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AL
EDUCATION
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REVISION GUIDE
Economics
for the IB DIPLOMA
Paul Hoang
( HODDER
EDUCATION
HETTE UK COMPANY
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© Paul Hoang 2014
First published in 2014 by
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Year 2016 2015 2014
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ISBN: 978-14718-0718-3
Contents
How to use this revision guide Vil

Getting to know the exam Viii
Assessment objectives and command terms X
Countdown to the exams Xii
Section 1 Microeconomics
Section 2 Macroeconomics 58
Section 3 International economics 111
Section 4 Development economics 143
Are you ready? 170

My revision notes 175
Glossary 178
Dedications
This book is dedicated to Mr Graham Hollamby, my economics teacher at Southwark
College, London.
My heartfelt thanks and love to Kin, Jake and Luke for always putting up with me.
My sincere thanks to my publisher (and fellow Arsenal fan), So-Shan Au, for her help
and guidance throughout this project.
Finally, my gratitude to Samson Wong, an outstanding student who provided invaluable
feedback from the perspective of an IB learner,
Acknowledgements
The Publishers would like to thank the following for permission to reproduce copyright
material:
Photos:
p- 86 © Tsvangirayi Mukwazhi/AP/Press Association Images.
Text:
p- 150: Figure 4.2, redrawn from http://fen.wikipedia.org/wiki/List-of-countries-by-
Human-Development-Index
Every effort has been made to trace all copyright holders, but if any have been
inadvertently overlooked the Publishers will be pleased to make the necessary
arrangements at the first opportunity.
. How to use this revision guide
Welcome to the Economics for the IB Diploma Revision Guide. This book will
help you plan your revision and work through it in a methodological way. It
follows the Economics syllabus topic by topic, with revision and exam practice
questions to help you check your understanding.
Features to help you succeed

(e ITa 113 Common mistakes Keyword definitions
These tips give advice that will help These identify typical mistakes that Definitions are provided on the
you boost your final grade. students make and explain how you pages where the essential key
can avoid them. terms appear. These keywords are
those that you can be expected
to define in exams. A glossary of
Worked examples other essential terms, highlighted
throughout the text, is given at the
Some parts of the course require you to carry out mathemarical calculations, end of the book.
plot graphs, and so on. These examples show you how.
EXAM PRACTICE
Exam practice is given for the type of questions you might get. For the longer
essay questions, sample sentences and paragraphs are given to show what
examiners are looking for in your essay answers. For easy reference, the exam
paper is indicated for each question. Use these questions to consolidate your
revision and to practise your exam skills.
EXAM PRACTICE (HL ONLY)

Some parts of the Economics course require you to carry out mathematical
calculations, plot graphs and so on. There are sample Paper 3 exam questions
interspersed in the chapters, with suggested answers online.
You can keep track of your revision by ticking off each topic heading in the
book. There is also a checklist at the end of the book. Use this checklist to
record progress as you revise. Tick each box when you have:
= revised and understood a topic
m used the Exam practice questions and gone online to check your answers.
Use this book as the cornerstone of your revision. Don't hesitate to write in it
and personalise your notes. Use a highlighter to identify areas that need further
work. You may find it helpful to add your own notes as you work through each
topic. Good luck!
viii Economics for the IB Diploma
Getting to know the exam

Exam paper Duration Format Topics Total marks
Paper 1 1.5 hours Essay 1 and 2 50

Paper 2 1.5 hours Data response 3and 4 40
Paper 3 (HL only) 1 hour Structured questions All 50
At the end of your Economics course you will sit two papers — Paper 1 and
Paper 2. Paper 1 is worth 30% of the final marks and Paper 2, 50% of the final
marks. The other assessed part of the course (20%) is made up of the Internal
Assessment, which is marked by your teacher.
HL students will sit an additional paper — Paper 3, worth 20%. For HL
students, Paper 1 is worth 30% of the final marks, and Paper 2 also 30% of
the final marks. The other assessed part of the course (20%) is the Internal
Assessment (or 1A) which is marked by your teacher.
Here is some general advice for the exams:
= Make sure you have learned the command terms (e.g. evaluate, explain,
outline). There is a tendency to focus on the content in a question rather
than the command term, but if you do not address what the command term
is asking of you then you will not be awarded marks. (Command terms are
covered on page x.)
= If you run out of room on the page, use continuation sheets and indicate
clearly that you have done this on the cover sheet.
= The fact that the question continues on another sheet of paper needs to be
clearly indicated in the text box provided.
= Plan your time carefully before the exams.
Paper1
Paper 1 (1.5 hours) contains two sections: Section A is based on
Microeconomics and Section B is based on Macroeconomics. You will need to
answer one of the two questions from each section. Part a) of each essay is worth
10 marks and part b) is worth 15 marks. Hence, the total number of marks for
this paper is 50.
w [t is necessary to include definitions in the essays, so make sure you have
learned the keyword definitions in this book.
= As the paper is only out of 50 marks, the questions cannot cover all aspects
of Microeconomics and Macroeconomics. It is therefore essential that you
thoroughly revise the whole of Topics 1 and 2 of the syllabus so that you can
tackle any questions that come up.
= The 10-mark questions do not involve any evaluation, but do require a
concluding statement that answers the question. The 15-mark questions do
require an evaluation.
» Wherever appropriate, include fully labelled diagrams and the application of
real-world examples to substantiate your answers.
How to use this revision guide ix
Paper 2
Paper 2 (1.5 hours) contains two sections: Section A contains two data-response
questions on International economics; you must answer one of these, which is
worth a total of 20 marks. In Section B you must answer one of the two data-
response questions on Development economics, again worth 20 marks. The
total marks for the paper is therefore 40.
In Paper 2 you may be given a range of data in various forms (e.g. diagrams,
graphs, charts and data tables) relating to a specific case study on International
economics and Development economics. Questions will test your knowledge of
Topic 3 and Topic 4 of the syllabus, and your ability to apply this to the given
case studies.
= Do not spend too much time on one of the two sections.
= Plan your time carefully (do this before the exam!). You should spend no
more than 45 minutes on each section.
= By practising past exam papers, you will be able to fine-tune your time
management; this may vary from student to student.
m Choose your questions carefully. Look at all sections of the data-response
questions before making your choices.
= You will be required to provide definitions (for the 2-mark questions) and to
draw relevant diagrams (for the 4-mark questions). Practise drawing accurate
and fully labelled diagrams.
= Some students write far too much for questions worth only 2 marks, and
then run out of time later on for the 8-mark question. Look carefully at the
number of marks available for each question and adjust the amount of time
you spend on that question accordingly.
= There are several parts to each data-response question — make sure you
answer all parts.
w Case studies help answer Paper 2 data-response questions — make sure you
read the stimulus material and analyse the supplementary data as you will be
expected to apply your knowledge.
x Economics for the IB Diploma
Paper 3 Expert tip

Only HL students take the Paper 3 (quantitative) examination. It is a 1-hour Do not attempt to answer all three
paper, with students required to answer any two of the three questions. guestions in this paper. While it is
= There are no evaluation-type questions in Paper 3. true that if a student attempts all the
= Paper 3 accounts for 20% of the overall weighting in the HL course. guestions and the marks for the top
two answered questions count, there
= Each question is marked out of 25. Students must answer two questions,
is a huge opportunity cost in such a
totalling up to 50 marks. This means there are 10 minutes remaining to strategy. Surely, you can answer two
check over your answers if you allocate about 1 minute per mark in the exam. guestions better in 60 minutes than
= Questions can test your knowledge from any of the four syllabus topics: you can three questions in the same
Microeconomics, Macroeconomics, International economics and time. Use any spare time you have
Development economics. to check over your calculations and
written answers.
Assessment objectives and command

terms
To successfully complete the course, you need to have achieved the following
assessment objectives:
AO1 Demonstrate knowledge and understanding of specified content,

including current economic issues and data
AO2 Demonstrate application and analysis of knowledge and understanding
by:
= applying economic concepts and theories to real-world situations
= identifying and interpreting economic data
= demonstrating the extent to which economic information is used
effectively in particular contexts
AO3 Demonstrate synthesis and evaluation by:
= examining economic concepts and theories
m using economic concepts and examples to construct and present an
argument
m discussing and evaluating economic information and theories
AO4 Select, use and apply a variety of appropriate skills and techniques by:
m producing well-structured written material, using appropriate
economic terminology, within specified time limits
m using correctly labelled diagrams to help explain economic concepts
and theories
= selecting, interpreting and analysing appropriate extracts from the
news media
m interpreting appropriate data sets
Source: IB Economics Guide, page 7
These assessment objectives are examined in the following way:
Assessment objective Paper 1 Paper 2 Paper 3

(HL only)
AQO1: Knowledge and 30% 35% 30%
understanding
AQ2: Application and analysis 30% 30% 30%
AQ3: Synthesis and 20% 25% -
evaluation
AO4: Selection, use and 20% 10% 40%
application of a variety of
skills and techniques
How to use this revision quide xi
Command terms indicate the depth of treatment required for a given

assessment statement. Assessment objectives 1 and 2 address simpler skills,
assessment objective 3 relates to higher-order skills, while assessment objective
4 refers to the skills of selecting, using and applying economic skills and
techniques.
It is essential that you are familiar with these terms, so that you are able
to recognise the type of response you are expected to provide as well as the
required depth of your response.
The following table shows all of the command terms, with an indication of
the depth required from your written answers.
Assessment objective Command terms Depth of answers

AO1: Knowledge and understanding Define These terms require you to learn and comprehend
Describe the meaning of information.
List
Outline
State
AQ2: Application and analysis Analyse These terms require you to use your knowledge to
Apply explain actual situations, and to break down ideas
Comment into simpler parts and see how these parts relate.
Distinguish
Explain
Suggest
AQ3: Synthesis and evaluation Compare These terms require you to rearrange component
Compare and contrast ideas into a new whole and make judgements
Contrast based on evidence or a set of criteria.
Discuss
Evaluate
Examine
Justify
To what extent
AQ4: Selection, use and application of Calculate These terms require you to demonstrate the
a variety of skills and techniques Construct selection and application of skills.
Derive
Determine
Draw
Identify
Label
Measure
Plot
Show
Show that
Sketch
Solve
Source: IB Economics Guide, page 9

Xii Economics for the IB Diploma
Countdown to the exams

4-8 WEEKS TO GO
Start by looking at the syllabus and make sure you know exactly what you
need to revise.
Look carefully at the checklist in this book and use it to help organise
your class notes and to make sure you have covered everything.
Work out a realistic revision plan that breaks down the material you need
to revise into manageable pieces. Each session should be around
25-40 minutes with breaks in between. The plan should include time for
relaxation.
Read through the relevant sections of this book and refer to the expert
tips, common mistakes, keyword definitions, case studies and worked
examples.
Tick oft the topics that you feel confident about, and highlight the ones
that need further work.
Look at past papers. They are one of the best ways to check knowledge
and practise exam skills. They will also help you identify areas that need
turther work.
Try different revision methods, for example summary notes, mind maps
and flash cards.
Test your understanding of each topic by working through the Exam
practice questions.
Make notes of any problem areas as you revise, and ask a teacher to go
over them in class.
1 WEEK TO GO
Aim to fit in at least one more timed practice of entire past papers,
comparing your work closely with the mark scheme. MY EXAMS
Examine the checklist carefully to make sure you haven’t missed any of PAPER 1
the topics.
.
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Tackle any final problems by getting help from your teacher or talking
them over with a friend. lime: s aaa st arereEr e e rE e par
.
LoEation: «oomessvessummmsnonssss
i
THE DAY BEFORE THE EXAMINATION

Look through this book one final time. Look carefully through the .
B oR
information about each exam paper to remind yourself what to expect,
including timings and the number of questions to be answered. [ime: S et resr e are s e e s e e e
Check the time and place of the exams. Location:

.
s meimass
s
Make sure you have all the equipment you need (e.g. extra pens, pencil
and ruler for diagrams, a watch, tissues and water). If you are an HL
student, make sure you have a GDC calculator for Paper 3. Date:
.
o
Allow some time to relax and have an early night so you are rested and
[ime: e saeaseses
e ts sttt
ready for the exams. There is a huge opportunity cost if you are not
.
refreshed! Location: ....cooevvrieeeeiiiraennann.
Ylaile- sl Microeconomics
1.1 Competitive markets: demand

and supply
Markets and demand
m The law of demand states that the quantity demanded for a good or service
falls as its price rises, ceteris paribus. Likewise, the quantity demanded rises at
lower prices.
= The demand curve shows the inverse relationship between price and
Keyword definitions
quantity demanded ofa product (see Figure 1.1).
A market is any place where
A transactions take place berween
buyers and sellers, for example
shares are traded in a stock market
and currencies are traded on the
As the price falls from foreign exchange market. Scarcity
Py to Py, the quantity
®
Price ($)
demanded rises from must exist for a market to exist.

Q) to Q. Demand is the willingness and
o
ability of customers to pay a certain

price in a market to obtain a
Demand particular good or service. It is
5 sometimes referred to as etfective
O Q Qo demand to distinguish it from a
Quantity demanded want or a desire to buy something.
Figure 1.1 The demand curve
There are three causes of the negative relationship between price and
Common mistake
quantity demanded:
= The income effect — as price falls, the real income of customers rises, i.e. they Be careful when using the concepts of
are able to buy more products at lower prices. demand’ and ‘quantity demanded’,
= The substitution effect — as the price of a good or service falls, more as these aie often confused by
; ; students in the exams. Demand refers
customers are able to pay, so they are more likely to buy the product, i.e. :
: : 4 . : to an entire demand curve, whereas
substitute it for alternative products that they might have previously bought. . .
A O : ) quantity demanded refers to a point
= Diminishing marginal returns — as people consume more of a particular good 40 damand curve
or service, the utility (return or satisfaction) gained from the marginal unit
declines, so customers will only purchase more at a lower price.
The market demand curve refers to the sum of all individual demand for a
product. It is found by adding up all individual demand at each price level (see
Figure 1.2). For example, if a cinema charges $10 for movie tickets and the
demand is 500 from male customers and 400 from female customers, then the
market demand is 900 cinema tickets per week.
PI$IA P$I4 P$I4

e Sl
Dm | By w
O 500 Q O AOD Q O 900 Q
Male customers Female customers Total customers
Figure 1.2 The market demand curve

2 Economics for the IB Diploma
Non-price determinants of demand

Price is not the only factor that affects the demand for a good or service. Factors
that change the demand (or shift the demand curve) for a good or service can Keyword definitions
be recalled using the acronym HIS AGE: Substitutes are products that can be
= Habits, fashion and tastes — products that become fashionable (e.g. used instead of each other, such as
smartphones) cause an increase in demand, whereas unfashionable items (e.g. Coca-Cola or Pepsi and tea or coftee.
last season’s clothes) reduce the level of demand. Complements are products that are
m Income — higher levels of income mean that customers are able and willing jointly demanded, such as cinema
to buy more goods and services. The average person in the USA, for example, movies and popcorn or pencils and
will have a higher level of demand for products compared with the average erasers.
person in Vietnam or Turkey.
When the demand for a product
m Substitutes and complements — if the price of a product falls, then it is likely
increases with a rise in income, it is
that the demand for the substitute product will also fall. By contrast, if the
called a normal good. These include
price of a product increases, then the demand for its complementary good is
both necessities and luxury products.
likely to fall.
= Advertising — marketing messages are used to inform, remind and persuade An inferior good has a negative
customers to buy a firm's products. Companies such as McDonald’s and relationship between income and
Samsung spend hundreds of millions of dollars each year on their advertising quantity demanded, i.e. customers
to increase the demand for their products. switch to a superior (luxury)
m Government policies — rules and regulations such as the legal age on the product as their income rises — for
purchase of tobacco and alcohol affect the demand for certain products. By example, canned food products
contrast, government initiatives to educate people about energy-efficient cars versus fresh food products.
could encourage more demand for environmentally friendly cars.
s Economy — whether the country is in a recession or boom has a huge impact
on the spending patterns of the population. For example, the global financial Expert tip
crisis of 2008 caused the demand for most goods and services around the Depending on the context of the
world to decline. good or service being considered,
two other potentially important
determinants of demand are the
weather and demographics (e.g. age,
gender, ethnicity or religious beliefs of
customers).
Movements along, and shifts of, the demand

curve
m A change in the price of a good or service causes a movement along the
demand curve.
m A price rise will cause a contraction in the quantity demanded for the product
m A fall in price will cause an expansion in the quantity demanded (see Figure 1.3).
A fall in price from Py to Pg

&= P causes demand to expand from
Q Q) to Qg, whereas a price rise
= Py from P; fo Py causes quantity It will be useful for you to know
demanded to fall from Q5 to Q. the difference between changes in
Py demand and changes in the quantity
Demand
demanded. A shift in demand is
caused by changes in non-price factors
that affect demand. A movement
© Q Q Qp
Quantity demanded along a demand curve is caused by
changes in the price of the product.
Figure 1.3 Movements in the demand curve
Section1 Microeconomics 3
= A change in non-price factors that affect demand cause a shift in the demand
Keyword definition
curve.
Price fluctuations cause movements
m An increase in demand is shown by a rightwards shift in the demand curve
along an existing demand curve. A
from D; to D5 (see Figure 1.4). At P;, demand increases from Q; to Q3.
rise in price results in a contraction
m By contrast, a decrease in demand is shown by shifting the demand curve
in quantity demanded, whereas a
to the left, from D; to D;, resulting in less quantity demanded at all price
fall in price causes an expansion in
levels.
quantity demanded.
A
A change in a non-price Common mistake

factor that affects
demand will shiff the
Students often claim that the
demand curve. imposition of a sales tax on a product
shifts its demand curve to the left.
This is incorrect as the tax is imposed
on firms, thereby raising their costs of
production. The tax increases the price
of the product, so therefore reduces
O @y Q Qs
¥
Quantity demanded the quantity demanded, i.e. it causes

a movement along the demand curve.
Figure 1.4 Shifts in the demand curve
Linear demand functions (HL only)

The demand curve is often graphed as a straight line for ease of illustration. The
linear demand function is Qg= a — bP, where:
= a=demand, irrespective of the price
m —b =slope of the demand curve, i.e. how the price affects the quantity demanded.
Any change in a will cause a change in demand, i.e. shift the demand curve.
Any change in b will change the quantity demanded and the steepness of the
demand curve.

PAPER 3
1 Plot a demand curve from the given linear demand function
Q= 800 — 25P. [4]
2 From the diagram below, solve the linear function of the demand curve. [2]
A
~D
o
Price of ($)
Demand
BOO
Quantity demanded
Make sure you know the difference between the cause of a shift and a movement
in demand. A shift in the demand curve is caused by changes in non-price factors
that affect demand, such as changes in income. A movement along a demand
curve is caused by changes in the price of the product.
SUpplg
The law of supply and the supply curve
The law of supply states that there is a positive relationship between the
quantity supplied of product and its price, ceteris paribus. This is shown
diagrammatically by a supply curve. There are two reasons for the positive Keyword definition
relationship between price and supply: Supply is the willingness and ability of
= Existing firms in the market can earn higher profit margins if they supply more. firms to provide a good or service at
= More firms enter the market as higher prices allow them to cover production a given price level, per time period.
COStS.
Movements along, and shifts of, the supply

curve
As with demand, the market supply curve is the sum of all individual producers’
supply curves at each price level.
A movement along a supply curve occurs if the price changes, causing a
change in the quantity supplied (see Figure 1.5).
Supply
A fall in price from Py to P

Expansion causes the quantity supplied fo
contract from Q5 to G whereas a
Price ($)
P3 ________________“/
price rise from P} to Py causes

Pyt ; i the quantity supplied to expand
! I from Q4 to Q5.
b, / o
+ Confraction
B QR @ & )
Quantity supplied
Figure 1.5 Movements along the supply curve
A shift in the supply curve is caused by changes in non-price factors that
affect supply, causing a change in supply. In Figure 1.6, a rightwards shift (from S,
to S;) shows an increase in supply, while a leftwards shift (from S; to S3) shows a
fall in supply.
T
shown by a rightward shift ARy
& of the 5’UPP}V curve from _ A shift in supply is caused by changes
8 S fol 5?- Similarly, g E‘“ L in non-price factors that affect supply
& Spply Isepresenlec by g (such as taxes and adverse weather).
leftward shift of the supply A : Vi % ol
curverfrom S a5 moveme!‘lt in supply is caused only
by changes in price.
o -
Quantity supplied
Figure 1.6 Shifts of the supply curve
The non-price determinants of supply
Table 1.1 Factors that change supply or shift the supply curve
Expert tip
Non-price How supply is changed by these determinants
determinants A useful way to remember some of the
of supply key non-price determinants of supply is
to use the acronym SWITCH, i.e.
Costs of Changes in any costs of production cause a shift in supply, for u Subsidies
production example changes in wages and rents. m Weather
m ICT (technology)
Taxes Indirect taxes are imposed on the supplier of a product, which
u Taxes
basically adds to the costs of production. Hence, taxes tend to
n Competitive supply and
reduce market supply.
= Hurdles (barriers to entry).
Subsidies Financial assistance from the government to help encourage
output by reducing costs of production for products that are
beneficial to society as a whole, for example the provision of
education, training and healthcare.
Technological Advances in technology mean that there can be greater levels

progress of output at every price level.
Expectations Price acts as a signal to producers to move their resources
to the provision of products with greater profitability. Thus,
expectations of price movements affect supply.
Competitive The output of a product (such as apples) takes place as an
supply alternative to other products (such as oranges), based on the
relative profitability of these products.
Joint supply The output of one product (such as cows) routinely leads to the
supply of another (such as milk).
Barriers to The number of firms in the market, determined by the nature
entry of barriers to entry to the industry, can affect the level of
supply.
Time Supply tends to be lower in the short run but can increase over
time — for example, it is difficult for farmers to increase their
supply of crops within a short period of time.
Weather The output of some products depends on the weather — for
example, agricultural output.
Linear supply functions (HL only)

The supply curve is often graphed as a straight line for ease of illustration. The
linear supply function is Q, = ¢ + dP, where:
m ¢ = supply, irrespective of the price (so this is also the intercept on the y-axis)
m +d = slope (or steepness) of the supply curve. A supply function normally has a
negative intercept, such as S=-800
Any change in ¢ will shift the supply curve.
+ 20P, as firms need to cover their
Any change in d will affect the price elasticity of the supply curve. production costs. Here, if P= $40,
then zero units of output is supplied.
Any price above $40 will create an
ability and willingness for firms to
EXAM PRACTICE (HL ONLY) supply their products. A positive
intercept means that even when
PAPER 3 the price is zero, the existence of
3 Plot a supply curve that has the linear supply function Q. =—100+ 10P. [4] government subsidies ensures that a
minimum level of output is supplied.
Market equilibrium
Equilibrium and changes to equilibrium

Equilibrium exists when the quantity demanded for a product is equal to the
quantity supplied (see Figure 1.7). Recall that changes in any of the non-price
determinants of supply or demand will cause a change in the market equilibrium
price. For example: Keyword definition
m A successful advertising campaign that promotes the consumption of fresh Market equilibrium occurs when
fish shifts its demand curve to the right, thereby raising the price and the quantity demanded for a
quantity traded. product is equal to the quantity
m A severe drought would shift the supply curve of agricultural products to the supplied of the product, i.e. there
left, leading to an increase in the price and a fall in the quantity traded. are no shortages or surpluses.
Supply
Price ($)
Equilibrium
price
Cemand
L.
>
O Equilibrium quantity traded
Quantity fraded
Figure 1.7 Market equilibrium
Excess supply occurs when the price is set above the equilibrium, i.e. a surplus
exists, as shown by the green area in Figure 1.8.
Surplus is created
when supply exceeds
demand because the
price is higher than the
market equilibrium.
Y
O Qg Qo
Quantity traded
Figure 1.8 Excess supply (surplus)
Excess demand occurs when the price is set below the equilibrium, i.e. a
shortage exists, as shown by the green area in Figure 1.9.
A shortage occurs
when demand exceeds
Price ($)
supply because the

i R . price is lower than the
market equilibrium.
O a o 0
Quantity traded
Figure 1.9 Excess demand (shortage)
If there is excess supply, there is a tendency for price to fall to remove the
surplus. If there is a shortage in the market, the price will tend to rise to remove
the excess demand.
Calculating and illustrating equilibrium using

linear equations (HL only)
Equilibrium exists when the demand and supply functions are equal, i.e.:
a—bP=c+dP

PAPER 3
4 Calculate the equilibrium price and quantity if the demand function is given as
Q4= 600 — 3P and the supply function is Q,=—100 + 2P. [3]
The role of the price mechanism
Resource allocation
Resources are finite in supply whilst wants (desires, or goods and services that
we would like to have) are infinite. This creates a situation of scarcity, which
subsequently imposes production choices about what to produce.
Due to limited resources, including money, economic agents have to make
choices. This results in an opportunity cost — for example, choosing to buy a
smartphone may come at the opportunity cost of buying a games console or
going on a holiday.
In a market economy, price has both a signalling function and an incentive
funcrion (see Figure 1.10). These functions result in the reallocation of resources
if price changes due to changes that affect the demand for or supply of a product.
S
If demand for a product increases, from
Dy to Dy, the equilibrium price will
increase from Py to Py, ceferis paribus.
This signals to firms fo raise their supply
as there is an incentive for them to do so
[greater levels of profits).
GQuantity fraded
Figure 1.10 Signalling and incentive functions of price

Market efficiency
Consumer surplus, producer surplus and

allocative efficiency
Keyword definitions
Consumer surplus refers to the benefits to buyers who are able to purchase a
product for less than they are willing to do so. By contrast, producer surplus
is the difference between the price that firms actually receive and the price
they were willing and able to supply at.
Allocative efficiency happens when resources are distributed so that consumers
and producers get the maximum possible benefit, which means no one can be
made better off without making someone else worse off (see Figure 1.11).
Points A, B and C represent

allocative efficiency as any
reallocation of resources will
make others worse off.
®c
Products Point D represents allocative
for males inefficiency as resources are
D®
underutilised.
PPC
Point E is not attainable given
the current resources of the
economy.
© &
Products for females
Figure 1.11 Allocative efficiency and the production possibility curve (PPC)
Consumer surplus is shown by the difference between what consumers are willing
to pay for a product and the amount they actually pay (see Figure 1.12). Hence, the
consumers’ marginal utility of consumption is greater than the market price.
Consumer surplus At the equilibrium price of Py, there are

customers who are willing and able to
Price ($)
pay a higher price, as shown by all

prices above the equilibrium price.
Thus, the shaded area represents the
fotal consumer surplus.
F.
ol
Quantity traded
Figure 1.12 Consumer surplus
Producer surplus occurs when firms are able to charge a higher price than they are
willing and able to (see Figure 1.13). Thus, they are able to earn abnormal profits.
At the equilibrium price of P, there are

S firms that are willing and able to supply
at a lower price, as shown by all prices
less than the equilibrium price. Thus, the
shaded area represents the tofal
producer surplus.
Producer surplus
Y
Quantity fraded
Figure 1.13 Producer surplus

Social surplus (or community surplus) is the sum of producer surplus and
consumer surplus (see Figure 1.14).
Consumer surplus
At the equilibrivm price of P, both
consumer and producer surplus are
Price ($)
maximised. A move away from the

oo
market equilibrium will make one of

these economic agents worse off.
Producer surplus
Y
Quantity traded
Figure 1.14 Allocative efficiency and social surplus
In a competitive market economy, allocative efficiency occurs at the market
equilibrium because both consumer and producer surplus are maximised at this
point.

PAPER 3
5 a Suppose the demand function for a product is given as Q4 = 80 — 2P whilst
its supply is given expressed as Q; = 2P. Plot the demand and supply curves
and identify the equilibrium price and equilibrium quantity. [4]
b Using your diagram from part a, calculate the quantity of excess demand at
a price of $10 per unit and the excess supply at a price of $40 per unit. [4]
6
A
8 S
e e
72 : !
ol il |
— | i !
s P e oy
i i i 8
O 1000 2000 3000 4000
Quantity (cans)
From the diagram above calculate the value of:

a consumer surplus [2]
b producer surplus [2]
c excess demand or supply at $6 [2]
d excess demand or supply at $2 [2]
1.2 Elasticity
Price elasticity of demand (PED)
Price elasticity of demand

Price elasticity of demand is calculated using the formula:
Keyword definition
percentage change in quantity demanded
Price elasticity of demand
percentage change in price
(PED) measures the degree
The mathematical value of PED is usually negative due to the law of demand — of responsiveness of quantity
for example, a rise in price tends to cause a fall in the quantity demanded. demanded for a product following
The value of PED for a product depends on the degree of customers’ ability a change in its price, along a given
and willingness to pay — for example, a rise in the price of a necessity will have a demand curve.
minimal impact, if any, on its level of demand.
Demand is price inelastic if a price change causes a relatively small change in
the quantity demanded, i.e. buyers are not highly responsive to changes in price
(see Figure 1.15).
A
As the price rises from Py fo

Py, the quantity demanded
B, Pylrmmamenmmnmnns falls by a smaller proportion
Q T from @y to Q. Examples of
g & Bptrmnnenmneneanneds products with low PED are
salt, alcohol, electricity,
cigaretfes and nail clippers.
Demand
O @ Q)
-
.
Quantity demanded
Figure 1.15 The price inelastic demand curve
By contrast, demand is said to be price elastic if there is a relatively large
change in the quantity demanded for a product following a change in its price
(see Figure 1.16).
A
As the price drops from Py to

P,, the quantity demanded
rises by a greater proportion
Price ($)
from Q; to Qp. Examples of

—
| products with high PED are

P
i chocolate bars, soft drinks,

o,
i cars and airline fravel.

e
O Q Qy
Y
—_—
Quantity demanded
Figure 1.16 The price elastic demand curve
Perfectly price inelastic demand exists when a change in price has no impact
on the quantity demanded, i.e. the PED value = Q. This suggests that there are
no substitutes for the product (see Figure 1.17).
As the price increases from Py to

P5, the quantity demanded
Demand remains unchanged at Q..
Redlistically, demand will
never be completely
Price ($)
independent of the price level,

but the demand for
prescription drugs, antivenom
or water would be very price
inelastic.
Y
O Q
Quantity demanded
Figure 1.17 The perfectly price inelastic demand curve
Perfectly price elastic demand exists when a change in price leads to no
demand, i.e. the PED value = infinity. This means that customers switch to
buying other substitutes if firms increase their price (see Figure 1.18).
A Demand only exists at a price
of P,. A rise in price above P,
& p leads fo an infinite change in
B T the quantity demanded. This
a situation will only exist if there
are perfect substitutes readily
available on the market.
O Quantity demanded
Figure 1.18 The perfectly price elastic demand curve
Unit elastic demand occurs when a given price change leads to the same percentage
change in the quantity demanded, i.e. the PED value = 1.0 (see Figure 1.19).
A
Pot------
i As the price increases from P,
& E to Py, the quantity demanded
@ i falls by the same proportion,
= : from Q) fo Q.
i Demand
P] -------- : -------------- 1
O Qs Q "
-—
Quantity demanded
Figure 1.19 The unit price elastic demand curve
On a normal downwards sloping linear demand curve, the value of PED
increases as the price level rises (and vice versa). This occurs because customers
will be more responsive to changes in prices at higher levels (price now accounts
for a greater proportion of consumers’ income).
Despite the gradient of the linear demand curve being the same, the
Whether the demand for a product
percentage change in demand is greater at higher price levels (see Figure 1.20). is price elastic or price inelastic really
A depends on the breadth of definition
of the product. A broadly defined
Mathematically, the PED value at the mid- good or service (such as food rather
point along a linear demand curve is than fruit, meat, apples or salmon) will
equal to 1. At prices above this point, PED be more price inelastic. There is clearly
is greater than 1 as customers become
Price ($)
no real substitute to food! However, it

more sensifive fo changes in price. By
contrast, at lower prices the PED value will is perhaps more useful to measure the
PED = <1 PED for specific brands or products,
be less than 1 as customers are far less
sensitive fo fluctuating price. such as carbonated soft drinks or
Canadian beef.
Demand
Y
Quantity demanded
Figure 1.20 PED along a linear demand curve
Common mistake
The concept of price elasticity of demand is fundamental to microeconomics It is technically incorrect to say that
analysis, so this is highly popular in the examinations. Both SL and HL students a product is "elastic” or ‘inelastic’.
should familiarise themselves thoroughly with this topic, including the calculation Instead, use the correct economics
of PED. terminology by saying that it is either
Elasticity is the only topic in the syllabus that requires SL students to carry out ‘price elastic’ or ‘price inelastic’
calculations. to signify that PED refers to the
responsiveness of demand to changes
in the price of the product.
PAPER 3
7 Explain why the price elasticity of demand for many primary commodities
(such as crude oil and iron ore) has a relatively low value, whilst the
demand for manufactured products has a relatively high PED value. [4]
8 A jeweller reduces the price of her platinum earrings from $400 to
$350 per unit, resulting in an increase in demand from 25 units to 30 units
per month. Calculate the value of the price elasticity of demand for the
earrings and comment on the result. [4]
9 Assume the demand for football match tickets at $50 is 50,000 per week.
If the football club raises its price to $60 per ticket and demand
subsequently falls to 45,000 per week, calculate the value of the price
elasticity of demand and interpret the result. [4]
Determinants of price elasticity of demand

Substitution — The greater the number, availability and price of close
substitutes there are for a good or service, the higher the value of its PED
will tend to be. By contrast, products with few substitutes (such as private
education and prescribed medicines) have price inelastic demand.
Income — The greater the proportion of consumers’ income spent on a good
or service, the more price elastic demand will be, ceteris paribus.
Necessity — Products that are regarded as essential (such as food, fuel and
housing) tend to be price inelastic as households will continue to purchase
Expert tip
these even if prices rise. By contrast, the demand for luxuries is relatively
price elastic. Although there are many
Habits, addictions, fashion and tastes — If a product is habit-forming (such determinants of PED, the key factors
can be remembered by THIS acronym:
as tobacco) or highly fashionable (such as smartphones), its PED tends to be
relatively price inelastic. = Time
Advertising and brand loyalty — Effective advertising for certain products m Habits, addictions and tastes
m Income
not only helps to shift the demand curve outwards to the right, but can also
= Substitutes (availability and price of)
reduce the PED for the product.
Time — People need time to change their habits and preferences. Over time,
they can adjust their demand based on more permanent price changes by
switching to alternative products.
Durability — The more durable a product is, such as home furniture or motor
Expert tip
vehicles, the more price elastic its demand tends to be as there is no urgency
to replace these if prices are high. The key determinant of the value
The costs of switching — If there are high costs involved for customers to of PED for a good or service is the
degree of substitution — the extent to
switch between brands or products, then demand tends to be price inelastic.
which consumers have access to close
For example, mobile phone subscribers are bound by lengthy contracts, thus
alternatives for the product.
switching between rival services is made less easy.
Applications of price elasticity of demand

m A firm that faces price inelastic demand can increase its prices to earn more
total revenue (see Table 1.2). Similarly, a firm that has price elastic demand
for its products can reduce its prices to earn more revenue (see Figure 1.21).
= Assuming that the PED for a firm’s exports is price elastic, it will generally
benefit from lower exchange rates (as export prices fall, so the firm becomes
more price-competitive).
m Firms with different PED values for their products can use price
discrimination to charge different customers different prices for essentially
the same product. For example, theme parks charge adults higher prices and
offer discounts for children and families to increase their revenues.
= Firms can pass on most of the incidence of indirect taxes on products that are
highly price inelastic — for example, products such as alcohol, tobacco and
petrol.
s Governments use PED to determine taxation policies — for example,
imposing heavy taxes on demerit goods such as cigarettes knowing that the
demand for such products is price inelastic (see Figure 1.15).
Table 1.2 The relationship between PED and total revenue
Price change Inelastic Unitary Elastic
Increased price Total revenue increases No change in revenue Total revenue falls
Reduced price Total revenue falls No change in revenue Total revenue increases
Common mistake
Ceteris paribus, a cut in price from P,
to Pp will lead o a net gain in sales Typically, students will write in the
revenue when demand is price elastic. exam that ‘price elastic’ means that
If price was fo increase, customers as the price of a good or service
]
Demand would simply swifch to other increases, its demand falls. This
substitutes, thereby generating a net describes the law of demand, i.e.
-
Gain E loss in total revenue. as price goes up, demand will fall
irrespective of whether demand
is price elastic or price inelastic.
Y
Gy
O
Instead, if demand is price elastic, the

Quantity demanded percentage fall in demand is greater
than the percentage increase in price.
Figure 1.21 Price elastic demand and total revenue
Cross price elasticity of demand (XED)
Cross price elasticity of demand and its

determinants
Cross price elasticity of demand (XED) is calculated using the formula:
percentage change in quantity demanded of product A
percentage change in price of product B
Complements have a negative XED value because a fall in the price of
one product, such as smartphones, leads to an increase in the demand for the
complementary product, such as downloaded applications (see Figure 1.22).
Substitutes have a positive XED value because an increase in the price of one
product, such as Pepsi Cola, leads to a rise in the demand for the alternative
product, such as Coca-Cola (see Figure 1.23).
Unrelated products, such as helicopters and wedding rings, have a XED value
of zero because the change in the price of one product does not directly affect
the demand for the other.
The stronger the relationship, the higher the coefficient of the XED. Close
Keyword definitions
substitutes have a high positive XED value, whilst strong complements have a
Cross price elasticity of demand
high negative XED value.
(XED) measures the degree of
A A responsiveness of demand for one
product following a change in the
price of another product.
&2 | e o Complements are products that are
8
a
g
2l A .
:: jointly demanded — for example,
cars and petrol, or a wedding dress
and wedding rings.
E : Dy
: D Substitutes are products that
& : : = can be used as alternatives — for
example, Apple iPhones or
Gluantity Quantity
Samsung Galaxy smartphones, and
Market for smariphones Market for downloadable apps private jets or helicopters.
Figure 1.22 Negative XED for complements
A A
\ S
............ . S]
s i & oo N3
8 : 3 i
e I : a [TTTTTTTTTTS ' i
i s A D,
i D : v D
O - O > ®
Quuantity Quantity
Market for Pepsi Market for Coca-Cola
Figure 1.23 Positive XED for substitutes

PAPER 3
10 The price of monthly disposable contact lenses increases from $24.50 to
$26.95 per pack and it is observed that the quantity demanded for contact
lens solution falls from 225 boxes to 200 boxes per month. Calculate the
XED and comment on your findings. [2]
11 Explain whether the value of the cross price elasticity of demand between
private and public transport is likely to be a high or low/positive or
negative value. [2]
Applications of cross price elasticity of demand

= Knowledge of XED can be useful for firms because it can help to predict the
effect on the quantity demanded if the price of a complementary good changes.
= [t can affect a firm’s pricing strategy depending on whether the XED value is
very high or otherwise. For example, popcorn and carbonated soft drinks in
cinemas are often expensive due to high XED with cinema tickets.
= [t allows firms to predict the effect on the quantity demanded for their
product (and hence total revenue) if a rival firm changes its price.
= [talso lets firms know the extent to which customers will switch between
competing brands, thus informing their pricing and marketing strategies to
remain competitive.

PAPER 3
12 Calculate the value of cross price elasticity of demand if the demand for
Pepsi drops by 10% following a fall in the price of Coca-Cola by 8%, and
comment on your finding. [2]
Income elasticity of demand (YED)
Income elasticity of demand and its determinants

Income price elasticity of demand (YED) is calculated using the formula:
percentage change in quantity demanded
Keyword definitions
percentage change in income
Income elasticity of demand
Normal goods (necessities and luxuries) have a positive YED value because (YED) measures the degree of
people will tend to buy more of these products as income levels increase, ceteris responsiveness of demand following
paribus (see Figure 1.24). a change in income.
Demand Normal goods are products that
customers tend to buy more of as
their income level increases. They
comprise necessities (such as food)
Income
and luxuries (such as cars).

Inferior goods are products with
a negative income elasticity of
© Quantity demand, i.e. the demand for such
products falls when consumer
Figure 1.24 Normal goods income levels rise.
Necessities have a YED value of between O and 1, i.e. demand is income inelastic Luxury goods are superior goods
as customers will continue to buy such essential needs even if prices begin to rise. and services as their demand is
Luxuries have a YED value that is greater than 1, i.e. demand is income highly income elastic, i.e. an
elastic because customers are relatively responsive to changes in income when increase in income leads to a
buying superior products. proportionally greater increase in
Inferior goods have a negative YED value, i.e. as income levels rise, customers the demand for luxuries.
will seek alternative superior-quality products (see Figure 1.25), for example
fresh meats instead of frozen meats.
Expert tip
Examples of inferior goods can vary
from one country to anocther. For
Income
example, in some countries a bicycle

Demand might not be regarded as an inferior
good, but could be classified as a
normal good. It is therefore important
for students to justify their reasoning.
© Quantity
Figure 1.25 Inferior goods

If demand is income inelastic, then a change in income causes a Common mistake
proportionally smaller change in the demand for a product.
Some students confuse YED with
PED in the examinations, stating that
EXAM PRACTICE (HL ONLY) demand is income elastic if customers
buy more when the price falls.
PAPER 3 Although there is an income effect if
price falls, YED measures how demand
13 Assume the income elasticity of demand for sausages is —0.25 and that there
changes following a change in income,
has been a 3% increase in consumer incomes. Calculate the percentage change
rather than changes in price.
in the demand for sausages, assuming all other things remain equal. [2]
Applications of income elasticity of demand

m Firms and governments can estimate the impact on different markets
following changes in national income (GDP) — for example, supermarkets
promote more inferior products during a recession. It can be difficult to classify certain
= By contrast, luxury goods and services are the most affected products during products as inferior or normal goods.
an economic downturn when national income declines. Hence, firms may For example, economy-class air travel
wish to diversify their output. may be considered as a luxury good as it
m Primary sector products such as oil and agricultural output have a relatively tends to account for a large percentage
low YED value. This has potentially beneficial implications for producers and of a consumer’s income. However, this
the economy as demand is stable despite fluctuations in the business cycle. is relatively cheap (or inferior) compared
= Secondary sector output (manufactured goods) has a higher YED value. This with business-class or first-class air
means demand is more sensitive to changes in income levels than for primary travel (luxury products).The key is good
sector output. reasoning and critical thinking.
= Tertiary sector output (services) has a relatively high YED value, so producers
and the economy suffer during an economic recession as customers are highly
Common mistake
responsive to the fall in their income.
It is incorrect to assume that inferior
goods are those that are of poor
quality standards as this is not the
Whilst it is not necessary to use the negative coefficient for PED (due to the law meaning of inferior goods. For
of demand), it is vital that students use the negative coefficient of YED when example, a Honda car is unlikely
referring to an inferior good (less is bought as real income levels rise) and the to be of poor quality but is inferior
positive YED value when referring to normal goods. to brands such as Audi, BMW or
Mercedes Benz.
Price elasticity of supply (PES)
Price elasticity of supply

Price elasticity of supply is calculated using the formula:
percentage change in quantity supplied
percentage change in price Keyword definition
Price elasticity of supply
Supply is price elastic if firms can quite easily increase supply without a time
(PES) measures the degree of
delay if there is an increase in the price of the product, for example mass-
responsiveness of quantity supplied
produced goods such as soft drinks. Such firms can gain a competitive advantage
of a product following a change in
as they are able to respond to changes in price.
its price along a given supply curve.
By contrast, supply is price inelastic if firms find it difficult to change
production in a given time period following a change in the market price.
m If PES > 1 then supply is price elastic, i.e. responsive to changes in price (see
Figure 1.26).
m If PES < 1 supply is price inelastic, i.e. unresponsive to changes in price (see
Figure 1.27).
m [f PES = 0 supply is perfectly price inelastic, i.e. a change in price has no
impact on the quantity supplied, as there is absolutely no spare capacity to
raise output (see Figure 1.28).
m [f PES = oo (infinity) supply is perfectly price elastic, i.e. supply can change
without any corresponding change in price due to the spare capacity that
exists at the current price level (see Figure 1.29).
m [f PES= 1 supply has unitary price elasticity, i.e. the percentage change in the
quantity supplied matches the proportional change in price (see Figure 1.30).

PAPER 3
14 Calculate the value of PES if the market price of beans increases from $2 per
kilo to $2.20 per kilo and causes the quantity supplied to rise from 10,000
kilos to 10,500 kilos. [2]
Section 1 Microeconomics 17
In this case, when price rises from

Supply Py to Py, there is plenty of spare
capacity for the firm, so the
quantity supplied can increase by a
Price ($)
greater proportion from Qy to Qy,

i.e. supply is price elastic.
Examples of products with price
elastic supply are mass-produced
goods such as carbonated soft
drinks and toothpaste.
Y
Quantity supplied
Figure 1.26 The price elastic supply curve
Supply In this case, when price rises from

P) to Py, there is very litlle spare
capacity for the firm, so the
quantity supplied can only rise by
Price ($)
a smaller proportion from Qy to Qs.

—
Examples are fresh fruit and

vegetables that take time to grow
5
[so supply is relatively

unresponsive fo changes in price).
Y
O Q Gy
—_—
Quantity supplied
Figure 1.27 The price inelastic supply curve
A
Here, supply is perfectly price
Supply inelastic at Q. Imespective of price
changes, the firm can only supply
o o Pt s a maximum of G, so changes in
= ]‘ 2 price have no impact on the
o quantity supplied, i.e. PES = 0. An
L P fremmmm
e mn e example is a football stadium or a
concert hall that cannot
accommodate more than the
seating capacity.
O Q. "
Quantity supplied
Figure 1.28 The perfectly price inelastic supply curve
Here, supply is perfectly price elastic at

a price of P,. For example, Duracell
might have a huge stock of batteries, so
Supply any increase in demand will simply
Price ($)
result in more Duracell batteries being

sold, without the price being raised.
Hence, as quantity supplied can
increase from Q@ to Q) irrespective of a
price change, the PES = oo.
O 5 O
Y
— e
Quantity supplied
Figure 1.29 The perfectly price elastic supply curve

Any supply curve that sfarts at

the origin (such as S, Sy or S3)
S 22 has a PES value equal to 1.
Price ($)
7’ This theoretical outcome

o means that a change in price
i 4 S causes the same proportional
i change in quantity supplied.
O Quantity supplied
Figure 1.30 The unitary price elasticity supply curve
Mathematically, supply curves have a different PES value at different points.
Supply is more price elastic at lower prices and more inelastic at higher prices.

