What is economics?

Economics is the scientific study of the ownership, use, and exchange of scarce resources - often shortened to the science of scarcity. Economics is regarded as a social science because it uses scientific methods to build theories that can help explain the behaviour of individuals, groups and organisations. Economics attempts to explain economic behaviour, which arises when scarce resources are exchanged.
In terms of methodology, economists, like other social scientists, are not able to undertake controlled experiments in the way that chemists and biologists are. Hence, economists have to employ different methods, based primarily on observation and deduction and the construction of abstract models. As the social sciences have evolved over the last 100 years, they have become increasingly specialised. This is true for economics, as witnessed by the development of many different strands of investigation including micro and macro economics, pure and applied economics, and industrialand financial economics. What links them all is the attempt to understand how and why exchange takes place, and how exchange creates benefits and costs for the participants.

The study of economics

The study of economics involves three related investigations. 1. Why scarce resources are exchanged?

2. How consumers and producers behave as they interact with each other in markets, in their attempt to achieve mutually beneficial exchange? 3. The role of government in compensating for the limitations of markets in achieving mutually beneficial exchange?

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The methods used by economists

Economists use scientific observation and deduction in their investigations. To achieve this they:

Describe and measure the exchanges they observe Economists describe changes in economic variables, and measure these changes over time. For example,
economists describe and measure how interaction in markets determines the prices of such diverse products as motor cars, houses, haircuts, and computer software. Measurement in economics can take many forms, including measuring absolute and relative quantities and values. When measuring relative values it is common to use index numbers.

Explain how interactions arise and create costs and benefits Economists try to explain the effects, or results, of economic transactions. For example, economists can
explain why, despite bubbles and crashes, the long-run trend in house prices in the UK has been upwards over the last 30 years, and can identify those who have been affected positively and negatively by this increase. Of course, economists also try to explain the short-term movements in prices, and how they also have costs and benefits.

Propose hypotheses, construct, and apply models to test these hypotheses. Like all scientists, economists develop hypotheses to explain why economic behaviour takes place, and then construct models to test these hypotheses. For example, economists may propose that price rises are caused by excess demand, and then attempt to construct a model of price that explains how excess demand can raise price. Economists frequently use versions of the demand and supply model to help explain
events such as house price trends and movements. Economic models usually employ graphical and mathematical analysis to help explain and illustrate such economic processes.

Gather data to put into the model

Models must be tested against the real world, which means gathering statistical data about real events. In this way, a model can be improved and revised when necessary. Predict behaviour based on these models. The ultimate goal of the economist is to predict future behaviour. For example, by using a demand and supply model and by inputting real data about the housing market, economists can show that even a small fall in bank lending can trigger behaviour that leads to a significant fall in house prices in the short run. The ultimate value of an economic model is that it can accurately predict the onset and the effect of an economic event. The better the model is, the more useful it is in helping economists make predictions. Economists assume that economic events and phenomena do not occur at random, but are determined by underlying and understandable causes. Unlike the pure scientist, economists cannot undertake controlled
experiments, so they must test their models in different ways. Statistical analysis of actual economic data can provide a flow of information from which to build models and test hypotheses. For example, by gathering data about changes in house prices it is possible to deduce factors that cause house prices to go up or down, and by how much. Economists use index numbers to help make comparisons between countries and over time. Correlation analysis can help determine the strength of particular causal relationships so thatstrong and weak relationships can be identified. For example, it might be possible to demonstrate that, of all the factors that have contributed to falling house prices, the reduced availability of credit is the single biggest factor.

The role of the professional economist

Professional economists apply their skills of description, analysis, model building, and prediction to generate knowledge and, from this, provide advice to private firms, to governments and other organisations.

Providing knowledge
1. The first function of the economist is to provide information, called economic intelligence, from which decisions can be made. For firms to survive and succeed, they need to take many decisions, but each decision carries with it a risk. The professional economist can help reduce such risks by gathering and analysing economic intelligence. This economic intelligence is only useful when it can be put into an economic model, and then applied to the decisions that need to be taken.

2. The second function of the professional economist is to interpret the data that has been gathered and provide informed advice to firms, organisations, and governments about the likely costs and benefits of the decisions they make. In providing advice, the economist will always make an assessment of the other options that could have been chosen. For example, a large petrol refiner and retailer may be faced with a significant rise in the costs of crude oil should it now raise price? After having made an assessment of all the pricing options, and having taken account of the likely response of rivals, the firm s chief economist may advise it to hold price constant perhaps the least common sense answer. To find out why, see: oligopoly

Positive and normative economics

As a social science, economics attempts to use the principles and methods of science to explain economic behaviour. This involves making positive statements about the economic world. Positive statements are those that can be verified, and are factual, such as: .. House prices have fallen by 15% over the last year... In contrast, normative statements are based on opinion and value judgement. Statements suggesting that something ought to happen, or that something is unfair , are normative because they are matters of opinion. For example, ..the recent fall in house prices is unfair to the rich.. .

This statement cannot be tested because it not based on anything testable. If there is an agreed definition of fairness, and it can be measured, then it might be possible to test the effect of the change in house prices on the degree of fairness experienced by a certain identifiable group of people defined as rich. Therefore, this statement is normative, impossible to verify, and based on opinion rather than fact.

The ceteris paribus rule

Economics is a social science, and, unlike the physical sciences, cannot engage in controlled experimentation to demonstrate how variables are connected. In the real world, economic variables such as price and income, are constantly changing, and this creates a problem in demonstrating the relationship between variables. For example, a fall in price is likely to lead to a rise in consumer demand if we assume nothing else changes. Of course, for independent reasons, income could also fall while demand does not rise. The fall in price could have been counteracted by a fall in income. The ceteris paribus rule, that all other things remain the same, is used whenever attempting to demonstrate the link between economic variables. See also: Exchange The economic problem Production possibility frontiers Index numbers

Exchange
Economic behaviour involves the exchange of one scarce resource for another. When people engage in paid work, they exchange their scarce time, effort, and skill for income, and, when people make purchases, they exchange their scarce income for scarce goods and services. Economic activity is driven by the need to exchange.

Wants and needs

The need to exchange has its roots in human biology. All humans are born with basic needs, including the need to eat and drink, the need to keep warm, and the need to be protected. These result in a sustained demand for food, drink, clothing, and shelter. In addition, the human species has wants, which also have a strong influence on behaviour. DVDs, computers and foreign holidays are all examples of wants. As incomes rise the relative importance of wants increases in relation to needs. In a modern and affluent economy, the satisfaction of wants frequently dominates economic activity, while in less developed economies the satisfaction of basic needs remain the overwhelming goal.

Consumption
The process of satisfying needs and wants is called consumption. The need and desire to consume is, clearly, what drives individual economic actions and provides the motive for engaging in an exchange of scarce resources. To be able to consume, individuals need to exchange their skill and effort, or their enterprise,

land or capital, for an income. They can then exchange this income for the scarce products they need or want. Through exchange, consumption is satisfied by a process called production.

Factors of production
Production involves the creation of goods and services by using scarce resources. Producers must exchange the income they earn for the scarce resources they need to enable them to produce. Therefore, both parties, producers and consumers, must exchange something they have for something others want.

There are four types of scarce resource used in the process of production.

1.

Land and natural resources

This includes the land on which production is located as well as the resources contained within the land, such as metals, minerals, and oil. The environment - the air, sea, rivers, and forests is also a scarce resource.

2.

Human capital

This includes the value of human skill and physical effort that is available to an economy, and is more commonly referred to as labour.

3.

Real capital

This includes all man-made assets which have been created to help produce goods and services, such as machinery and equipment. It also includes stocks of raw materials waiting to be used before they become goods and serves. The creation of capital is called investment.

4.

Enterprise

Enterprise is supplied by the entrepreneur who has two crucial roles: 1. Combining the other factors in such a way that goods and services can be produced in the most efficient way. 2. losses. Taking risks associated with the potential loss of assets or with making commercial

Scarce resources are also called factors of production. All production requires the input of scarce resources.

Types of production
Production is undertaken by firms, also known as enterprises, or businesses. There are three stagesofproduction: 1. Primary production, which involves the extraction of resources from the earth, such asagriculture, fishing, and mining. Land and natural resources are the main resources used in primary production. 2. Secondary, which involves the manufacture of semi-finished and finished consumer goods, such as computers, motor vehicles, and clothing. Labour and capital are the main resources used in the secondary sector. 3. Tertiary, which involves the distribution of products and the creation of services, such as road haulage, financial services, and healthcare. Human capital is usually the most essential resource used in tertiary production.

The role of money in exchange Money occupies a central role in market economies because it acts as a medium of exchange. The advent of money replaced the need for exchange through barter and enabled producers and factor owners to specialise. For example, without money, a hairdresser would have to accept another good or service as direct payment for a haircut. However, if the hairdresser is paid in potatoes, it means that he must pay for his assistant in potatoes, as well as pay himself in potatoes, and his suppliers. However, what if another client wants to pay in rice, and yet another in wheat? What is a haircut worth in terms of rice or wheat? Exchange through barter is very complex, and barter economies tend to remain highly undeveloped because direct trade is extremely difficult. Money allows complex trade and exchange Money is any asset that is acceptable in the settlement of a debt incurred in an exchange. For an asset to be widely used as money, it must have certain properties, including that the asset is portable, divisible, durable and stable in value. Some assets fulfil the role of money much better than other ones. Potatoes,

for example, would not make a good medium of exchange because they are not durable, nor do they have a stable value. Throughout history, gold and silver have frequently been used as money, given their divisibility into bars and coins. The introduction of paper money by the Chinese in the 9th Century AD marked a significant development in the evolution of money, especially given the ease with which different denominations could be created, and the portability of paper money in comparison with gold or coinage. It is said that the Chinese invented paper money because there was a shortage of metal to make coins. It is clear that the evolution of money as a medium of exchange, and as a store of wealth, had a considerable impact on the development of modern commerce, international trade, and global prosperity.
Go to: The economic problem

The economic problem

All societies face the economic problem, which is the problem of how to make the best use of limited, or scarce, resources. The economic problem exists because, although the needs and wants of people are endless, the resources available to satisfy needs and wants are limited.

Limited resources
Resources are limited in two essential ways: 1. Limited in physical quantity, as in the case of land, which has a finite quantity.

2. Limited in use, as in the case of labour and machinery, which can only be used for one purpose at any one time.

Choice and opportunity cost

Choice and opportunity cost are two fundamental concepts in economics. Given that resources are limited, producers and consumers have to make choices between competing alternatives. All economic decisions involve making choices. Individuals must choose how best to use their skill and effort, firms must choose how best to use their workers and machinery, and governments must choose how best to use taxpayer's money.

Making an economic choice creates a sacrifice because alternatives must be given up, which results in the loss of benefit that the alternative would have provided. For example, if an individual has 10 to spend, and
if books are 10 each and downloaded music tracks are 1 each, buying a book means the loss of the benefit that would have been gained from the 10 downloaded tracks. Similarly, land and other resources, which have been used to build a new school could have been used to build a new factory. The loss of the next best option represents the real sacrifice and is referred to as opportunity cost. The opportunity cost of choosing the school is the loss of the factory, and what could have been produced.

It is necessary to appreciate that opportunity cost relates to the loss of the next best alternative, and not just any alternative. The true cost of any decision is always the closest option not chosen.

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Samuelson's three questions

According to economist Paul Samuelson, all societies must provide the answer to three basic questions in order to solve the problem of scarcity.

What to produce?
What is the desired combination of goods and services for the economy? For example, how many resources

will be allocated to consumer goods, and many to capital goods? How to produce? What will be the combination of factors to create the desired output of goods and services at the lowest possible cost? For example, how much land, labour, and capital will be used produce consumer goods such as food, computers, and motor cars, and how much should be used to produce capital goods like machinery, roads, and bridges? For whom to produce? Who will get the output from the country s economic activity, and how much will they get? For example, who will get the food, computers, and cars that will be produced? This is often called theproblem of distribution.

Opportunity cost and production possibility frontiers

An opportunity cost will usually arise whenever an economic agent makes a decision about the best way to allocate scarce resources. Economic decisions about resource allocation inevitably require a sacrifice to be made. The opportunity cost of a decision quantifies this sacrifice, and considers other possible uses of scarce resources. Opportunity cost can be illustrated by using production possibility frontiers (PPFs) which provide a simple, yet powerful tool to illustrate the effects of making an economic choice.
A PPF shows all the possible combinations of two goods, or two options available at one point in time.

Production

possibilities

COMPUTERS (m 0 1 2 3 4 5 6 7 8 9

TEXTBOOKS (m) 70 69 68 65 60 55 48 39 24 0

Mythica, which is a hypothetical economy, produces only two goods textbooks and computers. When it uses all of its resources, it can produce five million computers and fifty five million textbooks. In fact, it can produce all the following combinations of computers and books.

Production possibility frontiers These combinations can also be shown graphically, the result being a production possibility frontier. The production possibility frontier (PPF) for computers and textbooks is shown here.

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Interpreting PPFs
Firstly, we can describe the opportunity cost to Mythica of producing a given output of computers or textbooks. For example, If Mythica produces 3m computers; the opportunity cost is 5m textbooks. This is the difference between the maximum output of textbooks that can be produced if no computers are produced (which is 70m) and the number of textbooks that can be produced if 3m computers are produced (which is 65m). Similarly, the opportunity cost of producing 7m computers is 31m textbooks - which is 70 - 39.

Production possibility frontiers

PPFs can also illustrate the opportunity cost of a change inthe quantity produced of one good. For example, supposeMythica currently produces 3 million computers and 65m textbooks. We can

calculate the opportunity cost toMythica if it decides to increase production from 3 million computers to 7 million, shown on the PPF as a movement from point A to point B.

The result is a loss of output of 26 million textbooks (from 65 to 39m). Hence, the opportunity cost to Mythica of this decision can be expressed as 26m textbooks. In fact, this is the same as comparing the static opportunity cost of producing 3m computers (5m textbooks) and 7m computers (31m textbooks).

Pareto efficiency
Any point on a PPF, such as points 'A' and 'B', is said to be efficient and indicates that an economy s scarce resources are being fully employed. This is also called Pareto efficiency, after Italian economist Vilfredo Pareto. Any point inside the PPF, such as point 'X' is said to be inefficient because output could be greater from the economy s existing resources.

Pareto

efficiency

Any point outside the PPF, such as point 'Z', is impossible with the economy s current scarce resources, but it may be an objective for the future. Pareto efficiency can be looked at in another way - when the only way to make someone better off is to make someone else worse off. In other words, Pareto efficiency means an economy is operating at its full potential, and no more output can be produced from its existing resources.

Pareto efficiency is unlikely to be achieved in the real world because of various rigidities andimperfections. For example, it is unlikely that all resources can be fully employed at any given point in time because some workers may be in the process of training, or in the process of searching for a new job. While searching for work, or being trained, they are unproductive. Similarly, an entrepreneur may have wound-up one business venture, and be in the process of setting-up a new one, but during this period, they are unproductive. Despite this, Pareto efficiency is still an extremely useful concept. It is a useful concept for two reasons: 1. It can be an objective for an economy because it can set a direction towards which an economy can move. 2. It can help highlight the imperfections and rigidities that exist in an economy and prevent Pareto efficiency being achieved.

Increasing opportunity cost

Opportunity cost can be thought of in terms of how decisions to increase the production of an extra, marginal, unit of one good leads to a decrease in the production of another good.

Opportunity

cost

According to economic theory, successive increases in the production of one good will lead to an increasing sacrifice in terms of a reduction in the other good. For example, as an economy tries to increase the production of good X , such as cameras, it must sacrifice more of the other good, Y, such as mobile phones.

This explains why the PPF is concave to the origin, meaning its is bowed outwards. For example, if an economy initially produces at A, with 8m phones and 10m cameras (to 20m), and then increases output of cameras by 10m, it must sacrifice 1m phones, and it moves to point B. If it now wishes to increase output of cameras by a further 10m (to 30m) it must sacrifice 2m phones, rather than 1m, and it moves to point C; hence, opportunity cost increases the more a good is produced.

Increasing

gradient

The gradient of the PPF gets steeper as more cameras are produced, indicating a greater sacrifice in terms of mobile phones foregone.

Marginal analysis Economic decisions are taken in a marginal way, which means that decisions to produce, or consume, are made one at a time. For example, a typical consumer does not decide to drink four cans of cola at the beginning of each day, rather they make four individual decisions, one at a time. Similarly, a baker does not decide to produce 5,000 loaves of bread in a year, but decides each day or week what to produce. Economic decisions are marginal because conditions are constantly changing, and consumers and producers would be highly irrational if they did not consider this. Hence, each production or consumption decision is assumed to be made one at a time so that changing conditions can be assessed.
Go to: Economic growth

Economic growth

Economic growth has two meanings: 1. Firstly, and most commonly, growth is defined as an increase in the output that an economy produces over a period of time, the minimum being two consecutive quarters. 2. The second meaning of economic growth is an increase in what an economy can produce if it is using all its scarce resources. An increase in an economy s productive potential can be shown by an outward shift in the economy s production possibility frontier (PPF).
Economic growth The simplest way to show economic growth is to bundle all goods into two basic categories, consumer andcapital goods. An outward shift of a PPF means that an economy has increased its capacity to produce.

What creates growth?

When using a PPF, growth is defined as an increase in potential output over time, and illustrated by an outward shift in the curve. An outward shift of a PPF means that an economy has increased its capacity to produce all goods. This can occur when the economy undertakes some or all of the following:

Employs new technology

Investment in new technology increases potential output for all goods and services because new technology is inevitably more efficient than old technology. Widespread 'mechanisation' in the 18th and 19th centuries enabled the UK to generate vast quantities of output from relatively few resources, and become the world's first fully industrialised economy. In recent time s, China's rapid growth rate owes much to the application of new technology to the manufacturing process. An economy will not be able to grow if an insufficient amount of resources are allocated to capital goods.

In fact, because capital depreciates some resources must be allocated to capital goods for an economy to remain at its current size, let alone for it to grow. Employs a division of labour, allowing specialisation
A division of labour refers to how production can be broken down into separate tasks, enabling machines to be developed to help production, and allowing labour to specialise on a small range of activities. A division of labour, and specialisation, can considerably improve productive capacity, and shift the PPF outwards. See also: Adam Smith

Employs new production methods

New methods of production can increase potential output. For example, the introduction of team working in the production of motor vehicles in the 1980s reduced wastage and led to considerable efficiency improvements.

Increases its labour force

Growth in the size of the working population enables an economy to increase its potential output. This can be achieved through natural growth, when the birth rate exceeds the death rate, or through net immigration, when immigration is greater than emigration.

Discovers new raw materials

Discoveries of key resources, such as oil, increase an economy s capacity to produce. Inward shift of a PPF A PPF will shift inwards when an economy has suffered a loss or exhaustion of some of its scarce resources. This reduces an economy's productive potential.

A PPF will shift inwards if:

Resources run out

If key non-renewable resources, like oil, are exhausted the productive capacity of an economy may be reduced. This happens more quickly as a result of the application of ultra-efficient production methods, and when countries over-specialise in producing goods from non-renewable resources.

Sustainable growth means that the current rate of growth is not so fast that future generations are denied the benefit of scarce resources, such as non-renewable resources, and a clean environment. Failure to invest A failure to invest in human and real capital to compensate for depreciation will reduce an economy's capacity. Real capital, such as machinery and equipment, wears out with use and its productivity falls over time. As the output from real capital falls, the productivity of labour will also fall. The quality and productivity of labour also depends on the acquisition of new skills. Therefore, if an economy does not invest in people and technology its PPF will slowly move inwards. Erosion of infrastructure A military conflict is likely to destroy factories, people, communications, and infrastructure. Natural disaster If there is a natural disaster, such as the 2005 boxing-day tsunami, or the Haiti earthquake of 2010, an economy s PPF will shift inwards.

Investment and economic growth

Allocating scarce funds to capital goods, such as machinery, is referred to as real investment. Investment

If an economy chooses to produce more capital goods than consumer goods, at point A in the diagram, then it will grow by more than if it allocated more resources to consumer goods, at point B. There is a trade-off between the short and the long run. In the short run, the economy must use resources to produce capital rather than consumer goods. Standards of living are reduced in the short run, as resources

are diverted away from private consumption. However, in the longer run the increased investment in capital goods enables more output of consumer goods to be produced.This means that standards of living
can increase by more than they would have if the economy had not made the short-term sacrifice.

Asymmetric growth
An economy can grow because of an increase in productivity in one sector of the economy - this is called asymmetric growth. Asymmetric growth For example, an improvement in technology applied to industry Y, such as motor vehicles, but not to X, such as food production, would be illustrated by a shift of the PPF from the Y-axis only.

Factor mobility
If workers, or other resources, are moved from one sector to another, then the position of the PPF will change, with an increase in the maximum output in the industry receiving the resources, and a fall in the maximum output of the industry losing resources.

Economic systems
There are two basic solutions to the economic problem as described by Paul Samuelson, namely free markets and central panning.

Free market economies

Markets enable mutually beneficial exchange between producers and consumers, and systems that rely on markets to solve the economic problem are called market economies. In a free market economy, resources are allocated through the exercise of free and self-directed market forces. This means that what to produce is determined consumers, and how to produce is determined by producers,

and who gets the goods is determined by the purchasing power of consumers. Market economies work by allowing the direct interaction of consumers and producers who are pursuing their own self-interest.

Command economies
The second solution is to allocate resources by a government, or an agency appointed by the government. This method is called central planning, and economies that exclusively use central planning are called command economies.

Command economies have certain advantages over free market economies, especially in terms of the coordination of scarce resources at times of crisis, such as a war or natural disaster. Free markets also fail at times to allocate resources efficiently, so remedies often involve the allocation of resources by government to compensate for these failures.

Mixed economies
There is a third type of economy involving a combination of market forces and central planning, called mixed economies. Mixed economies may have a distinct private sector, where resources are allocated primarily by market forces, such as the grocery sector of the UK economy. Mixed economies may also have a distinct public sector, where resources are allocated mainly by government, such as defence, police, and fire services. In many sectors, resources are allocated by a combination of markets and panning, such as healthcare and, which have both

public and private provision.

In r eality, all economies are mixed, though there are wide variations in the amount of mix and the balance between public and private sectors. For example, in Cuba the government allocates the vast majority of resources, while in Europe most economies have an even mix between markets and planning. Economic systems can be evaluated in terms of how efficient they are in achieving economic objectives.

Competitive markets
A competitive market is one in which a large numbers of producers compete with each other to satisfy the wants and needs of a large number of consumers. In a competitive market no single producer, or group of producers, and no single consumer, or group of consumers, can dictate how the market operates. Nor can they individually determine the price of goods and services, and how much will be exchanged. Competitive markets will form under certain conditions.

The formation of competitive markets

For markets to form a number of necessary conditions must be met, including: 1. The profit motive. Free markets form when the profit motive can be satisfied .... more 2. The principle of diminishability. Stocks of pure private goods will diminish as the good is purchased. .... more 3. The principle of rivalry. Consumers must compete with each other to get the benefitprovided by the good or service... more 4. The principle of excludability. For markets to form it is essential that consumers can be excluded from gaining the benefit that comes from consumption. .... more 5. The principle of rejectability. It is also necessary that consumers can reject goods if they do not want or need them.... more

The necessary conditions for market formation and success:

The profit motive

Free markets form when the profit motive can be satisfied. This means that goods and services can be allocated a price, out of which production costs can be paid and profits earned. These occur most easily with the production and supply of pure private goods.
Diminishability of private goods

Stocks of pure private goods will diminish as the good is purchased. For example, the purchase of a laptop computer by one consumer means there is one less available for other consumers. This isreferred to as the

principle of diminishability. Eventually, stocks will diminish to zero and as this happens, price will be driven up. Higher prices create an incentive for the producer to increase production.
Rivalry

Consumers must compete with each other to get the benefit provided by the good or service. For example, to be guaranteed a good seat at a restaurant, or at a music venue, consumers need to book in advance, or get there early - there is clearly a need to be competitive to secure the benefit of the good. This is called the principle of rivalry, and is clearly closely related to the principle of diminishability. Indeed,
many consider it to be just another way to explain the need for consumers to compete when stocks diminish. Excludability For markets to form it is essential that consumers can be excluded from gaining the benefit that comes from consumption. A storekeeper can stop consumers gaining the benefit of a product ifthey are unable or unwilling to pay. For example, a market for music can only be formed if the musicians perform in a venue where access is denied to those without a ticket, or where the songs can be recorded and sold through shops, via downloads, or through other media. This is called the principle of excludability. Rejectability It is also necessary that consumers can reject goods if they do not want or need them. For example, a

supermarket employee could not place an unwanted product into a shopper s basket and expect the shopper to pay for it at the checkout. This is called the principle of rejectability.

Ability to charge
When the conditions of diminishability, rivalry, excudability and rejectability are present it is possible for a market to form and for the seller to charge the buyer a price and for the buyer to accept or reject that price. It is also possible for the buyer to make a bid for a good or service, and for it to be accepted or rejected by the seller.

No information failure
For markets to work effectively there can be no significant information failure affecting the decisions of consumers and producers. It is assumed that the consumer of a private good or service knows what they are getting - they are able to estimate accurately the net benefit they are likely to derive. Net benefit is the private benefit to a consumer in terms of satisfaction, or utility, less the private cost associated with

buying the product. It equates to the concept of consumer surplus. For example, when a consumer walks into a newsagent to buy their favourite morning newspaper, they are likely to be clear about the net benefit they will derive. Consciously, subconsciously or instinctively they will make a calculation that buying the newspaper is worth it . On the plus side, this calculation may include the benefit of ten minutes entertainment over breakfast, and a further ten minutes completing the crossword at lunch. On the minus side, the calculation may include the sacrifice of buying the newspaper in terms of time, money, and opportunity cost. It can be assumed that the decision to make a purchase of a private good is based on the consumer s rational expectations. In other words, consumers base their decision to consume on a complete range of information gathered over the past, together with a prediction of the future.Therefore, previous experience of a product, and knowledge of the experiences of others is significant when consuming a private good.

No time lags
For a pure private good, there is no significant time lag between the purchase of the product and the net benefit derived by the consumer. For example, shortly after purchasing a morning newspaper it can be read, enjoyed, and disposed of.

No externalities
When consuming a pure private good there will be no negative externalities. This means that during the production of the good, and during its consumption and disposal after use, there is no negative impact on other citizens. This will either be because: 1. There is no waste or damage to the environment from consumption or production.

2. There is waste or potential damage to the environment, and consumers and producers know this, but a market exists to eliminate the waste or prevent damage to the environment. For example, the producer of the newspaper may create a harmful air-borne by-product during the printing process but they can buy, and may have an incentive to buy, a suitable air filter. Also, after reading the morning newspaper, it would be disposed of by the newsagent or caf who have bought a recycling bin which is placed outside their shop, or caf.

Property rights
For markets to form and operate successfully, consumers and producers must have property rights. Property rights mean that they have the right to own private property and protect it from theft or

damage, or from other people s waste, and from the pollution of others. If property rights cannot be established, the good is not a pure private good.

Incentives for entrepreneurs

The combined effects of the above characteristics means that markets will form becauseentrepreneurs will be willing to take risks associated with producing and supplying pure private goods. This is because consumers would be prepared to pay for the good, and producers can charge consumers at the point of consumption, from which they can earn revenue and make a profit.
When some of these conditions are absent, it is likely that market failure will exist.

Rationing, signalling and incentives

The interaction of buyers and sellers in free markets enables goods, services, and resources to be allocated prices. Relative prices, and changes in price, reflect the forces of demand and supply and help solve the economic problem. Resources move towards where they are in the shortest supply, relative to demand, and away from where they are least demanded.

The rationing function of the price mechanism

Whenever resources are particularly scarce, demand exceeds supply and prices are driven up. The effect of this is to discourage demand and conserve resources. The greater the scarcity, the higher the price and the more the resource is conserved. This can be seen in the market for oil. As oil slowly runs out, its price will rise, and this discourages demand and leads to more oil being conserved than at lower prices.

The signalling function of the price mechanism

Price changes send contrasting messages to consumers and producers. Rising prices give a signal to consumers to reduce demand or withdraw from a market completely, and they give a signal to producers that they should increase production or enter the market. Conversely, falling prices give a positive message to consumers, to consume more, but a negative message to producers, the produce less. For example, a fall in the price of PCs relative to laptop computers sends a message to producers to manufacture more laptops.

The incentive function of the price mechanism

An incentive is something that motivates a producer or consumer to follow a course of action or to change behaviour. Higher prices provide an incentive to producers to supply more, or to enter the market, because they provide the possibility or more revenue and increased profits. For example, a rise in the wage rate, which is the price of labour, provides an incentive for the unemployed to join the labour market.

Demand theory
Consumer demand and price

The relationship between price and quantity demanded is the starting point for building a model of consumer behaviour. Measuring the relationship between price and quantity demanded provides information which is used to create a demand schedule, from which a demand curve can be derived. Once a demand curve has been created, other determinants can be added to the model. Demand schedules QUANTITY
PRICE () 1.10 1.00 90 80 70 60 50 40 30 DEMANDED 0 100 200 300 400 500 600 700 800

A demand schedule shows the relationship between price and demand over a hypothetical range of prices. For example, the schedule opposite is based on a survey of college students who indicated how many cans of cola they would buy in a week, at various prices.

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Demand curves At higher prices, the quantity demanded is less than at lower prices. This relationship is easiest to see when a graph is plotted, as shown.

Demand curves generally have a negative slope. There are at least three accepted explanations of why demand curves slope downwards: 1. 2. 3. The law of diminishing marginal utility The income effect The substitution effect

Diminishing marginal utility

The first proof of the inverse relationship between price and quantity demanded is called the law of diminishing marginal utility. This suggests that as more of a product is consumed the marginal (additional) private benefit falls and consumers are prepared to pay less.

Most benefit is generated by the first unit of a good consumed because it satisfies all or a sustantial part of the immediate need or desire.
The second unit consumed generates less utility than the first, perhaps even zero, given that the consumer now has less need or less desire. With less benefit derived, the rational consumer is prepared to pay less for the second, and subsequent, units, as the marginal utility falls. Consider the following figures for utility derived by an individual when consuming bars of chocolate. While total utility continues to rise from extra consumption, the additional (marginal) utility from each bar falls. If marginal utility is expressed in a monetary form, the greater the quantity consumed the lower the marginal utility and the less the rational consumer would be prepared to pay. Utility
BARS TOTAL UTILITY 100 190 270 340 400 450 490 520 540 90 80 70 60 50 40 30 20 MARGINAL UTILITY

While total utility continues to rise from extra consumption, the additional (marginal) utility from each bar falls. If marginal utility is expressed in a monetary form, the greater the quantity consumed the lower the marginal utility and the less the rational consumer would be prepared to pay.

1 2 3 4 5 6 7 8 8

The income effect

The income and substitution effect can also be used to explain why the demand curve slopes downwards. If we assume that money income is fixed, the income effect suggests that, as the price of a good falls, real income - that is, what consumers can buy with their money income - rises and consumers increase their demand. Therefore, at a lower price, consumers can buy more from the same money income, and, ceteris paribus, demand will rise. Conversely, a rise in price will reduce real income and force consumers to cut back on their demand.

The substitution effect

In addition, as the price of one good falls, it becomes relatively less expensive. Therefore, assuming other alternative products stay at the same price, at lower prices the good appears cheaper, and consumers will switch from the expensive alternative to the relatively cheaper one. It is important to remember that whenever the price of any resource changes it will trigger both an i ncome and a substitution effect.

Exceptions
It is possible to identify some exceptions to the normal rules regarding the relationship between price and current demand.

