
Consequences 194
Policy Options for Closing the Deflationary Gap 194
D. The Inflationary Gap 196

Some Possible Causes 196
Consequences 198
E. The Aggregate Demand/Aggregate Supply Model of Income Determination 199

Aggregate Demand and Supply 199
The Aggregate Demand Curve 199
Aggregate Supply 200
The Long-Run Aggregate Supply Curve 201
The Short-Run Aggregate Supply Curve 202
The Equilibrium Level of Real Output and the General Price Level 204
Excess and Deficient Aggregate Demand 204
Using Fiscal Policy to Correct a Deficiency of Aggregate Demand 206
F. Financing Fiscal Policy: Budget Deficits and Public Sector Borrowing 207
Financing of the PSBR 208
The General Government Financial Deficit 209
Importance of Public Sector Borrowing 209
G. The Limitations of Fiscal Policy 210
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192 Macroeconomic Equilibrium and the Deflationary and Inflationary Gaps
Objectives
The aim of this unit, in conjunction with Study Unit 10, is to explain the determination of the
equilibrium levels of national income using the Keynesian macroeconomic model in a closed
and open economy and demonstrate how this can be of use to businesses.
 interpret, graph, and solve simple numerical examples of the form
Y  C  I  G  (X  M)
 explain how variations in the marginal propensity to save, consume, and import affects
the closed and open economy multiplier
 compare and contrast inflationary and deflationary gaps using Keynesian cross
diagrams
 discuss the components of government fiscal policy and explain how changes in these
components affect the equilibrium level of national income
 make judgements about the factors that determine the effectiveness of fiscal policy
 explain the implications of fiscal policy for government borrowing (Public Sector
Borrowing Requirement).
A. NATIONAL INCOME EQUILIBRIUM AND FULL

EMPLOYMENT
Earlier Views – Equilibrium Produces Full Employment
Earlier classical economists appreciated the concept of national income equilibrium but
believed that, if the economic forces were left to work freely, this equilibrium level would also
produce a situation of full employment. They argued that as incomes fell, labour costs would
also fall, until it became worthwhile for business entrepreneurs to increase their demand for
workers.
If instead of this happening there was large-scale unemployment, then it was argued that
the fault lay with trade unions and other institutional forces in the economy: they were
keeping up wages and prices and making labour overpriced in relation to the current level of
demand. The remedy for unemployment lay in forcing down wages despite any opposition
that might be encountered.
B. THE BASIC KEYNESIAN VIEW

Keynes accepted that, in the long run, it might be possible to bring down wages until labour
became so cheap that all workers wanting jobs could be found employment. However, he
regarded the price of such action, in terms of social distress and political conflict, as being
unacceptable in a modern society. He doubted whether society could withstand the conflicts
and pressures that would be set up by the attempt to bring down wages far enough to
achieve full employment.
Therefore for practical purposes, and in the interests of social and political peace, he
considered that it was better to regard the equilibrium level of national income and the level
at which all workers were fully employed as two separate levels, with no natural way of
coming together through the operation of the normal economic forces.
This concept of the separation of equilibrium and full employment levels of national income
is illustrated in Figure 11.1. Here, we return to the model based on the 45 line which, you
© ABE and RRC

Macroeconomic Equilibrium and the Deflationary and Inflationary Gaps 193
will remember, represents the curve where all income is expended. The intended levels of
expenditure at each level of income are shown by the curve C  J (consumer spending plus
total injections from investment, government and exports).
The equilibrium level, where intentions are fulfilled without changes in prices and stocks, is
Oe, where the C  J curve intersects the 45 line.
Figure 11.1: The separation of equilibrium and full employment levels
Expenditure
Deflationary gap
CJ
45
O e f National income
Suppose that possible output of goods and services available for purchase by the
community, given full employment of all those seeking work, would push up income to level
Of. However, at this level of income there is a gap between the 45 line and the C  J curve.
This gap indicates that possible expenditure at this income level is greater than intended
spending from the total forces of consumption, investment, government and exports.
C. THE DEFLATIONARY GAP

The basic model of the deflationary gap was shown in Figure 11.1. The gap arises when
total aggregate demand from household consumption, business investment, government
spending and net exports (C  I  G  (X  M)) is insufficient to absorb all the output that
could be produced if all available production factors, including those workers seeking
employment, were fully employed.
Possible Causes
Strict classical and monetarist economists believe that a deflationary gap would not exist if
both product and factor markets were free to perform their basic functions of bringing supply
into equilibrium with demand through changes in price. Closing a gap by the operation of
market forces alone would imply significant reductions in wages. However wage incomes
are a major influence on the level of consumer demand, so that any large-scale reduction in
wage levels would further depress the consumption element in aggregate demand. Fear of
© ABE and RRC

future unemployment and falling incomes would also depress demand and of course
business investment, so that there is no guarantee that greater wage flexibility in a modern
economy would close the gap. It could make it larger. Actions of business firms in making
workers redundant, and deliberately creating an atmosphere of insecurity in their workforces
to keep wage levels restrained, could be one of the initial causes of the deflationary gap.
Government action to reduce spending and to reduce the size of the public sector in the
economy could have a similar effect, both in reducing the G element in aggregate demand
and in undermining consumer and business confidence in the future of the economy, and so
causing the gap and then making it wider.
Consequences
The immediate and most visible consequence is a rise in unemployment and lengthening of
the time that the unemployed remain out of work. This is the feature that made the Great
Depression of the 1930s such a searing experience for all those who experienced it. It
shaped economic and political attitudes for a generation, until memories of the depression
became submerged beneath the more recent and longer-lasting experience of inflation.
Long-term unemployment creates severe social and personal problems, as well as being a
cruel waste of potentially productive economic resources. In Keynesian thinking it is
something that governments can and should seek to remedy and preferably avoid
altogether.
However, labour is not the only factor of production. In a severe economic depression all
factors are unemployed or underemployed. Land goes out of cultivation, business premises
remain empty and deteriorate, and machines lie idle and rust. If supply is greater than
demand in the factor and major product markets we would expect prices to fall. In some
markets, notably the private house and business property markets, there have been price
reductions. However, property is regarded as a form of wealth rather than as a consumer
good, and price reductions for private houses are not welcomed by households in the way
that price reductions for, say, furniture or private cars would be welcomed. People feel
poorer when the value of their home falls, especially if they have a mortgage loan that is
larger than the home's current market value (negative equity). Under these conditions home
movements and associated purchases are much reduced and in general consumer
spending is depressed.
Policy Options for Closing the Deflationary Gap

The implication of the basic Keynesian model of the deflationary gap is that the aggregate
demand curve of C  I  G  (X  M) or C  J (J standing for all the demand injections)
should be raised to bring the equilibrium level of national income closer to the full potential
employment level. This is illustrated in Figure 11.2.
© ABE and RRC

Figure 11.2: Raising the aggregate demand curve
Expenditure
C  J1
Deflationary
gap
CJ
The equilibrium level

of national income
rises from Oe to Of.
45
O e f National income
Since business investment (I) levels are a consequence of firms' experience of past and
current consumer demand, and their view of the probable future trend of this demand is also
dependent on net export levels, the potential for lifting I when C is depressed is limited.
However, there is one other element within total aggregate demand which is not necessarily
an inevitable part of the business cycle: government spending (G). Government spending is
the result of political decisions that can be taken independently of the national income and
consumer demand, if the government abandons the principle of the balanced budget
(spending equals taxation revenue). This of course is government spending on such
projects as road and communications development.
The possible result of increasing government spending is shown by the movement in the
C  J curve in Figure 11.2. Here, we see that the rise from C  J to C  J1, brought about by
an increase in government spending, is able to close the deflationary gap and remove large-
scale unemployment. This, very broadly, was the type of remedy advocated by Keynes for
the massive unemployment problem of the 1930s.
Unemployment in Britain did start to fall when government spending began to increase in
the face of approaching war, in the late 1930s. However, a remedy that was developed in
the 1930s does not necessarily apply quite so simply in the very different economic
conditions of today, and we need to examine the whole problem much more carefully (which
we shall do in subsequent study units).
Modern Keynesians now recognise that continued demand stimulation policies, aimed at
closing the deflationary gap by accepting an unbalanced budget and relatively high levels of
government borrowing, can have inflationary effects leading eventually to the problem of
stagflation, when both unemployment and prices rise together.
Keynesians now accept that the demand-management policies of the 1950s and 1960s
contributed to the high inflation suffered in the 1970s. Most are prepared to agree that they
© ABE and RRC

had understated a number of consequences of government measures to keep

unemployment low. These included:
 The rapid expansion of the public sector fed by injections of government spending,
and the relative contraction of the private sector as this became uncompetitive in world
markets. Expansion of public spending beyond the capacity of tax revenues to sustain
it led to large amounts of government borrowing. These combined to increase
inflationary pressures in the economy.
 Long periods of low unemployment, and a belief that governments would always act to
avoid high unemployment, gave labour unions an inflated view of their own power.
Union pressure to raise wages and achieve generous legislation to provide job
security, in spite of increased competition in world markets, aggravated the problem of
stagflation. It delayed the improvement in labour productivity that was needed to
increase domestic production, and slow down the decline in exports and rises in
imports experienced during the 1970s.
Modern Keynesians also recognise that the technological revolution of microelectronics has
fundamentally changed the structure of industry, and shifted the long-run labour to capital
ratio in modern production in favour of capital. They accept that industrial practices have to
become more efficient if firms are to compete successfully in world markets.
At the same time, Keynesians have retained their basic belief in the duty and ability of
government to intervene to mitigate the social effects of economic cycles and the
consequences of technological change. They do not believe that unregulated markets will
always lead to equilibrium conditions acceptable to modern society, and they continue to
place importance on the public sector provision of those goods and services that are
inadequately provided by private sector markets.
D. THE INFLATIONARY GAP

An inflationary gap is created when aggregate demand of C  J is greater than the supply of
goods and services provided when national income is operating at or near the full
employment level. Such a gap is illustrated in Figure 11.3.
Here total demand, from all the forces represented by the C  J curve, is forcing an
equilibrium level of national income above the level of total production and real spending
that is possible given full employment at income level Of. The pressure to buy goods and
services that are not being produced forces up prices. In this situation, total spending
intentions cannot be fulfilled, so that actual spending is lower than intended.
Some Possible Causes

Keynesian models are better at coping with unemployment than with inflation, and
Keynesian economics went into retreat in the face of the massive inflation of the 1970s and
1980s. Earlier Keynesians had been prepared to tolerate a low rate of inflation, perhaps
around three per cent, in the belief this provided a stimulus to demand and helped to keep
unemployment levels low.
Experience has shown that low inflation rates can very rapidly turn into high rates. The
inflationary gap produces price rises and waiting lists for goods and services. Unfortunately
these do not actually close the gap. If prices rise, people spend the money they had planned
to spend, but do not buy all the goods and services they had planned to acquire. The
spending pressure remains high and rising prices actually increase demand, since people
prefer to buy now at today's price rather than tomorrow at a higher price. If they finance this
spending by borrowing they increase the money supply and this adds further inflationary
pressures.
© ABE and RRC

Figure 11.3: The inflationary gap
Expenditure
CJ
Inflationary
gap
45
O f e
National income
In its simplest terms an inflationary gap arises when aggregate demand is greater than
aggregate supply, which is unable to respond sufficiently to reduce the excess demand. This
then raises two questions:
(a) What causes the excess demand?
(b) Why, if it is the function of a market economy for supply to respond to demand, is the
production system unable to meet total demand?
In their extreme forms, Keynesians and monetarists have given conflicting answers to these
questions. Today, they are closer together, but still place different emphasis on different
aspects. At this stage these differences are just outlined.
Keynesians have blamed excess demand on excess income which is running ahead of
potential production. More recently, they have been prepared to accept that money supply
and government borrowing have also played a significant part in stimulating demand.
Monetarists have tended to blame excessive demand on excess money supply (for reasons
that are explained later), but they have also linked this with rising wage levels made possible
by business borrowing. They have also linked excess money supply to government
spending and borrowing.
The original Keynesian model of the inflationary gap assumed that the production system
could respond to rising demand, up to the point where all production factors were fully
employed. A significant inflationary gap would only appear when the equilibrium level of
national product rose above the full employment level. This basic model offered little scope
for a convincing explanation for the stagflation of the 1970s and early 1980s, when both
inflation and unemployment were rising. Consequently Keynesians have had to accept
deficiencies in the production system at levels below full employment. As already explained,
they have tended to emphasise problems arising from a period of rapid structural change
caused by the contemporary technological revolution.
© ABE and RRC

Monetarists have traditionally been more prepared to see inflation and unemployment as
associated, rather than opposing problems of a troubled economy. They do not only regard
inflation as a cause of unemployment because of its effect on business productivity and
ability to compete in world markets. They also see inflation as being partly caused by
defects in the supply side of the economy that encourage people to remain unemployed
even though there is excess demand in the economy. Inefficient factor markets permit
unused production capacity to remain unused in spite of high levels of demand. However,
they have had to recognise the deflationary and unemployment consequences of their
monetary and market reform/supply side policies aimed at reducing inflation. Inflation control
has proved a far more difficult economic and social problem than the monetarists
anticipated.
Consequences
In the 1950s and early 1960s inflation rates were low by later standards. When the economy
was growing at unexpectedly encouraging levels, it was not uncommon for observers to
comment that a low rate of inflation might be healthy and stimulating for an economy.
However, as explained earlier, inflation tends to feed on itself, and can suddenly rise out of
control unless measures are taken to impose checks. The common socio-economic
problems arising from inflation have tended to be identified as:
 Countries with inflation rates higher than their trading partners and/or rivals soon price
themselves out of increasingly competitive world markets. Exports fall and imports
rise, so that an international payments problem undermines the currency (in ways that
are discussed more fully in a later unit). To this extent inflation leads to rising
unemployment.
 Confidence is lost in the stability of the domestic currency and financial structure.
Savings fall and there is a flight of capital in spite of any financial exchange controls
that might be imposed. In extreme cases a flight from money to physical goods fuels
further inflation.
 As long as most incomes rise faster than prices people can be misled by an
impression of rising wealth, particularly when high-value fixed assets such as houses
and land gain high monetary values. However, as more and more sections of the
population fail to maintain the real (inflation adjusted) value of their incomes, and living
standards fall for a growing number of people, there is a big increase in social
discontent. In extreme cases there is civil conflict, destruction of property and loss of
lives. At this stage there is a danger of complete social and political breakdown with
unpredictable consequences.
During the period of high and rising inflation of the 1970s there were still those who
defended inflation as being preferable to high unemployment. They argued that there would
be no undesirable consequences if all financial payments and obligations were to be "index
linked", i.e. if all monetary values were periodically adjusted by an agreed inflation measure.
Some even argued that this would itself gradually bring down the rate of inflation, since
there would be nothing to gain from raising prices when costs also rose at the same rate.
In practice, experience soon showed that although some degree of indexation was able to
preserve the value of some obligations, such as real yields on savings and the purchasing
power of pensions, inflation itself is too complex and uneven in its effects for it to be simply
indexed away into insignificance. It also became clear that the low-inflation countries, such
as Germany and Japan, were able to enjoy more successful economic growth and higher
living standards than the high-inflation countries such as Britain and Italy. Indexation was, of
course, no cure for the international trade problems of the high-inflation countries.
By the 1980s there was widespread agreement throughout Western Europe that inflation
was a major economic problem that governments had to solve. There was sufficient popular
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support for this for governments to risk taking measures that they knew would increase
unemployment in the short-term.
Indeed, it is now recognised that the Keynesian injections and withdrawals model,
represented by the 45 model of the economy, is incomplete. It leads to an over-optimistic
picture of the power of fiscal policy to alter permanently the equilibrium level of output in an
economy. To understand the nature of this limitation and work with a more realistic model of
income determination, we need to relate the level of demand in the economy to the
economy's supply capability.
E. THE AGGREGATE DEMAND/AGGREGATE SUPPLY

MODEL OF INCOME DETERMINATION
Aggregate Demand and Supply
The major limitations of the Keynesian injections/withdrawals model are that it focuses
exclusively on the demand side of the economy, and neglects completely the supply side of
the economy. Although the model can be used to illustrate the concepts of an inflationary or
deflationary gap, by relating the level of aggregate demand in the economy to its full
capacity output level, there is no consideration of the relationship between supply and the
price level. The Keynesian model is deficient when it comes to studying the relationship
between changes in aggregate demand and the general level of prices in an economy. To
understand the causes of inflation and deflation in an economy, and how changes in the
level of aggregate demand affect the price level as well as output and employment, a
different model is needed. This model is known as the aggregate demand (AD) and
aggregate supply (AS) model of income determination.
The Aggregate Demand Curve

An aggregate demand curve is illustrated in Figure 11.4. The aggregate demand curve looks
to be the same as the microeconomic demand curve used in earlier units, but appearances
can be deceptive. In the aggregate demand and supply diagram the vertical axis in the
diagram shows the level of prices in the economy as a whole, and not the price of a single
good or service. The price level is measured by an index number of prices, an average
measure of all the prices in the economy. This is not the same as the rate of inflation or
deflation, but a change in the general level of prices in an economy corresponds to the rate
of inflation or deflation. For example, the rise in the price level from P2 to P1 shown in
Figure 11.4 implies a positive rate of inflation in the economy. The horizontal axis measures
the level of real output or real national income in the economy, not the money value of
income or output. Real national income is the measure of output that matters for an
economy because it is this that determines the standard of living and the level of
employment. If the price of all the goods and services in the economy were to increase by
20 per cent, due to inflation, the value of national output measured in monetary terms would
also increase by 20 per cent; but no one would be any better off, because real output would
be the same. Actually, if the level of prices rose in an economy due to inflation while all the
other economic variables remained the same, the economy would be worse off in the sense
that the level of aggregate demand would be lower. This relationship is shown by the
downward slope of the aggregate demand (AD) curve from left to right. The downward
sloping AD curve results from the fact that as the general level of prices is reduced the real
value of the supply of money increases, and the level of the rate of interest decreases.
Without explaining this relationship in more detail at this stage, we can deduce that as the
general level of prices and the rate of interest decrease, consumers increase their
consumption expenditure and firms increase their borrowing and investment expenditure.
Thus, all other things remaining constant, as the general level of prices in the economy falls
© ABE and RRC

the C and I components of aggregate demand increase: the AD curve slopes downwards
from left to right as drawn in Figure 11.4.
Figure 11.4: Aggregate demand curve
Price
Level
P1
P2
Aggregate Demand (AD)

Curve
Y1 Y2 Real National Output
The entire aggregate demand curve will shift to either the left or the right if, without any
change in the level of prices in the economy, there is a change in one of the underlying
components of aggregate demand or the supply of money in the economy. For example, all
other things remaining constant including government tax revenue, an increase in the level
of government expenditure will shift the entire AD curve to the right. Conversely, all other
things remaining constant, a decision by consumers to spend less on consumption, which is
the same as a decision to save a larger fraction of their incomes, will result in a shift to the
left in the AD curve.
Aggregate Supply
Aggregate supply (AS) is the economy's total output of goods and services over a given
period of time. At the level of the whole economy, we have to recognise that there are two
distinct aggregate supply relationships. One is the economy's maximum sustainable level of
output. This is termed long-run aggregate supply (LRAS). The other aggregate supply
relationship shows how the economy can vary its output in the short term, and recognises
that for short periods of time it is possible to produce more real output than is sustainable
over longer periods. Think of it this way: it is possible for a person to increase their output by
cutting down on time spent sleeping and working longer hours each day. However after a
few days with little or no sleep, production would fall to zero because of the need to catch up
on lost sleep! This kind of relationship is represented by an economy's short-run aggregate
supply (SRAS) curve.
© ABE and RRC

The Long-Run Aggregate Supply Curve

The LRAS curve is illustrated in Figure 11.5. An economy's level of real national output, and
hence the standard of living in the economy, depends upon its natural resources, and its
stock of physical and human capital. Provided an economy has the capability to utilise its
natural resources effectively, then the greater its endowment of natural resources the higher
its level of real income. The more and the better the quality of an economy's physical capital,
the higher will be its level of real output. An economy's physical capital includes its
infrastructure of roads, ports, railways, airports, schools, universities and hospitals, plus all
its houses, offices and factories, plus all the vehicles, machinery and equipment. Likewise,
the higher the quality of the labour force in terms of education, training and skills, as well as
health and life expectancy, the greater will be their productivity and the level of real output in
the economy. It is these differences in natural resources, and physical and human capital,
that explain the differences in national income and living standards between countries.
While the importance of natural resources and physical capital is self evident in explaining
differences in income levels between countries, it is differences in human capital that
account for the greatest difference in many cases. The efficiency or productivity of the
labour force is a major determinant of real national output. This explains why education and
training are so important in determining living standards, and why they are given so much
emphasis in developed, high income, countries.
Figure 11.5: LRAS curve
Price
Level LRAS
Long Run Aggregate Supply Curve
Ye Real National Output
The LRAS curve is vertical at the level of real output determined by the full utilisation of all
the economy's factors of production. This point is also termed the point of full capacity
utilisation, the point of full employment, or full employment output. The LRAS curve is shown
as vertical, that is, completely price inelastic with respect to the general level of prices. This
is because once the economy is operating at its sustainable level of full capacity utilisation
merely increasing the level of prices in the economy will not result in any increase in real
output. Inflation alone does not have the power to make the economy more productive and
increase the availability of goods and services.
© ABE and RRC

The position of the LRAS curve is not fixed permanently. Economic growth resulting from
increases in the productivity of the economy's factors of production, and/or increases in the
available supply of labour and capital through investment, increases the full capacity level of
real output. That is, economic growth shifts the LRAS curve to the right. Equivalently, the
rightward shift of the LRAS curve through economic growth is equivalent to the rightward
expansion of an economy's production possibility frontier. The LRAS curve can also shift
inwards to the origin, although fortunately this is much less common, if an economy's
productive capacity is destroyed through war or natural disaster (such as an earthquake or
flooding).
The Short-Run Aggregate Supply Curve

Although an economy cannot maintain a level of total output permanently above that
corresponding to its full capacity utilisation output, unless it experiences real economic
growth, it can produce to the right of its LRAS curve in the short run. The explanation is
simple. Physical capital can be worked for longer periods without maintenance and repair,
even if this means that it will breakdown and wear out sooner than its designers intended.
Likewise, over short periods of time, workers and land can be worked more intensively and
for longer hours than is good for their longer-term health and productivity. However, working
an economy's fixed available supply of land and physical productive capital more intensively,
by employing more workers and increasing the hours worked, is subject to the law of
diminishing returns. This means that for a given level of money wages in an economy the
cost of each unit of additional output will rise. Thus the SRAS curve will slope upwards from
the left to the right and appear to look just the same as the individual firm and industry
supply curves considered in earlier units. An economy's SRAS curve is shown below in
Figure 11.6. That the economy's aggregate supply curve, at least in the short run, slopes
upward in the same way as a firm's supply curve should not be surprising, because the
aggregate supply curve is simply the sum of all the supply curves of individual firms.
Figure 11.6: SRAS curve
Price
SRAS
Level
Short Run Aggregate Supply Curve
Real National Output
© ABE and RRC

The upward slope of the curve shows that unit costs of production, and hence prices, rise
because of diminishing returns as the economy increases its level of real output from a
given stock of resources. Each SRAS curve is based upon the assumption of a given level
of money wage rates and rates of tax in the economy. Thus, in contrast with the economy's
LRAS curve which is fixed at each point in time, there are many possible SRAS curves at
any one time depending upon the level of money wages, taxes and import prices. Three
such SRAS curves are shown in Figure 11.7.
Figure 11.7: A set of SRAS curves
Price SRAS2
Level LRAS (Wage/cost level 2)
SRAS1
(Wage/cost level 1)
P2 SRAS3
E2 (Wage/cost level 3)
P1
E1
P3
E3
The curve SRAS1 is based upon a given level of money wages. The point of full
employment equilibrium is at E1 where the SRAS curve intersects the economy's LRAS
curve. At this point the level of prices in the economy is P1. Now suppose that there is an
increase in the level of money wages in the economy, without any corresponding increase in
productivity. This will cause the SRAS curve to shift upwards as shown by SRAS2 in Figure
11.7. At the new point of full employment equilibrium on the LRAS curve, E2, the level of
prices in the economy has increased in proportion to the increase in money wage rates, P2.
This illustrates the fundamental point that simply increasing money wages and other costs in
an economy, without any corresponding increase in productivity, will at full employment
merely lead to higher prices. The same applies if the increase in costs is due to a rise in the
cost of imported energy, such as oil. On the other hand, a reduction in the level of money
wage rates in the economy, or a fall in the price of imported raw materials and energy, or a
reduction in the level of indirect taxes, will shift the SRAS curve downwards to the right. This
is shown in Figure 11.7 by the movement from SRAS1 to SRAS3, and the fall in the general
price level from P1 to P3.
© ABE and RRC

The Equilibrium Level of Real Output and the General Price Level
The equilibrium level of real national output and the general level of prices in the economy is
determined by the interaction of aggregate demand and aggregate supply. The intersection
of the AD and SRAS curves determines the economy's equilibrium position in the short run.
In the short run the economy can suffer from deficient demand, and be in equilibrium with
unemployment, or experience excess demand, over full employment and inflation. If the
economy achieves full employment without excess aggregate demand the equilibrium point
will lie on its LRAS curve and all three curves must intersect at the same point. This is
shown at point E in Figure 11.8.
Figure 11.8: Equilibrium level of real output and general price level
Price
Level LRAS SRAS
Pe E
AD
Excess and Deficient Aggregate Demand

We have now brought together all the pieces of the aggregate demand and supply model for
the determination of the equilibrium levels of real national output and prices. We can use
this model to revisit the concept of inflationary and deflationary gaps examined using the
Keynesian 45 model earlier in this unit.
In Figure 11.9 the aggregate demand curve AD1 intersects the SRAS curve at point E1 to the
right of the LRAS curve. This illustrates a situation of excess aggregate demand in the
economy and corresponds to the inflationary gap of the earlier analysis. But in the AD/AS
model we can see that the point of equilibrium at E1 is unsustainable because the
associated level of real national output, Y1, is greater than the economy's long-run output
level, Ye. The excess demand will place upwards pressure on wages and hence prices in
the economy. The SRAS curve will shift upwards with the rise in the level of money wages
until a new point of equilibrium is reached at point E2 on the LRAS curve. The economy will
experience inflation as it moves to its sustainable equilibrium at point E2 with a higher
general level of prices in the economy, P2. Inflationary gaps are essentially self correcting
unless the economy experiences a further injection of aggregate demand during the
movement to the new equilibrium.
© ABE and RRC

Figure 11.9: Excess aggregate demand
SRAS2
Price
Level LRAS
SRAS1
E2
P2
E1
P1
P0
E0
AD
Ye Y1 Real National Output
Figure 11.10 illustrates a situation of deficient demand in the economy which corresponds to
that termed a deflationary gap in the earlier analysis. The aggregate demand curve AD1
intersects the SRAS curve at E1 and the associated equilibrium level of real national output
is Y1. National income level Y1 is less than the full employment capacity output level of Ye as
a consequence of the deficient level of aggregate demand. However, using the AD/AS
model we can see that the term deflationary gap is misleading, because the economy may
remain in its deficient demand equilibrium at point E1 without any change in the general level
of prices from P1.
Figure 11.10: Deficient aggregate demand
Price SRAS1
Level LRAS
SRAS2
E1
P1
P2 E2
AD1
Y1 Ye Real National Output
© ABE and RRC

What is the significant difference between the situation of excess aggregate demand
illustrated in Figure 11.9 and the situation of deficient aggregate demand illustrated in Figure
11.10? In the case of excess demand there a few if any forces in the economy to resist the
rise in prices that move the economy to its point of long-run equilibrium. In the case of
unemployment due to deficient aggregate demand, the economy's automatic adjustment
mechanism will only work if money wages and other costs fall to shift the SRAS curve
downwards and to the right, until it intersects the unchanged AD curve at point E2 on the
LRAS curve. If workers resist the attempt to cut their money wages, and it may be
individually rational for them to do so, this will prevent the economy from achieving full
employment. This is an example of how perfectly rational behaviour on the part of each
individual nevertheless leads to a collective or aggregate outcome that is socially
undesirable. In this situation, the appropriate policy response by the government is an
expansionary fiscal policy to boost aggregate demand, rather than a process of falling
wages and prices (deflation), in the economy.
Using Fiscal Policy to Correct a Deficiency of Aggregate Demand

While the concepts of inflationary and deflationary gaps are useful in illustrating the crucial
role of aggregate demand in determining the economy's equilibrium level of real output, and
hence employment, the neglect of the supply side of the economy fails to reveal the full
inflationary consequences of fiscal policy. As explained previously, once the economy is
operating on its long-run aggregate supply curve, any additional increases in aggregate
demand will merely serve to drive up prices and add to the rate of inflation. But what the
analysis also reveals is that even in situations of deficient aggregate demand and
unemployed resources in the economy, an increase in aggregate demand will lead to a
higher price level and inflation as well as increased real national income. That is, the
concept of a deflationary gap for states of the economy involving deficient aggregate
demand is misleading, if it is taken to imply that such a state is associated with falling prices.
Figure 11.11 illustrates how using fiscal policy to increase aggregate demand, even when
the economy is suffering from deficient aggregate demand, leads to a higher price level as
well as an increase in real national output.
Figure 11.11: Using fiscal policy to increase demand
Price
Level LRAS SRAS1
P2 E2
E1
P1
AD2
AD1
Y1 Ye Real National Output
© ABE and RRC

The initial level of aggregate demand is shown by AD1. The initial equilibrium in the economy
is at point E1 where AD1 intersects with the short-run aggregate supply curve, SRAS1. At
equilibrium point E1 the economy is operating below its full capacity as represented by the
position of the long-run aggregate supply curve, LRAS1, at Ye. The economy is suffering
from a deficiency of aggregate demand and its shortfall in real output is equal to the
distance Y1-Ye. At the initial equilibrium level of real national output of Y1 the general level of
prices in the economy is P1. If the government increases its level of expenditure by running
a budget deficit to increase the level of aggregate demand in the economy, the AD curve will
shift to the right. This is shown in Figure 11.11 by the movement to AD2. Provided the
government's expansionary fiscal policy, which will boost to demand through the multiplier
effect, is calculated correctly, the level of aggregate demand will increase until it intersects
SRAS1 at point E2 on the long-run aggregate supply curve. At point E2 the economy has
reached its full capacity point and unemployment will have fallen to its "natural" level.
However, in contrast to the earlier 45 analysis of the deflationary gap, the elimination of
demand deficient unemployment in the economy has resulted in a rise in the general level of
prices from P1 to P2, and a rate of inflation calculated as (P2  P1)/P1 per cent. This can be
seen by comparing Figures 11.10 and 11.11. In both diagrams the initial point of equilibrium
is one involving deficient aggregate demand at Y1. Without government action to boost AD,
as illustrated in figure 11.10, full employment can only be restored by a reduction in money
wages and prices that shifts the SRAS curve downwards. Comparing Figures 11.10 and
11.11, the point of full employment equilibrium (Ye) is achieved in both cases, but with the
significant difference that the level of prices in the economy is higher when aggregate
demand is increased through government policy.
Fiscal policy can be used to control inflation if aggregate demand is excessive, but its use
gives rise to inflation even when demand is deficient. This is not the only limitation on the
use of fiscal policy because, depending upon how it is financed and the economy's
exchange rate system, its power to reduce unemployment may be much less than
suggested by the kind of analysis shown in Figure 11.11.
F. FINANCING FISCAL POLICY: BUDGET DEFICITS AND