PAPER 3
15 Angry Birds is a highly popular video game created by Finnish company Rovio,
with over 12 million customers having paid $0.99 each to download the game
from Apple’s App Store. With the use of an appropriate diagram, explain why the
high level of demand for Angry Birds games has no effect on the selling price. [4]
Determinants of price elasticity of supply

The time period — Supply tends to be price inelastic in the short run, for
example the supply of fresh vegetables is dependent on the time it takes Expert tip
to harvest the products. In the long run, firms can adjust their levels of The determinants of supply elasticity
production according to price changes in the market. can be remembered by the acronym
The level of stocks — Firms with high inventories (stocks of unused raw materials, TICS:
work-in-progress and finished goods) tend to have relatively price elastic supply as Time
they are more able to respond quickly to a change in market prices. Inventory (stocks)
The degree of spare productive capacity — A firm with plenty of spare capacity Capacity
can increase supply with relative ease (without increasing its costs of production), Substitution (of factors of production)
so supply is relatively price elastic. The opposite applies for the long run.
The ease and cost of factor substitution — The easier it is to substitute
factors of production (such as labour and capital), the more price elastic
supply tends to be. Similarly, the more mobile factors of production are, the
greater the PES will be, ceteris paribus.
Applications of price elasticity of supply

Firms that have a high PES are highly responsive to changes in price and
other market conditions, so this makes them more competitive.
The PES for primary products is relatively low due to the comparatively long There are several ways firms can
time it takes to increase primary sector output, such as oil, iron, coal and improve the value of their PES:
agricultural harvests. m Create spare capacity.
By contrast, the PES for manufactured products is generally higher because m Keep large volumes of stocks
many of these can be mass-produced in shorter time periods, for example (inventories).
= Improved storage systems to
toothpicks, nails and LEGO toys.
prolong the shelf-life of products.
m Adopting or upgrading to the latest
technology.
= Improving distribution systems (how
the products get to the customers).
= Developing and training employees
to improve labour occupational
mobility (to perform a range of jobs).
EXAM PRACTICE (HL ONLY) Expert tip

A key determinant of PES is the nature
PAPER 3 of barriers to entry. The existence of
16 A 10% increase in the price of computer keyboards leads to an increase in copyrights and patents, for example,
output of 20%. Calculate the price elasticity of supply of computer keyboards reduces the number of potential firms
following this change in price. [2] in the industry and therefore lowers
the value of PES, ceteris paribus.
1.3 Government intervention
Indirect taxes
Specific taxes and ad valorem taxes and their

impact on markets
Taxes are levies (or charges) imposed by the government, thereby limiting
the output of certain goods and services and/or raising the price of goods and Keyword definitions
services paid by consumers. An indirect tax is a government
Indirect taxes raise the costs of production. Specific taxes cause a parallel levy on the sale of certain goods
shift in the supply curve to the left (see Figure 1.31), whilst ad valorem taxes and services. Examples include
pivot the supply curve (see Figure 1.32). specific taxes and ad valorem taxes.
The government will often intervene if the price mechanism fails to establish A specific tax, also known as a per
the socially optimal equilibrium — for example, taxing demerit goods such as unit tax, imposes a fixed amount
alcohol and tobacco to reduce their consumption. of tax on each product. Examples
Indirect taxes are a major source of government revenue. They can be include taxes on cigarettes, air
used to correct market failures, such as imposing fuel taxes on motorists. On a passenger tax and electronic road
macroeconomic scale, indirect taxes can be used to affect the level of aggregate pricing and road tolls.
demand, by changing the rate of sales taxes, for example. They are used to
An ad valorem tax imposes a
protect domestic firms from overseas rivals by imposing tariffs on imports.
percentage tax on the value of a
The imposition of indirect taxes means that consumers tend to lose out
good or service. Examples include
as they have to pay higher prices, especially if the demand is price inelastic.
property taxes, tariffs (taxes on
Producers also lose out as their costs of production increase. However, if PED
imports) and sales taxes.
is low then they are able to pass most of the tax onto customers without largely
affecting the level of demand.
The tax also creates a deadweight loss (the combined loss of consumer and
producer surplus), as shown by the shaded area in Figure 1.31.
Sy
59 The specific tax causes a parallel shift in the

supply curve from S; to S5, indicating an increase
in costs of production. This raises the market
Price ($)
Deadweight equilibrium price from Py to P> and reduces the

quantity traded from Q to Q5. The vertical
o
loss
distance between 5; and 55 is the value of the
specific tax.
O G
Quantity (units)
Figure 1.31 Imposition of a specific tax
A
7 52
The ad valorem (percentage) fax causes @

5 pivotal shift in the supply curve from Sy to
5 Popsemmnnneseng | S, because the absclute amount of the tax
‘é' plo A 4:___ is greater as the market price increases (as
= 1 ! ! indicated by the two red arrows). The
j i higher price reduces the equilibrium
| : quantity fraded from Q; to Q.
L D
O QG -
Quantity {units)
Figure 1.32 Imposition of an ad valorem tax
Tax incidence, and price elasticity of demand and

supply (HL only)
A greater proportion of the incidence of tax falls on consumers if the PED is
low, i.e. there is a lack of substitutes. This means that firms can pass on most of
the higher costs to consumers (see Figure 1.33).
The opposite is true when demand is price elastic, i.e. producers are unable to
pass on most of the indirect tax to the consumer because customers are highly
responsive to an increase in price (see Figure 1.34).
If the PES is high, consumers pay a greater proportion of the incidence of
tax. This is because firms are less able and willing to supply if production costs
increase, so buyers end up paying a greater burden of the tax (see Figure 1.35).
The imposition of a specific indirect tax shifts

the supply curve from Sy to 5,44y, thus raising
the equilibrium price from Py to Py. With the
relatively price inelastic demand curve, most
of the incidence of the tax is paid by consumers
[shown by the area in orange). The rest of the
fax is paid by the producer (shown by the area
_in red).
Quantity (units)
Figure 1.33 Tax incidence and price inelastic demand
Here, the relatively price elastic demand means

there are plenty of other substitutes, so the firm
cannot simply pass on the fax fo consumers in
Price ($)
the form of higher prices. The high PED means

consumers will be very responsive to an increase
in price. Thus, the producer pays the larger
proportion of the tax incidence.
Quantity {units)
Figure 1.34 Tax incidence and price elastic demand
Here, the relatively price elastic supply curve

means firms are highly responsive to changes
in price, so must pass on the tax fo consumers
in order for them to be able to supply. Thus,
the consumer pays the larger proportion of the Expert tip
fax incidence.
The incidence of tax falls mainly upon
the stakeholder group (consumers or
producers) that is less responsive to
Quuantity {units) changes in price, i.e. the group that
has the most price inelastic function.
Figure 1.35 Tax incidence and price elastic supply

PAPER 3 A
35 ———————————————————————————
T
ST
g
eee
Price ($)
s
[
O
se
T T
T T AT
e
T T TR
e
e
ST
Ln
R
i|
———k
¥
10 20 30 40 50
Quantity ('O00 units)
17 With reference to the above graph, calculate the following:

a Total tax revenue collected by the government from the imposition of
this tax. [2]
b Incidence of tax paid by the consumer. [2]
¢ The change in consumer spending (or producer revenue) following the
imposition of the tax. [2]
d The deadweight loss resulting from the tax. [2]
e The value of the producer surplus after the imposition of the tax. [2]
f The change in the value of consumer surplus after the tax has been
imposed. [2]
Subsidies
Impact on markets
Subsidies reduce the costs of production for firms, thus shifting the supply curve
outwards to the right (see Figure 1.36). Subsidies are given to producers for
several reasons: Keyword definition
= To encourage the output of merit goods such as education, training and A subsidy is financial assistance
healthcare services. from the government to encourage
m To limit negative externalities such as pollution by subsidising ‘green’ output (such as the sale of exports),
technologies. to reduce the price of certain merit
m To protect certain industries and to prevent a subsequent decline in goods (such as education, training
unemployment. and healthcare), or to keep down the
cost of living (such as food prices).
Consumers generally benefit from subsidies as the market price is lowered,
thus more people are able and willing to buy the good or service.
Producers also benefit from the subsidy as their production costs are reduced.
This helps to improve their competitiveness and profitability.
Whilst the government spends money on financing the subsidy, and there is
an opportunity cost in doing so, the net benefits to society may outweigh the
costs (in theory, at least). However, subsidies distort market forces and may
subsequently protect inefficient firms.
% 51 The subsidy enables firms to produce more
output and each and every level of output,
thus shifting the supply curve from S; o Ss.
This reduces the market price from Py to Py,
Price ($)
»
with quantity traded increasing from @y to

Gy, ceteris paribus. Hence, producers pass
1
on the green section of the subsidy to

consumers and retain the red section for
D lowering production costs.
O Q @2
Quantity (units)
Figure 1.36 Subsidies and market outcomes

PAPER 3
18 Suppose the demand and supply functions for a product are given as:
Qq=100- 5P
Q.=20+3P
a Calculate the equilibrium price and quantity. [3]
b Calculate the price required for producers to sell 80 units. [2]
¢ Suppose the government grants a $2.67 per unit subsidy on the product.
Calculate the new equilibrium price and quantity. [3]
d Using your answers from parts a and c, calculate the difference in consumer
spending on the product. [2]
e Calculate the total amount spent by the government on the subsidy. [2]
Price controls
Price ceilings: rationale, consequences and examples

A price ceiling can be used to protect the interest of consumers from soaring
prices, such as escalating rents or food prices. Following the imposition of a
price ceiling, consumer surplus is increased but producer surplus is reduced. Keyword definition
Consumers can benefit from the lower price after the imposition of the price A price ceiling (also known as
ceiling (see Figure 1.37). However, price ceilings distort market forces and
a maximum price) occurs when
therefore can result in an inefficient allocation of scarce resources. This creates
the government sets a price
a deadweight loss (see Figure 1.38).
below the market equilibrium
The excess demand can cause non-price rationing mechanisms (systems to price to encourage output and
restrict the allotment of goods and services). Examples include queuing (using consumption.
waiting time as a means of distributing products), ration coupons (tickets that
entitle individuals to buy a certain amount of a product) and most-favoured
customers (those who receive special, preferential treatment).
Maximum prices can also cause underground parallel markets to appear due
to the shortages in supply. In Figure 1.37, traders in parallel markets will charge
the high price of P,,,.
The maximum price, in this case imposed fo
control residential rents, results in more demand
(D4) than is supplied af the lower price (P;). This
results in excess demand, as shown by the area
in orange. This shortage is made up by
govemment supplying housing ata price of Py fo
stabilise rents in the economy.
Quantity [units)
Figure 1.37 Impacts of price ceilings
Deadweight
loss The maximum price reduces supply to 5y,
creating a shorfage. This reduces both
Price {$)
consumer and producer surplus, as shown

by the shaded areq, i.e. there is a
“““““““““ Price ceiling deadweight social welfare loss.
Excess
demand |
5 D
Quantity (units)
Figure 1.38 Welfare loss of price ceilings

PAPER 3 A
Supply
Price ($)
Maximum price
koo
Demand
Quantity [units)
19 With reference to the above graph, identify the following:

a The change in the value of consumer surplus following the imposition
of the price ceiling. [2]
b The value of producer surplus after imposition of the price ceiling. [1]
¢ The change in the firm's revenue. [2]
d The value of the shortage in the market. [2]
Price floors: rationale, consequences and

examples
Excess supply occurs when a price floor is imposed above the market
equilibrium price, because supply outweighs demand when prices are so high Keyword definition
(see Figure 1.39). A price floor, also known as a
minimum price, is the imposition
A
The minimum price, in this case offered fo of a price guarantee set above the
agricultural farmers, gives an incentive for market price to encourage supply of
producers to supply more |S1] than is demanded a certain good or service.
[Dy) at the higher price (P;). This results in excess
supply, as shown by the area in orange. This
Price ($)
surplus is bought at a price of P by the

govemnment fo support the farmers, and released
onto the market during fimes of bad harvest to
stabilise food prices.
Guuantity [units)
Figure 1.39 Consequences of price floors
A price floor guarantees suppliers a higher price than before. This also applies
in the labour market where more workers supply their labour services if there is
a minimum wage (see Figure 1.40).
The national minimum wage [NMW) is imposed

above the equilibrium wage rate, fo ensure all
Woage rate ($)
workers have a decent income. However, this

results in the supply of labour |§)) being greater
than the demand for labour (5). In theory, the
NMW results in excess supply of labour, i.e. the
higher costs of labour cause unemployment,
ceteris paribus.
Quantity (labour)
Figure 1.40 Consequences of a minimum wage
The inefficient allocation of resources results in a deadweight loss (see

Figure 1.41).
Expert tip
Whether a NMW causes
————————————————— ~—-- Price floor unemployment is debatable and
The minimum price reduces demand fo Dy, empirical studies are not conclusive. For
= | creating a surplus. This reduces both consumer example, the higher wage rates fuel
8 | and producer surplus as shown by the shaded extra consumption in the economy,
= ' area, so there is a deadweight loss fo society. thereby creating employment
opportunities. The government might
O
i
D, S
o, "
also have other priorities, for example
to correct market failure in the labour
Quantity (units) market, such as the exploitation of
low-skilled labour, to combat poverty
Figure 1.41 Welfare loss of price floors in the economy or simply to create
incentives to work.
Consumers tend to pay higher prices if price floors are imposed.

PAPER 3
20 Refer to the diagram below and answer the questions that follow.
A
5
a0 e o O .
= | |
§ 2= ST ST e
e 1 1
o) R ) ‘
| | | D
0 3000 5000 /000
Quantity {units}
a Explain what situation arises if the government imposes a price floor

of $30 for the product. [2]
b Calculate the change in consumer spending following the imposition
of the price floor. [2]
¢ Calculate the change in producer revenue following the imposition of
the price floor. [3]
d Suppose the government exports all the excess supply at $20 per unit.
Calculate the amount of taxpayers’ money needed to support this price
control scheme. [3]
1.4 Market failure

The meaning of market failure
Market failure as a failure to allocate resources

efficiently
Examples of market failure include:
= under-provision of merit goods, such as education and healthcare, as these
services would only be provided to those who were willing and able to pay Keyword definition
= under-provision of public goods, such as street lighting and public roads, Market failure exists when the
because producers cannot exclude those who do not pay from benefiting from price mechanism (the market
the provision of the service forces of demand and supply)
m over-provision of demerit goods such as tobacco, alcohol and gambling (as allocates scarce resources in an
there is a lack of government intervention in such markets) inefficient way, i.e. there is either
= abuse of monopoly power — charging customers prices above market over-provision or under-provision
equilibrium — and hence the associated inefficiencies. of certain goods and services.
Market failure occurs when the price mechanism cannot allocate resources
efficiently but causes external costs or external benefits of production or
consumption.
m Private benefits are the benefits of production and consumption enjoyed by a
firm, individual or government.
m Private costs of production and consumption are the actual costs incurred by
a firm, individual or government.
= Social benefits are the true (or full) benefits of consumption or production,
i.e. the sum of private benefits and external benetits.
m Social costs are the true (or full) costs of consumption or production, i.e. the
sum of private costs and external costs.
Types of market failure
The meaning of externalities

Marginal private benefit (MPB) is the additional value enjoyed by households
and firms from the consumption or production (output) of an extra unit of a
particular good or service. Keyword definition
Marginal private cost (MPC) is the additional cost of production for firms Externalities (or spillover effects)
or the extra charge paid by customers for the output or consumption of an extra are the external costs or benefits of
unit ofa good or service. an economic transaction, causing
External costs (also known as negative externalities) are costs incurred by the market to fail to achieve a
a third party in an economic transaction for which no compensation is paid. social optimum level of output,
Examples of external costs include: where marginal social benefits equal
second-hand (passive) smoking marginal social costs (MSB = MSC).
air pollution caused by fumes from a factory
noise pollution from a nightclub or nearby airport
litter on public beaches
child obesity from junk food and carbonated soft drinks
climate change fuelled by continual demand for higher levels of consumption
excessive advertising (known as advertising clutter) that causes visual blight.
External benefits (also known as positive externalities) are benefits enjoyed
by a third party from an economic transaction. Examples of products with
external benefits for which no money is paid directly by the beneficiary include:
= national defence
= law and order systems, for example police and emergency services
flood defence systems

sewage and waste disposal systems
street lighting
lighthouses
public parks, libraries and museums
public fireworks displays.
Marginal social benefit (MSB) is the added benefit to society from the
production or consumption of an extra unit of output, i.e. the sum of MPC and
marginal external costs.
Marginal social cost (MSC) is the extra cost of an economic transaction to
society, i.e. the sum of MPB and marginal external benetits.
The production and consumption of public goods and merit goods exert
positive externalities. The production and consumption of demerit goods exert
negative externalities such as pollution.
Negative externalities of production and

consumption
Negative externalities arise from the production or consumption of goods or
services that create negative spillover effects on a third party. These products
Keyword definition
are known as demerit goods (see Figures 1.42 and 1.43). Examples include:
Demerit goods are products that
cigarettes, alcohol, hard drugs, recreational drugs, junk food, prostitution and
create negative spillover effects (or
gambling.
negative externalities) to society.
Although it is assumed that people are rational economic agents, it is often
Hence their production and
the case that they are not the best judge of their own welfare, so the government
consumption result in social costs
intervenes to discourage the production and consumption of demerit goods — for
being greater than private costs of
example, age limits for drinking, smoking and driving.
production and consumption, i.e.
A MSC > MPC.
MSC ® In a free market without government
infervention, output will be at Q, where
MPC the MPC = MPB of production.
* However, the socially optimal level of
output is at Qs where MSC = MSB, with
a higher price of P. being charged.
e Hence, from society’s point of view,
there is overpreduction of demerit
goods.
® The shaded area shows the welfare
gain from reducing oufput of the
D =MPB=MSB demerit good from Q. fo Q.
o Q. Q.
Output
Figure 1.42 Negative externalities of production (of demerit goods)
A
MSC = MPC
* In a free market, output is at G, which
exceeds the socially optimal level at Q.
where the MSC = MSB, of consumption.
The negative externality accounts for the
difference between the AMSB and MPB.
® Hence, there is overconsumption of
demerit goods in the absence of
government intervention. When price is set equal to marginal
MPB e The shaded area shows the welfare loss cost (P= MC), economic welfare
of consumption (of products with is maximised, i.e. consumer and
negative externalities). producer surplus are maximised. This
is because the price that consumers
k.
-
are willing and able to pay matches

that of the producers.
Figure 1.43 Negative externalities of consumption (of demerit goods)
Policy responses to negative externalities

Governments try to solve market failure in two main ways:
= market-based policies — intervention in the price mechanism to make the
market forces of demand and supply operate more effectively — for example,
taxation and tradable permits
= government regulations such as environmental standards.
Taxation is used to ‘internalise’ negative externalities, i.e. the buyer and/or
seller pay for the true costs of their actions without any burden being placed on
third parties (see Figure 1.44) — for example, taxes on fuel, alcohol, tobacco and
the use of plastic carrier bags.
In Figure 1.44, the tax imposed on cigarettes has caused the supply curve
to shift from S; to S,y causing price to rise from P; to P; and the quantity
demanded to fall from Q; to Q,.
g> »
Expert tip
N
Remember that a specific tax is shown

s %}' Pyp-mmmmmmmmmemm—2 by the vertical distance between the
8 % two supply curves. The consumer
= B 1 : pays a higher price (P, — P;) and the
9 g reonpgimnannsg L producer pays the remainder (P; — Fy).
b > The more price inelastic the demand for
© Gp O the product, the greater the proportion
Quantity of cigarettes of the tax paid by the consumer.
Figure 1.44 Indirect tax on cigarettes
Table 1.3 The advantages and disadvantages of imposing a tax on the

production or consumption of products with negative externalities
Advantages Disadvantages
m |t increases the price and therefore should decrease the m The demand for many of these products (such as
guantity demanded, for example Ireland’s tax on plastic cigarettes, alcohol and petrol) tend to be price inelastic, i.e.
carrier bags aimed at reducing wastage and litter cut the tax may have little impact on the level of consumption.
demand by 90% in the first 3 months of implementation. m The tax on many of these products is regressive, so has
m |t creates tax revenue for the government, which can be a greater impact on low-income earners than on high-
used on other goods and services. Scotland, for example, income earners.
introduced a 5 pence tax per single-use bag in October m It can encourage smuggling and unofficial market activity.
2013 following success in countries such as Ireland, Wales,
Germany and Hong Kong.
Another market-based policy is to use tradable permits. These are pollution

rights issued to firms, thus capping the level of pollution from economic activity.
The policy creates incentives not to pollute so that excess permits can be sold to
other, less efficient, firms.
An increase in the demand for pollution permits would raise the price of
pollution rights, just like in any other market, but without affecting the level of
output and hence the level of pollution (see Figures 1.45 and 1.46). Hence, an
increase in the price of tradable permits also increases the opportunity cost to
firms that pollute.
e Tradable permits can be highly

effective in internalising negative
externalities of production. An increase
in demand for permits from Dy fo Dy simply
permits ($)
causes the price fo rise from Py fo Py.

Price of
e The level of pollution is capped by the

perfectly price inelastic supply curve of
D, D, pollution permits.
Quantity of permits
Figure 1.45 Increased demand for tradable permits
e Cver time, the govemnment might decide to

cut the number of permits, thus shifting the
supply of pollution permits from S; fo Ss.
Price of pollution
® This causes an increase in the price of pollution

permit ($)
permits, creating an incentive for firms to be more

efficient and to invest in cleaner fechnologies.
e Government revenue from issuing the
permits increases from O, Py, B, Q) fo
O, Py, A, @y due to the relatively price
inelastic demand for the pollution permits.
y L.
O Q& G
Quantity of permits
Figure 1.46 Reduced supply of tradable permits
Apart from market-based policies, governments can also impose regulations
to deal with negative externalities from production and consumption. Examples
include:
= laws to regulate where people can drive, cycle and gamble
m laws to make it illegal for people to smoke, eat or to talk on a mobile phone
while driving
m motorcyclists being made to wear a helmet and car passengers having to wear
seat belts
m airport authorities regulating the number of night flights to limit noise
pollution for nearby residents
m laws on the minimum age that a person must be before being legally allowed
to purchase cigarettes or alcohol, thus helping to reduce the consumption
of such demerit goods (see Figure 1.47). It is illegal to sell alcohol in Iran,
Bangladesh, Brunei Darussalam and Saudi Arabia.
regulations restricting where people can smoke. In many countries, smoking
is banned in public places such as shopping malls, bars, restaurants, airports,
railways stations and the beach.
A
&
g MSC & The ban on smoking In public places shifis
@ the demand curve for cigarettes from
B B[t , MPB to MSB.
* This results in the quantity of cigarettes
[ I
A i demanded fo fall from Q,, to Q) pt-

8 N
&£ % T
, mss M
O Q. @ -
Quantity of cigaretftes
Figure 1.47 The impact of regulations on the demand for cigarettes
Table 1.4 The advantages and disadvantages of imposing rules and

regulations to correct market failures
m Consumption of the good or service may m Restrictions cause underground (illegal) markets to develop where the
be reduced. good or service can be purchased, often at a very high price.
= Awareness of the negative impacts of = The government has no control over the quality of the goods produced
demerit goods (such as drinking and in underground markets, which in some cases can be dangerous for
driving) may change the behaviour of consumption, such as illegally distilled vodka or contaminated baby milk
people in the long term. powder.
m Awareness of the positive impacts of m People may still choose to break the rules — for example, underage smokers
consumption of merit goods (such as and drinkers of alcohol can bypass the law by obtaining false ID cards.
education) is raised. m The fine or punishment for ignoring the ban must be enforced and set
high enough to discourage consumption of the good or service.
EXAM PRACTICE Expert tip

Government regulation can be very
PAPER 1 effective in correcting market failures.
21 With the aid of a market failure diagram, explain why a government might use Parents in the UK get fined if they do
congestion zone charging to reduce the use of motor vehicles in city centres not send their children to school, and
such as London and Paris. [10] from 2015, full-time education in the
UK will be compulsory for children
up to the age of 18. The Hong Kong
government imposes a fine of HK$ 1500
($193) for each item of littering and for
smoking in public areas.
Positive externalities of production and
consumption
Examples of merit goods include education, healthcare provision, training,
research and development expenditure, and the provision of public sports and
recreation facilities (such as public swimming pools, sports grounds, museums Keyword definition
and public libraries). Merit goods are products that create
Merit goods are deemed to be of value by society (due to the positive positive externalities (spillover
externalities of production and consumption), i.e. they improve the general effects) when they are produced
standard of living in the economy. or consumed. Hence, the social
benefits from the production and
A S = MPC = MSC
consumption of merits goods are
greater than the private benefits.
Z p,
8
=P
MSB
D -
Output
Figure 1.48 Positive externalities of consumption of a merit good

In Figure 1.48, positive externalities exist because MSB > MPB of
consumption at all levels of output. This is due to the existence of positive
externalities of consumption. Hence, there is market failure at the free market
equilibrium (Q, and P.), i.e. there is underconsumption of the merit good.
The socially desirable level of output is where MSB = MSC, i.e. at output
level Q+. The shaded area in Figure 1.49 represents welfare loss due to the
underconsumption. With government intervention, resources are more
efficiently allocated with a greater level of output at Q.
® The free market fails to supply goods with Common mistake
A positive externalities at the socially optimum
level of output, i.e. where MSC = MSB Do not confuse the definition of
MPC [or at P« and Q). public goods with that for merit
MSC e There is underprovision of these goods and goods. Both the state (public) and
services as oulput is only Q,, causing the private sector of the economy provide
price to be higher at Py. merit goods, such as education and
® The shaded area represents the welfare loss health services. Merit goods can
associated with the market failure since also be rivalrous and excludable, for
production is lower [than the socially optimum
level) at Qi and price at Ps. example selective grammar schools,
e Government infervention means that output single-gender schools, religion-based
MPB = MSB
ro
increases to the socially optimum level, i.e. schools or private health clinics.
at G+ and a fall in price fo Pe«.
Output
Figure 1.49 Positive externalities of production

Government responses to positive externalities

A subsidy is a sum of money given to a producer to reduce the costs of
production (to encourage higher levels of output) or to consumers to reduce the
price of consumption. For example, governments often subsidise public transport
to discourage people from using private cars (see Figure 1.50).
1 MPC ® |f bus operators receive a subsidy, their

production costs fall, thus shifting the
supply from MPC to MSC.
Price of public
® The subsidy provides an incentive for

fransport ($)
o
3
more people to consume the good, thus

shifting demand from AMPB to MSB.
o
e Price falls from P, to P, and the quantity

demanded increases from Qp, to Q.
&
O Qn Qo
Quantity of public transport supply
Figure 1.50 The effects of a producer subsidy on public transport
In Figure 1.50, the specific subsidy is shown by the vertical distance between
MPC and MSC. The producer passes some of this subsidy to consumers in the
form of lower prices (from P, to P.) and keeps the remainder in the form of
lower production costs.
An increase in the use of public transport, due to the subsidy, should lower
congestion. Therefore the subsidy reduces the externality caused by driving
private vehicles.
In another example, the government in China provides a subsidy of up to
60,000 yuan ($9800) to buyers of electric and hydrogen vehicles in a bid to
combat rising air pollution.
Limitations of using subsidies to correct market failures include the following:
m Just as with taxation on negative production and consumption externalities, it
is difficult to set a precise subsidy that ensures MPC = MSC and MPB = MSB.
m The social return on the production and consumption of merit goods (such
as education or the provision of libraries, sports facilities and museums) is
difficult, if not subjective, to measure.
m If the price elasticity of demand for the good or service is inelastic, the lower
price (due to the subsidy) has little impact on the quantity demanded.
m There is always an opportunity cost in the provision of subsidies as the money
could have been used on other government projects.
Legislation is another government response to deal with the positive
externalities of production and consumption. Laws are used to encourage greater
consumption of goods and services with positive externalities, such as:
= compulsory education for children
m the requirement for school children to be vaccinated against certain diseases.
Advertising is a third approach to correcting market failures by influencing
behaviour, i.e. informing and educating the public about the benefits of
increased consumption. Examples include:
= the ‘5-a-Day’ programme run in countries such as Germany, the UK and the
USA in line with the World Health Organization's statement that people
should eat at least 400 grams (or five portions) of fruits and vegetables each
day (see Figure 1.51)
m schools educating students about safe sex and family planning
m advertising of health screening, for example to measure levels of cholesterol,
blood pressure and risks of chronic illnesses such as diabetes, stroke and
cancer
= advertising about the importance of environmental protections, for example
conserving energy, waste minimisation and recycling.
A e Effective advertising shifts the

- demand for fresh fruits and
= MPC = MSC vegetables from MPB to MSE.
& *"—% ® This boosts consumption from
22 Qi to Q-
ue 8 Pop "R ® Healthier people should mean
@R p Lo less absences from work and
£ m : school, with external benefits
i MPE D= MSB fo society and the economy.
O Gm G:‘Jr.:n;:fl
Quantity [fruits and vegetables)

Figure 1.51 The impact of advertising on demand for fruits and vegetables
Table 1.5 The advantages and disadvantages of education and advertising to

combat the problems of market failure
m Behaviour and consumption patterns of individuals and m Not all advertising is effective, i.e. advertising tactics may
firms change — there is a rise in the consumption of merit not necessarily work in changing people’s behaviour.
goods and a fall in the demand for demerit goods. For m It can take a long time to educate people and for the
example, people learn about the dangers of smoking, so advertised message to be accepted and acted upon.
fewer people smoke. m There is an opportunity cost of government expenditure
m Successful advertising may lead to a cultural change on advertising, i.e. the money might have been spent on
in behaviour, such as healthier diets, increased use of something else deemed to be more beneficial to society.
electric cars, recycling, waste reduction and the use of
renewable energy.
Direct provision of goods and services is a fourth government response to

market failure, such as provision of public transportation services, education and
healthcare.
The key advantage of direct government provision is that merit goods and
public goods become accessible to everyone, regardless of their income or social
status. However, government provision also has its limitations:
m Economic inefficiency — healthcare services (such as the UK’s National Health
Service) might encourage consumption beyond the socially optimum level. If
people do not have to pay for healthcare, they are more likely to overuse it.
m There is an opportunity cost of government provision as the money could
have been spent on something else, such as paying off government debt or
possibly lowering tax rates.
m In the case ofa shorrage of supply due to excess demand, it can be difficult
to decide who should be able to take advantage of the free government
service. For example, the waiting list for a hip replacement operation in a
government hospital may be very long.
Lack of public goods

The two main characteristics of public goods are:
= Non-rivalrous — A person’s consumption of a public good does not limit the
benefits available to other people. By contrast, a person’s consumption of a Keyword definition
private good reduces the amount available for other individuals. Public goods are goods and services
m Non-excludable — Firms cannot exclude people from the benefits of that exert positive externalities,
consumption, even if they do not pay. Hence, private-sector firms are with two key characteristics: non-
rivalrous and non-excludable.
unlikely to supply public goods.
Examples of public goods include: national defence, the emergency services
(police, fire and ambulance), streetlighting, lighthouses, weather warning
systems, public firework displays, radio broadcasts, drainage systems and free
downloadable apps for smartphones and tablet computers.
By contrast, private goods are rivalrous (e.g. cinema or theatre tickets),
excludable (e.g. airlines, restaurants and hotels) and rejectable (e.g. rice, books
or nail polish).
The lack of provision of public goods is another source of market failure. This
is largely due to the free rider problem — where those who do not pay cannot
be excluded from benefiting from the provision of public goods. Free riders are Common mistake
people who take advantage of the goods or services provided by the government
Students often claim that public goods
but have not contributed to government revenue through taxation.
are those provided by the public sector.
The existence of the free rider problem means that the market demand for a
This is incorrect. Public goods have
public good does not actually exist. In addition, its supply will be significantly three key characteristics resulting in no
below the social optimum level — if it exists at all. incentives for any private-sector firm
Direct provision of public goods is generally seen favourably as these to provide such goods and services.
improve well-being in the economy (since the MSB > MPB of production Hence, the government must do so.
and consumption). For example, most public goods would simply not be However, this is a consequence, rather
available if it were not for government provision. However, there is always than a definition, of public goods.
an opportunity cost involved in direct government provision. There is also
potential government failure from intervening in markets, as governments do
not necessarily know what is best for society. Expert tip
Note that some goods and services
Common mistake are non-rivalrous and non-excludable
only to some extent, for example
Students often confuse merit goods with public goods. Whilst it is true that merit
public roads. There is rivalry to some
goods and public goods both have positive externalities, public goods (such as
extent (which is why we have traffic
national defence and streelighting) are highly unlikely to be provided by private-sector
firms due to the free-rider problem. By contrast, merit goods are excludable (e.g. congestion) and there is some degree
of excludability (as drivers need a
education, healthcare and staff training) so are often provided by private-sector firms.
licence). Such products are known as
quasi-public goods.
EXAM PRACTICE
PAPER 1
22 Explain how merit goods and public goods are examples of market failure. [10]
Common access resources and the threat to

sustainability
Common access resources are, by definition, not owned by any particular
private individual so are vulnerable to overuse and abuse. Hence, they are often
referred to as open-access resources. Examples of CARs include: forests, fishing Keyword definition
erounds, rivers and the atmosphere. Common access resources
The negative externalities linked to CARs include: deforestation, (CARs), also known as a common-
overfishing, congestion, pollution, soil erosion, destruction of natural habitats pool resources (CPRs), refer to
and climate change. communal or public property. They
The lack of an effective pricing mechanism for CARs results in overuse are rivalrous in nature, but are
(or abuse), depletion and degradation of the resources because consumers non-excludable. As these resources
do not pay to use them. Clearly, this is inefficient and poses a threat to the are used by the general public, they
sustainability of the common access resource. suffer from overuse and therefore
The tragedy of the commons describes the consequences of the abuse and lack of sustainability.
inefficient use of CARs, where the user’s self-interest leads to the destruction of
these resources in the long run.
CARs and the resulting tragedy of the commons present problems for
economic sustainability as it becomes difficult to maintain or preserve the Common access resources differ
resources for future generations. from public goods because they are
The use of fossil fuels (those formed by natural processes, such as coal, subtractable (over-used) rather than
crude oil and natural gas) to satisfy economic activity can pose a threat to non-rivalrous (the use by an individual
sustainability. Fossil fuels can take millions of years to generate, so economic does not diminish the amount
activity depletes these scarce, non-renewable resources. available for others).
The existence of poverty in less economically developed countries (LEDCs)
can create a threat to sustainability because the over-exploitation of land for
agricultural use can lead to negative externalities, for example soil erosion.
Government responses to threats to sustainability

Legislation (laws and regulations) on the use of scarce resources include:
m laws to protect fish and marine life
m legislation to curb CO; emissions from cars and commercial vehicles.
A carbon tax is a per unit tax on greenhouse gas emissions. The purpose is
to create incentives for firms (and households depending on the scope of the
carbon tax) ro reduce pollution in order to reduce their tax liability.
m Carbon taxes are set by assessing the pollution costs and the associated
administrative costs of controlling the pollution.
m Establishing the correct tax level is key to the effectiveness of carbon taxes in
responding to market failures. If the tax is too low firms will simply continue
to pollute, whereas if the tax is too high the escalated costs negatively affect
profits, employment and consumers.
Cap-and-trade schemes (CATS) are government-regulated emissions trading
schemes using a market-based approach. The regulator sets a limit (the cap)
on the total amount of emissions allowed in an industry and firms are issued
emissions permits.
= Permits within a cap-and-trade scheme are freely traded (based on the price
mechanism), allowing more efficient firms to sell their excess permits. This
also creates an incentive for firms to develop clean technologies.
m Whilst CATS help to reduce carbon emissions, they can also raise a
significant amount of revenue for the government.
= The European Union Emissions Trading Scheme (EUETS), set up in 2005,
is one of the largest cap-and trade schemes. It aims to regulate economic
activity to prevent dangerous climate change.
m Critics of CATS argue that they are anti-competitive (against smaller firms)
and they can cause job losses (due to higher costs of production).
Funding for clean technologies is provided by governments to create
incentives for firms to adopt a sustainable approach. It includes:
m subsidies for the adoption of renewable energy sources, such as wind, sun and
biomass
m forest investment funding programmes to reduce emissions from deforestation
and the negative impacts of forest degradation.
However, policy responses to the threat to sustainability are limited by:
m the global lack of ownership of common access resources
m the escalating global demand for scarce resources, including fossil fuels, due
to higher levels of economic activity and globalisation
= the need for international cooperation to deal with these global issues
threatening sustainability (such as deforestation, overfishing and climate
change).
Asymmetric information
Asymmetric information exists when one economic agent (buyer or seller)
in an economic transaction has more information than the other in a certain
market — for example, life assurance policies, stock market products, pension
fund schemes, second-hand cars and works of art.
The existence of asymmetric information between buyers and sellers in a
market results in market failure and inefficiencies, i.e. consumer and producer
surplus are not maximised.
Governments can deal with this type of market failure in a number of ways:
m legislation, for example health warnings on cigarette packets
= regulation, for example rules and regulations about advertising (e.g. the UK’s
Advertising Standards Authority, which requires adverts to be ‘legal, decent,
honest and truthful’)
m provision of information, for example nutritional information on food
packaging.
Abuse of monopoly power

The lack of competition means that profit-maximising monopolists are likely
to supply less than the social optimum and charge higher prices, i.e. there is
productive and allocative inefficiency. This results in a welfare loss for society,
so the abuse of monopoly power (such as their ability to exploit consumer
surplus by using price discrimination) is a type of market failure.
Examples of abuse of monopoly power include:
monopolists charging excessively high prices
collusion — the agreement between firms with market power to set higher prices
predatory pricing — setting low prices, perhaps below the costs of production,
to force rival firms out of the industry.
Possible government responses to the abuse of monopoly power (to prevent
the market failing to reach an optimal allocation of resources) include the
following:
Legislation — It is illegal in most countries for monopolists to abuse their
monopoly power, such as charging excessively high prices or cutting prices
below production costs to force out rivals. In extreme cases, the government
can break up a monopoly if it becomes too powerful.
Regulation — Rules are set by governments to control the operation of firms
with monopoly power. For example, European Competition Law prohibits
anti-competitive acts and the abuse of monopoly power. Rail regulators check
the safety record of rail operators. Expert tip
Nationalisation — This occurs when the government takes control of Do not assume that monopolists
an industry previously in the private sector in order to run it in the best are 'bad’ for the economy. Instead,
interest of the public. Government control of certain industries prevents the consider the extent to which their
potential exploitation of monopoly power. behaviour is in the best interest of the
general public. Abuse of monopoly
Trade liberalisation — This refers to the reduction or removal of barriers
power is a type of market failure, so
to the exchange of goods and services between countries. This creates governments intervene to protect the
greater competition and thus reduces the potential for firms to exploit their interest of society as a whole.
monopoly power.

PAPER 3
23 Calculate the total value of the positive externality of production from the
information in the diagram. 2]
A MPC
MSC
& 15 b
1K)
E 10—l .
Hirsmoaemagoe === N MPB
= MSB
0 200 300 400 "

Quuantity {000 units)
1.5 Theory of the firm and market

structures (HL only)
Production and costs (HL only)
Production in the short run: the law of

diminishing returns (HL only)
Keyword definitions
The short run is the period of time when at least one factor of production,
such as land or capital, is fixed in the production process.
The long run is the period of time when all factors of production are
variable, so all costs of production are variable.
Diminishing returns occur in the short run when a variable factor input
(such as labour) is successively added to a fixed factor (such as capital),
which eventually reduces the marginal and hence total output.
In the short run, capital is likely to be a fixed factor because factory buildings,
machinery and capital equipment cannot be varied in the limited time period.
In the long run, the quantities of all factors of production are variable as there
is sufficient time to change output based on changes in the level of demand.
Average product refers to the output per unit of factor input — for example,
the average product of labour calculates the value of output per worker.
Marginal product measures the extra output due to a change in factor inputs. It is
calculated by dividing the change in total output by the change in factor inputs.
Total product is the sum of all physical output for a given amount of factor
inputs, for example the total output of the country’s labour force.
The relationship between AP, MP and TP is shown diagrammatically in
Figure 1.52.
MP = AP
Output (units]
¥
-e
O
Factor inputs [unifs) \
Figure 1.52 Relationship between marginal and average product costs

Average product is maximised at the output level where the average product
(AP) is equal to the marginal product (MP). This is because:
m if MP > AP the latter will rise
= if MP < AP the latter will fall.
Hence, AP is maximised when MP = AP.
Total product (TP) is maximised when the marginal product is equal to zero
because:
m if MP > 0 (i.e. positive) TP will rise
m If MP <O (i.e. negative) TP will fall.
Hence, TP must be maximised when MP = zero.
Expert tip
To understand the relationship between marginal and average product, consider
the example of average and marginal homework grades. If your last (marginal)
essay grade is greater than the average of all your previous essays, this would
increase your overall average essay grade. However, if your last essay was below
the average of your grades then the average essay grade would fall. Finally, if the
marginal essay grade is the same as your average, then there is no change to your
overall average essay grade.

PAPER 3
24 Study the data below for two real estate firms selling residential property over a typical weekend. The number of units sold
and the number of sales staff involved are also shown.
TOTAL SALES (%)
Sharma Realty 3,950,000 10 8
Mintjens Realty 3,800,000 14 10
Calculate the average product as measured by sales volume and sales value per worker for both Sharma Realty and
Mintjens Realty. Comment on which firm is more productive. [4]
25 a Calculate the missing average, total and marginal product values from the information shown in the table below. [4]
BOUF IBER O AT PRODU DTAL PROD! N:{dl PROD
5
b Using your calculations, plot a diagram on graph paper to show the average, total and marginal product curve. [4]
¢ Identify the units of labour that maximise total product. [1]
Cost of production: economic costs (HL only)

Economic costs are the explicit and implicit costs of all resources used by a firm
in the production process.
Explicit costs are the identifiable and therefore accountable costs related to the
output of a product. Examples include wages, raw material costs, utility bills and rent.
Implicit costs are the opportunity costs of the output, i.e. the income from
the best alternative that is foregone.
For example, a student might give up the opportunity to work in a job that
pays $25,000 per year and choose to study at university, which costs her $15,000
a year. The economic cost to the student is therefore $15,000 + $25,000 =
$40,000 per year.
Costs of production in the short run (HL only)

The short run (when there is at least one factor input fixed in supply) will vary
between industries — for example, the short run for aircraft manufacturers is
longer than that for bakers. Keyword definition
Total fixed costs are production costs that do not change with the level of
Fixed costs, such as insurance
output, for example rent, management salaries and loan interest repayments.
premiums and advertising costs,
Total variable costs are production costs incurred directly from the output of
do not change with the level of
a particular good or service — for example, variable costs for Emirates Airlines
output. By contrast, variable costs
include fuel and in-flight meals.
(such as labour costs and raw
Total costs are the aggregate amount of production costs spent on the output
material costs) continually rise
of a given good or service. They are calculated using the formula: with greater levels of output.
TC=TFC+TVC
Average costs are the unit costs of production. These are is calculated by
dividing the total costs of production (TC) by the output level (Q):
ac=1t
Q
Marginal costs are the costs of producing an extra unit of output. They are
calculated by dividing the change in total costs by the change in the level of
output:
MC=
_ATC
AQ
A e The downward-sloping section of the
SRAC curve is caused by MC being
lower than AC.
MC e AC will reach its minimum point when
MC = AC, i.e. af the minimum point
SRAC
Costs ($)
on the SRAC curve.

AFC W
SRAVC ® When MC > AC, the SRAC curve will
begin fo rise due to diminishing marginal
returns.
e MNotice that this relationship is the same
for the average product and marginal
> product.
< Quantity
Common mistake
Figure 1.53 The relationship between AC and MC Students often state that fixed costs
In the short run, average fixed costs (AFC) will continually fall with are those that do not change. This
is incorrect, as fixed costs can and
increased levels of output because the fixed costs are spread over an increasingly
do change - for example, rents and
larger level of output. For example:
salaries can change over time. The
s Assume fixed costs = $5000 and unit variable costs = $10
key is that fixed costs are the same,
= At 1000 units of output, AFC = (5000/1000) + 10 = $15.0 irrespective of the level of output.
m At 2000 units of output, AFC = (5000/2000) + 10=$12.5
This relationship is shown by the short run average variable cost (SRAVC)
curve. The vertical distance between SRAC and SRAVC is the AFC at each
output level. Notice that this is greater at a lower level of output than at larger
levels of output.

PAPER 3
26 Calculate the following costs from the data below:
a fixed costs of production [2]
b average fixed costs at 10 units and 15 units of output [3]
c average variable costs at 10 units and 15 units of output [3]
d average costs at 10 units and 15 units of output [3]
e the marginal cost of production [2]
OUTPUT VARIABLE COST ($) TOTAL COSTS ($)

10 2000 4545
15 2850 5395
The relationship between the product curves and the cost curves are shown
in Figure 1.54.
— MC
2 AC
£2
8
o
o ® The Ushaped average cost (AC] curve is

T—_ damm.lshrlng caused by the law of diminishing marginal
E marginal ienms » refurns (DMR) in the short run.
O | Output e In the same way, I.he average product (AP)
i of labour initially rises but once DMR seftles
A E in, the AP rises at a slower rate before
: declining due to the law of diminishing
i diminishing marginal returns.
' .~ marginal retumns
-g |;
S |i AP
i MP
o : -
Labour [units)
Figure 1.54 The relationship between marginal and average product and costs
Production in the long run: returns to scale

(HL only)
Increasing returns to scale occur when factor inputs are increased by a certain
amount, leading to output increasing by proportionately more. Thus, average
costs of production fall.
Decreasing returns to scale occur when factor inputs are increased by a
certain amount, leading to output increasing by proportionately less. Thus,
average costs of production rise.
Constant returns to scale occur when factor inputs are increased by a certain
amount, leading to output increasing by the same proportion. Thus, average
COSts remain constant.
Costs of production in the long run (HL only)

The long run average cost (LRAC) curve is ‘U’-shaped due to economies and
diseconomies of scale (see Figure 1.55). The minimum efficient scale occurs
when all economies of scale have been exploited, shown by the bottom of the
LRAC curve.
The LRAC curve encompasses all short run average cost (SRAC) curves. Common mistake
A Students often state that costs of

® The [RAC curve encompasses all SRAC production will fall as a firm increases
curves, representing the minimum average the scale of its operations. This is not
SRAC, costs at each level of output. quite correct — clearly it is cheaper
SRAC, ® The lowest point on the [RAC curve to produce 1000 cans of Coca-Cola
Costs ($)
represents maximum efficiency, known as than it is to produce 500,000 cans.

[RAC the minimum efficient scale [MES) of
production. However, it is cheaper to produce
each can on a larger scale, i.e.
' Minimum efficient scale [MES) economies of scale reduce the average
O Quantity costs of production.
Figure 1.55 The long run average cost (LRAC) curve

Internal economies of scale are generated and enjoyed within the firm
that operates on a large scale. By contrast, external economies of scale occur
within the industry, thus benefiting all firms. Factors that give rise to internal
economies of scale include the following:
m Specialisation — Specialised labour (such as divorce or criminal lawyers,
economics professors and aircraft pilots) is highly productive in the
output of goods and services, thus helping to reduce the average costs of
production.
= Efficiency — Specialised machinery, equipment and tools can be used to
their full potential to raise output (such as in car manufacturing or the
production of ball bearings), again helping to reduce the average costs of
production.
= Marketing — Effective advertising and branding boosts sales, so firms are able
to produce on a large scale. For example, Nike and McDonald’s are able to
market their brands to a global audience, thus reducing their marketing costs
per unit of sales.
m Indivisibilities — Large plants can only work effectively if large volumes of
output are generated, for example mass-produced cars, jam, soft drinks or
bottled water. By contrast, product differentiation, such as bespoke wedding
dresses, leads to higher unit costs.
External economies of scale arise from having specialised back-up services
available in a particular region where firms are located. For example, Silicon Valley
in Calitornia, USA is home to many of the best-known technology companies.
Diseconomies of scale occur when a firm becomes too large to manage
effectively, causing its unit costs to increase — for example, a firm increases
its factor inputs by 50% but the subsequent output only increases by 20%.
Diseconomies occur at all output levels beyond the MES point. Expert tip
Internal diseconomies of scale are caused by problems of coordination, Whereas internal economies of
control and communication within a firm. For example, as firms get larger, scale involve a movement down the
managers find it more difficult to coordinate, control and communicate with a LRAC curve, external economies of
scale will involve a downward shift
larger workforce, resulting in higher unit costs.
of the whole LRAC curve. Likewise,
Causes of external diseconomies of scale (those thart affect all firms in an
internal diseconomies are shown by a
industry) include:
movement up along the LRAC curve,
= traffic congestion causing costs to increase whilst external diseconomies shift the
= higher rent costs due to the high demand for firms locating in a certain area whole LRAC curve upwards.
= labour shortages in a particular area, thus leading to increased labour costs.