Giffen Goods

Giffen goods are those which are consumed in greater quantities when their price rises. These goods are named after the Scottish economist Sir Robert Giffen, who is credited with identifying them by Alfred Marshall in his highly influential Principles of Economics (1895). In essence, a Giffen good is a staple food, such as bread or rice, which forms are large percentage of the diet of the poorest sections of a society, and for which there are no close substitutes. From time to time the poor may supplement their diet with higher quality foods, and they may even consume the odd luxury, although their income will be such that they will not be a ble to save. A rise in the price of such a staple food will not result in a typical substitution effect, given there are no close substitutes. If the real incomes of the poor increase they would tend to reallocate some of this income to luxuries, and if re al incomes decrease they would buy more of the staple good, meaning it is an inferior good. Assuming that the money incomes of the poor are constant in the short run, a rise in price of the staple food will reduce real income and lead to an inverse income effect. However, most inferior goods will have substitutes, hence despite the inverse income effect, a rise in price will trigger a substituion effect, and demand will fall. In the case of a Giffen good, this typical response does not happen as there are no substitutes, and the price rise causes demand to increase. Example For example, a family living on the equivalent of just $150 a month, may purchase some bread (say 50 loaves at $2 each, which is the minimum they need to survive), and a luxury item at $50. If the price of bread rises by 25% to $2.50 per loaf, continuing to purchase 50 loaves would cost the individual $125, making the luxury unaffordable. They cannot reduce their consumption of bread, given that their current consumption is the minimum they require, and they cannot find a suitable substitute for their stable food. Not being able to afford the luxury would leave the family with an extra $25 to spend, and, given no alternatives to bread, they would purchase 10 more loaves each month. Hence the 25% price increase has resulted in a 20% increase in the demand for bread - from 50 to 60 loaves.

Veblen goods
Veblen goods are a second possible exception to the general law of demand. These goods are named after the American sociologist, Thorsten Veblen, who, in the early 20th century, identified a 'new' high-spending leisure class. According to Veblen, a rise in the price of high status luxury goods might lead members of this leisure class to increase in their consumption, rather than reduce it. The purchase of such higher priced goods would confer status on the purchaser - a process which Veblen called conspicuous consumption.

See: shifts in demand

Shifts in demand
The position of the demand curve will shift to the left or right following a change in an underlying determinant of demand. Increases in demand Increases in demand are shown by a shift to the right in the demand curve. This could be caused by a number of factors, including a rise in income, a rise in the price of a substitute or a fall in the price of a complement.
Demand schedule
PRICE () 1.10 1.00 90 80 ORIGINAL Qd 0 100 200 300 NEW Qd 100 200 300 400

A shift in demand to the right means an increase in the quantity demanded at every price. For example, if drinking cola

becomes more fashionable demand will increase at every price.

70 60 50 40 30

400 500 600 700 800

500 600 700 800 900

Increases in demand An increase in demand can be illustrated by a shift in the demand curve to the right.

Decreases in demand
Conversely, demand can decrease and cause a shift to the left of the demand curve for a number of reasons, including a fall in income, assuming a good is a normal good, a fall in the price of a substitute and a rise in the price of a complement. Demand schedule PRICE () ORIGINAL Qd NEW Qd For example, if the price of a substitute, such as fizzy orange, falls, then less cola is demanded at each price, as consumers switch to the substitute.
1.10 1.00 90 80 70 60 50 40 30 0 100 200 300 400 500 600 700 800 100 200 300 400 500 600 700

Decreases in demand Decreases in demand are shown by a shift of the demand curve to the left.

Market failures
Market failures arise when free markets fail to develop, or when they fail to allocate resources efficiently. There are several different types of market failure. Carbon emissions - carbon pollution is a significant negative externality and can result from a number of activities. Industrial pollution by sulphuric and nitric acid (acid rain) can arise as a byproduct of the production process in many industries, such as smelting and refining. Pollution can also arise fromtransportation, heating and lighting, and from waste storage and disposal. More...

Road congestion - there are a several reasons why roads have become increasingly congested. Firstly, the real cost of driving has fallen because motor vehicles and fuel are relatively cheaper than they used to be in real terms. More...

Healthcare provision - healthcare is classified as a merit goodbecause consuming it provides benefits to others as well as to the individual consumer. For example, inoculation against a contagious disease provides protection and clearly generates a private benefit as well as an external one, to those who are protected from catching the disease from those who are inoculated. However, few would want inoculation only to protect others. Therefore, the demand for healthcare will be less than the socially efficient quantity. More...

Unstable primary markets - some primary markets can become unstable and require intervention to help them stabilise. In particular, many food producers suffer three main economic problems; falling long term income; unstable prices; and loss of bargaining power to big supermarket chains. More...

Markets can fail in two basic ways: A complete failure A complete market failure exists when free markets are unable to allocate scarce resources to the satisfaction of a need or want. This occurs because there are insufficient incentives to encourageprofit-seeking firms to enter a market. This is commonly the case with pure public goods, such as street lighting, for which there is a
need, but private individuals would not be prepared to pay. If no-one is prepared to pay, no revenue can be derived, and no profit earned; hence no firm would enter the market.

A partial failure A partial failure can occur in four ways: 1. When some, but not all, of the necessary conditions for market formation exist. This
means that markets form, but will fail to develop and supply sufficient quantities of a good or service. In the case of merit goods, such as education, markets are inefficient because they under-supply these goods, and fail to meet society s demand. 2. When free markets over-supply a good or service, either because producers fail to take

into account the full costs of production to society, or because consumers fail to take into account the full costs of consumption to themselves, or society. Externalities and demerit goods are cases of free markets over-supplying.
3. Where there is a breakdown in self-regulation, as in the case of the financial crisis.

4. Where a market becomes highly unstable and fails to return quickly to a stable equilibrium, as in the case of some commodity markets. Some economists argue that all market failures are, in some way, the result of information failure. Go to: Types of market failure

Types of market failure

A market failure is a situation where free markets fail to allocate resources efficiently. Economists identify the following cases of market failure: Productive and allocative inefficiency Markets may fail to produce and allocate scarce resources in the most efficient way. Monopoly power Markets may fail to control the abuses of monopoly power. Missing markets Markets may fail to form, resulting in a failure to meet a need or want, such as the need for public goods, such as defence, street lighting, and highways. Incomplete markets Markets may fail to produce enough merit goods, such as education and healthcare. De-merit goods Markets may also fail to control the manufacture and sale of goods like cigarettes and alcohol, which have less merit than consumers perceive. Negative externalities Consumers and producers may fail to take into account the effects of their actions on third-parties, such as car drivers, who may fail to take into account the traffic congestion they create for others. Third-

parties are individuals, organisations, or communities indirectly benefiting or suffering as a result of the actions of consumers and producers attempting to pursue their own self interest. Property rights Markets work most effectively when consumers and producers are granted the right to own property, but in many cases property rights cannot easily be allocated to certain resources. Failure to assign property rights may limit the ability of markets to form. Information failure
Markets may not provide enough information because, during a market transaction, it may not be in the interests of one party to provide full information to the other party.

Unstable markets Sometimes markets become highly unstable, and a stable equilibrium may not be established, such as with certain agricultural markets, foreign exchange, and credit markets. Such volatility may require intervention. Inequality Markets may also fail to limit the size of the gap between income earners, the so-called income gap. Market transactions reward consumers and producers with incomes and profits, but these rewards may be concentrated in the hands of a few. Remedies In order to reduce or eliminate market failures, governments can choose two basic strategies:

Use the price mechanism The first strategy is to implement policies that change the behaviour of consumers and producers by using the price mechanism. For example, this could mean increasing the price of harmful products, through taxation, and providing subsidies for the beneficial products. In this way, behaviour is changed through financial incentives, much the same way that markets work to allocate resources.

Use legislation and force

The second strategy is to use the force of the law to change behaviour. For example, by banning cars from city centres, or having a licensing system for the sale of alcohol, or by penalising polluters, the unwanted behaviour may be controlled. In the majority of cases of market failure, a combination of remedies is most likely to succeed.

Inefficiency
Under certain circumstances, firms in market economies may fail to produce efficiently. Inefficiency means that scarce resources are not being put to their best use. In economics, the concept of inefficiency can be applied in a number of different situations. Pareto inefficiency

Paret i effi ie Pare e c e cy s ass c ate th ec st Vilf do to, and occ rs when an economy is not operating on the edge of its PPF and is, therefore, not fully e ploiting its scarce resources

This means that the economy is producing less than the maximum possible output of goods and services, from its resources odu ti in ffi i n Productive inefficiency occurs when a firm is not producing at its lowest un o . Unit cost is the average cost of production, which is found by dividing total costs of production by the number of units produced.
Pr tive i effi ie Productivity efficiency occurs when average cost is at its lowest.Average costs tend to fall initially as output rises, reach a low point - the point of maximum productive efficiency - then rise again.

It is possible that in markets where there is little competition, the output of firms will be low, and average costs will be relatively high. This is likely to occur if af fi s, or just one, dominate the market, as in the case of oli opol and onopol . in ffi i n

X inefficiency is a concept that was originally associated specifically with management inefficiencies, but can also be applied more widely. X inefficiency occurs when the output of firms is not the greatest it could be. It is likely to arise when firms ts where there is no incentive for managers tomaximise output. operate in highly un o p titi Allo ti in ffi i n Allocative inefficiency occurs when the consumer does not pay an efficien p ice. An efficient price is one that just covers the costs of production incurred in supplying the good or service.

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Allocative inefficiency

This occurs when the firm s price, P, equals the extra ( marginal) cost of supply, MC. This is efficient because the revenue received is just enough to ensure that all the resources used in the making of a product are sufficiently rewarded to
encourage them to continue supplying.

Receiving the value of marginal cost - no more and no less - is economically efficient because all factors derive a reward which just keeps them supplying their resource, including a normal profitfor the entrepreneur. Dynamic inefficiency Dynamic inefficiency occurs when firms have no incentive to become technologically progressive. This is associated with a lack of innovation, which leads to higher production costs, inferior products, and less choice for consumers. There are two ways in which firms can innovate: 1. New production methods, such as when applying new technology to an existing process. 2. New products, which are a feature of markets with highly competitive firms, such as those in the consumer electronics. Innovation, research, and development are expensive and risky, so firms will expect a fair level of profits in return. However, because the price mechanism may not generate profits for the supply of public and merit goods, there is often an absence of dynamic efficiency in these markets. Social inefficiency Social inefficiency occurs when the price mechanism does not take into account all the costs and benefits associated with economic exchange. The price mechanism will only take into account private costs and benefits arising directly from production and consumption, not the external costs and benefits incurred by third-parties.
Social inefficiency

Social costs refer to the total costs borne by society as a result of an economic transaction, and include private costs plus external costs. Social benefits are the private benefits plus external benefits resulting from a transaction.

A transaction is socially efficient if it takes into account costs and benefits associated with the transaction that is, the social costs and benefits. Go to:Cost-Benefit Analysis (CBA)

Cost benefit analysis (CBA)

Cost Benefit Analysis (CBA) is a method of appraising large scale investment projects, often involving public spending, such as rail links, motorways, and airports. The process involves estimating all the perceived private and external costs and benefits of alternative spending options, such as alternative sites for a new airport, and then selecting the option with the highest net benefit.
The process is subject to a system called discounting, which involves taking into account the rate of interest which could have been earned has the funds been invested in an interest bearing account. This must be deducted from the estimated gains from a project, because the funds could have sat in a bank and earned a reward without incurring a risk. Therefore, the rate of interest on investment funds represents an opportunity cost of capital spending.

Public-Private Initiatives
Increasingly, the private sector has been encouraged to form a partnership with the public sector to fund, construct, and manage large investment projects. One such partnership is the Private Finance Initiative (PFI), which was introduced in the UK in 1995. The PFI has been controversial because critics argue that the involvement of the private sector in projects associated with healthcare and transport might result in a reduction in safety in pursuit of reduced costs and increased profits.

Evaluation of CBA
It is clearly more efficient for public spending to be subject to rigorous analysis, rather than based on the whims of politicians. However, there are a number of criticisms of CBA, including: 1. It is often very costly to undertake, though usually this forms a very small proportion of total project spending. 2. Assessing the monetary value of external costs and benefits is often very difficult. What precisely is the value of the congestion that would be reduced if a new bi-pass were built around a busy town? How much extra tourist revenue will actually be gained from a new airport? How long will the building be used as a venue, as in the case of the Millennium Dome and the Olympic Stadium in London. One solution to this problem is shadow pricing, where analysts attempt to place a value on the costs and benefits of a decision or a project where an actual market price does not exist. 3. Changing circumstances can make initial projections appear grossly inaccurate. The

Wembley Stadium project went considerably over-budget, and the 2012 London Games are likely to be far more costly than originally estimated. Higher interest and inflation rates, and falling exchange rates can all dramatically affect costs.
4. Actual costs can also rise above planned costs as a result of moral hazard, where project managers go over budget because they expect that those who fund the project will make extra funds available, providing an insurance against their over-spending. 5. Ultimately, decisions to go ahead with projects are only guided by CBA, leaving politicians to make the final decision. Politicians are free, of course, to ignore the results of an appraisal.

Missing markets
A significant market failure is the failure to produce some goods and services, despite being needed or wanted. Markets can only form under certain conditions, and when these conditions are absent markets may struggle to exist. The most extreme case of a missing market is the case of pure public goods.

Pure public goods clearly provide a benefit to the consumer, but, for several reasons, are unlikely to exist in a market economy. Examples of pure public goods include national defence, the police service, and street lighting. Because markets for these goods are not likely to form they are called missing markets and are considered a special case where demand exists, but supply is absent. Pure public goods The market mechanism is likely to fail to supply pure public goods because entrepreneurs are unlikely to enter the market, given the impossibility of charging consumers at the point of consumption. Public goods have the following characteristics: Non-excludable
When a public good is supplied, it is impossible to exclude other individuals from deriving a benefit. For example, once street lighting is made available in an area, all passers -by can benefit, and no one can be denied access to it.

Non-diminishable
When a pure public good, such as street lighting, is consumed by one individual, the stock available for others does not diminish, as it would in the case of a private good. A pedestrian passing under a street light has no effect on the supply of lighting whatsoever. Non-diminishability is also known as the principle of non-rivalry. Because the stock of a public good does not diminish with use, consumers do not need to compete with each other to get access to them. For example, individuals do not need to queue to get access to street lighting.

Non-rejectable
Unlike a private good, consumers cannot reject a pure public good, and are forced to consume it. An individual cannot reject being defended by the armed forces of a country, nor can they reject the benefit of street lighting. When combined, these three characteristics deter potential suppliers because it would be impossible to charge users at the point of use.

Why will suppliers not be able to charge? Suppliers cannot charge at the point of consumption or use because of the free-rider problem. Noone would pay because the first person to pay for supply creates a free supply for everyone else!No one can be excluded from the market and prevented from consuming, and hence they are encouraged to become free-riders.
Because of this, suppliers are not able to generate any revenue, or make a profit, so a necessary condition for the formation of a market is absent, namely the absence of a profit incentive. With no incentive, entry into the market is deterred, resulting in a missing market.

Remedies
If we assume there is a limit to the formation and completion of markets, and a high probability that some markets might not exist at all, policy makers need to consider how demand can be satisfied. O ne of the roles of government is to allocate scarce resources to satisfy demand for public goods. There are several ways a governments can do this, including the following.
1. A government can take complete control over the initial planning, funding and operation of public goods like defence, policing and street lighting. Government can impose general taxes to pay for these services, rather than try to charge consumers directly. 2. With transport services, government can fund the building of the infrastructure, and contract-out the running and maintenance of the service to private firms, as with bridges, tunnels, motorways, and airports. Government is likely to fund the initial investment out of taxation, and it may be possible to charge consumers, if the free-rider problem can be solved. For example, tolls can be used to charge drivers wishing to use a motorway, and airports can charge landing fees to private airlines.

Incomplete markets

An incomplete market is one where some of the necessary conditions for market formation exist, but not all of them. In the case of incomplete markets, some entrepreneurs may enter the market because profits are possible. However, the firms that do start-up will only satisfy a small proportion of potential demand. In these incomplete markets, total supply is insufficient to meet the needs of consumers. In such cases a market may form, but will fail to develop completely - in other words it is an incomplete. There are several examples of incomplete markets, including the markets for quasi-public goodsand merit goods.

Quasi public goods

The market for quasi-public goods is an important example of an incomplete market. A quasi-public good is one that resembles a pure public good, but lacks some of its characteristics. A free market for pure public goods, like defence, is unlikely to exist at all, but for quasi-public goods, there is a strong possibility that free markets would satisfy a part of total demand. Quasi public goods are:
1. Partly-diminishable, and partly-rivalrous, which means that as quasi public good is consumed the stock available for others will diminish, but slowly. Hence some competition between consumers may occur. 2. Partly-excludable, which means once the goods are supplied some consumers can be

excluded from consumption. 3. Rejectable, which means consumers can reject the good, and they are not forced to consume it. The example of bridges
Major bridges could be funded by private enterprise because it is possible to operate a toll system, with barriers, and charge each motorist a crossing fee. Gradually, the cost of building the bridge would be covered, and eventually a profit could be made. However, free markets are unlikely to satisfy the need for all river crossings, because the revenue generated would be insufficient. Bridges are considered to be quasi public goods because some of the conditions necessary for market formation exist, but not all. 1. Bridges exhibit some diminishability, so that when drivers go over a bridge there are reducing the bridge-space for others. 2. Some rivalry exists between users of bridges because they often have to queue to cross, as there is an excess of demand over supply at the point of crossing. This indicates scarcity and provides an incentive for firms to because it creates the possibility charging users. 3. Because the owner of a bridge could put up barriers to stop drivers crossing, the free-rider problem is solved, and non-payers can be excluded. 4. Crossing a particular bridge to get to a destination can be rejected by drivers, because they can take another route which avoids any toll charges, hence bridges exhibit the characteristic of rejectability.

The formation of a market for using bridges

A market for bridges could emerge in an economy because the conditions for market formation are partly present. For example, although it would be extremely costly to build a bridge across a major river, an entrepreneur could generate revenue by constructing a toll, or turnpike, as they were originally called in the th 14 Century. If crossing by this particular bridge, rather than going a different way, creates a positive private benefit for users, in terms of time saved or safety, the entrepreneur can fix a price and charge users. A sufficiently low price can be charged to encourage vehicle owners to use the bridge, especially if the entrepreneur does not expect to make a profit in the short run. A range of prices can be charged to reflect different sizes of vehicles, and different times of crossing. Some revenue can be set aside for future maintenance of the bridge, and, in most respects, the bridge becomes a private good. However, building a network of toll bridges covering every river in the country would

be a very unattractive proposition for a private firm, not just because of the cost of building and maintaining but also because of the difficulty of charging each time the bridge is used. For example, if a farmer lives on one side of a river and works on the other side, goes home for lunch and makes three round trips across the river and back to deliver his produce, then on any given day the farmer will have to make at least ten trips and ten payments. Without an electronic method of payment, an employee would be needed to collect the money, and this would significantly slow down the traffic flow over the bridge. A much more efficient way to fund such bridges would be to impose a general tax, or rate, on local farmers, and beneficiaries, and build and maintain bridges through as general tax fund. This would avoid the problem of charging for each crossing.

Turnpikes
In the UK, turnpikes were an increasingly common way of paying for the maintenance costs of major roads from the early 18 th Century. The UK government allowed private companies, known as Turnpike Trusts, to put up tolls (turnpikes) to collect revenue to upkeep and extend the road system. However, by the 1850s railways took over from turnpikes as the most popular method of transport. The complex and fragmented turnpike system was also seen as an increasing barrier to trade across the UK, and it was effectively abandoned in the th late 19 Century as control of the building and maintenance of roads and bridges was given to local government, which collected revenue from local rates and received a subsidy from central government. The development and collapse of the turnpike system provides evidence of the difficulty of finding a single and effective way to fund and operate quasi-public goods.

New technology The introduction of new technology can often lead to the formation of new markets, and allows existing markets to become complete over time. This occurs for a number of reasons: 1. New technology can be used to reduce production costs and make it easier for private firms to break-even. 2. Technology improves the ability of firms to exclude entry to prevent free riders, such as the
use of automatic barriers across bridges. Number plate recognition systems can also be used to track and monitor attempts to avoid payments. 3. Computer systems can be used to enable suppliers to generate and store more knowledgeabout travellers and about peak flows, and hence reduce information failure, and increase efficiency. For example, cameras and computers can be used to monitor and measure traffic flows over a bridge. 4. Finally, new technology allows the possibility of creating fast and efficient payment

methods, which can avoid the need to queue to have access to public goods.

Merit goods
The market for merit goods is an example of an incomplete market. Merit goods have two basic characteristics:
Firstly, unlike a private good, the net private benefit to the consumer is not fully recognised at the time of consumption. Net private benefit is the utility from gained from consumption less any private cost incurred, and equates to net consumer surplus. In the case education, which is widely considered to be a merit good, pupils and students cannot possibly know the specific private benefit to them of getting good grades at school, college or university. They will be well aware of the sacrifice required to study, but will not know the benefits to them in terms of a future job, salary, status a nd skills. Therefore, with education, as with other merit goods, there is a significant information failure in terms of expected benefits. Secondly, while consumption of a merit good also generates an external benefit to others, from which society gains, this is unlikely to be known or recognised at the point of consumption. Given that decisions to consume are driven by self-interest, it is unlikely that this external ben efit will be taken into account when the

consumer of a merit good evaluates its worth. For example, an individual student is generally not motivated to study hard in order to benefit others later in life, although everyone associated with them will benefit from their education in some way. Beneficiaries include future employers and all those who consume the products supplied their employer, their family, and friends. The better job they obtain, the more tax they will pay, and the greater the benefit to those who receive welfare benefits and transfers. However, putting a value on these external benefits is impossible, especially at the point of learning.

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Health are Health are is also regarded as merit good. For example, al hough it is not possible to know exactly when t the benefit will arise, inoculation against a contagious disease clearly provides protection to the individual, and yields a private benefit. There isalso an external benefit to other individuals who are protected from catching the disease from those who are inoculated! However, few would choose inoculation simply to protect others! The suppl of merit goods Economic theory predicts that while markets may form to supply some merit goods, total supply will be insufficient to achieve a so iall effi ient level of consumption. A number of factors e xplain the lack of merit goods in a free market economy. There is a significant level ofinformation failure, in terms of both the private and the external benefits resulting from consumption of merit goods. For example, there is likely to be considerable information failure in terms of recognising the benefit to themselves, and to others, of regular health checks, eye tests, or visits to the dentist.
There may also be considerable time lags in deriving the benefit of a merit good. This is clearly the case with education, where the private benefits may not occur for ten or twenty years after consumption. Given that individuals are driven largely by self-interest, the external benefit of consuming a merit good is not likely to be included in the private calculation of buyers and sellers. However, society needs as many people as possible to be educated and healthy so that all individuals can receive the maximum external benefit. Finally, individuals and families on low incomes are not likely to be able to pay the full market price of merit goods, and will under-consume. For example, to continue to supply private education, tuition fees must be set to cover the full costs of supply. However, private fees are likely to be well in excess of what many low income families could afford to pay. Merit

Because of the above, it is likely that merit goods will be underconsumed and under-supplied.

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In a free market, the supply curve reflects marginal private cost (MPC), and the demand curve reflects the marginal private benefit (MPB), or utility, expected from consumption. However, the expected marginal private benefit is likely to be much greater than the actual benefit. This is because individual consumers of merit goods fail to perceive the true benefit them. Indeed, there is an to information failure, which results in theconsumer under-consuming.
Hence, on the graph, the actual marginal private benefit is higher, and to the right of the expected benefit curve. Merit goods and positi e consumption externalities With education, few students will know with any precision the benefit to themselves of being educated, let alone the benefit to others. In other words, there is imperfect information.

Merit - addi t e exter al e efit The demand curve reflects consumers expected benefit, but most benefit arises in the future and is unknown at the time of consumption. Market e uilibrium is at A , with Q merit goods supplied.

If the under-perceived private benefit is added to the expected benefit, then the demand curve will reflect the actual benefit, with e uilibrium atB. Finally, adding the external benefit- the positive impact on third-parties - gives the ma gina ocia benefit, at C (Q1), which is the socially efficient level of output. emedies for the under-suppl of merit goods
Markets fre uently fail to allocate sufficient resources to the production of merit goods hence governments may need to intervene and create an environment in which markets for meritgoods can form. The basic options are to adopt measures that increase consumer demand, or increase supply. Measures to increase suppl Market theory suggests that supply will increase in one of twoways either following a rise in price, which provides an incentive for private firms to enter the market, or by a subsidy, which reduces costs of supply. While a higher price encourages supply, it also discourages demand and results in less demand for a merit good. Hence, a subsidy would encourage both supply an demand. d Government could also choose to by -pass the market and take over responsibility for supplying the socially efficient quantity of merit goods. This is what happens with state education, healthcare, and national insurance. Alternatively, the government could pay the cost of supplying a merit good, and request that the individual consumer makes an out-of-pocket contribution to these costs, such as with prescription charges. Government could also cover some of the costs of private sector provision, suh as providing free training for c doctors, nurses and teachers, who may then work in private hospitals and schools.

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Government could also encourage private firms to enter the market by offering incentives. For example, private hospitals could be given cash incentives to increase the number of hospital beds available to National Health Service (NHS) patients, and private schools could be given grants to take state school pupils. Measures to increase demand A second approach to merit goods is to increase demand for them. This can be achieved either through
lowering price, which would expand demand, or by shifting the position of the demand curve. What price to set for a merit good is an issue facing policy makers. One option is to provide the service free at the point of consumption, as currently exists with NHS treatment. This would expand demand to its maximum, but it may encourage over-consumption, with the system becoming clogged-up with free riders and malingerers, diverting resources from the genuinely sick and needy. With education, a voucher system is a frequently proposed option to encourage demand for merit goods provided by the private sector. This system can be used to create a quasi market. Typical voucher schemes involve parents being allocated education vouchers, which they are then free to spend on any school of their choice. Parents can combine the vouchers with their own finance to pay for a place at any school either state or private. Supporters of vouchers argue that they allow a market to be completed effectively and in a way that enables poorer families to have access to the best schools. Over time, this will drive up the quality of all schools as they compete with each other for scarce vouchers. Follow link for article on educational vouchers. Finally, demand for a merit good could be increased providing knowledge, so that the consumer can make a more informed appraisal about the benefits of consuming merit goods.

Regulation Whenever government allocates resources on behalf of citizens, a potential principal-agent problem may arise. This means that public sector managers and employees may act in their own interests, and not in the interests of the government or taxpayer. In order to solve this problem, regulation may be necessary to ensure that the highest possible standards are achieved. For example, government may establish educational standards such as the national curriculum, and may set national targets for reducing hospital waiting lists. Regulations can help achieve standards in public healthcare and education that would occur in a more competitive environment.

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Funding higher education

In compensating for the failure of markets to supply public and merit goods, central and local government can intervene. In the case of pure public goods, such as defence and street lighting, the case for intervention is clear and unambiguous. However, in the case of merit goods and quasi public goods, there are disagreements about the precise role of government.
Most economists argue that governments have a crucial role in allocating resources to merit goods such as education and healthcare. Other economists prefer to highlight the failure of governments to allocate

resources efficiently. These free-market economists argue that markets should be encouraged to work whenever possible, even in terms of the provision of merit goods. Subsidies There is much debate about the extent to which higher education should be subsidised.Subsidies are one way to help achieve the socially optimal number of students going to university. The challenge is to achieve Q1 students, the socially efficient number, but universities need a fee of U to cover their costs of supply, at B. However, students will only be prepared to pay S, at C, which reflects their expectation of private benefit.

A subsidy of B - C (U - S) would provide the necessary incentives for universities to supply Q1 places, and for students to take-up this number. If funded in this way, students would contribute part of the real cost of their education by paying C, which is equivalent to the private benefit they expect to derive, and society , would contribute a further part of the cost of education (B - C) equivalent to the external benefit which is derived by society. This subsidy would be funded through taxation.

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A graduate tax In addition, or alternatively, a graduate tax can be justified to enable students to attend university at zero fees, or heavily discounted fees, while paying for the future benefit they will derive out of the income they gain from employment in the future.

Healthcare
Healthcare is classified as a merit good because consuming it provides benefits to others as well as to the individual consumer. For example, inoculation against a contagious disease provides protection and clearly generates a private benefit as well as an external one, to those who are protected from catching the disease from those who are inoculated. However, few would want inoculation only to protect others. Therefore, the demand for healthcare will be less than the socially efficient quantity.

Funding healthcare
Comprehensive, universal and free, from cradle to grave was the stated aim of the NHS when it was established in 1948. However, the cost of healthcare provision has risen to such an extent that many believe it is unsustainable.

The development of new technology, new treatments, and new drugs increases the NHS s ability to supply, but at the same time encourages demand to such an extent that demand substantially exceeds supply. This creates long waiting lists and shortages of hospital beds. A privatised NHS would allow prices to rise to reflect the true cost of supply. This would, of course, violate the principle of free and universal
treatment. However, rising costs have forced a re-think on funding.

The NHS is highly labour intensive, employing 1.3 million people. Indeed, only the Chinese army and the Indian state railways have more employees. This partly explains the enormous cost of funding the NHS. In 2008, estimated spending by the NHS was 92.6b, which amounted to 2,000 for every man, woman and child in the UK. (Source: DH website). The cost of a night s stay at a private hospital is around 400, excluding treatment, and a course of treatment could cost up to 300,000. Extra public money is unlikely to be enough to keep pace with the projected increase in demand for healthcare, which is being driven by an aging populating and rising expectations. In 2005, 17% of the population was over 65 and by 2015 it will rise to 25%. Funding options
The Wanless Report Funding of UK healthcare was the subject of the Wanless Report, named after report chairman, Derek Wanless. The report, which was published in 2002, considered four main options for funding healthcare, in two broad categories:

Publicly funded
1. Taxpayer funded, where healthcare funded by the taxpayer out of general government funds, using tax revenues from all sources, namely the current UK system. Healthcare is provided free to patients, with resource allocation being driven by need, rather than income and the operation of the price mechanism. 2. Social insurance, where employees and employers make compulsory contributions towards healthcare and where provision is also free at the point of need. This is often called theEuropean model of healthcare funding.

Privately funded
1. Private insurance - where individuals pay premiums (insurance fees) to private companies, and then claim when receiving treatment. This approach dominates healthcare funding in the USA, although it is currently under review given the large numbers of American citizens who have no private insurance, or who are significantly under-insured. See: Obama healthcare reforms Top-up private insurance means taking out insurance cover in addition to taxpayer funded or social insurance. 2. Out-of-pocket payments, where patients pay doctors or hospitals directly for their treatment, such as paying a fee for each visit to the doctor, for each treatment or medicine prescribed. Wanless recommended that the current system, based on general taxation, should continue because it achieved the right balance between equity and efficiency. The report was particularly critical of private insurance, regarding a system based on private insurance as: 1. 2. 3. Inequitable - unfair on the less well-off. Having high administration costs No incentive for cost control - note the problem of third-party payment.

The report was also against the use of out-of-pocket payments, because they lead to inequity andregressiveness. However, it accepted that the NHS should consider charging for non-medical services like bedside TV and phones. Wanless also recommended that the government should attempt to provide greater choice for patients.

Healthcare and moral hazard

If government intervenes to increase the supply of healthcare, there is a potential government failure in the form of moral hazard. This means that individuals, knowing that they can get free and effective healthcare, fail to take steps to avoid the risks that the healthcare insures against. For example:

y Over eating, because people know that there is free treatment for the problems associated with obesity, such as tablets for high blood pressure. y y
Smoking, because lung infections can easily be treated with antibiotics. Drug abuse, because emergency treatment is freely available.