PUBLIC SECTOR BORROWING
The difference between a government's total revenue or income and its total expenditure is
referred to as its budget deficit. In most countries a government's income is mainly obtained
from tax revenue. If a government plans to spend more than it expects to receive in the form
of tax revenue, or if tax receipts turn out to be less than anticipated when it planned its
expenditure, it will have a budget deficit. To fund a budget deficit a government must resort
to borrowing. Usually, such borrowing is based on the issue of securities (called bonds) to
investors in the capital market. In some countries the main investors are the country's
commercial banks. High levels of government borrowing are regarded as bad for an
economy, because they can crowd out private business investment and cause inflation. A
government budget deficit can cause inflation when a government does not fund its
borrowing needs by the issue of bonds to investors, but sells them to the central bank that
pays for them by printing money. Governments, unlike you or I, can "borrow" from
themselves by legally printing money!
The public sector borrowing requirement (PSBR) is the term once used in the UK to
describe the government's budget deficit. The term has been given a new name to avoid
confusion with the government's net borrowing position. The budget deficit is now termed
the public sector net cash requirement (PSNCR). The technical terms PSBR and PSNCR
are relevant for understanding official government statements and the national accounts, but
in everyday usage the term budget deficit conveys the same meaning. For the purpose of
simple economic analysis, all three terms can be treated as equivalent.
© ABE and RRC

By the 1970s the British government was recognising that there was a growing resistance
from all sections of the population to high taxation. At the same time there was strong
resistance to reductions in what was regarded as socially desirable public sector
expenditure. There was an evident temptation for the government to evade its difficulties by
the short-term remedy of increasing its borrowing. The monetarist inclined governments of
the 1980s sought to achieve balanced budgets and limit expenditure to the constraints of its
revenue receipts. However its apparent success in this objective was achieved by the device
of privatisation. This brought the government large sums of capital which were treated – and
spent – as revenue. By the early 1990s there was little left to privatise, and the public sector
borrowing requirement (PSBR) again became a major economic issue.
Financing of the PSBR

There are three main sources of finance for government borrowing. These are the non-
bank, non-building society private sector, the banks and building societies, and the overseas
sector.
The financial instruments whereby the government borrows from these three sources are all
roughly the same, although of course their relative importance is different in each sector.
The main instruments are:
 Notes and coin – the cash we carry in our pockets is technically considered to be
finance lent to the government. This dates from the origins of the bank note as a
receipt of money deposited with a bank. Although we no longer have to deposit gold or
silver with the Bank of England to obtain a Bank of England note, this still takes the
form of a receipt. Bank notes continue to carry the (now meaningless) "promise to pay
the bearer on demand the sum of ... ". The government could increase its borrowing
by ordering the central bank to print more and more notes. If it did so the notes would
soon lose their value and acceptability.
 Treasury bills – these are a kind of very formal IOU, issued for large sums and sold to
banks and other institutions prepared to lend money to the government on a short-
term basis.
 Bonds – bonds known as "gilts" (gilt-edged securities) are issued by the Treasury to
banks and other financial institutions as well as the public. Once they have been
issued they are marketable, i.e. they can be bought and sold through the Stock
Exchange at their current market price.
 Other Government "paper" – bonds, certificates, and other financial instruments sold
directly to the public and not to banks and building societies. The best known of these
paper securities are the national savings certificates and bonds that are issued
through post offices.
During the 1980s the British government sought to finance as much as possible of its PSBR
through the non-bank, non-building society private sector and the overseas sectors. This
was because these sources were thought to have less effect on the money supply than
borrowing from the banks. However, in a highly complex financial structure such as that of
the United Kingdom, there is some doubt as to whether that is really the case. The
government was also able to increase its revenue income by privatisation, i.e. by the sale of
shares in the former public corporations such as British Telecom, British Gas and British
Airways. These were turned into public liability companies and technically transferred from
the public to the private sectors of the economy. In doing this the government was accused
of "selling the family silver", and there is certainly some doubt as to the long-term desirability
of treating as revenue the proceeds of the sale of capital assets.
© ABE and RRC

The General Government Financial Deficit

The danger with all the major economic indicators is that governments and others find ways
to distort them, so that they cease to be a reliable guide to the true position they are
supposed to indicate. Some economists argue that the British PSBR can be subject to
distortions of the kind produced by privatisation receipts in the 1980s and early 1990s, and
is therefore not always a true indication of the relationship between the government's main
taxation revenues and expenditure. Likewise, the UK's New Labour governments after 1997
resorted to numerous dubious national income accounting changes. The reclassification of
certain categories of government expenditure created the impression that the government's
budget deficit, and accumulated debt as a percentage of GDP, appeared smaller than the
true economic position. For this reason economists argue that a more realistic picture of the
relationship between government revenue and expenditure is provided by the general
government financial deficit (GGFD). This is a simple measure of the difference between
total tax collections and the net spending by the whole of central and local government. It is
the measure that the finance ministries of all the member countries of the European Union
use to measure the performance of national fiscal policies.
Importance of Public Sector Borrowing

In the short run the amount of savings in the economy is fixed. If the total demand for
finance exceeds its supply from savings, the would-be borrowers have to compete for their
share of the available supply. Interest rates are the price of money and like any price they
depend fundamentally on the interaction of supply and demand.
Consequently, if the government wishes or is forced to increase its borrowing, it has to
compete with the business and personal sector. Thus there is a danger that interest rates
will rise, even though for other reasons the government might be seeking to keep them low.
If the government wishes to borrow from foreign investors, it will have to offer interest rates
that are attractive in world finance markets. If there is a fear of inflation in the home
economy, the government will have to offer interest rates that are higher than rates applying
in countries where inflation is less of a problem. Investors, quite naturally, wish to protect the
purchasing power of the money they invest. The level of public sector borrowing is thus one
of the factors influencing the level of interest rates within a country.
It is possible that public sector borrowing will increase the money supply and thus contribute
to inflationary pressures in the economy. The precise effect on money supply depends on
how the money is borrowed. Some economists argue that an increase in public sector
borrowing will only increase money supply if the government borrows from banks or building
societies. In these cases the government borrowing creates bank assets. These are then
balanced by increased lending by the banks, and the money multiplier operates to increase
the total of bank deposits within the economy. Bank deposits are the main element in the
total money supply.
It can be argued that increased borrowing from the personal, non-banking sector does not
have this effect. When the government borrows from private individuals there is simply a
transfer of purchasing power from the private to the public sector. The individual cannot
spend money lent to the government. There is no direct increase in the amount of money or
bank deposits in the community.
This is the direct effect, but indirectly the increased government borrowing may have further
consequences which do affect the money supply. If private individuals lend money to the
government, they cannot lend the same money to business firms or building societies.
These institutions may turn instead to banks for their finance, having been crowded out of
personal lending by the government. If business firms have to borrow more from banks
because they cannot raise money on the capital market, there will be an increase in bank
© ABE and RRC

deposits and lending, i.e. an increase in money supply with its potential for increasing
inflation.
Borrowing from overseas investors does not increase the domestic money supply, but it
does increase expenditure demand. If there is spare capacity in the economy this will
increase the demand for resources, stimulate production and reduce unemployment,
assuming that the government is going to spend the money borrowed on home produced
goods and services. If there are inflationary pressures in the economy, the increased
demand may increase these and contribute to rising prices. If the government spends on
foreign goods and services it will reduce the credit balance or increase the deficit on the
current balance of payments.
It is clear that there will be important economic consequences of a change in government
borrowing. What these are depends on the sources of borrowing and on how and where the
borrowed finance is spent.
G. THE LIMITATIONS OF FISCAL POLICY

Looking back from the vantage point of the early twenty-first century, it is now obvious that
much of the responsibility for the high inflation of the 1960s and 1970s (and with it the
eventual increase in unemployment) was due to the mistaken belief that fiscal policy was all
powerful, and that governments could use fiscal policy alone to permanently manage the
level of economic activity in the economy. The reality is that government expenditure
financed by printing money can only achieve one thing if pushed too far: accelerating
inflation and rising unemployment!
The policy solutions developed in the 1990s involved recognition of the limitations of the role
of the government and fiscal policy in a modern dynamic economy. The success of the new
policies is based upon:
 Recognition that fiscal policy cannot be considered independently from monetary
policy. The level of government expenditure, and the size of a government's budget
deficit in relation to the level of national income, both have serious implications for the
money supply and the level of interest rates in the economy. If inflation is to be
avoided, the government's borrowing requirement must be financed out of genuine
borrowing from the economy, and/or the rest of the world. It must not be financed from
the government borrowing from itself by requiring the central bank to print more
money for the government to spend. But even genuine borrowing has implications and
its own limitations. The more a government borrows, and the greater its budget deficit
as a percentage of national income, the more such borrowing pushes up the level of
interest rates in the economy. This leads to "interest rate crowding out".
Increasing levels of government borrowing from savers in the economy through the
financial system takes funds away from companies, and the level of private sector
investment in the economy is reduced. That is, the value of the government
expenditure multiplier is smaller than suggested by the Keynesian model of income
determination. This is because it ignores the way that increased government
expenditure crowds out private expenditure through its role in pushing up the level of
interest rates in the economy. This problem is made worse if the increased
government expenditure is spent on increased current consumption rather than
increased investment. By crowding out private sector investment the economy's future
productivity capacity is reduced, and with it the future growth rate of national income.
The end result of increased government expenditure (although it may appear
beneficial today, especially if it allows people to increase their consumption) is thus to
reduce the growth of future government tax revenue because this will decline with
future income! The correct policy response is to avoid interest rate crowding out by
© ABE and RRC

reducing the need for government borrowing. Government borrowing as a percentage

of national income can be reduced in two ways: by increasing taxation as a
percentage of national income, so that government expenditure is paid for without the
need to borrow; or alternatively, by reducing the share of government expenditure in
national income.
 It is also now recognised that increasing the level of taxation in an economy through
higher rates of tax, especially taxes on income and company profits, can also be
damaging to the economic performance of an economy. Therefore it follows that
increasing taxation is not likely to be a long-term solution.
As we have seen in this unit, the equilibrium level of national output is determined by
aggregate demand and aggregate supply. Any analysis of the role of government
expenditure in the economy that ignores the affect of fiscal policy on aggregate supply
is likely to seriously overstate the longer-term benefits of fiscal policy. Equal attention
needs to be given to aggregate supply as well as aggregate demand in the formulation
and implementation of fiscal policy. This is done through the government developing
"supply side policies". Such policies recognise the negative incentive effects of high
rates of income tax on people's willingness to work, and high rates of tax on
companies' willingness to take business risks and undertake investment in new
productive capacity. Supply side policies aim to reduce the disincentive effects of
taxation. They do this by restraining government expenditure and reducing the share
of government in national output, stimulating productivity by improving the quality of
the labour force through greater emphasis on education and incentives for increased
training, and policies to stimulate increased investment in new technologies.
 The share of government expenditure in total national income can be reduced by
"rolling-back the limits of the state" through privatising state-owned industries and
transferring functions undertaken by government to private sector firms.
 The eventual acceptance by many economists and governments that persistent long-
term inflation was essentially due to over expansion of a country's money supply has
resulted in a new approach to monetary policy.
 Government expenditure financed by government borrowing from its central bank
(printing money) only leads to inflation, and cannot create permanently higher
employment and living standards in an economy. Recognition of this has led many
governments to adopt a hands-off approach to monetary policy, by transferring
responsibility for the determination and operation of monetary policy to their central
bank. This is known as central bank independence and is usually, but not necessarily,
associated with the adoption of an inflation target policy by the central bank. What this
means is that the central bank undertakes monetary policy, without interference from
the government, with the aim of achieving an announced target rate of inflation in the
economy. (This is examined further in later units.)
 The final limiting factor with regards to the effectiveness of fiscal policy is an
economy's exchange rate system. Fiscal policy is at its most effective in an economy
which maintains a fixed value of its currency against another major currency, such as
the US dollar or the European Union (EU) euro. The downside of this policy is that it
leaves a country open to importing inflation to the rest of the world. This means that
those countries that want to achieve a low and predictable rate of inflation (because
this is now thought to be the most effective way of supporting economic growth and
full employment) must have a freely floating and not a fixed exchange rate. This
explains why those countries which have given their central bank its independence
from government in the conduct of monetary policy, such as the UK and the EU
eurozone countries, allow their currencies to float on the foreign exchange market. It
also explains why many economists and governments believed that fiscal policy was
more powerful than it proved to be from the 1970s onwards. In the period 1946–1973
© ABE and RRC

most countries operated a fixed exchange rate for their currency against the US dollar.
This was the period of the International Monetary Fund (IMF) fixed exchange rate
system. This system finally collapsed in 1973, when the world's leading economies
abandoned fixed exchange rates in favour of floating exchange rates because they
wanted to control inflation. Fiscal policy is weak in a country which operates with a
floating rather than a fixed exchange rate. (This is examined further in later units.)
Review Points
check that you have achieved the learning objectives. If you do not think that you
understand the aim and each of the objectives completely, you should spend more time
1. Outline the aggregate demand and supply model of income determination.

2. What is the difference between short-run and long-run aggregate supply?
3. Explain what is meant by a deflationary gap using the aggregate demand and supply
model of income determination.
4. Explain what is meant by an inflationary gap using the aggregate demand and supply
model of income determination.
5. Explain what is meant by "interest rate crowding out".
6. What is supply side policy? How does it differ from fiscal policy?
7. In an economy operating with a freely floating exchange rate is fiscal policy stronger or
weaker than if the economy operated a fixed exchange rate?
© ABE and RRC

213
Study Unit 12
Money and the Financial System
Contents Page
A. Money in the Modern Economy 214

Features and Types of Money 214
Functions of Money 215
High-Powered Money 216
B. The Financial System 216

Structure of the Financial System 216
The Retail Banks 217
Foreign Banks 218
Money Markets 218
Building Societies 219
Unit Trusts and Investment Trusts 219
Hedge Funds and Private Equity Funds 219
C. The Banking System and the Supply of Money 220

Money and Bank Credit 220
Credit Creation 220
Illustration 220
The Bank Credit Multiplier 221
D. The Central Bank 222

The Functions of the Central Bank 222
Modern Central Banking 223
E. Interest Rates 224

Importance of Interest Rates 224
The Determination of Interest Rates 225
The Pattern of Interest Rates 227
© ABE and RRC

214 Money and the Financial System
Objectives
The aim of this unit, in conjunction with Study Unit 13, is to explain and evaluate the
effectiveness of monetary policy in a closed and open economy and discuss the possible
impact of monetary policy on business decision-making.
 demonstrate an understanding of the relationship between the banking system and the
creation of money
 identify the components of the high-powered money stock and explain why these have
a magnified impact on the money supply
 explain the quantity theory of money and its role in explaining the rate of inflation
 discuss the components of monetary policy and explain how they work
 evaluate the factors that determine the effectiveness of monetary policy
 compare and contrast the relative effectiveness of fiscal and monetary policy.
A. MONEY IN THE MODERN ECONOMY

Features and Types of Money
Throughout history money has taken many forms. Almost anything can serve as money as
long as people are prepared to accept it in exchange. Acceptability is the one quality that
money must have. If this is lost, if people are no longer willing to trust it and thus refuse to
take it in exchange for real goods and services, then it is useless.
Other qualities can add to its usefulness. Ideally money should be:
 portable – it will not be much use as an aid to transfer if it cannot easily be moved
 divisible – it must be capable of reflecting a range of values; animals were once a
symbol of wealth but as money they had limitations – a valuation of one and a quarter
cows could prove difficult to pay!
 durable – saving presents problems if the money saved is likely to die, rot or rust away
 controllable – preferably in short supply, not too easily obtained and capable of being
controlled by an accepted authority
 recognisable – if people cannot recognise money as money they are unlikely to accept
it very readily.
One of the oldest forms of money, and one that is still in limited use, is gold. When, from
time to time, the world economy becomes unstable and other forms of money become less
acceptable, the price of gold always rises as people turn (or return) to it as a haven for their
threatened savings.
Other precious metals have often been used, especially silver, but this lacks some of the
qualities of gold. Many metals suffer deterioration over time.
To aid recognition, add acceptability and assist in measuring value, many communities over
the ages have fashioned coins from previous, semi-precious and base metals. With the
exception of a limited supply of gold, these are now used mainly for units of low value.
Metal is bulky and expensive to transport in large quantities so, from very early times, traders
have used paper as a more convenient substitute. Paper has always been used in two ways
as money:
© ABE and RRC

Money and the Financial System 215
(a) As a receipt or representation of precious metal or some more solid form of money and
exchangeable for the preferred form of money under certain conditions. The Bank of
England bank note still contains the "promise to pay the bearer on demand the sum of
... ". At one time the holder could exchange such notes for gold. Today handing over a
note at the Bank of England will only be met with another note, but the promise serves
as a reminder that the paper really just represents money and has no intrinsic value in
itself.
(b) As an instruction to a clearly identified person or organisation, or a promise from a
person or organisation, to make a payment under certain conditions. A letter of credit is
an instruction to make money available to the holder while a bill of exchange, still
widely used in international trade, is an unconditional promise to make a payment.
Such instruments of payment are almost as old as trade itself.
In recent years plastic cards have replaced or supplemented paper as conveyors of
instructions to make payments. The development of modern telecommunications has made
such cards, with their magnetic strips, among the most important means of carrying out
everyday trading transactions. As information technology continues to advance we can
expect these cards to gain further uses, but we can also expect that transactions will be
increasingly made by direct instructions through computers or over the telephone.
All of these convenient forms of payment by simple instruction depend on people's
willingness to hold their store of money in banks. Early banks actually did store the wealth of
their customers in the form of precious metals, but wealth is now stored purely in the form of
credit balances recorded in computers. No doubt today's method of storing money has not
yet reached its ultimate form, though in simple terms we can ignore all present and future
methods of transferring and storing money and simply refer to it as "bank credit". In this form
we can choose to store it as a bank deposit or use it to make payments by any of the
techniques made available to us by current technology.
Functions of Money
The functions of money are generally summarised as follows:
(a) Facilitating Exchange
The basic purpose of money, as we have already noted, is to make the exchange of
goods or services easier. Without money, people have to resort to direct exchange or
barter, and this is often wasteful, time-consuming and inefficient. Money allows trade to
develop much more freely.
(b) Measure of Value
Even if people do exchange goods directly, they can be more certain of fair dealing if
they can measure the value of their goods in terms of recognised money. If farmers
wish to exchange pigs and cows, they are helped if they know the values of both in
money terms.
(c) Measure of Deferred Payments
Exchange and trade can flow more freely if it is possible to carry forward debts of a
known amount. Money can help by standing as a measure for any payments that are
deferred for future settlement. For example, the farmers exchanging pigs and cattle
may agree that A took cattle from B to a higher value than the pigs he passed to B. If
the difference in value is expressed in money, then both know the size of the debt and
the future payment required. Money measurement may help them later to settle the
debt – say, with some other animal, perhaps sheep.
© ABE and RRC

(d) Store of Value

Finally, money can be kept as a store of value that can be held in reserve for
purchases not yet planned. This value can be held over time – as long as money value
does not fall.
The importance of acceptability has already been stressed. Without it, money cannot be
used in exchange. This is why a great deal of international trade is carried out in a relatively
few generally acceptable currencies – e.g. American dollars, Swiss francs, Japanese yen,
British pounds and euros. These currencies are all readily acceptable and transferable in
world trade and finance markets.
We can see that acceptability and transferability depend on the confidence of traders. If this
confidence is lost, then money ceases to have any value, because it cannot fulfil its essential
functions.
The function that causes the most problems is that of storing value. No form of money in the
modern world has escaped the problem of inflation – the tendency for money prices to rise
as time goes by. If all prices rise, then the value of money itself is falling. The difficulty of
storing value undermines confidence, acceptability and transferability, and so makes trade
generally more difficult and uncertain.
High-Powered Money
The measurement of money supply depends on how we define it. The wider our definition,
the more we have to measure. Difficulties in deciding precisely what should be counted as
money help to account for the fact that there are several possible definitions. These are can
be divided into two groups:
 Narrow money – M0, the narrowest definition, made up of the notes and coin in
circulation with the public and banks' till money and the banks' operational balances
with the central bank.
 Broad money – M4, made up of notes and coin and all private sector sterling bank and
building society deposits.
This distinction is more important than it might appear because of the special role of narrow
money in the banking system. The other name for narrow money is "high-powered money".
The term "high powered" indicates that it serves as the reserves of the commercial banks in
the economy and provides the basis for the creation of bank deposits. Because high-
powered money is "created" by the central bank, and hence directly under its control, it
enables the central bank to control the deposit creating activities of the commercial banks
and the broad money supply.
B. THE FINANCIAL SYSTEM

Structure of the Financial System
The financial system is made up of a range of banking and other financial institutions and
financial markets. These have undergone far-reaching changes in many countries in recent
years, especially in relation to the development of financial markets. You are likely to find a
number of terms used to describe banks and financial markets when you read textbooks and
financial journal articles.
The following subsections provide brief outlines of the various categories. You should also be
alert for references and descriptive accounts which appear from time to time in the leading
financial journals.
© ABE and RRC

The Retail Banks

These are the banks which handle the individual accounts, both small and large, of private
and business customers. In the UK they include such banks as Barclays, Royal Bank of
Scotland, LloydsTSB, HBOS, HSBC and Abbey. They are distinguished from investment
banks, such as Goldman Sachs. Investment banks are major participants in global financial
markets and handle only large sums of money (upwards from $1m), and concentrate their
activities in a limited number of major world financial centres. The large retail banks (also
known sometimes as branch banks) do engage in wholesale banking in addition to their
retailing functions, and the terms "retail" and "wholesale" really apply more to functions than
to separate, specialised institutions.
The major functions of a retail bank are:
(a) Safe-keeping of Money
This is the basic function of banking. Many customers still keep jewels and important
documents in bank safes. However, modern money is mostly in the form of
transferable credit, and this function is chiefly performed through the various types of
bank account held by customers. The current account is used for day-to-day
transactions. Other accounts are usually in the form of "time deposits", i.e. deposits
where an agreed period of notice is required for withdrawals without penalty. The
longer the period of notice and the higher the amount deposited, then the higher the
rate of interest paid by the bank. If immediate withdrawal is required then a certain
amount of interest is usually forfeited, though in some accounts immediate withdrawal
is permitted without an interest penalty provided a stated minimum sum remains in the
account. You should obtain details of the range of accounts offered by your own bank.
(b) Transfer of Money
Much of the daily work of the retail banks is concerned with making payments through
cheques, standing orders, direct debits and other written instructions, including bank
giro. Some of the work of money transfer has now been passed to the credit card
companies (themselves mostly owned by the large banks), but credit card payments
still require final settlement by a bank transfer. The large international banks are deeply
involved in foreign payments for the import/export trade. Bills of exchange are still used
extensively in handling trade payments, especially as these are very closely linked with
the extension of credit.
(c) Lending Money
Banks make most of their profits from lending money. Traditionally they have been
chiefly concerned with short-term loans – very "short-call" (overnight or 24-hour) loans
to other banking institutions, overdrafts, trade loans made by discounting bills of
exchange (usually for up to 60 to 90 days) and commercial loans for up to around two
years for business or approved private projects.
In recent years, banks have been encouraged (by government pressure or by
competition) to lengthen their lending terms. Clearing banks have entered the private
house mortgage market where loans can be made for 20 or more years. Of greater
importance to business has been the increased willingness of banks to lend for periods
of between five and ten years for business capital development.
(d) Money Management, Advisory and Agency Services
The banks have become increasingly involved in selling their financial skills to help
people manage their money. They also recognise that they have a responsibility to
provide financial help to business ventures which operate with bank money. Apart from
becoming financial consultants, banks are also becoming more actively involved in the
© ABE and RRC

fringe financial services such as insurance broking, investment advice and the handling
of trusts and estates.
More recently, a number of banks have entered the field of stockbroking. This has
been made possible by the Stock Exchange reforms of October 1986. The retail banks
also control a number of specialised subsidiaries, offering hire purchase, leasing and
factoring services to customers.
 Leasing is an alternative to hire purchase, and is used frequently by business
firms to obtain vehicles and equipment under a form of instalment credit.
 Factoring is used chiefly in foreign trade. A factor takes over responsibility for a
company's approved trade debts (debts owed to the company) and arranges
collection and administration, thus releasing cash to the company. It is an
expensive way of speeding up a firm's cash flow (the speed at which money
spent on production is recovered from sales) but worthwhile if the cash can be
used at greater profit than the cost of the factoring service.
Foreign Banks
A feature of recent years has been the globalisation of banking and financial markets and
the continued rise in importance of a number of international financial centres including
London, New York, Tokyo, Hong Kong and Singapore. Such centres attract foreign banks
and this is especially true of London, which is home to several hundred foreign banks as well
as the UK's retail banks. On the whole, there has not been any major or sustained
competition for the business of British industrial companies. Most foreign banks are
concerned chiefly with their own national organisations and with operations in wholesale
banking – i.e. lending large sums to other banks and financial institutions, usually on a short-
term basis. The increase in oil wealth has encouraged the entry to London of a number of
Middle Eastern banks.
The foreign banks are also active in what is termed the eurocurrency market, which handles
transactions in the bank deposits of banks held outside the banks' countries of origin. Thus
the dollar deposits of an American bank in London form part of the eurodollar market in
Britain. Eurocurrency markets have become a major part of the wholesale banking structure.
Money Markets
The term "money markets" is given to the markets in short-term money, in which all the main
banks, domestic as well as foreign, investment as well as retail, take part. By short-term
(when describing money markets) is meant a period of time from 1 to 364 days. Transactions
in funds for periods of a year or longer are usually termed capital market transactions, to
distinguish them from the very short-term nature of transactions in the money markets, most
of which are for days or weeks rather than months. There are a number of different money
markets in a developed financial system such as that found in the UK, the EU and the USA.
The most important money markets in the UK are the gilt repo market (sale of gilt-edged
securities), the interbank market, the certificate of deposit (CD) market, and the commercial
paper (CP) market.
These markets bring together domestic and foreign business organisations, all banks as well
as central and local government, all of which have funds that they have to keep almost liquid
but which they cannot afford to have lying idle. In the money market funds are not allowed to
lie idle. When London sleeps its money may be working hard in Sydney, Hong Kong,
Singapore, Tokyo and many other places. If you have £10 spare you will not earn much
interest by lending it overnight, but if you have £10 million it could easily be earning over
£1,000 while you sleep – and still be back in your account next morning ready to meet any
payment due to be made.
© ABE and RRC

Building Societies
Historically the main function of these institutions was the provision of funds for house
purchase by individual owner-occupiers. They are also a major channel for the savings of
individuals. The societies have expanded with the huge growth of private home ownership in
the United Kingdom. At the same time, there have been many mergers so that the number of
societies has been falling, but their average size has increased. The Building Societies Act
1986 opened the way for the larger building societies to convert to public companies as well
as becoming full banks.
Life Assurance Companies and Pension Funds
These are the most important financial institutions in terms of their role as the main long-
term investing institutions in the economy. The life and pension companies differ from
general insurance companies in that they provide long-term investment services, and do not
normally sell protection on an annual basis. For instance, a payment made for motor
insurance covers the cost of protection for the year of insurance. The premium thus buys a
specific and limited service. The typical life assurance or pension contract provides for a
return payment to be made at some time in the future, prior to which there is a continuing
obligation to pay premiums and a continuing obligation on the part of the company to invest
those premiums to the mutual benefit of the company and its policy holders. This gives the
life and pension companies substantial funds which they invest in a range of ways including
property, shares, and government bonds – or in direct lending to business. Today in the UK
they are the main investors and holders of company shares, corporate and government
bonds, and major participants in the financial markets.
Unit Trusts and Investment Trusts

These represent slightly different forms of pooling revenues to spread the risks of
investment.
Unit trusts are the more popular. A trust sets up a fund which is invested in a published range
of securities. The fund is divided into units of fairly small denominations which are then sold
to savers in a variety of ways. The unit trust holder thus has his or her savings effectively
spread over all the funds' investments. Units are bought and sold by the managers of the
fund, so that they do not pass through the Stock Exchange. The managers of course deal
through the Stock Exchange in the course of managing the fund's investments.
Investment trusts are limited companies which use their share capital to invest in other
companies. Their own shares are bought and sold through the Stock Exchange, and
shareholders are effectively investors in a range of other shares.
Hedge Funds and Private Equity Funds

In addition to unit and investment trusts (traditional examples of collective investment
organisations), there are a wide range of mutual funds and other more specialised forms of
investing institutions. These include hedge funds and private equity funds. Hedge funds
originated in the 1950s but have only risen to importance (and made news headlines) since
the 1990s. Hedge funds are intended for very wealthy investors, rather than the average
retail saver who invests through life insurance, unit trusts and mutual funds. Hedge funds
employ a wide range of strategies to try and achieve high rates of return irrespective of the
state of the economy. However, the fundamental rule in finance is that consistently high
returns on investments are impossible without taking on very high risks! What this means is
that while some hedge funds do produce high returns, others make equally spectacular
losses, which is why they are restricted to very rich investors not small savers.
© ABE and RRC