PAPER 3
27 Crispian's Candies has monthly fixed costs of $4800 and average variable costs
of $1.5. Demand for its candies is 4000 units each month. The average unit
price is $4. Students need to demonstrate that
a Calculate the average costs for Crispian’s Candies each month. [2] they clearly understand the distinction
. : e ; between internal economies of scale
b Calculate the units of output required for Crispian’s Candies to : I
Lant 5 (which relate to a specific firm) and
FEAK CVER. [2] external economies of scale (which
¢ Calculate the profit made by Crispian’s Candies each month. [2] relate to the whole industry).
Revenues (HL only)
Total revenue, average revenue and marginal

revenue (HL only)
Total revenue is the overall amount of money received by a firm from selling
its entire output. For example, Nike and Adidas receive most of their revenues
from the sale of sports apparel and sports equipment. It is calculated using the Keyword definition
following formula, where P = price and (Q = quantity sold: Revenue is the money received
from the sale of a firm's output.
TR=PxQ
Average revenue refers to typical price received from the sale of a good or
service. It is calculated using the formula:
Ar=1R
Q
Average revenue (AR) is mathematically the same as the price per unit (P).
This is because:
A
Q
and
TR=Px )
50
pe IR
Q
Hence
AR=P
For example, if a cinema earns $60,000 from the sale of tickets to 7500
customers, the average revenue (or average price) would be $60,000/7500 = $8
per ticket.
Marginal revenue is the extra revenue received from the sale of an extra unit
of output. It is calculated by dividing the change in total revenue by the change
in the level of output:
MC=——
_ATC
AQ
Mathematically, the marginal revenue (MR) curve intersects the x-axis at

the mid-point of a downward sloping demand (average revenue) curve, as in
Figure 1.56.
A
Revenues ($)
® The linear demand curve (average

revenue curve) is downward sloping
due to the law of demand.
e The marginal revenue curve falls
AR=D twice as steep as the AR curve. The
AR curve can only decline if the MR
\MR falls at a faster rate.
® When MR > 0O, the fotal revenue will
rise.
® \When MR < O, the fotal revenue will
fall.
® Hence, TR is maximised when MR = O.
2 Output
Figure 1.56 The relationship between marginal, average and total revenue

PAPER 3
28 a Use the diagram below to calculate the total revenue at $16. [2]
b Identify the average revenue when 120 units are sold. [1]
¢ Outline what the difference between area A and area B shows. [2]
A
R
ez Common mistake
8 A
Students often incorrectly use
Seall
the terms 'cost’ and ‘price’
interchangeably. Remember, costs (of
| Demand _ production) are paid for by firms in
O %0 120 - the production process, whereas price
is paid by the customer to purchase a
Quantity demanded
good or service.
Profit (HL only)
Economic profit and normal profit (HL only)

Normal profit is the minimum revenue needed to keep a firm in business.
Hence, it is also referred to as zero economic profit and occurs at the point
where a firm breaks even by covering both economic and implicit costs from its
sales revenue.
Break even means a firm does not make a profit or a loss. This occurs when Keyword definition
price is equal to average cost, or total revenue equals total costs, i.e.: Economic profit (abnormal profit)
exists when total revenue exceeds
P=ACorTC=TR the economic costs of a transaction,
Economic profit occurs when total revenue exceeds total economic costs. It thus creating incentives for firms to
is profit that is over and above normal profit. A firm might choose to continue produce.
to operate even if it earns zero economic profit because total revenue covers all
Dol ] o]
economic costs (both implicit plus explicit costs), so it still earns normal profit, i.e.
To understand the concept of zero
the minimum amount required to keep factors of production in their current use.
economic profit, consider the example
Negative economic profit occurs when a firm makes a loss, i.e. its total cost of a worker who earns $45,000. If
of production exceeds its total revenue. another company wanted to hire this
worker, the minimum salary offered
would have to be $45,000, ceteris
paribus.
PAPER 3
29 The table below refers to the costs and revenues of Tandy Toys Ltd when
operating at 5000 units of output per month.
15 COST/REVENUE ($)
Price $20
Raw materials per unit $8
Rent $7000
Salaries $8000
a Calculate the total cost of producing 5000 units. [2]

b Calculate the profit made by Tandy Toys Ltd if all its output is sold. [2]
Table 1.6 Costs and revenues formulae table
Type of cost or revenue Formula Annotation
total costs
Average cost —_— AC = E
quantity produced Q
total fixed cost TFC

Average fixed cost _ AFC =—
quantity produced Q
total variable cost TVC

Average variable cost _— AVC =——
quantity produced Q
_ total revenue TR
Average revenue (or price) _ AR=—
quantity traded Q
change in total costs ATC

Marginal cost g— MC = ——
changein output level AQ
change in total revenue ATR

Marginal revenue 2 - MR = ——
change in output level AQ
Total cost total fixed costs + total variable costs TC=TFC + TVC
Total revenue unit price x quantity traded TR=PxQ
Goals of firms (HL only)
Profit maximisation (HL only)

It is generally assumed that firms are profit maximisers, seeking to produce at
the level of output that generates the highest level of profits. This occurs at the
level of output where marginal cost equals marginal revenue (i.e. MC = MR):
s If MR > MC, firms increase their output because profits will rise.
m If MC > MR, firms reduce their output as the marginal cost outweighs the
Keyword definition
marginal revenue.
Profit maximisation is the assumed
m Hence, profits are maximised when MC = MR.
fundamental goal of private-sector
firms. It occurs when there is the
greatest positive difference between
total revenue and total costs.
Alternative goals of firms (HL only)
Table 1.7 Alternative goals of firms
Revenue maximisation Some firms might choose not to profit maximise (so earn less profits) but opt to
sell more, thus raising the popularity of the product to keep out other firms from
entering the industry.
Growth maximisation Many firms seek to expand their operations. Firms such as Coca-Cola, Subway
and McDonald’s have expanded throughout the world.
Satisficing This goal occurs when firms aim for a satisfactory or adequate level of profit,
rather than the maximum profit. This is because profit maximisation might require
significant expenditure of time, effort and financial resources.
Corporate social responsibility (CSR) Firms are increasingly involved in CSR, i.e. they consider the impact of business
activity on the environment and on social welfare. Examples include business
ethics (such as avoiding unethical advertising), sustainable operations (such as
avoiding excessive packaging) and measures to boost the welfare of workers
(such as a pleasant working environment and decent wages for all staff).
Perfect competition (HL only)
Assumptions of the model (HL only)

Assumed characteristics of perfect competition include the following:
= A very large number of buyers and sellers exist in the market.
m All firms in the industry sell a homogeneous product, i.e. products are identical. Keyword definitions
= Firms are price takers — no individual firm is large enough to have the Market structure refers to the
market power to influence the equilibrium output or the price. key characteristics of a particular
m Extremely low barriers to entry — there is freedom of entry into and exit from industry, for example the number
the perfectly competitive industry. and size of firms, the degree and
m Perfect information — buyers and sellers have perfect knowledge of prices. intensity of price and non-price
m There is perfect factor mobility, i.e. there are no barriers to the use of land, competition, and the nature of
labour, capital and enterprise, which are all adjusted according to changing barriers to entry.
market conditions. Perfect competition describes a
market structure where there is an
intensive degree of competition,
Where appropriate, try to use real-world examples in your written answers. with no individual firm being large
For perfect competition, a real-world example could be markets that sell fresh enough to have any market power
fruit and vegetables, where the demand is highly price elastic because firms sell to influence the price or quantity
homogeneous products (carrots or oranges from one vendor are no different traded.
from those sold by other firms in the market). No individual firm is large enough
to influence market supply or market price, i.e. firms are price takers. It is also
relatively easy for firms to enter or leave the market.
Revenue curves (HL only)

The demand curve for an individual firm in perfect competition is perfectly
price elastic (see Figure 1.57). A price above the market price means no
demand, due to perfect substitutes, yet there is no advantage in reducing price as
firms can sell their entire output at the higher price.
As the MR curve for an individual firm in perfect competition is horizontal,

the AR curve is also constant, i.e. it sells all output at the same market price.
Mathematically, since P = AR and AR is constant, then:
MR =AR
under perfect competition.
The perfectly competitive firm's average revenue curve (AR =MR=D) is
determined by the market forces of demand and supply (see Figure 1.57).
Expert tip
Price ($)
D=AR=MR
o
As there is perfect knowledge, a firm

trying to cut price would simply result
in others following, so there is no
benefit in doing so. Besides, firms are
O O
Quantity Quantity assumed to be price takers, so accept
the market price.
Figure 1.57 Revenue curves under perfect competition
Profit maximisation in the short run (HL only)

In the short run, it is possible for a perfectly competitive firm to make economic
profit (see Figure 1.58), negative economic profit (see Figure 1.59) or normal
profit (see Figure 1.60).
Common mistake
When drawing diagrams for theory
The profit maximising firm of the firm and market structures,
Costs and revenues ($)
produces Q+ output, where make sure you do not label the y-axis
MC = MR (point x]. As price
as 'Price’. The diagrams contain
D=AR=MR {w] is greater than the short
both cost and revenue curves, so the
2
run average cost (2], the firm

makes abnormal profits as correct label is ‘Costs and revenues ($)’
instead.
=
shown by the shaded area

W, X, Z, .
O Qx Output " Expert tip

Figure 1.58 Short-run economic profit To gain top marks, you must show
evidence of critical thinking. This
means you should consider the
advantages and disadvantages of
operating in competitive markets
— for example, healthy competition
SRAC The profit maximising can ensure consumers get the
firm produces where right products at the right price in

MC = MR ie at Q. As an efficient way. However, there
price (c) is less than the are limitations to the model — few
average cost (b), the firm
Q
D=AR=MR makes a loss in the short industries, if any, actually fit the
model in the real world. Branding
n
run, shown by the shaded

area a, b, d, c. means that most products are
heterogeneous in reality and it is not
possible for consumers to have perfect
O G Qutput - information about all prices for all
products.
Figure 1.59 Short-run negative economic profit
MC
SRAC
The profit maximising

firm produces where
I MC = MR ie. at Q. As
; D=AR=MR price |a} is equal to the
0
: average cost (b), the firm

i makes a zero economic
! profit (i.e. it breaks even.
o Q= Output -
Figure 1.60 Short-run zero economic profit
Profit maximisation in the long run (HL only)

In the long run, perfectly competitive firms can only earn normal profits (zero
economic profit), as shown in Figure 1.60. Any losses in the industry (see Figure
1.59) lead to some firms exiting, so total supply falls, leading to a higher market
price until the industry returns to normal profit.
Any abnormal profits in the industry will attract more firms to enter (see
Figure 1.61) due to the absence of barriers to entry. This raises market supply
(from S; to ;) and reduces the price (from P; to P;) until equilibrium is
restored.
A A MC
[RAC
5
| MC=
MR = AR = AC
Output Output
Figure 1.61 Long-run equilibrium competition

Hence, in the long run, perfectly competitive firms can only make normal
profits, i.e. AR = AC. As these firms are also profit maximisers, they produce at
the output level where MC = MR. This means the following long-run condition
must hold in perfectly competitive markets:
MR=MC =AR=AC
Shut-down price and break-even price (HL only)

An individual firm in perfect competition will not necessarily shut down if it
makes a loss in the short run. However, it has fixed costs irrespective of its level
of output. Therefore, by continuing to operate, even at a loss in the short run,
any revenue it can earn over and above its variable costs contributes towards
paying its fixed costs.
The shut-down price for profit-maximising firms in perfect competition
occurs at the point where MC = MR = AVC. The petfectly competitive firm’s
short-run supply curve will therefore be the part of the MC curve above its AVC
curve (shown by the red line in Figure 1.62).
In the long run, the perfectly competitive firm will not produce unless it can
cover all its costs. Hence, its supply curve is the MC curve above the SRAC
curve (the red line in Figure 1.63).
46
Costs ($) Economics for the IB Diploma
Y
Q Quantity
Figure 1.62 The short-run shut-down price
A
MC
SRAC
Costs ($)
Q Quuantity
Figure 1.63 The long-run shut-down price

PAPER 3
30 Use the information below to calculate:
a the break-even price
b the shut-down price. [4]
Monthly production costs for Adrian’s Awning Company
COMPONENTS AND MATERIALS $35,500
WAGES $45,000
R $30,000
OUTPUT (UNITS) 500
Perfect competition and efficiency (HL only)

Allocative efficiency occurs when firms produce at the optimal level of output
from society’s point of view, i.e. where the marginal social costs (MSC) of
production equal the marginal social benefits (MSB) of consumption. It is
achieved when firms charge a price equal to the marginal cost of production,
i.e. P=MC (or when MSB = MSC), i.e. no one can be made better off without
making someone else worse off.
Productive etficiency occurs at the output level where average costs are
minimised, i.e. where MC = AC. Hence, there is no wastage or unemployment
of scarce resources. It requires technical efficiency — when the maximum output
is produced with the minimum amount of factor inputs, i.e. the least-cost
method of output.
On a macroeconomic scale, productive efficiency occurs when the economy S {elTald]e

operates on its production possibility curve, i.e. it is not possible to produce
An economy can be productively
more goods and services for one stakeholder group without producing less for
efficient but allocatively inefficient at
another stakeholder group.
the same time, because the latter is
A key advantage of perfect competition is economic efficiency, because concerned with the optimal distribution
firms are: of scarce resources. For example, an
m allocatively efficient (charging a price that is equal to marginal cost) in both economy might devote a significant
the short run and the long run amount of resources to efficiently
= productively efficient (they operate at the lowest point on the average cost supply national defence (resulting in
curve) in the long run, although not necessarily in the short run (as they can a socially undesirable allocation of
temporarily earn abnormal profit). resources) rather than to supply public
education and healthcare services
(which are more socially desirable).
Monopoly (HL only)

A pure monopoly exists if only one firm supplies the whole market. In the USA,
this would include the United States Postal Service (the only service provider of
Keyword definition
first class postage) and the Federal Reserve (the sole supplier of banknotes and
A monopoly is a market structure
coins).
where there is a single supplier of
In reality, a monopoly exists in a market dominated by one firm with
a particular good or service, thus
significant market power, e.g. Coca-Cola (carbonated soft drinks), YKK (zip
having the power to influence the
fasteners), Tetra Pak (packaging) and Mabuchi (which makes 90% of the micro-
market supply and price.
motors used to adjust rear-view mirrors in cars).
The monopolist has significant market power as it controls enough of the
market supply to be able charge higher prices. Hence, it is a price maker (or Expert tip
price setter). Yet due to the absence of competition, the monopolist can supply
It is incorrect to claim that
at a lower level of output. Therefore, monopoly is less efficient than perfect monopolists can charge ‘'whatever’
competition due to the combination of higher prices and lower output than price they want because they are the
would be the case under perfect competition. single supplier of a good or service.
A monopolist is able to protect its prestigious position as customers and rivals Whilst monopolists have the ability
have imperfect knowledge. This includes the monopolist’s ability to protect its to control market supply, they cannot
trade secrets. control the level of market demand.
Monopolists can earn abnormal profit in the long run as there are extremely Customers will switch to, or seek,
high barriers to entry that prevent other firms from setting up in the industry, alternatives if prices rise too high.
i.e. there are no close substitutes. Hence, monopolists must lower prices
if they want to sell more.
Barriers to entry (HL only)

A monopolist can only remain so if in the long run there are extremely high
barriers to entry. These are obstacles that prevent other firms from effectively
entering the market. Hence, the nature and scale of barriers to entry permit the Keyword definition
monopolist to earn economic profit (abnormal profit). Barriers to entry are the obstacles
Barriers to entry can be classed as either artificial barriers or natural barriers. that prevent other firms from
Artificial barriers are deliberately set up by monopolists to prevent competition, effectively entering a particular
whereas natural barriers are obstacles that simply exist characteristically in the market, for example extremely high
industry. set-up costs or legal barriers.
Examples of artificial barriers to entry include the following:
= Advertising and branding, if effective, can act as significant entry barriers due
to the established brand loyalty of customers — for example, imagine trying to
compete against Coca-Cola!
m The existence of intellectual property rights, such as trademarks, copyright
and patents, helps to establish market power and market dominance.
= Large advertising budgets of existing firms can act as a deterrent to new
entrants.
m Predatory pricing involves the lowering of prices to prevent new firms
entering the market or to force weaker rivals out of the industry.
= Loyalty schemes, such as those used by credit card companies (e.g. American
Express and Visa), help to establish customer loyalty.
m Switching costs mean that customers find it uneconomical to change
between brands or products. For example, Apple uses a different operating
system and power chargers from its rivals.
Examples of natural barriers to entry include the following:
= High set-up costs discourage firms from entering some industries, for example Expert tip
airline manufacturing and pharmaceuticals.
Whether branding and advertising
= Sunk costs are those that cannot be recovered if a firm is unsuccessful and represent inefficiencies depends on
exits the industry, so high sunk costs act as an entry barrier. perspective and context. They can
m High research and development (R&D) costs in an industry act as a signal to help oligopolistic and monopolistic
potential entrants that they need large financial reserves to compete. firms to boost their sales thereby
= Huge economies of scale earned by the existing monopolist can deter new achieving some productive efficiency
entrants. gains through economies of scale.
= Ownership and control of essential resources for a certain industry create a However, they can also create
considerable barrier to entry — for example, favourable access to raw materials inefficiencies if branding and
such as oil. advertising act as a major artificial
m Legal constraints exist in some industries to prevent wasteful competition — for barrier to entry, given certain brands’
significant monopoly power.
example, postal services, railroad networks and electricity power generation.
Revenue curves and profit and revenue

maximisation (HL only)
The AR curve for a monopolist is the market demand curve, as it is assumed
there is a single supplier, i.e. the firm is the industry. Hence, the AR = D curve
is downward sloping because the monopolist must reduce price in order to sell
more output.
The gradient of the linear MR curve is twice that of the linear AR curve,
because for the AR to fall continually, the MR must fall at a faster rate.
The revenue-maximising monopolist will supply at the output level
where MR = 0, at Q,,, and charge a price of P, (see Figure 1.64). The profit-
maximising monopolist will supply at the output level where MC = MR, i.e.
at Qpm and charge a price of Py, whilst average costs are AC. The abnormal
profit earned is therefore shown by the red shaded area.
In the short run, a monopolist might choose to deliberately operate at a loss,
shown by the shaded green area (see Figure 1.65) in order to deter new entrants
or to force out a rival firm from the industry. In reality, such actions are likely to
be deemed illegal in most countries.
Mathematically, MR = 0 at the mid-point of the AR curve for the
monopolist. To the left of the mid-point of the AR curve, demand is relatively
price elastic. The monopolist will never choose to operate on the inelastic half
of its AR curve because MR will be negative, i.e. both revenue and profit cannot
be maximised if MR is negative.
Figure 1.64 Monopoly (long-run abnormal profit position)

Costs and revenues ($) Section1 Microeconomics 49
Students who claim that it is not

possible for a monopolist to make a
loss, given the lack of competition,
should really consider why a
monopolist might deliberately make a
Figure 1.65 Monopoly (short-run loss-making position) loss in the short run.

PAPER 3
31 With reference to the diagram below, identify the following:
a The price charged by the profit-maximising monopolist. [1]
b The total costs for the profit-maximising monopolist. [1]
¢ The amount of abnormal profit earned by the profit-maximising
monopolist. [1]
d The output level of the revenue-maximising monopolist. [1]
A
MC
&
g
o
g
G
S
Output
EXAM PRACTICE
PAPER 1
32 Explain why a monopolist is able to earn abnormal profits in the
long run. [10]
Natural monopoly (HL only) —— n

A natural monopoly exists when the industry can only sustain one supplier,
to avoid wasteful competition and to maximise economies of scale by having a
single provider. Natural monopolies exist in industries that have extremely high
fixed costs and sunk costs required to ensure supply. Hence, these costs can deter
entrants to the industry.
It is more economical to have a single supplier of postal services, gas pipes,
telephone cables, electricity cables and railway tracks since a monopolist could
provide these with substantial cost savings compared with many smaller firms in
direct competition. Therefore, trying to increase competition in such industries
actually creates a potential loss of efficiency as new entrants would mean a
wasteful duplication of scarce resources.
However, as there is the potential for natural monopolists to exploit their

power, governments tend to nationalise these industries or regulate them
heavily to protect the general public.
A
® The unregulated profitmaximising
monopolist will supply at Quy, where
MC = MR, thus eaming abnormal
profit (shown by the red areq).

e A single supplier can achieve huge
cost savings by operating at a larger
scale along its IRAC curve.
® The natural monopolist can supply
more at G, where P = MC, but will
make a loss [shown by the green
area). This loss could be subsidised
by the government.
O Gpm \ MR Gem
Quantity
Figure 1.66 Natural monopoly
Monopoly and efficiency (HL only)

Productive inefficiency occurs when a profit-maximising monopoly lacks
incentives to operate at the lowest point of its AC curve (see Figure 1.67). It
can limit supply, enabling it to charge a higher price than would be the case in
competitive markets.
Allocative inefficiency occurs when there is no incentive for a profit-
maximising monopolist to supply where P = MC due to the lack of competition.
Instead, for the monopolist, P > MC.
Arguably, if the market was more competitive, the output would be higher at
Qpc and price would be lower at P.. The resulting welfare loss (the combined
loss of consumer and producer surplus) is shown by the shaded red area.
Nevertheless, there are reasons why, despite their inefficiencies, monopolies are
desirable:
= As a monopolist controls the market supply, it can achieve huge economies
of scale, i.e. it can sell larger quantities and at lower average prices.
= A monopolist, rather than small highly competitive firms, is more likely to
have the financial ability to finance research and development (R&D) from
its economic profits.
= R&D helps to create new innovations (ideas, products and processes), thus
improving the productive capacity and international competitiveness of the
economy.
MC
AC
=
R
o
Il
Qs pc
Y
pm
Output
Figure 1.67 Monopoly and efficiency

Policies to regulate monopoly power (HL only)

If monopolies exploit their market power and act against the public interest
(perhaps by deliberately charging unreasonably high prices, restricting
competition, or by engaging in price fixing) then the government can intervene
to break up their monopoly powers. For instance, a merger between the two
largest firms in an industry can be prohibited if it is believed that the resulting
monopolist’s market dominance will be against the public’s interest.
In 2013, Visa and Mastercard were fined a record $7.25 billion for colluding
to fix their fees to commercial customers (retailers who pay to process credit
card payments).
Advantages and disadvantages of monopoly

compared with perfect competition (HL only)
Table 1.8 Advantages and disadvantages of monopolies
= As monopolists control industry supply, they operate on = Monopolies can be inefficient in terms of resource
a very large scale, thus benefiting from huge economies allocation. In pursuit of profit maximisation, they can
of scale, i.e. they can actually supply more output and at restrict output and/or charge a higher price, thus creating a
lower prices. welfare loss.
= Monopolists have the financial resources to invest in High barriers to entry prevent new firms from entering the
innovation. R&D expenditure can help to generate new market. This limits the degree of competition and ensures
ideas, new products and production processes. that monopolists can continue to charge relatively high
= Therefore, monopoly power can be an important source of prices.
international competitiveness against foreign competitors. Imperfect knowledge about prices and products can make
= Some monopolies can eliminate wasteful competition. it difficult for consumers to make rational choices — for
For example, it makes more economic sense to have one example, the confusing pricing policies used by mobile
supplier of postal services rather than allowing private- phone service providers mean that customers find it
sector firms to compete to provide such services since troublesome to switch between suppliers.
profit-seeking firms could be reluctant to service remote Monopolists may have less incentive to innovate than firms
areas. in competitive markets. The lack of competitive pressure
can mean that monopolists become complacent.
Monopolistic competition (HL only)

The assumed characteristics of monopolistic competition are:
m a large number of relatively small firms, each with insignificant market power
and supplying differentiated products
m absence of barriers to entry and exit from the industry.
Examples include clothing firms (such as H&M, Zara and Uniqlo),
hairdressers, florists and restaurants.
Product differentiation gives monopolistically competitive firms a small
degree of market power, i.e. such firms face a negatively sloping demand curve
for their product.
In the short run, these firms can earn abnormal profit. However, the lack of
entry barriers will attract new firms to the industry, thus reducing the market
price and profits. Equally, the firms can also make a loss (see Figure 1.68). At
the profit-maximising (or the loss-minimising) level of output, AC > AR, so a
loss is made, shown by the shaded area.
In the long run, abnormal profits attract new entrants, whereas losses cause
lower market supply, due to the absence of barriers to exit. Hence, only normal
profit is made in the long run (see Figure 1.69).
MC AC
Cosfs and revenues ($)
O
Output
Figure 1.68 Monopolistic competition (short-run loss minimisation position)

A
MC AC
O
Output
Figure 1.69 Monopolistic competition (long-run normal profit position)
EXAM PRACTICE
PAPER 1
3 3 Explain why product differentiation leads to a negatively sloped demand curve
in monopolistically competitive markets. [10]
Non-price competition (HL only)

Since monopolistically competitive firms produce differentiated products, non-
price competition is a key feature in such industries. Price competition is the
use of pricing strategies to compete. Examples include:
going-rate pricing — the pricing decision is based on the average price charged
by firms in the industry
loss-leader pricing — setting the price of a product below its cost price to
entice customers, who might also buy other, often related, products sold by
the firm
penetration pricing — used by new entrants that set a low introductory price
to establish some market share
promotional pricing — charging a low price to attract customers to raise brand
awareness and to develop customer loyalty
psychological pricing — for example, $9.99 can seem much cheaper than $10
to some customers.
Non-price competition refers to all other forms of competition. Examples
include the following:
Advertising is used extensively to differentiate between the products of firms.
Branding is used in an attempt to gain customer loyalty.
Packaging can be used to distinguish products from one another and to act as
a distinctive selling point, for example fruit juices, potato chips (crisps) and
specialised boxes for jewellery.
= Product development, such as special features and limited editions of a

product, or new innovative products being released to the market.
m Quality of service (the level of customer service) at hairdressers, restaurants
and other retailers can give firms a competitive advantage over their rivals.
m Similarly, after-sales care can also create competitive advantages for
monopolistically competitive firms, for example guarantees (warranties),
technical support and delivery service.
Monopolistic competition and efficiency (HL only)

Like monopolists, monopolistically competitive firms are neither allocatively
efficient nor productively efficient in both the short run and long run.
Inefficiencies can occur in monopolistically competitive markets due to the vast
degree of choice that consumers have.
Monopolistically competitive firms do not operate at the lowest point on
their AC curve (see Figure 1.69) because there are limited opportunities to
exploit economies of scale.
Like a monopolist, the monopolistically competitive firm is a price maker
(although to a lesser extent), so its price exceeds marginal cost (P > MC), as
seen in Figure 1.69.
Monopolistic competition compared with perfect

competition and monopoly (HL only)
Like perfect competition, there are many small producers in monopolistic
competition.
Product differentiation exists under monopolistic competition but not
necessarily under monopoly (despite being the only supplier, monopolists can
supply undifferentiated products). Due to this product differentiation, variety
(choice) is greater in monopolistic competition than in perfect competition
where firms only supply homogeneous products.
Monopolistically competitive firms can enjoy some economies of scale
although these are limited due to the size of the firm and the differentiated
products they supply.
Firms in perfect competition are productively and allocatively efficient in the
long run, whereas those in monopolistic competition are not. Both monopolistic
competition and monopoly are inefficient market structures in both the short
and long run, although monopolistically competitive firms have much less
market power. Whilst competition is generally beneficial, natural monopolists
eliminate wasteful competition.
Monopolistically competitive firms have a small degree of monopoly power.
Therefore, the demand curve of a monopolistically competitive firm is less price
elastic than that of a perfectly competitive firm.
There is an absence of barriers to entry and exit under both perfect
competition and monopolistic competition. Only monopolists earn abnormal
profits in the long run due to the nature of barriers of entry.
Oligopoly (HL only)

The assumed characteristics of an oligopoly are as follows:
m The industry is dominated by a small number of large firms — for example, Keyword definition
Samsung and Apple dominate the smartphone industry. An oligopoly is a markert structure
m Mutual interdependence — firms in oligopolistic markets consider the actions in which a few large suppliers, each
and reactions of their competitors when determining their price and non- with a high degree of market share,
price strategies. dominate the industry.
= Firms can produce differentiated products (e.g. breakfast cereal, book

publishing and music entertainment) or homogeneous products (e.g. oil, steel
and aluminium).
= Barriers to entry — there are considerable entry batriers to the industry,
including huge set-up costs and sunk costs.
Examples of oligopolistic industries include carbonated soft drinks, aircraft
manufacturers, petroleum, sportswear and laptop manufacturers.
Due to the market power that oligopolistic firms have, there is asymmetric
information in the industry, for example trade secrets. Oligopolistic firms are
often faced with the dilemma of whether to collude or to compete.
Concentration ratio Keyword definition
A three-firm concentration ratio measures the combined market share of the Concentration ratio measures
three largest firms in an industry — for example, the UK supermarket industry is the degree of market power in an
dominated by Tesco, Sainsbury’s and Morrisons with a three-firm concentration industry by adding the combined
ratio of over 65%. market shares of the largest few
The higher the concentration ratio for an industry, the more concentrated firms.
(oligopolistic) the market tends to be.
A clearer measure of market concentration is the Herfindahl Index, which gives

greater weighting to the market power of larger firms simply by squaring the
value of each market share. Assume that the three-firm concentration ratios for
Industry A and Industry B are both 65%:
m Industry A: Firm 1 = 30%, Firm 2 = 20% and Firm C = 15% market share
m Industry B: Firm 1 = 25%, Firm 2 = 20% and Firm C = 20% market share
The Herfindahl Index for Industry A = 302 + 202 + 152 = 1525
The Herfindahl Index for Industry B = 252 + 202 + 202 = 1425
Industry A has the higher Herfindahl Index value, so is more oligopolistic than
industry B, even though they have the same three-firm concentration ratio.
Game theory (HL only)

In game theory, the outcome of a firm depends on the actions taken by other
firms in the industry, with each firm having incomplete information about the
competitor’s intentions. Keyword definition
Game theory, or the prisoner’s dilemma, shows that oligopolistic firms can Game theory is an economic model
increase their profits through collusion rather than competing independently. It that attempts to explain the nature
also helps to explain why price fixing is unlikely to succeed due to the tendency of strategic interdependence in
for firms to ‘cheat’ (to outdo their rivals), as shown in Figure 1.70. oligopolistic markets by considering
the actions of competitors when
Adidas’s pricing policy making a decision, based on
High Low probable outcomes.
T A $50m B $60
22
> | $50m $20
G
o C $20m D $30m
23
< $60m $30m
Figure 1.70 Game theory
= The dominant strategy for Adidas and Nike is to collude and raise prices
together (decision A), yielding $50 million for each firm. Apart from
collusion being illegal in most parts of the world, there is always the
temptation for firms to cheat by opting for a low price strategy.
= However, if Adidas opts for a high-price strategy, Nike will earn $60 million
by adopting a low-price strategy (decision C).
= Anticipating this, Adidas is likely to adopt a low-price strategy, in the hope
that its rival charges a high price (decision B), thus allowing Adidas to earn
$60 million.
m Therefore, independent decision making by Adidas and Nike is likely to lead
to sub-optimal outcomes, with both failing to trust each other, and thus both
adopting a low-price strategy (decision D).
Open/formal collusion (HL only)
Collusive oligopoly exists when firms openly work together to limit the degree
of competition, thereby acting as a collective monopolist, for example firms Keyword definition
agreeing to simultaneously raise their prices. Collusion is more effective and Collusion is the agreement
easier to achieve if a very small number of dominant firms in an industry between two or more oligopolistic
produce a homogeneous product. firms to limit competition by
The primary goal of a cartel is to restrict competition in order to maximise restrictive trade practices, for
the profits for the colluding firms, which act as if they were a collective example price fixing or collectively
monopoly. For example, oligopolistic firms might use limit pricing — a pricing limiting output.
strategy used in a collusive oligopoly to set prices at a level that discourages new A cartel is formed when there
firms from entering the industry. is a formal agreement between
The most quoted example of a cartel is OPEC (Organization of Petroleum oligopolistic firms to collude, for
Exporting Countries), which limits the world supply of crude oil in order to example in fixing prices or the
keep prices high. However, cartels often break down in the long run because level of output in the industry,
individual firms have a tendency to cheat (lower prices and increase output) to thereby effectively acting as a
improve profitability at the expense of rival firms. monopolist.
Tacit/informal collusion (HL only)

Price leadership, a common form of tacit collusion, occurs when a firm (usually
the market leader) sets a price that is then accepted by other firms as the market
price. Banks often adjust their savings and mortgage rates by following the Keyword definition
pricing strategies of the largest firms in the industry. The same applies to petrol Tacit collusion occurs when
retailers. two or more oligopolistic firms
As collusion is illegal in most countries, it is usually undisclosed, i.e. implicitly (or informally) agree
collusion takes place without any formal or written agreement. In 2013, the EU to use restrictive trade practices,
Commission fined electronics giants Samsung, Philips, Toshiba, Panasonic and for example price cutting or price
LG a record €1.47 billion ($1.89bn) for conspiring to fix prices on some of their leadership.
products between 1996 and 2006.
Non-collusive oligopoly (HL only)

Price rigidity (stability) exists in non-collusive oligopolistic markets because
competitors would simply retaliate by matching any price reduction from a rival
firm. By contrast, firms in non-collusive oligopoly would not follow an increase Keyword definition
in price in order to gain a competitive edge. Non-collusive oligopoly exists
where firms in the industry
act strategically by competing
independently, taking into account
the likely or possible actions of
rival firms.
The kinked demand curve model is used to explain price rigidity (see
Figure 1.71). Keyword definition
The kinked demand curve is a
model that shows price rigidity
in oligopolistic markets because
competitors do not match a price
& hike but will follow any price
S reduction.
o At
@
2o B}
i ©
Q
o
o
Output
Figure 1.71 Price rigidity under non-collusive oligopoly

In Figure 1.71, it can be seen that the profit-maximising oligopolistic firm
produces at the output level where MC = MR, thus supplying Q,, at a price of
OA. Since AC = OB whilst AR = OA, the oligopolistic firm earns abnormal
profit, shown by the shaded area.
Due to the assumptions of mutual interdependence (a price hike is not
matched by competitors whereas a price reduction is followed by rivals) and
asymmetric information (game theory), there is a kink in the demand curve at
the price OA.
The kink of the AR (demand) curve creates the vertical section of the MR
curve due to the sudden change in the slope of the AR curve. Since profit
maximisation occurs at MC = MR, there is price rigidity (P remains at OA)
even if MC fluctuates between OC and OD.
In addition, the risk of price wars (when firms continually reduce prices
to outstrip their rivals) can lead to huge losses for firms. Therefore, non-price
competition is common in oligopoly.
Examples of non-price competition under oligopoly include:
= branding, for example Coca-Cola and Pepsi, Nike and Adidas, McDonald’s
and Burger King or Apple and Samsung
= added-value services, for example movies on-demand on certain airlines,
extended opening hours at certain supermarkets, or customer loyalty schemes
at certain retailers
= quality, for example Mercedes, BMW and Lexus, or Rolex and Omega.
Price discrimination (HL only)
Necessary conditions for the practice of price

discrimination (HL only)
Firms with market power (oligopolists and monopolists) are able to use price
discrimination. It occurs even if there are no differences in the cost of providing
the service to different consumers groups. Examples of price discrimination used
for students and adults include tickets for cinemas, airlines, swimming pools, Keyword definition
public transport operators an_d. theme parks.+ | S Price discrimination is the practice
The following three conditions must exist for effective price discrimination of charging different prices to
to take Elace: o _ different customers for essentially
m The firm must have some degree of market power, i.e. it must be a price- the same product
maker.
= Different customer groups with different price elasticities of demand (PED)

must exist —for example, adults and children have different willingness and
ability to pay for certain products.
= The firm must be able to separate the different consumer groups to prevent
resale of the product from one group to another.
The three degrees of price discrimination are as follows:
= First-degree price discrimination occurs when a firm can get each consumer
to pay the highest price that s/he is able and willing to pay, thereby
eliminating all consumer surplus, for example real estate agents and second-
hand car salespeople.
= Second-degree price discrimination occurs when discounted prices are used
for customers buying in bulk — for example, theme parks use annual passes
whilst supermarkets use ‘multipack’ offers.
m Third-degree price discrimination occurs when a different price is charged Expert tip
to different customers based on their different degrees of price elasticity of Do not assume that price
demand — for example hotels, theme parks, cinemas, taxi firms and airlines ‘discrimination’ is necessarily a ‘bad’
often charge different prices during peak and off-peak times. act of monopolists. Price discrimination
Figure 1.72 shows a train operator charging higher prices for adults than can lead to some consumer groups
children due to the different degrees of PED. The firm produces where MC = MR. with relatively price elastic demand
(such as students, pensioners and the
MC is horizontal as the extra cost of providing the service to an extra customer
unemployed) to consume more than if
on the train is literally zero (assuming the train is not full). The firm can therefore
a single market price is charged to all
gain revenue by using price discrimination to gain revenue from customers who consumer groups.
might not be willing or able buy tickets at the higher price.
Adults Children Combined

MR-
Output Qutput Output
Figure 1.72 Third-degree price discrimination and profit maximisation

-lailes WA Macroeconomics
2.1 The level of overall economic

activity
Economic activity
The circular flow of income model

In the circular flow model, households are individuals with effective demand for
goods and services, whereas firms are businesses that produce (or supply) goods Keyword definition
and services. The circular flow of income model
There are three types of withdrawal: savings (S), taxation (T) and import is a macroeconomic tool used to
expenditure (M) as money leaves the circular flow to banks, government and explain how economic activity and
the foreign sector respectively. national income are determined.
There are three types of injection: government spending (), investment
expenditure (I) and export earnings (X) as money enters the circular flow
thereby stimulating economic activity.
For national income equilibrium, the following condition must hold:
S+T+M=G+I1+X
The level of economic activity depends on the relative size of injections (J)
and withdrawals (W). If W > J then economic activity declines, and vice versa.
Income is the sum of the returns for use of the four factors of production:
return (or income) for land = rent Common mistake
return for labour = wages (and salaries) Students often describe income as
return for capital = interest the earnings that people gain from
return for enterprise = profit work. This is true for people only
able to supply their labour services.
Therefore,
Those with other factors of production
income = rent + wages + interest + profit (capital, land and enterprise) are
able to gain other sources of income
Figure 2.1 shows the following: (interest, rent and profit).
= Ina closed economy with only households and firms, households supply
factors of production (land, labour, capital and enterprise) to firms to
generate output of goods and services.
= In return, firms provide factor incomes to households, i.e. rent, wages,
interest and profit.
m With the income, households spend their money on goods and services
produced by firms, thus creating expenditure revenue for firms.
= Hence, the income flow is numerically the same value as the expenditure
flow and the output flow.
= In an open economy in the circular flow of income model, there is a
government sector, financial markets and foreign trade.
= In the financial sector, savings (S) represent a withdrawal whilst investments
(I) are injections.
= With a government sector, taxes (T) represent a withdrawal, whereas
government spending (G) is an injection.
= In an open economy, there is a foreign sector with international trade. Export
revenue (X) represents an injection to the circular flow, whereas import
expenditure (M) is a leakage.
m The circular flow of income and expenditure will change based on the
relative size of all withdrawals (W =S + T + M) and all injections
J=G+X+1.
Circular flow of income
Leakages Injections
* Taxes * Government spending
® Savings ® Investments
e Imports Hiisalalds ® Exports
ExpendiLume Factors of Goods and Re-nt, wages,

on goods and ; : interest,
: production services
services profit
Figure 2.1 The circular flow of income
Measures of economic activity

(GDP and GNP/GNI)
There are three ways to measure economic activity: the value of national output
(O), national income (Y) and national expenditure (E). Keyword definitions
m The output method of calculating economic activity adds up the final value Gross domestic product (GDP)
of newly produced goods and services during the year. is the value of all final output of
m The expenditure method of calculating economic activity adds up the total goods and services produced by
spending on newly produced goods and services during the year. firms within a country, per year.
m The income method of calculating economic activity adds up the total value Gross national product (GNP)
of all factor incomes earned during the year. is the value of all final output
All three methods give the same numerical result, i.e. O =Y = E, because of goods and services produced
the value of national output equals the value of what is spent on the output by a country’s citizens, both
(national expenditure). This expenditure becomes the (national) income to domestically and abroad.
households and firms that produced the output.
Using the expenditure method of calculating GDP, economists add the totals
of consumption expenditure (C), investment expenditure (I), government
expenditure (G) and export earnings (X) and then deduct the amount spent on
imports (M) by using the formula:
GDP=C+1+G+ (X-M)
Gross national product uses GDP but also accounts for net property income
from abroad, i.e. the difference between what residents earn from overseas
investments minus income earned by foreign residents within the domestic
economy:
GNP = GDP + net property income from abroad
Net property income from abroad refers to the difference in value between
incomes earned and incomes paid abroad.
Nominal GDP is measured using current market prices, i.e. the value of GDP
at the time of measurement. Real GDP takes account of fluctuations in prices
(inflation) over time.
Using real GDP (or real GNP) figures allows better comparisons of economic
activity over time by using constant market prices (the values are adjusted for
inflation over time). For example, if nominal GDP increases by 4% whilst the
general price level rises by 3%, then the average person’s income increases by
only 1% in real terms. (HL only)
GDP per capita means expressing the GDP per head of the population, i.e. it
averages out total GDP per person in the country. It is calculated using the formula:
total GDP
GDP per capita = ———
population size
GNP per capita (or GNI per capita) is calculated in the same way — by Expert tip
dividing the total GNP or GNI by the country’s population size.
The terms gross national product
A price deflator (or GDP deflator) is used to convert GDP at current prices
(GNP) and gross national income
to GDP at constant prices. (HL only)
(GNI) can be used interchangeably
for your IB examinations although in
EXAM PRACTICE (HL ONLY) reality GNP differs slightly from GNI.
The latter method deducts indirect
PAPER 3 business taxes, which differ between
1 Calculate the value of gross domestic product (GDP) and gross national countries, to enable more meaningful
international comparisons of national
product (GNP) from the given information: Consumption = $150bn,
output and econamic activity.
Investment expenditure = $60bn, Government spending = $55bn,
Export earnings = $31bn, Import expenditures = $28bn, Net income
earned abroad = —$8bn. [3]
2 Calculate the real gross domestic product (GDP) in 2013 and in 2014
and explain your results. [4]
h 4T\ NOMINAL GDP ($BEN) | GDP DEFLATOR
2013 260.0 106.7
2014 262.4 108.5
The use of national income statistics

National income statistics give an indication of standards of living in a country,
i.e. a higher real GDP per capita is associated with higher standards of living
for the average person. This is because a person’s standard of living is directly
dependent upon the amount of goods and services that s/he is able to consume.
National income statistics reveal the level of economic activity in the
country, which directly affects the average person’s social and economic
wellbeing. However, there are limitations in using national income statistics to
measure standards of living in a country, including:
m the distribution of income and wealth in the country
m varying rates of direct and indirect taxes between countries — for example
Andorra, Brunei Darussalam, Oman and Qatar have a zero rate of income tax
= differences in the cost of living, for example housing, education, healthcare
and basic amenities
the extent of social welfare benefits varying between countries
exchange rate fluctuations making international comparisons of GDP over
time less meaningful
m the composition of national output, for example North Korea's heavy
expenditure on armaments and weapons compared with the huge spending
on welfare benefits in Australia and the UK
m the extent to which national output generates negative externalities, thereby
limiting the sustainability of economic activity and the quality of life in the
country
m variations in the size of the unofficial economy (for goods and services that
are not officially traded, such as home-grown fruits and vegetables and Keyword definition
bartered services) Green GDP is a measure of GDP
= consideration of alternative measures of GDP to measure of standards of that accounts for environmental
living, for example the Human Development Index (HDI). destruction of economic activity by
Another alternative to measuring nominal (or real) GDP is to use green deducting the environmental costs
GDP. This is calculated using the formula: associated with the output of goods
and services.
green GDP = nominal GDP — environmental production costs
The business cycle
Short-term fluctuations and long-term trends
At the peak of the trade

F:yde., Scannisaclily A recovery in the business cycle occurs when
is at its highest i.eve!. the level of GDP starts to rise, thus recovering
Um.ampioyment is low, from the slump. The levels of consumption,
wh:_Ie ECneier and investment and net exports gradually rise, thus
A business confidence leading to employment opportunities in the long
levels are high. i
& beak Trend

g
2= \ Rescovaty Boom Economic
-
0 activity
5
£ P During a boom (or economic growth|, the level
3 : \ of economic activity rises, caused by any
2 Recession combination of an increase in consumption,
B Slump investment, government spending and net
export eamings. Technically, economic growth
occurs when GDP increases for two consecutive
quarters (& months).
G Time
There is a fall in GDP during an At the bottom of a recession in the trade cycle, a slump (or
economic recession. Technically, a| | trough| is said fo exist. There will be high unemployment
recession occurs when a couniry's | | while consumption, investment and net export eamnings will
GDP falls for two consecutive be low. Many businesses will have collapsed and
quarters. During a recession, there | | consumers have little confidence in the economy. Hence,
is a decline in consumption, government spending may be needed fo help the economy
investment and net exports (due fo | | to recover from the recession.
falling export eamings).
Figure 2.2 The business cycle
The boom is the peak of the business cycle where economic activity is at its
Keyword definition
highest level. Unemployment is low whilst consumer and business confidence
The business cycle describes the
levels are very high.
fluctuations in economic activity
During a recession the level of economic activity declines. Technically, this
in a country over time. These
occurs when GDP falls for two consecutive quarters. Business failure is common
fluctuations create a long-term
and unemployment rises. Recessions create uncertainty for firms and damage
trend of growth in the economy.
consumer confidence levels. The slump (or trough) occurs at the bottom of a
recession. There is mass unemployment as consumption, investment and net Economic growth is the increase in
export earnings remain low. the level of economic activity, i.e.
A recovery occurs when GDP rises after the trough. Consumption, the annual percentage growth in
investment and net exports gradually rise, thus creating employment national output.
opportunities and increasing business confidence.
The potential national output (potential GDP) of an economy is shown by
the long-term trend in the business cycle.
Exogenous shocks that affect the potential growth of an economy include Common mistake
global financial crises, the outbreak of infectious diseases and natural disasters
Students should be aware of the
such as earthquakes, tsunamis and severe flooding.
difference between a fall in GDP and
a fall in GDP growth. A fall in GDP
Expert tip (over two consecutive quarters) causes
Not all components of GDP necessarily fall during a recession — a boost in a recession, whereas a fall in GDP
government spending may be needed to help the economy recover from the growth means that the economy is
recession, such as the fiscal stimulus policies of many countries during the still growing, only at a slower rate
financial crisis of 2008. than before.
Economic growth increases the long-term productive capacity of the Expert tip
economy, illustrated by an outwards shift of the production possibility curve. It
The best-performing students are able
suggests that the economy is more prosperous, so the average person earns more
to show skills of evaluation and critical
income (see Figure 2.3).
thinking. Not all businesses suffer
during a recession. Counter-cyclical
businesses are those that do well and
survive during an economic downturn,
Economic growth can be shown for example suppliers of inferior goods
diagrammatically by an outwards
(such as fast food restaurants and
shift of the production possibility
Producer goods
/ curve for an economy. In this case, discount stores) and pawnbrokers.

a combination of an increase in the
quantity and quality of factors of
production shifts the PPC outwards
PPC2 fom PPCy to PPCy, creating more Expert tip
PPC, producer and consumer goods.
Make sure you know the difference
between current and constant prices.
O National income statistics reported
Y
Consumer goods
in current prices add the impact of
Figure 2.3 Economic growth inflation whilst those expressed as
constant prices have the effects of
inflation removed (allowing for better
comparisons of GDP over time).
2.2 Aggregate demand and V| ]

aggregate supply
Aggregate demand (AD)
The AD curve
ATV TTNe =]
In microeconomics, demand refers to the willingness and ability of consumers
to pay for a particular product at each price level. In macroeconomics, aggregate Keyword definition
demand (AD) refers to the value of total demand for all goods and services in Aggregate demand is the total
the economy, per time period. value of all goods and services
The AD curve shows the real national output that is purchased at each price demanded in the economy, per
level, per time period. It has a negative slope (i.e. it is downwards sloping) time period.
because when the general level of prices is high, the level of aggregate demand
tends to be low (see Figure 2.4).
A
&
T% e The higher the price level, the lower the level of
& aggregate demand fends to be, ceferis paribus.
%_ e Since AD has an inverse relationship with the
@ general [average) price level, the AD curve is
5 downwards sloping.
2
< AD
5 >
Real national ocutput (GDP)
Figure 2.4 The aggregate demand curve

There are three reasons for the downwards-sloping AD curve: 3 e lali]e]

= The Pigou wealth effect — English economist Arthur Pigou said that for
any given nominal value of income, a lower price level allows households, Pigou and Mundell-Fleming are
firms and the government greater purchasing power, resulting in greater not explicitly mentioned in the IB
Economics Guide, so students may
consumption, investment and government spending.
prefer to refer to the three key reasons
= Keynes’s interest-rate effect — A fall in the general price level causes interest for the downwards sloping AD curve
rates to drop, thus boosting the demand for money, ceteris paribus. This results as: the wealth effect, the interest rate
in greater consumption, investment expenditure and government spending, effect and the exchange rate effect.
i.e. higher aggregate demand.
= Mundell-Fleming’s exchange rate effect — As the general price level falls,
the interest rate also tends to fall, resulting in a depreciation of the exchange
rate. This will tend to increase the demand for net exports because domestic
products are cheaper, thus boosting AD.
The components of AD
The components of aggregate demand are consumption expenditure (C),
investment expenditure (I), government spending (G), exports earnings (X)
and import expenditure (M). Therefore:
AD=C+I1+G+(X-M)
Consumption is the total spending on goods and services by households in
the domestic economy, per time period. It is the largest component of aggregate
demand.
Investment is the capital expenditure of firms in the economy, for example
the purchase of fixed assets such as machinery, commercial vehicles and
buildings. This results in a larger productive capacity in the long run.
Government spending is the total expenditure on goods and services by Common mistake
the government, including education, healthcare, national security and social
Gross domestic product (GDP) is often
welfare schemes.
confused with aggregate demand
Net exports, given by the formula X — M, measures the difference between (AD). Whilst they are similar concepts,
the value of export earnings and import expenditure. GDP refers to the value of actual
expenditure in the economy over
the year, whereas AD refers to the
planned (or the expected) expenditure
in a given time period.
The determinants of AD or causes of shifts

in the AD curve
The determinants of aggregate demand refer to the factors that cause shifts in
the AD curve — for example, lower household and business indebtedness due Keyword definition
to reduced interest rates will shift the AD curve to the right, ceteris paribus (see Disposable income is earnings after
Figure 2.5). taxes have been accounted for, i.e.
Factors that cause a change in any component of aggregate demand the actual take-home income that
(AD=C +1+ G+ (X —M)) will cause a shift in the AD curve, ceteris paribus. workers are able to spend.
A
&
2@ : ;
An increase in aggregate demand
8 [rightwards shift of the AD curve) will
a raise national output at all price levels,
%’) ceferis paribus.
Zo
AD, Ay
- >
Real national output (GDP)
Figure 2.5 Shifts in the aggregate demand curve
Table 2.1 Factors that affect the level of consumption
Consumer confidence The more confident consumers are about the economy, the greater the level of consumption
will be. Consumer confidence is low during a recession and higher during a boom.
Interest rates Higher interest rates tend to reduce consumption as households with loans and mortgages
have lower income to use at their discretion.
Wealth Changes in household wealth have a positive impact on the level of consumption, i.e. the
wealthier households are, the more they tend to consume.
Personal income tax If the level of disposable income falls due to higher income tax, consumption will also fall,
ceteris paribus.
Household indebtedness The more debts that households have (perhaps due to credit card and mortgage debts) the
less income they have for consumption. Following the global financial crisis, US household
debt reached $14 trillion in 2009 — the same value as its GDP!
Table 2.2 Factors that affect the level of investment
Interest rates Higher interest rates tend to reduce investment because the cost of borrowing funds to invest
will increase.
Business confidence The greater the level of business confidence in the economy, the higher the level of investment
will be. Business confidence is high when the economy is in a boom.
Technology Technological progress and the associated productivity gains will tend to boost the level of
investment expenditure.
Business taxes The lower the rate of taxes in the economy, the more attractive investment becomes as firms
are more able to make a return on their investment. Some countries such as the Bahamas and
Estonia have a zero rate of corporation tax to attract foreign direct investment.
The level of corporate Like households, the more debts businesses have the less money they have available for
indebtedness investment expenditure. Indebtedness tends to increase during periods of rising interest rates
or during an economic downturn when firms struggle to survive.
Factors that affect the level of government spending include the following:
= DPolirtical priorities — government spending will vary depending on the
political priorities, for example increased national defence expenditure
during a war, or more spending on education and healthcare prior to a
general election (in order to win political votes).
= Economic priorities — the austerity measures following the global financial
crisis of 2008 have meant that governments across Europe and many other
parts of the world need to cut their spending in order to reduce their budget
deficits.
Factors that affect the level of net exports include the following:
m The income of trading partners — due to globalisation and interdependence,
when a country suffers from an economic downturn, there are negative
impacts on its trading partners.
m Exchange rates — a higher exchange rate tends to reduce the demand for
exports (as they become more expensive for foreign buyers), and vice versa.
m Changes in the level of protectionism — trade barriers such as tariffs and
quotas raise the price of imports, thus tending to reduce the demand for
foreign goods and services.
Aggregate supply (AS)
The meaning of aggregate supply

The short-run aggregate supply (SRAS) curve shows the total planned national
output at different price levels, ceteris paribus. Keyword definition
The SRAS curve is upwards sloping as higher prices attract more firms to raise Aggregate supply (AS) refers to
their output level (recall from microeconomics that the supply curve for a single the amount of real national output
firm is upwards sloping for the same reason). that firms are willing and able to
In the short run, a change in non-price factors that affect AS will shift the produce at each price level. It is a
SRAS curve (see Figure 2.6). These factors, which affect the cost of production, measure of an economy’s potential
include: output.
m changes in resource prices — for example, the price of oil or other raw
materials changes drastically
m changes in business taxes — for example, higher corporation taxes shift the
SRAS curve to the left
= changes in subsidies — for example, an increase in subsidies in numerous
industries will shift the SRAS curve to the right
= supply shocks — for example, a war, financial crisis, natural disasters, oil
shortages or an outbreak of an epidemic (such as swine flu, malaria or dengue
fever) will shift the SRAS curve to the left.
A
D {elladd]e]
SRAS, SRAS, SRAS,
The slope of the SRAS curve depends
/ H e Adverse changes in non-price on the extent to which there is spare
factors that affect AS will shift
capacity in the economy. The flatter
Price level ($)
/ the SRAS curve to the left, from

SRAS) to SRAS;. the SRAS curve, the greater that
\
/ —f—— e Favourable changes in non-price degree of spare capacity (underutilised

factors that affect AS will shift resources). This means that the SRAS
f the SRAS curve fo the right, from curve is relatively price elastic, and
//’ SRAS; to SRAS;. vice versa.
© Real national output (GDP)

Figure 2.6 Shifts in the SRAS curve
Alternative views of aggregate supply

Monetarists (or new classical economists) differ in their view of the long-run
aggregate supply (LRAS) curve from that of Keynesian economists. Monetarists
believe that the LRAS curve is vertical at the full employment level of output
(see Figure 2.7). Hence, LRAS is independent of the price level, as this
represents the maximum (potential) level of national output of the economy,
per time period.
The quantity and quality of factors of production affect the LRAS, i.e. the
quantity and quality of natural resources (land), labour, capital stock (e.g.
buildings and infrastructure) and entrepreneurship.
[RAS; IRAS, e According to the new classical model of [RAS,

aggregate supply is independent of the price
level in the long run, i.e, it is perfecily price
Price level ($)
inelastic at the full employment level of output | Yj).

e A rightwards shift of the [RAS curve results from
_ s an increase in the productive capacity of the
economy, e.g. an increase in the quantity and
quality of factors of production, including
technological progress.
O h Yo
Figure 2.7 The monetarist LRAS curve
By contrast, Keynesians believe that the AS curve has three sections (see
Figure 2.8), mainly due to the varying degrees of spare capacity in the economy.
Keynesians argue that wages are ‘sticky downwards’ (labour market inflexibility)
for the following reasons:
= Firms may prefer to cut employment rather than wages because pay cuts can
reduce worker morale and productivity.
= Existing employment contracts can also prevent wages from falling below the
agreed level.
m Workers get used to a certain wage rate and are inflexible, through trade
union action, in accepting pay cuts.
= [t is not legally possible to cut wages below the national minimum wage, even
during a major economic downturn.
A
Price level ($)
© Y %
Figure 2.8 The Keynesian AS curve
There is spare capacity in the economy up to the Y; level of national output,

perhaps due to a recession, high unemployment and ‘sticky’ wages. Hence, the
price level is stable even if national output changes.
The upwards-sloping section of the Keynesian AS curve shows increasing
demand for resources and labour shortages, thereby causing the price level to
rise as national output increases.
At the full employment level of national output (Yy), firms compete for limited
resources as the economy is at full capacity, thereby forcing up the general price
level even though the economy cannot produce beyond its productive capacity.
Shifts in the aggregate supply curve

Changes in the quantity and/or quality of factors of production result in
permanent shifts to the LRAS curve. Examples of such changes that shift the
AS curve include:
= improvements in efficiency — higher productivity of resources will shift the
AS curve to the right (see Figure 2.7)
= new technology — technological progress and innovations shift the LRAS
curve rightwards
m reduction in unemployment — a fall in the number of unemployed people

means that the productive capacity of the economy can increase, thus
shifting the AS curve to the right
= institutional changes — better infrastructure, such as improved road, rail and
air networks, enhance the economy's productive capacity, thus shifting the
AS curve outwards.
The quantity of factors of production can also be increased by discovering
new supplies (such as oil or other natural resources) or by a larger workforce
(perhaps due to migration of workers).
The quality of labour resources can be increased by improved education,
training and work practices.
Keynesians and monetarists differ in their view about the shape of the
LRAS curve. Figure 2.7 shows a shift of the LRAS curve from the monetarist
perspective, whilst Figure 2.9 shows the Keynesian view.
A
AS, AS,
Price level ($)
O
Real national ocutput (GDP)
Figure 2.9 Shifts in the Keynesian AS curve
Equilibrium
Short-run equilibrium
Short-run macroeconomic equilibrium occurs when aggregate demand and
aggregate supply intersect, thus determining the actual level of real national Keyword definition
output and the average price level. Changes in any factor that affect AD or AS Equilibrium in the economy exists
will change the equilibrium. For example, an increase in net exports or lower when aggregate demand is equal to
income tax will shift the AD curve rightwards, ceteris paribus (see Figure 2.10). aggregate supply, i.e. AD = AS.
A
SRAS e Short-run equilibrium is initially at

Average price level [$)
point A, where AD; = SRAS.

e lower inferest rates will tend fo shift
AD rightwards from ADy to AD,.
e This results in more national output
from Y7 to Y5) but an increase in
»
the general price level (from Py to Py).