The problem of third-party payment

In attempting to resolve the problem of healthcare provision and funding, private insurance has been promoted as an alternative to government funding. However, because a third-party, the insurance provider, bears the cost of any claim, there is an incentive to inflate claims and squander scarce resources. This is referred to as the problem of third party payment, and in such cases insurance suppliers simply pass

on the cost to all policyholders.

Creating internal markets

The NHS is centrally funded and has been so since its formation in 1948. However, given that governments may fail to allocate funds efficiently, and many believe that the NHS should be managed more like a p rivate enterprise. While most economists accept the inevitability of public funding, in order to reduce inefficiencies, many favour the use of internal markets within the existing state funded structure. These markets are often referred to as quasi markets, and they have become increasing seen as an effective means of allowing the price mechanism some role in healthcare resourcing. As part of these reforms, hospitals may compete with each other for patients from all over the UK, creating an element of competition that previously did not exist. Patients can exercise their choices, electing to be treated in the hospital of their choice. The most popular hospitals, and presumably the most efficient ones, treat more patients and gain more income from the taxpayer. As with real markets, resources are allocated according to consumer preferences. In addition, hospitals can contract out elements of their service, such as hospital cleaning, meals and ambulance services.

The problem of free healthcare

Given that healthcare is a merit good, it is largely provided free at the point of consumption. This means that the price mechanism cannot work to ration scarce resources, as it would for private goods. However, having no price means that there will be a shortage, given that demand will expand to its maximum. This will mean that health resources must be rationed through some other system, such as waiting lists. To understand why a shortage will arise we need to consider the supply of, and demand for, healthcare at different prices.

In the short run the supply of healthcare is fixed, and the supply curve is perfectly inelastic. Free healthcare The demand for healthcare is at its greatest when it is free to patients, and this means that there is an excess of demand over supply, with waiting lists for treatment and shortages of beds. In this case, waiting lists ration healthcare treatment, rather than charges.

Negative externalities
A negative externality is a cost that is suffered by a third party as a result of an economic transaction. In a transaction, the producer and consumer are the first and second parties, and third parties include any individual, organisation, property owner, or resource that is indirectly affected. Externalities are also referred to as spill over effects, and a negative externality is also referred to as an external cost.
Some externalities, like waste, arise from consumption while other externalities, like carbon emissions from factories, arise from production.

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Externalities commonly occur in situations where property rights over assets or resources have not been allocated, or are uncertain. For example, no one owns the oceans and they are not the private property of anyone, so ships may pollute the sea without fear of being taken to court.

Showing negative externalities

Negative externalities An external cost, such as the cost of pollution from industrial production, makes the marginal social cost (MSC) curve higher than the private marginal cost (MPC).

The socially efficient output is where MSC = MSB, at Q1, which is a lower output than the market equilibrium output, at Q.

Net welfare loss

Net welfare loss Net welfare loss can exist in two situations. Firstly, it exists when the marginal cost to society of a particular economic activity, such as manufacturing 200,000 computers, is greater than the marginal benefit to society. Secondly, it can exist when the marginal benefit of a given economic activity, such as producing 50,000m computers, is greater than the marginal cost.

The first situation can occur when the market produces 'too much', and the second when it produces 'too little'. Example For example, If we consider a manufacturer of computers which emits pollutants into the atmosphere, the free market equilibrium will occur when marginal private benefit = marginal private costs, at output Q and price P.

The market equilibrium is at point A. However, if we addexternal costs, the socially efficient output is Q1, at point B.

At Q marginal social costs (at C) are greater than marginal social benefits (at A) so there is a net loss. For example, if the marginal social benefit at A is 5m, and the marginal social cost at C is 10m, then the net

welfare loss of this output is 10m - 5m = 5m. In fact, any output between Q1 and Q creates a net welfare loss, and the area for all the welfare loss is the area ABC. Therefore, in terms of welfare, markets over-produce goods that generate external costs.

Remedies
Market Based Solutions:
Market-based solutions try to manipulate market forces to reduce the externality, by exploiting the price mechanism. One such market-based solution is to extend property rights so that third parties can negotiate with those individuals or organisations that cause the externality. British economist and Nobel Prize winner, Ronald Coase argued that the establishment of property rights would provide an efficient solution to the problem of externalities. As long as one party can establish a property right, there will be a bargaining process leading to an agreement in which externalities are taken into account. If property rights cannot be established, such as with the air, sea, or roads, then the only two options are: 1. 2. as: We learn to live with externalities, or: Government intervenes on our behalf through taxes or direct controls and regulations, such a. Taxing polluters, such as carbon taxes, or taxes on plastic bags. b. Subsidising households or firms to be non-polluters, such as giving grants for home insulation improvements. c. Selling permits to pollute, which may become traded by the polluters. d. Forcing polluters to pay compensation to those who suffer, such as making noise polluting airports pay for double-glazing. e. Road pricing schemes, such as the Electronic Road Pricing (ERP) system in Singapore, which is a pay-as-you-go, card-based, road-pricing scheme. f. Providing more information to consumers and producers, such as requiring that tickets to travel on polluting forms of transport, especially air travel, should contain information on how much CO2 pollution will be created from each journey. See also: pollution, carbon emissions and waste disposal

Pollution, carbon emissions and waste

Pollution is a significant negative externality and can result from a number of activities. Industrial pollution by sulphuric and nitric acid (acid rain) can arise as a by-product of the production process in many industries, such as smelting and refining. Pollution can also arise from transportation, heating and lighting, and from waste storage and disposal. Pollution can take a number of forms, including chemical pollution of the air, sea and rivers, and noise and visual pollution. Chemical and noise pollution can easily be measured, but visual pollution is much harder to measure as it is subject to personal judgement. Environmental economists attempt to develop alternative ways to achieve the socially desirable level of pollution in the short run, rather than to prevent it entirely. In the long run, the widespread application of green technology may enable the global economy to reduce dramatically what is considered to be the socially desirable level of pollution. Greenhouse gases

So-called greenhouse gases include naturally occurring gases such as carbon dioxide and methane, as well as those arising as a result of industrial production, transportation, and household consumption, including chlorofluorocarbons (CFCs) and hydrofluorocarbons (HFCs). Though occurring naturally, carbon dioxide emissions have increased significantly, largely as a result of burning fossil fuels. The combined result of these gases is to create a warming effect, which most scientists believe is responsible for global warming. Estimated growth in carbon dioxide emissions, 1970 - 2005

The environment as a scarce resource

The environment is regarded as a scarce resource and care for the environment is increasingly seen as an important economic objective. The key debate is the extent to which markets fail to conserve the environment as a scarce resource.

Why has pollution and waste increased?

Pollution and waste have increased for two main reasons: 1. Rapidly rising incomes since 1945 have increased consumption and production, which in turn has increased the amount of energy consumed, and the amount of waste produced. Rising incomes have led to a greater than proportionate increase in consumption of goods with a high income elasticity of demand, including motor cars, computers, TVs and 'white goods'. These products tend to have a very high carbon footprint in terms of the energy used in their manufacture, distribution, and use, and in terms of the excess packaging they use. Transportation of goods by airfreight and road haulage is a major contributor to carbon pollution. Rising incomes have also led to much greater use of private motor cars while at the same time contributing to a decline in demand for greener, inferior, forms of public transport such as tube and bus travel. 2. The real price of most consumer goods and many services has fallen over the last 50 years, and this has further stimulated consumption, production and the creation of waste. Increased competition and globalisation have reduced the real price of many consumer goods, and cheap package holidays have encouraged more air travel, and more chemical pollution.

The Kyoto Treaty

The purpose of the Kyoto Treaty, which was signed in Kyoto, Japan, in 1997, was to get the major industrialised economies of the world to commit to reduce their greenhouse gas emissions in two phases. The first phase ends in 2012, and the agreement states that signatories should reduce emissions to levels less than those occurring in 1990 by that date. The Treaty was signed by 156 countries and came into effect in 2004. The target for the first phase was for the EU as a single trading bloc to cut emissions by 8%, with the UK independently agreeing to a 20% reduction by 2010. Developing countries are not subject to the agreement,

though they have been widely encouraged to become more environmentally conscious. Many are concerned that, as a developing economy, China is not subject to the limits agreed in Kyoto, yet it is predicted that China will become one of the planets biggest polluters over the next 10 years. By 2003 the UK had reduced its greenhouse gases by 13% from its 1990 levels, and by 2006, emissions had fallen by 20%. (Source: Defra.gov.uk). However, other countries had not been so successful, with emissions from Spain and Portugal up by 42% and 37% respectively. (Source: The Times, December 2005). Under the Kyoto rules, if countries exceed their agreed limits in the first phase (2008 -2012) they are penalised by having to make up for the overshoot , plus a 30% further reduction, in the second phase (from 2013.) In global terms, growth in car usage and air travel is likely to make it difficult to achieve any of the targets. Unfortunately, the world s biggest polluter, the US, pulled out of the agreement in 2001, though Russia did eventually join in 2004. Despite the effects of the first and second Middle Eastern oil crises (1973 and 1979 respectively) which sharply increased the global price of oil, and the Kyoto Protocol, global carbon emissions have continued to rise over the last 35 years.

The Copenhagen UN Climate Change Summit, 2009

Delegates from 192 countries met in Copenhagen in late December 2009 to discuss ways to reduce global carbon emissions, which are widely regarded as contributing to global warming. The Conference was made necessary because the existing global targets are set out in the Kyoto Protocol are due to expire in 2012. The draft agreement required developed countries to reduce their emissions by 2020 to between 25% and 45% of 1990 levels, but there was strong resistance from the developed nations to such ambitious targets. Part of the deal involved developing countries receiving financial support to help them adjust to a low-carbon future. Negotiations also involved trying to agree an explicit target for temperature increases. If negotiations are successful, it is likely that a binding agreement will be signed during 2010.

Remedies
The economic theory of pollution suggests that producers and consumers do not take carbon and other chemical emissions into account when they calculate their marginal private cost and benefit. This makes it extremely difficult for markets to resolve the pollution problem. In theory, markets will work efficiently when those suffering from a specific instance of pollution can identify the polluter, and can take them to court. In this case, if found guilty, the polluter will consider the fine or legal damages a marginal private cost, and, to avoid further costs, will reduce pollution. This process might work with noise pollution from a specific factory, because local residents can take the owners to court. However, with carbon pollution, property rights over the atmosphere cannot be established, and specific polluters cannot be identified and sued directly. This means that there is no 'built-in' incentive to be a non-polluter. There are a number of remedies proposed under the Kyoto Treaty, and by environmental economists. Either remedies can exploit the price mechanism's ability to signal, ration and provideincentives, or they involve legislation and compulsion. Two schemes that arose out of the Kyoto agreement were the EU Emissions Trading market andcarbonoffsetting through the Clean Development Mechanism (CDM).

Tradable pollution permits

Tradable permits provide an incentive to polluters to internalise' the externality. Tradable permits to pollute involve: 1. The government, or an appointed agency, selling the right to generate a given quantity of pollution to firms in an industry. 2. These can be bought, and traded, with the result being: a. The high polluters have to buy more permits, which increases their costs, and makes them less competitive and less profitable. b. The low polluters receive extra revenue from selling their surplus permits, which makes them more competitive and more profitable. c. There is clearly an incentive to be a non-polluter!

Tradable Permits in the EU In response to the Kyoto Protocol the European Council adopted the Emissions Trading Directivein 2003. This directive set up a time frame for the establishment of the European Emissions Trading Scheme (ETS). Participants can: 1. Meet their emissions target by reducing their own emissions, or: 2. Reduce their emissions below their target and then sell, or store, the excess emission allowances, or: 3. Allow their emissions to stay above their target, and therefore purchase emissions allowances from other participants.

Carbon offsetting
Carbon offsetting involves the attempt to neutralise the effects of harmful CO 2 emissions resulting from consumption or production. Encouraging polluters to invest in, or donate to, a low carbon or carbon

reducing scheme can offset the carbon they produce.

Under the Kyoto Treaty, the Clean Development Mechanism (CDM) scheme was established to enable polluting countries in the industrialised world to offset their emissions by investing in carbon reducing schemes in developing countries. A typical example might involve an airline investing some of the revenue from ticket sales into a wind farm in a developing country. The high-carbon airline is attempting to offset some of its carbon by investing in a very low-carbon energy source. See: British Airways carbon offset scheme

Carbon accounts and carbon rations According to the UK' s Environment Agency, one way to meet targets for reducing greenhouse gas emissions is to set up a carbon account system for each individual or household, similar to the European carbon trading system currently being used to reduce emissions by industry. Each individual is given a unique identifying number, and when they make purchases, the carbon weight would be calculated and added to their account. Once the pre-agreed limit has been exceeded, individuals would be required to purchase unused credits from others. In this way, carbon is rationed, and ordinary individuals are encouraged to think about the carbon effect of their spending and consumption.

Pollution taxes
In many cases, it may efficient for government to impose specific taxes on polluting activities. The effect of the tax is to internalise the externality, and help achieve the socially efficient level of pollution. Pollution taxes Pollution taxes are increasingly common. Across Europe, national governments are experimenting with various rubbish taxes, based on weight of rubbish or numbers of rubbish bags used. However, one disadvantage of such schemes is that they encourage illegal dumping of waste.

Waste disposal
Increased waste is a significant negative externality, and like pollution, is a result of increased consumption and production.

Landfill taxes
A landfill site is an area of land that is set aside by local governments or private companies for the purpose of waste disposal. Sites are licensed and regulated by government. A landfill tax is an extra charge, on top of normal disposal fees, for disposing of waste, and is designed to encourage businesses to reduce the amount of waste they produce. In the UK landfill taxes are set at two rates - the lower rate is for inactive like rocks and soil, and the higher r ate, currently at 32 per tonne, is for active waste, such as plastics, chemicals, and metals.

Evaluation of market solutions

Selling permits to pollute, and taxing polluters work by manipulating market forces to encourage consumers and producers to take externalities into account when planning their consumption and production. In other words, polluters are forced to consider pollution as a private cost. However, in the case of pollution taxes, consumers might respond inelastically to the price rise, and while tax revenue is generated, polluting behaviour continues. With fuel taxes in particular, it is likely that consumers are relatively insensitive to higher prices, especially given the lack of suitable alternatives. Therefore, such taxes may be a good source of revenue for the Chancellor, but they may fail to make a sustantial impact on pollution. Permits to pollute force firms to take their pollution into account but, again, there is no guarantee that behaviour will be altered sufficiently to reduce pollution levels. Carbon offsetting has come in for special criticism because many schemes have been discovered to be bogus.

Command solutions
Command solutions try to by-pass markets and rely on legislation and the force of law. Government can pass laws which directly force consumers and firms to alter their behaviour. Examples include: 1. Banning sources of pollution, such as cars and factories, from urban areas 2. Forcing firms to install air filters setting up smokeless zones' 3. 4. Setting emission limits for motor vehicles, or emission control zones Fining those who break these laws or limits

The Clean Neighbourhoods Act In 2005, the Clean Neighbourhoods Act set the maximum fine for local polluters of 50,000 and up to 1 year in jail. The Act also enables local council officers to impose on the spot fines for light pollution including the dumping of cars and graffiti.

Evaluation
A major criticism of legislation and prohibition is that it is difficult and costly to police. There is also an assumption that government knows the best way to control behaviour, but, like markets, government may also suffer from information failure. See also: positive externalities

http://www.economicsonline.co.uk/Micro_g raphs/Welfare loss positive externalities.png Positive externalities

A positive externality is a benefit that is enjoyed by a third-party as a result of an economic transaction. Third-parties include any individual, organisation, property owner, or resource that is indirectly affected. While individuals who benefit from positive externalities without paying are considered to be free-riders, it may be in the interests of society to encourage free-riders to consume goods which generate substantial external benefits.
Most merit goods generate positive externalities, which beneficiaries do not pay for. For example, with healthcare, private treatment for contagious diseases provides a considerable benefit to others, for which they do not pay. Similarly, with education, the skills acquired and knowledge learnt at university can benefit the wider community in many ways. Unlike the case of negative externalities, which should be discouraged to achieve a socially efficient al location of scarce resources, positive externalities should be encouraged.

Encouraging positive externalities One role for government is to implement economic policies that promote positive externalities. There are two general approaches to promoting positive externalities; to increase the supply of, and demand for, goods, services and resources that generate external benefits. Increasing supply
Government grants and subsidies to producers of goods and services that generate external benefits will reduce costs of production, and encourage more supply. This is a common remedy to encourage the supply of merit goods such as healthcare, education, and social housing. Such merit goods can be funded out of central and local government taxation. Public goods, such as roads, bridges and airports, also generate considerable positive externalities, and can be built, maintained and fully, or part, funded out of tax revenue.

Increasing demand
Demand for goods, which generate positive externalities, can be encouraged by reducing the price paid by consumers. For example, subsidising the tuition fees of university students will encourage more young people to go to university, which will generate a positive externality for future generations. The ultimate encouragement to consume is to make the good completely free at the point of consumption, such as with freely available hospital treatment for contagious diseases.

Government can also provide free information to consumers, to compensate for the information failure that discourages consumption. If individuals are fully informed about the benefits of consuming goods and services that generate external benefits, they may develop a better understanding of the product and demand more of it. For example, public information broadcasts, such as aids awareness programmes, can reduce ignorance, and encourage the use of condoms.
An additional option is to compel individuals to consume the good or service that generates the external benefit. For example, if suspected of having a contagious disease, an individual may be forced into hospital to receive treatment, even against their will. In terms of education, attendance at school up until the age of 16 is compulsory, and parents may be fined for encouraging their children to truant.

Net welfare loss

The existence of a positive externality means that marginal social benefit is greater than marginal private benefit.

Net welfare loss

For example, in considering the market for education, free markets would supply quantity Q at price P. If the external benefit is included, the socially efficient output rises to quantity Q1. By consuming only quantity Q, marginal social benefit is above marginal social cost, and more of the good should be consumed. At Q, the marginal social cost is A (Q A), and the private benefit is also A (Q A) but the marginal social benefit is C (Q C). Therefore, if only Q is consumed, there is an opportunity cost to society, which is represented by the area of welfare loss, A, C, B.

Information failure
Information failure is another, significant, market failure and can occur in two basic situations. Firstly, information failure exists when some, or all, of the participants in an economic exchange do not have perfect knowledge. Secondly, information failure exists when one participant in an economic exchange knows more than the other, a situation referred to as the problem ofasymmetric, or unbalanced, information.
In both cases there is likely to be a misallocation of scarce resources, with consumers payin g too much or too little, and firms producing too much or too little. Information failure is common and appears to exist in numerous market exchanges. It can be argued that markets work best, that is they are at their most efficient, when knowledge is perf ect and is evenly shared by all the parties in a transaction. Hence, asymmetric knowledge is an economic problem because one party can exploit their greater knowledge.

There are many examples of information failure associated with economic transactions, including the following cases:
1. The job applicant, who fails to reveal at a job interview that they do not have a particular skill for the job. 2. The estate agent, who exploits the fact that a potential buyer of a property has very little knowledge about the property, and any possible problems. 3. The cigarette manufacturer, who does not inform smokers of the true health risk of smoking. 4. The buyer of a financial product, who is unaware of the true level of risk, as in the case of derivative products. 5. The seller of a pension, who misleads purchasers about the financial value of the pension. Indeed, widespread pension 'miss-selling' by large UK insurance companies, occurred at the end of the 1990s. See article on pensions miss-selling

The Lemons Problem

When parties to a transaction are ignorant of certain aspects of the transaction, such as the quality of the product they are buying, they are forced to make assumptions, often based on price. For example, a buyer may assume that goods are of poor quality if their price is low and that goods are of high quality if their p rice is high.

In some markets, only low quality products will be sold - the so-called lemons problem. The lemons problem was first analysed by American economist George Akerlof in 1970. Akerlof explored the problem associated with pricing second hand cars in the USA, which he called a lemons market a lemon is a derogatory term for a poor quality second-hand car. However, the lemon's problem has many wider implications in terms of understanding information failure in general. For example, in terms of second hand cars, buyers may be suspicious of the motives of seller, and w onder whether the car is a lemon . If an individual buys a new car for 30,000 and tries to sell on the second -hand market shortly after, they may be forced to accept a much lower price, given that buyers will be suspicious of the seller's motive. Not hav ing all the facts, potential buyers are likely to assume the worst and expect the car to have a problem - in other words, it is a lemon . Therefore, given that second hand cars will generally attract a low price, only those sellers who actually have poor quality cars will use this market. After a short period, it can be predicted that all cars sold on the second hand car market will be lemons. W hen applying this concept to other markets it can be suggested that, whenever there is information

failure, there is the possibility that markets will become lemons markets. If so, the supply of good quality products will fall and the supply of poor quality will products rise.

The principal-agent problem

Asymmetric information is also associated with the principal-agent problem. In an increasingly complex world, individual decision making often relies on the advice given by experts, and a potential principal-agent problem can occur whenever decision makers rely on advice from others with more knowledge than they have. For example, the shareholders of firms, the principals, usually delegate responsibility for day -to-day decision making to appointed managers, the agents. This creates a situation of asymmetric knowledge, with managers knowing much more than the shareholders, and raises the possibility of inefficiencies, especially when shareholders and managers have different objectives. Examples of these inefficiencies include situations when managers decide to take the easy life , knowing that shareholders will not find out, and managers deciding to cheat and not reveal information to shareholders. This may occur in situations involving insider dealing, where managers can exploit their knowledge of a business s prospects to buy or sell shares and make a personal gain.

Extra costs
From a firm s perspective, the principal-agent problem can increase costs, and make the firm less efficient than it could be. These inefficiencies include the costs associated with monitoring the performance of the managers and having to pay a premium to attract the best managers.

Moral hazard
Moral hazard occurs when people s behaviour is less careful than it could be, either because they believe that their carelessness will not be found out, or because they are encouraged to behave carelessly. This occurs because there is insurance protecting them from the adverse effects of their careless decision. For example, a pupil at school can idle along because they believe, either that their parents will provide insurance against their idling, or that the State will provide them with an income if they fail to get a job. There are many other examples of information failure, including the following situations: 1. 2. Consumers may under-estimate the net private and external benefit of merit goods. Consumers may over-estimate the net private and external cost of demerit goods.

3. Fishermen may not know the size of fish stocks and, as a result, over-fishing current stocks. 4. Firms may provide misleading information about products, such as producers of cosmetics claiming to make people beautiful, holiday brochures making resorts appear more attractive, and car drivers not knowing how much pollution they are creating.

Video

Remedies for information failure

Clearly, government has a considerable role in trying to ensure that some of these information failures are reduced or eliminated. The two basic strategies are to increase both the supply of, and demand for, information.

Increasing the supply of information:

Options to increase the supply of knowledge include: 1. Government may force producers to provide accurate information about products

through accurate labelling. For example, requiring that the alcoholic content of drinks is printed on alcoholic drinks, and stating the E numbers found in a product E numbers are the European system for indicating chemical additives in food and drink.
2. Public broadcasts to improve knowledge may also be made, such as informing smokers and drinkers of the true cost of their habit. To help inform the public, a government can subsidise public service TV and radio broadcasting, as in the case of BBC TV and radio. 3. Laws may be passed to force public limited companies to be more transparent, and publish their financial accounts, as well as have them audited to ensure accuracy. 4. Government may also regulate advertising standards to make advertising more informative, and less persuasive. 5. Employers may be forced to request that job applicants disclose information about themselves, such as whether they have a criminal record. 6. Government may force car owners to have their vehicles regularly checked by a Ministry of Transport (MOT) test, which provides some basic information to potential buyers. All cars over 3 years old must be tested each year, and this gives some assurance to potential buyers that the car is road worthy. 7. In addition to direct intervention, government may establish organisations to act asregulators and watchdogs, such as the Office of Fair Trading, which tries to ensure that firms compete fairly, and the Competition Commission, which investigates abuse of market dominance by firms with monopoly power. The Advertising Standards Authority(ASA) also promotes ethical advertising and regulates the advertising industry in an attempt to improve the accuracy of information available to consumers. The ASA is a self-regulatory body established in 1962, and insists that adverts should be ..honest, decent and truthful.. .. and in line with the principles of fair competition generally accepted in business.. .

Increasing the demand for information

1. Market theory suggests that demand for knowledge will increase if it is provided freely, or at low cost, hence consumers should not have to pay for information. However, consumers may become overwhelmed with information and fail to take it into account. 2. Government may also promote the formation of pressure groups such as anti-smoking groups, which campaign for more knowledge to be made available by producers. 3. In addition, promoting literacy, numeracy, and IT skills may help increase the demand for information. Having the skills to acquire knowledge can create an increase in demand for knowledge, and a greater appreciation of the value of information in making rational choices.

Lack of property rights

Markets are efficient at producing private goods, largely because producers and consumers have the right of ownership of the resources exchanged in an economic transaction involving a private good. However, markets are less efficient when property rights do not exist.

Many resources that are directly, or indirectly, used in an exchange have no specific or identifiable owner, and are collectively available for everyone to use. For example, goods transported by ship use the world s oceans, but there is no charge because on one owns the sea. Such resources are called common property resources, and they are free to use because it is too expensive, or physically impossible, to establish legal boundaries. An absence of boundaries allow free-riders uncontrolled access, which can result in the over-exploitation or misuse of the resource.
Examples of common property resources include; oceans, rivers and canals; beaches; the air; roads and pavements, and even images, words and ideas. Because property rights cannot be established, the effectiveness of markets in terms of the allocation, pricing and rationing of these resources is substantially reduced.

The effects of a lack of property rights

The absence of property rights can lead to a number of consequences: 1.

Opportunism may be encouraged, with individuals or groups exploiting the lack of private ownership. For example, because it is not possible to put a boundary around a song, other individuals can 'steal' the music and lyrics. With mo dern technology, it is easily possible to copy CDs
without paying for them. This is another example of the free rider problem, which means that the price mechanism is less effective at pricing goods that can easily be stolen. 2. Misuse of scarce resources is also likely, such as dropping litter on pavements, or deliberately spilling oil in the sea. This problem is made worse is accompanied by moral hazard that is, assuming that someone else will pick up the litter, or clean the seas. 3. Over-use of resources, such as the depletion of rain forests, over-fishing, and traffic congestion, is also associated with a lack of property rights. Over-use can also result in the general exhaustion of other natural resources, including the environment itself. The environment is, indeed, a scarce resource which can be depleted at will because so much of it cannot by protected by establishing property rights.

Remedies
Granting or extending property rights
Though complex to design and implement, government can grant property rights over scarce resources in an attempt to protect them from opportunism, misuse, and over-use. According to Ronald Coase, allocating property rights will encourage the appointed owners to protect the resource by allowing the owners to sue those who exploit the resource. When applied to resources that are under attack from pollution, extending property rights will enable the owners to sue the polluters. For example, the National Rivers Authority, now part of the Environment Agency, was created with powers to act as if it owned the UK s rivers. This allowed it to police the rivers and sue poll uters and opportunists, such as poachers. Once rights are allocated it may be possible to identify those individuals, firms or organisations that abuse or misuse the environment. Supporters of the extension of property rights see it a crucial to the formation and effective operation of markets. Property rights can be extended by creating laws to protect physical property; intellectual property, such as copyrights to protect ideas, songs, music, books and film; patents, to protect inventions; and trade marks to protect commercial images and logos. Property rights can also be extended by creating territorial waters around a coast. Once rights are established propert owners can police the use of their property, and penalise those who misuse it.

Depletion of fish stocks

Fish stocks around the world have fallen considerably, with stocks of cod, in particular, being heavily depleted. Most experts agree that the current levels of consumption are unsustainable.
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A study by Science magazine (2006) claimed that every seafood species would fall below commercially viable levels by 2048. There are a number of reasons for the depletion of fish stocks, including: 1. A lack of property rights over the sea, as ownership is difficult, if not impossible, for individuals to establish. 2. There is also information failure because fishermen do not know the size of available fish stocks. 3. Externalities are also associated with fishing, given that fisherman fail to take into account the impact of their actions on others, including the impact of over-fishing on other fishermen in the future. 4. The high fixed cost of boats is also an incentive to fish as much as possible in order to cover the fixed costs. 5. Fishermen are often heavily subsidised, w hich encourages them to catch more. This happens in the EU, through the Common Fisheries Policy. 6. There is also a Prisoner s Dilemma, which means there is an incentive for fishermen to catch as much as they can because that is what they expect others to do. A prisoner s dilemma is any situation where the pay-off from an action depends upon decisions made by other parties. This means that an individual s behaviour is influenced by the predictions that they make about how others will react in response to their behaviour. In this ca se, fishermen may predict that all other fishermen will try to catch as much as they can before the stocks run out. The combined outcome is that shrinking stocks encourage more fishing and not less! Even if fishermen agree to limit their catch many will expect others to cheat, hence cheating would become the norm . 7. Finally, widespread pollution of the sea has also contributed to the gradual depletion of fish stocks.

Remedies
There are a number of possible remedies for reducing the rate of fish stock depletion, including, attempts to reduce the demand for fish, and to increase the supply of fish.

Reducing the amount of fishing.

The quantity of fish caught could be reduced by: 1. Establishing or extending property rights over the sea, although this would be difficult to implement and police. 2. Imposing a special conservation tax on fishing. However, the effectiveness of such a tax would depend upon the elasticity of demand for fish. 3. Introducing a complete or partial ban on fishing. In 2005 the UK government, implementing EU Common Fisheries Policy, imposed a limit of 178 days on fishing days for British boats operating in the North Sea. However, there would be a welfare loss if too little fish are caught, including the loss jobs. An alternative approach might be get fishermen to sign up to a voluntary ban, though there may be an incentive to cheat. 4. Authorities can also reduce the size of fish quotas, especially for cod, which are at levels

close to extinction. In 2005, the EU reduced quotas for cod, herring, and whiting by 15%.(Source: The Times, December 2005). 5. Authorities can also legislate to limit the size of nets, or to increase the size of the mesh to enable the smaller fish to escape being caught. 6. Authorities can also issue special permits to fish, as a way of controlling the number of
fishermen, or fishing days. 7. Better information for fishermen on the current size of fish stocks, and estimates for the future. 8. Reduce or abolish subsidies - in 2002, through its Common Fisheries Policy, the EU agreed to stop subsidising boat building - the Common Fisheries Policy of the EU covers: 1. Conservation of fish stocks

2. Creation of a single and organised market for fish, and an external fisheries policy regarding other countries

Increasing the supply of fish

Reducing demand will lead to a replenishing of fish stocks, but supply can also be targeted directly, such as by giving subsidies to fish farmers. However, this would take time, and uses scarce resources which could be spent elsewhere.
A mixture of the above is likely to be the most effective in the long run, with the emphasis on a reduction in the amount of fishing undertaken. The case of fish highlights two basic strategies for reducing many market failures; either by altering behaviour by using the price mechanism, or circumventing the price mechanism and imposing solutions through legislation.

What if too few fish are caught?

If fishing is over-restricted, there is also a net welfare loss. Too few fish The socially optimal level of fishing is at Q1, but restricting output to Q2, say through a partial ban, would result in lost economic welfare of ECF.

Road congestion
There are a several reasons why roads have become increasingly congested, including the following.
The real cost of driving has fallen because motor cars, and even petrol, are relatively cheaper than they used to be in real terms - that is when taking inflation into account. 2. Public transport is seen by many as an inferior good, which means that as incomes rise, people switch away from inferior goods. 3. Roads are a common property resource, and as such, people are free to use them with little restriction. 4. The fixed cost of buying and owning a car, including the price, motor insurance, car tax, and depreciation, encourage drivers to use their cars as often as possible. 5. Information failure also has an influence on the amount of driving that happens. No single driver knows the full impact they have on others, and even if they know, they are unlikely to take it into account.