C. THE BANKING SYSTEM AND THE SUPPLY OF MONEY

Money and Bank Credit
Disagreements between economists about the motives for holding liquid money in
preference to other forms of wealth may not seem too important. In practice, they affect
government economic policies and the way they seek to control the economy through
interest rates. Anyone with a house mortgage or a bank loan knows only too well the effect
of changes in interest rates.
In order to take our understanding of the issues a little further, we must examine the
relationship between the demand for money and its supply.
The notion of a relationship between demand and supply may surprise you. In our earlier
examination of demand and supply for goods and services, these two market forces were
kept separate. However money is rather different. It is not "produced" like other
commodities, except in the very limited sense that gold and silver are produced. As we have
seen, most of the supply of modern money is not found in physical form at all – it is credit
held in bank accounts on behalf of the banks' customers. The total amount of credit held by
the banks on behalf of customers is not a fixed amount; it can itself be varied by the banks'
own actions.
Credit Creation
In fact banks can create credit through lending to their customers, and lending is a most
important – and profitable – part of a bank's activities. When people or firms borrow from the
banks, they use the amount borrowed to make payments to other people or firms, who
deposit the payments with their own banks. Suppose I borrow £2,000 from my bank to help
buy a new car. When I buy the car, I pay the Swifta Motor Company. Suppose this company
also has its accounts at the same bank. When I pay my cheque (drawn on the bank) to
Swifta, it then pays in my cheque to its own account. In effect, the bank has created £2,000
in one account (my loan account) and thereby increased the volume of its customer deposits
(through the extra £2,000 paid in by Swifta).
Thus, for the factor capital, we have the peculiar position that demand appears to create its
own supply.
You may think we have cheated by using one bank only in our example but, as long as there
is a fairly closed banking system in a country, the effect will be the same if different banks
are involved. In the UK, the great mass (over 80 per cent) of daily payments pass between
the four large clearing banks (Barclays, LloydsTSB, NatWest and HSBC), so that this close
relationship between demand, borrowing, depositing and supply does exist.
Illustration
In practice, the banks keep a proportion of all their funds in the form of coin, notes or
deposits with their own bank (the Bank of England), or in loans to other banking institutions,
which can very quickly be recalled. Such funds are the cash reserves of a bank and referred
to as high-powered money. If we call these reserves "cash" and assume, for simplicity, that a
country has a system of two banks only, each keeping 10 per cent of its assets in cash, then
we can give a very simple illustration of how the total supply of bank money can grow
following the injection of "new money" from some outside source.
Suppose that our two banks are A and B, and the initial injection is 100 currency units, which
goes to bank B. Bank A's customers borrow money to pay to customers of B, and vice versa.
The banks are of equal size.
© ABE and RRC

Bank A
Customer deposits 1,000 Held as: Cash 100
Loans 900
1,000
Bank B is in the same position. Then there is an injection of 100 to the deposits of A. Bank A
initially adds this to its cash – but idle cash earns no money. Therefore as soon as possible it
lends it to suitable customers, and its accounts then appear as follows.
Bank A
Loans 990
1,100
This additional lending soon gets paid into customer deposits of bank B, which also lends 90
per cent of this increase, so that its accounts appear as:
Bank B
Loans 981
1,090
Additional loans of 81 units have now been made to customers of bank B, who have made
payments to customers of bank A.
The process continues, and bank A's accounts become:
Bank A
Loans 1,063
1,181
Notice how the total of deposits (and hence the total money supply) is increasing, but
(because 10 per cent is being held back all the time) by a decreasing amount at each
lending/deposit round.
The Bank Credit Multiplier

This progression is called the bank credit (or money) multiplier. The total increase in our
example will be ten times the amount of the original injection. This is because:
1
Kb 
c
where:
Kb  value of the bank credit multiplier
c  proportion of customers' deposits held by the bank as "cash".
In our example, the proportion held as cash is 1/10 and so the value of Kb is 10.
© ABE and RRC

As the original injection was 100 (currency units), the final increase would be 1,000. Thus,
the greater the proportion of customer deposits that the banks are able to lend to other
customers, the greater will be the size of the bank multiplier and the effect of lending on total
money supply.
This power of the banks to "create money", and the close link between lending money and
the increase in total money supply, are both extremely important issues. You must make sure
you fully understand them.
Because of this close relationship between the demand for and the supply of money, we can
suggest that the supply of money is likely to have very similar features to the demand. Thus,
if we believe that there is a particular relationship between interest rates and the demand for
money, then a very similar relationship can be expected for interest rates and the supply of
money.
D. THE CENTRAL BANK

Of rather greater economic importance is the central bank – in the UK this is the Bank of
England. The central bank does not compete for ordinary commercial banking business. It is,
essentially, the banker to the rest of the banking system: the regulating body for private
sector commercial banking and the office link with other central banks and with international
financial organisations, especially the International Monetary Fund (IMF) and the Bank for
International Settlements (BIS).
The Functions of the Central Bank

The traditional functions of a central bank (further explanation of which can be found on
older textbooks on money and banking) are:
 Banker to the government – the government holds its bank account with the central
bank. This is used both for payments made from the rest of the economy to the
government and payments by the government in the economy. The central bank may
also be banker to the government in the sense that it provides loans to the
government, as well as arranging for the government to borrow from investors in the
financial system by issuing treasury bills (short-term securities) and bonds (long-term
securities).
 Banker to the banking system – the central bank provides the paper currency and coin
issued to the public through the banking system. As banker to the banks, it keeps the
accounts of the retail banks themselves. It facilitates the process of clearing the daily
balances resulting from all the transactions undertaken each day by the customers of
the banks when they receive and make payment using their bank accounts. In the UK,
the banks that maintain accounts with the Bank of England for the purpose of settling
the interbank debits and credits that result from their customers daily cheque
transactions are termed "clearing banks".
 Lender of last resort – the central bank is uniquely placed to lend to other banks in the
financial system because it manages the government's accounts, and can call upon
the government to print more money in an emergency situation. The central bank acts
as lender of last resort to the banking system in two ways:
(i) It controls the available supply of liquidity in the banking system on a daily basis
to maintain interest rates at the level it thinks appropriate to achieve its monetary
policy objective(s). It does this by determining, on a daily basis, the rate of
interest at which it is willing to provide funds to any bank facing a shortage of
liquidity, in exchange for government bonds and treasury bills.
© ABE and RRC

(ii) It stands ready to prevent the failure of any bank, and the loss of public
confidence in the soundness of the banking system, by providing emergency
loans to one or more of the retail banks in the economy. This would be necessary
if the banking system as a whole runs short of liquidity due to factors
unconnected with the central banks' own monetary policy actions. An example of
this is provided by the Bank of England's emergency support for Northern Rock
bank in 2007.
 Regulation and supervision of the banking system – it is responsible for the stability
and integrity of the institutions which make up the banking system.
 Monetary policy – it is responsible for the conduct of monetary policy. In the UK the
Bank of England has a duty to control the actual supply of money within the banking
system. The reasons for monetary controls, and the ways in which they may be
exercised, are examined in Study Unit 13.
 Management of a country's foreign currency reserves and responsibility for its
exchange rate policy.
In the UK the Bank of England keeps the nation's gold reserves and the international
accounts for money entering and leaving the country, as well as the nation's reserves in
other currencies. The Bank of England works closely with the central banks of other nations.
The Bank maintains continuous contacts with the major international banks, especially the
International Monetary Fund (the IMF is probably closest to being a genuine world bank).
The Bank has a duty to maintain the stability of the national currency in its exchange value
with other national currencies, and to cooperate with other countries and international
institutions to uphold the stability of the world financial system. It has a special account which
it can use to deal in sterling and other currencies in order to stabilise demand, supply and
exchange rates.
Modern Central Banking

Since the 1980s there has been an increasing trend by countries to change the role of the
central bank and reduce its functions. This is why the functions just detailed are referred to
as the "traditional" functions. The modern trend is to separate the functions of financing the
government, regulation and supervision of the banking system and monetary policy. The
central bank is given primary responsibility for using monetary policy to achieve a low rate of
inflation. The Ministry of Finance or Treasury is given full responsibility for funding
government borrowing. A separate financial regulatory authority is given responsibility for the
regulation and supervision of the banking system. In the European Union the European
Central Bank (ECB) is solely responsible for the formulation and operation of monetary
policy, independently of all the EU eurocurrency zone governments. In the UK the Bank of
England has operational independence for monetary policy, while the Financial Services
Authority (FSA) is responsible for the regulation and supervision of the financial system. The
UK Treasury is now solely responsible for managing the national debt and the financing of
additional government borrowing from the financial system. The reasons for this
development are considered further in Study Unit 13 dealing with Monetary Policy.
© ABE and RRC

E. INTEREST RATES
Importance of Interest Rates
We have seen how important borrowing and lending are to the workings of a modern
economy, but this dealing in money always takes place at a price. The price of money is
interest, and the level of interest has become an important issue in modern economics. The
reasons why interest rates have gained this importance include the following:
(a) Interest rates influence the level of business investment and business costs
If interest rates are high, new investment is discouraged. As most loans provide for
interest rates to be linked with bank base rates, the costs of existing borrowing rise.
The result of a prolonged period of high rates is that business efficiency declines. This
reduces the supply of business goods and services, and makes it more difficult for
businesses to compete with countries with lower interest rates.
(b) Interest rates influence the cost of public borrowing
The government, in one form or another, is by far the largest borrower of money. Some
government debt is subject to changing rates. A number of loans are linked to rates of
price increase, and the government's short debts (treasury bills) have to be constantly
renewed at current market rates. Governments have to pay interest out of revenue,
and taxation is the largest source of revenue. A large proportion of tax revenue thus
has to pay for the costs of past spending, and this proportion is not available for new
spending. Any rise in interest rates reduces the amount of public services that can be
provided from taxation, and makes the government dependent on further borrowing –
thus increasing future costs still further.
There is also a social effect. Remember that taxes are paid, directly or indirectly, from
income earned by labour. Interest goes to holders of capital, so that the higher the rate
of interest, the greater the effective transfer of income from labour to capital.
(c) Interest rates influence consumer spending
Much consumer spending on major capital goods and the more expensive household
durables is with the help of credit. If interest rates are high, consumers may go on
spending for a time but:
(i) they purchase less expensive goods, because a higher proportion of the amount
spent goes on borrowing costs, and
(ii) the burden of repayments takes up an increased proportion of income – leaving
less for other spending.
As everyone with a mortgage loan knows only too well, any increase in the interest
charged on the loan reduces the amount of household income left for spending on
other goods and services. If for any reason the household cannot meet the mortgage
payments the home may be repossessed. Changes in the rate of interest have become
of very great importance to large numbers of people.
High interest rates also appear to increase savings – partly, no doubt, because of the
discouragement to spending. An increase in saving and a reduction in consumer
spending can have a depressing effect on total business activity. A prolonged period of
very high rates can be an important influence leading to general depression and
increased unemployment.
© ABE and RRC

(d) Interest rates affect the rate of inflation

Because interest rates affect the cost of consumer spending, and because building
society and bank mortgage interest rates now affect around 60 per cent of all
households in Britain, any change in rates influences movements in the Retail Price
Index, the official measure of average price increases (inflation). If interest rates go up,
then inflation rises and people tend to spend less on new purchases. If spending also
falls, then unemployment may rise, even though prices are also rising.
Because of the direct impact of interest changes in all these ways, the ability to make
changes has become a major instrument of economic policy in all the main market
economies. Since most contemporary governments in the advanced market economies
appear to be pursuing mainly monetarist, anti-inflationary policies, they all rely on interest
rates to pursue their objectives.
The Determination of Interest Rates

Since interest rates have so many important influences on our lives, we should have some
knowledge of the processes which determine them. Interest is of course the price of money,
so that ultimately we would expect the forces of supply and demand in the finance markets
to determine the levels of interest ruling at any given time. This in fact is the basis for one of
the most widely accepted theories of interest rate determination. This theory suggests that
the market equilibrium rate of interest is that rate at which the stock of available capital is
equal to the demand for capital arising from its marginal efficiency.
The marginal efficiency of capital within the community is the average return from capital
investment available to business organisations. Our earlier discussion of business
investment showed that business firms can be expected to invest capital and to acquire
capital for investment as long as the return from investment is more than the cost of capital.
In this analysis, we can equate the cost of capital with the market rate of interest. Firms will
not knowingly invest where the return is less than the cost of capital (market rate of interest).
The interaction of supply of capital and its marginal efficiency is illustrated in Figure 12.1.
As there is only a limited number of high-yielding investment projects, we can expect the
marginal efficiency of capital (MEC) to fall as more capital is invested. The MEC curve is thus
downward sloping. The stock of capital is fixed at any given time, and is shown by the
vertical line which intersects with the MEC curve at interest rate i and quantity of capital q. At
this rate and quantity the demand for capital resulting from its MEC is just equal to its supply
– the capital stock – so that demand and supply are in equilibrium at interest rate i. At any
higher rate there is an excess of demand as at rate i1, where demand rises to q1 with supply
remaining at q. At rates above i there would be an excess of supply over demand.
© ABE and RRC

Figure 12.1: The interaction of supply of capital and its marginal efficiency
Interest
rate Stock of
Marginal Capital
Efficiency
of Capital
i1
Marginal Efficiency
of Capital
O q q1 Quantity of Capital
In the absence of any other influence, interest rates would be determined by considerations
of this nature. However, other influences are almost always present in the shape of
government or central bank intervention. Because some governments or central banks
intervene to move interest rates to levels thought necessary to achieve their desired
economic objectives, other governments also have to intervene to ensure that their
economies are not put at a disadvantage.
Governments or other regulatory bodies are likely to want to push rates higher than the
market equilibrium levels, if they wish to restrict demand and production in order to control
inflationary pressures. They may seek to bring rates below the equilibrium if they are faced
with high and rising unemployment and fear a deep recession-depression. By reducing the
cost of capital they hope to encourage business investment and consumer demand for
goods and services. No major trading country can afford to be too far out of line with interest
rates in other countries, otherwise there would be a huge movement of capital towards high-
rate countries and away from low-rate countries. This movement would put immense strains
on the low-rate countries' balance of payments and on their currency exchange rates.
Consequently the freedom of any individual government or central bank is restricted by the
actions of governments and banks in other countries. Finance now circulates in a genuinely
international market.
Governments can influence rates either by controlling the stock of capital, usually by
measures over bank lending, or by direct controls over the major banks. Notice that in Figure
12.1 the equilibrium rate will rise if the stock of capital line moves to the left and fall if it
moves to the right. This results from the general shape of the MEC curve.
The influence of the demand and supply of money, and the control of interest rates through
monetary policy, is examined in Study Unit 13.
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The Pattern of Interest Rates

Of course it must not be assumed that the market rate of interest applies to all borrowers
and lenders. In the first place financial institutions always charge their borrowers a higher
rate than they pay to depositors. In general those who lend money to others require a rate of
interest which reflects:
 The time period over which the loan is made. The longer the period the higher the
interest rate required, unless market rates are expected to fall over the period, when
long-term rates can sometimes fall below those for short-term lending.
 The ease with which money loaned can be recovered: the greater the degree of
liquidity. The more speedily and simply the money can be recovered, the lower the rate
of interest. Banks pay a higher rate on deposits where several months' notice is
required before repayment is made than on deposits which offer "instant access"
(immediate cash withdrawal).
 The credit standing of the borrower – large companies with a long record of financial
stability can obtain loans at lower rates than new, small companies.
 The degree of risk, which is in fact the underlying factor in all the above considerations.
Share dividends are not the same as interest payments but very similar principles
apply. If you look at the dividend yield as shown in a share price list in any of the
leading daily papers, you will see that the yield (dividend return as a percentage of the
price of the share) is much lower on shares in the most profitable and secure
companies than on shares of small companies in the riskier sectors of activity, e.g.
house builders.
You should examine the deposit accounts offered by several of the main banks and see how
far the differences in interest rates offered can be explained by these factors.
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Review Points
check that you have achieved those learning objectives covered in this unit. If you do not
think that you understand these objectives completely, you should spend more time
1. What is the difference between narrow and broad money in an economy?

2. What is high-powered money?
3. What is the bank credit multiplier?
4. Explain, using the bank credit multiplier, how an increase in the amount of cash (high-
powered money) in the banking system will affect the value of bank deposits and the
broad money supply.
5. What is the marginal efficiency of capital?
6. Explain how a reduction in the level of interest rates can affect the volume of bank
lending and the level of investment in the economy.
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229
Study Unit 13
Monetary Policy
Contents Page
A. Options for Holding Wealth 230

Physical Assets 230
Financial Securities 231
Liquid Money – Cash 231
B. Liquidity Preference and the Demand for Money 232
C. Implications of the Interest Sensitivity of the Demand for Money 234

Interest Rates and Demand for Goods and Services 234
Classical and Monetarist View 235
The Keynesian View of Interest Rates and Expenditure 235
Implications of the Differences 235
D. Changes in Liquidity Preference 237
E. The Quantity Theory of Money and the Importance of Money Supply 238
The Money Equation 238
Diagrammatic Representation of the Quantity Theory of Money 238
F. Methods of Controlling the Supply of Money 240

Interest Rate Control 240
Control over Banking Ratios 240
Direct Controls over Banks 240
Control of Government Borrowing 241
G. Monetary Policy and the Control of Inflation 241
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230 Monetary Policy
Objectives
The aim of this unit, in conjunction with Study Unit 12, is to explain and evaluate the
effectiveness of monetary policy in a closed and open economy and discuss the possible
impact of monetary policy on business decision-making.
 demonstrate an understanding of the relationship between the banking system and the
creation of money
 identify the components of the high-powered money stock and explain why these have
a magnified impact on the money supply
 explain the quantity theory of money and its role in explaining the rate of inflation
 discuss the components of monetary policy and explain how they work
 evaluate the factors that determine the effectiveness of monetary policy
 compare and contrast the relative effectiveness of fiscal and monetary policy.
A. OPTIONS FOR HOLDING WEALTH

There are three main ways in which wealth may be held. These are generally described as:
 physical assets
 financial assets (securities such as bonds and shares traded on stock exchanges)
 cash (liquid money).
Physical Assets
Examples of physical assets would include houses, land, furniture and private cars.
Everyone who has wealth of any kind will have some assets, as these are necessary to
everyday life in a modern society, but it is also possible to hold the wealth you wish to store
for the future in the form of assets. In this case your choice of which assets to hold will be
guided less by what you need or find useful in normal life, but by what you think is most likely
to hold or increase its value in the future. Since the future is uncertain you may or may not
choose correctly!
Holding wealth in the form of physical assets offers the following advantages:
 They are likely to be useful or enjoyable as well as valuable, and may remain so even
if they lose their value; for example, vintage wine may not increase in value as hoped
at the time of purchase, but it is very pleasant to drink.
 In periods of inflation or financial/political uncertainty, they are likely to hold or increase
their value when money is losing its purchasing power.
 They are visible symbols of wealth and status and this can be important for some
people.
On the other hand there are some serious disadvantages:
 They can excite envy and attract thieves; if as a result they have to be stored in a bank
vault, they cannot be enjoyed.
 They can be destroyed by fire or accident, or damage may reduce their value.
 Keeping physical assets involves costs such as insurance premiums, maintenance,
cleaning and guarding; and these costs can be heavy.
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Monetary Policy 231
 Fashions change, and what is in demand and valuable one year may be considered
unattractive and without value a few years later. This applies particularly to the so-
called "collectibles", such as works of art, coins and postage stamps. Those who
bought houses in the late 1980s know only too well that asset values can fall as well as
rise.
Therefore under normal circumstances, few people with wealth to store are likely to hold all
their wealth in the form of physical assets. This would be an option only when the normal
financial system was in danger of collapsing.
Financial Securities
Financial securities are mostly either titles to the ownership of property or rights to share in
the benefits of property ownership, or they are promises to make a future payment. It is often
an advantage to hold a written title to property, because ownership can be transferred by
handing over the written title or it can be used as a security for a loan. Similarly a written
promise to make a future payment will also have a value, and the right to receive the
payment can be sold to someone else.
To be useful as a financial instrument of course, the promise to pay must carry respect. An
undertaking by a major High Street bank will be more transferable, and therefore useful, than
one signed by an unknown individual. Such promises to pay or to repay a loan or debt on or
by a stated date, with interest payable to the holder in the meantime, are often known as
bonds or stocks. There are several different kinds of bonds issued by borrowers, but the
most common have the important feature that they pay a fixed annual rate of interest,
(usually referred to as the "coupon") to the investor holding the bond. The main categories of
bonds are government bonds and corporate bonds. In the UK bonds issued by the British
government are termed "gilt-edged securities" (gilts) and are an important element in the
capital market. Details of these can be obtained from most post offices and their market
prices are quoted daily in the financial press.
Wealth held in the form of bonds and securities, including the ordinary shares of companies,
can also be referred to as loanable funds. Besides ease of transfer, holding wealth in this
form has the advantage that it provides the holder with an income from interest or dividends
paid by the issuer of the securities. This is in contrast with owning physical assets, which
incurs costs of maintenance and insurance. As with any form of wealth there are risks of
suffering a loss. For example, if a company which has issued bonds fails and goes into
liquidation with insufficient assets to meet its obligations to bondholders, then the bonds are
worthless. The bonds of very risky companies are frequently called "junk bonds".
Liquid Money – Cash

Liquid money is most likely to be in the form of bank credit held in current accounts which,
technically, are "sight deposits", i.e. depositors can withdraw or transfer money without
having to give notice to the bank. Most people will hold some liquid money in order to make
payments by cheque, plastic card or cash in the form of notes and coin. However, since sight
deposits generally earn only insignificant rates of interest, if cash were wanted purely for
payment purposes the majority of people would keep only the minimum needed for their
regular payment needs. In practice, many people with sufficient wealth to be able to choose
between the three options may keep liquid money in preference to assets or securities.
Classical economists offered little explanation for this tendency, since they believed that the
desire to hold money in its liquid form depended mainly on the desire to use it for making
purchases. They did not attempt to relate the demand for liquidity to any other single
variable, such as interest rates. That such a relationship could exist was argued by the great
Cambridge economist of the 1930s, John Maynard Keynes, whose view of the elements in
the demand for liquidity, i.e. "liquidity preference", we will now look at.
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232 Monetary Policy
B. LIQUIDITY PREFERENCE AND THE DEMAND FOR

MONEY
Keynes believed that there was a connection between money and the level of interest rates
in the economy, and in his analysis he concentrated his attention on the choice between
holding money (liquidity) and bonds. He identified three elements in the attraction of money.
In doing so, he effectively elevated money to the status of a commodity for which there is a
demand in its own right – not simply as something to hold when other forms of wealth are
temporarily out of favour. The three elements in the preference for liquidity in Keynes's
theory are the transactions, the precautionary and the speculative motives.
(a) Transactions Motive
This is the desire to hold money because it is needed for the purchase of goods and
services, i.e. to carry out trading transactions.
(b) The Precautionary Motive
This is the need to have some liquid money available as a precaution against
unexpected developments, including favourable opportunities to purchase goods.
(c) The Speculative Motive
It is here that Keynes parted company from earlier teaching. Something of a financial
speculator himself, Keynes regarded the speculative element, as in the choice
between bonds and money, as particularly significant.
The opportunity for speculation (gambling) arises out of changes in interest rates, and
the fact that the interest on bonds is normally paid at a fixed rate. Suppose a bond's
fixed interest rate was five per cent – because it had been first issued at a time of fairly
low interest rates, when people were content to receive five per cent on their money.
Suppose that some years later interest rates in general had risen to 10 per cent, so
that anyone lending money at that time would want at least 10 per cent from the
borrower. Clearly, anyone holding a five per cent bond would not be able to sell it to
another at its original price. A purchaser would expect to receive two £100 bonds for
every £100 paid, because only then would he be able to secure a total interest
payment of £10, which is the amount he could obtain by lending his £100 elsewhere in
the financial marketplace.
Thus, with market rates of interest at around 10 per cent, we could expect the market
price of a £100 bond paying fixed interest of 5 per cent to be £50.
Now, suppose the market rate of interest started to fall, so that the best rate a lender
could obtain was 7.5 per cent. Anyone willing to buy bonds would now be prepared to
pay somewhere around £67. (If you cannot see why, then work out how many £100
bonds, paying interest at 5 per cent per year, you would need to give yourself an
annual payment of £15 in return for a total payment for the bonds of £200. When you
have decided that, then work out the price per bond.) This means that a fall in interest
rates from 10 per cent to 7.5 per cent would enable anyone who had purchased a 5
per cent bond for £50 to sell it for £67 – a handsome profit, especially if the change
had taken place over a fairly short time period.
We can deduce from this that, if interest rates are high and expected to fall, people
would wish to buy bonds. As bonds and money are seen as alternative forms of
holding financial wealth, the demand for money would consequently be low. By the
same reasoning, if interest rates are perceived to be low and expected to rise, people
would not want to be left holding bonds the value of which, as financial assets, is
falling. Instead they would sell bonds and hold money – the demand for which would
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Monetary Policy 233
thus be high. Roughly equivalent to bonds are ordinary shares of first-class industrial
and commercial companies, the profits of which might not be expected to fluctuate
greatly and the dividends of which are fairly constant.
What is high and what is low in relation to interest rates depends on a great many
other considerations, including people's experiences of rates in recent years. The 10
per cent used in the previous example would have been regarded as very high in the
early 1960s, but very low in the early 1980s. You should take an interest in the
movement of interest rates and in changes in the prices of bonds (government stocks)
while you are studying economics.
This stress on the speculative motive for holding money led Keynes to the belief that
the demand for money does have a direct relationship to interest rates. It was thus
possible to draw a demand for money curve or "liquidity preference curve" of the type
Figure13.1: Liquidity preference curve
Keynes’ view of relationship between liquidity preference and
changes in interest rate
Interest
rate %
A rise in rate from Oi to Oi1, reduces the

demand for money from Oq to Oq1,
because more people are willing to hold
i1 bonds as an alternative to money
i
Liquidity preference
(demand for money)
Liquidity trap
O q1 q Quantity of money
Notice that, at the lower rates of interest, the curve flattens out, creating a so-called
"liquidity trap". This is because no one believes that the rate is likely to fall further, so
there are no takers for bonds and people will wish to see a rise to a higher rate before
there can be any expectation of a fall and a chance for a speculative gain.
The modern view of the influence of money on interest rates gives less emphasis to
the speculative demand for money and the idea of a liquidity trap, but rather
incorporates the demand for money into the theory of the demand for assets in
general. Modern portfolio theory recognises that there is a demand for money as an
asset as well as for transactions purposes, and that changes in the level of interest
rates affect the demand for money (see Figure 13.2). However, it is also recognised
that there is a very close link between the supply of money and inflation, and that
inflation also has a significant influence on the demand for money as well as other
assets.
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234 Monetary Policy
Figure 13.2: Money supply and the rate of interest
Interest
Rate MS1 MS2
%
R1
R2
MD1
MD = MS MD = MS Quantity of
Money
C. IMPLICATIONS OF THE INTEREST SENSITIVITY OF THE

DEMAND FOR MONEY
Interest Rates and Demand for Goods and Services
We now return to an earlier statement concerning the demand for money. Money is but one
of a number of possible ways to hold wealth. Another way is to buy goods, so that we should
now consider what is likely to influence the desire to spend money in buying goods in
preference not only to holding money, but also to holding bonds or company shares. If we
then see interest-bearing or dividend-bearing securities as being in competition with goods
for a share of spending, we can also see that bonds, etc., are likely to be desirable, because
they yield an income. Goods do not yield an income but they offer other satisfactions. We
thus have to balance the desire to obtain an income with the desire to enjoy goods – and
services. If interest rates are high, then bonds and other income-yielding securities can
seem attractive, because of the income that they produce. If interest rates are low, the
income attraction is also low, and goods and services offer greater satisfactions.
Taking this approach, we can see a relationship between movements in interest rates and
movements in the demand for goods. When interest rates are high, the demand for goods is
low, because people prefer bonds. At low interest rates, demand for goods is high because
they seem more attractive than the low income obtainable from bonds. This relationship is
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Monetary Policy 235
Figure 13.3: Monetarist view of demand and changes in interest rate
Interest If interest rate rises from 0i to 0i1, the demand for

rate % goods and services falls from 0q, to 0q1, because
people are attracted towards buying bonds and other
income-yielding securities.
i1
total expenditure
(demand for
goods and
services)
0 q1 q
Quantity of goods
and services
Classical and Monetarist View

We can now summarise the classical and monetarist position with regard to interest rates
and money, and also with regard to interest rates and the demand for goods and services.
It is that the demand (and therefore the supply) of money is not very responsive to changes
in interest rates. Putting this in more formal economic language: money demand and supply
are interest rate inelastic.
On the other hand, the willingness to spend money on goods and services is responsive to
changes in interest rates: the expenditure demand for goods and services is interest rate
elastic.
The Keynesian View of Interest Rates and Expenditure

As we saw earlier, in the Keynesian view of the national economy, consumption (i.e. total
expenditure on goods and services) is mainly dependent on income levels. In other words,
the main influence on the level of consumer demand is seen as the level of income and not
the supply or the price of money (interest rates).
Therefore the Keynesian does not believe that changes in interest rates are likely to have
much effect on the level of expenditure (consumer demand). Again, the more formal
economic statement is that total expenditure or demand for goods and services is believed to
be interest-rate inelastic. In contrast, we have seen in this study unit that the Keynesian,
stressing the speculative motive in liquidity preference, believes the demand (and hence the
supply) of money is interest rate elastic.
Implications of the Differences

These two differing views of the relationship between interest rates, demand for money and
demand for goods and services have major implications for government policy, especially for
policy on money supply and the control of money supply.
Suppose it is possible for the government to engineer a reduction in the money supply – e.g.
by forcing the banks to reduce lending to customers – and so reduce their credit creation.
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236 Monetary Policy
Then this change in supply, like any other market shift, will result in a price change. Interest
is the "price of money", so a reduction in money supply can be expected to force up interest
rates. But the amount of change will depend on the supply and demand elasticities – on the
responsiveness of supply and demand to interest rates. Given that there will be some effect
on interest rates, this in turn will affect total demand for goods and services – again, the
extent of effect will depend on the relationship between expenditure demand and interest
rates.
Now we can begin to see the importance of the differences in views between Keynesians
and monetarists. These are illustrated in Figure 13.4.
Figure 13.4: Keynesian and monetarist views
(a) Keynesian view
Interest Interest
rate % supply(S1) rate %
Expenditure
i1
i
demand
supply(S)
O O q1 q
Quantity of money Quantity of goods and services
Money supply is reduced (the curve shifts from S to S1). Interest rates rise from Oi
to Oi1, but this rise produces a very small cut-back in demand, from Oq to Oq1.
(b) Monetarist view
Interest demand supply Interest

rate % (S) rate %
i1 Expenditure
i
supply
(S1)
O O q1 q
Quantity of money Quantity of goods and services
The process is the same as in the Keynesian view but the movements in interest
rates and the reduction in expenditure on goods and services are much greater
because of the differing elasticity.
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Monetary Policy 237
Keynesians believe that there is a close relationship between money demand and interest
rates, but this interest rate elasticity ensures that any shift in rates brought about by a forced
shift in supply also reduces demand: so in effect, the interest rate change is small.
Expenditure is not much influenced by interest rate anyway (it being influenced more by
income), and the small rise in interest produces little movement in expenditure.
The position according to the monetarist view is very different, although the mechanism is
the same. Demand remains largely unaffected by the shift in supply and the change in
interest rate, which is thus pushed up higher than in the Keynesian view. This steep rise in
rate produces a major reduction in the interest-responsive demand for goods and services.
In effect these are very marked contrasts, and you would expect the debate to be settled
fairly easily by research into actual interest rate and money supply changes. In practice,
economists' research faces a great many practical difficulties. As we shall see, not least the
problem of actually defining and measuring money supply and innovations that affect the
demand for money in the financial system.
However, the Keynesian-monetarist controversy of the 1970s and 1980s is now more of
interest to students of the history of economic thought, than for the understanding of
monetary policy. The overwhelming weight of empirical evidence and practical experience in
the conduct of monetary policy since the 1970s is that money matters, and monetary policy
is effective as a means of controlling the level of aggregate demand and hence the rate of
inflation.
D. CHANGES IN LIQUIDITY PREFERENCE