¢ The new equilibrium is therefore at
point B, where AD; = SRAS.
Apy
Y
© y ¥
Figure 2.10 Short-run equilibrium

Similarly, an outward shift of the SRAS curve will tend to increase real ek
national output and reduce the general price level. This might be caused
When analysing changes in aggregate
by factors such as improved training opportunities for employees or reduced
demand and aggregate supply,
IRUETESE TaECs, consider the concept of price elasticity
of demand (PED) and price elasticity of
in AD will have a far greater impact

PAPER 3 on the general price level if AS is price
3 Using an appropriate diagram, explain how a recession impacts on the short- inelastic.
run equilibrium position of an economy. [4]
4 With the aid of an aggregate demand and aggregate supply diagram, explain
what is likely to happen following a temporary reduction in both income tax
and corporation tax. [4]
Equilibrium in the monetarist/new

classical model
Full employment exists when the economy is operating at full capacity, i.e. it
is not possible to increase real national output as all resources are fully utilised. Kivivord defialtisn
This can be shown as a point on a production possibility frontier (PPF) or on an The full employment level of
AD-AS diagram (see Figure 2.11). output occurs when everyone who
Long-run equilibrium, according to monetarists, occurs at the potential or is willing and able to work is able
full employment level of real national output. In Figure 2.11, this is shown by to find employment. It exists ar the
the intersection of AD; and the LRAS, where Y;represents the full employment point where unemployment is at its
level of output. natural rate that can be maintained
In reality, it is rather difficult to know precisely the full employment level with price stability (zero rate of
of output. It can be impractical for every firm in the economy to operate at wiflation);
100% capacity and it is not easy to determine the number of people who are
voluntarily unemployed.
Common mistake
2 o v gl ekl f DS e Desite th tarminly i

LRAS & i : z o
3 ainployineit level oF GORDE (¥, incorrect to assume that full _

3 ® Any affempt fo increase aggregate demand, emplc:-yment ocr_:urs when there is zero
a such as from AD; to AD;, beyond the full unemployment in the economy. There
& employment level of national cutput () will will always be some degree of natural
S only be inflationary, causing the average price unemployment in the economy
< level fo increase from Py to Pp. due to frictional unemployment
AD; AD; (those between jobs) and structural
o v > unemployment (caused by skills
o mismatch). Instead, full employment
Feslnptiondleuipil (CLF) occurs at the natural rate of
Figure 2.11 Long-run equilibrium — Monetarist model unemployment.
In the new classical model, any short term fluctuations in national output
will only be temporary as market forces will restore equilibrium to the full
employment level of output in the long run. With reference to Figure 2.12:
= Long-run equilibrium is at the full employment level of national output (Y%)
with the average price level at P;.
= An increase in aggregate demand from AD; to AD, increases the average
price level from P; to P,, causing AS to expand along the SRAS; curve.
m This temporarily increases national output beyond its capacity, and so raises
production costs.
Hence, aggregate supply shifts from SRAS; to SRAS;, causing the average
price level to rise from P; to P3 and the economy operating back at Y.
[RAS SRAS,
Average price level ($)
L
R
=
O
Figure 2.12 Fluctuations in short-run equilibrium (1)
IRAS SRAS, e long run equilibrium is at Y}, with the general

price level initially at Py.
-~
® An increase in production costs causes a shift
SRAS; in aggregate supply from SRAS; to SRAS,, thus
raising the average price level to P, and
resulting in a fall in GDP from Y to Y.
e Government intervention fo raise aggregate
demand frem AD; to ADy simply increases the
average price level from P; fo Py, with the
economy operating back at Y.
AD) AD,
O oY
Y
Real national cutput (GDP)

Figure 2.13 Fluctuations in short-run equilibrium (2)
Therefore, monetarists (new classical economists) argue that demand-side

policies are ineffective in the long run. They prefer the use of supply-side
policies to shift the LRAS outwards to achieve economic growth.
Changes in long-run equilibrium are caused by factors that shift the LRAS
curve rightwards, i.e. supply-side policies. These include: improved productivity
of factors of production, technological progress and incentives to stimulate
inventions and innovations.
Equilibrium in the Keynesian model

Keynesians believe that wages are ‘sticky’ downwards, even during a recession,
so market forces struggle to restore equilibrium at the full employment level
of national output without the need for government intervention (using
expansionary fiscal policy and monetary policy).
The Keynesian model of macroeconomic equilibrium suggests that the
economy can be in equilibrium at any level of real national output where AD
intersects with AS (see Figure 2.14).
A
AS
Price level [$)
O
Y
Figure 2.14 Keynesian equilibrium
According to Keynesian economists, an increase in aggregate demand (from

AD; to AD,) will not cause inflationary pressures if there is spare capacity in
the economy. On the upwards sloping section of the AS curve, any increase
in aggregate demand (from AD, to AD; or from AD; to ADy) puts pressure on
resources (such as labour shortages) thus pushing up the average price level.
If aggregate supply is perfectly price inelastic (in the long run), any increase
in aggregate demand (beyond ADj) simply increases the average price level
as the economy cannot increase national output beyond the full employment
level (Yy).
Contrary to the new classical model, the Keynesian model shows that
increases in AD need not necessarily cause inflation in the economy, unless it is
operating at or near its full employment level of output.
A deflationary gap (also known as a recessionary gap) exists when the
real national output equilibrium (P, and Y, in Figure 2.15) is below the full
employment level of output (Yg). Without government intervention, the
economy can remain stuck in a deflationary gap.
[RAS ® The deflationary gap is shown by

2 spAS the shortfall of actual output (V)
g 5 from potential output (Yi.
TB / ® The govemnment can close this
= recessionary gap by using
G Pl 8 expansionary fiscal and/or
g ° : monetary policies to boost
0 | aggregate demand from AD,
= | to AD,.
e N AD
deflationary gap ) 5 _
o v ”
Figure 2.15 Keynesian model deflationary gap
By contrast, an inflationary gap exists if actual national output exceeds the

full employment level of output, i.e. AD increases along the vertical section
of the LRAS curve (see Figure 2.16), causing an increase in the average price
level.
An inflationary gap will occur if the government chooses to maintain full

employment, despite rising levels of aggregate demand putting pressure on the
ability of the economy to supply goods and services. This will lead to demand-
pull inflation, ceteris paribus.
[RAS
EE_- e The inflationary gap is shown by
o actual output (Y,) exceeding full
= employment output (Y.
8 e The government can reduce this
= inflationary gap by using tight
> fiscal and /or monetary policies to
o reduce aggregate demand from
5 ADy to AD5.
inflation N
O Y, Y. -
Figure 2.16 Keynesian model inflationary gap
The Keynesian multiplier (HL only)
The nature of the Keynesian multiplier (HL only)

Injections to the circular flow (export earnings, government spending and
investment) increase the value of the Keynesian multiplier. By contrast,
leakages (taxes, import expenditure and savings) cause negative multiplier Keyword definition
effects. The larger the value of withdrawals, the lower the value of the The Keynesian multiplier shows
multiplier, and vice versa. that any increase in the value of
The Keynesian multiplier shows the extent to which each additional dollar injections results in an even greater
injected into (or withdrawn from) the economy will increase (or reduce) the increase in the value of national
value of aggregate demand. It can therefore aid government decisions about income. It also shows that any
macroeconomic policies. increase in the value of withdrawals
The Keynesian multiplier is calculated using either of the formulae below: leads to a greater fall in the value of
national output.
1 1
1-MPC MPS+ MPT + MPM
i . i 1
Note that N is equivalent to ———— because the sum of
MPS + MPT + MPM
MPC, MPS, MPT and MPM always equals 1.
The scale of the multiplier depends on the shape of the Keynesian AS curve
(see Figure 2.8). If the economy is on the horizontal section of the AS curve,
the multiplier would increase real national output without any pressure on
the average price level due to mass unemployment. If the economy is on the
upwards-sloping section of the AS curve, the multiplier will have an impact on
both national output and the average price level.
However, if the economy is on the vertical section of the AS curve, the
multiplier has no impact on national output, but the associated increase in AD
simply leads to an increase in the average price level as the economy is already
operating at full employment.
The effectiveness of the multiplier is also subject to time lags, i.e. there is
a delay between changes in injections and leakages and any corresponding
changes in national output.
Keyword definitions
The marginal propensity to consume (MPC) measures the proportion of
each extra dollar of household income that is spent by consumers, i.e.
MPC = % An increase in the MPC will tend to increase the value of the
multiplier.
The marginal propensity to save (MPS) measures the proportion
AS
of each extra dollar of income that is saved by households, i.e. -
The marginal propensity to tax (MPT) measures the proportion of each

extra dollar of household income that is levied by the government, i.e. AT
AY
The marginal propensity to import (MPM) measures the proportion of each
extra dollar of household income that is spent on imports, i.e. MPM = —.
AY

PAPER 3
5 If an economy’s marginal propensity to consume is known to be 0.85,
calculate the size of the Keynesian multiplier. [2]
6 If export earnings increase by $200 million and the multiplier is 2.2,
calculate the change in real national income. [2]
7 If government spending increases by $85 million and the marginal
propensity to consume is known to be 0.75, calculate the amount by
which the aggregate demand curve will shift. [2]
8 Suppose a country in recession has a deflationary gap of $92 billion
and its marginal propensity to consume is 0.76. Calculate the amount of
government expenditure needed to close the recessionary gap in order to
restore equilibrium. [2]
It might be more natural to think about the multiplier leading to positive

impacts on the level of national output. However, the Keynesian multiplier also
refers to negative multiplier effects caused by a fall in injections or an increase
in withdrawals. For example, a rise in marginal rates of income tax will cause
negative multiplier effects.
Common mistake
Students should take care when using abbreviations in the exam as understanding
is often not shown. For example, ‘MPC’ can stand for a number of things:
monetary policy committee, marginal private costs or the marginal propensity to
consume. Be sure to explain any abbreviations that you use in the examinations.
2.3 Macroeconomic objectives

Low unemployment
The meaning of unemployment

Low unemployment is a key macroeconomic objective because it:
= complements economic growth (another macroeconomic objective) — higher Keyword definition
employment tends to lead to greater national expenditure. Hence, low Unemployment occurs when
unemployment tends to increase the standards of living in an economy. people are willing and able to work
® increases tax revenues from a range of sources such as income tax (from and actively seeking employment
employment), sales taxes (from increased expenditure) and stamp duty (from
but are unable to find work.
the sale and purchase of property)
m reduces the tax burden on the government because there is less of a need for
taxpayers to fund welfare benefits as more people are working
= prevents a ‘brain drain’ from the economy, whereby skilled workers pursue
better employment opportunities in other countries.
The unemployment rate calculates the percentage of the labour force that is
unemployed. It is calculated using the formula:
number of unemployed people % 100
labour force
The labour force consists of the employed, the self-employed and the
unemployed, i.e. all those in work and all those actively seeking employment.
For example, the unemployment rate in a country with a workforce of 50
million of which 5 million people are actively seeking employment but unable
to find employment is:
I
50m
0%
The United Nation’s International Labour Organization (ILO) states 15 as
the minimum age to enter the labour force. There is no official upper limit,
but many countries use a range between 65 and 70 — for example, the official
retirement age for women is 67 years in Norway, Poland and the USA.
The ILO measures a country’s unemployment based on the number of people
who are:
= willing to work, but unable to find it
= actively looking for work, i.e. they have looked for a job in the last 4 weeks,
and able to start work within the next 2 weeks, or
m waiting to start a new job within in the next 2 weeks.
Irrespective of the measure or definition of unemployment, it represents an
inefficient use of any economy’s scarce resources, thereby hindering its potential
national output.

PAPER 3
9 Use the data below for Country X to calculate the total number of people
unemployed. [2]
LABOUR FORCE 30 million
POPULATION OF WORKING AGE 35 million
UNEMPLOYMENT RATE 7.9%
10 Use the data below to calculate the unemployment rate. [3]

100 million
74.8%
15 million
20%
Difficulties in measuring unemployment

Hidden unemployment — Some people escape the official measure
of unemployment, resulting in an underestimation of the true rate of
unemployment. For example:
= discouraged workers are not willing to work, so are excluded from the
calculation of unemployment. The ILO measure of unemployment only
considers those who have looked for a job in the past 4 weeks.
m overstaffing occurs in firms that employ workers who are not fully utilised,
perhaps due to seasonal fluctuations in demand or due to legal constraints
such as employment contracts.
Underemployment — This exists when people are inadequately employed,
reflecting the underutilisation of the employed population, i.e. they are
technically employed but in jobs that do not fully use their skills or abilities,
such as:
m involuntary part-time workers who cannot find full-time employment
m overqualified workers, who have education, experience, skills and
qualifications beyond the requirements of their jobs.
Regional disparities — The measurement of unemployment is an average
measure, so therefore ignores disparities in regional rates of unemployment.
For example, unemployment in 2013 for the USA averaged 7.5%, but Nevada
recorded 9.6% unemployment, whilst North Dakota saw only 3.1%.
Ethnic disparities — Ethnic minority groups tend to suffer from higher-
than-average rates of unemployment, and for longer periods. For example, the
unemployment rate for African- Americans in New York is three times higher Expert tip
than the average official unemployment rate. Remember that not all people of
Age disparities — Unemployment rates among the young and older people working age are willing or able to
are higher than those officially reported for the nation. For example, Greece participate in employment. This will
partly depend on the country's welfare
and Spain experienced unemployment of around 28% in 2013, although youth
benefits scheme and social attitudes
unemployment reached 58.7% and 56.1% respectively.
towards women in the workforce. For
Gender disparities — Females tend to experience higher average rates of example, women in Saudi Arabia face
unemployment than men. On average, men also re-enter the labour market huge barriers to entering the labour
quicker. According to the ILO, gender inequalities in unemployment rates are force.
exceptionally high in the Middle East and North Africa.
EXAM PRACTICE
PAPER 2
11 According to the International Monetary Fund (IMF), Pakistan's annual
unemployment rate between 2007 and 2013 was kept steady at 5-6%. This,
according to the Central Intelligence Agency (CIA), meant that Pakistan's
gross domestic product grew by 3.7% in 2012 and another 5% in 2013. These
changes have helped to reduce some of the poverty in the country.
a Explain two reasons why it might be difficult at times to know the
exact rate of unemployment in a country. [4]
b Evaluate the possible consequences of low unemployment for the
Pakistani economy. [8]
Consequences of unemployment
The economic consequences of unemployment include the following:
m A loss of GDP — Lower gross domestic product (negative economic
growth) has detrimental consequences on the economy, including a
fall in its international competitiveness (ability to compete in overseas
markets).
m Loss of tax revenues — Unemployment results in lower income and
expenditure, thus resulting in lower tax revenues for the government.
= Increased cost of unemployment benefits — Unemployment creates an
increased opportunity cost of government expenditure on unemployment
benefits. Prolonged periods of high unemployment can therefore lead to
increased government debts.
= Loss of income for individuals — Unemployment results in lower household
income, with negative consequences for individuals and their families. If
prolonged, unemployment can cause (or increase) poverty in the economy.
s Greater disparities in the distribution of income — As women, the
young, ethnic minority groups and those living in rural areas tend to suffer
more from prolonged periods of unemployment, the result will be greater
discrepancies in the distribution of income and wealth.
The social consequences of unemployment include the following:
m Stress — The unemployed suffer from stress, depression, health problems
and low self-esteem. Prolonged periods of unemployment can lead to
homelessness and family breakdowns, such as arguments, separation and
divorce. In extreme cases, unemployment has led to suicides.
m Crime — The impact of unemployment in individuals can cause deprivation
and desperation, thus leading to increased crime, such as theft and vandalism.
= Indebtedness — Lower income, caused by unemployment, leads to increased
indebtedness for individuals, firms and the government. Indebtedness can
cause bankruptcy, leading to absolute poverty, hunger, disease, homelessness
and even suicides.
s Social deprivation — The local community can suffer if there is mass
unemployment, for example poverty, falling house prices (and hence asset
values) and increased crime rates.
Types and causes unemployment

Frictional unemployment occurs when people are in transition between jobs
due to the time delay between leaving a job and finding or starting a new one. It
is always present because it takes time for the labour market to match available
jobs with suitable candidates.
Structural unemployment (see Figure 2.17) occurs when the demand for
products in a particular industry continually falls, thus reducing the demand
for particular labour skills. It can also be caused by changes in geographical
locations of industries (for cost advantages) and labour market rigidities (such as
the unwillingness of workers to accept lower wage rates).
A
® The decline in the derived demand for labour
in an industry from Dj; to Dj5 causes the
S employment level to fall from Ny fo Noy.
e The industry suffers from structural and long-
term changes in demand, with wage rates
Wage rate ($)
falling from W, to W,
3
e |t is usually difficult for those in structural

unemployment to find a new job without
retraining.
D e The UK, for example, has experienced
structural unemployment in shipping, textiles,
.-
steel production, coal mining and car making.
O Y ¥
Employment level
Figure 2.17 Structural unemployment

Seasonal unemployment is caused by regular and periodical changes in S {ellal o]
demand for certain products. For example, fruit pickers are in high demand
The concept of hidden
during the summer months whilst retailers in many parts of the world hire more
unemployment is important to
temporary workers during the Christmas holiday season.
economists. There are plenty of
Cyclical unemployment (or demand-deficient unemployment) is the most
people who are not included in the
severe type of unemployment as it can affect every industry in the economy. It official calculation of unemployment
is caused by a lack of aggregate demand, which causes a fall in national income statistics (due to the choice of
(see Figure 2.18). measurement rather the core meaning
of unemployment - the non-use of
A
factors of production). It includes, for
e The decline in aggregate demand from example, discouraged workers who
Average price level (3]
AD; to AD, causes national output to have stopped actively searching for
fall from Y7 to Yo. employment.
® This creates widespread unemployment
.‘_
in the economy.
® Demand-deficient unemployment is
F
associated with a decline in the business

cycle [during recessions and slumps).
Y
MNational cufput
Figure 2.18 Demand deficient unemployment
Government policies to deal with unemployment

Governments can deal with the problems of unemployment in various ways,
depending on the types and causes of unemployment in the economy:
Frictional unemployment — This type of unemployment can be reduced
by improving information services to aid job seekers. However, imperfect
information in the labour market can worsen frictional unemployment as
people are unaware of available jobs.
Seasonal unemployment — Improving the skills of seasonally unemployed
workers helps to reduce occupational immobility. Policies to improve
education and training will give these people a better chance of re-
employment and the incentive to find work.
Structural unemployment — Governments can introduce a broader range of
vocational training programmes, greater access to university courses (to allow
people to retrain) and offer more job training opportunities. However, this
comes at an opportunity cost to taxpayers.
Cyclical unemployment — To combat this demand-deficient unemployment,
the government might choose to use expansionary fiscal policy and/or
expansionary monetary policy to stimulate economic activity and hence to
reduce the level of unemployment.
There are four generic policies for reducing unemployment as a whole: fiscal
policy, monetary policy, supply-side policy and protectionist policies:
= Expansionary fiscal policy — A reduction in taxes and/or increased
government expenditure should, all other things being equal, boost aggregate
demand and hence the derived demand for labour (see Figure 2.19).
A ® Fiscal policy [the use of taxation and
AS government spending policies fo influence
the level of economic activity) can be used
Average price level {$)
to tackle unemployment caused by

demand-side issues, such as cyclical and
structural unemployment.
;WP
Tax cuts and increased government

spending boost aggregate demand from
R
ADy to AD,, thus boosting real national

income from Y] fo Y. In turn, this will lead
AD] to more employment opportunities.
Y
MNational income
Figure 2.19 Expansionary fiscal policy to combat unemployment
= Expansionary monetary policy — A cut in interest rates and/or a devaluation

of the currency should stimulate consumer and business confidence levels, m
alongside increased consumption and net exports. In time, this will boost the
derived demand for labour in the economy (see Figure 2.20). When evaluating the effectiveness
of demand-side policies in reducing
A unemployment, note that fiscal and
§ e By lowering inferest rates, the cost of rmonetary policies might not deal with
borrowing falls, thus encouraging
households and firms to spend and the root cause(s) of unemployment,
Real wage rate ($)
invest, i.e. AD increases. such as incentives to work and a

® The higher AD boosts the derived reluctance to accept paid work at
demand for labour curve from D), to prevailing wage rates.
Do, thus reducing unemployment.
e The resulting rise in real wages from
Do W, to W attracts more labour, i.e.
: there is an expansion along the
| LDy " 5 curve.
© N Np
Employment of labour ()
Figure 2.20 Expansionary monetary policy and the labour market
m Supply-side policies — These are government policies used to deal with

imperfections in the labour market and to reduce unemployment caused by
supply-side factors. Examples include the following:
0 Investment in education and training helps unemployed people to gain
new skills so they can find employment — for example, retraining people
structurally unemployed in the manufacturing sector so they can find
employment in the tertiary sector.
0 Reduction in trade union powers will mean that labour unions are not in
such a strong bargaining position for higher wages in excess of inflation.
Government intervention to reduce the influence and power of trade
unions can help to reduce unemployment.
0 Employment incentives can be offered to firms for training and hiring the
long-term unemployed — for example, the government can offer these firms tax
allowances and/or subsidies to reduce their costs of training and hiring workers.
0 Reviewing of unemployment benefits can ensure that there are incentives
to seek employment rather than to rely on state welfare benefits. By Sl o]
making it more difficult for people to claim unemployment benetfits, people Whilst supply-side policies tend to
become more proactive in searching for jobs. have more permanent impacts on
m Protectionist policies — Trade barriers, such as tariffs and quotas, can be used employment, they take longer to
to safeguard domestic jobs from the threat of international competition. For accomplish compared with demand-
example, Japan imposes up to 778% import taxes on rice — the highest rate in side policies aimed at reducing
the world — to protect agricultural jobs in its country. unemployment in the economy.
EXAM PRACTICE
PAPER 2
12 In June 2010, Tesco opened Britain's first supermarket without any checkout
workers. Instead, one person is hired to supervise the five checkouts, mainly to
assist customers who have not used a self-service checkout before. The UK's
largest retailer employs around 221,000 workers in the UK but critics argue
that such technological advancement would cause mass job losses.
a Define the term unemployment. [2]
b Explain how the UK government could deal with the ‘mass job
losses’. [4]
Low and stable rate of inflation
The meaning of inflation, disinflation

and deflation
Keyword definitions
Inflation is the sustained rise in the average price level in an economy over Expert tip
time. This does not mean that the price of every good and service increases, Make sure you can distinguish
but on average the prices are rising. Governments set a target inflation rate between disinflation and deflation. A
as a key macroeconomic objective. fall in the rate of inflation (disinflation)
Deflation refers to the persistent fall in the average price level in an means that prices are still rising on
economy over time, i.e. the inflation rate is negative. It is caused by a average, only at a slower rate. Be clear
continual decline in aggregate demand and/or an increase in aggregate supply about the meaning of deflation — an
caused by technological progress. actual fall in the general price level.
Disinflation occurs when there is a fall in the rate of inflation (i.e. prices
are still rising, but at a slower pace) rather than an actual fall in the general
price level. Disinflation can lead to deflation if not controlled, with negative
consequences for the economy and standards of living in the country.
Diagrammatically, deflation results in lower average prices (see Figure 2.21)

whereas disinflation is shown by a smaller proportional increase in average
prices (see Figure 2.22).
A
&
T% The fall in aggregate demand
o = from AD) to AD; causes national
= l output to drop from Yy fo Yo with
0 Vi ss . the general price level falling from
g : P, to Py.
| AD;
o Y, ¥ T
e
National output
Figure 2.21 Deflation

SRAS e An increase in aggregate demand

from ADy to ADg causes national

output to rise from Y; to Yo but with
prices rising from Py to Ps.
e Disinflation occurs when the rate of
increase in AD slows down (from
AD; to AD;), reducing the rate of
increase in the general price level
ADq from Py to Ps.
National output
Figure 2.22 Disinflation
Inflation and deflation are typically measured by using a consumer
price index (CPI). This weighted index measures the change in prices of a
representative basket of goods and services consumed by the average household
in the economy. The prices of items such as staple food products, clothing,
petrol and transportation are likely to be included in the CPI. In the UK in
2013, ebooks and blueberries were among the goods in the CPI basket.
Different statistical weights are applied to reflect the relative importance of
the average household’s expenditure. For example, a 10% increase in the price
of petrol will affect people far more than a 50% increase in the price of light Common mistake
bulbs, batteries or tomatoes. Some students tend to think that
inflation is bad for the economy. This
is not likely to be true. Low rates of
inflation, of 1-2%, are not usually
harmful to the economy because
higher prices can encourage firms
to supply more output. It is when
inflation rises too quickly that it
can disrupt decision making for
households, firms and governments.
In fact, deflation is far more of an
economic problem than inflation
tends to be.
Measuring inflation and deflation

The statistical weighting in the CPI is based on the proportion of the average
household’s income spent on the items in the representative basket. For example,
if the typical household spends 15% of its income on food, then 15% of the
weighting in the CPI is assigned to food prices. Therefore, items of expenditure
that take a greater proportion of income are assigned a larger weighting. Changing
fashions and trends, such as greater household expenditure on smartphones and
tablet computers, require a review or update of the weighting in the CPI.
However, it must be noted that the CPI does not necessarily measure changes
in average price levels (and hence the cost of living) for all stakeholders in the
economy:
m The CPI only considers the expenditure of the ‘average’ household; whatever
this might actually mean in a multicultural society in the real world.
m Different income earners can experience a different rate of inflation because
their pattern of expenditure is not necessarily or accurately reflected by the
CPI. For example, the average pensioner or university student will have
different spending habits from a ‘typical’ family household.
= Inflation figures and calculations may not accurately reflect changes in
consumption patterns due to time lags in collecting data to compile the CPL.
Economists calculate an underlying rate of inflation (or core rate of
inflation), which is an adjusted measure of inflation that eliminates the sudden
or volatile fluctuations in prices of essential items of expenditure such as oil,
food and energy.
Economists also find the calculation of a producer price index (PPI) useful
for predicting inflation or deflation by measuring changes in the prices of
manufacturers and producers (rather than retailers who sell to consumers). The It should be noted that, as a price
PPI consists of three price indices: index, the CPI ignores changes in the
= raw materials, such as crude oil and copper guality of goods and services — for
= intermediate goods, such as components and other semi-finished goods sold example, the higher build quality of
modern computers, televisions, cars
to other manufacturers and producers
and smartphones is not represented in
= finished goods that are sold to retailers, such as Honda or BMW selling their the calculation of the CPI.
cars to franchised car showroom dealers (operators).
Calculating inflation (HL only)

The consumer prices index (CPI) is a weighted index of average consumer
prices of goods and services over time. It is the most common method used
to measure inflation (and hence changes in the cost of living) for a typical
household in the economy.
A base year, with an index number of 100, is used as the starting period
when calculating a price index such as the CPI. So, a price index of 115.2
means prices have in general increased by 15.2% since the base year.
Percentage changes in the index number are used to show inflation in
subsequent years. So, if prices were to rise by another 5% in the following year,
the price index number would become 120.96 (i.e. 115.2 x 1.05), or 20.96%
higher since the base year.
In practice, price changes in the CPI are measured on a monthly basis but
reported for a 12-month period. Calculating changes in the CPI will give the
rate of inflation. There are two steps to do this:
m Collection of the price data (for the representative basket of goods and
services of the average household), collected on a monthly basis.
= Assigning statistical weighting to each item of expenditure, representing
different patterns of spending over time.
Worked example
The simplified example below, with three products in the representative
basket of goods and services, shows how a CPI is calculated. Assume 2012 is
the base year, when the total price of the basket was $20.
Product Price in 2013 Price in 2014

Pizza $9 $10
Cinema ticket $10 $11
Petrol $3 $3.5
Total basket price $22.0 $24.5
To calculate the inflation between 2013 and 2014, first calculate the price
indices for the two years:
22
= 2013: iE x 100 =110 (prices in 2013 were 10% higher on average
than in 2012).
= 2014: $§;: x 100 =122.5 (prices in 2014 were 22.5% higher on average
than in 2012).
The inflation rate between 2013 and 2014 is the percentage change in the
price indices during these two periods:
122.5-110
%100 =11.36%
110
Worked example (Continued)

However, the products in the CPI are of different importance to the typical
household, so statistical weighting is applied to reflect this. Suppose, for
example, that food consumption accounts for 40% of average household
spending, entertainment represents 20%, transport equals 25% and all other
items account for the remaining 15%. To create a weighted CPI, economists
multiply the price index of each item by the statistical weighting for the
item. Applying the weights gives the following results:
Product Price index | Weight Weighted index

Food 110.0 0.40 110x 0.4=44.0
Entertainment 11560 0.20 115x0.2=23.0
Transport 116.4 0.25 116.4 x 0.25 =29.1
Others 123.3 0.15 1233 %x015=185
Weighted index 114.6
Whilst the price of food has increased the least (only 10%), the spending on
food accounts for 40% of the typical household so has a much larger impact
on the cost of living. Without using weighting, the average price index
would be 116.18, i.e. 110+115+ :l 6.4+123.3 . The weighted index
reduces the CPI to 114.6 because the relatively higher prices of non-food
items account for a smaller proportion of spending by the typical household.
Therefore, the use of a weighted CPI is more accurate in measuring changes
in inflation and hence the cost of living.
EXAM PRACTICE (HL ONLY) Expert tip

Although the CPI and RPI are the
PAPER 3 most widely used price indices for
13 The data below show the inflation rates for a country over 3 years. measuring inflation, they only take
an average measure. They therefore
4N 1st 2nd 3rd hide the fact that the prices of some
VSN[o] RV R 7Y 2.5 1.7 2:3 products increase more rapidly than
others, whilst the price of other
a Define the meaning of ‘inflation rate’. [2] products might have actually fallen.
b Explain why inflation was at its highest level in the third year. [3]
14 Calculate the weighted price index from the information below. [3]
Expert tip
ITEM PRICE INDEX | STATISTICAL WEIGHTING When evaluating the measurement
of inflation, it is worth remembering
Food and drink 120 10
that there are limitations of using the
CPI to measure inflation. For example,
Transportation 130 20
the CPI has no relevance for atypical
Leisure and entertainment 140 30 households. Housing costs also vary
enormously between countries,
Housing 150 40 making international comparisons
difficult. Finally, the CPI does not
reflect regional differences and
15 Calculate the inflation rate if the consumer price index changes from disparities in inflation.
123.0 in Year1 to 129.15
in Year 2. [2]
16 Calculate the consumer price index if there is 3.0% inflation during the
year if the price index was previously at 130. [2]
17 Calculate how much a basket of goods and services which is currently
priced at $1200 would be if the CPI increased from 125.0 to 135.0. [3]
EXAM PRACTICE Common mistake

Students often define the CPI with
PAPER 2 reference to changes in the average
18 The data below are for a hypothetical country, Jukeland. price of a representative basket of
goods, without acknowledging that
ITEM LYY N (e ) 0] 4 | \"'ialelN services are also included in the
Clothing 110 10 calculation.
Food 120 20
Housing 130 30
Others 140 40
a Define what is meant by a ‘consumer price index’ (CPI). [2]
b ‘The typical household in Jukeland spends more money on housing
than on food or clothing.” Explain this statement. [2]
¢ Use the data above to calculate a weighted price index for Jukeland. [4]
Consequences of inflation
Inflation can complicate planning and decision making for households, firms
and governments, with many consequences: Expert tip
= Menu costs — Inflation impacts on the prices charged by firms. Catalogues,
Governments aim to control inflation
price lists and menus have to be updated regularly and this is costly to
because it reduces the value of
businesses.
money and the spending power of
m Shoe leather costs — Inflation causes fluctuations in price levels, so customers households, governments and firms.
spend more time searching for the best deals, be it physically or online. They For example, inflation was around
might also have to make more regular cash withdrawals. Shoe leather costs 48% in Syria in 2013, meaning that
therefore represent an opportunity cost for customers. the general price level increased by an
m Consumers — The purchasing power of consumers declines when there is average of 48% in a year.
inflation, i.e. there is a fall in their real income because money is worth less
than before. Therefore, as the cost of living increases, consumers need more
money to buy the same amount of goods and services.
m Savers — Savers, be they individuals, firms or governments, will lose out from
inflation, assuming there is no change in interest rates for savings. Hence,
inflation discourages savings as money becomes less effective as a store of
value.
m Lenders — Creditors, be they individuals, firms or governments, will also lose
from inflation. This is because the money lent out to borrowers becomes
worth less than before due to inflation.
= Borrowers — By contrast, borrowers tend to gain from inflation as the money
they need to repay is worth less than when they initially borrowed it. For
example, a mortgage at 5% interest with inflation at 3.5% means that the
real interest rate is only 1.5%, i.e. the real value of the debt declines.
= Fixed-income earners — Fixed-income earners (such as salaried workers and
pensioners whose pay does not change with their level of output) are worse
off than before as the purchasing power of their fixed income declines with
higher prices.
= Low income earners — [nflation harms the poorest members of society far
more than those on high incomes. They tend to have a high price elasticity
of demand for goods and services. By contrast, those on high incomes and
accumulated wealth are not so affected by higher prices.
m Exporters — The international competitiveness of a country tends to fall
when there is domestic inflation as exports become less price-competitive.
This causes a drop in profits, leading to a fall in export earnings, lower
economic growth and higher unemployment.
= Importers — Imports become more expensive for individuals, firms and the
government due to the decline in the purchasing power of money. Hence,
inflation can cause problems for countries without many natural resources
such as petroleum, steel, rice and coffee.
= Employers — Workers are likely to demand a pay rise during times of inflation
to maintain their level of real income. As a result, labour costs of production
rise and profits margins decline, ceteris paribus.
Business confidence levels — The combination of uncertainty and the
lower expected real rates of return on investment (due to higher costs
of production) tends to lower the amount of planned investment in the
economy.
A wage-price spiral occurs when trade unions negotiate higher wages to keep
income in line with inflation, but this simply fuels inflation as firms raise
prices to maintain their profit margins.
Therefore, high inflation makes conditions far less predictable for economic
stability, i.e. there is greater uncertainty for consumers, producers and the
govemment.
PAPER 3
19 Study the data below and answer the questions that follow.
YEAR | INFLATION RATE (%) | WAGE INCREASE (%)
1 2.5 3.0
2 3.1 35
3 2.9 3.1
a In which year was there the largest increase in real wages? Explain your
answer. [3]
b Explain why average wages were higher in Year 3 than in Year 2. [3]
EXAM PRACTICE
PAPER 2
20 Iran’s inflation rate climbed above 30% in 2013, having reached 31.5% at the
end of the Islamic country’s calendar year. The country, with a population of
74 .8 million, had experienced double-digit inflation rates for most of the past
decade. At the end of 2010, the government reduced food and fuel subsidies,
thereby fuelling inflation. In addition, international sanctions due to Iran’s
disputed nuclear programme forced down the value of the Iranian rial, the
country’s official currency. This meant added pressure on higher prices in the
economy.
Inflation rate in Iran
g3:{[ely) INFLATION (%)

March 2012 26.4
Dec 2012 27.4
March 2013 31.5
d With reference to the data above, explain why prices in Iran were generally
higher in 2013 than in 2012. [4]
Explain two reasons why the Iranian government might aim to control the
level of inflation in its economy. [4]
Evaluate how some Iranians are likely to have been more affected than
others by the double-digit inflation rates. [8]
Consequences of deflation
The consequences of deflation depend on the cause. Benign deflation is
generally positive as the economy is able to produce more (an outwards shift of
the LRAS curve), thus boosting national output and employment, without an
increase in the general price level (see Figure 2.23).
4 ASq * Deflation can be caused by higher AS,

: i.e. increased productive capacity of
the economy.
e This drives down the general price
level of goods and services from Py to
>
4—
P, whlist increasing national income

from Y; to Y5.
>
* Such deflation is called benign

deflation [nonthreatening deflation),
perhaps caused by higher productivity
or fechnological progress.
MNational income
Figure 2.23 Deflation caused by supply factors

Economists are concerned with malign deflation, which is generally harmful
to the economy due to a decline in aggregate demand for goods and services,
often associated with an economic recession and rising levels of unemployment
(see Figure 2.24).
A3 e Deflation can also be caused by a

General price level ($)
leftwards shift of the aggregate

demand curve from AD; to AD;.
e This reduces national income from
=
_‘_
Y1 to Yo, and forces down the

B R ' | general price level from Py to Ps.
! E e This causes malign deflation
i ! AD; |deflation that is harmful to the
i | AD, economyj.
® Y, Y, >
—
MNational income
Figure 2.24 Deflation caused by demand factors

The consequences of malign deflation include the following:
s Cyclical unemployment — As deflation usually occurs due to a fall in
aggregate demand in the economy, this causes a fall in the derived demand
for labour, i.e. deflation can cause huge job losses in the economy.
s Bankruptcies — Consumers tend to spend less during periods of deflation, so
firms suffer from lower sales revenues and profits. This makes it more difficult
for them to pay their costs and liabilities (debts such as mortgages), thus
causing a large number of bankruptcies.
s Lower investment expenditure — Firms have less of an incentive to invest
because they receive lower prices and hence profitability. This can have a
detrimental impact on economic growth.
m A rise in the real value of debts — The real cost of debts (borrowing)
increases when there is deflation because real interest rates rise when the
price level falls. For example, if interest rates average 1.0% but the inflation
rate is —1.5%, then the real interest rate is 2.5%.
= A fall in the value of wealth — Due to declining profitability, share prices fall
The extent to which an economy
during times of deflation. This means that dividends and the capital returns is affected by malign deflation will
on holding shares also fall, thus reducing the wealth of shareholders. depend on the severity of deflation.
= Government debt — With more bankruptcies, unemployment and Portugal’s experience of zero rate
lower levels of economic activity, tax revenues fall whilst the amount of inflation in 2013 would have been
government spending rises (due to the economic decline associated with very different from Somalia’s -15.35%
malign inflation). This can create a budget deficit for the government. inflation rate in the same year.
= Declining confidence levels — With deflation and the subsequent rising real
value of debts, both consumer and business confidence levels fall, further
adding to the economic problems in the country — for example, consumers
may postpone their spending and firms postpone their investments.
EXAM PRACTICE
PAPER 2
21 For much of the past 20 years, Japan has suffered from deflation (see the chart below).
JAPAN INFLATION RATE
Annual change on consumer price index
4 - —4
L2
-0
.0
4 | | | | | L
Jan/95 Jan/98 Jan/01 Jan/04 Jan/07 Jan/10 Jan/13
a Define the term deflation. [2]
b Explain what evidence there is in the chart to suggest that Japan has suffered deflation for most of the
past 20 years. [2]
¢ Explain the impacts of prolonged deflation for the Japanese economy. [4]
Causes of inflation
There are two main causes of inflation: demand—pull inflation and cost—push
inflation. Demand—pull inflation is inflation triggered by higher levels of
aggregate demand in the economy, which drives up the general price level (see
Figure 2.25).
Hence, an increase in any determinant of aggregate demand (changes in
consumption, investment, government spending and net exports) will cause
demand—pull inflation, for example higher GDP per capita, income tax cuts or
lower interest rates.
A
A5y e During an economic boom,
consumption of goods and services
increases due to higher GDP per capita

and higher levels of employment.
e This is shown by a rightwards shiff of
—_—
the aggregate demand curve from AD;

=
to AD5, raising national income from Y,

AD7 1o Y, and increasing the general price
'AD level from Py to Ps.
]
O Y, Y,
¥
MNational income
Figure 2.25 Demand-pull inflation
Cost—push inflation is triggered by higher costs of production thus shifting An increase in aggregate demand has
aggregate supply to the left and forcing up average prices (see Figure 2.26). a minimal impact on inflation if there
Causes of cost—push inflation include higher imported prices for raw is spare capacity in the economy, i.e.
materials, components (semi-finished goods) and finished goods for sale, if aggregate supply is relatively price
higher wages in the economy, increased corporation taxes and soaring rents for elastic.
commercial properties.
SRAS, SRAS,
® Higher raw material costs,

increased wages, and soaring
rents shift the aggregate supply
F
curve from SRAS; to SRAS,.

—_—
e This forces up the average price

>
level from P} to P, but reduces

national income from Yj to Y5.
AD
O Yo Y,
Mational income
Figure 2.26 Cost—push inflation
Tvpes of inflation
Ak
Table 2.3 Types of inflation
Creeping Occurs when prices are rising slightly, i.e. very low rates of inflation up to around 3% per annum. It is
inflation the mildest form of inflation and presents few problems for the economy. More economically developed
countries (MEDCs) tend to experience creeping inflation.
Moderate Refers to single-digit inflation rates (less than 10% per year). Professor Paul A. Samuelson argues that
inflation moderate inflation represents a stable rate of inflation and is not a serious economic problem.
Strato Refers to double-digit, and often triple-digit, rates of inflation. It occurs if moderate inflation persists
inflation (continues to increase) and is not controlled. Prolonged periods of strato inflation (sometimes referred to
as chronic inflation) can lead to hyperinflation.
Hyperinflation Refers to extortionately high and uncontrollable rates of inflation —

for example, Zimbabwe’s macroeconomic mismanagement between
2003 and 2009 resulted in hyperinflation of 231,000,000% in
July 2008, resulting in the issue of 100 trillion Zimbabwean dollar
banknotes!
Expert tip Common mistake

It is difficult for an economy to break out of a downward deflationary spiral (Japan has Students are often guoted stating that
suffered deflation for much of the past 20 years). Business and consumer confidence demand-pull and cost—push are the
levels would need to increase significantly to boost aggregate demand. It might be two types of inflation. This is incorrect
possible, for example, to cut interest rates to encourage consumer spending and as these are the causes, not the types
increased investment in the economy. of inflation.
Government policies to deal with inflation

In general, inflation can be controlled by limiting the factors that cause
demand—pull inflation and cost—push inflation. For example, the government
can raise taxes and interest rates to limit consumption and investment
expenditure in the economy to control demand—pull inflation.
Policies to deal with demand—pull inflation include the following:
m Deflationary fiscal policy to reduce aggregate demand — for example, raising
both direct and indirect taxes to reduce consumption and/or lowering
government expenditure.
= Contractionary monetary policy — for example, raising interest rates and/or
reducing growth of the money supply to limit consumption and investment
expenditure.
m Supply-side policies to boost national output — for example, improving
productivity and/or labour relations in order to increase aggregate supply,
thus dampening the impact of inflation.
= Import controls to reduce the chances of experiencing imported inflation
(caused by higher import prices of essential goods and services such as oil and
financial services).
Policies to deal with cost—push inflation include the following:
m Negotiations with labour unions to match any annual wage rises with higher
productivity levels, thus limiting inflationary pressures by boosting aggregate
supply.
= Government intervention to limit annual nominal wage increases, thus
preventing a potential wage-price inflationary spiral.
= Subsidising production to moderate costs, and hence prices. Some countries,
such as Iran and France, have used subsidies for food and fuel to reduce price
inflation in the economy.
m Revaluation of the currency on the foreign exchange market, as the higher
exchange rate helps to lower the cost of imported raw materials, components
and finished goods.
Governments are likely to use a combination of contractionary monetary
policy, deflationary fiscal policy and supply-side policies to combat inflation.
Collectively, however, contractionary policies are likely to reduce the level
of economic activity, thus possibly harming economic growth, employment
opportunities and international trade.
Possible relationships between unemployment

and inflation (HL only)
The short-run Phillips curve shows a potential trade-off between inflation
and unemployment. A fall in unemployment, due to an increase in aggregate
demand, creates more consumption expenditure in the economy, thereby
fuelling inflation (see Figure 2.27).
The model is named after New Zealand economist William Phillips (1958)
who used data from the UK from 1861 to 1957 to show the trade-off between
the unemployment rate and the rate of change in nominal wages (which
correlates to price stability).
The short-run Phillips curve shows that there is a natural rate of
unemployment (NRU) — the unemployment rate that exists when the inflation
rate is zero. The NRU is the unemployment rate that exists at full employment,
i.e. where the demand for labour equals the supply of labour. It exists at the full
employment level of output, i.e. the sum of frictional, seasonal and structural
unemployment
When unemployment is above its natural rate, deflation occurs because the
inflation rate becomes negative.
An increase in aggregate demand will tend to cause a movement up (to the
left) along the short-run Phillips curve because unemployment falls whilst the
average price level begins to rise.
88
Wage inflation (%) Economics for the IB Diploma
Phillips curve
NRU
© Unemployment rclfe%
Figure 2.27 The short-run Phillips curve (SRPC)
The Phillips curve can shift over time. For example, a reduction in structural
unemployment will tend to shift the Phillips curve to the left.
Supply shocks shift the short-run Phillips curve to the right (creating a
higher NRU), for example oil crises, financial crises, natural disasters (such as
severe flooding or drought) and the spread of contagious (infectious) diseases.
The Phillips curve lost some credibility in the 1970s due to the existence of
stagflation — when unemployment rises (due to a fall in real national output) with
inflation occurring in the economy. Stagflation is often caused by supply shocks.
Subsequent studies of the Phillips curve showed that the trade-off between
inflation and unemployment only seemed to exist in the short-run. In the long
run, there is no trade-off (see Figure 2.28) because inflation would be stable.
A
LRPC ® The movement from point A fo point B can
be caused by expansionary fiscal and
monetfary policies.
e Real wages fall with inflation, so workers
Wage inflafion (%]
push for higher nominal wages.