1.

Road space as a scarce resource

Road-space is a scarce resource, which means that the more private individuals use road space the less is available for use by others. By creating the concept of road-space, policy makers are viewing roads, which were previously considered a public good, as a private good which can be charged for. The application of new technologies, like GPRS, can be used to create systems for charging for the use of road-space. Congestion creates external costs including; 1. 2. Extra travelling time. Increased business costs.

3. Emergency services, such as ambulances, police-cars and fire engines, find it harder to function effectively.

4. 5. 6.

Increased pollution, such as air and nois e. Increased probability of more accidents. More stress for drivers, cyclists, passengers and pedestrians.

The causes of congestion

It can be assumed that the demand for road -space will fall as the price rises, because ofincome and substitution effects of a higher price. Conge tion It can also be assumed that the supply of road-space is fixed in the short-run. If road-space is free, there will be congestion because demand exceeds supply at zero price.

The standard MSC = MSB diagram, showing congestion as an external cost can also be used to illustrate the Net Welfare Loss of too much driving.

Remedies for congestion

There are three basic remedies for road congestion, including increasing supply of road -space, reducing demand and increasing price.

Increase the suppl of road space

Firstly, government can increase the supply of road space by building more roads. Building more roads However, with more roads, drivers are encouraged to drive and the demand for road space increases. Demand shifts to the right, and congestion still exits! In addition, there are large building costs and an opportunity cost! There is also a long time lag between planning and availability.

Reduce the demand for road-space

Reduce demand Demand for road-space can be reduced in two ways by decreasing car ownership or by decreasing car usage.

1. 2.

Raising fuel taxes and car taxes. Increased driving license fees.

3. Providing bus lanes, better public transport, and no -parking routes, such as the UK red route scheme. 4. 5. 6. 7. Operating park and ride schemes. Increasing parking charges. Raising the age limit for driving. Legislating on the number of passengers in cars.

1. 2.

The costs of implementation. The UK s strong preference for cars.

3. If successful, there could be a loss of jobs in the car industry, and lost revenue to firms who rely on traffic flow.

Road pricing
Thirdly, the government could adopt a road pricing system by charging for the use of road -space. Road pricing has been used in Singapore, where electronic detectors are placed on bridges and drivers are charged for access to the road-space, that is, access to the road network. Road pricing New technology makes charging for the distance travelled a viable option for the future. This technology includes global positioning systems, roadside detectors,

However, set against these are

Measures might include

anddetector

tags in car windscreens. Trials of detector tags started in South London in early 2005. If road space is priced demand will contract to Q.

The London Congestion Charge

In April 2003, the Mayor of London introduced a 5 per day congestion charge. In July 2005, this was raised to 8 per day. Transport for London estimated that the impact on traffic flow was a reduction of 50,000 cars per day. It also estimated that:

y y y y

Journey times are 15% faster Bus journeys are up by 15% Taxi journeys are up by 20% Cycle usage is up by 30%

Source, Transport for London, February 2004

Criticisms of the congestion charge

While appearing successful at reducing traffic, critics have argued that: 1. 2. 3. It was very costly to introduce. Revenues from fines were much lower than expected. There were serious technical problems with the number plate recognition software.

4. It is unfair on those low paid that have to drive into London to work, such as key workers, such as nurses, ambulance drivers, and the police. 5. The charge is regressive in its impact, which means the poor pay proportionately more of their income on the charge than the rich. 6. Many businesses have suffered as people stop shopping in London. Despite the criticisms, there were plans to exten d the charge zone, but in 2008, the Mayor of London decided to abolish the western extension of the charge zone. In addition, plans for a congestion zone in Manchester were shelved after local residents voted against it.

Congestion charging, perversity and moral hazard

One problem with schemes to alter people s behaviour to achieve desired outcomes is that the reverse can happen, and people behave perversely. For example: 1. Speed cameras positioned at regular intervals on roads may encourage drivers to speed up between cameras. 2. Speed bumps on roads may encourage people to take longer trips to avoid them, hence increasing congestion and pollution. 3. As the costs of driving in London have increased, the illegal dumping of cars has also increased. See: Subsidising public transport

Public transport
Given that public transport generates external benefits, there is a strong case for subsidising non-private means of transport, such as bus, coach, tram and rail. The effect of a subsidy on public transport is to reduce the costs of supply to the provider. Subsidies to public transport A subsidy is likely to reduce public transport charges in graphical terms, the supply curve will shift to the right, reducing the equilibrium price. This will lead to an extension of demand, as more people are encouraged to use this form of transport. The increased demand is the combined result of the income and substitution effect. At a lower price, alternatives to public transport appear more expensive (the substitution effect), and, assuming money income remains constant, cheaper public transport results in an increase in real income (the income effect). Evaluation Even with a large subsidy, travellers may prefer the convenience of private transport implying that PED for public transport is inelastic. Research suggests that PED is, indeed, highly inelastic in the UK, with short run elasticities for bus travel, around (-) 0.4, tube travel (-) 0.3, and suburban rail (-) 0.6. Cross elasticities are estimated to be even lower, with the cross elasticity of demand between bus fares and car travel just (-) 0.1, at best. (Source: TRL Ltd, Demand for Public Transport A Practical Guide, edited by J Balcolme, 2004) In addition, the income effect of lower public transport prices may be very weak. Indeed, increases in real income may encourage greater use of private transport use, and discourage use of public transport, suggesting that public transport is an inferior good. Subsidization of public transport may result in a moral hazard, with state subsidies being regarded as an insurance against inefficient practices. Such inefficiency raises the cost of supply, and diverts scarce resources from more efficient uses. For example, bus companies may over-employ, and operate too many buses, which are run at half-empty for long periods. There is, of course, no guarantee that all of the state subsidy will be passed on to the passenger in terms of lower fares.
See: Road congestion

Unstable markets
Some primary markets can become unstable and require intervention to help them stabilise. In particular, many food producers suffer three main economic problems:
1. 2. 3. Falling long term income. Unstable prices. Loss of bargaining power to big supermarket chains.

Falling incomes
Farm incomes have fallen in the long term because the supply of food has increased. Supply has increased for a number of reasons, including: 1. The greater use of new technology, and better crop yields.

2. New entrants into the market, such as Vietnam, which entered the coffee market in the 1980s, have also helped shift the market supply curve to the right. 3. Loss of power to the big supermarket chains

4. Loss of power to the big supermarket chains, which means that supermarkets can dictate terms and prices to farmers. The buying power of supermarkets is referred to asmonopsony power. Farmers are price takers which means they have to accept the price that the supermarkets dictate, supermarkets are the price makers.

Falling incomes

Supply has increased due to the application of more efficient production methods and, in some cases, new entrants into the market. Demand is relatively priceinelastic, hence revenue falls following the price reduction.

However, demand has not increased in the long run, so revenue (P x Q) falls. In fact, the demand for some food has fallen over time. Revenue 0PAQ is clearly larger than revenue 0P1BQ1.

Video - unstable prices

Unstable prices
The cobweb diagram can be used to explain the tendency for price instability of agricultural products. Initially, we can assume a stable equilibrium price, followed by a negative supply shock, such as a crop disease, bad weather, political unrest or a war. Cobweb diagram Short run supply (Q1, at S1) ends up significantly less than planned (Q). Price is now driven up to P1. Next year, planned output rises to Q2, but this drives price down to P2.

The process continues until the price is so low that producers are driven out of the market. There is clearly a significant information failure farmers and growers are not fully aware of the impact of their decisions in one year on the price of products in the following year. A cobweb effect can also be triggered by a positive supply shock, such as an exceptionally good harvest.

Remedies
Buffer stocks
Buffer stocks are stocks of produce which have not yet been taken to market. They can help stabilise prices by taking surplus output and putting it into a store , or, with a bad harvest, stock is released from storage. A target price can be achieved through intervention buying and selling. Ceilings and floors The buffer stock managers are likely to establish a price ceiling, above which intervention selling will occur, and a price floor, below which intervention buying will take place.

Buffer stocks Buffer stocks can stabilise farm prices at the target price, and also help stabilise farmers incomes.

Evaluation of buffer stocks

While buffer stocks can help stabilise price, there are several disadvantages, including:

1. Additional costs to society, such asbuilding costs, extra storage, insurance and costs of managing the scheme. 2. Furthermore, some commodities cannot easily be stored because they are perishable.

3. The system relies on starting with a good harvest, indeed, without stocks in the system it is not possible to react to a poor harvest. 4. Buffer stocks do not prevent the initial problem from arising.

5. Critics argue that they distort the operation of free markets and prevent the price mechanism working effectively. 6. Finally, there is the potential problem of moral hazard, which means that buffer stocks provide an insurance against poor harvests and may encourage producers to be inefficient.

Guaranteed prices
Guaranteeing a price to producers (at P1 in the diagram below), irrespective of the output they produce, is another way of stabilising prices and incomes. Guaranteed prices A government or agency can establish a target price, and then guarantee to pay farmers and growers this price, whatever output is produced. If the market price rises above this guarantee, the market price will prevail. But if the market price falls below the guarantee, then the guaranteed price will prevail.

However, they can also be criticised because: 1. They encourage over-production creating a surplus of Q2 to Q1.This problem is particularly associated with the EU s Common Agricultural Policy (CAP).

2. They can promote inefficiency. For example, farmers may question whether it is worth bothering to be efficient if they are guaranteed a buyer.
3. There are also extra costs of storage or disposal.

Set-Aside programmes
Set-aside schemes involve farmers and growers being paid to take land out of production, and are used widely in the EU and USA. Set-aside can be effective because it can prevent surpluses happening in the first place, and hence avoid storage, distribution and management costs.

Export subsidies
An export subsidy involves producers being paid a subsidy to export their surpluses at artificially low prices. However, other countries may retaliate, and protect their own producers from cheap imports, because it can be argued that export subsidies are a form of unfair competition.

Quotas
Over-production can be controlled by allocating production quotas to producers. Quotas agreed quantities are that individual producers must produce, and a quota system can help prevent over or under production in response to economic shocks.

Better information about future shocks

Another way to stabilise markets is to encourage producers tomake better use of the internet and computer technology to predict the weather. This enables farmers and growers to predict the onset of other potential shocks so that they can react quickly. In addition, specialist knowledge and skills also be acquired by can studying agricultural courses at specialist colleges.

The Common Agricultural Policy

The EU protects its farmers and growers through its Common Agricultural Policy (CAP). Through the CAP, European farmers receive annual subsidies of around 30 billion each year.

The evolution of CAP

CAP was created by the Treaty of Rome (1957) to ensure food supplies for Europe, and prov a fair income ide for European farmers. Price support schemes, such as guaranteed prices, were first introduced in 1962, and became the main means of supporting European farmers. By the mid 1980s, over-production created massive surpluses and this led to m ajor reforms, including the use of set-aside programmes. By the early 1990s, there was a movement away from guaranteed prices towards direct subsidies to farmers, irrespective of the output they produced. The Fischler Reforms, of 2003, continued the proces of decoupling subsidies and farm output, and introduced s a green element to CAP, forcing farmers to meet environmental and animal welfare standards. The UK receives a controversial rebate against payments into the EU to compensate for that fact that it receives relatively little income from CAP in comparison with France and Spain.
Source: The Times, June 2005

CA finances Farming subsidies in the EU are based on the size of farms, so countries with the largest farms gain the most.
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France takes the biggest slice of the subsidies, with Spain and Germany a distant second and third. French farmers receive, on average, approximately 17,000 per capita.

Because the UK derives such a low proportion of its national income and employment from farming, it is given a rebate as compensation.

Labour market failures

Like product markets, labour markets can also fail. The main types of labour market failure are the existence of skills gaps, poaching, labour immobility and inequality.

Skills gaps, training and poaching

The theory of poaching suggests it will not benefit firms to provide workers with general skills that can be transferred from job to job. Firms are more likely to wait for other firms to spend money on training, and then poach workers with higher salaries, which they can afford because they have spent less on training. Poaching is an example of the free-rider problem similar to that associated with merit goods. In this case, training provides an external benefit to others, which they do not pay for. Therefore, in free markets, there is likely to be a skills gap, because insufficient levels of general skills, such as literacy, numeracy and IT skills, will be provided by private firms.

Remedies
Because there is little incentive for firms to train workers in general skills, the government can compe nsate by: 1. Providing vocational training by sponsoring college and university courses that are less

academic and more focussed on jobs and job skills.

2. Adding a skills component to academic courses, such as Keys Skills and Functional Skills in the National Curriculum. 3. Giving financial assistance, such as training grants or subsidised training loans, such

ascareer development loans.

4. Providing special training via the internet, such as the Learn Direct scheme, which is a recently established internet training service sponsored by the UK government.

Labour immobility
Labour immobility means that labour does not move to where it is in greatest demand. There are three types of labour immobility:

Geographical immobility
Geographical immobility occurs when workers are not willing or able to move from region to region, or town to town. Immobility is made worse by immense house price variation between regions. It may be extremely difficult for someone in Yorkshire to sell their property and buy an equivalent one in London. Other factors also contribute to geographical immobility, such as strong social and family ties, and paren ts being unwilling to disrupt their children s education by changing schools. The stresses ofmoving home can also be a deterrent to mobility for some.

Industrial immobility
Industrial immobility occurs when workers do not move between industries, such as moving from employment in the motor industry to employment in the insurance industry. Industrial immobility has affected the UK, and many other industrial countries, as the growth of service industries, and the decline of manufacturing industries, has increased the need for mobility.

Occupational immobility

Occupational immobility occurs when workers find it difficult to change jobs within an industry. For example, it may be extremely difficult for a doctor to retrain to be a dentist. Industrial and occupation immobility are most likely to happen when skills are not transferable between industry and job. Information failure also contributes to labour immobility because workers may not know where all the suitable jobs for them are. A resulting problem with labour market immobility is that it can create regional unemployment, which is a type of structural unemployment. This means that a change in the structure of industry leaves some people unable to respond by changing job, industry, or location and as a result, they remain temporarily or permanently unemployed. Immobility can also lead to rising labour costs, as firms have to increase wages to encourage workers to re locate.

Remedies
There are several actions a government can take to increase the amount of mobility in the labour market. Schemes either encourage workers to move or retrain, or give incentives for firms to relocate. Examples include: 1. Training and re-training schemes to enable labour to develop their general skills and become more employable in a variety of occupations or industries. General skills include transferable skills like numeracy, literacy and IT skills. 2. 3. 4. East. More information about job vacancies so that searching for work is easier. Subsidies to labour or firms, such as help with re-location expenses, and subsidised housing. Incentives to overseas firms locate subsidiaries in UK regions, such as in Wales or the North

5. Incentives to domestic firms to relocate to the regions, including providing tax breaks and investment grants. Incentive schemes in the UK include Enterprise Investment Schemesand Venture Capital Schemes.

Unequal distribution of income

Labour markets also contribute to the unequal distribution of income in the UK economy.

Unequal distribution of income

Markets may result in a very wide distribution of income, such that some individuals may receive no income at all.
Incomes are earned in a market when individuals sell or hire out their factor of production to others. Factor incomes include:

y y y y

Wages Rents Interest Profits

However, these incomes can vary considerably, and some individuals cannot earn even a moderate income. In a free market it may be difficult for some individuals to earn an income at all, leaving them unable to buy goods and services. Those who are likely to receive less than average incomes include:

1. 2. 3. 4.

The uneducated and unemployed The sick and disabled The elderly Those working in the unofficial labour market, such as illegal immigrants

Remedies
Progressive taxes
Governments can intervene in the labour market by altering personal disposable income via the tax and benefits system. This means employing a progressive tax system. Progressive taxes take proportionately more tax at higher incomes and proportionately less tax at lower incomes. If this is accompanied by welfare payments to those on lower incomes, any gap between high and low income earners can be reduced. Income tax in the UK is mildly progressive, because: 1. Individuals on very low incomes pay no income tax. Everyone can earn up to 6,475 before they pay income tax (2009). 2. 3. 4. A low tax band of 10% for those earning between 6,475 and just over 9,000. Middle-income earners pay tax on some of their income at the basic rate - currently 22%. Those on higher incomes pay tax on some of their income at a higher tax rate, such as 40%.

5. These tax bands help narrow the income gap between the well paid and poorly paid, or unemployed, and so help reduce inequality.

Regressive taxes
Regressive taxes are those where the tax paid, as a percentage of income, falls the higher the level of income, and hence where the burden of the tax is largely on the poor.

Example of a regressive tax

VAT, currently at 15.%, is a regressive tax as it takes no account of an individual s income. For example, consider three different drivers, all of whom drive the same distance each year, but each earn a different incomes.

y y y

Mr Brown earns 10,000 per year Mrs Green earns 50,000 Miss Black earns 200,000

If it is assumed that they all drive to work and buy 3000 litres of petrol per year at 1 per litre, of which 15% is VAT, then it can be seen that there is a considerable difference in terms of the proportion of their income that goes to the government in VAT:

y y y

Mr Brown earns 10,000 per year, and pays 4.5% of his income in petrol taxes Mrs Green earns 50,000, and pays 0.9%, and Miss Black earns 200,000, and pays 0.23%

Welfare benefits
Not all individuals have the opportunity or ability to sell their labour in the labour market. To help provide a basic level of personal income a government may also provide transfer benefits, such as: 1. 2. Unemployment benefit Old age pension

3. 4. 5. 6. 7.

Child benefit Sick benefit Disability benefit Tax credits, such as Working Family Tax Credits Subsidised housing costs

Criticisms
These benefits may compensate for the failure of labour markets to provide sufficient rewards, but such intervention can be criticised because: 1. It may create a disincentive effect, which occurs when individuals are discouraged from working hard, because they pay more taxes. 2. It may create moral hazard, where some individuals may not make an effort to find ways to improve their own position because the state provides insurance against poverty, unemployment and disability. See also: National Minimum Wage Equity Welfare reforms and universal benefit

Government failure
Government intervention to resolve market failures can also fail to achieve a socially efficient allocation of resources. Government failure is a situation where government intervention in the economy to correct a market failure creates inefficiency and leads to a misallocation of scarce resources.
Examples of government failure include: 1. Government can award subsidies to firms, but this may protect inefficient firms from competition and create barriers to entry for new firms because prices are kept artificially low. Subsidies, and other assistance, can lead to the problem of moral hazard. Taxes on goods and services can raise prices artificially and distort the efficient 2.

operation of the market. In addition, taxes on incomes can create a disincentive effect and discourage individuals from working hard. 3. Governments can also fix prices, such as minimum and maximum prices, but this can create distortions which lead to:
y
Shortages, which may arise when government fixes price below the market rate. Because public healthcare is provide free at the point of consumption there will be long waiting lists for treatment. y Surpluses, which may arise when government fixes prices above the natural market rate, as supply will exceed demand. For example, guaranteeing farmers a high price encourages over -production and wasteful surpluses. Setting a minimum wage is likely to create an excess of supply of labour in markets where the market clearing equilibrium is less than the minimum.

Information failure is also an issue for governments, given that government does not 4. necessarily know enough to enable it to make effective decisions about the best way to allocate scarce resources. Many economists believe in the efficient market hypothesis,which assumes that the market will always contain more information than any individual or government. The implication is that market prices and market movements should be free from interference because markets cannot be improved upon by individuals or governments.

5. Excessive bureaucracy is also a potential government failure. This is caused by the public sector when it tries to solve the principal-agent problem. Government must appoint bureaucrats to ensure that its objectives are pursued by the managers of public sector organisations, such as the NHS. 6. Finally, there is the problem of moral hazard associated with the payment of welfare benefits. If individuals know that the state will provide unemployment benefit, or free treatment for their poor health, they are less likely to take steps to improve their employability, or to avoid activities which prevent poor health, such smoking, a poor diet, or lack of exercise.

The national economy

The National Economy introduces macro-economic concepts, models, and theories, and explains how macro-economic problems are analysed, and policies evaluated.
Economic policy - is the deliberate attempt to generate increases in economic welfare. Since the late 1920s, when many advanced economies were on the brink of complete collapse, economists have recognised that there is a role for government in steering a macroeconomy towards increased economic welfare. More...

Inflation - inflation and deflation arise from changes in either the demand side or supply side of the macro-economy. Demandpull inflation usually occurs when there is an increase in
aggregate monetary demand caused by an increase in one or more of the components of aggregate demand (AD), but where aggregate supply (AS) is slow to adjust. More... Unemployment - there are a number of types of unemployment, defined in terms of cause and severity. Cyclical unemployment exists when individuals lose their jobs as a result of a downturn in aggregate demand (AD). If the decline in aggregate demand is persistent, and the unemployment long-term, it is called either demand deficient, general, or Keynesianunemployment. More... Poverty - the alleviation of poverty is increasingly seen as a fundamental economic objective. Poverty creates many economic costs in terms of the opportunity cost of lost output, the cost of welfare provision, and the private and external costs associated with exclusion from normal economic activity. These costs include the costs of unemployment, crime, and poor health. More...

Go to: 'What is macro-economics'?

Sustainable growth

Economic growth occurs when real output increases over time. Real output is measured by Gross Domestic Product (GDP) at constant prices, so that the effect of price rises on the value of national output is removed.
Sustainable economic growth means a rate of growth which can be maintained without creating other significant economic problems, especially for future generations. There is clearly a trade-offbetween rapid economic growth today, and growth in the future. Rapid growth today may exhaust resources and create environmental problems for future generations, including the depletion of oil and fish stocks, and global warming. Periods of growth are often triggered by increases in aggregate demand, such as a rise in consumer spending, but sustained growth must involve an increase in output. If output does not increase, any extra demand will push up the price level.

PPFs and economic growth

For an economy to continue to grow in the future, it needs to increase its capacity to grow. An increase in an economy s productive potential can be shown by an outward shift in the economy s PPF. Economic growth An increase in an economy s productive potential can be shown by an outward shift in its PPF.

Standards of living
Gross domestic product per capita is often regarded as the key indicator of the standards of living of the citizens of an economy, and of their economic welfare, though broader measures of economic welfare are increasingly used in preference to narrow GDP measures.

Measuring growth
GDP is the official base measure of output used in most economies, including the UK. Grossmeasurements record the output of all goods and services, including capital goods which have been purchased to replace existing capital goods. Replacing capital is called capital consumption, or depreciation. The alternative to Gross output is Net output, which indicates that depreciation is taken into account and deducted from the gross measurement. Domestic product is the value of all UK goods and services produced, including those produced for export. It does not include property income which flows into and out of the UK economy. Property income refers to income from various types of investment abroad, such as profits and dividends.When this is added, the measure becomes national product, called Gross National Product, GNP. Growth can be measured as an annual percentage increase in real GDP, and in terms of a general trend. The trend rate of growth is the long term non-inflationary average rate of growth for an economy. In the UK it is around 2.5% per year.

Why is stable growth an economic objective?

If growth rises significantly above or below the trend rate, the economy is experiencing excessive growth or low growth. If the rate becomes negative for at least 2 quarters in succession, the economy is in recession.

The trade cycle

Changes in real national income tend to be cyclical, but it is desirable that this cycle is stable rather than unstable. Unstable growth is popularly called boom and bust .
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Although an economy s growth is cyclical in nature, the underlying trend can be derived from annual growth statistics. Trends can be calculated by using a technique called moving averages. The UK trend rate over the last 25 years is around 2.5%. Excessive growth can lead to:
1. 2. 3. 4. 5. 6. 7. Goods and service inflation House price inflation Wage inflation Labour shortages Falling savings Excessive credit Trade difficulties

Low or negative growth can lead to:

1. 2. 3. 4. 5. 6. Goods deflation House price deflation Labour surpluses Unemployment Excessive debt burden Public sector debt

Predicting turning points Changes, or turning points, in the level of national income can be predicted and confirmed using along leading indicator which monitors changes in interest rates, business confidence and new housing startsups. Changes in these indicate that GDP is likely to change in 12 to 18 months time. A short leading indicator can be used to monitor changes in consumer credit and new car registrations. A lagging indicator monitors changes in unemployment and real investment and confirms that the turning point has occurred. All indicators help policy makers decide when to implement a policy and by what degree. UK growth rates
UK growth rates can be expressed in an index or as annual percentages.

The advantages of growth

Economic growth is associated with a number of material benefits which increase economic welfare. These include the following:

Higher GDP per capita A rise in real national income means that wages and profits are likely to rise. Assuming a stable population, this will raise GDP per capita. More public and merit goods A growing economy means that the public sector can receive more tax revenue and more resources can be allocated to public and merit goods, such as more roads, hospitals and schools. Positive externalities Public and merit goods generate considerable external benefits. More hospitals and schools mean a healthier and better-educated population, which generates other economic benefits in terms of the effectiveness of the labour force, and increases in long-term aggregate supply. More employment Growth is clearly likely to stimulate demand for labour, and it is likely that more people will be employed and fewer unemployed.

The disadvantages of growth

Economic growth also brings some costs which reduce economic welfare, including:

Negative externalities
As production and consumption increase, negative externalities, such as pollution and congestion, are likely to arise. There is also the likelihood of increased depletion of non-renewable resources, such as fossil fuels.

Inflation and balance of payments difficulties

Too rapid a rate of growth can also lead to two significant economic problems: inflationary pressure and a balance of payments deficit, as imports rise to satisfy an increasingly active household sector.

Widening income gap Growth can also widen the distribution of income, because some groups may benefit much more than others. Certainly in the UK, the relative income gap has widened during the growth years of 1992 to 2008. Limitations of using GDP per capita over time

There are several limitations of using GDP statistics for comparing changes in economic well-being over time, including:

Changes in the distribution of income Average GDP per capita may rise over time, but the distribution of income may widen. For example, a rise in the mean average income per head can be misleading because the average may rise because just a few of the population increase their personal income. Indeed, the meanaverage can rise, but the median, the mid-point in a range of numbers, can fall. Differences in hours worked
People may be working longer hours, in which case some of the growth may be through increased work, rather than through increased efficiency.

Unpaid work is not recorded

People may undertake unpaid work, and this may not be officially recorded.

Price changes Prices are unlikely to remain constant over time, so GDP figures must be converted to at constant prices and
measured from a base year. This process is called indexing and is required to avoid the distorting effects of inflation.

Negative externalities
The quality of life may suffer as GDP increases, although this is not included in GDP statistics. For example, more driving raises GDP, but also adds to CO 2 emissions, which can reduce the quality of life.

Changes in the quality of products Over time the quality of products tends to increase, so a given amount of income per capita in 2010 may purchase a higher quality product than it did in 2000. This is certainly true with high-technology consumer products, like PCs, laptops and mobile phones.

Limitations of using GDP statistics for international comparisons

Limitations of using GDP statistics for international comparisons include:

Differences in the distribution of income Although two countries may have similar GDP per capita figures, the distribution of income in each country may be very different. Differences in hours worked As when comparing a country over time, the number of hours worked to generate a given level of income may be quite different. For example, workers in the UK tend to work longer hours than those in France, and this would falsely inflate the GDP figures in the UK relative to France. International price differences International prices will also vary. This is significant because an individual's purchasing power is based on price in relation to income. To solve this problem, GDP statistics can be re-calculated in terms of purchasing power. The purchasing power of a currency refers to the quantity of the currency needed to purchase a given unit of a good, or common basket of goods and services. Purchasing power is clearly determined by the relative cost of living and inflation rates in different countries. Achieving purchasing power parity means equalising the purchasing power of two currencies by taking into account cost of living and inflation differences. For example, if we simply convert GDP in Japan to US dollars using market exchange rates, relative purchasing power is not taken into account, and the validity of the comparison is weakened. By adjusting rates to take into account local purchasing power differences, known as PPP adjusted exchange rates, international comparisons are more valid. Difficulty of assessing true values

The true value of public goods and merit goods, such as defence, education and transport infrastructure is largely unknown. This means that it is difficult to compare two countries with very different levels of spending on these goods and assets.

The unofficial economy

Similarly, the existence of a large unofficial economy may make comparisons based on official GDP very misleading. For example, comparing the official GDP of the UK and Russia may be misleading because of the size of Russia's unofficial economy. While all countries have unofficial economies, their size and significance can vary considerably.

Currency conversion
GDP figures for different countries must be converted to a common currency, such as the US dollar, and this may give misleading figures. For some countries, exchange rates against the US dollar may be unrepresentative of the true value of the currency, especially where international trade is relatively small. In such cases, converting to US dollars may significantly under-value national output. This explains why

conversion to purchasing power parity is often preferred to conversion to US dollars. Sustainable development and quality of life
In recognising that economic welfare is not simply about economic growth, in 1999 the UK government introduced a policy for sustainable development, and refined this further in 2005. Sustainable development is considered in four main categories using 20 main indicators, and 68 indicators in total. The categories are: 1. 2. 3. 4. Sustainable consumption and production Climate change and energy Natural resource protection and enhancing the environment Creating sustainable communities and a fairer world

Source: UK Department for the Environment, Food and Rural Affairs (Defra), 2009

See: Measures of Economic Welfare

Long term development

Economic development is a broader concept than economic growth and reflects social and economic progress and requires economic growth. Growth is an important and necessary condition for development, but it is not a sufficient condition. Growth alone cannot guarantee development.
One of the most compelling definitions of development is that given by Amartya Sen. According to Sen, development is about creating freedom for people and removing obstacles to greater freedom. Greater freedom enables people to choose their own destiny. Obstacles to freedom, and hence to development, include poverty, lack of economic opportunities, corruption, poor governance, lack of education and lack of health. (Source: Development as Freedom, AmartyaSen: 2001, Oxford University Press)

Indicators of development
The extent to which a country has developed may be assessed by considering a range of narrow and broad
indicators, including per capita income, life expectancy, education, and the extent of poverty.

The Human Development Index (HDI)

The HDI was introduced in 1990 as part of the United Nations Development Programme (UNDP)to provide a means of measuring economic development in three broad areas - per capita income, health and education. The HDI is used to track changes in the global position of specific countries over time.

Each year the UNDP produces a development report providing an update of changes during the year, along with a report on a special theme, such as global warming and development, and migration and development. The introduction of the index was an explicit acceptance that development is a considerablybroader concept than growth and should include a range of social and economic factors.

The HDI has two main features: A scale from 0 (no development) to 1 (complete development). A composite index based on three equally weighted components: 1. Longevity, measured by life expectancy at birth 2. Knowledge, measured by adult literacy and number of years children are enrolled at school 3. Standard of living , measured by real GDP per capita at purchasing power parity What the figures mean: y An index of 0 0.6 means low development - for example, in 2006 Ethiopia had an index number of 0.38 while in Bangladesh it was 0.51 y An index of 0.61 0.85 means medium development for example, in 2006 Croatia had an index of 0.85, while Brazil and the Ukraine had 0.80 and 0.79 respectively. y An index of greater than 0.90 means high development - for example, the HDI for France and the UK in 2006 were 0.95 and 0.94. respectively. The HDI is a very useful means of comparing the level of development of countries. GDP percapita alone is clearly too narrow an indicator of economic growth, and fails to indicate other aspects of
development, such as enrolment in school and longevity. Hence, the HDI is seen as a broader and more encompassing indicator of development than GDP, though GDP still provides one third of the index. HDI figures Low ranked countries

HDI middle ranked countries

HDI high ranked countries

Life expectancy
A variety of factors may contribute to differences in life expectancy, such as the stability of food supplies, war and the incidence of disease and natural disasters. According to World Bank figures, between 1980 and 1998 average life expectancy rose from 61 to 67 years, with the largest increases occurring in low and middle income countries. However, the changes are
not evenly distributed, and in many countries in sub-Saharan Africa, life expectancy is falling due to the AIDS epidemic. (Source: www.worldbank.org/depweb/)

Adult literacy
Adult literacy is usually defined as t he percentage of those aged 15 and above who are able to read and

write a simple statement on their everyday life. More extensive definitions of literacy include those based on the International Adult Literacy Survey. This survey tests the ability to understand text, interpret documents, and perform simplearithmetic.