So far we have looked at the consequences of changes in the quantity of money demanded
in response to changes in interest rates. We also need to consider the effect of a shift in the
demand for money or the whole liquidity preference curve, i.e. see the effects when people
wish to hold more (or less) liquid money at all relevant rates of interest.
If people desire to hold a higher proportion of their wealth in the form of liquid money, then
they will have less available for use as loanable funds or to purchase physical assets. The
logical consequences of reductions in each of these would be to reduce levels of business
investment.
 If the supply of loanable funds falls, we would expect interest rates to rise. This would
increase the investment costs faced by business firms and tend to reduce their
investment intentions.
 If expenditure on goods and services falls, this would reduce the aggregate level of
consumer expenditure and lead to a reduction in business investment. Firms invest in
order to increase future production. There is no point increasing future production if
current expenditure on goods and services is falling. The reduction in investment would
have a depressing effect on the equilibrium level of national income through the
investment accelerator and multiplier.
This process and the terms "investment multiplier" and "investment accelerator" are
explained in Study Unit 10. At this stage it is simply necessary to recognise that any
reduction in investment is likely to depress the general level of economic activity in a country.
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238 Monetary Policy
E. THE QUANTITY THEORY OF MONEY AND THE

IMPORTANCE OF MONEY SUPPLY
The Money Equation
Changes in the supply of money in an economy can affect the rate of interest and hence the
level of aggregate demand. Changes in the level of aggregate demand in relation to
aggregate supply, as we saw in Study Unit 11, affect the general level of prices in the
economy. Once the economy is operating at its full capacity/full employment level of output,
additional injections of aggregate demand by means of increases in the supply of money will
merely serve to drive up the level of prices. This provides the theoretical foundation for the
central banks' use of monetary policy to control demand and the rate of inflation. This
accords with the so-called monetarist view of money and inflation represented by the
quantity theory of money. This, in very simple form, can be stated as follows.
MV  PT
where:
M  money supply or stock
V  velocity of circulation of money (i.e. speed at which it circulates between buyers
and sellers)
P  average price of goods and services
T  number of transactions – i.e. volume of production
(T is sometimes written as Q, representing the quantity of production).
Now on its own, this equation tells us very little. However, the important issues lie in the
relationships between the elements of the equation. Monetarists regard V as fixed or fairly
fixed, and they also regard T (or Q) as fixed at a given level of technology. If these
assumptions are correct, then effectively the two variables in the equation are M and P. A
given change in M (the money supply) can be expected to produce a definite and predictable
change in P (average prices). The relationship will not always be as simple as this, because
allowance will have to be made for known variations in V and T, owing to forces outside the
monetary relationship (e.g. improvements in technology and changes in the financial
structure). It will also take time for any change in money supply to work through into general
price increases, so that time lags of up to two years are suggested – though monetarists are
not always in agreement over the precise time lag.
There is a further modification that many modern monetarists would make to this argument.
This recognises that prices tend to be flexible upwards but not downwards: thus it is argued,
if money supply is increased, then average prices will rise as already indicated; however, if
money supply is reduced sharply, then prices do not fall. The variable that has to give in this
situation is T (or Q), i.e. total output in the economy, as firms cut back production and
consequently employ fewer workers. The implication of this is that an attempt to cure
inflation by a sudden and sharp reduction in money supply will lead instead to an increase in
unemployment rather than a check or reversal in price rises. The reasons for this "ratchet
effect" for prices are that large firms are reluctant to reduce their product prices, and trade
unions and workers resist strongly any suggestion of a reduction in wages.
Diagrammatic Representation of the Quantity Theory of Money

We can illustrate the monetarist analysis of the relationship between changes in demand and
price quite simply, and this will also help to emphasise some of the assumptions on which
the view is based.
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Monetary Policy 239
We must first repeat the belief that changes in demand arise from changes in money supply
and the price of money. Remember that, all other things remaining equal, an increase in
money supply can produce a reduction in interest rates, which in turn can lead to a
significant increase in aggregate demand.
Look now at Figure 13.5, which illustrates the effect of an increase in aggregate demand.
The economy is initially in full employment equilibrium (Ye), determined by the point of
intersection of AD1 with the LRAS curve at point E1. The aggregate demand curve AD1 is
drawn on the assumption that the economy has a fixed supply of money MS1. This
assumption corresponds to that of a fixed M in the quantity theory equation. Yet the full
employment level of output corresponds to the fixed level of total transactions T or
production Q in the quantity theory equation. The position of the economy's LRAS curve can
change over time with economic growth. However in the absence of economic growth, the
economy's maximum level of sustainable real output or national income is fixed, and cannot
be increased by increasing the level of prices in the economy. This is what is shown by the
vertical LRAS curve, and is the same as the assumption made regarding the fixity of T or Q
in the quantity theory of money.
Figure 13.5: Increase in aggregate demand
Price
Level LRAS
P2 E2
E*
P1
E1
AD2(MS2)
AD1(MS1)
Ye Y* Real National
Output
Now assume that the central bank increases the supply of money in the economy from MS1
to MS2. All other things remaining unchanged, the increased supply of money will cause a
reduction in the level of interest rates in the economy, as shown in Figure 13.2. The
reduction in the level of interest rates will in turn lead to an increase in expenditure in the
economy, as shown in Figure 13.3. The increase in expenditure is the same as an increase
in the level of aggregate demand, and this is represented in Figure 13.5 by the shift to the
right in the aggregate demand (AD) curve from AD1 to AD2. To indicate that the shift in the
AD curve is the result of an increase in the supply of money in the economy, the two AD
curves have their associated supply of money indicated by MS1 and MS2.
At the initial equilibrium price level P1, following the increase in the supply of money the new
level of aggregate demand in the economy is E* on AD2. The level of aggregate demand at
E* is Y* and this is excessive relative to the economy's capacity output Ye. That is, it lies to
the right of the LRAS curve. Although the economy may be able to produce a higher level of
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240 Monetary Policy
output than Ye in the short run by operating on its initial SRAS curves (not shown in Figure
13.5 for clarity of exposition), the excess of aggregate demand in the economy will drive up
the level of prices. Indeed, the economy will continue to experience rising prices (inflation in
other words), until it reaches a new point of stable equilibrium at E2 on its LRAS curve. The
new point of equilibrium at E2 corresponds to the prediction of the quantity theory of money.
If the economy is subject to an increase in the nominal supply of money when it is already
operating at full capacity, all that will happen once the extra demand created has worked its
way through the economy will be a rise in the general level of prices in proportion to the
increase in the supply of money. That is, in figure 13.5 the increase in the supply of money
from MS1 to MS2 merely moves the economy up the LRAS curve from E1 to E2. The only
change is an increase in the level of prices from P1 to P2.
F. METHODS OF CONTROLLING THE SUPPLY OF MONEY

Whatever the argument on the precise timing and severity of policies needed to control
inflation, all monetarists believe that there has to be strong government control over the
supply of money. In fact, even Keynesians would accept that there has to be some degree of
control over money supply, though they would not elevate these controls to the important
place claimed by monetarists. We must now look at some of the methods by which
governments attempt to control the money supply. Remember that all our definitions of
money have been based on deposits held by banks or similar financial institutions, so that
you must expect control over money to appear as a form of control over the power of the
banking system to create credit.
Interest Rate Control

Remember that money supply and demand are very closely related. If the price of money
rises – i.e. if interest rates rise generally – then the demand for money can be expected to
fall, although an interval may be necessary for the full effects to be felt. If people wish to
borrow less, then the banks may be expected to lend less. If the banks lend less, then the
volume of deposits will rise more slowly, and money expansion may be checked. A
government or the central bank may therefore seek to control the supply of money through
its ability to influence the level of interest rates. This is the main method of controlling the
supply of money used by central banks in advanced economies.
Control over Banking Ratios

In Study Unit 12 we introduced the bank credit multiplier and saw how the proportion of
customer deposits held as cash affects the lending power of the banks. If the proportion is
one-tenth, then the multiplier is ten. If the proportion rises to one-eighth, then the multiplier
falls to eight, and so on. A central bank may seek to influence the value of the bank credit
multiplier by changing the value of the commercial banks cash reserve ratio. For example, to
reduce bank lending and hence the rate of growth of the money supply, the central bank
could increase the minimum ratio of bank cash reserves to deposits.
Direct Controls over Banks

The government, acting through the central bank, may require the commercial banks to keep
their customer lending within stated limits, or to discourage certain forms of lending, or forbid
lending for stated purposes. In a market economy or a mixed economy containing a
substantial free market element, such controls are unpopular and difficult to keep in force for
very long. They may be regarded as the first step towards total control of the banking system
or complete nationalisation of all banks.
These methods of control assume that the central bank does not itself operate directly in the
ordinary commercial finance markets. In some countries, the national central bank does lend
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Monetary Policy 241
directly to industrial and commercial organisations. In such countries, a government wishing

to control the money supply would have to keep careful and strict control over these lending
operations.
Control of Government Borrowing

A straightforward analysis of money supply and its changes suggests that an increase in
government borrowing will increase money supply only if this is financed through the banking
system. If it is financed by direct borrowing from the public, through sales of bonds, then
there is no increase in money supply, and there could be a reduction through the withdrawal
of money from private sector deposits with the banks to pay for the government securities.
Thus there is a connection between fiscal policy and monetary policy. The effective control of
the money supply and inflation requires governments to exercise fiscal discipline and limit
their expenditure to what they can pay for out of tax revenue and borrowing from the public,
not the banking system.
However, even in this case, there may be indirect consequences. If the government enters
the finance market to compete for a larger share of private savings, then firms may be
forced to borrow from the banks instead of raising money through issues of shares or
debentures (long-term securities). This suggests that the government is crowding out private
investment and forcing it into the banking system. Also, if the government forces up interest
rates because it is competing with building societies and banks and capital markets for
private savings, firms will be unwilling to incur long-term debt at high rates of interest.
Instead they will prefer to borrow on short-term and on more flexible terms from banks, in the
hope that future conditions will be more favourable for longer-term funding.
G. MONETARY POLICY AND THE CONTROL OF INFLATION

Money is important because a modern economy cannot function without an adequate supply
of a sound medium of exchange and an efficient financial system. However, as the quantity
theory of money demonstrates, an economy can have too much of a good thing in that
excessive growth of the money supply merely leads to inflation. Changes in the supply of
money can affect interest rates and the level of aggregate demand in the economy. If the
economy is suffering from deficient aggregate demand, an expansionary monetary policy will
lead to increased employment and real output. Monetary policy can be used in the same way
as fiscal policy to regulate the level of aggregate demand. What monetary policy cannot do
is create jobs and prosperity out of nothing. In a modern economy money is, after all, nothing
but pieces of paper and electronic records in bank computers. Once an economy is
operating at full capacity, its real output and citizens' standard of living is determined by its
stock of physical and human capital, not its supply of money. Continued expansion of the
supply of money in an economy thus eventually leads to inflation, not growth and prosperity.
One of the myths of economic development and growth is that they are both helped by
inflation and impossible without it. In fact, the clear message of the study of economic growth
in different countries is that there is no clear positive relationship between the rate of inflation
and the rate of economic growth. Some countries have experienced high rates of growth and
inflation, while other countries have suffered from high rates of inflation and economic
stagnation. In contrast, some economies have enjoyed low inflation combined with high rates
of real economic growth. What is established beyond any doubt is that once inflation
becomes established in an economy it tends to accelerate and, if unchecked, eventually
leads to economic disorder with falling output and increasing unemployment. High and
accelerating rates of inflation affect economic behaviour and distort the effective working of
markets. Because inflation erodes the value of money and undermines the logic of savings,
it stimulates current consumption and speculative investment in physical assets, especially
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242 Monetary Policy
land and property. Avoiding loss due to inflation takes priority over creating new jobs and real
wealth through productive investment in business.
The dangerous internal dynamics of inflation are due to the role of expectations. Once
inflation becomes established, people try to avoid its costs by anticipating the future rate of
inflation and taking appropriate avoiding actions. If the rate of inflation is expected to
increase, the sensible thing to do is spend more and save less before the expected increase
in the rate of inflation reduces the value of money and savings even further. But this merely
increases aggregate demand relative to aggregate supply, and puts even more upward
pressure on prices. This leads to the interesting conclusion that if people expect inflation to
increase and act accordingly, the actual rate of inflation will increase as expected. This leads
to self-reinforcing behaviour, or self-fulfilling expectations. Correctly anticipating an increase
in the rate of inflation leads people to anticipate yet further increases, and this behaviour
continues to fuel the acceleration in the rate of inflation. Once the rate of inflation starts to
accelerate, and people expect it to continue accelerating, it becomes difficult to reverse
people's expectations of its continuation.
Modern monetary policy is based on the view that inflation yields no permanent benefit for an
economy and can cause much economic harm if unchecked. Once inflation is fully accepted
in an economy, monetary policy looses all its power to do good but retains its power to cause
yet more inflation. For this reason it is better to avoid high rates of inflation, and the problem
of trying to reverse people's expectations of ever increasing inflation, by maintaining a very
low rate of inflation and creating the expectation that the rate of inflation will stay low.
Monetary policy can be used to achieve monetary stability if the government or the central
bank announces a target for the annual rate of inflation, and achieves the target by
managing the level of demand in the economy through its control of the rate of interest.
Countries that operate monetary policy on the basis of a target for the rate of inflation usually
also have an independent central bank. Central bank independence refers to the removal of
political control and interference from the conduct of monetary policy by the central bank. A
fully independent central bank, such as the European Central Bank (ECB), sets its own
target for the rate of inflation as well as operating monetary policy free of government
influence in such a way as to achieve its target. It is of the upmost importance for the
success of inflation targeting that the central bank is completely free of any control or
influence from the government, because such interference would undermine people's
confidence in the ability of the central bank to keep inflation under control at the target level.
For example in the UK, the government has set the target for the rate of inflation at two per
cent, plus or minus one per cent. The government has given the Bank of England the task of
achieving the target for the rate of inflation. To make sure that people believe that the Bank
of England will achieve the target and keep the UK's rate of inflation close to two per cent,
the government gave the Bank of England operational independence in 1997. What this
means is that the Bank of England now operates as an independent central bank. The Bank
of England is not fully independent, because the UK government still determines the target
for the rate of inflation. But given the target set by the government, the Bank has complete
autonomy. It is allowed to independently set a monetary policy to enable the economy to
achieve the target rate of inflation. This means that the Bank of England sets the level of the
rate of interest each month purely on the basis of the level required to control inflation and,
more significantly, people's expectations of the rate of inflation. An independent central bank
sets interest rates at the level required to achieve the target rate of inflation even when the
government, for either valid or politically motivated reasons, would prefer the central bank to
set the rate of interest at a different level. If the central bank's independence to determine
monetary policy is compromised by political interference, then public confidence in the
achievement of a low and stable rate of inflation is likely to be destroyed. Once the belief in
an effective anti-inflation policy is lost, the public will start to anticipate accelerating inflation
and inflation will return to undermine employment, output and living standards.
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Monetary Policy 243
Review Points
relevant sections.
1. Explain the meaning of the demand for money (liquidity preference).

2. Explain, using a demand for money curve diagram, why the demand for holding money
decreases as the rate of interest increases.
3. Outline the quantity theory of money
4. Explain how a central bank controls the level of short-term interest rates in the
economy.
5. How is the effectiveness of monetary policy affected by:
(i) the interest sensitivity of the demand for money, and
(ii) the interest sensitivity of investment expenditure?
6. What is an "independent central bank"?
7. What is an "inflation target"?
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244 Monetary Policy
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245
Study Unit 14
Macroeconomic Policy
Contents Page
A. The Major Economic Problems 246

What is an Economic Problem? 246
Inflation 246
Unemployment 247
Trade Difficulties 248
Regional Problems 248
Lack of Adequate Economic Growth 248
B. Policy Instruments Available to Governments 249

Fiscal Policies 249
Demand Management and the Deflationary Gap 251
Demand Management and the Inflationary Gap 252
Monetary Policies 252
Direct Controls 252
Government Spending 253
C. Policy Conflicts and Priorities 254

Difficulties in Pursuing all Objectives at Once 254
Differences in Priorities 254
D. Supply-side Policies 255

The Natural Rate of Unemployment 255
Supply-side Objectives 256
Taxation and Fiscal Measures 257
Trade Unions and Supply 258
Encouragement of Competition 259
The Removal of Bureaucratic Controls over Business 259
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246 Macroeconomic Policy
Objectives
The aim of this unit is to explain and interpret the main objectives of government
macroeconomic policy.
 explain the conflicts that can arise between various macroeconomic objectives
 use aggregate demand and supply diagrams to demonstrate how these conflicts arise
 discuss the possible advantages of using fiscal and monetary policy together to try to
reconcile conflicts in macroeconomic objectives
 show, using aggregate demand and aggregate supply diagrams, how the degree of
underutilisation of an economy's labour resources can affect the trade-offs between
economic growth, price stability, interest rates and unemployment.
A. THE MAJOR ECONOMIC PROBLEMS

What is an Economic Problem?
In many respects an economic problem, as perceived by a government, is an aspect of what
is generally known as the fundamental economic problem:
the attempt to satisfy unlimited wants with scarce resources, so that full satisfaction is
impossible and choices have to be made between competing claims on those
resources.
At the same time, this general problem is aggravated by inefficiencies in the production
system, so that the achievement of available resources is not as great as it might be.
In practice we can identify a number of distinct problems which afflict modern industrial
economies, and which are considered to be within the power of modern governments to
reduce, if not totally solve.
Inflation
As we have already noted, inflation is the term used to describe a condition of constantly
rising product and factor prices – the main factor price being wages: the price of labour.
Inflation is a problem because it makes the production and distribution system less efficient.
It creates uncertainties about costs, and it makes planning more difficult and uncertain. It
makes long-term agreements difficult to make, because past agreements become unjust as
the value of any agreed constant payment is steadily reduced. Money is unable to fulfil those
functions which depend on confidence that it will retain its purchasing power and
acceptability in the future. Savings lose their value, and people who have saved for future
needs feel a sense of injustice. Countries suffering the most severe rates of inflation find that
their exports become more expensive and difficult to sell in world markets, while imports
become cheaper and grow in volume.
If inflation is not checked, it increases in intensity until prices rise daily and all confidence in
money is lost. Trade reverts to a basis of barter, and all confidence in the financial system
collapses. This condition of hyperinflation is usually associated with extreme political and
social unrest and uncertainty for the future.
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Macroeconomic Policy 247
Unemployment
Unemployment is said to exist when resources, especially people available and seeking
work, cannot find employment. It is an economic problem, in the sense that the community
loses the production that could have been achieved, had all resources been employed.
Unemployment is also a major social problem, because work is an important element in a
person's standing in the community. A person who feels that he or she ought to be working
but who cannot find work often feels rejected by society and, not uncommonly, resorts to
antisocial behaviour.
We have already noted that Keynesians and monetarists have differing views concerning the
nature and causes of unemployment, and it is convenient here to summarise some of these
important differences.
 Both groups agree that there are elements of frictional and structural unemployment,
but monetarists believe that the structural element may be artificially higher than it
need be. This is because high state unemployment and welfare benefit payments
reduce the pressures to adjust to changing economic conditions. They also believe that
social attitudes and selfish protectionist motives by trade unions delay adjustment to
change.
 Keynesians believe that much unemployment is caused by a deficiency in total
demand consisting of household spending (C), business investment (I) and
government spending (G). This is termed "demand deficient unemployment".
Monetarists also believe in the possibility of demand deficient unemployment, but that
both monetary and fiscal policy are less powerful than argued by Keynesians in
combating such unemployment. Monetarists believe that the more effective
government policies are ones aimed at preventing the emergence of demand deficient
unemployment. Keynesians, on the other hand, focus on policies for reducing demand
deficient unemployment once it has happened, rather than looking to policies to
prevent its emergence.
 Monetarists believe that the natural rate of unemployment would be very small, if
markets were free to operate according to the unrestricted interplay of the normal
market forces of supply and demand. The effective functioning of markets requires a
low and stable rate of inflation. For this reason, monetarists see the effective control of
inflation as an essential precondition for preventing the emergence of demand deficient
unemployment. The natural rate of unemployment is that rate which exists when the
total demand for labour is roughly equal to total supply. People are then unemployed
for frictional reasons – the normal wear and tear of firms closing, people changing jobs
for personal reasons and so on, and for structural reasons – changes in the labour
market caused by shifts in product demand and changes in production technology. The
supply side of the economy is as important as the demand side in preventing a high
rate of unemployment. This means that governments also need to use supply-side
policies and encourage investment, education, labour flexibility, mobility and skills
training to boost productivity growth. A high rate of unemployment is therefore blamed
on imperfections in labour markets, barriers to productivity growth and inadequate
investment in physical and human capital. These are seen mainly in terms of failure to
understand and to adjust to structural change, undue trade union power and the
system of government taxation and benefits payments that penalises work effort and
entrepreneurship. Monetarists argue that a large part of high unemployment is
voluntary. This is in the sense that people are waiting for jobs they think suitable
instead of accepting what is available, and because they support trade union measures
which force wages above the market equilibrium and so reduce the demand for labour.
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Trade Difficulties
Trade difficulties are closely associated with inflation which increases export and reduces
import prices in world markets. Both Keynesians and monetarists would agree that rising
imports indicate a condition where demand is greater than the supply from the home
production system. However, whereas Keynesians would concentrate attention on what is
perceived as excess demand, monetarists pay more attention to failings in the supply or
production system. Monetarists would tend to regard this as inefficient for a variety of
reasons, including trade union power, lack of profit incentives, inefficient management and
often being associated with monopoly power and bureaucratic barriers to business
enterprise.
Trade difficulties are manifest in the structure of a country's balance of payments accounts
and are usually associated with deficits on the current account of the balance of payments.
However, in many cases a country's balance of payments problems are compounded by the
choice of inappropriate exchange rate policy.
Regional Problems
If you live and work in the United Kingdom, you will probably be aware that the central
problems of inflation and unemployment do not affect all areas of the country with equal
intensity. In the southern areas inflationary pressures seem to be greater, whereas
unemployment is generally more severe in the northern areas. If you lived in some other
country, you would probably be aware of similar regional differences. These are regarded as
economic problems, because the failure of some areas to develop as successfully as others
suggests that production is being lost through the underuse or inefficient use of available
scarce resources.
People tend to think that they are well or badly off, according to the comparisons they are
able to make with other people. If living standards and employment opportunities are very
different in different regions, there is likely to be social and political discontent. There is also
the problem that large-scale movement of people from one region to another to find
employment is a further possible cause of social unrest. Families are divided and pressures
build up on housing and other services in the more prosperous areas.
If you do not live in the UK, you should try to apply similar general principles and arguments
to the problems of your own country.
Lack of Adequate Economic Growth

What is adequate depends on what is achieved elsewhere. If the economy of the UK grows
at the rate of one per cent per year, this will be seen as inadequate if other countries of
similar size and stages of development are able to achieve growth rates of four per cent or
more.
It is also true that all the problems identified in this study unit so far seem fairly minor if the
economy is growing at what is seen as a fast rate, and if living standards for the great
majority of the people are rising fast and constantly. On the other hand, if there is very little
growth, then these problems become magnified and harder to solve. People's aspirations
may be raised by what they see being achieved in more successful economies, and there is
dissatisfaction and unrest at the failure to make similar progress at home. When there is a
high rate of growth, governments have resources to introduce measures which are politically
popular, and their chances of keeping power are greater. Low growth and inability to carry
out popular measures make it difficult for governments to stay in power, at least by
democratic means.
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B. POLICY INSTRUMENTS AVAILABLE TO

GOVERNMENTS
Fiscal Policies
Fiscal policies relate to the use of government spending and taxation as instruments to
influence the economy. The original idea behind fiscal policy was chiefly associated with
Keynesian ideas of using the power of governments to influence aggregate demand. The
assumption was that the economy is demand led, i.e. that total supply responds to changes
in total demand. It is now recognised that the supply side of the economy is just as important
as the demand side; the neglect of aggregate supply and inflation by Keynesians created an
over-optimistic view of the power of government fiscal policy. The Keynesian 45 degree
model of income determination overstates the effectiveness of fiscal policy, and for this
reason the more realistic aggregate demand and supply model is used.
Figure 14.1 illustrates an economy suffering from demand deficient unemployment. The
economy is in equilibrium at E1 with a level of real national output of OY1. The consequent
differences between what could be produced at the level of OYe, the full employment output
level, and the actual level of OY1, creates a deflationary gap represented by a – b. As long
as this gap remains, there will be unemployment, caused by the deficiency of aggregate
demand.
Figure 14.1: Economy suffering from demand deficient unemployment
Price SRAS
Level LRAS
a
E1
AD
O Y1 Ye Real National Output
Clearly the remedy this analysis suggests is to raise the aggregate demand curve by an
amount equal to a-b in order to remove the deflationary gap. This is shown in Figure 14.2.
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Figure 14.2: Removing the deflationary gap
Price SRAS
Level LRAS
E2
E1
AD2
AD1
O Y1 Ye Real National Output
The increase in aggregate demand in the economy is shown in Figure 14.2 by the movement
of the aggregate demand curve from AD1 to AD2. This increase in aggregate demand moves
the economy to a new equilibrium at point E2, where the SRAS curve intersects the LRAS
curve. The new equilibrium is on the LRAS curve, which means that the deflationary gap has
been eliminated and unemployment in the economy has been reduced. The movement of
the aggregate demand curve from AD1 to AD2 could have been achieved by the use of fiscal
policy or monetary policy. The diagram illustrates the consequence of the expansionary
policy, not the policy measures used by the government to achieve the increase in aggregate
demand. This means that the same diagram can be used to analyse the working of both
fiscal and monetary policy.
In the case of fiscal policy the increase in aggregate demand, represented by the rightward
shift in the AD curve in Figure 14.2, could have been achieved by the government increasing
its own expenditure without increasing taxation to pay for the increase, or by maintaining its
expenditure and reducing the amount of tax it collected. Either measure involves a
deterioration in the government's budget position and an expansionary fiscal policy.
Remember that in practice the government does not have to directly increase aggregate
demand by the full amount of the initial deficiency. This is because the income multiplier will
come into play, and the final increase in aggregate demand will be greater than the
magnitude of the government's initial fiscal injection.
If the government uses monetary policy to boost the economy and eliminate the deflationary
gap the diagram will look the same, but the rightward shift of the aggregate demand curve
from AD1 to AD2 will result from an expansionary monetary policy. The central bank will
undertake an open-market operation to reduce interest rates and increase the cash reserves
in the banking system. The reduction in the level of interest rates will lead to increased bank
lending and an even greater increase in the supply of money. The extra bank lending will be
used by business and household borrowers to increase investment and consumption
expenditure in the economy. As with the expansionary fiscal policy, the final increase in
consumption and investment expenditure will be greater than the initial stimulus to demand
caused by the increase in the money supply, due to the operation of the income multiplier
process.
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If an increase in demand is to reduce unemployment, then it must be assumed that total

supply – and therefore the demand for labour and other production factors – will rise in
response to the change in demand. The move up the short-run aggregate supply curve to
the point of full employment equilibrium on the long-run aggregate supply curve at E2 will
thus be associated with a rise in the level of prices in the economy or inflation. How much
prices rise as unemployment is reduced through the use of an expansionary fiscal policy
clearly depends upon the slope of the short-run aggregate supply curve. It also depends
upon the position of the short-run aggregate supply curve. This is because any increase in
the level of money wages and other cost of production as demand expands will cause the
short-run aggregate supply curve to shift upwards, and add further pressure to the rise in
prices. The upward pressure on prices will also affect inflationary expectations which, if
unchecked, may lead to further upward pressure on wages and other costs as workers and
firms seek to protect their wages and profits from erosion in value due to inflation. Suddenly,
the scope and ease of fiscal policy alone to restore the economy to full employment without
creating a worsening situation of inflation looks less certain than suggested by the simple
Keynesian model of income determination. Worse, the aggregate demand and supply curve
model shown in Figures14.1 and 14.2 assumes that the government knows precisely the
position of the LRAS curve and the exact extent of the deficiency of aggregate demand in
the economy. If the unemployment is a result of a decline in the economy's productive
potential, a leftward shift in the LRAS curve, fiscal expansion may create excess demand
and an inflationary gap!
Demand Management and the Deflationary Gap

If our theory suggests that to reduce unemployment we must raise total demand, then the
problem becomes one of how to achieve this. Our earlier national income analysis suggests
that this can be achieved by injections of new demand, which will then be multiplied within
the economy to produce the new and higher equilibrium level that is desired.
Keynesians argue that the desired effect can be achieved if the government is prepared to
operate with an unbalanced budget, i.e. if it spends more than it receives in taxation. This
means that to raise the total level of aggregate demand, the government can increase its
own spending (G) without increasing taxes, and/or reduce taxes in order to encourage
household spending. Remember that Keynesians believe that the most powerful influence on
total spending is income. A reduction in income tax will increase people's net disposable
income, so that they will increase their spending in accordance with the marginal propensity
to consume.
Fiscal policies are thus very important to the Keynesian. It is through the adjustment of
taxation, and income tax in particular, that the government is able to influence the level of
disposable income. Such changes in taxation will have an immediate effect on spending and
hence on aggregate demand, which in turn produces a change in supply and the level of
employment. The effect of the income tax reduction does not end there. The initial injection
of extra spending will produce a larger change, in accordance with the national income
multiplier. There will also be an additional impact resulting from the perception by business
firms that demand for their goods and services is increasing. To meet the increased demand,
they will increase investment: this produces a further injection in the economy, with a further
multiplying effect. The combination of investment accelerator and national income multiplier
will ensure that the total increase in demand will be larger than the initial injection achieved
by the tax reduction.
So the Keynesian relies on a fiscal policy of tax manipulation combined with a willingness to
tolerate an unbalanced budget to achieve and maintain full employment – or something as
close as possible to full employment – in the economy.
A reduction in indirect or expenditure taxes would also be expected to stimulate the
economy, because more of the consumer's gross spending will actually go to the suppliers of
© ABE and RRC

goods and services. Firms can be expected to increase the quantities they are willing to
supply at each level of market price – the supply curve will shift to the right. The precise
effect on output and price will depend on the slopes of the demand and supply curves. This
is analysed later in this study unit, but we can see that we would certainly expect some
increase in supply and employment following a reduction in indirect taxes. Such a reduction
could also mean the government having to be prepared to operate an unbalanced budget,
with revenue falling short of expenditure and the difference made good by borrowing.
Demand Management and the Inflationary Gap