® This is not sustainable, so the short run
Phillips curve shifts from SRPCy to SRPC,
with unemployment reverting to the NRU.
s e
® Hence, attempts to reduce unemployment

e
below its natural rate will be inflationary in

NRU | the long run, as shown by the movement
\ SRPCy | SRPCy from point B to point C.
2 Unemployment rate (%)

Figure 2.28 The long-run Phillips curve (LRPC)
The SRPC can shift outwards due to a decrease in SRAS, perhaps caused by
supply shocks such as an oil shortage, natural disaster or a global financial crisis.
In extreme situations, this can lead to stagflation.
Most governments strive to reduce the NRU (shifting the LRPC to the left)
by creating incentives to work and encouraging more (re)training schemes for
the unemployed to improve their occupational mobility.
Economic growth
The meaning of economic growth

Economists believe that sustained economic growth is an important
macroeconomic objective because it is the most practical measure of standards of Keyword definition
living in a country. Economic growth represents the long-term expansion in the Economic growth refers to an
productive capacity of the economy, i.e. the annual percentage change in GDP. increase in a country'’s real gross
Diagrammatically, economic growth can be shown by a rightwards shift of domestic product over time, i.e. the
the long-run aggregate supply curve (see Figure 2.29) or an outwards shift of the annual percentage change in real
production possibility curve (see Figure 2.30). national output.
Economic growth occurs when there is an increase in the quantity and/or
quality of factors of production, such as an increase in labour productivity or
improvements in the state of technology. Negative economic growth results in
a recession in the business cycle.
[RAS, LRAS;
¢ Economic growth can be shown by a
rightwards shift of the [RAS curve from
Price level {$)
[RAS, to [RAS, caused by an increase in

the potential output of the economy.
e This is caused by an increase in the quantity
and/or quality of factors of production.
O
MNational output
Figure 2.29 Economic growth and the LRAS
Figure 2.30 shows that economic growth occurs when there is an increase in
the actual output of the economy. This can result from the use of unemployed
resources (Point A to Point B) or from improved factor utilisation and increased
productive efficiency (Point B to Point C).
Expert tip
A
Although economic growth is
generally regarded as the key indicator
"-g e A combination of an increase in the of economic wellbeing or the general
3. quantity and quality of factors of standard of living in a country, there
- production shifts the PPC outwards are other measures, such as the
= from PPC; to PPCy, creating more Human Development Index (HDI).
Do producer and consumer goods.
This composite index measures
= @ PPC,
three dimensions of living standards:
A PPC, healthcare (life expectancy), education
< Consumer goods (years of schooling) and income levels
(real GDP per capita).
Figure 2.30 Economic growth and the PPC
Calculating economic growth (HL only)

Economic growth is measured by calculating changes in real gross domestic
product.
Changes in nominal GDP figures give gross domestic product at current
prices, whereas changes in real GDP figures give gross domestic product at
constant prices (allowing economists to compare growth rates over time
without the impact of price inflation).
A GDP deflator is an index number used to convert nominal GDP to real
GDP by eliminating the impact of inflation on the calculation of GDP. It can
therefore be seen as a measure of the general level of inflation in the economy.
Real GDP is calculated by dividing nominal GDP by the GDP price deflator
and then multiplying the result by 100.
Worked example
Real Nominal | Real

Nominal GDP GDP growth Growth
Year GDP ($bn) | deflator ($bn) rate (%) rate (%)
2012 120.0 100.0 120.00 = =
2013 126.5 102.8 123.05 5.41 2.54
2014 136.2 106.4 128.00 167 4.02
With 2012 as the base year, the nominal GDP is equal to real GDP for the
vear, i.e. $120bn.
With inflation running at 2.8% in 2013, the nominal value of GDP includes
higher prices due to inflation. A GDP deflator of 102.8 means that real GDP
is actually % = $123.05bn.
102.8
Worked example (Continued)

The real growth rate between 2012 and 2013 is therefore:
123.05-120.0
x100=2.54%
120
Note that growth in nominal GDP is higher:
126.05-120
x100=5.41%
120
Similarly, in 2014 the nominal GDP is deflated to yield:
136.2
%100 = $128.0bn
106.4
The growth rate between 2013 and 2014 is:
128 -123.05
x 100 =4.02%
12305
Note that growth in nominal GDP is again higher:
136.2—-126.5
x100=17.67%
126.5
Causes of economic growth

Factor endowments refer to the quantity and quality of a country’s factors of
production — for example, Saudi Arabia is well-endowed in the supply of oil,
France has plenty of arable land for its agricultural output, and Australia has
many natural resources such as coal, gold and iron ore.
Discovery of raw materials such as oil, or any other tradable commodity
in a country, will increase its productive capacity and so tend to shift the PPC
outwards.
The size and skills of the labour force impacts on the country’s economic
growth — for example, India’s large labour force and Germany’s highly skilled
workers have contributed to the economic growth of these countries.
The mobility of labour refers to the extent to which workers are willing and
able to change jobs (occupational mobility) and move to different locations for
employment (geographical mobility). The more mobile workers are, the greater
economic growth tends to be.
Labour productivity refers to the output produced in a given time period.
It is determined by several interrelated factors such as the qualifications,
experience, training, skills and motivation of the labour force. Higher
productivity tends to lead to greater economic growth.
Investment expenditure in capital and human resources is vital for long-
term competitiveness and economic growth as it boosts the country’s productive
capacity — for example, foreign direct investment can stimulate economic
erowth and development.
EXAM PRACTICE
PAPER 2
22 According to The Economist’s Economist Intelligence Unit, Macau's economy
grew by 14.3% in 2013 — the highest economic growth rate for any country in
the year. The island nation had enjoyed 9.8% growth in 2012 with gambling
revenue increasing by approximately 14% to about $38 billion, making it the
world's biggest gambling market ahead of Las Vegas. In 2011, Macau enjoyed
a stunning 20.7% growth rate. The country is also investing huge amounts of
money to attract a wider range of tourists with casino giants such as Sands and
MGM Resort also investing large sums of money into the economy.
a Define the term ‘economic growth’. [2]
b Explain how investment in Macau helps to boost its economic growth. [4]
Consequences of economic growth

Impacts on living standards — Economic growth tends to lead to higher
standards of living for the average person. Higher real income per head enables
people to spend more money to meet their needs and wants, thus helping to
eliminate absolute poverty in the country.
Unemployment — Economic growth leads to higher levels of employment
in the economy. This helps to raise consumption and encourages further
investment in capital, helping to sustain growth in the economy.
Inflation — If the economy grows rapidly due to excessive aggregate demand
in the economy, there is the danger of demand—pull inflation. This can lead to
the prices of goods and services rising to unstable levels, with a negative impact
on the economy’s international competitiveness.
Income distribution — Economic growth often creates greater disparities in
the distribution of income and wealth, widening the gap between rich and poor.
However, economic growth also leads to greater tax revenues, enabling the
government to redistribute income and wealth.
The current account of the balance of payments — The current account S {elladhi]e]
tends to improve with economic growth due to a higher value of net exports (a
Whilst economic growth is generally
component of aggregate demand).
seen as a desirable macroeconomic
Sustainability — Growth usually creates problems for the sustainability
objective, remember that individuals
of scarce resources and economic wellbeing, such as resource depletion (e.g. do not benefit equally from economic
deforestation and overfishing), pollution, congestion, damage to ecosystems, growth.
land erosion and climate change.
Equity in the distribution of income
The meaning of equity in the distribution

of income
Equity differs from equality in the distribution of income. Equity is based on
Keyword definitions
the argument that income inequalities (such as wage differentials) are needed
Equity means fairness, such as those
to create incentives for people to study and work harder. Equality means equal
with higher levels of qualifications,
distribution of income in the economy.
skills and experience being paid
Economies face unequitable distribution of income due to the natural
more, so justified inequalities exist.
unequal ownership of factors of production in a free market economy. For
example, consider the wage differentials between professional footballers, Equality means there is parity
doctors or pilots and those earning the national minimum wage. in income (earnings) between
individuals, i.e. everyone is paid
equally, so no inequalities exist.
Indicators of income equality/inequality
The degree of income equality (or inequality) can be measured by the relative
share of national income earned by given percentages of the population.
Deciles refer ro the statistical method of splitting data into tenths, with each
part accounting for 10% of the population. For example, if the top decile (10%)
of the income earners accounted for 45% of the national income, there would
be huge income inequalities.
Quintiles are used to divide statistical data into fifths, with each part
representing 20% of the population.
The Lorenz curve, named after US economist Max Otto Lorenz (1905), is a
graphical representation of income distribution in a country. [t shows the degree
of income inequality, such as the poorest 10% of income earners accounting for
just 1% of the nation’s income.
In Figure 2.31, the 45° line shows perfect equality in income distribution.
For example, at point A the first four deciles account for 40% of the national
income.
The Lorenz curve shows the actual income distribution in a country. Point
B in Figure 2.31 shows the hypothetical situation where 60% of the population
account for just 20% of the nation’s income. So, the top four deciles must earn
the remaining 80% of the national income.
The greater the area between the 45° line of total income equality and the
Lorenz curve (as shown by the area between the two curves), the greater the
income inequality in the country.
100 —
Cumulative share of income (%]
op
@
I
o~
o
|
b
]
A~
Llorenz curve
~
o
I
B
| | | | |
O
0 20 40 60 80 100
Cumulative share of population (%)
Figure 2.31 The Lorenz curve
The Gini coefficient, named after [talian statistician Corrado Gini

(1912), is a statistical tool that measures income inequality, with the outcome
ranging from O (complete equality) to 1 (total inequality). It is a numerical
representation of a country’s Lorenz curve.
At one extreme, if an individual accounted for all national income, the
Lorenz curve would pass through the coordinates (0, 0), (100, 0) and (100,100)
leading to a Gini coefficient equal to 1. At the other extreme, there is total
equality as shown by the (45°) line of perfect equality. The Gini coefficient is
calculated by the ratio of the area under the Lorenz curve to the area under the
45° line of complete equality, which has a total area of
Common mistake
100100 _ 5q00.
Do not misinterpret the Gini
In general, low-income countries and/or those that suffer from a high degree coefficient as a comparative measure
of corruption have a high Gini coefficient, such as Haiti (0.592) and South of national income between countries.
Africa (0.631). High-income countries tend to have a low Gini coefficient, such Different countries with the same
as Germany (0.283), Finland (0.269) and Denmark (0.240). Gini coefficient do not have the same
national income (GDP), as this tool
Most governments strive to achieve greater income equality over time.
is used simply to measure relative
They can use the Gini coefficient to measure whether income distribution is
equality in income distribution.
increasing or decreasing.
Poverty
Poverty refers to the state of an individual, household or country being
extremely poor, i.e. not having enough money to meet basic human needs such Keyword definitions
as food, clothing, shelter, healthcare and education. The World Bank describes Absolute poverty exists when people
poverty as a situation people want to escape. are deprived of basic human needs for
Definitions of poverty are relative because it varies considerably depending human survival. Those in absolute
on the situation in different countries. Feeling poor in Finland or Norway is poverty suffer from malnutrition,
different from living in poverty in Sierra Leone or Namibia. Different degrees of hunger, a lack of clean water, poor
poverty also exist within the borders of a country.
healthcare and inadequate shelter.
The relative poverty in a country is determined by examining the percentage Relative poverty refers to incomes,
of the population with earnings less than a predetermined percentage of the and hence consumption, below
median income within that country. the social norm within a country.
Tackling poverty is a key economic issue because, apart from humanitarian It can lead to damaging effects on
reasons, it represents economic inefficiency preventing people and economies individuals and families, including
from reaching their full potential. social exclusion. It is a comparative
measure, so relative poverty will
differ from country to country.
Causes of poverty
Table 2.4 Possible causes of poverty
Low income Without sufficient money, households will not be able to meet their basic human needs.
According to The United Nations and World Health Organization, people earning less than
$2 per day suffer from absolute poverty.
Unemployment Without a job, people are unlikely to be able to sustain their standard of living. The
consequences of unemployment include lower self-esteem and depression, and higher rates of
crime, violence, health problems and homelessness.
Lack of human capital The lack of sufficient provision of, and investment in, education and training leads to mass
poverty. Without the necessary knowledge and skills, the workforce will be unproductive and
national income will be significantly lower than its potential.
Overpopulation The lack of population control means that GDP per capita will tend to decline, thus causing
greater poverty in the country. Larger families also tend to suffer from relative poverty.
Gender inequalities More women tend to suffer from poverty than men, mainly due to social prejudice against
females. For example, women are less likely to be in paid employment on a full-time basis and
tend to earn less than men. This represents an inefficient use of labour resources.
Corruption and conflict Highly corrupt countries and those in political turmoil tend to have a high Gini coefficient,
causing mass poverty for the majority of the population.
Lack of natural resources The lack of natural resources and/or the poor management of these resources will generally
reduce a country’s potential net export earnings.
Natural disasters Major disasters such as tsunamis and earthquakes can wipe out much of a country’s scarce
resources, thus creating mass poverty. Countries can struggle to fully recover from major
natural disasters.
Consequences of poverty
The main causes of poverty are as follows:
s Low living standards — Those in poverty, be it absolute or relative,
experience a low quality of life as they are unable to meet their basic needs or The causes and consequences of
to experience a better standard of living. poverty can create a poverty trap,
m Lack of access to healthcare and education — Poverty-stricken people are i.e. the poor become even poorer.
unable to afford quality healthcare and education. This hinders the human For example, low incomes lead
capital of the country and thus compromises prospects of economic growth. to low savings, reduced funds for
= Conflict and war — History has shown that poverty often leads to political investments, reduced productivity,
lower national output and hence
instability and can even lead to war in extreme cases. This can lead to other
a diminished quality of life. This
issues, such as a mass emigration of the population, which undermines the increases poverty even further.
country’s ability to recuperate from poverty. Hence, eradicating poverty is a key
Clearly, poverty hinders the ability of governments to achieve other macroeconomic priority for many
macroeconomic objectives such as economic growth and low unemployment. governments.
The role of taxation in promoting equity

A major role of taxation is to promote income equality by redistributing income
to help the relatively less well-off in society. Keyword definitions
Direct taxes are taxes on earnings, whereas indirect taxes are taxes on A direct tax is a government levy
spending. Direct taxes, rather than indirect taxes, are used as a mechanism to on income, such as income tax and
redistribute income from the rich to the poor — for example, the highest earners corporation tax.
in Belgium pay up to 55% income tax. An indirect tax is a government
To create incentives to work, individuals are granted a personal tax allowance, levy on expenditure, such as a
i.e. they can earn up to a certain amount before they are taxed. The allowance goods and services tax (GST).
tends to rise with inflation — for example, in the UK, the tax allowance for
2013-2014 was £9440 and rose to £10,000 in 2014-2015.
Indirect taxes are often used to moderate spending on demerit goods such as
alcohol, tobacco and gambling.
Direct and indirect taxes can be further categorised:

= Progressive taxation charges a higher percentage tax as an individual’s
income rises, i.e. those who earn more pay a greater proportion of their
Common mistake
income in tax.
= Regressive taxation charges a greater proportion of tax on lower-income Too often, students incorrectly
earners — for example, sales taxes, such as value added tax (VAT) and goods define progressive taxes as a policy
and services tax (GST), account for a greater proportion of tax paid by the whereby individuals pay more taxes
as their income level rises. This is true
relatively poor.
for proportional taxes too, i.e. the
m Proportional taxation charges the same flat rate percentage tax, irrespective more you earn, the more you pay in
of how much an individual earns. Whilst more tax is paid in absolute terms as taxation. Instead, progressive taxation
an individual’s income rises, the percentage tax paid is fixed. charges more tax as a percentage of
A drawback in using proportional and progressive taxation to redistribute the individual’s income, i.e. the more
income is that they can create disincentives to work, thereby harming economic you earn, the greater the average rate
efficiency and economic growth. of tax paid.
Calculating the marginal and average rates of

tax (HL only)
The marginal rate of tax refers to the percentage of direct tax paid on the last
dollar of an individual’s income, i.e. the change in tax rate paid from a given
change in income, or —.
A¥
The average rate of tax refers to the amount of tax paid compared with the
amount of income earned, i.e. the total tax paid divided by the total income for
T
an individual, or —.
The average rate of tax zincreases under a progressive tax system with higher
incomes. Under a regressive tax system, the average rate of tax falls when
incomes rise.
Under a progressive tax system, an individual’s marginal rate of tax is greater
than his/her average rate of tax. Under a proportional tax system, as the rate of
tax is fixed, the marginal and average rate of taxation are the same.

PAPER 3
23 Suppose a country taxes an individual $5500 on earnings of $55,000 a year
and charges another person $1500 on earnings of $15,000 a year. Explain
what type of tax system the country uses. [2]
24 Use the data below to answer the following questions for an individual
who earns $40,000 per year.
a lIdentify the marginal rate of income tax. [1]
b Calculate the total amount of tax paid by the individual. [2]
¢ Calculate the average rate of income tax. [2]
d Calculate the average rate of tax for another individual who earns
$80,000 per year. [3]
INCOME TIER TAX RATE (%)
First $10,000 0
Next $20,000 10
Next $20,000 20
Thereafter 30
25 Calculate the average tax rate of individuals who earn $50,000 per year in a
country that charges a flat rate of 20% income tax and grants individuals a
tax allowance of $15,000. [2]
EXAM PRACTICE (CONTINUED)

26 Calculate the change in the amount of tax paid if an individual faces a
marginal tax rate of 45% when her income changes from $47,000 to
$55,000 per year. [2]
27 From the data below, calculate the tax paid by an individual who earns
$35,000 a year. [2]
INCOME TIER LY TN
$9000 0
$9001-$20,000 10
$20,001-$30,000 20
$30,001 and above 30
Other measures to promote equity

Apart from taxation policy, government expenditure enables socially desirable
eoods and services to be provided, for example healthcare services, education
and infrastructure. They might do this by directly providing the services or by
subsidising the output of these services.
Subsidies enable firms to provide socially desirable goods and services in
order to redistribute income, by making these merit goods available to everyone,
for example education and healthcare.
The provision of essential infrastructure (such as sanitation and clean water
supplies) helps to promote equality for those on low incomes and to eradicate
absolute poverty.
Transfer payments are another means that the government uses to
promote income equality by making payments to the less affluent without any When making or evaluating
corresponding exchange or change in output. Examples include: recommendations to promote
m old-age pensions —an income support scheme paid monthly to elderly people income equity, remember that
beyond retirement age who may not have any other form of income every government decision has
= unemployment benefits — transfer payments made to unemployed people to an opportunity cost. For example,
enable them to meet their basic human needs redistributing income and wealth
by using progressive taxes involves
m child allowances (also known as child benefits) — welfare payment made to
administrative costs to the
parents or guardians of children and teenagers, for spending on items such as
government.
food, clothing, schooling, transport and health check-ups.
The relationship between equity and efficiency

Economists can evaluate government policies to promote equality by assessing
their potential positive or negative effects on efficiency in the allocation of
scarce resources.
The three main ways of government intervention to promote equality are:
taxation policy, government expenditure (through direct provision or through
subsidies) and by transfer payments.
Whilst taxation provides necessary funds to pay for government expenditure
(direct provision and/or subsidies), it puts extra pressure on taxpayers and can
cause disincentives to work. The effectiveness of a country’s taxation policy can
be evaluated using the following criteria:
= Equitable — Taxes should be based on the principle of the taxpayer’s ability to
pay, otherwise it creates huge disincentive effects.
m Economic — The cost of collecting the tax should be a relatively small
proportion of the tax yield.
s Convenience — The methods and timing of tax payments should be made as
easy as possible for people to pay.
s Certainty — The amount and the deadline of the tax due should be
unquestionably clear, thus limiting late payments and the number of tax
evaders.
Transfer payments are costly and drain the limited budgets of governments.
Austerity measures following the global financial crisis of 2008 caused severe
economic problems for countries such as Portugal, [reland, Greece and Spain.
They can also cause laziness amongst the workforce.
There is an opportunity cost in the direct provision of goods and services to
redistribute income.
Subsidies, apart from being costly to taxpayers, can encourage firms to
become reliant on government funding, thus hindering economic efficiency in
the allocation of resources.
2.4 Fiscal policy

The government budget
Taxation policies can be used to redistribute income and wealth to benefit less
wealthy members of society. Taxation can also be used to help control the rate Keyword definition
of inflation in the economy, thus affecting its international competitiveness. Fiscal policy is the use of taxation
Government spending can then be used to improve standards of living, such and government expenditure
as by building schools, hospitals and transportation networks. Government policies to influence the level
expenditure is also a key component of aggregate demand, so an increase of economic activity and
in government spending helps to boost national output, jobs and economic macroeconomic objectives.
erowth.
Sources of government revenue
The main source of government revenue is from taxes. These can be classified as
either direct taxes (levied on earnings and income) or indirect taxes (levied on
expenditure).
Table 2.5 Examples of direct taxes
Income tax Levied on personal incomes, i.e. wages, interest, rent and dividends. In most countries, this is the main
source of tax revenue for the government.
Corporation tax Direct tax on the profits of businesses.
Capital gains tax Levy on the earnings made from investments such as buying shares and private property.
Inheritance tax Tax on the transfer of income and wealth, such as money or property bequeathed (passed onto)
another person.
Windfall tax Charged on individuals and firms that gain an unexpected one-off amount of money, such as a person
winning the lottery or the gains from a takeover bid for a firm.
Table 2.6 Examples of indirect taxes
Sales tax Indirect tax, such as value added tax (VAT) or goods and services tax (GST), charged on the
manufacturing, sale and consumption of goods and services.
Excise duties Indirect inland taxes imposed on certain produces. Depending on the country, these might include
alcohol, tobacco, petrol, soft drinks and gambling.
Customs duties Indirect cross-border taxes on foreign imports.

Stamp duty Progressive tax paid on the sale of commercial or residential property.
Carbon tax Tax on vehicle manufacturers or firms that produce excessive carbon emissions.
Other sources of government revenue include the following:

m The sale of goods and services. These come from state-owned enterprises,
such as national providers of postal services, the national broadcasting
corporation, the airport authority and nationwide railway operators.
m The sale of state-owned enterprises. Privatisation proceeds can be earned by
selling government-owned assets and enterprises. However, this is a short-
term policy as state-owned assets can only be sold once to the private sector.
= Sovereign wealth funds (SWF) are state-owned investment funds such as
stocks and shares, the bonds of other governments, investment in property
and gold reserves. These sources help to generate income to fund government
spending.
m Public-sector borrowing is used by government when its sources of revenue
(from taxes, state-owned enterprises and privatisation proceeds) do not meet
its spending needs.
Types of government expenditure

Government spending can be classified as:
= current expenditure — government spending on goods and services consumed
within the (current) year, i.e. it is expenditure for immediate operations and Ideally, the government would
benefits, for example wages and salaries for public-sector workers or current only borrow money to fund capital
expenditure (i.e. to fund investment
expenditure on education.
in the economy) and never to pay
= capital expenditure — long-term items of government spending (investment)
for transfer payments or current
that boost the economy’s productive capacity, for example infrastructure (e.g. expenditure.
as the building of new roads and airports).
= transfer payments — welfare payments from the government to third parties
without any corresponding return, for example unemployment benefits, old-
aged pensions and child allowances.
Ensure you understand the meaning of transfer payments. They are considered to
be part of government spending but do not appear as part of the national income
statistics as there is no corresponding output for transfer payments.
The budget outcome

The government’s revenues and expenditure are recorded in its annual budget.
There are three possible outcomes:
= A budget deficit exists if government spending is greater than government
revenue. This might occur during a recession when welfare payments tend to
rise whilst tax revenues fall due to rising unemployment.
= A budget surplus exists if government revenue exceeds public-sector
expenditure. This might occur during an economic boom when tax
revenues will be higher (due to increased earnings and consumption), whilst
government spending on transfer payments will tend to fall.
m A balanced budget occurs when the amount of government spending equals
the value of its revenues.
Governments strive to balance their budgets in the long run. Budget
surpluses tend to be politically unpopular with taxpayers. Budget deficits require Common mistake
government borrowing, which can be rather expensive due to interest charges Some students seem to think that
on the loans. a budget deficit is ‘bad’ for the
There is a negative correlation between government debt and the budget, i.e. economy. It is important to remember
the more money a government owes, the more likely that its budget will be in that a government might deliberately
deficit. spend more than it collects in revenue
A budget surplus can help to reduce public-sector debt caused by budget in order to stimulate the level of
deficits in previous years, whereas a budget deficit will tend to increase aggregate demand, especially during
an economic recession.
government debt.
The role of fiscal policy
Fiscal policy and short-term demand

management
Government expenditure (G) is a component of aggregate demand
(AD=C +1+ G + (X = M)). Thus, changes in the level of government
expenditure will influence the level of AD in the economy, ceteris paribus.
Similarly, consumption (C) is a component of aggregate demand. Changes in
taxes will influence the level of consumption, thus affecting the level of AD in
the economy.
Expansionary fiscal policy is used to stimulate the economy, by increasing
government spending and/or lowering taxes. This can boost domestic
consumption during an economic recession, thereby helping to close a
deflationary (recessionary) gap. By contrast, contractionary fiscal policy is used
to reduce the level of economic activity by decreasing government spending
and/or raising taxes. It is used to reduce inflationary pressures during an
economic boom, thus helping to close an inflationary gap.
The potential effects of expansionary fiscal policy or contractionary fiscal
policy will depend on the shape of the aggregate supply curve (see Figure 2.32):
= An increase in aggregate demand from AD; to AD; has no impact on the
price level as there is spare capacity. Thus expansionary policy is effective in
increasing real national output only.
m [f the economy is operating on the upwards-sloping section of the AS curve,
an increase in aggregate demand from AD; to ADj3 will cause an increase in
both national output and the general price level.
= However, if expansionary fiscal policy is used when the economy is at full
capacity (i.e. the AS curve is perfectly price inelastic at Yy), then attempts to
boost aggregate demand beyond AD, will simply cause inflation without any
corresponding increase in national output.
| The three opposite outcomes apply when analysing contractionary fiscal
policy, i.e. the consequences depend on the shape of the economy’s AS curve. Expert tip
A Ensure that you can explain the
difference between a deflationary gap
and an inflationary gap. The former
& occurs when the economy is below
2A iI full employment, i.e. fiscal stimulus
@ I (tax cuts and/or increased government
0,
= | ADy4 spending) is needed to close the
recessionary gap. The opposite
applies to an inflationary gap (when
real GDP exceeds potential GDP), so
O Y; " contractionary fiscal measures are
Real national output (GDP) needed to combat the subsequent
Figure 2.32 Fiscal policy and the AS curve inflationary pressures.
EXAM PRACTICE
PAPER 1
28 With the aid of an appropriate diagram, explain how the effectiveness
of expansionary fiscal policies depends on the shape of the aggregate
supply curve. [10]
29 Explain why expansionary fiscal policy can cause a budget deficit for
the government. [10]
The impact of automatic stabilisers

A progressive tax system and welfare benefits for the unemployed are good
examples of automatic fiscal stabilisers that help to cushion short-term Keyword definition
fluctuations in economic activity: An automatic stabiliser is a part
= During an economic boom, a progressive tax system means that the of fiscal policy that auromarically
government automatically receives more tax revenue, from increased tax influences national income,
revenues on income and spending. thus helping to even out short-
m At the same time, government spending on welfare benefits falls due to rising term fluctuations in the level of
levels of economic activity, thus dampening the increase in consumption economic activity.
expenditure.
m Thus, automatic stabilisers (higher tax revenues and lower welfare benefits
caused by higher levels of employment) help to reduce the growth rate,
thereby avoiding the risks of an unsustainable economic boom and
uncontrollable inflation.
Conversely, economic growth is negative in a recession, but automatic
stabilisers (such as more government spending on unemployment benetfits) help
to limit the fall in economic growth. This helps to inject some money into the
circular flow of income to boost aggregate demand.
The effectiveness of automatic stabilisers in reducing fluctuations in
economic activity is dependent on:
m the size of the government sector, i.e. government spending as a percentage
of GDP — the greater the level of government involvement, the more
effective are automatic stabilisers
m the degree of progressivity of the tax system — the more progressive the tax
system of the country, the more effective automatic stabilisers tend to be
m the scope of the welfare benefits system — automatic stabilisers will be more
effective in countries like Australia and the UK with a wide-reaching welfare
system.
Fiscal policy and its impact on potential output

Government spending (G) and consumption (C) are the two components of
aggregate demand most directly affected by fiscal policy.
Capital expenditure can help to promote long-term economic growth (the
increase in potential national output), for example investment in the country’s
infrastructure such as railways, road networks, airports and telecommunications
networks.
Fiscal policy can be used to directly promote long-term economic growth in
three main ways:
= Government spending on physical capital goods — Capital goods are tangible
assets used to produce other goods and services, for example machinery,
buildings and commercial vehicles.
s Government spending on human capital formation — Human capital
formation is the transformation process of using education and/or training to
create knowledge and skills to create a more skilled labour force.
= Provision of incentives for firms to invest — Government provision of tax
breaks and tax incentives helps to create an economic environment that is
conducive to investment. Government spending on infrastructure can also
help to encourage foreign direct investment.
Fiscal policy can be used indirectly to promote long-term economic growth
Expert tip
by creating an environment of low taxation that is favourable to private sector
investment by domestic and foreign firms. When evaluating the use of fiscal
Expansionary fiscal policy can also help to increase both consumer and policy, it is worth noting any potential
business confidence levels. This creates further incentives for firms to invest conflicts in the government'’s
macroeconomic objectives. For example,
in their labour force and in the economy. However, critics argue that the
the government might choose to use
effectiveness of expansionary fiscal policy depends on the (shape of the) AS contractionary fiscal policy to deal with
curve. It is also debatable whether demand-side policies alone are sufficient cost—push inflation, but unemployment
to achieve long-term economic growth; there is certainly a case for the use of is likely to occur as a consequence.
supply-side policies.
EXAM PRACTICE
HL students should be able to
PAPER 1 include the concept of the Keynesian
30 Explain how fiscal policy can be used to affect the level of aggregate demand multiplier when evaluating the
in an economy. [10] effectiveness of contractionary or
expansionary fiscal policies.
Evaluation of fiscal policy

The effectiveness of fiscal policy can be evaluated by consideration of various
factors:
m The ability to target sectors of the economy — Fiscal policy measures will
have a greater impact on some areas of the country than others due to
regional disparities in income and spending habits.
m The direct impact on aggregate demand — Expansionary fiscal policy can
help to achieve economic growth but tax cuts and increased government
spending can fuel demand—pull inflation.
= By contrast, contractionary measures to control inflation can cause
disincentives to work, lower productivity and unemployment.
m Spillover effects of government expenditure — Contractionary fiscal policy
via reduced public-sector spending can have detrimental effects on public
transportation, healthcare services and educational services. This can lead to
economic inefficiencies and market failure.
m The effectiveness of promoting economic activity in a recession — The global
financial crisis of 2008 saw governments across the world inject trillions of
dollars to stimulate the economy. However, the effectiveness of such policies
was hindered by the severity of the global recession.
= Budgetary constraints — The effectiveness of fiscal policy will depend on
the extent to which the government can afford to sustain a budget deficit.
Austerity measures in Greece and Spain were inevitable following the huge
debts incurred by the countries during the global financial crisis.
= Time lags — There are three problems with the timing of fiscal policy:
0 Recognition time lags — There is a time lag before recognising that
government intervention is needed to affect the level of economic activity.
This is because governments do not necessarily know if the economy is
growing too fast (or declining too quickly).
0 Administrative time lags — There is a time delay between recognising the
need for fiscal policy intervention and the time to actually implement an
appropriate action, such as approving tax changes or alterations to the
government budget.
0 Impact time lags — There is a time lag from implementation of fiscal policy
to seeing the actual effects on the economy. A cut in income tax, for
example, will take time to have a significant impact on the spending habits It is incorrect to assume that fiscal
of households. policy cannot impact on the supply-
= Political constraints — The political cycle (of re-electing political leaders side of the economy. For example,
and political parties) can cause artificial shocks to the business cycle — for income tax cuts can create incentives
example, large tax cuts might be used prior to a general election to gain for people to seek employment
political votes, rather than to tackle fundamental economic problems. and to work harder. Lower rates
= Crowding out — Financial crowding out occurs when increased government of corporation tax can help to
attract foreign direct investment in
borrowing (to finance its spending) causes interest rates to rise, thereby
the country, thereby boosting the
reducing private-sector investment expenditure due to the higher costs. economy’s potential output.
m Supply-side shocks — Fiscal policy is unable to deal with supply-side causes
of instability to the economy, for example oil crises, outbreak of infectious
diseases and major natural disasters.
EXAM PRACTICE Expert tip

A useful way to evaluate the
PAPER 1 effectiveness of fiscal policy in
31 Evaluate the extent to which fiscal policy is effective in achieving long-term achieving macroeconomic objectives
economic growth. [15] is to consider alternative perspectives.
For example, classical economists
argue that the private sector is
more efficient in spending money
than the government, and demand
PAPER 3 management causes a decline in
economic welfare. Monetarists argue
INCOME TAX Yy that the aggregate supply is perfectly
RATE - TOP CORPORATE STANDARD price inelastic in the long run, so
TAX BAND (%) | TAX RATE (%) | RATE (%) attempts to increase AD would simply
= be inflationary.
China 45 25 17
Singapore 20 17-19 7
UK 45 21 20
United Arab 0 0 0
Emirates
a Explain one drawback of the low tax rates in the United Arab
Emirates (UAE). [2]
b From the data above, explain two disadvantages for firms based in
China and the UK compared with those based in Singapore or the UAE. [4]
2.5 Monetary policy

Interest rates
Interest rates can refer to the price of borrowing money or the return from
saving money at financial institutions such as banks. The money supply refers Keyword definition
to the entire quantity of money circulating an economy, including notes and Monetary policy refers to the
coins, loans and savings deposits at banks. government’s use of interest rates
Like fiscal policy, governments use monetary policy to either expand or and the money supply to influence
contract economic activity to achieve their macroeconomic goals. For instance, the level of aggregate demand and
interest rate policy and manipulation of the money supply can be used to economic activity.
stabilise inflation.
Direct control of the money supply is relatively difficult as the definition
of money is quite loose and banks can create credit fairly easily. Hence, most
governments rely on interest rate policy to achieve economic stability.
Common mistake
When defining demand-side policies, students do not always refer to these as
macroeconomic policies in terms of both fiscal and monetary policy, i.e. both
policies are used to influence aggregate demand.
Interest rate determination
The interest rate can be described as the return for lenders of money or the
price of borrowing money. It is expressed as a percentage of the money loaned to
or borrowed by others.
The price of money is called the interest rate and the quantity of money is
called the money supply. The equilibrium interest rate is determined by the
intersection of the demand for, and supply of, money (see Figure 2.33).
The demand for money refers to the desire to hold money (rather than
saving it) to finance consumption and current expenditure. Interest rates tend
to rise when the quantity of money demanded exceeds the quantity supplied.
The supply of money refers to the total amount of money circulating in the
economy at any point in time. It will include bank notes and coins, bank
deposits, loans and credit. An increase in the money supply will tend to decrease
interest rates, and vice versa.
e The supply of money curve (S, is vertical at

@y quantity of money because the supply of
money is fixed by the central bank at any one
point in fime.
® At interest rates below the equilibrium, there
Interest rate
is excess demand for money. At an interest

rate of ry, excess demand is shown by the
distance G — Q.
* When interest rates are higher than the
equilibrium, more money is available than
people wish fo hold. At ry, excess supply of
money is Q) — Q3.
Y
O Q G Gy
Quantity of money
Figure 2.33 The demand for, and supply of, money
A change in either the demand for money or the supply of money will change
the equilibrium interest rate. For example, an increase in the money supply
caused by an inflow of funds from abroad or due to a lower cash reserve ratio,
lowers the interest rate, ceteris paribus.
The opportunity cost of holding money varies directly with the level of
interest rates, i.e. a fall in interest rates will reduce the opportunity cost of
holding money (there is not much of an opportunity cost if, like in Japan and
Hong Kong, interest rates have been close to 0%).
Whilst the central bank does not control the demand for money, it has a key In reality, there is no single interest
role in influencing the supply of money by manipulating interest rates. There ‘rate’ in an economy but a structure of
are several factors a central bank will consider when setting interest rates: different interest rates. This is because
m The state of the economy — For example, a deflationary gap may require a there are separate markets for
reduction in interest rates to prevent the economy from going into a deep different kinds of loan — such as bank
recession. overdrafts, credit cards and mortgages
— all of which charge different rates of
m The rate of growth of nominal wages — For example, higher costs of labour
interest. Borrowers also have different
usually mean that firms will increase prices. Higher interest rates might then
levels of risk — for example, lending to
be used to combat inflationary pressures. governments and large multinationals
= Business confidence levels — Lower interest rates tend to create incentives for tends to be less risky than lending to
investment expenditure due to the lower costs and hence risks of investment. private individuals.
m House prices — In many countries, house prices (the most valuable asset of
typical households) have a direct impact on the level of consumer confidence
and hence the value of consumption and potential economic growth in the Common mistake
economy. It is incorrect to assume that low
m The exchange rate — For example, lower interest rates might be needed to interest rates will stimulate aggregate
reduce the demand for the currency on the foreign exchange market. This demand and pull an economy out
will encourage the sale of exports, ceteris paribus. of recession. For example, Japan'’s
interest rates have been close to
zero since the mid-1990s yet firms
EXAM PRACTICE have struggled to survive despite the
easy access to money at almost zero
PAPER 1 cost. Low interest rates do not solve
33 Explain how monetary policy can be used to influence the level of macroeconomic problems on their
economic activity. [10] own.
The role of central banks

Executor of monetary policy — In most countries, the central bank or the
country’s monetary authority, is responsible for managing interest rates and the Keyword definition
exchange rate for its currency in order to achieve macroeconomic objectives. A central bank (or reserve bank)
Government’s bank — The central bank is responsible for the money of the is the monetary authority of a
government, including its foreign currency reserves. It maintains the accounts of country that oversees the entire
the government in the same way that commercial banks maintain the accounts banking system by managing the
of their customers. money supply, the nation’s currency
Bankers’ bank — The central bank is the regulator of the country’s and interest rates.
commercial banking system. For example, commercial banks must keep a
certain percentage of their cash reserves at the central bank so that it can
control the money supply and use these reserves in times of financial emergency. D {elladd]e]
Sole issuer of legal tender — As the supreme bank, the central bank is the The central bank will consider a range
sole issuer of bank notes and coins within the country. This helps to control the of factors before making a decision
money supply and brings uniformity and confidence to the monetary system. about changing interest rates in the
Lender of last resort — The central bank provides loans to commercial banks economy. For example, it will consider
the level of economic activity, the level
when necessary to prevent the risks of a financial crisis caused by limited cash
of inflation in the economy, and the
reserves and liquidity problems. Thus, this function helps to ensure that the outlook for the global economy:.
banking system runs smoothly.
Credit control — By controlling the cash reserves that commercial banks
must hold at the central bank, credit creation is managed more effectively. For
example, the central bank would raise the cash reserve ratio during an economic
boom to limit over-lending by commercial banks.
The role of monetary policy and

short-term demand management
Monetary policy is used to influence the level of economic activity. For
example, interest rate policy is often used to influence the level of aggregate
demand (recall that AD =C + 1+ G + (X = M)). Lower interest rates will tend
to shift the aggregate demand curve to the right for the following reasons:
= Consumption (C), investment (I) and government spending (G) are likely to
rise due to the cheaper cost of borrowing money. Households and firms with
existing loans might also benefit from lower interest repayments.
m Net exports (the value of exports minus imports) are likely to increase
because lower interest rates tend to cause a fall in the exchange rate. This
should make exports more attractive to foreign buyers, thus helping to
increase aggregate demand.
Expansionary monetary policy (or easy monetary policy) aims to increase
economic activity by reducing interest rates and/or expanding the money supply.
This makes borrowing more attractive because lower interest repayments are
charged on the loans. Therefore, expansionary monetary policy will shift the
aggregate demand curve to the right, ceteris paribus (see Figure 2.34), thereby
helping to close a deflationary (recessionary) gap.
A
LRAS
¢ Expansionary monetary policy [such as
SRAS a cut in interest rates| shifts aggregate
demand from AD, to AD;, ceferis
Price level ($)
paribus.
e This increases real national output from
Y7 to ¥, thereby closing the deflationary
gap [the difference between equilibrium
national output and the full employment
level of national cutput).
AD,
¥
O Y- Tt
Deflationary gap
Real national output
Figure 2.34 Expansionary monetary policy and deflationary gaps
If the economy operates at less than the full employment level (i.e. it is
operating on its SRAS curve), then expansionary monetary policy will tend to
It is possible for the real interest rate
increase aggregate demand with a corresponding rise in real national output.
to be negative. This happens when
However, a consequence of easy monetary policy is the potential emergence
the nominal (actual) interest rate
of inflationary pressures. This can be seen in Figure 2.34, with the average is less than the inflation rate — for
price level rising from P; to Py This is particularly the case if the economy is example, if the nominal interest
operating on the vertical part of its LRAS curve. rate is 3% whilst the inflation rate
Contractionary monetary policy (or tight monetary policy) can help to is 4.2%, then the real interest rate
close an inflationary gap. An increase in interest rates, for example, tends to is—=1.2% (i.e. 3 —4.2). This means
reduce consumption and investment in the economy, thereby reducing real that an individual with $1000 savings
national output (see Figure 2.35). would earn $50 interest, i.e. a total
of $1050 at the end of the year.
&
LRAS However, inflation causes something
e Tight monetary policy [such as higher
N interest rates) shifts the aggregate demand that cost $1000 a year ago to increase
SPAS curve leftwards from AD| fo AD,, ceferis to $1060, so in real terms the money
EE_- paribus. saved has fallen in value.
o e This shrinks real national output from Y7 fo
% Py Koo g v ¥}, so that actual output no longer
O B Lonommmrnronm i exceeds potential output.
= ' e Thus, confractionary monetary policy helps
I to close the inflationary gap, restoring Too often, students say that higher
ADy ! AD, prices back to f fom Py. interest rates reduce aggregate
© -
RS . demand because they create
incentives to save. Whilst this is
Inflationary gap partially the case, the impact on
Real national output borrowing is far more significant.
Figure 2.35 Contractionary monetary policy and inflationary gaps Interest rates tend to change by
0.25% at a time, which is barely
Tight monetary policy can be used to control the threat of inflation, an incentive for most individuals to
although higher interest rates can harm economic growth and therefore cause save more. However, an extra 0.25%
job losses in the long run. interest charge on people’s mortgages
will certainly have an impact on their
spending ability. The same applies to
firms with loans and mortgages.
Monetary policy and inflation targeting

An inflation rate target (or inflation targeting) refers to the practice of central
banks in some countries (such as Canada, Finland, New Zealand, South Africa
and the UK) to use monetary policy to achieve a specific rate of inflation. An
inflation target is used to provide a transparent goal in order to help control
inflation. This is because price stability will enhance confidence in the
economy.
Central banks use monetary policy to influence rather than to directly
determine rate of inflation.
It is the role of the government, rather than a monetary authority, to focus
on achieving and maintaining full employment and a low rate of inflation
(although monetary policy is used to achieve an inflation target, be it explicit or
implicit). If inflation is predicted to be higher than the target rate of inflation,
perhaps due to a housing boom or increased consumer confidence in the
economy, then contractionary monetary policy can be used, and vice versa.
Evaluation of monetary policy

The effectiveness of monetary policy can be evaluated through consideration of
the following factors:
Independence of the central bank allows decision makers, in theory, to act in
the best interest of the economy, without political interferences.
The ability to adjust interest rates incrementally means that policy makers
can monitor the effectiveness of monetary policy. It is common for interest
rates to change in increments of 0.25%, thus reducing the risks of causing
huge disruptions to the economy.
The ability to implement changes in interest rates relatively quickly means
that monetary policy can be used to influence and fine-tune macroeconomic
objectives. Central banks review the state of the economy and adjust interest
rates accordingly, often on a monthly basis.
Monetary policy may be preferred to fiscal policy because it can be
implemented more quickly. Tax changes require careful planning and are
time consuming, whilst government spending can be costly.
However, there are time lags to the reaction of households and firms to
changes in interest rates in the economy. This can make the effectiveness of
monetary policy less certain.
Changes in interest rates and the money supply can be destabilising to
the economy. For example, whilst the property (housing) market in many
countries is a key determinant of consumer confidence levels, it is highly
vulnerable to changes in interest rates.
Consumption and investment are not entirely dependent on interest rates.
The 2008 financial crisis meant interest rates were close to 0% in Japan, the
USA and Hong Kong, but the lack of business and consumer confidence led
to a prolonged economic recession.
In addition, households and firms have different interest elasticity of demand,
i.e. some groups are more affected by changes in interest rates than others.
This can make it difficult to estimate the extent to which monetary policy is
effective in influencing macroeconomic objectives.
The effectiveness of monetary policies aimed at increasing aggregate demand
is limited if the economy is in a deep recession because confidence levels are
low. Firms will not borrow money to invest, even at low rates of interest, if
the demand for their products remains low.
The effectiveness of monetary policies aimed at reducing aggregate demand is
limited too, as ‘hot money’ (the flow of money into the country to gain from
higher rates of interest) will increase the exchange rate. This makes exports
more expensive and so worsens the trade balance.
Conflict among government economic objectives exist, so a cut in interest
rates or an increase in the money supply (to influence the level of economic
activity, for example) can conflict with other macroeconomic objectives,
such as inflation (price stability).
The use of tight monetary policy can be counterproductive as it restricts
economic activity and discourages foreign direct investment in the country
— for example, higher interest rates raise the costs of production, which
negatively impacts on profits, jobs and economic growth.
Monetary policy influences aggregate demand rather than having a direct
impact on the economy’s long-run aggregate supply.
In the short run, monetary policy is generally more effective in dealing with
demand—pull inflation than in getting an economy out of an economic
depression, which might require the use of fiscal and supply-side policies.

PAPER 3
34 With the aid of an appropriate diagram, explain how the use of monetary
policy can help to close a deflationary (recessionary) gap. [4]
35 The diagram below shows the market for money in an economy, where
D, is the demand for money and S, shows the supply of money at
varying rates of interest.
A
Interest rate
— -
7=
|
1
1
I
I
1
1
e g
=]
T
1
|
I
I
|
I
1
1
I
O Q @ &
Quantity of money
a Outline why the supply of money curve (S,,) is vertical at the

@, quantity of money. [2]
b With reference to the diagram, explain which interest rate would
cause excess demand for money. [2]
2.6 Supply-side policies

The role of supply-side policies
Supply-side policies and the economy

Supply-side policies are aimed at increasing the production side of an economy,
i.e. boosting aggregate supply. This is achieved by improving the institutional Keyword definition
framework (the country’s system of rules and regulations) and the economy'’s Supply-side policies are
productive capacity to produce. government strategies aimed at
The productive capacity of the economy is improved by increasing the boosting the productive capacity
quantity and quality of the factors of production — for example, investment of the economy by increasing the
in education and training can improve labour mobility and enhance labour quality and/or quantity of factors of
productivity. production, for example spending
Supply-side policies are used because increases in the productive capacity on education and training to
of the economy can only be achieved through an increase in the economy’s improve the economy’s human
long-run aggregate supply, i.e. they are designed to make the economy more capital.
productively efficient in the long run.
Examples of supply-side policies include the following:
m Cuts in welfare benefits, such as unemployment benefits, to create incentives
to work.
m Labour market reforms, such as greater spending on education and training to
improve the quality and/or quantity of labour.
m Using tax cuts to create incentives to work.
= Removal of labour market imperfections, such as reducing the power of trade
unions.
Supply-side policies can be categorised as either market-based or
interventionist, although both aim to shift the LRAC curve outwards, i.e.
increasing the economy’s potential output.
Interventionist supply-side policies

The potential output of the economy refers to the productive capacity
(maximum possible output) if all factors of production are used efficiently. Keyword definition
Diagrammatically, the potential output of an economy is shown on its Interventionist supply-side
production possibility curve (PPC). policies are the deliberate attempts
The institutional framework refers to established systems, structures and by a government to deal with
contexts that shape the economic behaviour in a country, for example cultural market imperfections in the
norms and the legal system. economy, for example government
In the short run, interventionist supply-side policies (such as investment in retraining programmes to improve
human capital and new technology) increase aggregate demand but in the long the occupational mobility of the
run will increase the economy’s aggregate supply. structurally unemployed.
Investment in human capital

Human capital refers to the stock of knowledge, skills, expertise and experiences
of the workforce.
An important interventionist supply-side policy to increase human capital is
to spend on education and training to raise the skills, mobility and productivity of
the labour force. Government intervention in labour markets strives to enhance
the demand for and supply of labour. It also aims to improve labour mobility.
Investment in human capital increases national income as the expenditure
increases aggregate demand in the short run. In the long run, investment in
human capital improves the productive capacity of the economy as it increases a
country’s long-run aggregate supply.
Improved communication in the job market can help to reduce frictional
unemployment in the economy.
The increase in aggregate demand in the short run and the greater productive
capacity in the long run mean that investment in human capital is vital for
economic growth and development.
Investment in new technology

Policies that encourage investment in new technology have a short-term effect
on aggregate demand because such expenditure will increase AD, ceteris paribus.
Such policies include low interest rates and tax rebates, both of which can also
encourage foreign direct investment. However, in the long run, investment in
new technology can increase the productive capacity and productivity of the
economy, i.e. it shifts the country’s LRAS curve outwards.
Spending on research and development (R&D) can improve work
processes, thereby enhancing efficiency, for example automation in the car
making industry or the use of wireless technology to improve operations in the
workplace. R&D can also generate new products for consumption and export,
for example energy-saving light bulbs, daily disposable contact lenses, electric
cars, smartphones and tablet computers.
Therefore, investment in new technology can be an important source of
international competitive advantage.
Investment in infrastructure
As investment (I) is a key component of aggregate demand (AD=C+1+G +

(X —M)), the expenditure on improving the nation’s infrastructure will increase
AD in the short run, thus boosting economic growth, ceteris paribus. In the
long run, investment in infrastructure shifts the economy’s LRAS curve to the
right and attracts foreign direct investment. This helps the economy to flourish
further.
Examples of such investments include spending money on transportation
networks, telecommunications networks, electricity grids, waste disposal systems
and sewerage systems.
Industrial policies
Industrial policies are those that target specific key industries to promote
economic growth — for example, tax allowances can be used to protect domestic
infant industries from larger, well-known foreign rivals. Tax cuts targeted at
strategic industries can help to revive these industries, helping them to grow in
the long run.
A combination of tax breaks and subsidies on commercial loans can create
incentives for firms to locate in less prosperous areas of a country, thus reducing
unemployment and increasing the economy’s long-run aggregate supply.
Subsidies can also be granted to firms that hire youth workers, mature staff
and discouraged workers (those suffering from long-term unemployment).
Subsidies might also be offered on loans to encourage business start-ups.
Industrial policies, like all supply-side policies, can improve economic welfare
in terms of lower unemployment and increased earnings for those working in
these industries. Thus, industrial policies improve the likelihood of sustainable
economic growth.
Common mistake
EXAM PRACTICE Some students seem to think that
industrial policy is used primarily to
PAPER 1 increase competition in an economy.
36 Examine how supply-side policies can help to achieve any two This is incorrect as industrial policy is
macroeconomic objectives. [10] an interventionist supply-side policy.
Market-based supply-side policies

Both interventionist and market-based supply-side policies can be used to _
increase the long-run aggregate supply (LRAS) of the economy, thereby Keyword definition
boosting its potential output. Examples of market-based supply-side policies Market-based supply-side
include the following: policies focus on allowing the free
= income tax reforms to improve the incentive to work market to operate with minimal
m labour market reforms to increase aggregate supply government intervention by
= policies to encourage competition and efficiency improving market incentives
® tax incentives to encourage foreign direct investment. to increase investment and
productivity.
Policies to encourage competition

Privatisation is the sale or transfer of state-owned assets and operations to the
private sector. [t can make firms become more efficient in order to make a profit
and to survive.
Deregulation is the reduction or removal of barriers to entry into certain
industries to make markets more competitive and efficient, for example
getting rid of government rules and directives in a certain industry to promote
competition and greater efficiency.
Anti-monopoly regulation can also be used to promote competition in
targeted industries. This refers to competition law that controls the restrictive
practices of monopolists, hence limiting their market power in the industry.
On an international scale, trade liberalisation involves the reduction or
removal of trade barriers, such as tariffs and subsidies, to encourage competition
and efficiency. Allowing the free movement of capital flows and encouraging
foreign direct investment are further examples.
Labour market reforms

Supply-side economists argue that the underlying causes of imperfections in the
labour market are high rates of income tax and excessive regulations that reduce Keyword definitions
incentives to work. Supply-side policies that target labour market reforms, such Labour market reforms are
as lower rates of income tax, create incentives to work, i.e. they motivate people government policies designed
to seek employment opportunities. to create greater flexibility and
Market-based supply-side policies aim to make the labour market more efficiency in the labour market,
efficient, i.e. responsive to changes in the market forces of demand and supply. for example reducing the
A flexible labour force is responsive to changes in the economy — for example, power of labour unions, cutting
workers are able to adapt from declining industries to growing industries. unemployment benefits and
Reducing unemployment benefits can make the labour market more abolishing the national minimum
responsive to market forces, as the unemployed can no longer rely on welfare wage.
payments and so have a greater incentive or need to seek employment. A trade union is an organisation
Reducing the power of trade unions improves the efficiency of the labour that represents the common
market. For example, trade unions push for a (higher) national minimum interest of its members in work-
wage but this can be highly costly to firms, thereby artificially reducing their related matters, for example in
international competitiveness. negotiations over wages and
working conditions.
Incentive-related policies
Reducing direct taxes, such as cutting personal income tax for those earning
low incomes, can create incentives for people to work or to seek employment
opportunities. Hence, such market-based supply-side policies are designed to
reduce the level of unemployment.
Cuts in business taxes are used to create incentives to invest by reducing the
financial risks of investments. Similarly, cuts in capital gains taxes (imposed on
the profit of an asset once sold) can also encourage risk taking and investments
in the economy.
Evaluation of supply-side policies
The strengths and weaknesses of

supply-side policies
The advantages of supply-side policies are summarised in Table 2.7.
Table 2.7 The advantages of using supply-side policies to achieve

macroeconomic objectives
Improved economic Supply-side policies can be used to achieve sustainable economic growth by increasing the
growth potential capacity of the economy over time.
Lower inflation As supply-side policies increase the productive potential of the economy, they help to prevent
the general price level from rising beyond control.
Lower unemployment An increase in the productive capacity will tend to increase national output, thereby creating
jobs in the economy in the long term. Supply-side policies can also help to reduce both frictional
and structural unemployment.
Improved balance of Since supply-side policies can improve productivity and national output without pressures on
payments the general price level, the international competitiveness of the country should improve, thus
helping to increase exports.
Improved equity Interventionist supply-side policies can lower the natural rate of unemployment in the economy,
thus reducing inequality.
The limitations of using supply-side policies are outlined in Table 2.8.
Table 2.8 The limitations of using supply-side policies
Time lag The main criticism of supply-side policies is the time that it takes to reap the benefits. For
example, it might take decades for a nation to enjoy the benefits of an improved education
system or infrastructure in the country.
Decreased equity Interventionist supply-side policies do not necessarily improve equity in the distribution of
income in the economy, i.e. economic growth can create greater disparities (inequalities) in
income distribution.
Effect on the Supply-side policies strive to increase the potential output of the economy but this can come at
environment a huge opportunity cost to the natural environment.
=laileJ1Bcd INnternational economics
3.1 International trade
Free trade
The benefits of trade