GDP per capita

GDP per capita is the commonest indicator of material standards of living, and hence is included in the index of development. It is found by measuring Gross Domestic Product i n a year, and dividing it by the population. The Organisation for Economic Co-operation and Development (OECD)
The OECD also uses income as its basis by classifying developing countries in terms of:

LICs (Low income countries), such as: y Egypt y India y Pakistan MICs (Middle income countries), such as: y Barbados y Syria y Uruguay NICs (Newly industrialising countries), such as: y Argentina y Brazil y Mexico

Evaluation of the HDI

Despite the widespread use of the HDI, there are a number of criticisms that are often made. These include: 1. The HDI index is for a single country, and as such does not distinguish between different rates of development within a country, such as between urban and traditional rural communities. 2. Critics argue that the equal weighting between the three main components is rather arbitrary. 3. Development is ultimately about freedom, and there is nothing in the index which directly measures this. For example, access to the internet might be regarded by many as a freedom which improves the quality of individual's lives. 4. As with GDP per capita, the more narrow measure of living standards, there is no indication of the distribution of income. 5. In addition, the HDI excludes many aspects of economic and social life that co uld be regarded as contributing to or constraining development, such as crime, corruption, poverty, deprivation and negative externalities. 6. GDP is calculated in terms of purchasing power parity, and this value can frequently change.

See also: The Human Poverty Index - HPI See also: evaluation of GDP statistics

Stable prices

Price stability exists when average prices are constant over time, or when they are rising at a very low and predictable rate. Price inflation occurs when average prices are rising above this low and predictable rate, and price deflation occurs when average prices are falling. In both cases, the effects are potentially extremely harmful to a country s economic performance and to the welfare of its citizens. For this reason, price stability is commonly regarded as the single most importantmacro-economic objective.
For the UK, price stability means ensuring that the price level increases gradually, by an average of no more than 2% per year. The official target is 2%, though there is a safety margin of +/ - 1%. The Bank of England is forced to intervene if inflation falls outside of these limits.

The costs of inflation

Price inflation is regarded as a serious economic problem because it causes a number of significant costs to an economy, including the following:

It erodes the value of money and assets

A rise in the price level means, ceteris paribus, that money can buy fewer goods. If assets are stored in a monetary form, inflation means that asset values fall. This explains why, during inflationary periods, individuals often choose to put their wealth into physical assets, like property, rather than kee p it in a monetary form in a bank account.

It redistributes income from lenders to borrowers

Borrowers do better at times of rising prices because the real value of their repayments are reduced over time. Lenders need to charge a higher interest rate to compensate for the falling value of the repayments to them, and for the loss of liquidity suffered as the value of repayments fall.

It is bad for the balance of payments.

The balance of payments may deteriorate because domestic inflation stimulates import spending, given that imports appear relatively cheaper, and dampens export sales, as exports appear more expensive abroad.

It causes uncertainty and falling investment.

Firms respond unfavourably to inflation for several reasons. Firstly, infl ation dampens consumer confidence and spending, and reduces aggregate demand. Secondly, inflation increases costs and reduces competitiveness, which can lead to falling demand. Finally, firms may anticipate that interest rates will have to rise to deal with inflation, and this undermines business confidence. Falling confidence is likely to force firms to postpone capital investment.

It creates shoe leather and menu costs.

Shoe leather costs can be incurred during times of inflation when households and firms make an additional effort to seek out the best deals. These costs are also called search costs, reflecting the increased time spent

attempting to find the lowest available prices. The Internet, and the growth of price comparison sites, has considerably reduced the problem of search costs, making information freely and quickly available. Menu costs are associated with having to regularly re-price products to bring them in line with general inflation.

It can create unemployment

Inflation can lead to a loss of jobs through its effect on costs. As costs rise firms may substitute labour with other factors, such as new technology.

Inflation distorts the price mechanism

When average prices rise, the price mechanism cannot effectively fulfil its role as a resource allocating mechanism. Markets work best when prices go up and down, but if average prices rise continuously, resource allocation is distorted. The effect is significant when the rate of inflation is excessive.

It creates money illusion

Money illusion, also called inflation illusion, is a phenomenon that may arise when rising prices lead people to make irrational decisions. For example, if wages rise, workers may decide to work longer hours, but if inflation erodes the value of the wage rise they have been fooled into working longer.

Deflation
Price deflation, which means falling average prices, can also cause severe economic problems, including the following.

Consumers may delay consumption

Consumers may wait for prices to fall even further, and this can have a negative impact on AD, output and incomes.

Real interest rates are pushed up

Given that nominal interest rates cannot fall below zero, falling prices cause real rates to rise. For example, if nominal interest rates are currently 5% and inflation is 1%, real interest rates are 4% (which is 5% 1% = 4%). However, if the price level falls by 2%, real interest rates (5% [-2%]) rise to 7%. Of course, nominal rates can be reduced, but deflation tends to put upward pressure on real rates.

Rising debt burdens

Deflation will cause debt burdens to rise for households that have borrowed in the past. Many consumer and corporate debts are fixed, including fixed mortgages and personal loans, and repayments do not fall as prices fall, making the real price of the debt rise. For firms, falling prices also create a debt burden be cause, although revenues fall, debt repayments may remain at the old level, increasing the real debt burden.

Recession
Deflation can significantly reduce economic confidence, and households and firms may be encouraged to save rather than spend, despite falling interest rates. As non-essential spending falls, economic activity will fall, creating a deepening recession that even near zero interest rates may not budge. Long-term recession, following a period of deflation is often referred to as the Japanese disease, given that, for a long period during the 1990s, Japan seemed trapped in a deflationary spiral.

Measuring price changes

Measuring changes in average price levels requires the use of a device called an index. It is impossible to keep an accurate record of every price change for every good and service in the economy at all times. Using an index allows a general picture to develop to show the average price change for a sample of goods and services, measured at monthly intervals. The UK uses a number of indices to track price changes, including the Consumer Price Index (CPI), which was introduced in 2003, and the much older Retail Price Index (RPI). The CPI is based on the European Harmonised

Index of Consumer Prices (HICP), and its introduction in the UK allows for better inflation comparisons between the UK and Europe, as well as being a more accurate index.

Indices
All indices, like the CPI and RPI, have certain key features in common, including: The weighted index is arrived at by multiplying the individual price index by the weights.
% PRICE WEIGHTED GOODS INCOME INDEX WEIGHTS CHANGE INDEX SPENT A B C D 40 30 20 10 + 10 + 15 0 -8 110 115 100 92 4 3 2 1 440 345 200 92 1007/10 =107.7

Weighted Price Index

1.

The use of a sample of typical goods and services bought by average households.

2. The use of a sample of different retail outlets, such as corner shops, supermarkets, and specialist stores taken from across the country. 3. The tracking of changes in prices from a given starting point, a base year.

4. The allocation of different types of good with different weights to reflect their varying importance in the consumer s shopping basket. 5. Changes are expressed in terms of the number 100 . An index of 110 means 10% inflation since the base year, and an index of 92 means 8% deflation since the base year.

The CPI The Consumer Price Index (CPI) is calculated by tracking the price movements of 650 items, which represents a basket of goods and services typically bought by the average UK household. The basket is updated annually to keep it as representative as possible, and prices are checked on a monthly basis by recording prices at outlets across the UK. Goods and services OVERALL SUB CATEGORY WEIGHT % CATEGORIES are put into one of 12 categories, as shown: Food and beverages 11.8 22
Alcohol and tobacco Clothing and footwear Housing and household services Furniture and household goods Health Transport Communication Recreation and culture Education Restaurants and hotels Miscellaneous Source: ONS 4.4 5.7 12.6 6.6 2.2 15.1 2.3 14.5 2.1 12.8 9.9 4 11 5 11 3 6 1 17 1 8 11

RPIx and RPIy

Until 2003, the RPI was the main indicator of price changes and provided what was called the headline rate of inflation. The RPI was then adjusted to include or exclude particular items, including the RPIx and RPIy adjustments. The RPI is a broader measure of inflation than the CPI because it includes costs associated with housing, which the RPI does not. RPIx is the headline RPI index, minus changes in mortgage interest payments. Taking out mortgage repayments is considered a useful adjustment because the UK housing market plays a significant role in the wider macro economy. Given that over 60% of householders are owner occupiers, many of whom are repaying mortgages, changes in interest rates, and mortgage rates, can have a considerable impact on spending and the rest of the economy. Interest rates, which affect mortgage rates, are part of anti-inflationary policy, so it is argued there is a good reason to exclude mortgage costs. A rise in interest rates, designed to reduce inflationary pressure, would push up the RPI, but not the RPIx, so the effects of the policy can be better monitored by looking at RPIx. Hence, monitoring changes in the RPIx allows policy makers to see the underlying trend in inflation. RPIy is the RPIx minus changes in indirect taxes, such as VAT. Changes in VAT distort inflation data, and make the index less accurate in terms of measuring underlying inflationary pressure, hence it may be useful, at times of increasing VAT rates, to exclude the effects of these changes on retail prices. The RPIx and RPIy are measures of inflation still recorded and used in the UK, despite the introduction of the CPI in 2003. A large number of wage negotiations are based on the RPI, rather than CPI, which is one reason why the RPI is likely to be used in the future.

Comparing the CPI and RPI

Comparing the Retail Price Index (RPI) and the Consumer Price Index (CPI) raises the following issues:

Mathematical technique of calculation

The RPI uses an arithmetic average of price changes whereas the CPI uses a geometric average, which makes the CPI mathematically more precise. This is because it can continually capture the effects of changes in consumer spending patterns in response to inflation or deflation.

Adjustment
A potential problem with price indices is that they may not adjust quickly enough to reflect changes in spending. Indices are based on a sample of goods and services which are weighted according to how important the good is to the consumer. The importance of a good is based on how much of household income is spent on a product. For example, a typical household may spend 10% of their income on holidays, and therefore holidays will be given 10% of the weighting. But what happens if the cost of a holiday rises by 20%, as a result of a fall in Sterling? Consumers are likely to respond, and reduce their holiday spending. If they now spend only 5% of their income on holidays, the weighting used in the CPI index can be quickly adjusted to 5%. However, the older RPI could not be adjusted so quickly, and could not resolve the problem of changing spending patterns. Because of this, and because the CPI does not include housing costs, or council taxes, the RPI gives a slightly higher rate than does the CPI. The CPI gives a higher weighting to energy costs, so change in oil prices have a bigger impact on the CPI inflation rate. This means that the Bank of England, using the CPI, can set a target of 2% inflation, and not 2.5%. Despite this, the UK authorities still track the RPIx and RPIy.

Evaluation of all indices

In general terms all indices can be criticised for a number of reasons, including:

Are the samples representative?

If we look at specific types of household, we can get quite different measures of inflation to the general index. For example, if in a given year, the prices of textbooks and rented accommodation for students rise above the

average inflation rate, a household made up of students may face a relatively high inflation rate compared with a more typical household. In addition, there is likely to b e a regional variation from the average. Therefore, it is quite possible that a married doctor in Manchester experiences a personal inflation rate of 2% whereas a single bus driver living in London, experiences a personal inflation rate of 7%.

Do goods stay the same over time?

A motor vehicle may have inflated in price by 20% over a five-year period, but is this actually price inflation? The vehicle may be faster, more efficient on petrol, more comfortable, and safer - so much of the price increase is due to improvements in the vehicle and not to inflation. When products are fairly standardised, like a litre of milk, or a loaf of bread, quality changes will be small, and the price index will give a more accurate reading of genuine price inflation. With non -standardised products, indices are far less useful.

How up-to-date is the basket?

Indices are usually out of date because the basket used does do not always change quickly enough to reflect current fashions and spending trends. Improvements have been made in terms of adding new goods to the basket, but it still takes up to three years to include new products. Given that new technology products are initially sold at premium prices, the implication is that the current basket always understates true inflation because of the time lag in introducing new technology products.

Why not measure capital goods prices?

Only consumer goods tend to be considered in price indices because the focus of inflation measurement is on households, and not on firms. There is an argument that capital goods prices should be included in a general inflation index.

The 'two-speed' economy

On index may not be good enough if two different sectors of the economy are inflating at different rates. In the UK goods sector, inflation has fallen steadily over the last 15 years, with many goods actually deflating in price. In contrast, service sector inflation has continued at around 4% to 6% per year. An index will average out these two sectors, and it is this average rate that forms the basis of policymaking decisions. This certainly creates a dilemma for policy makers; should they be more conscious of service sector inflation or of goods sector deflation?

Targeting inflation
It is generally recognised that a small amount of inflation is acceptabl e, with the objective of monetary policy being low and predictable inflation rates. Certainly, given a choice between mild inflation and mild deflation, mild inflation would be the chosen option. Between 1997, when the Bank of England was made independent, and 2004 the (RPI) target rate for inflation was 2.5%, which was an acknowledgement that a little inflation was acceptable.

The CPI target

Since 2003, with the adoption of the CPI, the target has been 2%. The Bank of England must act by increasing or reducing interest rates to achieve this target. CPI and RPI 2008 - 2011

It can clearly be seen that the CPI and RPI give a broadly similar picture of retail inflation. Both the CPI and RPI fell during 2008 and early 2009 as a result of the globaldownturn. However, following poor crop harvests, rising food prices contributed to a surge in inflation during 2010. The RPI typically gives a higher value for inflation an it is more volatile. This is largely down to the different d significance of housing and housing costs in the two indices. The RPI is a broader measure than the CPI, and, unlike the CPI, includes a number of housing costs, such as council tax, mortgage repyments, and buildings a insurance. A higher and more volatile RPI can be explained because many housing costs, such as council tax and buildings insurance, have risen consistently over the last 15 years. In addition, the volatility of interest rates has had a significant impact on those households with variable rate mortgages. Go to: Causes of inflation and deflation

Causes of inflation and deflation

Inflation and deflation arise from changes in either the demand side or supply side of the macroeconomy. Demand pull inflation Demand pu inflation usually occurs when there is an increase in aggregate monetary demand caused by an increase in one or more of the co mponents of aggregate demand (AD), but where aggregate supply (AS) is slow to adjust.
Demand pull A rise in aggregate demand can pull up prices when there is little slack in the economy.

The commonest causes are demand shocks, such as: 1. 2. 3. 4. 5. Earnings rising above factor productivity. Cheaper credit, following a reduction in interest rates. Excessive public sector borrowing. A housing boom creating equity withdrawal and a positive wealth effect. Changes in the savings ratio.

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The savings ratio

The savings ratio indicates the percentage of disposable income which is saved, rather than spent. Sudden changes in the savings ratio are an indicator of future changes in spending and AD, and can be a prelude to inflation or deflation. A rise in the savings ratio indicates a decline in consumer confidence, whereas a fall in the savings ratio indicates a rise in confidence and spending, which can trigger an increase in the price leve l. Cost-push inflation Cost-push inflation occurs when an economy experiences a negative cost shock. Cost push An increase in costs causes the aggregate supply curve to shift upward and to the left, resulting in a rise in the price level, and a contraction of aggregate demand.

The commonest causes are:

1. 2. 3. 4. Oil price shocks, caused by wars or decisions by OPEC to restrict output. Increases in farm prices or general food prices, following a series of poor harvests. Rapidly rising wage costs. A fall in the exchange rate, which increases the price of all imports.

5. Imported cost push inflation A fall in the exchange rate A reduction in the exchange rate will mean that more Sterling is required to purchase a given quantity of imports in other words, the price of imports will rise. After a time-lag, this will feed its way into retail prices. For example, a motor vehicle imported from Germany

for 50,000 would cost 25,000 at an exchange rate of 1 - 2. If Sterling falls in value, to 1 = 1.90, then the Sterling price would rise to 26,316. Given that approximately 35% of the CPI basket of consumer goods and services are imports, the effect of a fall in the exchange rate is to raise the CPI. In addition, imported raw materials are also more expensive so costs of production will rise for those firms that source their inputs from abroad. Therefore, while a low exchange rate may be beneficial for exports, it has as a potentially inflationary effect on costs and prices.

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Causes of deflation
Deflation tends to occur when the economy s capacity, as indicated by the position of the AS curve, grows at a faster rate than AD. Firms have to cut prices in order to stimulate sales and get rid of stocks. Deflation Deflation can be triggered by an increase in supply. As business

and consumer confidence in the economy declines, AD falls, resulting in recession.

Unemployment
There are a number of types of unemployment, defined in terms of cause and severity. These include the following: Cyclical Cyclical unemployment exists when individuals lose their jobs as a result of a downturn in aggregate demand (AD). If the decline in aggregate demand is persistent, and the unemployment long-term, it is called either demand deficient, general, or Keynesian unemployment. For example, unemployment levels of 3
million were reached in the UK in the last two recessions (1980 -82 and 1990-92) and in the most recent (200809) recession, unemployment levels rose toover 2.4m. Demand deficienct unemployment This is caused by a lack of aggregate demand, with insufficient demand to generate

full employment.

Structural
Structural unemployment occurs when certain industries decline because of long term changes in market conditions. For example, over the last 20 years UK motor vehicle production has declined while car

production in the Far East has increased, creating structurally unemployed car workers.Globalisation is an
increasingly significant cause of structural unemployment in many countries.

Regional
When structural unemployment affects local areas of an economy, it is called regional unemployment. For

example, unemployed coal miners in South Wales and ship workers in the North East add to regional unemployment in these areas. Classical Classical unemployment is caused when wages are too high. This explanation of unemployment dominated
economic theory before the 1930s, when workers themselves were blamed for not accepting lower wages, or for asking for too high wages. Classical unemployment is also called real wage unemployment.

Seasonal
Seasonal unemployment exists because certain industries only produce or distribute their products at certain times of the year. Industries where seasonal unemployment is common include farming, tourism, and construction.

Frictional
Frictional unemployment, also called search unemployment, occurs when workers lose their current job and are in the process of finding another one. There may be little that can be done to reduce this type of unemployment, other than by providing better information to reduce the search time. This suggests that full employment is impossible at any one time because some workers will always be in the process of changing jobs.

Voluntary Voluntary unemployment is defined as a situation when workers choose not to work at the current equilibrium wage rate. For one reason or another, workers may elect not to participate in the labour market. Reasons suggested for the existence of voluntary unemployment include: excessively generous
welfare benefits, high rates of income tax and that the equilibrium wage rate is below the w age necessary to encourage individuals to supply their labour.

The natural' rate of unemployment

This is a term associated with new Classical and monetarist economists. It is defined as the rate of unemployment that still exists when the labour market it in equilibrium, and includes seasonal, frictional and voluntary unemployment. The US economist Milton Friedman first used the concept to help explain the connection between unemployment and inflation. Friedman argued that if unemployment fell below the natural rate there would be an increase in the rate of inflation. See also: the Phillips Curve. Over the last 30 years, employment in the service sector has increased to over 70% of total employment, while employment in manufacturing has decreased to under 20%. Since the 1940s employment in the primary sector, including agriculture, has been less that 3% of the workforce.

Recent changes have created two speed economy, with a booming service sector and a declining manufacturing one. The main reasons are: 1. 2. Globalisation and the rise of new low cost overseas competitor countries. Increased competition with the domestic product market.

3. The increasing comparative advantage of the UK as an international supplier of financial services. Structural unemployment and labour mobility Labour immobility is likely to increase structural unemployment. This is because those industries that are growing and need labour, often called sunrise industries, are not necessarily able to employ the sa me workers who have been displaced in the declining, sunset , industries.

There are three types of labour immobility:

Geographical immobility
Geographical immobility occurs when workers are not willing or able to move from region to region, or town to town. It is made worse by immense house price variation between regions. It may be extremely difficult for someone in Yorkshire to sell their property and buy an equivalent one in London. Other factors also contribute to geographical immobility, such as strong social and family ties, and parents being unwilling to disrupt their children s education by changing schools. The stresses ofmoving home can also be a deterrent to mobility for some.

Industrial immobility
Industrial immobility occurs when workers donot move between industries, such as moving from employment in motor industry to employment in the insurance industry. Industrial immobil has affected the ity UK, and many other industrial countries, as the growth of service industries, and the decline of manufacturing industries, has increased the need for mobility.

Occupational immobility
Occupational immobility occurs when workers find itdifficult to change jobs within a particular industry. For example, it may be very difficult for a doctor to retrain to be a dentist.

Industrial and occupation immobility are most likely to happen when skills are not transferable between industry and job. Information failure also contributes to labour immobility in general because workers may be immobile because they do not know where all the suitable jobs for them are. A resulting problem with labour market immobility is that it can create regional unempl oyment, which is a type of structural unemployment. This means that a change in the structure of industry leaves some people unable to respond by changing job, industry, or location and as a result, they remain temporarily or permanently unemployed. Immobility can also lead to rising labour costs, as firms have to increase wages to encourage workers to re locate.

Labour market or government failure?

New Classical economists would tend to see structural unemployment as an example ofgovernment failure. Labour markets do not clear, they argue, because wages are not allowed to adjust effectively, and the price mechanism is distorted. By removing distortions and imperfections in the labour market workers would move more quickly from job to job. For example, by keeping welfare benefits to a minimum there is an incentive to retrain and look for paid work. Welfare benefits can trap individuals into a life of unemployment because of the effects of moral hazard and the disincentive effect it creates. This increases labour immobility, and hence contributes to structural unemployment. However, labour immobility can also be addressed from the perspective of labour market failure. Training and re-training are regarded as merit goods, where individuals under perceive the long term benefit to themselves. They also fail to appreciate the positive externalities that training and re-training generate for the wider community. This means that there is a significant role for the state in providing free or subsidised training and retraining programmes. In addition, there is the potential situation of labour market poaching . Why should a firm in the booming service sector provide free training to a displaced worker from the manufacturing sector if the worker will leave for another job after training? There is a type of Prisoner s Dilemma facing firms. Why should firms do any training at all if they believe that workers will be poached by higher wages? The poac her can afford to pay higher wages because of savings in training costs.

Unemployment - measurement and costs

The unemployed are those individuals of working age who are capable of work, and are actively looking for work, but who are not employed. If labour is employed, but not effectively used, the situation is called underemployment.

Measuring unemployment
Measuring unemployment accurately is made difficult because of imperfect knowledge. Not all instances of unemployment are recorded, and some records of unemployment may not be accurate. Because the unemployed are eligible for benefits, some individuals may work, but not disclose it, and cl aim benefit. Conversely, many unemployed may not bother to inform the authorities, and this unemployment goes unrecorded.

The Claimant Count

The Claimant Count records those claiming unemployment benefit (Job Seekers Allowance, or JSA) and can prove they are actively looking for work. It excludes housewives and those on training schemes.

How useful is the Claimant Count?

The Claimant Count may not reflect the true level of unemployment in the UK economy, given that not all the unemployed will bother to claim, and some are deterred because they cannot prove they are looking for work. This is especially true of part-time employees who are much less likely to register as unemployed compared

with full-time workers. While some individuals may fraudulently claim,it is generally recognised that the Claimant Count under-estimates actual unemployment levels. UK Claimant Count

The International LabourOrganisation (ILO)

The labour force survey is undertaken by the International Labour Organisation (ILO) and is amore direct assessment of unemployment, rather than those who claim benefit. It is based on an interview of a sample of 60,000 households (approximately 120,000 people) and tries to measure unemployment as a whole, rather than those simply claiming bene fits. To be considered as being unemployed individuals must: 1. Have been out of work for 4 weeks. 2. Be able to start work in the next 2 weeks, so they must be readily available for work. 3. Workers only need to be available for work for one hour per week, so part-time unemployment is included in the measurement, though these workers are unlikely to claim unemployment benefit. This tends to make ILO unemployment much higher than the Claimant Count. UK unemployment The ILO survey gives a higher figure than the Clai ant Count. Sustained growth between 1994 and 2008 m pushed UK unemployment to a record low. Largely as a consequence of the financial crisis in 2008, the UK, along with many other advanced economies, went into a deep recession, with unemployment peaking at just under 2.5 million (7.9 ) in the first quarter of 2010.
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How useful is the ILO survey?

Since 2003, the Labour Force Survey has become the UK government s official measure of unemployment. However, critics argue that it over-estimates true unemployment by including people only looking for a few hours of part-time work per week. In addition, like all samples, it can be subject to sampling error, which reduces its accuracy.

The costs of unemployment

Opportunity cost

Unemployment represents an opportunity cost because there is a loss of output that workers could have produced had they been employed. The government also spends more on unemployment benefit; hence there is another opportunity cost. The money going on unemployment benefit could be spent on hospitals and schools.

Waste of resources

Resources not employed are left idle, and this is a waste to an economy education and training costs are wasted when individuals who have received these benefits do not work.

The Chancellor loses revenue.

The unemployed do not pay income tax, and pay less indirect tax as they spend less.

Erosion of human capital.

Many skills are acquired at work, and being unemployed means can me n fewer new skills are acquired, and a existing skills are lost.

Lower incomes.
The unemployed have lower personal incomes and lower standards of living. In addition, the unemployed also experience relatively poor physical and mental health.

Externalities.
There are further external costs associated with unemployment, such as increased crime, alcoholism and vandalism. See: Causes of unemployment

Unemployment types and causes

There are several types of unemployment, each one defined in terms of cause and severity. Cyclical Cyclical unemployment exists when individuals lose their jobs as a result of a downturn in aggregate demand (AD). If the decline in aggregate demand is persistent, and the unemployment long-term, it is called either demand deficient, general, or Keynesian unemployment. For example, unemployment levels of 3
million were reached in the UK in the last two recessions, between 1980 and 1982, and between 1990 and 1992. In the most recent recession of 2008-2010,unemployment levels rose to 2.4m in the last quarter of 2009, and are likely to peak at over 2.5m during 2010. (Source: ONS). Demand deficienct unemployment This is caused by a lack of aggregate demand, with insufficient demand to generate full employment.

Structural
Structural unemployment occurs when certain industries decline because of long term changes in market conditions. For example, over the last 20 years UK motor vehicle production has declined while car

production in the Far East has increased, creating structurally unemployed car workers.Globalisation is an
increasingly significant cause of structural unemployment in many countries.

Regional
When structural unemployment affects local areas of an economy, it is called regional unemployment. For

example, unemployed coal miners in South Wales and ship workers in the North East add to regional unemployment in these areas. Classical Classical unemployment is caused when wages are too high. This explanation of unemployment dominated
economic theory before the 1930s, when workers themselves were blamed for not accepting lower wages, or for asking for too high wages. Classical unemployment is also called real wage unemployment.

Seasonal
Seasonal unemployment exists because certain industries only produce or distribute their products at certain times of the year. Industries where seasonal unemployment is common include farming, tourism, and construction.

Frictional
Frictional unemployment, also called search unemployment, occurs when workers lose their current job and are in the process of finding another one. There may be little that can be done to reduce this type of unemployment, other than provide better information to reduce the search time. This suggests that full employment is impossible at any one time because some workers will always be in the process of changing jobs.

Voluntary

Voluntary unemployment is defined as a situation when workers choose not to work at the current equilibrium wage rate. For one reason or another, workers may elect not to participate in the labour market. There are several reasons for the existence of voluntary unemployment including excessively generous welfare benefits and high rates of income tax. Voluntary unemployment is likely to occur when the equilibrium wage rate is below the wage necess to encourage individuals to supply their labour. ary The natural rate of unemployment
This is a term associated with new Classical and monetarist economists. It is defined as the rate of unemployment that still exists when the labour market it in equilibrium, and includes seasonal, frictional and voluntary unemployment. The US economist Milton Friedman first used the concept to help explain the connection between unemployment and inflation Friedman argued that if unemployment fell below . the natural rate there would be an increase in the rate of inflation. See also: the Phillips Curve. Over the last 30 years, employment in the service sector has increased to over 70 of total employment, while employment in manufacturing has decreased to under 20 . Since the 1940s employment in the primary sector, including agriculture, has been less tha 3 of the workforce. t

Recent changes have created two speed economy, with a relatively bouyant service sector and a declining manufacturing one. The main reasons are: 1. 2. Globalisation and the rise of new low cost overseas competitor countries. Increased competition within the domestic product market.

3. The increasing comparative advantage of the UK as an international supplier of financial services. Structural unemployment and labour mobility Labour immobility is likely to increase structural unemployment. This is because those industries that are growing and need labour, often calledsunrise industries, are not necessarily able to employ the same workers who have been displaced in the declinin sunset industries. g,

There are three types of labour immobility:

Geographical immobility
Geographical immobility occurs when workers are not willing or able to move from region to region, or town to town. Geographical mobility is made worse by immensehouse price variation between regions. It may be extremely difficult for workers in Yorkshire to sell their home and buy an equivalent one in London.

Other factors also contribute to geographical immobility, such as strong social and family ties, and parents being unwilling to disrupt their children s education by changing schools. The stresses ofmoving home can also be a deterrent to mobility for some.

Industrial immobility
Industrial immobility occurs when workers do not move between industries, such as moving from employment in motor industry to employment in the insurance industry. Industrial immobility has affected the UK, and many other industrial countries, as the growth of service industries, and the decline of manufacturing industries, has increased the need for mobility.

Occupational immobility
Occupational immobility occurs when workers find it difficult to change jobs within an industry. For example, it may be very difficult for a doctor to retrain to be a dentist. Industrial and occupation immobility are most likely to happen when skills are not transferable between industry and job. Information failure also contributes to labour immobility because workers may be immobile because they do not know where all the suitable jobs for them are. A resulting problem with labour market immobility is that it can create regional unemployment, which is a type of structural unemployment. This means that a change in the structure of industry leaves some people unable to respond by changing job, industry, or location and as a result, they remain temporarily or permanently unemployed. Immobility can also lead to rising labour costs, as firms have to increase wages to encourage workers to relocate.

Labour market or government failure?

New Classical economists would tend to see structural unemployment as an example ofgovernment failure. Labour markets do not clear, they argue, because wages are not allowed to adjust effectively, and the price mechanism is distorted. By removing distortions and imperfections in the labour market workers would move more quickly from job to job. For example, by keeping welfare benefits to a minimum there is an incentive to retrain and l ook for paid work. Welfare benefits can trap individuals into a life of unemployment because of the effects of moral hazard and the disincentive effect it creates. This increases labour immobility, and hence contributes to structural unemployment. However, labour immobility can also be addressed from the perspective of labour market failure. Training and re-training are regarded as merit goods, where individuals under perceive the long term benefit to themselves. They also fail to appreciate the positive externalities that training and re-training generate for the wider community. This means that there is a significant role for the state in providing free or subsidised training and retraining programmes. In addition, there is the potential situation of labour market poaching. Why should a firm in the booming service sector provide free training to a displaced worker from the manufacturing sector if the worker will leave for another job shortly after training? Why should firms do any training at all if they believ e that workers will be poached by higher wages? The poacher can, of course, afford to pay higher wages because of savings in training costs. See: labour market failures

Inequality and equity

Equity means fairness or evenness, and achieving it is considered to be an economic objective. Despite the general recognition of the desirability of fairness, it is often regarded as too normativea concept given that it is difficult to define and measure. However, for most economists, equity relates to how fairly income and opportunity are distributed between different groups in society.
The opposite of equity is inequality, and this can arise in two main ways:

Inequality of outcome
Inequality of outcome from economic transactions occurs when some individuals gain much more than others from an economic transaction. For example, individuals who sell their labour to a single buyer, a monopsonist, may receive a much lower wage than those who sell their labour to a firm in a very competitive market. Differences in income are an important type of inequality of outcome.