Theoretically there is no reason why fiscal policies employed to reduce a deflationary gap
cannot be reversed to reduce an inflationary gap. This would mean reducing government
spending and increasing taxes, using any excess of tax revenue over expenditure to reduce
the national debt. However such policies meet serious constraints in practice. Attempts to cut
public sector spending may provoke fierce political resistance and will be politically
unpopular. We are all in favour of reduced government spending in general, but we all
oppose any cuts in those areas of spending that affect us and from which we benefit!
Similarly we all agree that taxation is necessary but we all dislike paying tax ourselves.
Consequently it is much easier for governments to reduce taxation and increase spending
than to raise taxation and reduce spending. It is therefore no surprise that Keynesian
demand management policies have been more successful in reducing deflationary than
inflationary gaps. As inflation came to be perceived as the major economic problem of the
1970s and 1980s, attention turned away from fiscal policy and towards monetary policy.
Monetary Policies
The theoretical basis of monetary policy, the money equation and the main elements of
monetary controls were examined in Study Unit 12. You should make sure you understand
how these differ from fiscal policies. Remember that monetarists and Keynesians share a
common belief: that the major cause of inflation is an excess of demand over available
supply. However the Keynesian belief that demand is mainly a function of the level of income
has led traditional Keynesians to rely chiefly on fiscal measures, and led later Keynesians to
support direct controls over the level of incomes. In contrast monetarists believe that
demand is mainly a function of the availability of money and credit (money supply), and this
has led to their reliance on monetary policy. Monetary policy involves the central bank's
ability to control of the supply of money to determine the level of short-term interest rates in
the economy and the publics' expectations regarding the future rate of inflation. A successful
monetary policy will achieve a low and stable (and hence predictable) rate of inflation. This in
turn will give the central bank the power to influence the level of long-term as well as short-
term interest rates.
Direct Controls
A government can always obtain the legal powers to control certain aspects of the economy,
but it must be remembered that these powers are usually only negative. A government can
prevent people or firms from doing certain things, but it has considerable difficulty in forcing
them into positive action – i.e. actually to do things it wants done – purely by the exercise of
its legal powers.
Because of the failure of governments to recognise the limitations of Keynesian demand
management fiscal policy, overambitious use of expansionary fiscal policies in the 1960s and
1970s led to ever higher rates of inflation and the associated problems created by
accelerating inflation. In the UK the denial of the role of money supply in fuelling inflation
compounded the problems created by excessive levels of government expenditure in relation
to taxation and the economy's supply capacity. Faced with worsening inflation, the
government resorted to the use of direct controls over prices and incomes. This was an
attempt to control inflation without reducing government expenditure and the rate of creation
© ABE and RRC

of money used to finance government deficit expenditure. Not surprisingly, such direct
controls failed because they confused cause and effect. A persistent acceleration in the rate
of inflation is impossible without new money creation. Continued growth of government
expenditure financed by expansion of the money supply will lead workers to demand higher
wages and firms to keep on raising prices. This behaviour is not the cause of the inflation but
simply a rational response to the inflation caused by the government's own policies. By the
1980s the truth dawned that direct controls were ineffective because they addressed the
symptoms not the cause of the problem of wage and price inflation. Direct controls,
especially over wages and prices, are now recognised as inappropriate and ineffective in a
market economy, and are now no longer used by governments.
One of the most controversial examples of the use of direct controls by the British
government has been the successive attempts made to regulate wages, and sometimes
prices. Regulation of price or factor price without also controlling the forces of supply and
demand is never successful, because it must lead to serious distortions in supply and
demand and it threatens to destroy the whole mechanism of the market. During all the
periods of attempted wage regulation, employers and unions found ways of overcoming the
controls in order to keep the labour markets working. Even so, shortages of skilled workers
sufficient to hold back the expansion of some profitable firms and industries have been
blamed on these controls. Such shortages made it difficult for firms to attract workers into
activities requiring long and difficult periods of training, when wages nearly as high could be
obtained from less demanding work. Nevertheless, the pay of people employed in the public
sector, which is largely insulated from the forces of supply and demand, continues to cause
problems. There does appear to be a need for guidance from some kind of authority for
public sector pay. As long as there are not generally agreed principles and the government
simply relies on its power as an employer, continued disputes and feelings of injustice are
highly likely.
Few economists believe that controls over wages and prices can ever be effective in a free
market economy. Such controls usually attempt to deal with the symptoms, not the cause of
the problem. Not only do they tend to cause new problems of their own, but the problems
they are intended to deal with, especially inflation, are invariably caused by governments
themselves. Governments generally think that they have more power than they actually
possess. When controls are imposed to prevent actions that people would otherwise take,
there will be attempts to evade the controls, and the government may be forced into
increasingly difficult, complex and expensive control measures. For instance, many countries
have sought to impose strict import controls, only to discover that they have created a major
smuggling industry. Many of those responsible for maintaining the controls simply use their
powers to increase their personal incomes with bribes from both legal and illegal traders. We
have only to note the problems of seeking to prevent the import of illegal drugs to see what
happens when a government tries to suppress trade for which there is an effective demand.
It is only too clear that a government cannot stop the abuse of drugs just by trying to prevent
drugs imports.
Government Spending
Government (public sector) spending is a major part of total demand, so that variations in
government spending can be used to influence the level of national income and product. The
Keynesian uses government spending as a "counter-cyclical" instrument. The government
can inject additional demand when household consumption and business investment are
considered to be too low, and reduce public sector spending when the economy is thought to
be overheating with excess demand from the private sector. In practice, it is easier for
governments to increase public sector spending than to reduce it.
The monetarist, while recognising the use of public sector spending as a means to regulate
the total level of economic activity, wishes to keep the total of this spending as low as
possible.
© ABE and RRC

However, both Keynesians and monetarists do agree that the pattern of economic activity
can be influenced by government spending decisions. For instance governments have
sought to encourage the development of the computer industry, by assisting investment and
by helping schools to buy British-made computers. Government can influence the
development of transport by spending on roads rather than on the railways. It can also try to
help particular regions by directing some public activities to them, and away from London.
However governments are generally limited in what they can do. For example, a government
may stop a firm from building a new factory in a particular place. However, if the firm says
that if it cannot have the factory where it wanted it, then it will not build a new factory at all,
there is very little the government can do. Similarly, a government may prohibit the import
(and sometimes the export) of particular goods or goods from or to particular countries, but it
cannot force people in foreign countries to buy goods made by its producers.
C. POLICY CONFLICTS AND PRIORITIES

Difficulties in Pursuing all Objectives at Once
Economists recognise the possible conflict of objectives in government macroeconomic
policy. The success of demand management depends on holding a very fine balance
between total demand and total supply, and any swing in one direction is going to lead to
difficulties. In order to reduce unemployment, the Keynesian will wish to expand demand,
and he would be prepared to operate an unbalanced budget. He accepts that this may bring
about some price inflation, and that it could also lead to rising imports and trade difficulties.
So to reduce unemployment, the Keynesian recognises that he may increase problems of
inflation and excess imports. Similarly, he will accept that action to bring trade into balance,
or to reduce the rate of inflation, will probably bring about a reduction in the growth of the
economy and in an increase in unemployment.
A monetarist will have a rather different analysis. He believes that in the long term,
successful achievement of economic growth, successful trade and full employment all
depend on an absence of inflation and a stable financial system. He believes that business
enterprise, freed to operate in unregulated markets, will achieve growth, exports and
employment, provided that the government keeps its own spending under control, keeps a
tight grip on the money supply, and avoids inflation. There is therefore no fundamental
conflict of aims in the monetarist analysis in the long term. However, starting from a position
of high inflation caused by misguided demand-management based on over-expansionary
fiscal and monetary policy measures, the monetarist believes that it is not possible to avoid
some increase in unemployment. The monetarist is also sceptical concerning Keynesian
remedies for regional problems, as explained in the next section of this study unit.
The monetarist does not believe that macroeconomic policies, as understood by the
Keynesian, are effective at all. The Keynesian is concerned with aggregates, in the belief
that injections of demand from government spending and tax reductions will operate on the
economy as a whole, to increase employment. The monetarist is not convinced that the
government has the power to influence the whole economy in this way, and he tends to
prefer supply-side policies which operate on the economy through improving the operation of
individual product markets – i.e. through microeconomic measures. If all or the majority of
individual markets operate more efficiently, then the economy as a whole will prosper.
Differences in Priorities
If to begin with, we adopt the Keynesian position, then it is clear that there has to be some
sense of priorities in choosing objectives. This is because not all can be pursued at once.
The Keynesian would argue that his most important objective is to achieve and maintain full
employment – but that this may have to be modified from time to time if inflation or trade
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difficulties become too serious. However, the main objective is always to avoid large-scale
unemployment and, if this is threatened, some inflation or trade imbalance may have to be
accepted.
Critics of Keynesian economics would suggest that in practice, governments do little more
than react to a series of crises. They lurch between expansion and deflation as each
problem becomes steadily more serious, and as the production system becomes
increasingly dislocated by sudden shifts in demand policy. They see the inevitable
consequence as uncontrollable inflation, which eventually brings about mass unemployment
as the production system fails to compete with more efficient foreign systems.
The monetarist thus argues that there is no alternative to controlling inflation and freeing
private sector markets from controls and barriers, so that they can expand production and
increase employment. In the meantime the effect of reducing public sector activity and
restoring a more competitive and efficient private sector is likely to cause strains and to
increase unemployment. We have seen earlier that monetarists differ in their approach to the
timing of policies. Some prefer a gradual approach, accepting that inflation should not be
brought down too swiftly, in order to avoid the social and political upsets of too rapid a rise in
unemployment. Others consider that the adjustment can be carried out more quickly and that
more vigorous methods can be applied to remove restrictions to industrial markets.
D. SUPPLY-SIDE POLICIES
The disappointing experience of demand management policies when inflation became a
major economic issue, and the monetarist argument that demand expansion almost
invariably led to inflation because of the failure of domestic production to respond quickly
enough to demand stimulation, led to the development of what became known as supply-
side economics. It is monetarists who are most closely associated with modern approaches
to the stimulation of supply. In this approach, supply-side economics is seen as the use of
microeconomic incentives to change the level of full employment, the level of potential output
and the natural rate of unemployment. The objectives are to increase total production, to
increase the productivity of labour, and to make producers more competitive in world
markets. A government pursuing supply-side policies wants business firms to produce more
and to employ more labour – but to do so profitably, in competitive markets.
The Natural Rate of Unemployment

Central to understanding the theory on which supply-side economics is based is the concept
of the natural rate of unemployment. This is the rate at which the labour market is in
equilibrium – i.e. in which labour demand is equal to labour supply, so that there are no
pressures to increase or decrease money wages.
The natural rate of unemployment will never be zero, because at any given time there will be
unemployment arising from two important causes. These are known as frictional and
structural causes. Frictional unemployment arises from the normal wear and tear of business
life. There will always be people changing jobs, for a whole range of different reasons. These
will include dissatisfaction with an employer or with working conditions, moving home, the
failure of individual firms or just simply boredom or the desire to do something different. It is
not always possible to move immediately from one job to another, although the average
length of time that a frictionally unemployed person can expect to be without work varies with
the level of total unemployment. It is not usually more than a few weeks.
Structural unemployment has two related meanings. On the one hand it arises from shifting
patterns of demand. For example if many women decide to give up wearing jeans and
trousers, and instead choose to wear skirts and dresses, then jeans manufacturers will have
to lay off workers, while skirt manufacturers will be expanding their activities. Different firms
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in different localities may be involved, and it is not always possible for workers in the
declining activity to move quickly into one that is expanding.
The other form of structural change is also known as "technological change". It arises from
changing production methods, usually from the increased use of machines, including
advanced electronic devices and computer software which can do a great deal of work
previously carried out manually. When this kind of change takes place, there is no immediate
compensating expansion in another activity. New technology always creates new activities
and occupations in time, but these may be very different from the old, requiring new and
different skills, and they are often located in completely new areas. Structural unemployment
from technological causes can be greater and more disruptive than that from shifts in
demand.
The two types of structural unemployment are often related, in the sense that new
technology creates new products which replace old ones. The transistor destroyed the radio
valve industry; the small electronic calculator destroyed the production of slide rules and
mechanical calculating machines. Modern electronics has changed a great deal of product
demand, and it has had a very great impact on the labour market.
It is clear then, that if we regard the natural rate of unemployment as being made up of
frictional and structural unemployment, it is likely to be much higher today than it was in the
1950s and the early 1960s, before the current electronics revolution. Where monetarists
differ from other (and particularly Keynesian) economists, is in their belief that the whole – or
almost the whole – of the actual amount of unemployment is natural unemployment. If the
actual rate of unemployment is seen as being at a level which is socially and politically
unacceptable – and economically damaging, in the sense that production that would be
possible at a higher level of employment is being lost – then the problem lies in reducing this
natural rate. Monetarists believe that this natural rate is too high, and that it can be reduced
by microeconomic (supply-side) policies.
Clearly then, monetarists and supporters of supply-side theories take an almost opposite
view to Keynesians on the basic causes of unemployment. Keynesians see unemployment
and inflation as opposite forms of national income disequilibrium (the deflationary and
inflationary gaps). Monetarist/supply-siders see unemployment and inflation as caused by
similar forms of market failure, with inflation as the primary result of this failure, helping to
produce unemployment by pricing domestic production and production workers out of
employment in world markets. Much supply-side policy, therefore, depends on removing
imperfections, including government intervention, from product and factor markets.
Supply-side Objectives
If you look at Figure 14.3 and bear in mind the earlier outline of objectives of supply-side
economics, you will realise that supply-side policies will be designed to shift the supply of
labour curve (SL curve) to the right – i.e. increase the number of workers prepared to work at
each wage level. This will reduce the natural rate of unemployment, and move the actual
demand for labour (and hence raise the production level) further to the right along the
demand curve by reducing the gap between union-imposed and the market-equilibrium level
of wages, and shift the demand-for-labour curve to the right by increasing employers'
production intentions. A number of possible ways of achieving these results may now be
examined.
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Figure 14.3: Effect of supply-side policies
Wage
rate £ LF WP
Wg A
B
Wn
Demand
for labour
O La Le Quantity of labour
Here are shown curves for the working population (WP), the actual supply of labour (LF) and
the demand for labour, as before. If there are income taxes, and other payments of the
nature of payroll taxes, then the wage cost may be OWg – the gross wage paid by
employers plus compulsory payments which employers have to make, whereas the net wage
actually received by the workers is OWn. The vertical distance AB represents the amount of
income tax and payroll taxes. If this distance could be eliminated, the supply and demand for
labour would move to the equilibrium position C, and employment would be at the higher
level of OLe. Income and payroll tax reductions would have reduced the amount of
unemployment by an extent depending on the slopes of the curves and the various distances
involved.
Taxation and Fiscal Measures

As far as the public sector spending side of fiscal measures is concerned, there is a desire to
reduce public sector spending in order to release resources of labour and capital for use in
the private sector. This is because it is believed that private sector activity is more likely to
generate further growth and employment, whereas much public sector activity and
employment has to be paid for by taxation, which operates as a burden on the private sector
and prevents its expansion.
The main objective is to reduce taxes both for employers and for employees. The effect of
an income tax reduction for workers is illustrated in Figure 14.4.
In practice, the government recognises that this is impossible to achieve for the total labour
market. However it may be possible for particular sections of the labour market which
currently suffer from high rates of unemployment, especially in the markets for lower-paid
and unskilled workers.
If the pattern of income and payroll taxes is changed to reduce the burden on the low-paid
workers, if necessary at the expense of the more-highly paid, the government will be able to
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avoid the criticism often levelled at tax reductions aimed at increasing labour supply. This
criticism is that the supply-of-labour curve is backward-sloping, so that above a given wage
rate, further increases in net wage will reduce rather than increase the willingness to work
(because above a certain income level workers are more likely to prefer increased leisure to
increased income). As long as the government's fiscal measures are concentrated on
helping those whose net wage is below OW in Figure 14.4, which illustrates this concept,
any achievement in increasing the net wage received by workers will raise the quantity of
labour being offered to producers.
Figure 14.4: Effect of an income tax reduction for workers
Wage
rate Supply of labour
O L Quantity of labour
Another aspect of supply-side fiscal policy is to increase the rewards of successful business
enterprise. This is likely to involve a number of fiscal measures, including a reduction in the
higher rates of income tax – i.e. the rates paid by high-income earners, on the assumption
that a high proportion of these will be employers or business managers who are responsible
for making the decisions that determine the level of output and for achieving business
success.
Other aspects of tax reduction may involve granting tax allowances for investment in
business enterprise by individuals, and reducing taxes on wealth and capital transfer. The
latter would be regarded by supply-side economists as penalties imposed on people who
have committed the "crime" of being successful in business, increasing the wealth of the
community and the employment opportunities of others.
Trade Unions and Supply

To monetarists and those accepting supply-side theories, trade unions are generally
regarded as being restrictive, reducing output, business profitability, competitive power, and
increasing unemployment. Therefore any weakening in the power of trade unions might be
expected to increase the ability of firms to survive and expand in competitive world markets,
to make business production more profitable and therefore, desirable, and to reduce
unemployment by allowing more workers to work at wages closer to the market equilibrium
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Encouragement of Competition
Supply-side economists would regard the possession of undue market power by any
organisation, whether worker or employer, as likely to reduce output and efficiency and raise
costs and prices. Competition and the weakening of monopoly power is thus seen as a
desirable objective, likely to lead to increased efficiency and production and, in the long run,
to a higher and more secure level of employment.
The Removal of Bureaucratic Controls over Business

It is a frequent complaint of business managers in many countries, especially developing
countries, that costs have been raised, efficiency reduced, and expansion hindered by the
great range of planning and other bureaucratic controls to which business is subject.
Many controls on business activity are imposed for generally sound social reasons. These
include the protection of the environment and the prevention of indiscriminate expansion of
industrial activity, the protection of workers from exploitation, and the protection of
consumers from unscrupulous or careless marketing and production. A defence can be
made for such measures considered in isolation but, taken as a whole their cost can become
too great. If the general result is to reduce output and employment, then the balance of cost
and social benefit may have swung against the overall interests of the community. The
problem is compounded further in two ways. In some cases the bureaucratic controls and
restrictions benefit private interest groups in society at the expense of the rest, and the
abolition of such restrictions is resisted strongly by those who benefit. The resistance to the
removal of such barriers is often strong in developing countries, where the regulation and
controls create widespread opportunity for bribes and corruption. The other reason why
regulations and bureaucratic controls are damaging is that they can impede necessary
change. The rate of technological progress increases dramatically and new products and
productive processes require significant change in the structure of industry. The use of
controls and restrictions to preserve old industries and ways of production, especially if faced
with increased competition from imports because other countries have embraced the
changes, may appear like a good way of preserving factories and jobs but it condemns the
economy to longer term decline.
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Review Points
relevant sections.
1. List the four main macroeconomic policy problems a country may face.
2. Explain the following terms:
– government budget deficit
– fiscal policy
– monetary policy
– supply side policy.
3. Draw an aggregate demand and supply diagram to show how the government can use
an expansionary fiscal policy to reduce demand deficient unemployment.
an expansionary monetary policy to reduce demand deficient unemployment.
a supply side policy to increase employment and reduce inflation.
6. Explain, with examples, why governments may face conflict between the achievement
of the objectives of macroeconomic policy.
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261
Study Unit 15
The Economics of International Trade
Contents Page
A. Gains from Trade and Comparative Cost Advantage 262

Common Advantages of Trade 262
Comparative Cost Advantage 263
Limitations to the Gains from Comparative Advantage 264
B. Trade and Multinational Enterprise 265

The Multinational Company 265
Reasons for Growth of Multinational Enterprise 265
Consequences of Multinational Enterprise 266
C. Free Trade and Protection 268

Advantages of Free Trade 268
Protection 268
Dangers of Trade Protection 271
D. Methods of Protection 272

Tariffs 272
Quotas 273
Embargoes 274
Voluntary Export Restraints 274
Export Subsidies and Bounties 274
Non-tariff Barriers 275
Exchange Control 275
E. International Agreements 275

Trading Blocs 275
GATT/WTO and the Liberalisation of Trade 278
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262 The Economics of International Trade
Objectives
The aim of this unit, in conjunction with Study Unit 16, is to explain the fundamental
advantages and disadvantages of free trade, including the principles of absolute and
comparative advantage.
 explain, using numerical examples, how gains from specialisation arise
 interpret data on opportunity cost
 identify economic reasons why governments may decide to promote free trade or
impose restrictions on free trade
 explain the impact of free trade on business in developed and/or developing
economies
 discuss the means that can be employed by governments to restrict or promote trade
and evaluate the advantages and disadvantages of employing policies to restrict free
trade.
A. GAINS FROM TRADE AND COMPARATIVE COST

ADVANTAGE
Common Advantages of Trade
Even without any assistance from economic theory, it is not difficult to list some important
advantages from international exchange. Among the more common benefits are the
following.
(a) Better Supply of Goods
Through international trade, a country may obtain goods which it could not obtain
otherwise. For instance Britain could not enjoy tropical fruit or manufactured goods
made of copper, nickel, and many other metals, if it were not for the existence of
international trade.
(b) Lower Costs
A country can obtain goods which it could not grow or produce itself, and it can also
obtain goods which it could grow or produce – but only at higher cost than in other
countries.
International trade, by opening up the whole world for trading purposes, increases the
size of the markets for various goods. Production on a larger scale is then possible,
allowing full advantage to be taken of economies of scale. For instance, if Switzerland
only made watches for its own comparatively small domestic market, the cost of
production per unit would be much higher than it is; in fact, Switzerland supplies many
parts of the world with watches.
(c) Famines can be Prevented
World trade reduces the likelihood of famine and of other results of shortages of
supply, since it is possible to offset temporary domestic shortages by getting additional
supplies from abroad.
(d) A Curb on Monopoly
The existence of international trade is an obstacle to the development of monopolies.
Even if there are monopolies in existence in one country, their control over prices will
be limited by the ever present threat of foreign competition.
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The Economics of International Trade 263
We must recognise that the threat of competition is often weakened by the

development of large multinational companies. Such companies tend to limit world
competition by agreements between themselves, and by their own power to absorb
competitors.
(e) Encouragement of International Cooperation
The existence of international trade also leads to a greater degree of interdependence
between sovereign states, and this should be a factor making for international peace
and friendly cooperation between nations.
Comparative Cost Advantage

In addition to these benefits, economic theory suggests a further benefit that enables us to
explain why countries may buy goods which they could quite well produce for themselves.
However, before examining the concept of comparative costs, we can consider an example
where there are some fairly obvious gains from specialisation and trade.
Let us assume that there are only two countries, A and B, and that these countries produce
only two commodities (disregarding any commodities which could not enter into international
trade), which are wheat and copper.
Assume that, for a given outlay (which might be measured in terms of labour and money):
 A can produce 300 units of wheat and 150 units of copper
 B can produce 150 units of wheat and 100 units of copper.
Country A apparently has an advantage over country B in the production of both wheat and
copper. Both commodities can be produced more cheaply in country A, as with a given
outlay more of each will be produced in A than in B. Will there be any scope at all for
international trade? The answer will be in the affirmative, provided that A's advantage over B
is not proportionately the same for both commodities. A country will thus tend to specialise in
the production of those commodities in which it has the greatest comparative advantage, or
the least comparative disadvantage.
Let us now illustrate this principle with the help of our example. In the absence of
international trade, A will produce 300 units of wheat and 150 units of copper, and for the
same outlay, B will produce 150 units of wheat and 100 units of copper. This makes a total of
450 units of wheat and 250 units of copper. In A the cost of production of wheat is half that of
copper, while in B it is two-thirds that of copper. As A's comparative advantage in the
production of wheat is greater than its advantage over B in the production of copper, it will
pay A to specialise in the growing of wheat and to leave copper production to B.
Suppose B abandons production of wheat and concentrates on copper: then A can make
good the lost 150 units of wheat by transferring half the original outlay from copper to wheat.
This still leaves A producing 75 units of copper, in addition to the increased 100 units of
copper in B. Thus, specialisation in each country has increased copper production without
any loss of wheat. Provided both countries trade with each other to share the increased
production, both can gain from specialisation and trade – and A can gain by reducing its
production of copper and importing from B, even though it is more efficient as a copper
producer.
Table 15.1 illustrates the example just described. Here, the "given outlay in resources" is
assumed to be 20 workers available for producing either commodity.
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Table 15.1: Advantages of specialisation
Country A Country B Total
Product Units Workers Units Workers Units

employed employed
(a) Before specialisation
Wheat 300 10 150 10 450

Copper 150 10 100 10 250
20 20
(b) After specialisation
Wheat 450 15 0 0 450

Copper 75 5 200 20 275
20 20
The same total resources (40 workers) now produce an additional 25 units of copper, without
any loss of wheat.
Limitations to the Gains from Comparative Advantage

It is sometimes argued that because of comparative advantage, there will always be gains
from international trade, and that such trade should be freed as much as possible from
government rules or restrictions. Before accepting this, we should remember that there can
be general gains from increased specialisation and international trade only if:
 production factors, including workers, are able to move from one activity to another
within each country – i.e. there is factor mobility within countries
 no factors are left unemployed and unproductive as a result of the movement resulting
from increased specialisation
 there is a demand for the increased product made possible by changes
 there is no movement of production factors between countries.
For instance in the example just given, if the advantage of country A arises out of superior
managerial skill, then the greatest gains might be achieved by exporting managers from A to
B and improving the standard of production in B.
These are very important qualifications, and they do not always hold good under modern
conditions. Production today is often highly specialised, and it is difficult – and sometimes
impossible – to transfer resources (including workers) from one activity to another within a
country. Machines are often built for one purpose only, people may take years to retrain, and
unions are often hostile to movement. Many people displaced from one activity are just not
able to learn the skills required for another (expanding) activity. In these circumstances, it is
not unusual to find high unemployment in some sectors of production and a shortage of
workers in another.
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B. TRADE AND MULTINATIONAL ENTERPRISE

The Multinational Company
The traditional theory of international trade based on the concept of comparative cost
advantage now requires some reconsideration. There is no general agreement on a precise
definition of a multinational company. For our purposes, we can regard it as any company
which produces goods and/or services in several different countries. The company must own
and directly control production facilities in the various countries. This is often referred to as
"direct investment" overseas, and it is in contrast to "portfolio investment", where the home
company simply owns shares or loan stock in foreign enterprises, and does not directly
control their activities.
The term "multinational" usually conjures up an image of a very large company – indeed, the
leading multinationals are giant enterprises. These include the oil producers and the mass-
production motor manufacturers. On the other hand, there are many small companies which
operate across national boundaries and take advantage of modern communications.
There are multinational companies owned and directed in many different countries, but the
majority are American, European or Japanese owned. Until recent years Japanese
companies preferred to concentrate production in Japan and export to the rest of the world,
but as a result of several trends and pressures they have now started to take the
multinational path to expansion.
Reasons for Growth of Multinational Enterprise

There have been some large world scale producers for a long time. The British Hudson Bay
Company and the British and Dutch East India Companies were large organisations as early
as the eighteenth century. However, these grew out of trading enterprises. Worldwide
manufacturing is a development that belongs more to the twentieth and twenty-first
centuries, and especially to the period after the Second World War.
There are many reasons for this development. Among those most commonly put forward are
the following.
(a) Improvements in Transport and Communications
In a world of air travel and international telephone, fax and telex links, it was possible
to retain control over the day-to-day activities of a worldwide enterprise in a way that
would have been impossible in earlier times.
(b) Efficient International Capital Markets
An international banking system has developed with the growth of world trade and the
spread of European influence in other continents. Bankers are often anxious to finance
local branches of the large worldwide companies, sometimes in preference to more
risky local business. Restrictions on capital movement from countries such as the USA
and the UK in the 1950s and 1960s also tended to ensure that money earned in
foreign countries was kept abroad to finance foreign direct investment, because if it
returned home it was likely to be kept there by government controls.
(c) Encouragement by Developing Countries
The developing countries in Africa, Asia and South America offered growing markets
for a wide range of goods. Many encouraged the entry of foreign manufacturing
companies as a means of speeding up national industrial development and of earning
much needed foreign currency from industrial exports.
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(d) Rising Costs and Production Difficulties in the Industrial Nations

Growing state intervention, the rise of trade union power and rapidly increasing wage,
land and other production costs in the USA and Europe encouraged many companies
to look to investment opportunities in developing countries. In such countries costs
were lower, and there was much less resistance to the introduction of new machines
and working methods.
Japanese companies have also been influenced by increasing production costs
(especially wage costs) within Japan, and have established production divisions in
other countries in both Asia and Europe.
(e) Product Life Cycle
If a company builds up a large export trade for a product, and if that trade is directed
towards countries whose development is a little behind that of the home country, the
time is likely to come when the export market in the developing countries is larger than
the domestic market in the country of manufacture. By this time in the life of the
product, it is probable that competition is developing from firms situated inside or
closer to the export market, and the home market may also be starting to decline. It
may well be that the production facilities will need replacing.
At this stage, the manufacturer is likely to consider setting up new production facilities
(factories and machines) in the developing countries, where markets are growing. The
remaining market at home can be fed from imports from the new factories.
In practice, some or all of these influences may be operating at the same time. The
more influences that do bear on an industry, the greater the likelihood that it will
become multinational in character.
(f) Trade Barriers
Some countries and groups of countries discourage imports by tariffs and other trade
barriers. The European Union (EU) has established free trade between members, but it
has many barriers to trade with non-members. It has been particularly restrictive
against agricultural imports from developing countries.
Consequences of Multinational Enterprise