International trade is the exchange of goods and services beyond national
borders. It involves the sale of exports (goods and services sold to overseas
buyers) and imports (foreign goods and services bought by domestic households
and firms). Countries need to trade because scarce resources are unevenly
distributed between countries, i.e. countries have different factor endowments.
Keyword definition
Economists believe that the benefits of free international trade tend to
Free trade occurs when nations
exceed the costs, i.e. although not everyone gains from free international
can exchange goods and services
trade, or gains equally, the net benefits to society are positive. The benefits of
without any trade barriers, such as
international trade are outlined below:
quantitative limits or taxes being
m Lower prices for consumers — Free trade reduces the costs of trading. For
imposed on imports.
example, unfavourable weather conditions in Sweden mean it is better off
importing tropical fruits from Jamaica.
m Greater choice for consumers — Free trade enables consumers and firms to Expert tip
access a larger variety of goods and services from different producers around
Make sure you can distinguish
the world. For example, Germans can choose to buy Lexus cars from Japan between the merits of international
rather than being limited to Audi, BMW or Mercedes models. trade and the merits of free trade —
m The ability of producers to benefit from economies of scale — By operating on they are not quite the same because
a larger scale in international markets, free trade enables firms to benefit from not all international trade entails free
economies of scale, i.e. cost savings that can be passed onto consumers in the trade. Thus, the merits of free trade
form of lower prices. (without any trade barriers) are greater
m The ability to acquire needed resources — Through trade, countries can than the benefits of international
access natural resources and capital goods that are not available domestically trade (which may involve some trade
to further their production. For example, the Maldives can purchase laptops, barriers).
motor vehicles and Hollywood movies from the USA.
= A more efficient allocation of resources — Free trade benefits the economy
as it encourages an efficient allocation of the world’s scarce resources. Free
trade forces domestic firms to focus on improving the quality of their output
due to foreign competition.
m Increased competition — Trade ensures that domestic firms become exposed
to competition from foreign firms. Hence, domestic firms are forced to
become more efficient, i.e. to produce goods and services at the lowest
possible cost.
m A source of foreign exchange — When countries sell exports, firms and
governments acquire foreign exchange (foreign currencies). This enables
them to make payments to other countries for the purchase of foreign goods
and services.
m Increased market size — International trade enables firms to earn more
revenues and profits. For example, American firms can sell products to a
domestic market of 316 million people, but can sell to a much larger market
of more than 2.4 billion potential customers in China and India.
m Improved international relations — The absence of trade barriers encourages
international trade and cooperation between countries. By contrast, if a
country uses trade barriers, then other countries are likely to retaliate by
doing the same.
EXAM PRACTICE Common mistake

It is incorrect to assume that free trade
PAPER 2 improves the welfare of all members
1 Bangladesh is one of the world’s largest producers of rice and tropical fruits. In of society. For example, some
Brunei Darussalam, crude oil and natural gas account for around 90% of the exporters might lose out due to the
country’s gross domestic product. This makes Brunei Darussalam one of the fierce competition from foreign rivals.
leading producers of oil in Southeast Asia.
a Outline one problem for Brunei Darussalam relying on oil exports. [2]
b Explain two reasons why countries such as Bangladesh and Brunei
Darussalam trade with each other. [4]
¢ Explain how Bangladesh's export of rice and tropical fruits helps its
farmers to achieve economies of scale. [4]
Absolute and comparative advantage (HL only)

An absolute advantage in the production of a good or service gives a country
a competitive edge because it is more productive and efficient. If country A Keyword definitions
spends $10m to make 40,000 units of output of a particular good whilst country Absolute advantage occurs when
B can only produce 30,000 units with the same amount of money, then country a country can produce more of
A has an absolute advantage in the output of that product. By specialising a good or service than another
in the output of the goods or service, the result is increased production and country using the same amount of
consumption (see Figure 3.1). resources (or is able to produce the
The conceprt of absolute advantage was coined by Scottish economist Adam same amount of a good or service
Smith (1723-90), extending his doctrine of specialisation and the division of using fewer resources).
labour. If countries specialised in the output of what they are most efficient at The term factor endowments
producing, world output would subsequently increase. refers to the quantity and quality of
Absolute advantage occurs mainly because different countries have different factors of production available in a
factor endowments — for example, Saudi Arabia is well endowed with oil, whilst country, such as natural resources
Thailand has the natural climate suitable for harvesting rice. and human capital. Countries well-
By contrast, some countries have an absolute disadvantage, i.e. they are endowed in natural resources tend
inefficient and unproductive in the output of given goods or services relative to to have a comparative advantage in
their trading partners. products using such resources.
50,000 ® Brazil's production possibility frontier (PPF)

shows that it can produce 100,000 wunits
_ 40.000 of coffee [compared with Vietnam's 50,000
K £ units) or 50,000 units of timber {compared
E with Vietnam's 40,000 units).
® Thus, Brazil has an absolute advantage in
the output of both coffee and timber.
Vietnam
—
0 50,000 100,0000
Coffee
Figure 3.1 Absolute advantage

Worked example
Suppose two countries, with the same amount of resources, produce books and clothes. Also assume that both countries
divide their resources equally between the production of books and clothes. The pre-trade situation is shown below:
Country Books (units) | Clothes (units)
Alpha 1000 500

Beta 750 1500
Total output 1750 2000
From the above, we can see that Alpha has an absolute advantage in producing books (it is more productive in producing
books), whilst Beta has an absolute advantage in the output of clothes (1500 units compared with Alpha’s 500 units).
If both countries decide to specialise based on their absolute advantage, then Alpha gives up 500 units of clothes to
produce an extra 1000 units of books. Similarly, Beta gives up 750 units of books to specialise in the production of
clothes, increasing its total output by an extra 1500 units:
Alpha 2000 0
Beta 0 3000
Therefore, total output increases via the countries specialising in the output of the product in which they hold an
absolute advantage. If Alpha and Beta now trade 800 units of their surplus with each other, the post-trade situation
now looks like this:
Alpha 1200 800
Beta 800 2200
Through trade, Alpha has an extra 200 units of books and an extra 300 units of clothes. Similarly, Beta has 50 more
units of books and 700 more units of clothes.
The theory of comparative advantage was put forward by British economist Keyword definition
David Ricardo (1772-1823), who suggested that countries should specialise Comparative advantage
in goods and services in which they have a comparative advantage (relatively exists when a country
lower unit costs of production). The theory suggests that countries should can produce a given
produce and trade products in which they have a comparatively low opportunity amount of output at a
cost, even if the trading partner has an absolute advantage in the output of both lower opportunity cost
products (see Figure 3.2). than another country, i.e.
A ® Despite Brazil having an absolute advantage it gives up less resources
in the output of both coffee and timber, than other countries in
comparative advantage exist. producing a certain good
50,000 ® Brazil's opportunity cost of producing timber
or service.
is 2 units of coffee, whereas Vietnam's
40,000 opportunity cost is only 1.25 units of coffee.
Timber
® Similarly, Vietnam's opportunity cost of coffee

Brazil is 0.8 units of timber but it is only 0.5
for Brazil. Hence it is cheaper for Brazil fo
give up producing fimber.
® Therefore, Brazil should specialise in and
Yl export coffee, whilst Vietnam should specialise
0 50,000 100,000 > in the output of timber.
Coffee
Figure 3.2 Comparative advantage

Sources of comparative advantage include differences in:

m factor endowments — for example, major oil exporting countries such as
Saudi Arabia, Russia and the United Arab Emirates are well endowed in oil
supply. These countries can increase production and consumption through
specialisation and international trade.
m levels of technology — for example, workers with access to the latest
machinery and technology will be far more productive than those using
outdated techniques.
m investment in research and development (R&D) — this can give countries
a competitive advantage in terms of innovation and inventions. R&D
expenditure can also generate new work processes that reduce the relative
costs of production.
m inflation — this can damage the comparative cost advantages of a country as
higher prices mean that foreign buyers are less willing and able to purchase
the exports of domestic firms.
m exchange rate fluctuations — these can affect the relative prices of exports and
imports. A long-term unfavourable change in the exchange rate can cause a
reduction in demand from domestic and overseas customers.
Worked example
Suppose that two countries, with the same amount of resources, produce books and clothes. Also assume that both
countries divide their resources equally between the production of fruits and toys. The pre-trade situation is shown below:
Country Fruits (units) | Toys (units)
Delta 3000 1500
Gamma 500 1000
Delta has an absolute advantage in the production of both toys and fruits, i.e. it is better at producing these goods than
country Gamma. However, Gamma can produce toys at a lower opportunity cost:
Country Fruits (units) | Toys (units) Opportunity cost
Delta 3000 1500 2.4
Gamma 500 1000 0.5:1
Whilst Delta has to give up 2 units of fruits to gain 1 unit of toys, Gamma only has to give up 0.5 units of fruits to produce
1 unit of toys. Hence, Gamma should specialise in the output of toys. Likewise, if Delta gives up 1 unit of toys, it can produce
2 units of fruits, whereas Gamma can only gain 0.5 units of fruits. Hence, Delta should specialise in the output of fruits.
Suppose Gamma specialises entirely in toys and Delta decides to switch 500 units of toys to produce (1000 extra units
of) fruits instead. Hence, the total output increases by 500 units of both fruits and toys:
Delta 4000 1000
Gamma 0 2000
If the countries trade their surpluses, say 700 units of each product, both countries now have more of fruits and toys
compared with what they started with, when there was no international trade:
Delta 3300 1700
Gamma 700 1300


PAPER 3
2 Use the production possibilities data below and an appropriate diagram to
explain which country should specialise in the production of Aris and which
country should specialise in the output of Walkers. [4]
COUNTRY ARIS (UNITS) WALKERS (UNITS)

Farrowland 1500 600
Mayland 2000 500
Limitations of the theory of comparative

advantage (HL only)
The theory has several limitations:
m [t assumes that comparative advantage is fixed, whereas in reality it is not.
For example, Hong Kong no longer has a comparative advantage in textiles
and the UK no longer has a relative cost advantage in the output of steel and
coal.
m [t assumes that there are no barriers to international trade, although this is
not necessarily the case in the real world, with tariffs and quotas still being
imposed by countries.
m [t is a static model, which ignores the fact that comparative advantages can
shift between countries over time.
m Whilst the theory explains how countries can gain from trade, it ignores the
disparities of the relative gains from trade, i.e. some countries will gain more
Expert tip
than others due to their better bargaining position and terms of trade.
m Transportation costs of trade are ignored in the calculation of comparative When evaluating the real-world
advantage. So, even if Australia is able to produce textbooks relatively relevance and limitations of
cheaper than the EU, transportation costs to Europe could mean Australia comparative advantage, ensure that
you do two things: (1) discuss the
has a comparative disadvantage.
shortcomings of the assumptions of
m [t is assumed that there is perfect occupational mobility of resources, i.e. the model of comparative advantage
factors of production can be switched between different industries without and (2) consider the arguments for
any loss of efficiency. This contradicts the idea of increased gains from trade and against free trade.
through specialisation.
The World Trade Organization (WTO)

The World Trade Organization (WTO) was established in 1995 to promote
trade liberalisation, to oversee multilateral trade agreements (free trade
agreements between multiple countries) and to resolve trade disputes between
member states.
The objectives of the WTO are as follows:
m To encourage free international trade. Member states are obliged to
reduce and remove artificial trade barriers such as subsidies (which reduce
production costs for domestic firms).
s To remove discriminatory treatment in trade relations between member
nations (except for those in trading blocs that have their own set of agreed
trade rules).
m To help provide trade opportunities for economically developing countries in
order to enhance their growth and development prospects.
The WTO has six functions:
s Administering WTO trade agreements — The WTO provides a forum for
members to negotiate trade rules and agreements, which become binding
contracts for governments to keep their trade policies within agreed
parameters.
1 16 Economics for the IB Diploma
Forum for trade negotiations — Members of the WTO are involved in

‘Rounds’ of negotiations. There have been nine Rounds so far, with the first
one focusing on lowering tariffs on imported goods. The latest Doha Round
of negotiations started back in 2001.
Handling trade disputes — The WTO acts as an arbitrator in trade disputes
between member states. [t acts to settle such disputes in a quick and objective
manner.
Monitoring national trade policies — The WTO regularly monitors the
national trade policies of its member states through its Trade Policy Review
Mechanism. This serves to encourage accountability and transparency on
trade policies on a multilateral level.
Technical assistance and training for economically developing countries —
Dol dhid]e]
Trade-related technical support and training are provided to help low-income
countries to better understand WTO obligations and agreements and thus Note that in some special circumstances
build their capacity to trade. the WTO will support maintaining
trade barriers (rather than promoting
Cooperation with other international organisations — The WTO collaborates
free trade), for example to protect
with other organisations to promote economic cooperation and growth, such consumers from the spread of disease
as the World Bank and the Organization for Economic Cooperation and (e.g. bird flu and swine flu).
Development (OECD).
Restrictions on free trade: trade

protection
Keyword definitions
Trade protection is the use of barriers to trade to safeguard a country from
excessive international trade and foreign competition.
Barriers to trade are obstacles to free trade, imposed by a government to
safeguard national interests by reducing the competitiveness of foreign firms.
Types of trade protection

Tariffs are import taxes — for example, the USA has used a 35% tariff on all
tyres imported from China. Tariffs raise the costs of production to importers,
thus raising the price of foreign goods in the domestic market, and thereby
lowering the amount of imported products (see Figure 3.3).
A tariff increases costs of production, thus shifting the supply curve up from
Sworld (free trade) tO Srariff, forcing the price up from P; to P;. Figure 3.3 shows the
effects of tariffs (or customs duties) on various stakeholders:
Domestic producers — Domestic firms will tend to gain from the tariff as they
will receive a higher price (P; rather than P;), and sell a larger quantity (Q;
rather than ;). The higher price also means that producer surplus increases
by the area a.
Foreign producers — Importers tend to lose out as the tariff reduces their price
competitiveness and they are only able to sell a reduced amount; they could
sell Q; — Q4 output before the tariff, but are only able to sell Q; — Q5 after the
imposition of the tarift.
Consumers — The value of consumer expenditure on imports is shown by
the area ¢ + e. As consumers now pay a higher price of P3, there is a loss in
consumer surplus, as shown by the area a + b + ¢ + d. Hence, consumers lose
out from the imposition of a tariff.
The government — Tariffs help to raise revenue for the government. The
tariff is shown by the vertical distance between P and P, and as the amount
imported is shown by the distance (Q; — (3, the government gains area c as
tax revenue.
Society — There is a welfare loss as a result of the imposition of the tariff, as
shown by the areas b + d.
Supply
& Expert tip

8 Only higher level students need to
o
P? ; ; 5+h::|rfl"F be able to use the tariff diagram
p a_~b ¢ ic (Figure 3.3) to calculate the effects
]/:/E: i ! Swor|d {free trade)
1 i e | | on domestic producers, foreign
; : L Demand producers, consumers and the
Y
O Gh Gy Qy Gy government.
Quantity supplied
Figure 3.3 The effects of tariffs (HL only)

PAPER 3
3 Use the diagram below to calculate the following:
a Consumer surplus before the imposition of the tariff. [2]
b Producer surplus before the imposition of the tariff. [2]
¢ Consumer surplus after the imposition of the tariff. [2]
d Producer surplus after the imposition of the tariff. [2]
e Revenue to the government after the imposition of the tariff. [2]
f The welfare loss after the imposition of the tariff. [2]
A
350 Supply
&
iS 200
i s :
1.50 | : ; S+Tc|rrFF
100 / et Sworld fiee frade]

507 I
1
D oL.
0 10 20 30 40 50
Quantity supplied ("O00kg)
Quotas are quantitative limits on the sale of a foreign good into a country —
for example, Indonesia imposes import quotas on fruits and vegetables from
Thailand. This limits the quantity imported and so causes an increase in the
market price of the foreign goods (see Figure 3.4).
Prior to protection, the volume of imports is shown by the distance Q) — Q4.
The quota is shown by the horizontal distance between Sg,mestic and
Sdomestic
+ quota (0T Q1 and Q3). This limits the amount of imports to Q — Qg. It
is not possible to import the product below a price of Pyopg.
A
Sdomesflc
Sdomestic + quota
Price {$)
quota
Pwerld
Ddo mestic &

-
O Q@ Q@ Q@ o
Quantity supplied (units)
Figure 3.4 The effects of quotas
Figure 3.4 shows the effects of import quotas on various stakeholders: Expert tip
m Domestic producers — The quota on imports enables domestic firms to supply
Higher level students need to be able
more to the market (Q; rather than Q). They are also able to charge a
to use the quota diagram to calculate
higher price of P, raising their revenue to the area P, x, Qz, 0. This
the effects on domestic producers,
can have a positive impact on domestic jobs. foreign producers, consumers and the
m Foreign producers — Before the imposition of the quota, revenue was government.
a+ b + c. After the quota is imposed, imports are reduced, so revenue falls to
b + c. Hence, they will lose out from the imposition of a quota.
m Consumers — Domestic consumers lose from the imposition of a quota as they
are charged a higher price (P rather than Py,.q4). In addition, they could Expert tip
previously buy Q4 under free trade, but can only buy Q4 after the quota is Critics of trade protection argue that
enforced. tariffs and quotas are regressive in
m The government — Whilst the effects of a quota are similar to those of a tariff, nature as consumers are forced to
there is no direct impact on the government as the quota does not generate pay higher prices than under free
any tax revenue. trade. The higher prices account for
a larger proportion of spending for
m Society — The reduced consumption resulting from the quota shifts
low-income earners, thus there is a
production away from more efficient imported products towards less efficient detrimental impact on the distribution
domestically produced goods. This misallocation of resources results in a net of income.
welfare loss, as shown by the shaded green area.

PAPER 3
4 Use the diagram below to identify the following:
a Consumer surplus before the imposition of a quota. [1]
b Producer surplus for domestic firms before the imposition of a quota. [1]
¢ Consumer surplus after the imposition of a quota. [1]
d Producer surplus for domestic firms after the imposition of a quota. [1]
e The welfare loss following the imposition of the quota. [1]
A
Sdomestlc
Sdomestic + quota
Price ($)
Siwvorid
Ddomesfic
Quantity supplied (units)
Subsidies are a form of financial assistance to local firms to help them

Expert tip
compete against foreign imports by lowering the costs of production. This helps
to protect local jobs — for example, the European Union subsidises its farmers to Higher level students need to be
encourage agricultural output (see Figure 3.5). able to use the subsidy diagram to
There are two types of subsidy that can be used to protect domestic industries: calculate the effects on domestic
producers, foreign producers,
m Production subsidies, the most common form, help to reduce the production
consumers and the government.
costs for domestic firms. The analysis below refers to production subsidies.
m Export subsidies are less wide-ranging as they are targeted at protecting
specific export-orientated firms.
Like quotas, the use of subsidies does not create any revenue for the
government. Instead, subsidies use up the government’s budget.
Figure 3.5 shows the effects of subsidies on various stakeholders:
m Domestic producers — Domestic firms gain from the subsidy as they are able
to supply more (Q; rather than Q). The amount received by domestic firms
is shown by the green shaded area. Note that they would still sell at the world
price of P,, after receiving the subsidy.
m Foreign producers — Before trade protection, foreign firms were able to sell ek
(93 — (21 amount of imports. However, the subsidy reduces the amount of
e : y When evaluating the use of subsidies
imports to Q3 — (.
as a type of trade protection, bear in
m Consumers — The consumption of the product is not affected as the price
mind that they can help to increase
remains at the world price, P,, so Q3 is traded. Consumers do, however, buy domestic employment (as local firms
more domestic goods, so whether they gain or lose depends on the relative are able to increase their output) but
quality of the foreign goods. the counter-argument is that there is
m The government — There is a negative impact on the government’s budget a huge opportunity cost to subsidising
due to the expenditure on production subsidies. Taxpayers are also worse off inefficient firms in the economy.
(shown by the green shaded area) as there is an opportunity cost of using this
money for subsidies.
Sdo mestic
Ssubsldy
Price {$)
;o
. ! Sworld (free tradel

| i D r.
O q Gh Q3
Quantity ("000kg)
Figure 3.5 The effects of subsidies on domestic producers

PAPER 3
5 Use the diagram below to calculate the following:
a The cost of the subsidy to the government. [2]
b The amount of imports before government intervention. [2]
¢ The amount of imports after government intervention. [2]
d The total amount spent by domestic consumers under free trade. [2]
e The total amount spent by domestic consumers after the imposition
of the subsidy. [2]
A
Sdomes’rlc
Ssubsldy
&
e
o
S .
10 7 I ) S‘W‘DI’ Id (free hade]
2 Tade
i r D .
O 5 12 15 25 30 -
Quantity [millions)
Administrative barriers are bureaucratic rules and regulations that

countries use as a form of protection, for example strict rules regarding food
safety, environmental standards and product quality. Complying with these
administrative barriers increases the costs for foreign firms.
Embargoes are bans on trade with a certain country, often due to political
and/or economic disputes (although they can be used for health and safety
reasons). An embargo rarely benefits local consumers, who suffer from a lack of
choice and higher prices due to the lack of supply.
Exchange controls are restrictions on the quantity of foreign exchange that
can be bought or sold by domestic residents, for example daily limits on the
amount of foreign currency that tourists or investors can exchange, thus limiting
the amount of foreign exchange available to importers.
EXAM PRACTICE
PAPER 2
6 Since 2009, China has been the world’s largest producer, consumer and
exporter of tyres, accounting for over 25% of the world’s output of car tyres.
The China Passenger Car Association reported that over 20 million new cars
were sold in China in 2013, with annual sales growth of over 10% expected
over the next few years.
According to the USA's Bureau of Labor Statistics, the average US employer
had to pay about $35 per hour (salary and benefits) to hire a production
line worker whereas an employer in China could do the same for just $1.36
per hour. America simply could not compete, thus prompting the need for
protectionist measures.
a With reference to the above information, explain two reasons why
countries use trade protection. [4]
b Discuss which method of trade protection would be best for the USA to
impose. Justify your answer. [8]
Arguments for trade protection (arguments

against free trade)
Trade protection can help to protect domestic jobs. In extreme cases, fierce
competition from foreign rivals can even force domestic firms out of business if
there is no trade protection.
Protectionism might be used for reasons of national security, i.e. to safeguard
the country from being too reliant on certain imports from other countries
(such as weapons and war machines). Protection is vital during times of political
conflict and turmoil such as a war.
Protectionist measures help to safeguard infant industries (new,
unestablished businesses) from foreign competition — for example, subsidies
help to reduce costs of production, quotas help to limit the degree of rivalry and
tariffs help domestic sunrise industries to gain a price advantage.
Protection is used to maintain health, safety and environmental
standards in the country. Governments may set minimum health, safety and
environmental standards for imported products such as medicines, food products
and motor vehicles to protect its citizens.
Trade protection prevents dumping and other forms of unfair competition.
Dumping occurs when foreign firms sell their products in large quantities at prices
deliberately below those charged by domestic firms, often below the cost value.
The impacts of anti-dumping protection include:
m Higher domestic consumption caused by lower expenditure on imports.
Higher sales and profits for domestic firms.
m [mprovement in the balance of payments on the current account for the
protected country.
Protection is a means of overcoming a balance of payments deficit. If a Expert tip
country’s expenditure on imports exceeds the revenue earned from its exports,
protectionist measures can be used to rectify this imbalance. The most common form of trade
protection is the use of tariffs. All
Protection can also be a source of government revenue. For example, India
other types of trade protection are
imposes a $535 per 10 gram tariff on the import of gold, thus helping to raise tax
collectively known as non-tariff
revenue for the government. barriers.
Arguments against trade protection (arguments

for free trade)
A misallocation of resources — Government intervention can distort market
signals and so lead to a global misallocation of resources. For example, protected
Expert tip
firms and industries can become too reliant on the government and thus
become inefficient. Whilst trade protection can provide
The danger of retaliation and trade wars — Other countries are likely to react short-term benefits for a country,
most economists believe that it is
by retaliating and imposing their own trade barriers. Such actions can cause
detrimental to economic growth and
trade wars (trade disputes), which ultimately hinder global economic growth development in the long term. Indeed,
and prosperity. such a view is supported by the World
The potential for corruption — Trade restrictions can create opportunities for Trade Organization.
bribes and the illegal smuggling of goods into a country.
Increased costs of production due to lack of competition — Protection can
create a lack of incentives for domestic firms and industries to control their costs
of production.
Higher prices for domestic consumers — Protectionist measures mean that
domestic consumers might not be able to purchase lower-priced imports, which
could be of higher quality than those produced domestically.
Increased costs of imported factors of production — Due to trade protection,
domestic producers might need to pay higher prices for vital imported raw
materials and components. This could lead to imported inflation, thus leading
to higher domestic prices.
Reduced export competitiveness — The lack of foreign competition and
incentives to be innovative means that the protection of domestic producers
can lead to inefficiencies and hence a decline in the country’s international
competitiveness.
3.2 Exchange rates

Freely floating exchange rates
Exchange rates are fundamental to international trade simply because different
countries use different currencies. The demand for exports of goods and services
falls if they become dearer, ceteris paribus. Similarly, the demand for exports
should rise if the price of imports becomes more expensive. Keyword definition
The foreign exchange market is the marketplace where national currencies An exchange rate is the price of
can be bought and sold. one currency measured in terms of
other currencies — for example, the
exchange rate of Australian dollars
(AUD) to Chinese yuan (CNY)
might be AUD1 = CNY5.5 (or 1
PAPER 2 yuan = AUDO.18).
7 With reference to the diagram below, calculate the exchange rate in terms
of US dollars. [2]
A
S¢
S
£
535 1.587 -—moomeo .
oo
O =
.1
n & I
= |
i De
O Q -
Quantity of pounds (£)

PAPER 3
8 Suppose the exchange rate between the British pound (GBP) and the US dollar
(USD) is GBP1 = USD1.55. Calculate the price for customers in Britain buying
American cars priced at USD35,500. [2]
9 a If the exchange rate of the US dollar to pounds sterling is $1 = £0.65,
calculate the price paid in pounds sterling by a British tourist spending
$45 on a theme park ticket in Florida, USA. [2]
b If the US dollar falls against the pound sterling to $1 = £0.6, calculate
the new amount that British tourists would have to pay in pounds
sterling for the same entrance ticket. [2]
10 a Suppose the exchange rate between the Australian dollar (AUD) and the
Chinese yuan renminbi (CNY) is AUD1 = CNY6.5. Calculate the price for
customers in China of buying textbooks priced at AUD65 from Australia. [2]
b Suppose that the exchange rate between the Canadian dollar ($) and
the British pound (£) is $1 = £0.65 and the euro (€) is $1 = €0.75.
Calculate the exchange rate of the British pound against the euro. [2]
Determination of freely floating exchange rates

In a freely floating exchange rate system, the value of a currency is determined
by the demand for, and supply of, the currency on the foreign exchange market —
for example, overseas tourists buy (demand) the currency by selling their own
(foreign) currencies.
An appreciation of the currency occurs when there is an increase in the
value of the exchange rate relative to another currency operating in a tloating
exchange rate system. Exports will tend to become more expensive whilst
imports will tend to become relatively cheaper.
A depreciation of the currency occurs when there is a fall in the value of the
exchange rate relative to another currency operating in a floating exchange rate
system.
An exchange rate that is set above the equilibrium level causes excess supply
of the currency, causing a subsequent fall in the exchange rate, i.e. equilibrium is
restored by market forces.
Countries that adopt a freely floating exchange rate system include: Belgium,
Chile, Luxembourg, Spain, Japan, New Zealand, Sweden and the United
Kingdom.
In Figure 3.6, higher demand for the Canadian dollar (CAD), perhaps due
to higher interest rates than in Brazil, is shown by a shift in demand from D; to
D;. This raises the exchange rate of the CAD from 2.05 Brazilian real (BRL)
to 2.25.
A
5 Sy
B 225 Lowosso NS
B 205F -
@
O
B
Dy Dy
O Quarnt >
vantity (CAD)
Figure 3.6 Currency appreciation of Canadian dollar

EXAM PRACTICE
PAPER 2
11 a Explain, with the aid of a numerical example, what is meant by an
‘appreciation’ in the value of a currency. [2]
b Discuss the likely effects of a country’s currency appreciation on its
exports and imports. [8]

PAPER 3
12 The exchange rate of British pounds (£) in terms of Hong Kong dollars ($) is
given by the following demand and supply functions:
Qq= 150 — 5P
Q,=-25+9P
Use the above information to:
a calculate the equilibrium exchange rate [2]
b calculate the equilibrium quantity (in billions of British pounds) traded [2]
¢ plot the demand and supply curves and identify the equilibrium
exchange rate [4]
d plot and identify the new equilibrium exchange rate if the supply
function changes to Q, = —32 + 9P. [2]
Causes of changes in the exchange rate

A change in any factor that affects the demand for, or supply of, a currency will
have an influence on the exchange rate. These factors include the following:
m Foreign demand for a country’s exports — An increase in the demand
for exports, perhaps due to improved quality or successful advertising,
will increase the demand for the country’s currency. Hence, there is an
appreciation of the currency, ceteris paribus.
Domestic demand for imports — An increase in the demand for imports,
perhaps due to an increase in the competitiveness of foreign firms, causes
an appreciation of the foreign currency. The higher demand is required to
facilitate the purchase of foreign goods and services.
Relative interest rates — A cut in interest rates in the economy will tend to
reduce incentives for investors, so they sell the domestic currency in search
of investments with better returns. This reduces the exchange rate, ceteris
paribus.
Relative inflation rates — An increase in the price of goods and services Expert tip
caused by domestic inflation will tend to decrease the demand for exports. All these factors can affect the
Therefore, the exchange rate will tend to fall in value as a result of exchange rate under a freely floating
inflation. exchange rate system. In addition,
Investment from overseas in a country’s firms, including: government intervention in the
0 foreign direct investment (FDI) — Inward FDI boosts the demand for a foreign exchange market can affect
currency — for example, Nissan’s factories in India require the Japanese the exchange rate. For example,
carmaker to buy Indian rupees to pay for labour and other production costs. if increased demand for US goods
causes an appreciation of the dollar,
By contrast, outward FDI increases the supply of a currency.
the US Federal Reserve can sell its
O portfolio investment — Foreign currency is demanded for the purchase of
dollar reserves (increasing its supply),
financial investments abroad, such as stocks, shares and bonds of overseas causing a fall in the value of its
firms and governments. Domestic currency is supplied when banks and the currency.
government lend money to overseas firms and governments.
Speculation — Foreign exchange traders and investment companies move

money around the world to take advantage of higher interest rates and
variations in exchange rates to earn a profit. As huge sums of money are
involved, it can cause exchange rate fluctuations.
An appreciation of the currency is caused by an increase in the demand for
the currency and/or a fall in the supply of the currency (see Figure 3.7).
A depreciation of the currency is caused by a decline in the demand for
the currency and/or an increase in the supply of the currency (see Figure 3.8).
e 5 .
= =
2 3
T L;_E.& B et | T o FRa
o§ ERypommeneag K| | =8 e,
N
| : D,
2 ‘_
© Q@ O
Quantity ($bn) Quantity ($bn)
Figure 3.7 Causes of currency appreciation
A
Price (€ per §)
Price € per )
———
m
2
-—
132
m
| I D2 L.
O 6y O
Quantity [$bn) Quantity [$bn)
Figure 3.8 Causes of currency depreciation
The effects of exchange rate changes

Exchange rate fluctuations have an impact on macroeconomic objectives:
s Employment — An appreciation of the currency will tend to reduce the Expert tip
demand for exports, leading to deteriorating profits. In the long run, this will When analysing the impact of
cause job losses (unemployment) in export-oriented industries. changes in exchange rates, students
m Inflation — Unemployment caused by the currency appreciation leads to should consider time lags. Whilst
lower consumption in the economy, thus reducing the inflation rate. If fluctuations in the exchange rate
the country relies heavily on certain imports, such as oil or food supplies, affect the economy, the impacts
the higher exchange rate helps to reduce the general price level even take time to happen, i.e. there is
further. a time delay between a change in
the exchange rate and its impact
m Economic growth — In the long run, economic growth is likely to fall due to
on economic growth, employment,
the combination of lower export sales and higher unemployment resulting inflation and the balance of payments.
from the higher exchange rate.
m Balance of payments — A currency appreciation tends to cause a fall in
exports because it is more difficult to sell goods and services in overseas
markets at a higher price. Cheaper imports leads to rising import penetration.
Therefore the current account balance worsens.
Exchange rate fluctuations also affect different stakeholders in different ways:
Customers have greater purchasing power when the exchange rate increases
— for example, if the exchange rate changes from $1.6 = £1 to $1.4 = £1, then
Americans would need fewer dollars to buy British goods and services.
m Exporters face more difficult trading conditions when the exchange rate Expert tip
increases because the prices of their goods and services become more
Note that the impact of a change in
expensive for foreign customers.
the value of the domestic currency
m Importers potentially gain from a stronger currency as this makes it cheaper
depends on the price elasticity of
for firms to import raw materials, components and finished goods from demand for imports (PED,,) — a
abroad. currency appreciation is likely to raise
the spending on imports if the PED,, is
price elastic.
EXAM PRACTICE
PAPER 2
13 Since China’s admission to the World Trade Organization in November 2001,
the USA has complained that the Chinese government has deliberately kept In theory, a lower exchange rate
its exchange rate artificially low. The low value of the yuan compared with the should lead to a decline in the
demand for imports as they become
dollar has contributed to the economic problems of the US economy.
more expensive. However, some
a Define the term exchange rate. [2] imports are price inelastic because of
b Explain two advantages of an undervalued yuan for the Chinese the lack of substitution or cannot be
economy. [4] produced in the domestic economy,
for example, Singapore’s import of ail
or rice. Hence, countries might spend
more on imports when the exchange
rate falls in value.
Government intervention
Fixed exchange rates

A fixed exchange rate system exists when the central bank (or monetary
authority) buys and sells foreign currencies to ensure that the value of its
currency stays at the pegged value, i.e. a single fixed rate.
Revaluation occurs when the price of a currency operating in a fixed
exchange rate system is officially and deliberately increased.
Devaluation occurs when the price of a currency operating in a fixed
exchange rate system is officially and deliberately lowered. The international
competitiveness of a country can be improved by a currency devaluation, as
exports become relatively cheaper.
The government intervenes in foreign exchange markets to maintain its
fixed exchange rate at a predetermined level by buying (demanding) or selling
(supplying) foreign currency reserves.
It is possible to change the pegged (fixed) rate over time — for example, the
Hong Kong dollar (HKD) was originally fixed at HK$5.65 = USD1 back in
1972. As the USA’s economy developed, its currency was revalued to HK$7.8 in
1983 and has since been fixed at that rate (see Figure 3.9).
A Common mistake
Students often use the terms
Price (HK$ per USD)
‘appreciation’ and ‘revaluation’

interchangeably (or confuse
/.8 ‘depreciate’ with 'devalue’).
Remember, currency appreciations
and depreciations occur under a
freely floating exchange rate system,
whereas a revaluation or devaluation
O of the currency occurs under fixed and
Quuantity (USD)
managed exchange rate systems.
Figure 3.9 The fixed exchange rate system
The fixed exchange rate is achieved by the respective governments buying

and selling foreign currencies to maintain the ‘peg’. For example, if the HKD
falls in value the Hong Kong Monetary Authority can buy (demand) enough
HKD (thus raising its price) to maintain the fixed exchange rate.
Managed exchange rates (managed float)

In a managed exchange rate system, the government or central monetary
authority intervenes periodically in the foreign exchange market to influence
the exchange rate by affecting the demand for, and supply of, the domestic
currency.
Intervention is used to prevent large and sudden fluctuations in the exchange
rate, which could happen if currencies were left entirely to the market forces
of demand and supply. This helps to create certainty and confidence in the
CCONomy.
China’s currency, the yuan (CNY), is pegged to the US dollar (USD),
although the rate has been allowed to appreciate slowly over time (from
CNY6.8 in January 2009 to CNY6.15 5 years later). The managed float has
helped to control China'’s export growth and to offset its inflation.
Table 3.1 The advantages and disadvantages of over- and undervalued

exchange rates
Overvalued currency Imported goods become Exports become less
cheaper so there is competitive, causing
downward pressure on lower profits in export
the rate of inflation. industries.
Domestic producers As imports become
are forced to be more cheaper and exports
efficient to compete more expensive, there is
with the cheaper foreign a negative impact on the
imports. balance of payments.
Undervalued currency Exports become cheaper, Imports become more
leading to growth and expensive, which
employment in export can lead to imported
industries. inflation, i.e. imported
Imports become more raw materials and
expensive for consumers, components are more
so they switch to buying costly, thus affecting the
domestic goods. general price level.
Evaluation of different exchange rate systems

The main advantage of fixing exchange rates is that it reduces uncertainties for
international trade. This allows firms, both foreign and domestic, to be certain
about future costs and prices, thereby encouraging international trade and
exchange. Similarly, fixed exchange rates remove uncertainties and volatility
caused by currency fluctuations due to speculation in the foreign exchange
market.
However, fixing exchange rates reduces the country’s ability to use monetary
policy to affect the economy (which would be particularly useful during an
economic recession). There is also a huge opportunity cost in using large
amounts of foreign exchange reserves on a daily basis to maintain the fixed rate.
The opposite impacts apply to floating exchange rates — for example,
they can create instability and uncertainties to international trade, although
exchange rates are more responsive to changes in the economy.
3.3 The balance of payments

The structure of the balance of
payments
The meaning of the balance of payments

The role of the balance of payments (BOP) is to record credit items (all
payments received from other countries) and debit items (all payments made to
other nations). Keyword definition
Credit items on the BOP include revenues earned from the export of goods The balance of payments is a
and services, foreign direct investment and capital transfers. For example, the financial record of a country’s
expenditure of French tourists visiting the UK would be recorded as a credit transactions with the rest of the
item on the UK’ balance of payments (see Table 3.2). world for a given time period,
Debit items on the BOP include the purchase of imports of foreign goods usually over 1 year. This includes
and services, income transfers overseas, and the repatriation of profits the country’s trade in goods and
from multinational companies in the economy. These transactions have a services with other countries.
corresponding outflow of money from the domestic economy.
Essentially, the balance of payments is a record of a country’s sources and uses
of foreign exchange with its trading partners.
In theory, the balance of payments (BOP) must always balance over time
because a country, like an individual, can only spend what it earns.
Table 3.2 Examples of credit and debit items for the UK economy
Debit (outflow or import

Credit (inflow or export earning) expenditure)
The purchase of UK-produced chemical UK Government maintaining foreign
products by German companies embassies overseas
American tourists flying to the UK on UK supermarkets’ purchase of
British Airways Australian wine and meat products
Global sales of Harry Potter books by A large British firm buying a fleet of
British author J. K. Rowling lorries (trucks) from Japan
French tourists buying theatre tickets to The UK government paying interest
see Les Misérables in London on its borrowing (debts)
The components of the balance of payments

accounts
The balance of payments consists of three accounts: the current account, the
capital account and the financial account.
The structure of the balance of payments accounts is shown in Table 3.3.
This can vary from one country to another. However, the version here is used in
the IB Economics curriculum and assessment.
Table 3.3 The structure of the balance of payments
1. Current account 2. Capital account 3. Financial account
m Balance of trade in m Capital transfers = Direct investment

goods m Transactions in = Portfolio investment
m Balance of trade in non-produced, = Reserve assets
services non-financial assets
m Income
m Current transfers
current account = capital account + financial account + errors and omissions
Source: /IB Economics Guide, first examinations 2013, page 98
The current account
The current account is a record of all exports and imports of goods and services,
plus its net investment income from overseas assets and the net balance of
transfers made between countries by individuals and governments. The account
is usually reported per year.
There are four components of the current account:
m Balance of trade in goods — this records all exports and imports of physical
goods (e.g. rice, computers and motor vehicles) between a country and the
rest of the world.
m Balance of trade in services — this records all exports and imports of services
(e.g. insurance, banking, management consultancy and tourism) between a
country and the rest of the world.
m Income — this records the income receipts (inflows) earned from foreign
investments minus the income payments (outflow) of factor incomes paid to
foreign investors. Investment income consists of the inflows and outflows of
wages, rent, interest and profit.
m Current transfers — this records the inflows and outflows of payments that
are not made in exchange for anything (e.g. official development assistance,
grants, concessionary loans and donations) between a country and the rest of
the world.
The balance of trade (or trade balance) is the difference between a country’s
total export earnings and its total import expenditure on both goods and
services. The balance of trade is typically the largest component of the current
account.
A current account deficit occurs when a country spends more money than it
S {elTad ] o]
earns, i.e. the sum of money flowing out of a country exceeds the money flowing
into the country. A current account surplus exists if a country has a positive Remember the GIST of the current
account, i.e. that it is made up of four
net balance on its current account. A current account deficit can occur due to a
components:
combination of two factors:
m Goods - the trade in physical goods
m Lower demand for exports — This is mainly caused by exports being = Income — investment income from
relatively more expensive to foreign buyers. It can be caused by higher labour overseas assets
costs in the domestic economy, falling incomes (perhaps due to a recession) m Services — the trade in services
or a higher exchange rate making exports dearer. m Transfers — current transfers (of
m Increased demand for imports — Domestic buyers tend to buy more imports private individuals and government)
if they are relatively cheaper and/or of better quality — for example, a higher between countries
exchange makes it cheaper to buy foreign goods and services.
Section3 International economics 129
EXAM PRACTICE (HL ONLY) R

Higher-level students must be able
PAPER 3 to calculate elements of the balance
14 Use the data below to calculate the balance of trade. [2] of payments from a set of data, as in
these Paper 3 practice questions.
Food, beverages and tobacco —3558

Qil 4305
Finished manufactured goods —685
Others —1886
Transportation —632
Communications -531
Insurance 1450
Others 3776
15 Use the data below to calculate the current account balance. [4]
BALANCE BALANCE
(0]S I 17.1B]2 OF TRADE INVESTMENT CURRENT
IN GOODS IN SERVICES | INCOME TRANSFERS
CREDIT (+)
DEBIT (-)
Balance of trade for country K ($billion), 2014
Exports 85
Goods 57
Services 28
Imports
Goods 88
Services 15
Balance of trade in goods

Balance of trade in services
Trade balance
a Define the term 'balance of trade in services'. [2]

b Calculate the missing figures in the data above. [4]
Trade in goods = —$18.3bn
e Trade in services = +$21.8bn
e Netincome = + $6.7bn
e Net current transfers = — $5.6bn
Outline what is meant by 'net income’. [2]
w
Calculate the value of the balance of trade on the balance of payments. [2]
o
Calculate the value of the current account on the balance of payments. [2]
n
The capital account

The capital account is the smallest component of the balance of payments. It
records the different forms of capital inflows and outflows of a country during a
given time period, for example foreign currency flows and bank deposits. Here
are some examples:
m If Indian citizens buy shares in American banks, this is recorded as a credit
item on the USAs capital account and a debit item on India’s capital
account. However, the dividends earned by the Indian shareholders would be
a credit item for India and a debit item for the USA.
m [f Chinese citizens purchase US government bonds, the USA receives a
capital injection of money (credit item) whereas China will have a debirt
(outflow) on its capital account.
The two components of the capital account are:
m Capital transfers — These are the net monetary movements of capital goods
used in the production process (e.g. machinery and equipment) and financial
assets (e.g. investment grants and debt forgiveness, i.e. the cancellation of
debts for highly indebted poor countries).
m Transactions in non-produced, non-financial assets — The exchange of
money in non-produced assets, i.e. natural resources (e.g. commodities such
as minerals) and intangible assets (e.g. patents, copyrights, trademarks and
internet domain names).
Financial assets, such as money or bonds, are of little physical value (the
paper they are printed on is of little value). Instead, their value is based on what
the asset represents. By contrast, non-financial assets (such as gold) are assets
with physical value.
Less economically developed countries (LEDCs) tend to have a capital
account deficit as there is financial instability and mounting government debts
and loans.
The financial account

The financial account records a country's net transactions in external financial
assets and liabilities, for example foreign direct investment, the purchase or sale
of real estate (land), and investments in stock markets. It records the difference
between sales of domestic assets to foreign buyers and purchases of foreign assets
by domestic buyers.
A financial capital inflow occurs when foreigners loan money to domestic
citizens by acquiring domestic assets.
The three main components of the financial account are:
m Direct investment — This refers to the inflows and outflows of long-term
investments in physical capital, for example foreign ownership of domestic
assets such as property and land. Direct investments are mainly undertaken
by multinational corporations (MNCs).
m Portfolio investment — The buying and selling of stocks, shares, government
bonds, pension funds and other financial investments in foreign companies is
collectively known as portfolio investment. Essentially, these assets represent
international borrowing and lending.
m Reserve assets — This refers to official reserves that are readily available to
a government for direct financing of international payments imbalances and
to affect its exchange rate, for example gold reserves and foreign exchange
assets.
The relationship between the accounts

In theory, the overall balance of payments (BOP) must always balance because
in the long term a country can only spend what it earns, i.e. the sum of all credit
items equals the sum of debit items. However, it is possible to run a deficit in
one component of its BOP so long as it can ‘balance’ this by having a surplus on
another account. For example:
m Hong Kong has a deficit on its current account but funds this by having a
surplus on its financial account due to favourable conditions for FDI, i.e. it
must have a surplus to provide it with the foreign exchange to pay for the
excess of imports over exports.
m China, Norway, Germany and Saudi Arabia have a current account surplus
but can run a deficit on their capital account or financial account by directly
investing the surplus in foreign countries and/or accumulating foreign
CUITENCY reserves.
This means that the current account and the financial account are
interdependent. A country with a current account deficit consumes more than
it produces so has to pay for this extra output somehow, i.e. through a surplus on
its financial account (and vice versa).
In reality, the balance of payments will not balance as there are too many
transactions to account for. To resolve this problem, errors and omissions
are used to represent statistical discrepancies when compiling the accounts.
Therefore the following condition must hold:
current account = capital account + financial account + errors and omissions
Current account deficits
The relationship between the current account

and the exchange rate
A current account deficit exists when the sum of the outflows from the
current account exceeds the inflows into the account — for example, net import
expenditure on goods and services is greater than net export earnings. A current
account deficit shows the country is spending more than it is earning, so it must
require more foreign exchange whilst it faces lower demand for its own currency
as exports decline.
In theory, the deficit is automatically resolved under a freely floating
exchange rate system because it makes exports relatively cheaper and imports
relatively more expensive. Export earnings should rise and import expenditure
should fall, restoring equilibrium. This analysis refers to a current
However, this is more problematic in a fixed exchange rate system unless a account deficit. The opposite would
devaluation of the currency is approved. If so, this should improve the current apply to a current account surplus,
account in the same way, as with a depreciation of the currency. for example, it would put upwards
In a managed exchange rate system, a current account deficit is resolved by pressure on the exchange rate so, in
combining market forces and central bank intervention by buying and selling theory, a currency appreciation should
of foreign currencies to reduce the value of the domestic currency in overseas eventually automatically reduce the
surplus.
markets.
Implications of a persistent current account

deficit (HL only)
Foreign ownership of domestic assets — A current account deficit has to be
financed by a surplus on the financial account, often in the form of FDI, i.e.
more domestic assets become owned by foreign MNCs. There are opposing
implications of this:
m FDI can help to boost aggregate demand in the economy, thus boosting
economic growth.
m FDI and foreign ownership of domestic assets can cause leakages in the circular
flow of income as MNCs remit income and profits back to their home countries.
Exchange rates — A persistent deficit on the current account will deplete the
country'’s foreign currency reserves. For countries reliant on key imports such as
oil, a declining currency can fuel imported inflation, with its negative impacts
on GDP and employment.
Interest rates — As a persistent current account deficit puts downward
pressure on the exchange rate, governments may be tempted to raise interest
rates to attract foreign currency and capital inflows. However, higher interest
rates can be contractionary and reduce aggregate demand.
Indebtedness — If a country does not have sufficient financial reserves to fund
its persistent current account deficit, it will have to borrow money from abroad. In general, a large and persistent
The country therefore goes into debrt, with its related problems, for example current account deficit suggests
mounting interest repayments, lower growth and job losses. that the country is uncompetitive in
international markets, which causes
International credit ratings — Credit rating refers to the credit worthiness
detrimental consequences for the
of a borrower based on the likely ability to repay the debt. A persistent
domestic economy such as lower
current account deficit tends to reduce a country’s credit rating as it can signal aggregate demand and job losses.
underlining structural problems for the economy. Thus, current account deficits will
Demand management — Contractionary demand management policies might have a negative impact on economic
be used to reduce the demand for imports to correct a persistent current account growth and standards of living.
deficit. However, this can negatively affect growth and employment.
EXAM PRACTICE
PAPER 2
18 Sri Lanka is a major exporter of tea and coconuts. The chart below shows the balance of trade for Sri Lanka from
2004-2013.
Sri lanka balance of trade (US $ million)
B
~500 4, — —500
~1000 - — —1000
~1500 — —1500
~2000 — —2000
-2500 H — —2500
-3000 i T i | —3000
Jan/06 Jan/08 Jan/10 Jan/12
a Define the term 'balance of trade’. (2]

b Explain two possible causes of Sri Lanka’s persistent balance of trade deficit. [4]
EXAM PRACTICE (HL ONLY) Common mistake