Inequality of opportunity
Inequality of opportunity occurs when individuals are denied access to institutions or employment, which limits their ability to benefit from living in a market economy. For example, children from poor homes may be denied access to high quality education, which limits their ability to achieve high levels of income in the future..

Does inequality serve a purpose?

Market economies rely on the price mechanism to allocate resources. This means that economic resources are allocated prices which reflect demand and supply, which operate via incentives. For example, rising wages act as an incentive to labour to become more employable, and provide a reward for those that do. Inequality, therefore, acts as an incentive to improve and specialise in producing those goods, services, and resources that command the highest reward. However, critics of unregulated market economies raise doubts about the need for such vast differences in income that exist in the UK, and many other economies, and that significantly smaller differences would create a sufficient incentive to reward effort, ability, and wealth creation. For example, an average wage of 5,000 per week for a professional footballer would be more than sufficient to encourage gifted young footballers to want to become a professional player. This compares with wages of over 100,000 per week for the best players.

Measuring inequality of income

The two main methods for measuring inequality are the Lorenz curve and the Gini index.

The Lorenz curve

A Lorenz curve shows the % of income earned by a given % of the population. Lorenz curve A perfect income distribution would be one where each % received the same % of income.

Perfect equality would be, for example, where 60% of the population gain 60% of national income. In the above Lorenz curve, 60% of the population gain only 20% of the income, hence the curve diverges from the line of perfect equality of income. The further the Lorenz curve is from the 45 degree line, the less equal is the distribution of income. Showing greater inequality Changes in the position of the Lorenze curve indicates changes in the distribution of income. In this example, the curve for 2010 is further away from the line of equal distribution than the curve in 1990, implying a wider distribution of income.

The Gini co-efficient and index The Gini co-efficient or index is a mathematical device used to compare income distributions over time and between economies. The Gini co-efficient can be used in conjunction with the Lorenz curve. It is calculated by comparing the area under the Lorenz curve and the area from the 450 line to the right hand and 'x' axis. In terms of the Gini index, t he closer the number is to 100 the greater the degree of inequality.

See also: Gini index

Equity and efficiency

When markets are free from imperfections, such as information failure and externalities, resources will be allocated in such a way that efficiency will be achieved. In attempting to achieve equity, governments may intervene and distort the workings of the market so that while equity is gained, efficiency is lost. For example,

welfare payments help narrow the gap between rich and poor, but they may create moral hazard and produce a disincentive effect, so that welfare recipients remain dependent on welfare payments into the long run. This is known as the equity-efficiency trade-off.

Causes of inequality of income

There are several possible reasons for the widening gap between rich and poor in the UK, including: 1. The increased labour market participation of married females, greatly adding to the incomes of married-couple households. 2. Single parents, who constitute a large share of the lowest quintile, have done proportionately badly as benefits have not kept pace with earnings - benefits are linked to inflation, not to average earnings. 3. 4. The same is true for the increasing numbers of low paid pensioners. The wages of skilled workers have risen in comparison with unskilled.

5. Trade union power has been eroded which, along with the abolition of Wage Councils in 1993, has meant that protection for low paid has decreased. 6. The rise of the unofficial labour market means that there appears to be a growing number of low paid immigrant workers, who work for cash and are paid much less than the national minimum wage. 7. A reduction in the level of progressiveness of the tax and benefits system, which occurred from the early 1980s. Prior to this, top marginal tax rates had a considerable re-distributive effect. 8. A rise of share ownership, and increasingly profitable performance of the stock market, which has increased incomes for shareholders. 9. Given that the general trend is for house prices and shares prices to be greater than the general price level, owners of property and financial assets, such as shares, have generally done much better than non-owners. Rising house and share prices have increased personalwealth which can be translated into spending via equity withdrawal. 10. A rapid increase in executive pay, often referred to as elite compensation. However, it can be argued that high pay levels are necessary to avoid a Lemons Problem. Those subscribing to this view argue that unless executive pay rates are set above the market rate, the recruitment process would be clogged-up with poor quality applicants. 11. An increasingly flexible labour market, with more workers being employed part-time, as opposed to full time, would help increase income inequalities. See: income gap See also: polices to reduce inequality and poverty

Income gaps
An income gap is a gap in income between one group and another. Looked at in terms of the whole economy, the commonest income gap is that between 'rich' and 'poor', with the 'rich' usually being defined at the top 20% of income earners (the top quintile), and the poor the bottom 20% (bottom quintile.) However, it is possible to look at the income gap between many groups, such as males and females, urban and rural dwellers, and between people living in different regions of a country. Absolute income gap
An absolute income gap refers to the difference between different groups in terms of actual income.

In terms of the UK, though income going to all groups is rising, it is clear that the richest 20% have increased their income by a much greater amount than the poorest 20%.

The gap between rich and poor in 1997, expressed as a ratio was roughly 3/1 (21,000 compared with 7,000.) By 2006, this ratio had increased to around 5.5/1. (55,000 compared with 10,000). As can be seen, although the gap narrowed for a short period between 1990 and 1996, it has increased steadily over the period.

Relative income gap

A relative income gap refers to the difference between groups in terms of the share of total income going to different groups.

As can be seen, the relative position of the middle three quintiles remained constant between 1977 and 2006, while the position of the poorest 20% worsened. The only group to have increased their share of total income was the top 20%. See also: Poverty

See also: Equity See also: Inequality

Poverty
The alleviation of poverty is increasingly seen as a fundamental economic objective. Poverty creates many economic costs in terms of the opportunity cost of lost output, the cost of welfare provision, and the private and external costs associated with exclusion from normal economic activity. These costs include the costs of unemployment, crime, and poor health. In addition, the poor have little disposable income, and so cannot spend and generate income for firms and jobs for other individuals. There are two ways to define poverty: Absolute poverty Absolute poverty is poverty that is unrelated to a particular economic or social context. In other words it is a general definition of poverty which is valid at all times and for all economies. Agreeing such a definition is extemely hard to do. One straightforward definition of absolute poverty is being unable to subsist that is, unable to eat, drink, have shelter and clothing. A common monetary measure is ..receiving less than $1 a day . Relative poverty It can be argued that poverty is best understood in a relative way what is poor in New York is not the same as in Mumbai. One approach is to look at deprivation , the poor being defined as those who are deprived from the benefits of a modern economy, such as clean water and education. The Human Poverty Index - HPI
The Human Poverty Index (HPI), which was introduced in 1997, is a composite index which assesses three elements of deprivation in a country - longevity, knowledge and a decent standard of living. There are two indices; the HPI 1, which measures poverty in developing countries, and the HPI-2, which measures poverty in OCED developed economies.

HPI-1 (for developing countries)

The first element is longevity, which is def ined as the probability of not surviving to the age of 40. The second element is knowledge, which is assessed by looking at the adult literacy rate. The third element is to have a decent standard of living. Failure to achieve this is identified by the pe rcentage of the population not using an improved water source and the percentage of children under-weight for their age.

As a region of the world, Sub-Saharan Africa has the highest level of poverty as a proportion of total population, at over 60%. The second poorest region is Latin America, with 35% of its population living in poverty.

HPI-2 (for developed - OECD countries)

The indicators of deprivation are adjusted for advanced economies in the following ways: Longevity, which for developed countries is considered as the probability at birth of not surviving to the age of 60. Knowledge is assessed in terms of the percentage of adults lacking functional literacy skills, and; A decent standard of living is measured by the percentage of the population living below the poverty line, which is defined as those below 50% of median household disposable income, and social exclusion, which is indicated by the long-term unemployment rate.

Go to: Oxfam

Macro-economic policy
Policy makers
Economic policy in a modern economy is designed and implemented by government and its designated agents and institutions. The main economic policy-making departments in the UK are; the Treasury, headed by The Chancellor of the Exchequer; the Department for Work and Pensions (DWP), the Department for Children Schools and Families (DCFS), and theDepartment for Business, Enterprise and Regulatory Reform (BERR). The Treasury, the Chancellor, and the Prime Minister
The Treasury is the UK government s main economic policymaking department. In practice, the Chancellor of the Exchequer is the head of the Treasury, though his or her official title, The Second Lord of The Treasury, indicates that historically and constitutionally the Prime Minister is the official head. The Prime Minister is the First Lord of the Treasury.

The Budget The budget is delivered in two parts, with the first part being the autumn statement (also known as the pre-budget report) which details expected spending and is made in November each year. The second part is the budget statement, which is announced in April and details the tax changes for the coming financial (fiscal) year. The budget statement also contains the government s view on the likely impact of fiscal policy for the coming year in terms of whether the effects are likely to be expansionary, contractionary or neutral. The Bank of England
The UK's central bank is the Bank of England, located in London s famous Threadneedle Street. Since 1997, when it was made independent of government, it has been solely responsible for determining UK monetary policy.

The nine-member Monetary Policy Committee (MPC) of the Bank is headed by the Governor of the Bank of England and is the main decision making committee of the Bank. The Inflation Report

The Bank of England produces a quarterly Inflation Report which has two purposes; to shape the work of the MPC and to provide information to the general public and specific interested parties. The Inflation Report, which has been produced by the Bank of England since 1993, usually covers the following areas:
1. 2. 3. 4. 5. Money and asset prices Demand conditions Supply and output conditions Costs and prices The prospects for inflation in the coming period of time

Demand and supply-side policy

To help achieve policy objectives, policy making authorities have at their disposal a number of policy tools, or instruments. These are:

Demand-side policies
1. 2. 3. 1. 2. 3. 4. Fiscal policy, which involves changes in taxation or government spending. Monetary policy, which involves changes in interest rates or the supply of money. Exchange rate policy, which involves changes in the level of Sterling. Improving competition and efficiency in product markets. Improving competition and productivity in factor markets, especially labour markets. Providing incentives for households to work or save. Providing incentives for firms to produce and invest.

Supply-side policies

Fiscal policy
Fiscal policy is the deliberate alteration of government spending or taxation to help achieve desirable macro-economic objectives by changing the level and composition of aggregate demand (AD). Types of fiscal policy
There are two types of fiscal policy, discretionary and automatic. 1. Discretionary policy refers to policies which are decided, and implemented, by one-off policy changes. 2. Automatic stabilisation, where the economy can be stabilised by processes called fiscal drag and fiscal boost.

Fiscal drag
If direct tax rates are progressive, which means that the % of income, then a rapid increase in national income will be slowed down automatically. Fiscal drag means that, as incomes rise, the impact of rising incomes for the better

off is reduced as they pay proportionately higher taxes, and the impact of rising incomes on the poor and unemployed is reduced as they come off benefits, and start to pay tax. The effet is that the increase in c disposable income is moderated. Since 1997, the number of top-rate taxpayers has increased indicating the extent of fiscal drag.

Fiscal boost
Similarly, a potentially rapid and deep decrease in national income would be prevented by fiscal boost. Fiscal boost means as incomes fall in a recession the impact of falling incomes for the better off is softened as they pay proportionately lower taxes, and retain more posttax income. The impact of falling income is to increaseunemployment, but rather than experience a complete collapse in personal income, the unemployed, and the poor, receive benefits, and spend more than they would have without such benefits. Hence, a downturn in the economy is also moderated .

Government expenditure
Central and local government the public sector - spends money for a variety of reasons, including: 1. To supply goods and services that the private sector would fail to do, such as public goods, including defence, roads and bridges; merit goods, such as hospitals and schools; and welfare payments and benefits, including unemployment and disability benefit. 2. To achieve supply-side improvements in the macro-economy, such as spending on education and training to improve labour productivity. 3. To inject extra spending into the macro-economy, so as to achieve increases in aggregate demand and economic activity.

4.

To reduce the negative effects of externalities, such as setting pollution limits.

5. To subsidise industries that may need, for one reason or another financial support which would not be available from the private sector. 6. To help redistribute income and achieve more equity.

Local government is very important in terms of the administration of spending. For example, spending on the NHS and education are administered locally, though local authorities.

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Spending The main areas of UK government spending in 2009, which totalled 671b, were welfare and pensions (social protection ), health, education, public order and safety, and defence.

Central government borrowing If revenue is insufficient to pay for expenditure, there will be a fiscal deficit. In this situation, government must borrow by selling long term bonds or short term bills. Bonds are long-term securities that pay a fixed rate of return over a long period until maturity, such as 10 years after they are originally issued, and are bought by financial institutions looking for a safe return. Government can also sell Treasury Bills, which are issued into the money markets to help raise short-term cash. Bills have a life of 90 days only, whereupon they are repaid.
In 2009, UK government borrowing totalled 175b, which was the equivalent of 25 of total spending. Local government borrowing Local authorities can also borrow if their combined revenue from the Council Tax and central government support is insufficient to meet local spending. If the borrowing requirements of both central and local governmentare combined, the amount of borrowing is called the public sector net cash requirement (PSNCR). Fiscal deficits vary with the business cycle. During periods of economic growth, tax yields rise, and spending on welfare payments fall, pushing the public finances towards a surplus. During periods of economic slowdown, tax yields fall and welfare payments rise, pushing the economy towards a fiscal deficit.

The Chancellor's Golden Rules

The Chancellor s golden rules for borrowing, which were first established in 1997 by ChancellorGordon Brown, were to balance the books over a trade cycle, and only to borrow to fund capital projects, such as road

building. These rules were relaxed in 2008 by Chancellor Alistair Darling, to enable planned spending brought forward in an attempt to inject spending into the ailing UK economy.

Public sector spending

Using public spending to stimulate economic activity has been a key option for successive governments since Keynes. Keynes argued that public spending should be increased at times of recession to compensate for falling private spending. There are two types of spending: 1. Current spending, which is expenditure on wages and raw materials. Current spending is short term, and has to be renewed each year. 2. Capital spending, which is spending on physical assets like roads, bridges, hospital buildings, and equipment. Capital spending is long term as it does not have to be renewed each year - it is also called spending on social capital .

Evaluation of public spending The advantages

1. Public spending can have a considerable impact on the level of AD, and compensate for failings in other components of AD, such as a fall in household spending on consumer goods and firms spending on capital goods. 2. If the spending is on capital items, then infrastructure can be improved, and this can help improve economic growth. 3. Spending on infrastructure also provides an external benefit to the rest of the economy.

4. Public spending can be targeted to achieve a wide range of economic objectives, such as reducing unemployment, achieving more equity, road building, action against poverty, and re-building city centres.

The disadvantages
1. There may be a considerable time-lag between spending and the benefits of spending. For example, a decision to increase spending on education will take months to implement, and years and decades to see the full benefits. Indeed, the full benefits may never be seen because of information failure. 2. In trying to promote growth or reduce unemployment government spending can be inflationary, especially if the government has to borrow from the financial markets or if the spending is too fast, such as with an increase in current spending on wages. 3. There is a potential trade off between unemployment and inflation, first analysed by A.W. Phillips. If the aim of an increase in public spending is to create jobs there is the strong possibility that inflation will be created, and growth in jobs may only be temporary as the economy readjusts to the previous level of unemployment. 4. A major constraint to government spending across the EU is a country's membership of theStability and Growth Pact. This pact limits government borrowing to no more than 3% of national income in any one year, and to no more than an accumulated public debt of 60% of the value of national income. The purpose of the Stability Pact is to stop Euro area countries weakening the value of the Euro by printing money , which occurs when governments borrow from the money markets. The UK Chancellor has imposed a different constraint that borrowing is acceptable if it funds capital, rather than current, public sector spending. However, the financial crisis of 2008 - 2010 and the subsequent global recession, forced many countries to break this pact, as they borrowed substantial amounts to help stimulate their domestic economies. Perhaps the worst case to emerge was that of Greece, whose annual deficit exceeded 12% of GDP in 2009 (four times the pact limit), and whose accumulated deficit is predicted to reach 135% of GDP by 2011 (twice the agreed limit). The situation for Greece is made especially worse given the size of its hidden economy, estimated at over 30% of GDP. (Sources: The Guardian and The Telegraph).

Source ONS

Revenue and tax policy

Central and local government must raise revenue in order to meet its spending commitments. Revenue is raised from a number of sources including: Taxation
Direct taxes, such as income tax and corporation tax, and indirect taxes such as Value Added Tax (VAT), are the main sources of revenue to the UK Treasury.

National insurance
National insurance is a compulsory contribution from both employer and employee to provide workers with a minimum welfare payment during periods of unemployment.

Charges
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Both central and local government can charge for using resources under their control, such as parking charges, prescription charges, and TV licences.

Privatisation
The sale of state-owned assets, such as public utilities like gas, water, and electricity, has in the past provided windfall revenue to the UK government. The sale of property rights provides a similar source of revenue, such as selling licences to broadcasters and to mobile phone companies for the right to use the public airwaves .

Borrowing

Borrowing has become an increasingly significant source of funding for many governments. If a government does not have enough revenue to fund its spending plans, it may borrow from the commercial banks or the public by selling short term securities, called bills, and long term securities, called bonds. Both central and local government may need to borrow heavily from time to time to fund spending commitments. Ta sources

Local government revenue

Local authorities in the UK have the power to raise revenue via a local tax called the Council Tax. However, council taxes do not cover all local spending, and local authorities are usually subsidised by central government through a grant. Reform of local authority finances has been proposed, with the following options being considered: 1. A local income tax

2. A local sales tax, or specific local charges, such as the London Congestion Charge Changing tax rates Taxes can be raised or lowered to control or expand household spending, and AD. Income tax can be adjusted in a number of ways, such as by changing: 1. The ta free allowance all income earners are allowed to earn an amount of income before they start to pay tax. For example, the personal tax free allowance in the UK for 20112012 was 7,475. Therefore, to stimulate demand, this could be increased to give households more disposable income. 2. The basic ta rate - which in 2011 was 20 . Basic rate means the rate that affects most income earners. 3. The number of ta bands for example, before 2009 there were three bands of: 0- 2320 of taxable income from savings is taxed at 10 ; 0 34,800, taxed at 20 tax, and over 34,800 is taxed at 40 , which is the higher tax rate. By adding new lower or higher bands the level of consumption and the distribution of income can be altered.In 2009 a new higher tax band of 50 was added for people earning over 150,000. 4. The range of income in each band each band could be widened or narrowed by increasing or reducing the range of income in each band. Evaluation of tax policy The advantages

1. Indirect taxes can be targeted very specifically at altering behaviour, such as polluter paystaxes, and taxes on demerit goods. 2. 3. Taxation can stabilise the macro-economy automatically, through fiscal drag and boost. Discretionary changes in direct taxes can help regulate aggregate demand.

4. Taxes and welfare spending can also be used to help reduce the income gap between rich and poor, reduce poverty, and to help to promote equity.

The disadvantages
1. Changing tax rates, allowances and bands, is a highly complex business, especially in comparison with changing interest rates. Because of this changes are relatively infrequent, with only small adjustments being made each year in the annual budget. 2. Households may increase or reduce their savings following tax changes, so the effect on household spending of an increase or decrease in taxes may be weak. 3. There may be considerable time-lags between changing taxes and changes in household spending. 4. Higher taxes may have a disincentive effect on work and enterprise, as some individuals alter their perception of the relative costs and benefits of work, in compariso n with leisure.

Monetary policy
Monetary policy involves altering base interest rates, which ultimately determine all other interest rates in the economy, or altering the quantity of money in the economy. Many economists argue that altering exchange rates is a form of monetary policy, given that interest rates and exchange rates are closely related. The Monetary Policy Committee
The Bank of England s Monetary Policy Committee (MPC) has responsibility for monetary policy in the UK. The MPC has nine members, four of whom are appointed by the Chancellor. The MPC has one goal to hit its inflation target of 2%. The inflation target is symmetrical because a rate of inflation below the target is considered as damaging as a rate of inflation above the target.

Changing the official base rate, which alters the cost of borrowing across the economy, is the most visible tool used by the MPC. The MPC's team of experts meet each month to discuss current and future monetary policy options, and set a rate which they believe will steer the economy towards achieving the target inflation rate. The official moneymarket rate

The rate set by the MPC is the repo rate, which is the rate that the Bank of England will charge in the moneymarkets for short-term loans to other banks or financial institutions. Other rates of interest in the economy, such as mortgage and credit card rates, will adjust in line with changes to the official rate.

How does interest rate policy work?

Interest rates are set so that the inflation target can be met in the future. It takes up to two years for a rate change to affect inflation, so the Bank of England must try to predict the state of the economy two years in advance.

The interest rate transmission mechanism

Interest rates transmit their way to aggregate demand in the following ways: 1. Household demand is affected because changes in interest rates affect savings, which indirectly affect spending. 2. For households or firms with existing debt, such as a mortgage, a change in rates affects repayments, and hence individuals have more (or less) cash after servicing their debts. Changes in rates affect the cash-flow of firms and households. 3. In the case of new debt to fund spending, borrowing is also encouraged (or discouraged) following interest rate changes. 4. Interest rates also affect consumer and business confidence, which in turn affects spending.

5. Asset values are also affected by interest rates. A fall in rates will tend to increase the profitability of firms and they may pay higher dividends to shareholders. This can trigger an increase in household spending. Similarly, a rate fall makes savings less attractive and property more attractive, increasing the value of property and household wealth. 6. Finally, interest rates may affect the exchange rate, which can also influence export demand. For example, a rise in interest rates may raise the exchange rate, pushing up export prices and reducing overseas demand. Changes in the exchange rate also affect the price of imports, which also affect the inflation rate.

Summary of the transmission mechanism of monetary policy

Recent UK interest rates

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In recent years.interest rates have been adjusted to reflect changing inflationary pressure, and general macro-economic conditions.

Time line

1999 2000
Rates were relatively high at 6 to restrict demand 2000 2003 In order to stimulate demand, between 2000 and 2003 rates we pushed down to what was then their lowest re level for 25 years. 2003 - 2007 Rates were pushed up into a neutral zone at around 5 and edged towards the restrictive zone by the middle of 2007. 2008 - 2010 Rates were pushed down to a record low of 0.5 tostimulate household spending in the wake of thecredit crunch.

Showing the effect of a reduction in interest rates

If we assume the economy has an output gap, then a reduction in interest rates by the Bank of England will increase aggregate demand because saving is discouraged, new borrowing and spending is encouraged, and confidence and investment will increase. The effect of the increase in aggregate demand on real output and the price level depends upon the elasticity of aggregate supply.

Lower interest rates Assuming the economy is at or very near to full employment, a reduction in interest rates may over-stimulate aggregate demand beyond the capacity of the economy to respond in the short run.

In this case, the effect is mainly on the price level rather than output and jobs. Evaluation of monetary policy The advantages
1. Evidence shows that, in normal conditions, interest rates have a direct and powerful effect on household spending, which suggests that UK consumers are highly interest rate elastic. 2. The Bank of England s Monetary Policy Committee is independent from government and can make decisions free from political interference. 3. Interest rates can be adjusted on a monthly basis, which contrasts with discretionary fiscal policy which cannot be adjusted at such regular intervals. 4. While the full effects of interest changes may not be experienced for up to a year, there is often an immediate effect on confidence. The time-lag on output is estimated to be around one year, and on the price level, around two years.

The disadvantages
1. There are still time lags to see the full effects, and there are some negative effects.

2. Raising interest rates can negatively affect on investment spending and the housing market, and the exchange rate and hence the balance of payments. 3. There is also the problem of the dual economy - are high rates set for the booming service sector, or low rates for the depressed manufacturing and export sector? 4. The money supply is difficult to control in practice, so controlling interest rates is preferable.

5. Interest rates may fall to very low levels du ring a deep recession, and while the demand for credit may rise, the supply may become trapped in the system, known as the liquidity trap. See also: Bank of England

The Bank of England

The Bank of England was founded in 1694 and nationalised in 1948. It was made independent in 1997, and has a number of roles, including:

Deciding interest rates In order to keep UK inflation at a specific rate of 2% (+/- 1%), the Bank of England has sole responsibility for deciding the level of base interest rates. The Bank produces its own statistics and undertakes detailed monetary analysis to help it create financial stability. The actual rate that is manipulated is the repo rate, which is short for repurchase agreement rate, is the rate at which the Bank of England buys back securities it has previously sold in the money markets. The
money markets include banks, building societies, and specialist securities dealers. Altering the repo rate affects short-term liquidity in the monetary system, which eventually has an effect on all other rates.

Overseeing the money supply The Bank of England oversees the supply of money in the economy to ensure that there is just
sufficient liquidity in the economy.

Managing foreign reserves The Bank of England also manages the UK foreign exchange reserves to ensure that the country settles its international debts. Providing banking facilities The Bank also provides banking facilities to the high street banks, and all credit banks in the UK must keep an account with the Bank of England. The Bank also provides facilities to the UK government, which keeps its accounts with the Bank. Regulating the UK banking system An increasingly controversial feature of the Bank of England s role is the regulation of the UK banking system. The current regulatory structure in the UK involves three separate organisations, the Bank of England, the UK Treasury, and the Financial Service Authority (FSA). However, the recent banking crisis has raised serious questions about the effectiveness of banking regulation, and the role of the Bank in this process. Lender of last resort The Bank also acts as lender of last resort, which means that, given a liquidity shortage in the banking system the Bank of England will provide funds as a last resort . Issuing notes and coins Finally, the Bank is responsible for controlling the issue of new notes and coins.

European monetary policy

The European Central Bank (ECB) was formed in 1998 and works with EU member s national central banks to oversee and co-ordinate EU monetary policy.
Activities of the ECB 1. The primary objective of the ECB is to ensure price stability, by keeping the European price index below 2% but also close to 2% to avoid the danger of deflation.

2. To help achieve price stability the ECB manages short-term EU interest rates and the money supply. 3. Like the Bank of England, the ECB also provides liquidity to the European system when needed. If an EU country joins the Euro zone its central bank cedes much of its power to the ECB.

Long run neutrality of money

The underlying economic philosophy of the ECB is that, in the long run, real income and the level of employment is not determined by the money supply. The main objective of monetary policy is to achieve short term price stability as this is seen as the way to provide an economic framework for supply side growth. The policy instrument used is short term interest rates.

Exchange rate policy

The exchange rate of an economy affects aggregate demand through its effect on export and import prices, and policy makers may exploit this connection.
Deliberately altering exchange rates to influence the macro-economic environment may be regarded as a type of monetary policy. Changes in exchanges rates initially work there way into an economy via their effect on prices. For example, if 1 exchanges for $1.50 on the foreign exchange market, a UK product selling for 10 in the UK will sell for $15 in New York. If the exchange rate now appreciates, so that 1 buys $1.60, the UK product in New York will now sell for $16. Assuming that demand in New York is price inelastic, this is good news for UK exporters because revenue in USDs will rise. However, if demand is elastic in New Y ork, the effect of the appreciation of the Pound would be damaging to UK exporters. If the UK also imports goods from the USA, the rise in the exchange rate would mean that a $10 US product is now cheaper in London, falling from 6.67p to 6.25p. Importers do relatively well from the appreciation of the pound, in that the cost of imported raw materials or finished goods falls. Therefore, whenever the exchange rate changes there will be a double effect, on both import and export prices. Changes in import and export prices will lead to changes in import and export volumes, causing changes in import spending and export revenue. Exchange rates can be manipulated so that they deviate from their natural equilibrium rate. To stimulate exports, rates would be held down, and to reduce inflationary pressure rates would be kept up. While the Bank of England does not specifically target the exchange rate, the Monetary Policy Committee (MPC) will take exchange rates into account. Clearly, the MPC would prefer a relatively high rate, as this reduces the price of imports and works against inflationary pressure. However, the MPC must keep an eye on export competitiveness, and, if rates rise excessively, UK exports will become uncompetitive.

How exchange rates are manipulated

Exchange rates can be manipulated by buying or selling currencies on the foreign exchange market. To raise the value of the pound the Bank of England buys pounds, and to lower the value, it sells pounds. Rates can also be manipulated through interest rates, which affect the demand and supply of Sterling via their effect on inflows of hot money. Altering exchange rates is commonly regarded as a type of monetary policy.

Effects of a reduction in the exchange rate

Assuming the economy has an output gap, a reduction in the exchange rate will reduce export prices, and, assuming demand is elastic, export revenue will increase. A fall in the exchange rate A fall in the exchange rate will also raise import prices, and assuming elasticity of demand, import spending will fall. The

combined effect is an increase in AD and an improvement in the UK balance of payments.

Cost-push inflation A fall in the exchange rate is inflationary for a second reason - the cost of imported raw materials adds to production costs and creates cost-push inflation.

Evaluation of exchange rate policy The main advantage of manipulating exchange rates is that, because a large share of UK output istraded internationally, changes in exchange rates will have a powerful effect on AD. For example, lowering exchange rates, called devaluation, can:
1. 2. 3. Raise aggregate demand Increase national output (GDP) Create jobs, amplified through the multiplier effect

4. In addition, assuming the demand for imports and exports are price sensitive (price elastic), devaluation will lead to an improvement in the balance of payments - although this can also lead to inflation Alternatively, raising exchange rates (revaluation) can: 1. 2. 3. Help reduce excessive aggregate demand Keep inflation down Although the export sector may suffer and jobs might be lost

On balance, UK policy makers in recent years have preferred to allow the financial markets to determine exchange rates, rather than manipulate them for policy objectives. The last time exchange rates were directly targeted was between 1985 and 1992, when the UK shadowed movements in the Deutschmark, and then, from 1990 to 1992, when the UK became a member of the exchange rate fixing Exchange Rate Mechanism (ERM).

Policies to reduce inequality and poverty

Reducing inequality and poverty, and promoting equity, are important macro-economic objectives. The widening income gap between the rich and poor has highlighted the need to understand the causes of relative inequality and poverty, and to construct suitable policies to reduce poverty and narrow the income gap. The principles of horizontal and vertical equity
Policy towards inequality and poverty is influenced by the desire to achieve both horizontal and vertical equity. Horizontal equity means that, as a guideline for tax and benefits policy, individuals in the same financial circumstances have the same fundamental ability to pay taxes, and, therefore, should be taxed at the same rate. The principle of vertical equity suggests that, when individuals are in different circumstances and ha ve different abilities to pay, they should not be taxed at the same rate. The UK tax system, like many, tries to achieve both horizontal and vertical equity. Income tax is calculated as a % of earnings, so as income rises the tax take rises, meaning that I ndividuals earning the same income will be taxed at the same rate, and those earning more or less will pay more or less tax. The system also has bands of tax, with a tax-free allowance, so that at very low income, no tax is paid, and at very high income t he upper tax band will apply. Horizontal equality is achieved because everyone pays in the same tax band pays the same tax. This means that a high earning individual will get the same tax -free allowance as the low paid, and will pay tax at the same rate as others over the different bands of income.

The tax and benefits system

Governments can intervene to promote equity, and reduce inequality and poverty, through the tax and benefits system. This means employing a progressive tax and benefits system which takes proportionately more tax from those on higher levels of income, and redistributes welfare benefits to those on lower incomes.

Stages of redistribution
Original income can be adjusted in a number of ways to either increase or decrease post-taxincome.

Cash benefits
Cash benefits are designed to help those on low or zero original income, and include contributory and noncontributory benefits. Contributory benefits, such as pensions and job-seekers' allowance, are those where individuals or employers make a contribution into the National Insurance Fund. Non-contributory benefits, such as housing benefit, income support, carer's benefit and child support, do not require a previous contribution to have been made. Generally, there are tests to see if individuals actually need these benefits, called means tests, though child benefit is not means tested and is a universal benefit available to all families with children.

Direct taxes
Income tax in the UK is mildly progressive and helps to redistribute income. This is because: 1. Individuals on very low incomes pay no income tax. Everyone can earn up to 6,475 before they pay income tax (2009). 2. A low tax band of 10% exists for those earning between 6,475 and just over 9,000.