Multinational enterprise involves a transfer of production capacity from one country to
another. It has consequences for the home country of the multinational company, the host
countries where new enterprises are established, and for the whole pattern of international
trade and production.
(a) Consequences for the Home Country
If a British manufacturing company decides to locate a new factory in Brazil rather than
in England, then England loses the investment to Brazil. From the British point of view,
this is called "divestment" – i.e. the loss of productive investment. The decision may
mean a loss of some capital. However research indicates that much foreign investment
takes place with the help of locally raised capital, and that the amount of finance
exported, even to developing countries, is relatively small.
In the home country there is a loss of production work and jobs are lost. Most of these
jobs are likely to be in the routine work of manufacturing – the unskilled and semi-
skilled jobs and the work of supervision. The more highly skilled work of research,
planning, marketing, etc. is still likely to be controlled by the home headquarters of the
multinational company. Home country nationals are also likely to be asked to fill
managerial and skilled technical jobs in the overseas country. It is possible that there
are now more British people working overseas than there were in the days of the
British Empire. The American and Japanese multinational companies are even more
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likely than the British to ensure that managerial and technical posts are filled by their
own nationals.
Another consequence of divestment for the home country is that visible exports fall and
visible imports rise. Invisible earnings rise, as the overseas sections of multinationals
pay fees and royalties for patents and services, and remit profits to the home country.
Of course profits go to the owners of capital – insurance firms and funds – and do little
to make good the loss of jobs suffered by industrial workers. There is also a good
chance that the profits will be reinvested in further foreign production, and not used to
develop business at home.
(b) Consequences for the Host Country
The host country gains jobs and some capital investment. If local capital is raised, then
this is denied to the country's own domestic industry and commerce. The country also
gains export earnings and saves some import payments, by having producers of
products for world markets within its own economy. There is some doubt whether it
gains the full value of production though, because the home part of the multinational
company will require heavy payments for technical and managerial services, as well as
a substantial share of profits. It is notable that the group of what are now called the
"newly industrialised countries" (Korea, Greece, Hong Kong, Mexico and others)
nevertheless still have a balance of payments deficit with the advanced industrial
countries. This is in spite of gaining a substantial share of world production of a
growing number of industries (textiles, shoe manufacture, electronic equipment).
It is frequently claimed that host countries gain benefits from importing managerial
skills and technical know-how. There is certainly some transfer of managerial skill and
technology but this can be exaggerated, especially where the majority of skilled
functions are kept for nationals of the home country, and where the home country
retains full control over all research and development.
It will be in the interests of the multinationals to keep factor costs low, and for labour to
be non-unionised. This means they will not encourage the development of domestic
industries which may prove to be competitors, both in selling products and as
employers of production factors. If factors (especially wage costs) do start to rise, then
the multinational may be able to transfer production to another country, leaving the
original host country worse off than before.
(c) Consequences for International Trade
There is no doubt that the growth of multinational enterprise has changed the pattern
of international trade. Visible trade is no longer a matter of a flow of basic materials to
the western industrialised countries and a counter-flow from them of manufactured
goods. Manufacturing is now carried out in a very wide range of countries, though
much of it is still controlled by and relies on technology supplied by the advanced
industrial nations.
Even more important perhaps, is that the multinational companies have shown the
importance of factor transfer between countries. Consider again the example of
specialisation based on comparative advantage given earlier in this study unit. You will
see that the whole process is transformed if we allow for the possibility that A's
superiority in the production of both products is the result of superior managerial skill,
and that this skill could be transferred from country A to country B. We cannot then
predict the result of the transfer, because this will depend on which industries are
affected, and on which terms the transfer takes place.
What we can say is that multinational enterprise on a large scale further undermines
the theory of comparative cost advantage as the basis for international trade and
exchange. Multinationals will locate in those areas where costs will be lowest for
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themselves in absolute terms. They are not concerned with the domestic comparative
or opportunity costs of local factors they employ. They will seek that combination of
local and "transported" factors (managerial skill and technology) which will give the
production levels required at minimum cost. This is likely to mean that some parts of
the production process will take place in one country and some in others. We can now
see the association between the growth of multinational enterprise and the trade in
semi-manufactures, much of which is intra-company trade – i.e. transfer between
sections of the multinational companies.
C. FREE TRADE AND PROTECTION

Advantages of Free Trade
The principle of comparative advantage shows that free trade and specialisation brings gains
to the participating countries. So long as a country has a comparative advantage in
producing something it can benefit from specialising in its production, and trading the surplus
over home consumption for other materials and products from abroad.
The advantages of free trade can be summarised as being that:
 countries can specialise and increase production safe in the knowledge that they can
export their surplus
 resources are allocated efficiently
 countries can export surpluses and import what they need
 countries gain economies of scale from access to the world market
 competition from imports increases efficiency and limits the creation of monopolies
 free movement of capital allows countries to develop their industries
 political links develop between countries.
The factors of production are immobile. Land, most labour and invested capital cannot move
between countries. Only enterprise, uncommitted capital and some labour can move to
where the other factors are abundant and production can be organised. Free trade
overcomes the immobility of factors: it permits the free movement of the product of immobile
factors so that countries worldwide can benefit from an abundant factor endowment in any
place.
Access to the global market is essential for developing countries if they are to achieve
economic growth. Trade with the developed economies would give the developing nations a
large market for their goods and the opportunity to import new technology. Firms could gain
economies of scale and new techniques; competition would increase efficiency; monopolies
are avoided. Production for export helps to diversify the economy: it reduces dependence on
what is often a single crop subject to disasters, like sudden frosts which halve the output of
coffee.
Protection
All trading nations engage in some form of trade protection, as governments have to face
political pressures from powerful domestic interest groups. At the same time they are often
reluctant to admit that they are imposing barriers, so they may avoid the formal measures
that would invite retaliation and invite censure from the World Trade Organisation (WTO).
Instead they make use of a variety of devices to delay imports or make them more
expensive. These include cumbersome import procedures with complicated documentation
or "safety measures" with a dubious safety value.
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At the same time the more formal measures still survive, and are employed by individual
countries and regional groups such as the European Union. The main such measures are:
 import tariffs, also known as customs duties, which are taxes imposed on goods when
they enter a country or one of a group of countries such as the EU, which contrast with
 import quotas, which are quantitative restrictions on the import of goods.
We examine these and other forms of protection in the next section of this study unit.
The belief that free trade (trade free from imposed restrictions) should be encouraged as
much as possible is linked closely to the theory of comparative cost advantage. However, the
benefits of comparative advantage have been shown to depend on the existence of
competitive markets, absence of monopoly power, full employment, and ready factor transfer
within countries and no factor transfer between countries. Instead of this, we have a world
economy dominated by the monopoly or oligopolistic power of the large multinational
enterprises. Few industries approach anywhere near the conditions of perfect competition,
domestic economies are highly specialised, there is large-scale unemployment and little
factor transfer within countries but important transfers between countries. In these
conditions, we have to ask whether the case for free trade should be questioned and that for
import controls looked at more seriously.
If a country does decide that, in its own case, the possible benefits of controls outweigh the
dangers, the following arguments can be advanced in favour of the use of protectionist
measures.
(a) Protection of "Infant" Industries
"Infant" industries need protection from foreign competition until they become strong
enough to stand on their own feet. They are those industries which are being
introduced to a country where the industry has not previously been present. The
absence of external economies makes the costs of production high for new industries.
In other countries, which are in competition with the country imposing the duties, the
industries are already in existence and are therefore enjoying external economies of
scale. As the infant industry grows, skills and productivity, as well as external
economies, will grow also, so increasing the industry's relative competitive advantage.
Domestic pressures for protecting home industries are always greatest in periods of
economic recession and high unemployment, as in the early years of the 1990s. There
are also many people within the EU who would like to try and avoid the challenge of
the emerging industrial nations of Asia, by erecting high barriers against the entry of
goods from non-EU countries. On the whole, the opponents of increased trade
protection have managed to contain the protectionist pressures, while the
establishment of the WTO should ensure that these temptations will continue to be
resisted and that further progress will be made towards reducing the present barriers.
(b) Protection against Dumping
It is sometimes suggested that measures are needed to protect a country against the
dumping of foreign goods. "Dumping" means the application to international trade of
the methods of a discriminating monopoly. Goods are sold abroad at a lower price than
at home. This is done partly in order to avoid swamping the home market with a surfeit
of goods which would bring down home prices, and partly in order to kill off foreign
competition by undercutting it on its own markets. The alternative is "stockpiling",
which means the goods may be released in times of need, or sold over a number of
years under a controlled agreement. Dumping is generally looked upon as an unfair
trading practice, and for that reason industries fearing competition from dumped goods
ask for tariff protection.
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Here again some objections may be raised. The main objection is that many
industrialists begin to complain if they have to face competition from foreign goods
which are cheaper than their own. However this does not represent dumping if the
exported goods are sold at the same prices at which they are available in their home
markets. The home producers may simply be inefficient. Also, when dumping takes
place, the imposition of protective duties may be too slow a weapon, since by the time
the new duties have been introduced, the dumped goods may already be in the
country.
(c) Increase in Employment
Controls cut imports and therefore there may be an increased demand for home-
produced goods, and a resulting increase in employment. Income is directed away
from foreign exports and towards domestic producers. On the other hand, if there is
already full employment at home, such measures will tend to be inflationary in their
effects.
(d) Improvement of the Terms of Trade
The imposition of import duties may lead to an improvement in the terms of trade,
particularly where the goods taxed are in inelastic supply and elastic demand.
(e) National Security
Key industries, such as agriculture and those producing goods which are important for
the defence of the country, must be maintained for security reasons. A wide diversity of
industries is important to a country, as it renders it independent of foreign supplies
which may be jeopardised in the event of war.
(f) Improvement of the Balance of Payments
This point has also been discussed already. However you should remember that the
balance of payments is not only concerned with imports but also with exports, and the
government will have to consider what effect the imposition of protectionist measures
by a country will have on that country's exports.
(g) Possibility of Shifting the Burden
This is a hope which concerns any tax – i.e. that someone else will pay it. We have
shown that this is likely to happen only if the foreign country's need to supply us is
much greater than our own need to acquire that country's goods. This will be the case
where foreign supply is inelastic – i.e. does not respond readily to price changes –
while our demand for imported goods is elastic. If the higher price resulting from the
imposition of import duties were to be passed on to the home consumer, purchases
would drop substantially and the tendency would be to make up for the higher duty by
reducing the import price of the commodity. If the price to the consumer in the
importing country rises by less than the full amount of duty, the balance of the duty has
in effect been borne by the exporter, in the form of a lower price received for the
exported goods.
(h) Equalising the Costs of Production
It is sometimes suggested that competition from foreign producers who enjoy lower
production costs is unfair, and that import duties should be levied at rates which would
equalise costs, so that foreign and home producers would then compete on equal
terms. This argument is quite nonsensical. International trade takes place just because
there are comparative cost differences between different countries. If every country
were to impose duties equal to existing cost differences, international trade would
practically disappear.
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There is also a practical argument against the theory just outlined. Cost differences
may refer to one of two things: they may refer to basic costs (i.e. differences in wage
rates, rents or interest rates) or they may refer to total costs.
For instance, the fact that wages in a certain country are lower than in the United
Kingdom does not necessarily mean that either wage costs or total costs in that
country are lower than in the UK. It might be that labour is less efficient than UK labour,
or it may be wastefully employed. Moreover labour is only one factor of production, and
its productivity usually depends on both managerial skill and the availability of modern
capital equipment. Countries with low wage costs are often short of capital, so that
finance and equipment are frequently scarce and expensive. Countries with high wage
costs, but with high levels of labour and managerial skills and ready access to capital,
need to adopt different production methods from those applied in low wage cost
countries.
Dangers of Trade Protection

The case against import controls is based on the following factors.
(a) Continued Faith in the Benefits of Free Trade Based on Comparative Cost
Advantage
It can be argued that multinational enterprise, unemployment and specialised
production represent modifications and imperfections only, and do not change the
fundamental truth and importance of the benefits to be derived from international
specialisation and trade. According to this view, efforts should be made to reduce the
harmful effects of these – including efforts to reduce the monopoly power of large
multinationals – and to increase trade, not to interfere with it.
(b) The Fear of International Retaliation
If all countries sought to reduce, and impose barriers against, imports, total trade and
production would fall, and unemployment would increase in all countries. Far from
being a cure for unemployment, the spread of protectionism would increase it.
(c) Reduction in Industrial Efficiency
Those who believe that competition is the main incentive to business efficiency fear
that protecting domestic industry against foreign competition would make firms less
able to compete in world markets. The longer controls lasted, the more they would be
needed, and the country would lose the variety of products provided by imported
goods. Its standard of living would fall with this loss of choice, as increasingly inefficient
firms required more and more resources to produce less and less.
Those who favour import controls argue that the case for free trade based on comparative
advantage has been weakened, as already explained. They also argue that controls are no
more harmful to world trade than the other measures which have been used in the past to
correct balance of payments deficits, and much less harmful to domestic production. They
may even be less harmful than deflation and devaluation, because they can be more
discriminating. Deflation harms all forms of production. Deflation also damages domestic
industry by reducing total demand, and this tends to harm some industries more than others.
When demand rises again, these industries may not be able to recover, with the result that
imports rise to an even greater extent than before. Successive deflations produce ever-
increasing imports.
Import controls can be applied more heavily in those industries where the home firms are
weakest and, it is argued, help them to recover their lost markets. Where home industries
have been completely lost or very seriously weakened by past policies, it is suggested that
state aid may be necessary to bring about recovery. In these cases, continued protection
would be needed until they were strong enough to compete again in world markets.
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Supporters of import controls argue that as the total effect is no worse than other measures
to reduce balance of payments deficits, there is no reason why the danger of retaliation
would be any greater. They also suggest that controls have the effect of reducing the
propensity to import rather than the absolute level of imports, and so allow the economy to
expand more readily. Any reduction in the marginal propensity to import will increase the
value of the national income multiplier. An expanding economy could actually permit more
total imports – rather than less – as a part of increased total consumption.
D. METHODS OF PROTECTION
A country which has nevertheless decided to restrict the freedom of international trade can
use many methods. The main methods of protection are:
 tariffs (customs duties)
 quotas
 embargoes
 voluntary export restraint (VER)
 export subsidies and bounties
 non-tariff barriers applied through safety rules and administrative controls
 exchange control.
Tariffs
Tariffs – or customs duties – are taxes on imported goods and so of course they raise money
for the government. The object is to raise the cost of the imported goods so that importers
have to raise prices or accept reduced profits. The imports thus suffer a competitive
disadvantage compared with home produced substitutes. The tariff raises the price paid for
the imported good by the domestic consumer and reduces the quantity purchased. Thus
domestic producers supply more to the market, and foreign suppliers provide less than if
there were no tariff.
Customs duties may be imposed by a specific duty of so much per item or per tonne or ad
valorem (by value). Specific duties work best for goods of low value and high weight, such as
iron. Ad valorem duties obviously have more impact as goods increase in value, so they are
best applied to items like jewellery and those whose prices change often.
The amount received by foreign exporters may be the same or less than before the tariff
depending on the elasticity of demand. The more price elastic is the demand for the product,
the more the producers have to absorb the effect of the tax to prevent a loss of sales which
would cause them a loss. The effects of a tariff are shown in Figure 15.1.
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Figure 15.1: The effects of a tariff
Price
Domestic Domestic
demand supply
World price
 tariff
a b c d
World
market price
1 2 3 4
Q Q Q Q
Quantity
The gross cost to consumers of the rise in price caused by a tariff is the sum of the areas
abcd
where:
 a represents a redistribution of income from consumers to producers
 b is the production cost arising from the misallocation of domestic resources
 c is the tariff revenue paid by consumers to the government, and
 d is the loss of consumption in the country imposing the tariff.
Areas b and d added together give the net costs of tariff protection to the economy. Tax and
the additional domestic supply remain in the economy.
Not only do consumers pay a higher price and buy less, but there is also some loss of
economic welfare because they are forced to buy the domestic product, which restricts their
choice.
Quotas
Quotas are restrictions on the quantity of a product which can be imported.
While the purpose of protective customs duties is to restrict the import of goods by making
them more expensive to the home consumer in order to persuade consumers not to buy
them, the purpose of import quotas is to lay down the exact quantity of a commodity which
may be imported in a given period of time. Import quotas may, but need not, be
accompanied by customs duties. If they are, it means that the limited amount of goods which
may be imported is subject to the duty as well. Quotas first came into prominence during the
1920s and 1930s, but they have also been widely used since the Second World War.
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The reasons why some countries prefer to substitute quotas for customs duties or to
strengthen protective duties by quotas are as follows:
(a) Protective duties are sometimes considered to be insufficiently protective. This is
particularly the case where the duty is a specific one rather than one related to the
value of the imported goods. A specific duty is one which is imposed at so many pence
(or pounds) per unit of commodity. At a time of quickly rising prices the specific duty
becomes a declining proportion of the price of the commodity, and so loses much of its
protective value. Frequent changes in the rate of duty may be difficult to administer,
and would also lead to strong protests from the countries importing the goods. Thus a
quota appears to provide the simplest solution to the problem.
(b) Quotas may generally be altered by administrative means – e.g. by an order by the
Department of Trade and Industry. On the other hand customs duties are taxes, and as
such they are subject to parliamentary control. If it is desired to strengthen or to relax
protection, a change in customs duties might be hotly contested in Parliament, while a
change in quotas could be brought into effect without much ado.
(c) Many pre-war international trade agreements expressly prohibited the participating
countries from changing their existing customs duties, and the imposition of quotas
was one way of getting round this restriction.
(d) Quotas also lend themselves admirably to a policy of discrimination. With customs
duties, the same rate of duty will normally be payable on goods of a certain kind,
irrespective of the country from which they come. A country wishing to reduce the
volume of its imports may wish to cut down imports from a particular source – e.g.
because the country concerned has a so-called hard currency, i.e. a currency which is
in short supply. This end may be achieved by a quota scheme under which different
countries are allocated different quotas, the quotas for goods from countries with soft
currencies being rather more generous than those for countries with hard currencies.
(e) An occasionally heard (if mistaken) argument in favour of quotas is that quotas, unlike
customs duties, will not lead to higher prices. This argument is wrong because, if a
quota is effective in the sense that it lowers the supply of certain imported goods, these
goods will then be in scarce supply in relation to the demand. This situation will
inevitably lead to higher prices.
Embargoes
An embargo is a total ban on imports or exports, usually applied for political reasons. A
recent example is the United Nations embargo on exports of armaments to Iraq and on oil
exports from Iraq.
Voluntary Export Restraints

VERs are quotas operated by exporting countries. They are usually applied to avoid the
more severe effects of government imposed tariffs and quotas. Thus Japanese car
manufacturers operate a VER on car exports to the UK and the EU. A VER tends to prevent
new firms from entering the export market. The permitted exports tend to be the more
expensive versions of goods, as this earns the most profit from a restricted quantity.
Export Subsidies and Bounties

These can be of the visible type, where a bounty is paid to exporters by the government
according to how much they send abroad. WTO rules generally forbid bounties, so hidden
subsidies tend to be provided instead. For example, exporters get government insurance
against political and commercial risks at very low rates, tax concessions on equipment used
for making exports and help with borrowing to finance export production.
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Non-tariff Barriers
This is a term used to cover a multitude of measures applied to restrict imports, especially
where countries cannot use tariffs and quotas because they belong to WTO or a free trade
area. They include oppressive safety measures, like the USA requirement for destructive car
tests, which would require the whole annual output of a small specialist manufacturer to be
crashed. France attempted to keep out Far Eastern video recorders by insisting they went
through one small, remote customs post where there were bound to be very long delays in
clearing them. In the 1970s Britain required importers to pay an advance deposit on all
goods: this imposed an extra borrowing cost and pushed up the price of imports. Around the
same time the UK had two rates of VAT: the higher rate applied to goods like motorbikes
which were mostly imported.
The term is also applied, when discussing trade liberalisation, to all restrictive measures
except tariffs. This is because tariffs are the only measure to be visible and measurable with
accuracy. Agreements to reduce tariffs are pointless if duties are replaced by other measures
which are difficult to police.
Exchange Control
Control is enforced in many countries by requiring all buying and selling of foreign exchange
to be done through the central bank; the currency is not convertible into other currencies of
the holder's choice. The government can then allocate foreign exchange to whichever
activities it considers should have priority. This is effectively the same as a quota and is
subject to the same dangers. Governments can avoid some of the problems by auctioning
off foreign exchange, as was done in Nigeria. The amount released to auction is determined
by the state of the balance of payments. Governments have also set multiple exchange rates
– for example the South African rand had a commercial and a financial rate until 1995 – and
they can alter the value of the currency to make exports cheaper and imports dearer.
In recent years many governments have recognised economic damage done by exchange
and capital controls, as well as their ineffectiveness in achieving what they were intended to
achieve, and abolished them either completely or in large part. This is especially true of the
world's developed countries and newly developed countries. The important exceptions
amongst the world's rapidly developing countries in 2008 are China and India. However, both
China and India have relaxed their controls, and indicated their intention to move to even
greater freedom of currency and capital mobility.
E. INTERNATIONAL AGREEMENTS
Trading Blocs
Countries can join together in several different ways to obtain the benefits of free trade
among themselves while keeping others out. What is included in the agreement depends on
the political will of the members; they may be unwilling to expose agriculture to competition,
or to accept the full degree of international specialisation which goes with completely free
trade. Giving up some control of their national economies makes it difficult for countries to
enter into these agreements.
There are effects on the direction of trade – some countries benefit and others lose. These
blocs all have tariff walls which discriminate against imports from non-members. Trade may
be diverted by the tariff from a low-cost producer country which is a non-member to a high-
cost member state. The effects of trading blocs have to be carefully evaluated to see if they
really do benefit the citizens of the member countries, and not just protect inefficient
producers.
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(a) Types of Bloc

The types of international integration are as follows.
 In preference areas countries agree to levy reduced or preferential tariffs on
imports from qualifying countries. The EU operates a system of preferences
through its Association Convention, covering the former colonies of member
countries.
 Free trade areas are where the members abolish tariffs on trade between
themselves, but each country keeps its own tariff on imports from outside the
area. This makes it necessary to have rules of origin to prevent imports being
brought in through the lowest external tariff country. The North American Free
Trade Area and the Association of South East Asian Nations are examples.
 Customs unions have free trade within the area with a common external tariff.
 Common markets are customs unions with additional measures to encourage the
mobility of the factors of production and capital. The EU opened its common
internal market on 1 January 1993. Citizens of the member countries can live
and work anywhere in the EU, capital can move freely and there is a continuing
programme of harmonisation of standards and regulations to permit the free flow
of goods and services. The 1991 Maastricht Treaty agreed to a programme to
move to economic and monetary union and to take the first steps towards
political union by agreeing common foreign policies. Since 2003 the single
European currency, the euro, has replaced the previous national currencies of
the 15 member countries of the eurozone.
(b) Effects of a Bloc
Creating a trade bloc has two major effects:
 Trade creation – when a country which previously placed tariffs on imports from
another member and produced the goods itself switches to buying such goods
from another member country, this creates trade (although it may cause
structural unemployment).
 Trade diversion, when the removal of barriers inside the bloc results in trade
being switched from a more efficient producer outside the union to a less efficient
one inside.
In addition to the benefits of trade creation, there are other benefits from setting up a
free trade area:
 Economies of scale develop because the member countries now have a much
larger "home" market.
 Specialisation in products having a comparative advantage creates greater
opportunities of economies of scale.
 Greater efficiency is enforced because the members' industries are exposed to
more competition.
 Consumer welfare is increased as people have more, better quality and cheaper
goods, with more variety, to choose from.
 There is more political cooperation as the member countries develop common
policies and become more dependent on each other.
Against this must be set loss of political and economic independence, because the
countries must take into account the policies and rules of the bloc when deciding their
own policies.
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The larger the trading bloc the greater the potential benefits, because of the better
chance of including the lowest cost producer and the bigger opportunities for
economies of scale. There will be more opportunities for trade creation, whereas there
will have been a lot of duplication, and large cost differences, between the production
of the members before the union. There will be more to be gained from specialisation.
This is especially the case when there were high tariffs before the union; there would
then have been a lot of domestic production for relatively small markets. The lower the
external tariffs imposed by the union the better, as this reduces the possibilities of
trade diversion.
(c) Monetary Union: the Single European Currency
As early as 1970 the (then) EEC had a plan and a programme aimed at achieving
economic and monetary union by 1980. By 1974 the attempt had failed, although the
development of the European Monetary System (EMS) in 1979 gave a new impetus to
monetary union and, until its breakdown after 1992, the monetary discipline it imposed
appeared to bring the economies of the Member States closer to convergence.
The Maastricht Treaty laid down rules and a timetable for monetary union through a
series of stages, culminating in the establishment of a common currency and
associated financial institutions and policies. The key stage was reached in 1998 with
confirmation of the countries meeting the convergence criteria, and EMU started on 1
January 1999. The convergence criteria were that:
 planned or actual government budget deficits should not exceed three per cent of
GDP at market prices
 the ratio of total government debt should not exceed 60 per cent of GDP at
market prices
 one-year inflation rates must be within 1.5 per cent of the three best performing
economies
 one-year long-term interest rates must be within two per cent of the three best
performing economies
 currency of Member States must have remained within the narrow ERM band for
the two previous years without devaluation.
Some softening of the requirements in the treaty, allowing for the debt ratio to be
reducing and for the annual deficit to be ignored if it is temporary, enables more
countries to meet the criteria. (Ironically, Britain – which has reserved the right to opt
out and hold a referendum on future membership – is one of the few nations able to
meet all the criteria.)
The European Central Bank, located in Germany, took over from the European
Monetary Institute and became responsible for monetary policy as part of the
European System of Central Banks (ESCB), the other members being the national
central banks. The European Central Bank has to ensure that the ESCB carries out the
tasks imposed on it by Maastricht, namely:
 to define and implement the monetary policy of the EU
 to conduct foreign exchange operations
 to hold and manage the foreign exchange reserves of the Member States of the
EU
 to promote the smooth operation of the payments system for cross-border
monetary transfers
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 to contribute to the smooth conduct of policies concerning prudential supervision

of credit institutions
 to ensure the stability of the financial system.
The jury is still out on the success of European Monetary Union and the euro. The role
and status of the euro on the world's money markets since its introduction as a full
currency in 2003 has gradually improved, so that it now rivals the US dollar as a major
international currency. It did not fare well in value against the US dollar over the early
years of its existence, although its loss of value against other currencies made
euroland highly competitive against other countries. However since 2005, it has risen
in value against the US dollar and other major currencies.
There have been undoubted benefits to industry and commerce for the euro-using
countries of the EU, with the problems and costs of doing business in two currencies
disappearing. This has had the expected incentive and led to increased inter-regional
trade between the euro-using countries.
The main unresolved policy debate has been over the implication of a single currency
for fiscal policy, and the need to maintain fiscal discipline and integrate fiscal policies.
This implies that countries have to give up much of their control of their individual
economic policies. France, Italy and Germany have all broken the requirement for
fiscal discipline and exceeded the maximum permitted figure for the ratio of
government budget deficit to GDP. In addition several countries, especially France,
have tried to compromise the independence of the European Central Bank by bringing
pressure on it to relax its policy stance against inflation.
GATT/WTO and the Liberalisation of Trade

In 1944 the 23 countries which established the United Nations met at Bretton Woods. Their
purpose was to set up three new bodies with the objective of improving the workings of the
international economy after the war. These were the International Bank for Reconstruction
and Development (the World Bank), the International Monetary Fund (IMF) and the
International Trade Organisation. The first two of these were approved:
 The World Bank has funded major projects, social development and private
enterprises in developing countries, by using the capital subscribed by the member
countries as collateral for its borrowing.
 The IMF holds substantial resources, paid in members' subscriptions, which can be
used to help countries with balance of payments difficulties. Its establishment
represented an amazing transfer of sovereign powers by countries to an international
body – during the period of fixed exchange rates up to 1972, it was given control of
exchange rates.
However the International Trade Organisation was too much for the 23 countries to accept –
they would not give up sovereign power over their trade. The result was the General
Agreement on Tariffs and Trade (GATT), which has no controlling powers but has attempted
to get countries to agree to liberalise trade through a series of conferences.
Trade liberalisation has been carried forward in a series of GATT Rounds (talks) which
started in 1947 and reached the eighth (the Uruguay Round) in 1986. By that time, the
average level of tariffs had been reduced from 40 per cent to 7 per cent. GATT had also had
considerable success in ending trade discrimination, but several problems remained where
major countries and groups had entrenched positions.
There are now over 100 members who agree to abide by the "most favoured nation" rule,
which means that one member that grants trade concessions to another agrees to extend
them to all members of GATT.
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Since it started in 1986, the Uruguay Round continued in a series of meetings, but by 1993 it
had failed to make progress on certain vital areas. These included agricultural subsidies and
protection for textiles, which are of interest to developing countries, and intellectual property
(patents, etc.) and trade in services where the developed countries wanted protection.
However there was a last minute agreement in December 1993 which went far beyond
anything which could have been expected in 1986. The new deal came into force in 1995,
eliminating tariffs on 40 per cent of manufactured goods and reducing others substantially.
Non-tariff barriers were also reduced and a new transparency in international protection
established, as easy-to-hide non-tariff barriers were replaced by published tariffs. A new
framework of rules on subsidies, trade restrictions and public purchases was agreed,
agriculture was brought fully into GATT for the first time, and trade in intellectual property
was also covered for the first time, giving protection to patents, copyright and trademarks.
The French managed to exclude audio-visual services from the deal and the USA was
unwilling to permit the inclusion of maritime services. Financial services were only partly
liberated, with a reciprocity rule applying between countries, so that any liberalisation by one
partner has to be matched by the other.
Despite these limitations, the agreement represents the largest ever liberalisation of trade
and is expected to make the world $6 trillion wealthier – developed countries benefit from the
removal of barriers to services, and developing countries benefit from freeing trade in
agriculture and textiles.
For the longer term, the most significant development may have been the transformation of
GATT into the new World Trade Organisation in 1993, with real powers to police protective
practices. The WTO was immediately faced with a trade dispute between America and
Japan over trading practices, and another between America and China over intellectual
property, and has been dogged by disputes about the influence of developed countries and
multinational companies, and under-representation of the interests of developing countries.
This has meant that further trade liberalisation has been limited, although a major agreement
on telecommunications was concluded in 1997. However, the most significant development
since 1997 has been the granting of full membership of WTO to China, and the dramatic rise
of China to become one of the world's leading exporters of manufactured goods.
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Review Points
each of the objectives completely, you should spend more time rereading the relevant
sections.
1. Explain the meaning of comparative advantage.