Students seem to regularly confuse
PAPER 3 the concept of budget deficits
19 ‘A current account deficit on the balance of payments is undesirable during a with balance of payments deficits.
recession but is not really a problem during periods of economic growth.’ It is incorrect to say that a budget
deficit means that a country’s import
a Define the term 'current account deficit'. [2]
spending is greater than its export
b Explain the validity of the above statement. [4] earnings (as budget deficits are
concerned with government fiscal
policies).
Expert tip
A deficit on the current account that is manageable is not necessarily a bad thing.
For example, the deficit might be the result of strong economic growth, with
residents purchasing more foreign goods and services. This allows the country’s
residents to enjoy a higher standard of living, as they are able to benefit from
access to a wider range of good quality imports.
Methods to correct a persistent current account

deficit (HL only)
Expenditure switching policies — These policies are intended to encourage
households and firms to buy domestically produced goods and services rather
than imported alternatives by raising the relative price of imports or reducing
the relative price of exports. Examples include the following:
m Export promotion — These are policies that stimulate the demand for exports,
for example export subsidies and tax concessions for export-orientated firms.
m Trade protection — These measures reduce the competiveness of imports,
thereby making domestic consumption more attractive — for example, tariffs
(import taxes) raise the price of imports, whilst quotas are quantitative limits
on the amount of available imports.
m Currency devaluation — The central bank can devalue its exchange rate to
reduce the price of exports and make imports more expensive.
Expenditure reducing policies — These policies are designed to cut a current
account deficit by lowering disposable income to limit aggregate demand
and import expenditure in particular. This is usually achieved through use of
contractionary fiscal and monetary policies:
m Contractionary fiscal policy — These measures use a combination of higher
taxes and reduced government spending to reduce consumption, including
the amount of money available to spend on imports.
m Contractionary monetary policy — Higher interest rates make new and
existing loans more expensive, so both households and firms reduce their
demand for imports.
Supply-side policies — These policies strive to raise the productive capacity
of the economy and to increase its international competitiveness. Examples
include:
m investment in education and healthcare to improve the economy’s human
capital (investment to improve the skills and productivity of the workforce),
thereby raising the quality of exports and improving the country’s long-term
international competitiveness
m investment in infrastructure to support businesses and industries, especially
those engaged in export-orientated markets
m measures to encourage export-driven business start-ups and industries, such as
the use of government subsidies and tax incentives.
Expenditure-switching policies do not always work because:
m price is not always the deciding factor in determining the level of demand for
goods and services. Customers will consider non-price factors that determine
the demand for products, for example quality, functionality and brand
loyalty.
m trade protection can cause other countries to retaliate by creating their own
trade barriers. Such disharmony will reduce the benefits of free international
trade.
m currency devaluations only work under a system of fixed exchange rates, yet
the falling value of the currency can cause imported inflation (higher-priced
imports of essential products such as crude oil, raw marterials and foodstuft).
Expenditure-reducing policies such as higher taxes can cause huge
disincentive effects, negatively affecting economic growth and development.
Contractionary policies can also cause mass-scale unemployment in the
economy.
Whilst supply-side policies aim to make domestically produced goods and
services more competitive, they tend to take a long time to materialise. Hence,
the implementation of supply-side policies to rectify a persistent current account
deficit tends to be very costly.
The Marshall-Lerner condition and the J-curve

effect (HL only)
Under a fixed exchange rate system, a government can devaluate its exchange
rate to resolve a current account deficit. In theory, this will make exports
relatively more attractive to overseas buyers and make imports more expensive
for domestic citizens, thus improving the account.
Similarly, a country with a current account deficit and operating under a
floating exchange rate system should experience an improvement if there is
downward pressure (depreciation) on its exchange rate.
However, a devaluation or depreciation of the currency will only work in
rectifying a current account deficit if the sum of the price elasticities of demand
for exports (X) and imports (M) is greater than 1, i.e. price elastic. This rule is
called the Marshall-Lerner condition:
PEDy + PEDy > 1
Hence, if PEDy + PEDy = 1 then a currency devaluation or depreciation has
no impact on the current account deficit. Likewise, if PEDy + PEDy < 1 then
the fall in the exchange rate will actually worsen the deficit further.
The J-curve effect is an economic model that shows that following a
currency depreciation the balance of trade worsens before it gets better (see
Figure 3.10). The effect is caused by time lags, such as:
m limited access to information — people are not aware of the currency
devaluation
®m ongoing contracts — so firms cannot take advantage of the currency devaluation
m existing habits and tastes — in the short run, buyers might not be responsive
to the currency devaluation and so continue to buy imports at a higher price
(and export at a lower price).
In other words, households and firms in both domestic and foreign markets
need time to adjust to the changes in the price of exports and imports.
The ] curve will only materialise (i.e. a fall in the value of the exchange rate
in rectifying a current account deficit) if the Marshall-Lerner condition holds.
Surplus (+) A ® The lower exchange rate causes a rise

in the price of imports and a fall in the
price of exports.
Trade balance (X — M|
® This worsens the deficit as the PEDy

and PEDy, remain price inelastic in
O > the short term.
fime In the long ferm, the PEDy and PEDy,
will increase as households and firms
adjust to the relative price changes,
with the lower exchange rate boosting
Deficit (-] ¥ exports and reducing imports.
Figure 3.10 The J curve
Expert tip
The previous analysis can work for countries with a persistent current account
surplus (an ‘upside-down’ J curve) that they want to eliminate by raising the value
of the exchange rate.
Surplus (+) A
=
=
e
3 O ==
% Time
£
i@
'_..
o
Deficit (-] ¥
Current account surpluses
The relationship between the current account

and the exchange rate
A current account surplus exists when the sum of the inflows from the current
account exceeds the outflows into the account — for example, the value of net export
earnings on goods and services is greater than the value of net import expenditure.
A surplus on the current account can occur due to a combination of two
factors:
m Higher demand for exports — This could be caused by improved domestic
manufacturing competitiveness, higher labour productivity or higher incomes
in overseas markets (foreign households and firms have more disposable
income to spend on the country's exports).
m Reduced demand for imports — Domestic buyers will tend to buy fewer imports
if they are more expensive or of lower quality than those provided by domestic
firms, choosing instead to buy more home-produced goods and services.
A current account surplus shows that the country is earning more than it
is spending, so there is a greater demand for its currency as exports increase.
Hence, there is greater upwards pressure on its exchange rate.
In general, a current account surplus means that the country is a net lender
to the rest of the world, whereas it would be a net borrower from the rest of the
world if it ran a current account deficit.
A current account surplus is generally seen as positive for an economy, especially
if it is due to export-orientated growth and development strategies, as used in
countries such as China, India, Mexico, Indonesia, South Korea and Turkey.
Alternatively, the current account surplus could signify that the country is
spending less on imports than its trading partners because of relatively lower
incomes. Thus, households have a relatively lower standard of living as they are Expert tip
unable to access a wider range of goods and services.
A surplus on the current account
In addition, many countries with a persistent or rising current account surplus is not necessarily a good thing.
(such as Kuwait and Qatar) are heavily dependent on export earnings and a For example, Romania, a former
high savings rate, but with weak domestic aggregate demand. communist nation, had a trade surplus
In a freely floating exchange rate system, the currency appreciation, caused by using trade protection. This limited
by a persistent current account surplus, results in a fall in the demand for access to foreign goods and services,
exports and a rise in the demand for imports. Thus, the fall in the exchange rate thus lowering living standards.
automatically eliminates the current account surplus.
Implications of a rising current account surplus

(HL only)
Lower domestic consumption — A current account surplus can be caused
by lower domestic expenditure on imports, which is not necessarily good for
households and firms if it is due to a lower level of income.
Lower domestic investment — Domestic investment is likely to fall due to
inflationary pressures caused by the current account surplus. A higher exchange
rate, associated with a current account surplus, is also likely to reduce foreign
direct investment.
Currency appreciation — The higher demand for exports can cause the Expert tip
domestic currency to appreciate in value. Subsequently, exporters will find it
increasingly difficult to sell to foreign buyers who have to pay higher prices for A sustained current account surplus
could be desirable as higher export
the products.
sales help to create jobs. Major oil
Reduced export competitiveness — Higher demand for exports and a higher exporters such as Saudi Arabia,
exchange rate can lead to higher export prices. Therefore, a current account Kuwait, Qatar and the United Arab
surplus can diminish the international competitiveness of the country over time. Emirates have consistently enjoyed
current account surpluses, thus
boosting their GDP and standards of
EXAM PRACTICE living. However, a consequence of a
sustained current account surplus is
PAPER 2
that job losses are created in other
20 Kuwait is one of the world's largest net exporters of oil. The chart below shows countries — for example, the USA has
the ratio of the country’s current account balance relative to its gross domestic blamed China for sustaining a large
product (GDP) from 2000 to 2013. current account surplus, thus causing
Kuwait current account to GDP large-scale unemployment in America.
60 — 60
54.8
50 - 50
40 - — 40
30 - 30
20 - - 20
11.18
10 - i ] e 11 i) By B ] | [ L 10 Common mistake
Jan/00 Jan/02 Jan/04 Jan/06 Jan/08 Jan/10 Jan/12 Students often assume that a balance
of payments disequilibrium refers only
a Define the term 'current account surplus’. [2] to a deficit. Whilst this is not entirely
b Explain two consequences of Kuwait's persistent current account surplus incorrect, disequilibrium can also refer
from 2000 to 2013. [4] to a surplus.
Expert tip
Whether a rising current account surplus is desirable depends on the causes of
the surplus. For example, if the surplus is due to increased use of trade protection
measures, then there are welfare losses to society. If the surplus is due to export-
orientated policies, then the country should experience economic growth.
3.4 Economic integration

Forms of economic integration
Forms of economic integration include:
m preferential bilateral and mulrilateral trade agreements Keyword definition
m trading blocs, such as free trade areas, customs unions and common markets Economic integration refers to the
® monetary union
process of countries becoming more
m foreign direct investment (FDI)
interdependent and economically
unified. It can be achieved by
m globalisation and expansion of multinational corporations.
preferential trade agreements
between member governments to
remove trade barriers.
Preferential trade agreements

A bilateral trade agreement is a contractual trade arrangement between two
countries, such as closer economic partnership agreements (CEPAs). For
example, Hong Kong and China'’s CEPA signed in 2004 created improved cross- Keyword definition
border trade and investment between the two countries. A preferential trade agreement is
A multilateral trade agreement is a legally binding trade deal between more a trade deal between two or more
than two countries, for example in a free trade area. Such trade agreements are countries that gives special or
made within the guidelines of the World Trade Organization (WTQO), i.e. an favourable terms and conditions,
agreement to reduce or remove international trade barriers. such as tax exemptions or tax
As bilateral trade agreements are made between two countries only, they concessions.
have far greater flexibility than multilateral trade agreements. The latter can
involve many countries, so they are far more complex.
Preferential trade agreements (PTAs) give certain countries special and easier
access to specific products in a market due to advantages such as the reduction
or removal of tariffs and non-tariff barriers to international trade.
In line with WTO rules, PTAs must adhere to the principle of non-
discrimination. This means that a country cannort discriminate against other
WTO member countries by imposing higher trade barriers on one country
whilst reducing the trade barriers on imports from another country.
The two exemptions to the principle of non-discrimination are bilateral trade
agreements and regional trading blocs such as the European Union. In both
cases, non-member countries can have higher trade barriers imposed.
Trading blocs
Economic integration within a trading bloc will intensity the degree of
competition for producers within the member countries. However, firms can
Keyword definition
benefit from access to a larger market without trade barriers, thereby benefiting
from economies of scale. Whilst a trading bloc promotes free trade with its A trading bloc is a group of
countries that agree to economic
member countries, the bloc imposes trade barriers for non-member states.
There are three categories of trading bloc, with varying degrees of economic integration and freer international
integration:
trade by removing trade barriers
m A free trade area (FTA) is the least economically integrated trading bloc, with one another.
where member countries agree to remove trade barriers with one another, but
impose separate trade barriers with non-member countries, for example the
North American Free Trade Agreement (NAFTA).
m A customs union is a group of member countries that engage in free trade
and impose a common external tariff for non-member countries, i.e. all
members impose the same trade restrictions on non-member states.
m A common market is the most integrated trading bloc. This is a customs
union that, in addition to imposing the same trade restrictions on non-
member nations, allows the free movement of goods, services, capital and
labour between its member countries.
Some economists argue that economic integration, especially common

markets, causes a loss of national economic sovereignty, i.e. the lost opportunity
to enjoy economic independence. For instance, trading blocs might impose
stricter environmental legislation and labour laws.
In addition, detrimental changes in the economic conditions of one member
country (such as inflationary pressures or an economic recession) are likely to
affect the economic performance of all member countries.
Another drawback of joining a trading bloc is that it could lead to more
unemployment in the short run. This is due to the increased intensity of
competition facing domestic firms in the trading bloc.
Nevertheless, most economists believe that trade protection, rather than
economic integration, is harmful to households and firms. This is due to the
dynamic efficiency gains from free trade and because of the reduced choice and
higher prices under trade protection.
Make sure you can use real-world examples in the external examinations. This
means that you should be able to give examples of the various categories of trade
bloc:
m Free trade areas include the North American Free Trade Agreement (NAFTA), a
trilateral trade agreement between the USA, Canada and Mexico to promote
trade and investment.
m Customs unions include the European Union (EU), or the five member countries
of the Southern African Customs Union (SACU) — Botswana, Lesotho, Namibia,
South Africa and Swaziland.
= Common markets include the Caribbean Community (CARICOM), which
promotes economic integration and cooperation among its 15 member
countries.
Trade creation and trade diversion (HL only)

The formation of a customs union is likely to cause both trade creation and
trade diversion. Economic integration improves the welfare of the economy if it Expert tip
leads to more trade creation than trade diversion. Higher level students need to be able
Trade creation occurs when economic integration shifts trade deals away to distinguish between trade diversion
from higher-cost producers from outside the trading bloc to lower-cost producers and trade creation. Remember that
within the trading bloc, due to the removal of trade barriers. a disadvantage of joining a regional
Trade diversion occurs when economic integration shifts trade deals away trading bloc is trade diversion,
from lower-cost producers outside the trading bloc to higher-cost producers whereas a key benefit of joining is
within the trading bloc due to the trade agreements of the customs union. trade creation with member countries.
Economic integration allows multinational corporations (MNC:s) to locate
overseas in member states and to export without trade barriers. Thus, MNCs
can gain easier access to larger markets and operate on a much larger scale.
Trade creation therefore helps them towards economies of scale.
Arguments for limiting the degree of economic integration include: the need
to protect domestic infant industries from international rivals, political and
strategic reasons (economic and political sovereignty) and the protection of
domestic employment.
Monetary union
To achieve monetary union, members of a common market must first agree to
permanently fix their exchange rates to use a common currency and to establish Keyword definition
a common central bank to be responsible for monetary policy. This means that A monetary union exists when
there is convergence of interest rates within the monetary union, so member member states of a common market
states do not have flexibility in exercising their own monetary policy. adopt a single currency and hence a
A well-known example of monetary union is the 17 member states common central bank that oversees
(collectively called the ‘eurozone’) of the European Union that use the euro monetary policy.
as their common currency. Monetary policy is exercised through the European

Central Bank (ECB).
For full monetary union, a single (common) currency is used by all member
countries. This is not the case within the European Union member states.
Advantages of monetary union

There is exchange rate certainty as a common currency is used. This eliminates
the risks associated with international trade due to exchange rate fluctuations
and uncertainties.
Trade creation will occur between members of a single currency area due to
the preferential trade agreement and the confidence in the use of a common
currency. The use of a common currency also eliminates transaction costs
as there is no need to exchange foreign currencies between members of the
monetary union.
Similarly, the use of a common currency attracts inward investment from
non-member states due to the removed risks associated with exchange rate
fluctuations. Inward investment will have a positive impact on economic
growth and employment in the monetary union.
There is price transparency, i.e. households and firms can compare prices
across different member states at a glance.
Disadvantages of monetary union

There is a loss of economic freedom and flexibility as countries within the
monetary union are unable to adjust macroeconomic policies to deal with their
own specific economic problems. For example, a country with relatively high
unemployment cannot reduce interest rates to stimulate its economy.
Similarly, the actions taken by the common central bank have an asymmetric
impact on different countries due to their varying circumstances. For example,
contrasting rates of inflation and unemployment in Greece and Germany mean
that a common monetary policy might not work for either country.
Members of a monetary union are also deprived of exercising their own
exchange rate policy. With independence, the country can depreciate its
currency during a recession or to combat a balance of payments deficit. This
autonomy is not possible in a monetary union.
EXAM PRACTICE
PAPER 2
21 Using appropriate examples, differentiate between a customs union and
a monetary union. [4]
22 Using an appropriate diagram, explain how economic integration can
benefit the economy. [4]
3.5 The terms of trade (HL only)

The meaning of the terms of trade
(HL only)
The terms of trade (TOT) is measured using the same currency, by comparing
the index of average export prices against the index of average import prices, i.e.:
Keyword definition
index of average export prices <100 The terms of trade (TOT) is an
terms of trade (TOT) =
index of average import prices index number that expresses the
value of average export prices
Thus, when the average price of exports rises, the TOT increases — divided by the average of import
prices, per time period. An
economists call this an improvement in the terms of trade because the country
can potentially buy more imports with the same amount of exports (it can increase in the ratio indicates an
import more products than before as its exports are worth more). improvement the terms of trade,
i.e. the country can buy more
The TOT differs from the exchange rate, which measures the price of exports
in terms of foreign currencies. imports for the same amount of
Note that the TOT only indicates relative price movements of imports and exports as before. By contrast, a fall
exports; it does not tell us anything about the volume of trade (which depends in the ratio means a deterioration
on the price elasticity of demand for both exports and imports) or the quality of in the terms of trade.
the exports and imports.
Measurement (HL only)

As countries trade a huge amount of goods and services, the terms of trade are
measured using a weighted price index of average prices of exports and imports.
Index numbers are used to calculate the terms of trade, as this simplifies the
calculations and allows for easier comparisons rather than expressing prices in
different currencies (which tend to fluctuate over time).
In general, the more imports that a country can purchase from each sale of
exports, the better off it will be.
Worked example
Average price of oil | Price index | Average price of | Price index | TOT T
Year ($ per unit) (oil) tea ($ per unit) (tea) (USA) (Sri Lanka)
2011 98 94.2 320 111.1 84.8 L1379

2012 104 100.0 288 100.0 100.0 100.0
2013 109 104.8 254 88.2 118.8 84.2
In the above table, 2012 is base year, so the price indices of oil and tea are assigned an index number of 100. The
price index for tea in 2011 is calculated as:
320
—— % 100=111.1
288
Similarly, the price index for oil in 2013 is calculated as:
109
—x 100=104.8
104 .
Finally, to work out the terms of trade for the USA, we need to divide the price index of the export (oil) by the index
price of imports (tea). So, the TOT for 2013 is:
104.8
x 100=118.8
88.2
The TOT for Sri Lanka is calculated by dividing the price index for its export (tea) by its import (oil), so for example
its TOT in 2011 was:
1L x100=117.9
94.2
So, in this worked example, the terms of trade have improved for the US economy between 2011 and 2013.

PAPER 3
23 a Suppose the price index for exports is 110 and that for imports is 105.
If export prices rise on average by 10% whilst import prices rise by 5%,
calculate the terms of trade. [2]
b Comment on the change in the terms of trade. [2]
24 Refer to the information below for a given country and answer the questions
that follow. Assume that 2012 is the base year.
(30 elo (0 0] 1Y PRICE OF MILK IMPORTS
b4 7.\ ($ PER UNIT) ($ PER UNIT)
2012 430.0 19.2
2013 481.6 22.6
2014 505.7 23.7
a Calculate the price index of rice exports in 2013. [2]

b Calculate the price index of milk imports in 2013. [2]
¢ Calculate the terms of trade in 2013. [2]
d Comment on the change in the terms of trade for the country. [2]
Causes of changes in the terms of

trade (HL only)
There are essentially two main causes of a change in the terms of trade —
changes in the average price of exports or changes in the average price of
imports. Examples of such changes in the short term include the following:
Changes in the demand for exports and imports — A fall in the demand for
exports will tend to reduce the relative price of exports thereby worsening the
terms of trade, i.e. each unit of exports buys fewer units of imports.
Changes in the global supply of key inputs — An increase in the price of
important inputs to the production process, such as oil, will improve the
TOT for countries that export such products and deteriorate the TOT for
countries that need to import such commodities.
Changes in relative inflation rates — Demand—pull inflation, for example, can
cause domestic prices to rise, thereby improving the country’s TOT because
the relative price of exports will rise. Note that this does not mean that
inflation itself is necessarily good for the country.
Changes in relative exchange rates — A currency depreciation will reduce the
relative price of exports, thus worsening the terms of trade.
In the long term, there are three main causes of changes in the terms of trade:
Changes in world income levels — Typically, higher household incomes will
lead to an increase in the demand for goods and services, especially those that Expert tip
are relatively income elastic in demand. This helps to improve the TOT for Whilst most students seem to be
countries that produce and export such products. able to define the terms of trade,
Changes in productivity — Long-term changes in supply cause the productive they are often unable to use real-
capacity of the economy to increase, so national output rises. This results world examples to substantiate their
in exports being produced at a lower cost and hence price, consequently answers. Use a well-known example
deteriorating the terms of trade. to help — for example, the price
inelastic demand for oil and its low
Technological developments — Advances in technology help to achieve
supply mean that the terms of trade
productivity gains and hence boost the productive capacity of the economy. will tend to improve in the short-term
Although this deteriorates the TOT, the improved competitiveness of for oil-rich countries such as Kuwait.
domestic firms is a positive impact on the economy.
Consequences of changes in the terms

of trade (HL only)
Long-term changes in the terms of trade can cause a global redistribution of
income and wealth — for example, China’s improved TOT over the past few
decades has led the nation to economic supremacy.
There are higher costs of debt servicing (repayment of loans plus interest
charges) if the TOT deteriorates. This is because more exports are needed to pay
off the foreign loans following deterioration in the TOT. This is because a larger
volume of exports is now needed to pay for the purchase of imports.
The demand for primary-sector products produced in less economically
developed countries (LEDCs) tends to be highly price inelastic, but they
often face deteriorating terms of trade. In addition, the income elasticity of
demand (YED) is low for primary-sector output. Hence, LEDCs that focus on
primary industries lose out as consumers will spend proportionately more on
manufacturing and tertiary-sector jobs as their incomes rise.
Changes in the terms of trade can improve or worsen the balance of
payments current account depending on the price elasticity of demand (PED)
for both imports and exports:
m A deteriorating TOT due to lower export prices (caused by a lower exchange
rate) will increase export revenues if the demand for exports is price elastic,
i.e. there is a proportionally higher amount of spending on exports following
the fall in average export prices.
m An improvement in the TOT due to higher export prices is beneficial to the
economy if the demand for exports is price inelastic, i.e. foreign customers are
relatively unresponsive to the higher average price of exports.
The advantages and disadvantages of changes in the TOT are outlined in
Tables 3.4 and 3.5:
Table 3.4 Advantages and disadvantages of an improvement in the TOT
m Export revenues will increase if demand for exports is price = If demand for exports is price elastic, export revenues will
inelastic. This improves the current account balance. fall, thereby worsening the current account balance.
m The country can consume more imports, giving citizens m If demand for imports is price elastic, import expenditure
greater choice. will rise, thus worsening the current account balance.
m Debt servicing is made easier as the country can repay its m An improvement in the TOT can lower both national
borrowing more easily. income and employment.
Table 3.5 Advantages and disadvantages of a deterioration in the TOT
m If demand for exports is price elastic, a deterioration in the = If demand for imports is price inelastic, a deterioration in the
TOT will lead to an improvement in the current account. TOT will cause a negative effect on the current account.
m A deterioration in the TOT can lead to higher demand for m If the demand for exports is price inelastic, a deterioration in
exports as export prices are relatively lower. the TOT will cause a negative effect on the current account.
m A deterioration in the TOT can lead to higher aggregate m Higher-priced imports can cause imported inflation in the
demand and more job opportunities as export earnings rise. economy if the country relies on certain foreign imports,
such as oil.
Common mistake
Students often mistake an
improvement in the terms of trade to
Whether or not a change in the TOT is beneficial to the economy depends on the be beneficial to the domestic economy.
price elasticity of demand for exports and imports. Lower export prices (which Whilst this might be the case, relatively
cause a deterioration in the TOT) can cause an increase in export revenues if the higher exports prices (which led to
PED for exports and imports is elastic. This improves the current account on the the improved terms of trade) are not
balance of payment, so can be beneficial to the economy. necessarily beneficial to the economy.
Y-lails11R‘] Development economics
4.1 Economic development
The nature of economic growth and

economic development
Economic growth and economic development

Economic growth is the increase in the value of real gross domestic product
(GDP) per capita over time. It is therefore a quantitative variable of economic
wellbeing. Keyword definition
Economic development is an intangible concept that considers qualitative Economic development includes
variables. It is multidimensional, encompassing factors that raise the general economic growth in addition to
standard of living in a country, for example political freedom, reduced income qualitative determinants of quality
inequalities, greater self-esteem, and the reduction of poverty. of life, for example a reduction in:
There is a positive relationship between a country’s economic growth and its poverty, income inequality, gender
economic development, i.e. the wealthier a country is, the higher its standards inequality, political oppression and
of living tend to be. unemployment.
However, it is possible for some people to live happier lives in the absence
of higher incomes as economic growth can bring about negative consequences
such as pollution, climate change and environmental damage. In addition,
economic growth does not always lead to a higher standard of living for the
majority of people, so there is no economic development in such cases. For
example, if a country spends significantly more on national defence then growth
may occur but not necessarily development.
Economic growth can also lead to greater income inequality (as in the case of
Hong Kong, which has the world’s largest wealth gap).
Economic growth can be caused by productivity gains caused by the
increased use of technology and automation (such as self-service checkouts in
supermarkets) but this results in technological unemployment. Thus, economic
erowth does not necessarily lead to economic development. Nevertheless,
economic growth is usually needed over the long term for there to be economic Expert tip
development. After all, to meet their infinite wants, people need to earn more i & incotrect to lise the tatms
income. ‘economic growth’ and ‘economic
Economists prefer to use real GDP per capita figures rather than real GNP development’ interchangeably.
per capita as a measure of growth and development in LEDCs. This is because Economic growth is often regarded
real GDP per head measures the national income (level of economic activity) as a prerequisite to economic
earned within the borders of the LEDC. development but there are far
Sustainable economic development refers to development that meets the more factors that contribute to
needs of the present generation without compromising the ability of future development
_ ; than simply an increase
in real incomes.
generations to meet their needs.
Sources of economic growth and development in

LEDCs
= An increase in the quantity and quality of physical capital through
foreign direct investment (FDI). This helps to create jobs and to boost the
productive capacity of the economy.
= An increase in the quantity and quality of human capital through improved
education and healthcare, to boost the productivity of the labour force.
= The development and adoption of technology that is appropriate to
the context of the LEDC, for example farming technologies and capital
investments that increase the productivity and competitiveness of
agricultural industries.
= Institutional changes to the banking, legal and political systems of the
country to enable economic transactions to be carried out with relative ease.
These changes are required to facilitate trade, attract FDI and boost both
consumer and business confidence.
Common characteristics of LEDCs

SV ]
Low levels of GDP per capita — LEDCs have a low national income per head of
the population, partly due to their relatively low GDP and partly due to their
relatively high birth rate. The World Bank classifies countries according to their
level of gross national income (GNI) per capita.
High levels of poverty — LEDCs suffer from high levels of extreme poverty.
According to the United Nations, 1.2 billion people still live in extreme
poverty, with most of these living in LEDCs.
Relatively large agricultural sectors — In general, LEDCs have a relatively
large primary sector, in particular, agriculture. However, the income elasticity of Expert tip
demand for agricultural products is relatively low, making it difficult for LEDCs Whilst these characteristics are
to develop. common to many LEDGCs, it is wrong
Large urban informal sectors — LEDCs have a large informal sector, i.e. to assume that all LEDCs have the
where economic activities are not officially registered or recorded. In LEDCs, same features and that there are no
the informal sector is important for many people’s survival and accounts for a exceptions to these generalisations.
large proportion of employment in urban areas. For example, although GDP per
High birth rates — Whilst most LEDCs experience low rates of economic capita may be low in LEDCs, there
erowth they suffer from relatively high rates of population growth. This will can certainly be extremely wealthy
individuals in the country.
tend to cause a fall in the GDP per capita, thus limiting economic development.

PAPER 3
1 Assume that a less economically developed country has a real GDP per capita
of $2000 compared with $35,000 in a wealthier country. If both countries have
economic growth of 2.5%, calculate the change in the per capita income gap
between the two countries. [2]
2 Assume that in a less economically developed country the real gross national
income (GNI) increases from $50 billion to $54 billion and that the population
increases from 68 million to 71 million. Calculate the change in the LEDC's real
GNI per capita. [2]
The poverty trap

The poverty trap (or poverty cycle) is a vicious cycle of poverty causing greater
poverty. Low-income earners spend most, if not all, of their income on meeting
their essential needs, so they have insufficient funds to invest in their future and
are trapped in poverty (see Figure 4.1).
Low levels of GDP per capita will tend to cause LEDC:s to suffer from a low
savings ratio. This means that such countries have limited funds from savings for
investment expenditure, thereby hindering their future productive capacity and
economic development.
Low-income countries are often unable to break the poverty cycle as they
have little, if any, savings to fund the necessary investment in factors needed for
economic development. These include:
= physical capital, for example tools, machinery, transportation networks and
sewerage systems
= human capital, leading to low levels of education and skills, and poor health.
This will have an impact on rates of infant mortality, maternal mortality and life
expectancy.
= natural capital, i.e. the stock of indispensable natural resources from the Earth'’s
ecosystems will be depleted and will not be replenished without the necessary
capital investments.
Low-income households also struggle to break the poverty trap because banks
are unlikely to lend money to very poor families, as there is a high risk of them
defaulting on the loans.
It is common that poverty is transmitted from generation to generation — for
example, a poor family that is unable to access education has a relatively low
chance of getting out of poverty. This leads to malnutrition and a physically weak
labour force.
Because of this poverty trap, government intervention is required to bring
people out of extreme poverty, for example through investment in education to
increase human capital or improving employment opportunities for women. If a
country is so poor that government intervention is not possible, then it will need
to rely on foreign aid.
Low
income
Low
productivity
Low
savings
low
investment
Figure 4.1 The poverty cycle
Diversity among LEDCs

The differences between LEDCs can be extreme:
= Resource endowment — Countries have different quantities and qualities of
natural resources. For many LEDCs, the main exports consist of agricultural
products, whilst some LEDCs, such as Angola, have oil and mineral reserves.
= History (colonial or otherwise) — Many LEDCs were former colonies of
countries such as Spain and Britain. Colonisation often meant wealthier
countries extracting marketable resources from LEDCs rather than investing in
the countries for economic development.
= Political systems — LEDCs have a range of political systems, including
dictatorship (e.g. North Korea) and democracy (e.g. Botswana, Ghana and Peru).
= DPolitical stability — political turmoil and corruption can hinder economic
development.
= Climate — LEDCs have varying weather conditions, which can directly Expert tip
impact on production. Agricultural output is clearly dependent on the
Rapid population growth in LEDCs
climate, but climate can also affect people’s productivity levels in other
can limit any increase in real GDP as
economic activities.
it reduces the GDP per capita. Hence,
= Population — whilst LEDC:s tend to have large and/or growing populations all other things bein?g equl::-)ll high
(e.g. Bangladesh and Ethiopia), others do not (e.g. Mali and Burkina Faso). population growth hinders economic
Some LEDCs have very fast-growing populations (e.g. Niger and Rwanda.) development as there are competing
pressures on the Earth’s scarce
resources, such as agricultural land.
International development goals

The Millennium Development Goals (MDGs) of the United Nations consist of
eight international anti-poverty development targets, to be achieved by all 193
UN member countries by 2015. The eight MDGs are as follows:
REDUCE
CHILD MORTALITY
IMPROVE MATERNAL
HEALTH
Source: www.un.org/millenniumgoals
1 Eradicate extreme poverty and hunger, i.e. reduce the number of people
whose income is below $1.25 a day and those who suffer from hunger (e.g.
underweight children). According to the United Nations, about 870 million
people around the world are undernourished.
2 Achieve universal education to (at least) primary level, i.e. raise the school
enrolment rate and the literacy rate. The UN estimates that 123 million
youths (aged 15-24) lack basic skills in reading and writing, with over 60%
of these being female.
3 Promote gender equality and empower women — for example, there are
huge gender inequalities in Saudi Arabia, where women are not allowed to
vote or to drive. Gender equality covers educational attainment and wage
differentials between men and women.
4 Reduce child mortality rates, i.e. lower the infant mortality rate and raise
the number of young children who are immunised against measles. The UN
claims that those born into poverty are almost twice as likely to die before
the age of 5 than children born into wealthier families.
5 Improve maternal health, i.e. raise the proportion of births supported by
skilled health professionals such as doctors and nurses. UN figures show
that almost 50 million babies worldwide are delivered each year without the
skilled care of health professionals.
6 Combat diseases such as HIV/AIDS and malaria, i.e. stop the spread of HIV/
AIDS (through increased use of condoms and other contraceptive measures)
and major diseases such as malaria and tuberculosis.
Ensure environmental sustainability, for example reducing energy use and

=1
carbon emissions whilst improving access to clean water sources and better
sanitation.
Develop a global partnership for development, i.e. address the needs of
a0
LEDC:s such as debt servicing, debt relief, sustainable debt, infrastructure

and employment opportunities for women and the youth.
Remember that economic growth does not always lead to economic development.
Indeed, economic growth can help to eradicate extreme poverty, but it does not
necessarily promote gender equality or other international development goals.
EXAM PRACTICE
PAPER 2
3
USA 7.3
China 4.1
n 4.1
Bangladesh 4.5
Azerbai 5.2 9
40.0 43
Zambia 8.1 14
Burundi 35.0 10
a Define the term nominal GDP. [2]
b Using the above data, explain the multidimensional nature of economic development. [4]
4.2 Measuring development

Measurement methods
Single indicators of measuring development

Real GDP per capita — This is a single indicator of economic development that
calculates the value of national output of a country (its gross domestic product)
divided by its population. It is the most used single indicator of standards of Keyword definition
living within a country (see Table 4.1). A single indicator refers to a
statistical measure of economic
Table 4.1 GDP per capita (selected countries) development that uses one
particular gauge, such as literacy
Country GDP ($bn) GDP per capita ($) Population (million) rate, income per capita or life
China 8,250.0 6,094 1,353.82 expectancy.
Sweden 538.3 56,956 9.54
Luxembourg 58.42 113,533 0.524

Expert tip
Using GDP per capita to gauge the
Real GNI per capita — As an alternative single indicator, this measure also level of economic development in
LEDCs can be misleading, as the
calculates real GDP per person but includes the net value of what the country
value of parallel markets (unofficial
earns from overseas investments, i.e. net property incomes earned abroad by
transactions) is unrecorded.
nationals of the country.
The most common single measure of the standard of living (or wellbeing)
of a nation is to calculate its gross national income per capita, adjusted for
differences in the cost of living between countries.
If a country’s GDP is greater than its GNI, as in the case of many LEDCs,
this means that it has debts owed to foreign creditors and/or it has productive
assets owned by foreign individuals and firms. Hence, GNI tends to be a better
measure than GDP to measure development in LEDCs. For example, many
migrant workers from the Philippines, Indonesia and Sri Lanka remit large
amounts of money from their employment in overseas countries back to their
home country, so the GNI exceeds the GDP.
Comparing GDP and GNI figures of different countries can be meaningless
due to variations in exchange rates and costs of living. Hence, purchasing
power parity (PPP) is used — the exchange rate that equates the price of a
basket of the same traded goods and services in different countries.
Hence, PPP equates the cost of living across countries, so that GDP per
capita at PPP exchange rates enables a more meaningful comparison of differing
costs of living (and hence standards of living) across different countries.
LEDC:s tend to have a higher GDP per capita when measured using PPP
because prices of similar goods and services (and hence the costs of living) in
these countries tend to be lower than in MEDCs.
EXAM PRACTICE (HL ONLY) T

PAPER 3 Whichever measure of income is used
4 Suppose the exchange rate between Demland and Danland is 1 dems to 3.5 to measure economic development
dans. If a Big Mac burger costs 3.5 dems and there is purchasing power parity, (real GDP/GNI per capita or PPP
calculate the price of a Big Mac burger in Danland. [2] exchange rate of GDP/GNI), itis
worth noting that other essential
components of development are
Health indicators measure health-related measures of the quality of life, such as: ignored, such as income and wealth
= longevity (life expectancy at birth) inequalities, gender inequalities,
= expenditure on healthcare as a percentage of GDP political freedom and environmental
= mortality rates, for example of children aged 5 and below per 1000 of the issues.
population (see Table 4.2).
Table 4.2 Health indicators: life expectancy and mortality rates for selected countries
Health indicators Life expectancy at birth (years) Under-5 mortality rate (per 1000 live births)
Japan 83.6 3
Hong Kong 83.0 3
Switzerland 82.5 5
Lesotho 48.7 85
Guinea-Bissau 48.6 150
Sierra Leone 48.1 174
Education indicators measure education-related quality-of-life factors, such

as literacy rates and the mean average years of schooling (see Table 4.3).
Table 4.3 Education indicators: years of schooling and literacy rates for selected countries
Education indicators Mean years of schooling (years) Adult literacy rate (% of population aged 15+)
USA 123 99.0
Norway 12.6 100.0
New Zealand 125 99.0

Ethiopia 2.0 35.1
Niger 1.4 28.7
Mozambigue 1.2 56.1

Composite indicators of measuring development

Composite indicators are more complicated to compile as they include more
than one measure of economic development. However, they are considered to
Keyword definition
be better measures of economic development than single indicators as they are
A composite indicator is a
more comprehensive.
statistical method that combines
The most widely used composite indicator of economic development is the
single indicators of economic
Human Development Index (HDI), created by Pakistani economist Mahbub ul
development into a combined
Haq and Indian economist Amartya Sen in 1990 as part of the United Nations
index such as the Human
Development Programme.
Development Index.
In general, there is a direct correlation between a country’s GDP/GNI per
capita and its ranking of economic development using composite indicators.
The Human Development Index (HDI)

The Human Development Index (HDI) is a composite indicator (of life
expectancy, educational attainment and income) used as an alternative to
real GDP or GNI per capita as a measure of economic development. The HDI
measures three dimensions of human development:
= Healthcare — this measures life expectancy at birth. The better the healthcare
in a country, the greater social and economic wellbeing tends to be.
= Education — this indicator measures the mean (average) years of schooling
and the expected years of schooling in the country.
= Income levels — the higher the national income (using purchasing power
parity) of a country, the greater human development tends to be.
The three dimensions of the HDI are assigned equal statistical weighting in
the index. The value of the HDI is between 0 (extreme underdevelopment) and
1 (very high human development), for example Australia’s HDI might be 0.981,
whereas Sierra Leone’s HDI might be 0.336. LEDCs such as Niger, Mozambique,
Chad, Burkina Faso and Mali have a very low HDI. MEDCs such as Norway,
Australia, Germany, Canada and Japan have a very high HDI.
Economic development can occur if there is a reduction in inequality
and absolute poverty. This improves the HDI, but it does not mean that the
country's GDP/GNI necessarily increases. Similarly, although a country’s GDP/
GNI can increase without any improvement in the provision of healthcare and
education, its HDI ranking will fall relative to its GDP/GNI ranking.
However, there are limitations in using the HDI as a composite measure of
development and standards of living:
= Qualitative factors — the HDI ignores qualitative measures affecting
standards of living, such as gender inequalities and human rights.
= Income distribution — the HDI does not take account of inequitable income
distribution, and so is less accurate in measuring living standards and human
development for the ‘average’ person.
= Environmental issues — the HDI ignores environmental and resource
depletion as a consequence of economic growth. This includes the negative
externalities associated with increased output and consumption, such as
pollution and environmental degradation.
m Cultural differences — although the HDI is a composite indicator, it ignores
cultural differences and interpretations of the meaning of ‘standards of living’
and ‘quality of life'; both vital aspects of human development.
= Sustainable development — the HDI ignores the concept of sustainable
development, i.e. consuming more now can mean a lower standard of living
for future generations.
>
. Very high )
[:l High |
[ Medium
- low
y
. Data unavailable
Figure 4.2 HDI in 2013
EXAM PRACTICE
PAPER 2
5 Study the information below, which shows the Human Development Index for
four countries: Australia, Ethiopia, Russia and Vietnam.
Country HDI Country HDI It is incorrect to assume that countries

A 0.929 C 0.593 with a high GNI per capita have a
high HDI. This is not necessarily the
B 0.755 D 0.363 case — for example, Kuwait, Qatar and
Liechtenstein have a higher GNI per
a Define the term "Human Development Index’. [2] capita than the USA and Hong Kong,
b Identify the four countries based on the given HDI figures in the table and but a lower HDI.
explain the reasoning behind your answers. [4]
4.3 The role of domestic factors

Domestic factors and economic
development
There are five domestic factors (those within the control of the country in
question) that contribute to the economic development of LEDCs:
» education and health
= use of appropriate technology
= access to credit and micro-credit
= empowerment of women
= income distribution.
All five domestic factors have positive externalities of production and
consumption for LEDCs.
Education and health

Education and healthcare provision can help to increase labour productivity
(output per worker). The quality of labour is clearly dependent on its level of
educational attainment, skills, training and health. It will also depend on the
use of appropriate technology such as the capital used.
Investment in education and healthcare will shift an economy’s long-run

aggregate supply curve to the right, ceteris paribus. Alternatively, the subsequent
increase in the economy’s productive capacity can be shown using a production
possibility frontier diagram (see Figure 4.3).
A
® [nvestment in education and healthcare

are prerequisites for economic
development in LEDCs.
Education
/ ® |nvestment in education and healthcare

will increase labour productivity, thus
PPE shifting the economy's productive
2 capacity outwards from PPF; fo PPFs,
PPF, ceferis paribus.
O Expert tip
Y
Healthcare
Remember that education and health
Figure 4.3 Education, healthcare and economic development are important aspects of the United
Nations Millennium Development
According to the children’s charity UNICEF educated women are at least Goals (MDG), for example eradicating
twice as likely to encourage their children to attend school at primary level. In extreme poverty and hunger, reducing
some cultures, parents prefer boys to attend school whilst girls are expected to child mortality, improving maternal
remain at home to help with household responsibilities. health and combating diseases such
Individuals who have greater access to healthcare have better nutrition, so as HIV/AIDS.
are more productive and enjoy a better quality of life.
EXAM PRACTICE
PAPER 2
6 Using an appropriate diagram, explain how investment in education and
healthcare can affect a country’s real national income. [4]
The use of appropriate technology

The use of appropriate technology is a key domestic factor determining the
scope of economic development. For example, micro-credit schemes allow
individuals to invest in technologies that increase the productive capacity of the
economy (see Figure 4.4).
Technology can be classified as capital-intensive technologies or labour-
intensive technologies:
= Capital-intensive technologies rely on the use of capital in the production
process, such as in oil refining, telecommunications and motor manufacturing.
= Labour-intensive technologies rely more on the use of labour, for example
basic tools and equipment such as bicycles, wheelbarrows and hand-powered
water pumps.
Economic development in LEDCs relies more on labour-intensive
technologies to create jobs and income for the population of the country to
escape from extreme poverty. For example, women in LEDCs can use sewing
machines to be far more productive than when doing the same jobs by hand.
® Advances in technology and the use of Expert tip

LRAS LRAS appropriate technologies lead to a favourable :
& ! * cggngz in the p{oduc%ve capacity of the Remember that not all P
T econormy. growth leads to economic
2 ¢ This is shown by an outwards shift of the development. For example,
§ i economy's long run aggregate supply from technological progress that boosts
o LRAS; to LRAS,, thus increasing national capital productivity and causes
. Income from Y; fo Ys. mass unemployment (technological
O Y Yy " unemployment) can create economic
National cutput growth, but this does not equate to
Figure 4.4 Productive capacity and the use of appropriate technology L e laAmEGE
However, economic development can be interrupted if foreign currencies are

required to purchase spare parts or to maintain the technologies.
Many LEDC:s suffer from a lack of infrastructure, such as transportation and
telecommunications networks. This hinders their chances of economic growth
and development.
Access to credit and micro-credit

Credit schemes offer access to borrowed money. The provision of credit is
important to economic development because individuals and firms that cannot
borrow simply cannot invest in any physical, human or natural capital — all
essential for economic development.
Micro-credit schemes are loans of small amounts to individuals on low
incomes in LEDCs for self-employment projects that generate income, so they
can care for themselves and their families. They promote an entrepreneurial
culture, and so help to stimulate economic growth and development.
The idea of micro-credit financing was developed by Bangladeshi banker,
economist and Nobel peace prize winner Muhammed Yunus (2006). The system
grants small-sized loans to those (especially women) who cannot ordinarily
borrow money from financial institutions.
Commercial banks and non-government organisations (NGQOs) are the main
providers of micro-loans. Most banks will charge relatively high interest rates
due to the high risks of lending money to the poor. NGOs tend to charge lower
interest rates, striving instead to stimulate development.
Criteria used to determine which individuals qualify for micro-credit include:
= the borrower’s credit rating (past record of ability to pay debts)
the value of the borrower’s assets
= how much debt the borrower can afford.
Those who qualify for micro-credit schemes are required to attend classes on
financial management. Thus, such schemes have educational and social benefits
to the economy.
The key advantage of micro-credit schemes is that they can simultaneously
enhance gender equality and income distribution. The World Bank and United
Nations are supporters of micro-credit schemes as a form of economic and
human development, especially as they can be used to empower women.
However, the lack of property rights in LEDCs is a major source of poverty
because individuals have little, if any, collateral (financial security on their
assets) to borrow money to fund development projects.
Arguments against the use of micro-credit schemes include the following:
= They do not create job opportunities on a large enough scale to increase the
LEDC's productive capacity.
= High interest rates are charged by commercial banks because those on low
incomes are usually not credit-worthy.
= Micro-entrepreneurs in LEDCs are extremely vulnerable to external shocks
(unexpected changes) in the economy, such as adverse weather conditions
affecting supply. These firms may not be maintainable, so micro-credit does
little for sustainable economic development.
= Micro-entrepreneurs tend to have limited qualifications, skills, training and
experience (as they lack opportunities and access to education). Hence, there
is a high chance of the funds being misused or ineffectively used, thus leading
to business failures.
= The self-employed in LEDCs often have unstable incomes yet endure a huge
degree of risk, so many people who qualify for micro-credit choose to take
jobs at factories instead, as there is greater financial stability. This clearly
defeats the purpose of micro-credit schemes.
The empowerment of women

Gender inequality is a barrier to economic and human development because
it limits the quantity and quality of labour resources in the production process.
Economists therefore believe that empowering women is a vital development
strategy in reducing poverty in LEDCs. Ignoring gender disparities is detrimental
to people’s wellbeing and to the economic and human development of all
countries, but LEDCs in particular.
The empowerment of women (gender equality) helps to end social and
cultural discrimination against females — for example, women in Saudi Arabia
are not allowed to work with men, vote or drive, which hinders labour
productivity and national output.
Empowerment of women can have a huge impact on their self-esteem and
productivity. In the long term, this has positive effects on maternal health and
reducing child mortality (both Millennium Development Goals of the United
Nations).
Countries that fail to empower women and promote gender equality, such
as Ghana and Rwanda, face the problem of lower productivity, and slower
economic and human development, as approximately half of their population
are denied opportunities to improve their standard of living.
The World Development Report from the World Bank recommends four
priorities to promote gender equality and to empower women:
= Reducing excess female mortality and closing education gaps where they remain.
Improving healthcare provision for women and educating females are two of the
most significant investments for fostering human development in LEDCs.
= Improving access to economic opportunities for women — for example,
increasing opportunities for women to participate in the labour force and
improving women’s access to credit and other productive resources.
= Increasing women’s voice and agency in the household and society, i.e.
improving the ability of females to make effective choices and to transform
their choices into desired outcomes, including decision making over family
formation and freedom from the risk of violence.
= Limiting the reproduction of gender inequality across generations. For
example, China’s one-child policy (since 1979) was used to alleviate social,
economic and environmental problems. However, as a consequence of this
policy there has been a major gender imbalance in favour of boys.
Income distribution
Income distribution refers to how the national income of a country is spread
among its population. Unequal distribution of national income exists when
the relatively rich minority account for the majority of the country’s national Common mistake
income, i.e. it is not distributed proportionately. It is incorrect to assume that all
Economic development depends not only on growth in national income trading activities in unofficial (parallel)
but also on the distribution of income. Income inequalities hinder economic markets are illegal. Whilst these are
development as the poor do not have access to education, healthcare, credit or unrecorded, many of these trades in
micro-credit. LEDCs may be in the form of barter
A high and rising degree of income inequality in many LEDCs is seen as a (swapping) or payments made in kind
major barrier to economic development. After all, the eradication of poverty (using goods and services to trade
does not only depend on growth in national income but also on how that rather than money). Hence, unofficial
income is distributed. trade is not necessarily illegal trade,
A more equal distribution of income will mean that those in extreme poverty but has an indirect impact on income
distribution.
are more likely to be able to access education and healthcare. This helps to
improve human development and raise the level of productivity in the economy.
Greater income equality also reduces the likelihood of corruption, which is
a major obstacle to human development in many LEDCs. Corruption and civil
unrest distort market forces and create disincentives for individuals and firms to
take entrepreneurial risks.
1 54 Economics for the IB Diploma
The main way to redistribute income from the rich to the poor is to Expert tip
implement an effective progressive tax system, i.e. increasing marginal tax bands
All five domestic factors affecting
as income levels rise. However, there are three key reasons why it is difficult for
economic development are affected
LEDC:s to raise tax revenues:
by the political regime of the country
= Only a small proportion of the population pay income taxes, as so many in question, i.e. political instability
people are poor and because LEDCs tend to have a large unofficial (parallel) and conflict impact on the economic
market. development of a country. For
= Similarly, as the level of official economic activity is low, the revenue example, corruption in many LEDCs
collected from corporation tax tends to be low. This is especially the case if has reduced the effectiveness of
LEDG:s offer financial assistance to domestic firms and/or tax incentives to domestic policies aimed at improving
encourage foreign direct investment (FDI). development. In some countries, such
= Low incomes and the lack of international trade in many LEDCs mean that as Angola, the informal (unofficial)
there is minimal tax revenue earned from tariffs (taxes on imports). market has far exceeded the reported
gross domestic product (GDP).
Ineffective tax systems in LEDCs have hindered income redistribution and International agencies such as the
hence economic and human development. World Bank and the IMF cannot
operate effectively without political
stability.
EXAM PRACTICE
PAPER 2
7 The charts below show health expenditure as a percentage of the total GDP in
Gambia (Figure 4.5) and Luxembourg (Figure 4.6) from 2000 to 2010.
6.4 — — 6.4
6.2 - 6.2
& — - &
5.8 H — 5.8
5.6 - 5.0
5.4 —5.4
5.2 i i i i i i .7
Jan /00 Jan/02 Jan /04 Jan/06 Jan /08 Jan/ 10
Figure 4.5 Health expenditure (% of GDP) in Gambia