3. Middle income earners pay tax on some of their income at the basic rate , which is currently 22%. 4. 5. Those on higher incomes pay tax on some of their income at a higher tax rate, such as 40%. A higher rate of 50% for those earning over will also come into effect in April 2010.

These tax bands help narrow the income gap and so help reduce inequality.

Indirect taxes

In contrast, indirect taxes are regressive meaning that, as a percentage of income, the proportion of tax paid declines at higher income levels, and, as such, the burden of the tax is largely on the poor. This means that, as a rule, indirect taxes widen the income gap. The progressive effects of direct tax, and regressive effects of indirect tax generally cancel each other out.

Benefits in kind
Benefits in-kind are those services, such as healthcare and education, that are provided free or heavily discounted at the point of consumption. These benefits can make a considerable impact on final income, increasing it considerably for the poorest, and narrowing the gap between rich and poor.

Criticisms of progressive taxes and benefits

Taxes and benefits clearly compensate for the failure of labour markets to provide sufficient original income for all citizens. However, such intervention can be criticised because: 1. It may create a disincentive effect, which occurs when individuals are discouraged from working hard because they pay more of their income in taxes. 2. It may create moral hazard, where some individuals may not look for ways to improve their own position because the state provides insurance against poverty, unemployment, and disability.

The National Minimum Wage

The long-term aim of a minimum wage is to remove the problem of poverty pay, which exists when the earnings from paid work do not result in a living wage and fail to push people out of poverty. See also: National Minimum Wage

Policies to reduce unemployment

Unemployment is a major cause of poverty and inequality. Unemployment can be reduced by: 1. 2. 3. 4. See also: poverty Government sponsored job creation schemes. A monetary or fiscal stimulus to aggregate demand. Active labour market policies to increase employability, such as re-training schemes. Welfare-to-work schemes which encourage labour market participation.

The balance of payments

Maintaining a balance of payments with the rest of the world is a macro-economic objective. In simple terms, if the balance of payments balances, then the combined receipts from selling goods and services abroad, and from the return on investments abroad, equals the combined expenditure on imports of goods and services, and investment income going abroad. The balance of payments is also an official account of international payments, published in a document called the Pink Book . Statistics on UK imports and exports have been gathered in the UK since 1687.
As an official record, the balance of payments is divided into two accounts - the current accountand the capital and financial account.

The current account

The current account is made up of the following payments:

Trade in goods

These items include the import and export of finished goods, such as cars, and computers; semi-finished goods, such as parts and components for assembly, and commodities, such as oil, tea and coffee. Trade in services
Trade services include financial services, tourism, and consultancy.

Investment income
Investment income, which includes overseas profits, such as those from business activities of subsidiaries located abroad; interest received from UK financial investment and loans abroad and; dividends from owning shares in overseas firms.

Transfers
Transfers in items such as gifts, donations to charity and overseas aid

The current account - 2009 (b)

Current account (2009) The Current Account for 2009 showed that the UK had a deficit of 18b.
ITEM Goods Services Income Transfers TOTAL CREDITS (b) 227 158 173 16 576 DEBITS (b) 310 109 143 31 594 BALANCE () -93 49 30 -14 -18

The Capital and Financial Account

The Capital and Financial Account records the flows of capital and finance between the UK and the rest of the world. Types of flow include the following: 1. Real foreign direct investment (FDI), such as a UK firm setting up a manufacturing plant in South Africa. 2. Portfolio investment, such as UK citizens buying shares in an overseas firm in anticipation of a long term return. 3. Short-term speculative flows, called hot money, where speculators invest abroad in order to obtain the highest return in the short run. For example, a UK fund manager working for a major UK investment bank may buy shares in a US hi-tech firm in the hope of making a fast return. Speculators may quickly sell shares and other financial assets if a short-term profit has been made. 4. Official financing, which occurs when governments, or their agents, buy or sell currencies, securities and other assets to create an inflow or outflow in the balance of payments accounts. For example, when a deficit occurs it may be financed through the Bank of England acting for the government. In an accounting sense the Bank of England must ensure that the account balances the bottom line of the account must always equal zero.

Financing deficits and surpluses The financing of a deficit is achieved by:

1. 2. 1. Selling gold or holdings of foreign exchange, such as US dollars, yen or euros, or: Borrowing from other Central Banks or the International Monetary Fund (IMF). Buying gold or currencies.

A surplus will be disposed of by:

2. Paying off debts. The Balancing Item In theory, the Capital and Financial Account balance should be equal and opposite to the Current Account balance so that the overall Account balances, but in practice this is only achieved by the use of a balancing item. The balancing item is defined as the device used to compensate for errors and omissions in the balance of payments data, and which brings the final balance of payments account to zero.

Recent Current Account balance

Trade problems and policies

With the exception of 1997, in every year since 1987 the UK has recorded a trade deficitin goods and services. This deficit reached a peak of 45.90 billion in 2006. The deficit tends to follow a cy clical pattern, as shown in the chart.
UK Current Account 1990 - 2010

Recent trade figures

Is a current account deficit a problem?

A deficit can be a problem under certain circumstances, including the following: 1. 2. 3. 4. It is a persistent deficit that does not self-correct over time. The deficit forms a large share of GDP. There are no compensating inflows of investment income or inward capital account flows. The central bank has low reserves.

5. The economy has a poor record of repaying debt. Economic growth and trade In the UK, there is a strong connection between a growing economy and trade deficits. Soon after the economy went into recession in 1990, the trade deficit began to fall quickly.However, as the economy came out of recession and into a period of strong growth from 1993, the trade deficit began to rise quickly, and continued to rise through the next 15 years. The recent recession, which started in late 2008, quickly reduced the deficit.

Video

Causes of a current account deficit

There are several possible causes of a persistent current account deficit, including the following:

Excessive growth
If the economy grows too quickly and rises above its own trend rate, which in the UK is around 2.5%, then domestic output (AS) may not be able to cope with domestic aggregate demand.When national income rises above its trend rate it is likely that income elasticity of demand for luxury imports such as motor cars is relatively high, so that imports rise relative to exports. Graph to illustrate the increase in imports, reflecting an elastic income elasticity of dema nd

De-industrialisation
An increasing trade deficit may be a symptom of long-term de-industrialisation. The UK started to lose its manufacturing base in the 1970s, and this process has continued over the last 30 years.

High export prices

High export prices will occur if a country's inflation is higher than its competitors, or if its currency is over valued which will reduce its price competitiveness.

Non-price competitiveness
Non-price factors can discourage exports, such as poorly designed products, poor marketing or a worsening reputation for reliability.

Low levels of investment in human capital

This involves a lack of investment in education and training, which reduces skill levels relative to competitor countries and forces countries to produce low value exports.

Poor productivity
An economy might not be producing enough from its scarce factors of production. Labour productivity, which is defined as output per worker, plays an important role in a country scompetitiveness and trade performance, and the UK has suffered from poor productivity. Theproductivity gap is the gap between the UK s relatively poor productivity performance and that of the UK s leading competitors.

Low levels of investment in real capital

This could be caused by excessive long-term interest rates, or low levels of research and development.

Low levels of investment in human capital

This involves a lack of investment in education and training, which reduce skill levels relative t o competitor countries and force countries to produce low value exports.

The rise of alternative global suppliers

While the UK has slowly deindustrialised, emerging economies like China and India have increased their share of world trade, with their firms benefitting from access to new technology and from economies of scale. This has reduced the likelihood of smaller UK manufacturers selling abroad, while at the same time increased the likelihood of UK households and firms importing from these economies.

Policies to reduce a deficit

There are four basic strategies for dealing with a persistent deficit.

Deflating demand
Deflating demand means deliberately reducing consumer spending, or reducing its rate of growth, through fiscal contraction, such as raising direct taxes, or by monetary contraction, such as raising interest rates or reducing the availability of credit. As a by-product of this, imports are also likely to fall, hence deflating demand is said to work by a process called expenditure reduction. This policy targets general household spending, and given that imports are dependent on spending, then imports will fall as spending falls. The connection between spending and imports is called the marginal propensity to import, which is expressed as:

Evaluation:
The main criticism of deflationary policy is that, as spending-power must fall, personal incomes and standards of living will also fall, and this can trigger demand deficient unemployment. However, different deflationary policies may result in different effects. For example, raising interest rates may work more quickly than raising tax rates. For the above reasons, deflation is a politically unpopular policy option. Voters are much more likely to be concerned with recession and unemployment than with a balance of payments deficit, hence politicians are unlikely to prioritise the reduction of a deficit. It is also difficult to predict the precise effect of a fall in spending on imports, which requires an accurate calculation of the marginal propensity to import. The cross diagram The cross diagram can be used to illustrate how deflation works. The cross diagram shows the relationship between injectionsand withdrawals and nationa l income, Y.

The export line is horizontal because it is determined by overseas GDP and not domestic GDP.

The import line is upward sloping, assuming a positive marginal propensity to import (mpm) this means that as income (Y) increases, imports (M) will increase. For example, if the mpm is 0.4, then a 1 increase in income leads to an increase in imports of 40p. The higher the mpm, the steeper the gradient of the import line. Deflating demand, therefore, reduces income and spending with income (Y) falling to Y1, so that imports (M) fall but exports (X) are left unaffected.

Devaluation
The second policy option to improve the current account is devaluation, which involves the deliberate reduction in the value of a country s currency. It works by expenditure switching, which means that the policy encourages consumers to alter the distribution of their spending, rather than the total level of spending. A fall in the exchange rate will, ceteris paribus, reduce export prices encouraging overseas consumers to switch to UK products. This is likely to lead to a rise in export demand. Devaluation will also lead to an increase in import prices, encouraging UK consumers to switch away from imports to domestically produced pro ducts. This will lead to a fall in import demand.

Evaluation
Devaluation relies on the assumption that the sum of price elasticity of demand for imports and exports is elastic (>1), the so-called Marshall-Lerner condition. However, this may not be satisfied in the short run, or even the longer run. Devaluation may also trigger cost-push inflation, where a fall in the value of a currency will increase the price of imported goods, in terms of the domestic currency. Devaluation could be interpreted as a hostile move against other countries and may lead to retaliation by competitors, so that no long term benefit is derived by the devaluing country.

Import and export elasticity To understand the Marshall-Lerner condition, it is necessary to reconsider price elasticity of demand. It should be noted that imports and exports refer to the value of spending on imports and the value of revenue from exports. The value of these payments is derived from the prices of imports and exports multiplied by the quantity of imports and exports. For example, if country Asells 100 tonnes of steel to country B for A$1000 per tonne, export revenue earned by A is A$100,000. If we assume that the exchange rate of A$ against B$ is 4-1, then country B will have paid B$250 per tonne and spent B$25,000 in total. If the exchange rate of country A now falls to 5/1, the impact of this on A s export revenue depends on how many tonnes it now sells at the cheaper rate. Country B will now only have to pay B$200 per tonne following devaluation, a fall from B$250, to B$200, of 20%. If demand is elastic, say (-) 2.0, then the 20% devaluation will lead to a 40% increase in demand, from 100 tonnes to 140 tonnes. The result is that payments from Bto A rise from B$25,000 to (140 x 200) B$28,000. The Marshall-Lerner rule simply says that so long as the combined elasticities of demand for imports and exports are greater than 1, devaluation will improve the balance of payments on current account.
The cross diagram - showing devaluation We can also use the cross diagram to illustrate the impact of devaluation.

Assuming the Marshall-Lerner condition: 1. 2. 3. The J Curve The J curve shows what can happen to a country s balance of payments when it devalues its currency. If we assume the Marshall-Lerner condition is satisfied, devaluation will improve the balance of payments. The export line will shift up, and: The import line will shift down. At the existing GDP (Y), the deficit will fall.

If the condition is not satisfied, devaluation will worsen the balance of payments. The J-Curve effect exists because the condition is met in the long run but not the short run. In the short run, households and firms may not respond immediately to a change in price caused by a change in the exchange rate. There are a number of reasons for this: 1. Consumers may wait and see if the price rise is sustained.

2. Businesses may find it difficult to switch to or from an overseas supplier. It may take considerable search time to find alternatives. 3. Households and firms do not purchase consumer durables very often, so changes in exchange rates only take effect when decisions to purchase are made. 4. Consumers may be loyal to overseas brands.

5. Price is not the only factor that affects demand for imports - indeed, there are many other non-price factors.

Direct controls
A third option to help reduce a current account deficit is to impose direct controls on imports by erecting barriers against imports or by providing assistance to exporters. Specific measures include: 1. Tariffs

2. Non-tariff barriers, such as quotas, subsidies to domestic firms and discrimination against imports and in favour of domestic firms.

Evaluation
In the short run, trade barriers may help to reduce imports and help improve the current account. However, retaliation is a likely response, and any short-term gains will be eroded away. Therefore, direct controls are not generally considered an effective long-term solution to a current account deficit.

Supply-side policy

Finally, supply-side policy could be used to help improve an economy s ability to produce. There are several actions that a government can take to improve supply-side performance. These measures include improving labour productivity and labour market flexibility .

Evaluation
Supply-side policy can provide a highly effective policy framework for long term improvement in competitiveness and current account performance. The main problem is that supply-side policy may take decades to work and is not a quick-fix.

Supply-side policy
Supply side policy includes any policy that improves an economy s productive potential and its ability to produce. There are several individual actions that a government can take to improve supply-side performance.

Improving productivity of factors

Measures to improve factor productivity, which is the marginal output generated by factors inputs, include the following: 1. Using the tax system to provide incentives to help stimulate factor output, rather than to alter demand, is often seen as central to supply-side policy. This commonly means reducing direct tax rates, including income and corporation tax. Lower income tax will act as an incentive for unemployed workers to join the labour market, or for existing workers to work harder. Lower corporation tax provides an incentive for entrepreneurs to start and so increase national output. 2. Other supply-side policies include the promotion of greater competition in labour markets, through the removal of restrictive practices, and labour market rigidities, such as the protection of employment. For example, as part of supply-side reforms in the 1980s, trade union powers were greatly reduced by a series of measures including limiting worker's ability to call a strike, and by enforcing secret ballots of union members prior to strike action. 3. Measures to improve labour mobility will also have a positive effect on labour productivity, and on supply-side performance. 4. Better education and training to improve skills, flexibility, and mobility also called human capital development. Spending on education and training is likely to improve labour productivity and is an essential supply-side policy option, and one favoured by recent UK governments. A government may spend money directly, or provide incentives for private suppliers to enter the market. Government may also set and monitor standards of teaching, and force schools to include a skills component in their curriculum. 5. The adoption of performance-related pay in the public sector is also seen as an option for government to help improve overall productivity. 6. Government can encourage local rather than central pay bargaining. National pay rates rarely reflect local conditions, and reduce labour mobility. For example, national pay rates for Postmen do not reflect the fact that in some areas they may be in short supply, while in other areas there may be surpluses. Having different rates would enable labour to move to where it is needed most.

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Improving the performance of firms

Measures to improve competition and efficiency in product markets, especially in global markets, are also a significant part of supply-side policy. Example of measures include:

1. Government may help to improve supply-side performance by giving assistance to firms to encourage them to use new technology, and innovate. This can be done through grants, or through the tax system. 2. Deregulation of product markets may be implemented to bring down barriers to entry, encourage new and dynamic market entrants, and improve overall supply-side performance. The effect of this would be to make markets more competitive and increase efficiency. Promoting competition is called competition policy. 3. Privatisation of state industry was a central part of supply -side policy during the 1980s and 1990s, and helped contribute to the spread of an enterprise culture. As long as privatisation is accompanied by measures to promote competition, there are likely to be efficiency gains for the firm, and productivity gains for the employees. 4. Supply side performance can also be improved if there is a constant supply of new firms. Small businesses are often innovative and flexible, and can be helped in a number of ways, including start-up loans and tax breaks. The effects of supply-side policy Successful supply-side policy will shift the AS curve to the right.

Evaluation The advantages

1. Supply-side policies can help reduce inflationary pressure in the long term because of efficiency and productivity gains in the product and labour markets. 2. They can also help create real jobs and sustainable growth through their positive effect on labour productivity and competitiveness. Increases in competitiveness will also help improve the balance of payments. 3. Finally, supply-side policy is less likely to create conflicts between the main objectives ofstable prices, sustainable growth, full employment and a balance of payments. This partly explains the popularity of supply-side policies over the last 25 years. The disadvantages 1. However, supply-side policy can take a long time to work its way through the economy. For example, improving the quality of human capital, through education and training, is unlikely to yield quick results. The benefits of deregulation can only be seen after new firms have entered the market, and this may also take a long time. 2. In addition, supply-side policy is very costly to implement. For example, the provision of education and training is highly labour intensive and extremely costly, certainly in comparison with changes in interest rates.

3. Furthermore, some specific types of supply-side policy may be strongly resisted as they may reduce the power of various interest groups. For example, in product markets, profits may suffer as a result of competition policy, and in labour markets the interests of trade unions may be threatened by labour market reforms. 4. Finally, there is the issue of equity. Many supply-side measures have a negative effect on

the distribution of income, at least in the short-term. For example, lower taxes rates, reduced union power, and privatisation have all contributed to a widening of the gap between rich and poor.

Conflicts of policy objectives

Conflicts of policy objectives occur when, in attempting to achieve one objective, another objective is sacrificed. There are numerous potential policy conflicts, including:

Full employment vs low inflation

The conflict between employment and prices is the most widely studied in economics. If policy makers attempt to undertake job creation by injecting demand into the economy, by expansionaryfiscal or monetary policy, there is a danger that prices will be driven up. This conflict is best explained by reference to the Phillips Curve. It is likely that the trade-off still exists, despite the UK economy approaching full employment and prices still remaining stable in recent years.

Economic growth vs stable prices

This conflict is similar to th e unemployment-inflation trade-off, and can be understood through thePhillips Curve and the AD/AS model. If, through a fiscal or monetary stimulus of aggregate demand, the economy grows too quickly, aggregate supply may not be able to respond and prices may be driven up.

Economic growth vs a balance of payments

As an economy grows, import spending is stimulated relative to export revenue. Policy makers have to be aware that a dash for growth could lead to balance of payments problems.

Economic growth vs negative externalities

Sustainable growth is defined in terms of the extent to which current economic growth rates do not cause unnecessary damage to the environment, especially in the future. Economic growth does, of course, generate both consumption and production externalities, such as rising carbon emissions and global warming, excessive waste, and the depletion of global fish stocks.

Flexibility vs equity
In attempting to achieve a flexible economy, which is one that copes with globalisation, the distribution of income may widen. For example, a flexible economy can be partly achieved by having a flexible labour market, but to achieve this there may be an increase in part-time employment and a reduction in worker protection and job security. However, it can also be argued that, in the long term, a reduction in unemployment associated with flexibility more than compensates for a rise in part-time work and job insecurity.

Crowding-out public sector vs private sector

Crowding-out is another widely studied conflict. The belief in the existence of crowding-out has profoundly shaped economic policy over the last 20 years. Crowding-out is essentially a conflict between the public and private sector. For example, public sector borrowing to compensate for market failures and provide public and merit goods, might drive up long term interest rates and crowd-out private sector investment. Hence, the desire to achieve short term stability might put at risk the prospects for long term growth.

Globalisation and policy conflicts

The rise of globalisation has meant that economic shocks from one part of the world can quickly spread around the global economy. The recent financial crisis is a case in point. The interconnectedness of the global economy creates problems for domestic policy makers, as the source of inflation or unemployment may be the global economy, and outside of the control of domestic governments. ressive taxes and benefits, Many argue that automatic shock absorbers, including flexible labour markets, prog and a floating exchange rate, are critical for the success of a country actively participating in the global economy.

The Phillips curve

The Phillips curve shows the relationship between unemployment and inflation in an economy. Since its discovery by British economist AW Phillips, it has become an essential tool to analyse macro -economic policy.
Go to: Breakdown of the Phillips curve

The Phillips curve and fiscal policy

Background After 1945, fiscal demand management became the general tool for managing the trade cycle. The consensus was that policy makers should stimulate aggregate demand (AD) when faced with recession and unemployment, and constrain it when experiencing inflation. It was also generally believed that economies faced either inflation or unemployment, but not together - and whichever existed would dictate which macro-economic policy objective to pursue at any given time. In addition, the accepted wisdom was that it was possible to target one objective, without having a negative effect on the other. However, following publication of Phillips s research in 1958, both of these assumptions were called into question. Phillips analysed annual wage inflation and unemployment rates in the UK for the period 1860 1957, and then plotted them on a scatter diagram. The data appeared to demonstrate an inverseand stable relationship between wage inflation and unemployment. Later economistssubstitutedprice inflation for wage inflation and the Phillips curve was born. When economists from other countries undertook similar research, they also found very similar curves for their own economies.
The Phillips Curve Phillips analysed annual wage inflation and unemploymentrates in the UK for the period 1860 1957, and then plotted them on a scatter diagram.

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Explaining the Phillips curve

The curve suggested that changes in the level of unemployment have a direct and predictable effect on the level of price inflation. The accepted explanation during the 1960 s was that a fiscal stimulus, and increase in AD, would trigger the following sequence of responses:
1. 2. 3. 4. 5. 6. An increase in the demand for labour as government spending generates growth. The pool of unemployed will fall.

Firms must compete for fewer workers by raising nominal wages. Workers have greater bargaining power to seek out increases in nominal wages. Wage costs will rise. Faced with rising wage costs, firms pass on these cost increases in higher prices.

Exploiting the Phillips curve

It quickly became accepted that policy-makers could exploit the trade off between unemployment and inflation - a little more unemployment meant a little less inflation. 'Stop-go' policy During the 1960s and 70s, it was common practice for governments around the world to select a rate of inflation they wished to achieve, and then expand or contract the economy to obtain this target rate.

During the 1960s and 70s, it was common practice for governments around the world to select a rate of inflation they wished to achieve, and then expand or contract the economy to obtain this target rate. This policy became known as stop-go, and relied strongly on fiscal policy to create the expansions and contractions required.

The breakdown of the Phillips curve

By the mid 1970s, it appeared that the Phillips Curve trade off no longer existed - there no longer seemed a stable pattern.
The breakdown of the Phillips curve The stable relationsip between unemployment and inflation appeared to have broken down. It was possible to have a

number of inflation rates for any given unemplpyment rate.

American economists Friedman and Phelps offered one explanation - namely that there is not one Phillips curve, but a series of short run Phillips Curves and a long run Phillips Curve, which exists at the natural rate of unemployment (NRU). Indeed, in the long-run, there is no trade-off between unemployment and inflation . The new-Classical explanation the importance of expectations Although there are disagreements between new-Classical economists and monetarists, the general line of argument about the breakdown of the Phillips curve runs as follows.
Expectations Assume that the economy

starts from an equilibrium position at point A, with inflation currently at zero, and unemployment at the natural rate of 10% (NRU = 10%). Secondly, given the public s concern with unemployment, assume the government attempts to expand the economy quickly by way of a fiscal (or monetary) stimulus, so that AD increases and unemployment falls.

Initially, the economy moves to B, and there is a fall in unemployment to 3% (at U1 ) as jobs are created in the short term. Having more bargaining power, workers bid-up their nominal wages. As wage costs rise, prices are driven-up to 2% (at P1). The effects of the stimulus to AD quickly wear out as inflation erodes any gains by households and firms. Real spending and output return to their previous levels, at the NRU. According to the new-Classical view, what happens next depends upon whether the price inflation has been understood and expected in which case there is no money illusion or whether it is not expected in which case, money illusion exists. If workers have bid-up their wages in nominal terms only, they have suffered from money illusion, falsely believing they will be better off in this case, the economy will move back to point A at the NRU, but with inflation only a temporary phenomenon. However, if they understand that price inflation will erode the value of their nominal wage increases, they will bargain for a wage rise that compensates them for the price rise. Again, the economy will move back to the NRU (with unemployment at 10%), but this timecarrying with it the embedded inflation rate of 2% an move to 2 point C. The economy will hop to SRPC (which has a higher level of expected inflation i.e. 2%, rather than 0%). Any further attempt to expand the economy by increasing AD will move the economy temporarily to D.However, in the long-run the economy will inevitably move back to the NRU. The conclusion drawn was that any attempt to push unemployment below its natural rate would cause accelerating inflation, with no long-term job gains. The only way to reverse this process would be to raise unemployment above the NRU so that workers revised their expectations of inflation downwards, and the economy moved to a lower short-run Phillips curve

Using AD/AS to demonstrate the Phillips Curve effect

This process can also be explained through AD-AS analysis.

Accelerating inflation

Assume the economy is at a stable equilibrium, at Y. An increase in government spending will shift AD from AD to AD1, leading to a rise in income to Y1, and a fall in unemployment, in the short term.

However, households will successfully predict the higher price level, and build these expectations into their wage bargaining. As a result, wage costs rise and the AS shifts up to AS1 and the economy now moves back to Y, but with a higher price level of P2.

New Keynesian interpretation

New Keynesians explain the breakdown of the simple Phillips curve in terms of the Non-Accelerating Inflation Rate of Unemployment (NAIRU.
NAIRU

NAIRU, which exists at the Long Run Phillips Curve, is the rate of unemployment at which inflation will stabilise - in other words, at this rate of unemployment, prices will rise at the same rate each year.

Does the trade-off still exist?

Between 1993 and 2008, unemployment fell to record lows, but inflation did not rise, as predicted by the Phillips curve. Many economists explain this by pointing to the successful supply-side policiesthat have been pursued over the last 20 years.

Supply side policies

It is argued that the effectiveness of supply side policies has meant that the economy can continue to expand without inflation.

Indeed, many argue that the long run Phillips Curve still exists, but that for the UK it has shifted to the left .

Recent UK Inflation and Unemployment

Recent statistics support the view that the extreme trade off between unemployment and inflation that occurred in the past no longer exists. Effective supply side reforms have meant that the UK can expand without experiencing inflation. The improvements in labour market flexibility have helped, along with increased labour immigration both of which have eased pressure in the labour market at times of growth.

The independence of the Bank and England has also played a role in reducing expectations of inflation and weakening the link between current and future inflation. However, this does not necessarily mean that a Phillips Curve no longer exists. During the most recent period observed - 2007 to 2009 - the Phillips Curve relationship appears to have re-established itself, with unemployment rising and inflation falling.

Fiscal policy, government spending

The public sector, which involves government spending, revenue raising, and borrowing, has a crucial role to play in any mixed economy. The purpose of government expenditure
Government spends money for a variety of reasons, including: 1. To supply goods and services that the private sector would fail to do, such as public goods, including defence, roads and bridges; merit goods, such as hospitals and schools; and welfare payments and benefits, including unemployment and disability benefit. 2. To achieve supply-side improvements in the macro-economy, such as spending oneducation and training to improve labour productivity. 3. To reduce the negative effects of externalities, such as pollution controls.

4. To subsidise industries which may need financial support, and which is not available from the private sector. For example, transport infrastructure projects are unlikely to attract private finance, unless the public sector provides some of the high-risk finance, as in the case of the UKs Private Finance Initiative PFI. During 2009, the UK government provided huge subsidies to the UK banking sector to help deal with the financial crisis. Agriculture is also an industry which receives large government subsidies. See: CAP. 5. To help redistribute income and achieve more equity.

6. To inject extra spending into the macro-economy, to help achieve increases in aggregate demand and economic activity. Such a stimulus is part of discretionary fiscal policy. Local government is extremely important in terms of the administration of spending. For example, spending on the NHS and on education are administered locally, though local authorities. Approximately 75% of all public spending is by central government, and 25% is by local government.

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Central and local government (public sector) spending

Using public spending to stimulate economic activity has been a key option for successive governments since the 1930s when British economist, John Maynard Keynes, argued that public spending should be increased when private spending and investment were inadequate. There are two types of spending: 1. Current spending, which is expenditure on wages and raw materials. Current spending is short term and has to be renewed each year. 2. Capital spending, which is spending on physical assets like roads, bridges, hospital buildin gs and equipment. Capital spending is long term as it does not have to be renewed each year - it is also called spending on social capital .

Where does the spending go?

The main areas of UK government spending in 2008, which totalled 575b, were:
1. 2. 3. 4. 5. Social protection Health Education Public order and safety Defence

Types of fiscal policy

Fiscal policy is the deliberate adjustment of government spending, borrowing or taxation to help achieve desirable economic objectives. It works by changing the level or composition of aggregate demand (AD). There are two types of fiscal policy, discretionary and automatic. 1. Discretionary policy refers to policies that are implemented through one-off policy changes.

2. Automatic stabilisation, where the economy can be stabilised by processes called fiscal drag and fiscal boost.

Central government borrowing

Government must borrow if its revenue is insufficient to pay for expenditure - a situation called afiscal deficit. Borrowing, which can be short term or long term, involves selling government bondsor bills. Bonds are long term securities that pay a fixed rate of return over a long period until maturity, and are bought by financial institutions looking for a safe return. Treasury bills are issued into the money markets to help raise short term cash, and last only 90 days, whereupon they are repaid.

Local government borrowing

If the revenue from the council tax and central government support is insufficient to meet spending commitments, local authorities can also borrow by issuing bonds. Only around 25% of local authority spending is financed by local revenue raising, 75% coming from central government and by borrowing. (Source: Local Government Association)

Public Sector Net Borrowing

If the borrowing requirements of both central and local government is combined, the amount of borrowing required is called the public sector net borrowing (PSNB). The need to borrow varies considerably with the business cycle. During periods of economic growth, tax yields rise and spending on welfare payments fall, pushing the public finances towards a surplus. During periods of economic slowdown, tax yields fall and welfare payments rise, pushing the economy towards a fiscal deficit. In 2009, the government introduced a new measure of public sector borrowing, called Public Sector Net Borrowing Ex (PSNBEx). This measure excludes payments to the financial sector to ease the credit crisis. See: Public Sector Net Borrowing Ex (www.statistics.gov.uk) See: The 2010 Budget

The Chancellor s golden rules for borrowing

The Chancellor s golden rules for sustainable investment are firstly, to balance the books over a trade cycle, and secondly, only to borrow to fund capital projects, such as road building.

Borrowing, and the financial crisis

According to the Institute for Fiscal Studies (IFS), the central government net borrowing requirement in 2009, of approximately 150b, was almost double initial estimates. The main reason for this overshoot was the rescue package for the banking sector, following the globalfinancial crisis.
This package included: 1. 2. Source: IFS, 2009 37b for recapitalisation of the main banks, RBS, Lloyds and HBOS. 21b to the Bank of England to help refinance the financial services sector.

Fiscal deficits and the National Debt

Fiscal deficits occur when the revenue received by a government is less than spending during a financial year. These deficits will create the need to borrow by selling government securities - bills and bonds.

What is the national debt?

The national debt is the cumulative amount of annual borrowing that occurs when government spending is greater than revenue.
National debt b 2005 Hypothetical example to Government illustrate how the national 500 Spending debt is calculated. Revenues 480 Borrowing National Debt 20 20 2006 550 520 30 50 2007 600 560 40 90 2008 650 600 50 140

What causes a rising national debt?

A rising national debt can happen when tax revenues fall and government spending rises as the economy slows down or goes into recession, or when householders and firms spend less, so less VAT is collected, and householders and firm receive less income, so revenues from income taxes fall. The UK national debt, 1910 - 2010

The advantages of discretionary public spending as a fiscal tool

Public spending can stimulate the macro-economy Public expenditure can be used to help stimulate the macro-economy at times of low and negative growth. This works by increasing the level of aggregate demand, and can compensate for failings in other components of aggregate demand, such as a fall in household spending on consumer goods and firms spending on capital goods. It can also be used to complement monetary policy or when monetary policy has proved ineffective. This could be the case when interest rates are already low, but the economy still needs stimulating, as occurred throughout the advanced economies following the financial crisis and consequent global recession. Public spending can improve the infrastructure of an economy If the spending is on capital items, then infrastructure can be developed, which can help improve competitiveness and economic growth. Infrastructure projects are usually far too expensive for the private
sector to tackle on its own.