2. Explain the meaning of absolute advantage.
3. Outline the benefits of free trade.
4. What are the arguments that may be used to justify restrictions on trade between
countries?
5. What is the difference between a tariff and a quota when used to restrict international
trade?
6. A country that currently use tariffs and quotas to restrict international trade announces
that it is going to abolish all barriers to international trade and allow completely free
trade. Explain the possible economic benefits of the new policy if foreign firms decide
to invest in the country by building new factories.
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281
Study Unit 16
National Product and International Trade
Contents Page
A. International Trade and the Balance of Payments 282

Trade Revenues and the National Income 282
The Balance of Payments Accounts 286
Structure of the Accounts 286
B. Balance of Payments Problems, Surpluses and Deficits 289

Current Balance Surplus 289
Current Balance Deficit 290
Causes of a Persistent Current Balance Deficit 290
C. Balance of Payments Policy 293

Devaluation or Depreciation 293
Deflation 294
Import Controls 295
Need for a Healthy Business System 295
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282 National Product and International Trade
Objectives
The aim of this unit, in conjunction with Study Unit 15, is to explain the fundamental
advantages and disadvantages of free trade, including the principles of absolute and
comparative advantage.
 explain how the various measures of the external account (for example, current
account, capital account, balance on visible trade) are constructed
 describe the different factors which determine the state (surplus/deficit) of these
accounts.
A. INTERNATIONAL TRADE AND THE BALANCE OF

PAYMENTS
Trade Revenues and the National Income
We now return to our basic model of national income. Remember our proposition that:
total expenditure  total spending  total product
In a closed economy, where there are no foreign payment transactions (or where these are
ignored):
 total income can be expressed as Y  C  S  T, and
 total expenditure, which also represents total demand (the desire to spend), can be
expressed as E  C  I  G
where:
Y  national income
C  consumer spending
S  household saving
T  taxation
E  total spending
I  business investment and
G  government current capital spending
From these propositions, we saw that when national income and expenditure are in
equilibrium – when total spending demand equals total production and income – then,
because C features on both sides of the national income/expenditure identity,
STIG
If the government pursues a balanced-budget policy, then this will force savings towards
equality with investment.
When we open up the economy to take into account foreign payment transactions, then this
pattern has to be modified. If for simplicity we ignore non-trading transactions in international
payments, then we can limit our consideration to the production of goods and services.
Some of these will be produced at home and give rise to domestic factor incomes (exports),
and others will be produced in other countries and bought at home (imports). Thus, some
part of total income will be leaked away through spending on imports, while total spending
demand will be augmented by the expenditure of foreign people on a country's exports.
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National Product and International Trade 283
Imports are therefore a leak from the circular flow of economic activity, while exports can be
regarded as an injection.
Using the symbol M for imports (because I has already been used for investment) and X for
exports (because E has already been used for expenditure), we can now incorporate trading
transactions into the model. We can do this either by adding to both sides of the equilibrium
equation, i.e.
or we can emphasise the rather separate nature of these transactions by keeping M and X
together. We can then ignore them on the income side and include them on the expenditure
side, to produce:
C  S  T  C  I  G(X  M)
where X  M represents the net expenditure flow resulting from the balance of trading
transactions. If import payments exceed export receipts, then the net result is of course
negative.
Notice that C has been reintroduced here, because we can regard much spending on
imports as being a part of household consumption. Total import spending from total income
will of course be made up of spending on consumer goods, investment goods, and goods
required by the government.
If total imports equal total exports in value, then there is no direct effect on the size of the
national income flow. Leaks are just balanced by injections. If import payments are greater
than export receipts, then there is a contraction in the circular flow. If export payments are
greater than import payments, then there is an increase. Remember always that it is
payments that concern us, not volume. These effects can be illustrated as in Figures 16.1(a)
and (b).
Here we see how a net excess of import payments brings down the equilibrium level of
national income (Figure 16.1(a)), while a net excess of export earnings increases it (Figure
16.1(b)). This is what normal common sense leads us to expect. People gain jobs and earn
incomes by providing and selling goods and services for export. On the other hand, if people
spend their incomes on foreign-made goods, then this leads to the creation of jobs and
incomes in foreign countries.
Another method of illustrating this is shown in the graphs of Figures 16.2(a) and (b). In
Figure 16.2(a), we see the effect of increasing injections by net export earnings – the
equilibrium level of national income rises from Oe to Oe1.
In Figure 16.2(b), imports raise the slope of the withdrawals (S  T  M) curve to bring down
the equilibrium income level (from Oe to Oe1). Notice that net exports are shown as a parallel
line, indicating that they do not rise directly as national income rises, whereas imports are
shown as having a greater effect at higher income levels. This is because the consumption
element in imports increases with higher incomes, showing a behaviour pattern similar to
that of any other form of consumption.
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Figure 16.1: Changing the equilibrium level by imports and exports
National
expenditure When import payments
exceed export earnings
national income falls
from Oe to Oe1
CIG
ME
 45 National
O
e1 e income
 Net imports
ME
National
expenditure When exports exceed
imports, national income
rises from Oe to Oe1
EM
CIG
Net exports
45
O e e1 National income
© ABE and RRC

Figure 16.2: Another illustration of the effect of imports and exports
Injections
withdrawals
ST
I  G  X with X  M
IG

O
 e e1 National income
Injections
withdrawals
S  T  M (M  X)
ST
IG

O
 e1 e National
income
These illustrations help us to appreciate how imports reduce the value of the national income
multiplier, in the sense that:
(a) increased consumption on imports makes the withdrawal curve steeper; the value of
the multiplier is 1/w and any increase in the value of w, which represents the steepness
of the withdrawal curve (the propensity to withdraw), reduces the value of the
reciprocal of w;
(b) any increase in the import element in business investment spending reduces the net
rise in I and, hence the injection brought about by I; if a firm buys machines made in
another country, it is not creating jobs in home factories;
© ABE and RRC

(c) any government spending on imports reduces the value of G to the domestic income in
exactly the same way.
There is nothing strange in any of these propositions. They are exactly what we would
expect. However, we should remember that they all assume that the home and foreign
economies are entirely distinct – i.e. that the home economy is not affected in any way by
changes in foreign economies. A little further thought causes us to doubt this. Modern
economies are closely interrelated.
It is true that there is no direct relationship between the size of the national income of
country A and the level of exports to country B. However, if the two countries are trading
partners, the national income of country B and its ability to buy goods from A will depend to
some extent on its ability to sell its own products to A. There is a connection, and we should
beware of making over-simple deductions from the apparently obvious propositions just
given.
The Balance of Payments Accounts

The balance of payments is defined as a systematic record of all economic transactions
between the residents of a country and the rest of the world during a period of time.
The national accounts which give details of payments and receipts and general financial
transactions with other countries are called the "balance of payments accounts". They mostly
follow a fairly standard pattern, so that, although the following details relate chiefly to the
United Kingdom, the main principles involved are likely to apply to most countries.
There are two main accounts:
 the balance of payments on current account
 transactions in external assets and liabilities (the capital account).
The current account is divided into:
 the visible trade account – the balance of trade
 the invisible trade account – services, transfers and interest, profits and dividends.
It is important to remember that the accounts represent flows of money. These flows are in
the opposite direction to those of goods and services. For example, exports flow out,
payment for them flows in; British ships carry goods for German firms and payment flows in.
Capital investment by UK companies in America is an outflow of money, whereas the
purchase by Americans of shares in British companies is an inflow.
Structure of the Accounts

The balance of payments accounts are shown in Table 16.1, where a minus sign represents
money flowing out of the country and a plus sign indicates money flowing in. We shall then
go on to discuss what the various items mean.
© ABE and RRC

Table 16.1: The Balance of Payments Accounts
£ billion
Current account
Goods
Exports +121.4
Imports –134.6
Balance of visible trade –13.2
Services
Exports +36.6
Imports –31.6
Interest, profits and dividends
IPD receipts +74.0
IPD payments –71.0
Transfers
Transfer receipts +5.4
Transfer payments –10.5
Balance of invisible trade +2.9
Balance of payments on current account –10.3
Transactions in external assets and

liabilities (the Capital account)
Direct and portfolio investment
Investment overseas –102.9
Investment into the country +49.5
Net investment –53.4
Bank transactions
Lending abroad +12.7
Borrowing abroad +23.7
Net lending and borrowing +36.4
General Government Transactions
Overseas assets –0.6
Overseas liabilities –0.1
Net increase or decrease –0.7
Domestic Non-banks transactions
Lending overseas –10.1
Borrowing overseas +12.7
Net lending and borrowing +2.6
Net transactions in assets and liabilities +8.3
(balance of payments on capital account)
Balancing item +2.7
(Note: The figures may not add because of rounding)
© ABE and RRC

(a) Visible Trade

When we think of trade, we usually think first of trade in actual physical goods, such as
cars, oil, and food. This is normally called the trade in "visible goods", and the balance
between the value of imports and exports is often called the "visibles balance". The
correct term for this balance is the trade balance or balance of trade.
Visible trade is usually classified into a number of broad groups, and it is a useful
exercise to look at the composition of UK trade on the basis of these groups. (You
should try to obtain similar figures for your own country, if this is not the UK.) The main
classes are the following:
 food, beverage and tobacco
 basic materials
 mineral fuels and lubricants
 semi-manufactured goods
 finished manufactured goods.
(b) Direction of Visible Trade Flows
You should also be aware of the main trading partners in this general process of
international exchange. For example, Britain's main trading partner has, for some
years, been the rest of the European Union (EU).
(c) Invisible Trade
Invisible trade is so called to distinguish it from trade in goods, which are tangible
items. It consists of:
 Services including sea and air transport, tourism, consultancy and financial
services.
 Interest, profits and dividend (IPD) comprises the annual flow of interest
payments, profits from business and dividend payments on shares coming into a
country from its lending and physical and financial investments overseas, less
the payments of interest, profit and dividends due to foreign banks, companies
and investors flowing out of the country.
 Transfers of funds to or receipts from other countries for non-trading and non-
commercial transactions. The main source of transfers usually involves
governments. For example, in the UK the government is responsible for most
transfers in the form of grants to developing countries, subscriptions to
international organisations like the United Nations and net payments to the EU.
Private transfers include payments to dependants abroad by UK residents, and
gifts.
The amount of IPD earnings depends on the amount invested in the past. Direct
investment refers to the purchase of foreign assets. It includes buying control of firms
in other countries, establishing subsidiaries and acquiring land and property. Portfolio
investment is in stocks and shares. IPD receipts are influenced by the level of interest
rates and the conditions in the economy which affect interest and dividend payments.
Profits and dividends in the balance of payments can cause confusion about how they
appear in the accounts. If a British company has a wholly owned subsidiary overseas
which earns a profit, the invisible earnings are the profit remitted to the UK. But the
part of the profit which is retained in the overseas subsidiary is treated as a capital
outflow, and appears under direct investments in the capital account. If the British
company does not control the overseas subsidiary but receives a share of the profit, it
only appears in the invisible account.
© ABE and RRC

(d) The Capital Account

The correct name for this account is "transactions in external assets and liabilities".
This account records only changes in assets and liabilities. For example, in the UK
when the pound rises in value against other currencies, it becomes relatively cheap for
British companies to invest abroad. Whereas if the dollar is strong compared to
sterling, American investors will buy assets in the UK. Portfolio investment is
undertaken by insurance companies, pension funds, unit trusts and investment trusts
to diversify their portfolios and to seek gains from rising share prices in rapidly growing
countries.
(e) The Balancing Item
The balancing item is a statistical adjustment to account for the failure to record some
of the thousands of items in the current and capital accounts. It is the difference
between the recorded entries in the balance of payments accounts and the change in
official foreign exchange reserves.
Although people, the media and politicians talk about a country having a balance of
payments deficit or surplus this is technically incorrect. When you hear or read about a
country's balance of payments problem, usually it is a deficit or surplus on a country's current
account that is being referred to. Because the balance of payments accounts are based on
double-entry bookkeeping, the balance of payments of a country will "always balance".
However in effect this balance may have to be achieved by borrowing, from payments from
past reserves and with the help of a balancing item which is often quite substantial! For
example, if a country's balance of payments accounts show that it has imported far more
goods and services in a year than it has exported to the rest of the world, it must also have
already financed this deficit in some way unless the rest of the world has become very
generous and supplied the goods and services for free! The really important balance though,
is the current one. This shows whether the country is trading profitably and successfully or
not. It is the current balance which is the best indication of a country's economic health. No
country can overspend its current income and draw on past savings or borrow from other
countries for ever.
B. BALANCE OF PAYMENTS PROBLEMS, SURPLUSES

AND DEFICITS
Current Balance Surplus
We have seen how a surplus of revenue from all forms of export over payments for imports
results in the equilibrium level of national income being raised.
The implications depend on whether or not the extra money available for spending pushes
the national income equilibrium above the full employment level. If it does – i.e. if demand for
goods and services is greater than the amount of goods and services available for purchase
– then there will be inflation: prices will rise, or there will be shortages.
If it does not, then the extra inflow of money will generate extra economic activity, and
unemployment will fall. The general level of employment and standard of living of the country
will rise. This is often known as an "export-led boom".
However if there is pressure on the country's capacity to produce sufficient to meet the
higher level of total demand, inflation may still be avoided. This is possible if the country
exports some of the surplus money by investing abroad, or by making loans or grants to
other countries. This may help these countries to develop their economies, and it will also
help the revenue-exporting country's invisible balance in future years.
© ABE and RRC

The ability to allow or to encourage money to be used abroad will also help the country's
political power and influence. It is little wonder that governments seek to achieve a balance
of payments surplus on current account.
Current Balance Deficit

The equilibrium level of national income is reduced by an import surplus. In this case, money
flows out of the country and the flow of goods and services in relation to the pressure is
increased.
Again the immediate effect depends on the existing level of economic activity. If the economy
is operating under inflationary conditions, with demand greater than can be satisfied at full
employment, the deficit will reduce the inflationary pressure. People who cannot buy home-
produced goods, because not enough are being made, will buy foreign goods instead.
However, if the economy is operating at lower than full employment, then the effect is to
increase that rate of unemployment – more people will lose their jobs, and more machines
will be idle.
In an advanced country, this can be only a fairly short-term effect, as a deficit causes other
problems. These problems lead to measures to correct the deficit, and there are then yet
further effects on the price level and on the extent of unemployment.
In a developing country, a deficit can be tolerated for a longer period, if it can be financed by
foreign countries or by loans from the International Monetary Fund. This might be done as
measures to raise general world living standards and increase the speed of world economic
development.
In the advanced country, the outflow of funds to pay for imports will be greater than the inflow
paid for exports. This means that the demand for foreign currencies to pay for foreign-
produced goods and services is greater than the demand for the home currency to pay for
that country's goods sold abroad. In this situation, the exchange value of the home currency
is likely to fall.
Causes of a Persistent Current Balance Deficit

It is difficult to work out effective remedies for a balance of payments deficit, unless the
causes of the problem are known. We have to admit that there is some uncertainty on this
question. However it is possible to examine some of the influences operating on the pattern
of a nation's trade.
(a) Changes in the Terms of Trade
The "terms of trade" measures the relative movement of import and export prices. It is
calculated from:
unit value index of exports
 100
unit value index of imports
The unit value index represents the average movement in price of a unit of imports or
exports. The "unit" itself is a kind of average of all types of visible imports and exports.
The terms of trade thus gives a general indication of how average import and export
prices are moving. As an illustrative example, the actual calculations for the UK for
1983 to 1993 are shown in Table 16.2.
© ABE and RRC

Table 16.2 Terms of trade
1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993
Unit Value Indices (1990 = 100)

Exports
All goods CGTO 86.3 93.1 98.1 88.4 91.5 92.4 96.6 100.0 101.4 103.5 114.8
Non-oil CGSX 76.6 82.4 87.6 88.5 91.5 94.3 97.5 100.0 102.3 105.0 116.9
goods
Imports
All goods CGTP 84.2 91.8 96.3 91.9 94.6 93.7 97.7 100.0 101.2 102.1 110.5
Non-oil CGSY 80.0 87.3 91.7 92.1 94.8 95.0 98.2 100.0 101.7 102.9 111.8
goods
Terms of trade
All goods CGTQ 102.5 101.4 101.9 96.2 96.7 98.6 98.9 100.0 100.2 101.4 103.9
Non-oil CGSZ 95.8 94.4 95.5 96.1 96.5 99.3 99.3 100.0 100.6 102.0 104.6
goods
We can analyse the results of changes illustrated by the index. At one time, a rise in
the index was regarded as being favourable because a given quantity of higher-priced
exports could earn enough to buy more imports. In the modern world, the results of
trading-price movements are a little more complex.
 Import Prices Rise Faster than Export Prices
The effect will depend upon the elasticity of demand for imports. We can assume
that in an advanced country, the demand for imported raw materials and foods
and oil is fairly price inelastic. However the demand for most manufactured
(especially consumer) goods is likely to be price elastic – provided that the home
country is able to manufacture acceptable substitutes for foreign-made products.
In this case, the demand for the price inelastic goods will fall in a smaller
proportion than the rise in price, so that the total cost of payments for these
imports will rise. In the case of imports the demand for which is price elastic, the
fall in demand will be greater in proportion to the rise in price, and the total cost
of these imports will fall.
For a country such as Britain, where over half of the imports consist of
manufactured goods, the effect of a change in import prices will depend on which
imports are most affected. A price increase on foods, basic materials or imported
oil would create a balance of payments deficit or make an existing deficit worse.
If it is the prices of the manufactured goods that rise, we would expect there to
be a fall in the total cost of imports. That is of course if demand is price elastic. If
in fact there are not sufficient home-produced alternatives to make good the
higher-priced imported products, then the demand may turn out to be inelastic
and upset the predictions relating to total revenue.
For a developing country, most imports are likely to be demand inelastic if they
are needed to promote development, so that a rise in import prices would make
for a deficit or aggravate an existing deficit.
 Rise in Export Prices
Again, the effect depends on the price elasticity of demand for exports. In this
connection, a developing country exporting basic materials with price inelastic
demand would gain, and would receive an increase in total export earnings. In a
© ABE and RRC

developing country, it might be difficult to absorb a large balance of payments

surplus, and much of it might have to be invested abroad until the home
economy could be developed. This was the case of some oil exporting countries
when they gained from oil price rises.
One problem for a developing country that relies on the export of a few basic
commodities is that its living standards are very much at the mercy of world
prices of these commodities. When prices are high, the country might develop a
standard of living highly dependent on imports, and this might be very difficult to
maintain if world prices of the exported goods fall. It would be no use trying to
stimulate demand by reducing prices, because this would only cut export
earnings still further.
For a country such as Britain, chiefly exporting manufactured goods, export
demand is likely to be price elastic and a price rise – caused, perhaps, by home
inflation – is likely to lead to a fall in total export earnings, and hence to a deficit
or the worsening of an existing deficit.
(b) Economic Weakness
Many economists think that relative price movements are little more than a symptom of
economic conditions, rather than a basic cause of those conditions. For a developing
country, a balance of payments deficit may simply reflect the world market situation
that ensures that total export earnings for the volume of goods exported are not
sufficient to provide enough money to pay for the goods and services needed for
development. The position will be made worse if:
 world demand is declining for the country's basic exports, or
 there is a failure in production, resulting from natural disaster or other causes –
e.g. a crop failure or internal conflict, or
 there is a high demand for imported consumer goods from a section of the
population that has developed a fashion or taste for imported clothes, cars or
food.
For an advanced country, the problem may be caused by a weak economic or
business structure, an economy that is less successful than that of competing nations.
If production is cut by poor working methods, under-investment in modern machinery
or labour disputes, then export earnings are likely to fall and imports and the cost of
imports rise, almost regardless of price advances, in favour of the home country. For
example Germany and Japan have been consistently more successful in exporting
than Britain and the USA.
(c) Activities of Multinational Companies
About a third of international trade is made up of payments between the different parts
of multinational empires. These companies, operating on a world scale, may prefer to
move production away from high-cost, highly-taxed and closely-regulated countries to
other areas where they have lower costs and more control over production methods. It
is notable that countries with a high proportion of multinationals – the USA and Britain
– tend to have persistent problems with their balance of payments. On the other hand
Germany and Japan, which until recently have not produced worldwide enterprises,
have had very successful export records and few balance of payments difficulties. It
will be interesting to see which effect the development of German and Japanese
multinationals has on those countries' payments balances.
© ABE and RRC

C. BALANCE OF PAYMENTS POLICY

There are three main remedies for a balance of payments deficit. These are devaluation
(depreciation), deflation and import controls.
Devaluation or Depreciation
By devaluation or depreciation we mean the reduction in the exchange value of a nation's
currency in terms of foreign currencies. For example, before devaluation a British pound
might be equal to US$2, but after devaluation it may be equal to only US$1.5.
If a country allows its currency to float on the foreign exchange market, then the value of its
currency will fall if demand for the currency falls. For example if the demand for pounds falls
and that for US dollars rises, the price of the pound is likely to fall relative to that of the US
dollar. This is called depreciation, and is a normal part of the operation of foreign exchange
markets.
Devaluation happens when a country operates a fixed exchange rate policy (see Study Unit
17), and the government decides to reduce the fixed value. The government can then simply
change the value by declaration.
In whichever way it is brought about, a depreciation/devaluation raises the price of imports
and reduces the price of exports, at least in the short term.
It is important to understand the distinction between devaluation (action by governments
when exchange rates are fixed) and depreciation (fall in value of a currency as a result of
market movements). But you must also recognise that governments do intervene in currency
markets to try to influence market movements, and a change in interest rates is sometimes
brought about by a government in a deliberate attempt to change the currency value.
The J Curve
It is sometimes pointed out that in the very short term firms cannot change their plans. It
takes a little time for traders to react to international price changes resulting from exchange
rate movements. Consequently, a swift devaluation or depreciation will increase the prices of
imports and decrease those of exports without changing quantities traded to any great
extent. The immediate effect of the price changes will be to deepen the balance of payments
deficit. However fairly soon plans and trading patterns are modified, and we would expect
demand for imports to fall and foreign demand for exports to rise. The result would be to
reduce the deficit and, if the reactions were strong enough, to turn it into a surplus. This is
illustrated by what is usually known as the J curve, as illustrated in Figure 16.3.
Importance of Demand Elasticities
For the changed trading pattern to replace a balance of payments deficit by a surplus, the
rise in demand for exports at the reduced world price must increase export revenues by a
greater amount than any increase in import costs resulting from the import price rise. It will of
course help if the import costs actually fall. The desired gain in net revenues can only come
about if the combined price elasticities of demand for exports and imports add up to a value
that is more negative than –1.
Effect in Industrial and Developing Countries
In the case of a developed country such as the UK, where manufactured goods dominate
exports and form a high proportion of imports, we would expect a devaluation to have a
favourable effect on the balance of payments in the short term.
© ABE and RRC

Figure 16.3: The J curve
£ Millions
Current balance of payments

O
Time

The rise in import prices and the

fall in export prices will make a
balance of payments deficit
worse until trading patterns react
to the changed prices and export
revenues rise and import costs
fall.
In the long term, this beneficial effect of increasing net earnings is likely to be weakened.
Any rise in the prices of imported fuels, raw materials and foods must soon increase the
costs of manufacturing. It will also lead to an increase in the living costs of the workers. If the
workers are able to secure wage increases in an attempt to restore living standards, then
manufacturing costs will again rise. Inflation of both prices and wages thus erodes the
competitive price advantages gained for exports against imports by the devaluation. If
inflation continues at a high rate, the export price advantage may be lost very quickly.
For a developing country, both exports and imports are likely to be price inelastic. Thus the
result of a devaluation in this case is to worsen an existing balance of payments deficit. The
devaluation will reduce total export earnings and increase total import costs. Therefore
devaluation will not help a developing country with balance of payments problems. It may
help an advanced industrial country, but probably only in the short term. In itself, devaluation
does nothing to cure the basic economic weakness which gave rise to the trading imbalance
in the first place.
Deflation
Spending on imports is a form of consumption that is usually regarded as being dependent
on the level of income of a community. The higher the income, the more is likely to be spent
on imports. So one way to correct a balance of payments deficit is to reduce import levels or,
at least to stop them rising too fast. A government faced with a balance of payments problem
may seek to reduce disposable income in the hands of consumers, and so reduce all
consumption expenditure. This will cut the demand for imports and also reduce the strength
of demand for home-produced goods, so releasing them for export markets – if firms can be
persuaded to make a bigger export effort. The government will achieve deflation by:
 reducing its own spending and the demand for workers in the public sector
 increasing taxes, and so reducing consumers' disposable (after-tax) incomes
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 increasing interest rates by restricting the money supply, so making it difficult for firms
and households to maintain investment and consumption expenditure.
For a developing country deflation is unlikely to be a satisfactory solution, because the
imports are needed for economic development. Also, if living standards are already very low,
any reduction could lead to violent social and political unrest.
Import Controls
Countries can also attempt to remedy a persistent current account deficit by introducing
control over imports through measures such as quotas and tariffs.
Supporters of controls suggest that the danger of retaliation is not as great as is often
assumed, and they say that only with the protection of controls can the economy be fully
revised. They usually also suggest that massive government aid would be needed for
industrial modernisation and investment, and that the government would have to have
greater controls over industry if it were to provide this aid. Taxes would also be likely to stay
high if this policy were adopted.
Other people remember that it was the attempt of individual countries to impose controls
over imports, and at the same time keep on exporting, that led to the trade wars of the earlier
part of the twentieth century. These in turn helped to bring about the very severe depression
and unemployment in the 1930s. They feel that the risk of such a tragedy being repeated is
too great to allow import controls to be tried. However, the demand for controls is very strong
in the face of what are often termed "unfair trading practices" of some countries.
Another danger is that industries do not in fact reorganise behind the protective barrier, and
simply become less competitive and rely on satisfactory home demand. This is why
advocates of import controls also tend to advocate increased public control to force
modernisation.
The demand for import controls always increases during an economic recession, when there
tends to be strong political pressure from industries with high unemployment rates or
suffering from economic change to be given protection from foreign competition. There was
a tendency in the late 1980s and early 1990s for informal methods of protection – the use of
various administrative devices to make importing more difficult and expensive – to increase.
The then GATT (General Agreement on Tariffs and Trade) negotiations for reducing tariff and
other barriers in order to encourage world trade (originally due to be completed in 1992)
encountered many difficulties, as governments sought to defend their own politically powerful
groups – including of course the farmers.
The negotiations were eventually concluded by the end of 1994, and some progress was
made towards further trade liberalisation. However progress was extremely modest in
relation to the three major trading blocs of the EU, North America and Japan. At the
beginning of 1995, GATT was replaced by a more structured body, the World Trade
Organisation (WTO), which was given limited powers to enforce agreements and discourage
openly protectionist measures. These were quickly tested by a trading dispute between the
USA and Japan, though this was resolved without breaching WTO rules.
Need for a Healthy Business System

A balance of trade deficit for an advanced industrial country is a sign of economic weakness,
and the only really effective long-term remedy is to strengthen the country's business
structure. This means increased investment and business modernisation. This helps to
explain why much more attention is given by governments than previously to the use of
supply-side economic policy. Demand management policies alone are incapable of providing
a lasting solution to balance of trade problems. The causes of a country's economic
weakness in the face of stronger foreign competition are not always fully understood. They
may be social or political, as much as economic. Devaluation, deflation and import controls
© ABE and RRC

are only short-term remedies. All may aggravate the weakness if no healthy business system
is encouraged. There is unlikely to be a quick and easy solution, and some reduction in living
standards may be inevitable before economic health is restored.
Review Points
relevant sections.
1. All other things remaining unchanged, how will an increase in the propensity to import
affect the equilibrium level of national income of a country?
2. All other things remaining unchanged, how will an increase in foreign demand for a
country's exports affect the position of its aggregate demand curve and its equilibrium
level of national income?
3. Explain the difference between the current and capital accounts of the balance of
payments.
4. If the balance of payments account must always balance explain the different ways in
which a country can finance a deficit on its current account.
5. List the benefits to a country of allowing foreign direct investment into the country.
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297
Study Unit 17
Foreign Exchange
Contents Page
A. International Money 298

The Need for International Money 298
Gold – its Use and Limitations 298
Uses of National Currencies 299
B. Exchange Rates and Exchange Rate Systems 300

What are Exchange Rates? 300
Effect of Exchange Rate Changes 300
The Formation of Exchange Rates 301
The Purchasing Power Parity Theory 301
Exchange Rate Structures 302
C. Exchange Rate Policy 306
D. Macroeconomic Policy in Open Economy 307
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298 Foreign Exchange
Objectives
The aim of this unit is to explain how exchange rates are determined and to evaluate the
relative merits of fixed and floating exchange rate regimes.
 explain the differences between the key terms used in the analysis of exchange rates:
devaluation, depreciation, revaluation and appreciation
 explain the terms of trade
 examine the concept of purchasing power parity theory and its implications
 identify the relationship between fiscal/monetary policy and fixed/floating exchange
rates
 explain the ways in which government manipulation of exchange rates can generate a
competitive advantage.
A. INTERNATIONAL MONEY
The Need for International Money
We have seen earlier in the course that anything can serve as money, as long as it is
accepted as money. It will be accepted only as long as it can be readily used to purchase
real goods and services. Therefore money ceases to have any value as money when it
cannot be easily traded for goods.
So the area of acceptability is extremely important for the value of any form of money, and
this is a point of very great concern for matters of international finance and trade.
Therefore when one country sells goods to another, it wishes to be paid in a form of money
(currency) which it can readily use to purchase its own goods elsewhere, or which it can
change into its own currency to pay its own workers and suppliers at home.
You might think that it would all be a lot simpler if every country in the world used exactly the
same currency, which would then be universal, and which would not be identified with any
one nation.
Gold – its Use and Limitations

In a sense, there is a form of money which is universally acceptable and which is not
associated with any one nation. This is gold, which has been used as money in almost every
part of the world since the dawn of civilisation. Gold has all the qualities required of money. It
is noticeable that whenever a country's financial or political system seems to be in a state of
collapse, those able to do so abandon paper money in favour of gold which, if they can take
it with them to another country, is readily acceptable there. Some international trading
contracts are also arranged in terms of gold, and most countries keep at least part of their
reserves in gold, the world price of which is a fairly good indicator of the general state of
political tension in the world.
However, there is just not enough gold to meet the entire world's trading needs, and the
natural supply of gold is very unevenly distributed between countries. If gold were the only
international form of money, those countries where gold is found would have a degree of
political power that other countries would find unacceptable. Moreover because gold, as a
physical good, is in fixed supply in any given period, any of the metal that is held in reserve is
withdrawn from circulation – and, thus, it cannot be used in exchange. Some countries, such
as the USA, have such a large share of total world supplies in their reserves that they can
influence its price (value in exchange for goods) by their sales in world markets.
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Foreign Exchange 299
Gold – and, indeed, any other precious metal – does not provide an easy solution to the
problems of international currency.
Uses of National Currencies

An attempt has been made to produce a form of "paper gold", to serve as a genuinely
international currency. This resulted in the "special drawing rights" (SDRs) produced by the
International Monetary Fund. But it has been found difficult to reach agreement on the issue
and control of SDRs, and they have only a limited use in exchange and as a reserve.
The problem with any form of international currency is that there must also be some system
of international control which all countries will accept. This immediately introduces political
implications which so far have proved impossible to reconcile.
Consequently, the great mass of world trade has to be conducted in the normal national
currencies of the world. Some of these are more acceptable than others, chiefly because
some countries have stronger economies than others, and some governments have firmer
control over their national economic and financial systems than others. For simplicity, we can
identify four classes of currency used in international trade.
(a) The United States Dollar
The US dollar is the most widely acceptable currency, and it is used throughout the
world. Many of the world's commodities and services are valued in dollars. They
include oil and hotel charges. Dollars are also widely used in the internal trade of many
countries, whose own currencies are very weak because of severe domestic inflation.
(b) Other Major Trading Currencies
The currencies of many of the other leading trading nations of the world have a wide
acceptability, though not as universal and general as the US dollar. When the dollar
itself is under pressure and losing some of its exchange value, one or more of these
currencies becomes a refuge for international finance. Among the main trading and
reserve currencies in this group are the euro, the Japanese yen, the British pound
sterling, and the Swiss franc.
(c) Currencies with Limited Acceptability
Some currencies may be acceptable within a particular region. There are also many
currencies, especially those of African countries and those of North Korea and
Myanmar/Burma, that have almost no circulation or acceptability outside the national
boundaries (and often are not too popular within the country either!). Sometimes a
national government discourages international exchange involving its currency, as a
means of keeping greater control and preventing the export of wealth. In other cases,
the currency is too weak to support any external trade, or the official value in exchange
for other currencies maintained by the national government is so unrealistic that no one
who can possibly avoid it is willing to exchange foreign money at that rate.
(d) The "Basket" Currencies
These are currencies which are not the currencies of any nation, but their exchange
value is based on a weighted basket of those currencies with which they are
associated. The weights relate to the relative use of the various currencies for
purposes of trade and international finance.
The main basket currency now is SDRs issued by the International Monetary Fund,
although previously the ecu (European currency unit) was the basis for certain
transactions within the (old) European Monetary System.
One of the advantages of using such a currency as a basis for valuing trading
transactions, even if actual payments are made in a national currency, is that the
© ABE and RRC

basket currency fluctuates much less than any one of the individual national
currencies. This is because changes in its value are simply the weighted average of all
changes among the underlying currencies. Some of these are likely to cancel each
other out: a falling currency could be balanced by a rising one. At present use of a
basket currency for business trade and settlement purposes is restricted by lack of
general availability, and also by lack of any widespread awareness of the position.
People generally feel happier to stay with a currency they know and understand.
Trade may often be conducted by barter arrangements with some countries with weak
currencies. For these agreements, some form of acceptable valuation is necessary. Again
the basis of this tends to be the United States dollar, either directly or indirectly (e.g. through
oil).
B. EXCHANGE RATES AND EXCHANGE RATE SYSTEMS