8.4 — — 8.4
8.2~ — 8.2
8| ¥
7.8+ — /.8
7.6 — 7.0
7.4 — 7.4
7.2 =2
7 -1 7
6.8 .8
jcml/ 00 Jcmlf 02 Janlj’OA Jcml/ 06 Jcml/OB Jonlf 10
Figure 4.6 Health expenditure (% of GDP) in Luxembourg
With reference to Figure 4.5 and Figure 4.6, explain how health expenditure
as a percentage of GDP contributes to an economy'’s economic
development. [4]
8 Using an appropriate diagram, explain how economic growth can lead to
economic development. [4]
4.4 The role of international trade

International trade and economic
development
Trade problems facing LEDCs

There are potential gains from international trade that can help countries to
experience economic development, for example export revenue for domestic
producers and increased employment opportunities for workers. However,
international trade can cause problems for many LEDCs, thus creating barriers
to economic development. Such barriers include the following three factors:
m over-specialisation on a narrow range of products
= price volatility of primary-sector output
= inability of LEDCs to access and compete in international markets.
Over-specialisation on a narrow range of products

= Over-specialisation refers to an individual or country focusing on producing
only a small range of products for trade. Thus, over-specialisation limits
m Food and agricultural exports account for a large proportion of total export
earnings for most LEDC:s.
Price volatility of primary-sector output

= Price volatility refers to unstable market prices for primary-sector output,
such as agricultural production and mining.
= A major drawback of LEDC:s specialising in the output of primary-sector
exports is that the prices of primary products are highly volatile and often
exhibit a downwards trend.
= In many LEDCs, rechnological progress is relatively slow in primary-
sector production, thus limiting the ability of LEDCs to compete on an
international scale.
= Supply of primary-sector output tends to be inelastic in supply, so producers
cannot respond quickly to changes in the market. Again, this puts LEDCs in
an unfavourable position.
= Consequences of a long-term decline in the average price of primary-
sector output include a fall in export earnings for LEDCs, a fall in domestic
employment and a deteriorating current account on the balance of payments.
s LEDCs are more vulnerable to external shocks such as adverse weather
conditions and natural disasters, thus making price predictions highly
inaccurate. Such volatility in prices therefore creates uncertainty and
obstructs international trade.
Inability to access international markets

= Many LEDC:s find it difficult to enter foreign markets, especially when The syllabus guide states that students
trying to compete with MEDCs. For example, France, the UK and the USA must be able to explain how these
subsidise their domestic agricultural industries, so farmers in LEDCs simply factors are barriers to development
cannot compete. for LEDCs with reference to specific
m LEDG:s struggle to access international markets due to the trade protection examples. Make sure you revise the
policies imposed by MEDC:s in regional trading blocs. For example, the examples given in class or through
European Union (EU) imposes a common external tariff on non-member your own studies.
countries such as LEDCs.
Long-term changes in the terms of trade (HL only)

The terms of trade (TOT) refers to the index of average export prices in
relation to the index of average import prices. If average export prices rise
relatively to average import prices, the terms of trade have improved as each
dollar of export earnings can now buy more imports.
In LEDCs, primary-sector output dominates national incomes and
employment. However, primary-sector output tends to receive lower prices than
tertiary-sector output in the long term, thus worsening the terms of trade for
LEDC:s. Therefore, LEDCs that rely on the export of primary-sector output tend
to face a deterioration in their TOT over the long term.
A deterioration in the terms of trade means that the country has to sell a
greater volume of exports to finance a given amount of imports.
In general, the gains from international trade favour more economically
developed countries (MEDCs) due to their better terms of trade and because of
the highly unequal distribution of income in LEDCs.
A long-term deterioration in the terms of trade for an LEDC will have
several detrimental impacts:
= Mounting debt problems occur as the LEDC struggles to pay for imports from
its low export earnings.
= Financing international trade becomes more difficult for the LEDC.
= Rising unemployment due to the deteriorating TOT limits economic growth
and therefore employment opportunities.
Ultimartely, this leads to falling standards of living for the citizens of the
LEDC in the long run.
Trade strategies for economic growth and

Import substitution
Import substitution is an inward-looking strategy of economic growth and
development that encourages domestic production and the purchase of domestic
output through protectionist policies such as tariffs and quotas. It is a development
strategy often used to protect infant industries from larger foreign producers.
However, there are drawbacks of using import substitution as a growth and
development strategy. For example, consumers pay higher prices, so there is
a loss of consumer surplus and the use of trade protection is detrimental to
economic efficiency.
Export promotion
Export promotion is an outward-looking strategy of economic growth and
development through international trade with overseas customers. Countries
that adopt an outward development strategy tend to benefit from increased
specialisation and a greater choice of goods and services being available.
Export promotion exposes domestic firms to foreign competition, possibly
resulting in greater efficiency, higher productivity and relatively lower
production costs. Supporters of this trade strategy for economic development
advocate international trade, while supporters of import substitution prefer to
use trade protection.
Trade liberalisation
Trade liberalisation involves the freeing up of international trade without
government interference in the exchange of goods and services across borders,
for example the removal of tariffs and quotas. Another way to achieve this is to
remove barriers and restrictions to foreign direct investments (FDI). This would
enable multinational corporations to operate within the LEDC, thus creating
employment opportunities.
The argument for trade liberalisation is based on the notion that free trade
and market forces improve the global allocation of resources, thereby improving
economic efficiency. In turn, this leads to economic growth and development.
However, negative impacts of trade liberalisation policies include
unemployment (caused by privatisation as firms cut costs and achieve
efficiency) and social welfare losses due to less government involvement (i.e.
cuts in government spending), affecting many people in LEDCs.
The role of the WTO

The World Trade Organization (WTQ) is the international body set up to
encourage and oversee non-discriminatory and open trade negotiations between
its member countries. The WTO has the right to create favourable international
trade terms for LEDC:s. It also has the right to sanction member countries that
violate their trade agreements, thereby helping to promote economic harmony
between its members.
By encouraging international trade, the WTO stimulates economic growth
and development for the global economy.
Bilateral trade agreements

Bilateral trade agreements are preferential international trade deals between
two countries that strive to reduce and/or abolish trade barriers such as tariffs
and quotas. Some examples, such as those between Canada and China or the
USA and Costa Rica lead to an increase in export earnings for both countries.
In addition, this leads to an increase in gross domestic product and more job
opportunities in both countries.
A potential disadvantage of bilateral trade agreements is that foreign goods
from the partner country could be more appealing to consumers, thus causing
problems for domestic firms.
Regional trade agreements

Regional trade agreements are preferential international trade deals that rely on
economic cooperation between member states located near to each other, for
example the Association of South East Asian Nations (ASEAN) and the North
American Free Trade Agreement (NAFTA).
Benefits of regional trade agreements that involve LEDCs include trade
creation between the member countries (as a result of economic cooperation)
and reduced dependency on MEDC:s.
A problem for some countries engaged in regional trade agreements is that
they have had to bail out weaker trading partners. For example, France and
Germany have supported vulnerable members of the EU such as Portugal, Italy,
Greece and Spain during the euro debt crisis.
Diversification
Diversification is an economic growth and development strategy that involves
countries broadening their supply of goods and services in export markets.
It helps to overcome the problems of over-specialisation (which tends to
limit economic growth and development for many LEDCs) and create new
employment opportunities.
Diversification can help LEDCs to reduce their vulnerability to falling prices
in primary-sector output and declining terms of trade. It can also help LEDCs
to reduce their vulnerability to external supply-side shocks such as extreme
weather conditions or natural disasters.
However, diversification carries potential disadvantages. For instance, there
is a relatively high risk of failure as LEDCs lack expertise and higher costs are
incurred due to a broader range of products being manufactured.
EXAM PRACTICE
PAPER 2
9 With the aid of an appropriate diagram, explain how the price volatility of
primary products creates a barrier to economic development. [4]

PAPER 3
10 Brazil is the world's largest exporter of coffee. However, market reforms in
former communist Vietnam have caused a significant increase in the global
supply of coffee.
The world’s top five coffee exporters (kilograms)
Brazil 2550 million

Vietnam 900 million
lvory Coast 696 million
Indonesia 411 million
Ethiopia 330 million
Suggest how the situation above is likely to affect the terms of trade for coffee
exporters. [4]
4.5 The role of foreign direct

investment (FDI)
Foreign direct investment and

multinational corporations (MNGCs)
The meaning of FDI and MINCs

Foreign direct investment is the money devoted by MNCs to business
operations abroad, for example building production facilities overseas or Keyword definitions
acquiring (taking over) a domestic firm. It can thus help to improve economic Foreign direct investment (FDI)
development in LEDCs. For example, China’s investment projects in Latin refers to the long-term capital
America and sub-Saharan Africa have helped to create jobs and boost economic expenditure of multinational
growth in these regions. companies in overseas countries,
Globalisation and the promotion of freer international trade by the World such as Apple’s manufacturing
Trade Organization (WTQO) has encouraged a significant increase in foreign plants in China.
direct investment in LEDCs. Multinational corporations
More economically developed countries (MEDCs) account for the (MNC:s) are businesses that operate
vast majority of the world’s FDI. This is because the largest multinational in two or more countries, i.e. they
corporations are from MEDCs. MNCs have production plants and/or service have operations outside of their
operations in overseas countries — for example, Nike has production facilities home country, such as Japan’s
in Indonesia. These MNCs have grown by using joint ventures and strategic Toyota, Nissan and Honda, which
alliances with firms in LEDCs. This has resulted in a large increase in FDI in all have production plants in the
LELX s, UK and USA.
FDI expenditure is highly dependent on changes in the state of the world

economy. During economic booms, FDI tends to rise significantly as firms
believe that they can increase their profits by expanding overseas.
Reasons why MINCs expand into LEDCs

Table 4.4 Reasons why MNCs expand into LEDCs
Cheaper production costs Many MNCs have operations in LEDCs in order to exploit lower costs of production —
for example, it is far cheaper for Nike to hire workers in Indonesia, China and Vietnam
than in the USA.
Economies of scale By operating on a larger scale due to a larger customer base, MNCs are able to exploit
economies of scale, thereby reducing their unit costs of production. By operating in
overseas markets, MNCs are also able to achieve risk-bearing economies.
Access to natural resources MNCs are keen to expand into LEDCs because many LEDCs are well-endowed in
natural resources, which can then be exploited.
Increased sales revenue Access to fast-growing economies with large populations, such as Indonesia, Nigeria,
Bangladesh, Vietnam and Ethiopia, presents enormous opportunities for MNCs.
Avoiding trade barriers By locating within the LEDC, the multinational corporation is able to avoid trade
barriers such as tariffs, quotas and administrative obstacles. For example, the German
carmaker Volkswagen has production plants in India, Indonesia and Nigeria.
Logistical reasons MNCs locate overseas to reduce delivery times to customers in LEDCs and emerging
markets. For example, the US power-tool firm Black & Decker has production units in
China, so its products sold in East Asia do not have to be exported from the USA.
Financial incentives In order to attract FDI, the governments of LEDCs often offer MNCs incentives to
locate in their country, including tax rebates, grants, subsidies and cheaper rents.
Characteristics of LEDCs that attract FDI

= Low-cost factor inputs — In many LEDCs, an abundant supply of labour
means relatively lower labour costs. In addition, many LEDCs are rich in
natural resources — for example, Angola and Sudan are rich in oil supplies.
Thus, MNCs are attracted to establish themselves in such countries.
= A regulatory framework that favours profit repatriation — Laws and
regulations are usually less strict in LEDCs, thereby allowing MNCs to be
exempt from directives such as minimum-wage laws and safety regulations.
= Favourable tax rules — As LEDCs often compete to attract FDI, favourable
tax rules are granted to MNC:s that locate in their country, such as low rates
of corporation tax or delayed tax payments.
Expert tip
Economics is based on the assumption that economic agents (households and
firms) act rationally, i.e. in their own best interest. This suggests that MNCs spend
money on FDI in order to increase their own revenues and profits, rather than
to promote economic development. After all, companies operate to satisfy the
financial interests of their shareholders rather than to create social welfare.
Advantages and disadvantages of FDI for LEDCs

Table 4.5 Advantages and disadvantages of FDI for LEDCs
m Foreign direct investment is a major source of national = Although FDI helps to create employment opportunities in
income for LEDCs. It is far more stable than financial aid, LEDCs, MNCs often bring in their own management teams
with long-term benefits for LEDCs. In the long run, FDI in whilst locally hired employees are low-skilled workers. This
LEDCs helps to shift both the long-run aggregate supply reduces the benefits of skills transfer to the LEDCs.
and aggregate demand curves to the right. The lenient regulatory framework in LEDCs means that
= Higher national income, resulting from FDI, can help MNCs often exploit their position by:
LEDCs to close their savings gap. As the level of savings o disregarding issues of health and safety at work, for
in the LEDC increases, more funds become available for example long working hours and poor working conditions
investment in the economy, with long-term benefits to o ignoring the external costs of their activities in LEDCs, for
the country. example pollution of the natural environment (land, air
m The profits generated from the investments of MNCs in and sea) and the depletion of non-renewable resources.
an LEDC contribute to the country’s tax revenues. FDI from large MNCs makes domestic rivals less competitive
m FDI allows the transfer of technology and more efficient due to the advantages enjoyed by the MNCs, for example
work practices from MEDCs to LEDCs. economies of scale, technological know-how and tax
m FDI and direct rivalry from MNCs can force domestic rebates from the LEDC government. In extreme cases, this
producers in the host country to become more efficient can lead to the collapse of domestic firms.
and competitive. In most cases, the profits generated by MNCs are
m FDI by a multinational corporation provides many repatriated to their home country rather than reinvested to
employment opportunities in an LEDC. This has the added further improve the facilities and infrastructure in LEDCs.
benefits of skills transfer from MEDCs to LEDCs, higher Thus, critics argue that MNCs exploit and profit from LEDCs
consumption expenditure and increased income tax without really giving much back.
revenue for the government. Some MNCs are criticised for having too much power when
= The presence of MINCs in LEDCs provides domestic negotiating tax breaks and other financial incentives. Many
households and firms with a wider range of choice. LEDCs have very limited bargaining power as MNCs have
Increased competition can also lead to lower prices in the the option to redirect their FDI to neighbouring LEDCs that
economy. are willing to offer better conditions.
m The (potential) presence of MNCs often encourages Critics argue that the growing presence and power of MNCs
governments in LEDCs to invest in infrastructure. creates a loss in the cultural, political and economic identity
MNCs may also help to provide some of the funding of LEDCs in favour of economically developed nations, for
for this. Such investments help to benefit the country as example the consumption of fast foods, soft drinks and
a whole. expensive branded goods.
Common mistake
EXAM PRACTICE
Students often comment that MNCs
PAPER 2 exploit workers by paying them low
11 Explain how foreign direct investment (FDI) can help less economically wages. Whilst wages paid to workers
4] in LEDCs are comparatively lower than
developed countries (LEDCs) to break out of the poverty trap.
in the MNC's home country, they are
12 Using an appropriate diagram, explain how FDI can help less economically usually higher than wages paid by
developed countries (LEDCs) to achieve economic growth. [4] local firms. It would be unreasonable
to expect MINCs to pay workers in
Nicaragua the same wages as workers
in the USA due to the different costs
of living in these countries.
4.6 The roles of foreign aid and

-
multilateral |
development assistance :
Foreign aid
Foreign aid refers to assistance in the form of goods and services granted to LEDCs
for the purpose of economic development. It is concessional and non-commercial,
i.e. it is a gift from the donor rather than a loan. Foreign aid makes up for the
shortcomings of the free market that fails to provide assistance to LEDCs during
times of need, such as emergency relief aid following a natural disaster.
Foreign aid to LEDCs can be granted by governments of donor countries

or by non-governmental organisations (NGOs), such as Oxfam. Donations by
private individuals are usually made through an NGO.
NGOs operate independently of any form of government, often pursuing
aims to improve social wellbeing. Examples of such NGOs include Oxfam and
the Bill & Melinda Gates Foundation.
Classifications and types of aid

Official development assistance (ODA) is foreign aid from donor governments,
rather than from NGOQOs.
Humanitarian aid refers to altruistic aid, typically given to save lives and
maintain human dignity in response to violence, natural disasters and national
emergencies. [t consists of food aid, medical aid and emergency relief aid (e.g.
aid for reconstruction work).
Development aid is foreign aid aimed at helping recipient countries to
achieve their economic development objectives, for example to eradicate
extreme poverty, improve education, reduce child mortality and improve the
overall standards of living.
Development aid can be provided by individual countries, by NGOs, or by
multilateral organisations such as the World Bank and Save the Children.
In general, the priority of development aid from NGOs is to provide foreign
aid on a small scale to help LEDCs to achieve development objectives.
Development aid includes the following:
= Grants — These comprise non-repayable financial assistance provided by
governments, i.e. they do not have to be repaid. Most grants are given to
fund specific projects.
= Concessional long-term loans — Also known as soft loans, these are loans
with highly favourable conditions, such as low interest rates and long
repayment periods.
= Project aid — As the name suggests, this is foreign aid for specific
developmental projects, such as financial support for schools (education) or
for hospitals and sanitation (healthcare).
m Programme aid — This is financial aid given to a specific industry, for
example funding of education or the financial sector.
Tied aid is financial assistance granted with conditions attached — usually
the need to spend the foreign aid on buying products from the donor country.
Bilateral foreign aid is often a feature of tied (conditional) aid.
Tied aid is often criticised as the LEDC’s requirement to buy goods and
services from the donating country might not be appropriate. It is often
perceived as an indirect subsidy for suppliers in the donor country. Hence, tied
aid can harm the competitiveness of LEDCs. Nevertheless, a valid reason for (or Foreign aid can be classified according
advantage of) tied aid is that it ensures that financial aid is used for appropriate to the source and the purpose.
purposes whilst benefiting the donor country.
Motivation for giving aid

Table 4.6 Motivation for giving aid
Motives for giving aid Details

Humanitarian motives Foreign aid is provided for humanitarian reasons, for example emergency relief to help with
natural disasters or wars. It is also given to achieve the UN’s Millennium Development Goals
(MDGs), such as eradicating famine and improving maternal health.
Economic motives Donors give ODA because it is in their financial interest to do so as this builds better economic
ties with the recipient countries — for example, tied aid provides economic benefits to the donor
country.
Political motives Many European countries such as the UK and France provide ODA to their former colonies.
Historically, the USA has provided ODA to support capitalism and free market practices.
Japan has given aid to Nicaragua to influence its vote on banning whaling.
The IB Guide specifies that students need to be able to compare and contrast
the extent, nature and sources of official development assistance (ODA) for two
LEDCs. A good start is to read the free UNDP online report on ODA:
http:/tinyurl.com/It970z0
Evaluation of foreign aid
Advantages of foreign aid

= Without foreign aid, many of the world’s poorest countries would struggle
to ever get out of the poverty cycle. Thus, there are both humanitarian and
economic benefits to providing ODA.
= Foreign aid in the form of ODA and concessionary long-term loans can be
used to increase the productive capacity of the LEDC, thus helping it to
achieve economic growth.
= Foreign aid can help to reduce or eradicate extreme poverty (one of the UN'’s
Millennium Development Goals).
= As aform of injection into the circular flow of income, foreign aid can help
to reduce inequalities and unemployment in the LEDC.
Disadvantages of foreign aid

= Foreign aid in the form of loans imposes interest repayments, so this adds to
Expert tip
the financial burden of many LEDCs, especially as debts have to be repaid in
foreign currencies. ‘Give a man a fish, and you feed him
= LEDCGCs tend to prefer more favourable terms of international trade to help for a day; show him how to catch fish,
their economic development than outright foreign aid — for example, food and you feed him fora lifetime’ (Anne
Isabella Thackeray Ritchie, 1837-1919).
aid and tied aid do little for the long-term prosperity of an LEDC.
This is a useful quote to remember for
= Most economists argue that economic development should be based on the aid versus trade debate regarding
promoting free international trade, such as increasing the exports of LEDCs, economic development.
instead of relying on foreign aid. This is because ODA does not necessarily
lead to development, whereas trade does.
= Foreign aid can create economic dependence on donors from MEDCs. This Expert tip
does not help the country to develop in the long run.
When evaluating foreign aid,
= Corrupt governments in LEDCs often misuse foreign aid rather than passing on consider the following questions as a
the funds to local projects that would benetit local industries and communities. framework:
= More often than not, ODA is insufficient to really help LEDCs develop their
= What are the types of foreign aid
economies. The aftershock of the global financial crisis of 2008 also led to a being given?
decline in donations (as a percentage of the GDP of MEDCs).
= What are the underlying motives
m The type of foreign aid given is not always appropriate — for example it might
behind giving this aid?
promote capital-intensive projects rather than labour-intensive output,
m Is the foreign aid being given for the
which are better suited for LEDCs. Foreign aid might also involve political
right reasons?
interferences rather than direct economic benefits.
Multilateral development assistance

Multilateral development assistance is foreign aid delivered through
international institutions such as the World Bank and the International
Monetary Fund (IMF).
These multilateral institutions are international organisations made up of
member governments around the world. These member states pool resources
together, thus enabling large-scale development programmes to be funded.
Multilateral development assistance is generally seen as a less political form

of foreign aid than bilateral aid and tied aid as it encourages international
cooperation rather than focusing on the financial interests of donor countries.
Multilateral development assistance often takes the form of non-
concessionary loans, i.e. lending that incurs interest and repayment periods
determined by market forces. However, this differs from commercial bank
lending as the loans are specitically for development purposes.
The role of the International Monetary Fund (IMF)

The International Monetary Fund (IMF) is an international multilateral
financial institution set up in 1944 by 29 member countries. Today, there are
188 members of the IMFE. Its goal is to oversee the international financial system
and to promote global monetary cooperation. Thus, the IMF helps to facilitate
sustainable economic growth and development.
The IMEF fulfils its role by assessing the economic policies of all member states
in order to stabilise exchange rates and making short-term non-concessional
loans to countries that experience difficulties making their international
payments.
Traditionally, most of the lending from the IMF went to LEDCs. However,
the global financial crisis of 2008 saw a significant amount of lending to MEDCs
with huge balance of payments problems, such as Portugal, Italy, Ireland and
Greece.
The governance of the IMF is often criticised because the wealthier member
states have a greater share of the voting rights. Thus, the welfare of LEDCs and
their development priorities are often overlooked.
The role of the World Bank

The World Bank is the international organisation that lends money to LEDCs
for economic development projects and structural change. The majority of loans
are for physical capital projects, for example irrigation systems, road networks,
schools, hospitals and transportation links.
The World Bank was set up in 1944 (at the same time as the IMF) to provide
foreign development assistance (concessionary and non-concessionary lending)
to low- and middle-income countries to reduce poverty and improve standards
of living. It is made up of two international financial institutions:
= The International Bank for Reconstruction and Development (IBRD) —
The IBRD provides loans to middle-income countries (not LEDCs), so the
funds are not technically classified as foreign aid. Most of the lending from
the World Bank is made by the IBRD.
= The International Development Association (IDA) — Member countries
of the IDA offer concessionary, interest-free loans of up to 30 years to low-
income countries in order to reduce poverty.
The World Bank is the largest and most familiar development bank in the
world. It made around $30 billion in development loans and assistance in 2013. Common mistake
It has been criticised for offering most of its lending to middle-income countries Many students tend to think of the
rather than to LEDCs that face conditions of extreme poverty, especially as its World Bank as a single institution, but
requirements for eligibility of funding disqualify many poor and heavily indebted it comprises the IBRD and the IDA.
countries,

PAPER 3
13 In 1970, the world’s wealthiest countries agreed to donate 0.7% of their annual gross national income (GNI) as official
development assistance (ODA). Although the USA is often the largest donor in monetary terms, it ranks amongst the
smallest when measured against the 0.7% target.
4=
ODA as percent of GNI
G T T o T
1960 1970 1980 1990 2000 2010
Figure 4.7 ODA from the USA at constant prices (US$ billion)
ODA as percent of GNI (2012) ODA-USD billion (2012)

Greece = lceland
ltaly | =1 Greece
Korea ]| ] g s Luxembourg
Spain s New Zealand
~ Japan | il Portugal
United States | ] £ Ireland
Iceland L Austria
Pifiuggl 1 . N Finland
ustria ] !
MNew Zealand | : ! éoreifi
DAC Tofal : Sl
Canada : glf |
Australia ] —1 1 D O]’:
Germany : I
e : Switzerland
Switzerland ] ] ' MNorway
Belgium : Sweden
Ire?cmd : Awustralia
Finland 7 ' 1 : MNetherlands
United Kinfi;dom ] ; ' : Canada
Netherlands ] . : Japan
Denmark T ] France
Norway | ' ' = Germany
Sweden | . . . United Kingdom
Luxembourg : United States
| | |
0 0.25 0.5 375 ]
Figure 4.8 ODA from selected OECD countries
a Define the terms ‘gross national income (GNI)' and 'official development assistance (ODA)". [4]
b Using the information above, Figures 4.7 and 4.8, and your knowledge of economics, evaluate the effectiveness of
foreign aid in contributing to economic development. [8]
4.7 The role of international debt

Foreign debt
The meaning of foreign debt

Internal debt is the money owed by a country to domestic lenders, such as
private banks, because the government has a budget deficit (government
Keyword definition
expenditure exceeds government revenues). By contrast, external debt is money
Foreign debt (or external debt)
owed to foreign creditors (lenders).
refers to loans of a country that
Creditors are the financial institutions that lend money to others. Foreign
need to be repaid to overseas
creditors include commercial banks, foreign governments and international
lenders such as the World Bank
financial institutions such as the World Bank and the IME
and the IME.
Debts can be incurred by private individuals, firms and/or the government.
Foreign debts are often incurred by countries with weak institutions (including
the domestic monetary system) and poor infrastructure, forcing them to borrow
from foreign creditors to develop their economies.
Foreign debt is a potentially serious matter for many LEDCs because the
burden of interest payments and strict loan terms have often resulted in huge
opportunity costs, for example cutting expenditure on education and healthcare
in order to repay these loans.
It is not uncommon for LEDCs to be heavily indebted because relatively
high interest rates and/or domestic inflation reduce the value of their currency
(foreign debts have to be repaid in foreign currencies). This makes their debt
financing increasingly unsustainable.
The problems of foreign debt can be traced back to the global oil crisis of
1973 when oil prices increased by 500% due to the Arab—Israeli War (or the
Yom Kippur War). This created a huge surplus of profit for exporters of oil, Common mistake
deposited in banks, with the money being lent to LEDCs. Not all debt is detrimental to the
The subsequent oil crisis of 1979 caused a worldwide recession, with LEDCs wellbeing of LEDCs. This depends on
unable to export enough of their commodities to pay off their debts. Many the level of affordability of the debt.
LEDCs defaulted on their loans. Borrowing money to fund structural
Foreign debt can cause both economic and social instability. For example, the changes and economic development
global financial crisis caused huge problems, even for MEDCs — unemployment can be beneficial to LEDCs — it is when
reached 28% in both Spain and Greece. Ultimately, high levels of foreign debts the foreign debt is unaffordable that
can make LEDCs even poorer. problems arise.
Heavily indebted countries

Some countries have become so heavily indebted that they have had to
reschedule their debt repayments to banks and other lenders. Debt rescheduling
means lengthening the time it takes to repay the loans, often leading to further
Keyword definition
borrowing and escalating debts.
A heavily indebted poor country
HIPC:s are also highly vulnerable to external shocks that are beyond their
(HIPC) is a low-income nation
control, such as natural disasters and oil crises (which cause inflation). These
with a huge outstanding debt,
shocks add to their soaring debts.
making it eligible for special
Some HIPCs suffer from debt overhang, i.e. existing debts are so unaffordable
financial assistance from the IMF
that they find it extremely difficult to borrow more money. Debts incurred by
and the World Bank.
some HIPCs exceed government revenue from taxpayers, thus causing a debt
trap, i.e. they are unable to ever repay their debts.
In extreme cases, the failure of HIPCs to repay foreign debts has caused
perpetual debts to occur, i.e. taking out subsequent loans to service (pay for)
existing debts. This reduces their financial status, thus making future foreign
investment in these countries less attractive.
In many cases, LEDCs incur huge debts because loans and financial aid
are misused by corrupt leaders, for example to finance military spending and
weapons.
The mounting debt burden faced by HIPCs has led to international pressures
for creditors to cancel the debts (known as debt forgiveness) in an attempt to
restart or improve the economic development of HIPCs. However, this could
cause some HIPCs to become complacent (or reckless) as they are protected
from their irresponsible behaviour, so may continue to be careless in the future.
Instead, conditional assistance can be given to HIPCs, i.e. debt relief granted
on the condition that HIPCs meet a range of targets for structural changes,
such as poverty-reduction programmes. Debt relief includes both partial and
complete debt forgiveness for HIPCs.
The rescheduling of debt and conditional assistance are mainly facilitated by
international financial institutions such as the IMF and the World Bank. Both
these organisations have key roles in resolving the international debt problems
of LEDCs and HIPCs.
The International Monetary Fund (IMF) acts as an international lender
of last resort to countries with urgent or major balance of payments problems.
If a country is expected to default on its loans, the IMF can intervene, using
conditional assistance.
The World Bank is an international finance organisation concerned with
lending money on a long-term basis to LEDCs to assist in their economic
development.
International debt and the balance of payments

The servicing of international debts can cause balance of payments problems for
the indebted country.
Many LEDCs have a high debt service ratio (the ratio of foreign debr,
including interest repayments, to its export earnings). This means that they
need to generate more export earnings to fund their foreign debts. A low debt
service ratio suggests a healthier financial position.
HIPCs import far less than their populations need from MEDC:s as there is
a long-term decline in the real value of their own exports and their currencies.
Expert tip
Some HIPCs spend more money on debt financing than they spend on
education or healthcare. HL students should consider the nature
There is less of an incentive for direct investment in highly indebted of deteriorating terms of trade faced
by most LEDCs, i.e. a fall in the index
countries. This has a negative impact on the financial account of the balance of
of average export prices to average
payments of such countries. import prices. This creates further
Portfolio investment in highly indebted countries is also likely to fall, again problems for LEDCs as each unit of
having a negative impact on the financial account. For example, investor exports is worth less than before in
confidence in Iceland fell dramatically following the nation’s debt crisis and funding their import expenditure.
collapse of banks during the global financial crisis.

PAPER 3
14 With reference to the table below, explain why excessive foreign debt creates a
problem for the economic development of a country. [4]
COUNTRY DEBT-TO-GDP RATIO (%)

Zimbabwe 150.9
Lebanon 139.5
Bhutan 89.4
Guyana 63.3
4.8 The balance between markets

and intervention
Strengths and weaknesses of market-

orientated policies
Market-orientated policies
Market-orientated policies focus on increasing the productive capacity of the
economy by improving healthcare, education and infrastructure to achieve
economic development. They also focus on improving the supply-side of the Keyword definition
economy by using the price mechanism (e.g. tfloating exchange rates rather than Market-orientated policies
fixed or managed exchange rate systems) and liberalised capital flows between are dynamic, outward-looking,
countries (the free movement of foreign exchange). macroeconomic policies used
Supporters of market-orientated policies argue that market forces allocate to stimulate economic growth
resources efficiently, thus enhancing economic development. Such policies and development via market
also create incentives to invest in the economy. Examples of market-orientated forces, for example using anti-
policies include: monopoly regulation to encourage
= Deregulation — This refers to the reduction or removal of rules and competition and efficiency.
regulations in a particular industry, therefore creating a grearer degree of
competition and encouraging market forces to allocate resources.
= Trade liberalisation — This refers to policies that encourage free trade,
including the free movement of capital flows, by removing barriers to
international trade. The IMF believes that trade liberalisation promotes
economic growth, development and poverty reduction.
= Privatisation — This is the process of transferring ownership of public-sector
assets to private-sector ownership. Private-sector firms, driven by financial
motives, are argued to be more economically efficient than bureaucrats
running public-sector organisations.
= Labour market reforms — These are policies that remove inefficiencies in
the labour market, thereby creating greater flexibility and productivity, for
example reducing the power of labour unions, cutting unemployment benefits
and abolishing minimum wages.
= Tax reforms — Lower rates of income tax and corporation tax create
incentives to work and to supply, i.e. tax reforms can motivate people to seek
employment opportunities and firms give greater incentives for firms to raise
output, thus achieving growth and development.
Strengths of market-orientated policies

m Efficiency — The key benefit of market-orientated development policies, such
as trade deregulation and privatisation, is that resources are allocated more
efficiently than through government intervention in economic activity.
= Competitiveness — Labour market reforms, for example, create incentives to
work. These policies therefore help to improve labour market flexibility and
productivity, resulting in a more internationally competitive labour force.
= Economic growth — The profit motive in free markets encourages people to
work hard and firms to take entrepreneurial risks, such as expenditure on
investment and innovation. Thus, market-orientated policies have a positive
impact on economic growth.
= Benefits of free trade — Free trade policies can lead to many benefits, such
as increased consumer choice, lower prices and improved quality. They also
enable firms to sell to more customers, beyond the borders of the country.
This inevitably contributes to growth and development.
= Investment opportunities — The liberalisation of trade and capital flows

reduces barriers to international trade and exchange. This is an important
factor in attracting foreign direct investment (FDI), i.e. the capital
expenditure of multinational corporations in overseas economies.
Weaknesses of market-orientated policies

= Market failure — The inability of any market-orientated policy to deal with
market failure is its main weakness — for example, negative production and
consumption externalities are not dealt with. LEDCs also lack sufficient
provision of merit goods such as education and healthcare.
m The development of a dual economy — This occurs when two distinct
economic sectors exist within a country, with different levels of development.
It is common in LEDCs with a low-income sector catering for local demand
and another for export-driven international markets.
= Income inequalities — The advantages of economic development do not
automatically trickle down to benefit the poorer members of society, so
government intervention is required to tackle the problems of income
inequalities. Tax reforms can also cause income inequalities.
Strengths and weaknesses of

interventionist policies
Interventionist-orientated policies
Interventionist policies are used to correct market deficiencies, such as
providing adequate housing to ensure a minimum social safety net for
all members of society. This is highly unlikely to occur in the absence of
Keyword definition
government intervention.
Interventionist-orientated policies
The provision of merit goods (such as education and healthcare) and public
refer to the use of government
goods (such as flood control systems and street lighting) help to improve the
involvement to stimulate or regulate
economic development for the majority of people in society.
Government intervention is also required to provide appropriate
infrastructure, such as roads, ports, airports and telecommunications networks.
Proper infrastructure is needed to encourage foreign direct investment (FDI) to
support economic development.
Interventionist-orientated policies are used to protect the welfare of workers,
for example by establishing health and safety at work legislation and by setting
minimum wages. They can also be used to protect the welfare of consumers, for
example anti-monopoly legislation.
Strengths of interventionist policies

= Provision of infrastructure — Without government intervention, there would
be a lack of infrastructure (the physical structures required for the effective
operation of society), for example roads, railways and telecommunications
networks.
= Investment in human capital — The private sector is unlikely to provide
sufficient investment in human capital through education and training,
especially in LEDCs. Thus interventionist policies are required to encourage
more provision of such merit goods.
= Provision of a stable macroeconomic economy — Development requires
government intervention to provide a safe and stable economic environment
to protect the interest of the economy by interventionist demand and
supply-side policies.
= Provision of a social safety net — Interventionist policies through direct

government provision and a social welfare system ensure that all members of
society have access to basic necessities, thus preventing absolute poverty in
the economy.
Interventionist policies can be used to tackle inequalities, which hinder the
development and prosperity of LEDCs. For example, cultural and historical
contexts in many countries mean that women are not given the same
opportunities as men. Thus, intervention is necessary.
Intervention is also required when a country faces a major emergency or
disaster, such as a civil war. Without intervention, the productive capacity of
the country will decline along with a fall in FDI and standards of living.
Weaknesses of interventionist policies

m Excessive bureaucracy — This refers to administrative systems, structures
and regulations. There is over-regulation in many LEDCs, which leads to
economic inefficiencies rather than economic growth and development.
Common mistake
= Poor planning — Political instability and conflict, common in many LEDCs,
can cause major delays in production, thus limiting opportunities for Students often claim that eradicating
corruption is a prerequisite to
economic development. The lack of market signals (forces of demand and
economic development. It is unlikely
supply) means that the planning is often unrealistic.
that corruption can be eradicated
= Corruption — Dishonest governments that misuse sources of finance reduce (it exists in economically developed
the effectiveness of policies intended to promote economic development. countries too), but development
Corruption reduces trust between individuals, firms and governments, thus occurs when corruption is reduced.
acting as a deterrent to FDI.
Market with government intervention

Good governance refers to the moral conduct of public affairs and the
management of public resources. It can be seen as the opposite of corruption,
so is important for the development process of an economy. Good governance
applies to anyone in a position of responsibility with decision-making power,
including government officials, lawmakers, the military, scientific researchers
and religious leaders.
Good governance requires the following:
= transparency in government policies and government affairs
= determined effort to limit corrupt practices, such as enforced fines and
sanctions
= provision of a welfare safety net for citizens who suffer from ill health and/or
unemployment
= accountable and law-abiding policies.
Due to the advantages of interventionist-orientated policies and market-
orientated policies, a complementary approach may be the best way to
achieve economic development, i.e. a balanced use of both market-orientated
development policies and government intervention.
Evidence suggests that neither extremes work in the real world, for example
the collapse of communism due to its bureaucratic inefficiencies in the latter
part of the twentieth century and the need for government intervention
following the global financial meltdown of 2008.
Are you ready?
Use this checklist to record progress as you revise. Tick each box when you
have:
= revised and understood a topic
= tested yourself using the Exam practice questions and gone online to check
your answers.
('
Competitive markets: demand and supply
Markets and demand
Supply
Market equilibrium
The role of the price mechanism
Market efficiency
Elasticity
Price elasticity of demand (PED)
Cross price elasticity of demand (XED)
Income elasticity of demand (YED)
Price elasticity of supply (PES)
Indirect taxes
Subsidies
Price controls
Market failure
The meaning of market failure
Types of market failure

Are you ready? 171
- s
Theory of the firm and market structures (HL only)
Production and costs
Revenues
Profit
Goals of firms
Perfect competition
Monopoly
Monopolistic competition
Oligopoly
Price discrimination
Section 2 Macroeconomics
The level of overall economic activity
Economic activity
The business cycle
Aggregate demand and aggregate supply
Aggregate demand (AD)
Aggregate supply (AS)
Equilibrium
The Keynesian multiplier (HL only)
Macroeconomic objectives
Low unemployment
Low and stable rate of inflation
Economic growth
Equity in the distribution of income

b
-
Fiscal policy
The government budget
The role of fiscal policy
Monetary policy
Interest rates
The role of monetary policy and short-term

demand management
Supply-side policies
The role of supply-side policies
Interventionist supply-side policies
Market-based supply-side policies
Evaluation of supply-side policies
Section 3 International economics
International trade
Free trade
Restrictions on free trade: trade protection
Exchange rates
Freely floating exchange rates
The balance of payments
The structure of the balance of payments
Current account deficits
Current account surpluses

Are you ready? 173
- E
Economic integration
Forms of economic integration
The terms of trade (HL only)
The meaning of the terms of trade (HL only)
Causes of changes in the terms of trade (HL only)
Conseqguences of changes in the terms of trade (HL only)
Section 4 Development economics

Economic development
The nature of economic growth and

Measuring development
Measurement methods
The role of domestic factors
Domestic factors and economic development
The role of international trade
International trade and economic development
The role of foreign direct investment (FDI)
Foreign direct investment and multinational

corporations (MNCs)
The roles of foreign aid and multilateral

development assistance
Foreign aid
Multilateral development assistance

-
The role of international debt
Foreign debt
The balance between markets and intervention
Strengths and weaknesses of market-oriented policies
Strengths and weaknesses of interventionist policies
.
My revision notes
My revision notes 177
Glossary
Ad valorem tax imposes a percentage Cost—push inflation is triggered by Expansion see Movements
tax on the value of a good or higher costs of production thus
Expenditure reducing policies are
service. Examples include property shifting aggregate supply to the left
designed to cut a current account
taxes, tariffs (taxes on imports) and and forcing up average prices.
deficit by lowering disposable
sales taxes.
Cross price elasticity of demand income to limit aggregate demand
Aggregate demand is the total value of (XED) measures the degree of and import expenditure in
all goods and services demanded in responsiveness of demand for one particular.
the economy, per time period. product following a change in the
Expenditure switching policies are
price of another product.
Allocative efficiency happens when intended to encourage households
resources are distributed so that Consumer surplus refers to the and firms to buy domestically
consumers and producers get the benefits to buyers who are able to produced goods and services rather
maximum possible benefit; thus no purchase a product for less than than imported alternatives by
one can be made better off without they are willing to do so. raising the relative price of imports
making someone else worse off. or reducing the relative price of
Current account deficit exists when
eXports.
Asymmetric information exists when the sum of the outflows from the
one economic agent (buyer or current account exceeds the inflows Explicit costs are the identifiable
seller) in an economic transaction into the account — for example, net and therefore accountable costs
has more information than the import expenditure on goods and related to the output of a product.
other in a certain market — for services is greater than net export Examples include wages, raw
example, life assurance policies, earnings. material costs, utility bills and rent.
stock market products, pension
Deflationary gap (also known as a External costs (also known as
fund schemes, second-hand cars
recessionary gap) exists when the negative externalities) are costs
and works of art.
real national output equilibrium is incurred by a third party in an
Bilateral trade agreement is a below the full employment level of economic transaction for which no
contractual trade arrangement output. compensation is paid.
between two countries, such
Demand—pull inflation is inflation Green GDP is a measure of GDP
as closer economic partnership
triggered by higher levels of aggregate that accounts for environmental
agreements (CEPAs).
demand in the economy, which destruction from economic activity
Business cycle describes the drives up the general price level. by deducting the environmental
fluctuations in economic activity costs associated with the output of
Diminishing returns occur in
in a country over time. These goods and services.
the short run when a variable
fluctuations create a long-trerm
factor input (such as labour) is Gross domestic product (GDP) is the
trend of growth in the economy.
successively added to a fixed factor value of all final output of goods
Cap-and-trade schemes (CATS) are (such as capital), which eventually and services produced by firms
government-regulated emissions reduces the marginal and hence within the country, per year.
trading schemes using a market- total output.
Gross national product (GNP) is
based approach. The regulator
Disposable income is earnings after the value of all final output of
sets a limit (the cap) on the total
taxes have been accounted for, i.e. goods and services produced by a
amount of emissions allowed in
the actual take-home income that country’s citizens, both domestically
an industry and firms are issued
workers are able to spend. and abroad.
emissions permits.
Economic costs are the explicit and Human Development Index (HDI)
Circular flow of income model is
implicit costs of all resources used is a composite indicator (of life
a macroeconomic tool used to
by a firm in the production process. expectancy, educational attainment
explain how economic activity and
and income) used as an alternative
national income are determined. Economic growth is the increase in
to real GDP or GNI per capita as a
the level of economic activity, i.e.
Complements are products that are measure of economic development.
the annual percentage growth in
jointly demanded, such as cinema
national output. Implicit costs are the opportunity
movies and popcorn or pencils and
costs of the output, i.e. the income
erasers. Economic profit occurs when total
from the best alternative that is
revenue exceeds total economic
Contraction see Movements foregone.
costs. It is profit that is over and
above normal profit. A firm might
choose to continue.
Glossary 179
Income elasticity of demand Marginal private cost (MPC) is the Merit goods are products that create
(YED) measures the degree of additional cost of production for positive externalities (spillover
responsiveness of demand following firms or the extra charge paid effects) when they are produced
a change in income. by customers for the output or or consumed. Hence, the social
consumption of an extra unit of a benefits from the production and
Indirect tax is a government levy
good or service. consumption of merit goods are
on the sale of certain goods and
greater than the private benefits.
services. It includes specific taxes Marginal propensity to consume
and ad valorem taxes. (MPC) measures the proportion Micro-credit schemes are loans of
of each extra dollar of household small amounts to individuals on
Inferior goods have a negative
relationship between income and income that is spent by low incomes in LEDC:s for self-
employment projects that generate
quantity demanded, i.e. customers consumers, i.e. MPC = B income, so they can care for
switch to a superior (luxury) AY '
themselves and their families.
product as their income rises (e.g. An increase in the MPC will
canned food products versus fresh tend to increase the value of the Movements are caused by price
food products). multiplier. fluctuations along an existing
demand curve. A rise in price
Interest rates can refer to the price Marginal propensity to import
results in a contraction in quantity
of borrowing money or the return (MPM) measures the proportion
demanded, whereas a fall in price
from saving money at financial of each extra dollar of household
causes an expansion in quantity
institutions such as banks. income that is spent on imports,
demanded.
International trade is the exchange of i.e. MPM = 2M Multilateral trade agreement is a
goods and services beyond national AY
legally binding trade deal between
borders. It involves the sale of Marginal propensity to save (MPS)
more than two countries, for
exports (goods and services sold measures the proportion of each
example in a free trade area. Such
to overseas buyers) and imports extra dollar of income that is
trade agreements are made within
(foreign goods and services bought saved by households, i.e. 2 the guidelines of the World Trade
by domestic households and firms). AY
Organization (WTO).
Keynesian multiplier is a model that Marginal propensity to tax (MPT)
measures the proportion of each Natural monopoly exists when
shows that any increase in the
extra dollar of household income the industry can only sustain
value of injections results in an
that is levied by the government, one supplier, to avoid wasteful
even greater increase in the value
AT competition and to maximise
of national income. It also shows i.e.
economies of scale by having a
that any increase in the value of AY
single provider.
withdrawals leads to a greater fall in Marginal social benefit (MSB) is the
the value of national output. added benefit to society from the Normal goods are products that
Labour force consists of the production or consumption of an customers tend to buy more of as
employed, the self-employed and extra unit of output, i.e. the sum of their income level increases. They
the unemployed, i.e. all those in MPC and marginal external costs. comprise necessities (such as food)
and luxuries (such as cars).
work and all those actively seeking Marginal social cost (MSC) is
employment. the extra cost of an economic Normal profit is the minimum
transaction to society, i.e. the sum revenue needed to keep a firm in
Long run is the period of time when all
of MPB and marginal external business. Hence, it is also referred
factors of production are variable, so
all costs of production are variable. benefits. to as zero economic profit and
occurs at the point where a firm
Luxury goods are superior goods and Market equilibrium occurs when the
breaks even by covering both
services as their demand is highly quantity demanded for a product
economic and implicit costs from
is equal to the quantity supplied
income elastic, i.e. an increase in its sales revenue.
income leads to a proportionally of the product, i.e. there are no
greater increase in the demand for shortages or surpluses. Poverty trap (or poverty cycle) is a
vicious cycle of poverty causing
luxuries. Market failure exists when the price
greater poverty. Low-income
Marginal private benefit (MPB) mechanism (the market forces
earners spend most, if not all, of
is the additional value enjoyed of demand and supply) allocates
their income on meeting their
by households and firms from scarce resources in an inefficient
essential needs, so they have
the consumption or production way, i.e. there is either over-
insufficient funds to invest in their
(output) of an extra unit of a provision or under-provision of
future and are trapped in poverty.
particular good or service. certain goods and services.
180 Glossary
Price elasticity of supply Social benefits are the true (or Supply is the willingness and ability of
(PES) measures the degree of full) benefits of consumption or firms to provide a good or service at
responsiveness of quantity supplied production, i.e. the sum of private given price levels, per time period.
of a product following a change in benefits and external benefits.
Trade creation occurs when economic
its price along a given supply curve.
Social costs are the true (or full) costs integration shifts, trade deals away
Private benefits are the benefits of consumption or production, from higher-cost producers from
of production and consumption i.e. the sum of private costs and outside the trading bloc to lower-
enjoyed by a firm, individual or external costs. cost producers within the trading
government. bloc, due to the removal of trade
Specific tax, also known as a per unit
barriers.
Private costs of production and tax, imposes a fixed amount of tax
consumption are the actual costs on each product. Examples include Trade diversion occurs when
incurred by a firm, individual or taxes on cigarettes, air passenger tax economic integration shifts
government. and electronic road pricing and trade deals away from lower-cost
road tolls. producers outside the trading bloc
Producer surplus is the difference
to higher-cost producers within
between the price that firms Subsidy is financial assistance from the
the trading bloc due to the trade
actually receive and the price they government to encourage output
agreements of the customs union.
were willing and able to supply at. (such as the sale of exports), to
reduce the price of certain merit Unemployment occurs when people
Revenue is the money received from
goods (such as education, training are willing and able to work and
the sale of a firm’s output.
and healthcare), or to keep down the actively seeking employment but
Short run is the period of time when cost of living (such as food prices). are unable to find work.
at least one factor of production,
Substitutes are products that can be
such as land or capital, is fixed in
used instead of each other, such
the production process.
as Coca-Cola or Pepsi and tea or
coffee.

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Section 3 International economics 111

Section 4 Development economics 143

Are you ready? 170

Features to help you succeed

EXAM PRACTICE (HL ONLY)

Getting to know the exam

Paper 1 1.5 hours Essay 1 and 2 50

Paper 3 Expert tip

Assessment objectives and command

AO1 Demonstrate knowledge and understanding of specified content,

Source: IB Economics Guide, page 7

These assessment objectives are examined in the following way:

Assessment objective Paper 1 Paper 2 Paper 3

Command terms indicate the depth of treatment required for a given

Assessment objective Command terms Depth of answers

Source: IB Economics Guide, page 9

Countdown to the exams

THE DAY BEFORE THE EXAMINATION

Check the time and place of the exams. Location:

1.1 Competitive markets: demand

demanded rises from must exist for a market to exist.

ability of customers to pay a certain

PI$IA P$I4 P$I4

Figure 1.2 The market demand curve

Non-price determinants of demand

Movements along, and shifts of, the demand

A fall in price from Py to Pg

A change in a non-price Common mistake

Quantity demanded the quantity demanded, i.e. it causes

Linear demand functions (HL only)

EXAM PRACTICE (HL ONLY)

Movements along, and shifts of, the supply

A fall in price from Py to P

price rise from P} to Py causes

The non-price determinants of supply

Technological Advances in technology mean that there can be greater levels

Linear supply functions (HL only)

Equilibrium and changes to equilibrium

supply because the

Calculating and illustrating equilibrium using

EXAM PRACTICE (HL ONLY)

The role of the price mechanism

Figure 1.10 Signalling and incentive functions of price

Consumer surplus, producer surplus and

Points A, B and C represent

Consumer surplus At the equilibrium price of Py, there are

pay a higher price, as shown by all

At the equilibrium price of P, there are

Figure 1.13 Producer surplus

maximised. A move away from the

market equilibrium will make one of

EXAM PRACTICE (HL ONLY)

From the diagram above calculate the value of:

Price elasticity of demand

As the price rises from Py fo

As the price drops from Py to

from Q; to Qp. Examples of

| products with high PED are