Public spending can generate positive externalities Spending on infrastructure, healthcare, and education also provides an external benefit to the rest of the economy which can have long run effects in comparison with reductions in interest rates, which are often short-term. Public spending can be targeted
Public spending can be targeted to achieve a wide range of specific economic objectives, such as reducing unemployment, achieving more equity, road building, action against poverty, and re-building city centres.

The disadvantages of public spending

Time lags There may be a considerable time-lag between spending and the benefits that arise. For example, a decision to increase spending on education will take many months and maybe years to implement, and many years or decades to see the full benefits. Indeed, the full benefits may never be measured and recorded because of information failure. Public spending can be inflationary In trying to promote growth or reduce unemployment government spending can be inflationary, especially if the government has to borrow from the financial markets or if the spending is rising too quickly, as might occur if public sector pay increases without an efficiency gains. Monetarist economists, such as Milton Friedman, are anti-fiscal in their approach to demand management, preferring to regulate aggregate demand by controlling the quantity of money in circulation. Government spending, they argue, in inherently inflationary, so the best role for government, also suggested by the Newclassical economists, is to improve supply-side performance, especially labour productivity. New-classical economists, such as Robert Lucas, highlight what see as the general failure of government to influence consumer behaviour. Markets tend to clear effectively if left alone, hence a government should not interfere in the working of markets. If government does interference, say by increasing spending, and this is expected, then people will expect an inflationary effect, and will bargain for higher wages. The increase in wages shifts the AS curve to the left, with no gain in aggregate output. If people understand how policy operates, its effect on the real economy will be much weaker. In what often appears a rather odd assertion, new-Classical economists argue that demand management only works when it is unanticipated by firms and households. The New-classical approach is highly critical of relying on past events to predict the future. If policy-makers rely exclusively on gathering and using past statistics, they are unlikely to make very accurate predictions. They argue that the only way to influence economic performance in the long run is by improving the conditions of supply rather than trying to create economic growth by increasing demand. Public spending can generate a debt burden Borrowing to fund spending will add to the national debt and can create an excessive debt burden for future generations.

Trade-offs There is a potential trade off between unemployment and inflation, first analysed by A.W. Phillipsin the 1950s. If the aim of public spending is to create jobs, there is the strong possibility that prices will be driven-up, and any growth in jobs will only be temporary as the economy quickly readjusts to the previous level of unemployment. Crowding out Crowding-out theory is closely associated with the economists Bacon and Eltis , who looked at the apparent
de-industrialisation of the UK economy during the 1960s and 1970s. Crowding out can be defined at the process of squeezing out the privately owned manufacturing sector by the expansion of the public sector. It is argued that crowding out occurs because of the inherent scarcity of financial and real resources. The more the (inefficient) public sector uses scarce resources, the less resources are available for the more efficient and productive private sector. Bacon and Eltis identified two types of crowding out.

y Financial crowding out - if the public sector expands and needs to borrow from the financial sector interest rates may be driven up. This leads to a reduction in private sector investment. y Resource , or physical, crowding out - in a similar way, as the public sector expands there is an increase in the demand for other resources which drives up their price, including wages and rents hence the private sector suffers.

Source: Bacon, R, and Eltis, W, 1976: Britain's Economic Problem - too few producers, McMillan
Political constraints A major constraint to government spending across the EU is membership of the Stability and Growth Pact which limits government borrowing to no more than 3% of national income in any one year, and accumulated public debt should not exceed 60% of the value of national income. The purpose of the Stability Pact was to prevent euro area countries weakening the value of the Euro by printing money, which occurs when governments borrow from the money markets. In the late 1990s, the UK Chancellor imposed a different constraint that borrowing is acceptable if it funds capital, rather than current public sector spending the so-called golden rules. However, by 2006 a large number of EU countries had exceeded the debt limits laid down in the Stability Pact. Greek debts
I n 2010, Greece needed a massive bail-out from other members of the euro area to cope with debts which were estimated to be running at over 120% of GNP.

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See: Fiscal stabilisers and discretionary tax policy

Fiscal stabilisers and discretionary tax policy

Revenue is required by central and local government in order to pay for its spendingcommitments. The main source of revenue is taxation, and taxes can be used to stabilise the economy in two main ways through the automatic stabilisers of fiscal drag and boost, and by discretionary tax policy.

Fiscal drag
If we assume that direct tax rates are progressive, which occurs when the % of income going in taxes increases with income, and welfare benefits are paid, then any increase in national income will be slowed down automatically. This process is called fiscal drag. Fiscal drag occurs in two ways. Firstly, when incomes rise, aggregate demand will not rise at the same rate because the better off pay proportionately higher taxes, and spending growth is constrained. Secondly, the effect on the poor and unemployed is reduced as they come off benefits, and start to pay tax. The effect is that the increases in disposable income are moderated.

Fiscal boost
Conversely, a decrease in national income is also moderated through fiscal boost. Fiscal boost means that as incomes fall the impact for the better off is softened as they pay proportionately lower taxes, and retain more post-tax income. Without welfare benefits, falling incomes will create more unemployment and poverty. However, because the unemployed and poor receive benefits, and spend more than they would have without such benefits, the downturn in the economy is also moderated .

Top rate taxpayers Since 1997, the number of top rate tax payers has increased indicating the extent of fiscal drag.

Discretionary changes to tax rates

In addition to automatic stabilisation, taxes can be raised or lowered to control or expandhousehold spending and aggregate demand. This is referred to as discretionary fiscal policy. Income tax can be adjusted in a number of ways, such as by changing: 1. The tax free allowance all income earners are allowed to earn an amount of income before they start to pay tax. For example, the personal tax free allowance in the UK for 2011-2012 was 7,475. Therefore, to stimulate demand, this could be increased to give households more disposable income. 2. The basic tax rate - which in 2011 was 20%. Basic rate means the rate that affects most income earners. 3. The number of tax bands for example, before 2009 there were three bands of: 0 - 2320 of taxable income from savings is taxed at 10%; 0 34,800, taxed at 20% tax, and over 34,800 is taxed at 40%, which is the higher tax rate. By adding new lower or higher bands the level of consumption and the distribution of income can be altered. In 2009 a new higher tax band of 50% was added for people earning over 150,000.. 4. The range of income in each band each band could be widened or narrowed by increasing or reducing the range of income in each band.

It should be noted that changes in individual taxes, and taxes rates, would have a short-term discretionary effect as well as altering the long-term structure of taxes and the ability of the economy to automatically self-correct after a shock.

The advantages of using taxes

Discouraging unwanted behaviour Indirect taxes can be targeted to alter behaviour, such as to reduce polluting activities by the use of polluter-pays taxes, or to reduce cigarette and alcohol consumption by special duties on tobacco and alcohol. Encouraging wanted behaviour Indirect taxes can also encourage desirable behaviour, like the consumption of more merit goodssuch as education and healthcare. In this case, tax rates can be reduced to zero, and production and supply could be subsidised. Supply-side incentives
The tax system can also be used to encouragework and effort and increase the activity rate of labour. In the 1980s American economist, Art Laffer, considered the impact of higher taxes on incentives. Laffer proposed that at tax rates of 100 and 0 the government receives no revenue. At 100 tax, no one would work, and at 0 tax, no tax would be paid. However, between 0 and 100 tax rate the government derives a tax yield, the graph for which became known as the Laffer curve. Laffer curve As tax rates rise a disincentive effect begins. There is a substitution effect as leisure becomes more attractive and work less attractive.

However, the disincentive effect will only work under certain circumstances. To understand this we must distinguish the income and substitution effects. The substitution effect suggests that, following an increase in direct taxes, substitutes to work, namely leisure, seem more attractive and people will work less, often called the Laffer effect. The income effect suggests that an increase in taxes will reduce people s real income, and they will need to work harder to achieve the same level of real income. These two effects are contradictory. If the income effect is greater than the substitution effect, an increase in taxes will lead to more labour being supplied. However, if the substitution effect is greater an increase in taxes will lead to less labour being supplied. Laffer s legacy is the raised awareness that increasing taxes to pay for public spending may, through its disincentive effect, lead to long-term supply side problems. Automatic stabilisation In the short and medium term, taxation can be used to automatically stabilise the macro-economy through fiscal drag and boost. These processes act as a natural shock absorber to economic shocks. Additional measures to stimulate aggregate demand

Discretionary changes in direct taxes can help regulate aggregate demand when shocks are severe, or when other policies are ineffective, as in the financial crisis of 2008-2009. As part of an emergency package, many national governments reduced taxes, like VAT, so that they could give an extra boost to their ailing economies. Redistribution of income Tax policy can also be used to help re-distribute income, and help achieve equity. In terms of achieving equity, indirect taxes like VAT are regressive and create an inequitable burden, the largest burden being on the poor and low paid. Income tax and other direct taxes can be made progressive and can help achieve equity, but they may have a disincentive effect leading to inefficiencies. Hence, because equity and efficiency are in conflict, the best resolution is a mix between direct and indirect to achieve a balance between the needs of equity and efficiency.

The disadvantage of tax policy

Complexity Changing tax rates, allowances and bands, is highly complex, especially in comparison with changing interest rates. Because of this, changes are relatively infrequent, with only small adjustments made each year in the annual budget. Only under dramatic circumstances, as in the financial crisis, are tax changes put into effect. Avoidance Households may increase or reduce their savings following tax changes, so the final effect of an increase or decrease in taxes on household spending may be weak. Taxes can be avoided in other ways, and this avoidance may contribute to the rise of an unofficial hidden economy. Time lags There may be considerable time-lags between changing taxes and changes in household spending or other behaviour. Demand for many products is price and income elastic, so demand may not respond quickly or by a great amount to changes in indirect and direct taxes. An obvious example of this is taxation of fuel, where, despite taxes representing around 75% of the retail price of petrol, demand remains stubbornly high.

Monetary policy
Modern monetary policy has been shaped by the different schools of economic theory that emerged over the past 100 years. Monetary policy involves altering interest rates or the supply of money in the economy. Many economists consider that the manipulation of exchange rates is a form of monetary policy, given that exchange rates are affected by changes in interest rates. The Monetary Policy Committee.
Monetary policy in the UK is the responsibility of the Bank of England s Monetary Policy Committee (MPC). The MPC has nine members, four of whom are appointed by the Chancellor. The MPC has one goal, to hit its inflation target of 2%. The inflation target is symmetrical, meaning that a rate of inflation below the target is considered as problematic as a rate of inflation above the target.

Changing official base interest rates is the most visible tool used by the MPC, whose team of economists meet each month to discuss current and future monetary policy options.

The Repo rate

Repo is short for repurchase agreement, and the repo rate is the rate at which the Bank of England buys back securities it has previously sold in the money markets. The money markets include banks, building societies and specialist securities dealers. Altering th e repo rate affects short-term liquidity in the monetary system, which quickly has an effect on all other rates. Other rates of interest in the economy, such as mortgage rates, will adjust in line with changes to the official rate.

Why the inflation target is not zero

According to the Bank of England, there are two reasons why the inflation target is set above zero:

Real interest rates can become negative

A positive rate allows real interest rates to become negative at times of weak demand. Realinterest rates are nominal rates, less the inflation rate. Nominal interest rates can never benegative, as banks will always charge for lending. If inflation is 0%, nominal and real interest rates must be the same, hen ce, like nominal rates, real rates cannot be negative. It may be helpful for the Bank of England to make real interest rate negative at times of a deep recession, so having a positive inflation target allows this to happen.

Safety margin
Inflation cannot be measured with perfect precision, and it is safer to have a positive inflation target as this provides a margin of safety.

How does interest-rate policy work?

Interest rates are set so that the inflation target can be met in the future. In fact, it takes up to two years for a rate change to affect inflation, so the Bank of England must try to predict the state of the economy two years in advance! Interest rates transmit their way to aggregate demand in the following ways:

y Changes in the official rate affect all markets rates, such as overdraft, mortgage, and credit card rates. Consumer demand is affected in a number of ways including affecting savings, which indirectly affect spending, and spending itself. For households or firms with existing debt, such as a mortgage, a change in rates affect repayments, and hence individuals have more (or less) cash after servicing their debts. Changes in rates affect the cash-flow firms and households. y In the case of new debt to fund spending, borrowing is also encouraged, or discouraged, following interest rate changes. Interest rates also affect consumer and business confidence, and spending.

y Asset prices are also affected by interest rates. For example, a fall in rates will tend to make firms more profitable and they may pay higher dividends to shareholders, which can trigger an increase in spending. Similarly, a rate fall makes property more attractive, increasing the value o f property and household wealth. y Changes in the official rate also affect general expectations and confidence, which alters consumer and corporate behaviour. For example, a rise in rates indicates a tighter monetary stance and has a negative impact on consumer and corporate sentiment, leading to the postponement of discretionary spending. y Finally, interest rates may affect the exchange rate, which can also influence export demand. For example, a rise in interest rates may raise the exchange rate, pushing up export prices and reducing overseas demand. Changes in the exchange rate also affect the price of imports, which also affect the inflation rate, through its effect on imported costs. For example, a fall in the exchange rate increases import prices and creates cost-push inflation. In this case, a rise in interest rates will push up the exchange rate and ease any cost-push inflationary pressures.

Summary of the transmission mechanism of monetary policy

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Recent UK interest rates

In recent years, interest rates have been frequently adjusted to reflect changing macro-economic conditions.

1999 2000
Rates were relatively high at 6% to restrict demand.

2000 2003.
Rates fell quickly to their lowest level for 25 years, helping to stimulate demand.

2003-2007
Rates were pushed up into a neutral zone at around 5%, but by 2007 they were edging up towards the restrictive zone.

2008 -2010
In response to the deepening recession, rates were slashed to levels unprecedented in modern times.

The effect of a reduction in interest rates

If we assume the economy has an output gap then a reduction in interest rates by the Bank of England will, ceteris paribus, increase aggregate demand. Lower interest rates A reduction in interest rates will stimulate aggregate demand. This creates a positive effect on economic growth, but at the potential cost of inflationary pressure.

The increase in aggregate demand occurs for seveal reasons, including: 1. 2. 3. 4. 5. 6. 7. Falling savings More new borrowing Lower costs of servicing existing debts Rising confidence Greater export demand Rising asset values Rising business investment

Pushing rates too low is inflationary

Assuming the economy is at or very near to full employment, a reduction in interest rates by the Bank of England may over-stimulate aggregate demand beyond the capacity of the economy to respond in the short run. In this case, the effect is mainly on the price level rather than output and jobs.

Therefore, interest rates can be used to help stabilise the macro-economy, and help create stable growth and stable prices. Policy induced shocks need to be avoided, so changes in interest rates tend to be small usually 0.25% at a time. However, the depth of the recession in 2008, and its speed of onset, forced the Bank of England to reduce rates more quickly than in 'normal' economic times.

The advantages of interest rate policy

Powerful and direct Evidence shows that interest rates have a direct and powerful effect on household spending, the evidence suggesting that UK consumers are interest rate elastic. Independent The Bank of England s Monetary Policy Committee is independent of government and can make decisions free from political interference. Easy to implement Interest rates can be changed on a monthly basis, which contrasts with changes in discretionary fiscal policy, which cannot be made at such regular intervals. Quick effect on confidence While the full effects of interest changes may not be experienced for up to two years, there is often an immediate effect on confidence. The time lag affecting output is estimated to be around one year, and on the price level, around two years.

The advantages of interest rate policy

There are still time lags to see the full effects, and there are some other negative effects, including: Investment can suffer Investment spending is inversely related to interest rates, and higher rates increase the opportunity cost of investment. Long term, economic growth will suffer if high interest rates persist. The housing market can suffer The housing market is very sensitive to changes in interest rates, so individual changes tend to be small, partly so as not to have an excessive effect on housing. The dual economy There is also the problem of the dual economy. Should rates be set high to control the inflating service sector, or low rates for the depressed manufacturing and export sector? Unlike previous recessions, in the current recession all sectors of the economy have been suffering in a similar way, so rates have been set at historically low levels without any fear of inflation. The liquidity trap Reducing interest rates in a recession may be ineffective because of the so-called liquidity trap. This theory is associated with Keynes, and his analysis of the Great Depression. In a recession interest rates will fall towards zero, as in the UK during 2009, following the financial crisis. In this case, banks and other financial intermediaries prefer to hold cash rather than make loans. Therefore, while borrowing may be stimulated, liquidity is not released through the system - it is 'trapped' and unavailable. This acts to deepen a recession and weaken the real economy. In this case, authorities may have to by-pass the banks and pump money directly into the public's hands. Allocating spending vouchers is one way this could be achieved. This is often referred to a 'helicopter' or 'parachute' money. More formally, the process is called quantitative easing.

Quantitative easing
Quantitative easing is a process whereby the Bank of England, under instructions from the Treasury, buys up existing bonds in order to add money directly into the financial system. The process of doing this is called open market operations, and it is regarded as a last resort when low interest rates fail to work. When interest rates approach zero, but an economy remains in recession, further interest cuts are impossible. This situation faced central bankers in early 2009. Interest rate policy in these circumstances becomes impotent, as nominal interest rates cannot fall below zero. This, together with cash hoarding by individuals, corporations and commercial banks, resulted in liquidity being trapped in the banking system. In this situation quantitative easing may be necessary to boost liquidity and stimulate lending. Quantitative easing involves the following steps:

y The Bank of England purchases existing corporate and government bonds held by banks and corporations with electronic money, rather than notes and coins. y These funds are credited to the bank and become a reserve asset. y This means that, via the credit multiplier, banks can lend out to corporate and individual customers. y The hope is that lending starts to flow, which will lead to an increase in household and corporate spending, and aggregate demand. This, it is argued, will help pull an economy out of recession.

Monetary Policy in Europe

The European Central Bank (ECB)
The ECB meets on a monthly basis to determine two things: 1. 2. The level of interest rates across the euro area - the 16 countries that share the euro The quantity of money in circulation

The primary purpose of the ECB is to control euro area inflation so that the value of the euro remains constant and strong. It also provides liquidity into the syst em when needed. If an EU country joins the euro area, its central bank cedes most of its power to the ECB. EU monetary institutions are fundamentally anti-fiscal, and greatly influenced by the monetarist view. Europe s view can be summarised as:

y y y

Fiscal policy is less useful than monetary policy to help stabilise the macro -economy. Too much borrowing will harm the stability of the Euro, hence the Stability Pact. Fiscal policy is less useful than supply -side policy to help create long-term growth.

Asymmetric inflation target

Unlike the Bank of England's inflation target, which is symmetrical, the ECB target is asymmetrical. This means that while inflation cannot rise above 2%, there is no figure which it is must not fall below. Critics argue that this creates an in-built recessionary bias, with no specific policy intervention required if deflation occurs. In the UK, the target is 2% +/- 1, so that an inflation rate of less than 1% triggers a monetary stimulus.

Euro area interest rates

Euro area interest rates have been fairly stable since 2000, with rates averaging around 2%.

Even before the financial crisis, the one-size-fits-all approach had been running into difficulty. This was

largely because of increasing differences in the performance of the various euro area countries, including differences in growth rates, fiscal deficits, trade balances, and house prices.

The poor macro-economic performance of the Euro area

In recent years growth rates in the EU have lagged behind those of the USA and the UK. The poor growth record of the euro area may be down to the inflexible economies of its member countries, rather than monetary policy. In other words, the underlying problems of Europe are more to do with poor supply-side performance than ineffective demand-side policy. The ECB itself recognises that growth problems are more down to national governments failing to come to terms with globalisation, that with ineffective monetary policy. In addition, the ECB has been generally reluctant to reduce interest rates to deal with sluggish growth, mainly due to fears about raising inflationary expectations. However, the financial crisisof 2008-09 has forced the ECB to reduce interest rates to a historically low level, at 1.5%. Despite this, the Eur o area is likely to continue to suffer from a deep recession which, by late 2009, was running at (-) 4%. Critics argue that, unless the economy is flexible, a fiscal or monetary stimulus to help the financial crisis may simply drive up prices. In addition, a fiscal stimulus could also lead to balance of payments problems, and if funded by borrowing, could crowd-out the private sector. The Stability Pact also provides the ultimate constraint against a fiscal stimulus, although the depth of the financial crisis has caused debt levels to rise well above those set down in the pact.

Quantitative easing
Quantitative easing is a process whereby the Bank of England, under instructions from the Treasury, buys up existing bonds in order to add money directly into the financial system. The process of doing this is called open market operations, and it is regarded as a last resort when low interest rates fail to work.
When interest rates approach zero, but an economy remains stubbornly in recession, further interest cuts are impossible. This is the position that faced central bankers in early 2009. Interest rate policy in these circumstances becomes impotent as nominal interest rates cannot fall below zero. This, together with cash hoarding by individuals, corporations and commercial banks, resulted in liquidity being trapped in the banking system. In this situation quantitative easing may be necessary to boost liquidity and stimulate lending. Quantitative easing involves the following steps: 1. The Bank of England purchases existing corporate and government bonds held by banks and corporations with 'electronic money', rather than notes and coins. 2. These funds are credited to the bank and become a reserve asset.

3. This means that, via the credit multiplier, banks can lend out to corporate and individual customers. The hope is that: 1. 2. Bank lending starts to flow again, leading to increased household and corporate spending. Aggregate demand increases and the economy moves out of recession.

European monetary policy

The European Central Bank

The European Central Bank (ECB) oversees EU monetary policy. Activities of the ECB 1. Ensuring that EU prices are stable, that is below 2% but also close to 2% to avoid the danger of deflation 2. Managing EU interest rates and money supply

3. Providing liquidity to the system when needed If an EU country joins the Euro zone its central bank cedes much of its power to the ECB.

Long run neutrality of money

The underlying economic philosophy of the ECB is that, in the long run, real income and the level of employment, that is the 'real economy' is not determined by the money supply. The main objective of monetary policy is to achieve short term price stability as this is seen as the way to provide an economic framework for supply side growth. The policy instruments used is short term interest rates. See: monetary union See: European Financial Stability Fund

Exchange rate policy

The exchange rate of an economy affects aggregate demand through its effect on exports and imports, and policy makers can exploit this connection.
Exchange rates can be manipulated so that they deviate from their natural rate. Many economists regard exchange rate manipulation as a type of monetary policy. Rates need to be held down to stimulate exports, and pushed up to reduce inflationary pressure. While the Bank of England does not specifically target the exchange rate, the MPC will consider exchange rates. Clearly, during times of inflationary pressure the MPC would prefer a relatively high rate as this reduces the price of imports and works to dampen inflationary pressure. However, the MPC must keep an eye on export competitiveness, and if rates move too high UK exports will become uncompetitive.

How are exchange rates manipulated?

Exchange rates can be manipulated by buying or selling currencies on the foreign exchange market. To raise the value of the pound the Bank of England buys pounds, and to lower the value, it sells pounds. The Bank of England can influence exchange rates through its Exchange Equalisation Account (EEA). This account, which holds the UK's gold and foreign currency reserves, and its holdings of IMF Special Drawing Rights (SDRs), was specifically established in 1932 to stabilise the value of the pound, though its role is now much wider. Rates can also be manipulated through interest rates, which affect the demand and supply of Sterling via their effect on inflows of hot money. Some currencies are subject to exchange controls by the relevant national central bank. This means that the central bank will only allow buying and selling through their own system, rather than be subject to the level of fluctuation associated with fully floating rates. Although most countries abandoned exchange controls many years ago, some, like China and Cuba still practice exchange rate control, though controls in China were relaxed in 2006. See: article in China Daily

Effects of a reduction in the pound

Assuming the economy has an output gap, a reduction in Sterling will reduce export prices, and, assuming demand is elastic, raise export revenue.

It will also raise import prices, and assuming elasticity of demand is greater than one, reduce import spending. The combined effect is an increase in AD and an improvement in the UK balance of payments.

Evaluation of exchange rate policy

The main advantage of manipulating exchange rates is that, because a large share of UK output is traded internationally, changes in exchange rates will have a powerful effect on aggregate demand. For example, lowering exchange rates (called devaluation) can: 1. 2. 3. Raise aggregate demand Increase national output (GDP) Create jobs, amplified through the multiplier effect

4. Assuming the demand for imports and exports are price sensitive (price elastic), lead to an improvement in the balance of payments, though this can also lead to inflation Alternatively raising exchange rates (revaluation) can: 1. 2. 3. Help reduce excessive aggregate demand Keep inflation down Though the export sector may suffer and jobs can be lost

On balance, UK policy makers in recent years have preferred to allow the financial markets to determine exchange rates, rather than manipulate them for policy objectives. The last time exchange rates were directly targeted was between 1985 and 1990, when the UK shadowed movements in the Deutschmark, and then, from 1990 to 1992, became a member of the exchange rate fixing Exchange Rate Mechanism (ERM). However, in the euro-area-16, there is a much greater emphasis on keeping the exchange rate stable, as this is a central pillar of euro-area policy.

Supply-side policy
Supply side policy includes any policy that improves an economy s productive potential and its ability to produce. There are several individual actions that a government can take to improve supply-side performance.

Improving productivity of factors

Measures to improve factor productivity, which is the marginal output generated by factors inputs, include the following: 1. Using the tax system to provide incentives to help stimulate factor output, rather than to alter demand, is often seen as central to supply-side policy. This commonly means reducing direct tax rates, including income and corporation tax. Lower income tax will act as an incentive for unemployed workers to join the labour market, or for existing workers to work harder. Lower corporation tax provides an incentive for entrepreneurs to start and so increase national output. 2. Other supply-side policies include the promotion of greater competition in labour markets, through the removal of restrictive practices, and labour market rigidities, such as the protection of employment. For example, as part of supply-side reforms in the 1980s, trade union powers were greatly reduced by a series of measures including limiting worker's ability to call a strike, and by enforcing secret ballots of union members prior to strike action. 3. Measures to improve labour mobility will also have a positive effect on labour productivity, and on supply-side performance. 4. Better education and training to improve skills, flexibility, and mobility also called human capital development. Spending on education and training is likely to improve labour productivity and

is an essential supply-side policy option, and one favoured by recent UK governments. A government may spend money directly, or provide incentives for private suppliers to enter the market. Government may also set and monitor standards of teaching, and force schools to include a skills component in their curriculum. 5. The adoption of performance-related pay in the public sector is also seen as an option for government to help improve overall productivity. 6. Government can encourage local rather than central pay bargaining. National pay rates rarely reflect local conditions, and reduce labour mobility. For example, national pay rates for Postmen do not reflect the fact that in some areas they may be in short supply, while in other areas there may be surpluses. Having different rates would enable labour to move to where it is needed most.

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Improving the performance of firms

Measures to improve competition and efficiency in product markets, especially in global markets, are also a significant part of supply-side policy. Example of measures include: 1. Government may help to improve supply-side performance by giving assistance to firms to encourage them to use new technology, and innovate. This can be done through grants, or through the tax system. 2. Deregulation of product markets may be implemented to bring down barriers to entry, encourage new and dynamic market entrants, and improve overall supply-side performance. The effect of this would be to make markets more competitive and increase efficiency. Promoting competition is called competition policy. 3. Privatisation of state industry was a central part of supply-side policy during the 1980s and 1990s, and helped contribute to the spread of an enterprise culture. As long as privatisation is accompanied by measures to promote competition, there are likely to be efficiency gains for the firm, and productivity gains for the employees. 4. Supply side performance can also be improved if there is a constant supply of new firms. Small businesses are often innovative and flexible, and can be helped in a number of ways, including start-up loans and tax breaks. The effects of supply-side policy Successful supply-side policy will shift the AS curve to the right.

Evaluation

The advantages 1. Supply-side policies can help reduce inflationary pressure in the long term because of efficiency and productivity gains in the product and labour markets. 2. They can also help create real jobs and sustainable growth through their positive effect on labour productivity and competitiveness. Increases in competitiveness will also help improve the balance of payments. 3. Finally, supply-side policy is less likely to create conflicts between the main objectives ofstable prices, sustainable growth, full employment and a balance of payments. This partly explains the popularity of supply-side policies over the last 25 years. The disadvantages 1. However, supply-side policy can take a long time to work its way through the economy. For example, improving the quality of human capital, through education and training, is unlikely to yield quick results. The benefits of deregulation can only be seen after new firms have entered the market, and this may also take a long time. 2. In addition, supply-side policy is very costly to implement. For example, the provision of education and training is highly labour intensive and extremely costly, certainly in comparison with changes in interest rates. 3. Furthermore, some specific types of supply-side policy may be strongly resisted as they may reduce the power of various interest groups. For example, in product markets, profits may suffer as a result of competition policy, and in labour markets the interests of trade unions may be threatened by labour market reforms. 4. Finally, there is the issue of equity. Many supply-side measures have a negative effect on

the distribution of income, at least in the short-term. For example, lower taxes rates, reduced union power, and privatisation have all contributed to a widening of the gap between rich and poor.

Conflicts of policy objectives

Conflicts of policy objectives occur when, in attempting to achieve one objective, another objective is sacrificed. There are numerous potential policy conflicts, including:

Full employment vs low inflation

The conflict between employment and prices is the most widely studied in economics. If policy makers attempt to undertake job creation by injecting demand into the economy, by expansionaryfiscal or monetary policy, there is a danger that prices will be driven up. This conflict is best explained by reference to the Phillips Curve. It is likely that the trade-off still exists, despite the UK economy approaching full employment and prices still remaining stable in recent years.

Economic growth vs stable prices

This conflict is similar to th e unemployment-inflation trade-off, and can be understood through thePhillips Curve and the AD/AS model. If, through a fiscal or monetary stimulus of aggregate demand, the economy grows too quickly, aggregate supply may not be able to respond and prices may be driven up.

Economic growth vs a balance of payments

As an economy grows, import spending is stimulated relative to export revenue. Policy makers have to be aware that a dash for growth could lead to balance of payments problems.

Economic growth vs negative externalities

Sustainable growth is defined in terms of the extent to which current economic growth rates do not cause unnecessary damage to the environment, especially in the future. Economic growth does, of course, generate both consumption and production externalities, such as rising carbon emissions and global warming, excessive waste, and the depletion of global fish stocks.

Flexibility vs equity
In attempting to achieve a flexible economy, which is one that copes with globalisation, the distribution of income may widen. For example, a flexible economy can be partly achieved by having a flexible labour market, but to achieve this there may be an increase in part-time employment and a reduction in worker protection and job security. However, it can also be argued that, in the long term, a reduction in unemployment associated with flexibility more than compensates for a rise in part-time work and job insecurity.

Crowding-out public sector vs private sector

Crowding-out is another widely studied conflict. The belief in the existence of crowding-out has profoundly shaped economic policy over the last 20 years. Crowding-out is essentially a conflict between the public and private sector. For example, public sector borrowing to compensate for market failures and provide public and merit goods, might drive up long term interest rates and crowd-out private sector investment. Hence, the desire to achieve short term stability might put at risk the prospects for long term growth.

Globalisation and policy conflicts

The rise of globalisation has meant that economic shocks from one part of the world can quickly spread around the global economy. The recent financial crisis is a case in point. The interconnectedness of the global economy creates problems for domestic policy makers, as the source of inflation or unemployment may be the global economy, and outside of the control of domestic governments. Many argue that automatic shock absorbers, including flexible labour markets, progressive taxes and benefits, and a floating exchange rate, are critical for the success of a country actively participating in the global economy.