What are Exchange Rates?
We have seen that various national currencies are used in international trade, and we must
now examine a little more closely what is involved when one currency is exchanged for
another. The exchange rate is the rate at which the national currency can be exchanged for
the currencies of other countries. Therefore there is not one rate but many, relating to all the
different countries in the world. Some of the leading rates are shown in those banks which
have a bureau de change (i.e. which can provide an over-the-counter service for changing
currencies).
The principal rate which is of interest to most countries is the one relating to the main
currency in use in international trade, the US dollar. For this reason we will concentrate on
the US dollar/British pound relationship. For example, if the exchange rate is:
$1.20  £1
then £1 can be exchanged for $1.20 (ignoring dealing and other costs of exchange). Thus:
£100  $120
If however the rate changes to $1.10, then £100 becomes worth only $110.
Effect of Exchange Rate Changes

Suppose there is a fall in the value of the pound in terms of US dollars, so that in the space
of a few months, the rate falls from $1.30 to $1.10. There is then an immediate effect on the
prices at which traders are prepared to trade in international markets.
Say a manufacturer is prepared to sell a motor vehicle provided they receive £5,000. At the
rate of $1.30 (again ignoring transactions costs), the manufacturer could sell the car in the
USA for $6,500 (5,000  1.30). Suppose the pound falls in value and is worth only $1.10.
Now the manufacturer will accept $5,500 (5,000  1.10) if they still wish to receive £5,000 for
the car. Thus a fall in the currency value makes exports cheaper in foreign prices. Cheaper
goods are likely to be easier to sell and, provided the increase in sales is proportionately
more than the change in dollar price, exporters can hope to receive more revenue for their
exports – hence, the use of devaluation to help in correcting a balance of payments deficit.
On the other hand imports become dearer, and this will affect the pound price of goods
imported from other countries. Suppose the vehicle manufacturer buys steel from abroad
and pays for it in US dollars. Each $1,000 worth of steel, which used to cost £769.23 (1,000
 1.3), now costs £909.09 (1,000  1.1). Most manufactured goods contain materials
imported from other countries, so that manufacturing costs inevitably rise following a fall in
the exchange rate.
© ABE and RRC

There will also be other effects. A high proportion of British food and many consumer goods
come from overseas – and so they rise in price. Living costs are pushed up and workers
seek wage increases in order to try to maintain their living standards. If they succeed, then
labour costs rise, and also manufacturing costs – and prices are also likely to rise. Under
circumstances such as these, it is highly unlikely that manufacturers will reduce their foreign
prices by as much as the full fall in currency value. In our example, the motor manufacturer
will want more than £5,000. We can see that the effects of currency changes are far-
reaching, and not always too certain.
The Formation of Exchange Rates

The exchange rate represents the price of the national currency and, like any other price; it
is formed ultimately by the forces of supply and demand. These in turn are the result of the
trade flows of imports and exports. In order to pay for imports priced in US dollars, the United
Kingdom has to earn dollars by selling British goods and services to other countries. The
more Britain can export, then the more dollars the country earns.
However British firms want to receive their payments in pounds. To obtain pounds to pay for
British goods and services, foreign firms have to sell their own currencies in the markets for
foreign exchange and buy pounds. So the greater the demand for British products in world
markets, the higher is the demand for pounds in the currency exchanges. Conversely, the
higher the demand in Britain for foreign products, the more pounds have to be sold to obtain
the foreign currencies needed to pay for them. It is evident that one immediate cause of a
change in currency exchange rates is the way the balance of payments is changing. If the
balance is in surplus, then revenue from exports is greater than that paid for imports, and the
supply of foreign pounds is high. So the pound is likely to rise in exchange value. A
persistent balance of payments deficit has exactly the reverse result. The weaker the
balance of payments, the weaker the pound is likely to be.
The views of traders and bankers about future movements in trade flows and currency
exchange rates will also have an effect. For instance, traders often have to hold large sums
of money for a few days or weeks, in anticipation of having to make large payments. They
cannot afford to have money lying idle, so they lend it out in return for interest. They do not
want to see the interest earned being lost through a fall in the exchange value of their
money. This means that any suspicions that the pound is likely to fall will persuade the
traders that their money is more safely kept in some other currency. This reduces the
demand for pounds and increases the demand for foreign currencies, and so adds to the
pressure resulting from a weak balance of payments. (Unless, as did the UK in 1989–91, the
government tries to maintain an artificially high exchange rate through forcing up interest
rates in order to attract sufficient foreign capital into the country to counterbalance the
outflow of funds paid for imports.)
The Purchasing Power Parity Theory

If the immediate cause of exchange rate changes is a change in the flow of trade, then we
are forced to ask whether it is possible to identify influences on these trade flows.
Various attempts have been made to explain these, and one such attempt is based on the
view that they are directly linked to changes in inflation rates – i.e. in the relative purchasing
power of the various national currencies. This is often referred to as the "purchasing power
parity theory". This theory states that the percentage depreciation of the home currency
against a particular foreign currency can be expected to be equal to the excess of the home
rate of price inflation over the other country's rate of price inflation. In other words, it is held
that changes in currency values reflect changes in the purchasing power of the various
national currencies. If country A has a higher rate of inflation than country B, then its
currency buys fewer goods, and consequently it will fall in exchange value in terms of the
currency of country B. This will continue until B's currency returns to the position where it will
© ABE and RRC

purchase roughly the same quantity of goods in A, when converted to A's currency, as it did
before the price inflation. The theory is attractive but it is not entirely supported by the
available evidence. It fails to take into account elements other than price which affect the
demand for exports and imports. The theory also assumes perfect markets in currencies, but
in practice governments tend to intervene to defend exchange rates. Governments can
influence the rate of interest offered to investors or depositors of money. Traders may be
persuaded to leave funds in London in pounds, in order to earn high interest rates likely to
more than compensate for any change in exchange value.
In the long term, currency movements are most probably influenced by relative rates of
inflation; in the short term this consideration can be outweighed by other influences such as
interest rates, trade flows and political stability. You should also remember that as in other
markets, buyers and sellers are as much concerned with the future as with the present and
the past. If the market thinks that a currency is likely to fall in the future, it will anticipate that
belief by selling now so that expectations can be self-fulfilling. This does not mean that the
market is always right. Anticipations about future movements are based on past experience,
so that the market may not recognise that a fundamental shift has taken place until this
becomes completely clear and then it may overreact.
For example, between 1962 and 1992 Britain had a generally poor record in controlling
inflation. By 1995 currency markets remained sceptical about future inflation rates in Britain,
in spite of the declared intentions of the British government and its relative successes
between 1992 and 1995. Over a similar period Japan's economic record had been one of
spectacular success, so that the market continued to believe that its economic problems of
the first half of the 1990s were likely to be temporary. It is quite feasible that the judgement
of the currency markets was wrong in the mid-1990s for both countries. The currency traders
risked losing a great deal of money if their beliefs were wrong and only future events will
show whether or not they were correct.
Exchange Rate Structures

There are basically two types of exchange rate system – fixed and floating exchange rates.
There may be variants on these, but the basic principles remain the same.
(a) Fixed Exchange Rates
It is very rare to have an exchange rate structure that is rigidly fixed. Some movement
within a band either side of a central rate is normal. The more confident governments
are that they can maintain the agreed rates, the narrower the band within which
floating is permitted. A movement towards either the floor or the ceiling of the band
requires action to correct the rate. The usual short-term action is to change interest
rates to attract – or discourage – capital movements, but longer-term action through
taxation or a fundamental shift in government spending or policy priorities is likely to be
needed. If the government is unable or unwilling to take action to restore the agreed
exchange rate, or if its action is unsuccessful, then the rate will have to be changed. If
member countries cannot agree on a satisfactory change the whole structure becomes
unstable.
The problem with any fixed exchange rate structure is reconciling the desired level of
stability with sufficient flexibility to allow changes to take place as economic conditions
change. National economies are dynamic. They are subject to constant change. A
system designed to prevent short-term fluctuations can easily block desirable long-
term developments, until the currency values get so out of touch with reality that a
structural upheaval becomes inevitable.
Nevertheless there have been a number of important attempts to create exchange rate
structures to provide the stability that business firms desire.
© ABE and RRC

The longest, most comprehensive and for many years the most successful attempt
was the Bretton Woods system (see Study Unit 15). This linked the main currencies to
the United States dollar throughout the 1950s and 1960s – a period of generally rising
world living standards and of considerable prosperity for the Western world. The
European Community's Exchange Rate Mechanism (ERM) sought to reproduce the
Bretton Woods conditions. It had a roughly similar system of limited currency
movements within defined bands, and operated during the 1980s and 1990s in the
lead up to the establishment of the single European currency. Supporters of such
systems usually claim that they:
 provide the stability and reduction in currency risks that traders need if they are
to expand trade and production
 oblige governments to pursue financially responsible economic policies designed
to control inflation and curb the tendencies of communities to live beyond the
means provided by their production and trading systems.
Opponents of fixed rate structures point out that periods of apparent exchange rate
stability tend to be punctuated with intense speculative crises and periods of serious
and damaging instability. This happens when finance markets realise that a major
currency (usually sterling!) has become overvalued and they suspect that the
government does not have the power to prevent a devaluation. A series of crises led to
the abandonment of the Bretton Woods system in the early 1970s and a similar crisis
led to the withdrawal of sterling from the ERM in 1992.
Opponents also point out that the only measures that governments can take to uphold
the exchange value of a currency in the short term are extremely damaging to their
domestic economies and further undermine long-term confidence in the currency. A
monetarist government will rely on high interest rates to keep capital in the country, but
these high rates can have a devastating effect on consumer demand and business
investment, as shown in Britain in the period 1989–1992. A Keynesian government
would raise taxation and curb wages and other incomes, and this would have a similar
deflationary effect to high interest rates. Clearly a government seeking to maintain an
overvalued currency will damage its own domestic economy, create high
unemployment and destroy business firms. Living standards fall in the interests of an
artificial currency stability, which cannot be sustained for more than a short period.
Currency exchange rates represent the market price of a nation's currency. They are
the international traders' valuation of the nation's production system. Stable exchange
rates can only be achieved when economies are themselves stable, prosperous and
competitive in world markets. A falling exchange rate is the symptom of an unhealthy
economy. To prop it up artificially is like propping up a weak patient and pretending that
the patient is fit and well. It is as dangerous to the economy as it is to a sick person,
and eventually all such pretences have to be abandoned.
(b) Floating Exchange Rates
When the price of the currency in terms of every other currency is set by demand and
supply in the market, the country is said to have a freely floating exchange rate. If the
demand increases and the supply remains the same, the exchange rate rises
(appreciates); should the supply increase faster than demand, the rate falls
(depreciates). There are no exchange controls and the government does not intervene
in the market. Figures 17.1 and 17.2 show how changes in demand and supply affect
the exchange rate of a currency.
© ABE and RRC

Figure 17.1: The effect of increased UK exports or more investment in Britain
Rate of
exchange S
($ per £)
R1
D2
D1
Quantity of £
O Q Q1 demanded per period
Figure 17.2: The effect of increased UK imports or more UK investment abroad
Rate of
exchange
($ per £) S1
S2
R1
Quantity of £
O Q Q1 demanded per period
If Britain's exports increase there will be more demand from importers to exchange
their currencies into sterling. The pound will also be in demand if people want to invest
more in the UK, either in deposits and shares or in physical assets. More sterling will
be supplied if importers in Britain are buying more from overseas and require more
foreign currency. UK investment abroad increases the supply of pounds.
Just as in any other market, an increase in demand for pounds, with supply
unchanged, will cause the price of sterling to rise or appreciate – more dollars have to
be paid for each pound. Conversely an increase in supply, with demand remaining the
same, would cause the currency to depreciate and each dollar would buy more pounds
– i.e. the price of a pound has fallen.
© ABE and RRC

Governments have often attempted to manage floating exchange rates: this is called
"dirty floating". A government may intervene in the market to buy or sell its currency
because it wants to hold down a rise in the rate, which would affect international
competitiveness, or support a rate, to keep foreign investments.
There have been attempts by the major industrial countries to influence the exchange
rate of the US dollar. Many commodities and raw materials, especially oil, are priced
worldwide in dollars; a rise in the value of the dollar for speculative reasons
unconnected to trade could cause inflation. When, in 1991, the dollar rose by a quarter
against the Deutschmark, the G7 (the seven most industrialised nations) took
concerted action to stem the rise by central bank intervention to sell dollars. In 1995
the dollar was falling against other currencies because of fears about the effect of the
very large US government deficit and the political situation. This led to a flight into the
Deutschmark, a rise in its rate and a depreciation of other currencies. The effect is to
make the exports of appreciating countries less competitive and those of depreciating
ones more so – this is destabilising and has nothing to do with the trading position of
the countries. Central banks intervened to buy dollars in an attempt to prevent further
falls in the rate.
Even when all the major central banks act together, they cannot have a significant
effect on the foreign exchange market. The sheer size of the market's daily dealings
makes the reserves of the industrialised countries look small. The banks can try to
influence the feeling in the market so that dealers change their attitude to the future of
the currency.
The advantages of floating exchange rates are:
 There is an inbuilt adjustment mechanism. If imports exceed exports, the
currency will depreciate and exports become relatively cheaper in foreign
countries, thus helping to increase exports. There is no need for government
intervention.
 There is continuous adjustment of the rate, in contrast to the infrequent, large
and disruptive revaluations in fixed systems.
 Domestic economic policy can be managed independently of external constraints
imposed by the need to maintain the exchange rate.
 There is no possibility of imported inflation, as the exchange rate adjusts relative
prices.
 There is no need for large official reserves (unless there is managed floating).
 Adjustments to the exchange rate are made by the market: they are not delayed
by political considerations.
The disadvantages of floating exchange rates are:
 They create uncertainty and raise the costs of international activities because of
the need to cover risk.
 There are no restraints on inflationary domestic economic policies.
 Changes in the rate may be due to speculation or flight from weakening
currencies and have nothing to do with the trading position of the country. This
may make exports relatively dearer and imports cheaper and cause a payments
deficit.
The impact of a change in a floating exchange rate depends on the price elasticities of
demand for exports and imports. If both are elastic, a fall in the rate will reduce
imports, which become dearer in the home market, and increase exports, which
become cheaper in foreign markets. The opposite happens if the rate appreciates. If
© ABE and RRC

the demand for exports abroad is inelastic, the effect of depreciation will be that the
volume of exports does not increase but the lower price earns less foreign exchange. If
imports are price inelastic, the rise in their price does not reduce demand significantly
and more foreign exchange is bought to pay for them: this worsens the balance of
payments. Higher import prices for materials, components and finished goods may
cause inflation.
C. EXCHANGE RATE POLICY

Exchange rate policy refers both to a country's choice of exchange rate regime and its use of
its exchange rate to achieve its macroeconomic policy objectives. In the late 1940s and most
of the 1950s exchange rate policy would have been largely focused on the decision whether
to adopt a rigidly fixed exchange rate regime or allow a country's currency to float freely.
A freely floating exchange rate enabled a government to use monetary and fiscal policy
measures to achieve the internal objectives of macroeconomic policy, without the constraint
of worrying about its external balance of trade position.
On the other hand, a fixed exchange rate regime was seen as beneficial to the promotion of
international trade, because it removed exchange rate uncertainty from importing and
exporting activities. A commitment to fixed exchange rates also reflected the desire to avoid
using frequent exchange rate devaluations as a means of attempting to gain unfair
advantage from international trade.
Frequent changes in exchange rates led to competitive devaluations and damaging trade
wars in the 1930s. Reflecting on this experience, which led to a collapse of international
trade and merely served to spread unemployment around the world rather than the benefits
from trade, countries favoured fixed exchange rates with the formation of the International
Monetary Fund in 1945.
More recently, the choice of exchange rate regime has been recognised to exert a big
influence on the relative effectiveness of monetary and fiscal policy. In addition, the choice of
a fixed exchange rate regime means that a country loses the ability to determine its own rate
of inflation, and must accept that it will experience a rate of inflation determined by the rest of
the world. In contrast, the choice of a freely floating exchange rate means that a country is in
control of its own rate of inflation because its nominal exchange rate will adjust to isolate it
from the world rate of inflation. (Go back to Study Unit 16 and revise your understanding of
purchasing power parity if you do not understand how this process works). Thus, if a
government wants to achieve a low rate of inflation as its main objective of macroeconomic
policy, it is likely to favour a freely floating exchange rate regime.
The other aspect of exchange rate policy has to do with the objectives of achieving full
employment and a high rate of economic growth based on exporting; this is referred to as
export led growth, and involves the terms of trade. We introduced the concept of the terms
of trade in Study Unit 16. To recap, the terms of trade measures the relative movement of
import and export prices. It is calculated from:
unit value index of exports
 100
unit value index of imports
The unit value index represents the average movement in price of a "unit" of imports or
exports. The unit itself is a kind of average of all types of visible imports and exports. The
terms of trade thus gives a general indication of how average import and export prices are
moving. A high terms of trade is beneficial for a country, provided it goes hand in hand with a
high demand for its exports. But a high terms of trade also results from overvaluation of a
country's currency, and if this leads to falling exports and rising imports the country will
suffer. A country can manipulate its exchange rate to alter its terms of trade.
© ABE and RRC

A country may adopt a fixed value for its currency that is deliberately undervalued, so that its
export industries have a big competitive advantage in international markets. This policy will
worsen its terms of trade and make imports expensive, but it can lead to export led growth
and a very large surplus on its balance of trade. The low terms of trade means that the
country suffers a lower standard of living than it could achieve if it increased its exchange
rate, or allowed its currency to appreciate. This is because it is selling its exports "cheaply" in
international markets relative to what it has to pay for its imports. But on the plus side, if its
exchange rate is sufficiently undervalued as to give its firms a really big cost advantage in
exporting, and it can resist the pressure from those countries experiencing huge trade
deficits as the counterpart of its huge trade surplus to revalue its currency, then its industry,
employment and growth will prosper. The best example in recent times of a country
deliberately maintaining an undervalued fixed exchange rate to boost its economic growth is
provided by the rise to dominance of China as one of the world's leading export nations.
Such a policy does not come without its economic consequences. As explained next,
maintaining a fixed exchange rate leaves a country open to importing inflation. Artificially
depressing the terms of trade to gain an advantage in exporting adds further to domestic
inflationary pressure by increasing the price of imports. This is the problem experienced by
China towards the end of the first decade of the twenty-first century.
China is not the first or only country to seek to grow its domestic economy through export-led
growth based on maintaining an undervalued currency. The best example is provided by
Japan. Japanese economic policy towards its exchange rate under the IMF Bretton Woods
system of fixed exchange rates was to keep its currency seriously undervalued, and resist all
pressure, especially from its main export market in the USA, to revalue its currency.
Japanese success as one of the world's leading exporters owes much to its exchange rate
policy. Since Japan adopted a floating exchange rate in the 1970s, the Japanese
government and the Bank of Japan have managed the exchange rate through intervention in
the foreign exchange market, to limit its appreciation and maintain Japanese companies
export competitiveness. The extent of the intervention is seen most clearly whenever the yen
appreciates against the US dollar and looks like increasing to such an extent that the US
dollar falls below 100 yen to the dollar. When this happens the yen soon loses value again
and depreciates in value against the US dollar, much to the relief of Japanese based
exporters.
D. MACROECONOMIC POLICY IN OPEN ECONOMY

In Study Units 13 and 14 we explained, using both the Keynesian 45 degree model and the
aggregate demand and supply model of income determination, how governments could use
monetary and fiscal policies to influence the level of demand in the economy and achieve the
objectives of macroeconomic policy. In the analysis of income determination we allowed for
exports as an injection of aggregate demand and imports as a withdrawal of aggregate
demand from the economy, but neglected the economy's exchange rate regime. This was
done to simplify the analysis and make the exposition easier to follow. However by ignoring
the type of exchange rate operated by a country we have overstated the effectiveness of
monetary and fiscal policies and the power of a government to control the economy.
Economics teaches us that there are some things that are beyond the control of
governments. For example, when the demand for a good or service increases its price will
rise, unless the increase in demand is matched by an equal increase in supply. The rise in
price may be unpopular but it is unavoidable, because no government can abolish scarcity,
and the laws of economics, by decree. The same applies to macroeconomic policy. It can be
proved (but will be simply stated here to avoid a long and complex piece of analysis) that a
government cannot control all three of the following macroeconomic variables at the same
time: the rate of interest, the exchange rate and the rate of inflation.
© ABE and RRC

Governments face a dilemma or policy conflict when it comes to choosing between these
three variables. They can only choose to determine the value of one of the three as a policy
objective or target. Once they have fixed the value of one of the three, the values of the
other two variables will be determined by market forces. Thus if a government decides to fix
the value of its currency against that of another country by adopting a fixed exchange rate
regime, the government will have to accept that it cannot also determine the level of interest
rates in the economy and control the rate of inflation. Rather, the government will have to
vary the rate of interest to defend its fixed value of its exchange rate, and how it changes the
level of its rate of interest will be dictated by rate change overseas. Likewise, the rate of
inflation in the country will be determined partly by the level of interest rates and the rate of
inflation in the global economy. If a government decides that its most important
macroeconomic policy objective is to control the rate of inflation, then it must sacrifice its
ability to simultaneously determine its exchange rate and level of interest rates.
This particular dilemma explains why most of the world's advanced economies have
abandoned fixed exchange rates in favour of floating exchange rates, and given their central
banks independence to use interest rates to achieve a fixed target for the rate of inflation.
Given the choice between a fixed exchange rate and achieving a target rate of inflation,
many governments have decided that a floating exchange rate is a small price to pay for
achieving control over the rate of inflation. Conversely, those countries that have opted to
operate a fixed exchange rate regime for trade advantage reasons, especially China, have
discovered the hard way that eventually this policy choice leads to the problem of increasing
domestic inflation.
An open economy enables a country to enjoy the gains from international trade, but it also
constrains the choice of macroeconomic policy objectives. There is a further consequence:
the choice of exchange rate regime also affects the effectiveness of monetary and fiscal
policies in controlling demand in the economy. Governments need to recognise that:
 Fiscal policy is most effective and monetary policy least effective if a country operates
a fixed exchange rate regime.
 Monetary policy is most effective and fiscal policy least effective if a country operates a
freely floating exchange rate.
The explanation for this involves the rate of interest. Remember that as the level of national
income increases, so does the demand for money. If the supply of money remains constant,
this will cause the rate of interest to increase. Remember also that increased borrowing by a
government, to finance its budget deficit, will drive up the level of the rate of interest. If
economies are open to international trade and financial flows, then differences in interest
rates between countries will cause investing institutions to move funds between countries in
search of the highest return. The flow of funds into and out of a country will result in pressure
on its exchange rate to change. The implication of these relationships depends upon a
country's exchange rate regime.
Consider a country operating a fixed exchange rate regime. The country's central bank will
have to use the rate of interest and intervention in the foreign exchange market to maintain
the exchange rate at the fixed level chosen by the government. If the government
undertakes an expansionary fiscal policy, the resultant upward pressure on the rate of
interest will attract an inflow of money from the rest of the world. If this is unchecked, it will
cause the exchange rate to appreciate above its fixed rate value. This will force the central
bank to intervene in the foreign exchange market, by buying foreign currency at the fixed
rate and increasing the supply of the domestic currency. The increased supply of the
domestic currency will put downward pressure on the rate of interest. The net result is that
the expansionary fiscal policy is unchecked by any induced off-setting rise in interest rates.
Fiscal policy is thus highly effective in this case. In contrast, monetary policy is largely
ineffective under a regime of fixed interest rates. For example, an expansionary monetary
policy will lower the domestic rate of interest and cause an outflow of funds from the
© ABE and RRC

economy. The outflow of the domestic currency increases its supply relative to demand on
the foreign exchange market, and causes downward pressure on the exchange rate. To
maintain the fixed value for the exchange rate, the central bank has to intervene in the
foreign exchange market by selling foreign currencies from the country's reserves, and in
return take domestic currency out of the market. The consequence of this buy back of
domestic currency by the central bank is to push the domestic rate of interest back up to its
value before the expansionary monetary policy was undertaken. The net result of the
attempted expansionary monetary policy is that the domestic money supply and the rate of
interest return to their initial values, but the country has a small stock of foreign currency
reserves.
If a country operates with a freely floating exchange rate regime the previous conclusions
regarding the effectiveness of fiscal and monetary policy are reversed completely. The value
of the exchange rate is now determined by the forces of demand and supply in the foreign
exchange market, without any intervention by the central bank. An expansionary monetary
policy reduces the rate of interest and causes funds to flow overseas in search of a higher
return. Without any intervention by the central bank, the increased supply of domestic money
on the foreign exchange market will cause the currency to depreciate, i.e. the value of the
exchange rate will be reduced. This depreciation of the exchange rate has two
consequences which enhance the effectiveness of monetary policy in boosting demand. The
depreciation of the currency will make exports more competitive, and thus boost the demand
for the country's exports. The depreciation in the exchange rate also makes imports more
expensive, and will cause domestic demand to switch from imports towards domestic
suppliers. Both of these effects, the strength of which depends upon elasticity of demand
and supply, increase injections and reduce withdrawals from the circular flow of income. This
reinforces the initial boost to demand from the reduction in interest rates. Monetary policy is
highly effective in this case. The same process works in reverse to strengthen the demand
reducing effect of a contractionary monetary policy.
With a freely floating exchange rate fiscal policy is largely ineffective, because of the way in
which it induces off-setting changes in the exchange rate. For example, an expansionary
fiscal policy which initially boosts demand and causes the rate of interest to rise. The rise in
the domestic interest rate relative to the level overseas will cause foreign demand for its
currency to rise on the foreign exchange market and its value to appreciate. As the currency
appreciates the country's export competitiveness will decline, and it will experience a decline
in its exports. At the same time, the appreciation of the currency will make imports and
overseas travel more attractive. Thus as the government's fiscal expansion increases
injections into the circular flow of income, either in the form of more G, or C and I, the
induced affect on the rate of interest and the exchange rate produces an off-setting decline
in X and increase in M. Fiscal policy is thus rendered ineffective due to interest rate and
exchange rate "crowding out".
This explanation is simplified, and in practice monetary and fiscal policy are never completely
ineffective whichever exchange rate regime a country operates. This is because freely
floating exchange rates are rarely left completely free by central banks, and funds are not
completely free of all restrictions to move between all countries. However, the basic point
remains valid. It helps to explain why, following the adoption of floating exchange rates by
many governments from the 1970s onwards, much more importance is given to monetary
policy to control the level of demand and hence the rate of inflation in an economy. Fiscal
policy is still used to influence aggregate demand, but much less so than in the 1950s and
1960s, when most countries adopted a fixed exchange rate regime. Today fiscal policy is
used more to achieve supply-side objectives rather than regulate aggregate demand in the
economy.
© ABE and RRC

Review Points
You should go back to the start of this unit and check that you have achieved the learning
objectives. If you do not think that you understand the aim and each of the objectives
completely, you should spend more time rereading the relevant sections.
1. Explain the difference between devaluation/revaluation and depreciation/appreciation

of currencies on the foreign exchange market.
2. What is purchasing power parity?
3. If a country has a higher rate of inflation than other countries then its nominal
exchange rate will eventually depreciate to maintain purchasing power parity.
True or false?
4. What is meant by the terms of trade?
5. Explain the meaning of "export led growth".
6. What are the advantages of a country choosing a freely floating rather than a fixed
exchange rate?
7. Monetary policy is more effective than fiscal policy if a country chooses to operate a
fixed floating exchange rate regime.
True or false?
© ABE and RRC

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Business Management

ABE STUDY MANUAL

ECONOMIC PRINCIPLES AND THEIR APPLICATION TO BUSINESS

The Association of Business Executives

Diploma in Business Management

ECONOMIC PRINCIPLES AND THEIR APPLICATION

Unit Title Page

Introduction to the Study Manual v

1 The Economic Problem and Production 1

2 Consumption and Demand 17

3 Demand and Revenue 27

5 Costs, Profit and Supply 73

Unit Title Page

6 Markets and Prices 97

7 Market Structures: Perfect Competition versus Monopoly 125

8 Market Structures and Competition: Monopolistic Competition and

9 The National Economy 155

10 Determination of National Product: The Keynesian Model of Income

11 Macroeconomic Equilibrium and the Deflationary and Inflationary

Unit Title Page

12 Money and the Financial System 213

13 Monetary Policy 229

14 Macroeconomic Policy 245

15 The Economics of International Trade 261

16 National Product and International Trade 281

17 Foreign Exchange 297

Introduction to the Study Manual

The Association of Business Executives

Unit Title: Economic Principles and Their Unit Code: EEPAB

Candidates will be able to:

1. Explain the problem of scarcity, the concept of opportunity cost,

1.1. Explain the problems of scarcity and opportunity cost. Explain

2. Explain the theory of consumer choice using the concept of

2.1. Explain the concept of utility. Explain what is meant by marginal

3. Discuss the theory of costs, explaining the differences and

3.1. Explain, with reference to appropriate examples, the difference

ABE, ABE Study Manual – Economic Principles and their Application to

Sloman J, Economics (2002), Pearson Higher Education

Taylor M, Mankiw N, Economics (2006), Thomson Learning

A. Basic Economic Problems and Systems 4

D. Some Assumptions Relating to the Market Economy 14

© ABE and RRC

How to Use the Study Manual

© ABE and RRC

A sound knowledge and understanding of economics is essential for understanding the

© ABE and RRC

A. BASIC ECONOMIC PROBLEMS AND SYSTEMS

© ABE and RRC

Choice and Opportunity Cost

© ABE and RRC

© ABE and RRC

Enterprise as a Production Factor

© ABE and RRC

Nevertheless this identification of enterprise in terms of individual risk-taking raises a great

Fixed and Variable Factors of Production

© ABE and RRC

Number of workers Quantity of production

© ABE and RRC

© ABE and RRC